CFA Level 1 (Book-C)

Next: Introduction
Corporate Finance - Introduction

The material set forth in this chapter will comprise approximately 8% of the questions on your
upcoming CFA Level 1 examination. Keep in mind that CFA Institute's exam questions are
comprehensive. Be sure to know not only what these topics are, but how they relate to each
other.

Within this section, we will discuss the agency problems associated with the agent-principal
relationship, the calculations and uses of the cost of capital in capital budgeting, the calculations
and applications of Net Present Value (NPV), the types of risks and risk analysis techniques, the
effect of leverage on a company or project's return, and the various dividend theories and related
calculations.

Next: Agent-Principle Relationship
Corporate Finance - Agent-Principle Relationship

Potential Agency Problems
An agency relationship occurs when a principal hires an agent to perform some duty. A conflict, known
as an "agency problem", arises when there is a conflict of interest between the needs of the principal
and the needs of the agent.

In finance, the two primary agency relationships that exist are between:
Managers and stockholders
Managers and creditors

1. Stockholders versus Managers
If the manager owns less than 100% of the firm's common stock , a potential agency problem
between mangers and stockholders exists.
Managers, at times, may make decisions that have the potential to be in conflict with the best
interests of the shareholders. For example, managers may grow their firm to escape a takeover
attempt to increase their own job security. However, a takeover may be in the shareholders'
best interest.
2. Stockholders versus Creditors
Creditors decide to loan money to a corporation based on the riskiness of the company, its
capital structure and its potential capital structure. All of these factors will affect the company's
potential cash flow, which is the main concern of creditors.
Stockholders, however, have control of such decisions through the managers.
Since stockholders will make decisions based on their best interest, a potential agency problem
exists between the stockholders and creditors. For example, managers could borrow money to
repurchase shares to lower the corporation's share base and increase shareholder return.
Stockholders will benefit; however, creditors will be concerned given the increase in debt that
would affect future cash flows.

Motivating Managers to Act in Shareholder's Best Interest
Four primary mechanisms are used to motivate managers to act in stockholders' best interests:
Managerial compensation
Direct intervention by stockholders
Threat of firing
Threat of takeovers

1. Managerial Compensation
Managerial compensation should be constructed not only to retain competent managers, but to align
managers' interests with those of stockholders as much as possible.
This is typically done with an annual salary plus performance bonuses and company shares.
Company shares are typically distributed to managers either as:
o Performance shares, where managers will receive a certain number shares based on the
company's performance.
o Executive stock options, which allow the manager to purchase shares at a future date
and price. With the use of stock options , managers are aligned closer to the interest of
the stockholders as they themselves will be stockholders.
2. Direct Intervention by Stockholders
Today, the majority of a company's stock is owned by large institutional investors, such as mutual funds
and pensions. As such, these large institutional stockholders have the ability to exert influence on
mangers and, as a result, the firm's operations.

3. Threat of Firing
If stockholders are unhappy with current management, they can encourage the existing board of
directors to change the existing management, or stockholders may even re-elect a new board of
directors that will accomplish the task.
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4. Threat of Takeovers
If a stock price deteriorates because of management's inability to run the company effectively,
competitors or stockholders may take a controlling interest in the company and bring in their own
managers.

To learn more about governance, please see the article, Governance Pays.

Next: Capital Budgeting Basics
Corporate Finance - Capital Budgeting Basics

What is Capital Budgeting?
Capital budgeting is defined as the process of planning for projects on assets with cash flows of a period
greater than one year.

These projects can be classified as:

Replacement decisions to maintain the business
Existing product or market expansion
New products and services
Regulatory, safety and environmental
Other, including pet projects or difficult to evaluate projects

Additionally, projects can also be classified as mutually exclusive or independent:
- Mutually exclusive projects indicate there is only one project among all possible projects that can be
accepted.
- Independent projects are potential projects that are unrelated, and any combination of those projects
can be accepted.
The Importance of Capital Budgeting
Capital budgeting is important for many reasons:
- Since projects approved via capital budgeting are long term, the firm becomes tied to the project and
loses some of its flexibility during that period.
- When making the decision to purchase an asset, managers need to forecast the revenue over the life
of that asset.
- Lastly, given the length of the projects, capital-budgeting decisions ultimately define the strategic plan
of the company.

For more on capital budgeting, check out our basic tutorial.

Next: The Cost of Capital
Corporate Finance - The Cost of Capital
The following sections discuss the cost of capital in terms of its components, calculations, and company
internal targets. Readers should know the costs that make up the weighted cost of capital (WACC).

Interpreting the Cost of Capital
Given the importance of capital budgeting, a company should use the weighted average of the costs of
the various types of capital it may use in financing its operations.

A company uses debt, common equity and preferred equity to fund new projects, typically in large sums.
In the long run, companies typically adhere to target weights for each of the sources of funding. When a
capital budgeting decision is being made, it is important to keep in mind how the capital structure may
be affected.

Cost Components
A company's weighted average cost of capital (WACC) is comprised of the following costs:
1.Cost of debt
2.Cost of preferred stock
3.Cost of retained earnings
4.Cost of external equity

1. Cost of Debt
In the WACC calculation, the after-tax cost of debt is used. Using the after-tax cost takes into account
the tax savings from the tax-deductibility of interest.

The after-tax cost of debt can be calculated as follows:

Formula 11.1
After-tax cost of debt = k
d
(1-t)

Look Out!
It is important to note that k
d
represents thecost to
issue new debt, not the firm\'s existing debt.

Example: Cost of Debt
Newco plans to issue debt at a 7% interest rate. Newco's total (both federal and state) tax rate is 40%.
What is Newco's cost of debt?
Answer:

k
d
(1-t) = 7% (1-0.40) = 4.2%

2. Cost of Preferred Stock
Cost of preferred stock (k
ps
) can be calculated as follows:

Formula 11.2
k
ps
= D
ps
/P
net

where:
Dps = preferred dividends
Pnet = net issuing price

Example: Cost of preferred stock
Assume Newco's preferred stock pays a dividend of $2 per share and it sells for $100 per share. If the
cost to Newco to issue new shares is 4%, what is Newco's cost of preferred stock?

Answer:
k
ps
= D
ps
/P
net
= $2/$100(1-0.04) = 2.1%

Next: Cost of Retained Earnings

Corporate Finance - Cost of Retained Earnings

3. Cost of retained earnings
Cost of retained earnings (k
s
) is the return stockholders require on the company's common stock.

There are three methods one can use to derive the cost of retained earnings:
a) Capital-asset-pricing-model (CAPM) approach
b) Bond-yield-plus-premium approach
c) Discounted cash flow approach

a) CAPM Approach
To calculate the cost of capital using the CAPM approach, you must first estimate the risk-free rate (r
f
),
which is typically the U.S. Treasury bond rate or the 30-day Treasury-bill rate as well as the expected
rate of return on the market (r
m
).

The next step is to estimate the company's beta (b
i
), which is an estimate of the stock's risk. Inputting
these assumptions into the CAPM equation, you can then calculate the cost of retained earnings.

Formula 11.3

Example: CAPM approach
For Newco, assume r
f
= 4%, r
m
= 15% and b
i
= 1.1. What is the cost of retained earnings for Newco using
the CAPM approach?

Answer:
k
s
= r
f
+ b
i
(r
m
- r
f
) = 4% + 1.1(15%-4%) = 16.1%

b) Bond-Yield-Plus-Premium Approach
This is a simple, ad hoc approach to estimating the cost of retained earnings. Simply take the interest
rate of the firm's long-term debt and add a risk premium (typically three to five percentage points):
Formula 11.4
k
s
= long-term bond yield + risk premium

Example: bond-yield-plus-premium approach
The interest rate on Newco's long-term debt is 7% and our risk premium is 4%. What is the cost of
retained earnings for Newco using the bond-yield-plus-premium approach?

Answer:
k
s
= 7% + 4% = 11%

c) Discounted Cash Flow ApproachAlso known as the "dividend yield plus growth approach". Using the
dividend-growth model, you can rearrange the terms as follows to determine k
s
.

Formula 11.5
k
s
= D
1
+ g;
P
0

where:
D
1
= next year's dividend
g = firm's constant growth rate
P
0
= price
Typically, you must also estimate g, which can be calculated as follows:

Formula 11.6
g = (retention rate)(ROE) = (1-payout rate)(ROE)

Example: discounted cash flow approach
Assume Newco's stock is selling for $40; its expected return on equity (ROE) is 10%, next year's
dividend is $2 and the company expects to pay out 30% of its earnings. What is the cost of retained
earnings for Newco using the discounted cash flow approach?

Answer:
g must first be calculated:
g = (1-0.3)(0.10) = 7.0%

k
s
= 2/40 + 0.07 = 0.12 or 12%
Exam Tips and Tricks
Of the three approaches to determine the cost of retained
earnings, be most familiar with the CAPM approach and the
dividend-yield-plus-growth approach

Next: Cost of Newly Issued Stock
Corporate Finance - Cost of Newly Issued Stock

4. Cost of external equity
Cost of newly issued stock (k
c
) is the cost of external equity, and it is based on the cost of
retained earnings increased for flotation costs (cost of issuing common stock). For a constant-
growth company, this can be calculated as follows:

Formula 11.7
k
c
= D
1
__ + g
P
0
(1-F)

where:
F = the percentage flotation cost, or (current stock price - funds going to company) /
current stock price

Example: cost of newly issued stock
As in our previous example for Newco, assume the company's stock is selling for $40, its
expected ROE is 10%, next year's dividend is $2 and the company expects to pay out 30% of its
earnings. Additionally, assume the company has a flotation cost of 5%. What is Newco's cost of
new equity?
Answer:
k
c
= 2 + 0.07 = 0.123, or 12.3%
40(1-0.05)

It is important to note that the cost of newly issued stock is higher than the company's cost of
retained earnings. This is due to the flotation costs.

Next: Target Capital Structure
Corporate Finance - Target Capital Structure
The target (optimal) capital structure is simply defined as the mix of debt, preferred stock and common
equity that will optimize the company's stock price. As a company raises new capital it will focus on
maintaining this target (optimal) capital structure.
Look Out!
It is important to note is that while the target structure is the
capital structure that will optimize the company\'s stock
price, it is also the capital structure that minimizes the
company\'s weighted-average cost of capital (WACC).

Calculating Weighted Average Cost of Capital
A company's weighted average cost of capital (WACC) is calculated as follows:

Formula 11.8
WACC = (w
d
) [k
d
(1-t)] + (w
ps
)(k
ps
) + (w
ce
)(k
ce
)

Where:
W
d
= weight percentage of debt in company's capital structure
W
ps
= weight percentage of preferred stock in company's capital structure
W
ce
= weight percentage of common stock in company's capital structure

As discussed previously, the weights of debt, preferred securities and common equity are based on the
company's target (optimal) capital structure.
Look Out!
One thing to note is that the weights should be based on the
market value of the firm\'s securities, unless the firm\'s book
value shown on the balance sheet is similar to the market
value.

Example: WACC
For Newco, assume the following weights: w
d
= 40%, w
ps
= 5% and w
ce
= 55%. Compute Newco's
weighted average cost of capital using the costs calculated in the examples above. For the purposes of
this example, assume new equity comes from retained earnings and the discounted cash flow approach
is used to derive k
ce
.

Answer:
WACC = (w
d
)(k
d
)(1-t) + (w
ps)
(k
ps)
+ (w
ce
)(k
ce
)
WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.12)
WACC = 0.084, or 8.4%

Taking the example further, suppose new equity needs to come from newly issued common stock; the
WACC would then be calculated using a k
c
of 12.3%. Thus our WACC would be as follows:
WACC = (w
d
)(k
d
)(1-t) + (w
ps)
(k
ps)
+ (w
ce
)(k
ce
)
WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.123)
WACC = 0.086 or 8.6%

For more on the WACC, including its components and importance, check out the following article:
Investors Need A Good WACC.

Next: Marginal Cost of Capital
Corporate Finance - Marginal Cost of Capital

The marginal cost of capital (MCC) is the cost of the last dollar of capital raised, essentially the cost of
another unit of capital raised. As more capital is raised, the marginal cost of capital rises.
With the weights and costs given in our previous example, we computed Newco's weighted average cost
of capital as follows:

WACC = (w
d
)(k
d
)(1-t) + (w
ps)
(k
ps)
+ (w
ce
)(k
ce
)
WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.12)
WACC = 0.084, or 8.4%

We originally determined the WACC for Newco to be 8.4%. Newco's cost of capital will remain
unchanged as new debt, preferred stock and retained earnings are issued until the company's
retained earnings are depleted.

Example: Marginal Cost of Capital
Once retained earnings are depleted, Newco decides to access the capital markets to raise new equity.
As in our previous example for Newco, assume the company's stock is selling for $40, its expected ROE is
10%, next year's dividend is $2.00 and the company expects to pay out 30% of its earnings. Additionally,
assume the company has a flotation cost of 5%. Newco's cost of new equity (k
c
) is thus 12.3%, as
calculated below:

k
c
= 2 + 0.07 = 0.123, or 12.3%
40(1-0.05)

Answer:
Using this new cost of equity, we can determine the WACC as follows:

WACC = (w
d
)(k
d
)(1-t) + (w
ps)
(k
ps)
+ (w
ce
)(k
ce
)
WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.123)
WACC = 0.086, or 8.6%
The WACC has been stepped up from 8.4% to 8.6% given Newco's need to raise new equity.

Figure 11.1

Look Out!
At some point, as the company continues to raise capital, the
MCC can be higher than the WACC.

MCC Vs. WACC
The marginal cost of capital is simply the weighted average cost of the last dollar of capital raised. As
mentioned previously, in making capital decisions, a company keeps with a target capital structure.
There comes a point, however, when retained earnings have been depleted and new common stock has
to be used. When this occurs, the company's cost of capital increases. This is known as the "breakpoint"
and can be calculated as follows:

Formula 11.9
Breakpoint for retained earnings = retained earnings
w
ce

Example:

For Newco, assume we expect it to earn $50 million next year. As mentioned in our previous examples,
Newco's payout ratio is 30%. What is Newco's breakpoint on the marginal cost curve, if we assume w
ce
=
55%?

Answer:
Newco's breakpoint = $50 million (1-0.3) = $63.6 million
0.55

Thus, after Newco raises roughly $64 million of total capital, new common equity will need to be issued
and Newco's WACC will increase to 8.6%.

Factors that affect the cost of capital can be categorized as those that are controlled by the company
and those that are not.

Next: Factors Affecting the Cost of Capital
Corporate Finance - Factors Affecting the Cost of Capital

These are the factors affecting cost of capital that the company has control over:

1. Capital Structure Policy
As we have been discussing above, a firm has control over its capital structure, targeting an
optimal capital structure. As more debt is issued, the cost of debt increases, and as more equity is
issued, the cost of equity increases.

2. Dividend Policy
Given that the firm has control over its payout ratio, the breakpoint of the MCC schedule can be
changed. For example, as the payout ratio of the company increases the breakpoint between
lower-cost internally generated equity and newly issued equity is lowered.

3. Investment Policy
It is assumed that, when making investment decisions, the company is making investments with
similar degrees of risk. If a company changes its investment policy relative to its risk, both the
cost of debt and cost of equity change.

Uncontrollable Factors Affecting the Cost of Capital
These are the factors affecting cost of capital that the company has no control over:

1. Level of Interest Rates
The level of interest rates will affect the cost of debt and, potentially, the cost of equity. For
example, when interest rates increase the cost of debt increases, which increases the cost of
capital.
2. Tax Rates
Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases,
decreasing the cost of capital.

Next: Payback Period
Corporate Finance - Payback Period

Payback Period
Payback period (PP) is the number of years it takes for a company to recover its original investment in
a project, when net cash flow equals zero. In the calculation of the payback period, the cash flows of the
project must first be estimated. The payback period is then a simple calculation.

Formula 11.10
PP = years full recovery + unrecovered cost at beginning of last year
cash flow in last year
The shorter the payback period of a project, the more attractive the project will be to management. In
addition, management typically establishes a maximum payback period that a potential project must
meet. When two projects are compared, the project that meets the maximum payback period and has
the shortest payback period is the project to be accepted. It is a simplistic measure, not taking into
account the time value of money, but it is a good measure of a project's riskiness.
Look Out!
For payback periods, the decision rules are as follows:
If payback period < the minimum payback, accept the project
If payback period > the minimum payback, reject the project

Example: Payback Period
Assume Newco is deciding between two machines (Machine A and Machine B) in order to add capacity
to its existing plant. The company estimates the cash flows for each machine to be as follows:

Figure 11.2: Expected after-tax cash flows for the new machines

Calculate the payback period of the two machines using the above cash flows and decide which new
machine Newco should accept. Assume the maximum payback period the company establishes is five
years.
Answer:
First it would be helpful to determine cumulative cash flow for the machine project. This is done in the
following table:

Figure 11.3: Cumulative cash flows for Machine A and Machine B

Payback period for Machine A = 4 + 1,000 = 4.67
1,500

Payback period for Machine B = 2 + 0 = 2.00
0
Both machines meet the company's maximum payback period. Machine B, however, has the shortest
payback period and is the project Newco should accept.

2. Discounted Payback Period
The one issue we mentioned with the payback period is that it does not take into account the time value
of money, but the discounted payback period does.The discounted payback period discounts each of the
estimated cash flows and then determines the payback period from those discounted flows.

Example: discounted payback period
Using our last example above, determine the discounted payback period for Machine A and Machine B,
and determine which project Newco should accept. As calculated previously, Newco's cost of capital is
8.4%.

Figure 11.4: Discounted cash flows for Machine A and Machine B

Answer:
Payback period for Machine A = 5 + 147 = 5.24
616

Payback period for Machine B = 2 + 262 = 2.22
1178

Machine A now violates management's maximum payback period of five years and should thus be
rejected. Machine B meets management's maximum payback period of five years and has the shortest
payback period.

Next: Net Present Value (NPV) and the Internal Rate of Return (IRR)
Corporate Finance - Net Present Value (NPV) and the
Internal Rate of Return (IRR)

Net Present Value
Using the company's cost of capital, the net present value (NPV) is the sum of the discounted cash flows
minus the original investment.

Formula 11.11

Look Out!
Projects with NPV > 0 increase stockholders return
Projects with NPV < 0 decrease stockholders return

Example: Net Present Value
Using the cash flows in the previous examples, calculate the NPV for each machine and decide which
project Newco should accept. As calculated previously, Newco's cost of capital is 8.4%.
Answer:
NPV
A
= -5,000 + 500 + 1,000 + 1,000 + 1,500 + 2,500 + 1,000 = $469
(1.084)
1
(1.084)
2
(1.084)
3
(1.084)
4
(1.084)
5
(1.084)
6

NPV
B
= -2,000 + 500 + 1,500 + 1,500 + 1,500 + 1,500 + 1,500 = $3,929
(1.084)
1
(1.084)
2
(1.084)
3
(1.084)
4
(1.084)
5
(1.084)
6

Given that both machines have NPV > 0, both projects are acceptable. However, for mutually exclusive
projects, the decision rule is to choose the project with the greatest NPV. Since the NPV
B
> NPV
A
, Newco

should choose the project for Machine B.

Internal Rate of Return
The internal rate of return (IRR) on a project is the rate of return at which the projects NPV equals zero.
At this point, a project's cash flows are equal to the project's costs. Similar to how management must
establish a maximum payback period, management must also set what is known as a "hurdle rate", the
minimum rate of return a company will accept for a project.

When a project is reviewed with a hurdle rate in mind, the greater the IRR is above the hurdle rate, the
greater the NPV, and conversely, the further the IRR is below the hurdle rate, the lower the NPV.
Look Out!
For the IRR, the decision rules are as follows:
If IRR > hurdle rate, accept the project
If IRR< hurdle rate, reject the project

For a project to be accepted, the IRR must be greater than or equal to the hurdle rate. If a company is
deciding between two projects, the project with the highest IRR is the project to be accepted.
Formula 11.12

The IRR formula is quite difficult to calculate without the use of a financial calculator. Thus, a financial
calculator is highly recommended to solve for a project's IRR. Otherwise trial and error must be used.

Next: The NPV Profile
Corporate Finance - The NPV Profile

The NPV profile is a graph that illustrates a project's NPV against various discount rates, with
the NPV on the y-axis and the cost of capital on the x-axis. To begin, simply calculate a project's
NPV using different cost-of-capital assumptions. Once these are calculated, plot the values on
the graph.

Figure 11.5

Look Out!
Since the IRR is the discount rate where the NPV of a
project equals zero, the point where the NPV crosses
the x-axis is also the project's IRR.

Next: Cash Flow and NPV Applications
Corporate Finance - Cash Flow and NPV Applications

Accounting Profits
Accounting profits are cash flows that include non-cash inflows/outflows such as depreciation.

Cash Flows
Cash flows are a firm's actual cash inflows/outflows and are important in capital budgeting.

Example: Net Cash Flows
Assume Newco has $10,000 in annual depreciation and $20,000 in accounting net income. Because the
$10,000 in annual depreciation is not an actual cash outflow, the $20,000 in accounting net income is
not the true cash flow to the firm.
If, while all else is constant, annual depreciation were to decline by $5,000 to $5,000, accounting net
income would increase to $25,000, but actual cash flow would remain unchanged. However,
calculations of net cash flow exclude the effects of depreciation.

Formula 11.13

For purposes of capital budgeting,
Net Cash Flow = Net Income + Depreciation
Answer: Therefore, net cash flow would be equal to $30,000 ($20,000 net income +$10,000
depreciation) before the changes in depreciation and $30,000 ($25,000 net income + $5,000
depreciation) after the changes in depreciation.
Incremental Cash Flow and Capital Budgeting
Once a company makes a decision to accept a project, an incremental cash flow is then the cash flow
that is added to the firm's existing cash flow as a result of accepting a new project.

However, in determining incremental cash flows from a new project, problems arise, such as:

1. Sunk Costs
These are the initial outlays required to analyze a project that cannot be recovered even if a project is
accepted. As such, these costs will not affect the future cash flows of the project and should not be
considered when making capital-budgeting decisions.
Suppose Newco is considering whether to make an addition to its current plant to increase production.
To determine if the new addition is worthwhile, Newco hired a consulting firm for $50,000 to analyze
the addition and the effect it will have on production. The $50,000 is considered a sunk cost. If the
project is rejected, the $50,000 will still be paid, and if the project is accepted, the $50,000 will not
affect the future cash flows of the addition.

2. Opportunity Cost
This is the cost of not going forward with a project or the cash outflows that will not be earned as a
result of utilizing an asset for another alternative. For example, the opportunity cost of Newco's new
addition considered above is the cost of the land on which Newco is considering putting the new plant
addition. As such, it should be included in the analysis of the project.

3. Externality
Additionally, in the consideration of incremental cash flows of a new project, there may be effects on
the existing operations of the company to consider, known as "externalities". For example, the addition
to Newco's plant is for the purpose of producing a new product. It must be considered if the new
product may actually take away or add to sales of the existing product.

4. Cannibalization
This is the type of externality where the new project takes sales away from the existing product.

Changes in Net Working Capital
A change in net working capital is essentially the changes in current assets minus changes in current
liabilities. Within the capital-budgeting process, a project typically adds to current assets given
additional inventories or potential increases in accounts receivables from new sales. The increases to
current assets, however, are offset by current liabilities needed to finance the new project.

Overall, there may be change to net working capital from the new project.
If the change in net working capital is positive, the change to current assets outweighs the
change in the current liabilities.
If, however, the change in net working capital is negative, the change to current liabilities
outweighs the change in current assets.

Next: Advantages and Disadvantages of the NPV and IRR Methods
Corporate Finance - Advantages and Disadvantages of the
NPV and IRR Methods

While useful NPV and IRR methods are useful methods for determining whether to accept a project,
both have their advantages and disadvantages.

Advantages:
With the NPV method, the advantage is that it is a direct measure of the dollar contribution to
the stockholders.
With the IRR method, the advantage is that it shows the return on the original money invested.
Disadvantages:
With the NPV method, the disadvantage is that the project size is not measured.
With the IRR method, the disadvantage is that, at times, it can give you conflicting answers
when compared to NPV for mutually exclusive projects. The 'multiple IRR problem' can also be
an issue, as discussed below.
The Multiple IRR Problem
A multiple IRR problem occurs when cash flows during the project lifetime is negative (i.e. the project
operates at a loss or the company needs to contribute more capital).

This is known as a "non-normal cash flow", and such cash flows will give multiple IRRs.

Why Do NPV and IRR Methods Produce Conflicting Rankings?
When a project is an independent project, meaning the decision to invest in a project is independent of
any other projects, both the NPV and IRR will always give the same result, either rejecting or accepting a
project.

While NPV and IRR are useful metrics for analyzing mutually exclusive projects - that is, when the
decision must be one project or another - these metrics do not always point you in the same direction.
This is a result of the timing of cash flows for each project. In addition, conflicting results may simply
occur because of the project sizes.
Look Out!
The timing of cash flows as well as project sizes can
produce conflicting results in the NPV and IRR
methods.

Example: NPV and IRR Analysis
Assume once again that Newco needs to purchase a new machine for its manufacturing plant. Newco
has narrowed it down to two machines that meet its criteria (Machine A and Machine B), and now it has
to choose one of the machines to purchase. Further, Newco has assumed the following analysis on
which to base its decision:

Figure 11.6: Potential Machines for Newco

Answer:
We first determine the NPV for each machine as follows:

NPV
A
= ($5,000) + $2,768 + $2.553 = $321
NPV
B
= ($10,000) + $5,350 + $5,106 = $456

According to the NPV analysis alone, Machine B is the most appropriate choice for Newco to purchase.

The next step is to determine the IRR for each machine using our financial calculator. The IRR for
Machine A is equal to 13%, whereas the IRR for Machine B is equal to 11%.

According to the IRR analysis alone, Machine A is the most appropriate choice for Newco to purchase.

The NPV and IRR analysis for these two projects give us conflicting results. This is most likely due to the
timing of the cash flows for each project as well as the size differential between the two projects.

The Post-Audit's Role
The post-audit process in the capital-budgeting process is quite important. In the post-audit process, an
analyst examines a company's capital-budgeting decisions to see how the actual results from the
projects compare to the results the company estimated. The post-audit process gives the company a
sense of not only how the projects are performing, but also how good its inputs were.

If a project's actual results differed significantly in a negative direction, the post-audit process will help
the company learn where it went wrong with respect to inputs so that the same mistake will not be
made when analyzing future projects.

Next: Applying NPV Analysis to Project Decisions
Corporate Finance - Applying NPV Analysis to Project
Decisions

As a primer, readers should remember that:

Expansion projects are projects companies invest in to expand the earnings of its business.

Replacement projects, are projects that companies invest in to replace old assets in order to
maintain efficiencies.

Example: NPV Analysis
Assume Newco is planning to add new machinery to its current plant. There are two machines
Newco is considering, with cash flows as follows:


Calculate the NPV for each machine and decide which machine Newco should invest in. As
calculated previously, Newco's cost of capital is 8.4%.

Formula 11.14

Answer:
NPV
A
= -5,000 + 500 + 1,000 + 1,000 + 1,500 + 2,500 + 1,000 = $469
(1.084)
1
(1.084)
2
(1.084)
3
(1.084)
4
(1.084)
5
(1.084)
6

NPV
B
= -2,000 + 500 + 1,500 + 1,500 + 1,500 + 1,500 + 1,500 = $3,929
(1.084)
1
(1.084)
2
(1.084)
3
(1.084)
4
(1.084)
5
(1.084)
6

When considering mutually exclusive projects and NPV alone, remember that the decision rule is
to invest in the project with the greatest NPV. As Machine B has the greatest NPV, Newco
should invest in Machine B.

Determining a Project's Cash Flows
When beginning capital-budgeting analysis, it is important to determine the cash flows of a
project. These cash flows can be segmented as follows:

1. Initial Investment Outlay
These are the costs that are needed to start the project, such as new equipment, installation, etc.

2. Operating Cash Flow over a Project's Life
This is the additional cash flow a new project generates.

3. Terminal-Year Cash Flow
This is the final cash flow, both the inflows and outflows at the end of the project's life, such as
potential salvage value at the end of a machine's life.

Look Out!
It is important to note that while interest expense is
included in a company\'s earnings per share, it is not
included in operating cash flows as it is already in the
discounting process.

Example: Expansion Project
Let us begin with our previous example. Newco is looking to add to its production capacity and
is looking closely at investing in Machine B. Machine B has a cost of $2,000, with shipping and
installation expenses of $500 and $300 in net working capital. Newco expects the machine to last
for five years, at which point Machine B will have a book value (BV) of $1,000 ($2,000 minus
five years of $200 annual depreciation) and a potential market value of $800.
With respect to cash flows, Newco expects the new machine to generate an additional $1,500 in
revenues and costs of $200. We will assume Newco has a tax rate of 40%. The maximum
payback period that the company established is five years.

As required in the LOS, calculate the project's initial investment outlay, operating cash flow over
the project's life and the terminal-year cash flow for the expansion project.

Answer:
Initial Investment Outlay:
Machine cost + shipping and installation expenses + change in net working capital = $2,000 +
$500 + $300 = $2,800

Operating Cash Flow:
CF
t
= (revenues - costs)*(1 - tax rate)
CF
1
= ($1,500 - $200)*(1 - 40%) = $780
CF
2
= ($1,500 - $200)*(1 - 40%) = $780
CF
3
= ($1,500 - $200)*(1 - 40%) = $780
CF
4
= ($1,500 - $200)*(1 - 40%) = $780
CF
5
= ($1,500 - $200)*(1 - 40%) = $780

Terminal Cash Flow:
Tips and Tricks
For determining the terminal cash flow, the key
metrics are salvage value of the asset, net working
capital and tax benefit/loss from the asset.

The terminal cash flow can be calculated as illustrated:

Return of net working capital +$300
Salvage value of the machine +$800
Tax reduction from loss (salvage < BV) +$80
Net terminal cash flow $1,180
Operating CF
5
+$780
Total year-five cash flow $1,960

For determining the tax benefit or loss, a benefit is received if the book value of the asset is more
than the salvage value, and a tax loss is recorded if the book value of the asset is less than the
salvage value.

Example: Replacement Project
Now, let us assume that rather than investing in an additional machine, Newco is exploring
replacing its current machine with a newer, more efficient machine. Based on the current market,
Newco can sell the old machine for $200, but this machine has a book value of $500.

The new machine Newco is looking to invest capital in has a cost of $2,000, with shipping and
installation expenses of $500 and $300 in net working capital. Newco expects the machine to last
for five years, at which point Machine B would have a book value of $1,000 ($2,000 minus five
years of $200 annual depreciation) and a potential market value of $800.

With respect to cash flows, Newco expects the new machine to generate an additional $1,500 in
revenues and costs of $200. We will assume Newco has a tax rate of 40%. The maximum
payback period that the company established is five years.

As required in the LOS, calculate the project's initial investment outlay, operating cash flow over
the project's life and the terminal-year cash flow for the replacement project.

Answer:
Initial Investment Outlay
Computing the initial investment outlay of a replacement project is slightly different than the
computation for an existing project. This is primarily because of the expected cash flow a
company may receive on the sale of the equipment to be replaced.

Value of the old machine = sale value + tax benefit/loss
= $200 + $120
= $320

Sale of old equipment + machine cost + shipping and installation expenses + change in net
working capital = $320 + $2,000 + $500 + $300 = $3,120
Look Out!
In the analysis of either an expansion or a replacement
project, the operating cash flows and terminal cash
flows are calculated the same.
Operating cash flow:

CF
t
= (revenues - costs)*(1 - tax rate)
CF
1
= ($1,500 - $200)*(1 - 40%) = $780
CF
2
= ($1,500 - $200)*(1 - 40%) = $780
CF
3
= ($1,500 - $200)*(1 - 40%) = $780
CF
4
= ($1,500 - $200)*(1 - 40%) = $780
CF
5
= ($1,500 - $200)*(1 - 40%) = $780

Terminal Cash Flow:
The terminal cash flow can be calculated as illustrated:

Return of net working capital +$300
Salvage value of the machine +$800
Tax reduction from loss (salvage < BV) +$80
Net terminal cash flow $1,180
Operating CF
5
+$780
Total year 5 cash flow $1,960

Next: Comparing Projects With Unequal Lives
Corporate Finance - Comparing Projects With Unequal
Lives

As mentioned previously, NPV and IRR can sometimes lead to conflicting results in the analysis
of mutually exclusive projects. One reason for this potential problem is the timing of the cash
flows of the mutually exclusive projects. As a result, we need to adjust for the timing issue in
order to correct this problem.

There are two methods used to make the adjustments:

1. Replacement-chain method
2. Equivalent annual annuity

Example:
Once again, assume Newco is planning to add new machinery to its current plant. There are two
machines Newco is considering, with cash flows as follows:


Compare the two projects with unequal lives using both the replacement-chain method and the
equivalent annual annuity (EAA) approach.

1. Replacement-Chain Method
In this example, Machine A has an operating lifespan of six years. Machine B has an operating
lifespan of three years. The cash flows for each project are discounted by Newco's calculated
WACC of 8.4%.
NPV of Machine A is equal to $2,926.
NPV of Machine B is equal to $1,735.
The initial analysis indicates that Machine A, with the greater NPV, should be the project
chosen.
The IRR of Machine A is equal to 8.3%.
The IRR of Machine B is equal to 15.5%.
This analysis indicates that Machine B, with the greater IRR, should be the project chosen.
The NPV analysis and the IRR analysis have given us differing results. This is most likely due to
the unequal lives of the two projects. As such, we need to analyze the two projects over a
common life.

For Machine A (project 1), the lifespan is six years. For Machine B (project 2), the lifespan is
three years. Given that the lifespan of the longest project is six years, in order to measure both
over a common life, we must adjust the lifespan of Machine B to six years.
Because the lifespan of Machine B is three years, the lifespan of this project needs to be doubled
to equal the six-year lifespan of Machine A. This indicates that another Machine B would have
to be purchased (to get two machines with a lifespan of three years each) to get to the six-year
lifespan of Machine A - hence, the replacement-chain method.

The new cash flows would be as follows:

Figure 11.9: Cash flows over a common life

NPV of Machine A remains $2,926.
NPV of Machine B is now $3,098 given the adjustment.
The initial analysis indicates that Machine B, with the greater NPV, should be the project chosen.
Recall, this is different from our first analysis where Machine A was chosen given its greater
NPV.
The IRR of Machine A remains 8.3%.
The IRR of Machine B remains 15.5%.

Look Out!
Note, while the NPV has changed given the additional
cash flows, the IRR for the projects remain the same.

This analysis indicates that Machine B, with the greater IRR, should be the project chosen.
Recall, this is the same as our first analysis, where Machine B was chosen given its greater IRR.

With the cash flows adjusted with the replacement-chain method, both the NPV and the IRR
arrive at the same conclusion. With this adjusted analysis, Machine B (project 2), should be the
project accepted.

2. Equivalent-Annual-Annuity Approach
While easy to understand, the replacement-chain method can be time consuming. A simpler
approach is the equivalent-annual-annuity approach.

This is the procedure for determining EAA:

1) Determine the projects' NPVs.
2) Find each project's EAA, the expected payment over the project's life, where the future value
of the project would equal zero.
3) Compare the EAA of each project and select the project with the highestEAA.

From our example, the NPV of each project is as follows:
-NPV of Machine A is equal to $2,926.
-NPV of Machine B is equal to $1,735.

To determine each project's EAA, it is best to use your financial calculator.

- For, Machine A (project 1), our assumptions are as follows:

i = 8.4% (the company's WACC)
n = 6
PV = NPV = -2,926
FV = 0
Find PMT

For Machine A, the EAA (the calculated PMT) is $640.64.

- For Machine B (project 2), our assumptions are as follows:

i = 8.4% (the company's WACC)
n = 3
PV = NPV = -1,735
FV = 0
Find for PMT

For Machine B, the EAA (the calculated PMT) is $678.10.

Answer
Machine B should be the project chosen as it has the highest EAA, which is $678.10, relative to
Machine A whose EAA is $640.64.

Inflation Effects on Capital Budgeting Analysis
Inflation exists and should not be forgotten when making capital-budgeting decisions. It is
important to build inflation expectations into the analysis. If inflation expectations are left out of
the capital-budgeting analysis, the NPV calculated from the biased cash flows will be incorrect.

As an example, suppose Newco unintentionally leaves out its inflation expectations when
determining the plant addition. Since inflation expectations are included in the WACC, and PV
of each cash flow is discounted by the WACC, the NPV will be incorrect and have a downward
bias.

Next: Types of Risk
Corporate Finance - Types of Risk

Like anything, projects do have risks. There are three types of project risks associated with capital
budgeting:

1. Stand-Alone Risk
This risk assumes the project a company intends to pursue is a single asset that is separate from the
company's other assets. It is measured by the variability of the single project alone. Stand-alone risk
does not take into account how the risk of a single asset will affect the overall corporate risk.
2. Corporate Risk
This risk assumes the project a company intends to pursue is not a single asset but incorporated with a
company's other assets. As such, the risk of a project could be diversified away by the company's other
assets. It is measured by the potential impact a project may have on the company's earnings.

3. Market Risk
This looks at the risk of a project through the eyes of the stockholder. It looks at the project not only
from a company's perspective, but from the stockholder's overall portfolio. It is measured by the effect
the project may have on the company's beta.

Next: Risk-Analysis Techniques
Corporate Finance - Risk-Analysis Techniques
It is important to keep in mind that when a company analyzes a potential project, it is forecasting
potential not actual cash flows for a project. As we all know, forecasts are based on assumptions
that may be incorrect. It is therefore important for a company to perform a sensitivity analysis on
its assumptions to get a better sense of the overall risk of the project the company is about to
take.

There are three risk-analysis techniques that should be known for the exam:

1. Sensitivity Analysis
Sensitivity analysis is simply the method for determining how sensitive our NPV analysis is to
changes in our variable assumptions. To begin a sensitivity analysis, we must first come up with
a base-case scenario. This is typically the NPV using assumptions we believe are most accurate.
From there, we can change various assumptions we had initially made based on other potential
assumptions. NPV is then recalculated, and the sensitivity of the NPV based on the change in
assumptions is determined. Depending on our confidence in our assumptions, we can determine
how potentially risky a project can be.

2. Scenario Analysis
Scenario analysis takes sensitivity analysis a step further. Rather than just looking at the
sensitivity of our NPV analysis to changes in our variable assumptions, scenario analysis also
looks at the probability distribution of the variables. Like sensitivity analysis, scenario analysis
starts with the construction of a base case scenario. From there, other scenarios are considered,
known as the "best-case scenario" and the "worst-case scenario". Probabilities are assigned to the
scenarios and computed to arrive at an expected value. Given its simplicity, scenario analysis is
one the most frequently used risk-analysis techniques.
3. Monte Carlo Simulation
Monte Carlo simulation is considered to be the "best" method of sensitivity analysis. It comes up
with infinite calculations (expected values) given a number of constraints. Constraints are added
and the system generates random variables of inputs. From there, NPV is calculated. Rather than
generating just a few iterations, the simulation repeats the process numerous times. From the
numerous results, the expected value is then calculated.

Next: Security Market Line and Beta Basics
Corporate Finance - Security Market Line and Beta Basics

The security market line (SML) is simply a plot of expected returns of investments with respect to its
beta, market risk. Expected values are calculated with the following equation:

Formula 11.15
E
s
= r
f
+ B
s
(E
mkt
- r
f
)
Where:
r
f
= the risk-free rate
B
s
= the beta of the investment
E
mkt
= the expected return of the market
E
s
= the expected return of the investment
The beta is thus the sensitivity of the investment to the market or current portfolio. It is the measure of
the riskiness of a project. When taken in isolation, a project may be considered more or less risky than
the current risk profile of a company. Through the use of the SML as a means to calculate a company's
WACC, this risk profile would be accounted for.

Example:
When a new product line for Newco is considered, the project's beta is 1.5. Assuming the risk-free rate is
4% and the expected return on the market is 12%, compute the cost of equity for the new product line.

Answer:
Cost of equity = r
f
+ B
s
(E
mkt
- r
f
) = 4% + 1.5(12% - 4%) = 16%

The project's required return on retained earnings is thus 16% and should be used in our calculation of
WACC.

Estimating Beta
In risk analysis, estimating the beta of a project is quite important. But like many estimations, it can be
difficult to determine.
The two most widely used methods of estimating beta are:

1. Pure-Play Method
When using the pure-play method, a company seeks out companies with a product line that is similar to
the line for which the company is trying to estimate the beta. Once these companies are found, the
company would then take an average of those betas to determine its project beta.

Suppose Newco would like to add beer to its existing product line of soda. Newco is quite familiar with
the beta of making soda given its history. However, determining the beta for beer is not as intuitive for
Newco as it has never produced it.

Thus, to determine the beta of the new beer project, Newco can take the average beta of other beer
makers, such as Anheuser Busch and Coors.

2. Accounting-Beta Method
When using the accounting-beta method, a company would run a regression using the company's
return on assets (ROA) against the ROA for market benchmark, such as the S&P 500. The accounting
beta is the slope coefficient of the regression.

The typical procedure for developing a risk-adjusted discount rate is as follows:

1. A company first begins with its cost of capital for the firm.
2. The cost of capital then must be adjusted for the riskiness of the project, by adjusting the company's
cost of capital either up or down depending on the risk of the project relative to the firm.

For projects that are riskier, the company's WACC would be adjusted higher and if the project is less
risky, the company's WACC is adjusted lower. The main issue in this procedure is that it is subjective.

Capital Rationing
Essentially, capital rationing is the process of allocating the company's capital among projects to
maximize shareholder return.

When making decisions to invest in positive net-present-value (NPV) projects, companies continue to
invest until their marginal returns equal their marginal cost of capital. There are times, however, when a
company may not have capital to do this. As such, a company must ration its capital among the best
combination of projects with the highest total NPV.

Next: Factors that Influence a Company's Capital-Structure Decision
Corporate Finance - Factors that Influence a Company's
Capital-Structure Decision

The primary factors that influence a company's capital-structure decision are:

1. Business Risk
Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk,
the lower the optimal debt ratio.

As an example, let's compare a utility company with a retail apparel company. A utility company
generally has more stability in earnings. The company has les risk in its business given its stable revenue
stream. However, a retail apparel company has the potential for a bit more variability in its earnings.
Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the
business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a
lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its
responsibilities with the capital structure in both good times and bad.

2. Company's Tax Exposure
Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of
financing a project is attractive because the tax deductibility of the debt payments protects some
income from taxes.

3. Financial Flexibility
This is essentially the firm's ability to raise capital in bad times. It should come as no surprise that
companies typically have no problem raising capital when sales are growing and earnings are strong.
However, given a company's strong cash flow in the good times, raising capital is not as hard. Companies
should make an effort to be prudent when raising capital in the good times, not stretching its
capabilities too far. The lower a company's debt level, the more financial flexibility a company has.
The airline industry is a good example. In good times, the industry generates significant amounts of sales
and thus cash flow. However, in bad times, that situation is reversed and the industry is in a position
where it needs to borrow funds . If an airline becomes too debt ridden, it may have a decreased ability
to raise debt capital during these bad times because investors may doubt the airline's ability to service
its existing debt when it has new debt loaded on top.

4. Management Style
Management styles range from aggressive to conservative. The more conservative a management's
approach is, the less inclined it is to use debt to increase profits. An aggressive management may try to
grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's
earnings per share (EPS).

5. Growth Rate
Firms that are in the growth stage of their cycle typically finance that growth through debt, borrowing
money to grow faster. The conflict that arises with this method is that the revenues of growth firms are
typically unstable and unproven. As such, a high debt load is usually not appropriate.

More stable and mature firms typically need less debt to finance growth as its revenues are stable and
proven. These firms also generate cash flow, which can be used to finance projects when they arise.

6. Market Conditions
Market conditions can have a significant impact on a company's capital-structure condition. Suppose a
firm needs to borrow funds for a new plant. If the market is struggling, meaning investors are limiting
companies' access to capital because of market concerns, the interest rate to borrow may be higher
than a company would want to pay. In that situation, it may be prudent for a company to wait until
market conditions return to a more normal state before the company tries to access funds for the plant.

Next: Business and Financial Risk
Corporate Finance - Business and Financial Risk

To further examine risk in the capital structure, two additional measures of risk found in capital
budgeting:

1. Business Risk
A company's business risk is the risk of the firm's assets when no debt is used. Business risk is the risk
inherent in the company's operations. As a result, there are many factors that can affect business risk:
the more volatile these factors, the riskier the company. Some of those factors are as follows:
Sales risk - Sales risk is affected by demand for the company's product as well as the price per
unit of the product.
Input-cost risk - Input-cost risk is the volatility of the inputs into a company's product as well as
the company's ability to change pricing if input costs change.
As an example, let's compare a utility company with a retail apparel company. A utility company
generally has more stability in earnings. The company has les risk in its business given its stable revenue
stream. However, a retail apparel company has the potential for a bit more variability in its earnings.
Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the
business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a
lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its
responsibilities with the capital structure in both good times and bad.

2. Financial Risk
A company's financial risk, however, takes into account a company's leverage. If a company has a high
amount of leverage, the financial risk to stockholders is high - meaning if a company cannot cover its
debt and enters bankruptcy, the risk to stockholders not getting satisfied monetarily is high.
Let's use the troubled airline industry as an example. The average leverage for the industry is quite
high (for some airlines, over 100%) given the issues the industry has faced over the past few years. Given
the high leverage of the industry, there is extreme financial risk that one or more of the airlines will face
an imminent bankruptcy.

Effect of Changes in Sales or Earnings on EBIT
Differing amounts of debt financing cause changes in EPS and thus a company's stock price. The
calculations for EBIT and EPS are as follows:

Formula 11.16
EBIT = sales - variable costs - fixed costs
EPS = [(EBIT - interest)*(1-tax rate)] / shares outstanding

This LOS is best explained by the use of an example.

Example:
The following is Newco's cost of debt at various capital structures. Newco has $1 million in total assets
and a tax rate of 40%. Assume that, at a debt level of zero, Newco has 20,000 shares outstanding.

Figure 11.10: Newco's cost of debt at various capital structures

In addition, Newco has annual sales of $5 million, variable costs are 40% of sales and fixed costs are
equal to $2.4 million. At each level of debt, determine Newco's EPS.

Answer:
At debt level 0%:
Shares outstanding are 20,000 and interest costs are 0.
EPS = [($5,000,000 - 2,000,000 - 2,400,000-0)*(1-0.4)]/20,000
EPS = $18 per share

At debt level 20%:
Shares outstanding are 16,000 [20,000*(1-20%)] and interest costs are 8,000 (200,000*0.04).
EPS = [($5,000,000 - 2,000,000 - 2,400,000-8,000)*(1-0.4)]/16,000
EPS = $22.20 per share

At debt level 40%:
EPS = [($5,000,000 - 2,000,000 - 2,400,000-24,000)*(1-0.4)]/12,000

At debt level 60%:
EPS = [($5,000,000 - 2,000,000 - 2,400,000-48,000)* (1-0.4)]/8,000
EPS= $41.40 per share

At debt level 80%:
EPS = [($5,000,000 - 2,000,000 - 2,400,000-80,000)* (1-0.4)]/4,000

With each increase in debt level (accompanied with the decrease in shares outstanding), Newco's
earnings per share increases.

Next: Operating Leverage and its Effects on a Project's Expected Rate of Return
Corporate Finance - Operating Leverage and its Effects on a
Project's Expected Rate of Return

Operating leverage can be defined as the degree to which a company uses fixed costs in its
operations. The higher the fixed costs as a percentage of total costs, the higher the company's operating
leverage. For companies with high operating leverage, a small change in company revenues will result in
a larger change in operating income since most costs are fixed rather than variable.

Degree of Leverage
The degree of leverage within a company can be calculated based on various metrics.

Some common metrics include:
1. Degree of operating leverage
2. Degree of financial leverage
3. Degree of total leverage

We will discuss operating leverage within this section.

Degree of Operating Leverage
Degree of operating leverage (DOL) is the percentage change in operating income, also known as EBIT,
divided by the percentage change in sales. It is the measure of the sensitivity of EBIT to changes in sales
as a result of changes in operating expenses. Degree of operating leverage is also commonly estimated
using production output.

Formula 11.18

DOL = change in EBIT/EBIT or Q (P - V)
change in sales/sales Q(P - V)- F

A key shortcut to remember is that, if fixed costs of the project are equal to 0, the DOL is actually 1.

Example: Degree of Operating Leverage
Newco produces 140,000 units annually. With Project 1, the company's variable costs are $20 per unit,
and its fixed costs total $2.4 million. With Project 2, the company's variable costs are $30 per unit, and
its fixed costs total $2 million. Newco has the ability to see each unit at $50. Compute the DOL for
Project 1 and Project 2.
Answer: Project 1 DOL = 140,000(50-20)/140,000(50-20) - 2,400,000 = 2.33

With Project 1, for every percentage increase in sales, the company's EBIT will increase 2.33 times; a
10% increase in sales will lead to a 23.3% increase in EBIT.

Project 2 DOL = 140,000(50-30)/140,000(50-30)-2,000,000 = 3.50

With Project 2, for every percentage increase in sales, the company's EBIT will increase 3.50 times; a
10% increase in sales will lead to a 35.0% increase in EBIT.

Next: Financial Leverage
Corporate Finance - Financial Leverage

Financial leverage can be defined as the degree to which a company uses fixed-income securities, such
as debt and preferred equity. With a high degree of financial leverage come high interest payments. As a
result, the bottom-line earnings per share is negatively affected by interest payments. As interest
payments increase as a result of increased financial leverage, EPS is driven lower.

As mentioned previously, financial risk is the risk to the stockholders that is caused by an increase in
debt and preferred equities in a company's capital structure. As a company increases debt and preferred
equities, interest payments increase, reducing EPS. As a result, risk to stockholder return is increased. A
company should keep its optimal capital structure in mind when making financing decisions to ensure
any increases in debt and preferred equity increase the value of the company.

Degree of Financial Leverage
This measures the percentage change in earnings per share over the percentage change in EBIT. This is
known as "degree of financial leverage" (DFL). It is the measure of the sensitivity of EPS to changes in
EBIT as a result of changes in debt.

Formula 11.19
DFL = percentage change in EPS or EBIT
percentage change in EBIT EBIT-interest

A shortcut to keep in mind with DFL is that, if interest is 0, then the DLF will be equal to 1.
Example: Degree of Financial Leverage
With Newco's current production, its sales are $7 million annually. The company's variable costs of sales
are 40% of sales, and its fixed costs are $2.4 million. The company's annual interest expense amounts to
$100,000 annually. If we increase Newco's EBIT by 20%, how much will the company's EPS increase?

Answer:
The company's DFL is calculated as follows:
DFL = ($7,000,000-$2,800,000-$2,400,000)/($7,000,000-$2,800,000-$2,400,000-$100,000)
DFL = $1,800,000/$1,700,000 = 1.058

Given the company's 20% increase in EBIT, the DFL indicates EPS will increase 21.2%.

Next: Sales and Leverage
Corporate Finance - Sales and Leverage

A company's costs include both fixed and variable costs. The breakeven quantity of sales is the
sales amount where both fixed and variable costs are covered. Breakeven quantity of sales:

Formula 11.17
BE
Q
= Fixed Costs
Price - Variable Costs

Example:
Assume Newco's product costs for two different products are the figures below. Calculate
Newco's breakeven quantity of sales and determine the company's gain or loss at various sales
levels for each product.

Figure 11.11: Newco's cost breakdown for Product 1

Figure 11.12: Newco's cost breakdown for Product 2

Answer:

Product 1:
For Newco, the breakeven quantity of its product is:
BE
Q
= $2,400,000/($50 - $20) = 80,000 units

At various sales levels, the company's gains or losses are as follows:

Figure 11.13: Sales analysis
Units Sold Sales/(Loss)
20,000 ($1,800,000)
40,000 ($1,200,000)
60,000 ($600,000)
80,000 $0
100,000 $600,000
120,000 $1,200,000
140,000 $1,800,000

Product 2:
For Newco, the breakeven quantity of its product is:
BE
Q
= $1,800,000/($50 - $20) = 60,000 units

At various sales levels, the company's gains or losses are as follows

Figure 11.14: Sales analysis
Units Sold Sales/(Loss)
20,000 ($1,200,000)
40,000 ($600,000)
60,000 $0
80,000 $600,000
100,000 $1,200,000
120,000 $1,800,000
140,000 $2,400,000

Look Out
Note from the examples above, the higher a company's
fixed costs, if all else is constant, the higher a
company's breakeven quantity.

Next: Effects of Debt on the Capital Structure
Corporate Finance - Effects of Debt on the Capital Structure

Using Greater Amounts of Debt
Recall that the main benefit of increased debt is the increased benefit from the interest expense as
it reduces taxable income. Wouldn't it thus make sense to maximize your debt load? The answer
is no.

With an increased debt load the following occurs:
Interest expense rises and cash flow needs to cover the interest expense also rise.
Debt issuers become nervous that the company will not be able to cover its financial
responsibilities with respect to the debt they are issuing.

Stockholders become also nervous. First, if interest increases, EPS decreases, and a lower stock
price is valued. Additionally, if a company, in the worst case, goes bankrupt, the stockholders are
the last to be paid retribution, if at all.

In our previous examples, EPS increased with every increase in our debt-to-equity ratio.
However, in our prior discussions, an optimal capital structure is some combination of both
equity and debt that maximizes not only earnings but also stock price. Recall that this is best
implied by the capital structure that minimizes the company's WACC.

Example:
The following is Newco's cost of debt at various capital structures. Newco has a tax rate of 40%.
For this example, assume a risk-free rate of 4% and a market rate of 14%. For simplicity in
determining stock prices, assume Newco pays out all of its earnings as dividends.
Figure 11.15: Newco's cost of debt at various capital structures

At each level of debt, calculate Newco's WACC, assuming the CAPM model is used to calculate
the cost of equity.

Answer:
At debt level 0%:
Cost of equity = 4% + 1.2(14% - 4%) = 16%
Cost of debt = 0% (1-40%) = 0%
WACC = 0%(0%) + 100%(16%) = 16%
Stock price = $18.00/0.16 = $112.50

At debt level 20%:
Cost of equity = 4% + 1.4(14% - 4%) = 18%
Cost of debt = 4%(1-40%) = 2.4%
WACC = 20%(2.4%) + 80%(18%) = 14.88%
Stock price = $22.20/0.1488 = $149.19

At debt level 40%:
Cost of equity = 4% + 1.6(14% - 4%) = 20%
Cost of debt = 6% (1-40%) = 3.6%
WACC = 40%(3.6%) + 60%(20%) = 13.44%
Stock price = $28.80/0.1344 = $214.29

Recall that the minimum WACC is the level where stock price is maximized. As such, our
optimal capital structure is 40% debt and 60% equity. While there is a tax benefit from debt, the
risk to the equity can far outweigh the benefits - as indicated in the example.

Company vs. Stock Valuation
The value of a company's stock is but one part of the company's total value. The value of a
company comprises the total value of the company's capital structure, including debtholders,
preferred-equity holders and common-equity holders. Since both debtholders and preferred-
equity holders have first rights to a company's value, common-equity holders have last rights to a
company value, also known as a "residual value".

Next: Tax and Bankruptcy Costs
Corporate Finance - Tax and Bankruptcy Costs

Tax Effect on the Cost of Capital
With respect to taxes, it is important to keep in mind that interest payments on debt can be
deducted as expenses and thus reduce overall taxes. However, a company cannot report
dividends as an expense, so dividends have no effect on the taxes of a company. This is
important for a company to keep in mind when determining and making changes to its capital
structure.

Bankruptcy Effect on the Cost of Capital
Bankruptcy costs can also significantly affect a company's cost of capital. When a company
invests in debt, the company is required to service the debt by making required interest
payments. Interest payments alter a company's earnings as well as cash flow. For each company
there is an optimal capital structure, including a percentage of debt and equity, a balance between
the tax benefits of the debt and the equity. As a company continues to increase its debt over the
amount stated by the optimal capital structure, the cost to finance the debt becomes higher as the
debt is now riskier to the lender. The risk of bankruptcy increases with the increased debt load.
Since the cost of debt becomes higher, the WACC is thus affected. With the addition of debt, the
WACC will at first fall as the benefits are realized, but once the optimal capital structure is
reached and then surpassed, the increased debt load will then cause the WACC to increase
significantly.

Next: The MM Capital Structure vs. The Tradeoff Theory of Leverage
Corporate Finance - The MM Capital Structure vs. The
Tradeoff Theory of Leverage

Modigliani and Miller's Capital-Structure Irrelevance Proposition
Modigliani and Miller, two professors in the 1950s, studied capital-structure theory intensely.
From their analysis, they developed the capital-structure irrelevance proposition. Essentially,
they hypothesized that in perfect markets, it does not matter what capital structure a company
uses to finance its operations.

The MM study is based on the following key assumptions:
No taxes
No transaction costs
No bankruptcy costs
Equivalence in borrowing costs for both companies and investors
Symmetry of market information, meaning companies and investors have the same
information
No effect of debt on a company's earnings before interest and taxes

Look Out
The MM capital-structure irrelevance proposition
assumes:
(1) no taxes and, (2) no bankruptcy costs.

In this simplified view, it can be seen that without taxes and bankruptcy costs, the WACC should
remain constant with changes in the company's capital structure. For example, no matter how the
firm borrows, there will be no tax benefit from interest payments and thus no changes/benefits to
the WACC. Additionally, since there are no changes/benefits from increases in debt, the capital
structure does not influence a company's stock price, and the capital structure is therefore
irrelevant to a company's stock price.

However, as we have stated, taxes and bankruptcy costs do significantly affect a company's stock
price. In additional papers, Modigliani and Miller included both the effect of taxes and
bankruptcy costs.

The MM Capital-Structure Irrelevance Proposition
The MM capital-structure irrelevance proposition assumes no taxes and no bankruptcy costs. As
a result, MM states that the capital structure is irrelevant and has no impact on a company's stock
price.
The Tradeoff Theory of Leverage
The tradeoff theory assumes that there are benefits to leverage within a capital structure up until
the optimal capital structure is reached. The theory recognizes the tax benefit from interest
payments. Studies suggest, however, that most companies have less leverage than this theory
would suggest is optimal.

In comparing the two theories, the main difference between them is the potential benefit from
debt in a capital structure. This benefit comes from tax benefit of the interest payments. Since the
MM capital-structure irrelevance theory assumes no taxes, this benefit is not recognized, unlike
the trade-off theory of leverage, where taxes and thus the tax benefit of interest payments are
recognized.

Next: Signaling Prospects Through Financing Decisions
Corporate Finance - Signaling Prospects Through Financing
Decisions

One of the key assumptions Modigliani and Miller make in their work is that market information is
symmetric, meaning companies and investors have the same information with respect to the
company's future projects/investments. This assumption, however, is not realistic. When making capital
decisions, a company's management should have more information than an investor, which implies
asymmetric information.

A financing decision is a way in which a company can inadvertently signal its prospects to investors .
For example, suppose Newco decides to finance a new project with equity. Newco's additional equity
would in fact dilute stockholder value. Since companies typically try to maximize stockholder value,
would an equity offering be a bad signal? The answer is yes.
There would be some benefit from the project to the stockholders; however, the dilution from the
offering would offset some of that benefit. If a company's prospects are good, management will finance
new projects with other means, such as debt, to avoid giving any negative signals to the market .
Look Out!
Financing a capital project with equity may be a signal to
investors that a company's prospects are not good.

Next: Degree of Total Leverage
Corporate Finance - Degree of Total Leverage
By combining the degree of operating leverage with the degree of financial leverage we obtain the
degree of total leverage (DTL). If a firm has a high amount of operating leverage and financial leverage, a
small change in sales will lead to a large variability in EPS.

Formula 11.20
DTL = Q(P - V)
Q(P - V) - F - I
Example: degree of total leverage
Using our previous example, say Newco produces 140,000 units annually. The company's variable costs
are $20 per unit, and its fixed costs total $2.4 million. The company's annual interest expense amounts
to $100,000 annually. If Newco's sales increase by 20%, what is the impact to the company's EPS?
Answer:
DTL = 140,000(50-20)/140,000(50-20)-2,400,000 - $100,000 = 2.47

If Newco's sales increase by 20%, the company's EPS will increase by 49.4% (20%)(2.47).

Next: Dividend Theories
Corporate Finance - Dividend Theories

Dividend Irrelevance Theory
Much like their work on the capital-structure irrelevance proposition, Modigliani and Miller also
theorized that, with no taxes or bankruptcy costs, dividend policy is also irrelevant. This is
known as the "dividend-irrelevance theory", indicating that there is no effect from dividends on a
company's capital structure or stock price.

MM's dividend-irrelevance theory says that investors can affect their return on a stock regardless
of the stock's dividend. For example, suppose, from an investor's perspective, that a company's
dividend is too big. That investor could then buy more stock with the dividend that is over the
investor's expectations. Likewise, if, from an investor's perspective, a company's dividend is too
small, an investor could sell some of the company's stock to replicate the cash flow he or she
expected. As such, the dividend is irrelevant to investors, meaning investors care little about a
company's dividend policy since they can simulate their own.

Bird-in-the-Hand Theory
The bird-in-the-hand theory, however, states that dividends are relevant. Remember that total
return (k) is equal to dividend yield plus capital gains. Myron Gordon and John Lintner
(Gordon/Litner) took this equation and assumed that k would decrease as a company's payout
increased. As such, as a company increases its payout ratio, investors become concerned that the
company's future capital gains will dissipate since the retained earnings that the company
reinvests into the business will be less.

Gordon and Lintner argued that investors value dividends more than capital gains when making
decisions related to stocks. The bird-in-the-hand may sound familiar as it is taken from an old
saying: "a bird in the hand is worth two in the bush." In this theory "the bird in the hand' is
referring to dividends and "the bush" is referring to capital gains.

Tax-Preference Theory
Taxes are important considerations for investors. Remember capital gains are taxed at a lower
rate than dividends. As such, investors may prefer capital gains to dividends. This is known as
the "tax Preference theory".

Additionally, capital gains are not paid until an investment is actually sold. Investors can control
when capital gains are realized, but, they can't control dividend payments, over which the related
company has control.
Capital gains are also not realized in an estate situation. For example, suppose an investor
purchased a stock in a company 50 years ago. The investor held the stock until his or her death,
when it is passed on to an heir. That heir does not have to pay taxes on that stock's appreciation.

The Dividend-Irrelevance Theory and Company Valuation
In the determination of the value of a company, dividends are often used. However, MM's
dividend-irrelevance theory indicates that there is no effect from dividends on a company's
capital structure or stock price.

MM's dividend-irrelevance theory says that investors can affect their return on a stock regardless
of the stock's dividend.

For example, suppose, from an investor's perspective, that a company's dividend is too big. That
investor could then buy more stock with the dividend that is over his or her expectations.
Likewise, if, from an investor's perspective, a company's dividend is too small, an investor could
sell some of the company's stock to replicate the cash flow he or she expected. As such, the
dividend is irrelevant to investors, meaning investors care little about a company's dividend
policy since they can simulate their own.

The Principal Conclusion for Dividend Policy

The dividend-irrelevance theory, recall, with no taxes or bankruptcy costs, assumes that a
company's dividend policy is irrelevant. The dividend-irrelevance theory indicates that there is
no effect from dividends on a company's capital structure or stock price.

MM's dividend-irrelevance theory assumes that investors can affect their return on a stock
regardless of the stock's dividend. As such, the dividend is irrelevant to an investor, meaning
investors care little about a company's dividend policy when making their purchasing decision
since they can simulate their own dividend policy.

How Any Shareholder Can Construct His or Her Own Dividend Policy.
Recall that the MM's dividend-irrelevance theory says that investors can affect their return on a
stock regardless of the stock's dividend. As a result, a stockholder can construct his or her own
dividend policy.
Suppose, from an investor's perspective, that a company's dividend is too big. That
investor could then buy more stock with the dividend that is over the investor's
expectations.
Likewise, if, from an investor's perspective, a company's dividend is too small, an
investor can sell some of the company's stock to replicate the cash flow the investor
expected.

As such, the dividend is irrelevant to an investor, meaning investors care little about a company's
dividend policy since they can simulate their own.

Next: Dividend Growth Rate and the Effect of Changing Dividend Policy
Corporate Finance - Dividend Growth Rate and the Effect of
Changing Dividend Policy

Calculating a Company's Implied Dividend Growth Rate
Recall that a company's ROE is equal to a company's earnings growth rate (g) divided by one minus a
company's payout rate (p).

Formula 11.21

ROE = g
(1-p)

g = ROE * (1-p)

Example:
Let's assume Newco's ROE is 10% and the company pays out roughly 20% of its earnings in the form of a
dividend. What is Newco's expected growth rate in earnings?

Answer:
g = ROE*(1 - p)
g = (10%)*(1 - 20%)
g = (10%)*(0.8)
g = 8%

Given an ROE of 10% and a dividend payout of 20%, Newco's expected growth rate in earnings is 8%.

Signaling An Earning's Forecast Through Changes in Dividend Policy
Much like a company can signal the state of its operations through its use of capital-financing projects,
management can also signal its company's earnings forecast through changes in its dividend policy.

Dividends are paid out when a company satisfies its internal needs for cash. If a company cuts its
dividends, stockholders may become worried that the company is not generating enough earnings to
satisfy its internal needs for cash as well as pay out its current dividend. A stock may decline in this
instance.

Suppose for example Newco decides to cuts its dividend to $0.25 per share from its initial value of $0.50
per share. How would this be perceived by investors?
Most likely the cut in dividend by Newco would be perceived negatively by investors. Investors would
assume that the company is beginning to go through some tough times and the company is trying to
preserve cash. This would indicate that the business may be slowing or earnings are not growing at the
rate it once had.

To learn more about dividends, read: The Importance of Dividends

The Clientele Effect.
A company's change in dividend policy may impact in the company's stock price given changes in the
"clientele" interested in owning the company's stock. Depending on their personal tax situation, some
stockholders may prefer capital gains over dividends and vice versa as capital gains are taxed at a lower
rate than dividends. The clientele effect is simply different stockholders' preference on receiving
dividends compared to capital gains.

For example, a stockholder in a high tax bracket may favor stocks with low dividend payouts compared
to a stockholder in a low tax-bracket who may favor stocks with higher dividend payouts.

Next: Setting Dividends
Corporate Finance - Setting Dividends
The residual-dividend model is a model that a company can utilize to set a target dividend
payout ratio.

The residual-dividend model is based on three key pieces:
1. An investment opportunity schedule (IOS),
2. Target capital structure
3. Cost of external capital
Look Out!
Stockholders' preferences for dividends do not affect
the residual-dividend model.

Procedure for the Residual-Dividend Model

1. The first step in the residual dividend model to set a target dividend payout ratio to determine
the optimal capital budget.

2. Then, management must determine the equity amount needed to finance the optimal capital
budget. This should be done primarily through retained earnings.

3. The dividends then are paid out with the leftover, or residual, earnings. Given the use of
residual earnings, the model is known as the "residual-dividend model".

As an example, Newco generates sales of $7 million with earnings of $2 million. The company's
optimal capital structure is 50% equity/50% debt. With $2 million in earnings, Newco reinvests
the entire amount back into the company. In this case, Newco would have to borrow $2 million
to maintain its optimal capital structure.

If Newco, however, needed to reinvest only half of the $2 million back into the company, Newco
would then have $1 million in residual earnings to pay dividends. Given the reduced
reinvestment, the company would thus have to borrow only $1 million to maintain its optimal
capital structure.
Advantage of the Residual-Dividend Model
With capital-projects budgeting, the residual-dividend model is useful in setting longer-
term dividend policy.
Disadvantage of the Residual Dividend Model
Dividends may be unstable. Earnings from year to year can vary depending on business
situations. As such, it is difficult to maintain with certainty stable earnings and thus a
stable dividend.

While the residual-dividend model is useful for longer-term planning, many firms do not use the
model in calculating dividends each quarter.

Next: Dividend Payment Procedures
Corporate Finance - Dividend Payment Procedures
Dividend payouts follow a set procedure as follows:

Declaration date
Ex-dividend date
Holder-of-record date
Payment date

1. Declaration Date

Declaration date is the announcement that the company's board of directors approved the
payment of the dividend.

2. Ex-Dividend Date
The ex-dividend date is the date on which investors are cut off from receiving a dividend. If for
example, an investor purchases a stock on the ex-dividend date, that investor will not receive the
dividend. This date is two business days before the holder-of-record date.

The ex-dividend date is important as, from this date and forward, new stockholders will not
receive the dividend. As a result, the stock price of the company will be reflective of this. For
example, on and after the ex-dividend date, a stock most likely trades at lower price, as the stock
price is adjusted for the dividend that the new holder will not receive.

3. Holder-of-Record Date
The holder-of-record (owner-of-record) date is the date on which the stockholders who are to
receive the dividend are recognized.
Look Out!
Remember that stock transactions typically settle in
three business days.

Understanding the dates of the dividend payout process can be tricky. We clear up the confusion
in the following article:

4. Payment Date
Last is the payment date, the date on which the actual dividend is paid out to the stockholders of
record.
Example of the process of dividend payment
Suppose Newco would like to pay a dividend to its shareholders. The company would proceed as
follows:

1.On Jan 28, the company declares it will pay its regular dividend of $0.30 per share to holders
of record on Feb 27, with payment on Mar 17.
2.The ex-dividend date for the dividend is Feb 23 (usually four days before of the holder-of-
record date). On Feb 23 new buyers do not have a right to the dividend.
3.At the close of business on Feb 27, all holders of Newco's stock are recorded, and those
holders will receive the dividend.
4.On Mar 17, the payment date, Newco mails the dividend checks to the holders of record.

Next: Stock Dividends and Repurchases
Corporate Finance - Stock Dividends and Repurchases

Like cash dividends, stock dividends and stock splits also have effects on a company's stock price. Stock
splits occur when a company perceives that its stock price may be too high. Companies tend to want to
keep their stock price within an optimal trading range.

While stock prices will most likely rise after a split or dividend (remember price increases are caused by
positive signals a company generates with respect to future earnings), if positive news does not follow,
the company's stock price will generally fall back to its original level.

There is an argument that stock splits and stock dividends are unnecessary and do little more than
create more stocks.

Stock Split
In a stock split, a company will divide each share of its existing stock into multiple shares to bring down
the company's stock price.

Example:
Suppose Newco's stock reaches $60 per share. The company's management believes this is too high and
that some investors may not invest in the company as a result of the initial price required to buy the
stock. As such, the company decides to split the stock to make the entry point of the shares more
accessible.

For simplicity, suppose Newco initiates a 2-for-1 stock split. For each share they own, all holders of
Newco stock therefore receive two Newco shares priced at $30, and the company's shares outstanding
double. Keep in mind that the company's overall equity value remains the same. Say there are 1 million
shares outstanding and the company's initial equity value is $60 million ($60 per share x 1 million shares
outstanding). The equity value after the split is still $60 million ($30 per share x 2 million shares
outstanding).

To learn more about stock splits, read: Understanding Stock Splits

Stock Dividends
Stock dividends are similar to cash dividends; however, instead of cash, a company pays out stock. As a
result, a company's shares outstanding will increase, and the company's stock price will decrease. For
example, suppose Newco decides to issue a 10% stock dividend. Each current stockholder will thus have
10% more shares after the dividend is issued.

Stock Repurchase
A stock repurchase occurs when a company asks stockholders to tender their shares for repurchase by
the company. This is an alternate way for a company to increase value for stockholders. First, a
repurchase can be used to restructure the company's capital structure without increasing the company's
debt load. Additionally, rather than a company changing its dividend policy, it can offer value to its
stockholders through stock repurchases, keeping in mind that capital gains taxes are lower than taxes on
dividends.
Advantages of a Stock Repurchase
Many companies initiate a share repurchase at a price level that management deems a good
entry point. This point tends to be when the stock is estimated to be undervalued. If a company
knows its business and relative stock price well, would it purchase its stock price at a high level?
The answer is no, leading investors to believe the management perceives its stock price to be at
a low level.
Unlike a cash dividend, a stock repurchase gives the decision to the investor. A stockholder can
choose to tender his shares for repurchase, accept the payment and pay the taxes. With a cash
dividend, a stockholder has no choice but to accept the dividend and pay the taxes.
At times, there may be a block of shares from one or more large shareholders that could come
into the market, but the timing may be unknown. This problem may actually keep potential
stockholders away since they may be worried about a flood of shares coming onto the market
and lessening the stock's value. A stock repurchase can be quite useful in this situation.
Disadvantage of a Stock Repurchase
From the perspective of an investor, a cash dividend is dependable, usually quarterly. A stock
repurchase, however, is not. For some investors, the dependability of the dividend may be more
important. As such, investors may invest more heavily in a stock with a dependable dividend
than in a stock with less dependable repurchases.
A company may be in a position where it ends up paying too much for the stock it repurchases.
For example, say a company repurchases its shares for $30 per share on June 1. On June 10, a
major hurricane damages the company's primary operations. The company's stock therefore
drops down to $20. Thus, the $10-per-share difference is a lost opportunity to the company.
Overall, stockholders who offer their shares for repurchase may be at a disadvantage if they are
not fully aware of all the details. As such, an investor may file a lawsuit with the company, which
is seen as a risk.
Price Effect of a Stock Repurchase
A stock repurchase typically has the effect of increasing the price of a stock.

Example: Newco has 20,000 shares outstanding and a net income of $100,000. The current stock price is
$40. What effect does a 5% stock repurchase have on the price per share of Newco's stock?

Answer: To keep it simple, price-per-earnings ratio (P/E) is the valuation metric used to value Newco's
price per share.

Newco's current EPS = $100,000/20,000 = $5 per share
P/E ratio = $40/$5 = 8x

With a 2% stock repurchase, the following occurs:
Newco's shares outstanding are reduced to 19,000 shares (20,000 x (1-.05))
Newco's EPS = $100,000/19,000 = $5.26

Given that Newco's shares trade on 8 times earnings, Newco's new share price would be $42, an
increase from the $40 per share before the repurchase.

Next: Introduction

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