IIMB PGP/PGPBA 2023-25 – Term 2

Section H
Nitin Vishen

Corporate
Finance

Office Hours: By Appointment, D108

Topic 7

Capital Budgeting:
NPV and Other Investment Criteria
 Learning Objectives
 Learn how Managers evaluate investment options.

 To understand the methods:

 NPV
 Payback Period
 Book Rate of Return
 Internal Rate of Return (IRR)

 Advantages and disadvantages of these methods!

 • You are the CFO, and the CEO comes to you with project X.
• How do you decide to go ahead with the project or not?

• Step1: Project all cash flows of the project X

You are the • Step 2: Decide an appropriate cost of capital for X (How?)
CFO! • Step 3: Calculate Present Value (PV) of all cash flows as the
given cost of capital.

• Step 4: Calculate NPV by subtracting initial investment

• Step 5: If NPV > 0, take the project!

Review the Basics
CEO asks Why does NPV > 0 rule work?

Current Value of your firm = $10mn

= $1mn cash + $9mn [PV(Current Operations)]

Project X’s present value = PV(X)

If you invest $1mn cash in Project X, Firm Value = $9mn + PV(X)

So, if PV(X) > $1mn (the investment) Investing in X increases Firm Value
 Net Present Value (NPV)

1. The NPV rule offers a clear benchmark— accept projects with positive NPV.

2. NPV depends solely on the all cash flows, none are unaccounted for.

3. A dollar today is worth more than a dollar tomorrow.

4. Net present value depends solely on the forecasted cash flows from the project and the
opportunity cost of capital.

5. Because present values are all measured in today’s dollars, you can add them up.
• NPV NPV NPV
 Payback Period

Competing Accounting Rate of Return

Methods to NPV

Internal Rate of Return (IRR)

CFO Survey: Investment Evaluation Techniques
 Payback Period

Competing Accounting Rate of Return

Methods to NPV

Internal Rate of Return (IRR)

 Example: Cab vs Car
• You do not own a car, and depend on a car to go anywhere.
• You go to office 250 days/year, & other trips on another 50 days.
• On average, you spend Rs 1000/day on cab rides
• So, total annual cab spending = 300 x Rs 1000 = Rs 3 lakhs

• Instead you could buy a Car worth Rs 10 lakhs

• You estimate that you will require fuel worth Rs 200 everyday.
• Assuming no maintenance cost, how long will buying a car
compensate for cab rides?

• Annual Fuel Cost: Rs 200 x 300 = Rs 60,000

• Annual Savings in Daily Expenses: Rs 3,00,000 – Rs 60,000 = Rs
2,40,000

• Payback period = Rs 10,00,000 / Rs 2,40,000 ≃ 4 years

• In 4 years, the car will pay for itself
 Payback Period
• Payback Period: The number of years it takes before
the cumulative forecasted cash flow equals the initial
outlay.

• The Payback Rule says to only accept projects that

“pay back” in the desired time frame.

• This method is flawed:

• It ignores later-year cash flows.
• It ignores the present value of future cash flows
• The cut off period is arbitrary.
 Examine the three projects and note the mistake we
Payback Period would make if we insisted on only taking projects with
a payback period of 2 years or less.

Project 𝑪𝟎 𝑪𝟏 𝑪𝟐 𝑪𝟑 Payback Period NPV

A -2000 500/1.1 = 455 500/1.1 = 413 5000/1.1 = 3757 3 2624
B -2000 500/1.1 = 455 1800/1.1 = 1488 0 - -58
C -2000 1800/1.1 = 1636 500/1.1 = 413 0 2 50
 Why do managers use
Payback method?

• It is simple to communicate project

profitability in terms of payback period.

• Managers want to deliver projects in

shorter time-periods.

• Small firms might find it easier to raise

capital for projects with quicker payback-
periods.
 Chapter 5 - Question 2

a) If the opportunity cost of capital is 10%, which projects have positive NPV?
b) Calculate the payback period for each project.
c) Which project(s) would a firm using the payback rule accept if the cutoff
period is three years?
 Chapter 5 - Question 2 – Solution

(a)
NPVA = –$1,000 + $1,000 / (1 + .10) = –$90.91

NPVB = –$2,000 + $1,000 / (1 + .10) + $1,000 / (1 + .10)2 + $4,000 / (1 + .10)3

+ $1,000 / (1 + .10)4 + $1,000 / (1 + .10)5
= $4,044.73

NPVC = –$3,000 + $1,000 / (1 + .10) + $1,000 / (1 + .10)2 + $1,000 / (1 + .10)4 + $1,000 / (1 + .10)5
NPVC = $39.47
 Chapter 5 - Question 2 – Solution

(a) If the opportunity cost of capital is 10%, which projects have a positive NPV?
>>> Projects B and C have positive NPVs.

(b) Calculate the payback period for each project.

>>> Payback A = 1 year
>>> Payback B = 2 years
>>> Payback C = 4 years

(c) Which project(s) would a firm using the payback rule accept if the cutoff period is three years?
>>> Accept projects A and B
 Payback Period

Competing Accounting Rate of Return

Methods to NPV

Internal Rate of Return (IRR)

 Accounting Rate of Return

• Accounting rate of return is also called Book Rate of Return.

• Managers rarely use this measurement to make decisions.
• Ignores Time Value of Money
• No clear benchmark
• The components reflect tax and accounting figures, not market values or cash flows.
 Payback Period

Competing Accounting Rate of Return

Methods to NPV

Internal Rate of Return (IRR)

 Internal Rate of Return (IRR)

• IRR is the discount rate at which NPV = 0.

NPV

• Internal Rate of Return Rule

• Invest in any project offering a rate of return that is higher than the opportunity
cost of capital.

Payoff
• Rate of return for a single−payoff 1 period investment
Investment
 Internal Rate of Return (IRR)

You can purchase a turbo-powered machine tool gadget for $4,000. The
investment will generate $2,000 and $4,000 in cash flows for 2 years, respectively.
What is the IRR on this investment?

NPV

NPV
 You can purchase a turbo-powered machine
Internal Rate of tool gadget for $4,000. The investment will
generate $2,000 and $4,000 in cash flows for 2
Return (IRR) years, respectively. What is the IRR on this
investment?

Rate 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
𝐶 -4000 -4000 -4000 -4000 -4000 -4000 -4000 -4000 -4000 -4000 -4000 -4000
𝑃𝑉(𝐶 ) 2000 2000 1905 1818 1739 1667 1600 1538 1481 1429 1379 1333
𝑃𝑉(𝐶 ) 4000 4000 3628 3306 3025 2778 2560 2367 2195 2041 1902 1778
𝑁𝑃𝑉 2000 1533 1124 764 444 160 -95 -324 -531 -718 -889
Internal Rate
of Return (IRR)

Internal Rate of Return (IRR) Rule of Investment Decision:

Opportunity Cost of Capital < Internal Rate of Return
Pitfall 1—Lending vs Borrowing?
Project C0 C1 IRR NPV at 10% Transaction
A −1,000 +1,500 +50% +364 Lending
B +1,000 −1,500 +50% −364 Borrowing
600
400
200
0
-200
-400
-600
A B
Pitfall 1—Lending vs Borrowing?

• Another example of Project B is Insurance Firm’s cash flows:

Positive Initially (Premium), and Negative later (Claim)

• With some cash flows, the NPV of the project increases as the
discount rate increases.

• This is contrary to the normal relationship between NPV and

discount rates.
Pitfall 2a—Multiple Rates of Return 1

Certain cash flows can generate NPV = 0 at two different discount rates.
𝑪𝟎 𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝟒 𝑪𝟓 𝑪𝟔 𝑪𝟕 𝑪𝟖 𝑪𝟗 𝑪𝟏𝟎
-30 10 10 10 10 10 10 10 10 10 -65

As many IRRs, as many changes in sign of Cash Flows

Modified IRR
𝑪𝟎 𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝟒 𝑪𝟓 𝑪𝟔 𝑪𝟕 𝑪𝟖 𝑪𝟗 𝑪𝟏𝟎 IRR = 3.5%, 19.54%
-30 10 10 10 10 10 10 10 10 10 -65

Companies sometimes get around the problem of multiple rates of return by discounting
the later cash flows back at the cost of capital until there remains only one change in the
sign of the cash flows!

Calculate Present Value in year 5 of all the subsequent cash flows at 10% cost of capital:

Modified Cash Flows:

Now there is only one change in sign of cash flows. So, you will get only one IRR of 13.7%
Pitfall 2b—No Internal Rate of Return
It is not possible to calculate an IRR, but NPV is positive.
Project C0 C1 C2 IRR (%) NPV at 10%
C +1,000 −3,000 +2,500 None +339
600

500

400

300

200

100

0
0%
4%
8%
12%
16%
20%
24%
28%
32%
36%
40%
44%
48%
52%
56%
60%
64%
68%
72%
76%
80%
84%
88%
92%
96%
100%
Pitfall 3—Mutually Exclusive Projects
• Firms sometimes need to choose between multiple alternative ways
of utilizing the same resource
• IRR sometimes ignores the magnitude of the project.
Project C0 C1 IRR NPV at 10%
D −10,000 +20,000 100 +8,182
E −20,000 +35,000 75 +11,818

• Salvage IRR Method by taking incremental cash flows:

Project C0 C1 IRR NPV at 10%
E-D −10,000 +15,000 50 +3,636
Pitfall 3:
Mutually
Exclusive
Projects
Pitfall 3:
Mutually
Exclusive
Projects
 Pitfall 4—What Happens When There Is
More Than One Opportunity Cost of Capital

• We assume that discount rates are stable during the term of the project.
• This assumption implies that all funds are reinvested at the IRR.
• This assumption might not be true for all projects.
 Verdict on IRR?

• IRR is fairly popular!

• A bit difficult to use compared to NPV method
• But if it is used properly, it would give the same investment decision!

• For a standard project cash flow structure:

• Initial Investment followed by Positive Cash Inflows
• IRR is easy to apply
 Verdict on IRR?

In case of mutually exclusive projects (Pitfall 3):

• Financial Managers never observe all possible project alternatives, as opposed
to operational managers!

• If higher IRR is prescribed, it is possible that the operational managers will take
the first project they evaluate

• Or they might end up choosing very-short lived projects with higher IRR but
lower NPV
Chapter 5 – Question 12

The opportunity cost of capital is 9%

a) Should you pick the higher IRR project? Explain.
b) How can you use the IRR Rule to choose the best project?
c) Which project has higher NPV?
 Chapter 5 – Question 12 - Solution

(a) Should you take B as it has higher IRR? Explain!

No. Project A requires a larger capital outlay, it is possible that Project A has both a lower IRR and a
higher NPV than Project B. (In fact, is greater than for all discount rates less than
10%.) Because the goal is to maximize shareholder wealth, NPV is the correct criterion.
 Chapter 5 – Question 12 - Solution

(b) How can you use the IRR Rule to choose the best project?

To use the IRR criterion for mutually exclusive projects, calculate the IRR for the incremental cash flows!

C0 C1 C2 IRR
A - B −200 +110 +121 10%
Because the IRR for the incremental cash flows exceeds the cost of capital, the additional investment in
A is worthwhile.
 Chapter 5 – Question 12 - Solution

(c) Which project has higher NPV?

NPVA = –$400 + $250 / 1.09 + $300 / 1.092 = $81.86

NPVB = –$200 + $140 / 1.09 + $179 / 1.092 = $79.10
Chapter 5 – Question 13
 Chapter 5 – Question 13
• The Titanic Shipbuilding Company has a non-cancellable
contract to build a small cargo vessel.
• Construction involves a cash outlay of $250,000 at the end of
each of the next 2 years.
• At the end of the 3rd year, the company will receive payment
of $650,000.
• The company can speed up construction by working an extra
shift.
• In this case, there will be a cash outlay of $550,000 at the
end of the first year followed by a cash payment of $650,000
at the end of the 2nd year.
• Use the IRR rule to show the approximate range of
opportunity cost of capital at which the company should
work the extra shift?
 Chapter 5 – Question 13
𝟏 𝟐 𝟑
Normal Shift -250 -250 +650
Extra Shift -550 +650 0
Incremental Cash Flow -300 +900 -650
20.00

10.00

0.00

-10.00
NPV

-20.00
DISCOUNT RATE (%)
-30.00

-40.00

-50.00

-60.00
 Chapter 5 – Question 13
NPV = 0
= [–$550,000 – (–$250,000)] / (1 + IRR)1
+ [$650,000 – (–$250,000)] / (1 + IRR)2
+ ($0 – $650,000) / (1 + IRR)3

NPV = 0
= –$300,000 / (1 + IRR)
+ $900,000 / (1 + IRR)2
–$650,000) / (1 + IRR)3

Because the cash flows change direction twice, there are two IRRs.
The IRRs for the incremental flows are approximately 21.13 percent
and 78.87 percent. If the cost of capital is between these two rates,
Titanic should work the extra shift.
 IRR in Excel

IRR: Internal Rate of Return on a series of regularly spaced cash flows

IRR in Excel

XIRR: The same as IRR, but for irregularly spaced cash flows!
IIMB PGP/PGPBA 2023-25 – Term 2
Section H
Nitin Vishen

Corporate
Finance

Office Hours: By Appointment, D108

Topic 8

Capital Budgeting :
Making Investment Decisions with the NPV Rule
Learning Objectives
 Forecast cash flows for a capital
budgeting project

 Handle issues related to inflation,

hidden cash flows, and accounting
issue

 Account for corporate income taxes

 Solve realistic, complex capital

budgeting problems when the timing
of alternatives varies
 Making Investment Decisions
with the NPV Rule

• How do you decide whether to invest in a project

or not?
• Use the NPV Rule

• How do you calculate NPV?

• Step 1: Project Cash Flows
• Step 2: Discount at Opportunity Cost of Capital
 Making Investment Decisions
with the NPV Rule

Practical Issues in forecasting Cash Flows

• How soon will the new project start?

• What will be the likely revenue?
• What will be the costs?
• How long will the project last?
 Making Investment Decisions
with the NPV Rule

We will dive deep into:

• Forecasting a project’s cash flows

• Corporate Income Taxes
• Example of a project analysis
Forecasting a Project’s Cash Flows
Five Rules on What to Discount:
1. Discount Cash Flows, Not Profits.

2. Discount incremental cash flows; ignore non-incremental flows.

3. Treat inflation consistently.

4. Separate investment and financing decisions.

5. Forecast cash flows after taxes.

 Rule 1: Discount Cash Flows, Not Profits.

• NPV depends on expected future cash flows

• Cash flow = Cash Received – Cash Paid Out
Forecasting
a Project's • Cash Flow Accounting Profit

Cash Flow • Accounting Profit Measure of a firm’s performance!

• To calculate accounting profits, Cash flows are

adjusted in two principal ways:
1. Capital Expenditures
2. Working Capital
 Rule 1: Discount Cash Flows, Not Profits.

Forecasting
Capital Expenses:
• Record capital expenditures when they occur.

a Project's • To determine cash flow from income, add back

depreciation and subtract capital expenditure.
Cash Flow Working Capital:
• Difference between company’s short-term
assets and liabilities.
 Rule 1: Discount Cash Flows – Capital Expenses
Cash Expenditure has two parts:
• Current Expenditures (e.g. wages)
• Capital Expenditures (e.g. Purchase of New Machinery)

While calculating Accounting Profit:

• You subtract Current Expenditures from Current Revenues
• But do not deduct Capital Expenditure! Why?
• Example: If a firm buys a machine for $1mn Is the firm performing poorly? The firm has only
exchanged its cash for the new machine.
• You spread the cost of machinery over its forecasted life using depreciation.
• If $1mn investment is depreciated by $100,000 a year for 10 years. This depreciation is treated as
an annual expense, but all the cash went out in year 1 itself
 Rule 1: Discount Cash Flows – Capital Expenses

Calculate NPV of a project Year 1 Year 2

that cost $2000 initially. Cash Inflow $1,500 $500
Less Depreciation -1000 -1000
Use discount rate of 10% Accounting Income +$500 -$500

500 500
𝑁𝑃𝑉 𝑢𝑠𝑖𝑛𝑔 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 = − = $41.32
1.1 1.1

Is the project worth taking?

1500 500
𝑁𝑃𝑉 𝑢𝑠𝑖𝑛𝑔 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠 = −2000 + + <0
1.1 1.1

No! At any positive discount rate, the cash flows will give a negative NPV.
 Rule 1: Discount Cash Flows – Capital Expenses

A supermarket installs a new machine. The machine costs $250,000, and projected
profit per machine is as follows:

Calculate the actual cash flows from the machines.

 Rule 1: Discount Cash Flows – Capital Expenses

Accounting Profit Cash Flow

1. Add back depreciation (which is not cash outflow)
2. Subtract Capital Expenditure (which is a cash outflow)
 Rule 1: Discount Cash Flows – Working Capital
Working Capital: Difference between company’s short-term assets and liabilities.

Short-term Assets: Accounts Receivables (customers’ unpaid bills) and Inventories of raw material
and finished goods.

Short-term Liabilities: Accounts Payable (Bills you have not paid) and Accruals (liabilities of wages
or taxes that have been incurred but not paid).

Example:
 Rule 1: Discount Cash Flows – Working Capital

Sale was made in Period 2:

Accounting Profit at Period 2:

Rule 1: Discount Cash Flows – Working Capital
 Rule 1: Discount Cash Flows – Working Capital

An increase in current liabilities represents cash inflow. If you delay paying your bills (an increase
in accounts payable), cash flow is higher. If your firm did not pay for its purchase of raw materials
until Period 2, there would be an increase in payables in Period 1, and our cash flow calculation
would change like this:
 Rule 1: Discount Cash Flows – Working Capital

Some mistakes regarding working capital calculations:

1. Forgetting about working capital entirely.

2. Forgetting that working capital may change during the life of the project.
• If you sold $100,000 of goods a year, and collect the amount after 6 months, you would have
$50,000 unpaid bills.
• If you increase prices by 10%, revenues will rise to $110,000.
• If collection period remains 6 months, unpaid bills rise to $55,000.
• So, Additional investment in working capital = $5000

3. Forgetting that working capital is recovered at the end of the project.

• At the end of the project, unpaid bulls are collected (hopefully) ⇒ Cash Inflow.
 Chapter 6 – Question 10

Calculate net working capital and cash flows!

Net working capital = accounts receivable + inventory – accounts payable

Cash flows = +Decrease (−Increase) in net working capital

2021 2022 2023 2024 2025

Net working
$50,000 $230,000 $305,000 $250,000 $0
capital

Cash flows –$50,000 – $180,000 –$75,000 $55,000 $250,000

 Rule 2: Discount Incremental Cash Flows only.

Include:
Forecasting • Include all incidental effects.
• Forecast product sales today but also recognize
a Project's after-sales cash flows.

Cash Flow
• Remember salvage value.
• Include opportunity costs.

Exclude:
• Forget sunk costs.
• Beware of allocated overhead costs.
 Rule 2: Discount Incremental Cash Flows only.

The value of a project depends on all the additional

Forecasting cash flows that follow from project acceptance.

a Project's Four common incremental cash flows:

Cash Flow
1. Include the project’s effects on the firm’s other
business
2. Recognize after-sales cash flows
3. Remember Salvage Value
4. Include Opportunity Costs
Rule 2: Discount Incremental Cash Flows only

Include: The project’s effects on the firm’s other business

For example, recently Honda launched a new SUV Honda Elevate; sales of Honda
Amaze went down
Rule 2: Discount Incremental Cash Flows only

Include: The project’s effects on the firm’s other business

So why does Honda roll out the new product?
• To meet the demand in the SUV market.
• Amaze is getting outdated.
• Honda cares about overall sales.
Rule 2: Discount Incremental Cash Flows only

Include: Recognize all After Sales Cash Flows

• Financial Managers should forecast all incremental cash flows generated by an

investment.
• Sometimes these incremental cash flows last for decades.
• When GE commits to the design and production of a new jet engine, the cash inflows
come first from the sale of engines and then from service and spare parts.
• A jet engine will be in use for 30 years
Rule 2: Discount Incremental Cash Flows only

Include: Remember Salvage Value

• When a project comes to an end, you may be able to sell the plant/equipment or
redeploy the assets elsewhere in the business.
• If you sell the equipment, you must pay tax on the difference between the sale price
and book value of the asset.
• The salvage value (net of any taxes) represents a positive cash flow to the firm.
• If the asset is used elsewhere in the business, the cash saved from not buying a new
asset is also a positive cash flow.
Rule 2: Discount Incremental Cash Flows only

Include: Opportunity Costs

• The cost of a resource may be relevant to the investment decision even when no cash
changes hands.

• Example: A new manufacturing operation uses land that could otherwise be sold for
$100,000. This resource is not free: it has opportunity cost, which is the cash it could
generate for the company if the project were rejected and the land was sold.

• To calculate opportunity costs, you need to take the difference between the cash flows
with the project and those without the project
Rule 2: Discount Incremental Cash Flows only

Include: Opportunity Costs

To calculate opportunity costs, you need to take the difference between the cash flows
with the project and those without the project
Rule 2: Discount Incremental Cash Flows only

Exclude: Allocated Overhead Costs

Overhead Costs include supervisory wages, rent, fuel, etc.

If these overhead costs are not related to any one project, but for
the entire firm.

We only include only extra expenses that would result from the
project.
Rule 2: Discount Incremental Cash Flows only

Exclude: Sunk Costs

Consider:
1. $50mn R&D expense for a new drug Should you go for clinical trial?
2. A railroad company has spent $50mn on engineering & consultancy services,
should they go ahead with the construction of a new high-speed rail line?
3. New software development has proved more costly than anticipated, would
you scrap the project?

These expenditures are sunk cost, and should be ignored while deciding to
accept/reject the project!
 Rule 3: Treat Inflation Consistently.
Forecasting
a Project's •
•
Consistently handle inflation.
Nominal interest rates discount nominal cash flows.

Cash Flow •
•
Real interest rates discount real cash flows.
Results are the same.
Rule 3: Treat Inflation Consistently

You invest in a project that will produce real cash flows of −$100 in Year 0 and
then $35, $50, and $30 in the 3 respective years. If the nominal discount rate is
15% and the inflation rate is 10%, what is the NPV of the project?
Rule 3: Treat Inflation Consistently

Cash Flows 𝑪𝟎 𝑪𝟏 𝑪𝟐 𝑪𝟑
Real -100 +35 +50 +30
Nominal -100 35 × 1.1 = 38.5 05 × 1.1 = 60.5 30 × 1.1 = 39.5
 Rule 3: Treat Inflation Consistently

The message is quite simple:

1. Discount nominal cash flows at nominal discount rate

2. Discount real cash flows at real discount rate
3. Never min real cash flows with nominal discount rates or nominal flows with
real rates.
Chapter 6 – Question 6
Question:
• Mr X will be paid $100,000 one year from now. This is nominal
flow, which he discounts at 8% nominal discount rate.
• PV = 100,000/1.08 = $92,593
• Inflation rate = 4%. Calculate PV of Mr X’s payment using the
equivalent real cash flow and real discount rate.

Answer:
• Real Cash Flow = $100,000 / (1 + .04) = $96,154
• r = (1 + .08) / (1 + .04) – 1 = .03846, or 3.846%
• PV = $96,154 / (1 + .03846) = $92,593
 Rule 4: Separate Investment and Financing Decisions.

• Suppose you finance a project partly with debt

Forecasting • Question: How should you treat the proceeds from the
debt issue and the interest and principal payments on
a Project's the debt?

Cash Flow • Answer: Neither subtract the debt proceeds from the
required investment nor recognize the interest and
principal payments on the debt as cash outflows.

• Treat the project as if it was all equity financed!

 Rule 5: Remember to Deduct Taxes.

• Taxes are expense just like wages and raw material

Forecasting •
•
Cash Flow should be estimated on after-tax basis
Subtract tax payment from pre-tax cash flow
a Project's • Then discount the net cash flow

Cash Flow • Be sure to subtract Cash Taxes, and not reported

taxes.
• These two could be different due to difference in
depreciation methods
 Question

A firm is considering investment in a new manufacturing plant. The site is owned by the company but existing
buildings would need to be demolished. Which of the following should be treated as incremental cash flows?

• The market value of the site:

• Incremental Cash Outflow
• The market value of the existing buildings :
• Incremental Cash Outflow
• Demolition costs and site clearance :
• Incremental Cash Outflow
• The cost of new access road put in last year :
• Sunk Cost
 Question
A firm is considering investment in a new manufacturing plant. The site is owned by the company but existing
buildings would need to be demolished. Which of the following should be treated as incremental cash flows?

• Lost cash flows on an existing product that will be replaced by the new proposal :
• Incremental Cash Outflow
• Future depreciation of the new plant :
• Non-incremental Cash Flow
• The reduction in the firm's tax bill resulting from depreciation of the new plant :
• Incremental Cash Flow
• The initial investment in inventories of raw materials :
• Incremental Cash Outflow
• Money already spent on engineering design of the new plant :
• Sunk Cost
Corporate Income Tax Rates
Country Corporate Tax Rate (%)
Australia 30
Brazil 34
Canada 15
China 25
France 33
Germany 16
India 30
Ireland 13
Japan 23
United Kingdom 19
United States 21
 Corporate Income Taxes

• Tax rates applicable to companies vary – across time and countries (and across types of
business). We will – typically – take a single corporate income tax rate as given (for simplicity). For
instance, in India this may be 30% and in the US 21%.

• Expenses are usually tax-deductible in the year they are incurred. This means they reduce or offset
taxable income that year. Capex is, mostly, an exception and must be depreciated.
• Depreciation rules/schemes set by the (relevant) tax authority vary. Common types include the
Straight Line method, and the Written Down Value method. Sometimes, an “accelerated”
scheme/option may be available.

• Losses in a given year may be used to offset/reduce taxable income in later years (“carry-forwards”)
 Corporate Income Taxes

Depreciation Deductions:
• When firms calculate taxable income, they do not deduct capital expense.
• But they deduct depreciation, typically, on a straight-line!

Example:
• If a firm spends $10000 to buy equipment with 5-year life.
• It can deduct depreciation (Straight-line: $10000/5=$2000) from annual profits
• Assume Tax Rate = 30%
• Tax saving or Depreciation Tax Shield = 30% x $2000 = $600
• Some countries allow accelerated depreciation Higher depreciation in early years
 Corporate Income Taxes

Tax on Salvage Value:

• If a company sells an asset at the end of a project, it must pay tax on the
difference between the asset’s salvage value and the depreciated value.

Example:
• A firm purchases a machine for $10000
• Depreciates it for 5 years, and then sells it for $1000
• The firm has to pay tax on $1000 sale
 Corporate Income Taxes

Tax Loss Carry-Forwards:

• When firms make profits, the pay tax on profits.
• If a firm makes losses, it can carry forward the losses to offset future tax obligations.

Example:
• In US, losses can be carried forward indefinitely and used to offset up to 80% of future
income.
• A manufacturer loses $100,000 in 2020 but earns $100,000 in 2021 and 2022.
• It pays no tax in 2020 as there are no profits.
• In 2021, it can use $80,000 (=80% x $100,000) of the loss to offset income
• So, tax paid in 2021 = 21% x $20,000 = $4,200
• In 2022, the firm can use the remaining $20,000 carried forward, paying tax of 21% x
$80000 = $16,800
 Chapter 6 – Question 12

Straight-line Schedule 1 2 3 4 5 6 7 8 9 10 Total

Straight-line, 10-year 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 10.0
Tax Shields at 40% Tc 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 4.0
PV(Tax Shields) at 10% 0.4 0.3 0.3 0.3 0.2 0.2 0.2 0.2 0.2 0.2 2.5

PV of immediate write-off 4.0

 Framework for calculating Free Cash Flows
Free Cash Flow: Cash not required for operations or investment; is available as payout to shareholders.

Total Cash Flow CFCapital Investment CFOperations CFChanges in Working Capital

• Capital Investment: Up-front investment in plant, equipment, research, start-up costs, & other outlays.
• Operating Cash Flow: Net increase in sales revenue from the new project less outlays.
• Investment in Working Capital: Represents a negative cash flow.

Additional Investment in Working Capital = Increase in Inventory

+ Increase in Accounts Receivable
– Increase in Accounts Payable

Total cash flow is the sum of cash flows from capital investment, operations, & changes in working capital.
 Framework for calculating Free Cash Flows

Operating Cash Flow: Net increase in sales revenue from the new project less outlays.

Three ways of calculating Operating Cash Flow:

1. Operating Cash Flow = Revenues – Expenses – Taxes

2. Operating Cash Flow = After-tax Profit + Depreciation
3. Operating Cash Flow = (Revenues – Expenses) (1 – Tax Rate) + (Tax Rate Depreciation)

Tax Rate Depreciation = Depreciation Tax Shield

 Chapter 6 – Question 13

• If the $50,000 installation cost is expensed at the end of year 1, the value of the tax shield is:
• PV = ($50,000 × .25) / (1 + .05) = $11,905

• If the $50,000 cost is capitalized and then depreciated using a five-year straight-line depreciation, the value of the
tax shield is:
• PV = (.25 × $50,000 × 0.20) × [1/1.05 + 1/1.052 + 1/1.053 +1/1.054 + 1/1.055 ] = $10,824

• If the installation cost can be expensed, then the tax shield is larger, which means the after-tax cost is smaller.
 Project Step-by-step
walkthrough an
Analysis example of calculating
project’s cash flows
after accounting for
taxes!
 IM&C Company Wants
to Sell a New Fertilizer
1. You are the CFO of International Mulch and Compost
Company (IM&C).
2. You need to analyze a proposal for selling a new fertilizer
3. You have 7-year forecasts of the project that requires
$12mn investment in Plant and Machinery
4. In year 7, the machinery can be dismantled and sold for
$1949 (forecasted salvage value)
5. Assume that the machinery will be fully depreciated over
6 years using straight-line depreciation for $2mn a year.
6. You need to calculate the cash flows!
7. Assume all values are nominal amounts.
8. We will assume negative tax as cash inflow, assuming
IM&C can use the tax loss on the new fertilizer project to
shield income from the rest of the operations.
IM&C Company Wants to Sell a New Fertilizer
Forecasts (in $000) with $12mn Investment:

Period 0 1 2 3 4 5 6 7
1. Capital investment 12,000 -1,949
2. Accumulated depn. 2,000 4,000 6,000 8,000 10,000 12,000 0
3. Year-end book value 12,000 10,000 8,000 6,000 4,000 2,000 0 0
4. Working capital 550 1,289 3,261 4,890 3,583 2,002 0
5 Revenues 523 12,887 32,610 48,901 35,834 19,717
6 Expenses 4,000 3,037 8,939 20,883 30,809 23,103 13,602
7 Depreciation 2,000 2,000 2,000 2,000 2,000 2,000 0
8 Pretax profit (5-6-7) -4,000 -4,514 1,948 9,727 16,092 10,731 4,115 1,949
9 Tax (@21%) -840 -948 409 2,043 3,379 2,254 864 409
10 Net income (8 - 9) -3,160 -3,566 1,539 7,684 12,713 8,477 3,251 1,540
 IM&C Company Wants to Sell a New Fertilizer
Calculating Cash Flows from Capital Investments, Operations, and Working Capital:
Period 0 1 2 3 4 5 6 7
Panel A: Capital Investment
1 Capital investment -12,000 0 0 0 0 0 0 0
2 Sale of fixed assets 1,949
3 Less tax on sale (@21%) -409
Cash flow from capital investment
4 (1 + 2 - 3) -12,000 0 0 0 0 0 0 1,540
Panel B: Operating Cash Flow
5 Revenues 0 523 12,887 32,610 48,901 35,834 19,717
6 Expenses 4,000 3,037 8,939 20,883 30,809 23,103 13,602
7 Depreciation 0 2,000 2,000 2,000 2,000 2,000 2,000
8 Pretax profit (5 - 6 - 7 ) -4,000 -4,514 1,948 9,727 16,092 10,731 4,115
9 Tax (@21%) -840 -948 409 2,043 3,379 2,254 864
10 Profit after tax (8 - 9) -3,160 -3,566 1,539 7,684 12,713 8,477 3,251
11 Operating cash flow (5 - 6 - 9) -3,160 -1,566 3,539 9,684 14,713 10,477 5,251
*Operating Cash Flow = Revenues – Expenses – Taxes = After-tax Profit + Depreciation = (Revenues – Expenses) × (1 – Tax Rate) + (Tax Rate × Depreciation)
IM&C Company Wants to Sell a New Fertilizer
Period 0 1 2 3 4 5 6 7

Panel A: Capital Investment

Cash flow from capital investment
4 (1 + 2 - 3) -12,000 0 0 0 0 0 0 1,540
Panel B: Operating Cash Flow
11 Operating cash flow (5 - 6 - 9) -3,160 -1,566 3,539 9,684 14,713 10,477 5,251 0
Panel C: Investment in Working Capital
12 Working capital 550 1,289 3,261 4,890 3,583 2,002 0
13 Change in working capital 550 739 1,972 1,629 -1,307 -1,581 -2,002
14 Cash flow from investment in working capital (-14) -550 -739 -1972 -1629 1307 1581 2002
Panel D: Project valuation
15 Total project cash flow (4 + 11 + 14) -15,160 -2,116 2,800 7,712 13,084 11,784 6,832 3,542
16 Discount factor at 20% 1 0.833 0.694 0.579 0.482 0.402 0.335 0.279
17 Present value (15 x 16) -15,160 -1,763 1,944 4,463 6,310 4,736 2,288 988
18 NPV 3,806
 Chapter 6 – Question 7
Year 0 1 2 3 4 5 6 7
Nominal Cash Flows -15,160 -2,116 2,800 7,712 13,084 11,784 6,832 3,542

Restate the net cash flows in the previous analysis in real terms.
Discount the restated cash flows at a real discount rate.
Assume at 20% nominal rate and 10% expected inflation.
Should the NPV change?

Year 0 1 2 3 4 5 6 7
Real Cash Flows -15,160 -1,924 2,314 5,794 8,937 7,317 3,856 1,818
NPV for Real Cash Flows 3,806
 Accelerated Depreciation and First-Year Expensing
1. Depreciation is a non-cash expense.
2. It is important only because it reduces taxable income.
3. Tax-shield = Depreciation × Tax rate
4. Most common method of Depreciation: Straight-line
depreciation, which allowed IM&C to write off a fixed
proportion of the initial investment each year.
5. Some countries permit firms to depreciate their investments
more rapidly!
6. Since 2018, firms in US have been permitted to write off the
entire amount of their investment in plant and machinery
immediately.
7. What happens to NPV of the fertilizer project, assuming that
the full $12mn investment can be depreciated immediately?
8. Accelerated Depreciation affects cash flows only through
lower taxes early on ⇒ Increases Discounted value of cash
flows
 IM&C Company Wants to Sell a New Fertilizer
Accelerated Depreciation and First-Year Expensing
Period 0 1 2 3 4 5 6 7
Panel A: Capital Investment
1 Capital investment -12,000 0 0 0 0 0 0 0
2 Sale of fixed assets 1,949
3 Less tax on sale (@21%) -409
Cash flow from capital investment
4 (1 + 2 - 3) -12,000 0 0 0 0 0 0 1,540
Panel B: Operating Cash Flow
5 Revenues 0 523 12,887 32,610 48,901 35,834 19,717 0
6 Expenses 4,000 3,037 8,939 20,883 30,809 23,103 13,602 0
7 Depreciation 12000 0 0 0 0 0 0 0
8 Pretax profit (5 - 6 - 7 ) -16,000 -2,514 3,948 11,727 18,092 12,731 6,115 0
9 Tax (@21%) -3,360 -528 829 2,463 3,799 2,674 1,284 0
10 Profit after tax (8 - 9) -12,640 -1,986 3,119 9,264 14,293 10,057 4,831 0
11 Operating cash flow (5 - 6 - 9) -640 -1,986 3,119 9,264 14,293 10,057 4,831
*Operating Cash Flow = Revenues – Expenses – Taxes = After-tax Profit + Depreciation = (Revenues – Expenses) × (1 – Tax Rate) + (Tax Rate × Depreciation)
IM&C Company Wants to Sell a New Fertilizer
Accelerated Depreciation and First-Year Expensing
Period 0 1 2 3 4 5 6 7

Panel A: Capital Investment

Cash flow from capital investment
4 (1 + 2 - 3) -12,000 0 0 0 0 0 0 1,540
Panel B: Operating Cash Flow
11 Operating cash flow (5 - 6 - 9) -640 -1,986 3,119 9,264 14,293 10,057 4,831
Panel C: Investment in Working Capital
12 Working capital 550 1,289 3,261 4,890 3,583 2,002 0
13 Change in working capital 550 739 1,972 1,629 -1,307 -1,581 -2,002
14 Cash flow from investment in working capital (-13) -550 -739 -1972 -1629 1307 1581 2002
Panel D: Project valuation
15 Total project cash flow (4 + 11 + 14) -12,640 -2,536 2,380 7,292 12,664 11,364 6,412 3,542
16 Discount factor at 20% 1 0.833 0.694 0.579 0.482 0.402 0.335 0.279
17 Present value (15 x 16) -12,640 -2,113 1,653 4,220 6,107 4,567 2,147 988
18 NPV 4929
Chapter 6 – Question 1
A sample NPV analysis for the project.
 • Reliable Electric is considering a proposal to
Chapter 6 – Question 1 manufacture a new type of industrial electric motor
that would replace most of its existing product line.
• A research breakthrough has given Reliable a 2-year
lead on its competitors.
 Chapter 6 – Question 1
• Capital expenditure:
• $8 million for new machinery and $2.4 million for a warehouse extension. The full cost of the extension has been charged
to this project, although only about half of the space is currently needed. Since the new machinery will be housed in an
existing factory building, no charge has been made for land and building.
• Comment:
• If the spare warehouse space will be used now or in the future for a different project, then this project should be credited
with these benefits.
• Charge opportunity cost of the land and building.
• The salvage value at the end of the project should be included.
• Research and Development: $1.82 million spent in 2020. This figure was corrected for 10% inflation from the time of
expenditure to date. Thus, 1.82 × 1.1 = $2 million.
• Comment: Research and development is a sunk cost and should not be counted as incremental cash flow.
• Working capital: Initial investment in inventories.
• Comment:
• Will additional inventories be required as volume increases?
• Recovery of inventories at the end of the project should be included.
• Is additional working capital required due to changes in receivables and payables?
 Chapter 6 – Question 1
• Revenue: These figures assume sales of 2,000 motors in 2022, 4,000 in 2023, and 10,000 per year from 2024 through
2031. The initial unit price of $4,000 is forecasted to remain constant in real terms.
• Comment:
• Do the revenue forecasts consider changes in competition?
• Is the entire analysis being conducted in real terms or does the price need adjusted to nominal terms?

• Operating costs: These include all direct and indirect costs. Operating costs per unit are forecasted to remain constant in
real terms at $2,000.
• Comment: Is the analysis being done in real or nominal terms?

• Overhead: Marketing and administrative costs, assumed equal to 10% of revenue.

• Comment: Only incremental costs should be included. Are the overhead costs incremental?

• Depreciation: Straight-line for 10 years.

• Comment: Depreciation is not a cash flow, but depreciation does affect tax payments. Can the entire capital expenditure
can be written off in the first year?
 Chapter 6 – Question 1
• Interest: Charged on capital expenditure and working capital at Reliable's current borrowing rate of 15%.
• Comment: It is bad practice to deduct interest charges. Value the project as if it is all equity-financed.

• Income: Revenue less the sum of research and development, operating costs, overhead, depreciation, and
interest.
• Comment: That is Correct!

• Tax: 30% of income. Income is negative in 2021. This loss is carried forward & deducted from taxable income
in 2023.
• Comment: If Reliable has profits on its remaining business, the tax loss should not be carried forward.

• Net cash flow: Assumed equal to income less tax.

• Comment: Depreciation is a non-cash expense. Interest expense should be excluded.

• Net present value: NPV of net cash flow at a 15% discount rate.
• Comment: Discount rate should reflect project characteristics; it is not equivalent to the firm’s borrowing rate.
 Chapter 6 – Question 1 – Sample Analysis
Part b:

What additional information would you need to construct a version of Table in Q1 that makes sense?

• Potential use of warehouse

• Opportunity cost of building
• Other working capital items
• More realistic forecasts of revenues and costs
• Company’s ability to use tax shields
• Opportunity cost of capital
• Ensure all values are either nominal or real; do not mix.
• Inflation rate
 Chapter 6 – Question 1
• All Assumptions:
• Revenues: Sales of 2,000 motors in 2022, 4,000 motors in 2023, and 10,000 motors thereafter. The unit price is assumed
to decline from $4,000 (real) to $2,490 (real) when competition enters in 2024. The latter is the figure at which new
entrants’ investment in the project would have NPV = 0.
• Operating Costs: We assume direct labor costs decline progressively from $2,500 per unit in 2022, to $2,250 in 2023,
and to $2,000 in real terms in 2024 and after.
• Other Costs: We assume true incremental costs are 10% of revenue.
• Capital Expenditure: $8 million for machinery; $5 million for market value of factory; $2.4 million for warehouse
extension (we assume that the surplus capacity will eventually be needed but cannot be used in the interim). We
assume salvage value of $3 million in real terms less tax at 30%.
• Working Capital: We assume inventory in year t is 9.1% of expected revenues in year (t + 1). We also assume that
receivables less payables, in year t, is equal to 5% of revenues in year t.
• Depreciation Tax Shield: Based on 30% tax rate and an immediate write-off. This is a simplifying and probably inaccurate
assumption; the factory is currently owned by the company and may already be partially depreciated. We assume the
company can use tax shields to cover income from other parts of the business.
• Tax: 30% of revenue less costs
• Inflation: 10% per year
• Real Opportunity Cost of Capital: Assumed 20% since it is a new type of product- likely riskier than Reliable’s current
borrowing rate.
 Chapter 6 – Question 1 – Sample Analysis
2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032
Unit Sales 2000 4000 10000 10000 10000 10000 10000 10000 10000 10000
Revenue per unit 4000 4000 2490 2490 2490 2490 2490 2490 2490 2490
Labor cost per unit 2500 2250 2000 2000 2000 2000 2000 2000 2000 2000
Other costs % of Revenue 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%
Cash Flows from Investment
Capital Expenditure 15.4
Salvage Value 3 0
Tax (@30%) 0.9 0
Cash Flows from Investment -15.4 0 0 0 0 0 0 0 0 0 2.1 0

Revenues 8 16 24.9 24.9 24.9 24.9 24.9 24.9 24.9 24.9

Inventory (9.1% of Rev at t+1) 0.728 1.456 2.2659 2.2659 2.2659 2.2659 2.2659 2.2659 2.2659 2.2659 0 0
AR-AP (5% of Rev at t) 0.4 0.8 1.245 1.245 1.245 1.245 1.245 1.245 1.245 1.245 0
Changes in Working Capital:
Increase in Inventory 0.728 0.728 0.8099 0 0 0 0 0 0 0 -2.2659 0
Increase in AR-AP 0.4 0.4 0.445 0 0 0 0 0 0 0 -1.245
Cash Flows from Investments in
Working Capital -0.728 -1.128 -1.2099 -0.445 0 0 0 0 0 0 2.2659 1.245
 Chapter 6 – Question 1 – Sample Analysis
2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032
Unit Sales 2000 4000 10000 10000 10000 10000 10000 10000 10000 10000
Revenue per unit 4000 4000 2490 2490 2490 2490 2490 2490 2490 2490
Labor cost per unit 2500 2250 2000 2000 2000 2000 2000 2000 2000 2000
Other costs % of Revenue 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%
Revenues 0 8 16 24.9 24.9 24.9 24.9 24.9 24.9 24.9 24.9 0
Operating labor costs 0 5 9 20 20 20 20 20 20 20 20 0
Other costs 0 0.8 1.6 2.49 2.49 2.49 2.49 2.49 2.49 2.49 2.49 0
Depreciation 15.4 0 0 0 0 0 0 0 0 0 0 0
Pre-tax Profit -15.4 2.2 5.4 2.41 2.41 2.41 2.41 2.41 2.41 2.41 2.41 0
Tax -4.62 0.66 1.62 0.723 0.723 0.723 0.723 0.723 0.723 0.723 0.723 0
Operating CF 1 (Rev - Exp - Tax) 4.62 1.54 3.78 1.687 1.687 1.687 1.687 1.687 1.687 1.687 1.687 0
Operating CF 2 (After-tax Profit +
Depr) 4.62 1.54 3.78 1.687 1.687 1.687 1.687 1.687 1.687 1.687 1.687 0
Operating CF3 (Rev-Exp)x(1-Tx)+Dep
Tax Shield 4.62 1.54 3.78 1.687 1.687 1.687 1.687 1.687 1.687 1.687 1.687 0

Total Cash Flow -11.508 0.412 2.5701 1.242 1.687 1.687 1.687 1.687 1.687 1.687 6.0529 1.245
Discounted Cash Flow -11.508 0.34333 1.78479 0.71875 0.81356 0.67797 0.56497 0.47081 0.39234 0.32695 0.97758 0.16756
NPV -4.2694
 Chapter 6 – Question 1 – Sample Analysis

($ in real 000's) 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032
Unit Sales - 2,000 4,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 -
Revenue per unit - 4,000 4,000 2,490 2,490 2,490 2,490 2,490 2,490 2,490 2,490 -
Labor cost per unit - 2,500 2,250 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 -
Other costs % of Revenue - 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% -

Capital Expenditure (15,400) - - - - - - - - - 3,000 -

Changes in Working Capital:

∆ Inventories (Inc.) Dec. (728) (728) (810) - - - - - - - 2,266 -
∆ AR Less AP (Inc.) Dec. - (400) (400) (445) - - - - - - - 1,245
Depreciation Tax Shield 4,620 - - - - - - - - - (900) -
Revenues - 8,000 16,000 24,900 24,900 24,900 24,900 24,900 24,900 24,900 24,900 -
Operating labor costs - (5,000) (9,000) (20,000) (20,000) (20,000) (20,000) (20,000) (20,000) (20,000) (20,000) -
Other costs - (800) (1,600) (2,490) (2,490) (2,490) (2,490) (2,490) (2,490) (2,490) (2,490) -
Tax - (660) (1,620) (723) (723) (723) (723) (723) (723) (723) (723) -
Net Cash Flow (11,508) 412 2,570 1,242 1,687 1,687 1,687 1,687 1,687 1,687 6,053 1,245

NPV (at 20%) = $ (4,269)

IIMB PGP/PGPBA 2023-25 – Term 2
Section H
Nitin Vishen

Corporate
Finance

Office Hours: By Appointment, D108

Topic 9

Risk and Return

 Chapter 9
Risk and the Cost of Capital
 Topics Covered

• How modern theories about risk and return

discussed in previous chapters are applied to
capital budgeting decisions?
• The estimation of
• Beta
• Company cost of capital
• Project cost of capital
• Analyze projects where the risk of the project
changes over its lifetime
 Company Cost of Capital

• A company’s cost of capital is the opportunity cost of capital for an investment in all the
firm’s assets and is the correct discount rate for its average-risk project

• If a firm has no debt, the company’s cost of capital equals its cost of equity, i.e., the expected
rate of return on the company’s common stock.

• If a firm has both debt and equity, the company’s cost of capital is computed by considering a
portfolio of its debt and equity financing. Company’s beta is also its Asset Beta.

• A firm’s value can be stated as the sum of the value of its various assets.
• “The value-additivity principle.”
 Asset Beta
• Company cost of capital is based on the average beta of the assets.
• The average beta of the assets is based on the percentage of funds in each asset.
• Assets = Debt + Equity

• If a firm has both debt and equity, the company’s cost of capital is computed by
considering a portfolio of its debt and equity financing.
 Company Cost of Capital with No-Debt
J&J Market Value (Billions $ in 2020 Q3)
Assets: A = $380 𝛽 = 0.75 Equity: E = $380 𝛽 = 0.75

• Johnson & Johnson (J&J) has no-debt. Book Value of its Assets = $60bn
• We can infer the market value of J&J’s assets from its market cap.
• Beta must be the same on both sides of the balance sheet!
• If , then if J&J has no-debt,
• J&J’s shareholders bear all the risks of J&J’s assets

• If and Market Risk Premium = 7%, then, using CAPM

• J&J’s cost of capital:
Debt and the Company Cost of Capital and
Measuring the Cost of Equity
Capital structure: the mix of debt and equity within a company.

Value of a firm:
 Company Cost of Capital with Debt and Equity
CSX Market Value (Billions $ in 2020 Q3)
Assets: A = $380 𝛽 =? Debt: D = $16.5 (22%) 𝛽 = 0.2
Equity: E = $60 (78%) 𝛽 = 1.18
Total: V = $76.5 Total: V = $76.5
• CSX, a Railroad Company has both debt equity
• What is CSX’s asset beta?
• CSX is a portfolio of its debt and equity financing. So,

𝑫 𝑬
𝜷𝑨 = 𝜷𝑫 × + 𝜷𝑬 ×
𝑽 𝑽

⇒ 𝛽 = 0.2 × 0.22 + 1.18 × 0.78 = 0.96

• CSX’s Cost of Capital = 𝑟 = 𝑟 + 𝛽 𝑟 − 𝑟 = 2 + 0.96 × 7 = 8.8%
 Question
• Suppose you mistakenly use a debt ratio from book financial
statements instead of market values.
• Assume you are analysing a successful publicly-traded company,
are your estimates of the company cost of capital likely to be too
high or too low?

𝐷 𝐸
𝑟 =𝑟 × +𝑟 ×
𝑉 𝑉

• Answer: Too low.

• For a successful publicly traded company, Market Value of Equity
>> Book Value of Equity
Debt Beta
• Asset Beta:
• We use asset beta to calculate the company cost of capital

• So, how do we get Debt Beta?

• Debt Beta for most creditworthy firms would be zero.
• For others, estimating it is difficult. It would include valuing the riskiness of debt of a firm
with respect to the market returns.
• It would include valuing corporate default risk, illiquidity of corporate bonds, etc.

• What is easily available, though, is the cost of debt!

Weighted Average of Betas or Returns?
• It is easier to calculate cost of debt, compared to its beta!
• We can use CAPM to estimate the cost of equity.

• For CSX, 𝛽 = 1.18, 𝑟 = 2%, 𝑟 − 𝑟 = 7%,

𝑟 =𝑟 +𝛽 𝑟 −𝑟 = 2 + 1.18 × 7 = 10.3%

• If the Cost of Debt 𝑟 = 3.4%, the company’s Weighted Average Cost of Capital (WACC) is:

𝑫 𝑬
𝒓𝑨 = 𝒓𝑫 × + 𝒓𝑬 ×
𝑽 𝑽

⇒ 𝑟 = 3.4 × 0.22 + 10.3 × 0.78 = 8.8%

 Question
• A firm reports 50% debt and 50% equity on its (book) balance sheet.
• The market cap of the firm’s equity is double book value.
• Debt is trading close to book value at a current interest rate of 4%.
• The equity beta: 𝛽 = 1, 𝑟 = 2%, and market risk premium is 7%.
• What is the firm’s cost of capital?

• As market value of equity is double the book value, and book =

1 ⇒ Using Market Value of Equity: = , =
• 𝑟 =𝑟 +𝛽 𝑟 −𝑟 = 2 + 1 × 7 = 9%
• 𝑟 = 𝑟 × + 𝑟 × = 4 × + 9 × = 7.33%
 Three Warnings
• Is debt the cheaper way to finance?
• Typically, the cost of debt is cheaper that that of equity.
• Does that mean that substituting cheap debt for expensive equity will reduce the cost of capital for the firm?
• No! As 𝐷/𝑉 increases, cost of remaining equity rises, offsetting the advantage from cheap debt. We will
discuss this in detail next week.

• What is the value of risk-free rate you should take?

• In 2020, 3-month treasury rate = 0.1%, & 20-year US treasury bond yield = 1.4%
• Most financial managers would take long-term risk-free rate in CAPM formula.

• Interest is tax-deductible!
• In WACC, we should adjust the cost of debt for the taxes saved on interest payments.
• You could use the After-tax cost of debt.
 Investments that are not Average Risk?

• A company’s cost of capital is not necessarily the correct discount rate for a new investment
project that the firm takes up.
• A new investment project can be riskier or safer than the firm’s average risk.
• In principle, the cash flows of each project should be discounted it own opportunity cost of
capital, commensurate with the risk of the project.
• A firm’s value can be stated as the sum of the value of its various assets.
• The value-additivity principle:
• You could value projects A and B, as if they were separate firms, using their different discount
rates.

• Example: Johnson and Johnson invests in a new Biotech Research Project. Does this project’s
cost of capital equal that of producing Baby Oil (an existing product)?
 Company vs.
Project
Cost of Capital

J&J’s company cost of capital = 7.3%.

If J&J could evaluate each project’s beta,

it should accept any project lying above the upward-sloping security market line.

If J&J used 7.3% as cost of capital for every project, it would reject some good low-risk projects,
and accept many poor high-risk projects.

7.3% is the correct discount rate only if the project beta is 0.75.
Estimating Beta & the Cost of Capital

• Estimating the company cost of capital requires estimating the expected return
on a portfolio of the company’s debt and equity.
• Yield to Maturity (YTM) of the bonds issued by a company are a good measure of
its cost to debt
• To calculate cost of equity, you use CAPM.
• The Security Market Line (SML) shows the relationship between return and risk.
• CAPM uses beta as a proxy for risk.
 Beta of US Steel Company

Mar. 2010- Feb. 2015 Mar. 2015-Feb. 2020

 Beta of ExxonMobil

Mar. 2010- Feb. 2015 Mar. 2015-Feb. 2020

 Beta of Consolidated Edison

Mar. 2010- Feb. 2015 Mar. 2015-Feb. 2020

Estimating Beta & the Cost of Capital

• The Betas for all three stocks change during the later half of the last decade.
• So, updating Beta with recent returns is prudent.
• However, you can be reasonably sure that Beta of US Steel > ExxonMobil > ConEd.
• measures the goodness of fit.
• In this case, we explain the firm’s returns using market returns.
• In case of ExxonMobil, Half of the risk is explained by market, the other
half is idiosyncratic.
• Standard Errors or SE (reported in brackets next to beta) are the extent of
mismeasurement of beta.
• You can use them to set up confidence intervals. 95% confidence interval is
• Example: For ExxonMobil,
Portfolio Beta

• You can use portfolio beta for industries.

• Portfolio standard error is lower, as it eliminates the diversifiable risk.
• Example: An equally weighted portfolio of railroad companies can be used to
calculate the beta of the railroad industry:
Beta Standard Error
Canadian Pacific 1.07 0.18
CSX 1.18 0.24
Kansas City Southern 0.97 0.20
Norfolk Southern 1.33 0.18
Union Pacific 1.09 0.16
Industry portfolio 1.13 0.14
 Analysing Project Risk
• Not all projects of a firm will have the average firm risk!
• How do you make judgements about costs of capital for projects
or lines of business when you suspect that risk is not average?
• You can look at Pure Plays!
• Pure play companies are public firms that specialize in one
activity.
• Example: If an airline company needs to assess the risk of
investing in a new company headquarters, its own asset beta is
useless. Asset beta of a real estate firm specializing in Office
Buildings (a pure play) is more appropriate.
 Analysing Project Risk
• Think about conglomerates: Reliance Industries or Berkshire
Hathaway, Tata Group, ITC, etc.
• ITC has Hotels, FMCG, IT, Packaging, etc
• Overall company cost of capital is useless.
• Cost of capital of pure plays in the relevant industries will be more
useful.
• If a good comparable (pure play) is not available for a project, a
financial manager should be careful about:
• a) The determinants of asset betas
• b) Diversifiable Risk
 Project Risk: Determinants of Asset Betas
1. Cyclicality: Firms whose earnings are strongly dependent on the
state of business cycle are high-beta firms.
E.g. Luxury Hotels, Steel, Airlines industries etc are highly correlated
with overall performance of the economy

2. Operating Leverage: A production facility with high fixed costs,

relative to variable costs has high operating leverage.
High operating leverage means high asset beta.
Cash Flow = Revenue – Fixed Cost – Variable Cost
 • The Table shows Forecasted Cash Flows of two
Operating Technologies during economic booms and crises.

Leverage • Expected Costs and Sales are same for both Technologies
• Technology A: All Costs are Variable
and Risk • Technology B: Costs are fixed at $135 mn
• Higher Operating Leverage Higher Beta
 Question
Which of these projects is likely to have the higher asset beta,
other things equal? Why?

Q1. The sales force of project A is paid a fixed annual salary.

Project B’s sales force is paid in commissions only.
A1. Project A; a project with higher fixed costs generally has
higher operating leverage, which leads to a higher beta

Q2. Project C is a first-class-only airline. Project D is a well-

established Milk supplier.
A2. Project C; airline revenue is more cyclical than milk revenue.
 Project Risk: Diversifiable Risk
• We have defined risk as asset beta of a firm, industry, or project.
• However, in everyday usage risk means Bad Outcome.
• For Example: Iridium satellite in 2009 collided with Russia’s
defunct Cosmos 2251 in space, and was blown to pieces.
• Iridium-Cosmos hazards does not affect asset beta, and should
not affect discount rate of the project.
• For an investor, this risk was diversifiable.
• Instead, they should be accounted in Expected Cash Flows from
the project!
 • A Project produces 1 cash flow: $1mn in 1 year

Adjust • PV @ 10% = = $1mn/1.1 = $909,100

Cash Flows
Cash Flow (mn $) Probability Expected Cash Flow
1.2 0.25
$ 1mn

for Bad
1.0 0.50
0.8 0.25

Outcomes • A new uncertainty comes up where a 10% chance of a

hazard can make cash flow 0.
Cash Flow (mn $) Probability Expected Cash Flow
1.2 0.225
1.0 0.45
$ 0.9mn
0.8 0.225
0 0.10

• PV @ 10% = = $0.9mn/1.1 = $818,000

A. requity = rf + (rm – rf)
requity = .04 + 1.5  .06
requity = .13, or 13%

B. rassets = (D / V)rdebt + (E / V)requity

rassets = $4m / ($4m + 6m) × .04 + $6m / ($4m + 6m) × [.04 + 1.5(.06)]
rassets = .094, or 9.40%
C. The cost of capital depends on the risk of the project being evaluated. If the risk of the project is similar
to the risk of the other assets of the company, then the appropriate rate of return is the company cost of
capital. Here, the appropriate discount rate is 9.4 percent.

D. rassets = (D / V)rdebt + (E / V)requity

rassets = $4m / ($4m + 6m) × .04 + $6m / ($4m + 6m) × [.04 + 1.2(.06)]

rassets = .0832, or 8.32%

Question
Q. If a company uses its company cost of
capital to evaluate all projects, will it
underestimate or overestimate the value of
high-risk projects?

A. Over-estimate the value of high-risk

projects. As it discounts the future cash
flows at a rate less that commensurate risk.
Question
A firm has following capital structure:

Security Beta Total Market Value ($ million)

Debt 0 100
Preferred Stock 0.20 40
Common Stock 1.20 299

1) What is the firm’s asset Beta?

2) Assume that the CAPM is correct! What is the discount rate that the firm
should set for investments that expand the scale of its operations without
changing its asset beta? . Ignore taxes
Answer
Security Beta Total Market Value ($ million)
Debt 0 100
Preferred Stock 0.20 40
Common Stock 1.20 299

1) What is the firm’s asset Beta?

Answer: Total market value = $100m + 40m + 299m = $439m
= ($100m/$439m) × 0 + ($40m/$439m) × .20 + ($299m/$439m) × 1.20 = .836

2) Assume that the CAPM is correct! What is the discount rate that the firm should
set for investments that expand the scale of its operations without changing its asset
beta? . Ignore taxes
Answer: r = rf + (rm – rf) = .05 + .836(.06) = .1001, or 10.01%
IIMB PGP/PGPBA 2023-25 – Term 2
Section H
Nitin Vishen

Corporate
Finance

Office Hours: By Appointment, D108

Topic 10

Capital Structure:
Does the Debt Policy Matter?
 Factory
Real Assets: Machine
Patent
Assets used to produce goods
Brand
and services
Company Culture

Firm’s
Assets Financial Assets:
Financial claims to the income
Bonds
Loans
generated by the firm’s real Shares
assets
Financial Manager: Investment and Financing Decisions

Investment decision: Purchase of real assets.

Financing decision: Sale of financial assets.

 Capital Structure
• Capital structure is how a company funds its overall
operations and growth.
• A firm can borrow (debt) from lenders to fund its capital
requirements. If the firm uses debt, it is said to be
financially levered.
• It can also sell the ownership rights (equity) in the
company.
• The debt-to-equity (D/E) ratio is called the capital
structure of a firm.

• So, does the capital structure (D/E) of a firm matter?

• Capital structure matters in practice.
• But we will start with a simplistic scenario (frictionless or
perfect financial markets) where we do not
Modigliani-Miller Theorem

Images from Investopedia

 Learning Outcomes
• To understand MM’s Propositions 1 and 2.
• To understand the assumptions under which
these propositions are derived.
• To understand the traditional position on
capital structure.
• To understand the weighted-average cost of
capital (WACC).
• To understand the effect of leverage on the
firm’s value, cost of debt, cost of equity, and
the overall cost of capital under MM’s
propositions and under the traditional
position.
Modigliani-Miller Theorem

Proposition 1:
When there are no taxes and capital markets function well, it makes no difference whether
the firm borrows or individual shareholders borrow. Therefore, the market value of a
company does not depend on its capital structure.

Proposition 2:
The expected rate of return on the common stock of a levered firm increases
in proportion to the debt-to-equity ratio (D/E), expressed in market values.
 Modigliani-Miller Proposition 1

• What is the optimal capital structure (D/E) that maximizes the value of the firm?
• Modigliani and Miller say that in a perfect market, a firm’s value does not depend
on its choice of capital structure!

• What is a perfect financial market?

• A financial market with no frictions like taxes, transaction costs, bankruptcy costs,
information asymmetry between the firm management and investors, etc.
Modigliani-Miller Proposition 1 (Illustration)

Assume 2 firms that generate the same stream of operating profits, and
differ only in their capital structure.

• Firm U is unlevered, i.e., it has no debt. Then, the Value of the Firm
equals the Value of its Equity , or

• Firm L is levered, i.e., it has debt and equity both. Then, the Value of the
Firm equals the Value of its Equity plus the Value of its Debt
, or .
Modigliani-Miller: Proposition 1 (Illustration)

Which firm would you prefer to invest in Firm U or Firm L?

You buy common stock in the unlevered firm U:

• You invest in Firm U
• Total Dollar Return Profits

You buy debt and equity of levered firm L:

• You invest in Firm L
• Dollar Return from Debt Interest
• Dollar Return on Equity (Profit – Interest)
• Total Dollar Return Profits
 Modigliani-Miller Proposition 1 (Illustration)

• Total dollar return on both investments (Firm U and Firm L) is 0.01 Firm’s Profits
• So, both investments have the same pay-off
• Therefore,
• Two investments that have the same payoff should also have the same price.
• The value of the unlevered firm must be equal to that of the levered firm.
 Modigliani-Miller Proposition 1 (Illustration)

Consider a different scenario:

You borrow and buy common stock in the unlevered firm U:

• You invest in Firm U, and simultaneously borrow on your own account
• Total Investment
• Total Dollar Return Interest Profits Profit – Interest

You buy only equity of levered firm L:

• You invest in Firm L
• Total Dollar Return (Profit – Interest)
 Modigliani-Miller Proposition 1 (Illustration)

• Total dollar return on both investments (Firm U and Firm L) is 0.01 Profits - Interest
• So, both investments have the same pay-off
• Two investments that have the same payoff should also have the same price.
• Therefore, and

• MM Proposition1: The market value of any firm is independent of its capital structure.
 The Law of Conservation of Value

Assets Debt
+
Equity
• PV(A+B) = PV(A)+PV(B)
• The value of an asset is preserved regardless of the nature of the claims against it.
• So, MM Proposition 1: Firm Value is determined on the left-hand side of the balance
sheet by real assets – not by the proportions of debt and equity issued to buy the assets.
• So, it should not matter is the assets were bought using a combination of common and
preferred stocks, or long term versus short term, secured versus unsecured, senior versus
subordinated, and convertible versus non-convertible debt
• Combining assets or splitting them up will not affect values as long as they do not affect
investors choices
 Modigliani-Miller Proposition 1 (Example)

Macbeth Spot Removers

Number of Shares 1,000
• Macbeth Spot Removers will produce a
level stream of earnings in perpetuity. Price Per Share $ 10
Market Value of Shares $10,000
• It has no leverage. Assume No Taxes.
Possible Outcomes
• All the operating income is paid as
Operating Income ($) 500 1,000 1,500 2,000
dividends to the common stockholders.
Earnings Per Share ($) 0.50 1.00 1.50 2.00
• Expected Earnings/Share = $1.50
Returns of Shares (%) 5 10 15 20
• But actual EPS is risky, i.e., uncertain! Expected
Outcome
 Modigliani-Miller Proposition 1 (Example)
Macbeth Spot Removers
Number of Shares 500
Price Per Share $ 10
Market Value of Shares $5,000
• Macbeth Spot Removers raises $5,000 Market Value of Debt $5,000
debt @ 10% interest rate, and Interest @ 10% $500
repurchases 500 shares.
Possible Outcomes
• Assume No taxes. Operating Income ($) 500 1,000 1,500 2,000
• Pay Interest before paying dividends to Interest ($) 500 500 500 500
the common stockholders Equity Earnings ($) 0 500 1,000 1,500
Earnings Per Share ($) 0 1.00 2.00 3.00
Returns of Shares (%) 0 10 20 30
Expected
Outcome
Modigliani-Miller
Proposition 1 (Example)

• The CEO of the firm argues that the effect of

leverage depends on the company’s income.
• Due to debt, Higher income Higher return
to Shareholders
• Equity returns = 10% if the income is $1000.
This equals the interest rate on the debt.
• The CEO expects the company to do well, so
she argues that raising debt will increase the
shareholder’s returns.
Modigliani-Miller Operating Income ($)
With Debt
500 1,000 1,500 2,000
Proposition 1 (Example) Interest ($) 500 500 500 500
Equity Earnings ($) 0 500 1,000 1,500

• The financial manager of Macbeth Earnings Per Share ($) 0 1.00 2.00 3.00
argues that the investors could borrow Returns of Shares (%) 0 10 20 30
on their own account.
No Debt
• An investor could use $10 of his own Operating Income ($) 500 1,000 1,500 2,000
money, borrows further $10, and then
Earnings Per Share ($) 0.50 1.00 1.50 2.00
invests the total in 2 unlevered (No
Debt) Macbeth shares Returns of Shares (%) 5 10 15 20

• This is exactly the same set of payoffs as Pay offs of Investor who borrows to Invest
the investor would gain by buying one Earnings on 2 shares ($) 1 2 3 4
share in the levered company.
Interest ($) 1 1 1 1
• If Macbeth goes ahead and borrows it Net Earnings ($) 0 1 2 3
will not provide the investors anything
that they could not do by themselves. Returns of $10 investment (%) 0 10 20 30
Modigliani-Miller Proposition 2

• The Expected Rate of Return on the common stock of a levered firm increases in
proportion of the debt-to-equity ratio (D/E), expressed in market values.

• The rate of increase depends on

• Expected rate of return on a portfolio of all the firm’s securities

• Expected return on Debt
 Modigliani-Miller Proposition 2

MM Proposition 1: In perfect capital markets, a firm’s borrowing decision does not affect either its
operating income or its total market value. So, the borrowing decision does not affect the expected return
on the firm’s assets

Expected return on a portfolio equals a weighted average of the expected returns on its individual holdings.
So, expected return on a portfolio of a firm’s securities (debt and equity):

𝑬 𝑨 𝑨 𝑫
Modigliani-Miller Proposition 2

Macbeth Spot Removers No Debt Equal Debt & Equity

Market Value of Shares ($) 10,000 5,000
Market Value of Debt ($) 0 5,000
E[Operating Income ($)] 1,500 1,500

No Debt:

Equal Debt & Equity:

Question! Macbeth Spot Removers
Market Value of Shares ($)
No Debt
10,000
Equal Debt & Equity
5,000
Market Value of Debt ($) 0 5,000
E[Operating Income ($)] 1,500 1,500

If Macbeth decides to issue $4,000 of debt at the interest rate of 10% rather than the
$5,000 as originally planned. What would be its cost of equity?

So,
Modigliani-Miller Proposition 2

Macbeth Spot Removers No Debt Equal Debt & Equity

E[Earnings Per Share ($)] 1.5 2
Price Per Share ($) 10 10
E[Returns of Shares (%)] 15 20

• Leverage increases Earnings per Share & not Price per Share
• The value of a share depends not only on the payments to shareholders, but also
on the rate at which those cash flows are discounted.
• Change in expected earnings stream is exactly offset by a change in the rate at
which the earnings are discounted.
Modigliani-Miller Proposition 2

• MM Proposition 1: Financial leverage has no effect on shareholders is wealth

• MM Proposition 2: Rate of return shareholders expect to receive on their shares
increases as the firm’s Debt-to-Equity ratio increases

• How can shareholders be indifferent to increased leverage when it increases their

expected return?
• Any increase in expected return is exactly offset by an increase in financial risk!
 Modigliani-Miller Proposition 2

• MM Proposition 2: Rate of return

shareholders expect to receive on their No Debt
shares increases as the firm’s Debt-to-
Equity ratio increases Operating Income ($) 500 1,000 1,500 2,000
Earnings Per Share ($) 0.50 1.00 1.50 2.00
Returns of Shares (%) 5 10 15 20
• Any increase in expected return is exactly
offset by an increase in financial risk! With Debt
Operating Income ($) 500 1,000 1,500 2,000
• No Debt: A decline of $1000 in operating Interest ($) 500 500 500 500
income reduces equity return by 10 Equity Earnings ($) 0 500 1,000 1,500
percentage points
Earnings Per Share ($) 0 1.00 2.00 3.00
• Equal Debt and Equity: A decline of $1000
in operating income reduces equity return Returns of Shares (%) 0 10 20 30
by 20 percentage points
 Debt-Equity
rE rA
Chapter 16 – Question 15 Ratio
0.00 0.108 0.108
0.10 0.113 0.108
0.50 0.132 0.108
A firm is financed 80% by common stock and 20% by bonds. 1.00 0.156 0.108
The expected return on the common stock is 12% and the 2.00 0.204 0.108
rate of interest on the bonds is 6%. Assuming that the bonds 3.00 0.252 0.108
are default risk free, draw a graph that shows the expected
return of the firm’s common stock (𝑟 ) and the expected R a te s o f R e tu rn
return on the package of common stock and bonds 𝑟 for
different debt-equity ratios. rE
.2 5 0

Company cost of capital: .2 0 0

𝑟 = 0.8 × 0.12 + 0.2 × 0.06 = 10.8% .1 5 0

𝐷 𝐷 .1 0 8 rA
𝑟 =𝑟 + 𝑟 −𝑟 × = 0.108 + 0.108 − 0.06 ×
𝐸 𝐸
.0 6 0 rD

1 2 3 D e b t / E q u ity
Leverage and the Cost of Equity

Overall Company Cost of Capital:

If a new project has the same risk as the firm’s existing business, the appropriate discount
rate for the cash flows is 12.75% , firm’s cost of capital.
 Leverage and the Cost of Equity
• If the firm borrows more the
required turn on equity will
rise.
• But, the required return on the
combination of debt and equity
(or, the return on assets) will
remain constant at 12.75%
• Because the proportions of
debt and equity also change
• More debt means the cost of
equity increases but at the
same time the proportion of
equity declines
 Leverage and the Cost of Equity
• As a firm borrows more the risk
of debt slowly increases.
• Lenders become concerned
that they may not get their
money back and seek higher
compensation in terms of
higher interest rates.
• Proposition 2 continues to
predict that the expected
return on the combination of
debt and equity does not
change.
• Because some of the operating
risk is transferred from
stockholders to bond holders
Leverage and the Cost of Equity – Question!
New Capital Old Capital
Structure Structure

Under the old capital structure, . So,

Under the new capital structure, if what is the corresponding ?
Capital Structure and Financial Risk (Equity Beta)

If , then

If the firm refinances to a , and , then

Unlevering Beta

• Borrowing creates financial leverage.

• Financial leverage does not affect the risk of the firm’s assets, and thus does not
affect the expected return on the firm’s assets.
• But financial leverage pushes up the risk of equity
• Shareholders demand higher return due to this increase in financial risk
• Sometimes debt can be hidden. E.g. leases, pension liabilities…

• Unlever Beta go from observed to

𝑬 𝑨 𝑨 𝑫
 Financial Leverage has No Magic!
Context: Many managers think that increasing debt can decrease the overall cost of capital
of the company, as debt is cheaper.
MM: No there is no such magic in Financial leverage.

Debt has two costs:

1. Interest Rate that the lender requires
2. Higher return that equity holders demand to compensate them for the extra risk
resulting from leverage

It is possible that some shareholders do not want to borrow by themselves (they want
limited liability they do not want to bear the risk of firm default)
Such investors prefer levered firms, and might pay a premium
 Question
Let us say Macbeth’s stock had a beta of 0.9
when it was all equity-financed!
Macbeth then issues $5,000 debt which has
zero beta.
What happens to
a) Beta of Macbeth’s assets?
b) Beta of Macbeth’s Equity?

a) Remains the same!

b)
 Weighted Average Cost of Capital (WACC)

• Interest paid on the firms borrowing can be deducted from taxable income.
• The after-tax cost of debt
• Where is the marginal corporate tax rate
• So, cost of capital becomes the after-tax Weighted Average Cost of Capital

• After-tax WACC is used as a discount rate to get the PV(Free Cash Flows) of a firm.
• After-tax WACC is lower than the opportunity cost of capital because it includes a
downward tax adjustment.
 Weighted Average Cost of Capital (WACC)

If what is the company cost of capital?

Company cost of capital:

If , what is the after tax Weighted Average Cost of Capital?

 Weighted
Average Cost of
Capital (WACC)

• If there are no taxes, company

cost of capital remains constant
with debt.

• In case of taxes and debt,

companies will receive a tax
shield on their interest
payments After-tax WACC
declines as debt increases
 Chapter 16 – Question 21

Omega Corporation has 10,000,000 shares outstanding at $55 per share. The firm has
estimated the expected rate of return to shareholders at about 12%. It has also issued long
term bonds at an interest rate of 7% and has a debt value of $200 million. It pays tax at a
marginal rate of 21%.
a) What is omegas after tax WACC?

D = $200mn, E = $55 mn = $550mn, V = D+E = $750mn

 Chapter 16 – Question 21

Omega Corporation has 10,000,000 shares outstanding at $55 per share. The firm has
estimated the expected rate of return to shareholders at about 12%. It has also issued long
term bonds at an interest rate of 7% and has a debt value of $200 million. It pays tax at a
marginal rate of 21%.
b) How much higher would WACC be if Omega used no debt at all?
Assume: is unaffected by capital structure or interest-tax shields.

The after-tax WACC would equal the company cost of capital

Chapter 16 – Question 17
Archimedes Levers is financed by a mixture of debt
and equity.
• ,
• ,
• ,
• , ,
Fill the blanks!
Chapter 16 – Question 17
, , , ,
Find !

Use CAPM:

• E f E m f
• E
• E
Chapter 16 – Question 17
, , , ,
Find !

Use CAPM:

• D f D m f
• D
• D
Chapter 16 – Question 17
, , , ,
Find and !

• A D E
• A

•
•
 Supplementary Question
Two firms, U and L, are identical except for their capital structure. Both will earn $150 in a
boom and $50 in a slump. There is a 50 percent chance of each event. U is entirely equity-
financed, and therefore shareholders receive the entire income. Its shares are valued at
$500. L has issued $400 of risk-free debt at an interest rate of 10%, and therefore $40 of L’s
income is paid out as interest. There are no taxes and other market imperfections. Investors
can borrow and lend at the risk-free rate of interest.

a) What is the value of L’s stock?

b) Suppose that you invest $20 in U’s stock. Is there an alternative investment in L that
would give identical payoffs in boom and slump? What is the expected payoff from such a
strategy?
c) Now suppose that you invest $20 in L’s stock. Design an alternative strategy with identical
payoffs from U.
d) Now show that MM’s proposition II holds.
 Supplementary Question
Two firms, U and L, are identical except for their capital structure. Both will earn $150 in a
boom and $50 in a slump. There is a 50 percent chance of each event. U is entirely equity-
financed, and therefore shareholders receive the entire income. Its shares are valued at
$500. L has issued $400 of risk-free debt at an interest rate of 10%, and therefore $40 of L’s
income is paid out as interest. There are no taxes and other market imperfections. Investors
can borrow and lend at the risk-free rate of interest.

a) What is the value of L’s stock?

Because the firms are identical except for capital structure, and there are no taxes or other
market imperfections, the total values of these companies must be the same.

Thus, L’s stick is worth $500-$400 = $100

 Supplementary Question
Two firms, U and L, are identical except for their capital structure. Both will earn $150 in a
boom and $50 in a slump. There is a 50 percent chance of each event. U is entirely equity-
financed, and therefore shareholders receive the entire income. Its shares are valued at
$500. L has issued $400 of risk-free debt at an interest rate of 10%, and therefore $40 of L’s
income is paid out as interest. There are no taxes and other market imperfections. Investors
can borrow and lend at the risk-free rate of interest.
b) Suppose that you invest $20 in U’s stock. Is there an alternative investment in L that would
give identical payoffs in boom and slump? What is the expected payoff from such a strategy?

• If you own $20 of U’s stock, you own 4% of the outstanding shares and are entitled to
if there is a boom, and if there is a slump

•
 Supplementary Question
Two firms, U and L, are identical except for their capital structure. Both will earn $150 in a
boom and $50 in a slump. There is a 50 percent chance of each event. U is entirely equity-
financed, and therefore shareholders receive the entire income. Its shares are valued at
$500. L has issued $400 of risk-free debt at an interest rate of 10%, and therefore $40 of L’s
income is paid out as interest. There are no taxes and other market imperfections. Investors
can borrow and lend at the risk-free rate of interest.
b) Suppose that you invest $20 in U’s stock. Is there an alternative investment in L that would
give identical payoffs in boom and slump? What is the expected payoff from such a strategy?
 Supplementary Question
Two firms, U and L, are identical except for their capital structure. Both will earn $150 in a
boom and $50 in a slump. There is a 50 percent chance of each event. U is entirely equity-
financed, and therefore shareholders receive the entire income. Its shares are valued at
$500. L has issued $400 of risk-free debt at an interest rate of 10%, and therefore $40 of L’s
income is paid out as interest. There are no taxes and other market imperfections. Investors
can borrow and lend at the risk-free rate of interest.
b) Suppose that you invest $20 in U’s stock. Is there an alternative investment in L that would
give identical payoffs in boom and slump? What is the expected payoff from such a strategy?

• The equivalent investment is to purchase 4% of L’s outstanding stock, which will cost
(0.04 $100) = $4, and to invest $16 at the risk-free rate. The total amount invested is the
same ($20). In a boom, you are entitled to: [(0.10 $16) + (0.04) ($150 - $40)] = $6, and in
a slump you are entitled to: [(0.10 $16) + (0.04) ($50 - $40)] = $2
•
 Supplementary Question
Two firms, U and L, are identical except for their capital structure. Both will earn $150 in a
boom and $50 in a slump. There is a 50 percent chance of each event. U is entirely equity-
financed, and therefore shareholders receive the entire income. Its shares are valued at
$500. L has issued $400 of risk-free debt at an interest rate of 10%, and therefore $40 of L’s
income is paid out as interest. There are no taxes and other market imperfections. Investors
can borrow and lend at the risk-free rate of interest.
c) If you invested only $20 in L’s stock. Design an alternative strategy with identical payoffs
from U.

If you own $20 of L’s common stock, you own 20% of the outstanding shares and, thus, are
entitled to [0.20 ($150 - $40)] = $22 if there is a boom.
Assume you buy outstanding shares in U worth . But you had only $20, so, you
borrowed the remaining .
For identical boom payoff
 Supplementary Question
Two firms, U and L, are identical except for their capital structure. Both will earn $150 in a
boom and $50 in a slump. There is a 50 percent chance of each event. U is entirely equity-
financed, and therefore shareholders receive the entire income. Its shares are valued at
$500. L has issued $400 of risk-free debt at an interest rate of 10%, and therefore $40 of L’s
income is paid out as interest. There are no taxes and other market imperfections. Investors
can borrow and lend at the risk-free rate of interest.
c) If you invested only $20 in L’s stock. Design an alternative strategy with identical payoffs
from U.
If you own $20 of L’s common stock, you own 20% of the outstanding shares and, thus, are
entitled to [0.20 ($150 - $40)] = $22 if there is a boom, and [0.20 ($50 - $40) = $2 if there is
a slump.
The equivalent investment is to purchase 20% of U’s outstanding stock, which costs: (0.20
$500) = $100 and to borrow $80 at the risk-free rate. The total invested is the same $20. In a
boom you are entitled to: [(-0.10) ($80) + (0.20 $150)] = $22 and in a slump you are
entitled to: [(-0.10) ($80) + (0.20 $50)] = $2
 Supplementary Question
Two firms, U and L, are identical except for their capital structure. Both will earn $150 in a
boom and $50 in a slump. There is a 50 percent chance of each event. U is entirely equity-
financed, and therefore shareholders receive the entire income. Its shares are valued at
$500. L has issued $400 of risk-free debt at an interest rate of 10%, and therefore $40 of L’s
income is paid out as interest. There are no taxes and other market imperfections. Investors
can borrow and lend at the risk-free rate of interest.
d) Now show that MM’s proposition II holds.

MM Proposition 2: The expected rate of return on the common stock of a levered

firm increases in proportion to the debt-to-equity ratio (D/E), expressed in market values.

. ×$ . ×$ . ×$( ) . ×$( )
For U, . For L,
$ $
Using Proposition II formula:
IIMB PGP/PGPBA 2023-25 – Term 2
Section H
Nitin Vishen

Corporate
Finance

Office Hours: By Appointment, D108

Topic 11

Capital Structure:
Leverage and Firm-Value with Taxes
 Industry Book Debt Ratio
Pharmaceuticals
Semiconductors
0.07
0.24 How much should a
Computer software
Food
0.26
0.32 Corporation Borrow?
Oil 0.35
Machinery 0.35
• Do MM Propositions derived for frictionless markets, apply
Construction 0.39 to real world?
Transportation 0.40 • If debt policy did not matter, then financial managers
Paper 0.40 should not worry about it.
Aerospace 0.40 • They could have a routine or erratic debt policy, and it
would not matter.
Chemicals 0.41
Autos 0.46
• However, financial managers do worry about debt policy!
Clothing 0.46
Utilities 0.49 • Growth Companies borrow less compared to matured
Retail 0.53 firms.
Telecoms 0.55
Factors affecting
Capital Structure

• Corporate and personal taxes

• Costs of bankruptcy and financial distress
• Asymmetric information, and agency costs.

We will combine MM’s insights with these

market frictions, to understand Financial
Managers’ decision of Capital Structure
Debt and Taxes
• Advantage of Debt Financing: Interest that the company pays is a tax-deductible
expense

• Restriction on this benefit in the US Tax System: Net amount of interest that
companies can deduct is limited to 30% of EBIT (Earnings Before Interest and
Taxes).
• In this course, we will ignore this limit.

• The tax deductibility of interest increases the total income that can be paid out to
bondholders and stockholders.
 Tax Deductibility of Interest
Income Statement of Firm U Income Statement of Firm L
Earnings before interest and taxes $1,000 $1,000
Interest paid to bondholders (@8%) 0 80
Pretax income $1,000 $ 920
Tax @ 21% 210 193
Net income to stockholders $ 790 $ 727
Total income to both bondholders $0 + 790 = $790 $80 + 727 = $807
and stockholders
Interest tax shield (0.21 × interest) $0 $17

Total Debt Value = $1000, and Interest Rate = 8%,

Annual Tax Shield =
 Tax Deductibility of Interest
Annual Tax Shield =

Total Income (to pay bondholders + equity holders) increases by Tax Shield amount.
In effect the government pays 21% of the interest expense of the levered firm.

Suppose debt of firm L is fixed and permanent Firm refinances its debt continuously
Then Firm L has a $17 cash flow every year.

You can think of tax shields as assets depend on tax rate, and Firm Earning > Interest
 Tax Deductibility of Interest
Annual Tax Shield =

The appropriate discount rate for tax shields

If the firm will produce these tax shields in perpetuity,

In practice, rather than fixed debt value, firms fix their D:E ratio Debt value will
fluctuate, and hence PV(Tax Shield) needs to be discounted at a higher discount rate.
 Interest Tax Shield and Equity Value
Normal Balance Sheet (Market Values)
• MM say the value of a pie (Firm’s Assets) does
not depend on how it is sliced (Debt + Equity) Asset value (present value of Debt
after-tax cash flows)
Equity
• There is a 3rd slice: Government
Total assets Total value

• Firm can raise debt to reduce the Expanded Balance Sheet (Market Values)
Government’s slice Increase debt + equity Pre-tax asset value (present Debt
holders’ income value of pre-tax cash flows)
Government’s claim (present
• Extended B/S reports Pre-tax Asset Value value of future taxes)
Equity
Total pre-tax assets Total pre-tax value
 Question!
Suppose that the Fleetwood Group borrows $15 million at an
interest rate of 6%. The corporate tax rate is 25%.
1. What is the present value of the tax shield if the debt is fixed
and permanent?
A.
2. How would your answer change if the interest rate on the
debt was 8%?
A. It would not
3. Suppose that instead of the debt being fixed, it was
rebalanced in the future to maintain a constant proportion of
Fleetwood's market value. Would you use a higher or lower
discount rate to value the tax shields? Would this result in a
higher or lower value for these tax shields?
A. Interest Tax shields will vary Higher discount Rate
 Johnson & Johnson Balance Sheet Dec 2020 (mn $)

Book Values
Difference between Market and
Net working capital $ 8,744 $ 32,635 Long-term debt
Book Value of Assets = Difference
between Market and Book Value of Long-term assets 123,657 36,488 Other long-term
Equity liabilities
63,278 Equity
Total net assets $132,401 $132,401 Total value
PV(Tax Shield) calculated at 21% tax
rate, assuming fixed and perpetual Market Values
debt Net working capital $ 8,744 $ 32,635 Long-term debt
PV interest tax 6,853 36,488 Other long-term
What happens if J&J borrows shield liabilities
$10,000 mn more debt, and Long-term assets 426,128 408,602 Equity
repurchases the same amount of Total net assets $477,725 $477,725 Total value
shares?
 J&J Balance Sheet with $10bn more Debt

What happens if J&J borrows $10,000 Book Values

mn more debt, and repurchases the Net working capital $ 8,744 $ 42,635 Long-term debt
same amount of shares? Long-term assets 123,657 36,488 Other long-term
liabilities
Tax Bill Reduction 53,278 Equity
Total net assets $132,401 $132,401 Total value

Market Values
Firm Value rises by $2,100mn
Net working capital $ 8,744 $ 42,635 Long-term debt
PV interest tax 8,953 36,488 Other long-term
J&J repurchased $10bn shares, but shield liabilities
overall equity value dropped only by Long-term assets 462,128 400,702 Equity
$7.9bn Equity holders gained $2.1 bn
Total net assets $479,825 $479,825 Total value
 J&J Balance Sheets with & without additional $10bn Debt
Book Values
Net working 8,744 32,635 Long-term Net working 8,744 42,635 Long-term debt
capital debt capital
Long-term 123,657 36,488 Other long- Long-term 123,657 36,488 Other long-term
assets term liabilities assets liabilities
63,278 Equity 53,278 Equity
Total net 132,401 $132,401 Total value Total net 132,401 132,401 Total value
assets assets
Market Values
Net working $ 8,744 $ 32,635 Long-term debt Net working 8,744 42,635 Long-term debt
capital capital
PV interest 6,853 36,488 Other long- PV interest tax 8,953 36,488 Other long-term
tax shield term liabilities shield liabilities

Long-term 426,128 408,602 Equity Long-term Equity

assets assets 462,128 400,702
Total net 477,725 477,725 Total value Total net assets 479,825 479,825 Total value
assets
Chapter 17 – Question 3
Book ($) Market ($)
Net Working Capital 20 40 Debt Net Working Capital 20 40 Debt
Long-term Assets 80 60 Equity Long-term Assets 140 120 Equity
100 100 160 160

Assume that MM's theory holds with taxes. There is no growth, and the $40 of debt is expected to be
fixed and permanent. Assume a 40% corporate tax rate.
1. How much of the firm's value in dollar terms is accounted for by the debt-generated tax shield?
2. How much better off will the firm's shareholders be if it borrows $20 more and uses it to
repurchase stock?

Answers:
1) PV tax shield = Tc × D = .40 × $40 = $16
2) Increase in equity = Tc × ΔD = .40 × $20 = $8
Supplementary Question 4
Milton Industries expects free cash flow of $5 million each year. Milton’s corporate tax rate
is 35% and its unlevered cost of capital is 15%. The firm also has outstanding debt of
$19.05 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?
Answers:
FCF = $5mn. Tc = 35%. . D=$19.05mn

a) PV of Perpetual FCF with no debt, Firm Value

.

b) PV of Perpetual Tax Shields =

Firm Value = $33.33mn + $6.67mn = $40mn
 MM’s Proposition 1 Corrected for Taxes:

If debt is fixed, permanent:

MM and
Corporate Tax The formula implies that firm value and stockholders' wealth
continue to go up as D increases. So, should firms load up on wealth?

• With “corrected” MM theory, $2.1 billion came too easily for J&J
• It violates the law that there is no such thing as a money machine.
• And if Johnson & Johnson's stockholders would be richer with
$42,635 mn of corporate debt, why not $52,635 or $62,635 mn?
 Is the optimal debt policy to be 100% debt-financing?
MM were not that fanatical about it. No one would expect
the formula to apply at extreme debt ratios.

There are several reasons why our calculations overstate the

MM and value of interest tax shields.
Corporate Tax • Debt may not be fixed and perpetual.
• Some firms face marginal tax rates less than 21%.
• No interest tax shields unless there are sufficient profits to
shield.
• The amount of interest that can be deducted is limited to
30% of EBIT.
FY 2021-22

.1
India

.09
PAT/Assets
• 30,000 Indian Firms from

.08
CMIE ProwessDx Database
• D/E is calculated using .07
Book values and not
market values
.06

0 .2 .4 .6 .8 1
D/E
Costs of Financial Distress

Costs of Financial Distresses:

1. Direct Costs: The direct costs of bankruptcy and the extra costs of managing a business
undergoing bankruptcy and reorganization.
2. Indirect Costs: Costs that arise when customers, suppliers, and employees can no longer be
confident of a business's viability.
3. Agency Costs that stem from conflicts of interest between shareholders and bondholders.
 Bankruptcy Costs
• Stockholders exercise their right to default in case of corporate bankruptcies.
• That right is valuable; when a firm gets into trouble, limited liability allows stockholders
simply to walk away from it, leaving all its troubles to its creditors.
• The former creditors become the new stockholders, and the old stockholders are left with
nothing.

What if Stockholders in corporations did not have limited liability:

• Consider two firms with identical assets and operations: Ace Limited & Ace Unlimited
• Both have promised to repay $1,000 (principal and interest) next year.
• Ace Limited has limited liability, but Ace Unlimited, does not; its stockholders are
personally liable for its debt.
Payoffs: Ace Limited
Payoffs: Ace Unlimited
 Bankruptcy Costs
Compare next year's possible payoffs to the creditors and stockholders of these two firms:

• When next year's asset value turns out to be less than $1,000.
• In this case, Ace Limited defaults.
• Its stockholders walk away; their payoff is zero.
• Bondholders get the assets worth $500.
• But Ace Unlimited's stockholders can't walk away.
• They have to pay up $500 from their own pocket, the difference between asset value and the
bondholders' claim.

When Ace Limited goes bankrupt, it is an operating problem having nothing to do with financing. Given
poor operating performance, the right to go bankrupt–the right to default- is a valuable privilege.
 Bankruptcy Costs

• Bankruptcies are thought of as corporate funerals!

• The mourners (creditors and especially shareholders) look at their firm's present sad state.

• Drop in value of their securities Cost of Bankruptcy

• The decline in the value of assets is what the mourning is really about.
• That decline has no necessary connection with financing.
• The bankruptcy is a legal mechanism for allowing creditors to take over when the decline
in the value of assets triggers a default.
• Bankruptcy is not the cause of the decline in value. It is the result.
 Bankruptcy Costs
• Bankruptcy is a legal mechanism allowing creditors to take over when a firm defaults.
• Bankruptcy costs are the costs of using this mechanism.
• We did not consider bankruptcy costs in earlier figures (Ace Limited and Ace Unlimited)
• Even when Ace Limited defaults and goes bankrupt, its combined payoff to the
bondholders and stockholders remains the same as the combined payoff to the
bondholders and stockholders of Ace Unlimited.
• Thus, Overall Market Values of the two firms now (after bankruptcy) must be identical.
• Ace Limited's stock is worth more than Ace Unlimited's stock because of Ace Limited's
right to default.
• Ace Limited's debt is worth correspondingly less.
Ace Limited
Total payoff to Ace
Limited security holders
net of bankruptcy costs.

There is a $200 (lawyer’s

fee) bankruptcy cost in
the event of default
(shaded area).
 Bankruptcy Costs
• Increased leverage affects the present value of the costs of financial distress.
• If Ace Limited borrows more, it increases the probability of default and the value of the
lawyers' claim.
• High Debt increases PV(costs of financial distress) & reduces Ace's present market value.

• The costs of bankruptcy come out of stockholders' pockets.

• Creditors foresee the costs they will have to pay if default occurs.
• So, creditors demand higher compensation (higher interest rate) in advance even when the
firm does not default These interest rates increase with expected default risk
• This reduces the possible payoffs to stockholders and reduces the present market value of
their shares.
Question
 Evidence on Bankruptcy Costs
• Bankruptcy costs add up!

• The failed energy giant Enron paid $757 million in legal, accounting, and other professional fees
during the time that it spent in bankruptcy.
• The estimated direct costs of sorting out the 65,000 claims on the assets of Lehman Brothers was
$5.9 billion.
• These are a small fraction of the companies' asset values.

• Lawrence Weiss, who studied 31 firms that went bankrupt between 1980 and 1986, found average
costs of about 3% of total book assets and 20% of the market value of equity in the year prior to
bankruptcy.
 Evidence on
Bankruptcy Costs
• Bankruptcy eats up a larger fraction of asset
value for small companies than for large ones.
There are significant economies of scale in
going bankrupt.

• For example, a study of smaller U.K.

bankruptcies by Franks and Sussman found
that fees (legal and accounting) and other
costs soaked up roughly 20% to 40% of the
proceeds from liquidation of the companies.

• IBBI Report: Assets of distressed firms in

bankruptcy realize only about 41% of their
estimated value in 1 year, 21% in 3 years
Direct versus Indirect Costs of Bankruptcy
On top of legal and administrative (direct) costs of bankruptcy, there are indirect costs.

• Consent of the bankruptcy court is required for routine business decisions, e.g.
sale/purchase of assets

• Proposals to reform and revive the firm are thwarted by impatient creditors, who
stand first in line for cash from asset sales or liquidation of the entire firm.

• Sometimes the bankruptcy court is so eager to maintain the firm as a going concern
that it allows the firm to engage in negative-NPV activities.
 Indirect Costs of Bankruptcy

Example: Eastern Airlines entered the "protection" of the bankruptcy court in 1989.
• At the time, it had profit-making routes and salable assets such as planes and
terminal facilities.
• A prompt liquidation would have generated enough cash to pay off all debt and
preferred stockholders.
• However, Bankruptcy judge was keen to keep Eastern's planes flying at all costs, so
he allowed the company to sell many of its assets to fund hefty operating losses.
• When Eastern finally closed down after two years, there was almost nothing for
creditors, and the company ran out of cash to pay legal expenses.
 • Indirect costs of bankruptcy are tough to estimate.
• Bankruptcy proceedings are often lengthy and complex.

Direct
• That is why creditors are reluctant to force bankruptcy.
• In principle, creditors would be better off to seize the

versus
assets as soon as possible. But to avoid bankruptcy costs,
creditors often overlook defaults in the hope of nursing the
firm over a difficult period.
Indirect • There is an old financial saying, “Borrow $1,000 and you've
got a banker. Borrow $10,000,000 and you've got a
Costs of partner.”
• Creditors may also shy away from bankruptcy because they
Bankruptcy worry that they might not get a full-priority over the
stockholders.
• Example: If the government is also one of the shareholders,
its interests would be to save jobs of the firm’s employees,
rather than interests of bondholders. Bankruptcy courts
may favor the government here.
 • Firm only needs to pay interest to postpone

Financial bankruptcy for many years.

• During this time, the firm can recover and pay off
Distress its debt

without Even the threat of financial distress can be costly:

• Customers worry about resale, service, etc.
Bankruptcy • Suppliers might not give trade credit (accounts
payables)
• Good employees might leave
 When a firm is in trouble, the interests of debt-
holders and equity-holders can diverge
• Equity-holders have a secondary claim on firm’s
Agency assets and income
• Equity-holders might play games at the expense of
Costs of the debt-holders and the overall firm value

Financial Five Games:

Distress 1. Risk Shifting

2. Not Contributing Equity Capital
3. Cash In and Run
4. Playing for Time
5. Bait and Switch
 Agency Costs of Financial Distress
Circular File Company (Book Values)
Example: Circular File Company
Net working capital $ 20 $ 50 Bonds outstanding
• Assume the firm has only 1 share
Fixed assets 80 50 Common stock
and 1 bond outstanding
Total assets $100 $100 Total value
• The stockholder is CEO of the firm
• Bond holder is someone else.
• Company has $50 of 1-year debt. Circular File Company (Market Values)
Net working capital $20 $27 Bonds outstanding
Fixed assets 10 3 Common stock
Total assets $30 $30 Total value

The firm is financially distressed: Face Value of Debt > Market Value of Firm

© McGraw Hill
 • Suppose that Circular has $10 cash.
Game 1: Risk Shifting • CEO controls investment and operating decisions
• The following investment opportunity comes up:

• Let us say, the CEO computes the NPV of the project as -$2.
• Will he go ahead with the project?
• Cash decreases by $10, Fixed Assets Increase by $10-$2 = $8
• Bond Value drops as it is backed by risky asset!
• If the project fails, the shareholder loses nothing.
• If the project succeeds, the shareholder gains substantially even after paying bondholders
Risk Shifting

Circular File Company (Market Values: Pre Project)

Net working capital $20 $27 Bonds outstanding

Fixed assets 10 3 Common stock
Total assets $30 $30 Total value

Circular File Company (Market Values: Post Project)

Net working capital $ 10 $ 22 Bonds outstanding
Fixed assets 18 6 Common stock
Total assets $28 $28 Total value

Firm value falls by $2, but equity holder gains $3.

FedEx’s Gamble
 Game 2: Refusing to Contribute Equity Capital
• If Circular File Company has no cash to play a wild gamble.
• A Good Investment Opportunity comes up:
• Safe Asset worth $10, PV(Cash Flows) = $15, NPV = $5
• Project by itself will not save the firm, but is a good first step
• Let us say CEO can issue and buy 2 new shares worth $10.
• In the New Balance Sheet, total firm value might be $15 higher ($10 new capital + $5 NPV)

Circular File Company (Market Values: Post Project)

Net working capital $ 20 $ 35 Bonds outstanding
Fixed assets 25 10 Common stock
Total assets $45 $45 Total value
 Game 2: Refusing to Contribute Equity Capital
• Bond Value: $27 $35, increase of $8 due to new safe assets
• Stock Value: $3 $10, increase of $7, despite investing $10
• Stockholder will reluctant to invest new equity capital
• Debt Overhang Problem: Firm management will pick riskier projects that do not maximize overall
firm value, in case of excessive debt.
Circular File Company (Market Values: Pre Project)
Net working capital $20 $27 Bonds outstanding
Fixed assets 10 3 Common stock
Total assets $30 $30 Total value
Circular File Company (Market Values: Post Project)
Net working capital $ 20 $ 35 Bonds outstanding
Fixed assets 25 10 Common stock
Total assets $45 $45 Total value
More Games!
Cash In and Run: Distressed Firm decides to
pay shareholders as much cash dividend as
possible. At the expense of Debt-holders.

Playing for Time: Stockholders use delay

tactics with creditors. E.g.: Artificially inflate
earnings to delay recognition of distress.

Bait and Switch: Start with conservative policy,

then later switch and issue a lot more debt. It
can dilute the claims of old debt-holders.
 • Henrietta Ketchup has two possible investment
Example: Ms. Ketchup projects.

Faces Credit Rationing • She wants to borrow $10 from bank.

• Bank might not lend the entire amount, if it
suspects gambling behavior by the owner.
E[Payoff] to Bank E[Payoff] to Owner
• Owner can give the bank veto-power on
Project 1 $10 $5
investment decisions to gain the bank’s
Project 2 0.5×10+0.5×0=$5 0.5×(24-10)=$7 confidence.
Costs of Distress and Asset Type
• Let us say your firm’s only asset is a large fully-
mortgaged hotel
• Recession hits, occupancy falls Default on Mortgage
• Bank can take control and sell the hotel to another
owner.
• Very low cost of bankruptcy.

• Instead, say your firm’s assets were employees,

technology, investment opportunities. Example: A tech
firm
• Firm gets distressed Stockholders are reluctant to
invest, and employees start leaving
• When this firm defaults on debt, Bank will find is
difficult to sell assets like technology (intangible asset).
 Chapter 17 – Question 15
The Salad Oil Storage (SOS) Company has financed a large part of its facilities with long-term debt. There is a
significant risk of default, but the company is not on the ropes yet. Explain:
a) Why SOS stockholders could lose by investing in a positive-NPV project financed by an equity issue?
b) Why SOS stockholders could gain by investing in a negative-NPV project financed by cash?
c) Why SOS stockholders could gain from paying out a large cash dividend?
Answers:
a) SOS stockholders could lose if they invest in the positive NPV project and then SOS becomes bankrupt. Under
these conditions, the benefits of the project accrue to the bondholders.
b) If the new project is sufficiently risky, then, even though it has a negative NPV, it might increase stockholder
wealth by more than the money invested. This is a result of the fact that, for a very risky investment,
undertaken by a firm with a significant risk of default, stockholders benefit if a more favorable outcome is
actually realized, while the cost of unfavorable outcomes is borne by bondholders.
c) Again, think of the extreme case: Suppose SOS pays out all of its assets as one lump-sum dividend.
Stockholders get all of the assets, and the bondholders are left with nothing. (Note: fraudulent conveyance
laws may prevent this outcome.)
The Trade-Off
Theory of Capital
Structure

Trade-Off Theory: Theory

that capital structure is
based on trade-off between
• Tax savings.
• Distress costs of debt.
 Division % of Firm Value

Supplementary Question 3
Food 50
Electronics 30
Chemicals 20

Amalgamated Products has three operating divisions: Food, Chemicals and Electronics.
To estimate the cost of capital for each division, Amalgamated has identified the following three
principal competitors: Estimated Equity Beta Debt/(Debt+Equity)
United Foods 0.8 0.3
General Electronics 1.6 0.2
Associated Chemicals 1.2 0.4
Assume these betas are accurate estimates and that the CAPM is correct. Assume further that
Amalgamated is exempt from corporate income tax.
a) Assuming that the debt of these firms is risk-free, estimate the asset beta for each of
Amalgamated’s divisions.
b) Amalgamated’s ratio of debt to debt plus equity is 0.4. If your estimates of divisional betas are
right, what is Amalgamated’s equity beta?
c) Assume that the risk-free interest rate is 7 percent and that the expected return on the market
index is 15 percent. Estimate the cost of capital for each of the Amalgamated’s divisions.
d) How much would your estimates of each division’s cost of capital change if you assumed that
debt has a beta of 0.2?
 Supplementary Question 3
Division % of Firm Value Estimated Equity Beta Debt/(Debt+Equity)
Food 50 United Foods 0.8 0.3
Electronics 30 General Electronics 1.6 0.2
Chemicals 20 Associated Chemicals 1.2 0.4

a) Assuming that the debt of these firms is risk-free, estimate the asset beta for each of
Amalgamated’s divisions.
• Asset Betas: 𝛽 = 𝛽 × +𝛽 × and 𝛽 = 0
• Food = 0.8×0.7 = 0.56, Electronics = 1.6×0.8 = 1.28, Chemicals = 1.2×0.6 = 0.72

b) Amalgamated’s ratio of debt to debt plus equity is 0.4. If your estimates of divisional betas are
right, what is Amalgamated’s equity beta?
• D/V = 0.4, 𝛽 = 0.5 × 0.56 + 0.3 × 1.28 + 0.2 × 0.72 = 0.808
.
• 𝛽 =β + β −β × = 0.808 + 0.808 × = 0.808 × 1.67 = 1.35
.
 Supplementary Question 3
Division % of Firm Value Estimated Equity Beta Debt/(Debt+Equity)
Food 50 United Foods 0.8 0.3
Electronics 30 General Electronics 1.6 0.2
Chemicals 20 Associated Chemicals 1.2 0.4

c) Assume that the risk-free interest rate is 7 percent and that the expected return on the market
index is 15 percent. Estimate the cost of capital for each of the Amalgamated’s divisions.

• CAPM: 𝑟 = 𝑟 + 𝛽 𝑟 − 𝑟 = 7% + 𝛽 15% − 7% = 7% + 𝛽 × 8%

• Food: 𝑟 = 7 + 0.56 × 8 = 11.48%

• Electronics: 𝑟 = 7 + 1.28 × 8 = 17.24%
• Chemicals: 𝑟 = 7 + 0.72 × 8 = 12.76%
 Supplementary Question 3
Division % of Firm Value Estimated Equity Beta Debt/(Debt+Equity)
Food 50 United Foods 0.8 0.3
Electronics 30 General Electronics 1.6 0.2
Chemicals 20 Associated Chemicals 1.2 0.4

d) How much would your estimates of each division’s cost of capital change if you assumed that
debt has a beta of 0.2?
• CAPM: 𝑟 = 𝑟 + 𝛽 𝑟 − 𝑟 = 7% + 𝛽 15% − 7% = 7% + 𝛽 × 8%
• 𝛽 =𝛽 × +𝛽 ×

• Food: 𝛽 = 0.2 × 0.3 + 0.8 × 0.7 = 0.62, 𝑟 = 7 + 0.62 × 8 = 11.96%

• Electronics: 𝛽 = 0.2 × 0.2 + 1.6 × 0.8 = 0.62, 𝑟 = 7 + 1.32 × 8 = 17.56%
• Chemicals: 𝛽 = 0.2 × 0.4 + 1.2 × 0.6 = 0.8, 𝑟 = 7 + 0.8 × 8 = 13.40%