MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

2253 Corporate Finance

EISERT / GAVRILOVA / OLIVEIRA

MODULE I

LECTURE SLIDES
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Session 1:
1.1 Introduction
1.2 Investment decisions (NPV, IRR)

2
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Instructors
Sections TA, TB : Tim Eisert

Email: tim.eisert@novasbe.pt

Sections TC, TD : Miguel Oliveira

Email: miguel.oliveira@novasbe.pt

Sections TE, TF: Ekaterina Gavrilova

Email: ekaterina.gavrilova@novasbe.pt

3
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Teaching assistants
• Miguel Marques miguel.marques@novasbe.pt
• David Pinto david.pinto@novasbe.pt
• João Caetano joao.caetano@novasbe.pt
• João Costa Delgado joao.c.delgado@novasbe.pt
• Mafalda Afonso mafalda.afonso@novasbe.pt
• Mehdi Lehlali mehdi.lehlali@novasbe.pt
• Miguel Marecos Duarte miguel.m.duarte@novasbe.pt

4
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Textbook
Berk, Jonathan and Peter DeMarzo (BD), Corporate Finance,
Prentice Hall.
• Textbook (recommended but not required)
• The lecture notes are self-contained

Supplementary Resources:
• Brealey, Richard A., Myers, Stewart C., and Franklin Allen (BMA), Principles of
Corporate Finance, McGraw-Hill.
• Grinblatt, Mark and Sheridan Titman (GT), Financial Markets and Corporate
Strategy, McGraw-Hill Irwin.
• Ivo Welch (W), Corporate Finance, http://book.ivo-welch.info/home/

5
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Session formats
• Lectures

–Mostly theoretical material will be covered

• Exercise sessions

–We will be solving problems related to the material covered in the lectures

6
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Important dates
Make-up classes for Sections TA, TB
No class Make-up class
October 5 (holiday) October 16

No Make-up classes for Sections TC, TD, TE, TF

7
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Course assignments and final exam

• 15% - Case study Ocean Carriers - Deadline: October 1, 8pm

• 25% - Valuation of one company - Deadline: November 19, 8pm

• 60% - Final exam – Date: December 20, 8.30am

One-bonus point for attending at least 75% of classes and

completing in-class quizzes

8
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Group assignments
Case study Ocean Carriers & Company Valuation

• Group composition: 3-5 students

- Sign-up your group on Moodle. Deadline: September 17, 8pm

- It will remain the same for both assignments

• Submission: Link on Moodle

• Late submissions are not accepted (if Moodle is down, send an email to
miguel.marques@novasbe.pt)

9
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

In-class quizzes
• Starting next week, available on Moodle.

• Must be in class to complete the quiz and only counts if you are
attending the correct session

• 10-15 minutes quizzes with 5-8 multiple choice questions

• Attending class and completing at least 75% of quizzes: one bonus

point in your final grade

10
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Problem sets (not graded)

• Problem sets and solutions will be provided on Moodle on a
regular basis.

• They will help you to check your understanding and retain the
knowledge that you gained in class.

11
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Final exam
• Takes place at 8.30am on December 20

• 90-minutes closed-book exam on Wiseflow (paperless exam)

• 14 MC questions and 2 open questions, of which:

–2 MC questions will be taken from in-class quizzes

–2 MC questions will be taken from the problem sets

12
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Moodle forum and office hours

• Moodle forum: post your questions about problem sets and
slides
–Reply time within 48 hours

• Instructor office hours: by appointment

• TA office hours: TBA

13
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Changing sections
Students are not allowed to change sections. Requests
are to be made formally to the Masters team, not to the
professor in charge.

14
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

How to prepare
• After each class review the lecture slides
• Solve the problem sets
• Work in groups
• Ask for help

15
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Questions?

Comments?

Concerns?

16
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Institutional details

17
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Corporate finance
Goal is to maximize shareholder value through long-term and short-
term financing planning and the implementation of various strategies

Main firm activities:

• Capital financing

• Capital investment

• Dividends and return on capital

• Working capital management

18
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

The role of firms

• Goal of the Firm
– Shareholders will agree that they are better off if management
makes decisions that maximize the value of their shares
• The Firm and Society
– Often, a corporation’s decisions that increase the value of the firm’s
equity benefit society as a whole
– It becomes a problem when increasing the value of the firm’s equity
comes at the expense of others (negative externalities)

19
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Corporate finance course at glance

Investment • NPV, IRR, Payback, Profitability index
• Capital budgeting
decisions • Assignment: Ocean Carrier case study

Financing decisions • Capital structure

• Taxes

• How to value a company?

Company valuation • Advanced valuation methods, including real options
• Assignment: company valuation

• Bankruptcy and financial distress

Advanced CF topics • Agency problems and asymmetric information

• Payout policy
• Corporate governance and employee compensation

20
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Types of firms
• Sole Proprietorship

• Partnership

• Limited Liability Company

• Corporation

21
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Corporation (1/2)
• A legal entity separate from its owners

• Has many of the legal powers individuals have such as the ability to
enter into contracts, own assets, and borrow money

• The corporation is solely responsible for its own obligations; its

owners are not liable for any obligation the corporation enters into

22
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Corporation (2/2)
• Ownership
– Represented by shares of stock
– Owner of stock is called shareholder (or stockholder, or equity
holder)
– Sum of all ownership value is called equity
– There is no limit to the number of shareholders and, thus, to the
amount of funds a company can raise by selling stock
– Owner is entitled to dividend payments

23
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Ownership vs. control

• In a corporation, ownership and direct control
are typically separate.
• Board of Directors
– Elected by shareholders
– Have ultimate decision-making authority
• Chief Executive Officer (CEO)
– Board typically delegates day-to-day decision
making to CEO

24
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Financial manager
• Responsible for
–Investment decisions
–Financing decisions
–Cash management

25
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Agency problems
• Managers may act in their own interest rather than in the best
interest of the shareholders

• One potential solution is to tie management’s compensation to

firm performance

• How should performance be measured?

26
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Corporate bankruptcy
• Reorganization

• Liquidation

27
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Corporations and the stock market

• Public Company

– Stock is traded by the public on a stock exchange

• Private Company

– Stock may be traded privately

• The stock market provides liquidity to shareholders

– Liquidity: the ability to easily sell an asset for close to the price at
which you can currently buy it

28
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Primary and secondary markets

• Primary Markets

– When a corporation itself issues new shares of stock and sells

them to investors, they do so on the primary market

• Secondary Markets

– After the initial transaction in the primary market, the shares

continue to trade in a secondary market between investors

29
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Financial decision making

30
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Net Present Value

• 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.

• 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

–Only accept those projects with positive NPV because accepting them is
equivalent to receiving their NPV in cash today.

31
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Example
• You have saved up $25,000 for a new car.
• A car dealer is offering the car you want for a price of $25,000 with 0%
financing for one year or a cash price of $23,500.

Ø If the applicable interest rate is 4%, which deal is better, the cash
deal or the 0% financing deal?

32
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
• If you take the 0% financing offer, the benefit is that you won’t have to pay
$25,000 for a year. However, if you pay cash, you will save $1,500 today. We
therefore convert the cost in one year to a present value at the 4% interest rate:
–PVCost of 0% deal today = $25,000/1.04 = $24,038.46
–The cost in today’s dollars is $24,038.46. This is greater than the cash price
today. Taking the cash deal is equivalent to getting:
$24,038.46 - $23,500 = $538.46 today

33
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Choosing among alternatives

• We can also use the NPV decision rule to choose among projects.

• To do so, we must compute the NPV of each alternative, and then select the
one with the highest NPV.

• This alternative is the one which will lead to the largest increase in the value
of the firm.

34
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Example
• You have $10,000 to invest and are considering three one-year risk-free
investment options:
1.Invest up to $10,000 in a T-Bill paying 2%
2.Invest in a project that costs $6,000 and returns $6,100 in one year
3.Invest in a project that costs $4,000 and returns $4,100 in one year

ØHow should the $10,000 investment be allocated?

35
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
• Since all of investment options are for one year and risk-free, the
appropriate discount rate is 2%. The PV of each investment @ 2% is:
1.Investing $10,000 in the T-Bill
•NPV = $10,000(1.02)/1.02 - $10,000 = $0.00
2.Investing $6,000 and receiving $6,100
•NPV = $6,100/1.02 - $6,000 = -$19.61
3.Investing $4,000 and receiving $4,100
•NPV = $4,100/1.02 - $4,000 = $19.61

36
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution (ctd.)
• Given that the #2 investment has a negative NPV, it should not be
considered. However, only investing in #3 uses just $4,000 of the available
funds to invest, yielding a total NPV of
($4,100 + $6,000)/1.02 - $10,000 = -$98.04

• The optimal strategy is to invest $4,000 in #3 and $6,000 in the T-Bill. The
NPV of this strategy is
[$4,100 + $6,000(1.02)]/1.02 - $10,000 = $19.61

37
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution (ctd.)
• Even though the NPV of the T-Bill investment is $0, it is a better
investment than not investing those funds at all.

• Thus, the total NPV of investing $4,000 in Project 3 and $6,000 in T-Bills
yields an NPV of $19.61 (NPV of Project 3) plus an NPV of $0 (NPV of T-
Bill), yielding a total NPV of $19.61

38
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

NPV and cash needs

• Regardless of our preferences for cash today versus cash in the future,
we should always maximize NPV first.

• We can then borrow or lend to shift cash flows through time and find
our most preferred pattern of cash flows.

39
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

NPV of trading securities and firms’ decisions

• In a normal market (no arbitrage, competitive), the NPV of buying or
selling a security is zero.

NPV (Buy security) = PV (All cash flows paid by the security) - Price(Security)
= 0

NPV (Sell security) = Price(Security) - PV (All cash flows paid by the security)
= 0

40
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

NPV of trading securities and firms’ decisions

• Separation Principle
–We can evaluate the NPV of an investment decision separately from the
decision the firm makes regarding how to finance the investment or any
other security transactions the firm is considering.
–Caveat: informational frictions sometimes invalidate this result (to study
later)

41
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Example
• Consider a risk-free investment that costs $7000 and pays $8500 in one
year.

• You can either pay all cash for the investment or you can borrow half and
pay cash for the other half. If you borrow $3500, you will be required to pay
back $3710 in one year.

• The risk-free rate is 6%.

Ø What is the project’s NPV? Is the NPV affected if you borrow some of the
funds?

42
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
• If you pay all cash, the NPV of the project is
$8500/(1.06) - $7000 = $1018.87

• If you borrow $3,500 to finance half of the project, the NPV of the project is
($8500 - $3710)/1.06 - $3500 = $1018.87

• The method of financing the investment does not impact the value of the
investment.

43
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Valuing a portfolio
• The Law of One Price also has implications for packages of securities:
–Consider two securities, A and B. Suppose a third security, C, has the same
cash flows as A and B combined. In this case, security C is equivalent to a
portfolio, or combination, of the securities A and B.

• Value Additivity:

Price(C) = Price(A + B) = Price(A) + Price(B)

44
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Value additivity and firm value

• To maximize the value of the entire firm, managers should make
decisions that maximize NPV.

• The NPV of the decision represents its contribution to the overall value
of the firm.

45
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Impact of risk on valuation

• When cash flows are risky, we must discount them at a rate equal to
the risk-free interest rate plus an appropriate risk premium.

• The appropriate risk premium will be higher the more the project’s
returns tend to vary with overall risk in the economy.

46
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

NPV and stand-alone projects

• Consider a take-it-or-leave-it investment decision involving a single, stand-
alone project for Fredrick’s Feed and Farm (FFF):
–The project costs $250 million and is expected to generate cash flows of
$35 million per year, starting at the end of the first year and lasting
forever.

• The NPV of the project is calculated as:

35
NPV = - 250 +
r

–The NPV is dependent on the discount rate.

47
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

NPV of FFF project

• If FFF’s cost of capital is 10%,

the NPV is $100 million, and
they should undertake the
investment.

48
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Internal Rate of Return (IRR)

• The IRR of a project is the discount rate at which the NPV of
the project equals to zero:

C1 C2 CT
NPV = C 0 + + + ... + = 0
1 + IRR (1 + IRR) 2
(1 + IRR) T

• Notice the similarity between IRR and YTM!

49
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Alternative rules vs NPV rules

• Sometimes alternative investment rules may give the same answer
as the NPV rule, but at other times they may disagree.
–When the rules conflict, the NPV decision rule should be followed.

50
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

The Internal Rate of Return (IRR) rule

• The rule: Take any investment if and only if the IRR exceeds the cost of capital.

• The IRR Investment Rule will give the same answer as the NPV rule in many,
but not all, situations.

• In general, the IRR rule works for a stand-alone project if all of the project’s
negative cash flows precede its positive cash flows (i.e., the NPV of a project
is a smoothly declining function of the discount rate).
–In the FFF project, whenever the cost of capital is below the IRR of 14%, the
project has a positive NPV, and you should undertake the investment.

51
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Applying the IRR rule

• In other cases, the IRR rule may disagree with the NPV rule and thus be
incorrect.
–Situations where the IRR rule and NPV rule may be in conflict:
1) Delayed Investments
2) Multiple IRRs
3) Nonexistent IRR

52
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Pitfall 1: Delayed Investments

–Assume you have just retired as the CEO of a successful company. A
major publisher has offered you a book deal.
–The publisher will pay you $1 million upfront if you agree to write a book
about your experiences.
–You estimate that it will take three years to write the book. The time you
spend writing will cause you to give up speaking engagements amounting
to $500,000 per year. You estimate your opportunity cost to be 10%.

53
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Pitfall 1: Delayed Investments (ctd.)

–Should you accept the deal? Calculate the IRR.

–The IRR is greater than the cost of capital. Thus, the IRR rule indicates you
should accept the deal. But…
500, 000 500, 000 500, 000
NPV = 1,000,000 - - 2
- 3
= - $243,426
1.1 1.1 1.1

–Since the NPV is negative, the NPV rule indicates you should reject the deal.

54
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Pitfall 1: Delayed Investments (ctd.)

• When the benefits of an investment occur before the costs, the NPV is an
increasing function of the discount rate.

55
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Pitfall 2: Multiple IRRs

–Suppose Star informs the publisher that it needs to sweeten the deal
before he will accept it.
–The publisher offers $550,000 advance and $1,000,000 in four years
when the book is published.
–Should he accept or reject the new offer?

56
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Pitfall 2: Multiple IRRs (ctd.)

–The cash flows would now look like

–The NPV is calculated as

500, 000 500, 000 500, 000 1, 000, 000
NPV = 550,000 - - - -
1 + r (1 + r ) 2
(1 + r ) 3
(1 + r ) 4

57
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Pitfall 2: Multiple IRRs (ctd.)

–By setting the NPV equal to zero and solving for r, we find the IRR. In this
case, there are two IRRs: 7.16% and 33.67%.
–Because there is more than one IRR, the IRR rule cannot be applied.
–Between 7.16% and 33.67%, the book deal has a negative NPV. Since your
opportunity cost of capital is 10%, you should reject the deal.

58
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Pitfall 2: Multiple IRRs (ctd.)

59
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Pitfall 3: Nonexistent IRR

–Finally, Star is able to get the publisher
to increase his advance to $750,000, in
addition to the $1M when the book is
published in four years.
–With these cash flows, no IRR exists;
there is no discount rate that makes
NPV equal to zero.

60
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

IRR Versus the IRR Rule

–While the IRR rule has shortcomings for making investment decisions,
the IRR itself remains useful.
–IRR measures the average return of the investment and the sensitivity
of the NPV to any estimation error in the cost of capital.

61
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Choosing between projects

• Mutually Exclusive Projects
–When you must choose only one project among several possible
projects, the choice is mutually exclusive.
–NPV Rule
•Select the project with the highest NPV.
–IRR Rule
•Selecting the project with the highest IRR may lead to mistakes
(additional pitfalls)

62
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Example
• A venture capitalist is considering Initial First-Year Growth Cost of
Project
investing in several projects. Investment Cash Flow Rate Capital
Dating App $250,000 $55,000 4% 7%
Green Energy $350,000 $75,000 4% 8%
• You have researched several options Water Purification $400,000 $120,000 5% 8%
for her and come up with the “Smart” Clothes $500,000 $125,000 8% 12%
following cash flow estimates.

Ø Which investment should you recommend to the venture capitalist?

63
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Example– Solution
• Assuming each business lasts indefinitely, we can compute the present value of
the cash flows as a constant growth perpetuity. The NPV of each project is
$55,000
NPV (Dating App) = -$250,000 + = $1,583,333
7% - 4%
$75,000
NPV (Green Energy) = -$350,000 + = $1,525, 000
8% - 4%
$120,000
NPV (Water Purification) = -$400,000 + = $3,600,000
$2, 600, 000
8% - 5%
$125,000
NPV ("Smart" Clothes) = -$500,000 + = $2, 625, 000
12% - 8%

• Thus, all of the alternatives have a positive NPV. But because we can only choose
one, the water purification is the best alternative.

64
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

IRR rule and differences in scale

• If a project’s size is doubled, its NPV will double. This is not the case with IRR.
Thus, the IRR rule cannot be used to compare projects of different scales.

• Considering the previous example, the IRR of the Green Energy project is 25.4%,
whereas for Water Purification is 35% à same ranking as NPV.

• But suppose you have a threefold-scaled version of Green Energy:

− IRRs are the same
− NPV of scaled-up Green Energy is now bigger: $4,575,000 (vs. $3,600,000 for
Water Purification)

65
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Other pitfalls of IRR rule with mult. projects

• Another problem with the IRR is that it can be affected by changing the timing
of the cash flows, even when the scale is the same.
−IRR is a return, but the dollar value of earning a given return depends on how
long the return is earned.
• Compare a project with the same investment and same risk as Green Energy,
except it provides only one positive cash flow of $560,000 in one year:
− IRR is 60% (bigger than 25.4%)
− NPV@8% is $168,519 (smaller than $1,525,000)

66
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Other pitfalls of IRR rule with mult. projects

• Differences in risk: an IRR that is attractive for a safe project need not be
attractive for a riskier project.

• Suppose Water Purification now has a cost of capital of 12% instead of 8%:
− NPV drops to $1,314,286
− Becomes less attractive than Green Energy (@small scale), even though it
has higher IRR

• The higher cost of capital means a higher IRR is necessary to make the
project attractive.

67
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 1.1
• Consider the following projects:

• Estimate each project’s IRR by graphing the NPV profile for each.

68
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 1.1 – Solution

69
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 1.2
• Rearden Metals is considering opening a strip mining operation to provide
some of the raw materials needed in producing Rearden metal.
• The initial purchase of the land and the associated costs of opening up
mining operations will cost $100 million today.
• The mine is expected to generate $16 million worth of ore per year for the
next 12 years.
• At the end of the 12th year Rearden will need to spend $20 million to
restore the land to its original pristine nature appearance.
Ø What is the number of IRRs?

70
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 1.2 - Solution

Even though there are two sign
changes, this is only a necessary
(but not sufficient) condition for
the existence of two IRRs. In our
case it is easy to see that the
NPV(r=0%) is equal to 72;
whereas the NPV(r ⟶∞)=-100.
Therefore it has to be the case
that there is only one IRR. This is
shown in the graph below:

71
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Session 2:
2.1 Investment decision rules (ctd)
2.2 Capital budgeting

72
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

2.1 Investment decision rules (ctd)

73
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

The incremental IRR rule

• Apply the IRR rule to the difference between the cash flows of the
two mutually exclusive alternatives (the increment to the cash
flows of one investment over the other).

• Apply the basic IRR Rule on the incremental project.

74
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Shortcomings of incremental IRR rule

• The incremental IRR may not exist.

• Multiple incremental IRRs could exist.

• The fact that the IRR exceeds the cost of capital for both projects does not
imply that either project has a positive NPV.

• When individual projects have different costs of capital, it is not obvious

which cost of capital the incremental IRR should be compared to.

75
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 2.1
• Suppose your firm is considering two different projects, one that lasts one
year and another that lasts five years. The cash flows for the two projects
look like this:
– Project L: Initial investment of 100 and a single future cash flow of 200 in 5 years.
– Project S: Initial investment of 100 and a single future cash flow of 125 in 1 year.

Ø What is the IRR of each proposal? What is the incremental IRR? If your firm’s
cost of capital is 10%, what should you do?

76
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 2.1 – Solution

• Compute the IRR of Project L using the annuity calculator:
NPER RATE PV PMT FV Excel formula
Given 5 -100 0 200
Solve 14.87% =RATE(5,0,-100,200)
for rate

• Compute the IRR of Project S using the annuity calculator:

NPER RATE PV PMT FV Excel formula
Given 1 -100 0 125
Solve 25% =RATE(1,0,-100,125)
for rate

77
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 2.1 – Solution (ctd.)

• We can calculate the incremental IRR this way:
Project 0 1 2 3 4 5
L -100 200
S -100 125
Difference 0 -125 200

NPER RATE PV PMT FV Excel formula

Given 4 -125 0 200
Solve 12.47% =RATE(4,0,-125,200)
for rate

• Because the 12.47% incremental IRR is bigger than the cost of capital of
10%, the long-term project is better than the short-term project, even
though the short-term project has a higher IRR.

78
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Equivalent annual cost (EAC)

• EAC is the annual cost of owning and maintaining an asset determined by
dividing the net present value of the asset purchase, operations and
maintenance cost by the present value of annuity factor
• Main benefit is the ability to compare assets/projects with unequal useful
lives
!" !#$ ! !
• 𝑁𝑃𝑉 = 𝐸𝐴𝐶
$
$
• 𝐸𝐴𝐶 = 𝑁𝑃𝑉 !" !#$ !!

79
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 2.2
• Suppose you need to purchase a new piece of equipment for your business.
• The cost of capital of the company is 11% per year.
• Both machines have the same production capacity and efficiency.
Machine A Machine B
Initial cost $15,000 $18,000
Useful life 8 years 10 years
Electricity annual cost $1,000 $850
Maintenance check $800 annually (years 1-7) $1,500 at year 2,4,6 and 8

80
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 2.2 - Solution

!" !#!!% !" !" !#!!% !#
NPV Machine A = 15,000 + 1,000 + 800 =23,915.88
!!% !!%

EAC (Machine A) = 4,647.36

!" !#!!% !$% ! !

NPV Machine B = 18,000 + 850 + 1,500 < + +
!!% !#!!% & !#!!% '
! !
+ = = 26,664.23
!#!!% ( !#!!% "

EAC (Machine B) = 4,527.62

81
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

The Payback rule

• The payback period is the amount of time it takes to recover or pay back
the initial investment.

• If the payback period is less than a pre-specified length of time, you accept
the project. Otherwise, you reject the project.

• The payback rule is used by many companies because of its simplicity.

82
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

The Payback rule – example

–Projects A, B, and C each have an • Solution
expected life of five years.
–Payback A
–Given the initial cost and annual cash
flow information, what is the payback •$80 ÷ $25 = 3.2 years
period for each project? –Project B
•$120 ÷ $30 = 4.0 years
A B C
Cost $80 $120 $150 –Project C
Cash Flow $25 $30 $35 •$150 ÷ $35 = 4.29 years

83
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

The Payback rule – pitfalls

• Ignores the project’s cost of capital and time value of money.

• Ignores cash flows after the payback period.

• Relies on an ad hoc decision criterion (i.e., cutoff points are selected

arbitrarily).

84
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 2.3
Consider the following three independent projects with the cash flows given in the table.

Project C₀ C₁ C₂ C3 C4
A -5,000 +1,000 +1,000 +3,000 0
B -1,000 0 +1,000 +2,000 +3,000
C -5,000 +1,000 +1,000 +3,000 +5,000

a) What is the payback period on each of the following projects?

b) Given that the cutoff period is 2 years, which projects would you accept?
c) If you use a cutoff period of 3 years, which projects would you accept?
d) If the opportunity cost of capital is 10%, which projects have positive NPV?

85
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 2.3 - Solution

a) Project C₀ C₁ C₂ C₃ C₄ Payback period (years)
A -5000 1000 1000 3000 0 3
B -1000 0 1000 2000 3000 2
C -5000 1000 1000 3000 5000 3

b) If the cutoff period is 2, only B is accepted

c) If the cutoff period is 3, all projects are accepted

Project C₀ PV(C₁) PV(C₂) PV(C₃) PV(C₄) Discounted payback period (years) NPV
A -5000 909.09 826.45 2253.94 0.00 - -1010.52
B -1000 0.00 826.45 1502.63 2049.04 3 3378.12
C -5000 909.09 826.45 2253.94 3415.07 4 2404.55

d) Projects B and C have positive NPV.

86
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Projects with different resource constraints

• Consider three possible projects with a $100 million budget constraint:

87
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Profitability index
• The profitability index can be used to identify the optimal combination of
projects to undertake:

Value Created NPV

Profitability Index = =
Resource Consumed Resource Consumed

–From the previous table, we can see it is better to take projects II & III
together and forgo project I.

88
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Example
• Suppose your firm has five positive NPV projects to choose from.
• There is not enough manufacturing space in your plant to undertake all
projects.
Square feet
Project NPV needed
Project 1 100,000 40,000
Project 2 88,000 30,000
Project 3 80,000 38,000
Project 4 50,000 24,000
Project 5 12,000 1,000
Total 330,000 133,000

Ø Use the profitability index to choose among the projects, given that you only
have 100,000 square feet of unused space.

89
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
• Step 1: compute the PI for each project:

Square feet Profitability Index

Project NPV needed (NPV/Sq. Ft)
Project 1 100,000 40,000 2.50
Project 2 88,000 30,000 2.93
Project 3 80,000 38,000 2.11
Project 4 50,000 24,000 2.08
Project 5 12,000 1,000 12.00
Total 330,000 133,000

90
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution (ctd.)
• Step 2: rank order them by PI and see how many projects you can have
before you run out of space:

Square
feet Profitability Index Cumulative total
Project NPV needed (NPV/Sq. Ft) space used
Project 5 12,000 1,000 12.00 1,000
Project 2 88,000 30,000 2.93 31,000
Project 1 100,000 40,000 2.50 71,000
Project 3 80,000 38,000 2.11 --
Project 4 50,000 24,000 2.08 95,000

91
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Shortcomings of profitability index

• In some situations, the profitability index does not give an accurate answer.
–Consider the following example where you have $200M to invest:
($Million) NPV Investment PI
Proj. 1 100 200 0.5
Proj. 2 50 80 0.625
Proj. 3 35 40 0.875

–You should actually choose project 1, which has the lowest profitability
index (maximal total NPV).

• Also, with multiple resource constraints, the profitability index can break
down completely.

92
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 2.4
Onti Pharmaceuticals has $1 million Project Investment (in NPV (in ‘000s)
allocated for capital expenditures. Which ‘000s)
of the following projects should the 1 300 66
company accept to stay within the $1 2 200 -4
million budget? How much does the
3 250 43
budget limit cost the company in terms of
its market value? Assume that the 4 100 14
opportunity cost of capital for each project 5 100 7
is 11%. 6 350 63
7 400 48

93
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 6 - Solution
Project Investment NPV PI=NPV/Investment
1 300 66 0.22
2 200 -4 -0.02
3 250 43 0.172
4 100 14 0.14
5 100 7 0.07
6 350 63 0.18
7 400 48 0.12

Thus, given the budget of $1 million, the best the company can do is to accept
Projects 1, 3, 4, and 6. If the company accepted all positive NPV projects, the
market value (compared to the market value under the budget limitation) would
increase by the NPV of Project 5 plus the NPV of Project 7: $7,000 + $48,000 =
$55,000. Thus, the budget limit costs the company $55,000 in terms of its
market value.

94
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Session 2.2:
Capital budgeting
(theory)

95
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Forecasting earnings
• Capital Budget
–Lists the investments that a company plans to undertake.

• Capital Budgeting
–Process used to analyze investments and decide which to accept.

• Incremental Earnings
–The amount by which the firm’s earnings are expected to change as a result
of the investment decision.

96
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Revenue and cost estimates: example

• Linksys has completed a $300,000 feasibility study to assess the
attractiveness of a new product, HomeNet.

• The project has an estimated life of four years.

• Revenue Estimates
– Sales = 100,000 units/year
– Per Unit Price = $260

97
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Revenue and cost estimates: example (ctd.)

• Cost Estimates
–Up-Front R&D = $15,000,000
–Up-Front New Equipment = $7,500,000
•Expected life of the new equipment is five years
•Housed in existing lab
–Annual Overhead = $2,800,000
–Per Unit Cost = $110

98
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Incremental earnings forecast for HomeNet

99
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Capital expenditures and depreciation

• The $7.5 million in new equipment is a cash expense, but it is not directly
listed as an expense when calculating earnings.
−Instead, the firm deducts a fraction of the cost of these items each year
as depreciation.

• Straight Line Depreciation

–The asset’s cost is divided equally over its life.
Annual Depreciation = $7.5 million ÷ 5 years = $1.5 million/year

100
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Interest expense
• In capital budgeting decisions, interest expense is typically not included.

• The rationale is that the project should be judged on its own, not on
how it will be financed.

101
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Taxes
• Marginal Corporate Tax Rate
–The tax rate on the marginal or incremental dollar of pre-tax income. Note:
a negative tax is equal to a tax credit
Income Tax = EBIT ´ tc

• Unlevered Net Income Calculation

Unlevered Net Income = EBIT ´ (1 - tc )
= (Revenues - Costs - Depreciation) ´ (1 - tc )

102
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Indirect effects on incremental earnings

• Opportunity Cost
–The value a resource could have provided by its best alternative use.
–In the HomeNet project example, space will be required for the
investment.
–Even though the equipment will be housed in an existing lab, the
opportunity cost of not using the space in an alternative way (e.g., renting
it out) must be considered.
–Suppose this space could be otherwise rented for $200,000 per year.
–The opportunity cost increases expenses from $2.8 million to $3 million.

103
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Indirect effects on incremental earnings (ctd.)

• Project Externalities
–Indirect effects of the project that may affect the profits of other business
activities of the firm. Cannibalization is when sales of a new product
displaces sales of an existing product.
• In the HomeNet example, 25% of sales refer to customers who would have
purchased an existing Linksys wireless router if HomeNet were not available.
–Because this reduction in sales of the existing wireless router is a
consequence of the decision to develop HomeNet, we must include it when
calculating HomeNet’s incremental earnings.

104
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

HomeNet example: with indirect effects

–Suppose that the existing router sells for $100 per unit with a cost of $60
per unit.

105
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Sunk costs and incremental earnings

• Sunk costs are costs that have been or will be paid regardless of the decision
whether or not the investment is undertaken.
−Sunk costs should not be included in the incremental earnings analysis.

• Example 1: Past Research and Development Expenditures

–Money that has already been spent on R&D is a sunk cost and therefore
irrelevant.
–The decision to continue or abandon a project should be based only on the
incremental costs and benefits of the product going forward.

106
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Sunk costs and incremental earnings (ctd.)

• Example 2: Fixed Overhead Expenses
–Typically overhead costs are fixed and not incremental to the project and
should not be included in the calculation of incremental earnings.

• Example 3: Unavoidable Competitive Effects

–When developing a new product, firms may be concerned about the
cannibalization of existing products.
–However, if sales are likely to decline in any case as a result of new products
introduced by competitors, then lost sales should be considered a sunk cost.

107
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Real-world complexities
• Typically,
–sales will change from year to year
–the average selling price will vary over time
–the average cost per unit will change over time

108
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Free Cash Flow and NPV

• The incremental effect of a project on a firm’s available cash is its free cash
flow à need to adjust incremental earnings.

• Step 1: Capital Expenditures and Depreciation

–Capital Expenditures are the actual cash outflows when an asset is
purchased. These cash outflows are included in calculating free cash flow.
–Depreciation is a non-cash expense. The free cash flow estimate is
adjusted for this non-cash expense.

109
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Free Cash Flow and NPV (ctd.)

• Step 2: Net Working Capital (NWC)
Net Working Capital = Current Assets - Current Liabilities
= Cash + Inventory + Receivables - Payables

–Most projects will require an investment in net working capital.

•Trade credit is the difference between receivables and payables.

–The increase in net working capital is defined as

DNWCt = NWCt - NWCt - 1

110
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

HomeNet example (ctd.)

• HomeNet’s NWC requirements:

111
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

HomeNet example (ctd.)

• Adjusting for capital expenditures, depreciation and working capital:

112
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Calculating Free Cash Flow directly

𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝐶𝑜𝑠𝑡𝑠 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 × 1 − τ)

𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 = 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝐸𝑥 − ∆𝑁𝑊𝐶

𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝐶𝑜𝑠𝑡𝑠 × 1 − τ) − 𝐶𝑎𝑝𝐸𝑥 − ∆𝑁𝑊𝐶 + τ) ×𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛

–The term tc × Depreciation is called the depreciation tax shield.

113
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Calculating the NPV

FCFt 1
PV ( FCFt ) = = FCFt ´
(1 + r ) t
(1 + r ) t
 
t = year discount factor

• HomeNet NPV (cost of capital = 12%)

114
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Further adjustments to FCF

• Other Non-cash Items
–Amortization
• Timing of Cash Flows
–Cash flows are often spread throughout the year
• Accelerated Depreciation
–Modified Accelerated Cost Recovery System (MACRS) depreciation

115
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Further adjustments to FCF (ctd.)

• Liquidation or Salvage Value

Capital Gain = Sale Price - Book Value

Book Value = Purchase Price - Accumulated Depreciation

After-Tax Cash Flow from Asset Sale = Sale Price - (tc ´ Capital Gain)

116
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Further adjustments to FCF (ctd.)

• Terminal or Continuation Value
–This amount represents the market value of the free cash flow from the
project at all future dates.

• Tax Carryforwards
–Tax loss carryforwards and carrybacks allow corporations to take losses
during its current year and offset them against gains in nearby years.

117
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

HomeNet example (ctd.)

• Break-Even Analysis
–The break-even level of an input is the level that causes the NPV of the
investment to equal zero.
–HomeNet IRR Calculation

118
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

HomeNet example (ctd.)

• Break-Even Analysis
–Break-Even Levels for HomeNet

119
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Sensitivity analysis
• Sensitivity Analysis shows how the NPV varies with a change in one of the
assumptions, holding the other assumptions constant.

120
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Sensitivity analysis (ctd.)

121
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Scenario analysis
• Scenario Analysis considers the effect on the NPV of simultaneously
changing multiple assumptions.
−HomeNet example (ctd.) – alternative pricing strategies:

122
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Scenario analysis (ctd.)

• Price and volume combinations for HomeNet with equivalent NPV

123
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Session 3:
Introduction to stock valuation

124
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Primary and secondary markets

• Primary Markets

– Sales of new shares to raise new capital

• Secondary Markets

– Trading of second-hand shares (no new capital raised)

Stock can be organized in different ways:

• Exchanges

• OTC (over-the-counter)

125
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Auction vs dealer markets

• Auction markets
–NYSE, London Stock Exchange, Tokyo Stock Exchange, Frankfurt Stock
Exchange

–Trades on the exchange are executed when an offer and bid is matched

• Dealer markets
–NASDAQ

–All trades take place between investor and dealer. Rare for equities, more
frequent for bonds

126
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Types of equity instruments

• Common stocks
–Cash flow rights and voting rights
• Preferred stocks
–Cash flow rights (typically higher than common stocks) and no voting rights
• Convertible preferred stocks
• Warrants
• ADRs (American Depository Receipts)
• ETFs (Exchange traded funds)

127
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

The Dividend-Discount model

We can value stocks using NPV approach as well

PV(stock)=PV(expected future dividends)

This is always true even if investors buy stocks not just for dividends but also
for capital gains

𝐷𝑖𝑣! + 𝑃!
𝑃& =
1+𝑟
Div! P! − P&
Expected return = r = +
P& P

128
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

The Dividend-Discount model

• The price of any stock is equal to the present value of the expected future dividends it will pay:
¥
Div1 Div2 Div3 Divn
P0 =
1 + rE
+
(1 + rE ) 2
+
(1 + rE ) 3
+  = å
n =1 (1 + rE ) n

• Constant Dividend Growth: firm’s future dividends states that they will grow at a constant rate, g:

• Constant Dividend Growth Model (aka “Gordon growth” model): the value of the firm depends on
the current dividend level, the cost of equity, and the growth rate:
Div1
P0 =
rE - g

129
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Dividend vs. Investment growth

• A Simple Model of Growth
–Dividend Payout Ratio: the fraction of earnings paid as dividends each year
+,-./.01!
𝐷𝑖𝑣* = 23,-41 67*1*,.8/.0!
×𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑒*

𝐸𝑃𝑆*

–Assuming the number of shares outstanding is constant, a firm can increase its dividend by…
…increasing its earnings (net income) OR increasing its dividend payout ratio

–A firm can do one of two things with its earnings…

…pay them out to investors OR retain and reinvest them.

130
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

A simple model of growth

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

• If the firm keeps its retention rate constant, then the growth rate in dividends will equal the growth
rate of earnings.:
Change in Earnings
Earnings Growth Rate =
Earnings
= Retention Rate ´ Return on New Investment
g = Retention Rate ´ Return on New Investment

131
 MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

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 firm’s investments:

–Cutting the firm’s dividend to increase investment will raise the stock price if, and only if, the
new investments have a positive NPV.

(1) Caveat: things are a bit different with informational asymmetries. To study later.

132
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Example
• Dren Industries is considering expanding into a new product line.

• Earnings per share are expected to be $5 this year and are expected to grow at 5% p.a. without the
new product line but growth would increase to 7% if the new product line is introduced.

• To finance the expansion, Dren would need to cut its dividend payout ratio from 80% to 50%.

Ø If Dren’s equity cost of capital is 11%, what would be the impact on Dren’s stock price if they
introduce the new product line? Assume the equity cost of capital will remain unchanged.

133
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
• First, calculate the current price for Dren if they do not introduce the new product. To calculate the
price, D1 is needed. To find D1, EPS1 is required:

EPS1 = EPS0 × (1 + g) = $5.00 × 1.05 = $5.25

D1 = EPS1 × Payout Ratio = $5.25 × 0.8 = $4.20

• Thus, the current price without the new product should be $70 per share.

P0 = D1/(rE - g) = $4.20/(0.11 - 0.05) = $70.00

134
 MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution (ctd.)
• Next, calculate the expected current price for Dren if they introduce the new product:

EPS1 = EPS0 × (1 + g) = $5.00 × 1.07 = $5.35

D1 = EPS1 × Payout Ratio = $5.35 × 0.50 = $2.675

• Thus, the current price is expected to fall from $70 to $66.875 if the new product line is introduced.

P0 = D1/(rE - g) = $2.675/(0.11 - 0.07) = $66.875

Ø Harder question: what if the cut in dividends was temporary and lasted for 10 years?

135
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

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.
Ø During this period of high growth, these firms often retain 100% of their earnings to exploit
profitable investment opportunities.
Ø 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.

136
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Changing growth rates (ctd.)

• Dividend-Discount Model with Constant Long-Term Growth:

DivN + 1
PN =
rE - g

Div1 Div2 … + Div 1 æ Div ö

P0 = + +  N
+ N ç
N + 1
÷
1 + rE (1 + rE ) 2
(1 + rE ) N
(1 + rE ) è rE - g ø

137
 MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Example
Source: Nasdaq
WMT dividends
• Consider the recent dividend data for Walmart: $0.54

$0.53

$0.52
ØUsing the dividend-growth model, compute the
$0.51
stock price of Walmart, assuming a 4% discount
rate(1) $0.50

$0.49
ØCompare your result with Walmart’s current
stock price. $0.48

$0.47

$0.46
8/14/2013 12/27/2014 5/10/2016 9/22/2017 2/4/2019 6/18/2020

(1) This corresponds to a risk premium of about 2.25% with respect to current 10-yr Treasury yields (~1.75% on Sep 20 2019). As we’ll see later this is a reasonable risk premium.

138
 MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
• Our valuation:
− Annual growth rate of about 2% in recent years (also worth noting WMT has been growing its
dividends for over 40 years!)
− Using the Gordon Growth model:
𝟎. 𝟓𝟑×𝟒×𝟏. 𝟎𝟐
𝑷𝟎 = = 𝟏𝟎𝟖. 𝟏𝟐
𝟎. 𝟎𝟒 − 𝟎. 𝟎𝟐 Additional questions:

• What discount rate would let us

• Current stock price for WMT: match the actual price?

• How would our valuation look like

if we had used 3% vs 4% as a
discount rate?

139
 MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Dividend-Discount model: final remarks

• Limitations:
− There is a tremendous amount of uncertainty associated with forecasting a firm’s dividend growth rate
and future dividends.

− Small changes in the assumed dividend growth rate can lead to large changes in the
estimated stock price.

• HOWEVER… it is a theoretically appealing model, since in principle dividends can be traded

separately and thus the dividend-discount model, as long as correctly implemented, needs to
hold via no arbitrage(1)

(1) Limitation is that dividend strips with very long horizons (example: 20 years) are typically not traded. Liquidity can also be problematic. Interesting recent video on this new emerging asset class
(isolated dividend) by Wharton Professor Jules van Binsbergen at the NYSE: https://www.youtube.com/watch?v=mDyWeC4m36o [ADVANCED MATERIAL]

140
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

The Discounted Free Cash Flow (DCF) 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 firm’s equity, taking its cash,
paying off all debt, and owning the unlevered business.

141
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

The Discounted Free Cash Flow (DCF) model

• Valuing the Enterprise

− Free Cash Flow: cash flow available to pay both debt holders and equity holders:
 
Unlevered Net Income

Free Cash Flow = EBIT ´ (1 - tc ) + Depreciation
- Capital Expenditures - Increases in Net Working Capital

−DCF Model:

V0 = PV (Future Free Cash Flow of Firm)

V0 + Cash 0 - Debt 0
P0 =
Shares Outstanding 0

142
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Implementing the DCF model

• Since we are discounting cash flows to both equity holders and debt holders, the free cash flows
should be discounted at the firm’s weighted average cost of capital, rwacc
– If the firm has no debt, rwacc = rE

FCF1 FCF2 FCFN VN

V0 = + +  + +
1 + rwacc (1 + rwacc ) 2
(1 + rwacc ) N
(1 + rwacc ) N

• Often, the terminal value is estimated by assuming a constant long-run growth rate gFCF for free cash
flows beyond year N, so that

FCFN + 1 æ 1 + g FCF ö
VN = = ç ÷ ´ FCFN
rwacc - g FCF è (rwacc - g FCF ) ø

143
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Connection to capital budgeting

• The firm’s free cash flow is equal to the sum of the free cash flows from the firm’s current and future
investments, so…
…we can interpret the firm’s 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 firm’s enterprise value.
Ø To maximize the firm’s share price, we should accept projects that have a positive NPV.

144
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Valuation based on comparable firms

• 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.
– Sometimes used just to compute terminal value (complement to DCF valuation)

• Example of a multiple: forward PE; decomposing in the context of the Gordon Growth model:

P0 Div1 / EPS1 Dividend Payout Rate

Forward P/E = = =
EPS1 rE - g rE - g

à Important to be careful with selection of comparables!!

145
 MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Example – Southwest Airlines

JetBlue American Delta United Alaska Av.
PE 11.6 8.01 8.68 8.99 15.9 10.6
EV/EBITDA 5.2 7.04 6.52 5.81 7.65 6.4 Target
EV/Revenue 0.81 0.92 1.17 0.88 1.17 1.0 PE 45.8
EV/EBITDA 48.9
Southwest EV/Revenue 40.2
EPS 4.3
EBITDA (Billions) 4.2 Actual Price 54.7
Revenue (Billions) 22.3
Net Debt (Billions) 0.5
Outstanding Shares (Millions) 537.5

Note: data @ ~12pm Sep. 24 2019

146
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Limitations of multiples
• When valuing a firm using multiples, there is no clear guidance about how to adjust for
differences in expected future growth rates, risk, or differences in accounting policies.

• Comparables only provide information regarding the value of a firm relative to other firms in
the comparison set.
–Using multiples will not help us determine if an entire industry is overvalued.

• Discounted cash flows methods have the advantage that they can incorporate specific
information about the firm’s cost of capital or future growth.

147
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

A way of adjusting: multiples regressions

Source: Prof. Damodaran’s website

148
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Stock valuation: final remark

• No single technique provides a final answer regarding a stock’s true value.

• All approaches require assumptions or forecasts that are too uncertain to provide a definitive
assessment of the firm’s value.

• Most real-world practitioners use a combination of these approaches and gain confidence if the
results are consistent across a variety of methods.

149
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Session 3.2:
Introduction to stock valuation
(selected problems)

150
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 3.1
You’re at the end of 2018, XYZ Inc. has a current price of €50 and it will pay €2
dividends in one year. Please answer the following questions:

What is expected the price of its stock one year from now after paying the
dividend if its equity cost of capital is 10%?

What is the expected dividend yield?

What is the expected capital gain rate?

151
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 3.1 - Solution

Pt=2018 = 50

(Pt= 2019 + E[Div] ) / (1+0.1) = 50

(Pt= 2019 + 2 ) / (1+0.1) = 50

Pt= 2019 = 50 * 1.1 – 2 = 53

Dividend yield = 2 / 50 = 4%

Capital gains rate = (53 – 50) / 50 = 6%

152
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 3.1 (cont.)

Breaking news, XYZ has just released the information that it will also pay a
dividend of €4 two years from now to its shareholders. Assuming the stock
price today is still €50, please answer the questions:

What is the price of the stock two years from now right after paying the second
dividend?

What is the expected capital gain rate per year?

What is the expected dividend yield per year?

153
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 3.1 – Solution (cont.)

E[Div2019] / (1+0.1) + (E[Divt= 2020] + Pt= 2020) / (1+0.1)^2 = 50

2 / (1+0.1) + (4 + Pt= 2020) / (1+0.1)^2 = 50

Pt= 2020 = 54.3

Capital gains rate = sqrt(54.3/50) -1 = 4.2%

Dividend yield = rE – CapG rt. = 10% - 4.2% = 5.8%

154
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 3.2
Consider a firm that is going to pay a dividend at the end of this year, 2018,
of €2.21. Afterwards dividends will grow at 8% per year, for the following 5
years (until the end of 2023), after that dividends will grow at a constant
rate of 1.5%. Assuming an equity cost of capital of 9%, what is the firm’s
stock price at the end of 2018?

155
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 3.2 - Solution

Using the dividend discount model:

2018 2019 2020 2021 2022 2023 2024

Dividend 2.21 2.39 2.58 2.78 3.01 3.25 3.30
Discount factor 0.92 0.84 0.77 0.71 0.65
PV(Dividend) 2.19 2.17 2.15 2.13 2.11 28.56
Price 39.31

So, the stock’s price would be €39.31.

156
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 3.3
Company XYZ plans to retain all of its earnings for the next two years. Earnings at
the end of this year will be $3 million. For the subsequent two years, the firm will
retain 30% of its earnings. It will then retain 12% of its earnings from that point
onward. Each year, retained earnings will be invested in new projects with an
expected return of 20% per year. The equity cost of capital is 8.6%, what price
would you estimate for the stock price?

157
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 3.3 - Solution

t=1 t=2 t=3 t=4 t=5 t=6
Retention rate 100% 100% 30% 30% 12% 12%
Project expected return 20% 20% 20% 20% 20% 20%
EPS growth rate 20% 6% 6% 2.4% 2.4%
EPS 3 3.6 4.32 4.58 4.85 4.97
Dividends 3.02 3.21 4.27 4.37

Dividend growth rate 6.00% 33.26% 2.40%

Discount factor 0.92 0.85 0.78 0.72 0.66
Discounted Dividends 2.36 2.30 2.83 46.70
Price 54.20

158
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 3.4
Company Bigfloor Inc (Bf) expects earnings at the end of this year of 6.2 per share,
and it plans to pay a €3.9 dividend at that time. Bf will retain €2.3 per share of its
earnings to reinvest in new projects with an expected return of 11% per year.
Suppose Bf will maintain the same dividend payout rate, retention rate, and return
on new investments in the future and will not change its number of outstanding
shares. The equity cost of capital is 9%.

What growth rate of earnings would you forecast?

What price would you estimate for the stock today?

159
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 3.4 - Solution

g = retention rate * return on new investments = (2.3 / 6.2) * 11% = 4.08%

P = 3.9 / (9% – 4.08%) = 79.27

160
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 3.4 (cont.)

Suppose instead a dividend of €4.9 was paid per share at the end of this year
and retained only €1.3 per share in earnings. If Bf maintains this higher
payout rate in the future, what stock price would you estimate now? Should
the company raise its dividend?

161
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 3.4 – Solution (cont.)

Retention rate = 1.3 / 6.2 = 20.97%

P = 4.9 / (9% - (1.3/6.2) * 11%) = 73.20

Bf should not raise its dividend, since the stock price would fall.

162
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 3.4 (cont.)

Redo the question but now suppose your equity cost of capital is 12%. What
stock price would you expect under these circumstances? As a manager
what would be your comment on the new projects?

163
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 3.4 – Solution (cont.)

After dividend is raised we have P = 4.9 / (12% - (1.3/6.2) * 11%) =
50.55 which is a lower price than in the previous exercise. However,
we must compare it to the price before the dividend is raised, with
the new capital cost of equity.

Before dividends were raised P (div=3.9) = 3.9 / (12% - 4.08%) = 49.24.

So under these circumstances the stock price would increase. This is
because the return on new investments is not sufficient to
compensate the capital cost of equity. Meaning the NPV of that
investment is not positive.

164
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 3.5
You decide to do a multiple analysis for a beverage company, Soda Corp. From
your database you got that for financial year of 2018 Soda Corp had and EBITDA
of 51.3m, Short-term Financial Debt of 99m, long-term financial debt of 8m, Cash
and Cash equivalents of 3.3m and earnings of 38.41m with 23m shares
outstanding.
a) Suppose that Vater, Inc., has an enterprise value to EBITDA multiple of 11.08
and a P/E multiple of 17.09. What share price would you estimate for Soda
Corp using each of these multiples?
b) Suppose that Poppydrink Inc has an enterprise value to EBITDA multiple of
7.07 and a P/E multiple of 17.36. What share price would you estimate for Soda
Corp using each of these multiples.

165
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 3.5 - Solution

a) Using EV/EBITDA:

EV = 51.3 × 11.08 = 568.40 million,

P = (568.40 – 107 + 3.3) / 23 = 20.20 million

Using P/E:

P = 17.09 × (38.41 / 23) = 28.54 million

166
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 3.5 – Solution (cont.)

b) Using EV/EBITDA:

EV = 51.3 × 7.07 = 362.69 million,

P = (362.69 – 107 + 3.3) / 23 = 11.26 million

Using P/E:

P = 17.36 × (38.41 / 23) = 28.99 million

167
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Session 5:
Capital structure I – no frictions
(theory I)

168
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Financing a firm with equity

• You are considering an investment opportunity.
–For an initial investment of $800 this year, the project will generate cash flows of either $1400 or
$900 next year, depending on whether the economy is strong or weak, respectively. Both
scenarios are equally likely.

–The project cash flows depend on the overall economy and thus contain market risk. As a result,
you demand a 10% risk premium over the current risk-free interest rate of 5% to invest in this
project.

ØWhat is the NPV of this investment opportunity?

169
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Financing a firm with equity (ctd.)

• The cost of capital for this project is 15%. The expected cash flow in one year is
½($1400) + ½($900) = $1150.

• The NPV of the project is

$1150
NPV = -$800 + = -$800 + $1000 = $200.
1.15

170
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Financing a firm with equity (ctd.)

• If you finance this project using only equity, how much would you be willing to pay for the
project?

$1150
PV (equity cash flows) = = $1000
1.15

–If you can raise $1000 by selling equity in the firm, after paying the investment cost of
$800, you can keep the remaining $200, the NPV of the project NPV, as a profit.

171
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Financing a firm with equity (ctd.)

• Unlevered Equity: Equity in a firm with no debt

• Because there is no debt, the cash flows of the unlevered equity are equal to those of the project.

• Shareholder’s returns are either 40% or –10%.

–The expected return on the unlevered equity is
•½ (40%) + ½(–10%) = 15%.
•Because the cost of capital of the project is 15%, shareholders are earning an appropriate return
for the risk they are taking.

172
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Financing a firm with debt and equity

• Suppose you decide to borrow $500 initially, in addition to selling equity.
–Because the project’s cash flow will always be enough to repay the debt, the debt is risk free,
and you can borrow at the risk-free interest rate of 5%. You will owe the debt holders
•$500 × 1.05 = $525 in one year.

• Levered Equity: Equity in a firm that also has debt outstanding

• Given the firm’s $525 debt obligation, your shareholders will receive only $875 ($1400 – $525 =
$875) if the economy is strong and $375 ($900 – $525 = $375) if the economy is weak.

173
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Financing a firm with debt and equity (ctd.)

ØWhat price E should the levered equity sell for?

ØWhich is the best capital structure choice for the entrepreneur?

174
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Financing a firm with debt and equity (ctd.)

• Modigliani and Miller argued that with perfect capital markets, the total value of a firm should
not depend on its capital structure.
–They reasoned that the firm’s total cash flows still equal the cash flows of the project and,
therefore, have the same present value.

• Because the cash flows of the debt and equity sum to the cash flows of the project, by the
Law of One Price the combined values of debt and equity must be $1000.
–Therefore, if the value of the debt is $500, the value of the levered equity must be $500.
•E = $1000 – $500 = $500.

175
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Financing a firm with debt and equity (ctd.)

• Because the cash flows of levered equity are smaller than those of unlevered equity, levered equity
will sell for a lower price ($500 versus $1000).
–However, you are not worse off. You still raise a total of $1000 by issuing both debt and levered
equity. Consequently, you would be indifferent between these two choices of capital structure.

• Leverage increases the risk of the equity of a firm.

–It is inappropriate to discount the cash flows of levered equity at the 15% used for unlevered
equity. Levered equity investors require a higher expected return to compensate for increased risk.

176
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Financing a firm with debt and equity (ctd.)

• The returns to equity holders are very different with and without leverage.
–Unlevered equity has a return of either 40% or –10%, for an expected return of 15%.
–Levered equity has higher risk, with a return of either 75% or –25%.
•To compensate for this risk, levered equity holders receive a higher expected return of 25%.

177
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

The effect of leverage on risk and return

• The relationship between risk and return can be evaluated more formally by computing the
sensitivity of each security’s return to the systematic risk of the economy.
• Because the debt’s return bears no systematic risk, its risk premium is zero.
• In this particular case, the levered equity has twice the systematic risk of the unlevered equity and,
as a result, has twice the risk premium.

178
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

In summary
• In the case of perfect capital markets, if the firm is 100% equity financed, the equity holders will
require a 15% expected return.

• If the firm is financed 50% with debt and 50% with equity, the debt holders will receive a return
of 5%, while the levered equity holders will require an expected return of 25% (because of their
increased risk).

• Leverage increases the risk of equity even when there is no risk that the firm will default.
–Thus, while debt may be cheaper, its use raises the cost of capital for equity. Considering both
sources of capital together, the firm’s average cost of capital with leverage is the same as for the
unlevered firm.

179
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

MM I: leverage, arbitrage, and firm value

• The Law of One Price implies that leverage will not affect the total value of the firm.
–Instead, it merely changes the allocation of cash flows between debt and equity, without altering
the total cash flows of the firm.

• Modigliani and Miller (MM) showed that this result holds more generally under a set of conditions
referred to as perfect capital markets :
–Investors and firms can trade the same set of securities at competitive market prices equal to the
present value of their future cash flows.
–There are no taxes, transaction costs, or issuance costs associated with security trading.
–A firm’s financing decisions do not change the cash flows generated by its investments, nor do
they reveal new information about them.

180
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

MM I: leverage, arbitrage, and firm value

• MM Proposition I
–In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows
generated by its assets and is not affected by its choice of capital structure.

• MM established their result with the following argument:

–In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm’s
security holders is equal to the total cash flow generated by the firm’s assets.
•Therefore, by the Law of One Price, the firm’s securities and its assets must have the same total
market value.

181
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Market Value Balance Sheet

• A balance sheet where:
– All assets and liabilities of the firm are included (even intangible assets such as reputation,
brand name, or human capital that are missing from a standard accounting balance sheet).
– All values are current market values rather than historical costs.

• The total value of all securities issued by the firm must equal the total value of the firm’s assets.

• Changing the capital structure therefore alters how the value of the assets is divided across
securities, but not the firm’s total value.

182
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Market Value Balance Sheet

• Using the market value balance sheet, the

value of equity is computed as follows:

Market Value of Equity =

Market Value of Assets - Market Value of Debt and Other Liabilities

183
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Application: leveraged recap(italization)

• Leveraged Recapitalization: When a firm uses borrowed funds to pay a large special
dividend or repurchase a significant amount of outstanding shares

• Example:
–Harrison Industries is currently an all-equity firm operating in a perfect capital market,
with 50 million shares outstanding that are trading for $4 per share.
–Harrison plans to increase its leverage by borrowing $80 million and using the funds to
repurchase 20 million of its outstanding shares.

184
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Application: leveraged recap(italization) (ctd.)

Market Value Balance Sheet after Each Stage of Harrison’s Leveraged Recapitalization ($ millions):

185
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Application: leveraged recap(italization) (ctd.)

• Initially, Harrison is an all-equity firm and the market value of Harrison’s equity is $200 million (50
million shares × $4 per share = $200 million) and equals the market value of its existing assets.

• After borrowing, Harrison’s liabilities grow by $80 million, which is also equal to the amount of
cash the firm has raised. Because both assets and liabilities increase by the same amount, the
market value of the equity remains unchanged.

186
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Application: leveraged recap(italization) (ctd.)

• To conduct the share repurchase, Harrison spends the $80 million in borrowed cash to
repurchase 20 million shares ($80 million ÷ $4 per share = 20 million shares).

• Because the firm’s assets decrease by $80 million and its debt remains unchanged, the market
value of the equity must also fall by $80 million, from $200 million to $120 million, for assets and
liabilities to remain balanced.

ØThe share price is unchanged. With 30 million shares remaining, the shares are worth $4 per
share, just as before ($120 million ÷ 30 million shares = $4 per share).

187
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Application: leveraged recap(italization) (ctd.)

Homework
• What is Harrison’s share price if the CEO would decide to distribute the dividends worth of $80
million (instead of repurchasing the shares)?

188
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Final words on recap(italization)

• A firm can change its capital structure at any time by issuing new securities and using the
funds to pay its existing investors.

• An example is a leveraged recapitalization in which the firm borrows money (issues debt) and
repurchases shares (or pays a dividend).

• MM Proposition I implies that such transactions will not change the value for shareholders.

189
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

MM II: leverage, risk, and the cost of capital

• Leverage and the Equity Cost of Capital (step 1)
–MM’s first proposition can be used to derive an explicit relationship between leverage and
the equity cost of capital.

• Leverage and the Equity Cost of Capital (step 2)

–MM Proposition I states that(1)

E + D = U = A.
–The total market value of the firm’s securities is equal to the market value of its assets,
whether the firm is unlevered or levered.

(1) E is market value of equity in a levered firm, D is market value of debt in a levered firm, U is market value of equity in an unlevered firm, and A is market value of the firm’s assets.

190
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

MM II: leverage, risk, and the cost of capital

• Leverage and the equity cost of capital (step 3): The return on unlevered equity (RU) is related to
the returns of levered equity (RE) and debt (RD):
E D
RE + RD = RU
E + D E + D
• Solving for RE:

Risk without
leverage Additional risk
due to
leverage

• The levered equity return equals the unlevered return, plus a premium due to leverage.
–MM Proposition II: The amount of the premium depends on the amount of leverage, measured
by the firm’s market value debt-equity ratio, D/E.

191
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Back to our example…

• Recall from before:
– If the firm is all-equity financed, the expected return on unlevered equity is 15%.
– If the firm is financed with $500 of debt, the expected return of the debt is 5%.

• Therefore, according to MM Proposition II, the expected return on equity for the
levered firm is

500
rE = 15% + (15% - 5%) = 25%
500

192
 MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Capital budgeting and the WACC

• If a firm is unlevered, all of the free cash flows generated by its assets are paid out to its equity holders.
–The market value, risk, and cost of capital for the firm’s assets and its equity coincide and therefore
rU = rA
• If a firm is levered, project rA is equal to the firm’s weighted average cost of capital.
–Unlevered Cost of Capital (pretax WACC)(1)
æ Fraction of Firm Value ö æ Equity ö æ Fraction of Firm Value ö æ Debt ö
rwacc º ç ÷ ç ÷ + ç ÷ ç ÷
è Financed by Equity ø è Cost of Capital ø è Financed by Debt ø è Cost of Capital ø
E D
= rE + rD
E + D E + D

rwacc = rU = rA
(1) If the firm’s capital structure is made up of multiple securities, then the WACC is calculated by computing the weighted average cost of capital of all of the firm’s securities.

193
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023 WACC and Leverage with Perfect Capital Markets:

Capital budgeting
and the WACC (ctd.)
• With no debt, the WACC is equal to the
unlevered equity cost of capital.
• As the firm borrows at the low cost of
capital for debt, its equity cost of capital
rises. The net effect is that the firm’s WACC
is unchanged.

194
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Levered and unlevered betas

• The effect of leverage on the risk of a firm’s securities can also be expressed in terms of beta:

E D D
bU = bE + bD b E = bU + ( bU - b D )
E + D E + D E

• Unlevered Beta: a measure of the risk of a firm as if it did not have leverage, which is
equivalent to the beta of the firm’s assets.

• If you are trying to estimate the unlevered beta for an investment project, you should base
your estimate on the unlevered betas of firms with comparable investments.

195
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Example

196
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution

197
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Estimating WACC
There are two approaches to estimating the required returns on a firm’s financial assets:

1. Estimate required rate of return based on the riskiness of the asset (e.g. application of
CAPM)
– Best approach for stocks

2. Estimate implied discount rates from asset prices and expected cash flows
– Best approach for debts and preferred stocks
– Tougher for common stocks
– It depends on the assumption that assets are fairly priced

198
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Estimating the equity cost of capital

• The Capital Asset Pricing Model (CAPM) is a practical and intuitive way to estimate the
cost of capital

• The cost of capital of any investment opportunity equals the expected return of
available investments with the same beta (systematic risk).

• The estimate is provided by the Security Market Line equation:

ri =rf +b i ´ (E[RMkt ]-rf )

Risk Premium for Security i

199
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Industry asset betas

• In estimating the beta of assets, we can rely on the estimates of asset betas for
multiple firms in the same industry.

• Doing this will reduce the estimation error of the estimated beta for the project or for
the assets of the company.

200
 MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Example: airline industry

UAL DAL EW-Portfolio
Net Debt 14.74 15.4 n.a.
Market Cap 22.5 37.5 n.a.
D/V 40% 29% 34%
Beta_e 1.158 1.129 1.143
Beta_assets 0.70 0.80 0.75

Average asset beta for Similar number is obtained if we

United and Delta is 0.75 compute asset beta of EW portfolio
using average leverage ratio
Note: data @ ~12pm Sep. 24 2019
Assumes zero beta for debt
Net Debt and Market Cap are in USD Billions

201
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Estimating the debt cost of capital

• Debt Yields Versus Returns:

–Yield to maturity is the IRR an investor will earn from holding the bond to maturity and
receiving its promised payments.

–If there is little risk the firm will default, yield to maturity is a reasonable estimate of
investors’ expected rate of return.

–If there is significant risk of default, yield to maturity will overstate investors’ expected
return.

202
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Estimating the debt cost of capital (ctd.)

• Consider a one-year bond with YTM of y. For each $1 invested in the bond today, the issuer
promises to pay $(1 + y) in one year.

• Suppose the bond will default with probability p, in which case bond holders receive only $(1 + y - L),
where L is the expected loss per $1 of debt in the event of default (aka “loss given default”).

• So the expected return of the bond is

rd = (1 - p)y + p(y - L) = y – pL
= Yield to Maturity – Prob(default) X Expected Loss Rate

• The importance of the adjustment depends on the riskiness of the bond.

203
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Adjusting for default

• Annual default rates by rating class:

• The average loss given default for unsecured debt is 60%.

• Example: according to the table, the annual average default rate for B-rated bonds is 5.5%
Ø So the expected return to B-rated bondholders during average times is 0.055 X 0.60=3.3%
below the bond’s quoted yield.

204
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Debt betas
• Alternatively, we can estimate the debt cost of capital using the CAPM.

• Debt betas are difficult to estimate because corporate bonds are traded infrequently.

• One approximation is to use estimates of betas of bond indices by rating category:

205
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Example

206
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
• Given the low rating of debt, we know the YTM of KB Home’s debt is likely to overstate its
expected return.

• Using the estimates from the table on slide 203 and a LGD of 60%, we have
rd = 6% - 5.5% x (0.6) = 2.7%

• Alternatively, using the debt betas from the table on slide 204 and a 5% risk premium we obtain
rd = 1% + 0.26 x 5% = 2.3%

207
 MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Final remarks on using the CAPM

• There are a large number of assumptions made in the estimation of cost of capital using the CAPM.
Ø How reliable are the results?

1. The types of approximation are no different from those made throughout the capital budgeting
process. Errors in cost of capital estimation are not likely to make a large difference in NPV estimates.

2. CAPM is practical, easy to implement, and robust.

3. CAPM imposes a disciplined approach to cost of capital estimation that is difficult to manipulate.

4. CAPM requires managers to think about risk in the correct way.

208
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Capital structure fallacies

209
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Leverage and Earnings per Share

– Example
• LVI is currently an all-equity firm. It expects to generate earnings before
interest and taxes (EBIT) of $10 million over the next year.
• Currently, LVI has 10 million shares outstanding, and its stock is trading for
a price of $7.50 per share.
• LVI is considering changing its capital structure by borrowing $15 million at
an interest rate of 8% and using the proceeds to repurchase 2 million
shares at $7.50 per share.

210
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Leverage and Earnings per Share (ctd.)

•Suppose LVI has no debt. Because there is no interest and no taxes, LVI’s earnings would equal
its EBIT and LVI’s earnings per share without leverage would be
Earnings $10 million
EPS = = = $1
Number of Shares 10 million

•If LVI recapitalizes, the new debt will obligate LVI to make interest payments each year of $1.2
million/year.
–$15 million × 8% = $1.2 million
•As a result, LVI will have expected earnings after interest of $8.8 million.
–Earnings = EBIT – Interest = $10 million – $1.2 million = $8.8 million
•Earnings per share rises to $1.10
–$8.8 million ÷ $8 million shares = $1.10
•LVI’s expected earnings per share increases with leverage.

211
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Leverage and Earnings per Share (ctd.)

•Are shareholders better off? LVI Earnings per Share with and without Leverage:
–NO! Although LVI’s expected EPS rises
with leverage, the risk of its EPS also
increases. While EPS increases on
average, this increase is necessary to
compensate shareholders for the
additional risk they are taking, so LVI’s
share price does not increase as a
result of the transaction.

Note: Leveraged recapitalization will increase

expected EPS whenever the firm’s after-tax
borrowing cost is less than the ratio of
expected earnings to the share price.

212
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Equity issuances and dilution

Ø Dilution
–An increase in the total of shares that will divide a fixed amount of earnings.

Ø It is sometimes (incorrectly) argued that issuing equity will dilute existing

shareholders’ ownership, so debt financing should be used instead.

213
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Equity issuances and dilution (ctd.)

• Example:

− Suppose Jet Sky Airlines (JSA) currently has no debt and 500 million shares of stock
outstanding, which is currently trading at a price of $16.

− Last month the firm announced that it would expand and the expansion will require the
purchase of $1 billion of new planes, which will be financed by issuing new equity.

214
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Equity issuances and dilution (ctd.)

− The current (prior to the issue) value of the equity and the assets of the firm is $8 billion.
§ 500 million shares × $16 per share = $8 billion

− Suppose JSA sells 62.5 million new shares at the current price of $16 per share to raise the
additional $1 billion needed to purchase the planes.

215
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Equity issuances and dilution (ctd.)

–The market value of JSA’s assets grows because of the additional $1 billion in cash the firm has
raised.
–The number of shares increases.
•Although the number of shares has grown to 562.5 million, the value per share is unchanged
at $16 per share.

–As long as the firm sells the new shares of equity at a fair price, there will be no gain or loss to
shareholders associated with the equity issue itself.
–Any gain or loss associated with the transaction will result from the NPV of the investments
the firm makes with the funds raised.

216
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Beyond the propositions

• Conservation of Value Principle for Financial Markets
–With perfect capital markets, financial transactions neither add nor destroy value, but
instead represent a repackaging of risk (and therefore return).
•This implies that any financial transaction that appears to be a good deal may be
exploiting some type of market imperfection.

217
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Session 5.1:
Ocean Carriers case
discussion

218
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Session 5.2:
Capital structure I – no frictions
(selected problems)

219
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 1

• Going back to the example in the online lecture notes: Suppose the entrepreneur
borrows $700 (rather than $500) when financing the project.

• According to Modigliani and Miller,

Ø what should the value of the equity be?
Ø what is the expected return?

220
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
Ø Because the value of the firm’s total cash flows is still $1000, if the firm borrows $700, its equity
will be worth $300. The firm will owe $700 × 1.05 = $735 in one year.

Ø Thus, if the economy is strong, equity holders will receive $1400 − 735 = $665, for a return of
$665/$300 − 1 = 121.67%. If the economy is weak, equity holders will receive $900 − $735 = $165,
for a return of $165/$300 − 1 = −45.0%.
1 1
Ø The equity has an expected return of (121.67%) + (-45.0%) = 38.33%
2 2
Ø Note that the equity has a return sensitivity of 121.67% − (−45.0%) = 166.67%, which is
166.67%/50% = 333.34% of the sensitivity of unlevered equity.

Ø Its risk premium is 38.33% − 5%= 33.33%, which is approximately 333.34% of the risk premium of
the unlevered equity, so it is appropriate compensation for the risk.

221
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 2
Acort Industries owns assets that have a 75% probability of having a market value of $48 million
one year from now. There is a 25% chance that the assets will be worth only $18 million. The
current risk-free rate is 5%, and Acort’s assets have a cost of capital of 10%.

a) If Acort is unlevered, what is the current market value of its equity?

b) Suppose instead that Acort has debt with a face value of $18 million due in one year.
According to MM, what is the value of Acort’s equity in this case?

c) What is the expected return of Acort’s equity without leverage? What is the expected return
of Acort’s equity with leverage?

222
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
a) MVA = [0.75 (48) + 0.25 (18)]/1.10 = $36.82m

b) MVD = 18/1.05 = 17.143. Therefore, MVE = 36.82 – 17.143 = $19.677m

c) Without leverage, r = 10%

With leverage, r = (0.75 ´ 30)/19.677 – 1 = 14.35%.

223
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 3
Cisoft is a highly profitable technology firm that currently has $5 billion in cash. The firm
has decided to use this cash to repurchase shares from investors, and it has already
announced these plans to investors. Currently, Cisoft is an all-equity firm with 6 billion
shares outstanding. These shares currently trade for $20 per share. Cisoft has issued no
other securities except for stock options given to its employees. The current market value
of these options is $10 billion.

With perfect capital markets, what is the market value of Cisoft’s equity after the share
repurchase? What is the value per share?

What is the share price if Cisoft would distribute the dividends worth of $10 billion instead
of repurchasing the shares?

224
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
Non-cash assets = equity + options – cash = 20 × 6 + 10 – 5 = 125 billion.

Share repurchase
Equity after repurchase = 120 – 5 =115
Number of shares repurchased = 5B/20 = 0.25B
Share price = 115/5.750 = $20

Dividend distribution
Equity after dividends paid = 120 – 5 =115
Dividend per share= 5B/6B = $0.83
Share price after dividends paid = 115/6B = $19.17
Notice: share price before dividends ($20) = dividends ($0.83) + Share price after dividends ($19.17)

225
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 4
Hardmon Enterprises is currently an all-equity firm with an expected return of 12%. It is
considering a leveraged recapitalization in which it would borrow and repurchase existing shares.

a) Suppose Hardmon borrows to the point that its debt-equity ratio is 0.50. With this amount of
debt, the debt cost of capital is 5%. What will the expected return of equity be after this
transaction?

b) Suppose instead Hardmon borrows to the point that its debt-equity ratio is 1.50. With this
amount of debt, Hardmon’s debt will be much riskier. As a result, the debt cost of capital will
be 7%. What will the expected return of equity be in this case?

c) A senior manager argues that it is in the best interest of the shareholders to choose the
capital structure that leads to the highest expected return for the stock. How would you
respond to this argument?

226
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
a) re = ru + (d/e)(ru – rd) = 12% + 0.50(12% – 5%) = 15.5%
b) re = 12% + 1.50(12% – 7%) = 19.5%

c) Returns are higher because risk is higher—the return fairly compensates for the risk.

227
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 5
Global Pistons (GP) has common stock with a market value of $470 million and debt with a value
of $299 million. Investors expect a 13% return on the stock and a 5% return on the debt. Assume
perfect capital markets.
a) Suppose GP issues $299 million of new stock to buy back the debt. What is the expected
return of the stock after this transaction?
b) Suppose instead GP issues $71 million of new debt to repurchase stock.
i. If the risk of the debt does not change, what is the expected return of the stock after this
transaction?
ii. If the risk of the debt increases, would the expected return of the stock be higher or
lower than in part (i)?

228
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
a) wacc= 470/(470+299)×13% + 299/(470+299) × 5%=9.89%

b) i. re = ru + (d/e)(ru – rd) = 9.89% + (370/399) × (9.89% - 5%) = 14.42%

ii. if rd is higher, re is lower. The debt will share some of the risk.

229
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 6
Mercer Corp. is a firm with 10 million shares outstanding and $84 million worth of debt
outstanding. Its current share price is $73. Mercer’s equity cost of capital is 8.5%. Mercer has just
announced that it will issue $354 million worth of debt. It will use the proceeds from this debt to
pay off its existing debt, and use the remaining $270 million to pay an immediate dividend.
Assume perfect capital markets.

a) Estimate Mercer’s share price just after the recapitalization is announced, but before the
transaction occurs.

b) Estimate Mercer’s share price at the conclusion of the transaction. (Hint: Use the market
value balance sheet.)
c) Suppose Mercer’s existing debt was risk free with a 4.39% expected return, and its new debt
is risky with a 4.93% expected return. Estimate Mercer’s equity cost of capital after the
transaction.

230
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
a) MM Þ no change, $73

a) Initial enterprise value = 73 ´ 10 + 84 = 814 million

Equity after dividends = 730 – 270 = 460
Share price = 460/10 = $46

c) Ru = (730/814) ´ 8.5% + (84/814) ´ 4.39% = 8.08%

Re = 8.08% + (354/460)(8.08% – 4.93%) = 10.50%

231
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 7
Yerba Industries is an all-equity firm whose stock has a beta of 0.70 and an expected
return of 18.50%. Suppose it issues new risk-free debt with a 6.50% yield and repurchases
5% of its stock. Assume perfect capital markets.
a) What is the beta of Yerba stock after this transaction?
b) What is the expected return of Yerba stock after this transaction?
Suppose that prior to this transaction, Yerba expected earnings per share this coming
year of $4.50, with a forward P/E ratio (that is, the share price divided by the expected
earnings for the coming year) of 10.
c) What is Yerba’s expected earnings per share after this transaction? Does this change
benefit shareholders? Explain.
d) What is Yerba’s forward P/E ratio after this transaction? Is this change in the P/E ratio
reasonable? Explain.

232
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
:.<:
a) 𝛽7 = 0.95×𝛽4 → 𝛽4 = = 0.737
:.=>
?@.>:%B:.:>×D.>:%
b) 𝑟7 = 0.95×𝑟4 + 0.05×6.50% → 𝑟4 = :.=>
= 19.13%

c) P = 10(4.50) = $45. Borrow 5%(45) = 2.25, interest = 6.5%(2.25) = 0.14625.

Earnings = 4.50 – 0.14625 = 4.35375, earnings per share = 4.35375/0.95 = $4.58.
No benefit; risk is higher. The stock price does not change.
d) P/E = 45/4.58 = 9.83. It falls due to higher risk.

233
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 8
You are CEO of a high-growth technology firm. You plan to raise $160 million to fund
an expansion by issuing either new shares or new debt. With the expansion, you
expect earnings next year of $31 million. The firm currently has 9 million shares
outstanding, with a price of $67 per share. Assume perfect capital markets.
a) If you raise the $160 million by selling new shares, what will the forecast for next
year’s earnings per share be?

b) If you raise the $160 million by issuing new debt with an interest rate of 8%, what
will the forecast for next year’s earnings per share be?

c) What is the firm’s forward P/E ratio (that is, the share price divided by the
expected earnings for the coming year) if it issues equity? What is the firm’s
forward P/E ratio if it issues debt? How can you explain the difference?

234
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
a) Issue 160/67 = 2.388 million new shares, 11.388 million shares outstanding. New EPS =
$31M/11.388M = $2.72 per share.

b) Interest on new debt = 160 × 8% = 12.8 million. The interest expense will reduce
earnings to 31 – 12.8 = $18.2 million. With 9 million shares outstanding, EPS =
$18.2M/9M = $2.02 per share.

c) By MM, share price is $67 in either case. PE ratio with equity issue is 67/2.72 = 24.63. PE
ratio with debt is 67/2.02 = 33.13.

The higher PE ratio is justified because with leverage, EPS will grow at a faster rate.

235
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Session 6:
Capital structure II – taxes
(theory)

236
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

The interest tax deduction

• Corporations pay taxes on their profits after interest payments are deducted. Thus, interest
expense reduces the amount of corporate taxes.
Ø This creates an incentive to use debt.

• Consider Macy’s which had earnings before interest and taxes of approximately $2.8 billion in
2014 and interest expenses of about $400 million. Macy’s marginal corporate tax rate was 35%.

• As shown on the next slide, Macy’s net income in 2014 was lower with leverage than it would
have been without leverage.

237
 MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

The interest tax deduction (ctd.)

Macy’s Income with and without leverage, 2014 ($ millions)

• Macy’s debt obligations reduced

the value of its equity.
• But the total amount available to
all investors was higher with
leverage.

238
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

The interest tax deduction (ctd.)

• Without leverage, Macy’s was able to pay out $1820 million in total to its investors.
• With leverage, Macy’s was able to pay out $1960 million in total to its investors.
• Where does the additional $140 million come from?

• Interest Tax Shield: The reduction in taxes paid due to the tax deductibility of interest
–In Macy’s case, the gain is equal to the reduction in taxes with leverage: $980 million − $840 million
= $140 million. The interest payments provided a tax savings of 35% × $400 million = $140 million.

239
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Valuing the interest tax shield

• When a firm uses debt, the interest tax shield provides a corporate tax benefit each year.

• This benefit is computed as the present value of the stream of future interest tax shields the
firm will receive.

• The cash flows a levered firm pays to investors will be higher than they would be
without leverage by the amount of the interest tax shield.

æ Cash Flows to Investors ö æ Cash Flows to Investors ö

ç ÷ = ç ÷ + (Interest Tax Shield)
è with Leverage ø è without Leverage ø

240
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Cash flows of the levered and unlevered firm

241
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

The interest tax shield and firm value

• MM Proposition I with taxes:
–The total value of the levered firm exceeds the value of the firm without leverage due to the
present value of the tax savings from debt.

V L
= V U
+ PV (Interest Tax Shield)

242
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

The interest tax shield with permanent debt

• Typically, the level of future interest payments is uncertain due to changes in the marginal tax
rate, the amount of debt outstanding, the interest rate on that debt, and the risk of the firm.
–For simplicity, we will consider the special case in which the above variables are kept constant.

• Suppose a firm borrows debt D and keeps the debt permanently. If the firm’s marginal tax rate is
tc , and if the debt is riskless with a risk-free interest rate rf , then the interest tax shield each year
is tc × rf × D, and the tax shield can be valued as a perpetuity.

t c ´ Interest t c ´ (rf ´ D)
PV (Interest Tax Shield) = =
rf rf
= tc ´ D

243
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Example
• Suppose ALCO plans to pay $60 million in interest each year for the next eight years, and then
repay the principal of $1 billion in year 8.

• These payments are risk free, and ALCO’s marginal tax rate will remain 39% throughout this period.

Ø If the risk-free interest rate is 6%, by how much does the interest tax shield increase the
value of ALCO?

244
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
• The annual interest tax shield is

$1 billion × 6% × 39% = $23.4 million for eight years.

1 1
PV (Interest Tax Shield) = $23.4 million ´ (1 - 8
)
6% 1.06
= $145.31 million

245
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

The interest tax shield with permanent debt

• If the debt is fairly priced, no arbitrage implies that its market value must equal the present
value of the future interest payments (even if debt is NOT risk-free):
Market Value of Debt = D = PV (Future Interest Payments)

• If the firm’s marginal tax rate is constant, then

PV (Interest Tax Shield) = PV (t c ´ Future Interest Payments)

= t c ´ PV (Future Interest Payments)
= tc ´ D

• Notice that implicitly, the discount rate (or expected return) of the tax shields is simply rD

246
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Taxes and the weighted cost of capital

• Weighted Average Cost of Capital (WACC): Important! When using the WACC to
discount operational cash flows, we are
embedding financing choices into the
E D
rWACC = rE + rD (1 - tc ) valuation exercise.
E+D E+D
$250 $100
rWACC = 15% + 7%(1 - 0.34) = 12.03%
$250 + $100 $250 + $100

• With tax-deductible interest, the effective after-tax borrowing rate is rD(1 − tc)

247
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Taxes and the weighted cost of capital

• How does rwacc compare with rU?

–Unlevered cost of capital (or pretax WACC)

•Expected return investors will earn by holding the firm’s assets
•In a world with taxes, it can be used to evaluate an all-equity project with the same risk
as the firm.

–In a world with taxes, WACC is less than the expected return of the firm’s assets.
•With taxes, WACC can be used to evaluate a project with the same risk and the same
financing as the firm.

248
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

WACC with taxes (ctd.)

The WACC with and without corporate taxes

249
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Example
• Cavo Corp’s equity cost of capital is 15%, and its debt cost of capital is 7%.

• The corporate tax rate is 34%.

• The firm has $100 million in debt outstanding and a market capitalization of $250 million.

Ø What is Cabo’s unlevered cost of capital?

Ø What is Cavo’s weighted average cost of capital?

250
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
• Cavo’s unlevered cost of capital is

E D
rU = rE + rD
E+D E+D
$250 $100
βU = 15% + 7% = 12.71%
$250 + $100 $250 + $100

251
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution (ctd.)
• Cavo’s WACC is
E D
rWACC = rE + rD (1 - tc )
E+D E+D
$250 $100
rWACC = 15% + 7%(1 - 0.34) = 12.03%
$250 + $100 $250 + $100

• Or
D
rWACC = rU - τ C rD
E+D
$100
= 12.71% - (7%)0.34 = 12.03%
$250 + $100

252
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Interest tax shield with a target D/E ratio

• When a firm adjusts its leverage to maintain a target debt-equity ratio, we can compute its
value with leverage, VL, by discounting its free cash flow using the weighted average cost of
capital.

• The value of the interest tax shield can be found by comparing the value of the levered firm, VL,
to the unlevered value, VU, of the free cash flow discounted at the firm’s unlevered cost of
capital, the pretax WACC.

253
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Example
• Harris Solutions expects to have free cash flow in the coming year of $1.75 million, and its
free cash flow is expected to grow at a rate of 3.5% per year thereafter.

• Harris Solutions has an equity cost of capital of 12% and a debt cost of capital of 7%, and it
pays a corporate tax rate of 40%.

Ø If Harris Solutions maintains a debt-equity ratio of 2.5, what is the value of its interest tax
shield?

254
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
• We can estimate the value of Harris Solution’s interest tax shield by comparing its value with
and without leverage.

• We compute its unlevered value by discounting its free cash flow at its pretax WACC:
E D
Pretax WACC = rE + rD
E+D E+D
æ 1 ö æ 2.5 ö
=ç ÷12% + ç ÷ 7% = 8.43%
è 1 + 2.5 ø è 1 + 2.5 ø

• Because Harris Solution’s free cash flow is expected to grow at a constant rate, we can value it
as a constant growth perpetuity:
$1.75 million
V =U
= $35.50 million
8.43% - 3.50%

255
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution (ctd.)
• To compute Harris Solution’s levered value, we calculate its WACC:
E D
WACC = rE + rD (1 - t C )
E+D E+D
æ 1 ö æ 2.5 ö
=ç ÷12% + ç ÷ 7%(1 - .40) = 6.43%
è 1 + 2.5 ø è 1 + 2.5 ø

• Thus, Harris Solution’s value including the interest tax shield is

$1.75 million
V =L
= $59.73 million
6.43% - 3.50%

• The value of the interest tax shield is therefore:

PV(Interest Tax Shield) = VL - VU = $59.73 - $35.50 = $24.23 million

256
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Levered and unlevered betas with a target D/E ratio

•With taxes, we can write the fundamental valuation identity as

V = Vu + TS = D + E

where Vu is the value of the firm as if it was totally financed with equity and TS the present value
of tax shields

•Equilibrium returns on both sides of the identity also need to be identical (law of one price / no
arbitrage):
𝑉! 𝑉! 𝐷 𝐷
𝒓! + 1 − 𝒓 "# = 𝒓$ + 1 − 𝒓% ⇔
𝑉 𝑉 𝑉 𝑉
𝐷 𝑇𝑆
𝒓% = 𝒓! + 𝒓! − 𝒓$ + 𝒓 "# − 𝒓!
𝐸 𝐸
Equation (1)

257
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Levered and unlevered betas with a target D/E ratio

•Assuming the risk of tax shields is ru—which is reasonable if the firm is targeting a leverage
ratio—we may then write, using equation (1):
𝐷
𝒓% = 𝒓! + 𝒓! − 𝒓$
𝐸

•By the CAPM the following three expressions are correct:

𝒓𝒆 = 𝒓' + 𝛽% 𝒓( − 𝒓'
𝒓! = 𝒓' + 𝛽! 𝒓( − 𝒓'
𝒓$ = 𝒓' + 𝛽$ 𝒓( − 𝒓'

258
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Levered and unlevered betas with a target D/E ratio

•The last four expressions combined give us the formula for levering/unlevering beta under the
assumption that rTS=rU:

D
b e = b u + (b u - b d )
E

•If we further assume βd=0, this simplifies into

æ Dö
b e = b u ç1 + ÷
è Eø

259
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Levered and unlevered betas with perpetual debt

•Assuming perpetual debt—which implies the risk of the tax shields corresponds to the risk of debt—
the value of tax shields is given by the Modigliani-Miller formula:
𝑇𝑆 = 𝑡) 𝐷

•We may then write (using again equation (1)):

𝐷
𝒓% = 𝒓! + 𝒓! − 𝒓$ 1 − 𝑡)
𝐸

260
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Levered and unlevered betas with perpetual debt

•Making use of the CAPM we now obtain a different leverage/unleverage formula:

D
b e = b u + (b u - b d )(1 - tc )
E

•If we further assume βd=0, this simplifies into the commonly-used expression:

æ D ö
b e = b u ç1 + (1 - tc )÷
è E ø

261
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Session 6.2:
Capital structure II – taxes
(selected problems)

262
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 6.1
Arnell Industries has just issued $15 million in debt (at par). The firm will pay interest only on this
debt. Arnell’s marginal tax rate is expected to be 35% for the foreseeable future.
a. Suppose Arnell pays interest of 7% per year on its debt. What is its annual interest tax shield?
b. What is the present value of the interest tax shield, assuming its risk is the same as the loan?
Ten years have passed since Arnell issued $15 million in perpetual interest only debt with a
7% annual coupon. Tax rates have remained the same at 35% but interest rates have dropped so
Arnell’s current cost of debt capital is 2%.
c. What is Arnell’s annual interest tax shield?
d. What is the present value of the interest tax shield today?

263
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
a. Interest tax shield = $15 ´ 7% ´ 35% = $0.3675 million

$0.3675
b. PV(Interest tax shield) = = $5.25 million
7%

c. Interest tax shield = $15 ´ 7% ´ 35% = $0.3675 million

$0.3675
d. PV(Interest tax shield) = = $18.375 million.
2%

Alternatively, new market value of debt is D = (15 ´ 0.07)/0.02 = $52.5 million. Tc ´ D = 35% ´ 52.5 = $18.375
million.

264
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 6.2
Rally Inc. is an all-equity firm with assets worth $25 billion and 10 billion shares outstanding.
Rally plans to borrow $10 billion and use these funds to repurchase shares. The firm’s corporate
tax rate is 35%, and Rally plans to keep its outstanding debt equal to $10 billion permanently.
a. Without the increase in leverage, what would Rally’s share price be?
b. Suppose Rally offers $2.75 per share to repurchase its shares. Would shareholders sell for
this price?
c. Suppose Rally offers $3.00 per share, and shareholders tender their shares at this price.
What will Rally’s share price be after the repurchase?
d. What is the lowest price Rally can offer and have shareholders tender their shares? What will
its stock price be after the share repurchase in that case?

265
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
25
a. Share price = = $2.50 per share
10

b. Just before the share repurchase:

Assets = 25 (existing) + 10 (cash) + 35% ´ 10 (tax shield) = $38.5 billion

E = 38.5 – 10 = 28.5 billion, share price = 28.5/10=$2.85/share

Therefore, shareholders will not sell for $2.75 per share.

10 18.5
c. Remaining Shares = 10 - = 6.667 billion. Share price = = $2.775 share.
3 6.667

10
d. From (b), fair value of the shares prior to repurchase is $2.85. At this price, Rally will have 10 - = 6.49
2.85
18.5
million shares outstanding, which will be worth = $2.85 after the repurchase. Therefore, shares will be
6.49
willing to sell at this price.

266
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 6.3
Kurz Manufacturing is currently an all-equity firm with 27 million shares outstanding and a
stock price of $15 per share. Although investors currently expect Kurz to remain an all-
equity firm, Kurz plans to announce that it will borrow $65 million and use the funds to
repurchase shares. Kurz will pay interest only on this debt, and it has no further plans to
increase or decrease the amount of debt. Kurz is subject to a 38% corporate tax rate.
a. What is the market value of Kurz’s existing assets before the announcement?
b. What is the market value of Kurz’s assets (including any tax shields) just after the debt
is issued, but before the shares are repurchased?
c. What is Kurz’s share price just before the share repurchase? How many shares will
Kurz repurchase?
d. What are Kurz’s market value balance sheet and share price after the share
repurchase?

267
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
a. Assets = Equity = $15 × 27 = $405 million

b. Assets = 405 (existing) + 65 (cash) + 38% × 65 (tax shield) = $494.7 million

$429.7 million
c. E = Assets – Debt = 494.7 – 65 = $429.7 million. Share price = = $15.91 .
27

65
Kurz will repurchase = 4.085 million shares.
15.91

d. Assets = 405 (existing) + 38% ´ 65 (tax shield) = $429.7 million

Debt = $65 million

E = A – D = 429.7 − 65 = $364.7 million

$364.7
Share price = = $15.91 per share .
27 - 4.085

268
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 6.4
Milton Industries expects free cash flow of $18 million each year. Milton’s corporate tax rate is
38%, and its unlevered cost of capital is 16%. Milton also has outstanding debt of $75.25 million,
and it expects to maintain this level of debt permanently.
a. What is the value of Milton Industries without leverage?
b. What is the value of Milton Industries with leverage?

269
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
18
a. V =
U
= $112.5 million
0.16

b. V = V + t C D = 112.5 + 0.38 ´ 75.25 = $141.10 million

L U

270
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Exercise 6.5
Acme Storage has a market capitalization of $72 million and debt outstanding of $100 million.
Acme plans to maintain this same debt-equity ratio in the future. The firm pays an interest rate
of 7.4% on its debt and has a corporate tax rate of 38%.
a. If Acme’s free cash flow is expected to be $13.76 million next year and is expected to grow at
a rate of 2% per year, what is Acme’s WACC?
b. What is the value of Acme’s interest tax shield?

271
MASTERS IN FINANCE – CORPORATE FINANCE – FALL 2023

Solution
FCF 13.76
a. V = E + D = 172 =
L
= . Therefore WACC = 10%.
WACC - g WACC - 0.02

D 100
b. Pretax WACC = WACC + rDt C = 10% + ( 7.4% )( 0.38% ) = 11.63%
E+D 172

FCF 13.76
V =U
= = $142.81 million
pretax WACC - g 0.1163 - 0.02
PV ( Interest Tax Shield ) = V L - V U = 172 - 142.81 = $29.19 million

272