Professional Documents
Culture Documents
By: Andrew Iu
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Table of Contents
Reminders 4
Chapter 4 4
Chapter 5 4
Chapter 6 4
Chapter 10 & 11 4
Chapter 7 4
Questions to Review 5
Chapter 9 5
Chapter 22 5
Chapter 11 5
Week 1, Class 1 6
1.1 What is Corporate Finance? 6
1.2 Corporate Securities as Contingent Claims on Total Firm Value 6
1.3 The Corporate Firm 6
1.4 Goals of the Corporate Firm 8
1.5 Financial Institutions, Financial Markets and the Corporation 8
1.6 Trends in Financial Markets and Management 8
Week 1, Class 2 10
4.1 The Financial Market Economy 10
4.2 Making Consumption Choices Over Time 10
4.3 The Competitive Market 10
4.4 The Basic Principle 11
4.5 Practicing the Principle 11
4.6 Illustrating the Principle 11
4.7 Corporate Investment Decision Making 11
Week 2, Class 1 13
5.1 The One-Period Case 13
5.2 The Multiperiod Case 13
5.3 Compounding Periods 13
5.4 Simplifications 13
5.5. What is a Firm Worth? 14
Week 3, Class 1 15
6.2 How to Value Bonds 15
6.3 Bond Concepts 15
Week 3, Class 2 16
The Term Structure of Interest Rates 16
The Expectations Hypothesis 16
The Liquidity Preference Theory 16
Week 4, Class 2 17
6.4 The Present Value of Common Stocks 17
6.5 Estimates of Parameters in the Dividend Discount Model 17
6.6 Growth Opportunities 17
6.7 The Dividend Growth Model and the NPVGO Model (Advanced) 18
6.7 Price-Earnings Ratio 18
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Week 5, Class 1 19
15.1 Common Stock 19
15.2 Corporate Long-Term Debt: The Basics 19
15.3 Preferred Shares 20
15.4 Income Trusts 21
15.5 Pattens of Long-Term Financing 21
Week 6, Class 1 22
10.1 Returns 22
10.2 Holding Period Returns 22
10.3 Return Statistics 22
10.4 Average Stock Returns and Risk-Free Returns 22
10.5 Risk Statistics 22
10.6 More on Average Returns 22
Week 6, Class 2 23
11.1 Individual Securities 23
11.2 Expected Return, Variance, and Covariance 23
11.3 Risk and Return for Portfolios 23
11.4 The Efficient Set for Two Assets 23
11.5 The Efficient Set for Many Securities 24
11.6 Diversification: an Example 25
Week 8, Class 1 26
11.7 Riskless Borrowing and Lending 26
11.8 Market Equilibrium 27
11.9 Relationship between Risk and Expected Return (CAPM) 28
Week 8, Class 1 (cont’d) 30
12.1 Factor Models: Announcements, Surprises and Expected Returns 30
12.2 Risk: Systematic and Unsystematic 30
12.3 Systematic Risk and Betas 30
12.4 Portfolios and Factor Models 30
12.5 Betas and Expected Returns 31
12.6 The Capital Asset Pricing Model and the Arbitrage Pricing Theory 31
12.7 Parametric Approaches to Asset Pricing 31
Week 8, Class 1 32
13.1 The Cost of Equity Capital 32
13.2 Estimation of Beta 32
13.3 Determinants of Beta 32
13.4 Extensions of the Basic Model 33
13.6 Reducing the Cost of Capital 33
Week 8, Class 2 34
14.1 Can Financing Decision Create Value? 34
14.2 A Description of Efficient Capital Markets 34
14.3 & 14.4 The Different Types of Efficiency and the Evidence for Each 34
14.5 The Behavioural Challenge to Market Efficiency 36
14.6 Empirical Challenges to Market Efficiency 36
14.7 Reviewing the Differences 36
14.8 Implications for Corporate Finance 36
Week 9, Class 1 37
7.1 Why Use NPV? 37
7.2 The Payback Period Rule 37
7.3 The Discounted Payback Period Rule 37
7.4 The Average Accounting Return 37
7.5 The Internal Rate of Return 37
7.6 Problems with the IRR Approach 38
7.7 Profitability Index (PI) 40
W9,C2 - W10,C2 41
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8.1 Incremental Cash Flows 41
8.2 The Majestic Mulch and Compost Company: An Example 41
8.3 Inflation and Capital Budgeting 41
8.4 Alternative Definitions of Operating Cash Flow 41
8.5 Applying the Tax Shield Approach to the Majestic Mulch and Compost Company Pro-
ject 42
8.6 Investments of Unequal Lives: The Equivalent Annual cost method 42
Appendix 8A - Capital Cost Allowance 43
Week 11, Class 1 44
22.1 Types of Leases 44
22.2 Accounting and Leasing 44
22.3 Taxes and Leases 44
22.4 The Cash Flows of Financial Leasing 44
22.4 A Detour on Discounting and Debt Capacity with Corporate Taxes 45
22.5 NPV Analysis of the Lease-Versus-Buy Decision 45
22.8 Does Leasing Ever Pay? The Base Case 45
22.9 Reasons for Leasing 45
22.9 Some Unanswered Questions 45
Week 11, Class 2 46
9.1 Decision Trees 46
9.2 Sensitivity Analysis, Scenario Analysis and Break-Even Analysis 46
9.3 Monte Carlo Simulation 46
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Reminders
Chapter 4
• The change in x resulting from an investment project is the NPV. It is NOT the change in Y.
The change in Y is NPV(1+r)
Chapter 5
• LOOK FOR ANNUITY’S IN ADVANCE/ARREARS.
Chapter 6
• The YTM is always given at an annual rate, but is compounded semi-annually or to match
the payment increments. Do NOT discount without converting to EAR.
• YTM = APR
• When applying spot rates (to bond pricing) apply the one-year spot rate to the first coupon
payment, the two-year spot rate to the second, and so on.
• Remember that spot rates are cumulative and future rates are not cumulative.
• (6A.12 - liquidity premiums apply only to the given time horizon).
• To calculate the value of a share in x periods, compound the growth of the dividend forward
to that period and apply the perpetuity formula. Do not simply perform a future value calcu-
lation (this does not account for the growth rate).
• In a dividend pricing question, where this is a finite growing annuity and a terminal perpetu-
ity, remember to grow the first dividend of the perpetuity by the correct amount
Chapter 10 & 11
• Variance is the sum of the squared residuals divided by N - 1 NOT SIMPLY N
• WHEN CALCULATING THE VALUE OF THE SD FOR A PORTFOLIO, REMEMBER TO SQUARE ROOT
THE VARIANCE
• When calculating covariance, remember that the SIGNS MATTER. It is not like variance,
where the signs are irrelevant. The formula is (observation - average), not (average - obser-
vation).
• Read the question carefully
• The expected return on a portfolio is the weighted expected return on the securities
• The formula for the variance of a portfolio is (Xa)²(Var(a)) + 2(Xa)(Xb)Cov(a,b)...
• NOT -2(Xa)(Xb)Cov(a,b)
• The portfolio with the least risk is called the minimum variance portfolio
• Get the variance on a portfolio calculation right! MULTIPLY the weights by the SDs.
Chapter 7
• In the AAR calculation, the value of the denominator is the average book value
• This implies that you actually need to add up each year’s book value and divide by the
number of years!
• Do not simply take the average of the first and last years’ book values
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Questions to Review
Chapter 9
• 9.1 - remember to look carefully at the time periods.
• 9.12 - remember to multiply by 1-t when performing break-even sales questions
• 9.7, part 2 - remember to add depreciation to fixed costs for the numerator in the break-
even formula
Chapter 22
• 22.11
• lease payments are after tax
• if a company receives no tax shield, use the before-tax interest rate as the discount rate
Chapter 11
• 11.1 - Remember to when calculating the weighted expected returns to calculate the %
weight correctly
• 11.3 - Read the question carefully
• 11.7 - When calculating a portfolio variance/SD under varying probabilities, remember that
you must first determine the portfolio return under each scenario and then calculate the
portfolio’s variance from there
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Week 1, Class 1
1.1 What is Corporate Finance?
• The value of the firm is equal to the debt plus the equity; the mixture of capital can alter the value of
the firm. If this is the case, the capital mixture generating the most value must be chosen.
• Value creation depends upon cash flows. Retained cash flows, in excess of the cash flows paid to credi-
tors (debt holders) and shareholders, increase the value of the firm.
• The treasurer is responsible for handling cash flows, analyzing capital expenditures, and making financ-
ing plans. The controller handles the accounting function, which includes taxes, costs and financial
accounting, and information systems.
• Since debt and equity securities depend on the value of the firm, these securities are said to be contin-
gent claims on the total firm value.
Finance I Notes
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Sole Proprietorship Partnership Corporation
Definition Business owned by one Business owned by two Business entity created
person. or more people. There a distinct ‘legal person’
are two types: composed of one or
1) general partnership more actual individuals
- each partner or legal entities.
agrees to share some
management work
and liability.
2) limited partnership
- one partner is a
general partner and
the limited partners
do not participate
in managing the
business.
Complexity of Set-Up No formal charter re- Some written docu- Incorporators must
quired (and therefore ments required, de- prepare articles of in-
the cheapest). pending of partnership corporation and a set
complexity. of bylaws.
Liquidity and Market- Equity investment is Units subject to restric- Common stock can be
ability limited to sole proprie- tions on transferability. listed on exchange.
tor’s personal wealth. There is no market for
trading units.
Voting Rights Complete control by Some voting control by Each share typically has
owner. limited partners; gen- one vote; shareholders
eral partners manage elect a board of direc-
firm. tors who, in turn, se-
lect senior manage-
ment.
Reinvestment and Divi- Broad latitude on rein- Partnerships are gener- Broad latitude on rein-
dend Payout vestment and dividend ally prohibited from vestment and dividend
payout. reinvesting partnership payout.
cash flow. All net cash
flow is distributed to
partners.
• Income trusts hold the debt and equity of an underlying business and distribute income to unitholders.
• Since it is not a corporation, unitholders originally did not enjoy limited liability; however, limited
liability was extended to trust holders later as the structure grew in importance.
• For the same reason, distributions are taxed only in the hands of the unitholders.
Finance I Notes
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• The corporation is a company form used to solve the problem of raising large amounts of cash. Because
sole proprietorships and partnerships have limited lives, limited transferability of issues and unlimited
liability for owners, raising capital is very difficult for these forms of business organization.
• Set-of-Contracts Viewpoint: view of the corporation as a set of contracting relationships among indi-
viduals who have conflicting objectives, such as shareholders and mangers. This view point suggests
that the corporate firm will attempt to maximize the shareholders’ wealth by taking actions that in-
crease the current value per share of existing stock in the firm.
• There are three distinct sets of corporate interests: shareholders, directors and executives.
• It is assumed that these two groups will behave in a self-interested manner.
• Shareholders (the principals) hire managers (the agents) to act on their behalf.
• The costs of aligning managers’ goals with shareholders’ goals are called agency costs. These include:
• Monitoring costs; and
• Incentive costs.
• Residual losses are the lost wealth to shareholders due to divergent behaviour of managers.
• Williamson proposes the notion of expense preference: that managers prefer certain types of expenses
(office furniture, company cars, etc.)
• Donaldson argued that the basic financial objective of managers is the maximization of corporate
wealth, which is the amount of wealth over which management has control. This is not the same as
shareholder wealth.
• Shareholders align managerial interests with their own through several mediums:
• They control the election of the board of directors;
• Contracts with management and compensation arrangements (such as stock option plans); and
• The dropping of share price leaves a company vulnerable to takeovers (by other firms, for in-
stance).
• Stakeholders include shareholders, management, employees, customers, suppliers and the public.
• Financial institutions serve as intermediaries between fund suppliers (investors) and fund raisers (corpo-
rations, governments, etc.).
• Indirect finance refers to the use of an intermediary to match lenders and borrowers of funds. The
spread on the interest rates rendered to each party is the intermediary’s profit-making mechanism.
• Direct finance refers to the circumventing to the intermediary by the lender and borrower.
• Short term debt securities trade in money markets; these are often called money-market instruments.
• Capital markets are forums for raising long-term debt or equity.
• The money market is a dealer market (dealers buy and sell securities are their own risk), as opposed to
an auction market (where buyers and sellers trade directly with one another).
• Primary markets are those markets where securities are initially issued.
• Placements of new issues can be either:
• Private - sold to buy-side financial institutions like pension funds and mutual funds.
• Public - sold to retail investors.
• In this case, underwriting is often conducted by a banker or group of bankers (called a
syndicate). This process involves the bankers purchasing the issue and reselling it; profit is
made on the spread between the purchase price and the sale price.
• Secondary markets are markets where securities are traded after they are issued.
• There are two kinds of secondary markets
• Auction markets - buyers and sellers interact directly to exchange securities.
• Dealer markets - a collection of dealers buy and sell securities (called over-the-counter mar-
ket).
• Stocks that trade on an organized exchange (i.e., an auction market) are said to be listed.
• The foreign exchange market is the world’s largest over-the-counter (dealer) market.
Finance I Notes
8
• Financial engineering involves the designing of new securities and new financial processes. Successful
financial engineering:
• Controls risk; and
• Reduces tax
Finance I Notes
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Week 1, Class 2
4.1 The Financial Market Economy
C
Y
Maximum possible
consumption now
Consumption Now
X A
4.3 The Competitive Market
X + Y/(1+r)
• We assume perfectly competitive financial markets in which all agents are price takers. This results
from three conditions:
• Trading is costless; market access is free;
• Information on borrowing and lending is readily available; and
• There are many traders and no single trader can influence the market.
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• If the possibility exists of borrowing and lending at different interest rates (assuming the same level of
risk), arbitrage will occur to close the interest rate spread.
• Not only are financial markets a benchmark, they are also mechanisms for enabling investments.
• Note that as long as an investment project has a positive NPV, the consumption mix curve is shifted
outward (the individual does not necessarily have to sacrifice current consumption, regardless of the
size of the investment).
• The separation theorem states that the regardless of consumption preference, if an investment in-
strument has a positive NPV, it should be purchased. The value of an investment to an individual does
not depend on consumption preferences.
slope = -(1+r)
Y + X(1+r) + ∆Y
• Assume investment instrument 1 has a return (r1) greater
than the market rate (r). It shifts the budget line up by ∆Y.
• ∆X is called the NPV of the investment. It is equal to ∆Y
divided by (1+r).
Y + X(1+r) B
• ∆Y = ∆X • (1+r)
Consumption Now
X A
X + Y/(1+r)
• Net present value = present value of the cash flow [ CF / (1+r) ] less the outlay (cost of the invest-
ment).
• NPV is a measure of the amount of cash an investor would require today to substitute for the invest-
ment.
• If NPV > 0, the consumption mix curve shifts outward and the investment should be undertaken; if NPV
< 0, the investment should not be undertaken. This is called the NPV rule.
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• Shareholders in a firm will be unanimous in accepting positive NPV projects (since they will always in-
crease the value of the firm).
• One difference between the firm and the individual is that the firm has no consumption endowment.
• Regardless of the consumption preferences (patient or impatient) of individual shareholders, positive
NPV will always be accepted.
• If an individual investor wishes to consume today, his shares will increase by his ownership portion
of the NPV; if an investor wishes to consume in one year, his shares will increase by his ownership
portion of the NPV times (1+r).
• As long as managers follow the NPV rule, they will be acting in the best interest of shareholders.
NPV Quantity
Consumption Now
Starting point:
consumption now = 0, consumption in one year = 0
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Week 2, Class 1
5.1 The One-Period Case
• The present value factor is the element multiplied by the future cash flow to determine its present
value.
• The present value of a set of cash flows is simply the sum of the present values of the individual cash
flows.
• The NPV is equal to the sum of the present values of all the future cash less the outlay
• The stated annual interest rate is the annual interest rate without consideration for compounding (also
called annual percentage rate).
• The effective annual rate (EAR) is the annual rate when a consideration is made for compounding.
• The conversion formula (to determine EAR) is (1 + r/m)^m -1, m is the number of compounding
periods per year.
• Therefore, the future value calculation changes to:
• FV = PV(1+r/m)^(m•n)
• If interest is compounded continuously (that is, m is infinite in the above equation), then the future
value calculation is:
• FV = PV • e^(r•t)
• Because interest accrues continually upon interest, continuous compounding generates the highest
FV of any compounding period.
5.4 Simplifications
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• Last, apply the annuity formula (below) where the discount rate is the monthly rate (deter-
mined in the second step) and the number of compounding periods is the total number of
months the mortgage will exist for.
PV = C / (r-g) PV = C / r
Annuity Tricks
I. Delay annuity
• If an annuity begins more than one period from the present (at the end of period x), to determine
the present value of the annuity:
• Calculate the PV of the annuity at the end of period x-1 (normal calculation); and
• Discount the above quantity to the present (PV / (1+r)^(x-1)).
II. Annuity in advance
• The above annuity formula assumes the annuity begins payment in one period (called an annuity in
arrears).
• If the annuity begins payment immediately (annuity in advance), with t payments in total, then to
calculate the PV of this annuity:
• Calculate the annuity’s PV with the above formula but with payments t-1; and
• Add the first payment to this quantity.
III. Infrequent annuity
• If an annuity has payments less frequently than every year (every x years), then to determine the
PV of this annuity:
• Adjust the discount rate by compounding the EAR x times; and
• Using this discount rate, apply the above formula.
IV. Equating Present Value of Two Annuities
• In the case of two separate annuities (typically where one is a cash inflow and one is an outflow),
to determine the coupon (payment amount) on the outflow annuity, equate the present value of
this annuity with the present value of the inflow annuity and solve for C.
• A firm is akin to any investment project: it is worth the sum of the present values of all its future cash
flows.
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Week 3, Class 1
6.2 How to Value Bonds
• In a pure discount bond, or a zero-coupon bond, the holder receives no cash payment until maturity.
• The date when the issuer makes the last payment is called the maturity date or simply maturity. The
bond expires on this date.
• Level coupon bonds make regular payments to the holder (coupons) as well as the principal in the final
period.
• The principal is sometimes called the face value or the denomination.
• Bonds issued in Canada typically have $1,000 face values.
Present value of a bond = present value of an annuity (where C is the coupon payment) + the present
value of the principal
• The stated price (clean price) is calculated by removing the effect of accrued interest; the dirty price
is the sum which is actually paid
• Clauses which allow the issuer to repurchase bonds are called call provisions.
• A fixed-rate preferred stock that provides the holder with a fixed dividend is a perpetuity.
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Week 3, Class 2
The Term Structure of Interest Rates
• A spot rate is the cumulative rate of interest over a given period.
• r1 (spot rate 1) over period 1
• r2 (spot rate 2) over period 1 and period 2 (cumulative element)
• The yield to maturity on a multi-period bond yields an average (of sorts) on the spot rates over the
bond’s periods.
• The forward rate is the expected rate over a given interval (past period 1). It is a non-cumulative rate.
• (1+r2)^2 = (1+r1)•(1+f2), where f2 = forward rate in period 2.
• The forward rate over period 1 is equal to the spot rate over period 1.
• The value of a zero-coupon bond after period 1 is given by F / (1+r)^2, where F = the face value and r is
the spot rate for one year, beginning at the end of period 1. The question becomes how do we deter-
mine r.
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Week 4, Class 2
6.4 The Present Value of Common Stocks
• There are two ways to value a stock:
A. The present value of all future dividends; or
B. The present value of a finite stream of dividends plus the present value of the future share sale
price.
• The second method is actually identical to the first since the future share price is a function of the pre-
sent value of the dividends received after the sale of the shares.
• There are three growth rate adjustments
A. Zero growth
1. Share price = DIV / r
B. Constant growth
1. Share price = DIV / (r-g)
C. Differential growth
1. Growth rate changes over time
2. Compute the share price manually (calculate present values over different interest rate in-
tervals and discount and sum all of these in the present).
• Note that the growth is derived under the assumption that future return on retained earnings and the
retention rate are equal to their past values.
• G cannot exceed r; if it does, the analyst has likely made projections for the next few years, but not ad
infinitum
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6.7 The Dividend Growth Model and the NPVGO Model (Advanced)
• A steady growth in dividends results from a continual investment in growth opportunities, not just an
investment in a single opportunity. Therefore, it is worthwhile to compare the dividend growth model
with the NPVGO model when growth occurs through continual investing.
• Under the dividend discount model, we divide the dividend by the discount rate less the growth (which
is calculated as the retention rate times the return on retained earnings)
• Under the NPVGO model, we calculate the value of a stock in three parts:
• First, we calculate the present value of the NPVs of each year’s investment
• Since each year’s NPV grows by a constant rate (the growth rate) and each year’s NPV is dis-
counted at the discount rate (to the power of the year number), the NPVGO is simply a perpe-
tuity where,
• The numerator is the NPV in year 1
• The denominator is the difference between the discount rate and the growth rate
• Second, we calculate the value of the share as a cash cow (EPS / r).
• Last, we sum these two quantities together
• These approaches will yield the same current share prices
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Week 5, Class 1
15.1 Common Stock
• Common stock (or common shares) stock has no special preference either in dividends or in bank-
ruptcy
• Some stock have a stated value called the par value
• Common shareholders are protected by limited liability
• Authorized shares specify the maximum number of shares a corporation can issue
• Book value of equity = retained earnings + contributed surplus + share capital + adjustments to equity
• The market value of shares is typically higher than book-value per share
• Replacement value refers to the current cost of replacing the assets of the firm
• Market value, book value and replacement value are all equal when a firm purchases an asset
• The following ratios measure the performance of the firm’s asset purchases
• Market-to-book value ratio of common stock
• Tobin’s Q ratio (market value of assets to replacement value of assets)
• Dividends
• Unless a dividend is declared by the board of directors, it is not a liability
• Dividends are not tax-deductible
• Dividends received by individual shareholders are partially sheltered; Canadian corporations that
own shares in other companies are 100% tax protected
• Classes of Shares
• Share classes often have different voting rights
• Nonvoting shares must receive dividends no lower than dividends on voting shares
• Nonvoting shares allow management to retain control
• US stocks with superior voting rights typically trade at 5% higher than their nonvoting counterparts
• Coattail provisions give nonvoting shareholders the right to vote or to convert their shares into vot-
ing shares in the case of a takeover bid
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• Corporations can legally default at any time on its liability (this can be a valuable option)
• The main differences between debt and equity include:
• Debt is not an ownership interest
• The device used by creditors to protect themselves is the loan contract (indenture)
• The payment of interest is a cost of doing business and is therefore tax deductible
• The government effectively a tax-subsidy on the use of debt
• Unpaid debt is a liability.
• If not paid, creditors can claim the firm’s assets. This may result in liquidation or bankruptcy
• When corporations try to create a debt security that is really equity, they are trying to obtain the tax
benefits of debt while eliminating its bankruptcy costs
Types of debt
• Debenture: unsecured corporate debt
• Bond: secured by a mortgage on the corporate property
• Note: short-term obligation (less than 7 years)
• Long-term debt is any debt longer than one-year from the date is originally issued and is sometimes
called funded debt
• A sinking fund is an account managed on behalf of the issuer by a bond trustee for the purpose of retir-
ing all or part of the bond prior to the stated maturity.
• Sinking funds reduce the risk of the company repaying the principal and also enhance liquidity
• Call provisions give the firm the right to pay a specific amount (call price) to retire (extinguish) the
debt before the stated maturity date
• Canada plus calls have a dynamic call price which are designed such that the call premium compen-
sates investors for the difference in interest between the original bond and new debt issued to replace
it.
• Seniority indicates preference in position over other lenders. Some debt is subordinated.
• Debt cannot be subordinated to equity
• Security is a form of attachment to property; it provides that the property can be sold in the event of
default to satisfy the debt for which security is given.
• A mortgage is used for security on tangible property
• Holders of such debt have prior claim on mortgaged assets
• An indenture is the written agreement between the corporate debt issuer and the lender, setting forth
maturity date, interest rate and all other terms.
• Restrictive covenants:
• Restrictions on further indebtedness
• A maximum on the amount of dividends that can be paid
• A minimum level of working capital
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• Hence, most preferreds are held by corporate investors
• Lightly taxed companies (or those protected by tax shelters) benefit from issuing preferreds over debt
(since they do no benefit from the tax shield created by the debt but enjoy lowering financing costs on
preferred - since yields are lower)
• Other reasons for issuing preferreds (for heavily taxed companies) include:
• Regulated public utilities companies can pass the tax advantage of issuing preferred shares on to
their customers because of the way pricing formulas are built
• Preferreds do not involve the same bankruptcy threats as debt
• Issuance of preferreds does not influence firm control
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Week 6, Class 1
10.1 Returns
• Total earnings = dividend income + capital gain (- capital loss)
• Total cash if stock is sold = initial investment + total dollar earnings
= proceeds from sale + dividends
• Regardless of whether a gain is realized, it must included in returns
• Dividend yield = Dividend (in one period) / Price (today)
• Capital gains yield = [ Price (in one period) - Price (today) ] / Price (today)
• Return (percentage) = dividend yield + capital gains yield
• The normal distribution is the bell-shaped, symmetric distribution which any actual distribution will
approach as the number of observations approaches infinity
• The standard deviation measures the spread of the normal distribution
• 68.26% of observations will fall within one standard deviation of the mean
• 95.44% of observations will fall within two standard deviations of the mean
• 99.74% of observations will fall within three standard deviations of the mean
• Therefore, for instance, if the mean is 11.1% and the SD is 16.03%, there is less than a 5% chance
that an observation (a year’s return) will outside the range -20.90% to 43.16%
• Value at risk (VaR) represents the maximum possible loss at a certain confidence level
• In the above example, the probability of an observation falling below -20.90% is 2.28%.
• Therefore, the VaR on a 200 million investment is 41.8 million (200 • -20.90%), provided we are
willing accept that there is a 2.28% chance that the return is lower
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Week 6, Class 2
11.1 Individual Securities
• Covariance is a statistic measuring the interrelationship between two securities.
• Alternatively, this relationship can be stated in the correlation between two securities.
A (Xa)²(Var(Ra)) (Xa)(Xb)(COV(a,b))
B (Xa)(Xb)(COV(a,b)) (Xb)²(Var(Rb))
• The variance of the portfolio equals the sum of the elements in the above matrix
• The SD of a portfolio will always be less than the weighted average SD of the individual securities when
the correlation between the securities is less than 1 (this applies to discussions of two or more securi-
ties)
• This is attributable to the affects of diversification
• This explains why the standard deviation of most stocks are lower than the index
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Expected return on portfolio
It is impossible for an investor to choose any point off the curved lined
(the curved line assume the correlation coefficient is below 1). This is
called the opportunity set, feasible set or efficient set.
This is the point of minimal risk (the lowest possible standard deviation and vari-
ance). This is called the minimum variance portfolio.
• We can apply the same logic to international and domestic exposure. Simply make A a domestic portfo-
lio and B an international portfolio. Mixing these portfolios together creates a more efficient set (since
the correlation coefficient between the two portfolios is less than 1)
• One caution regarding this analysis is that expected returns (as calculated by historical averages) can
be unrealistic if they are based upon periods in history which are atypical (ex: during crises or unusual
bull markets)
Any point between MV and F lies on the effi- Any point within this region can be chosen, but no beyond it can.
cient set. A rational investor will choose a
point on this line. Any point below this line
implies a lower expected return with the
same risk. F
D
MV
C
24
A B ... N
• Again, the variance of the portfolio is the sum of the elements in this matrix.
• Notice that the number of terms containing covariance increases as the matrix grows.
• In general,
• The number of terms whose value depends upon individual-security variance (unsystemic risk) is N
• The number of terms whose value depends on covariance is N²-N or N(N-1)
• Hence, covariance becomes increasingly important as N grows
Average VAR
Average COV
Number of securities
25
Week 8, Class 1
11.7 Riskless Borrowing and Lending
• The standard deviation of portfolio (risk) which includes a risky security and a risk-less security is equal
to the weight of the risky security times the standard deviation of the security. This results from the
fact that:
• The variance on a risk-less security is zero (since it never deviates from the expected return)
• The covariance between the two securities is zero (since every residual of the risk-less security is
zero)
• Alternatively, borrowing at the risk-free rate will amplify returns (since the marginal expected return
on the risky security will exceed the cost of borrowing).
• However, it will cause the weight of the risky security to exceed 100% (for example, investing
$1,000 and borrowing $200 at the risk-less rate will cause the weight to be 120%).
• This will also amplify the standard deviation
• This assumes the investor can borrow at the risk-free rate (which is impossible). The borrowing rate
is higher than the risk-less rate, which implies that the marginal standard deviation (SD added via
leverage) will exceed the marginal gain in expected return.
Risk-free rate
26
• A rational investor will only choose portfolios along the capital market line
• The separation principle argues that investors make two separate decisions:
• 1) The investor first:
• Estimates the expected returns on risky assets
• Estimates the variances and covariances of the risky assets
• Calculates the efficient frontier (from MV to T to F in the below)
• Determines the point of tangency (T in the below)
• 2) The investor, depending on their risk aversion, determines how to mix the risky portfolio T with
risk-free assets (representing movement along the capital market line from the risk-free level to
above the tangency point)
T E
Risk-Free C
Rate
Tangency point is the ideal mixture of risky assets.
B At this point, the portfolio contains no borrowing or
lending of risk-free assets.
Any point on this line is
A attainable by mixing the
portfolio at point x with
risk-free assets.
Standard deviation on portfolio
I Bull 15 25
II Bull 15 15
III Bear -5 -5
27
State Type of Economy Return on Market (%) Return on Security (%)
IV Bear -5 -15
II
III
• The formula for beta is the covariance of market portfolio’s return to the security return divided by the
market portfolio’s variance.
• Beta = COV(Ri, Rm) / VAR(Rm)
• The average beta above all securities in the market is equal to 1
• The variance of an individual security is only important if the investor is looking to hold a portfolio of
only one security
• The beta of an individual security is important for decision making when the investor’s portfolio is well
diversified (representative of the market portfolio)
• Under the homogenous expectations hypothesis, all investors hold the market portfolio. While most
investors do not hold the market portfolio exactly, they do hold portfolios diversified enough to allow
beta to serve as a good risk measure.
28
• Beta (since it is a good measure of risk for most investors (since most investors something akin to
the market portfolio)) is positively related to return
• Under this model:
• If beta = 0, the return on the security equals the risk-free return
• If beta = 1, the return on the security equals the expected market return
Expected
market return
Beta
Beta = 1
1) Linearity: the SML is a straight line. This follows from the fact that we can artificially create an point
on the SML line by mixing a beta 1 security (ie, a market portfolio) with risk-free borrowing or lending.
Therefore:
1) if a security is below the line, its price will fall (since no rational investor will purchase it
when they can capture a higher return/risk ratio by mixing a market portfolio and risk-free
investments). A falling price will drive expected returns higher until the security lies on the
SML.
2) if a security lies above the line, investors will push the price of the security higher (because it
offers a greater return/risk ratio) and therefore the expected returns lower until the security
is positioned on the SML.
2) Portfolios as well as securities: the SML applies to securities as well as portfolios. A portfolio can be
positioned on the line by taking its beta (weighting the securities’ betas) and multiplying by the risk
premium.
3) Potential confusion: the SML (Security Market Line) and the CML (Capital Market Line) are not the
same. The SML determines the expected return of a single security based upon its beta; the CML de-
termines the expected return on the optimal portfolio (market portfolio) based upon standard devia-
tion (not the same as beta).
29
Week 8, Class 1 (cont’d)
12.1 Factor Models: Announcements, Surprises and Expected Returns
• Actual return = expected return + uncertain (risky) return
• The uncertain return component results from any news which the market could not anticipate (ex:
earnings surprises, key executives leaving, sudden drop in interest rates, etc.)
• Events which the market anticipates are said to be discounted
• For instance, a company’s earnings release will often not have a significant influence on the
market since the market discounted this news item (included the news when it calculated ex-
pected return)
• An announcement = expected + surprise
• If the market anticipates a 0.5% increase in GNP, and the actual figure is 1.5%, the surprise (or
innovation) is 1%.
• The expected component drives expected returns
• The surprise component drives the uncertain return
• News refers to the surprise component of an announcement; the expected component will have no in-
fluence on share price since it will already be discounted
30
• Unsystematic risk can be diversified away (third component of the equation)
• Systematic risk cannot (second term in the equation)
• In the previous chapter, systematic risk was argued to be the result of positive covariances; in
this chapter, this risk is the result of a factor. Since a single factor drives the positive covari-
ances, the arguments are analogous
12.6 The Capital Asset Pricing Model and the Arbitrage Pricing Theory
Pedagogy Application
Arbitrage Pricing Theory • The model adds factors until the • The model can handle multiple
unsystematic risk of any security factors while CAPM cannot
is uncorrelated with the unsys-
tematic risk of every other secu-
rity
31
Week 8, Class 1
13.1 The Cost of Equity Capital
• Firms can pursue two courses of action
if they have extra cash:
• Distribute it to shareholders via
dividends
Project’s IRR
• Reinvest in a project
• Firms should pursue the latter if the
expected return is superior (assuming Positive NPV Projects
the risk is the same on the project as SML
it is on the firm) on the available pro-
ject than what investors could achieve
elsewhere in the market
• In other words, the IRR on the
project must exceed the expected
return for the firm overall
• The expected return is the cost of Risk-free rate
equity:
• E(R) = Rf + B (E(Rm) - Rf) Negative NPV Projects
32
• BAsset (1 + (1-t)(D/E)) = BEquity
• BAsset represents the unlevered beta of the security - it is the beta which would exist if the firm was
financed by purely equity
• The Bequity will always be greater than or equal to the BAsset
• From the above formula, it is apparent that leverage increases Beta
33
Week 8, Class 2
14.1 Can Financing Decision Create Value?
• There are three ways to create value from financing opportunities (earn positive NPVs):
• Fool investors: complex securities can sometimes be sold for more than their fair value (for in-
stance, issuing stocks and warrants)
• By the efficient market hypothesis, this should be impossible
• Reduce cost or increase subsidies: packaging securities with a strategy to:
• Minimize overall tax; or
• Reduce the cost of underwriting/issuance (investment bankers, lawyers, accountants, etc.)
• Create a new security: conducting financial innovation to offer risk/reward trade-offs which are
not easily replicable.
• This allows firms to issue securities at higher costs (and hence raise capital more cheaply)
14.3 & 14.4 The Different Types of Efficiency and the Evidence for Each
• There are three forms of market efficiency which depend upon classifications of information.
• Because the form of efficiency depends upon the availability of information:
• Strong form implies semi-strong form efficiency
• Semi-strong form implies weak-form efficiency
34
Form Informa- Description Support / Evidence
tion Type
Semi- Publicly • A market is semi-strong efficient if it incorpo- • Event studies: the re-
Strong available rates all publicly available information includ- lease of information in
Form informa- ing published accounting statements as well as time t should be re-
tion historical price information flected in the abnormal
period at time t. There
should be no carry-over
from past events
• Mutual-fund perform-
ance: mutual funds are
consistently unable to
outperform the market
(implying that analyz-
ing all publicly avail-
able information is
futile)
• Growth in ETFs con-
firms investors agree it
is impossible to regu-
larly outperform the
market
Strong Private & • Any information pertinent to the value of a • Little supporting evi-
Form Public in- security is fully incorporated (this includes dence; insiders are
formation even private information) able to consistently
earn excess returns
• This implies corporate insiders should not be
able to profit for private information
Degree of informa-
tion availability
35
Efficient Markets Misconceptions
• The Efficacy of Dart Throwing: all the EMH says is that manager will not be able to outperform the
market for a sustained period of time (or at least that it is highly improbable).
• Price fluctuations: price fluctuations to imply randomness - share prices are constantly reacting to new
information
• Shareholder disinterest: because only a portion of outstanding shares are traded each day, it implies
markets are inefficient - this is incorrect because many more investors are following a share on a given
day than are trading on that day.
36
Week 9, Class 1
7.1 Why Use NPV?
• Increases firm value for shareholders (simple decision rule)
• Value-additivity - the principle that the value of the firm rises by the NPV of the project
• Three key attributes of NPV are:
• NPV uses cash flows - earnings are an artificial construct
• NPV uses all the cash flows of the project
• NPV discounts the cash flows properly (at the appropriate discount rate)
• With small projects, the payback period rule may be useful; for large projects, NPV is the overriding
method
• Problems
• AAR uses accounting numbers (earnings & book value) which are somewhat arbitrary
• AAR does not take into account timing (no present value calculations involved)
• AAR requires an arbitrary cut-off
• Advantage: easy to calculate from numbers already in the accounting system
37
NPV
Positive NPV
Projects
IRR
Discount
Negative rate
NPV Projects
NPV
Positive NPV
Projects
IRR
Discount
rate
Negative
NPV Projects
38
• Modified IRR (MIRR) handles this problem by combining cash flows into only two cash flows by
shifting cash flows along the time line
• By discounting and summing cash flows, there will be only one sign change and hence only one
IRR
• However, MIRR employs an discount rate )and this implies the project’s evaluation is not
strictly internal)
• Scale problem - IRR does not consider the size of the project; hence, it is possible for one project to a
higher NPV while the other has a higher IRR
• Solution: calculate the IRR on the incremental cash flows. If this is above the discount rate, accept
the larger project.
• Timing problem - because two different projects will have different temporal cash flow distributions,
they will have different sensitivities to changes in the discount rate
• The investment with more cash flow distributed in a later time-period will be more sensitive to
changes in the discount rate (the slope of the NPV line below is steeper)
• To solve this problem:
• Calculate the incremental IRR
• If the discount rate is below this incremental IRR, purchase the investment with heavier
cash flows later
• If the discount rate is above, purchase the investment with earlier cash flows
NPV
Incremental
IRR
Discount
IRR IRR rate
A
39
• Redeeming qualities:
• No discount rate is required
• The project’s benefits are summarized in one number
Three considerations:
• Independent projects
• Accept if PI > 1
• Reject if PI < 1
• Mutually exclusive projects
• Accept if incremental PI > 1
• Capital rationing
• If we do not have enough financing to fund all positive NPV projects:
• Choose the projects with the highest PIs
• PI therefore helps to ration capital
40
W9,C2 - W10,C2
8.1 Incremental Cash Flows
• In calculating the NPV of a project, only cash flows that are incremental to the project should be used.
Incremental cash flows are the changes in the firm’s cash flows that occur as a direct consequence of
accepting the project.
• A sunk cost is a cost which has been incurred in the past; these costs do not enter out analysis
• Lost revenues can be viewed as costs. They are called opportunity costs because, by taking the pro-
ject, the firm forgoes other opportunities for using the assets.
• Side effects are classified as either
• Erosions - reduction in sales as a result of a project
• Synergy - increase in cash flows (more inflows or less outflows) resulting from existing projects by
accepting a new project
• Allocated costs should be viewed as a cash outflow of a project only if it is an incremental cost to the
project
• Interest expenses are not considered in calculating cash flows since we assume financing is purely
equity-based
41
• Net income + depreciation (bottom-up approach)
• Sales - costs - taxes (top-down approach)
• (Sales - costs) * (1 - t) + depreciation * t (tax-shield approach)
• The only cash flow effect of depreciation is to reduce taxes
• t * depreciation is the called the depreciation tax shield
8.5 Applying the Tax Shield Approach to the Majestic Mulch and Compost Company Project
• The tax shield approach involves disaggregating cash flows into components and taking the present
value of each of these.
• The sum of the present values of each of these cash flow series equals the NPV of the project.
• The four cash flow series are:
• After tax operating cash flows: (Revenue - operating expenses) * (1 - t)
• Changes in NWC, which is composed of
• Required cash balance
• Accounts receivable
• Accounts payable
• Inventory
• Other short-term financing mechanisms
• Equipment flows
• Investing costs
• Salvage returns
• The tax shield benefits
• There are two components to the PV of the tax shield
• The incremental cash flow resulting from the CCA
• The lost protection after the asset is sold
• There components culminate in the following formula
• First, determine the equivalent annual cost of the new machine (the replacement)
• Second, determine the PV of the cost for holding the old machine for one additional
• Compound this PV forward one period and compare it with the EAC for the replacement machine
• If this quantity exceeds the EAC, purchase the replacement immediately
42
Appendix 8A - Capital Cost Allowance
• Since capital cost allowance is deducted in computing taxable income, larger CCA rates reduce taxes
and increase cash flows.
• When an asset is sold, the UCC in its asset class (or pool) is reduced by what is realized on the asset or
by its original cost, whichever is less. The amount is called the adjusted cost of disposal (ACD)
43
Week 11, Class 1
22.1 Types of Leases
• A lease is a contactual agreement between a lessee and a lessor. The agreement establishes that the
lessee has the right to use an asset and in return must make periodic payments to the lessor
• The lessor owns the asset
• The lessor can be either the original manufacturer or an independent leasing company
• If the company is an independent lessor, the lease is called a direct lease
• If the company is the manufacturer, the lease is a sales type lease
• The lessee uses the asset
• There are two broad types of leases
• Operating (service) leases
• Operating leases are not fully amortized - the term of the lease is less than the economic life
of the asset
• Lessor must maintain and insure the leased asset (service)
• Cancellation option - gives the lessee the right to cancel the lease before the expiration date
• Financial leases
• Do not provide maintenance or service
• Financial leases are fully amortized
• Lessee usually has a right to renew the lease on expiration
• Financial leases cannot be cancelled
• The lessee must make all payments are face bankruptcy
• There are two specific types of financial leases
• Sale and lease-back back: a company sells assets to another firm and immediately leases
• Advantages
• Lessee immediately receives cash while still retaining use of the asset
• Lessor make gain a tax advantage over and above purchase cost (when the PV of
the lease payments is included)
• Leveraged lease:
• The lessor puts up no more than 40-50% of the asset’s cost
• Lenders supply the remaining financing
• Lender has two protections:
• First lien on the asset
• In the event of loan default, the lender receives the lease payments
A lease must be capitalized if one of the following four conditions are met:
I. The lease transfers ownership of the property by the end of the term of the lease
II. The lease permits the purchase of the asset below fair market value
III. The lease is for 75% of the asset’s economic life
IV. The PV of the lease payments is above 90% of the asset’s fair market value at the beginning of the
lease
44
• Remember that lease payments are discounted at the after-tax rate (since they are tax de-
ductible)
• The tax shield
• The initial investment outlay / salvage value
45
Week 11, Class 2
9.1 Decision Trees
• In decision-tree modelling, we break our analysis into branches which are weighted by probability. The
steps are
• determine the NPV of each branch
• discount the NPV of each branch to t=0
• weight each branch NPV by probability
• deduct initial investment costs which are common to all branches
• Often times different parts of the decision trees will have different discount rate - apply the correct
rates when moving through time on the tree
Sensitivity analysis
• In a sensitivity analysis, we create base-case, pessimistic and optimistic case for the variables
• Revenue
• Market size
• Market share
• Price
• Cost
• Variable
• Fixed
• Investment size
• A different NPV is calculated for each projection (each variable’s NPV is calculated under a base-case,
pessimistic and optimistic assumption)
• Advantages
• Removes the false sense of security
• Reveals which variables are most important (to which variables is NPV most sensitive?) and there-
fore require further research
• Disadvantages
• Make unwittingly create a false sense of security (if the ‘pessimistic projections’ are too optimistic)
• Sensitivity analysis treats each variable as autonomous when this is not the case (many variables
are related)
Scenario analysis
• Scenario analysis removes this last disadvantage of sensitivity analysis but considering a variety of sce-
narios where multiple variables are changes
Break-even analysis
PV of After-tax revenue + PV of CCA tax shield = PV of after-tax Variable Costs + PV of after-tax Fixed
Costs + Initial Investment Cost
• In a Monte Carlo simulation, we construct probabilities for each variable in a cash flow projection and
run the model many times to get a cash flow distribution
• This is divided into a number of steps:
• 1 - Specify the basic models
• Break the cash flow model into variables
46
• 2 - Specify a probability distribution for each variable in the model
• 3 - The computer draws one outcome
• 4 - Repeat the procedure
• 5 - Calculate NPV
• Determine a distribution for the cash flows and use this to calculate the NPV
47