FINS1613: Business FinanceUniversity of New South Wales

1 Forms of Organisations and FinancialManagers

The 3 Decisions in BusinessFinance

1. The Investment Decision2. The Financing Decision3. The Dividend Decision

Types of CompaniesSole

ProprietorshipPartnership Corporation

1 owner 2+ owners Manyshareholders

Owner = manager Owners =managers

Owners =/=managers

Cheap and simpleto set up

Cheap and simpleto set up

Expensive andcomplicated

Difficult to raisecapital/transferownership

Difficult to raisecapital/transferownership

Easy to raisecapital/transferownership

Unlimited Liability Unlimited Liability Limited LiabilityFirm objectives Primary: maximize shareholderwealth. Secondary: Social/ethical, e.g. environmentAgency Issues When agent has differentpriorities to principal they act on behalf on (e.g.managers and shareholders)2 Financial MathematicsSimple interest = (1 + )Compound interest = 1 += 1 +Ordinary annuity = 1 1 +

= 1 + 1Annuity due = (1 + ) 1 1 + = (1 + ) 1 + 1Perpetuity =Uneven cash flows PV of investment = sum ofPVs of all individual cash flowsEffective interest rate = 1 + 1Bond pricing= 1 1 + + 1 +Interest rate risk r goes up, price at which bondcan be resold goes down BUT income fromreinvesting coupon payments goes up. Risk isgreater for longer maturityDefault risk Bond issuer may go bankruptTerm structure of interest rates Relationshipbetween bond yields and terms to maturityMarket expectation hypothesis Yields onlonger maturity bonds reflect market expectations offuture short maturity bondsLiquidity premium hypothesis Investorsdemand higher returns on longer maturityinvestments because they are riskier, due to beingmore sensitive to interest rate changesMarket segmentation hypothesis Differentrates for different maturities are the result ofdifferent demand from different market segments

Types of SharesOrdinary Shares Preference Shares

Paid after in liquidation Paid first in liquidationNo fixed dividend Usually receive a fixed dividendVoting rights No voting rights

Share valuation= ( )/(1 + ) = (1 + ) = 3 Methods of Evaluating ProjectsTypes of investments Replacement of assets:

o To maintain businesso To improve efficiency

Expansion (into new markets/products) Safety/environmental (comply with regulation)Payback period Time until initial investment isrecoveredDiscounted payback period Payback periodusing discounted cash flowsNet present value (NPV) Sum of present valuesof all cash flows including negative cash flow ofinitial investmentInternal rate of return (IRR)Discount rate that would set NPV equal to 00 + 1 1 + + 2 1 + + + 1 + = 0Modified IRRVersion of IRR that removes implicit assumption thatpositive cash flows could be reinvested at IRR

4 Projecting Future Cash Flows ofProjectsFactors that alter project free cash flows: Requires fixed assets negative cash flow

Depreciation dollar value of assets used up tax liability so is added to projects net income If interest charges are removed beforediscounting, do not remove again when estimatingcash flowsIncremental cash flows Those created ifproject goes ahead. Factors affecting incrementalcash flows include sunk costs, existing assets of thefirm and possible impacts of project of other parts ofthe firm.Different types of projects Expansion project incremental cash flows arein/out flows the project creates Replacement project incremental cash flowsare only the extra in/out flows from new assetEvaluating projects Initial investment = upfront costs + necessary

in NOWC Operating cash flows incremental cash flows

over the life-span of the project Net cash flows each year sum of cash flows in

each area above; used for NPVEnding a project early Abandon project if NPVof future cash flows < 0Corporate risk Risk a project represents forentire firm. Affects share price and firm stability,very difficult to measure for just one project as thefirm is involved with many. Risk that a project represents for entire firm Important because: influences share price &

firm stability, undiversified shareholdersexposed

Very difficult to measure for just one project asfirms involved with many

Stand-alone risk Risk involved in the projectalone Important because: highly correlated with other

types of risk eg) corporate and market Easy to measure; can be done via sensitivity

analysis, scenario analysis, monte carlosimulation

Market risk Risk it presents to a well-diversified investor Important because cant be eliminated by

diversificationUsing project risk in capital budgetingRisk is reflected in capital budgeting by adjustingdiscount rate to evaluate risk cash flows riskyproject has discount rateTiming investments Decision tree can be usedto show different results from investing at differenttimes; choose option with highest positive NPVOptimal capital budgetingOptimal capital budget all profitable independentproject + any selected mutually exclusive projectsSteps: Determine firms discount rate Scale rate to represent the risk of each division

in the firm Calculate cash flows and NPV for the firms

accepted projectsTaxation and capital budgetingClassical approach company pays corporate taxon earnings, shareholders pay income tax on anydividends paid double taxing.Dividend imputation system Government givesinvestors franking credits on dividends subject todouble taxation, reducing tax liabilityDifferent types of companies Fully integrated with tax system and issue fully

franked shares

Not integrated with tax system eg) soletrader, partnership no franking credits

Partially integrated with tax system partiallyfranked shares

Re capital budgeting Under classical taxsystem, after-tax cash flows should be used toevaluate projects. Under imputation system, pre-taxcash flows should be used. Partially integrated firmsmust estimate effective corporate tax rateincorporating franking credits and use this in capitalbudgeting.5 Return and RiskExpected rate of return = = Variance = Standard deviation = = ( )/ 1Portfolio return = Correlation

, = , , 1 , 1DiversificationShares generally have a positive correlation that isless than 1, allowing for (limited) risk reduction byspreading risk among different shares(diversification)

Market (systematic) risk eg) r changes, growthshocksFirm specific (diversifiable) risk eg) new CEO,new project

Risk premium for market risk = No risk premium for diversifiable riskThe measure of market risk beta= += , Values for beta: Market return has = 1 Average stock has = 1 > 1 stock more risky than average < 1 stock less risky than average Most real stock 0.5 < < 1.5 negative if stock had negative correlation with

market very rareCapital Asset Pricing Model (CAPM)SML equation = + ( ) or= + ( )

is slope of the SMLBeta for a portfolio = = + ( )

Obstacles to testing CAPM Theory is about expected returns, can onlymeasure and use realised returns to estimate Theory requires that market portfolio used tocalculate s include all risky assets, includingintangibles (e.g. human capital)6 Cost of CapitalMotivations for estimating cost of capital To get hurdle rate To provide cost of capital for accountingcalculations of Economic Value Added (EVA)(monopoly regulators aim to set this to 0)Components of capital Debt ( ) Preferred shares ( ) Ordinary equity ( )Debt Pretax cost = market yield to maturity ofissued debt. After-tax cost should be used:= (1 )Preferred shares Pay out a fixed dividend. Costis similar to paying interest on debt; divide preferredshare dividend by preferred share price to get rate=Equity Use CAPM or dividend discount model= + ( )= = ( / ) + WACC (Weighted average cost of capital)= = (1 ) + +As the average cost of all company activities, WACCis an appropriate hurdle rate for evaluating projectsFactors influencing WACC Investment policy of firm --> riskiness of its

assets - risk = WACC Market conditions eg) r, average risk premium Firms capital structure and dividend policy

Tax imputation and WACC Effective company tax rate and tax subsidy for

debt will be depending on amount of companytax which is claimed as personal tax

Dividends must be grossed up by the attachedfranking credits eg) for cost of equity with DFC,market/company return for CAPM regression

6.1.1 Types of project risk Standalone risk cash flow variability Corporate risk effect of project on total firm

cash flow Market risk effect on firms market / beta risk

o Market risk is theoretically correct formaximizing wealth of diversifiedshareholder

o Corporate risk relevant to undiversifiedshareholder, creditors and employees

o Balance these considerations usingjudgements

6.1.2 Project risk adjustment procedures Subjective adjustment of WACC for projects of

different risk Evaluate project as if standalone company and

estimate for market risk adjustment Use one of above to establish cost of capital for

each division and use that for the divisionsprojects:

o Pure play find companies that operateonly in the same areas as the division,estimate and average s --> difficult

o Accounting beta regress divisions ROAagainst ROA of companies in similarmarkets --> these s are somewhatcorrelates, but difficult to get ROAs forprojects that dont exist

7 Capital StructureFinancial leverage use of debt and preferredstockFinancial risk additional risk resulting fromfinancial leverageBEP Basic Earning Power = EBIT / assetsROE Return on Equity = NI after tax / OETIE times Interest Earned = EBIT / interest To expected ROE, must have BEP > kd,

because if not then interest expense >operating income produced by debt-financedassets; therefore leverage income

As debt , TIE because EBIT is unaffected bydebt and interest expense (Int Exp = kdD)

BEP is unaffected by financial leverageThe effects of taxes on capital structure(Ignoring financial distress)= + [ / ]i.e. = + PV of annual tax savingsCosts of financial distress firm borrows, probability it will default Direct costs liquidation costs (legal,

accounting fees) Indirect costs lost sales, value for assets in

illiquid markets, managerial time, firm specifichuman capital etc= + [ / ] [ ]

Company taxes and personal taxes= + 1 1 1 1 where tc corporate tax rate , ts shareholder taxrate (average div + cap gains rates), td debt taxrate. Provided [ ] > 0, VL > VU. But withimputation, no advantage for un/levered firm.Imputation removes any tax advantage for debt,other reasons for debt if return > cost

Degree of operating leverage = 1 +( / )Degree of financial leverage = 1 +[ /( + )]Degree of total leverage = Optimal capital structure Mix of debt,preferred and common equity at which share priceis maximised.The Hamada Equation= [1 + (1 )( / )] Note: in CAPM is LOther factors re target capital structure: Industry average debt ratio TIE ratios under different scenarios Lender / rating agency attitudes Reserve borrowing capacity Effects of financing on control Asset structure Expected tax rateModigliani-Miller Irrelevance Theory Capitalstructure is irrelevant to firms value. Assumesshareholders have same info as managers, nobankruptcy costs, no taxes.Signaling theory suggests firms should use debtthan MM suggests. This unused debt capacity helpsavoid stock sales, which stock price because ofsignaling effects.If we assume managers have better info thanoutsiders and that managers act in best interest ofshareholders, then management would Issue shares if they think it is overvalued Issue debt if they think stock is undervalued Hence, investors view stock offering as a

negative signal empirically cause share priceto