1 Lecture 1 FINM7007 Applied Corporate Finance CHAPTER 1, 3, 4, 6, 9

- Introduction and course outline

- Foundations
o Present values and NPV rule
o No arbitrage
o Separation principle
- Time Value of Money
- Valuation of Bonds and Stocks

Financial Management
- The study of how financial managers decide
what projects to invest in, and
how these projects should be funded.
- Involves the comparison of risky cash flows through time.
- Success is judged in terms of value.

The Tasks of Financial Management
Tasks:
- Investment decision,
- Financing decision,
- Risk management
Focus on investment and financing decisions

What are the Issues?
Consider:
Toll Holdings management is evaluating an investment of $20 million in a new complex at
Mascot for handling both international and domestic freight. The project has an expected
life of 10 years.
The investment committee proposed to implement this proposal in two stages, depending
upon demand.
The committee also raised the possibility of developing a complementary freight facility in the
UK and US.
Question:
What is involved in evaluating this investment opportunity?

Cash Flow Estimation
- What are the relevant cash flows associated with the investment proposal.
- How sensitive is the projects NPV to the projected freight demand?
How do I incorporate this in my analysis?
- What is the possible impact of competitors?

2 Lecture 1 FINM7007 Applied Corporate Finance CHAPTER 1, 3, 4, 6, 9
- How do we incorporate this in our analysis?
- How do we allow for the development of freight complexes in both the UK and the US?
- Would the analysis change?
- Are the risks facing Toll Holdings any different?

The Cost of Capital
What is the cost of capital against which the project is evaluated?
- Estimating the cost of capital
The risk/return trade-off and the CAPM.
Do we do the analysis before or after taxes?
How do we estimate the cost of equity?
What is the appropriate risk-free rate of return?
How is the market risk premium estimated?
How is beta (factors) estimated?
How do we estimate the cost of debt?
What is the appropriate risk-free rate of return?

What Form of Financing Should be Used?
- Can Toll Holdings leverage choice its' value?
current funds from debt rather than equity
Is it optimal to rely predominantly on debt financing?
Is there an optimal capital structure?
What is the impact of taxes?
Can the choice of financing tell the market anything about
the firm and/or the project?

- Can Toll Holdings choice of financing affect the projects value?
Are the financing and investments decisions independent?
What of the differences in obligations and issue costs for the various
security types?
- Does it matter where the project is sited or how it is funded?

Foundations: NPV
The net present value (NPV) of a project or investment is the difference between the
present value of its benefits and the present value of its costs.



The NPV Decision Rule
When making an investment decision, take the alternative with the highest NPV.
Choosing this alternative is equivalent to receiving its NPV in cash today.
(Benefits) (Costs) = NPV PV PV
(All project cash flows) = NPV PV

3 Lecture 1 FINM7007 Applied Corporate Finance CHAPTER 1, 3, 4, 6, 9

Accepting or Rejecting a Project
Accept those projects with positive NPV because accepting them is
equivalent to receiving their NPV in cash today.

Reject those projects with negative NPV because accepting them would
reduce the wealth of investors.

Foundations: Separation Principle
- Financing decisions do not create value but adjust the timing and risk of cash
flows to meet the needs of the firm or its investors
- Value is created by undertaking investment opportunities
- Implication: Evaluate investment opportunities separately for the decision as to
how to finance them

Foundations: No Arbitrage
Arbitrage
The practice of buying and selling equivalent goods in different markets to take
advantage of a price difference. An arbitrage opportunity occurs when it is
possible to make a profit without taking any risk or making any investment.
Normal Market
A competitive market in which there are no arbitrage opportunities.

Determining the No-Arbitrage Price
Unless the price of the security equals the present value of the securitys cash flows, an
arbitrage opportunity will appear.
No Arbitrage Price of a Security
Price(Security) (All cash flows paid by the security) = PV

Example


4 Lecture 1 FINM7007 Applied Corporate Finance CHAPTER 1, 3, 4, 6, 9


Foundations: Time Value of Money












5 Lecture 1 FINM7007 Applied Corporate Finance CHAPTER 1, 3, 4, 6, 9
Three Rules of Time Travel
Financial decisions often require combining cash flows or comparing values. Three rules
govern these processes.

Perpetuities, Annuities, and Other Special Cases
When a constant cash flow will occur at regular intervals forever it is called a
perpetuity.
The value of a perpetuity is simply the cash flow divided by the interest rate.
Present Value of a Perpetuity
( in perpetuity) =
C
PV C
r

Annuities
- When a constant cash flow will occur at regular intervals for N periods it is
called an annuity.

- Present Value of an Annuity
1 1
(annuity of for periods with interest rate ) 1
(1 )
| |
=
|
+
\ .
N
PV C N r C
r r

- Future Value of an Annuity
( )
(annuity) V (1 )
1
1 (1 )
(1 )
1
(1 ) 1
= +
| |
= +
|
+
\ .
= +
N
N
N
N
FV P r
C
r
r r
C r
r


6 Lecture 1 FINM7007 Applied Corporate Finance CHAPTER 1, 3, 4, 6, 9
Growing Perpetuities
- Assume you expect the amount of your perpetual payment to increase at a
constant rate, g.

- Present Value of a Growing Perpetuity
(growing perpetuity)

=

C
PV
r g


Zero-Coupon Bonds
- Zero-Coupon Bond
Does not make coupon payments
Always sells at a discount (a price lower than face value), so they are
also called pure discount bonds
Treasury Bills are U.S. government zero-coupon bonds with a maturity of
up to one year.
- Suppose that a one-year, risk-free, zero-coupon bond with a $100,000 face value
has an initial price of $96,618.36. The cash flows would be:

Although the bond pays no interest, your compensation is the difference
between the initial price and the face value.

- Yield to Maturity
The discount rate that sets the present value of the promised bond payments
equal to the current market price of the bond.
Price of a Zero-Coupon bond

(1 )
=
+
n
n
FV
P
YTM

For the one-year zero coupon bond:





Thus, the YTM is 3.5%.
1
100,000
96,618.36
(1 )
=
+ YTM
1
100,000
1 1.035
96,618.36
+ = = YTM

7 Lecture 1 FINM7007 Applied Corporate Finance CHAPTER 1, 3, 4, 6, 9
Yield to Maturity of an n-Year Zero-Coupon Bond
1
1
| |
=
|
\ .
n
n
FV
YTM
P

Example


- Risk-Free Interest Rates
A default-free zero-coupon bond that matures on
date n provides a risk-free return over the same period. Thus, the Law of
One Price guarantees that the
risk-free interest rate equals the yield to maturity on such a bond.

Risk-Free Interest Rate with Maturity n
=
n n
r YTM


Coupon Bonds
- Coupon Bonds
Pay face value at maturity
Pay regular coupon interest payments

- Treasury Notes
U.S. Treasury coupon security with original maturities of 110 years

- Treasury Bonds
U.S. Treasury coupon security with original maturities over 10 years


8 Lecture 1 FINM7007 Applied Corporate Finance CHAPTER 1, 3, 4, 6, 9
Example


- Yield to Maturity
The YTM is the single discount rate that equates the present value of the
bonds remaining cash flows to its current price.

Yield to Maturity of a Coupon Bond
1 1
1
(1 ) (1 )
| |
= +
|
+ +
\ .
N N
FV
P CPN
y y y


Interest Rate Changes and Bond Prices
- There is an inverse relationship between interest rates and bond prices.
As interest rates and bond yields rise, bond prices fall.
As interest rates and bond yields fall, bond prices rise.

The Yield Curve and Bond Arbitrage
- Using the Law of One Price and the yields of default-free zero-coupon bonds,
one can determine the price and yield of any other default-free bond.

- The yield curve provides sufficient information
to evaluate all such bonds.


9 Lecture 1 FINM7007 Applied Corporate Finance CHAPTER 1, 3, 4, 6, 9
Valuing a Coupon Bond Using Zero-Coupon Yields
- The price of a coupon bond must equal the present value of its coupon payments
and face value.
Price of a Coupon Bond
2
1 2
(Bond Cash Flows)
V

1 (1 ) (1 )
=
+
= + + +
+ + +
n
n
PV PV
CPN CPN CPN F
YTM YTM YTM

2 3
100 100 100 1000
$1153
1.035 1.04 1.045
+
= + + = P


Coupon Bond Yields
- Given the yields for zero-coupon bonds, we can price a coupon bond.
2 3
100 100 100 1000
1153
(1 ) (1 ) (1 )
+
= = + +
+ + +
P
y y y
2 3
100 100 100 1000
$1153
1.0444 1.0444 1.0444
+
= + + = P


Treasury Yield Curves
- Treasury Coupon-Paying Yield Curve
Often referred to as the yield curve
- On-the-Run Bonds
Most recently issued bonds
The yield curve is often a plot of the yields on
these bonds.

Corporate Bonds
- Corporate Bonds
Issued by corporations
- Credit Risk
Risk of default

Corporate Bond Yields
- Investors pay less for bonds with credit risk than they would for an otherwise
identical default-free bond.

10 Lecture 1 FINM7007 Applied Corporate Finance CHAPTER 1, 3, 4, 6, 9
- The yield of bonds with credit risk will be higher than that of otherwise identical
default-free bonds.
Corporate Yield Curves for Various Ratings, September 2005

Valuation of Shares
Stock Prices, Returns, and the Investment Horizon
- A One-Year Investor
Potential Cash Flows
Dividend
Sale of Stock
Timeline for One-Year Investor

Since the cash flows are risky, we must discount them at the
equity cost of capital.
- A One-Year Investor
1 1
0


1
| | +
=
|
+
\ . E
Div P
P
r

If the current stock price were less than this amount, expect investors to
rush in and buy it, driving up the stocks price.
If the stock price exceeded this amount, selling it would cause the stock
price to quickly fall.

Dividend Yields, Capital Gains, and Total Returns
1 0 1 1 1
0 0 0
Dividend Yield Capital Gain Rate

1
+
= = +
E
P P Div P Div
r
P P P

- Dividend Yield
- Capital Gain
Capital Gain Rate

11 Lecture 1 FINM7007 Applied Corporate Finance CHAPTER 1, 3, 4, 6, 9

- Total Return
Dividend Yield + Capital Gain Rate
The expected total return of the stock should equal the expected
return of other investments available in the market with equivalent
risk.

A Multi-Year Investor (cont'd)
- What is the price if we plan on holding the stock for N years?
1 2
0 2
E E E E

1 (1 ) (1 ) (1 )
= + + + +
+ + + +
N N
N N
Div P Div Div
P
r r r r

This is known as the Dividend Discount Model.

3 1 2
0
2 3
1
E E E E

1 (1 ) (1 ) (1 )

=
= + + + =
+ + + +

n
n
n
Div Div Div Div
P
r r r r

- The price of any stock is equal to the present value of the expected future
dividends it will pay.

The Discount-Dividend Model
- Constant Dividend Growth
The simplest forecast for the firms future dividends states that they will grow
at a constant rate, g, forever.

- Constant Dividend Growth Model
1
0
E


=

Div
P
r g

1
E
0
= +
Div
r g
P

The value of the firm depends on the current dividend level, the cost of equity,
and the growth rate.

Dividends Versus Investment and Growth
- A Simple Model of Growth
Dividend Payout Ratio
The fraction of earnings paid as dividends each year

12 Lecture 1 FINM7007 Applied Corporate Finance CHAPTER 1, 3, 4, 6, 9
E
Earnings
Dividend Payout Rate
Shares Outstanding
=
t
t
t t
t
PS
Div

- A Simple Model of Growth
Assuming the number of shares outstanding is constant, the firm can do two
things to increase its dividend:
Increase its earnings (net income)
Increase its dividend payout rate

A firm can do one of two things with its earnings:
It can pay them out to investors.
It can retain and reinvest them.
Change in Earnings New Investment Return on New Investment =

New Investment Earnings Retention Rate =

Retention Rate
Fraction of current earnings that the firm retains
Change in Earnings
Earnings Growth Rate
Earnings
Retention Rate Return on New Investment
=
=

Retention Rate Return on New Investment = g

If the firm keeps its retention rate constant, then the growth rate in dividends
will equal the growth rate of earnings.

- Profitable Growth

If a firm wants to increase its share price, should it cut its dividend and invest
more, or should it cut investment and increase its dividend?
The answer will depend on the profitability of the
firms investments.
- Cutting the firms dividend to increase investment will raise
the stock price if, and only if, the new investments have a
positive NPV.
Example

13 Lecture 1 FINM7007 Applied Corporate Finance CHAPTER 1, 3, 4, 6, 9


Changing Growth Rates
We cannot use the constant dividend growth model to value a stock if the growth rate is
not constant.
For example, young firms often have very high initial earnings growth rates.
During this period of high growth, these firms often retain 100% of their
earnings to exploit profitable investment opportunities. As they mature, their
growth slows. At some point, their earnings exceed their investment needs
and they begin to pay dividends.
Although we cannot use the constant dividend growth model directly when growth is not
constant, we can use the general form of the model to value a firm by applying the

14 Lecture 1 FINM7007 Applied Corporate Finance CHAPTER 1, 3, 4, 6, 9
constant growth model to calculate the future share price of the stock once the expected
growth rate stabilizes.
1
E


+
=

N
N
Div
P
r g

Dividend-Discount Model with Constant Long-Term Growth
1 1 2
0 2
E E E E E
1

1 (1 ) (1 ) (1 )
+
| |
= + + + +
|
+ + + +
\ .
N N
N N
Div Div Div Div
P
r r r r r g

Example


15 Lecture 1 FINM7007 Applied Corporate Finance CHAPTER 1, 3, 4, 6, 9

The Discounted Free Cash Flow Model
- Discounted Free Cash Flow Model
Determines the value of the firm to all investors, including both equity and
debt holders
Enterprise Value Market Value of Equity Debt Cash = +

The enterprise value can be interpreted as the net cost of acquiring the
firms equity, taking its cash, paying off all debt, and owning the unlevered
business.

- Valuing the Enterprise
Unlevered Net Income
Free Cash Flow (1 ) Depreciation
Capital Expenditures Increases in Net Working Capital
= t +

c
EBIT


- Discounted Free Cash Flow Model
0
(Future Free Cash Flow of Firm) = V PV


16 Lecture 1 FINM7007 Applied Corporate Finance CHAPTER 1, 3, 4, 6, 9
0 0 0
0
0
Cash Debt

Shares Outstanding
+
=
V
P


- Implementing the Model
Since we are discounting cash flows to both equity holders and debt
holders, the free cash flows should be discounted at the firms weighted
average cost of capital, r
wacc
. If the firm has no debt, r
wacc
= r
E
.
1 2
0
2
wacc wacc wacc wacc

1 (1 ) (1 ) (1 )
= + + + +
+ + + +
N N
N N
FCF V FCF FCF
V
r r r r

Often, the terminal value is estimated by assuming a constant long-run
growth rate g
FCF
for free cash flows beyond year N, so that:
1
wacc wacc
1

( )
+
| | +
= =
|

\ .
N FCF
N N
FCF FCF
FCF g
V FCF
r g r g


Example


17 Lecture 1 FINM7007 Applied Corporate Finance CHAPTER 1, 3, 4, 6, 9

- Connection to Capital Budgeting
The firms free cash flow is equal to the sum of the free cash flows from
the firms current and future investments, so we can interpret the firms
enterprise value as the total NPV that the firm will earn from continuing its
existing projects and initiating new ones.
The NPV of any individual project represents its contribution to the
firms enterprise value. To maximize the firms share price, we
should accept projects that have a positive NPV.

Valuation Based on Comparable Firms
- Method of Comparables (Comps)
Estimate the value of the firm based on the value of other, comparable
firms or investments that we expect will generate very similar cash flows
in the future.





18 Lecture 1 FINM7007 Applied Corporate Finance CHAPTER 1, 3, 4, 6, 9
Valuation Multiples
- Valuation Multiple
A ratio of firms value to some measure of the firms scale or cash flow

- The Price-Earnings Ratio
P/E Ratio
Share price divided by earnings per share
- Trailing Earnings
Earnings over the last 12 months
- Trailing P/E
- Forward Earnings
Expected earnings over the next 12 months
- Forward P/E
0 1 1
1 E E
/ Dividend Payout Rate
Forward P/E

= = =

P Div EPS
EPS r g r g

- Firms with high growth rates, and which generate cash well in excess of their
investment needs so that they can maintain high payout rates, should have high
P/E multiples.
Example
Problem
Best Buy Co. Inc. (BBY) has earnings per share
of $2.22.
The average P/E of comparable companies stocks
is 19.7.
Estimate a value for Best Buy using the P/E as a valuation multiple.
Solution
The share price for Best Buy is estimated by multiplying its earnings per
share by the P/E of comparable firms.
P
0
= $2.22 19.7 = $43.73

Stock Valuation Techniques: The Final Word
- No single technique provides a final answer regarding a stocks true value. All
approaches require assumptions or forecasts that are too uncertain to provide a
definitive assessment of the firms value.
Most real-world practitioners use a combination of these approaches and
gain confidence if the results are consistent across a variety of methods.