Understanding Financial Management

(MCR006)

Cyril Jankoff
Greg Whateley

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Session #1 - The Introduction: Finance Manager and Financial Systems

This Session focuses on what will be covered in this subject.

Overview

There is a long list of problems that confront an organisation’s financial manager (Chief Financial
Officer) s and shareholders. We will commence with a brief discussion of the role of the financial
manager and is followed by an examination of the different legal forms. Most common
organisational forms are discussed but the emphasis will be on the company form. We will
consider the financial function of the manager and the goal of the company, which is to maximise
shareholder wealth. It is this goal that requires that we recognise its conflicts such as agency and
ethical problems.

The key financial decisions facing the financial manager

In running a business, the financial manager faces three key basic decisions, and these decisions
should be made in a way that maximises the current value of the company’s shares. The three
decisions are:
 which productive assets the company should buy (capital budgeting),
 how the company should finance the productive assets purchased (financing decision) and
 how the company should manage its day-to-day financial activities (working capital
decisions).

The basic forms of business organisation in Australia

The three basic ways to run a business are as a sole trader, a partnership or a company (public or
private). The owners of a business select the form of organisation that they believe will best allow
management to maximise the value of the business. Most large businesses elect to trade as public
companies because of the ease of raising money; the major disadvantage is high regulation and
compliance costs. Very small businesses tend to organise as sole traders or partnerships. The
advantages of these forms of organisation include ease of formation and taxation at the personal
income tax rate. The major disadvantage is the owners’ unlimited personal liability, and it is
because of this major disadvantage smaller businesses also trade as a company, but as a private
company, rather than a private one which has all the disadvantages of regulation.

Managing the financial function of a large company

In a large company, the financial manager generally goes by the title of chief financial officer
(CFO). The CFO reports directly to the company’s CEO. Positions reporting directly to the CFO
generally include the accountant, the risk manager, the company secretary and the internal auditor.
Often it includes the procurement and sales managers. The audit committee of the board of
directors is also important in the financial function. The committee hires the external auditor for the
company, and the internal auditor, external auditor and compliance officer all report to the audit
committee. The owners of a company are called its shareholders, and may be directors as well,
which usually occurs in smaller firms. A director is an elected officer of the firm, who manages the
business of the firm, and is a member of the Board of Directors, called the ‘Board’. The Board
represents the shareholders' interests and ensures that the company's management acts on their
behalf. The CEO has ultimate management responsibility and decision-making power in the firm,
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and reports directly to the board of directors, which is accountable to the company’s owners. It is
not considered a good practice to have the CEO on the Board because it is a natural conflict of
interest for executives to serve equally on the entity that supervises them. The CFO reports directly
to the CEO and manages all aspects of the company’s financials.

The Goal of the Company

The goal of the financial manager is to maximise the current value of the company’s shares.
Maximising share value is an appropriate goal because it forces management to focus on
decisions that will generate the greatest amount of wealth for shareholders. Since the value of a
share (or any asset) is determined by its cash flows, management’s decisions must consider the
following:
 the size of the cash flow (larger is better),
 the timing of the cash flow (sooner is better), and
 the riskiness of the cash flow (given equal returns, lower risk is better).

Agency conflicts: separation of ownership and control

In most large companies, there is a significant degree of separation between management (those
who manage the company, including the directors) and ownership (the shareholders). As a result,
shareholders have little control over managers, and management may thus be tempted to pursue
its own self-interest rather than maximising the wealth of the owners. The resulting conflicts give
rise to agency costs. Ways of reducing agency costs include developing salary agreements that
link employee salary to the longer-term company’s performance and having independent boards of
directors’ monitor management. Care is required here as Enron is the classic example of the
renumeration incentive going very wrong.

The importance of ethics in business

If we lived in a world without ethical norms, we would soon discover that it would be difficult to do
business. As a practical matter, the law and market forces provide important incentives that foster
ethical behaviour in the business community, but they are not enough to ensure ethical behaviour.
An ethical culture is also needed. In an ethical culture, people have a set of moral principles — a
moral compass — that helps them identify ethical issues and make ethical judgements without
being told what to do.

Key things to take away

 Identify the key financial decisions facing the financial manager of any company.
 Know the strengths, weaknesses of the basic forms of business organisation.
 The corporate goal should be about maximising the current value of the company's shares,
that is to maximise the wealth of the shareholders.
 Presence of agency conflicts affect the goal of maximising shareholder value.
 Ethics are important in the study of corporate finance.
 The financial system institutions move money from lender-savers (whose income exceeds
their spending) to borrower-spenders (whose spending exceeds their income)
 Interest rates tend to follow business cycle.
 During periods of economic expansion interest rates tend to rise (and vice versa).

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Session #2 - The time value of money and Discounted Cash Flow

This Session focuses on compounding, discounting and the time value of money

Overview

The material covered in this and the next Session form the foundation for understanding the
material following and may be viewed as the most fundamental concepts of finance along with risk
and return.

The time value of money

The idea that money has a time value is one of the most fundamental concepts in the field of
finance. The concept is that a dollar today is worth more than a dollar received in the future. That is
your money is worth more today than at some point in the future because, if you had the money
now, you could invest it and earn interest. Thus, the time value of money is the opportunity cost of
forgoing consumption today.

The trade-off

Applications of the time value of money focus on the trade-off between current dollars and dollars
received at some future date. This is an important element in financial decisions because most
investment decisions require the comparison of cash invested today with the value of expected
future cash inflows. Time value of money calculations facilitate such comparisons by accounting for
both the magnitude and timing of cash flows. The general rule is that investment opportunities are
undertaken only when the current value of future cash inflows exceeds the current cost of the
investment (the initial cash outflow).

Future value and compounding

There are several key terms -

 The future value is the sum to which an investment will grow after earning interest;
 The principal is the amount of the investment;
 Simple interest is the interest paid on the original investment; the amount of money earned
on simple interest remains constant from period to period;
 Compound interest includes not only simple interest, but also interest earned on the
reinvestment of previously earned interest, the so-called earning ‘interest on interest’;
 For future value calculations, the higher the interest rate, the faster the investment will
grow.

Present value and discounting

The present value is the value today of an amount, or amounts, in the future. Calculating the
present value involves discounting future cash flows back to the present at an appropriate discount
rate. The process of discounting cash flows adjusts the cash flows for the time value of money.
Mathematically, the present value factor is the reciprocal of the future value factor, or 1/(1 + i).

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Key things to take away

 The materials in this and the next Session are vital for an understanding of the subject.
 Compounding converts a present value into its future value, considering the time value of
money.
 Discounting converts a future value into its present value, considering the time value of
money.
 Using the above you can determine the present and future value for multiple cash flow and
an ordinary annuity.
 The general rule is that investment opportunities are undertaken only when the current
value of future cash inflows exceeds the current cost of the investment (the initial cash
outflow).
 The effective annual interest rate (EAR) is the appropriate way to annualise interest rates
and calculate EAR.

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Session #3 - Risk and Return

This Session focuses on how risk and return affect investing.

Overview

This is a key Session in that it addresses the measurable aspect of the risk and return relationship
for assets. It provides important background material for later Sessions such as the cost of capital,
capital budgeting, and dividends.

The relationship between risk and return

It is understandable that investors require greater returns for taking greater risk. They prefer the
investment with the highest possible return for a given level of risk or the investment with the
lowest risk for a given level of return.

Quantitative measures of return

The total holding period return on an investment consists of a capital appreciation component and
an income component. Investors do not care whether they receive a dollar of return through capital
appreciation or as a cash dividend, as they value both sources of return equally.

The expected returns

The expected return is a weighted average of the possible returns from an investment, where each
of these returns is weighted by the probability that it will occur.

The variance and standard deviation as measures of risk

The standard deviation of returns is a measure of the total risk associated with the returns from an
asset. It is useful in evaluating returns in finance because the returns on many assets tend to be
normally distributed, that is the measure tells us about the probability that a return will fall within a
particular distance from the expected value or within a particular range. That is, the standard
deviation is a measure of how spread-out numbers are from the simple average of the group. In a
bell-shaped curve, we can say that any value is -
 Likely to be within 1 standard deviation (68 out of 100 should be, that is 68%);
 Very likely to be within 2 standard deviations (95 out of 100 should be, 95%);
 Almost certainly within 3 standard deviations (99.7 out of 100 should be, 99.7%).

Risk and diversification

Diversification is a strategy of investing in two or more assets whose values do not always move in
the same direction at the same time to reduce risk. This reduces risk because some of the
changes in the prices of individual assets offset each other resulting in the overall volatility in the
value of the portfolio to be lower than if it were invested in a single asset. An example is an
investor deciding to invest in property and shares to reduce risk through diversification.

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Systematic risk

Systematic risk is risk you cannot diversify. Investors care about systematic risk because they can
eliminate unique (non-systematic) risk by holding a diversified portfolio. Diversified investors will
bid up prices for assets to the point at which they are just being compensated for the systematic
risks they must bear.

Are you identifying,

assessing, treating and
monitoring and reviewing
your financial
management risks?

The Capital Asset Pricing Model (CAPM)

The CAPM is a model that shows the relationship between expected risk and expected return on
an investment, based on the accepted theory that the higher the risk associated with an
investment, the higher the required return. From the CAPM we know what rate of return investors
will require for an investment with a particular amount of systematic risk (beta). This means that we
can use the expected return predicted by the CAPM as a benchmark for evaluating whether
expected returns for individual assets are sufficient. If the expected return for an asset is less than
that predicted by the CAPM, then the asset is an unattractive investment because its return is
lower than the CAPM indicates it should be. However, if the expected return for an asset is greater
than that predicted by the CAPM, then the asset is an attractive investment because its return is
higher than it should be. Beta is a measure of the price volatility of a security or portfolio, compared
with the market -
 Zero beta: A zero-beta portfolio is a portfolio constructed to have zero systematic risk;
 Beta of 1: This is the level of risk where the market is. This risk is called ‘systemic’ risk, or
‘market’ risk, and is the risk that influences many assets.

Key things to take away

 Investors require greater returns for taking greater risk and prefer the investment with the
highest possible return for a given level of risk or the investment with the lowest risk for a
given level of return. Investors value both capital appreciation and dividend sources of
return equally. The expected return is a weighted average of the possible returns from an
investment.
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 Standard deviation is a measure of how spread-out numbers are from the simple average
of the group. It is a measure of the total risk associated with the returns from an asset and
tells us about the probability that a return will fall within a particular distance from the
expected value or within a particular range.
 Diversification is a strategy of investing in two or more assets whose values do not always
move in the same direction at the same time to reduce risk.
 Investors care about only systematic risk. This is because they can eliminate unique risk by
holding a diversified portfolio.
 The Capital Asset Pricing Model (CAPM) is the equation of the security market line (SML)
showing the relationship between expected return (E(R)) and Beta.

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Session #4 - Bond valuation and the structure of interest rates

This Session focuses on bonds and how they are valued or priced in the marketplace.

Overview

The bond valuation models presented in this Session are derived from the present value materials
discussed.

Capital market efficiency

An efficient capital market is a market where security prices reflect the knowledge and
expectations of all investors. Public markets, for example, are more efficient than private markets
because issuers of public securities are required to disclose a great deal of information about these
securities to investors and investors are constantly evaluating the prospects for these securities
and acting on the conclusions from their analyses by trading them. Market efficiency is important to
investors because it assures them that the securities, they buy are priced close to their true value.

The Corporate bonds

The market for corporate bonds is a very large market in which the most important investors are
large institutions. Most trades in this market take place through dealers in the over the counter
(OTC) market, and the corporate bond market is relatively thin. Prices of corporate bonds tend to
be more volatile than prices of securities that trade more frequently, such as share and money
markets, and the corporate bond market tends to be less efficient than markets for these other
securities.

Bond valuation

The value of a bond is equal to the present value of the future cash flows (coupons and principal
repayment) discounted at the market rate of interest for bonds with similar characteristics. Bond
prices vary negatively with interest rates because the coupon rate on most bonds is fixed at the
time the bond is issued. Therefore, as interest rates go up, investors seek other forms of
investment that will allow them to take advantage of the higher returns. Because the bond’s
coupon payments are fixed, the only way the yields can be adjusted to the current market rate of
interest is to reduce the bond’s price. Interest rate increases decreased the Silicon Valley Bank’s
bond prices leading to the bank’s 2023 collapse.

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 Watch out if the bank
collapses.

Bond yields

A bond’s coupon rate is the stated interest rate on the bond when it is issued. Australian bonds
typically pay interest semi-annually, whereas European bonds pay once a year. The yield to
maturity is the expected return on a bond if it is held to its maturity date. The effective annual yield
is the yield an investor earns in one year, adjusting for the effects of compounding. If the bond
pays coupon payments more often than annually, the effective annual yield will be higher than the
simple annual yield because of compounding.

Interest rate risk

Because interest rates are always changing in the market, all investors who hold bonds are subject
to interest rate risk. Interest rate risk is uncertainty about future bond values caused by fluctuations
in interest rates. Three of the most important bond theorems are -
 Bond prices are negatively related to interest rate movements;
 For a given change in interest rates, the prices of long-term bonds will change more than
the prices of short-term bonds;
 For a given change in interest rates, the prices of lower coupon bonds will change more
than the prices of higher coupon bonds.

The structure of interest rates

Default risk is the risk that the issuer (borrower) will be unable to pay its debt obligation (interest
and the principal). Since investors are risk averse, they must be paid a premium to purchase a
security that exposes them to default risk. The default risk premium has two components: (1)
compensation for the expected loss if a default occurs and (2) compensation for bearing the risk
that a default could occur. All factors held constant, the degree of default risk a security possesses
can be measured as the difference between the interest rate on a risky security and the interest
rate on a default-free security.

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The term structure of interest rates

The level and shape of the yield curve are determined by three factors: (1) the real rate of interest,
(2) the expected rate of inflation and (3) interest rate risk. The real rate of interest is the base
interest rate in the economy and varies with the business cycle. The real rate of interest affects
only the level of the yield curve and not its shape. The expected rate of inflation does affect the
shape of the yield curve. If investors believe inflation will be increasing in the future, for example,
the curve will be upward sloping, as long-term rates will contain a larger inflation premium than
short-term rates. Finally, interest rate risk, which increases with a security’s maturity, adds an
upward bias to the slope of the yield curve.

Key things to take away

 An efficient capital market is a market where security prices reflect the knowledge and
expectations of all investors.
 Prices of corporate bonds tend to be more volatile than prices of securities that trade more
frequently, such as share and money markets.
 The value of a bond is equal to the present value of the future cash flows (coupons and
principal repayment) discounted at the market rate of interest for bonds with similar
characteristics.
 A bond’s yield to maturity changes daily as interest rates increase or decrease.
 Because interest rates are always changing in the market, all investors who hold bonds are
subject to interest rate risk.
 Default risk is the risk that the issuer (borrower) will be unable to pay its debt obligation
(interest and the principal) causing investors to be paid a premium to purchase a security
that exposes them to default risk.
 The level and shape of the yield curve are determined by three factors.

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Session #5 - Share Valuation

This Session focuses on equity securities (shares) and how they are valued.

Overview

We will consider the fundamental factors that determine a share’s price or value, and then several
valuation models that estimate this price. These models tell us what the share’s price should be
and can then be used to compare our estimate against the actual market price.

The four types of secondary market for shares

The four types of secondary markets are: (1) direct search, (2) broker, (3) dealer and (4) auction. In
direct search markets, buyers and sellers seek each other out directly. In broker markets, brokers
bring buyers and sellers together for a fee. Trades in dealer markets go through dealers who buy
securities at one price and sell at a higher price. The dealers face the risk that prices could decline
while they own the securities. Auction markets have a fixed location where buyers and sellers
confront each other directly and bargain over the transaction price.

Ordinary and preference shares and the ordinary share valuation

Preference shares represent ownership in a company and entitle the owner to a dividend, which
must be paid before dividends are paid to ordinary shareholders. Like bonds, preference share
issues have credit ratings, are sometimes convertible to ordinary shares and are often callable.
Unlike owners of ordinary shares, owners of non-convertible preference shares do not have voting
rights and do not participate in the company’s profits beyond the fixed dividends they receive.
Because of their strong similarity to bonds, many financial analysts treat preference shares that are
not true perpetuities as a form of debt rather than equity.

The general dividend valuation model

The general dividend valuation model values a share as the present value of all future cash
dividend payments, where the dividend payments are discounted using the rate of return required
by investors for a particular risk class.

Some simplifying assumptions about share valuation

The problems with the general dividend valuation model are that the exact discount rate that
should be used is unknown, dividends are often uncertain, and some companies do not pay
dividends at all. To make the model easier to apply, we make assumptions about the dividend
payment patterns of businesses. These simplifying assumptions allow the development of more
manageable models, and they also conform with the actual dividend policies of many companies.
Dividend patterns include the following: (1) dividends are constant (zero growth); (2) dividends
have a constant growth pattern (they grow forever at a constant rate g); and (3) dividends grow first
at a non-constant rate then at a constant rate.

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Valuing preference shares

When a preference share has a maturity date, financial analysts value it as they value any other
fixed obligation — that is, like a bond. To value such a preference share, we can use the bond
valuation model we have already covered. Before using the model, we need to recognise that we
will be using dividends in the place of coupon payments and that the par value of the share will
replace the par value of the bond. Additionally, in Australia, both bond coupons and preference
share dividends are paid semi-annually. When a preference share has no stated maturity, it
becomes perpetuity, with the dividend becoming the constant payment that goes on forever.

Key things to take away

 Investors have the choice of several investments including options, bonds, shares and
property
 There are two markets, primary (when the security is first issued) and secondary (all
subsequent transactions)
 There are four types of secondary markets direct search, broker, dealer and auction.
 There are two types of equity securities -
o Ordinary shares: they represent a basic ownership
claim in a company and have voting rights;
o Preference shares also represent ownership interest in a company, but they get
preferential treatment over ordinary shares in relation to dividends and capital in a
windup. They have no voting rights and are often seen as a special type of bond.
 The general dividend valuation model values a share as the present value of all future cash
dividend payments, where the dividend payments are discounted using the rate of return
required by investors for a particular risk class.
 Since preference share dividends are declared by the board of directors, failure to pay
dividends does not result in default.
 Failure to pay a preference share dividend as promised is a serious financial breach and
signals to the market that company is in serious financial difficulty.

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Session #6 - The fundamentals of capital budgeting

This Session focuses on capital budgeting and includes a discussion of the types of capital
projects that companies undertake and how the capital budgeting process is managed within the
company.

What is capital purchasing?

Capital budgeting is the process that a business uses to determine which proposed fixed asset
purchases it should accept, and which should be declined. This could be the purchase of a large
truck, a property, a factory or a business. This process is used to create a quantitative view of each
proposed fixed asset investment, thereby giving a rational basis for making a judgment.

How do we budget for capital purchasing?

We have a few traditional unsophisticated methods (including the Payback or the Accounting Rate
or Return, also called the Average Rate of Return) but these have their drawbacks and thus affect
the accuracy of the information they provide. We now have more sophisticated methods including
the Net Present Value, Internal Rate of Return, Modified Internal Rate of Return and the
Discounted Payback methods. The difference between these two categories is that the
‘sophisticated’ methods discount the cash flows, and this results in more accurate information for
decision making. See the below Exhibit.

Exhibit 6.1 Various Capital Expenditure Evaluation Methods

Methods

Traditional or un-sophisticated Time-adjusted or sophisticated

[Non-discounted cash flow methods] [Discounted cash flow methods]

Payback (PB) Accounting Rate Net

NetPresent
Present Internal Rate of Modified Discounted
of Return (ARR) Value(NPV
Value )
(NPV) Return (IRR) Internal Rate of Payback (DPB)
Return (MIRR)

Note: If possible, you should be using the time adjusted (discounted) methods. One could
use the net present value and the discounted payback methods together.

What is discounting?

Discounting was discussed in Session 2 (Time value of money and discounted cash flows), where
we saw that if we have a series of cash flows over several years you cannot compare the sums to
be received or paid today with that in the future. To compare we need to discount the future sums

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to today’s dollar values. For example, if we are to receive $10,000 in 4 years from now it will be
worth only $6,830 today if discounted at 10%. Conversely, if we invest $6,830 at 10% our
investment should have grown to $10,000 in 4 years, with the difference being $3,270 (that is,
$10,000 - $6,630). Thus, we need to compare ‘apples with apples’ and this is done by using
discounting, as the $3,270 difference affects the accuracy of decision making. Hence, as a rule we
seek to use discounting methods if we can.

What are the different methods?

In summary the different methods are as follows -

 Payback this is how long it will take to pay back your initial investment;
 Accounting Rate of Return this is just the total income for the project divided by the total
invested, and this it is an average return on the investment. It is also called the ‘Average
Rate of Return’;
 Net Present Value is how much the future cash flows will total in today's dollars compared
to the present value of what we spend. The rule is to only accept the project if the NPV is
positive, that is where the present value of future cash inflows exceeds the present value of
outgoings;
 The Internal Rate of Return is what interest rate is needed to use to get a zero net present
value and you then compare that rate to the one you seek for the project and take the
project if the IRR exceeds the rate you seek. As this method can result in a mathematical
error it should not be used. However, it is still being widely used;
 The Modified Internal Rate of Return is a modification of the internal rate of return and as
such aims to resolve some problems with the IRR. It assumes that positive cash flows are
reinvested at the firm's cost of capital and that the initial outlays are financed at the firm's
financing cost;
 The Discounted Payback method uses discounting to make this method more accurate,
but it still has its problems as cashflows after the payback date are ignored, even if these
cash flows are large.

Which method to use?

The best overall method is the net present value method because it gives the most accurate
answer. However, it does take some effort to learn and then understand how to do the calculation,
but the most difficult part is the determination of the cash flows and the discount rate. What often
occurs is that both the net present value method and the payback method are used together.
When using the payback method, it would be better to use the discounted version to obtain more
accuracy. The problem with the payback method irrespective whether to discounted or not is that
once the payback time has been determined the method requires one to ignore the subsequent
cash flows. Therefore, it is not a good method to use unless one wants to determine risks. That is,
in theory a project which pays back in two years is seen to be less risky than one which pays back
in five years. However, the cash flows need to be considered and that is the role of the net present
value method.

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How did capital purchasing activity go?

It is beneficial to have a post capital project implementation review. Managers should also conduct
ongoing reviews of capital projects in progress. The review should challenge the business plan,
including the cash flow projections and the operating cost assumptions. Management should also
evaluate people responsible for implementing a capital project.

Key things to take away

 Capital budgeting decisions are the most important investment decisions made by
management.
 Net present value (NPV) is the most important capital budgeting tool.
 The payback period tool has drawbacks: (a) amounts are not discounted; and (2) ignores
post payback figures.
 The accounting rate of return (ARR) method is not a capital expenditure decision-making
tool.
 The internal rate of return (IRR) for a capital project can make mistakes, thus focus on the
NPV method.
 It is beneficial to have a post audit review of a capital project.

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Session #7 - Cash flows and capital budgeting

The focus of this class is on the detail on how to do the capital budgeting calculation.

Overview

This is an important Session for all students as they will undoubtedly be involved in project analysis
at some point in their careers. The material in this Session is central to Finance and incorporates
several tools described in earlier Sessions.

Calculating project cash flows

The incremental after-tax free cash flows, FCFs, for a project equal the expected change in the
total after-tax cash flows of the company if the project is adopted. The impact of a project on the
company’s total cash flows is the appropriate measure of cash flows because these are the cash
flows that reflect all the costs and benefits from the project.

How are your cashflows? Does your company have onerous obligations?

Estimating cash flows in practice

The five general rules are as follows -

 Rule 1: Include cash flows and only cash flows in your calculations. Shareholders care
about only the impact of a project on the company’s cash flows;
 Rule 2: Include the impact of the project on cash flows from other product lines. If a project
affects the cash flows from other projects, we must take this fact into account in NPV
analysis to fully capture the impact of the project on the company’s total cash flows;
 Rule 3: Include all opportunity costs. If an asset is used for a project, the relevant cost for
that asset is the value that could be realised from its most valuable alternative use. By

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 including this cost in the NPV analysis, we capture the change in the company’s cash flows
that is attributable to the use of this asset for the project;
 Rule 4: Forget sunk costs. The only costs that matter are those to be incurred from now;
 Rule 5: Include only after-tax cash flows in the cash flow calculations. Since shareholders
receive cash flows after taxes have been paid, they are concerned only about after-tax
cash flows.

Projects with different lives

The lowest common multiple method is the method of making two investments the same by
assuming repeated investments over an identical period. The NPV perpetuity (NPV∞) of an
investment is the total NPV of an investment if it is replaced with an identical investment, at the end
of its useful life, infinitely. The equivalent annual cost (EAC) is the annualised cost of an investment
that is stated in nominal dollars. In other words, it is the annual payment from an annuity that has
the same NPV and the same life as the project. Since it is a measure of the annual cost or cash
inflow from a project, the EAC for one project can be compared directly with the EAC from another
project, regardless of the lives of those two projects.

When to harvest an asset

The appropriate time to harvest an asset is that point in time where harvesting the asset yields the
largest present value, in today’s dollars, of the project NPV.

Key things to take away

 The incremental after-tax free cash flows are relevant in evaluating a project.
 The five general rules for incremental after-tax free cash flow calculations are -
o Include cash flows and only cash flows in your calculations;
o Include the impact of the project on cash flows from other product lines;
o Include all opportunity costs;
o Forget sunk costs;
o Include only after-tax cash flows in the cash flow calculations.
 Know the concepts of lowest common multiple, NPV (net present value) perpetuity and
equivalent annual value, and apply them to compare projects with unequal lives, decide
when to replace an existing asset and calculate the opportunity cost of using an existing
asset.
 The appropriate time to harvest (or replace) an asset is the point in time where harvesting
(or replacing) the asset yields the largest present value of the project NPV.

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Session #8 - Cost of Capital

The focus of this Session is on the tools needed to determine the company’s cost of capital and
understand the complications and corresponding limitations associated with this value.

Overview

The cost of capital appears to be a relatively simple concept that is described by a static equation.
In this Session we will use the weighted average cost of capital (WACC) as a snapshot that is
based on the companywide systematic risk, which is affected by the current portfolio of projects as
well as the financial leverage that the company is employing. We will also consider the
subcomponents of WACC: the cost of debt, the cost of ordinary equity, and the cost of preferred
equity for the company.

The ‘Company’s overall cost of capital

The weighted average cost of capital (WACC) for a company is a weighted average of the current
costs of the different types of financing that a company has used to finance the purchase of its
assets. When the WACC is calculated, the cost of each type of financing is weighted according to
the fraction of the total company value represented by that type of financing. The WACC is often
used as a discount rate in evaluating projects because it is not possible to directly estimate the
appropriate discount rate for many projects. A single discount rate reduces inconsistencies that
can arise when different analysts in the company use different methods to estimate the discount
rate and can also limit the ability of analysts to manipulate discount rates to favour pet projects.

Cost of debt

The cost of debt can be calculated by solving for the yield to maturity of the debt using the bond
pricing model, calculating the effective annual yield and adjusting for tax.

Cost of equity capital

The cost of ordinary shares can be estimated using the CAPM (described in Session 3), the
constant-growth dividend formula and a multistage-growth dividend formula. The cost of
preference shares can be calculated using the perpetuity model for the present value of cash
flows.

Using the WACC in Practice

When a company uses a single rate to discount the cash flows for all of its projects, some project
cash flows will be discounted using a rate that is too high and other project cash flows will be
discounted using a rate that is too low. This can result in the company rejecting some positive NPV
projects and accepting some negative NPV projects. It will bias the company towards accepting
more risky projects and can cause the company to create less value for shareholders than it would
have if the appropriate discount rates had been used. One approach to using the WACC is to
identify a company that engages in business activities that are like those associated with the
project under consideration and that has publicly traded shares. The returns from this pure-play
company’s shares can then be used to estimate the ordinary share beta for the project. In

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instances where pure-play companies are not available, financial managers can classify projects
according to their systematic risks and can use a different discount rate for each classification.

Key things to take away

 The weighted average cost of capital (WACC) for a company is a weighted average of the
current costs of the different types of financing that a company has used to finance the
purchase of its assets.
 The WACC is used as a discount rate to evaluate projects (in NPV and IRR calculations)
because it is not possible to directly estimate the appropriate discount rate for many
projects.
 The cost of debt for a company can be calculated by solving for the yield to maturity of the
debt using the bond pricing model, calculating the effective annual yield and adjusting for
tax.
 The cost of ordinary shares can be estimated using the CAPM, the constant-growth
dividend formula and a multistage-growth dividend formula.
 The cost of preference shares can be calculated using the perpetuity model for the present
value of cash flows.
 The WACC is estimated using the weighted cost of each individual type of financing.
 The WACC is the appropriate discount rate for evaluating a project only when it has cash
flows with systematic risks that are the same as those for the company as a whole.

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Session #9 - How Companies Raise Capital

The focus of this Session is on how companies raise capital so that they can acquire the
productive assets needed to grow and remain profitable.

Overview

The Session begins by examining how many new businesses acquire their first equity funding, and
then subsequent funding options. This Session allows readers to get a grasp of how companies
can raise long-term capital in both public and private markets.

Bootstrapping

Bootstrapping is the process by which many entrepreneurs raise ‘seed’ money and obtain other
resources necessary to start new businesses. Seed money often comes from the entrepreneur’s
savings and credit cards and from family and friends. Bootstrapping is important for the economy too,
because business start-ups are a significant factor in determining and sustaining long-term economic
growth in an economy. Indeed, some governments have invested heavily in business incubators,
hoping to foster new business formation.

Venture Capital

Venture capitalists specialise in helping businesses move to the next stage by advising management
and providing early-stage financing. Because of the high risk of investing in start-up businesses,
venture capitalists finance projects in stages and often require the owners to make a significant
personal investment in the company. The owners’ equity stake signals their belief in the viability of
the project and ensures that management actions are focused on building a successful business.
Risk is also reduced through syndication and because of the venture capitalist’s in-depth knowledge
of the industry and technology.

Initial public offering (IPO)

The major advantages of entering public markets are that they provide companies with access to
large quantities of money at relatively low cost, enable companies to attract and motivate good
managers, and provide liquidity for existing shareholders, such as entrepreneurs, other managers
and venture capitalists. Disadvantages include the high cost of the IPO, the cost of ongoing
Australian Securities and Investments Commission (ASIC) disclosure requirements, the need to
disclose sensitive information, and possible incentives to focus on short-term profits rather than on
long-term value maximisation.

IPO pricing and cost

When underwriting new securities, investment bankers prefer that the issue be underpriced because
it increases the likelihood of a successful offering, and reduces the likelihood that the underwriter will
end up buying unsubscribed securities. Furthermore, many investment bankers will argue that some
underpricing helps attract long-term institutional investors who help provide stability for the share
price. The total cost of issuing an IPO includes three elements: (1) the underwriter’s spread (this is
the difference between the amount paid by the underwriting group in a new issue of securities and
the price at which securities are offered for sale to the public. It is the underwriter's gross profit

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margin, usually expressed in points per unit of sale, ehether bond or stock); (2) outof- pocket
expenses, which can include legal fees, ASIC lodgement fees and other expenses; and (3) the cost
of underpricing. The total cost of bringing an open public offer to market is lower than the cost of
issuing an IPO because these seasoned offerings do not include a large underpricing cost and
underwriting spreads are smaller.

Private markets and bank loans

There are a number of advantages to private placement, even for companies with access to the
public markets, and include that a private placement may be more cost effective and can be
accomplished much more quickly. In addition, some larger companies, especially those owned by
entrepreneurs or families, may not wish to be exposed to the public scrutiny that comes with public
sales of securities.

Watch out, as government induced

interest rate increases could squash
your business!

Advantages of borrowing from a commercial bank

Most small and medium-sized companies borrow from commercial banks on a regular basis. There
are advantages of this borrowing rather than selling securities in financial markets. Small and
medium-sized companies may have limited access to the financial markets. For these companies,
banks provide not only funds but a full range of services, including financial advice. Furthermore, if a
company’s financial circumstances change over time, it is much easier for the company to borrow or
renegotiate the debt contract with a bank than with other lenders. For many companies, bank
borrowing may be the lowest cost source of funds. Bank term loans are business loans with
maturities greater than 1 year. Most bank term loans have maturities from 1 to 5 years, though the
maturity may be as long as 10 years. The cost of the loans depends on three factors: the reference
rate, an adjustment for default risk and an adjustment for the term to maturity.

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Key things to take away

 Many entrepreneurs raise seed money and other resources necessary to start a new
business through bootstrapping.
 Venture capitalists specialise in helping businesses to progress by advising management
and providing early-stage financing.
 The major advantages of entering public markets are that they provide companies with
access to large quantities of money at relatively low cost, enable companies to attract and
motivate good managers, and provide liquidity for existing shareholders.
 Underwriters prefer new security offerings to be under-priced as it increases the likelihood
of a successful offering.
 Most small and medium-sized companies borrow from commercial banks on a regular
basis. There are advantages of this borrowing rather than selling securities in financial
markets.

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Session #10 - Capital Structure Policy

This Session discusses capital structure and how it affects company value.

Overview

This Session discusses capital structure and how it affects company value. It introduces the
Modigliani and Miller (M&M) theory of capital structure as well as the three major assumptions
required for the theorem to hold. These assumptions are (1) that neither the company nor the
investor is subject to tax, (2) there are no information or transactions costs, and (3) the way in
which the company is financed does not affect its real investment policy.

The Modigliani and Miller propositions

Modigliani and Miller made two propositions-

 M&M Proposition 1 states that the value of a company is unaffected by its capital structure
if the following three conditions hold: (1) there is no tax, (2) there are no information or
transaction costs and (3) capital structure decisions do not affect the real investment
policies of the company;
 M&M Proposition 2 states that the expected return on a company’s equity increases with
the amount of debt in its capital structure. This proposition also shows that the expected
return on equity can be separated into two parts: (1) a part that reflects the risk of the
underlying assets of the company, and (2) a part that reflects the risk associated with the
financial leverage used by the company. This proposition helps managers understand the
implications of financial leverage for the cost of the equity they use to finance the
company’s investments.

The use of debt

Using debt financing provides several benefits. A major benefit is the tax deductibility of interest
payments. Since interest payments are tax deductible and dividend payments are not, distributing
cash to security holders through interest payments can increase the value of a company. Debt is
also less expensive to issue than equity. Finally, debt can benefit shareholders in certain situations
by providing managers with incentives to maximise the cash flows produced by the company and
by reducing their ability to invest in negative NPV projects. The costs of debt include insolvency
and agency costs. Insolvency costs arise because financial leverage increases the probability that
a company will get into financial distress. Direct insolvency costs are the out-of-pocket costs that a
company incurs when it gets into financial distress, while indirect insolvency costs are associated
with actions the people who deal with the company take to protect their own interests when the
company is in financial distress. Agency costs are costs associated with actions taken by
managers and shareholders who are acting in their own interests rather than in the best interests
of the company. When a company uses financial leverage, managers have incentives to take
actions that benefit themselves at the expense of shareholders, and shareholders have incentives
to take actions that benefit themselves at the expense of lenders. To the extent that these actions
reduce the value of lenders’ claims, the expected losses will be reflected in the interest rates that
lenders require.

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Capital structure theories

There are two main theories, with empirical evidence supporting both theories, suggesting that
each help explain the capital structure choices made by managers. The theories are -
 The trade-off theory says that managers balance, or trade off, the benefits of debt against
the costs of debt when choosing a company’s capital structure in an effort to maximise the
value of the company;
 The pecking order theory says that managers raise capital as they need it in the least
expensive way available, starting with internally generated funds, then moving to debt, then
to the sale of equity. In contrast to the trade-off theory, the pecking order theory does not
imply that managers have a particular target capital structure.

Practical considerations in choosing a capital structure

The practical considerations that concern managers when they choose a company’s capital
structure include the impact of the capital structure on financial flexibility, risk, profit and the control
of the company. Financial flexibility involves having the necessary financial resources to take
advantage of unforeseen opportunities and to overcome unforeseen problems. Risk refers to the
possibility that normal fluctuations in operating profits will lead to financial distress. Managers are
also concerned with the impact of financial leverage on their reported profit, especially on a per-
share basis. Finally, the impact of capital structure decisions on who controls the company also
affects capital structure decisions.

Key things to take away

 M&M have two propositions. The first states that the value of a company is unaffected by its
capital structure as long as there are no taxes, no information or transaction costs and
capital structure decisions do not affect the real investment policies of the company. The
second states that the expected return on a company's equity increases with the amount of
debt in its capital structure.
 Using debt financing provides several benefits, including the deductibility of interest
payments and lower issue costs than equity. Costs of debt financing include insolvency and
agency costs.
 There are two key capital structure theories. The first is the trade-off theory which states
that managers trade-off the benefits of debt against the costs of debt when choosing a
company's capital structure. Whereas the second, the pecking order, theory says that
managers raise capital as they need it in the least expensive way available. Empirical
evidence suggests that these two theories help to explain the capital structure choices
made by managers.
 Practical considerations that managers are concerned with when choosing a company’s
capital structure include impact on financial flexibility, risk, profit and control of the
company.

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Session 11 - Options and Corporate Finance

This Session considers the description, valuation, and use of options.

Overview

This Session considers the description, valuation, and use of options. The discussion considers
financial options and how they are valued in a simple model, agency costs of debt and the ways in
which managers use financial options to alter their companies’ exposures to various types of risks.

Financial options

An option is the right, but not the obligation, to buy or sell an asset for a given price on or before a
specific date. The price is called the exercise or strike price, and the date is called the exercise
date or expiration date of the option. The right to buy the asset is known as a “call option”. The
pay-off from a call option equals $0 if the value of the underlying asset is less than the exercise
price at expiration. If the value of the underlying asset is higher than the exercise price at
expiration, then the pay-off from the call option is equal to the value of the asset value minus the
exercise price. The right to sell the asset is called a “put option”. The pay-off from a put option is $0
if the value of the underlying asset is greater than the exercise price at expiration. If the value is
lower than the exercise price, then the pay-off from a put option equals the exercise price minus
the value of the underlying asset.

Option valuation

The value of an option is affected by five factors: (1) the current price of the underlying asset, (2)
the exercise price of the option, (3) the volatility of the value of the underlying asset, (4) the time
left until the expiration of the option, and (5) the risk-free rate. Calculations are required to value
call and put options, both at expiration and at some point, before the expiration date.

Real options

Real options that are associated with investments include options to defer investment, make
follow-on investments, change operations, and abandon projects. Traditional NPV analysis is
designed to decide to accept or reject a project at a particular point in time. It is not intended to
incorporate potential value associated with deferring the investment decision. Incorporating the
value of the other options into an NPV framework is technically possible but would be very difficult
to do because the rate used to discount the cash flows would change over time with their riskiness.
In addition, the information necessary to value real options using the NPV approach is not always
available.

Agency costs

There are two principal classes of agency conflicts. The first is between shareholders and lenders.
When there is a risk of insolvency, shareholders may have incentives to increase the volatility of
the company’s assets, turn down positive NPV projects, or pay out assets in the form of dividends.
Shareholders have these incentives because their pay-off functions look like those for the owners
of a call option. The second is between managers and owners. Managers tend to prefer less risk
than shareholders and prefer to distribute fewer assets in the form of dividends because their pay-

26
off functions are more like those of lenders than those of shareholders. These preferences are
magnified by the fact that managers are risk-averse individuals whose portfolios are not well
diversified.

Agency disputes ae not uncommon.

Options and risk management

A company can adjust its exposure to risks associated with commodity prices, interest rates,
foreign exchange rates, and equity prices by buying or selling options. For example, a company
that is concerned about the prices it will receive for products that will be delivered in the future can
purchase put options to eliminate that risk partially or totally.

Key things to take away

A company can adjust its exposure to risks associated with commodity prices, interest rates,
foreign exchange rates, and equity prices by buying or selling options. Agency conflicts arise
between shareholders and lenders (creditors and bondholders) and between shareholders and
managers because the interests of shareholders, lenders and managers are not perfectly aligned.

27
POST SCRIPT: A key rule

A key rule is whatever you do in Finance, is that you MUST plan!

I did not plan … sniff sniff …

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Session #12 – Summary and Revision

In this subject we will consider the financial function of the manager and the goal of the company,
which is to maximise shareholder wealth. It is this goal that requires that we recognise its conflicts
such as agency and ethical problems.

Session #1 – Overview

Life is not easy for the financial manager, also called the Chief Financial, Officer, or CFO). The
corporate goal should be about maximising the current value of the company's shares, that is to
maximise the wealth of the shareholders. Presence of agency conflicts affect the goal of
maximising shareholder value. Ethics are important in the study of corporate finance.

Session #2 - The time value of money

The time value of money materials in this and the next Session are vital for an understanding of the
subject. Your money is worth more today than at some point in the future because, if you had the
money now, you could invest it and earn interest. The general rule is that investment opportunities
are undertaken only when the current value of future cash inflows exceeds the current cost of the
investment (the initial cash outflow).

Session #3 - Risk and return

It is understandable that investors require greater returns for taking greater risk. This Session
addressed the measurable aspect of the risk and return relationship.

Session #4 - Bond valuation and the structure of interest rates

An efficient capital market is a market where security prices reflect the knowledge and
expectations of all investors. Prices of corporate bonds tend to be more volatile than prices of
securities that trade more frequently, such as share and money markets. Because interest rates
are always changing in the market, all investors who hold bonds are subject to interest rate risk.

Session #5 - Share valuation

The general dividend valuation model values a share as the present value of all future cash
dividend payments, where the dividend payments are discounted using the rate of return required
by investors for a particular risk class.

Session #6 - The fundamentals of capital budgeting

Capital budgeting decisions are the most important investment decisions made by management.
Net present value (NPV) is the most important capital budgeting tool.
The payback period tool has two main drawbacks: amounts are not discounted, and it ignores post
payback figures. The accounting rate of return (ARR) method is not a capital expenditure decision-
making tool. The internal rate of return (IRR) for a capital project can make mistakes. We thus
focus on the NPV method, but one can also use the payback method, preferably using discounted
figures, to help determine risk. It is beneficial to have a post audit review of a capital project.

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Session #7 – Cash flows and capital budgeting

The incremental after-tax free cash flows, FCFs, for a project equal the expected change in the
total after-tax cash flows of the company if the project is adopted. The impact of a project on the
company’s total cash flows is the appropriate measure of cash flows because these are the cash
flows that reflect all the costs and benefits from the project.

Session #8 – The cost of capital

The weighted average cost of capital (WACC) for a company is a weighted average of the current
costs of the different types of financing that a company has used to finance the purchase of its
assets. The WACC is used as a discount rate to evaluate projects (in NPV and IRR calculations)
because it is not possible to directly estimate the appropriate discount rate for many projects.

Session #9 – How companies raise capital

Companies need to raise capital so that they can acquire the productive assets needed to grow
and remain profitable. There are several alternatives including bootstrapping, venture capitalists,
public markets and underwriters. Most small and medium-sized companies borrow from
commercial banks on a regular basis as there are advantages of this borrowing rather than selling
securities in financial markets.

Session #10 - Capital structure policy

Using debt financing provides several benefits. A major benefit is the tax deductibility of interest
payments, and debt is less expensive to issue than equity. The costs of debt include insolvency
and agency costs.

Session #11 - Options and Corporate Finance

A company can adjust its exposure to risks associated with commodity prices, interest rates,
foreign exchange rates, and equity prices by buying or selling options. Agency conflicts arise
between shareholders and lenders (creditors and bondholders) and between shareholders and
managers because the interests of shareholders, lenders and managers are not perfectly aligned.

Key thing to remember

This subject provided a systematic study of corporate finance. A key rule is whatever you do in
Finance, you MUST plan!

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Associate Professor Cyril Jankoff is currently Program Director of the EDM MBA and Associate
Director, Undergraduate Studies at the UBSS Melbourne CBD Campus

Emeritus Professor Greg Whateley is currently Deputy Vice Chancellor, UBSS and Vice
President (Academic) at GCA.

31