FinMa II Presentation 1

Return to NPV
Example
The government is lending you $100,000 for 10 years
at 3% and only requiring interest payments prior to
maturity. Since 3% is obviously below market, what
is the value of the below market rate loan?
repayment loan of PV -
pmts interest of PV - borrowed amount NPV =
Return to NPV
Example
The government is lending you $100,000 for 10 years at 3% and only
requiring interest payments prior to maturity. Since 3% is obviously below
market, what is the value of the below market rate loan?
Assume the market return on equivalent risk projects is 10%.
012 , 43 $
988 , 56 000 , 100
) 10 . 1 (
000 , 100
) 10 . 1 (
000 , 3
000 , 00 1 NPV
10
10
1
=
=
=

= t
t
Random Walk Theory
The movement of stock prices from day to day
DO NOT reflect any pattern.
Statistically speaking, the movement of stock
prices is random (skewed positive over the long term).
Random Walk Theory
$103.00
$100.00
$106.09
$100.43
$97.50
$100.43
$95.06
Coin Toss Game
Heads
Heads
Heads
Tails
Tails
Tails
Random Walk Theory
S&P 500 Five Year Trend?
or
5 yrs of the Coin Toss Game?
80
130
Month
L
e
v
e
l
Random Walk Theory
S&P 500 Five Year Trend?
or
5 yrs of the Coin Toss Game?
80
130
180
230
Month
L
e
v
e
l
Efficient Market Theory
Last
Month
This
Month
Next
Month
$90

70

50
Microsoft
Stock Price
Cycles
disappear
once
identified
Actual price as soon as upswing is
recognized
Random Walk Theory
Random Walk Theory
R
e
t
u
r
n

i
n

w
e
e
k

t

+

1
,

(
%
)

Return in week t, (%)
FTSE 100
(correlation = -.08)
Random Walk Theory
R
e
t
u
r
n

i
n

w
e
e
k

t

+

1
,

(
%
)

Nikkei 500
Random Walk Theory
R
e
t
u
r
n

i
n

w
e
e
k

t

+

1
,

(
%
)

DAX 30
Random Walk Theory
R
e
t
u
r
n

i
n

w
e
e
k

t

+

1
,

(
%
)

S&P Composite
Weak Form Efficiency
Market prices reflect all historical information
Semi-Strong Form Efficiency
Market prices reflect all publicly available
information
Strong Form Efficiency
Market prices reflect all information, both public
and private
Fundamental Analysts
Research the value of stocks using NPV and other
measurements of cash flow

Technical Analysts
Forecast stock prices based on the watching the
fluctuations in historical prices (thus wiggle
watchers)
-16
-11
-6
-1
4
9
14
19
24
29
34
39
Days Relative to annoncement date
C
u
m
u
l
a
t
i
v
e

A
b
n
o
r
m
a
l

R
e
t
u
r
n

(
%
)
Announcement Date
-40
-30
-20
-10
0
10
20
30
40
1
9
6
2
1
9
7
7
1
9
9
2
R
e
t
u
r
n

(
%
)
Funds
Market
Average Annual Return on 1493 Mutual Funds and the
Market Index
0
5
10
15
20
First Second Third Fourth Fifth
A
v
e
r
a
g
e

R
e
t
u
r
n

(
%
)
IPO
Matched Stocks
IPO Non-Excess Returns
Year After
Offering
2000 Dot.Com Boom
883 , 12
08 . 092 .
6 . 154
) (
2000 March
=
=
g r
Div
index PV
589 , 8
074 . 092 .
6 . 154
) (
2002 October
=
=
g r
Div
index PV
Lessons of Market Efficiency
Markets have no memory
Trust market prices
Read the entrails
There are no financial illusions
The do it yourself alternative
Seen one stock, seen them all

M&M (Debt Policy Doesnt Matter)
Modigliani & Miller
When there are no taxes and capital markets
function well, it makes no difference whether the
firm borrows or individual shareholders borrow.
Therefore, the market value of a company does
not depend on its capital structure.
Assumptions
By issuing 1 security rather than 2, company
diminishes investor choice. This does not reduce
value if:
Investors do not need choice, OR
There are sufficient alternative securities
Capital structure does not affect cash flows e.g...
No taxes
No bankruptcy costs
No effect on management incentives
Profits 01 . 01V .
urn Dollar Ret Investment Dollar
U

L
L L
L
L
01V .
Profits 01 . ) E 01(D . Total
Interest) - Profits ( 01 . 01E . Equity
Interest .01 01D . Debt
=
+

) .01(V
interest) - Profits ( 01 . 01E .
L L
L
D =

Interest) - Profits ( 01 . ) D 01(V . Total
Profits 01 . 01V . Equity
Interest .01 - 01D . Borrowing
L U
U
L
+

Example - Macbeth Spot Removers - All Equity Financed
20 15 10 % 5 (%) shares on Return
2.00 1.50 1.00 $.50 share per Earnings
2,000 1,500 1,000 $500 Income Operating
D C B A
Outcomes
10,000 $ Shares of Value Market
$10 share per Price
1,000 shares of Number
Data
Expected
outcome
Example
cont.
50% debt
30 20 10 0% (%) shares on Return
3 2 1 $0 share per Earnings
500 , 1 1,000 500 $0 earnings Equity
500 500 500 $500 Interest
000 , 2 1,500 1,000 $500 Income Operating
C B A
Outcomes
5,000 $ debt of ue Market val
5,000 $ Shares of Value Market
$10 share per Price
500 shares of Number
Data
D
Example - Macbeths - All Equity Financed
- Debt replicated by investors
30 20 10 0% (%) investment $10 on Return
3.00 2.00 1.00 0 $ investment on earnings Net
1.00 1.00 1.00 $1.00 10% @ Interest : LESS
4.00 3.00 2.00 $1.00 shares two on Earnings
D C B A
Outcomes
MM'S PROPOSITION I

If capital markets are doing their job,
firms cannot increase value by tinkering
with capital structure.

V is independent of the debt ratio.

AN EVERYDAY ANALOGY
It should cost no more to assemble a
chicken than to buy one whole.
No Magic in Financial Leverage
Proposition I and Macbeth
20 15 (%) share per return Expected
10 10 ($) share per Price
2.00 1.50 ($) share per earnings Expected
Equity and Debt Equal
: Structure Proposed
Equity All
: Structure Cuttent
Macbeth continued
Leverage and Returns
securities all of ue market val
income operating expected
r assets on return Expected
a
= =
|
.
|
\
|
+
+
|
.
|
\
|
+
=
E D
E
r
E D
D
r r
E D A
M&M Proposition II
15 .
000 , 10
1500
r r
A E
= =
= =
( )
V
D
r r r r
D A A E
+ =
Macbeth continued
M&M Proposition II
15 .
000 , 10
1500
r r
A E
= =
= =
( )
20% or 20 .
5000
5000
10 . 15 . 15 .
=
+ =
E
r
Macbeth continued
( )
V
D
r r r r
D A A E
+ =
Leverage and Risk
20% - 0 20% shares on Return
$2.00 - 0 2 ($) share per Earnings : debt % 50
10% - 5% 15% shares on Return
$1.00 - 0.50 1.50 ($) share per Earnings equity All
Change
$500
Income
to $1,500
Operating
Macbeth continued
Leverage increases the risk of Macbeth shares
Asset Value 100 Debt (D) 40
Equity (E) 60
Asset Value 100 Firm Value (V) 100

r
d
= 7.5%
r
e
= 15%

Market Value Balance Sheet example
% 75 . 12
100
60
15 .
100
40
075 . =
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\
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+
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.
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\
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=
|
.
|
\
|
+
+
|
.
|
\
|
+
=
A
E D A
r
E D
E
r
E D
D
r r
Asset Value 100 Debt (D) 40
Equity (E) 60
Asset Value 100 Firm Value (V) 100

r
d
= 7.5% changes to 7.875%
r
e
= ??

Market Value Balance Sheet example continued
What happens to Re when debt costs rise?
% 0 . 16
100
60
100
40
07875 . 1275 .
=
|
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|
\
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+
|
.
|
\
|
=
e
e
r
r
|
.
|
\
|
+
|
.
|
\
|
=
V
E
B
V
D
B B
E D A
( )
D A A E
B B
V
D
B B + =
WACC
|
.
|
\
|
+
|
.
|
\
|
= =
V
E
r
V
D
r r WACC
E D A
WACC is the traditional view of capital
structure, risk and return.
r
D
V
r
D
r
E
r
E
=WACC
WACC
r
D
E
r
D
r
E
M&M Proposition II
r
A
Risk free debt Risky debt
r
D
V
r
D
r
E
WACC
WACC (traditional view)
r
D
V
r
D
r
E
WACC
WACC (M&M view)
After Tax WACC
The tax benefit from interest expense
deductibility must be included in the cost of
funds.
This tax benefit reduces the effective cost of
debt by a factor of the marginal tax rate.
|
.
|
\
|
+
|
.
|
\
|
=
V
E
r
V
D
r WACC
E D
Old Formula
After Tax WACC
|
.
|
\
|
+
|
.
|
\
|
=
V
E
r
V
D
Tc r WACC
E D
) 1 (
Tax Adjusted Formula
After Tax WACC
Example - Union Pacific

The firm has a marginal tax rate of 35%.
The cost of equity is 10.0% and the
pretax cost of debt is 5.5%. Given the
book and market value balance sheets,
what is the tax adjusted WACC?
After Tax WACC
Example - Union Pacific - continued
Balance Sheet (Market Value, billions)
Assets 22.6 7.6 Debt
15 Equity
Total assets 22.6 22.6 Total liabilities
MARKET VALUES
After Tax WACC
|
.
|
\
|
+
|
.
|
\
|
=
V
E
r
V
D
Tc r WACC
E D
) 1 (
Debt ratio = (D/V) = 7.6/22.6= .34 or 34%

Equity ratio = (E/V) = 15/22.6 = .66 or 66%
After Tax WACC
|
.
|
\
|
+
|
.
|
\
|
=
V
E
r
V
D
Tc r WACC
E D
) 1 (
( ) ( )
% 8 . 7
078 .
66 . 10 . 34 . ) 35 . 1 ( 055 .
=
=
+ = WACC

FinMa II Presentation 1

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Return to NPV

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