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


Introduction and course outline Foundations Present values and NPV rule No arbitrage 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 ManagementTasks: Investment decision, Financing decision, Risk managementFocus 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? 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 CapitalWhat 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: NPVThe 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.

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 ArbitrageThe 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 MarketA competitive market in which there are no arbitrage opportunities.

Determining the No-Arbitrage PriceUnless 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


Foundations: Time Value of Money

Three Rules of Time TravelFinancial 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

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

Present Value of an Annuity

Future Value of an Annuity

Growing Perpetuities Assume you expect the amount of your perpetual payment to increase at a constant rate, g.

Present Value of a Growing Perpetuity

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 MaturityThe 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

For the one-year zero coupon bond:

Thus, the YTM is 3.5%. Yield to Maturity of an n-Year Zero-Coupon Bond


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

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


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

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.

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

Coupon Bond Yields Given the yields for zero-coupon bonds, we can price a coupon bond.

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. 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 SharesStock 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

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

Dividend Yield Capital Gain Capital Gain Rate

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?

This is known as the Dividend Discount Model.

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

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

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.