Lecture 2 15feb2011

Master in Business Administration (M.B.A.
LECTURE 2
Corporate Finance
Dr Andry Rakotovololona
arakotovololona@LSBF.org.uk
CONTENTS
Time: 10.00 – 11.30 or 14.00 – 15.30
1. Arbitrage & Law of One Price
2. Risk and Return

MBA – Corporate Finance
3. Interest Rates
4. Time Value for Money
After Break: 11.45 – 13.00 or 15.45 – 17.00

5. DDM, CAPM & Cost of Equity
6. Valuing Bonds & Cost Of Debt
7. WACC
7. Debt and Taxes
8. Q&A
9. Thank You !
February 15, 2011 2

Textbook References
Berk, J. & DeMarzo, P., “Corporate Finance: The

Core”, 2nd Edition, Pearson Global Edition, 2011
− Chapter 3.
− Chapter 4
− Chapter 5
− Chapter 8.
− Chapter 15.
February 15, 2011 3

1. ARBITRAGE & LAW OF ONE PRICE
Arbitrage
− The practice of buying and selling equivalent

goods in different markets to take advantage of
a price difference.
An arbitrage opportunity occurs when it is
possible to make a profit without taking any
risk or making any investment.
investment
Normal Market
− A competitive market in which there are no
arbitrage opportunities.
opportunities
February 15, 2011 4
Law of One Price
− If equivalent investment opportunities trade
simultaneously in different competitive markets,
then they must trade for the same price in both
markets.
− Determining the No-Arbitrage
Arbitrage Price.
Unless the price of the security equals the present
value of the security’s cash flows, an arbitrage
opportunity will appear.
No-Arbitrage Price of a Security:
Security
Price(Security) = PV (All cash flows paid by the security)
February 15, 2011 5

2. RISK AND RETURN
The higher the risk of an investment, the higher will be

the return required by the providers of the capital:
− Impacts on the cost of capital Put simply, if a

company only invests in ‘safe’
‘ projects or offers the
providers of capital a guaranteed return on their
capital, then the cost of such capital to the company
would be low.
− Conversely, for higher risk investments the cost of

capital to the company will be high to compensate
the investors for the additional risk.
risk
February 15, 2011 6

Elements Of Return
Return Required is a combination of two elements

for a given financial instrument:
1. Risk-free return:: level of return expected of an

investment with zero risk to the investor.
2. Risk premium: return required above and beyond
the risk-free rate for an investor to be willing to
invest in the company.
Risk Free Return
− Risk-free
free rate is normally equated to the return
offered by short-dated
dated government bonds or
treasury bills (gilts).
February 15, 2011 7

“Pecking Order Theory” & Degree Of Risk
Risk Free
Rate of Higher Risk
Investment
Return
Government Secured Unsecured Mezzanine

Debt Loan Notes Loan Notes Finance
Hierarchy of ranking/authority derived from the “Principle of Least

Effort or Least Resistance”.
Resistance
February 15, 2011 8
Government debt is the least risky as it will always be
repaid.
Short term debt is generally regarded as risk free
rather than long term government debt: Why?
− Although the long term debt can be repaid,

investors could lose out on the return and the
capital value if economic conditions change
materially.
Secured loan notes are corporate debts: Secured
S on
the company’s assets with either a fixed charge (on
specific assets) or a floating charge (over all the
assets):
− Sometimes referred to as debentures with two
components: the loan itself and the charge on the
assets.
February 15, 2011 9
Unsecured loan notes:: Debt that the company sells
without any security,, therefore not protected and
carries significant risk.
Mezzanine finance:: Broad name for a variety of
financial instruments – Typically unsecured, and may

be subordinated to other loans (secured or
unsecured), so less likely to be repaid if the company
fails.
− Very high risk and rank just above the ordinary
share capital in terms of risk.
Ordinary shares: Most risky investments and rank last
in both the order of their holders receiving an annual
return (dividend) or the payment of their capital in
case of bankruptcy.
February 15, 2011 10

Price of Risk
Risky vs. Risk-free Cash Flows

Cash Flows & Market Prices (in $):

Comparison between a Risk-Free Bond (4%) and an Investment in the
Market Portfolio

− Assume there is an equal probability of either a
weak economy or strong economy.
economy
Price(Risk-free Bond) = PV(Cash Flows)

= ($1100 in one year) ÷ (1.04 $ in one year
yea / $ today)
= $1058 today
− Expected Cash Flow (Market Index)

½ ($800) + ½ ($1400) = $1100
− Although both investments have the same
expected value, the market index has a lower
value since it has a greater amount of risk.
risk

Risk Aversion & Risk Premium
Risk Aversion
− Investors prefer to have a safe income rather
than a risky one of the same average amount.

Risk Premium
− The additional return that investors expect to
earn to compensate them for a security’s risk.
− When a cash flow is risky,
risky to compute its present
value we must discount the cash flow we expect
on average at a rate that equals the risk-free
risk
interest rate plus an appropriate risk premium.
premium

Expected Gain at end of year
Expected return of a risky investment =
Initial Cost
− Market return if the economy is strong

(1400 – 1100) / 1100 = 40%

− Market return if the economy is weak
(800 – 1000) / 1000 = –20%
− Expected market return
½ (40%) + ½ (–20%)
20%) = 10%

3. INTEREST RATES
The Effective Annual Rate (EAR)

− Indicates the total amount of interest that will be

earned at the end of one year.
year
− Considers the effect of compounding.
− Also referred to as the Effective Annual Yield
(EAY) or Annual Percentage Yield (APY)

Adjusting Discount Rate to Different
Time Periods
Earning a 5% return annually is not the same as

earning 2.5% every six months.
months
General Equation for Discount Rate Period

Conversion:
n
Equivalent n-Period Discount Rate = (1 + r) - 1
− (1.05)0.5 – 1= 1.0247 – 1 = 0.0247 = 2.47%.
→ Note: n = 0.5 since we are solving for the
six month (or 1/2 year) rate.

Annual Percentage Rate
APR indicates the amount of simple interest earned in one

year.
→ Simple interest is the amount of interest earned

without the effect of compounding.
compounding
The APR is typically less than the EAR.
The APR itself cannot be used as a discount rate.
rate
The APR with k compounding periods is a way
of quoting the actual interest earned each
compounding period:
APR
Interest Rate per Compounding Period =
k-Periods / year
Converting an APR into an EAR
k
 APR 
1 + EAR = 1 + 
 k 
− The EAR increases with the frequency of

compounding.
− Continuous compounding is compounding every
instant.

Example
Effective Annual Rates for a 6% APR with Different

Compounding Periods:
A 6% APR with continuous compounding results in

an EAR of approximately 6.1831%.

The Determinants of Interest Rates
Inflation and Real Versus Nominal Rates

− Nominal Interest Rate:: The rates quoted by

financial institutions and used for discounting or
compounding cash flows.
− Real Interest Rate: The rate of growth of your
purchasing power, after adjusting for inflation:
1 + r Growth of Money
Growth in Purchasing Power = 1 + rr = =
1 + i Growth of Prices

The Real Interest Rate
r − i
rr = ≈ r − i
1 + i
Where, rr = real interest rate,

r = nominal interest rate,
i = rate of inflation.

U.S. Interest Rates and Inflation Rates,
1960–2009
Source: US Treasury and Us Bureau of Labour Statistics.

4. TIME VALUE OF MONEY
The Three Rules of Time Travel:


Example: The Rules of Time Travel
Suppose we plan to save $1000 today, and $1000

at the end of each of the next two years.
If we can earn a fixed 10% interest rate on our

savings, how much will we have three years from
today?
The time line would look like this:

FUTURE VALUING a Stream of Cash-Flows
Cash

February 15, 2011

26
PRESENT VALUING a Stream of Cash-Flows
Cash

Present Value of a Cash Flow Stream:

N N
Cn
PV = ∑ PV (C )
n = 0
n = ∑
n = 0 (1 + r ) n
Annuities
When a constant cash flow will occur at regular

intervals for a finite number of N periods, it is
called an annuity.
Present Value of an Annuity

N
C C C C C
PV = + 2
+ 3
+ ...+ N
=∑ n
(1+ r) (1+ r) (1+ r) (1+ r) n=1 (1+ r)

Perpetuities
When a constant cash flow will occur at regular

intervals forever it is called a perpetuity:
− Investment = $100 reinvested every year.

− Interest per year = 5%.

The value of a perpetuity is simply the Cash Flow (CF)
divided by the interest rate (r).
Present Value of a Perpetuity:
CF
PV (CF in perpetuity ) =
r
Using the terminology of shares in the above formula we
get:
Dividend
Share Price (P0 ) =
KE
Where KE = Cost of Equity

d = Constant Dividend per annum
P0 = Market Price of the share at year 0 (excl. dividend
that has just been paid)

Growing Perpetuities
Assume you expect the amount of your perpetual

payment to increase at a constant rate g.
Present Value of a Growing Perpetuity
C
PV (growing perpetuity) =
r-g

5. COST OF EQUITY
Definition:
The rate of return required by a shareholder.
This may be calculated in one of two ways:

1. Dividend-Discount
Discount Model (DDM).
2. Capital Asset Pricing Model (CAPM).

DIVIDEND DISCOUNT MODEL
To understand how to calculate the cost of equity,

equity we
start with the closely related calculation of the
company’s share price:

− Calculation = dividend valuation model equates
the share price to the PV of the dividends received
by the shareholders.
− Cash-Inflow
Inflow from the dividends a perpetuity that
reflects the permanent nature of the share capital.

Applying the Dividend Discount Model
What is the price if we plan on holding the stock for N

years?
Div1 Div2 DivN PN

P0 = + + + N
+
1 + rE (1 + rE ) 2
(1 + rE ) (1 + rE ) N
− This is known as the Dividend Discount Model.

Model
rE : Equity cost of capital.
Note:: the above equation holds for any
horizon N.
Thus all investors (with the same beliefs) will attach
the same value to the stock, independent of their
investment horizons.
∞
Div1 Div2 Div3 Divn
P0 = + 2
+ 3
+ = ∑ (1 + rE ) n
1 + rE (1 + rE ) (1 + rE ) n =1
The price of any stock is equal to the present value of the

expected future dividends it will pay.

Constant Dividend Growth
− The simplest forecast for the firm’s future dividends
states that they will grow at a constant rate g, forever.

Constant-Dividend
Dividend Growth Model
Div1
P0 =
rE − g
Div1
Then, rE = + g is the Cost of Equity.
P0
− The value of the firm depends on the current dividend

level, the cost of equity,, and the growth rate.

Solution:
Div $2.36
P0 = = = $39.33
rE - g 0.075 - 0.015

Estimating Growth Of Dividends
The first method of determining growth g is:
D0
g= n -1
Dn
Where D0 = current dividend.

Dn = dividend n-years
years ago.

The GORDON’S GROWTH MODEL is another way of
estimating the growth of dividends:
− Two ways of writing the formula for this model
which both mean exactly the same thing,
g = r ×b
Where r = Return on Reinvested Funds.
b = Proportion of Funds Retained.

In the exam formula sheet the examiner might give you a
slightly different version:
g = rE × b
where rE = Return on Equity

b = Proportion of Funds Retained
The rationale behind the model = growth of dividends

only occurs if a company retains some of its earnings to
reinvest in the business.
If company paid out all its earnings as dividends = no
growth as no new investments or projects which would
generate the additional profits,
− Thus, profits would be the same and therefore
dividends would also be the same every year.
year
CAPITAL ASSET PRICING MODEL
Definition:
The Capital Asset Pricing Model (CAPM) is a model
that values shares by measuring the risk of a

particular share against the risk of the overall market
in all shares.
It can also be applied to financial instruments other
than shares.
The basic idea → There is a relationship between risk
and return:
− All investors have a general idea of the trade-offs
that they collectively expect between risk and
return for all shares – a sort of average.
Are the investors in the market acting rationally ?
− If we can understand/quantify the general
relationship between risk and return for the whole
market Knowing the risks and returns
associated with a particular share will drive to its
price.
− By acting rationally investors require an
adjustment to a particular share price to reflect the
increased or decreased risk associated with that
share.
There are two stages to the full explanation of the
CAPM:
a) Systematic and unsystematic risk.
risk
b) The CAPM formula.

Systematic & Unsystematic Risk
Definition of Systematic Risk:

Risk
Risk affecting all the company shares in the market
(the stock market).

Caused by economy-widewide considerations but not
caused by factors specific to particular shares,
− Increase in interest rates will tend to depress all
share prices.
− Similarly, a recession will also depress all share
prices.
Definition of Unsystematic Risk:
Risk
Risk associated with intrinsic and specific parameters
associated with individual companies.

Diversification
Constructing a portfolio with one share and

gradually adding other shares will tend to
reduce the total risk of the portfolio.

portfolio
− Example: if you buy shares in ice cream
producers or sun glasses producers, you
should also buy shares in umbrella
manufacturers so you balance and reduce
the risks posed by the weather.

In theory, if you buy shares representing all
the shares in the market in proportion to their
market capitalizations,, you would have what
is referred to as a ‘market
market portfolio’
portfolio and you
would have diversified away all the company
specific or unsystematic risks.
risks
However, even if you have a very well
diversified portfolio such that you have
diversified away all the unsystematic risk you
will still be left with the systematic risk.

Most of the unsystematic risk is eliminated with a portfolio of about

30 different shares.
shares
Portfolio Implications
To avoid risk altogether, an investor must invest

in a portfolio consisting entirely of risk-free
securities such as government debt.

A ‘balanced portfolio’’ of all the stocks and shares
in the stock market will suffer systematic risk
which is the same as the average systematic risk
in the market.
Individual shares will have systematic risk
characteristics which are different from this
market average,
− Their risk will be determined by the industry
sector and gearing.. Some shares will be more
risky and some less.
β (Beta) Factors
The β factor was devised as a means to measure the

systematic risk of a single company share or a
portfolio.
− The market portfolio is taken to be the benchmark
and is given a β factor of 1.
1
− All other shares or portfolios will have a β factor
greater or smaller than 1 depending on their
systematic risk which is measured by considering
their required returns:
If β factor of 0.5 SShare or portfolio return
moves in line with the market return but only
half as much.
If β factor of 2 Share or portfolio return
moves in line with the market return but twice
February 15, 2011
as much. 50
Example: Suppose the returns on shares in ABC plc
tend to vary twice as much as returns from the market
as a whole,
− So that if market returns went up by 6%, ABC’s

returns would go up by 12%.
− If market returns fell by 4% then ABC’s returns
would fall by 8%.
− Then, ABC would be said to have a β factor of 2.
The β factor is thus the measure of a share’s volatility
in terms of the market’s systematic risk.

Return Calculations Involving CAPM
From CAPM, we can derive the following mathematical
formula for the required return for a particular share:
(K E - RF ) = β.(R
.(RM - RF )
Where KE = Required (Expected) Return from Individual Share.
β = Beta Factor of Individual Share.
RF = Risk-free
free Rate of Interest.
RM = Return on Market Portfolio
This means that the expected excess return of the
particular share over the risk free rate equals the
share’s β times the expected excess return of the
market over the risk free rate.
rate
The return of a particular share is the share’s β times
the return required on the market.
The difference between the return on the market
portfolio and the risk free return (RM – RF) is referred to
as the market risk premium or the equity risk premium
(ERP).
The risk free rate is the rate on short term gilts which
are effectively risk free.
The above equation can be re-written
re as:
K E = RF + β.(R
.(RM - RF ) This is the Cost of Equity

Criticisms of CAPM
1. CAPM = single period model the values calculated are only
valid for a finite period of time and will need to be recalculated
or updated at regular intervals.
2. CAPM assumes no transaction costs associated with trading

securities.
3. Any beta value calculated will be based on historic data and may
not be appropriate currently particularly so if the company has
changed the capital structure or their type of business.
4. Market return may change considerably over short periods of
time.
5. CAPM assumes an efficient investment market where it is
possible to diversify away risk Not necessarily the case as
some unsystematic risk may remain.
6. Additionally the idea that all unsystematic risk is diversified away
will not hold true if stocks change in terms of volatility.
6. VALUING BONDS
Understanding bonds and their pricing is useful:

− The prices of risk-free

free government bonds can be
used to determine the risk-free interest rates,
− Firms often issue bonds to fund their own
investments, and the returns investors received
is one factor in determining the cost of capital,
capital
− Bonds provide an opportunity to know how
securities can be priced in a competitive market.

Bond Cash Flows, Prices, and Yields
Bond Terminology
− Bond Certificate:: States the terms of the bond.

− Maturity Date: Final repayment date.
− Term: The time remaining until the repayment
date.
− Coupon: Promised interest payments.
− Face Value: Notional amount used to compute
the interest payments.

− Coupon Rate: Determines the amount of each
coupon payment, expressed as an APR.
− Coupon Payment:
Coupon Rate × Face Value

CPN =
Number of Coupon Payments per Year

Zero-Coupon Bonds
Zero-Coupon Bond
− Does not make coupon payments.

− Always sells at a discount (a price lower than
face value), so they are also called pure discount
bonds.
− Treasury Bills are U.S. government zero-coupon
zero
bonds with a maturity of up to one year.

Yield to Maturity
− The discount rate that sets the present value of
the promised bond payments equal to the
current market price of the bond.
− Price of a Zero-Coupon
Coupon bond:
FV
P =
(1 + YTM n ) n
− Yield to Maturity of an n-Year Zero-Coupon Bond
1
 FV  n
YTM n =   − 1
 P 

Example
Yield to Maturity: For the one-year

one zero coupon
bond
100,000
96,618.36 =
(1 + YTM 1 )
100,000
1 + YTM 1 = = 1.035
96,618.36
→ Thus, the YTM is 3.5%.

3.5%

Coupon Bonds
Yield to Maturity
− The YTM is the single discount rate that equates

the present value of the bond’s remaining cash
flows to its current price.
− Yield to Maturity of a Coupon Bond:
1  1  FV
P = CPN × 1 − N 
+
y  (1 + y )  (1 + y ) N
Discounts & Premiums
Bond Prices Immediately After a Coupon Payment

The Effect of Time on Bond Prices
“Revert to Par”

Yield to Maturity & Bond Price Fluctuations

7. COST OF DEBT
The cost of debt is the rate of return that debt
providers require on the funds that they provide:
− We would expect this to be lower than the cost of
equity because the risk is lower than the risk

associated with equity.
The market value of debt is assumed to be the
present value of its future cash flows:
flows
− To calculate the market value of debt
Determine all the cash flows associated with
Determine
the debt (typically the interest payments and
the final value at which the debt will be
redeemed),
Discount them at an appropriate rate to give
Discount
the present value of the debt (i.e. the current
February 15, 2011 market value). 65
Terminology
1. Loan notes, bonds and debentures are all types of debt issued
by a company. Gilts and treasury bills are debt issues by a
government.
2. Traded debt is always quoted in $100 nominal units or blocks
3. Interest paid on the debt is stated as a percentage of nominal
value ($100 as stated). This is known as the coupon rate. It is
not the same as the cost of debt.
4. Debt can be:
a) Irredeemable – never paid back
b) redeemable at par (nominal value)
c) or redeemable at a premium or discount (for more or less).
5. Interest can be either fixed or floating (variable).
Irredeemable Debt With Tax
The calculation is based on the PV of a perpetuity as
seen above, but we calculate the return on the debt for a
given market price.
i.(1- T)
KD =
P0
Where i = Interest Paid

T = Marginal Tax Rate
P0 = Market Price excl. interest on the loan stock
(similar to excl. dividend for shares).

Cost Of Redeemable Debt with Tax
The KD for a redeemable debt is given by the IRR of the
relevant cash flows:
− The relevant cash flows would be:

The market value of the debt/bond.
The interest payment per period.
The redemption value of the debt/bond.
Annual interest payments for year-1
year to year-n = i(1 - T).
Discount each cash-flow
flow (@ a rate above or below the
coupon rate).

Interpolate the IRR using the following formula:
 NPVRLow 
IRRInterpolation = RLow +   x RHigh - RLow
( )
 NPVR - NPVR 
 Low High 
If the current market value and the redemption value are the
same the irredeemable debt formula can be used.
used

Cost of Redeemable Debt Evaluation
COST OF BOND CAPITAL

Bond Current Market Value = £98

Maturity before Redemption = 3 Years
Tax rate = 25%
Net Interest Payable = £6 * (1 - 0.25) = £4.5
Redemption Price = £100

Cost of Bond
Year Description Cash-Flow * (1-t) DCF1 - 6% PV1 DCF2 - 4% PV2
0 Market Value -98 1.000 -98.00 1.000 -98.00
1 Interest 4.5 0.943 4.25 0.962 4.33

2 Interest 4.5 0.890 4.00 0.925 4.16
3 Interest + Par Value 104.5 0.840 87.74 0.889 92.90
NPV -2.01 3.39

IRR 5.26%
Kd = IRR 5.24%
5.24% = IRR(CF0 : CF3 ; 6%) IRR = LR + [NPV LR / (NPV LR – NPV HR)] * (HR - LR)

Convertible Debt
Convertible debt is a loan note with an option to

convert the debt into shares at a future date with a
predetermined price.
In this situation the holder of the debt will logically
choose the option which provides the greater value:
1. The share value on conversion,
conversion or
2. The cash redemption value,
value if not converted.

Example
General information:
− Taxation Rate = 30%

Convertible Debt Information:
− Interest Rate on Debt = 8%
− Debt Book Value = £110,000,000
− Debt Market Price = £110
− Treasury Bond (Risk-Free)
Free) Rate = 3.5%
− Redemption at Par (£100) = 8 years

Cost of Convertible Debt
Year Description Cash flow *(1-t) DCF 1 - 8% PV1 DCF 2 - 2% PV2
0 Market Value -110 1.000 -110.000 1.000 -110.000
1 Interest 5.6 0.926 5.185 0.980 5.490
2 Interest 5.6 0.857 4.801 0.961 5.383
3 Interest 5.6 0.794 4.445 0.942 5.277

4 Interest 5.6 0.735 4.116 0.924 5.174
5 Interest 5.6 0.681 3.811 0.906 5.072
6 Interest 5.6 0.630 3.529 0.888 4.973
7 Interest 5.6 0.583 3.268 0.871 4.875
8 Interest + Par 105.6 0.540 57.052 0.853 90.129
NPV -23.792 16.372
IRR 4.45%
Kd = IRR 4.11%
IRR = LR + [NPV LR / (NPV LR – NPV HR)] * (HR - LR) -23,792

23,792 = Sum (Market Value & InterestPV1)
4.11% = IRR ( Σ CF0 : CF8 ; 8%)

Bank Debt (Non Tradeable Debt)
A substantial proportion of the debt of companies is

not traded.
Bank loans and other non-traded
traded loans have a cost of
debt equal to the coupon rate adjusted for tax:
K Loan =Interest (Coupon) Rate × (1-T)

Example
Bank Loan information:

− Loan Interest Rate = 10%

− Loan Book Value = £10,000,000
Cost of Bank Loan

Interest on Loan 10.0%
kL (After-Tax) = 10% * (1-0.30) 7.0%

Preference Shares
Definition:
A preference share is a fixed rate charge to the company
in the form of a dividend rather than in terms of interest.

Preference shares are normally treated as debt rather than
equity but they are not tax deductible.
deductible Therefore, we do
not deduct the tax in calculating the cost.
They can be treated using the dividend-discount model
with no growth:
D
K PS =
P0

8. WEIGHTED AVERAGE COST OF CAPITAL
(WACC)
WACC is the average of cost of the company’s

financing (equity, loan notes, bank loans,
preference shares) weighted according to the

proportion each element bears to the total pool
of funds.

Example
General information:
− Taxation Rate = 30%

Equity information:
− Ordinary Shares issued = 140,000,000
− Ordinary Share price = £8.50
− Equity Beta = 1.3
− Market Return (Expected by Equity Investors) =
14%

Convertible Debt Information:
− Interest Rate on Debt = 8%
− Debt Book Value = £110,000,000
− Debt Market Price = £110

− Treasury Bond (Risk-Free)
Free) Rate = 3.5%
− Redemption at Par (£100) = 8 years
Bank Loan information:
− Loan Interest Rate = 10%
− Loan Book Value = £10,000,000

WACC Calculations
Cost of Equity
Rf 3.5%
Beta (β) 1.3

RM 14%
RM- Rf 10.5%
Ke = RF+β (Rm-Rf) 17.15%
Cost of Bank Loan

Interest on Loan 10.0%
kL (After-Tax) = 10% * (1-0.30) 7.0%

Cost of Convertible Debt
Year Description Cash flow *(1-t) DCF 1 - 8% PV1 DCF 2 - 2% PV2
0 Market Value -110 1.000 -110.000 1.000 -110.000
1 Interest 5.6 0.926 5.185 0.980 5.490
2 Interest 5.6 0.857 4.801 0.961 5.383
3 Interest 5.6 0.794 4.445 0.942 5.277

4 Interest 5.6 0.735 4.116 0.924 5.174
5 Interest 5.6 0.681 3.811 0.906 5.072
6 Interest 5.6 0.630 3.529 0.888 4.973
7 Interest 5.6 0.583 3.268 0.871 4.875
8 Interest + Par 105.6 0.540 57.052 0.853 90.129
NPV -23.792 16.372
IRR 4.45%
Kd = IRR 4.11%
IRR = LR + [NPV LR / (NPV LR – NPV HR)] * (HR - LR) -23,792

4.11% = IRR ( Σ CF0 : CF8 ; 8%)

Nb Shares * Share Price = 140,000,000 * £8.50 =
£1,190,000,000
Workings for WACC

Number of Shares 140
Value of Equity 1190 £121,000,000 = (£110,000,000 / £100) * £110
Value of Debt 121

Bank Loan 10
Value of Capital Cost of Capital VC * CC
Equity 1190 17.15% 204.09
Covertible Debt 121 4.11% 4.97
Bank Loan 10 7.00% 0.70
1321 209.76
WACC 15.88%
WACC = 15.88% = 209.76 / 1,321 209.76 = 204.09 + 4.97 + 0.70

Use Of WACC
WACC = cost of capital

− Can be used to evaluate the company’s investment projects if certain
conditions apply.
Main thing to be considered: Average cost of capital or Marginal cost of
capital is appropriate:
1. WACC appropriate if the company adopts a “pooled funds” approach to
financing its projects and:
The company will maintain its existing capital structure in the long
run (i.e. same financial risk);
The project has the same degree of systematic (business) risk as
the company has now.
2. WACC also appropriate if the project is insignificant relative to the size
of the company.
3. However, if funds are to be raised specifically for a project with the
funds raised matched to the project, then the marginal cost of capital
may be more appropriate

9. DEBT & TAXES
The Law of One Price implies:

− All financial transactions have an NPV of zero,

and neither create nor destroy value.
However, if capital structure does matter, then it
must stem from a market imperfection:
− Tax is one of these imperfections.
imperfections
Corporations pay taxes on their profits after
interest payments are deducted:
− Thus, interest expense reduces the amount of
corporate taxes
→ This creates an incentive to use debt.
debt
Example
Consider Safeway, Inc. which had earnings before

interest and taxes of approximately $1.85 billion in
2008, and interest expenses of about $350 million.

Safeway’s marginal corporate tax rate was 35%.

Interest Tax Deduction
Safeway’s debt obligations reduced the value of its

equity. But the total amount available to all
investors was higher with leverage.

Interest Tax Shield
− The reduction in taxes paid due to the tax
deductibility of interest
Interest Tax Shield = Corporate Tax Rate × Interest Payments
− In Safeway’s case, the gain is equal to the

reduction in taxes with leverage:
leverage
$648 million − $525 million = $123 million.
The interest payments provided a tax savings
of 35% × $350 million = $123 million.

Cash Flows of the Unlevered and Levered Firm

The WACC with and without Corporate Taxes

6. Questions & Answers
Q&A

DOMINUS ILLUMINATIO MEA
Thank You !

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Master in Business Administration (M.B.A.

1. Arbitrage & Law of One Price

2. Risk and Return

4. Time Value for Money

After Break: 11.45 – 13.00 or 15.45 – 17.00

February 15, 2011 2

Berk, J. & DeMarzo, P., “Corporate Finance: The

February 15, 2011 3

− The practice of buying and selling equivalent

Price(Security) = PV (All cash flows paid by the security)

February 15, 2011 5

The higher the risk of an investment, the higher will be

− Impacts on the cost of capital Put simply, if a

− Conversely, for higher risk investments the cost of

February 15, 2011 6

Return Required is a combination of two elements

1. Risk-free return:: level of return expected of an

February 15, 2011 7

Government Secured Unsecured Mezzanine

Hierarchy of ranking/authority derived from the “Principle of Least

− Although the long term debt can be repaid,

financial instruments – Typically unsecured, and may

February 15, 2011 10

Risky vs. Risk-free Cash Flows

Cash Flows & Market Prices (in $):

February 15, 2011 11

Price(Risk-free Bond) = PV(Cash Flows)

− Expected Cash Flow (Market Index)

February 15, 2011 12

than a risky one of the same average amount.

February 15, 2011 13

− Market return if the economy is strong

(1400 – 1100) / 1100 = 40%

February 15, 2011 14

The Effective Annual Rate (EAR)

− Indicates the total amount of interest that will be

February 15, 2011 15

Earning a 5% return annually is not the same as

General Equation for Discount Rate Period

February 15, 2011 16

APR indicates the amount of simple interest earned in one

→ Simple interest is the amount of interest earned

− The EAR increases with the frequency of

February 15, 2011 18

Effective Annual Rates for a 6% APR with Different

A 6% APR with continuous compounding results in

February 15, 2011 19

Inflation and Real Versus Nominal Rates

− Nominal Interest Rate:: The rates quoted by

February 15, 2011 20

Where, rr = real interest rate,

February 15, 2011 21

Source: US Treasury and Us Bureau of Labour Statistics.

February 15, 2011 22

The Three Rules of Time Travel:

February 15, 2011 23

Suppose we plan to save $1000 today, and $1000

If we can earn a fixed 10% interest rate on our

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February 15, 2011 25

February 15, 2011

February 15, 2011 27