Financial Management

For
MBA Program

Banbul Shewakena
(Assistant Professor of Financial Management)

1
 Chapter 1
Overview of Finance

2
 What is business?

• According to well-known professors William Pride,

Robert Hughes, and Jack Kapoor, business is 'the
organized effort of individuals to produce and sell, for
a profit, the g&s that satisfy society's needs.‘
• A business, then, is an organization which seeks to
make a profit through individuals working toward
common goals.
• The goals of the business will vary based on the type
of business and the business strategy being used.
• Regardless of the preferred strategy, businesses must
provide a service, product, or good that meets a need
of society in some way.

3
characteristics
• There are three key characteristics that
must be met to have a business.
1. businesses must be the result of individuals
working together in an organized way.
2. businesses must satisfy a societal need.
3. businesses must seek to make a profit.

4
 Forms of Business organization

1. A sole proprietorship
is a business that has a single owner who is responsible for
making decisions for the company.
2. A partnership
consists of two or more individuals who share the responsibility
of running the company.
3. A corporation
 is one of the most recognizable business structures and has a
separate identity from the owners of the company.
 One or more owners may participate as shareholders of a
corporation.
5
The d/c b/n the three forms of business
Formation
• A sole proprietorship or a partnership may be formed
without filing any formal paperwork.
• The creators of a corporation, however, must file a
document known as the articles of incorporation.
Liability
• The owner(s) of a sole proprietorship or a partnership
may be held liable for any business activity and/or
obligation.
• Corporate shareholders, however, usually are liable only
for the amount they invested.
6
The d/c b/n the three forms of business…
Record Keeping
• Corporations are required to keep strict records of meetings and other
similar administrative activities,
while
• a sole proprietorship or a partnership typically is not required to do so.
Size
• A sole proprietorship can have only a single owner,
but
a partnership or a corporation may have any number of owners.
Taxes
• The owner of a sole proprietorship is required only to report the business’
earnings on tax return,
while
• a corporation or a partnership must file a separate return for the business.
7
 What is Finance?
 If we trace the origin of finance, there is evidence to
prove that it is as old as human life on earth.
 The word finance was originally a French word.
 In the 18th century, it was adapted by English
speaking communities to mean “the management of
money.”
 Since then, it has found a permanent place in the
English dictionary.
 Today, finance is not merely a word else has
emerged into an academic discipline of greater
significance.
 Finance is now organized as a branch of Economics. 8
 What is Finance……
• Furthermore, the one word which can easily
replace finance is “EXCHANGE."
• Finance is nothing but an exchange of available
resources.
• Finance is not restricted only to the exchange
and/or management of money.
• A barter trading system is also a type of finance.
• Thus, we can say, Finance is an art of managing
various available resources like money, assets,
investments, securities, etc.
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 What is Finance……..
• At present, we cannot imagine a world
without Finance.
• In other words, Finance is the soul of our
economic activities.
• To perform any economic activity, we
need certain resources, which are to be
pooled in terms of money (i.e. in the
form of currency notes, other valuables,
etc.). 10
 What is Finance……..
• Finance is a prerequisite for obtaining physical
resources, which are needed to perform
productive activities and carrying business
operations such as sales, pay compensations,
reserve for contingencies (unascertained
liabilities) and so on.
• Hence, Finance has now become an organic
function and inseparable part of our day-to-day
lives.
• Today, it has become a word which we often
encounter on our daily basis. 11
 What is Finance…….
1. In General sense,
• "Finance is the management of money and other
valuables, which can be easily converted into
cash."
2. According to Experts,
• "Finance is a simple task of providing the necessary
funds (money) required by the business of entities
like companies, firms, individuals and others on the
terms that are most favourable to achieve their
economic objectives."
12
 What is Finance…….
3. According to Entrepreneurs,
• "Finance is concerned with cash. It is so, since, every
business transaction involves cash directly or
indirectly.“
4. According to Academicians,
• "Finance is the procurement (to get, obtain) of funds
and effective (properly planned) utilization of funds.
• It also deals with profits that adequately compensate
for the cost and risks borne by the business."

13
 Career Opportunities in Finance
Capital Market and Institution
 Many finance major works in FIs including bank and insurance
company, mutual funds, and investment banking firms
Investment
 Works for brokerage houses either in sales or security analysts
 Other works in banks, mutual funds, or insurance companies in
the management of their investment.
Financial Management
 broadest of the three
 One with the greatest number of job opportunities
 It is very important in all types of business including banks and
other financial institutions as well as industrial and retail firms
 FM is also important in government operations from school to
hospital, highway departments.
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Job opportunities in Financial Management

 Making decision regarding plant expansion

 Choosing what types of securities to issues
when financial expansion
 Deciding the credit terms
 Deciding on the inventory the firm can carry
 Deciding on the amount of cash to be kept on
hand
 Merger analysis
 Decision on firms earnings
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 What is Financial Management?
• FM means planning, organizing, directing and
controlling the financial activities such as
procurement and utilization of funds of the
enterprise.
• It means applying general management
principles to financial resources of the
enterprise.

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 Objectives of Financial Management

The FM is generally concerned with

procurement, allocation & control of financial
resources of a concern. The objectives can be-
• To ensure regular and adequate supply of funds
to the concern.
• To ensure adequate returns to the shareholders
which will depend upon the earning capacity,
market price of the share, expectations of the
shareholders.
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 Objectives of Financial Management

• To ensure optimum funds utilization. Once the

funds are procured, they should be utilized in
maximum possible way at least cost.
• To ensure safety on investment, i.e, funds should
be invested in safe ventures so that adequate rate
of return can be achieved.
• To plan a sound capital structure-There should be
sound and fair composition of capital so that a
balance is maintained between debt and equity
capital.
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 Functions of Financial Management

1. Estimation of capital requirements:

 A finance manager has to make estimation
with regards to capital requirements of the
company.
 This will depend upon expected costs and
profits and future programmes and policies
of a concern.
 Estimations have to be made in an adequate
manner which increases earning capacity of
enterprise.
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 Functions of Financial Management…

2. Determination of capital composition: 

 Once the estimation have been made, the
capital structure have to be decided.
 This involves short- term and long- term debt
equity analysis.
 This will depend upon the proportion of
equity capital a company is possessing and
additional funds which have to be raised
from outside parties.
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Functions of Financial Management…
3. Choice of sources of funds: For additional funds to
be procured, a company has many choices like-
– Issue of shares and debentures
– Loans to be taken from banks and financial institutions
– Public deposits to be drawn like in form of bonds.
• Choice of factor will depend on relative merits and
demerits of each source and period of financing.
4. Investment of funds: The finance manager has to
decide to allocate funds into profitable ventures so
that there is safety on investment and regular
returns is possible.
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Functions of Financial Management…

5. Disposal of surplus: 
 The net profits decision have to be made by the
finance manager.
 This can be done in two ways:
A. Dividend declaration - It includes identifying the
rate of dividends and other benefits like bonus.
B. Retained profits - The volume has to be decided
which will depend upon expansional,
innovational, diversification plans of the company.
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 Functions of Financial Management…

6. Management of cash: 
• Finance manager has to make decisions with
regards to cash management.
• Cash is required for many purposes like
payment of wages and salaries, payment of
electricity and water bills, payment to creditors,
meeting current liabilities, maintainance of
enough stock, purchase of raw materials, etc.

23
 Functions of Financial Management…

7. Financial controls: 
The finance manager has not only to plan,
procure and utilize the funds but he also has to
exercise control over finances.
This can be done through many techniques like
ratio analysis, financial forecasting, cost and
profit control, etc.

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 What are the Goals of the Firm?
(General Goals)

 Survival
 Avoid financial distress and bankruptcy
 Beat the competition
 Maximize sales or market share
 Minimize costs
 Maximize profits
 Maintain steady earnings growth.

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Shortcomings of these General Goals

Problems
 These goals are either associated with
increasing profitability or reducing risk.
 Could increase current profits while harming firm (e.g., defer
maintenance, issue common stock to buy Treasury-bills,
etc.).
 Does not specify timing or duration of expected returns.
 Calls for a zero payout dividend policy.
 They are not consistent with the long-term interests of
shareholders.
So it is necessary to find a goal that can encompass
both profitability and risk.
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The Real Goal of the Firm
Maximization of
Shareholder Wealth!
Shareholders’ wealth can be
measured as the current value per
share of existing shares.

27
 Strengths of Shareholder Wealth
Maximization
 Takes account of: current and
future profits and EPS; the timing,
duration, and risk of profits;
dividend policy; and all other
relevant factors.
 Thus, share price serves as a
barometer for business
performance.
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The Modern Organization

Modern Organization

Shareholders

There exists a
SEPARATION between
owners and managers.
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 Role of Management

Management acts as an agent

for the owners (shareholders)
of the firm.

 An agent is an individual authorized

by another person, called the
principal, to act in the latter’s behalf.

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 Agency Theory
 Jensen and Meckling developed a
theory of the firm based on agency
theory.

 Agency Theory is a branch of

economics relating to the
behavior of principals and their
agents.
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 Agency Theory
 Principals must provide incentives
so that management acts in the
principals’ best interests and then
monitor results.
 Incentives include stock options,
perquisites, and bonuses.

32
 Social Responsibility
 Wealth maximization does not stop the
firm from being socially responsible.
 Assume we view the firm as producing
both private and social goods.
 Then shareholder wealth maximization
remains the appropriate goal in
governing the firm.

33
Functions of the Financial Manager

Occasional Profitability
Daily

Cash management (receipt Intermediate financing

and disbursement of funds) Bond issues
Credit management Leasing Goal:
Inventory control Short- Stock issues Trade-off Maximize
term financing Capital budgeting shareholder
Exchange and interest rate Dividend decisions wealth
hedging Forecasting
Bank relations

Risk
 Organization of the Financial
Management Function

Board of Directors

President
(Chief Executive Officer)

Vice President Vice President Vice President

Operations Finance Marketing

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 Organization of the Financial
Management Function

Vice President of Finance

Treasurer Controller
Capital Budgeting Cost Accounting
Cash Management Cost Management
Credit Management Data Processing
Dividend Disbursement General Ledger
Fin Analysis/Planning Government Reporting
Pension Management Internal Control
Insurance/Risk Mngmt Preparing Fin Stmts
Tax Analysis/Planning Preparing Budgets
Preparing Forecasts

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 The Objective of the Firm

The objective of the firm is to maximize shareholder

value by increasing the value of the company's stock.
It has to be noted however that not all businesses are
organized as corporations. Corporations have three
distinct characteristics:
1.Corporations are legal entities, i.e. legally
distinct from its owners and pay their own taxes.
2.Corporations have limited liability, which
means that shareholders can only loose their
initial investment in case of bankruptcy.
3.Corporations have separated ownership and
control as owners are rarely managing the firm.
37
The Objective of the Firm…
The advantage of separation of ownership and
control is:
it allows share ownership to change without
influencing the day-to-day business.
The disadvantage of separation of ownership and
control is the agency problem, which incurs agency
costs.
•Agency costs are incurred when:
1. Managers do not maximize shareholders’ value
2. Shareholders monitor the management
38
 Conflicts Between Managers and
Stockholders
 Managers are naturally inclined to act in their
own best interests (which are not always the
same as the interest of stockholders).
 But the following factors affect managerial
behavior:
 Managerial compensation plans
 Direct intervention by shareholders
 The threat of firing
 The threat of takeover

39
The Objective of the Firm…

In a corporation the financial manager is

responsible for three basic decisions:
1. Investment decision
2. Dividend Decision
3. Financing decision

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The Objective of the Firm…
1. investment decision

is concerned with investment in real assets.

Concerned with evaluating the risk involved, measuring

the cost of funds and estimating expected benefit from a
project.

Investment decisions includes investment in fixed assets

(called as capital budgeting).

Investment in current assets are also a part of investment

decisions called as working capital decisions.
41
 2. Financing decision

Deals with how these investments should be

financed.
They relate to the raising of finance from
various resources which will depend upon
decision on type of source, period of
financing, cost of financing and the returns
thereby.

42
 3. Dividend decision

is concerned with the distribution of dividend

The finance manager has to take decision with
regards to the net profit distribution.
Net profits are generally divided into two:
A. Dividend for shareholders- Dividend and the rate of
it has to be decided.
B. Retained profits- Amount of retained profits has to
be finalized which will depend upon expansion and
diversification plans of the enterprise.
Plays a crucial activity in today’s corporate era

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 CHAPTER 2

Financial Planning
and
Analysis of Financial Statements

44
 Overview
• Ratios facilitate comparison of:
– One company over time
– One company versus other companies
• Ratios are used by:
– Lenders to determine creditworthiness
– Stockholders to estimate future cash flows and
risk
– Managers to identify areas of weakness and
strength
45
 Income Statement
2010 2011E
Sales $5,834,400 $7,035,600
COGS 4,980,000 5,800,000
Other expenses 720,000 612,960
Deprec. 116,960 120,000
Tot. op. costs 5,816,960 6,532,960
EBIT 17,440 502,640
Int. expense 176,000 80,000
EBT (158,560) 422,640
Taxes (40%) (63,424) 169,056
Net income ($ 95,136) $ 253,584
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 Balance Sheets: Assets

2010 2011E
Cash $ 7,282 $ 14,000
S-T invest. 20,000 71,632
AR 632,160 878,000
Inventories 1,287,360 1,716,480
Total CA 1,946,802 2,680,112
Net FA 939,790 836,840
Total assets $2,886,592 $3,516,952

47
 Balance Sheets: Liabilities & Equity

2010 2011E
Accts. Payable $ 324,000 $ 359,800
Notes payable 720,000 300,000
Accrual 284,960 380,000
Total CL 1,328,960 1,039,800
Long-term debt 1,000,000 500,000
Common stock 460,000 1,680,936
Ret. Earnings 97,632 296,216
Total equity 557,632 1,977,152
Total L&E $2,886,592 $3,516,952
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 Other Data

2010 2011E
Stock price $6.00 $12.17
# of shares 100,000 250,000
EPS -$0.95 $1.01
DPS $0.11 $0.22
Book val. per sh. $5.58 $7.91
Lease payments $40,000 $40,000
Tax rate 0.4 0.4
49
 Five Categories of Fin. Ratios
• Liquidity
• Asset Mgmt
• Debt Mgmt
• Profitability
• Market Value

50
 Five Categories of Fin. Ratios
• Liquidity: Ability to meet current obligations
• Asset Mgmt: Proper & effective use of assets
– Asset utilization (i.e., Total Asset Turnover Ratio:
• TAT = Sales / T. Assets
• Debt Mgmt: extent of debt & level of safety
afforded creditors
– Debt utilization (i.e., Equity Multiplier:
• EM = T. Assets / T. Eqty

51
 Five Categories of Fin. Ratios
• Profitability: reflects effects of liquidity, asset
mgmt, & debt on operating results
– Expense Control: Profit Margin:
• PM = Net Income / Sales

• Market Value: indicators of what investors

think of firm’s past results & future prospects

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 Liquidity Ratios
• Can the company meet its short-term
obligations using resources it currently has on
hand?

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Forecasted Current and Quick Ratios for
2011.
• CR10 = CA/CL= $2,680
$1,040

= 2.58.
• QR10 =CA - Inv.
CL
=$2,680 - $1,716
$1,040
= 0.93.
54
 Comments on CR and QR

2011E 2010 2009 Ind.

CR 2.58 1.46 2.3 2.7

QR 0.93 0.5 0.8 1.0

Expected to improve but still below industry

average.
Liquidity position is weak.

55
 Asset Management Ratios
• How efficiently does firm use its assets?
• How much does firm have tied up in assets for
each dollar of sales?

56
Inventory Turnover Ratio vs. Industry Average

Inv. Turnover=Sales/Inventories
=$7,036
$1,716
= 4.10.
2011E 2010 2009 Ind.
Inv. T. 4.1 4.5 4.8 6.1

57
 Comments on Inventory Turnover
• Inventory turnover: Below Industry average
• Firm might have old inventory, or its control
might be poor.
• No improvement is currently forecasted.

58
DSO: average number of days from sale until
cash received.
DSO=Receivables/Average sales per day

Receivables
Sales/365

$878
$7,036/365
= 45.5 days.

59
 Appraisal of DSO
• Firm collects too slowly, and situation is
getting worse.
• Poor credit policy.

2011 2010 2009 Ind.

DSO 45.5 39.5 37.4 32.0

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 Fixed Assets and Total Assets
Turnover Ratios
• Fixed assets turnover= Sales             
Net fixed assets
= $7,036
$837
= 8.41
• Total assets turnover=     Sales       
Total assets
= $7,036
$3,517
= 2.00
61
 Fixed Assets and Total Assets
Turnover Ratios
• FA turnover: expected to exceed industry average.
Good.
• TA turnover not up to industry average. Implication?
Caused by excessive current assets (A/R and
inventory).

2011E 2010 2009 Ind.

• FA TO 8.4 6.2 10.0 7.0
• TA TO 2.0 2.0 2.3 2.5
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 Chapter 3
Present Value and Opportunity Cost of
Capital

• Present and future value calculations rely on the

principle of time value of money.
Time value of money: One dollar today is worth more than
one dollar tomorrow.
 why time has time value?
The following four factors are responsible for money to
have time value:
• Consumption Preference: Individuals prefer current
consumption to future consumptions. So people would
have to be offered more in the future to give up current
consumption. 63
 Cont’d
• Inflation: general increase in prices (inflation) erodes the
purchasing power of money. Hence, the value of money
decreases with time when there is inflation.

• Uncertainty (Risk): As compared to today’s money, future

cash flows have risks (default risk). Hence, delaying cash
collection means assuming greater risks. Individuals want
to be rewarded for this additional risk assumed.

• Investment Opportunities: cash received today could be

invested and fetch additional income.
Time value of money demonstrates that, all things being
equal, it is better to have money now than later.
64
 3.1. Compounded versus Simple Interest
• Basically, simple interest is interest paid on the original
principal only.
• However, compound interest is the interest earned not only
on the original principal, but also on all interests earned
previously.
• In other words, at the end of each year, the interest earned
is added to the original amount and the money is
reinvested.
Example
1. Compute interest on 100 ETB deposit for two years at a rate
of 5% using simple and compound interest.

65
 Simple and Compound Interest…
Solution
1. Simple interest rate
I=prt
= 100*5%*2=10ETB
I =10ETB

66
 2. Compound Interest
I=prt
100*5%*1=5ETB
105*5%*1=5.25ETB
I= 5ETB+5.25ETB = 10.25ETB
Or
Compound Interest (Ic) = P × (1 + i) n – P
= 100*(1+0.05)^2
=100*(1.05)^2
=110.25-10
10.25
67
 3.2 The Present Value

•Present value (PV) is the value today of a future

cash flow. To find the present value of a future
cash flow, Ct, the cash flow is multiplied by a
discount factor:
(1)PV = discount factor * Ct;

The discount factor (DF) is the present value of

€1 future payment and is determined by the rate
of return on equivalent investment alternatives
in the capital market.
68
 PV….
Example
2. Assume you want to receive 100ETB after
1year. What amount has to be deposited
today at a rate of 5%?
PV=

69
 PV…..
Example
• What is $570 next year worth now, at an
interest rate of 10% ?
• PV = $570 / (1+0.10)1 = $570 / 1.10
= $518.18 (to nearest cent)

70
 2.3 The Future Value

• The future value (FV) is the amount to which an

investment will grow after earning interest. The
future value of a cash flow, C0 , is

Example
3. Assume you have deposited 100ETB today at a
rate of 5%. What will be the amount after two
years?
FV=100*(1.05)^2
= 100*1.1025
= 110.25 71
 FV…
Example
1. $1000 lump sum investment earning 10
percent interest per year. Determine the value
of your investment at the end of two years

72
 2.4 Principle of Value Additivity

The principle of value additivity states that

present values (or future values) can be added
together to evaluate multiple cash flows. Thus, the
present value of a string of future cash flows can
be calculated as the sum of the present value of
each future cash flow:

73
 2.4 Principle of Value Additivity…
• The principle of value additivity can be applied to
calculate the present value of the income stream
Example:
• Compute the present value of the following income
stream of €1,000, €2000 and €3,000 in year 1, 2
and 3 from now, respectively. 10% interest rate
• PV= 1,000/(1.1)^1 + 2,000(1.1)^2 + 3,000(1.1)^3

74
2.5 Net Present Value
•Most projects require an initial
investment.
•Net present value is the difference
between the present value of future cash
flows and the initial investment, C0,
required to undertake the project:

•Note that if C0 is an initial investment,

then C0 < 0. 75
 NPV…
Example
4. Your friend needs 10,000 ETB, and will pay you back
10,700 ETB in a year. Is it good investment when you get
10% elsewhere?
NPV=

If NPV is positive the project is value adding- so invest on it.

If NPV= 0 – not investing unless you have other purpose
If NPV= -ve – not investing

76
• Project X requires an initial investment of $35,000 but is
expected to generate revenues of $10,000, $27,000 and
$19,000 for the first, second and third years,
respectively. The target rate of return is 12%. Since the
cash inflows are uneven, the second formula listed
above is used.
• NPV = {$10,000 / (1 + 0.12)1} + {$27,000 / (1 + 0.12)2} + {$19,000 / (1 + 0.12)3} - $35,000
NPV = $8,929 + $21,524 + $13,524 - $35,000
NPV = $8,977

77
• Project Y also requires a $35,000 initial
investment and will generate $27,000 per year
for two years. The target rate remains 12%.
Because each period produces equal revenues,
the first formula above can be used.
• NPV = $27,000/(1 + 0.12)2 - $35,000
NPV = $45,631 - $35,000
NPV = $10,631

78
 2.6 Perpetuities and Annuities

A Perpetuity is a constant cash flow that is

paid (received) at a regular time interval forever.
PV = C/i
Where: C is the periodic cash flow, and
i is the discount rate
Cases to be used – bond, real estate
example
5. What is the present value of perpetuity paying
1000 ETB at the end of each year. r=8%
PV=
79
 2.6 Perpetuities and Annuities

Growing perpetuity
In case the cash flow of the perpetuity is
growing at a constant rate rather than being
constant, the present value formula is slightly
changed.
PV of Growing Perpetuity = C1/(r-g)
Example
6. Consider example three if there is a growth of
5% what is the PV of perpetuity?

80
 2.6 Perpetuities and Annuities

Annuities, however, are regular cash

flows that occur at equal intervals of time for a
fixed period of time and fixed interest (discount)
rate.

81
 Types of Annuities

Ordinary Annuity: a series of equal payments made at the end of each

period.

PV = PMT [1- (1/(1+i)n]

i
FV = PMT [(1+i)n - 1)]
i
Where: PMT is the periodic cash flows,
i is the discount rate, and
n is the number of periods

82
 Ordinary Annuity……
Example
7. Assume part of your portfolio is bond. One
particular bond will pay you 1000ETB for five
years at the end of each year. What is the
present value of the cash flows if the interest
rate is 10%?
PV of Annuity = 1000((1-1/(1+0.1)^5)
0.1

83
Example
8. If at the end of each month a saver deposited
100ETB into a saving account that paid 6%
compounded monthly, how would she/he has
at the end of 10years?
FV annuity = 100(1+0.06)^5-1
0.06

84
 Types of Annuities….
Annuity Due: a series of equal cash
payments made at the beginning of each
period.
PV = PMT (1-1/(1+i) n
i
FV = PMT [(1+i) n - 1] * (1+ i)
i
Growing Annuities: a cash flow that grows
at a constant rate and paid at a regular
interval of time.

85
Example
9. The tressurer of ABC imports expects to invest
50,000 ETB of the firms funds in a long term
investment vehicle at the beginning of each year
for the next 5years. He expects that the company
will earn 6% interest that will compounded
annually. What is the value of payments at the
end of 5years?
FV annuity = ?

86
Example
10.

87
 2.7 Nominal and Real Rates of Interest
Inflation is the rate at which prices as a whole are
increasing, whereas nominal interest rate is the
rate at which money invested grows.
The formula for converting nominal interest rate
to a real interest rate is:

88
2.7 Nominal and Real Rates of Interest

Cash flows can either be in current

(nominal) or constant (real) dollars.
If you deposit €100 in a bank account with an
interest rate of 5 percent, the balance is €105
by the end of the year.
Whether €105 can buy you more goods and
services than €100 today depends on the rate
of inflation over the year.

89
Example
• Suppose you bought 1000 ETB renaissance
dam bond with a coupon rate of 5.5%, the
inflation rate reported by government is 4%.
What is the real interest rate?
RR= (1+RN)/(1+RI) -1

90
 Chapter 4

Bond and Stock

Evaluation

91
 2.8 Valuing Bonds Using Present Value Formulas
•A bond is a debt contract that specifies a fixed set of
cash flows which the issuer has to pay to the
bondholder. The cash flows consist of a coupon
(interest) payment until maturity as well as repayment
of the par value of the bond at maturity.
•The value of a bond is equal to the present value of the
future cash flows:
1. Value of bond = PV(cash flows) = PV(coupons) +
PV(par value)
•Since the coupons are constant over time and received
for a fixed time period the present value can be found
by applying the annuity formula.
92
Example
11. Suppose ABC company issues 3years bond
with par value of 1000 ETB, that pays 4%
interest rate annually, which is also prevailing
market interest rate. What is the PV of the
payment?

93
 Answer
• PV= c1/(1+i)n C2/(1+i)n+…..+ Cn/(1+i)n
= 40/(1+0.04)1 + 40/(1+0.04)2 + 1040/(1.0.04)3

94
 Valuing Bonds…

• Because bond prices change when the interest

rate changes, the rate of return earned on the
bond will fluctuate with the interest rate.
• Thus, the bond is subject to interest rate risk.
• All bonds are not equally affected by interest
rate risk, since it depends on the sensitivity to
interest rate fluctuations.
• The interest rate required by the market on a
bond is called the bond's yield to maturity.
95
 Valuing Bonds…

• Yield to maturity is defined as the discount rate

that makes the present value of the bond equal
to its price.
• Moreover, yield to maturity is the return you
will receive if you hold the bond until maturity.
• Note that the yield to maturity is different from
the rate of return, which measures the return
for holding a bond for a specific time period.

96
 Valuing Bonds…

•The yield to maturity required by

investors is determined by:
1.Interest rate risk
2.Time to maturity
3.Default risk

97
 Valuing Bonds…

Generally, there exist five important relationships related to a

bond's value:
1. The value of a bond is inversely related to changes in the
interest rate. Is it true?
PV= c1/(1+i)n C2/(1+i)n+…..+ Cn/(1+i)n
2. Market value of a bond will be less than par value if
investor’s required rate is above the coupon interest rate.
3. As maturity approaches the market value of a bond
approaches par value.
4. Long-term bonds have greater interest rate risk than do
short-term bonds .
5. Sensitivity of a bond’s value to changing interest rates
depends not only on the length of time to maturity, but also on
the patterns of cash flows provided by the bond. 98
 2.9 Valuing Stocks Using Present Value Formulas: The
Dividend Discount Model
• The price of a stock is equal to the present value
of all future dividends. The intuition behind this
insight is that the cash payoff to owners of the
stock is equal to cash dividends plus capital gains
or losses. Thus, the expected return that an
investor expects from investing in a stock over a
set of period of time is equal to:

• At the limit, the current stock price, P0 , can be

expressed as the sum of the present value of all
future dividends. 99
12.

100
 Discounted Dividend Growth Model: The
Gordon Growth Model
• In cases where firms have constant growth
in the dividend a special version of the
discounted dividend model can be applied.
If the dividend grows at a constant rate, g,
the present value of the stock can be found
by applying the present value formula for
perpetuities with constant growth.

101
Example
12. Assume ABC company pays 3ETB dividend , a
required return is 5%, the dividend is expected
to grow by 3%. What is the value of the
stock?
Po= ?

102
 2.10. The Net Present Value Investment Rule
• Net present value is the difference between a project's
value and its costs. Steps in determining NPV:
1. Forecast cash flows;
2. Determine the appropriate opportunity cost of capital,
which takes into account the principle of time value of
money and the risk-return trade-off;
3. Use the discounted cash flow formula and the
opportunity cost of capital to calculate the present value
of the future cash flows;
4. Find the net present value by taking the difference
between the present value of future cash flows and the
project's costs.
103
 NPV…
To understand why the net present value rule leads to better
investment decisions than the alternatives it is worth considering the
desirable attributes for investment decision rules.
The goal of the corporation is to maximize firm value.
A shareholder value maximizing investment rule is:
- Based on all cash flows
-Taking into account time value of money
- Taking into account differences in risk

104
 NPV…
The net present value rule meets all these requirements
and directly measures the value for shareholders
created by a project.
This is far from the case for several of the alternative
rules such as the Book rate of return, the payback
period, and the Internal Rate of Return.
Though both NPV and IRR methods give the same
investment decisions (whether to accept or reject a
project), they may not give the same ranking of
projects, which is a problem in case of mutually
exclusive projects.

105
 CHAPTER - 4
3. Risk, Return and Opportunity Cost of Capital

3.1 Risk and Risk Premium

3.1.1. Risk
is uncertainty, likely hood, chance, probability
is the difference between actual and the
expected one
3.1.2. Risk premium
• The risk premium on financial assets
compensates the investor for taking risk.
• The risk premium is the difference b/n the
return on the security and the risk free rate.
106
3. Risk, Return and Opportunity Cost of Capital

Measurement of Risk
• The risk of financial assets can be measured
by the spread in potential outcomes.
• The variance and standard deviation on the
return are standard statistical measures of
this spread.

107
 Risk-Return Tradeoff

•Investors will not take on additional risk

unless they expect to be compensated with
additional return.
•The risk-return tradeoff relates the expected
return of an investment to its risk.
•Low levels of uncertainty (low risk) are
associated with low expected returns, whereas
high levels of uncertainty (high risk) are
associated with high expected returns.

108
 Risk-Return Tradeoff…
• It follows from the risk-return tradeoff that
rational investors will when choosing between
two assets that offer the same expected return
prefer the less risky one.
• Thus, an investor will take on increased risk only
if compensated by higher expected returns.
Conversely, an investor who wants higher returns
must accept more risk.
• The exact trade-off will differ by investor based
on individual risk aversion characteristics (i.e. the
individual preference for risk taking).
109
 3.2 The Effect of Diversification on Risk
• The risk of an individual asset can be measured by the
variance on the returns.
• The risk of individual assets can be reduced through
diversification.
• Diversification reduces the variability when the prices
of individual assets are not perfectly correlated. (is the
risk of investing on car and tier can be diversified?)
• In other words, investors can reduce their exposure to
individual assets by holding a diversified portfolio of
assets.
• As a result, diversification will allow for the same
portfolio return with reduced risk. 110
 Effect of Diversification….

• More generally the standard deviation of a

portfolio is reduced as the number of
securities in the portfolio is increased.(the
law of large number)
• The reduction in risk will occur if the stock
returns within our portfolio are not perfectly
positively correlated.
• As the number of stocks in the portfolio
increases the exposure to risk decreases.
111
 Effect of Diversification….

• However, portfolio diversification cannot

eliminate all risk from the portfolio.
• Thus, total risk can be divided into two types of
risk: (1) Unique risk and (2) Market risk.
• Unique risk can be diversified away, whereas
• market risk is non-diversifiable.
• Total risk declines until the portfolio consists of a
certain number of securities, then for each
additional security in the portfolio the decline
becomes very slight.
112
Portfolio Risk
Total risk = Unique risk + Market risk
Unique Risk
– Risk factors affecting only a single asset or a small group of assets
– Also called
o Idiosyncratic risk
o Unsystematic risk
o Company-unique risk
o Diversifiable risk
o Firm specific risk
– Examples:
o A strike among the workers of a company, an increase in the interest rate a
company pays on its short-term debt by its bank, a product liability suit.
Market Risk
– Economy-wide sources of risk that affect the overall stock
market. Thus, market risk influences a large number of assets, each to a greater or
lesser extent.
– Also called
o Systematic risk
o Non-diversifiable risk
– Examples:
• Changes in the general economy or major political events such as changes in
general interest rates, changes in corporate taxation, etc.
113
 Effect of Diversification….
• As diversification allows investors to
essentially eliminate the unique risk, a
well-diversified investor will only
require compensation for bearing the
market risk of the individual security.
• Thus, the expected return on an asset
depends only on the market risk.

114
 Measuring return
• 1. MEASURING HISTORICAL RETURN

PERIOD RETURN
Ri
1
2 12
3 20
4 -10
5 14
6 9
 Ri = 60

a. What is the mean return or average return?

115
Solution
• Historical return /Average return
n
E (R) =  Ri /n
i=1
=60/6
=10
116
MEASURING EXPECTED (EX ANTE)
RETURN

EXPECTED RATE OF RETURN

n
E (R) =  pi Ri
i=1
• Bharat Foods Stock
state of the economy pi ri Er
• 1. Boom 0.30 16 4.8
• 2. Normal 0.50 11 5.5
• 3. Recession 0.20 6 1.2

E(R ) = SpiRi = 11.5

117
118
 3.3 Measuring Market Risk

• Market risk can be measured by beta, which

measures how sensitive the return is to market
movements.
• Thus, beta measures the risk of an asset relative
to the average asset.
• By definition the average asset has a beta of one
relative to itself.
• Thus, stocks with betas below 1 have lower than
average market risk; whereas a beta above 1
means higher market risk than the average asset.
119
 Measuring Risk Using Historical Return
PERIOD RETURN DEVIATAION SQUARE OF DEV.
Ri R (Ri - R) (Ri - R)2
1 15 10 5 25
2 12 10 2 4
3 20 10 10 100
4 -10 10 -20 400
5 14 10 4 16
6 9 10 -1 1
 Ri = 60  (Ri - R)2 = 536
R = 10
 (Ri - R)2
2 = = 107.2  = [107.2]1/2 = 10.4
n -1

120
MEASURING EXPECTED (EX ANTE)
RETURN AND RISK

STANDARD DEVIATION OF RETURN

 2 =  pi (Ri - E(R) )2

121
 • Bharat Foods Stock
State of the
Economy pi Ripi Ri (Eri Ri-E(R) (Ri-E(R))2 pi(Ri-E(R))2
1. Boom 0.30 16 4.8 11.2 125.44 37.632
2. Normal 0.50 11 5.5 5.5 30.25 15.125
Recession 0.20 6 1.2 4.8 23.04 4.608
E(R ) = SpiRi = 11.5 Spi(Ri –E(R))2 = 57.36 σ 2 = [Spi(Ri-E(R))2 = (57.635) = --
%

122
123
124
 MEASUREMENT OF COMOVEMENTS IN SECURITY RETURNS

• To develop the equation for calculating portfolio

risk we need information on weighted individual
security risks and weighted comovements between
the returns of securities included in the portfolio.

• Comovements between the returns of securities

are measured by covariance (an absolute measure)
and coefficient of correlation (a relative measure).

125
 Hypothetical example
Economic growth (Xi) S&P 500 return (yi)
2.1 8
2.5 12
4 14
3.6 10

Cov(x,y) =  (xi-x) (yi-y)

n-1

126
• Mean of x= 2.1+2.5+4+6 )/4= 3.1
• Mean of y= 8+12+14+10)/4= 11
• Cov. (x,y)= (2.1-3.1)(8-11)+ (2.5-3.1)(12-11)+ (4-
3.1)(14-11)+(3.6-3.1)(10-11)/4-1
• =4.6/3= 1.53
• Interpretation
• Since positive, the variables are positively related.
They move together in the same direction.
• Are affected in the same way with a market.
127
• Variance of the market is; s 2 = (yi-y) 2
=(8-11) 2 + (12-11) 2 + (14-11) 2 + (10-11) 2
=9+1+9+1
=20
s 2 = 1.53/20
= 0.0765
Lower risk than the market

128
 Comevement of expected return
• COV (Ri , Rj) = p1 [Ri1 – E(Ri)] [ Rj1 – E(Rj)]

+ p2 [Ri2 – E(Rj)] [Rj2 – E(Rj)]

+ pn [Rin – E(Ri)] [Rjn – E(Rj)]

129
 Illustration
• The returns on assets A and B under five possible states of nature are given below
 
• State of nature Probability Return on asset 1 Return on asset 2
• 1 0.10 -10% 5%
• 2 0.30 15 12
• 3 0.30 18 19
• 4 0.20 22 15
• 5 0.10 27 12
•  
• The expected return on asset 1 is :
• E(RA) = 0.10 (-10%) + 0.30 (15%) + 0.30 (18%) + 0.20 (22%) + 0.10 (27%) = 16%

• The expected return on asset 2 is :

• E(RB) = 0.10 (5%) + 0.30 (12%) + 0.30 (19%) + 0.20 (15%) + 0.10 (12%) = 14%
•  
• The covariance between the returns on assets 1 and 2 is calculated below :
130
•  
•  

1. State of nature 2. P (2) Ra (3) Rai-a (4) Rbi (5) Rbi-b (6) (2) x (4) x
(6)
•1 0.10 -10% -26% 5% -9% 23.4
•2 0.30 15% -1% 12% -2% 0.6
•3 0.30 18% 2% 19% 5% 3.0
•4 0.20 22% 6% 15% 1% 1.2
•5 0.10 27% 11% 12% -2% -2.2
Sum = 26.0
 
Thus the covariance between the returns on the two assets is 26.0.

131
 CO EFFIENT OF CORRELATION

Cov (Ri , Rj)

Cor (Ri , Rj) or ij =
 (Ri , Rj)
ij
i j
ij = ij . i . j
• where ij = correlation coefficient between the returns on
securities i and j
• ij = covariance between the returns on securities i
and j
• i , j = standard deviation of the returns on securities
i and j
132
 3.4 Portfolio risk and return

• The expected return on a portfolio of stocks is a

weighted average of the expected returns on the
individual stocks. Thus, the expected return on
a portfolio consisting of n stocks is:
n
Portfolio Re turn   wi * ri
i 1

• Where wi denotes the fraction of the portfolio

invested in stock i and ri is the expected return on
stock i.

133
 Hypothetical example on portfolio return

• A portfolio consisting of asset A and asset B.

Asset A make up 1/3 of the portfolio and has
expected return of 18% . Asset B make up the
other 2/3 of the portfolio and it is expected to
earn 9%. What is the expected return of the
portfolio?

134
 Solution
Rp = wArA+wBrB
= 1/3(18) + 2/3(9)
= 6%+6%
= 12%

135
 Example.
• Example A portfolio consists of four
securities with expected returns of 12%,
15%, 18%, and 20% respectively. The
proportions of portfolio value invested in
these securities are 0.2, 0.3, 0.3, and 0.20
respectively.
1. Compute the portfolio expected return.

136
 3.4.1 Portfolio Variance

In the top left corner of Table 2, you weight the variance on

stock 1 by the square of the fraction of the portfolio invested
in stock 1. Similarly, the bottom left corner is the variance of
stock 2 times the square of the fraction of the portfolio
invested in stock 2. The two entries in the diagonal boxes
depend on the covariance between stock 1 and 2. The
covariance is equal to the correlation coefficient times the
product of the two standard deviations on stock 1 and 2. The
portfolio variance is obtained by adding the content of the
four boxes together:
137
 Portfolio Variance…

• The benefit of diversification follows

directly from the formula of the portfolio
variance, since the portfolio variance is
increasing in the covariance between
stock 1 and 2. Combining stocks with a
low correlation coefficient will therefore
reduce the variance on the portfolio.
138
Portfolio Variance…

139
• Example : w1 = 0.6 , w2 = 0.4,

1 = 10%, 2 = 16%

12 = 0.5

1. Compute the portfolio variance.

140
• p = [0.62 x 102 + 0.42 x 162 +2 x 0.6 x 0.4 x 0.5
x 10 x 16]½
= 10.7%
• The average standard deviation of two
securities is 13, which is less than standard
deviation of the portfolio, which is 10. Thus
diversification reduces risk.
141
 Portfolio Variance…

For a portfolio of n stocks the portfolio variance is equal

to:

142
 3.4.2 Portfolio's Market Risk

• The market risk of a portfolio of assets is a

simple weighted average of the betas on the
individual assets.

143
 3.5 Portfolio Theory

• Portfolio theory provides the foundation for estimating

the return required by investors for different assets.
• i.e., Through diversification the exposure to risk could
be minimized, which implies that portfolio risk is less
than the average of the risk of the individual stocks.
• Markowitz theory- risk can be reduced through
diversification.
• He is the founder of “Modern Portfolio Theory’’ and
His finding greatly changed the asset mgt industry &
his theory still considered as cutting edge in a portfolio
mgt.
144
 3.5 Portfolio Theory…

• There are two main concepts in MPT

1. Any investors goal is to minimize return for any
level of risk
2. Risk can be reduced by creating a diversified
portfolio of unrelated assets.
• To illustrate this consider Figure 3, which shows
how the expected return and standard deviation
change as the portfolio is comprised by different
combinations of the Nokia and Nestlé stock.

145
Portfolio Theory…

146
 Portfolio Theory…

• If the portfolio invested 100% in Nestlé the

expected return would be 10% with a standard
deviation of 20%. Similarly, if the portfolio
invested 100% in Nokia the expected return would
be 15% with a standard deviation of 30%.
However, a portfolio investing 50% in Nokia and
50% in Nestlé would have an expected return of
12.5% with a standard deviation of 21.1%. Note
that the standard deviation of 21.1% is less than
the average of the standard deviation of the two
stocks (0.5 *20% + 0.5 *30% = 25%). This is due
to the benefit of diversification. 147
 Portfolio Theory…
• In similar vein, every possible asset
combination can be plotted in risk-return
space. The outcome of this plot is the
collection of all such possible portfolios,
which defines a region in the risk-return
space.
• As the objective is to minimize the risk for a
given expected return and maximize the
expected return for a given risk, it is preferred
to move up and to the left in Figure 4.
148
 Portfolio Theory…

The solid line along the upper edge of this region is known as the
efficient frontier. Combinations along this line represent portfolios
for which there is lowest risk for a given level of return. Conversely,
for a given amount of risk, the portfolio lying on the efficient
frontier represents the combination offering the best possible return.
Thus, the efficient frontier is a collection of portfolios, each one
optimal for a given amount of risk. 149
 Portfolio Theory…
•The Sharpe-ratio measures the amount of return above the
risk-free rate a portfolio provides compared to the risk it
carries.

•Where ri is the return on portfolio i, rf is the risk free rate

and σi is the standard deviation on portfolio i's return. Thus,
the Sharpe-ratio measures the risk premium on the portfolio
per unit of risk.
•Example
•Assume the return on the market is 12% and the risk free
rate is 4%. What will be the return of the portfolio when the
st.dev is 2? 150
• In a well-functioning capital market
investors can borrow and lend at the
same rate. Consider an investor who
borrows and invests a fraction of the
funds in a portfolio of stocks and the rest
in short-term government bonds.
• In this case the investor can obtain an
expected return from such an allocation
along the line from the risk free rate rf
through the tangent portfolio in Figure 5.
151
• As lending is the opposite of
borrowing the line continues to the
right of the tangent portfolio, where the
investor is borrowing additional funds
to invest in the tangent portfolio.
• This line is known as the capital
allocation line and plots the expected
return against risk (standard deviation).

152
 Figure 5: Portfolio theory

Market
Expected Return (%) portfolio

Risk free rate

Standard Deviation

153
•The tangent portfolio is called the market
portfolio. The market portfolio is the portfolio on
the efficient frontier with the highest Sharpe-ratio.

•Investors can therefore obtain the best possible

risk return trade-off by holding a mixture of the
market portfolio and borrowing or lending.

•Thus, by combining a risk-free asset with risky

assets, it is possible to construct portfolios whose
risk-return profiles are superior to those on the
efficient frontier.
154
 3.6 Capital Assets Pricing Model (CAPM)

The Capital Assets Pricing Model (CAPM) derives the

expected return on an asset in a market, given the risk-
free rate available to investors and the compensation for
market risk.
CAPM specifies that the expected return on an asset is a
linear function of its beta and the market risk premium.
Expected return on stock i =ri=rf+ βi (rm-rf )
Where rf is the risk-free rate, βi is stock i's sensitivity to
movements in the overall stock market, whereas (r m - rf )
is the market risk premium per unit of risk.
155
 CAPM…
Thus, the expected return is equal to the risk
free-rate plus compensation for the exposure
to market risk.
As βi is measuring stock i's exposure to
market risk in units of risk, and the market risk
premium is the compensations to investors per
unit of risk, the compensation for market risk
of stock i is equal to the βi (rm - rf).
Figure 6 illustrates CAPM:
156
 CAPM…

Market
Security Market Line
Expected Return (%)
portfolio

Slope = (rm - rf)

Risk free rate

Beta () 1.0

157
The relationship between risk and required return is
plotted on the securities market line, which shows
expected return as a function of risk.
Thus, the security market line essentially graphs the
results from the CAPM theory.
The x-axis represents the risk (beta), and the y-axis
represents the expected return.
The intercept is the risk-free rate available for the
market, while the slope is the market risk premium (rm
- r f)
CAPM is a simple but powerful model. Moreover it
takes into account the basic principles of portfolio
selection: 158
 1.Efficient portfolios (Maximize expected
return subject to risk).
2.Highest ratio of risk premium to standard
deviation is a combination of the market
portfolio and the risk-free asset.
3.Individual stocks should be selected based
on their contribution to portfolio risk.
4.Beta measures the marginal contribution
of a stock to the risk of the market portfolio.

159
• CAPM theory predicts that all assets should be
priced such that they fit along the security market
line one way or the other.
• If a stock is priced such that it offers a higher
return than what is predicted by CAPM, investors
will rush to buy the stock.
• The increased demand will be reflected in a
higher stock price and subsequently in lower
return.

160
• This will occur until the stock fits on the security
market line.
• Similarly, if a stock is priced such that it offers a
lower return than the return implied by CAPM,
investor would hesitate to buy the stock.
• This will provide a negative impact on the stock
price and increase the return until it equals the
expected value from CAPM.

161
 Testing the CAPM
Beta vs. Average Risk Premium
Average Risk
Premium

30 SML

Investors
20

10
Market
Portfolio
0

1.0
Portfolio Beta

162
 Hypothetical example on CAPM
• Question
Asset Beta
X 1.5
Y 0.8
Z 2.5
Rf = 4%
Rm = 12%
Rx = Rf+Bx (Rm-Rf)
= 4%+1.5(12%-4%)
= 16%
Compute Ry, Rz 163
 3.7 Alternative Asset Pricing Models: APT

APT is a well known method of pricing an asset.

Arbitrage Pricing Theory (APT) assumes that the return on
a stock depends partly on macroeconomic factors and
partly on noise, which are company specific events.
Thus, under APT the expected stock return depends on an
unspecified number of macroeconomic factors plus noise:
Expected return =a+b1 r factor1 + b2 r factor2 +...+ bn . r factorn
+noise
Where b1, b2,...,bn are the sensitivity of the stock return to
each factor.
Er = rf + b1(rf1-rf) + b2(rf2-rf) + ……… bn(rfn-rf)
164
 APT…

The model-derived rate of return

will then be used to price the asset
correctly - the asset price should
equal the expected end of period
price discounted at the rate
implied by the model.
165
 APT…
• As such the theory does not specify what the
factors are except for the notion of pervasive
macroeconomic conditions.
• Examples of factors that might be included
are return on the market portfolio, an interest
rate factor, GDP, exchange rates, oil prices,
etc.
• Similarly, the expected risk premium on each
stock depends on the sensitivity to each
factor (b1, b2,...,bn) and the expected risk
166
 APT…
Expected Rate of Return=

In the special case where the expected risk

premium is proportional only to the
portfolio's market beta, APT and CAPM
are essentially identical.
APT theory has two central statements:

167
 APT…
1.A diversified portfolio designed to
eliminate the macroeconomic risk (i.e.
have zero sensitivity to each factor) is
essentially risk-free and will therefore be
priced such that it offers the risk-free rate
as interest.
2.A diversified portfolio designed to be
exposed to e.g. factor1, will offer a risk
premium that varies in proportion to the
portfolio's sensitivity to factor1. 168
 3.7.2 Consumption Beta

If investors are concerned about an

investment's impact on future consumption
rather than wealth, a security's risk is related
to its sensitivity to changes in the investor's
consumption rather than wealth. In this case
the expected return is a function of the stock's
consumption beta rather than its market beta.
Thus, under the consumption CAPM the
most important risks to investors are those
that might cutback future consumption.
169
 3.7.3 Three-Factor Model

•The three factor model is a variation of the

arbitrage pricing theory that explicitly states that
the risk premium on securities depends on three
common risk factors: a market factor, a size factor,
and a book-to market factor:

Where the three factors are measured in the following way:

- Market factor is the return on market portfolio minus the risk-free

rate
- Size factor is the return on small-firm stocks minus the return on
large-firm stocks (small minus big)
- Book-to-market factor is measured by the return on high book-to-
market value stocks minus the return on low book-value stocks (high
170
minus low)
 CHAPTER -5
Long Term Investment Decision
5.1 Cost of Capital with Preferred Stocks

•Some firms issue preferred stocks. In this case

the required return on the preferred stocks should
be included in the company's cost of capital.

Where firm value equals the sum of the market value of

debt, common, and preferred stocks.
171
• Where firm value equals the sum of the market
value of debt, common, and preferred stocks.
• The cost of preferred stocks can be calculated by
realizing that a preferred stock promises to pay a
fixed dividend forever.
• Hence, the market value of a preferred share is
equal to the present value of a perpetuity paying
the constant dividend:

172
Value of Preferred Stock

Thus, the cost of a preferred stock is

equal to the dividend yield.

Where
DIV = dividend
P= is price

173
Value of Preferred Stock…..

5.2 Cost of Capital for New Projects

A new investment project should be
evaluated based on its risk, not on
company cost of capital.

174
 Calculating Free Cash Flows

Free cash flow (FCF) is a measure of how

much cash a business generates after
accounting for capital expenditures such as
buildings or equipment.
This cash can be used for expansion,
dividends, reducing debt, or other purposes
Investors care about free cash flows as these
measure the amount of cash that the firm can
return to investors after making all
investments necessary for future growth. 175
 Calculating Free Cash Flows

Free cash flows can be calculated using

information available in the income
statement and balance sheet:
Free Cash Flow = Profit after Tax +
Depreciation + Investment in Fixed
Assets + Investment in Working Capital

176
What Should You Do With This Information?

• Companies that have a healthy free cash flow

have enough funds on hand to meet their bills
every month, plus some left over.
• A company with rising or high free cash flow
generally is doing well and might want to
consider expanding, whereas a company with
falling or low free cash flow (or no money left
over after covering the bills) may need to
restructure.
177
 Valuing Businesses

The value of a business is equal to the present value of all future

(free) cash flows using the after-tax WACC as the discount rate. A
project’s free cash flows generally fall into three categories:
1.Initial Investment
– Initial outlays including installation and training
costs
– After-tax gain if replacing old machine
2.Annual free cash flows: – Profits,
interests, and taxes – Working capital
3.Terminal Cash Flows
– Salvage value
– Taxable gains or losses associated with
the sale of assets.
178
 Valuing Businesses…

For long-term projects or stocks (which last

forever) a common method to estimate the
present value is to forecast the free cash flows
until a valuation horizon and predict the value of
the project at the horizon.
Both cash flows and the horizon values are
discounted back to the present using the after-tax
WACC as the discount rate:

179
 Valuing Businesses…

Where
FCFi = denotes free cash flows in year i,
WACC = the after-tax weighted average cost of capital and
PVt = the horizon value at time t.

180
There exist two common methods of how to
estimate the horizon value.
1.Apply the constant growth discounted
cash flow model, which requires a forecast
of the free cash flow in year t+1 as well as a
long-run growth rate (g):

181
 2. Apply multiples of earnings, which
assumes that the value of the firm can be
estimated as a multiple on earnings before
interest and taxes (EBIT) or earnings
before interest, taxes, depreciation, and
amortization (EBITDA):
PVt = EBIT Multiple . EBIT
PVt = EBITDA Multiple . EBITDA

182
 Valuing Businesses…

Example:
- If other firms within the industry trade at 6
times EBIT and the firm's EBIT is forecasted
to be €10 million, the terminal value at time t
is equal to 6*10 = €60 million.

183
 Capital budgeting in practice
Firms should invest in projects that are worth more than they
cost. Investment projects are only worth more than they cost
when the net present value is positive.
The net present value of a project is calculated by discounting
future cash flows, which are forecasted.
Thus, projects may appear to have positive NPV because of
errors in the forecasting.
To evaluate the influence of forecasting errors on the estimated
net present value of the projects several tools exist:

184
 Capital budgeting in practice…

1. Sensitivity Analysis
– Analysis of the effect on estimated NPV when underlying
assumptions change, e.g. market size, market share or
opportunity cost of capital.
– Sensitivity analysis uncovers how sensitive NPV is to
changes in key variables.

185
 Capital budgeting in practice…

2. Scenario Analysis
Analyzes the impact on NPV of a particular
combination of assumptions.
Scenario analysis is particularly helpful if variables
are interrelated, e.g. if the economy enters a
recession due to high oil prices, both the firm’s cost
structure, the demand for the product and inflation
might change.

186
 Capital budgeting in practice…

Senario Analysis ……
Thus, rather than analyzing the effect on NPV of a
single variable (as sensitivity analysis) scenario
analysis considers the effect on NPV of a consistent
combination of variables.
– Scenario analysis calculates NPV in different states,
e.g. pessimistic, normal, and optimistic.
Pessimistic – what happen when the economy enter
into recession
Increase in oil price which leads to
 Inflation
 Change of dd for the produt
 change of cost structure
187
 Capital budgeting in practice…

3. Break Even Analysis

 Analysis of the level at which the company breaks
even, i.e. at which point the present value of
revenues are exactly equal to the present value of
total costs.
 Thus, break-even analysis asks the question how
much should be sold before the production turns
profitable.

188
 Capital budgeting in practice…

4. Simulation Analysis – Monte Carlo simulation

considers all possible combinations of outcomes by
modeling the project.
Monte Carlo simulation involves four steps:
1. Modeling the project by specifying the project's
cash flows as a function of revenues, costs,
depreciation and revenues and costs as a function of
market size, market shares, unit prices and costs.
2. Specifying probabilities for each of the underlying
variables, i.e. specifying a range for e.g. the expected
market share as well as all other variables in the model
3. Simulate cash flows using the model and
probabilities
assumed above and calculate the net present value
189
 Why Projects Have Positive NPV

In addition to performing a careful analysis of the

investment project's sensitivity to the underlying
assumptions, one should always strive to understand
why the project earns economic rent and whether the
rents can be sustained.
Economic rents are profits that are more than cover
the cost of capital.
Economic rents only occur if one has:
- Better product -
Lower costs
- Another competitive
edge 190
 Why Projects Have Positive NPV…

Even with a competitive edge one should not assume

that other firms will watch passively. Rather one
should try to answer these questions:
- How long can the competitive edge be sustained?
- What will happen to profits when the edge
disappears?
- How will rivals react to my move in the
meantime?
o Will they cut prices?
o Will they imitate the product?
Sooner or later competition is likely to
eliminate economic rents.
191
 MARKET EFFICIENCY
• MARKET EFFICIENCY - DEFINITION AND TESTS.
Efficient market is one where the market price
is an unbiased estimate of the true value of
the investment.

192
 Market Efficiency

In an efficient market the return on a

security is compensating the investor for
time value of money and risk.
The efficient market theory relies on the
fact that stock prices follow a random
walk, which means that price changes are
independent of one another.
Thus, stock prices follow a random walk if
- the movement of stock prices from day to
day do not reflect any pattern. 193
 Market Efficiency…

- Statistically speaking, the movement of stock prices is

random.
- Time series of stock returns has low autocorrelation. In an
efficient market competition ensures that:
- New information is quickly and fully assimilated into
prices.
- All available information is reflected in the stock price.
- Prices reflect the known and expected, and respond
only to new information - Price changes occur in an
unpredictable way.
The efficient market hypothesis comes in three forms:
weak, semi-strong and strong efficiency.
194
 Market Efficiency…

Weak form efficiency

- Market prices reflect all historical price
information.
Semi-strong form efficiency
- Market prices reflect all publicly available
information.
Strong form efficiency
-Market prices reflect all information, both
public and private.
Slides: 36,37, & 38.
195
 Classical Stock Market anomaly
January-effect
Small poor-performing small cap stocks have historically tended to go
up in January, whereas strong-performing large caps have tended to
rally in December. The difference in performance of small cap and
large cap stock around January has be coined as the January-effect.
New-issue puzzle
Although new stock issues generally tend to be underpriced, the initial
capital gain often turns into losses over longer periods of e.g. 5 years.
S&P-Index effect
Stocks generally tend to rise immediately after being added to an
index (e.g. S&P 500, where the index effect was originally
documented).
Weekend effect
Small cap stocks have historically tended to rise on Fridays and fall on
Mondays, perhaps because sellers are afraid to hold short positions in
risky stocks over the weekend, so they buy back and re-initiate. 196
 Behavioural Finance

Behavioural finance applies scientific research on cognitive and

emotional biases to better understand financial decisions.
Cognitive refers to how people think. Thus, behavioral finance
emerges from a large psychology literature documenting that
people make systematic errors in the way that they think: they
are overconfident, they put too much weight on recent
experience, etc.
Behavioural finance might help us to understand some of the
apparent anomalies. However, critics say it is too easy to use
psychological explanations whenever there is something we do
not understand. Moreover, critics contend that behavioral finance
is more of a collection of anomalies than a true branch of finance
and that these anomalies will eventually be priced out of the
market or explained by appealing to market microstructure
arguments. 197
 CHAPTER - 6
6. Corporate Financing and Valuation

• How corporations choose to finance their investments

might have a direct impact on firm value.
• Firm value is determined by discounting all future
cash flows with the weighted average cost of
capital, which makes it important to understand
whether the weighted average cost of capital can
be minimized by selecting an optimal capital
structure (i.e. mix of debt and equity financing).
• To facilitate the discussion consider first the
characteristics of debt and equity. 198
 Debt Characteristics

Debt has the unique feature of allowing the

borrowers to walk away from their obligation to
pay, in exchange for the assets of the company.

“Default risk” is the term used to describe the

likelihood that a firm will walk away from its
obligation, either voluntarily or involuntarily.

“Bond ratings” are issued on debt instruments to

help investors assess the default risk of a firm.

199
 Debt Characteristics

Debt maturity
Short-term debt is due in less than 1Y
Long-term debt is due in more than 1Y
Debt can take many forms:
Bank overdraft
Commercial papers – used to finance your short term
financial needs. Rated as low credit risk. Eg. Promissory note
Mortgage loans
Bank loans
Subordinated convertible securities – which can be
converted to common stock at the option of the holder
Leases
Convertible bond
200
 6.2 Equity Characteristics

Ordinary shareholders:
- Are the owners of the business
- Have limited liability
- Hold an equity interest or residual claim on cash flows
- Have voting rights
Preferred shareholders:
-Shares that take priority over ordinary shares in
regards to dividends
- Right to specified dividends
- Have characteristics of both debt (fixed dividend) and
equity (no final repayment date)
- Have no voting privileges 201
 Debt Policy

The firm's debt policy is the firm's choice of mix of debt and
equity financing, which is referred to as the firm's capital
structure.

The prior section highlighted that this choice is not just a simple
choice between the financing sources: debt or equity.

There exist several forms of debt (accounts payable, bank debt,

commercial paper, corporate bonds, etc.) and two forms of equity
(common and preferred), not to mention hybrids.

However, for simplicity capital structure theory deals with

which combination of the two overall sources of financing
that maximizes firm value.
202
 Does the Firm's Debt Policy affect Firm Value?

The objective of the firm is to maximize shareholder value.

A central question regarding the firm's capital structure
choice is therefore whether the debt policy changes firm
value?
The starting point for any discussion of debt policy is the
influential work by Miller and Modigliani (MM), which
states the firm's debt policy is irrelevant in perfect
capital markets.
In a perfect capital market no market imperfections exist,
thus, alternative capital structure theories take into account
the impact of imperfections such as taxes, cost of bankruptcy
and financial distress, transaction costs, asymmetric
information and agency problems.
203
 1. Debt Policy in a Perfect Capital Market

The intuition behind Miller and Modigliani's

famous proposition I is that in the absence of
market imperfections it makes no difference
whether the firm borrows or individual
shareholders borrow. In that case the market value
of a company does not depend on its capital
structure. To assist their argument Miller and
Modigliani provide the following example:

204
 Debt Policy in a Perfect Capital Market …

Consider two firms, firm U and firm L, that

generate the same cash flow.
– Firm U is all equity financed (i.e. firm U is
unlevered).
– Firm L is financed by a mix of debt and equity
(i.e. firm L is levered).
Letting D and E denote debt and equity,
respectively, total value V is represented by:

205
- VU = EU for the unlevered Firm U
-VL = DL + EL for the levered Firm L
-Then, consider buying 1 percent of either firm U or
1 percent of L. Since Firm U is wholly equity
financed the investment of 1% of the value of U
would return 1% of the profits.
-However, as Firm L is financed by a mix of debt
and equity, buying 1 percent of Firm L is equivalent
to buying 1% of the debt and 1% of the equity.
-The investment in debt returns 1% of the interest
payment, whereas the 1% investment in equity
returns 1% of the profits after interest. 206
 Value of the firm
investment Return
1% Firm U 1%.Vu = EU 1%profit

1%firm L = 1%(DL + EL)

1%of D 1%DL 1% of interest
1%of E 1%EL 1%(profit-Inte)
1%(DL+EL)=1%VL =1%profit

207
 Miller and Modigliani's Proposition I

•In a perfect capital market firm value is

independent of the capital structure.
MM-theory demonstrates that if capital markets are
doing their job, firms cannot increase value by changing
their capital structure.
In addition, one implication of MM-theory is that
expected return on assets is independent of the debt
policy.
The expected return on assets is a weighted average of
the required rate of return on debt and equity.
208
Miller and Modigliani's Proposition I

209
 Miller and Modigliani's Proposition II

In a perfect market, a higher debt-

to-equity ratio leads to a higher
required return on equity, because
of the higher risk involved for
equity-holders in a company with
debt.

210
 Miller and Modigliani's Proposition II

At first glance MM's proposition II seems to be

inconsistent with MM’s proposition I, which states
that financial leverage has no effect on shareholder
value.
However, MM's proposition II is fully consistent
with their proposition I as any increase in expected
return is exactly offset by an increase in financial
risk borne by shareholders.
The financial risk is increasing in the debt-equity
ratio, as the percentage spreads in returns to
shareholders are amplified: 211
 Miller and Modigliani's Proposition II

• If operating income falls the percentage,

decline in the return is larger for levered
equity since the interest payment is a fixed
cost the firm has to pay independent of the
operating income.
• Finally, notice that even though the expected
return on equity is increasing with the
financial leverage, the expected return on
assets remains constant in a perfect capital
market. 212
 Miller and Modigliani's Proposition II

 Intuitively, this occurs because when

the debt-equity ratio increases the
relatively expensive equity is being
swapped with the cheaper debt.
Mathematically, the two effects
(increasing expected return on equity
and the substitution of equity with debt)
exactly offset each other.
213
How Capital Structure Affects the Beta Measure of Risk

Beta on assets is just a weighted-average of the

debt and equity beta:

Similarly, MM's proposition II can be expressed

in terms of beta, since increasing the debt-equity
ratio will increase the financial risk, beta on
equity will be increasing in the debt-equity ratio.

214
 How Capital Structure Affects the Beta Measure of Risk…..

• Again, notice MM's proposition I translates

into no effect on the beta on assets of
increasing the financial leverage.
• The higher beta on equity is exactly being
offset by the substitution effect as we swap
equity with debt and debt has lower beta than
equity.

215
 How Capital Structure affects Company Cost of
Capital

The impact of the MM-theory on company cost of capital can

be illustrated graphically.
Figure 9 assumes that debt is essentially risk free at its low
levels, whereas it becomes risky as the financial leverage
increases.
The expected return on debt is therefore horizontal until the
debt is no longer risk free and then increases linearly with the
debt-equity ratio.
MM's proposition II predicts that when this occurs the rate of
increase in rE will slow down.
Intuitively, as the firm has more debt, the less sensitive
shareholders are to further borrowing. 216
Ke is the cost of equity
Ko is overall cost of capital
Kd is the cost of debt
D/E is debt-equity ratio 217
 2. Capital Structure Theory When Markets are Imperfect

MM-theory conjectures that in a perfect capital market

debt policy is irrelevant.
In a perfect capital market no market imperfections exists.
However, in the real world corporations are taxed, firms
can go bankrupt and managers might be self-interested.
The question then becomes “What happens to the optimal
debt policy when the market imperfections are taken into
account?”
Alternative capital structure theories therefore address the
impact of imperfections such as taxes, cost of bankruptcy
and financial distress, transaction costs, asymmetric
information and agency problems. 218
 Introducing Corporate Taxes and Cost of Financial Distress

When corporate income is taxed, debt financing has one

important advantage: Interest payments are tax deductible.

The value of this tax shield is equal to the interest payment

times the corporate tax rate, since firms effectively will pay
(1-corporate tax rate) per dollar of interest payment.

Where TC is the corporate tax rate.

219
 Introducing Corporate Taxes and Cost of Financial Distress …

After introducing taxes MM's proposition I should

be revised to include the benefit of the tax shield:
Value of firm = Value of all-equity financed +
PV(tax shield)

Where:
Value of all equity financed=NI/k
220
 Example- Value of unlevered firm
Option –I
ALL EQUITY FINANCING-100% E
Sales…………………………………10,000
Costs…………………………………(6,000)
EBIT…………………………………....4,000
Interest……………………………………..0
EBT………………………………………4000
Tax (.4*4000)…………………….(1,600)
N/P…………………………………….2,400ETB

Vu=NI/k
Given k=16%
= 2,400/0.16
= 15,000
221
Example- debt and equity proportion
Option –II
50%D and 50%E
Sales…………………………………10,000
Costs…………………………………(6,000)
EBIT…………………………………....4,000
Interest…………………………………(600)
EBT………………………………………3,400
Tax (.4*3,400)……………………..(1,360)
N/P…………………………………….2,040ETB

VL= Vu+Tc*D
=15,000+0.4(5000)
= 15,000+2,000
=17,000
222
 Introducing Corporate Taxes and Cost of Financial Distress …

In addition, consider the effect of introducing the cost

of financial distress.
Financial distress occurs when shareholders exercise
their right to default and walk away from the debt.
Bankruptcy is the legal mechanism that allows
creditors to take control over the assets when a firm
defaults.
Thus, bankruptcy costs are the cost associated with
the bankruptcy procedure.
The corporate finance literature generally distinguishes
between direct and indirect bankruptcy costs:
223
 Direct bankruptcy costs are the legal and
administrative costs of the bankruptcy procedure such
as
·Legal expenses (lawyers and court fees)
·Advisory fees
Indirect bankruptcy costs are associated with how the
business changes as the firm enters the bankruptcy
procedure. Examples of indirect bankruptcy costs are:
Debt overhang
as a bankruptcy procedure might force the firm
to pass up valuable investment projects due to
limited access to external financing.
224
 Scaring off costumers:
a prominent example of how bankruptcy can scare
off customers is the Enron scandal. Part of Enron's
business was to sell gas futures (i.e. a contract that for
a payment today promises to deliver gas next year).
However, who wants to buy a gas future from a
company that might not be around tomorrow?
Consequently, all of Enron's futures business
disappeared immediately when Enron went bankrupt.
Agency costs of financial distress:
managers might be tempted to take excessive risk to
recover from bankruptcy.
Moreover, there is a general agency problem
between debt and shareholders in bankruptcy, since
shareholders are the residual claimants. 225
• The cost of financial distress will increase
with financial leverage as the expected cost
of financial distress is the probability of
financial distress times the actual cost of
financial distress.
• As more debt will increase the likelihood of
bankruptcy, it follows that the expected cost
of financial distress will be increasing in the
debt ratio.

226
 In summary, introducing corporate
taxes and cost of financial distress
provides a benefit and a cost of
financial leverage.
The trade-off theory conjectures that
the optimal capital structure is a
trade-off between interest tax shields
and cost of financial distress.

227
 The Trade-off Theory of Capital Structure

The trade-off theory states that the optimal capital

structure is a trade-off between interest tax shields and cost
of financial distress:
Value of firm = Value of all-equity financed + PV(tax
shield) - PV(cost of financial distress).
The trade-off theory can be summarized graphically.
The starting point is the value of the all-equity financed
firm illustrated by the black horizontal line in Figure 10.

228
 The Trade-off Theory of Capital Structure

The present value of tax shields is then added to form the red line.
Note that PV(tax shield) initially increases as the firm borrows
more, until additional borrowing increases the probability of
financial distress rapidly.
In addition, the firm cannot be sure to benefit from the full tax
shield if it borrows excessively as it takes positive earnings to save
corporate taxes.
Cost of financial distress is assumed to increase with the debt
level.

229
Figure 10, Trade-off theory of capital structure
Maximum
value of firm

Costs of
financial
distress

PV of
interest
tax shields

Value of
unlevered
firm

Optimal Debt level

debt level
As the graph suggests an optimal debt policy exists which maximizes firm value.
230
In summary, the trade-off theory states that capital
structure is based on a trade-off between tax
savings and distress costs of debt.
Firms with safe, tangible assets and plenty of
taxable income to shield should have high target
debt ratios.
The theory is capable of explaining why capital
structures differ between industries, whereas it
cannot explain why profitable companies within the
industry have lower debt ratios (trade-off theory
predicts the opposite as profitable firms have a
larger scope for tax shields and therefore
subsequently should have higher debt levels). 231
 The pecking order theory of capital structure

The pecking order theory has emerged as alternative

theory to the trade-off theory.
Rather than introducing corporate taxes and financial
distress into the MM framework, the key assumption of
the pecking order theory is asymmetric information.
Asymmetric information captures that managers
know more than investors and their actions therefore
provide a signal to investors about the prospects of the
firm.
The intuition behind the pecking order theory is derived
from considering the following string of arguments:
232
 The pecking order theory…
If the firm announces a stock issue it will drive down the
stock price because investors believe managers are more likely
to issue when shares are overpriced.
Therefore firms prefer to issue debt as this will allow the firm to
raise funds without sending adverse signals to the stock market.
Moreover, even debt issues might create information problems
if the probability of default is significant, since a pessimistic
manager will issue debt just before bad news get out.
This leads to the following pecking order in the financing
decision:
1. Internal cash flow
2. Issue debt
3. Issue equity
233
 The pecking order theory…

The pecking order theory states that internal

financing is preferred over external financing,
and if external finance is required, firms
should issue debt first and equity as a last
resort. Moreover, the pecking order seems to
explain why profitable firms have low debt ratios:
This happens not because they have low target
debt ratios, but because they do not need to obtain
external financing. Thus, unlike the trade-off
theory the pecking order theory is capable of
explaining differences in capital structures within
industries. 234
 Weighted Average Cost of Capital
All variables in the weighted average cost of
capital (WACC) formula refer to the firm as a
whole.

Where TC is the corporate tax rate. The after-

tax WACC can be used as the discount rate if
1.The project has the same business risk as
the average project of the firm
2.The project is financed with the same
amount of debt and equity 235
 Hypothetical example
• Consider a firm with a debt and equity ratio of 40% and 60%
respectively. The required rate of return on debt and equity is
7% and 12.5% respectively. Assuming a 30% corporate tax rate.
What is the after tax WACC of the firm?
• The firm is considering investing in a new project with a
perpetual stream of cash flows of $11.83 million per year pre
tax. The project has the same risk as the average project of the
firm
• Given an initial investment of $125million, which is financed
with 20% debt, what is the value of the project?
• The first insight is that although the business risk is identical ,
the project is financed with lower financial leverage. Thus the
WACC cannot be used as the discount rate for the project.
Rather, the WACC should be adjusted.
236
 Chapter 7
Dividend Policy and Payout

Distributions to Shareholders:
Dividends and Repurchases

237
 Does the Firm's Dividend Policy Affect Firm Value?
The objective of the firm is to maximize shareholder
value. A central question regarding the firm's dividend
policy is therefore whether the dividend policy changes
firm value?
As the dividend policy is the trade-off between retained
earnings and paying out cash, there exist three opposing
views on its effect on firm value:
1.Dividend policy is irrelevant in a competitive
market
2.High dividends increase value
3.Low dividends increase value
The first view is represented by the Miller and Modigliani
dividend-irrelevance proposition. 238
 Do investors prefer high or low payouts?

• There are three dividend theories:

– Dividends are irrelevant: Investors don’t
care about payout.
– Dividend preference, or bird-in-the-hand:
Investors prefer a high payout.
– Tax effect: Investors prefer a low payout.

239
 1. Miller and Modigliani Dividend-
Irrelevance Proposition
In a perfect capital market the dividend policy is
irrelevant. Assumptions
o No market imperfections
o No taxes
o No transaction costs

240
 Miller and Modigliani Dividend-
Irrelevance Proposition…
• Investors are indifferent between dividends
and retention-generated capital gains. If they
want cash, they can sell stock. If they don’t
want cash, they can use dividends to buy
stock.
• Modigliani-Miller support irrelevance.
• Implies payout policy has no effect on stock
value or the required return on stock.
• Theory is based on unrealistic assumptions (no
taxes or brokerage costs).

241
 Dividend Preference (Bird-in-the-Hand)
Theory
• Investors might think dividends (i.e., the-bird-
in-the-hand) are less risky than potential
future capital gains.
• Also, high payouts help reduce agency costs by
depriving managers of cash to waste and
causing managers to have more scrutiny by
going to the external capital markets more
often.
• Therefore, investors would value high payout
firms more highly and would require a lower
return to induce them to buy its stock.
242
 Tax Effect Theory
• Low payouts mean higher capital gains. Capital
gains taxes are deferred until they are realized,
so they are taxed at a lower effective rate than
dividends.
• This could cause investors to require a higher
pre-tax return to induce them to buy a high
payout stock, which would result in a lower
stock price.

243
 Chapter-8
Options

An option is a contractual agreement that gives the

buyer the right but not the obligation to buy or sell
a financial asset on or before a specified date.
However, the seller of the option is obliged to
follow the buyer's decision.

244
 Chapter-8
Options

Call option: Right to buy a financial asset at a specified

exercise price (strike price) on or before the exercise date.
Put option: Right to sell a financial asset at a specified
exercise price on or before the exercise date.
Exercise price (Striking price): The price at which you buy or
sell the security.
Expiration date: The last date on which the option can be
exercised.

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 Reader Two
Financial Objectives and Shareholder Wealth
Investors maximize their wealth by selecting
optimum investment and financing opportunities,
using financial models that maximize expected
returns in absolute terms at minimum risk.
The normative objective of financial management
should be:
To implement investment and financing decisions
using risk-adjusted wealth maximizing criteria, which
satisfy the firm’s owners (the shareholders) by placing
them all in an equal, optimum financial position. 246
 Financial Objectives and Shareholder Wealth…
•Armed with agency theory, you will discover that
the function of strategic financial management can
be deconstructed into four major components
based on the mathematical concept of expected
net present value (ENPV) maximization:
•The investment, dividend, financing and
portfolio decisions.
•In our ideal world, each is designed to maximize
shareholders’ wealth using the market price of an
ordinary share (or common stock to use American
parlance) as a performance criterion.
247
 Financial Objectives and Shareholder Wealth…

The over-arching, normative objective

of strategic financial management
should be the maximization of
shareholders’ wealth represented by
their ownership stake in the
enterprise, for which the firm’s
current market price per share is a
disciplined, universal metric.
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 Wealth Creation and Value Added
Modern finance theory regards capital
investment as the springboard for
wealth creation. Essentially, financial
managers maximize stakeholder wealth
by generating cash returns that are more
favorable than those available elsewhere.
In a mature, mixed market economy, they
translate this strategic goal into action
through the capital market.
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 The Investment and Finance Decision
•Investment policy selects an optimum
portfolio of investment opportunities that
maximizes anticipated net cash inflows
(ENPV) at minimum risk.
•Finance policy identifies potential fund
sources (equity and debt, long or short)
required to sustain investment, evaluates the
risk-adjusted returns expected by investors
and then selects the optimum mix that will
minimize their overall weighted average cost of
capital (WACC). 250
In terms of the corporate investment
decision, a firm’s WACC represents the
overall cut-off rate that justifies the
financial decision to acquire funding for
an investment proposal (as we shall
discover, a zero NPV).
In an ideal world of wealth maximization,
it follows that if corporate cash profits
exceed overall capital costs (WACC) then
NPV will be positive, producing a positive
EVA. 251
Thus, if management wish to increase
shareholder wealth, using share price (MVA)
as a vehicle, then it must create positive EVA
as the driver.
- Negative EVA is only acceptable in the short
term.
- If share price is to rise in the long term, then a
company should not invest funds from any
source unless the marginal yield on new
investment at least equals the rate of return
that the provider of capital can earn elsewhere
on comparable investments of equivalent risk.
252
• Economic Value Added (EVA), is an
estimate of a firm's economic profit –
being the value created in excess of the
required return of the company's
investors (shareholders and debt holders).
Quite simply, EVA is the profit earned by
the firm less the
cost of financing the firm's capital. The
idea is that value is created when the
return on the firm's economic capital
employed is greater than the cost of that
253
• The firm's Market Value Added,
or MVA, is the discounted sum
(present value) of all future
expected economic value added.
• The firm's Market Value Added,
or MVA, is the discounted sum
(present value) of all future
expected economic value added.
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THANK YOU

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