School of Business

BCO222

Business Finance II

A Student Handbook First Edition

© 2011 Pine Academy Group, International

This book is a compilation of the various sources as stated in References
and is restricted for use by students of Institut Prima Bestari ONLY.
 PREFACE

This course examines the management of a diverse workforce and the benefits
of creating this diversity. Topics include understanding human behavior in an
organization, changing marketplace realities, employment systems, affirmative
action, behavior modification for employees and other topics related to a
multicultural workforce.

Upon completion of the course, students will be familiar with:

1. The basic knowledge of financial management, the concepts and skills of

financial planning within a business.

2. The usage of financial statement and the scheme of appropriate action.

3. The practical knowledge with regard to the use of financial management

information
Table of Contents

1.0 The Role and Environment of Managerial Finance .................................... 2

1.0.1 Learning Goals ................................................................................ 2
1.1 What is Finance? .................................................................................... 2
1.2 The Managerial Finance Function .......................................................... 6
1.3 Goal of the Firm ...................................................................................... 8
1.3.1 Maximize Profit??? .......................................................................... 8
1.3.2 Maximize Shareholder Wealth!!! ...................................................... 8
1.3.3 What About Other Stakeholders? .................................................... 9
1.4 The Role of Ethics ................................................................................ 11
1.4.1 Ethics Defined ............................................................................... 11
1.4.2 Considering Ethics......................................................................... 11
1.4.3 Ethics & Share Price...................................................................... 12
1.5 The Agency Issue ................................................................................. 13
1.5.1 The Agency Problem ..................................................................... 13
1.5.2 Resolving the Problem .................................................................. 13
1.6 Financial Institutions & Markets ............................................................ 14
1.6.1 Financial Institutions ...................................................................... 14
1.6.2 Financial Markets .......................................................................... 14
1.7 The Money Market ................................................................................ 16
1.8 The Capital Market ............................................................................... 17
1.9 Broker Markets and Dealer Markets ..................................................... 18
1.10 International Capital Markets ................................................................ 19
1.11 Business Taxes .................................................................................... 20
1.11.1 Ordinary Income ............................................................................ 20
1.11.2 Average & Marginal Tax Rates ...................................................... 21
1.11.3 Tax on Interest & Dividend Income................................................ 21
1.11.4 (Tax Deductibility): Debt versus Equity Financing ......................... 22
1.11.5 Capital Gains ................................................................................. 23
2.0 Cash Flow and Financial Planning ........................................................... 25
2.0.1 Learning Goals .............................................................................. 25
2.1 Analyzing the Firm’s Cash Flows .......................................................... 25
2.1.1 Depreciation .................................................................................. 26
2.2 Developing the Statement of Cash Flows ............................................. 27
2.2.1 Classifying Inflows and Outflows of Cash ...................................... 28
2.2.2 Interpreting Statement of Cash Flows ........................................... 30
2.3 Operating Cash Flow ............................................................................ 31
2.4 Free Cash Flow .................................................................................... 32
2.5 The Financial Planning Process ........................................................... 33
2.5.1 Long-Term (Strategic) Financial Plans .......................................... 33
2.5.2 Short-Term (Operating) Financial Plans ........................................ 34
2.6 Cash Planning ...................................................................................... 36
2.6.1 Cash Budgets ................................................................................ 36
2.6.2 Cash Budgets An Example: Coulson Industries ............................ 37
2.7 Evaluating the Cash Budget ................................................................. 41
 2.7.1 Coping with Uncertainty in the Cash Budget ................................. 41
2.8 Profit Planning ...................................................................................... 43
2.8.1 Pro Forma Statements .................................................................. 43
2.8.2 Weaknesses of Simplified Approaches ......................................... 49
3.0 Risk and Return ....................................................................................... 51
3.0.1 Learning Goals .............................................................................. 51
3.1 Risk and Return Fundamentals ............................................................ 51
3.1.1 Risk Defined .................................................................................. 52
3.1.2 Return Defined .............................................................................. 53
3.1.3 Historical Returns .......................................................................... 54
3.2 Risk of a Single Asset ........................................................................... 55
3.2.1 Discrete Probability Distributions ................................................... 55
3.2.2 Continuous Probability Distributions .............................................. 56
3.3 Return Measurement for a Single Asset ............................................... 57
3.3.1 Expected Return ............................................................................ 57
3.3.2 Standard Deviation ........................................................................ 58
3.3.3 Coefficient of Variation .................................................................. 60
3.4 Portfolio Risk and Return ...................................................................... 61
3.4.1 Portfolio Return.............................................................................. 61
3.4.2 Expected Return and Standard Deviation ..................................... 62
3.4.3 Risk of a Portfolio .......................................................................... 64
3.4.4 Adding Assets to a Portfolio .......................................................... 67
3.4.5 The Capital Asset Pricing Model (CAPM) ...................................... 68
3.4.6 Some Comments on the CAPM..................................................... 74
4.0 Interest Rate & Bond Valuation ................................................................ 77
4.0.1 Learning Goals .............................................................................. 77
4.1 Interest Rates & Required Returns ....................................................... 77
4.1.1 Interest Rate Fundamentals .......................................................... 77
4.1.2 The Real Rate of Interest .............................................................. 78
4.1.3 Inflation and the Cost of Money ..................................................... 79
4.1.4 Nominal or Actual Rate of Interest (Return) ................................... 79
4.2 Term Structure of Interest Rates .......................................................... 81
4.3 Theories of Term Structure ................................................................... 82
4.3.1 Expectations Theory ...................................................................... 82
4.3.2 Liquidity Preference Theory ........................................................... 82
4.3.3 Market Segmentation Theory ........................................................ 82
4.4 Risk Premiums ..................................................................................... 83
4.4.1 Issue and Issuer Characteristics.................................................... 83
4.5 Corporate Bonds .................................................................................. 85
4.5.1 Legal Aspects of Corporate Bonds ................................................ 85
4.5.2 Cost of Bonds to the Issuer ........................................................... 86
4.5.3 General Features........................................................................... 87
4.5.4 Bond Yields ................................................................................... 88
4.5.5 Bond Prices ................................................................................... 88
4.5.6 Bond Ratings ................................................................................. 89
4.5.7 International Bond Issues .............................................................. 91
 4.6 Valuation Fundamentals ....................................................................... 92
4.7 Basic Valuation Model .......................................................................... 93
4.8 Bond Valuation ..................................................................................... 94
4.8.1 Bond Fundamentals ...................................................................... 94
4.8.2 Basic Bond Valuation .................................................................... 94
4.9 Yield to Maturity (YTM) ......................................................................... 99
4.9.1 Semiannual Interest and Bond Values ........................................ 101
4.10 Coupon Effects on Price Volatility....................................................... 103
4.11 Current Yield ....................................................................................... 104
4.12 Summary ............................................................................................ 105
5.0 Stock Valuation ...................................................................................... 107
5.0.1 Learning Goals ............................................................................ 107
5.1 Differences Between Debt & Equity .................................................... 107
5.2 The Nature of Equity Capital............................................................... 108
5.2.1 Voice in Management .................................................................. 108
5.2.2 Claims on Income & Assets ......................................................... 108
5.2.3 Maturity........................................................................................ 108
5.2.4 Tax Treatment ............................................................................. 108
5.3 Common Stock ................................................................................... 109
5.3.1 Ownership ................................................................................... 109
5.3.2 Par Value..................................................................................... 109
5.3.3 Preemptive Rights ....................................................................... 110
5.3.4 Authorized, Outstanding, and Issued Shares .............................. 110
5.3.5 Voting Rights ............................................................................... 111
5.3.6 Dividends ..................................................................................... 111
5.3.7 International Stock Issues ........................................................... 112
5.3.8 Preferred Stock............................................................................ 113
5.3.9 Issuing Common Stock................................................................ 114
5.4 Venture Capital ................................................................................... 115
5.4.1 Organization and Investment Strategies ...................................... 115
5.4.2 Deal Structure and Pricing ........................................................... 116
5.5 Going Public ....................................................................................... 117
5.6 The Investment Banker’s Role............................................................ 120
5.6.1 Cost of Investment Banking Services .......................................... 121
5.7 Common Stock Valuation ................................................................... 122
5.7.1 Market Efficiency ......................................................................... 122
5.7.2 Market Adjustment to New Information........................................ 122
5.7.3 The Efficient Market Hypothesis .................................................. 123
5.7.4 The Behavioral Finance Challenge.............................................. 124
5.8 Stock Valuation Models ...................................................................... 125
5.8.1 The Basic Stock Valuation Equation............................................ 125
5.8.2 The Zero Growth Model............................................................... 125
5.8.3 Constant Growth Model ............................................................... 126
5.8.4 Variable-Growth Model ................................................................ 127
5.8.5 Free Cash Flow Model ................................................................ 130
5.9 Other Approaches to Stock Valuation ................................................. 133
 5.9.1 Book Value .................................................................................. 133
5.9.2 Liquidation Value ......................................................................... 133
5.9.3 Price/Earnings (P/E) Multiples ..................................................... 133
5.10 Decision Making and Common Stock Value ....................................... 134
5.10.1 Changes in Dividends or Dividend Growth .................................. 134
5.10.2 Changes in Risk and Required Return ........................................ 135
6.0 Capital Budgeting Cash Flows ............................................................... 138
6.0.1 Learning Goals ............................................................................ 138
6.1 The Capital Budgeting Decision Process............................................ 138
6.1.1 Steps in the Process.................................................................... 139
6.2 Basic Terminology .............................................................................. 140
6.2.1 Independent versus Mutually Exclusive Projects ......................... 140
6.2.2 Unlimited Funds versus Capital Rationing ................................... 140
6.2.3 Accept-Reject versus Ranking Approaches ................................ 140
6.2.4 Conventional versus Nonconventional Cash Flows ..................... 141
6.3 The Relevant Cash Flows................................................................... 142
6.3.1 Major Cash Flow Components .................................................... 142
6.3.2 Expansion Versus Replacement Decisions ................................. 143
6.3.3 Sunk Costs Versus Opportunity Costs ........................................ 143
6.3.4 International Capital Budgeting ................................................... 144
6.4 Finding the Initial Investment .............................................................. 145
6.5 Finding the Terminal Cash Flow ......................................................... 153
6.6 Summarizing the Relevant Cash Flows .............................................. 154
7.0 Capital Budgeting Techniques ............................................................... 156
7.0.1 Learning Goals ............................................................................ 156
7.0.2 Chapter Problem ......................................................................... 156
7.1 Payback Period .................................................................................. 158
7.1.1 Pros and Cons of Payback Periods ............................................. 158
7.2 Net Present Value (NPV) .................................................................... 160
7.3 Internal Rate of Return (IRR) .............................................................. 162
7.4 Net Present Value Profiles.................................................................. 164
7.5 Conflicting Rankings ........................................................................... 165
7.6 Which Approach is Better? ................................................................. 168
8.0 Risk and Refinements in Capital Budgeting ........................................... 170
8.0.1 Learning Goals ............................................................................ 170
8.0.2 Introduction to Risk in Capital Budgeting ..................................... 170
8.1 Behavioral Approaches for Dealing with Risk ..................................... 172
8.1.1 Risk and Cash Inflows ................................................................. 172
8.1.2 Sensitivity Analysis ...................................................................... 173
8.1.3 Scenario Analysis ........................................................................ 174
8.1.4 Simulation .................................................................................... 174
8.2 International Risk Considerations ....................................................... 175
8.3 Risk-Adjusted Discount Rates ............................................................ 176
8.3.1 Review of CAPM ......................................................................... 176
8.3.2 Using CAPM to Find RADRs ....................................................... 177
8.3.3 Applying RADRs .......................................................................... 177
 8.3.4 RADRs in Practice ....................................................................... 180
8.4 Risk-Adjustment Techniques .............................................................. 181
8.4.1 Portfolio Effects ........................................................................... 181
8.5 Capital Budgeting Refinements .......................................................... 182
8.5.1 Comparing Projects With Unequal Lives ..................................... 182
8.6 Recognizing Real Options .................................................................. 187
8.7 Capital Rationing ................................................................................ 189
8.7.1 IRR Approach .............................................................................. 190
8.7.2 NPV Approach............................................................................. 190
9.0 The Cost of Capital ................................................................................ 192
9.0.1 Learning Goals ............................................................................ 192
9.1 An Overview of the Cost of Capital ..................................................... 192
9.1.1 The Firm’s Capital Structure ........................................................ 193
9.1.2 Some Key Assumptions .............................................................. 193
9.1.3 The Basic Concept ...................................................................... 194
9.2 Specific Sources of Capital ................................................................. 196
9.2.1 The Cost of Long-Term Debt ....................................................... 196
9.2.2 The Cost of Preferred Stock ........................................................ 199
9.2.3 The Cost of Common Stock ........................................................ 200
9.3 The Weighted Average Cost of Capital............................................... 203
9.4 The Marginal Cost & Investment Decisions ........................................ 206
10.0 Leverage and Capital Structure .............................................................. 215
10.0.1 Learning Goals ............................................................................ 215
10.1 Leverage............................................................................................. 215
10.2 Breakeven Analysis ............................................................................ 217
10.2.1 Algebraic Approach ..................................................................... 217
10.2.2 Graphical Approach ..................................................................... 219
10.2.3 Changing Costs and the Operating Breakeven Point .................. 220
10.3 Operating Leverage ............................................................................ 221
10.3.1 Measuring the Degree of Operating Leverage ............................ 222
10.3.2 Fixed Costs and Operating Leverage .......................................... 223
10.4 Financial Leverage ............................................................................. 224
10.4.1 Measuring the Degree of Financial Leverage .............................. 225
10.5 Total Leverage.................................................................................... 226
10.5.1 Measuring the Degree of Total Leverage .................................... 226
10.5.2 The Relationship of Operating, Financial and Total Leverage ..... 227
10.6 The Firm’s Capital Structure ............................................................... 229
10.6.1 Types of Capital........................................................................... 229
10.6.2 External Assessment of Capital Structure ................................... 230
10.6.3 Capital Structure of Non-U.S. Firms ............................................ 230
10.7 Capital Structure Theory ..................................................................... 232
10.7.1 Tax Benefits ................................................................................ 232
10.7.2 Probability of Bankruptcy ............................................................. 233
10.7.3 Agency Costs Imposed by Lenders ............................................. 239
10.7.4 Asymmetric Information ............................................................... 240
10.8 The Optimal Capital Structure ............................................................ 241
 10.9 EPS-EBIT Approach to Capital Structure ........................................... 242
10.9.1 Basic Shortcoming of EPS-EBIT Analysis ................................... 243
10.10 Choosing the Optimal Capital Structure .......................................... 244
11.0 Dividend Policy....................................................................................... 250
11.0.1 Learning Goals ............................................................................ 250
11.1 Dividend Fundamentals ...................................................................... 250
11.1.1 Cash Dividend Payment Procedures ........................................... 251
11.1.2 Tax Treatment of Dividends ........................................................ 254
11.2 Dividend Reinvestment Plans ............................................................. 255
11.3 The Relevance of Dividend Policy ...................................................... 256
11.3.1 The Residual Theory of Dividends............................................... 256
11.3.2 Arguments for Dividend Irrelevance ............................................ 258
11.4 Factors Affecting Dividend Policy ....................................................... 260
11.4.1 Legal Constraints......................................................................... 260
11.4.2 Contractual Constraints ............................................................... 260
11.4.3 Internal Constraints ..................................................................... 261
11.4.4 Growth Prospects ........................................................................ 261
11.4.5 Owner Considerations ................................................................. 261
11.4.6 Market Considerations ................................................................. 262
11.5 Types of Dividend Policies .................................................................. 263
11.5.1 Constant-Payout-Ratio Policy ...................................................... 263
11.5.2 Regular Dividend Policy .............................................................. 264
11.5.3 Low-Regular-and-Extra Dividend Policy ...................................... 265
11.6 Other Forms of Dividends ................................................................... 266
11.6.1 Stock Dividends ........................................................................... 266
11.6.2 Stock Splits .................................................................................. 268
11.6.3 Stock Repurchases ..................................................................... 269
11.6.4 Stock Repurchases Viewed as a Cash Dividend ......................... 269
Tutorials and Assignments ................................................................................ 270
Tutorial - Cash Flow and Financial Planning ................................................. 270
Warm-up Exercises ................................................................................... 270
Problems.................................................................................................... 271
Tutorial - Risk & Return ................................................................................. 276
Warm-up Exercise ..................................................................................... 276
Problem ..................................................................................................... 278
Tutorial - Interest Rate and Bond Valuation .................................................. 282
Tutorial - Capital Budgeting ........................................................................... 286
Tutorial - Capital Budgeting NPV................................................................... 291
Tutorial - Cost of Capital................................................................................ 300
References ....................................................................................................... 305
Course Syllabus ................................................................................................ 306
Past Examinations ............................................................................................ 311
Semester 1, 2010 Final Examination ............................................................. 311
List of Figures

Figure 1-1: Corporate Organization ...................................................................................................... 4

Figure 1-2: Financial Activities .............................................................................................................. 7
Figure 1-3: Share Price Maximization .................................................................................................. 9
Figure 1-4: Flow of funds..................................................................................................................... 15
Figure 1-5: Supply and Demand......................................................................................................... 19
Figure 2-1: Cash Flows ....................................................................................................................... 27
Figure 2-2: Short-Term Financial Planning ........................................................................................ 34
Figure 3-1: Risk Preferences .............................................................................................................. 54
Figure 3-2: Bar Charts ......................................................................................................................... 55
Figure 3-3: Continuous Probability Distributions ............................................................................... 56
Figure 3-4: Bell-Shaped Curve ........................................................................................................... 60
Figure 3-5: Correlations....................................................................................................................... 64
Figure 3-6: Diversification.................................................................................................................... 64
Figure 3-7: Possible Correlations ....................................................................................................... 66
Figure 3-8: Risk Reduction.................................................................................................................. 66
Figure 3-9: Beta Derivation a .............................................................................................................. 69
Figure 3-10: Security Market Line ...................................................................................................... 72
Figure 3-11: Inflation Shifts SML ........................................................................................................ 73
Figure 3-12: Risk Aversion Shifts SML .............................................................................................. 73
Figure 4-1: Supply–Demand Relationship ......................................................................................... 78
Figure 4-2: Impact of Inflation ............................................................................................................. 80
Figure 4-3: Treasury Yield Curves...................................................................................................... 81
Figure 4-4: Bond Values and Required Returns................................................................................ 98
Figure 4-5: Time to Maturity and Bond Values .................................................................................. 98
Figure 5-1: Cover of a Preliminary Prospectus for a Stock Issue ..................................................118
Figure 5-2: The Selling Process for a Large Security Issue ...........................................................120
Figure 5-3: Stock Quotations ............................................................................................................ 121
Figure 5-4: Decision Making and Stock Value.................................................................................134
Figure 6-1: Conventional Cash Flow ................................................................................................141
Figure 6-2: Nonconventional Cash Flow ..........................................................................................141
Figure 6-3: Cash Flow Components................................................................................................. 142
Figure 6-4: Relevant Cash Flows for Replacement Decisions .......................................................143
Figure 6-5: Taxable Income from Sale of Asset .............................................................................. 147
Figure 7-1: Bennett Company’s Projects A and B ........................................................................... 157
Figure 7-2: Calculation of NPVs for Bennett Company’s Capital Expenditure Alternatives ......... 161
Figure 7-3: Calculation of IRRs for Bennett Company’s Capital Expenditure Alternatives .......... 163
Figure 7-4: NPV Profiles....................................................................................................................164
Figure 8-1: NPV Simulation...............................................................................................................174
Figure 8-2: CAPM and SML .............................................................................................................. 177
Figure 8-3: Calculation of NPVs for Bennett Company’s Capital Expenditure Alternatives Using
RADRs ................................................................................................................................................178
Figure 8-4: Investment Opportunities Schedule .............................................................................. 190
Figure 9-1: WMCC Schedule ............................................................................................................ 212
Figure 10-1: Breakeven Analysis ...................................................................................................... 219
Figure 10-2: Operating Leverage...................................................................................................... 221
Figure 10-3: Probability Distributions ...............................................................................................238
Figure 10-4: Expected EPS and Coefficient of Variation of EPS ...................................................239
Figure 10-5: Cost Functions and Value............................................................................................242
Figure 10-6: EBIT–EPS Approach.................................................................................................... 243
Figure 10-7: Estimating Value........................................................................................................... 247
Figure 11-1: Dividend Payment Time Line......................................................................................253
Figure 11-2: WMCC and IOSs .......................................................................................................... 257
List of Tables

Table 1-1: Strengths and Weaknesses of the Common Legal Forms of Business Organization .... 3
Table 1-2: Other Limited Liability Organizations.................................................................................. 5
Table 1-3: Career Opportunities in Managerial Finance ..................................................................... 5
Table 1-4: Corporate Tax Rate Schedule .......................................................................................... 20
Table 2-1: Inflows and Outflows of Cash ........................................................................................... 28
Table 2-2: Baker Corporation Income Statement ($000) for the Year Ended December 31, 2009
.............................................................................................................................................................. 28
Table 2-3: Baker Corporation Balance Sheets ($000) ...................................................................... 29
Table 2-4: Baker Corporation Statement of Cash Flows ($000) for the Year Ended December 31,
2009 ...................................................................................................................................................... 30
Table 2-5: The General Format of the Cash Budget ......................................................................... 36
Table 2-6: A Schedule of Projected Cash Receipts for Coulson Industries ($000) ........................ 37
Table 2-7: A Schedule of Projected Cash Disbursements for Coulson Industries ($000).............. 38
Table 2-8: A Cash Budget for Coulson Industries ($000) ................................................................. 39
Table 2-9: A Cash Budget for Coulson Industries ($000) ................................................................. 40
Table 2-10: A Scenario Analysis of Coulson Industries’ Cash Budget ($000) ................................ 42
Table 2-11: Vectra Manufacturing’s Income Statement for the Year Ended December 31, 2009. 43
Table 2-12: Vectra Manufacturing’s Balance Sheet, December 31, 2009 ...................................... 44
Table 2-13: 2010 Sales Forecast for Vectra Manufacturing ............................................................. 44
Table 2-14: A Pro Forma Income Statement, Using the Percent-of-Sales Method, for Vectra
Manufacturing for the Year Ended December 31, 2010 ................................................................... 45
Table 2-15: A Pro Forma Balance Sheet, Using the Judgmental Approach, for Vectra
Manufacturing (December 31, 2010).................................................................................................. 48
Table 3-1: Popular Sources of Risk Affecting Financial Managers and Shareholders ................... 52
Table 3-2: Historical Returns for Selected Security Investments (1926–2006) .............................. 54
Table 3-3: Assets A and B .................................................................................................................. 55
Table 3-4: Expected Values of Returns for Assets A and B ............................................................. 57
Table 3-5: The Calculation of the Standard Deviation of the Returns for Assets A and B ............. 59
Table 3-6: Historical Returns, Standard Deviations, and Coefficients of Variation for Selected
Security Investments (1926–2006) ..................................................................................................... 59
Table 3-7: Expected Return, Expected Value, and Standard Deviation of Returns for Portfolio XY
.............................................................................................................................................................. 63
Table 3-8: Forecasted Returns, Expected Values, and Standard Deviations for Assets X, Y, and Z
and Portfolios XY and XZ .................................................................................................................... 65
Table 3-9: Correlation, Return, and Risk for Various Two-Asset Portfolio Combinations .............. 65
Table 3-10: Selected Beta Coefficients and Their Interpretations ................................................... 69
Table 3-11: Beta Coefficients for Selected Stocks (July 10, 2007) .................................................. 70
Table 3-12: Mario Austino’s Portfolios V and W ................................................................................ 70
Table 3-13: Summary of Key Definitions and Formulas for Risk and Return.................................. 75
Table 4-1: Debt-Specific Issuer- and Issue-Related Risk Premium Components .......................... 84
Table 4-2: Data on Selected Bonds.................................................................................................... 88
Table 4-3: Moody’s and Standard & Poor’s Bond Ratings a ............................................................ 89
Table 4-4: Characteristics and Priority of Lender’s Claim of Traditional Types of Bonds .............. 90
Table 4-5: Characteristics of Contemporary Types of Bonds ........................................................... 91
Table 4-6: Valuation of Assets by Celia Sargent ............................................................................... 93
Table 4-7: Bond Values for Various Required Returns (Mills Company’s 10% Coupon Interest
Rate, 10-Year Maturity, $1,000 Par, January 1, 2010, Issue Paying Annual Interest) ................... 96
Table 4-8: Summary of Key Valuation Definitions and Formulas for Any Asset and for Bonds .. 105
Table 5-1: Key Differences between Debt and Equity Capital .......................................................107
Table 5-2: Organization of Institutional Venture Capital Investors .................................................115
Table 5-3: Calculation of Present Value of Warren Industries Dividends (2010–2012) ...............128
Table 5-4: Dewhurst, Inc.’s Data for the Free Cash Flow Valuation Model................................... 131
Table 5-5: Calculation of the Value of the Entire Company for Dewhurst, Inc. .............................132
Table 5-6: Summary of Key Valuation Definitions and Formulas for Common Stock ..................136
Table 6-2: The Basic Format for Determining Initial Investment ....................................................145
Table 6-3: Tax Treatment on Sales of Assets .................................................................................145
Table 6-4: Calculation of Change in Net Working Capital for Danson Company .........................148
Table 6-5: Powell Corporation’s Revenue and Expenses (Excluding Depreciation and Interest) for
Proposed and Present Machines...................................................................................................... 150
Table 6-6: Depreciation Expense for Proposed and Present Machines for Powell Corporation . 150
Table 6-7: Calculation of Operating Cash Inflows Using the Income Statement Format ............. 151
Table 6-9: Incremental (Relevant) Operating Cash Inflows for Powell Corporation .....................152
Table 6-10: The Basic Format for Determining Terminal Cash Flow............................................. 153
Table 7-1: Capital Expenditure Data for Bennett Company ...........................................................156
Table 7-2: Relevant Cash Flows and Payback Periods for DeYarman Enterprises’ Projects ..... 159
Table 7-3: Calculation of the Payback Period for Rashid Company’s Two Alternative Investment
Projects ...............................................................................................................................................159
Table 7-4: Discount Rate–NPV Coordinates for Projects A and B ................................................164
Table 7-5: Reinvestment Rate Comparisons for a Project a ..........................................................165
Table 7-6: Project Cash Flows After Reinvestment ........................................................................ 166
Table 7-7: Preferences Associated with Extreme Discount Rates and Dissimilar Cash Inflow
Patterns .............................................................................................................................................. 167
Table 7-8: Summary of Key Formulas/Definitions and Decision Criteria for Capital Budgeting
Techniques ......................................................................................................................................... 168
Table 8-1: Cash Flows and NPVs for Bennett Company’s Projects .............................................. 171
Table 8-2: Scenario Analysis of Treadwell’s Projects A and B.......................................................173
Table 8-3: Bennett Company’s Risk Classes and RADRs .............................................................180
Table 8-4: Major Types of Real Options ..........................................................................................187
Table 8-5: Rankings for Tate Company Projects ............................................................................ 190
Table 9-1: Summary of Key Definitions and Formulas for Cost of Capital .................................... 210
Table 9-2: Calculation of the Weighted Average Cost of Capital for Duchess Corporation ......... 211
Table 9-3: Weighted Average Cost of Capital for Ranges of Total New Financing for Duchess
Corporation......................................................................................................................................... 211
Table 9-4: Investment Opportunities Schedule (IOS) for Duchess Corporation ..........................213
Table 10-1: General Income Statement Format and Types of Leverage ...................................... 216
Table 10-2: Operating Leverage, Costs, and Breakeven Analysis ................................................218
Table 10-3: Sensitivity of Operating Breakeven Point to Increases in Key Breakeven Variables220
Table 10-4: The EBIT for Various Sales Levels .............................................................................. 221
Table 10-5: Operating Leverage and Increased Fixed Costs .........................................................223
Table 10-6: The EPS for Various EBIT Levels a ............................................................................. 224
Table 10-7: The Total Leverage Effect.............................................................................................228
Table 10-8: Debt Ratios for Selected Industries and Lines of Business (Fiscal Years Ended 4/1/05
through 3/31/06)................................................................................................................................. 230
Table 10-9: Sales and Associated EBIT Calculations for Cooke Company ($000) ......................233
Table 10-10: Capital Structures Associated with Alternative Debt Ratios for Cooke Company .. 234
Table 10-11: Level of Debt, Interest Rate, and Dollar Amount of Annual Interest Associated with
Cooke Company’s Alternative Capital Structures ........................................................................... 235
Table 10-12: Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company.............. 236
Table 10-13: Expected EPS, Standard Deviation, and Coefficient of Variation for Alternative
Capital Structures for Cooke Company............................................................................................237
Table 10-14: Required Returns for Cooke Company’s Alternative Capital Structures .................245
Table 10-15: Calculation of Share Value Estimates Associated with Alternative Capital Structures
for Cooke Company...........................................................................................................................246
Table 10-16: Important Factors to Consider in Making Capital Structure Decisions ....................248
Table 11-1: Applying the Residual Theory of Dividends to Overbrook Industries for Each of Three
IOSs (Shown in Figure 11-2) ............................................................................................................ 258
1 The Role and Environment of Managerial
Finance

1
1.0 The Role and Environment of Managerial Finance
1.0.1 Learning Goals
1. Define finance, its major areas and opportunities available in this field,
and the legal forms of business organization.
2. Describe the managerial finance function and its relationship to
economics and accounting.
3. Identify the primary activities of the financial manager.
4. Explain the goal of the firm, corporate governance, the role of ethics,
and the agency issue.
5. Understand financial institutions and markets, and the role they play in
managerial finance.
6. Discuss business taxes and their importance in financial decisions.

1.1 What is Finance?

• Finance can be defined as the art and science of managing money.
• Finance is concerned with the process, institutions, markets, and
instruments involved in the transfer of money among individuals,
businesses, and governments.

Major Areas & Opportunities in Finance: Financial Services

• Financial Services is the area of finance concerned with the design
and delivery of advice and financial products to individuals,
businesses, and government.
• Career opportunities include banking, personal financial planning,
investments, real estate, and insurance.

2
Major Areas & Opportunities in Finance: Managerial Finance
• Managerial finance is concerned with the duties of the financial
manager in the business firm.
• The financial manager actively manages the financial affairs of any
type of business, whether private or public, large or small, profit-
seeking or not-for-profit.
• They are also more involved in developing corporate strategy and
improving the firm’s competitive position.
• Increasing globalization has complicated the financial management
function by requiring them to be proficient in managing cash flows in
different currencies and protecting against the risks inherent in
international transactions.
• Changing economic and regulatory conditions also complicate the
financial management function.

Table 1-1: Strengths and Weaknesses of the Common Legal Forms of Business Organization

3
 9

Figure 1-1: Corporate Organization

4
 Table 1-2: Other Limited Liability Organizations

Table 1-3: Career Opportunities in Managerial Finance

5
1.2 The Managerial Finance Function
• The size and importance of the managerial finance function depends
on the size of the firm.
• In small companies, the finance function may be performed by the
company president or accounting department.
• As the business expands, finance typically evolves into a separate
department linked to the president as was previously described in
Figure 1-1.

The Managerial Finance Function: Relationship to Economics

• The field of finance is actually an outgrowth of economics.
• In fact, finance is sometimes referred to as financial economics.
• Financial managers must understand the economic framework within
which they operate in order to react or anticipate to changes in
conditions.
• The primary economic principal used by financial managers is
marginal cost-benefit analysis which says that financial decisions
should be implemented only when added benefits exceed added
costs.

The Managerial Finance Function: Relationship to Accounting

• The firm’s finance (treasurer) and accounting (controller) functions
are closely-related and overlapping.
• In smaller firms, the financial manager generally performs both
functions.
• One major difference in perspective and emphasis between finance
and accounting is that accountants generally use the accrual method
while in finance, the focus is on cash flows.

6
• The significance of this difference can be illustrated using the
following simple example.
• The Nassau Corporation experienced the following activity last year:

Sales $100,000 (1 yacht sold, 100% still uncollected)

Costs $ 80,000 (all paid in full under supplier terms)

• Now contrast the differences in performance under the accounting

method versus the cash method.

INCOME STATEMENT SUMMARY

ACCRUAL CASH
Sales $100,000 $0
Less: Costs (80,000) (80,000)
Net Profit/(Loss) $ 20,000 $(80,000)

• Finance and accounting also differ with respect to decision-making.

• While accounting is primarily concerned with the presentation of financial
data, the financial manager is primarily concerned with analyzing and
interpreting this information for decision-making purposes.
• The financial manager uses this data as a vital tool for making decisions
about the financial aspects of the firm.

Figure 1-2: Financial Activities

7
1.3 Goal of the Firm
1.3.1 Maximize Profit???

Which Investment is Preferred?

Earnings per share (EPS)

Investment Year 1 Year 2 Year 3 Total (years 1-3)
Rotor $ 1.40 $ 1.00 $ 0.40 $ 2.80
Valve $ 0.60 $ 1.00 $ 1.40 $ 3.00

• Profit maximization fails to account for differences in the level of cash

flows (as opposed to profits), the timing of these cash flows, and the risk
of these cash flows.

1.3.2 Maximize Shareholder Wealth!!!

• Why?
• Because maximizing shareholder wealth properly considers cash flows,
the timing of these cash flows, and the risk of these cash flows.
• This can be illustrated using the following simple stock valuation equation:

level & timing

of cash flows
Share Price = Future Dividends
Required Return risk of cash
flows

8
 • The process of shareholder wealth maximization can be described using
the following flow chart:

Figure 1-3: Share Price Maximization

1.3.3 What About Other Stakeholders?

• Stakeholders include all groups of individuals who have a direct economic
link to the firm including employees, customers, suppliers, creditors,
owners, and others who have a direct economic link to the firm.
• The "Stakeholder View" prescribes that the firm make a conscious effort to
avoid actions that could be detrimental to the wealth position of its
stakeholders.
• Such a view is considered to be "socially responsible."

9
Corporate Governance
• Corporate Governance is the system used to direct and control a
corporation.
• It defines the rights and responsibilities of key corporate participants such
as shareholders, the board of directors, officers and managers, and other
stakeholders.
• The structure of corporate governance was previously described in Figure
1-1.

Individual versus Institutional Investors

• Individual investors are investors who purchase relatively small quantities
of shares in order to earn a return on idle funds, build a source of
retirement income, or provide financial security.
• Institutional investors are investment professionals who are paid to
manage other people’s money.
• They hold and trade large quantities of securities for individuals,
businesses, and governments and tend to have a much greater impact on
corporate governance.

The Sarbanes-Oxley Act of 2002

• The Sarbanes-Oxley Act of 2002 (commonly called SOX) eliminated many
disclosure and conflict of interest problems that surfaced during the early
2000s.
• SOX:
– established an oversight board to monitor the accounting industry;
– tightened audit regulations and controls;
– toughened penalties against executives who commit corporate
fraud;
– strengthened accounting disclosure requirements;
– established corporate board structure guidelines.

10
1.4 The Role of Ethics
1.4.1 Ethics Defined
• Ethics is the standards of conduct or moral judgment—have become an
overriding issue in both our society and the financial community
• Ethical violations attract widespread publicity
• Negative publicity often leads to negative impacts on a firm

1.4.2 Considering Ethics

• Robert A. Cooke, a noted ethicist, suggests that the following questions be
used to assess the ethical viability of a proposed action:
– Does the action unfairly single out an individual
or group?
– Does the action affect the morals, or legal rights of any individual or
group?
– Does the action conform to accepted moral standards?
– Are there alternative courses of action that are less likely to cause
actual or potential harm?

• Cooke suggests that the impact of a proposed decision should be

evaluated from a number of perspectives:
– Are the rights of any stakeholder being violated?
– Does the firm have any overriding duties to any stakeholder?
– Will the decision benefit any stakeholder to the detriment of another
stakeholder?
– If there is a detriment to any stakeholder, how should it be
remedied, if at all?
– What is the relationship between stockholders and stakeholders?

11
1.4.3 Ethics & Share Price
• Ethics programs seek to:
– reduce litigation and judgment costs
– maintain a positive corporate image
– build shareholder confidence
– gain the loyalty and respect of all stakeholders

• The expected result of such programs is to positively affect the firm's

share price.

12
1.5 The Agency Issue
1.5.1 The Agency Problem
• Whenever a manager owns less than 100% of the firm’s equity, a potential
agency problem exists.
• In theory, managers would agree with shareholder wealth maximization.
• However, managers are also concerned with their personal wealth, job
security, fringe benefits, and lifestyle.
• This would cause managers to act in ways that do not always benefit the
firm shareholders.

1.5.2 Resolving the Problem

• Market Forces such as major shareholders and the threat of a hostile
takeover act to keep managers in check.
• Agency Costs are the costs borne by stockholders to maintain a
corporate governance structure that minimizes agency problems and
contributes to the maximization of shareholder wealth.
• Examples would include bonding or monitoring management behavior,
and structuring management compensation to make shareholders
interests their own.
• A stock option is an incentive allowing managers to purchase stock at
the market price set at the time of the grant.
• Performance plans tie management compensation to measures such as
EPS growth; performance shares and/or cash bonuses are used as
compensation under these plans.
• Recent studies have failed to find a strong relationship between CEO
compensation and share price.

13
1.6 Financial Institutions & Markets
• Firms that require funds from external sources can obtain them in three
ways:
– through a bank or other financial institution
– through financial markets
– through private placements

1.6.1 Financial Institutions

• Financial institutions are intermediaries that channel the savings of
individuals, businesses, and governments into loans or investments.
• The key suppliers and demanders of funds are individuals, businesses,
and governments.
• In general, individuals are net suppliers of funds, while businesses and
governments are net demanders of funds.

1.6.2 Financial Markets

• Financial markets provide a forum in which suppliers of funds and
demanders of funds can transact business directly.
• The two key financial markets are the money market and the capital
market.
• Transactions in short term marketable securities take place in the money
market while transactions in long-term securities take place in the capital
market.
• Whether subsequently traded in the money or capital market, securities
are first issued through the primary market.
• The primary market is the only one in which a corporation or government
is directly involved in and receives the proceeds from the transaction.
• Once issued, securities then trade on the secondary markets such as the
New York Stock Exchange or NASDAQ.

14
Figure 1-4: Flow of funds

15
1.7 The Money Market
• The money market exists as a result of the interaction between the
suppliers and demanders of short-term funds (those having a maturity of a
year or less).
• Most money market transactions are made in marketable securities
which are short-term debt instruments such as T-bills and commercial
paper.
• Money market transactions can be executed directly or through an
intermediary.
• The international equivalent of the domestic (U.S.) money market is the
Eurocurrency market.
• The Eurocurrency market is a market for short-term bank deposits
denominated in U.S. dollars or other marketable currencies.
• The Eurocurrency market has grown rapidly mainly because it is
unregulated and because it meets the needs of international borrowers
and lenders.

16
1.8 The Capital Market
• The capital market is a market that enables suppliers and demanders of
long-term funds to make transactions.
• The key capital market securities are bonds (long-term debt) and both
common and preferred stock (equity).
• Bonds are long-term debt instruments used by businesses and
government to raise large sums of money or capital.
• Common stock are units of ownership interest or equity in a corporation.

17
1.9 Broker Markets and Dealer Markets
• Broker markets consists of national and regional securities exchanges,
which are organizations that provide a marketplace in which firms can
raise funds the sale of new securities and purchasers can resell securities
• Dealer markets consist of both the Nasdaq market and and the over-the-
counter (OTC) market, where the (unlisted) shares of smaller firm shares
are sold and traded.
• The key difference between broker and dealer markets is a technical point
dealing with the way trades are executed.
• When a trade occurs in a broker market, buyers and sellers are brought
together and the trade takes place on the floor of the exchange.
• In contrast, buyers and sellers are never actually brought together in a
dealer – transactions are executed by securities dealers that make
markets in certain securities.
• The New York Stock Exchange (NYSE) is the most famous of all broker
markets and accounts for about 60% of the value of shares traded in the
U.S. stock markets.
• Trading is conducted through an auction process where specialists
“make a market” in selected securities.
• As compensation for executing orders, specialists make money on the
spread (bid price – ask price).
• The over-the-counter (OTC) market is an intangible market for
securities transactions.
• Unlike organized exchanges, the OTC is both a primary market and a
secondary market.
• The OTC is a computer-based market where dealers make a market in
selected securities and are linked to buyers and sellers through the
NASDAQ System.
• Dealers also make money on the “spread.”

18
1.10 International Capital Markets
• In the Eurobond market, corporations and governments typically issue
bonds denominated in dollars and sell them to investors located outside
the United States.
• The foreign bond market is a market for foreign bonds, which are bonds
issued by a foreign corporation or government that is denominated in the
investor’s home currency and sold in the investor’s home market.
• Finally, the international equity market allows corporations to sell blocks
of shares to investors in a number of different countries simultaneously.
• This market enables corporations to raise far larger amounts of capital
than they could raise in any single national market.

The Role of Securities Exchanges

Figure 1-5: Supply and Demand

19
1.11 Business Taxes
• Both individuals and businesses must pay taxes
on income.
• The income of sole proprietorships and partnerships is taxed as the
income of the individual owners, whereas corporate income is subject to
corporate taxes.
• Both individuals and businesses can earn two types of income—
ordinary income and capital gains income.
• Under current law, tax treatment of ordinary income and capital gains
income change frequently due frequently changing tax laws.

1.11.1 Ordinary Income

• Ordinary income is earned through the sale of a firm’s goods or services
and is taxed at the rates depicted in Table 1.4 on the following slide.

Example
Calculate federal income taxes due if taxable income is $80,000.
Tax = .15 ($50,000) + .25 ($25,000) + .34 ($80,000 - $75,000)
Tax = $15,450

Table 1-4: Corporate Tax Rate Schedule

20
1.11.2 Average & Marginal Tax Rates
• A firm’s marginal tax rate represents the rate at which additional income
is taxed.
• The average tax rate is the firm’s taxes divided by taxable income.

Example
What is the marginal and average tax rate for the previous example?
Marginal Tax Rate = 34%
Average Tax Rate = $15,450/$80,000 = 19.31%

1.11.3 Tax on Interest & Dividend Income

• For corporations only, 70% of all dividend income received from an
investment in the stock of another corporation in which the firm has less
than 20% ownership is excluded from taxation.
• This exclusion is provided to avoid triple taxation for corporations.
• Unlike dividend income, all interest income received is fully taxed.

21
1.11.4 (Tax Deductibility): Debt versus Equity Financing
• In calculating taxes, corporations may deduct operating expenses and
interest expense but not dividends paid.
• This creates a built-in tax advantage for using debt financing as the
following example will demonstrate.

Example
Two companies, Debt Co. and No Debt Co., both expect in the coming
year to have EBIT of $200,000. During the year, Debt Co. will have to pay
$30,000 in interest expenses. No Debt Co. has no debt and will pay not
interest expenses.

• As the example shows, the use of debt financing can increase cash flow
and EPS, and decrease taxes paid.
• The tax deductibility of interest and other certain expenses reduces their
actual (after-tax) cost to the profitable firm.
• It is the non-deductibility of dividends paid that results in double taxation
under the corporate form of organization.

22
1.11.5 Capital Gains
• A capital gain results when a firm sells an asset such as a stock held as
an investment for more than its initial purchase price.
• The difference between the sales price and the purchase price is called a
capital gain.
• For corporations, capital gains are added to ordinary income and taxed
like ordinary income at the firm’s marginal tax rate.

23
2 Cash Flow and Financial Planning

24
2.0 Cash Flow and Financial Planning
2.0.1 Learning Goals
1. Understand tax depreciation procedures and the effect of
depreciation on the firm’s cash flows.
2. Discuss the firm’s statement of cash flows, operating cash flow, and
free cash flow.
3. Understand the financial planning process, including long-term
(strategic) financial plans and short-term (operating) plans.
4. Discuss the cash-planning process and the preparation, evaluation,
and use of the cash budget.
5. Explain the simplified procedures used to prepare and evaluate the
pro forma income statement and the pro forma balance sheet.
6. Evaluate the simplified approaches to pro forma financial statement
preparation and the common uses of pro forma statements.

2.1 Analyzing the Firm’s Cash Flows

• Cash flow (as opposed to accounting “profits”) is the primary focus
of the financial manager.
• An important factor affecting cash flow is depreciation.
• From an accounting perspective, cash flow is summarized in a firm’s
statement of cash flows.
• From a financial perspective, firms often focus on both operating
cash flow, which is used in managerial decision-making, and free
cash flow, which is closely monitored by participants in the capital
market.

25
2.1.1 Depreciation
• Depreciation is the systematic charging of a portion of the costs of
fixed assets against annual revenues over time.
• Depreciation for tax purposes is determined by using the modified
accelerated cost recovery system (MACRS).
• On the other hand, a variety of other depreciation methods are often
used for reporting purposes.
• Financial managers are much more concerned with cash flows
rather than profits.
• To adjust the income statement to show cash flows from operations,
all non-cash charges should be added back to net profit after taxes.
• By lowering taxable income, depreciation and other non-cash
expenses create a tax shield and enhance cash flow.

• Question:
– If as a business owner you could design a depreciation
schedule to look the way you wanted it to, what would it look
like?
• Exactly!
– As long as you have positive taxable income, you would
always prefer to expense it (100% depreciation). Remember,
a dollar saved today is worth more than a dollar saved
tomorrow!

26
2.2 Developing the Statement of Cash Flows
• The statement of cash flows summarizes the firm’s cash flow over
a given period of time.
• The statement of cash flows is divided into three sections:
– Operating flows
– Investment flows
– Financing flows
• The nature of these flows is shown in Figure 2-1 on the following
slide.

Figure 2-1: Cash Flows

27
2.2.1 Classifying Inflows and Outflows of Cash
• The statement of cash flows essentially summarizes the inflows and
outflows of cash during a given period.
Table 2-1: Inflows and Outflows of Cash

Table 2-2: Baker Corporation Income Statement ($000) for the Year Ended December 31, 2009

28
Table 2-3: Baker Corporation Balance Sheets ($000)

29
Table 2-4: Baker Corporation Statement of Cash Flows ($000) for the Year Ended December 31,
2009

2.2.2 Interpreting Statement of Cash Flows

• The statement of cash flows ties the balance sheet at the beginning
of the period with the balance sheet at the end of the period after
considering the performance of the firm during the period through
the income statement.
• The net increase (or decrease) in cash and marketable securities
should be equivalent to the difference between the cash and
marketable securities on the balance sheet at the beginning of the
year and the end of the year.

30
2.3 Operating Cash Flow
• A firm’s Operating Cash Flow (OCF) is the cash flow a firm
generates from normal operations—from the production and sale of
its goods and services.
• OCF may be calculated as follows:

NOPAT = EBIT x (1 – T)

OCF = NOPAT + Depreciation

OCF = [EBIT x (1 – T)] + Depreciation

• Substituting for Baker Corporation, we get:

OCF = [$370 x (1 - .40) + $100 = $322

• Thus, we can conclude that Baker’s operations are generating
positive operating cash flows.

31
2.4 Free Cash Flow
• Free Cash Flow (FCF) is the amount of cash flow available to debt
and equity holders after meeting all operating needs and paying for
its net fixed asset investments (NFAI) and net current asset
investments (NCAI).

FCF = OCF – NFAI - NCAI

• where:

NFAI = Change in net fixed assets + Depreciation

NCAI = Change in CA – Change in A/P and Accruals

• Using Baker Corporation we get:

NFAI = [($1,200 - $1,000) + $100] = $300

NCAI = [($2,000 - $1,900) + ($800 - $700)] = $0

FCF = $322 – $300 - $0 = $22

• This FCF can be used to pay its creditors and equity holders.

32
2.5 The Financial Planning Process
• Financial planning involves guiding, coordinating, and controlling
the firm’s actions to achieve its objectives.
• Two key aspects of financial planning are cash planning and profit
planning.
• Cash planning involves the preparation of the firm’s cash budget.
• Profit planning involves the preparation of both cash budgets and
pro forma financial statements.

2.5.1 Long-Term (Strategic) Financial Plans

• Long-term strategic financial plans lay out a company’s planned
financial actions and the anticipated impact of those actions over
periods ranging from 2 to 10 years.
• Firms that are exposed to a high degree of operating uncertainty
tend to use shorter plans.
• These plans are one component of a company’s integrated strategic
plan (along with production and marketing plans) that guides a
company toward achievement of its goals.
• Long-term financial plans consider a number of financial activities
including:
• Proposed fixed asset investments
• Research and development activities
• Marketing and product development
• Capital structure
• Sources of financing
• These plans are generally supported by a series of annual budgets
and profit plans.

33
2.5.2 Short-Term (Operating) Financial Plans
• Short-term (operating) financial plans specify short-term financial
actions and the anticipated impact of those actions and typically
cover a one to two year operating period.
• Key inputs include the sales forecast and other operating and
financial data.
• Key outputs include operating budgets, the cash budget, and pro
forma financial statements.
• This process is described graphically on the following slide.

Figure 2-2: Short-Term Financial Planning

34
• As indicated in the previous exhibit, short-term financial planning
begins with a sales forecast.
• From this sales forecast, production plans are developed that
consider lead times and raw material requirements.
• From the production plans, direct labor, factory overhead, and
operating expense estimates are developed.
• From this information, the pro forma income statement and cash
budget are prepared—ultimately leading to the development of the
pro forma balance sheet.

35
2.6 Cash Planning
2.6.1 Cash Budgets
• The cash budget or cash forecast is a statement of the firm’s
planned inflows and outflows of cash.
• It is used to estimate short-term cash requirements with particular
attention to anticipated cash surpluses and shortfalls.
• Surpluses must be invested and deficits must be funded.
• The cash budget is a useful tool for determining the timing of cash
inflows and outflows during a given period.
• Typically, monthly budgets are developed covering a 1-year time
period.
• The cash budget begins with a sales forecast, which is simply a
prediction of the sales activity during a given period.
• A prerequisite to the sales forecast is a forecast for the economy,
the industry, the company and other external and internal factors
that might influence company sales.
• The sales forecast is then used as a basis for estimating the monthly
cash inflows that will result from projected sales—and outflows
related to production, overhead and other expenses.
Table 2-5: The General Format of the Cash Budget

36
2.6.2 Cash Budgets An Example: Coulson Industries
• Coulson Industries, a defense contractor, is developing a cash
budget for October, November, and December. Halley’s sales in
August and September were $100,000 and $200,000 respectively.
Sales of $400,000, $300,000 and $200,000 have been forecast for
October, November, and December. Historically, 20% of the firm’s
sales have been for cash, 50% have been collected after 1 month,
and the remaining 30% after 2 months. In December, Coulson will
receive a $30,000 dividend from stock in a subsidiary.
• Based on this information, we are able to develop the following
schedule of cash receipts for Coulson Industries.
Table 2-6: A Schedule of Projected Cash Receipts for Coulson Industries ($000)

• Coulson Company has also gathered the relevant information for the
development of a cash disbursement schedule. Purchases will
represent 70% of sales—10% will be paid immediately in cash, 70%
is paid the month following the purchase, and the remaining 20% is
paid two months following the purchase. The firm will also expend
cash on rent, wages and salaries, taxes, capital assets, interest,
dividends, and a portion of the principal on its loans. The resulting
disbursement schedule thus follows.

37
 Table 2-7: A Schedule of Projected Cash Disbursements for Coulson Industries ($000)

• The Cash Budget for Coulson Industries can be derived by

combining the receipts budget with the disbursements budget. At
the end of September, Coulson’s cash balance was $50,000, notes
payable was $0, and marketable securities balance was $0.
Coulson also wishes to maintain a minimum cash balance of
$25,000. As a result, it will have excess cash in October, and a
deficit of cash in November and December. The resulting cash
budget follows.

38
 Table 2-8: A Cash Budget for Coulson Industries ($000)

• The Cash Budget for Coulson Industries can be derived by

combining the receipts budget with the disbursements budget. At
the end of September, Coulson’s cash balance was $50,000, notes
payable was $0, and marketable securities balance was $0.
Coulson also wishes to maintain a minimum cash balance of
$25,000. As a result, it will have excess cash in October, and a
deficit of cash in November and December. The resulting cash
budget follows.

39
Table 2-9: A Cash Budget for Coulson Industries ($000)

40
2.7 Evaluating the Cash Budget
• Cash budgets indicate the extent to which cash shortages or
surpluses are expected in the months covered by the forecast.

• The excess cash of $22,000 in October should be invested in

marketable securities. The deficits in November and December
need to be financed.

2.7.1 Coping with Uncertainty in the Cash Budget

• One way to cope with cash budgeting uncertainty is to prepare
several cash budgets based on several forecasted scenarios (e.g.,
pessimistic, most likely, optimistic).
• From this range of cash flows, the financial manager can determine
the amount of financing necessary to cover the most adverse
situation.
• This method will also provide a sense of the riskiness of alternatives.
• An example of this sort of “sensitivity analysis” for Coulson Industries
is shown on the following slide.

41
Table 2-10: A Scenario Analysis of Coulson Industries’ Cash Budget ($000)

42
2.8 Profit Planning
2.8.1 Pro Forma Statements
• Pro forma financial statements are projected, or forecast, financial
statements – income statements and balance sheets.
• The inputs required to develop pro forma statements using the most
common approaches include:
– Financial statements from the preceding year
– The sales forecast for the coming year
– Key assumptions about a number of factors
• The development of pro forma financial statements will be
demonstrated using the financial statements for Vectra
Manufacturing.

Table 2-11: Vectra Manufacturing’s Income Statement for the Year Ended December 31, 2009

43
 Table 2-12: Vectra Manufacturing’s Balance Sheet, December 31, 2009

• Step 1: Start with a Sales Forecast

– The first and key input for developing pro forma financial
statements is the sales forecast for Vectra Manufacturing.
– The previous sales forecast is based on an increase in price
from $20 to $25 per unit for Model X and from $40 to $50 per
unit for Model Y.
– These increases are required to cover anticipated increases in
various costs, including labor, materials, & overhead.
Table 2-13: 2010 Sales Forecast for Vectra Manufacturing

44
• Step 2: Preparing the Pro Forma Income Statement
– A simple method for developing a pro forma income statement
is the “percent-of-sales” method.
– This method starts with the sales forecast and then expresses
the cost of goods sold, operating expenses, and other
accounts as a percentage of projected sales.
– Using the Vectra example, the easiest way to do this is to
recast the historical income statement as a percentage of
sales.
– Using these percentages and the sales forecast we developed,
the entire income statement can be projected.
– The results are shown on the following slide.
– It is important to note that this method implicitly assumes that
all costs are variable and that all increase or decrease in
proportion to sales.
– This will understate profits when sales are increasing and
overstate them when sales are decreasing.

Table 2-14: A Pro Forma Income Statement, Using the Percent-of-Sales Method, for Vectra
Manufacturing for the Year Ended December 31, 2010

45
– Clearly, some of the firm’s expenses will increase with the
level of sales while others will not.
– As a result, the strict application of the percent-of-sales
method is a bit naïve.
– The best way to generate a more realistic pro forma income
statement is to segment the firm’s expenses into fixed and
variable components.
– This may be demonstrated as follows.

46
• Step 3: Preparing the Pro Forma Balance Sheet
– Probably the best approach to use in developing the pro forma
balance sheet is the judgmental approach.
– Under this simple method, the values of some balance sheet
accounts are estimated and the company’s external financing
requirement is used as the balancing account.
– To apply this method to Vectra Manufacturing, a number of
simplifying assumptions must be made.
1. A minimum cash balance of $6,000 is desired.
2. Marketable securities will remain at their current level of
$4,000.
3. Accounts receivable will be approximately $16,875 which
represents 45 days of sales on average [(45/365) x $135,000].
4. Ending inventory will remain at about $16,000. 25% ($4,000)
represents raw materials and 75% ($12,000) is finished goods.
5. A new machine costing $20,000 will be purchased. Total
depreciation will be $8,000. Adding $20,000 to existing net
fixed assets of $51,000 and subtracting the $8,000
depreciation yields a net fixed assets figure of $63,000.
6. Purchases will be $40,500 which represents 30% of annual
sales (30% x $135,000). Vectra takes about 73 days to pay
on its accounts payable. As a result, accounts payable will
equal $8,100 [(73/365) x $40,500].
7. Taxes payable will be $455 which represents one-fourth of the
1998 tax liability.
8. Notes payable will remain unchanged at $8,300.
9. There will be no change in other current liabilities, long-term
debt, and common stock.

47
 10. Retained earnings will change in accordance with the
pro forma income statement.

Table 2-15: A Pro Forma Balance Sheet, Using the Judgmental Approach, for Vectra
Manufacturing (December 31, 2010)

48
2.8.2 Weaknesses of Simplified Approaches
• The major weaknesses of the approaches to pro forma statement
development outlined above lie in two assumptions:
– That the firm’s past financial performance will be replicated in
the future
– That certain accounts can be forced to take on desired values
• For these reasons, it is imperative to first develop a forecast of the
overall economy and make adjustments to accommodate other facts
or events.

49
3 Risk and Return

50
3.0 Risk and Return
3.0.1 Learning Goals
1. Understand the meaning and fundamentals of risk, return, and risk
aversion.
2. Describe procedures for assessing and measuring the risk of a
single asset.
3. Discuss the measurement of return and standard deviation for a
portfolio and the concept of correlation.
4. Understand the risk and return characteristics of a portfolio in terms
of correlation and diversification, and the impact of international
assets on a portfolio.
5. Review the two types of risk and the derivation and role of beta in
measuring the relevant risk of both a security and a portfolio.
6. Explain the capital asset pricing model (CAPM) and its relationship
to the security market line (SML), and the major forces causing shifts
in the SML.

3.1 Risk and Return Fundamentals

• If everyone knew ahead of time how much a stock would sell for
some time in the future, investing would be simple endeavor.
• Unfortunately, it is difficult—if not impossible—to make such
predictions with any degree of certainty.
• As a result, investors often use history as a basis for predicting the
future.
• We will begin this chapter by evaluating the risk and return
characteristics of individual assets, and end by looking at portfolios
of assets.

51
3.1.1 Risk Defined
• In the context of business and finance, risk is defined
as the chance of suffering a financial loss.
• Assets (real or financial) which have a greater chance of loss are
considered more risky than those with a lower chance of loss.
• Risk may be used interchangeably with the term uncertainty to refer
to the variability of returns associated with a given asset.
• Other sources of risk are listed on the following slide.

Table 3-1: Popular Sources of Risk Affecting Financial Managers and Shareholders

52
3.1.2 Return Defined
• Return represents the total gain or loss on an investment.
• The most basic way to calculate return is as follows:

Robin’s Gameroom wishes to determine the returns on two of its video

machines, Conqueror and Demolition. Conqueror was purchased 1 year
ago for $20,000 and currently has a market value of $21,500. During the
year, it generated $800 worth of after-tax receipts. Demolition was
purchased 4 years ago; its value in the year just completed declined from
$12,000 to $11,800. During the year, it generated $1,700 of after-tax
receipts.

53
3.1.3 Historical Returns
Table 3-2: Historical Returns for Selected Security Investments (1926–2006)

Figure 3-1: Risk Preferences

54
3.2 Risk of a Single Asset
Norman Company, a custom golf equipment manufacturer, wants to
choose the better of two investments, A and B. Each requires an initial
outlay of $10,000 and each has a most likely annual rate of return of 15%.
Management has estimated the returns associated with each investment.
The three estimates for each assets, along with its range, is given in Table
3-3. Asset A appears to be less risky than asset B. The risk averse
decision maker would prefer asset A over asset B, because A offers the
same most likely return with a lower range (risk).

Table 3-3: Assets A and B

3.2.1 Discrete Probability Distributions

Figure 3-2: Bar Charts

55
3.2.2 Continuous Probability Distributions

Figure 3-3: Continuous Probability Distributions

56
3.3 Return Measurement for a Single Asset
3.3.1 Expected Return
• The most common statistical indicator of an asset’s risk is the
standard deviation, k, which measures the dispersion around the
expected value.
• The expected value of a return, r-bar, is the most likely return of
an asset.

Table 3-4: Expected Values of Returns for Assets A and B

57
3.3.2 Standard Deviation
 The expression for the standard deviation of returns, k, is given in
Equation 5.3 below.

58
 Table 3-5: The Calculation of the Standard Deviation of the Returns for Assets A and B

Table 3-6: Historical Returns, Standard Deviations, and Coefficients of Variation for Selected
Security Investments (1926–2006)

59
 Figure 3-4: Bell-Shaped Curve

3.3.3 Coefficient of Variation

• The coefficient of variation, CV, is a measure of relative dispersion
that is useful in comparing risks of assets with differing expected
returns.
• Equation 5.4 gives the expression of the coefficient of variation.

60
3.4 Portfolio Risk and Return
• An investment portfolio is any collection or combination of financial
assets.
• If we assume all investors are rational and therefore risk averse,
that investor will ALWAYS choose to invest in portfolios rather than
in single assets.
• Investors will hold portfolios because he or she will diversify away a
portion of the risk that is inherent in “putting all your eggs in one
basket.”
• If an investor holds a single asset, he or she will fully suffer the
consequences of poor performance.
• This is not the case for an investor who owns a diversified portfolio
of assets.

3.4.1 Portfolio Return

• The return of a portfolio is a weighted average of the returns on
the individual assets from which it is formed and can be calculated
as shown in Equation 5.5.

61
3.4.2 Expected Return and Standard Deviation
Assume that we wish to determine the expected value and standard
deviation of returns for portfolio XY, created by combining equal portions
(50%) of assets X and Y. The expected returns of assets X and Y for each
of the next 5 years are given in columns 1 and 2, respectively in part A of
Table 3-7. In column 3, the weights of 50% for both assets X and Y along
with their respective returns from columns 1 and 2 are substituted into
equation 5.5. Column 4 shows the results of the calculation – an expected
portfolio return of 12%.

As shown in part B of Table 3-7, the expected value of these portfolio

returns over the 5-year period is also 12%. In part C of Table 3-7, Portfolio
XY’s standard deviation is calculated to be 0%. This value should not be
surprising because the expected return each year is the same at 12%. No
variability is exhibited in the expected returns from year to year.

62
Table 3-7: Expected Return, Expected Value, and Standard Deviation of Returns for Portfolio XY

63
3.4.3 Risk of a Portfolio
• Diversification is enhanced depending upon the extent to which the
returns on assets “move” together.
• This movement is typically measured by a statistic known as
“correlation” as shown in the figure below.

Figure 3-5: Correlations

• Even if two assets are not perfectly negatively correlated, an investor

can still realize diversification benefits from combining them in a
portfolio as shown in the figure below.

Figure 3-6: Diversification

64
Table 3-8: Forecasted Returns, Expected Values, and Standard Deviations for Assets X, Y, and Z
and Portfolios XY and XZ

Table 3-9: Correlation, Return, and Risk for Various Two-Asset Portfolio Combinations

65
Figure 3-7: Possible Correlations

Figure 3-8: Risk Reduction

66
3.4.4 Adding Assets to a Portfolio

Portfolio
Risk (SD)
Unsystematic (diversifiable) Risk

σM

Systematic (non-diversifiable) Risk

0 # of Stocks
35

Portfolio
Risk (SD)
Portfolio of Domestic Assets Only

Portfolio of both Domestic and

International Assets
σM

0 # of Stocks
36

67
3.4.5 The Capital Asset Pricing Model (CAPM)
• If you notice in the last slide, a good part of a portfolio’s risk (the
standard deviation of returns) can be eliminated simply by holding a
lot of stocks.
• The risk you can’t get rid of by adding stocks (systematic) cannot
be eliminated through diversification because that variability is
caused by events that affect most stocks similarly.
• Examples would include changes in macroeconomic factors such
interest rates, inflation, and the business cycle.
• In the early 1960s, finance researchers (Sharpe, Treynor, and
Lintner) developed an asset pricing model that measures only the
amount of systematic risk a particular asset has.
• In other words, they noticed that most stocks go down when interest
rates go up, but some go down a whole lot more.
• They reasoned that if they could measure this variability—the
systematic risk—then they could develop a model to price assets
using only this risk.
• The unsystematic (company-related) risk is irrelevant because it
could easily be eliminated simply by diversifying.
• To measure the amount of systematic risk an asset has, they
simply regressed the returns for the “market portfolio”—the portfolio
of ALL assets—against the returns for an individual asset.
• The slope of the regression line—beta—measures an assets
systematic (non-diversifiable) risk.
• In general, cyclical companies like auto companies have high betas
while relatively stable companies, like public utilities, have low betas.
• The calculation of beta is shown on the following slide.

68
 Figure 3-9: Beta Derivation a

Table 3-10: Selected Beta Coefficients and Their Interpretations

69
Table 3-11: Beta Coefficients for Selected Stocks (July 10, 2007)

Table 3-12: Mario Austino’s Portfolios V and W

70
 • The required return for all assets is composed of two parts: the
risk-free rate and a risk premium.

The risk premium is a The risk-free rate (RF) is

function of both market usually estimated from
conditions and the asset the return on US T-bills
itself.

• The risk premium for a stock is composed of two parts:

• The Market Risk Premium which is the return required for investing
in any risky asset rather than the risk-free rate
• Beta, a risk coefficient which measures the sensitivity of the
particular stock’s return to changes in market conditions.
• After estimating beta, which measures a specific asset or portfolio’s
systematic risk, estimates of the other variables in the model may be
obtained to calculate an asset or portfolio’s required return.

71
Benjamin Corporation, a growing computer software developer, wishes to
determine the required return on asset Z, which has a beta of 1.5. The
risk-free rate of return is 7%; the return on the market portfolio of assets is
11%. Substituting bZ = 1.5, RF = 7%, and rm = 11% into the CAPM yields
a return of:

rZ = 7% + 1. 5 [11% - 7%]
rZ = 13%

Figure 3-10: Security Market Line

72
 Figure 3-11: Inflation Shifts SML

Figure 3-12: Risk Aversion Shifts SML

73
3.4.6 Some Comments on the CAPM
• The CAPM relies on historical data which means the betas may or
may not actually reflect the future variability of returns.
• Therefore, the required returns specified by the model should be
used only as rough approximations.
• The CAPM also assumes markets are efficient.
• Although the perfect world of efficient markets appears to be
unrealistic, studies have provided support for the existence of the
expectational relationship described by the CAPM in active markets
such as the NYSE.

74
Table 3-13: Summary of Key Definitions and Formulas for Risk and Return

75
4 Interest Rate & Bond Valuation

76
4.0 Interest Rate & Bond Valuation
4.0.1 Learning Goals
1. Describe interest rate fundamentals, the term structure of interest
rates, and risk premiums.
2. Review the legal aspects of bond financing and bond cost.
3. Discuss the general features, yields, prices, popular types, and
international issues of corporate bonds.
4. Understand the key inputs and basic model used in the valuation
process.
5. Apply the basic valuation model to bonds and describe the impact of
required return and time to maturity on bond values.
6. Explain the yield to maturity (YTM), its calculation, and the
procedure used to value bonds that pay interest semiannually.

4.1 Interest Rates & Required Returns

• The interest rate or required return represents the price of money.
• Interest rates act as a regulating device that controls the flow of
money between suppliers and demanders of funds.
• The Board of Governors of the Federal Reserve System regularly
asses economic conditions and, when necessary, initiate actions to
change interest rates to control inflation and economic growth.

4.1.1 Interest Rate Fundamentals

• Interest rates represent the compensation that a demander of funds
must pay a supplier.
• When funds are lent, the cost of borrowing is the interest rate.

77
 • When funds are raised by issuing stocks or bonds, the cost the
company must pay is called the required return, which reflects the
suppliers expected level of return.

4.1.2 The Real Rate of Interest

• The real interest rate is the rate that creates an equilibrium
between the supply of savings and the demand for investment funds
in a perfect world.
• In this context, a perfect world is one in which there are no inflation,
where suppliers and demanders have no liquidity preference, and
where all outcomes are certain.
• The supply-demand relationship that determines the real rate is
shown in Figure 4-1.

Figure 4-1: Supply–Demand Relationship

78
4.1.3 Inflation and the Cost of Money
• Ignoring risk factors, the cost of funds is closely tied to inflationary
expectations.
• The risk-free rate of interest, RF, which is typically measured by a 3-
month U.S. Treasury bill (T-bill) compensates investors only for the
real rate of return and for the expected rate of inflation.
• The relationship between the annual rate of inflation and the return
on T-bills is shown on the following slide.

4.1.4 Nominal or Actual Rate of Interest (Return)

• The nominal rate of interest is the actual rate of interest charged by
the supplier of funds and paid by the demander.
• The nominal rate differs from the real rate of interest, r* as a result
of two factors:
– Inflationary expectations reflected in an inflation premium (IP),
and
– Issuer and issue characteristics such as default risks and
contractual provisions as reflected in a risk premium (RP).
• Using this notation, the nominal rate of interest for security 1, r1 is
given in equation 6.1, and is further defined in equations 6.2 and 6.3.

79
Figure 4-2: Impact of Inflation

80
4.2 Term Structure of Interest Rates
• The term structure of interest rates relates the interest rate to the
time to maturity for securities with a common default risk profile.
• Typically, treasury securities are used to construct yield curves
since all have zero risk of default.
• However, yield curves could also be constructed with AAA or BBB
corporate bonds or other types of similar risk securities.

Figure 4-3: Treasury Yield Curves

81
4.3 Theories of Term Structure
4.3.1 Expectations Theory
• This theory suggest that the shape of the yield curve reflects
investors expectations about the future direction of inflation and
interest rates.
• Therefore, an upward-sloping yield curve reflects expectations of
higher future inflation and interest rates.
• In general, the very strong relationship between inflation and interest
rates supports this theory.

4.3.2 Liquidity Preference Theory

• This theory contends that long term interest rates tend to be higher
than short term rates for two reasons:
– long-term securities are perceived to be riskier than short-term
securities
– borrowers are generally willing to pay more for long-term
funds because they can lock in at a rate for a longer period of
time and avoid the need to roll over the debt.

4.3.3 Market Segmentation Theory

• This theory suggests that the market for debt at any point in time is
segmented on the basis of maturity.
• As a result, the shape of the yield curve will depend on the supply
and demand for a given maturity at a given point in time.

82
4.4 Risk Premiums
4.4.1 Issue and Issuer Characteristics

• The data in the table below is from May 17, 2004.

83
• The data in the table below is from May 17, 2004.

Table 4-1: Debt-Specific Issuer- and Issue-Related Risk Premium Components

84
4.5 Corporate Bonds
• A bond is a long-term debt instrument that pays the bondholder a
specified amount of periodic interest rate over a specified period of
time.
• The bond’s principal is the amount borrowed by the company and
the amount owed to the bond holder on the maturity date.
• The bond’s maturity date is the time at which a bond becomes due
and the principal must be repaid.
• The bond’s coupon rate is the specified interest rate (or $ amount)
that must be periodically paid.
• The bond’s current yield is the annual interest (income) divided by
the current price of the security.
• The bond’s yield-to-maturity is the yield (expressed as a compound
rate of return) earned on a bond from the time it is acquired until the
maturity date of the bond.
• A yield curve graphically shows the relationship between the time to
maturity and yields for debt in a given risk class.

4.5.1 Legal Aspects of Corporate Bonds

• The bond indenture is a legal document that specifies both the
rights of the bondholders and the duties of the issuing corporation.
• Standard debt provisions in the indenture specify certain record
keeping and general business procedures that the issuer must
follow.
• Restrictive debt provisions are contractual clauses in a bond
indenture that place operating and financial constraints on the
borrower.
• Common restrictive covenants include provisions that specify:
• Minimum equity levels

85
 • Prohibition against factoring receivables
• Fixed asset restrictions
• Constraints on subsequent borrowing
• Limitations on cash dividends.
• In general, violations of restrictive covenants give bondholders the
right to demand immediate repayment.

• Sinking fund requirements are restrictive provisions often included

in bond indentures that provide for the systematic retirement of
bonds prior to their maturity.
• The bond indenture identifies any collateral (security) pledged
against the bond and specifies how it is to be maintained.
• A trustee is a paid individual, corporation, or commercial bank trust
department that acts as the third party to a bond indenture.

4.5.2 Cost of Bonds to the Issuer

• In general, the longer the bond’s maturity, the higher the interest
rate (or cost) to the firm.
• In addition, the larger the size of the offering, the lower will be the
cost (in % terms) of the bond.
• Also, the greater the risk of the issuing firm, the higher the cost of
the issue.
• Finally, the cost of money in the capital market is the basis form
determining a bond’s coupon interest rate.

86
4.5.3 General Features
• The conversion feature of convertible bonds allows bondholders
to exchange their bonds for a specified number of shares of common
stock.
• Bondholders will exercise this option only when the market price of
the stock is greater than the conversion price.
• A call feature, which is included in most corporate issues, gives the
issuer the opportunity to repurchase the bond prior to maturity at the
call price.
• In general, the call premium is equal to one year of coupon interest
and compensates the holder for having it called prior to maturity.
• Furthermore, issuers will exercise the call feature when interest
rates fall and the issuer can refund the issue at a lower cost.
• Issuers typically must pay a higher rate to investors for the call
feature compared to issues without the feature.
• Bonds also are occasionally issued with stock purchase warrants
attached to them to make them more attractive to investors.
• Warrants give the bondholder the right to purchase a certain number
of shares of the same firm’s common stock at a specified price
during a specified period of time.
• Including warrants typically allows the firm to raise debt capital at a
lower cost than would be possible in their absence.

87
4.5.4 Bond Yields
• A bond’s yield or rate of return is frequently used to assess its
performance over a given period, typically 1 year.
• The three most widely cited yields are:
– Current yield
– Yield to maturity (YTM)
– Yield to call (YTC)

4.5.5 Bond Prices

• Because most corporate bonds are purchased and held by
institutional investors, bond trading and price data is not readily
available to individuals.
• Although most corporate bonds are issued with a par or face value
of $1,000, all bonds are quoted as a percentage of par.
• See Table 4-2

Table 4-2: Data on Selected Bonds

88
4.5.6 Bond Ratings
Table 4-3: Moody’s and Standard & Poor’s Bond Ratings a

89
Table 4-4: Characteristics and Priority of Lender’s Claim of Traditional Types of Bonds

90
 Table 4-5: Characteristics of Contemporary Types of Bonds

4.5.7 International Bond Issues

• Companies and governments borrow internationally by issuing
bonds in the Eurobond market and the foreign bond market.
• A Eurobond is issued by an international borrower and sold to
investors in countries with currencies other than the currency in
which the bond is denominated.
• In contrast, a foreign bond is issued in a host country’s financial
market, in the host country’s currency, by a foreign borrower.

91
4.6 Valuation Fundamentals
• The (market) value of any investment asset is simply the present
value of expected cash flows.
• The interest rate that these cash flows are discounted at is called the
asset’s required return.
• The required return is a function of the expected rate of inflation
and the perceived risk of the asset.
• Higher perceived risk results in a higher required return and lower
asset market values.

92
4.7 Basic Valuation Model

Table 4-6: Valuation of Assets by Celia Sargent

93
4.8 Bond Valuation
4.8.1 Bond Fundamentals
• A noted earlier, bonds are long-term debt instruments used by
businesses and government to raise large sums of money, typically
from a diverse group of lenders.
• Most bonds pay interest semiannually at a stated coupon interest
rate, have an initial maturity of 10 to 30 years, and have a par value
of $1,000 that must be repaid at maturity.

4.8.2 Basic Bond Valuation

Mills Company, a large defense contractor, on January 1, 2007, issued a
10% coupon interest rate, 10-year bond with a $1,000 par value that pays
interest semiannually.

94
95
Table 4-7: Bond Values for Various Required Returns (Mills Company’s 10% Coupon Interest
Rate, 10-Year Maturity, $1,000 Par, January 1, 2010, Issue Paying Annual Interest)

96
97
Figure 4-4: Bond Values and Required Returns

Figure 4-5: Time to Maturity and Bond Values

98
4.9 Yield to Maturity (YTM)
• The yield to maturity measures the compound annual return to an
investor and considers all bond cash flows. It is essentially the
bond’s IRR based on the current price.
• Note that the yield to maturity will only be equal if the bond is selling
for its face value ($1,000).
• And that rate will be the same as the bond’s coupon rate.
• For premium bonds, the current yield > YTM.
• For discount bonds, the current yield < YTM.
The Mills Company bond, which currently sells for $1,080, has a 10%
coupon interest rate and $1,000 par value, pays interest annually, and has
10 years to maturity. What is the bond’s YTM?

$1,080 = $100 x (PVIFArd,10yrs) + $1,000 x (PVIFrd,10yrs)

99
100
4.9.1 Semiannual Interest and Bond Values

Assuming that the Mills Company bond pays interest semiannually and
that the required stated annual return, rd is 12% for similar risk bonds that
also pay semiannual interest, substituting these values into Equation 6.8a
yields

101
102
4.10 Coupon Effects on Price Volatility
• The amount of bond price volatility depends on three basic factors:
– length of time to maturity
– risk
– amount of coupon interest paid by the bond
• First, we already have seen that the longer the term to maturity, the
greater is a bond’s volatility
• Second, the riskier a bond, the more variable the required return will
be, resulting in greater price volatility.
• Finally, the amount of coupon interest also impacts a bond’s price
volatility.
• Specifically, the lower the coupon, the greater will be the bond’s
volatility, because it will be longer before the investor receives a
significant portion of the cash flow from his or her investment.

103
4.11 Current Yield
• The Current Yield measures the annual return to an investor based
on the current price.

Current = Annual Coupon Interest

Yield Current Market Price

For example, a 10% coupon bond which is currently

selling at $1,150 would have a current yield of:

Current = $100 = 8.7%

Yield $1,150

104
4.12 Summary
Table 4-8: Summary of Key Valuation Definitions and Formulas for Any Asset and for Bonds

105
5 Stock Valuation

106
5.0 Stock Valuation
5.0.1 Learning Goals
1. Differentiate between debt and equity.
2. Discuss the rights, characteristics, and features of both common and
preferred stock.
3. Describe the process of issuing common stock, including venture
capital, going public and the investment banker’s, and interpreting
stock quotations.
4. Understand the concept of market efficiency and basic common
stock valuation using zero growth, constant growth, and variable
growth models.
5. Discuss the free cash flow valuation model and the book value,
liquidation value, and price/earnings (P/E) multiple approaches.
6. Explain the relationship among financial decisions, return, risk, and
the firm’s value.

5.1 Differences Between Debt & Equity

Table 5-1: Key Differences between Debt and Equity Capital

107
5.2 The Nature of Equity Capital
5.2.1 Voice in Management
• Unlike bondholders and other credit holders, holders of equity capital
are owners of the firm.
• Common equity holders have voting rights that permit them to elect
the firm’s board of directors and to vote on special issues.
• Bondholders and preferred stockholders receive no such privileges.

5.2.2 Claims on Income & Assets

• Equity holders have a residual claim on the firm’s income and
assets.
• Their claims can not be paid until the claims of all creditors, including
both interest and principle payments on debt have been satisfied.
• Because equity holders are the last to receive distributions, they
expect greater returns to compensate them for the additional risk
they bear.

5.2.3 Maturity
• Unlike debt, equity capital is a permanent form of financing.
• Equity has no maturity date and never has to be repaid by the firm.

5.2.4 Tax Treatment

• While interest paid to bondholders is tax-deductible to the issuing
firm, dividends paid to preferred and common stockholders of the
corporation is not.
• In effect, this further lowers the cost of debt relative to the cost of
equity as a source of financing to the firm.

108
5.3 Common Stock
• Common stockholders, who are sometimes referred to as residual
owners or residual claimants, are the true owners of the firm.
• As residual owners, common stockholders receive what is left—the
residual—after all other claims on the firms income and assets have
been satisfied.
• Because of this uncertain position, common stockholders expect to
be compensated with adequate dividends and ultimately, capital
gains.

5.3.1 Ownership
• The common stock of a firm can be privately owned by an
individual, closely owned by a small group of investors, or publicly
owned by a broad group of investors.
• Typically, small corporations are privately or closely owned and if
their shares are traded, this occurs infrequently and in small
amounts.
• Large corporations are typically publicly owned and have shares that
are actively traded on major securities exchanges.

5.3.2 Par Value

• Unlike bonds, common stock may be sold without par value.
• The par value of a common stock is generally low ($1) and is a
relatively useless value established in the firm’s corporate charter.
• A low par value may be advantageous in states where certain
corporate taxes are based on the par value of the stock.

109
5.3.3 Preemptive Rights
• A preemptive right allows common stockholders to maintain their
proportionate ownership in a corporation when new shares are
issued.
• This allows existing shareholders to maintain voting control and
protect against the dilution of their ownership.
• In a rights offering, the firm grants rights to its existing
shareholders, which permits them to purchase additional shares at a
price below the current price.

5.3.4 Authorized, Outstanding, and Issued Shares

• Authorized shares are the number of shares of common stock that
a firm’s corporate charter allows.
• Outstanding shares are the number of shares of common stock
held by the public.
• Treasury stock is the number of outstanding shares that have been
purchased by the firm.
• Issued shares are the number of shares that have been put into
circulation and includes both outstanding shares and treasury stock.

Golden Enterprises, a producer of medical pumps, has the following

stockholder’s equity account on December 31st.

110
5.3.5 Voting Rights
• Each share of common stock entitles its holder to one vote in the
election of directors and on special issues.
• Votes are generally assignable and may be cast at the annual
stockholders meeting.
• Many firms have issued two or more classes of stock differing
mainly in having unequal voting rights.
• Usually, class A common stock is designated as nonvoting while
class B is designated as voting.
• Because most shareholders do not attend the annual meeting to
vote, they may sign a proxy statement giving their votes to another
party.
• Occasionally, when the firm is widely owned, outsiders may wage a
proxy battle to unseat existing management and gain control.

5.3.6 Dividends
• Payment of dividends is at the discretion of the board of directors.
• Dividends may be made in cash, additional shares of stock, and
even merchandise.
• Because stockholders are residual claimants—they receive dividend
payments only after all claims have been settled with the
government, creditors, and preferred stockholders.

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5.3.7 International Stock Issues
• The international market for common stock is not as large as that for
international debt.
• However, cross-border trading and issuance of stock has increased
dramatically during the past 20 years.
• Much of this increase has been driven by the desire of investors to
diversify their portfolios internationally.
• Stock Issued in Foreign Markets
• A growing number of firms are beginning to list their stocks on
foreign markets.
• Issuing stock internationally both broadens the company’s
ownership base and helps it to integrate itself in the local
business scene.
• Foreign Stocks in U.S. Markets
• Only the largest foreign firms choose to list their stocks in the
U.S. because of the rigid reporting requirements of the U.S.
markets.
• Most foreign firms instead choose to tap the U.S. markets
using ADRs—claims issued by U.S. banks representing
ownership shares of foreign stock trading in U.S. markets.

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5.3.8 Preferred Stock
• Preferred stock is an equity instrument that usually pays a fixed
dividend and has a prior claim on the firm’s earnings and assets in
case of liquidation.
• The dividend is expressed as either a dollar amount or as a
percentage of its par value.
• Therefore, unlike common stock a preferred stock’s par value may
have real significance.
• If a firm fails to pay a preferred stock dividend, the dividend is said to
be in arrears.
• In general, and arrearage must be paid before common stockholders
receive a dividend.
• Preferred stocks which possess this characteristic are called
cumulative preferred stocks.
• Preferred stocks are also often referred to as hybrid securities
because they possess the characteristics of both common stocks
and bonds.
• Preferred stocks are like common stock because they are
perpetual securities with no maturity date.
• Preferred stocks are like bonds because they are fixed income
securities. Dividends never change.
• Because preferred stocks are perpetual, many have call features
which give the issuing firm the option to retire them should the need
or advantage arise.
• In addition, some preferred stocks have mandatory sinking funds
which allow the firm to retire the issue over time.
• Finally, participating preferred stock allows preferred stockholders
to participate with common stockholders in the receipt of dividends
beyond a specified amount.

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5.3.9 Issuing Common Stock
• Initial financing for most firms typically comes from a firm’s original
founders in the form of a common stock investment.
• Early stage debt or equity investors are unlikely to make an
investment in a firm unless the founders also have a personal stake
in the business.
• Initial non-founder financing usually comes first from private equity
investors.
• After establishing itself, a firm will often “go public” by issuing
shares of stock to a much broader group.

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5.4 Venture Capital
• Initial equity financing privately raised by startup or early stage
businesses comes from venture capital.
• Venture capitalists are usually formal businesses that maintain
strong oversight over firms they invest in and have clearly defined
exit strategies.
• Angel investors are one type of venture capitalist who tend to be
wealthy individuals who do not take part in management of a
business – instead, they invest in the equity of promising early stage
companies.

5.4.1 Organization and Investment Strategies

Table 5-2: Organization of Institutional Venture Capital Investors

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5.4.2 Deal Structure and Pricing
• Venture capital investments are made under legal contracts that
clearly allocate responsibilities and interests between all parties.
• Terms depend on factors related to the (a) original founders, (b)
business structure, (c) stage of development, and (d) other market
and timing issues.
• Specific financial terms depend upon (a) the value of the
enterprise, (b) the amount of funding required, and (c) the perceived
risk of the investment.
• To control the VC’s risk, various covenants are included in
agreements and the actual funding provided may be staggered
based on the achievement of measurable milestones.
• The contract will also have a defined exit strategy.
• The amount of equity to which the VC is entitled depends on (a) the
value of the firm, (b) the terms of the contract, (c) the exit terms, and
(d) minimum return required by the VC.

116
5.5 Going Public
• When a firm wishes to sell its stock in the primary market, it has
three alternatives.
• A public offering or IPO, in which it offers its shares for sale to the
general public (our focus).
• A rights offering, in which new shares are sold to existing
shareholders.
• A private placement, in which the firm sells new securities directly
to an investor or a group of investors.
• IPOs are typically made by small, fast-growing companies that
either:
• require additional capital to continue expanding, or
• have met a milestone for going public that was established in
a contract to obtain VC funding.
• The firm must obtain approval of current shareholders, and hire an
investment bank to underwrite the offering.
• The investment banker is responsible for promoting the stock and
selling its shares.
• The company must file a registration statement with the SEC.
• Part of the registration statement is a prospectus, which describes
the key aspects of the issue, the issuer, and its management and
financial position.
• While waiting for approval, prospective investors can review the
firm’s red herring, which is a preliminary prospectus.
• After the IPO is complete, the company must observe a quiet
period, which restricts company statements.

117
Figure 5-1: Cover of a Preliminary Prospectus for a Stock Issue

118
• Investment bankers and company officials promote the company
through a road show, a series of presentations to potential investors
throughout the country and sometimes overseas.
• This helps investment bankers gauge the demand for the offering
which helps them to set the initial offer price.
• After the underwriter sets the terms, the SEC must approve the
offering.

119
5.6 The Investment Banker’s Role
• Most public offerings are made with the assistance of investment
bankers which are financial intermediaries that specialize in selling
new securities and advising firms with regard to major financial
transactions.
• The main activity of the investment banker is underwriting, which
involves the purchase of the security issue from the issuing company
at an agreed-on price and bearing the risk of selling it to the public at
a profit.
• Underwriting syndicates are typically formed when companies bring
large issues to the market.
• Each investment banker in the syndicate normally underwrites a
portion of the issue in order to reduce the risk of loss for any single
firm and insure wider distribution of shares.
• The syndicate does so by creating a selling group which distributes
the shares to the investing public.

Figure 5-2: The Selling Process for a Large Security Issue

120
5.6.1 Cost of Investment Banking Services
• Investment bankers typically earn their return by profiting on the
spread.
• The spread is difference between the price paid for the securities by
the investment banker and the eventual selling price in the
marketplace.
• In general, costs for underwriting equity is highest, followed by
preferred stock, and then bonds.
• In percentage terms, costs can be as high as 17% for small stock
offerings to as low as 1.6% for large bond issues.

Figure 5-3: Stock Quotations

121
5.7 Common Stock Valuation
• Stockholders expect to be compensated for their investment in a
firm’s shares through periodic dividends and capital gains.
• Investors purchase shares when they feel they are undervalued
and sell them when they believe they are overvalued.
• This section describes specific stock valuation techniques after first
discussing the concept of market efficiency.

5.7.1 Market Efficiency

• Investors base their investment decisions on their perceptions of an
asset’s risk.
• In competitive markets, the interaction of many buyers and sellers
result’s in an equilibrium price—the market value—for each
security.
• This price is reflective of all information available to market
participants in making buy or sell investment decisions.

5.7.2 Market Adjustment to New Information

• The process of market adjustment to new information can be viewed
in terms of rates of return.
• Whenever investors find that the expected return is not equal to the
required return, price adjustment will occur.
• If expected return is greater than required return, investors will
buy and bid up price until new equilibrium price is reached.
• The opposite would occur if required return is greater than expected
return.

122
 • The expected return can be estimated by using the following
equation:
•

• Whenever investors find that the expected return is not equal to the
required return, a market price adjustment occurs.
• If the expected return is less than the required return, investors sell
the asset because they do not expect it to earn a return
commensurate with its risk.

5.7.3 The Efficient Market Hypothesis

• The efficient market hypothesis, which is the basic theory
describing the behavior of a “perfect” market specifically states:
– Securities are typically in equilibrium, meaning they are fairly
priced and their expected returns equal their required returns.
– At any point in time, security prices full reflect all public
information available about a firm and its securities and these
prices react quickly to new information.
– Because stocks are fairly priced, investors need not waste
time trying to find and capitalize on improperly priced
securities.

123
5.7.4 The Behavioral Finance Challenge
• Although considerable evidence supports the concept of market
efficiency, research collectively known as behavioral finance has
begun to cast doubt on this notion.
• Behavioral finance is a growing body of research that focuses on
investor behavior and its impact on investment decisions and stock
prices.
• Throughout this book, we ignore both disbelievers and behaviorists
and continue to assume market efficiency.

Stock Returns are derived from both dividends and capital gains, where
the capital gain results from the appreciation of the stock’s market price
due to the growth in the firm’s earnings. Mathematically, the expected
return may be expressed as follows:

E(r) = D/P + g

For example, if the firm’s $1 dividend on a $25 stock is expected to grow at

7%, the expected return is:

E(r) = 1/25 + .07 = 11%

124
5.8 Stock Valuation Models
5.8.1 The Basic Stock Valuation Equation

5.8.2 The Zero Growth Model

• The zero dividend growth model assumes that the stock will pay
the same dividend each year, year after year.

The dividend of Denham Company, an established textile manufacturer, is

expected to remain constant at $3 per share indefinitely. What is the value
of Denham’s stock if the required return demanded by investors is 15%?

P0 = $3/0.15 = $20

• Note that the zero growth model is also the appropriate valuation
technique for valuing preferred stock.

125
5.8.3 Constant Growth Model
• The constant dividend growth model assumes that the stock will pay
dividends that grow at a constant rate each year—year after year
forever.

Lamar Company, a small cosmetics company, paid the following per share
dividends:

PVIFrs,N X PN = PVIF15%,3 X P2009 = 0.658 X $21.00 = $13.82

P0 = $1.50/(0.15 – 0.07) = $18.75

• Assuming the values of D1, rs, and g are accurately estimated,

Lamar Company’s stock value is $18.75 per share.

126
5.8.4 Variable-Growth Model
• The non-constant dividend growth or variable-growth model
assumes that the stock will pay dividends that grow at one rate
during one period, and at another rate in another year or thereafter.
• We will use a four-step procedure to estimate the value of a share of
stock assuming that a single shift in growth rates occurs at the end
of year N.
• We will use g1 to represent the initial growth rate and g2 to
represent the growth rate after the shift.

Step 1. Find the value of the cash dividends at the end of each year, Dt,
during the initial growth period, years 1 though N.

Step 2. Find the present value of the dividends expected during the initial
growth period.

Step 3. Find the value of the stock at the end of the initial growth period,
PN = (DN+1)/(rs-g2), which is the present value of all dividends expected
from year N+1 to infinity, assuming a constant dividend growth rate, g2.

127
Step 4. Add the present value components found in Steps 2 and 3 to find
the value of the stock, P0, given in Equation 7.6.

The most recent annual (2006) dividend payment of Warren Industries, a

rapidly growing boat manufacturer, was $1.50 per share. The firm’s
financial manager expects that these dividends will increase at a 10%
annual rate, g1, over the next three years. At the end of three years (the
end of 2009), the firm’s mature is expected to result in a slowing of the
dividend growth rate to 5% per year, g2, for the foreseeable future. The
firm’s required return, rs, is 15%.

Steps 1 and 2. See Table 5-3 below.

Table 5-3: Calculation of Present Value of Warren Industries Dividends (2010–2012)

128
Step 3. The value of the stock at the end of the initial growth period (N =
2009) can be found by first calculating DN+1 = D2010.

D2010 = D2009 X (1 + 0.05) = $2.00 X (1.05) = $2.10

By using D2010 = $2.10, a 15% required return, and a 5% dividend growth
rate, we can calculate the value of the stock, P2009, at the end of 2009 as
follows:

P2009 = D2010 / (rs-g2) = $2.10 / (.15 - .05) = $21.00

Step 3 (continued). Finally, in Step 3, the share value of $21 at the end of
2009 must be converted into a present (end of 2006) value.

E(r) = D/P + g
Step 4. Adding the PV of the initial dividend stream (found in Step 2) to
the PV of the stock at the end of the initial growth period (found in Step 3),
we get:

P2006 = $4.14 + $13.82 = $17.96 per share

This example can be summarized using the time line below:

129
5.8.5 Free Cash Flow Model
• The free cash flow model is based on the same premise as the
dividend valuation models except that we value the firm’s free cash
flows rather than dividends.

• The free cash flow valuation model estimates the value of the entire
company and uses the cost of capital as the discount rate.
• As a result, the value of the firm’s debt and preferred stock must be
subtracted from the value of the company to estimate the value of
equity.

130
Dewhurst Inc. wishes to value its stock using the free cash flow model.
To apply the model, the firm’s CFO developed the data given in Table 5-4.

Table 5-4: Dewhurst, Inc.’s Data for the Free Cash Flow Valuation Model

Step 1. Calculate the present value of the free cash flow occurring from the
end of 2012 to infinity, measured at the beginning of 2012.

Step 2. Add the PV (in 2011) of the FCF for 2012 found in Step 1 to the
FCF for 2011 to get total FCF for 2011.

Total FCF2011 = $600,000 + $10,300,000 = $10,900,000

131
Step 3. Find the sum of the present values of the FCFs for 2007 through
2011 to determine, VC, and the market values of debt, VD, and preferred
stock, VP, given in Table 5-5 on the following slide.

Table 5-5: Calculation of the Value of the Entire Company for Dewhurst, Inc.

Step 4. Calculate the value of the common stock using equation 7.8.
Substituting the value of the entire company, VC, calculated in Step 3, and
the market value of the debt, VD, and preferred stock, VP, yields the value
of the common stock, VS.

VS = $8,628,620 - $3,100,000 = $4,728,620

P0 = $4,728,628 / 300,000 shares = $15.16 per share

132
5.9 Other Approaches to Stock Valuation
5.9.1 Book Value
• Book value per share is the amount per share that would be
received if all the firm’s assets were sold for their exact book value
and if the proceeds remaining after paying all liabilities were divided
among common stockholders.
• This method lacks sophistication and its reliance on historical
balance sheet data ignores the firm’s earnings potential and lacks
any true relationship to the firm’s value in the marketplace.

5.9.2 Liquidation Value

• Liquidation value per share is the actual amount per share of
common stock to be received if al of the firm’s assets were sold for
their market values, liabilities were paid, and any remaining funds
were divided among common stockholders.
• This measure is more realistic than book value because it is based
on current market values of the firm’s assets.
• However, it still fails to consider the earning power of those assets.

5.9.3 Price/Earnings (P/E) Multiples

• Some stocks pay no dividends—using P/E ratios are one way to
evaluate a stock under these circumstances.
• The model may be written as:

P0 = (EPSt+1) X (Industry Average P/E)

For example, Lamar’s expected EPS is $2.60/share and the industry

average P/E multiple is 7, then P0 = $2.60 X 7 = $18.20/share.

133
5.10 Decision Making and Common Stock Value
• Valuation equations measure the stock value at a point in time
based on expected return and risk.
• Any decisions of the financial manager that affect these variables
can cause the value of the firm to change as shown in the Figure
below.

Figure 5-4: Decision Making and Stock Value

5.10.1 Changes in Dividends or Dividend Growth

• Changes in expected dividends or dividend growth can have a
profound impact on the value of a stock.

Price Sensitivity to Chan ges in Dividends and Dividend Growth

(Usin g the Co nstant Growth Model)
D0 $ 2.00 $ 2.50 $ 3.00 $ 2.00 $ 2.00 $ 2.00
g 3.0% 3.0% 3.0% 3.0% 6.0% 9.0%
D1 $ 2.06 $ 2.58 $ 3.09 $ 2.06 $ 2.12 $ 2.18
rS 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%
P0 $ 29.43 $ 36.79 $ 44.14 $ 29.43 $ 53.00 $ 218.00

134
5.10.2 Changes in Risk and Required Return
• Changes in expected dividends or dividend growth can have a
profound impact on the value of a stock.

Price Sensitivity to Changes Risk (Required Return)

(Using the Constant Growth Model)
D0 $ 2.00 $ 2.00 $ 2.00 $ 2.00 $ 2.00 $ 2.00
g 3.0% 3.0% 3.0% 3.0% 3.0% 3.0%
D1 $ 2.06 $ 2.06 $ 2.06 $ 2.06 $ 2.06 $ 2.06
rS 5.0% 7.5% 10.0% 12.5% 15.0% 17.5%
P0 $ 103.00 $ 45.78 $ 29.43 $ 21.68 $ 17.17 $ 14.21

135
Table 5-6: Summary of Key Valuation Definitions and Formulas for Common Stock

136
6 Capital Budgeting Cash Flows

137
6.0 Capital Budgeting Cash Flows
6.0.1 Learning Goals
1. Understand the motives for key capital budgeting expenditures and
the steps in the capital budgeting process.
2. Define basic capital budgeting terminology.
3. Discuss relevant cash flows, expansion versus replacement
decisions, sunk costs and opportunity costs, and international capital
budgeting.
4. Calculate the initial investment associated with a proposed capital
expenditure.
5. Find the relevant operating cash inflows associated with a proposed
capital expenditure.
6. Determine the terminal cash flow associated with a proposed capital
expenditure.

6.1 The Capital Budgeting Decision Process

• Capital Budgeting is the process of identifying, evaluating, and
implementing a firm’s investment opportunities.
• It seeks to identify investments that will enhance a firm’s
competitive advantage and increase shareholder wealth.
• The typical capital budgeting decision involves a large up-front
investment followed by a series of smaller cash inflows.
• Poor capital budgeting decisions can ultimately result in company
bankruptcy.

138
6.1.1 Steps in the Process

• Proposal Generation
• Review and Analysis
Our Focus is
on Step 2 and 3 • Decision Making
• Implementation
• Follow-up

139
6.2 Basic Terminology
6.2.1 Independent versus Mutually Exclusive Projects
• Independent Projects, on the other hand, do not compete with the
firm’s resources. A company can select one, or the other, or both—
so long as they meet minimum profitability thresholds.
• Mutually Exclusive Projects are investments that compete in some
way for a company’s resources—a firm can select one or another
but not both.

6.2.2 Unlimited Funds versus Capital Rationing

• If the firm has unlimited funds for making investments, then all
independent projects that provide returns greater than some
specified level can be accepted and implemented.
• However, in most cases firms face capital rationing restrictions
since they only have a given amount of funds to invest in potential
investment projects at any given time.

6.2.3 Accept-Reject versus Ranking Approaches

• The accept-reject approach involves the evaluation of capital
expenditure proposals to determine whether they meet the firm’s
minimum acceptance criteria.
• The ranking approach involves the ranking of capital expenditures
on the basis of some predetermined measure, such as the rate of
return.

140
6.2.4 Conventional versus Nonconventional Cash Flows

Figure 6-1: Conventional Cash Flow

Figure 6-2: Nonconventional Cash Flow

141
6.3 The Relevant Cash Flows
• Incremental cash flows:
– are cash flows specifically associated with the investment, and
– their effect on the firms other investments (both positive and
negative) must also be considered.

For example, if a day-care center decides to open another

facility, the impact of customers who decide to move from one
facility to the new facility must be considered.

6.3.1 Major Cash Flow Components

Figure 6-3: Cash Flow Components

142
6.3.2 Expansion Versus Replacement Decisions
• Estimating incremental cash flows is relatively straightforward in the
case of expansion projects, but not so in the case of replacement
projects.
• With replacement projects, incremental cash flows must be
computed by subtracting existing project cash flows from those
expected from the new project.

Figure 6-4: Relevant Cash Flows for Replacement Decisions

6.3.3 Sunk Costs Versus Opportunity Costs

• Note that cash outlays already made (sunk costs) are irrelevant to
the decision process.
• However, opportunity costs, which are cash flows that could be
realized from the best alternative use of the asset, are relevant.

143
6.3.4 International Capital Budgeting
• International capital budgeting analysis differs from purely domestic
analysis because:
– cash inflows and outflows occur in a foreign currency, and
– foreign investments potentially face significant political risks
• Despite these risks, the pace of foreign direct investment has
accelerated significantly since the end of WWII.

144
6.4 Finding the Initial Investment

Table 6-2: The Basic Format for Determining Initial Investment

Table 6-3: Tax Treatment on Sales of Assets

145
Hudson Industries, a small electronics company, 2 years ago acquired a
machine tool with an installed cost of $100,000. The asset was being
depreciated under MACRS using a 5-year recovery period. Thus 52% of
the cost (20% + 32%) would represent accumulated depreciation at the
end of year two.

Book Value = $100,000 - $52,000 = $48,000

• Sale of the Asset for More Than Its Purchase Price

If Hudson sells the old asset for $110,000, it realizes a gain of $62,000
($110,000 - $48,000). Technically, the difference between the cost and
book value ($52,000) is called recaptured depreciation and the difference
between the sales price and purchase price ($10,000) is called a capital
gain. Under current corporate tax laws, the firm must pay taxes on both
the gain and recaptured depreciation at its marginal tax rate.

• Sale of the Asset for More Than Its Book Value but Less than Its
Purchase Price

If Hudson sells the old asset for $70,000, it realizes a gain in the form of
recaptured depreciation of $22,000 ($70,000–$48,000) which is taxed at
the firm’s marginal tax rate.

• Sale of the Asset for Its Book Value

If Hudson sells the old asset for its book value of $48,000, there is no gain
or loss and therefore no tax implications from the sale.

146
 • Sale of the Asset for Less Than Its Book Value

If Hudson sells the old asset for $30,000 which is less than its book value
of $48,000, it experiences a loss of $18,000 ($48,000 - $30,000). If this is
a depreciable asset used in the business, the loss may be used to offset
ordinary operating income. If it is not depreciable or used in the business,
the loss can only e used to offset capital gains.

Figure 6-5: Taxable Income from Sale of Asset

147
 • Change in Net Working Capital
Danson Company, a metal products manufacturer, is contemplating
expanding operations. Financial analysts expect that the changes in
current accounts summarized in Table 6-4 on the following slide will occur
and will be maintained over the life of the expansion.

Table 6-4: Calculation of Change in Net Working Capital for Danson Company

148
Powell Corporation, a large diversified manufacturer of aircraft
components, is trying to determine the initial investment required to
replace an old machine with a new, more sophisticated model. The
machine’s purchase price is $380,000 and an additional $20,000 will be
necessary to install it. It will be depreciated under MACRS using a 5-year
recovery period. The firm has found a buyer willing to pay $280,000 for
the present machine and remove it at the buyer’s expense. The firm
expects that a $35,000 increase in current assets and an $18,000 increase
in current liabilities will accompany the replacement. Both ordinary income
and capital gains are taxed at 40%.

Powell Corporation’s estimates of its revenues and expenses (excluding

depreciation and interest), with and without the new machine described in
the preceding example, are given in Table 6-5. Note that both the
expected usable life of the proposed machine and the remaining usable life
of the existing machine are 5 years. The amount to be depreciated with
the proposed machine is calculated by summing the purchase price of
$380,000 and the installation costs of $20,000.

149
Table 6-5: Powell Corporation’s Revenue and Expenses (Excluding Depreciation and Interest) for
Proposed and Present Machines

Table 6-6: Depreciation Expense for Proposed and Present Machines for Powell Corporation

150
Table 6-7: Calculation of Operating Cash Inflows Using the Income Statement Format

151
Table 6-9: Incremental (Relevant) Operating Cash Inflows for Powell Corporation

152
6.5 Finding the Terminal Cash Flow

Table 6-10: The Basic Format for Determining Terminal Cash Flow

Continuing with the Powell Corporation example, assume that the firm
expects to be able to liquidate the new machine at the end of its 5-year
useable life to net $50,000 after paying removal and cleanup costs. The
old machine can be liquidated at the end of the 5 years to net $10,000.
The firm expects to recover its $17,000 net working capital investment
upon termination of the project. Again, the tax rate is 40%.

153
6.6 Summarizing the Relevant Cash Flows

154
7 Capital Budgeting Techniques

155
7.0 Capital Budgeting Techniques
7.0.1 Learning Goals
1. Understand the role of capital budgeting techniques in the capital
budgeting process.
2. Calculate, interpret, and evaluate the payback period.
3. Calculate, interpret, and evaluate the net present value (NPV).
4. Calculate, interpret, and evaluate the internal rate of return (IRR).
5. Use net present value profiles to compare NPV and IRR techniques.
6. Discuss NPV and IRR in terms of conflicting rankings and the
theoretical and practical strengths of each approach.

7.0.2 Chapter Problem

Bennett Company is a medium sized metal fabricator that is currently
contemplating two projects: Project A requires an initial investment of
$42,000, project B an initial investment of $45,000. The relevant operating
cash flows for the two projects are presented in Table 7-1 and depicted on
the time lines in Figure 7-1.

Table 7-1: Capital Expenditure Data for Bennett Company

156
Figure 7-1: Bennett Company’s Projects A and B

157
7.1 Payback Period
• The payback method simply measures how long (in years and/or
months) it takes to recover the initial investment.
• The maximum acceptable payback period is determined by
management.
• If the payback period is less than the maximum acceptable payback
period, accept the project.
• If the payback period is greater than the maximum acceptable
payback period, reject the project.

7.1.1 Pros and Cons of Payback Periods

• The payback method is widely used by large firms to evaluate small
projects and by small firms to evaluate most projects.
• It is simple, intuitive, and considers cash flows rather than
accounting profits.
• It also gives implicit consideration to the timing of cash flows and is
widely used as a supplement to other methods such as Net Present
Value and Internal Rate of Return.
• One major weakness of the payback method is that the appropriate
payback period is a subjectively determined number.
• It also fails to consider the principle of wealth maximization
because it is not based on discounted cash flows and thus
provides no indication as to whether a project adds to firm value.
• Thus, payback fails to fully consider the time value of money.

158
 Table 7-2: Relevant Cash Flows and Payback Periods for DeYarman Enterprises’ Projects

Table 7-3: Calculation of the Payback Period for Rashid Company’s Two Alternative Investment
Projects

159
7.2 Net Present Value (NPV)
• Net Present Value (NPV): Net Present Value is found by subtracting
the present value of the after-tax outflows from the present value of
the after-tax inflows.

• Net Present Value (NPV): Net Present Value is found by subtracting

the present value of the after-tax outflows from the present value of
the after-tax inflows.

Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, technically indifferent

160
Using the Bennett Company data from Table 7-1, assume the firm has a
10% cost of capital. Based on the given cash flows and cost of capital
(required return), the NPV can be calculated as shown in Figure 7-2

Figure 7-2: Calculation of NPVs for Bennett Company’s Capital Expenditure Alternatives

161
7.3 Internal Rate of Return (IRR)
• The Internal Rate of Return (IRR) is the discount rate that will
equate the present value of the outflows with the present value of
the inflows.
• The IRR is the project’s intrinsic rate of return.

• The Internal Rate of Return (IRR) is the discount rate that will
equate the present value of the outflows with the present value of
the inflows.
• The IRR is the project’s intrinsic rate of return.

Decision Criteria
If IRR > cost of capital, accept the project
If IRR < cost of capital, reject the project
If IRR = cost of capital, technically indifferent

162
Figure 7-3: Calculation of IRRs for Bennett Company’s Capital Expenditure Alternatives

163
7.4 Net Present Value Profiles
• NPV Profiles are graphs that depict project NPVs for various
discount rates and provide an excellent means of making
comparisons between projects.

To prepare NPV profiles for Bennett Company’s projects A and B, the first
step is to develop a number of discount rate-NPV coordinates and then
graph them as shown in the following table and figure.

Table 7-4: Discount Rate–NPV Coordinates for Projects A and B

Figure 7-4: NPV Profiles

164
7.5 Conflicting Rankings
• Conflicting rankings between two or more projects using NPV and
IRR sometimes occurs because of differences in the timing and
magnitude of cash flows.
• This underlying cause of conflicting rankings is the implicit
assumption concerning the reinvestment of intermediate cash
inflows—cash inflows received prior to the termination of the
project.
• NPV assumes intermediate cash flows are reinvested at the cost of
capital, while IRR assumes that they are reinvested at the IRR.

A project requiring a $170,000 initial investment is expected to provide

cash inflows of $52,000, $78,000 and $100,000. The NPV of the project at
10% is $16,867 and it’s IRR is 15%. Table 7-5 on the following slide
demonstrates the calculation of the project’s future value at the end of it’s
3-year life, assuming both a 10% (cost of capital) and 15% (IRR) interest
rate.
Table 7-5: Reinvestment Rate Comparisons for a Project a

165
If the future value in each case in Table 7-5 were viewed as the return
received 3 years from today from the $170,000 investment, then the cash
flows would be those given in Table 7-6 on the following slide.

Table 7-6: Project Cash Flows After Reinvestment

Bennett Company’s projects A and B were found to have conflicting

rankings at the firm’s 10% cost of capital as depicted in Table 7-4. If we
review the project’s cash inflow pattern as presented in Table 7-1 and
Figure 7-1, we see that although the projects require similar investments,
they have dissimilar cash flow patterns. Table 7-7 on the following slide
indicates that project B, which has higher early-year cash inflows than
project A, would be preferred over project A at higher discount rates.

166
Table 7-7: Preferences Associated with Extreme Discount Rates and Dissimilar Cash Inflow
Patterns

167
7.6 Which Approach is Better?
• On a purely theoretical basis, NPV is the better approach because:
– NPV assumes that intermediate cash flows are reinvested at
the cost of capital whereas IRR assumes they are reinvested
at the IRR,
– Certain mathematical properties may cause a project with
non-conventional cash flows to have zero or more than one
real IRR.
• Despite its theoretical superiority, however, financial managers
prefer to use the IRR because of the preference for rates of return.

Table 7-8: Summary of Key Formulas/Definitions and Decision Criteria for Capital Budgeting
Techniques

168
8 Risk and Refinements in Capital
Budgeting

169
8.0 Risk and Refinements in Capital Budgeting
8.0.1 Learning Goals
1. Understand the importance of recognizing risk in the analysis of
capital budgeting projects.
2. Discuss breakeven cash inflow, scenario analysis, and simulation as
behavioral approaches for dealing with risk.
3. Discuss the unique risks that multinational companies face.
4. Describe the determination and use of risk-adjusted discount rates
(RADRs), portfolio effects, and the practical aspects of RADRs.
5. Select the best of a group of mutually exclusive projects using
annualized net present values (ANPVs).
6. Explain the role of real options and the objective and procedures for
selecting projects under capital rationing.

8.0.2 Introduction to Risk in Capital Budgeting

• Thus far in our exploration of capital budgeting, all projects were
assumed to be equally risky.
• The acceptance of any project would not alter the firm’s overall risk.
• In actuality, these situations are rare—project cash flows typically
have different levels of risk and the acceptance of a project does
affect the firm’s overall risk.
• This chapter will focus on how to handle risk.

170
Table 8-1: Cash Flows and NPVs for Bennett Company’s Projects

171
8.1 Behavioral Approaches for Dealing with Risk
• In the context of the capital budgeting projects discussed in this
chapter, risk results almost entirely from the uncertainty about future
cash inflows, because the initial cash outflow is generally known.
• These risks result from a variety of factors including uncertainty
about future revenues, expenditures and taxes.
• Therefore, to asses the risk of a potential project, the analyst needs
to evaluate the riskiness of the cash inflows.

8.1.1 Risk and Cash Inflows

Treadwell Tire, a tire retailer with a 10% cost of capital, is considering
investing in either of two mutually exclusive projects, A and B. Each
requires a $10,000 initial investment, and both are expected to provide
equal annual cash inflows over their 15-year lives. For either project to be
acceptable, NPV must be greater than zero. We can solve for CF using
the following:

172
8.1.2 Sensitivity Analysis
The risk of Treadwell Tire Company’s investments can be evaluated using
sensitivity analysis as shown in Table 8-2 on the following slide. For this
example, assume that the financial manager made pessimistic, most likely,
and optimistic estimates of the cash inflows for each project.

Table 8-2: Scenario Analysis of Treadwell’s Projects A and B

173
8.1.3 Scenario Analysis
• Scenario analysis is a behavioral approach similar to sensitivity
analysis but is broader in scope.
• This method evaluates the impact on the firm’s return of
simultaneous changes in a number of variables, such as cash
inflows, outflows, and the cost of capital.
• NPV is then calculated under each different set of variable
assumptions.

8.1.4 Simulation
• Simulation is a statistically-based behavioral approach that applies
predetermined probability distributions and random numbers to
estimate risky outcomes.
• Figure 8-1 presents a flowchart of the simulation of the NPV of a
project.
• The use of computers has made the use of simulation economically
feasible, and the resulting output provides an excellent basis for
decision-making.

Figure 8-1: NPV Simulation

174
8.2 International Risk Considerations
• Exchange rate risk is the risk that an unexpected change in the
exchange rate will reduce NPV of a project’s cash flows.
• In the short term, much of this risk can be hedged by using financial
instruments such as foreign currency futures and options.
• Long-term exchange rate risk can best be minimized by financing
the project in whole or in part in the local currency.
• Political risk is much harder to protect against once a project is
implemented.
• A foreign government can block repatriation of profits and even
seize the firm’s assets.
• Accounting for these risks can be accomplished by adjusting the
rate used to discount cash flows—or better—by adjusting the
project’s cash flows.
• Since a great deal of cross-border trade among MNCs takes place
between subsidiaries, it is also important to determine the net
incremental impact of a project’s cash flows overall.
• As a result, it is important to approach international capital projects
from a strategic viewpoint rather than from a strictly financial
perspective.

175
8.3 Risk-Adjusted Discount Rates
• Risk-adjusted discount rates are rates of return that must be
earned on given projects to compensate the firm’s owners
adequately—that is, to maintain or improve the firm’s share price.
• The higher the risk of a project, the higher the RADR—and thus the
lower a project’s NPV.

8.3.1 Review of CAPM

176
8.3.2 Using CAPM to Find RADRs

Figure 8-2: CAPM and SML

8.3.3 Applying RADRs

Bennett Company wishes to apply the Risk-Adjusted Discount Rate
(RADR) approach to determine whether to implement Project A or B. In
addition to the data presented earlier, Bennett’s management assigned a
“risk index” of 1.6 to project A and 1.0 to project B as indicated in the
following table. The required rates of return associated with these indexes
are then applied as the discount rates to the two projects to determine
NPV.

177
Figure 8-3: Calculation of NPVs for Bennett Company’s Capital Expenditure Alternatives Using
RADRs

178
179
8.3.4 RADRs in Practice
Table 8-3: Bennett Company’s Risk Classes and RADRs

180
8.4 Risk-Adjustment Techniques
8.4.1 Portfolio Effects
• As noted earlier, individual investors must hold diversified portfolios
because they are not rewarded for assuming diversifiable risk.
• Because business firms can be viewed as portfolios of assets, it
would seem that it is also important that they too hold diversified
portfolios.
• Surprisingly, however, empirical evidence suggests that firm value is
not affected by diversification.
• In other words, diversification is not normally rewarded and therefore
is generally not necessary.
• It turns out that firms are not rewarded for diversification because
investors can do so themselves.
• An investor can diversify more readily, easily, and costlessly simply
by holding portfolios of stocks.

181
8.5 Capital Budgeting Refinements
8.5.1 Comparing Projects With Unequal Lives
• If projects are independent, comparing projects with unequal lives
is not critical.
• But when unequal-lived projects are mutually exclusive, the impact
of differing lives must be considered because they do not provide
service over comparable time periods.
• This is particularly important when continuing service is needed from
the projects under consideration.

The AT Company, a regional cable-TV firm, is evaluating two projects, X

and Y. The projects’ cash flows and resulting NPVs at a cost of capital of
10% is given below.

182
The AT Company, a regional cable-TV firm, is evaluating two projects, X
and Y. The projects’ cash flows and resulting NPVs at a cost of capital of
10% is given below.

The AT Company, a regional cable-TV firm, is evaluating two projects, X

and Y. The projects’ cash flows and resulting NPVs at a cost of capital of
10% is given below.

183
Ignoring the difference in their useful lives, both projects are acceptable
(have positive NPVs). Furthermore, if the projects were mutually
exclusive, project Y would be preferred over project X. However, it is
important to recognize that at the end of its 3 year life, project Y must be
replaced, or renewed.

Although a number of approaches are available for dealing with unequal

lives, we will present the most efficient technique -- the annualized NPV
approach.

184
 Annualized NPV (ANPV)
The ANPV approach converts the NPV of unequal-lived mutually exclusive
projects into an equivalent (in NPV terms) annual amount that can be used
to select the best project.

1. Calculate the NPV of each project over its live using the appropriate
cost of capital.
2. Divide the NPV of each positive NPV project by the PVIFA at the given
cost of capital and the project’s live to get the ANPV for each project.
3. Select the project with the highest ANPV.

1. Calculate the NPV for projects X and Y at 10%.

NPVX = $11,248; NPVY = $18,985.
2. Calculate the ANPV for Projects X and Y.
ANPVX = $11,248/PVIFA10%,3 years = $4,523
ANPVY = $18,985/PVIFA10%,6 years = $4,359
3. Choose the project with the higher ANPV.
Pick project X.

185
186
8.6 Recognizing Real Options
• Real options are opportunities that are embedded in capital projects
that enable managers to alter their cash flows and risk in a way that
affects project acceptability (NPV).
• Real options are also sometimes referred to as strategic options.
• Some of the more common types of real options are described in the
table on the following slide.

Table 8-4: Major Types of Real Options

187
 NPVstrategic = NPVtraditional + Value of Real Options
Assume that a strategic analysis of Bennett Company’s projects A and B
(see Table 8-1) finds no real options embedded in Project A but two real
options embedded in B:
1. During it’s first two years, B would have downtime that results in
unused production capacity that could be used to perform contract
manufacturing;
2. Project B’s computerized control system could control two other
machines, thereby reducing labor costs.

Bennett’s management estimated the NPV of the contract manufacturing

option to be $1,500 and the NPV of the computer control sharing option to
be $2,000. Furthermore, they felt there was a 60% chance that the
contract manufacturing option would be exercised and a 30% chance that
the computer control sharing option would be exercised.

Value of Real Options for B = (60% x $1,500) + (30% x $2,000)

$900 + $600 = $1,500

NPVstrategic = $10,924 + $1,500 = $12,424

NPVA = $12,424; NPVB = $11,071; Now choose A over B.

188
8.7 Capital Rationing
• Firm’s often operate under conditions of capital rationing—they
have more acceptable independent projects than they can fund.
• In theory, capital rationing should not exist—firms should accept all
projects that have positive NPVs.
• However, research has found that management internally imposes
capital expenditure constraints to avoid what it deems to be
“excessive” levels of new financing, particularly debt.
• Thus, the objective of capital rationing is to select the group of
projects within the firm’s budget that provides the highest overall
NPV or IRR.

Tate Company, a fast growing plastics company with a cost of capital of

10%, is confronted with six projects competing for its fixed budget of
$250,000. The initial investment and IRR for each project are shown
below:

189
8.7.1 IRR Approach

Figure 8-4: Investment Opportunities Schedule

8.7.2 NPV Approach

Table 8-5: Rankings for Tate Company Projects

190
9 The Cost of Capital

191
9.0 The Cost of Capital
9.0.1 Learning Goals
1. Understand the key assumptions, the basic concept, and the specific
sources of capital associated with the cost of capital.
2. Determine the cost of long-term debt and the cost of preferred stock.
3. Calculate the cost of common stock equity and convert it into the
cost of retained earnings and the cost of new issues of commons
stock.
4. Calculate the weighted average cost of capital (WACC) and discuss
alternative weighting schemes.
5. Describe the procedures used to determine break points and the
weighted marginal cost of capital (WMCC).
6. Explain the weighted marginal cost of capital (WMCC) and its use
with the investment opportunities schedule (IOS) to make financing
and investment decisions.

9.1 An Overview of the Cost of Capital

• The cost of capital acts as a link between the firm’s long-term
investment decisions and the wealth of the owners as determined by
investors in the marketplace.
• It is the “magic number” that is used to decide whether a proposed
investment will increase or decrease the firm’s stock price.
• Formally, the cost of capital is the rate of return that a firm must
earn on the projects in which it invests to maintain the market value
of its stock.

192
9.1.1 The Firm’s Capital Structure

9.1.2 Some Key Assumptions

• Business Risk—the risk to the firm of being unable to cover
operating costs—is assumed to be unchanged. This means that the
acceptance of a given project does not affect the firm’s ability to
meet operating costs.
• Financial Risk—the risk to the firm of being unable to cover
required financial obligations—is assumed to be unchanged. This
means that the projects are financed in such a way that the firm’s
ability to meet financing costs is unchanged.
• After-tax costs are considered relevant—the cost of capital is
measured on an after-tax basis.

193
9.1.3 The Basic Concept
• Why do we need to determine a company’s overall “weighted average
cost of capital?”
Assume the ABC company has the following investment opportunity:
- Initial Investment = $100,000
- Useful Life = 20 years
- IRR = 7%
- Least cost source of financing, Debt = 6%

Given the above information, a firm’s financial manger would be inclined to

accept and undertake the investment.

• Why do we need to determine a company’s overall “weighted average

cost of capital?”
Imagine now that only one week later, the firm has another available
investment opportunity
- Initial Investment = $100,000
- Useful Life = 20 years
- IRR = 12%
- Least cost source of financing, Equity = 14%

Given the above information, the firm would reject this second, yet clearly
more desirable investment opportunity.

194
• Why do we need to determine a company’s overall “weighted
average cost of capital?”
• As the above simple example clearly illustrates, using this piecemeal
approach to evaluate investment opportunities is clearly not in the
best interest of the firm’s shareholders.
• Over the long haul, the firm must undertake investments that
maximize firm value.
• This can only be achieved if it undertakes projects that provide
returns in excess of the firm’s overall weighted average cost of
financing (or WACC).

195
9.2 Specific Sources of Capital
9.2.1 The Cost of Long-Term Debt
• The pretax cost of debt is equal to the the yield-to-maturity on the
firm’s debt adjusted for flotation costs.
• Recall that a bond’s yield-to-maturity depends upon a number of
factors including the bond’s coupon rate, maturity date, par value,
current market conditions, and selling price.
• After obtaining the bond’s yield, a simple adjustment must be made
to account for the fact that interest is a tax-deductible expense.
• This will have the effect of reducing the cost of debt.

Net Proceeds
Duchess Corporation, a major hardware manufacturer, is contemplating
selling $10 million worth of 20-year, 9% coupon bonds with a par value of
$1,000. Because current market interest rates are greater than 9%, the
firm must sell the bonds at $980. Flotation costs are 2% or $20. The net
proceeds to the firm for each bond is therefore $960 ($980 - $20).

• Before-Tax Cost of Debt

• The before-tax cost of debt can be calculated in any one of three
ways:
– Using cost quotations
– Calculating the cost
– Approximating the cost

196
• Before-Tax Cost of Debt
– Using Cost Quotations
– When the net proceeds from the sale of a bond equal its par
value, the before-tax cost equals the coupon interest rate.
– A second quotation that is sometimes used is the yield-to-
maturity (YTM) on a similar risk bond.

• Before-Tax Cost of Debt

– Calculating the Cost
– This approach finds the before-tax cost of debt by calculating
the internal rate of return (IRR).
– As discussed in earlier in the text, YTM can be calculated
using: (a) trial and error, (b) a financial calculator, or (c) a
spreadsheet.

• Before-Tax Cost of Debt

– Calculating the Cost

197
• Before-Tax Cost of Debt
– Calculating the Cost

• Before-Tax Cost of Debt

– Approximating the Cost

198
 Find the after-tax cost of debt for Duchess assuming it has
a 40% tax rate:
ri = 9.4% (1-.40) = 5.6%
This suggests that the after-tax cost of raising debt capital
for Duchess is 5.6%.

9.2.2 The Cost of Preferred Stock

Duchess Corporation is contemplating the issuance of a 10% preferred

stock that is expected to sell for its $87-per share value. The cost of
issuing and selling the stock is expected to be $5 per share. The dividend
is $8.70 (10% x $87). The net proceeds price (Np) is $82 ($87 - $5).

rP = DP/Np = $8.70/$82 = 10.6%

199
9.2.3 The Cost of Common Stock
• There are two forms of common stock financing: retained earnings
and new issues of common stock.
• In addition, there are two different ways to estimate the cost of
common equity: any form of the dividend valuation model, and the
capital asset pricing model (CAPM).
• The dividend valuation models are based on the premise that the
value of a share of stock is based on the present value of all future
dividends.

Using the constant growth model, we

rS = (D1/P0) + g

• We can also estimate the cost of common equity using the CAPM:

rE = rF + b(rM - rF).

• The CAPM differs from dividend valuation models in that it explicitly

considers the firm’s risk as reflected in beta.
• On the other hand, the dividend valuation model does not explicitly
consider risk.
• Dividend valuation models use the market price (P0) as a reflection
of the expected risk-return preference of investors in the
marketplace.

200
 • Although both are theoretically equivalent, dividend valuation models
are often preferred because the data required are more readily
available.
• The two methods also differ in that the dividend valuation models
(unlike the CAPM) can easily be adjusted for flotation costs when
estimating the cost of new equity.
• This will be demonstrated in the examples that follow.

• Cost of Retained Earnings (rE)

• Constant Dividend Growth Model

rs = D1/P0 + g

For example, assume a firm has just paid a dividend of $2.50 per share,
expects dividends to grow at 10% indefinitely, and is currently selling for
$50.00 per share.

First, D1 = $2.50(1+.10) = $2.75, and

rS = ($2.75/$50.00) + .10 = 15.5%.

• Cost of Retained Earnings (rE)

– Security Market Line Approach

rs = rF + b(rM - rF).
For example, if the 3-month T-bill rate is currently 5.0%, the market risk
premium is 9%, and the firm’s beta is 1.20, the firm’s cost of retained
earnings will be:

rs = 5.0% + 1.2 (9.0%) = 15.8%.

201
 • Cost of Retained Earnings (rE)

The previous example indicates that our estimate of the cost of

retained earnings is somewhere between 15.5% and 15.8%. At
this point, we could either choose one or the other estimate or
average the two.

Using some managerial judgment and preferring to err on the high

side, we will use 15.8% as our final estimate of the cost of retained
earnings.

• Cost of New Equity (r n)

– Constant Dividend Growth Model

rn = = D1/Nn - g
Continuing with the previous example, how much would it cost the firm to
raise new equity if flotation costs amount to $4.00 per share?

rn = [$2.75/($50.00 - $4.00)] + .10 = 15.97% or 16%.

202
9.3 The Weighted Average Cost of Capital

WACC = ra = wiri + wprp + wsrr or n

• Capital Structure Weights

The weights in the above equation are intended to represent a

specific financing mix (where wi = % of debt, wp = % of preferred,
and ws= % of common).

Specifically, these weights are the target percentages of debt and

equity that will minimize the firm’s overall cost of raising funds.

WACC = ra = wiri + wprp + wsrr or n

• Capital Structure Weights

One method uses book values from the firm’s balance sheet. For
example, to estimate the weight for debt, simply divide the book
value of the firm’s long-term debt by the book value of its total
assets.

To estimate the weight for equity, simply divide the total book value
of equity by the book value of total assets.

203
 WACC = ra = wiri + wprp + wsrr or n
• Capital Structure Weights

A second method uses the market values of the firm’s debt and
equity. To find the market value proportion of debt, simply multiply
the price of the firm’s bonds by the number outstanding. This is
equal to the total market value of the firm’s debt.

Next, perform the same computation for the firm’s equity by

multiplying the price per share by the total number of shares
outstanding.

WACC = ra = wiri + wprp + wsrr or n

• Capital Structure Weights

Finally, add together the total market value of the firm’s equity to
the total market value of the firm’s debt. This yields the total
market value of the firm’s assets.

To estimate the market value weights, simply dividend the market

value of either debt or equity by the market value of the firm’s
assets .

204
 WACC = ra = wiri + wprp + wsrr or n
• Capital Structure Weights

For example, assume the market value of the firm’s debt is $40
million, the market value of the firm’s preferred stock is $10 million,
and the market value of the firm’s equity is $50 million.

Dividing each component by the total of $100 million gives us

market value weights of 40% debt, 10% preferred, and 50%
common.

WACC = ra = wiri + wprp + wsrr or n

• Capital Structure Weights

Using the costs previously calculated along with the market value
weights, we may calculate the weighted average cost of capital as
follows:
WACC = .40(5.67%) + .10(9.62%) + .50(15.8%)
= 11.13%

This assumes the firm has sufficient retained earnings to fund any
anticipated investment projects.

205
9.4 The Marginal Cost & Investment Decisions
• The Weighted Marginal Cost of Capital (WMCC)
– The WACC typically increases as the volume of new capital
raised within a given period increases.
– This is true because companies need to raise the return to
investors in order to entice them to invest to compensate them
for the increased risk introduced by larger volumes of capital
raised.
– In addition, the cost will eventually increase when the firm runs
out of cheaper retained equity and is forced to raise new,
more expensive equity capital.

• The Weighted Marginal Cost of Capital (WMCC)

– Finding Break Points

Finding the break points in the WMCC schedule will allow us to

determine at what level of new financing the WACC will increase
due to the factors listed above.

BPj = AFj/wj

where:
BPj = breaking point form financing source j
AFj = amount of funds available at a given cost
wj = target capital structure weight for source j

206
 • The Weighted Marginal Cost of Capital (WMCC)
– Finding Break Points

Assume that in the example we have been using that the firm has $2
million of retained earnings available. When it is exhausted, the firm must
issue new (more expensive) equity. Furthermore, the company believes it
can raise $1 million of cheap debt after which it will cost 7% (after-tax) to
raise additional debt.

Given this information, the firm can determine its break points as follows:
BPequity = $2,000,000/.50 = $4,000,000
BPdebt = $1,000,000/.40 = $2,500,000

This implies that the firm can fund up to $4 million of new investment
before it is forced to issue new equity and $2.5 million of new investment
before it is forced to raise more expensive debt.
Given this information, we may calculate the WMCC as follows:

WACC for Ranges of Total New Financing

Range of total Source of Weighted
New Financing Capital Weight Cost Cost
$0 to $2.5 million Debt 40% 5.67% 2.268%
Preferred 10% 9.62% 0.962%
Common 50% 15.80% 7.900%
WACC 11.130%

$2.5 to $4.0 million Debt 40% 7.00% 2.800%

Preferred 10% 9.62% 0.962%
Common 50% 15.80% 7.900%
WACC 11.662%

over $4.0 million Debt 40% 7.00% 2.800%

Preferred 10% 9.62% 0.962%
Common 50% 16.00% 8.000%
WACC 11.762%

207
11.76% WMCC

11.75%
11.66%

11.50%

11.25%
11.13%

$2.5 $4.0 Total Financing

(millions)

• Investment Opportunities Schedule (IOS)

• Now assume the firm has the following investment opportunities
available:

Initial Cumulative
Project IRR Ivestment Investment
A 13.0% $ 1,000,000 $ 1,000,000
B 12.0% $ 1,000,000 $ 2,000,000
C 11.5% $ 1,000,000 $ 3,000,000
D 11.0% $ 1,000,000 $ 4,000,000
E 10.0% $ 1,000,000 $ 5,000,000

208
13.0% A WMCC
12.0% B

11.66%
This indicates
11.5% that the firm can
C accept only
Projects A & B.

11.13% D
11.0%

$1.0 $2.0 $2.5 $3.0 $4.0 Total Financing

(millions)

209
Table 9-1: Summary of Key Definitions and Formulas for Cost of Capital

210
 Table 9-2: Calculation of the Weighted Average Cost of Capital for Duchess Corporation

Table 9-3: Weighted Average Cost of Capital for Ranges of Total New Financing for Duchess
Corporation

211
Figure 9-1: WMCC Schedule

212
Table 9-4: Investment Opportunities Schedule (IOS) for Duchess Corporation

213
10 Leverage and Capital Structure

214
10.0 Leverage and Capital Structure
10.0.1 Learning Goals
1. Discuss leverage, capital structure, breakeven analysis, the
operating breakeven point, and the effect of changing costs on it.
2. Understand operating, financial, and total leverage and the
relationship among them.
3. Describe the basic types of capital, external assessment of capital
structure, the capital structure of non-U.S. firms, and capital
structure theory.
4. Explain the optimal capital structure using a graphical view of the
firm’s cost of capital functions and a zero-growth valuation model.
5. Discuss the EBIT-EPS approach to capital structure.
6. Review the return and risk of alternative capital structures, their
linkage to market value, and other important capital structure
considerations related to capital structure.

10.1 Leverage
• Leverage results from the use of fixed-cost assets or funds to
magnify returns to the firm’s owners.
• Generally, increases in leverage result in increases in risk and
return, whereas decreases in leverage result in decreases in risk
and return.
• The amount of leverage in the firm’s capital structure—the mix of
debt and equity—can significantly affect its value by affecting risk
and return.

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Table 10-1: General Income Statement Format and Types of Leverage

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10.2 Breakeven Analysis
• Breakeven (cost-volume-profit) analysis is used to:
– determine the level of operations necessary to cover all
operating costs, and
– evaluate the profitability associated with various levels of
sales.
• The firm’s operating breakeven point (OBP) is the level of sales
necessary to cover all operating expenses.
• At the OBP, operating profit (EBIT) is equal to zero.
• To calculate the OBP, cost of goods sold and operating expenses
must be categorized as fixed or variable.
• Variable costs vary directly with the level of sales and are a function
of volume, not time.
• Examples would include direct labor and shipping.
• Fixed costs are a function of time and do not vary with sales volume.
• Examples would include rent and fixed overhead.

10.2.1 Algebraic Approach

Using the following variables, the operating portion of a firm’s income
statement may be recast as follows:

P = sales price per unit

Q = sales quantity in units
FC = fixed operating costs per period
VC = variable operating costs per unit

• Letting EBIT = 0 and solving for Q, we get:

EBIT = (P x Q) - FC - (VC x Q)

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Table 10-2: Operating Leverage, Costs, and Breakeven Analysis

218
Example: Cheryl’s Posters has fixed operating costs of $2,500, a sales
price of $10 per poster, and variable costs of $5 per poster. Find the OBP.

Q = $2,500 = 500 posters

$10 - $5
• This implies that if Cheryl’s sells exactly 500 posters, its revenues
will just equal its costs (EBIT = $0).

• We can check to verify that this is the case by substituting as

follows:

EBIT = (P x Q) - FC - (VC x Q)

EBIT = ($10 x 500) - $2,500 - ($5 x 500)

EBIT = $5,000 - $2,500 - $2,500 = $0

10.2.2 Graphical Approach

Figure 10-1: Breakeven Analysis

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10.2.3 Changing Costs and the Operating Breakeven Point
Assume that Cheryl’s Posters wishes to evaluate the impact of several
options: (1) increasing fixed operating costs to $3,000, (2) increasing the
sale price per unit to $12.50, (3) increasing the variable operating cost per
unit to $7.50, and (4) simultaneously implementing all three of these
changes.

(1) Operating BE point = $3,000/($10-$5) = 600 units

(2) Operating BE point = $2,500/($12.50-$5) = 333 units

(3) Operating BE point = $2,500/($10-$7.50) = 1,000 units

(4) Operating BE point = $3,000/($12.50-$7.50) = 600 units

Table 10-3: Sensitivity of Operating Breakeven Point to Increases in Key Breakeven Variables

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10.3 Operating Leverage

Figure 10-2: Operating Leverage

Table 10-4: The EBIT for Various Sales Levels

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10.3.1 Measuring the Degree of Operating Leverage
• The degree of operating leverage (DOL) measures the sensitivity
of changes in EBIT to changes in Sales.
• A company’s DOL can be calculated in two different ways: One
calculation will give you a point estimate, the other will yield an
interval estimate of DOL.
• Only companies that use fixed costs in the production process will
experience operating leverage.

DOL = Percentage change in EBIT

Percentage change in Sales

• Applying this equation to cases 1 and 2 in Table 10-4 yields:

Case 1: DOL = (+100% ÷ +50%) = 2.0

Case 2: DOL = (-100% ÷ -50%) = 2.0

• A more direct formula for calculating DOL at a base sales level, Q, is

shown below.

DOL at base Sales level Q = Q X (P – VC)

Q X (P – VC) – FC

Substituting Q = 1,000, P = $10, VC = $5, and FC = $2,500

yields the following result:

DOL at 1,000 units = 1,000 X ($10 - $5) = 2.0

1,000 X ($10 - $5) - $2,500

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10.3.2 Fixed Costs and Operating Leverage
Assume that Cheryl’s Posters exchanges a portion of its variable operating
costs for fixed operating costs by eliminating sales commissions and
increasing sales salaries. This exchange results in a reduction in variable
costs per unit from $5.00 to $4.50 and an increase in fixed operating costs
from $2,500 to $3,000

DOL at 1,000 units = 1,000 X ($10 - $4.50) = 2.2

1,000 X ($10 - $4.50) - $2,500

Table 10-5: Operating Leverage and Increased Fixed Costs

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10.4 Financial Leverage
• Financial leverage results from the presence of fixed financial
costs in the firm’s income stream.
• Financial leverage can therefore be defined as the potential use of
fixed financial costs to magnify the effects of changes in EBIT on
the firm’s EPS.
• The two fixed financial costs most commonly found on the firm’s
income statement are (1) interest on debt and (2) preferred stock
dividends.

Chen Foods, a small Oriental food company, expects EBIT of $10,000 in

the current year. It has a $20,000 bond with a 10% annual coupon rate
and an issue of 600 shares of $4 annual dividend preferred stock. It also
has 1,000 share of common stock outstanding.

The annual interest on the bond issue is $2,000 (10% x $20,000). The
annual dividends on the preferred stock are $2,400 ($4/share x 600
shares).
Table 10-6: The EPS for Various EBIT Levels a

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10.4.1 Measuring the Degree of Financial Leverage
• The degree of financial leverage (DFL) measures the sensitivity of
changes in EPS to changes in EBIT.
• Like the DOL, DFL can be calculated in two different ways: One
calculation will give you a point estimate, the other will yield an
interval estimate of DFL.
• Only companies that use debt or other forms of fixed cost financing
(like preferred stock) will experience financial leverage.

DFL = Percentage change in EPS

Percentage change in EBIT

• Applying this equation to cases 1 and 2 in Table 10-6 yields:

Case 1: DFL = (+100% ÷ +40%) = 2.5

Case 2: DFL = (-100% ÷ -40%) = 2.5

• A more direct formula for calculating DFL at a base level of EBIT is

shown below.

DFL at base level EBIT = EBIT

EBIT – I – [PD x 1/(1-T)]

Substituting EBIT = $10,000, I = $2,000, PD = $2,400, and

the tax rate, T = 40% yields the following result:

DFL at $10,000 EBIT = $10,000

$10,000 – $2.000 – [$2,400 x 1/(1-.4)]

DFL at $10,000 EBIT = 2.5

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10.5 Total Leverage
• Total leverage results from the combined effect of using fixed costs,
both operating and financial, to magnify the effect of changes in
sales on the firm’s earnings per share.
• Total leverage can therefore be viewed as the total impact of the
fixed costs in the firm’s operating and financial structure.

Cables Inc., a computer cable manufacturer, expects sales of 20,000 units

at $5 per unit in the coming year and must meet the following obligations:
variable operating costs of $2 per unit, fixed operating costs of $10,000,
interest of $20,000, and preferred stock dividends of $12,000. The firm is
in the 40% tax bracket and has 5,000 shares of common stock
outstanding. Table 10-7 summarizes these figures.

10.5.1 Measuring the Degree of Total Leverage

DTL = Percentage change in EPS

Percentage change in Sales

• Applying this equation to the data Table 10-7 yields:

Degree of Total Leverage (DTL) = (300% ÷ 50%) = 6.0

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 • A more direct formula for calculating DTL at a base level of Sales, Q,
is shown below.

DTL at base sales level = Q x (P – VC)

Q x (P – VC) – FC – I – [PD x 1/(1-T)]

Substituting Q = 20,000, P = $5, VC = $2, FC = $10,000, I =

$20,000, PD = $12,000, and the tax rate, T = 40% yields the
following result:

DTL at 20,000 units = 20,000 X ($5 – $2)

20,000 X ($5 – $2) – $10,000 – $20,000 – [$12,000 x 1/(1-.4)]

DTL at 20,000 units = $60,000/$10,000 = 6.0

10.5.2 The Relationship of Operating, Financial and Total

Leverage

The relationship between the DTL, DOL, and DFL is

illustrated in the following equation:

DTL = DOL x DFL

Applying this to our previous example we get:

DTL = 1.2 X 5.0 = 6.0

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Table 10-7: The Total Leverage Effect

228
10.6 The Firm’s Capital Structure
• Capital structure is one of the most complex areas of financial
decision making due to its interrelationship with other financial
decision variables.
• Poor capital structure decisions can result in a high cost of capital,
thereby lowering project NPVs and making them more unacceptable.
• Effective decisions can lower the cost of capital, resulting in higher
NPVs and more acceptable projects, thereby increasing the value of
the firm.

10.6.1 Types of Capital

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10.6.2 External Assessment of Capital Structure
Table 10-8: Debt Ratios for Selected Industries and Lines of Business (Fiscal Years Ended 4/1/05
through 3/31/06)

10.6.3 Capital Structure of Non-U.S. Firms

• In recent years, researchers have focused attention not only on the
capital structures of U.S. firms, but on the capital structures of
foreign firms as well.
• In general, non-U.S. companies have much higher degrees of
indebtedness than their U.S. counterparts.
• In most European and Pacific Rim countries, large commercial
banks are more actively involved in the financing of corporate activity
than has been true in the U.S.

230
• Furthermore, banks in these countries are permitted to make large
equity investments in non-financial corporations—a practice
forbidden in the U.S.
• However, similarities also exist between U.S. firms and their foreign
counterparts.
• For example, the same industry patterns of capital structure tend to
be found around the world.
• In addition, the capital structures of U.S.-based MNCs tend to be
similar to those of foreign-based MNCs.

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10.7 Capital Structure Theory
• According to finance theory, firms possess a target capital
structure that will minimize its cost of capital.
• Unfortunately, theory can not yet provide financial mangers with a
specific methodology to help them determine what their firm’s
optimal capital structure might be.
• Theoretically, however, a firm’s optimal capital structure will just
balance the benefits of debt financing against its costs.
• The major benefit of debt financing is the tax shield provided by
the federal government regarding interest payments.
• The costs of debt financing result from:
• the increased probability of bankruptcy caused by debt
obligations,
• the agency costs resulting from lenders monitoring the firm’s
actions, and
• the costs associated with the firm’s managers having more
information about the firm’s prospects than do investors
(asymmetric information).

10.7.1 Tax Benefits

• Allowing companies to deduct interest payments when computing
taxable income lowers the amount of corporate taxes.
• This in turn increases firm cash flows and makes more cash
available to investors.
• In essence, the government is subsidizing the cost of debt
financing relative to equity financing.

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10.7.2 Probability of Bankruptcy
• The probability that debt obligations will lead to bankruptcy depends
on the level of a company’s business risk and financial risk.
• Business risk is the risk to the firm of being unable to cover
operating costs.
• In general, the higher the firm’s fixed costs relative to variable costs,
the greater the firm’s operating leverage and business risk.
• Business risk is also affected by revenue and cost stability.
• The firm’s capital structure—the mix between debt versus equity—
directly impacts financial leverage.
• Financial leverage measures the extent to which a firm employs
fixed cost financing sources such as debt and preferred stock.
• The greater a firm’s financial leverage, the greater will be its
financial risk—the risk of being unable to meet its fixed interest and
preferred stock dividends.

• Business Risk

Cooke Company, a soft drink manufacturer, is preparing to make a

capital structure decision. It has obtained estimates of sales and
EBIT from its forecasting group as show in Table 10-9.

Table 10-9: Sales and Associated EBIT Calculations for Cooke Company ($000)

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 • Business Risk

When developing the firm’s capital structure, the financial manager must
accept as given these levels of EBIT and their associated probabilities.
These EBIT data effectively reflect a certain level of business risk that
captures the firm’s operating leverage, sales revenue variability, and
cost predictability.

• Financial Risk

Let us assume that (1) the firm has no current liabilities, (2) its capital
structure currently contains all equity, and (3) the total amount of capital
remains constant at $500,000, the mix of debt and equity associated
with various debt ratios would be as shown in Table 10-10.

Table 10-10: Capital Structures Associated with Alternative Debt Ratios for Cooke Company

234
Table 10-11: Level of Debt, Interest Rate, and Dollar Amount of Annual Interest Associated with
Cooke Company’s Alternative Capital Structures

235
Table 10-12: Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company

236
Table 10-13: Expected EPS, Standard Deviation, and Coefficient of Variation for Alternative
Capital Structures for Cooke Company

237
Figure 10-3: Probability Distributions

238
 Figure 10-4: Expected EPS and Coefficient of Variation of EPS

10.7.3 Agency Costs Imposed by Lenders

• When a firm borrows funds by issuing debt, the interest rate charged
by lenders is based on the lender’s assessment of the risk of the
firm’s investments.
• After obtaining the loan, the firm’s stockholders and/or managers
could use the funds to invest in riskier assets.
• If these high risk investments pay off, the stockholders benefit but
the firm’s bondholders are locked in and are unable to share in this
success.
• To avoid this, lenders impose various monitoring costs on the firm.
• Examples would of these monitoring costs would:
• include raising the rate on future debt issues,
• denying future loan requests,
• imposing restrictive bond provisions.

239
10.7.4 Asymmetric Information
• Asymmetric information results when managers of a firm have
more information about operations and future prospects than do
investors.
• Asymmetric information can impact the firm’s capital structure as
follows:

Suppose management has identified an extremely lucrative

investment opportunity and needs to raise capital. Based on this
opportunity, management believes its stock is undervalued since
the investors have no information about the investment.

• Asymmetric information results when managers of a firm have more

information about operations and future prospects than do investors.
• Asymmetric information can impact the firm’s capital structure as
follows:

In this case, management will raise the funds using debt since they
believe/know the stock is undervalued (underpriced) given this
information. In this case, the use of debt is viewed as a positive
signal to investors regarding the firm’s prospects.

• Asymmetric information results when managers of a firm have more

information about operations and future prospects than do investors.
• Asymmetric information can impact the firm’s capital structure as
follows:

240
 On the other hand, if the outlook for the firm is poor, management
will issue equity instead since they believe/know that the price of
the firm’s stock is overvalued (overpriced). Issuing equity is
therefore generally thought of as a “negative” signal.

10.8 The Optimal Capital Structure

• In general, it is believed that the market value of a company is
maximized when the cost of capital (the firm’s discount rate) is
minimized.
• The value of the firm can be defined algebraically as follows:

241
 Figure 10-5: Cost Functions and Value

10.9 EPS-EBIT Approach to Capital Structure

• The EPS-EBIT approach to capital structure involves selecting the
capital structure that maximizes EPS over the expected range of
EBIT.
• Using this approach, the emphasis is on maximizing the owners
returns (EPS).

242
 • A major shortcoming of this approach is the fact that earnings are
only one of the determinants of shareholder wealth maximization.
• This method does not explicitly consider the impact of risk.

Example
EBIT-EPS coordinates can be found by assuming specific EBIT values
and calculating the EPS associated with them. Such calculations for
three capital structures—debt ratios of 0%, 30%, and 60% for Cooke
Company were presented earlier in Table 10-2. For EBIT values of
$100,000 and $200,000, the associated EPS values calculated are
summarized in the table with Figure 10-6.

Figure 10-6: EBIT–EPS Approach

10.9.1 Basic Shortcoming of EPS-EBIT Analysis

• Although EPS maximization is generally good for the firm’s
shareholders, the basic shortcoming of this method is that it does not
necessary maximize shareholder wealth because it fails to
consider risk.

243
 • If shareholders did not require risk premiums (additional return) as
the firm increased its use of debt, a strategy focusing on EPS
maximization would work.
• Unfortunately, this is not the case.

10.10 Choosing the Optimal Capital Structure

• The following discussion will attempt to create a framework for
making capital budgeting decisions that maximizes shareholder
wealth—i.e., considers both risk and return.

244
 • Perhaps the best way to demonstrate this is through the following
example:

Cooke Company, using as risk measures the coefficients of

variation of EPS associated with each of seven alternative capital
structures, estimated the associated returns as shown in Table 10-
14

Table 10-14: Required Returns for Cooke Company’s Alternative Capital Structures

By substituting the level of EPS and the associated required return into
Equation 10-12, we can estimate the per share value of the firm, P0.

245
Table 10-15: Calculation of Share Value Estimates Associated with Alternative Capital Structures
for Cooke Company

246
Figure 10-7: Estimating Value

247
Table 10-16: Important Factors to Consider in Making Capital Structure Decisions

248
11 Dividend Policy

249
11.0 Dividend Policy
11.0.1 Learning Goals
1. Understand cash dividend payment procedures, the tax treatment of
dividends, and the role of dividend reinvestment plans.
2. Describe the residual theory of dividends and the key arguments
with regard to dividend irrelevance and relevance.
3. Discuss the key factors involved in establishing a dividend policy.
4. Review and evaluate the three basic types of dividend policies.
5. Evaluate stock dividends from accounting, shareholder, and
company points of view.
6. Explain stock splits and stock repurchases and the firm’s motivation
for undertaking each of them.

11.1 Dividend Fundamentals

• A dividend is a redistribution from earnings.
• Most companies maintain a dividend policy whereby they pay a
regular dividend on a quarterly basis.
• Some companies pay an extra dividend to reward shareholders if
they’ve had a particularly good year. Many companies pay dividends
according to a preset payout ratio, which measures the proportion
of dividends to earnings.
• Many companies have paid regular dividends for over a hundred
years.
• Dividend growth tends to lag behind earnings growth for most
corporations (see next slide).
• Since dividend policy is one of the factors that drives an investor’s
decision to purchase a stock, most companies announce their

250
 dividend policy and telegraph any expected changes in policy to the
public.
• Therefore, it can be seen that many companies use their dividend
policy to provide information not otherwise available to investors.

11.1.1 Cash Dividend Payment Procedures

• Date of Record: The date on which investors must own shares in
order to receive the dividend payment.
• Ex Dividend Date: Four days prior to the date of record. The day
on which a stock trades ex dividend (exclusive of dividends).

In the financial press. Transactions in the stock on the ex dividend

date are indicated by an “x” next to the volume of transactions. In
general, stock prices fall by an amount equal to the quarterly
dividend on the ex dividend date.
• Date of Record: The date on which investors must own shares in
order to receive the dividend payment.
• Ex Dividend Date: Four days prior to the date of record. The day
on which a stock trades ex dividend (exclusive of dividends).
• Distribution Date: The day on which a dividend is paid (payment
date) to stockholders. It is usually two or more weeks before
stockholders who owned shares on the date of record receive their
dividends.
• Date of Record: The date on which investors must own shares in
order to receive the dividend payment.
• Ex Dividend Date: Four days prior to the date of record. The day
on which a stock trades ex dividend (exclusive of dividends).
• Distribution Date: The day on which a dividend is paid (payment
date) to stockholders. It is usually two or more weeks before

251
 stockholders who owned shares on the date of record receive their
dividends.

Example
At the quarterly dividend meeting on June 10th, the Rudolf Company board
of directors declared an $0.80 cash dividend for holders of record on
Friday, July 2nd. The firm had 100,000 shares of stock outstanding. The
payment (distribution) date was Monday, August 2nd. Before the meeting,
the relevant accounts showed the following.

Cash $200,000 Dividends Payable $ 0

Retained Earnings 1,000,000

When the dividend was announced by the directors, $80,000 of the

retained earnings ($.80/share x 100,000 shares) was transferred to the
dividends payable account. As a result, the key accounts changed as
follows:

Cash $200,000 Dividends Payable $ 80,000

Retained Earnings 920,000

Rudolf Company’s stock began selling ex dividend 2 business days prior to

the date of record, which was Wednesday, June 30th. This date was
found by subtracting 2 days from the July 2nd date of record. Purchasers
of Rudolf’s stock on Tuesday, June 29th or earlier received the rights to
the dividends; those who purchased the stock on or after June 30th did
not. Assuming a stable market, Rudolf’s stock price was expected to drop
by about $0.80 per share when it began selling ex dividend on June 30th.

252
On August 2nd, the firm mailed dividend checks to shareholders of record
as of July 20th. This produced the following balances in the key accounts
of the firm.

Cash $120,000 Dividends Payable $ 0

Retained Earnings 920,000

The net effect of the dividend payment is a reduction of the firm’s assets
(through a reduction in cash) and equity (through a reduction in retained
earnings) by a total of $80,000 (the dividend payment).

Figure 11-1: Dividend Payment Time Line

253
11.1.2 Tax Treatment of Dividends
• The Jobs and Growth Tax Relief Reconciliation Act of 2003
significantly changed the tax treatment of corporate dividends by
dropping the tax rate to the rate applicable on capital gains, which
has a maximum rate of 15%.
• Immediately after passage of the Act, many firms either initiated or
increased dividends paid to their shareholders and this reduction in
the degree of double taxation of dividends is expected to continue.

254
11.2 Dividend Reinvestment Plans
• Dividend Reinvestment Plans (DRIPS) enable stockholders to use
dividends received on the firm’s stock to acquire additional shares—
even fractional shares—at little or no transaction cost.
• With DRIPS, plan participants typically can acquire shares at about 5
percent below the prevailing market prices.
• From its point of view, the firm can issue new shares to participants
more economically, avoiding the under pricing and flotation costs
that would accompany the public sale of new shares.

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11.3 The Relevance of Dividend Policy
11.3.1 The Residual Theory of Dividends
• The residual theory of dividends suggests that dividend payments
should be viewed as residual—the amount left over after all
acceptable investment opportunities have been undertaken.
• Using this approach, the firm would treat the dividend decision in
three steps as follows:

Step 1: Determine the optimal level of capital expenditures which is

given by the point of intersection of the investment opportunities
schedule (IOS) and weighted marginal cost of capital schedule
(WMCC).

Step 2: Using the optimal capital structure proportions, estimate the

total amount of equity financing needed to support the expenditures
estimated in Step 1.

Step 3: Because the cost of retained earnings is less than new

equity, use retained earnings to meet the equity requirement in Step
2. If inadequate, sell new stock. If there is an excess of retained
earnings, distribute the surplus amount—the residual—as
dividends.

• In sum, this theory suggests that no cash dividend is paid as long as

the firm’s equity need is in excess of the amount of retained
earnings.
• Furthermore, it suggests that the required return demanded by
stockholders is not influenced by the firm’s dividend policy—a
premise that in turn suggests that dividend policy is irrelevant.

256
Overbrook Industries, a manufacturer of canoes and other small
watercraft, has available from the current period’s operations $1.8 million
that can be retained or paid out in dividends. The firm’s optimal capital
structure is 30% debt and 70% equity. Figure 11-2 depicts the firm’s
WMCC schedule along with three investment opportunity schedules
(IOSs). For each IOS, the level of total new financing or investment
determined by the point of intersection of the IOS and the WMCC has
been noted.

Figure 11-2: WMCC and IOSs

257
Table 11-1 shows that if IOS1 exists, the firm will pay out $750,000 in
dividends because only $1,050,000 of the $1,800,000 of available earnings
is needed. The table also shows the dividend payouts associated with
IOS2 and IOS3. Depending on which IOS exists, the firm’s dividend would
in effect be the residual, if any, remaining after all acceptable investments
have been financed.

Table 11-1: Applying the Residual Theory of Dividends to Overbrook Industries for Each of Three
IOSs (Shown in Figure 11-2)

11.3.2 Arguments for Dividend Irrelevance

• Merton Miller and Franco Modigliani (MM) developed a theory that
shows that in perfect financial markets (certainty, no taxes, no
transactions costs or other market imperfections), the value of a firm
is unaffected by the distribution of dividends.
• They argue that value is driven only by the future earnings and risk
of its investments.
• Retaining earnings or paying them in dividends does not affect this
value.

258
• Some studies suggested that large dividend changes affect stock
price behavior.
• MM argued, however, that these effects are the result of the
information conveyed by these dividend changes, not to the dividend
itself.
• Furthermore, MM argue for the existence of a “clientele effect.”
• Investors preferring dividends will purchase high dividend stocks,
while those preferring capital gains will purchase low dividend paying
stocks.
• In summary, MM and other dividend irrelevance proponents argue
that—all else being equal—an investor’s required return, and
therefore the value of the firm, is unaffected by dividend policy
because:

1. The firm’s value is determined solely by the earning power

and risk of its asset investments.
2. If dividends do affect value, they do so because of the
information content, which signals management’s future
expectations.
3. A clientele effect exists that causes shareholders to receive
the level of dividends they expect.

• Contrary to dividend irrelevance proponents, Gordon and Lintner

suggested stockholders prefer current dividends ant that a positive
relationship exists between dividends and market value.
• Fundamental to this theory is the “bird-in-the-hand” argument which
suggests that investors are generally risk-averse and attach less risk
to current as opposed to future dividends or capital gains.
• Because current dividends are less risky, investors will lower their
required return—thus boosting stock prices.

259
11.4 Factors Affecting Dividend Policy
11.4.1 Legal Constraints
• Most state securities regulations prevent firms from paying out
dividends from any portion of the company’s “legal capital” which is
measured by the par value of common stock—or par value plus
paid-in-capital.
• Dividends are also sometimes limited to the sum of the firm’s most
recent and past retained earnings—although payments in excess of
current earnings is usually permitted.
• Most states also prohibit dividends when firm’s have overdue
liabilities, is legally insolvent, or bankrupt.
• Even the IRS has ruled in the area of dividend policy.
• Specifically, the IRS prohibits firms from acquiring earnings to
reduce stockholders’ taxes.
• I the IRS can determine that a firm has accumulated an excess of
earnings to allow owners to delay paying ordinary income taxes (on
dividends), it may levy an excess earnings accumulation tax on
any retained earnings above $250,000 for most businesses.
• It should be noted, however, that this ruling is seldom applied.

11.4.2 Contractual Constraints

• In many cases, companies are constrained in the extent to which
they can pay dividends by restrictive provisions in loan agreements
and bond indentures.
• Generally, these constraints prohibit the payment of cash dividends
until a certain level of earnings are achieved or to a certain dollar
amount or percentage of earnings.
• Any violation of these constraints generally trigger the demand for
immediate payment.

260
11.4.3 Internal Constraints
• A company’s ability to pay dividends is usually constrained by the
amount of available cash rather than the level of retained earnings
against which to charge them.
• Although it is possible to borrow to pay dividends, lenders are
usually reluctant to grant them because using the funds for this
purpose produces not operating benefits that help to repay them.

11.4.4 Growth Prospects

• Newer, rapidly-growing firms generally pay little or no dividends.
• Because these firms are growing so quickly, they must use most of
their internally generated funds to support operations or finance
expansion.
• On the other hand, large, mature firms generally pay cash dividends
since they have access to adequate capital and may have limited
investment opportunities.

11.4.5 Owner Considerations

• The firm must establish a policy that has a favorable effect on the
wealth of the majority of its owners.
• If a firm has a large percentage of wealthy shareholders, it may
decide to pay out a lower percentage of its earnings to allow them to
delay the payment of taxes until they sell the stock.
• Because cash dividends are taxed at the same rate as capital gains,
this strategy benefits owners through tax deferral rather than as a
result of a lower tax rate.
• A second consideration is the owner’s investment opportunities.

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 • A firm should not retain funds for investment projects yielding lower
returns that the owners could obtain from external investments of
equal risk.
• A final consideration is the potential dilution of ownership.
• If a firm pays out a high percentage of earnings, new equity capital
will have to be raised with common stock.

11.4.6 Market Considerations

• Perhaps the most important aspect of dividend policy is that the firm
maintain a level of predictability.
• Stockholders that prefer dividend-paying stocks prefer a continuous
stream of fixed or increasing dividends.
• Shareholders also view the firm’s dividend payment as a “signal” of
the firm’s future prospects.
• Fixed or increasing dividends are often considered a “positive”
signal, while erratic dividend payments are viewed as “negative”
signals.

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11.5 Types of Dividend Policies
11.5.1 Constant-Payout-Ratio Policy
• With a constant-payout-ratio dividend policy, the firm establishes
that a specific percentage of earnings is paid to shareholders each
period.
• A major shortcoming of this approach is that if the firm’s earnings
drop or are volatile, so too will be the dividend payments.
• As mentioned earlier, investors view volatile dividends as negative
and risky—which can lead to lower share prices.

Peachtree Industries, a miner of potassium, has a policy of paying out 40%

of earnings in cash dividends. In the periods when a loss occurs, the firm’s
policy is to pay no cash dividends.

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11.5.2 Regular Dividend Policy
• A regular dividend policy is based on the payment of a fixed-dollar
dividend each period.
• It provides stockholders with positive information indicating that the
firm is doing well and it minimizes uncertainty.
• Generally, firms using this policy will increase the regular dividend
once earnings are proven to be reliable.

The dividend policy of Woodward Laboratories, a producer of a popular

artificial sweetener, is to pay annual dividends of $1.00 per share until per-
share earnings exceeded $4.00 for three consecutive years. At that point,
the annual dividend is raised to $1.50 per share, and a new earnings
plateau is established. The firm does not anticipate decreasing its
dividend unless its liquidity is in jeopardy. Data for Woodward’s earnings,
dividends, and average stock prices for the past 12 years follow.

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11.5.3 Low-Regular-and-Extra Dividend Policy
• Using this policy, firms pay a low regular dividend, supplemented
by additional dividends when earnings can support it.
• When earnings are higher than normal, the firm will pay this
additional dividend, often called an extra dividend, without the
obligation to maintain it during subsequent periods.
• This type of policy is often used by firms whose sales and earnings
are susceptible to swings in the business cycle.

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11.6 Other Forms of Dividends
11.6.1 Stock Dividends
• A stock dividend is paid in stock rather than in cash.
• Many investors believe that stock dividends increase the value of
their holdings.
• In fact, from a market value standpoint, stock dividends function
much like stock splits. The investor ends up owning more shares,
but the value of their shares is less.
• From a book value standpoint, funds are transferred from retained
earnings to common stock and additional paid-in-capital.

• Accounting Aspects
The current stockholder’s equity on the balance sheet of Garrison
Corporation, a distributor of prefabricated cabinets, is as shown in the
following accounts.

If Garrison declares a 10% stock dividend and the current market price of
the stock is $15/share, $150,000 of retained earnings (10% x 100,000
shares x $15/share) will be capitalized.

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The $150,000 will be distributed between the common stock (par) account
and paid-in-capital in excess of par account based on the par value of the
common stock. The resulting balances are as follows

Because 10,000 new shares (10% x 100,000) have been issued at the
current price of $15/share, $150,000 ($15/share x 10,000 shares) is shifted
from retained earnings to the common stock and paid-in-capital accounts.

• The Shareholder’s Viewpoint

– From a shareholder’s perspective, stock dividends result in
a dilution of shares owned.
– For example, assume a stockholder owned 100 shares at
$20/share ($2,000 total) before a stock dividend.
– If the firm declares a 10% stock dividend, the shareholder will
have 110 shares of stock. However, the total value of her
shares will still be $2,000.
– Therefore, the value of her share must have fallen to
$18.18/share ($2,000/110).

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 • The Company’s Viewpoint
– Disadvantages of stock dividends include:
• The cost of issuing the new shares
• Taxes and listing fees on the new shares
• Other recording costs
– Advantages of stock dividends include:
• The company conserves needed cash
• Signaling effect to the shareholders that the firm is
retaining cash because of lucrative investment
opportunities

11.6.2 Stock Splits

• A stock split is a recapitalization that affects the number of shares
outstanding, par value, earnings per share, and market price.
• The rationale for a stock split is that it lowers the price of the stock
and makes it more attractive to individual investors

Delphi Company, a forest products concern, had 200,000 shares of $2-par

value common stock outstanding and declares a 2-for-1 split. The total
before and after split impact on stockholders equity is:

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 • A reverse stock split reduces the number of shares outstanding
and raises stock price—the opposite of a stock split.
• The rationale for a reverse stock split is to add respectability to the
stock and convey the meaning that it isn’t a junk stock.

Research on both stock splits and stock dividends generally

supports the theory that they do not affect the value of shares.
They are often used, however, to send a signal to investors that
good things are going to happen.

11.6.3 Stock Repurchases

• A stock repurchase is the purchasing and retiring of stock by the
issuing corporation.
• A repurchase is a partial liquidation since it decreases the number
of shares outstanding.
• It may also be thought of as an alternative to cash dividends.
• Alternative reasons for stock repurchases:
• To use the shares for another purpose
• To alter the firm’s capital structure
• To increase EPS and ROE resulting in a higher market price
• To reduce the chance of a hostile takeover

11.6.4 Stock Repurchases Viewed as a Cash Dividend

• The repurchase of stock results in a type of reverse dilution.
• The net effect of the repurchase is similar to the payment of a cash
dividend.
• However, if the firm pays the dividend, the owner would have to pay
tax on the income.
• The gain on the increase in share price as a result of the
repurchase, however, would not be taxed until sold.

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Tutorials and Assignments
Tutorial - Cash Flow and Financial Planning
Warm-up Exercises
Question 1
The installed cost of a new computerized controller was $65,000. Calculate the
depreciation schedule by year assuming a recovery period of 5 years and using
the appropriate MACRS depreciation percentages given in Table 3.2 on page
108.

Question 2
Classify the following changes in each of the accounts as either an inflow or an
outflow of cash. During the year (a) marketable securities increased, (b) land and
buildings decreased, (c) accounts payable increased, (d) vehicles decreased, (e)
accounts receivable increased, and (f) dividends were paid.

Question 3
Determine the operating cash flow (OCF) for Kleczka, Inc., based on the
following data. (All values are in thousands of dollars.) During the year the firm
had sales of $2,500, cost of goods sold totaled $1,800, operating expenses
totaled $300, and depreciation expenses were $200. The firm is in the 35% tax
bracket.

Question 4
During the year, Xero, Inc., experienced an increase in net fixed assets of
$300,000 and had depreciation of $200,000. It also experienced an increase in
current assets of $150,000 and an increase in accounts payable and accruals of
$75,000. If operating cash flow (OCF) for the year was $700,000, calculate the
firm’s free cash flow (FCF) for the year.

Question 5
Rimier Corp. forecasts sales of $650,000 for 2010. Assume the firm has fixed
costs of $250,000 and variable costs amounting to 35% of sales. Operating
expenses are estimated to include fixed costs of $28,000 and a variable portion
equal to 7.5% of sales. Interest expenses for the corning year are estimated to
be $20,000. Estimate Rimier’s net profits before taxes for 2010.

270
Problems
Question 1
Finding operating and free cash flows. Consider the balance sheets and selected
data from the income statement of Keith Corporation that follows.

a. Calculate the firm’s accounting cash flow from operations for the year ended
December 31, 2009. using Equation 3.1.
b. Calculate the firm’s net operating profit after taxes (NOPAT) for the year
ended December 31, 2009, using Equation 3.2.

271
c. Calculate the firm’s operating cash flow (OCF) for the year ended December
31, 2009, using Equation 3.3.
d. Calculate the firm’s free cash flow (FCF) for the year ended December 31,
2009, using Equation 3.5.
e. Interpret, compare, and contrast your cash flow estimates in parts a, c, and d.

Question 2
Preparation of cash budget Sam and Suzy Sizeman need to prepare a cash
budget for the last quarter of 2010 in order to make sure they can cover their
expenditures during the period. Sam and Suzy have been preparing budgets for
the past several years and have been able to establish specific percentages for
most of their cash out-flows. These percentages are based on their take-home
pay (i.e., monthly utilities normally run 5% of monthly take-home pay). The
information below can be used to create their fourth-quarter budget for 2010.

a. Prepare a quarterly cash budget for Sam and Suzy covering the months
October through December 2010.
b. Are there are individual months that incur a deficit?
c. What is the cumulative cash surplus or deficit by the end of December 2010?

272
Question 3
Multiple cash budgets—Scenario analysis Brownstein, Inc., expects sales of
$100,000 during each of the next 3 months. It will make monthly purchases of
$60,000 during this time. Wages and salaries are $10,000 per month plus 5% of
sales. Brownstein expects to make a tax payment of $20,000 in the next month
and a $15,000 purchase of fixed assets in the second month and to receive
$8,000 in cash from the sale of an asset in the third month. All sales and
purchases are for cash. Beginning cash and the minimum cash balance are
assumed to be zero.

a. Construct a cash budget for the next 3 months.

b. Brownstein is unsure of the sales levels, but all other figures are certain. If the
most pessimistic sales figure is $80,000 per month and the most optimistic is
$120,000 per month, what are the monthly minimum and maximum ending
cash balances that the firm can expect for each of the 1-month periods?
c. Briefly discuss how the financial manager can use the data in parts a and b to
plan for financing needs.

273
Questions 4
Integrative—Pro forma statements Provincial Imports, Inc., has assembled past
(2009) financial statements (income statement and balance sheet below) and
financial projections for use in preparing financial plans for the coming year
(2010).

Information related to financial projections for the year 2010:

(1) Projected sales are $6,000,000.

(2) Cost of goods sold in 2009 includes $1,000,000 in fixed costs.
(3) Operating expense in 2009 includes $250,000 in fixed costs.
(4) Interest expense will remain unchanged.
(5) The firm will pay cash dividends amounting to 40% of net profits after taxes.
(6) Cash and inventories will double.

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(7) Marketable securities, notes payable, long-term debt, and common stock will
remain unchanged.
(8) Accounts receivable, accounts payable, and other current liabilities will
change in direct response to the change in sales.
(9) A new computer system costing $356,000 will he purchased during the year.
Total depreciation expense for the year will be $110,000.
(10) The tax rate will remain at 40%.

a. Prepare a pro forma income statement for the year ended December 31,
2010, using the fixed cost data given to improve the accuracy of the percent-
of-sales-method.
b. Prepare a pro forma balance sheet as of December 31, 2010, using the
information given and the judgmental approach. Include a reconciliation of the
retained earnings account.
c. Analyze these statements, and discuss the resulting external financing
required.

275
Tutorial - Risk & Return
Warm-up Exercise
Question 1
An analyst predicted last year that the stock of Logistics, Inc., would offer a total
return of at least 10% in the coming year. At the beginning of the year, the firm
had a stock market value of $10 million. At the end of the year, it had a market
value of $12 million even though it experienced a loss, or negative net income, of
$2.5 million. Did the analyst’s prediction prove correct? Explain using the values
for total annual return.

Question 2
Four analysts cover the stock of Fluorine Chemical. One forecasts a 5% return
for the coming year. A second expects the return to be negative 5%. A third
predicts a 10% return. A fourth expects a 3% return in the coming year. You are
relatively confident that the return will be positive but not large, so you arbitrarily
assign probabilities of being correct of 35%, 5%, 20%, and 40%, respectively, to
the analysts’ forecasts. Given these probabilities, what is Fluorine Chemical’s
expected return for the coming year?

Question 3
The expected annual returns are 15% for investment 1 and 12% for investment
2. The standard deviation of the first investment’s return is 10%; the second
investment’s return has a standard deviation of 5%. Which investment is less
risky based solely on standard deviation? Which investment is less risky based
on coefficient of variation? Which is a better measure given that the expected
returns of the two investments are not the same?

Question 4
Your portfolio has three asset classes. U.S. government T-bills account for 45%
of the portfolio, large-company stocks constitute another 40%, and small-
company stocks make up the remaining 15%. If the expected returns are 3.8%
for the T-bills, 12.3% for the large-company stocks, and 17.4% for the small-
company stocks, what is the expected return of the portfolio?

276
Question 5
You wish to calculate the risk level of your portfolio based on its beta. The five
stocks in the portfolio with their respective weights and betas are shown below.
Calculate the beta of your portfolio.

Question 6
a. Calculate the required rate of return for an asset that has a beta of 1.8, given
a risk-free rate of 5% and a market return of 10%.
b. If investors have become more risk-averse due to recent geopolitical events,
and the market return rises to 13%, what is the required rate of return for the
same asset?
c. Use your findings in part a to graph the initial security market line (SML), and
then use your findings in part b to graph (on the same set of axes) the shift in
the SML.

277
Problem
Question 1
Risk preferences Sharon Smith, the financial manager for Barnett Corporation,
wishes to evaluate three prospective investments: X, Y, and Z. Currently, the firm
earns 12% on its investments, which have a risk index of 6%. The expected
return and expected risk of the investments are as follows:

Expected Expected
Investment return risk index
X 14% 7%
Y 12 8
Z 10 9

a. If Sharon were risk-indifferent, which investments would she select? Explain

why.
b. If she were risk-averse, which investments would she select? Why?
c. If she were risk-seeking, which investments would she select? Why?
d. Given the traditional risk preference behavior exhibited by financial managers,
which investment would be preferred? Why?

Question 2
Risk analysis Solar Designs is considering an investment in an expanded product
line. Two possible types of expansion are being considered. After investigating
the possible outcomes, the company made the estimates shown in the following
table:

Expansion A Expansion B
Initial investment $12,000 $12,000
Annual rate of return
Pessimistic 16% 10%
Most likely 20% 20%
Optimistic 24% 30%

a. Determine the range of the rates of return for each of the two projects.
b. Which project is less risky? Why?
c. If you were making the investment decision, which one would you choose?
Why? What does this imply about your feelings toward risk?
d. Assume that expansion B’s most likely outcome is 21% per year and that all
other facts remain the same. Does this change your answer to part c? Why?

278
Question 3
Rate of return, standard deviation, coefficient of variation Mike is searching for a
stock to include in his current stock portfolio. He is interested in Apple Inc.; he
has been impressed with the company’s computer products and believes Apple
is an innovative market player. However, Mike realizes that any time you
consider a so-called high-tech stock, risk is a major concern. The rule he follows
is to include only securities with a coefficient of variation of returns below 0.90.

Mike has obtained the following price information for the period 2006 through
2009. Apple stock, being growth-oriented, did not pay any dividends during these
4 years.

Stock price
Year Beginning End
2006 $14.36 $21.55
2007 21.55 64.78
2008 64.78 72.38
2009 72.38 91.80

a. Calculate the rate of return for each year, 2006 through 2009, for Apple stock.
b. Assume that each year’s return is equally probable and calculate the average
return over this time period.
c. Calculate the standard deviation of returns over the past 4 years. (Hint: Treat
this data as a sample.)
d. Based on b and c determine the coefficient of variation of returns for the
security.
e. Given the calculation in d what should be Mike’s decision regarding the
inclusion of Apple stock in his portfolio?

279
Question 4
Portfolio return and standard deviation. Jamie Wong is considering building an
investment portfolio containing two stocks, L and M. Stock L will represent 40%
of the dollar value of the portfolio, and stock M will account for the other 60%.

The expected returns over the next 6 years, 2010—2015, for each of these
stocks are shown in the following table:

Expected return
Year Stock L Stock M
2010 14% 20%
2011 14 18
2012 16 16
2013 17 14
2014 17 12
2015 19 10

a. Calculate the expected portfolio return for each of the 6 years.

b. Calculate the expected value of portfolio returns over the 6-year period.
c. Calculate the standard deviation of expected portfolio returns over the 6-year
period.
d. How would you characterize the correlation of returns of the two stocks L and
M?
e. Discuss any benefits of diversification achieved by Jamie through creation of
the portfolio.

280
Question 5
Portfolio return and beta. Jamie Peters invested $100,000 to set up the following
portfolio one year ago:

a. Calculate the portfolio beta on the basis of the original cost figures.
b. Calculate the percentage return of each asset in the portfolio for the year.
c. Calculate the percentage return of the portfolio on the basis of original cost,
using income and gains during the year.
d. At the time Jamie made his investments, investors were estimating that the
market return for the coming year would be 10%. The estimate of the risk-free
rate of return averaged 4% for the coming year. Calculate an expected rate of
return for each stock on the basis of its beta and the expectations of market
and risk-free returns.
e. On the basis of the actual results, explain how each stock in the portfolio
performed relative to those CAPM-generated expectations of performance.
What factors could explain these differences?

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Tutorial - Interest Rate and Bond Valuation
Question 1

Question 2

282
Question 3

Question 4

Question 5

Question 6

283
Question 7

Question 8

Question 9

284
Question 10

Question 11

285
Tutorial - Capital Budgeting
Question 1
If Halley Industries reimburses employees who earn master’s degrees and who
agree to remain with the firm for an additional 3 years, should the expense of the
tuition reimbursement be categorized as a capital expenditure or an operating
expenditure?

Question 2
Canvas Reproductions, Inc., is considering two mutually exclusive investments.
Project A requires an initial outlay of $20,000 and has expected cash inflows of
$5,000 for each of the next 5 years. Project B requires an initial outlay of $25,000
and has expected cash inflows of $6,500 for each of the following 5 years. Use a
simple rate of return measure to determine which project the company should
choose.

Question 3
Iridium Corp. has spent $3.5 billion over the past decade developing a satellite-
based telecommunication system. It is currently trying to decide whether to
spend an additional $350 million on the project. The firm expects that this outlay
will finish the project and will generate cash flow of $15 million per year over the
next 5 years. A competitor has offered $450 million for the satellites already in
orbit. Classify the firm’s outlays as sunk costs or opportunity costs, and specify
the relevant cash flows

Question 4
A few years ago, Largo Industries implemented an inventory auditing system at
an installed cost of $175,000. Since then, it has taken depreciation deductions
totaling $124,250. What is the system’s current book value? If Largo sold the
system for $110,000, how much recaptured depreciation would result?

Question 5
Bryson Sciences is planning to purchase a high-powered microscopy machine
for $55,000 and incur an additional $7,500 in installation expenses. It is replacing
similar microscopy equipment that can be sold to net $35,000, resulting in taxes
from a gain on the sale of $11,250. Because of this transaction, current assets
will increase by $6,000 and current liabilities will increase by $4,000. Calculate
the initial investment in the high-powered microscopy machine.

286
Question 6
Relevant cash flow pattern fundamentals. For each of the following projects,
determine the relevant cash flows, classify the cash flow pattern, and depict the
cash flows on a time line.
a. A project that requires an initial investment of $120,000 and will generate
annual operating cash inflows of $25,000 for the next 18 years. In each of the
18 years, maintenance of the project will require a $5,000 cash outflow.

b. A new machine with an installed cost of $85,000. Sale of the old machine will
yield $30,000 after taxes. Operating cash inflows generated by the
replacement will exceed the operating cash inflows of the old machine by
$20,000 in each year of a 6-year period. At the end of year 6, liquidation of
the new machine will yield $20,000 after taxes, which is $10,000 greater than
the after-tax proceeds expected from the old machine had it been retained
and liquidated at the end of year 6.

c. An asset that requires an initial investment of $2 million and will yield annual
operating cash inflows of $300,000 for each of the next 10 years. Operating
cash outlays will be $20,000 for each year except year 6, when an overhaul
requiring an additional cash outlay of $500,000 will be required. The asset’s
liquidation value at the end of year 10 is expected to be zero.

Question 7
Book value and taxes on sale of assets. Troy Industries purchased a new
machine 3 years ago for $80,000. It is being depreciated under MACRS with a 5-
year recovery period using the percentages given in Table 3.2 on page 108.
Assume a 40% tax rate.

a. What is the book value of the machine?

b. Calculate the firm’s tax liability if it sold the machine for each of the following
amounts: $100,000; $56,000; $23,200; and $15,000.

Question 8
Tax calculations. For each of the following cases, determine the total taxes
resulting from the transaction. Assume a 40% tax rate. The asset was purchased
2 years ago for $200,000 and is being depreciated under MACRS using a 5-year
recovery period. (See Table 3.2 on page 108 for the applicable depreciation
percentages.)

a. The asset is sold for $220,000.

b. The asset is sold for $150,000.
c. The asset is sold for $96,000.
d. The asset is sold for $80,000.

287
Question 9
Calculating initial investment. Vastine Medical, Inc., is considering replacing its
existing computer system, which was purchased 2 years ago at a cost of
$325,000. The system can be sold today for $200,000. It is being depreciated
using MACRS and a 5-year recovery period (see Table 3.2, page 108). A new
computer system will cost $500,000 to purchase and install. Replacement of the
computer system would not involve any change in net working capital. Assume a
40% tax rate.

a. Calculate the book value of the existing computer system.

b. Calculate the after-tax proceeds of its sale for $200,000.
c. Calculate the initial investment associated with the replacement project.

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Question 10
Integrative—Determining relevant cash flows. Lombard Company is
contemplating the purchase of a new high-speed widget grinder to replace the
existing grinder. The existing grinder was purchased 2 years ago at an installed
cost of $60,000; it was being depreciated under MACRS using a 5-year recovery
period. The existing grinder is expected to have a usable life of 5 more years.
The new grinder costs $105,000 and requires $5,000 in installation costs; it has a
5-year usable life and would be depreciated under MACRS using a 5-year
recovery period. Lombard can currently sell the existing grinder for $70,000
without incurring any removal or cleanup costs. To support the increased
business resulting from purchase of the new grinder, accounts receivable would
increase by $40,000, inventories by $30,000, and accounts payable by $58,000.
At the end of 5 years, the existing grinder is expected to have a market value of
zero; the new grinder would be sold to net $29,000 after removal and cleanup
costs and before taxes. The firm is subject a 40% tax rate. The estimated
earnings before depreciation, interest, and taxes over the 5 years for both the
new and the existing grinder are shown in the following table. (Table 3.2 on page
108 contains the applicable MACRS depreciation percentages.)

Earnings before
depreciation, interest, and taxes
Year New grinder Existing grinder
1 $43,000 $26,000
2 43,000 24,000
3 43,000 22,000
4 43,000 20,000
5 43,000 18,000

Long-Term Investment Decisions

a. Calculate the initial investment associated with the replacement of the
existing grinder by the new one.
b. Determine the incremental operating cash inflows associated with the
proposed grinder replacement. (Note: Be sure to consider the depreciation in
year 6.)
c. Determine the terminal cash flow expected at the end of year 5 from the
proposed grinder replacement.
d. Depict on a time line the relevant cash flows associated with the proposed
grinder replacement decision.

289
Question 11
Determining relevant cash flows for a new boat Jan and Deana have been
dreaming about owning a boat for some time and have decided that estimating
its cash flows will help them in their decision process. They expect to have a
disposable annual income of $24,000. Their cash flow estimates for the boat
purchase are as follows:

Using these cash flow estimates, calculate the following:

a. The initial investment
b. Operating cash flow
c. Terminal cash flow
d. Summary of annual cash flow
e. Based on their disposable annual income, what advice would you give Jan
and Deana regarding the proposed boat purchase?

290
Tutorial - Capital Budgeting NPV
Question 1
All techniques with NPV profile—Mutually exclusive projects. Fitch Industries is in
the process of choosing the better of two equal-risk, mutually exclusive capital
expenditure projects—M and N. The relevant cash flows for each project are
shown in the following table. The firm’s cost of capital is 14%.

a. Calculate each project’s payback period.

b. Calculate the net present value (NPV) for each project.
c. Calculate the internal rate of return (!RR) for each project.
d. Summarize the preferences dictated by each measure you calculated, and
indicate which project you would recommend. Explain why.
c. Draw the net present value profiles for these projects on the same set of
axes, and explain the circumstances under which a conflict in rankings might
exist.

Question 2
Herky Foods is considering acquisition of a new wrapping machine. The initial
investment is estimated at $1.25 million, and the machine wilI have a 5-year life
with no salvage value. Using a 6% discount rate, determine the net present value
(NPV) of the machine given its expected operating cash inflows shown in the
table. Based on the project’s NPV, should Herky make this investment?

291
Question 3
Axis Corp. is considering investment in the best of two mutually exclusive
projects. Project Kelvin involves an overhaul of the existing system; it will cost
$45,000 and generate cash inflows of $20,000 per year for the next 3 years.
Project Thompson involves replacement of the existing system; it will cost
$275,000 and generate cash inflows of $60,000 per year for 6 years. Using an
8% cost of capital, calculate each project’s NPV and make a recommendation
based on your findings.

Question 4
Billabong Tech uses the internal rate of return (IRR) to select projects. Calculate
the IRR for each of the following projects arid recommend the best project based
on this measure. Project T-Shirt requires an initial investment of $15,000 and
generates cash inflows of $8,000 per year for 4 years. Project Board Shorts
requires an initial investment of $25,000 and produces cash inflows of $12,000
per year for 5 years.

Question 5
Cooper Electronics uses NPV profiles to visually evaluate competing projects.
Key data for the two projects under consideration is given in the following table.
Using these data, graph, on the same set of axes, the NPV profiles for each
project using discount rates of 0%, 8%, and the IRR.

292
Question 6
Payback comparisons. Nova Products has a 5-year maximum acceptable
payback period. The firm is considering the purchase of a new machine and must
choose between two alternative ones. The first machine requires an initial
investment of $14,000 and generates annual after-tax cash inflows of $3,000 for
each of the next 7 years. The second machine requires an initial investment of
$21,000 and provides an annual cash inflow after taxes of $4,000 for 20 years.

a. Determine the payback period for each machine.

b. Comment on the acceptability of the machines, assuming that they are
independent projects.
c. Which machine should the firm accept? Why?
d. Do the machines in this problem illustrate any of the weaknesses of using
payback? Discuss.

Question 7
Choosing between two projects with acceptable payback periods. Shell Camping
Gear, Inc., is considering two mutually exclusive projects. Each requires an initial
investment of $100,000. John Shell, president of the company, has set a
maximum payback period of 4 years. The after-tax cash inflows associated with
each project are as follows:

a. Determine the payback period of each project.

b. Because they are mutually exclusive, Shell must choose one. Which should
the company invest in?
c. Explain why one of the projects is a better choice than the other.

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Question 8
NPV. Calculate the net present value (NPV) for the following 20-year projects.
Comment on the acceptability of each. Assume that the firm has an opportunity
cost of 14%.

a. Initial investment is $10,000; cash inflows are $2,000 per year.

b. Initial investment is $25,000; cash inflows are $3,000 per year.
c. Initial investment is $30,000; cash inflows are $5,000 per year.

Question 9
Long-term investment decision, NPV method. Jenny Jenks has researched the
financial pros and cons of entering into an elite MBA program at her state
university. The tuition and needed books for a master’s program will have an
upfront cost of $100,000. On average, a person with an MBA degree earns an
extra $20,000 per year over a business career of 40 years. Jenny feels that her
opportunity cost of capital is 6%. Given her estimates, find the net present value
(NPV of entering this MBA program. Are the benefits of further education worth
the associated costs?

Question 10
Payback and NPV. Neil Corporation has three projects under consideration. The
cash flows for each project are shown in the following table. The firm has a 16%
cost of capital.

a. Calculate each project’s payback period. Which project is preferred according

to this method?
b. Calculate each project’s net present value (NPV). Which project is preferred
according to this method?
c. Comment on your findings in parts a and b, and recommend the best project
Explain your recommendation.

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Question 11
Internal rate of return. For each of the projects shown in the following table,
calculate the internal rate of return (IRR). Then indicate, for each project, the
maximum cost of capital that the firm could have and still find the IRR
acceptable.

Question 12
IRR—Mutually exclusive projects. Bell Manufacturing is attempting to choose the
better of two mutually exclusive projects for expanding the firm’s warehouse
capacity. The relevant cash flows for the projects are shown in the following
table. The firm’s cost of capital is 15%.

a. Calculate the IRR to the nearest whole percent for each of the projects.
b. Assess the acceptability of each project on the basis of the IRRs found in part
a.
c. Which project, on this basis, is preferred?

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Question 13
NPV, with rankings. Botany Bay, Inc., a maker of casual clothing, is considering
four projects. Because of past financial difficulties, the company has a high cost
of capital at 15%. Which of these projects would be acceptable under those cost
circumstances?

a. Calculate the NPV of each project, using a cost of capital of 15%.

b. Rank acceptable projects by NPV.
c. Calculate the IRR of each project and use it to determine the highest cost of
capital at which all of the projects would be acceptable.

Question 14
All techniques, conflicting rankings. Nicholson Roofing Materials, Inc., is
considering two mutually exclusive projects, each with an initial investment of
$150,000. The company’s board of directors has set a maximum 4-year payback
requirement and has set its cost of capital at 9%. The cash inflows associated
with the two projects are shown in the table.
a. Calculate the payback period for each project.
b. Calculate the NPV of each project at 0%.
c. Calculate the NPV of each project at 9%.
d. Derive the IRR of each project.
e. Rank the projects by each of the techniques used. Make and justify a
recommendation.

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Question 15
Payback, NPV, and IRR. Rieger International is attempting to evaluate the
feasibility of investing $95,000 in a piece of equipment that has a 5-year life. The
firm has estimated the cash inflows associated with the proposal as shown in the
table. The firm has a 12% cost of capital.

a. Calculate the payback period for the proposed investment.

b. Calculate the net present value (NPV,) for the proposed investment.
c. Calculate the internal rate of return (IRR), rounded to the nearest whole
percent, for the proposed investment.
d. Evaluate the acceptability of the proposed investment using NPV and IRR.
What recommendation would you make relative to implementation of the
project? Why?

297
Question 16
NPV, IRR, and NPV profiles. Thomas Company is considering two mutually
exclusive projects. The firm, which has a 12% cost of capital, has estimated its
cash flows as shown in the following table.

a. Calculate the NPV of each project, and assess its acceptability.

b. Calculate the IRR for each project, and assess its acceptability.
c. Draw the NPV profiles for both projects on the same set of axes.
d. Evaluate and discuss the rankings of the two projects on the basis of your
findings in parts a, b, and c.
e. Explain your findings in part d in light of the pattern of cash inflows associated
with each project.

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Question 17
Integrative—Investment decision Holliday Manufacturing is considering the
replacement of an existing machine. The new machine costs $1.2 million and
requires installation costs of $150,000. The existing machine can be sold
currently for $185,000 before taxes. It is 2 years old, cost $800,000 new, and has
a $384,000 book value and a remaining useful life of 5 years. It was being
depreciated under MACRS using a 5-year recovery period (see Table 3.2 on
page 108) and therefore has the final 4 years of depreciation remaining. If it is
held for 5 more years, the machine’s market value at the end of year 5 will be $0.
Over its 5-year life, the new machine should reduce operating costs by $350,000
per year. The new machine will be depreciated under MACRS using a 5-year
recovery period (see Table 3.2 on page 108). The new machine can be sold for
$200,000 net of removal and cleanup costs at the end of 5 years. An increased
investment in net working capital of $25,000 will be needed to support operations
if the new machine is acquired. Assume that the firm has adequate operating
income against which to deduct any loss experienced on the sale of the existing
machine. The firm has a 9% cost of capital and is subject to a 40% tax rate.

a. Develop the relevant cash flows needed to analyze the proposed

replacement.
b. Determine the net present value (NPV) of the proposal.
c. Determine the internal rate of return (IRR) of the proposal.
d. Make a recommendation to accept or reject the replacement proposal, and
justify your answer.
e. What is the highest cost of capital that the firm could have and still accept the
proposal? Explain.

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Tutorial - Cost of Capital
Question 1
Weekend Warriors, Inc. has 35% debt and 65% equity in its capital structure. The
firm’s estimated after-tax cost of debt is 8% and its estimated cost of equity is
13%. Determine the firm’s weighted average cost of capital (WACC).

Question 2
A firm raises capital by selling $20,000 worth of debt with flotation costs equal to
2% of its par value. If the debt matures in 10 years and has a coupon interest
rate of 8%, what is the bond’s IRR?

Question 3
Your firm, People’s Consulting Group, has been asked to consult on a potential
preferred stock offering by Brave New World. This 15% preferred stock issue
would be sold at its par value of $35 per share. Flotation costs would total $3 per
share. Calculate the cost of this preferred stock.

Question 4
Duke Energy has been paying dividends steadily for 20 years. During that time,
dividends have grown at a compound annual rate of 7%. If Duke Energy’s current
stock price is $78 and the firm plans to pay a dividend of $6.50 next year, what is
Duke’s cost of common stock equity?

Question 5
Oxy Corporation uses debt, preferred stock, and common stock to raise capital.
The firm’s capital structure targets the following proportions: debt, 55%; preferred
stock, 10%; and common stock, 35%. If the cost of debt is 6.7%, preferred stock
costs 9.2%, and common stock costs 10.6%, what is Oxy’s weighted average
cost of capital (WACC)?

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Question 6
Concept of cost of capital. Wren Manufacturing is in the process of analyzing its
investment decision-making procedures. The two projects evaluated by the firm
during the past month were projects 263 and 264. The basic variables
surrounding each project analysis, using the IRR decision technique, and the
resulting decision actions are summarized in the following table.

a. Evaluate the firm’s decision-making procedures, and explain why the

acceptance of project 263 and rejection of project 264 may not be in the
owners’ best interest.
b. If the firm maintains a capital structure containing 40% debt and 60% equity,
find its weighted average cost using the data in the table.
c. If the firm had used the weighted average cost calculated in part b, what
actions would have been indicated relative to projects 263 and 264?
d. Compare and contrast the firm’s actions with your findings in part c. Which
decision method seems more appropriate? Explain why.

Question 7
Cost of debt using both methods. Currently, Warren Industries can sell 15-year,
$1,000-par-value bonds paying annual interest at a 12% coupon rate. As a result
of current interest rates, the bonds can be sold for $1,010 each; flotation costs of
$30 per bond will be incurred in this process. The firm is in the 40% tax bracket.

a. Find the net proceeds from sale of the bond, Nd.

b. Show the cash flows from the firm’s point of view over the maturity of the
bond.
c. Use the IRR approach to calculate the before-tax and after-tax costs of debt.
d. Use the approximation formula to estimate the before-tax and after-tax costs
of debt.
e. Compare and contrast the costs of debt calculated in parts c and d. Which
approach do you prefer? Why?

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Question 8
Cost of preferred stock. Determine the cost for each of the following preferred
stocks.

Question 9
Cost of common stock equity—CAPM. J&M Corporation common stock has a
beta, b, of 1.2. The risk-free rate is 6%, and the market return is 11%.

a. Determine the risk premium on J&M common stock.

b. Determine the required return that J&M common stock should provide.
c. Determine J&M’s cost of common stock equity using the CAPM.

302
Question 10
Retained earnings versus new common stock. Using the data for each firm
shown in the following table, calculate the cost of retained earnings and the cost
of new common stock using the constant-growth valuation model.

The effect of tax rate on WACC. Equity Lighting Corp. wishes to explore the
effect on its cost of capital of the rate at which the company pays taxes. The firm
wishes to maintain a capital structure of 30% debt, 10% preferred stock, and
60% common stock. The cost of financing with retained earnings is 14%, the cost
of preferred stock financing is 9%, and the before-tax cost of debt financing is
11%. Calculate the weighted average cost of capital (WACC) given the tax rate
assumptions in parts a to c.

a. Tax rate = 40%

b. Tax rate = 35%
c. Tax rate = 25%
d. Describe the relationship between changes in the rate of taxation and the
weighted average cost of capital.

Question 11
WACC—Book weights. Ridge Tool has on its books the amounts and specific
(after-tax) costs shown in the following table for each source of capital.

a. Calculate the firm’s weighted average cost of capital using book value
weights.
b. Explain how the firm can use this cost in the investment decision-making
process.

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Question 12
Calculation of specific costs, WACC, and WMCC. Dillon Labs has asked its
financial manager to measure the cost of each specific type of capital as well as
the weighted average cost of capital. The weighted average cost is to be
measured by using the following weights: 40% long-term debt, 10% preferred
stock, and 50% common stock equity (retained earnings, new common stock, or
both). The firm’s tax rate is 40%.

Debt.The firm can sell for $980 a 10-year, $1,000-par-value bond paying annual
interest at a 10% coupon rate. A flotation cost of 3% of the par value is required
in addition to the discount of $20 per bond.

Preferred stock. Eight percent (annual dividend) preferred stock having a par
value of $100 can be sold for $65. An additional fee of $2 per share must be paid
to the underwriters.

Common stock. The firm’s common stock is currently selling for $50 per share.
The dividend expected to be paid at the end of the coming year (2010) is $4. Its
dividend payments, which have been approximately 60% of earnings per share in
each of the past 5 years, were as shown in the table.

It is expected that to attract buyers, new common stock must he underpriced $5

per share, and the firm must also pay $3 per share in flotation costs. Dividend
payments are expected to continue at 60% of earnings.

a. Calculate the specific cost of each source of financing.

(Assume that Rr = Rs.)
b. If earnings available to common shareholders are expected to be $7 million,
what is the break point associated with the exhaustion of retained earnings?
c. Determine the weighted average cost of capital between zero and the break
point calculated in part b.
d. Determine the weighted average cost of capital just beyond the break point
calculated in part b.

304
References
1. Lawrence J. Gitman. Principles of Managerial Finance (12th Edition). Pearson
Prentice Hall, 2009.

This book is a compilation of the various sources referred to above and is

restricted for use by students of Institut Prima Bestari ONLY.

305
Course Syllabus
Course Number: BCO222
Course Name: Business Finance II
Number of Credits: 3 Credits
Prerequisite: None
Instructor(s): Vincci Chan
E-mail: vincci@pine-academy.edu.my
Office Hours: By appointment
Office Location: By appointment
Office Phone: 088-448344

Course Description
This course examines the management of a diverse workforce and the benefits
of creating this diversity. Topics include understanding human behavior in an
organization, changing marketplace realities, employment systems, affirmative
action, behavior modification for employees and other topics related to a
multicultural workforce.

Course Objectives
Upon completion of the course, students will be familiar with:

1. The basic knowledge of financial management, the concepts and skills of

financial planning within a business.
2. The usage of financial statement and the scheme of appropriate action.
3. The practical knowledge with regard to the use of financial management
information

Instructional methods & Library Usage

Method of Instruction

This is a 12 week course. Each week you will be given a quiz assignment tested
on the topics covered on each week itself.

Assignments must be completed by the due dates as posted.

306
Textbooks & Resources
Recommended Text:
1) Lawrence J. Gitman, Principles of Managerial Finance, 12th Edition, Person
Education International, 2009

Grading
To complete this course successfully and receive credit, students must:

1 – Pass a mid-term examination and a final examination

2 – Participate actively in class sessions
3 – Turn in each week’s homework assignments on time
4 – Turn in all other assignments on time

EVALUATION:
The grade apportionment for will be as follows:
1) Class attendance and participation 10%
2) Coursework
Assignment 1: 10 %

Assignment 2 10%

3) Mid-term exam 20%

4) Final exam 50%

GRADING SCALE:
Exceptional = 80 - 100
Good = 65 - 79
Average = 56 - 64
Pass = 50 - 55

COURSE EXPECTATIONS:
It is the student’s responsibility to make up any missed work and late work shall
be penalized five (5) points per day for each day it is late unless the student has
received prior approval from the professor or presents a written doctor’s excuse
or evidence to justify that missed work. Students who are absent are expected to
keep up with the class process through contact with one or more colleagues
enrolled in the course rather than through their professor. Students will complete
and receive copies of contact-information forms for this purpose in the first and
second course meetings.

307
Assignment and Exam Schedule
Each week is a module of study called a Unit. We will complete each unit in
succession on a weekly basis.

Weekly Assignments may include (but are not limited to): Reading assignments
from the text, Written Assignments, Weekly Quizzes, and Group Projects.

You must complete all assignments, quizzes, by the posted due dates.

Each week you are responsible for TWO items:

1. Read the assigned chapters for the current Unit in the text as well as the
provided lecture notes. Read the text and take notes. I will provide you
additional material, but the bulk of information and detail is found through reading
the text and outside research.

2. Complete the requirements of the week. You must type your written
assignments in Word

***Written Assignments: Type your name on your work. Number each item,
and double space between answers. Spell-check your work. Do not type in colors,
use 12 point font, black, Arial or Times New Roman ONLY.***

Academic Misconduct
Please refer to the Pine Academy Academic Rules & Regulations for complete
information on grounds for punishment up to and including expulsion from
school. Listed below are examples of unacceptable behaviors and practices that
will result in penalties enforced against the offending student. Do not engage in
any of these practices personally, and please notify your instructor or the
program Dean if you are aware of any other students who have committed any of
these offenses.

Grounds for Academic Dishonesty/Misconduct

 Plagiarism – presenting the work of another as one’s own in a paper, exam,
or other assignment. Acknowledgment must be given for the use of another’s
ideas or language.
 Cheating on Examinations – copying another’s work or allowing your work to
be copied; using unauthorized notes; taking another’s exam or having
another take yours.
 Computer Use – software is protected by copyright. Students may not copy
the institution’s software without permission of the copyright holder.
Additionally, students may not place personal software on the institution’s
computers or damage or destroy either software or computers.
 Other Forms – other forms of academic dishonesty include: selling or
purchasing examinations, papers or other assignments and submitting or

308
 resubmitting the same paper for two different classes without explicit
authorization.

Grounds for Non-Academic Dishonesty/Misconduct

 Physical and/or psychological abuse, threat, or harassment.
 Initiation of, or causing to be initiated, any false report, warning or threat of
fire, explosion, or other emergency.
 Unauthorized use, possession, or storage of any weapon, dangerous
chemical or explosive element.
 Disrupting, obstructing or interfering with University-sponsored events.
 Theft of school equipment, products and supply materials.
 Unauthorized possession, use, sale, or distribution of alcoholic beverages or
any illegal or controlled substance.
 Gambling or holding raffle or lottery at the University without proper approval.
 Disorderly, lewd, or obscene conduct.

Drops & Withdrawals

If a student attends the course in the classroom, they are considered a student,
and will be expected to meet the requirements of the class. While we understand
that unforeseen situations do occur, Pine Academy maintains that should a
student wish to drop the course they may do so during the first week of the class
only, by seeing their Advisor and the Registrar.

If a student fails to attend the class at all during the first week of class, the
instructor from the course will drop the student.

309
Course Outline
Students will read and report on a minimum of one chapter per week from each
source, in general, according to instructions given by the professor on a weekly
basis. The following is an approximation of that schedule:

COURSE OUTLINE:
Topic/Assignment
Introduction to Managerial Finance
Week One The Role and Environment of Managerial
Finance
Week Two Cash Flow and Financial Planning
Important Financial Concepts
Week Three Risk & Return
Week Four Interest Rates and Bond Valuation
Week Five Stock Valuation
Week Six Mid term break
Week Seven Mid term test
Long Term Investment Decisions
Week Eight Capital Budgeting
Week Nine Capital Budgeting Techniques
Week Ten Risk and Refinements in Capital Budgeting
Long Term Financial Decisions
Week Eleven The Cost of Capital
Week Twelve Leverage, Dividend Policy and Capital
Structure
Week Thirteen Revision
Week Fourteen Final Exam

310
Past Examinations
Semester 1, 2010 Final Examination
Question 1 (20 Marks)

311
Question 2 (10 Marks)

Question 3 (15 Marks)

312
Question 4 (25 Marks)

313
Question 5 (10 Marks)

314
Question 6 (20 Marks)

315