This is to test computational and anylitical ability with respect to the various methods of capital. Please see the details in description given below

Collect the annual income statement of any company you know well for last four fiscal years. The selected company must be in process of expanding its business and plan to invest in new investment project. As a newly hired MBA in the capital budgeting division, you have bem asked to evaluate a new project using the Weighted Average Cost of Capital (WACC), Adjusted Present Value (APV), and Flow to Equity (FTE) methods. You will need to compute the appropriate cost of capital and the net present values with each method. Because this is the first assignment with the company, they want you to demonstrate your ability to apply the different methods of project evaluation. You must seek required information necessary to determine the free cash flows. Create spreadsheet in Excel to do all your calculations.

 

Note: Any information is not availabe you can assum and provide the relevant informations for asignmnet.

 

Questions

A)    
Determine the WACC for the company. Compute the NPV of the new project based on the free cash flows you calculated using WACC( 40 Marks)

B)     

Determin the NPV using the APV and FTE method. In both cases , assume the company maintained the target leverage ratio you computed in WACC ( 40 Marks)

 

C)      Compare the results under the three methods and explain how the resulting NPV’s are achieved under each three different methods ( 20 Marks) 

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CAPM: THEORY,
ADVANTAGES, AND
DISADVANTAGES
THE CAPITAL ASSET PRICING MODEL
RELEVANT TO ACCA QUALIFICATION PAPER F9

CAPM FORMULA
The linear relationship between the return
required on an investment (whether in stock
market securities or in business operations)
and its systematic risk is represented by the
CAPM formula, which is given in the Paper F9
Formulae Sheet:

E(ri) = Rf + βi(E(rm) – Rf)

E(ri) = return required on financial asset i
Rf = risk-free rate of return
βi = beta value for financial asset i
E(rm) = average return on the capital market

The CAPM is an important area of financial
management. In fact, it has even been suggested
that finance only became ‘a fully-fledged, scientific
discipline’ when William Sharpe published his
derivation of the CAPM in 19861.

CAPM ASSUMPTIONS
The CAPM is often criticised as being unrealistic
because of the assumptions on which it is based,
so it is important to be aware of these assumptions
and the reasons why they are criticised. The
assumptions are as follows2:

Investors hold diversified portfolios
This assumption means that investors will only
require a return for the systematic risk of their
portfolios, since unsystematic risk has been
removed and can be ignored.

Single-period transaction horizon
A standardised holding period is assumed by the
CAPM in order to make comparable the returns on
different securities. A return over six months, for
example, cannot be compared to a return over 12
months. A holding period of one year is usually used.

Investors can borrow and lend at the risk-free rate
of return
This is an assumption made by portfolio theory,
from which the CAPM was developed, and provides
a minimum level of return required by investors.
The risk-free rate of return corresponds to the
intersection of the security market line (SML) and
the y-axis (see Figure 1). The SML is a graphical
representation of the CAPM formula.

Perfect capital market
This assumption means that all securities are
valued correctly and that their returns will plot on
to the SML. A perfect capital market requires the

following: that there are no taxes or transaction
costs; that perfect information is freely available
to all investors who, as a result, have the same
expectations; that all investors are risk averse,
rational and desire to maximise their own utility;
and that there are a large number of buyers and
sellers in the market.

FIGURE 1: THE SECURITY MARKET LINE

While the assumptions made by the CAPM allow
it to focus on the relationship between return
and systematic risk, the idealised world created
by the assumptions is not the same as the real
world in which investment decisions are made by
companies and individuals.

Section F of the Study Guide for Paper F9 contains several references to the capital asset pricing
model (CAPM). This article is the last in a series of three, and looks at the theory, advantages,
and disadvantages of the CAPM. The first article, published in the January 2008 issue of student
accountant introduced the CAPM and its components, showed how the model can be used to
estimate the cost of equity, and introduced the asset beta formula. The second article, published in
the April 2008 issue, looked at applying the CAPM to calculate a project-specific discount rate to use
in investment appraisal.

Return
E(ri)

Rm

Rf

SML

1 β

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This investment decision is also incorrect,
however, since project B would be rejected if
using a CAPM-derived project-specific discount
rate, because the project IRR offers insufficient
compensation for its level of systematic risk4.

FIGURE 2: WACC OR CAPM?

ADVANTAGES OF THE CAPM
The CAPM has several advantages over other
methods of calculating required return, explaining
why it has remained popular for more than 40 years:

It considers only systematic risk, reflecting a
reality in which most investors have diversified
portfolios from which unsystematic risk has
been essentially eliminated.

For example, real-world capital markets are
clearly not perfect. Even though it can be argued
that well-developed stock markets do, in practice,
exhibit a high degree of efficiency, there is scope
for stock market securities to be priced incorrectly
and, as a result, for their returns not to plot on to
the SML.

The assumption of a single-period transaction
horizon appears reasonable from a real-world
perspective, because even though many investors
hold securities for much longer than one year,
returns on securities are usually quoted on an
annual basis.

The assumption that investors hold diversified
portfolios means that all investors want to hold a
portfolio that reflects the stock market as a whole.
Although it is not possible to own the market
portfolio itself, it is quite easy and inexpensive
for investors to diversify away specific or
unsystematic risk and to construct portfolios that
‘track’ the stock market. Assuming that investors
are concerned only with receiving financial
compensation for systematic risk seems therefore
to be quite reasonable.

A more serious problem is that, in reality,
it is not possible for investors to borrow at the
risk-free rate (for which the yield on short-dated
Government debt is taken as a proxy). The reason
for this is that the risk associated with individual
investors is much higher than that associated with
the Government. This inability to borrow at the
risk-free rate means that the slope of the SML is
shallower in practice than in theory.

Overall, it seems reasonable to conclude that
while the assumptions of the CAPM represent
an idealised rather than real-world view, there
is a strong possibility, in reality, of a linear
relationship existing between required return and
systematic risk.

WACC AND CAPM
The weighted average cost of capital (WACC)
can be used as the discount rate in investment
appraisal provided that a number of restrictive
assumptions are met. These assumptions
are that:

the investment project is small compared to
the investing organisation

the business activities of the investment
project are similar to the business activities
currently undertaken by the investing
organisation

the financing mix used to undertake the
investment project is similar to the current
financing mix (or capital structure) of the
investing company

existing finance providers of the investing
company do not change their required rates
of return as a result of the investment project
being undertaken.

These assumptions essentially state that WACC
can be used as the discount rate provided that

the investment project does not change either
the business risk or the financial risk of the
investing organisation.

If the business risk of the investment project is
different to that of the investing organisation, the
CAPM can be used to calculate a project-specific
discount rate. The procedure for this calculation
was covered in the second article in this series3.

The benefit of using a CAPM-derived
project-specific discount rate is illustrated in
Figure 2. Using the CAPM will lead to better
investment decisions than using the WACC in the
two shaded areas, which can be represented by
projects A and B.

Project A would be rejected if WACC was used
as the discount rate, because the internal rate
of return (IRR) of the project is less than that of
the WACC. This investment decision is incorrect,
however, since project A would be accepted if
a CAPM-derived project-specific discount rate
were used because the project IRR lies above the
SML. The project offers a return greater than that
needed to compensate for its level of systematic
risk, and accepting it will increase the wealth
of shareholders.

Project B would be accepted if WACC was
used as the discount rate because its IRR is
greater than the WACC.

C

Rf
0
SML

WACC

β
Company β

A
x

B
x

R
eq

ui
re

d
ra

te
o

f
re

tu
rn

%

D

linked performance objectives
performaNce obJectives 15 aNd 16 are reLevaNt to paper f9

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It generates a theoretically-derived relationship
between required return and systematic risk
which has been subject to frequent empirical
research and testing.

It is generally seen as a much better method of
calculating the cost of equity than the dividend
growth model (DGM) in that it explicitly takes
into account a company’s level of systematic
risk relative to the stock market as a whole.

It is clearly superior to the WACC in providing
discount rates for use in investment appraisal.

DISADVANTAGES OF THE CAPM
The CAPM suffers from a number of disadvantages
and limitations that should be noted in a balanced
discussion of this important theoretical model.

Assigning values to CAPM variables
In order to use the CAPM, values need to be
assigned to the risk-free rate of return, the return
on the market, or the equity risk premium (ERP),
and the equity beta.

The yield on short-term Government debt,
which is used as a substitute for the risk-free rate
of return, is not fixed but changes on a daily basis
according to economic circumstances. A short-term
average value can be used in order to smooth out
this volatility.

Finding a value for the ERP is more difficult.
The return on a stock market is the sum of the
average capital gain and the average dividend yield.
In the short term, a stock market can provide a
negative rather than a positive return if the effect of

falling share prices outweighs the dividend yield. It
is therefore usual to use a long-term average value
for the ERP, taken from empirical research, but it
has been found that the ERP is not stable over time.
In the UK, an ERP value of between 2% and 5% is
currently seen as reasonable. However, uncertainty
about the exact ERP value introduces uncertainty
into the calculated value for the required return.

Beta values are now calculated and published
regularly for all stock exchange-listed companies.
The problem here is that uncertainty arises in the
value of the expected return because the value of
beta is not constant, but changes over time.

Using the CAPM in investment appraisal
Problems can arise when using the CAPM to
calculate a project-specific discount rate. For
example, one common difficulty is finding suitable
proxy betas, since proxy companies very rarely
undertake only one business activity. The proxy
beta for a proposed investment project must be
disentangled from the company’s equity beta. One
way to do this is to treat the equity beta as an
average of the betas of several different areas of
proxy company activity, weighted by the relative
share of the proxy company market value arising
from each activity. However, information about
relative shares of proxy company market value may
be quite difficult to obtain.

A similar difficulty is that the ungearing
of proxy company betas uses capital structure
information that may not be readily available.
Some companies have complex capital structures

with many different sources of finance. Other
companies may have debt that is not traded, or
use complex sources of finance such as convertible
bonds. The simplifying assumption that the
beta of debt is zero will also lead to inaccuracy
in the calculated value of the project-specific
discount rate.

One disadvantage in using the CAPM in
investment appraisal is that the assumption of
a single-period time horizon is at odds with the
multi-period nature of investment appraisal. While
CAPM variables can be assumed constant in
successive future periods, experience indicates that
this is not true in reality.

CONCLUSION
Research has shown the CAPM to stand up well
to criticism, although attacks against it have been
increasing in recent years. Until something better
presents itself, however, the CAPM remains a very
useful item in the financial management toolkit.

REFERENCES
1 Megginson W L, Corporate Finance Theory,

Addison-Wesley, p10, 1996.
2 Watson D and Head A, 2007, Corporate

Finance: Principles and Practice, 4th edition,
FT Prentice Hall, pp222–3.

3 Project-specific discount rates, student
accountant, April 2008.

4 Watson and Head, pp252–3.

Tony Head is examiner for Paper F9

Corporate Finance

Objectives of the Course
On successful completion of this course, you should be able to:
Identify the purpose and relevance of Corporate Finance;
Explain the use of a variety of advance capital budgeting techniques;
Discuss the importance of risk and return in Corporate Finance;
Discuss the process determining the capital structure and dividend policy;
Apply financial derivatives in risk management; and
Discuss factors that affect shareholders’ wealth.

Topic 1: Value and Capital Budgeting
Net Present Value
How to Value Bonds and Stocks
Some Alternative Investment Rules
Net Present Value and Capital Budgeting
Risk Analysis, Options and Capital Budgeting

Topic 2: Risk and Return
Capital Market Theory: An Overview
Return & Risk: The Capital Asset Pricing Model (CAPM)
An Alternate View of Risk and Return: The Arbitrage Pricing Theory
Risk, Cost of Capital, and Capital Budgeting

Topic 3: Capital Structure and Dividend Policy
Corporate Financing Decisions and Efficient Capital Markets
Long-Term Financing: An Introduction
Capital Structure: Basic Concepts
Capital Structure: Limits to the Use of Debt
Valuation and Capital Budgeting for the Levered Firm
Dividend Policy: Why Does It Matter?

Topic 4&5: Long-Term Financing & Derivatives
Issuing Securities to the Public
Long-Term Debt
Leasing
Topic 5: Options, Futures, and Corporate Finance
Options and Corporate Finance: Basic Concepts -Warrants and Convertibles , Derivatives and Hedging Risk

Research!
Research is the art of seeing what everyone else has seen, and doing what no-one else has done.

The Time Value of Money
Which would you rather have — $1,000 today or $1,000 in 5 years?
Obviously, $1,000 today.
Money received sooner rather than later allows one to use the funds for investment or consumption purposes. This concept is referred to as the TIME VALUE OF MONEY!!

Why TIME?
NOT having the opportunity to earn interest on money is called OPPORTUNITY COST
Remember, one CANNOT compare numbers in different time periods without first adjusting them using an interest rate.

Compound Interest
When interest is paid on not only the principal amount invested, but also on any previous interest earned, this is called compound interest.
FV = Principal + (Principal x Interest)
= 2000 + (2000 x .06)

Future Value
If you invested $2,000 today in an account that pays 6% interest, with interest compounded annually, how much will be in the account at the end of two years if there are no withdrawals?
FV1 = PV (1+i)n = $2,000 (1.06)2 = $2,247.20
FV = future value, a value at some future point in time
PV = present value, a value today which is usually designated as time 0
i = rate of interest per compounding period
n = number of compounding periods

Future Value Example
John wants to know how large his $5,000 deposit will become at an annual compound interest rate of 8% at the end of 5 years.
FVn = PV (1+i)n FV5 = $5,000 (1+ 0.08)5 = $7,346.64

Present Value
Since FV = PV(1 + i)n.
PV = FV / (1+i)n.
Discounting is the process of translating a future value or a set of future cash flows into a present value.

Present Value Example
Joann needs to know how large of a deposit to make today so that the money will grow to $2,500 in 5 years. Assume today’s deposit will grow at a compound rate of 4% annually.
Calculation based on general formula: PV0 = FVn / (1+i)n
PV0 = $2,500/(1.04)5 = $2,054.81

Finding “n” or “i” when one knows PV and FV
If one invests $2,000 today and has accumulated $2,676.45 after exactly five years, what rate of annual compound interest was earned?

Annuities
An Annuity represents a series of equal payments (or receipts) occurring over a specified number of equidistant periods.
Examples of Annuities Include:
Student Loan Payments
Car Loan Payments
Insurance Premiums
Mortgage Payments
Retirement Savings

Dividend Policy
Learning Objectives
Important Terms
Mechanics of Dividend Payments
Cash Dividend Payments
M&M’s Dividend Irrelevance Theorem
The “Bird in the Hand” Argument
Dividend Policy in Practice
Relaxing the M&M Assumptions
Stock Dividends and Stock Splits
Share Repurchases
Summary and Conclusions

Dividend Policy
What is It?
Dividend Policy refers to the explicit or implicit decision of the Board of Directors regarding the amount of residual earnings (past or present) that should be distributed to the shareholders of the corporation.
This decision is considered a financing decision because the profits of the corporation are an important source of financing available to the firm.

Types of Dividends
Dividends are a permanent distribution of residual earnings/property of the corporation to its owners.
Dividends can be in the form of:
Cash
Additional Shares of Stock (stock dividend)
Property
If a firm is dissolved, at the end of the process, a final dividend of any residual amount is made to the shareholders – this is known as a liquidating dividend.

Dividends a Financing Decision
In the absence of dividends, corporate earnings accrue to the benefit of shareholders as retained earnings and are automatically reinvested in the firm.
When a cash dividend is declared, those funds leave the firm permanently and irreversibly.
Distribution of earnings as dividends may starve the company of funds required for growth and expansion, and this may cause the firm to seek additional external capital.

Corporate Profits After Tax
Retained Earnings
Dividends

Dividends versus Interest Obligations
Interest
Interest is a payment to lenders for the use of their funds for a given period of time
Timely payment of the required amount of interest is a legal obligation
Failure to pay interest (and fulfill other contractual commitments under the bond indenture or loan contract) is an act of bankruptcy and the lender has recourse through the courts to seek remedies
Secured lenders (bondholders) have the first claim on the firm’s assets in the case of dissolution or in the case of bankruptcy
Dividends
A dividend is a discretionary payment made to shareholders
The decision to distribute dividends is solely the responsibility of the board of directors
Shareholders are residual claimants of the firm (they have the last, and residual claim on assets on dissolution and on profits after all other claims have been fully satisfied)

Dividend Payments
Cash Dividend – Payment of cash by the firm to its shareholders.
Ex-Dividend Date – Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend.
Record Date – Person who owns stock on this date received the dividend.

Mechanics of Cash Dividend Payments
Declaration Date
this is the date on which the Board of Directors meet and declare the dividend. In their resolution the Board will set the date of record, the date of payment and the amount of the dividend for each share class.
when CARRIED, this resolution makes the dividend a current liability for the firm.
Date of Record
is the date on which the shareholders register is closed after the trading day and all those who are listed will receive the dividend.
Ex dividend Date
is the date that the value of the firm’s common shares will reflect the dividend payment (ie. fall in value)
‘ex’ means without.
At the start of trading on the ex-dividend date, the share price will normally open for trading at the previous days close, less the value of the dividend per share. This reflects the fact that purchasers of the stock on the ex-dividend date and beyond WILL NOT receive the declared dividend.
Date of Payment
is the date the cheques for the dividend are mailed out to the shareholders.

Dividend Policy
Dividends, Shareholders and the Board of Directors
There is no legal obligation for firms to pay dividends to common shareholders
Shareholders cannot force a Board of Directors to declare a dividend, and courts will not interfere with the BOD’s right to make the dividend decision because:
Board members are jointly and severally liable for any damages they may cause
Board members are constrained by legal rules affecting dividends including:
Not paying dividends out of capital
Not paying dividends when that decision could cause the firm to become insolvent
Not paying dividends in contravention of contractual commitments (such as debt covenant agreements)

Dividend Reinvestment Plans (DRIPs)
Involve shareholders deciding to use the cash dividend proceeds to buy more shares of the firm
DRIPs will buy as many shares as the cash dividend allows with the residual deposited as cash
Leads to shareholders owning odd lots (less than 100 shares)

Firms are able to raise additional common stock capital continuously at no cost and fosters an on-going relationship with shareholders.

Dividend Payments
Stock Dividends
Stock dividends simply amount to distribution of additional shares to existing shareholders
They represent nothing more than recapitalization of earnings of the company. (that is, the amount of the stock dividend is transferred from the R/E account to the common share account.
Because of the capital impairment rule stock dividends reduce the firm’s ability to pay dividends in the future.

Dividend Payments
Stock Dividends
Implications
reduction in the R/E account
reduced capacity to pay future dividends
proportionate share ownership remains unchanged
shareholder’s wealth (theoretically) is unaffected
Effect on the Company
conserves cash
serves to lower the market value of firm’s stock modestly
promotes wider distribution of shares to the extent that current owners divest themselves of shares…because they have more
adjusts the capital accounts
dilutes EPS
Effect on Shareholders
proportion of ownership remains unchanged
total value of holdings remains unchanged
if former DPS is maintained, this really represents an increased dividend payout

Dividend Payments
Stock Dividends
ABC Company
Equity Accounts
as at February xx, 20×9
Common stock (215,000) $5,000,000
Retained earnings 20,000,000
Net Worth $25,000,000
The company, on March 1, 20×9 declares a 10 percent stock dividend when the current market price for the stock is $40.00 per share.
This stock dividend will increase the number of shares outstanding by 10 percent. This will mean issuing 21,500 shares. The value of the shares is:
$40.00 (21,500) = $860,000
This stock dividend will result in $860,000 being transferred from the retained earnings account to the common stock account:

Dividend Payments
Stock Dividends
After the stock dividend:
ABC Company
Equity Accounts
as at March 1, 20×9
Common stock (236,500) $5,860,000
Retained earnings 19,140,000
Net worth $25,000,000

The market price of the stock will be affected by the stock dividend:
New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36
The individual shareholder’s wealth will remain unchanged.

Cash Dividend Payments
The Macro Perspective
Aggregate after-tax profits run at approximately 6% of GDP but are highly variable
Aggregate dividends are relatively stable when compared to after-tax profits.
They are sustained in the face of drops in profit during recessions
They are held reasonably constant in the face of peaks in aggregate profits.

Aggregate Dividends and Profits

Cash Dividend Payments
The Macro Perspective – Question
Why are dividends smoothed and not matched to profits?
The companies chosen here illustrate the dramatic differences between companies:
Some pay no dividends
Some pay consistent cash dividends representing substantial yields on current shares prices
The highest yields are found in the case of Income Trusts and large stable ‘blue-chip’ financials and utilities

Cash Dividend Payments
Dividend Yields

Modigliani and Miller’s Dividend Irrelevance Theorem
The value of M&M’s Dividend Irrelevance argument is that in the end, it shows where value can be created with dividend policy and why.

M&M’s Dividend Irrelevance Theorem
Assumptions
No Taxes
Perfect capital markets
large number of individual buyers and sellers
costless information
no transaction costs
All firms maximize value
There is no debt

M&M’s Dividend Irrelevance Theorem
Residual Theory of Dividends
The Residual Theory of Dividends suggests that logically, each year, management should:
Identify free cash flow generated in the previous period
Identify investment projects that have positive NPVs
Invest in all positive NPV projects
If free cash flow is insufficient, then raise external capital – in this case no dividend is paid
If free cash flow exceeds investment requirements, the residual amount is distributed in the form of cash dividends.

M&M’s Dividend Irrelevance Theorem
Residual Theory of Dividends – Implication
The implication of the Residual Theory of Dividends are:
Investment decisions are independent of the firm’s dividend policy
No firm would pass on a positive NPV project because of the lack of funds, because, by definition the incremental cost of those funds is less than the IRR of the project, so the value of the firm is maximized only if the project is undertaken.
If the firm can’t make good use of free cash flow (ie. It has no projects with IRRs > cost of capital) then those funds should be distributed back to shareholders in the form of dividends for them to invest on their own.
The firm should operate where Marginal Cost equals Marginal Revenue as seen in Figure on the following slide:

CHAPTER 22 – Dividend Policy
22 – 38
M&M’s Dividend Irrelevance Theorem
Internal Funds, Investment, and Dividends
FIGURE

$11,976 Million
Rate of Return

WACC
Internal Funds Available
OPTIMAL INVESTMENT
$177,607 Million

MC=MR

38

The “Bird-in-the-Hand” Argument
M&M’s Assumptions Relaxed
Risk is a real world factor.
Firm’s that reinvest free cash flow, put that money at risk – there is no certainty of investment outcome – those forfeit dividends that are reinvested…could be lost!
Remember the two-stage DDM?

The “Bird-in-the-Hand” Argument
M&M’s Assumptions Relaxed
Myron Gordon suggests that dividends are more stable than capital gains and are therefore more highly valued by investors.
This implies that investors perceive non-dividend paying firms to be riskier and apply a higher discount rate to value them causing the share price to fall.
The difference between the M&M and Gordon arguments are illustrated in Figure 2 on the following slide:
M&M argue that dividends and capital gains are perfect substitutes

CHAPTER 22 – Dividend Policy
22 – 41
The “Bird-in-the-Hand” Argument
M&M versus Gordon’s Bird in the Hand Theory

FIGURE 2

Gordon
OPTIMAL INVESTMENT
M&M

41

The “Bird-in-the-Hand” Argument
M&M versus Gordon’s Bird in the Hand Theory
Conclusions:
Firms cannot change underlying operational characteristics by changing the dividend
The dividend should reflect the firm’s operations through the residual value of dividends

Dividend Policy in Practice
Firms smooth their dividends
Firms tend to hold dividends constant, even in the face of increasing after-tax profit
Firms are very reluctant to cut dividends

Relaxing the M&M Assumptions
Welcome to the Real World!
Dividends and Signalling
Under conditions of information asymmetry, shareholders and the investing public watch for management signals (actions) about what management knows.
Management is therefore very cautious about dividend changes…they don’t want to create high expectations (this is the reason for extra or special dividends) that will lead to disappointment, and they don’t want to have investors over react to negative earnings surprises (the sticky dividend phenomenon)
(The Signalling Model is explained in Figure 3 found on the next slide.)

Relaxing the M&M Assumptions
The Signalling Model
FIGURE 3
et
$
1 2 3 Time

et*
dt*
dt

45

Relaxing the M&M Assumptions
Welcome to the Real World!
Agency Theory
Investors are wary of senior management so they seek to put controls in place.
There is a fear that managers may waste corporate resources by over-investing in low or poor NPV projects.
Gordon Donaldson argued this is the reason for the pecking order managements tend to use when raising capital
Shareholders would prefer to receive a dividend and then have management file a prospectus, justifying investment in projects and the need to raise the capital that was just distributed as a dividend.
Shareholders are prepared to pay those additional underwriting costs as an agency cost incurred to monitor and assess management.

46

Relaxing the M&M Assumptions
Welcome to the Real World!
Taxes and the Clientele Effect
Table (on the following slide) illustrates that different classes of investors face different tax brackets
Preference for dividends versus capital gains income depends on the province of residence and taxable income level leading to tax clienteles.
High income earners tend to prefer capital gains (there is an additional tax incentive for such individuals in that they can choose the timing of the sale of their investment…remember only ‘realized’ capital gains are subject to tax
Low income earners tend to prefer dividends
Conclusion – firm’s should not change dividend policy drastically since it upsets the existing ownership base.

48

Relaxing the M&M Assumptions
Taxes

49

Share Repurchases
Simply another form of payout policy.
An alternative to cash dividend where the objective is to increase the price per share rather than paying a dividend.
Since there are rules against improper accumulation of funds, firms adopt a policy of large infrequent share repurchase programs.

Share Repurchases
reasons for use:
Offsetting the exercise of executive stock options
Leveraged recapitalizations
Information or signalling effects
Repurchase dissident shares
Removing cash without generating expectations for future distributions
Take the firm private.

Disadvantages of Share Repurchases
they are usually done on an irregular basis, so a shareholder cannot depend on income from this source.
if regular repurchases are made, there is a good chance that Revenue Canada will rule that the repurchases were simply a tax avoidance scheme (to avoid tax on dividends) and will assess tax
there may be some agency problems – if managers have inside information, they are purchasing from shareholders at a price less than the intrinsic value of the shares.

Methods of Share Repurchases
tender offer:
this is a formal offer to purchase a given number of shares at a given price over current market price.
open market purchase:
the purchase of shares through an investment dealer like any other investor
this is not designed for large block purchases.
private negotiation with major shareholders
In any repurchase program, the securities commission requires disclosure of the event as well as all other material information through a prospectus.

Repurchase Example
Current EPS
= [total earnings] / [# of shares] = $4.4 m / 1.1 m = $4.00
Current P/E ratio
= $20 / $4 = 5X
EPS after repurchase of 100,000 shares
= $4.4 m / 1.0 = $4.40
Expected market price after repurchase:
= [p/e][EPSnew] = [5][$4.40] = $22.00 per share

Effects of A Share Repurchase
EPS should increase following the repurchase if earnings after-tax remains the same
a higher market price per outstanding share of common stock should result
stockholders not selling their shares back to the firm will enjoy a capital gain if the repurchase increases the stock price.

Advantages of Share Repurchases
signal positive information about the firm’s future cash flows
used to effect a large-scale change in the firm’s capital structure
increase investor’s return without creating an expectation of higher future cash dividends
reduce future cash dividend requirements or increase cash dividends per share on the remaining shares, without creating a continuing incremental cash drain
capital gains treated more favourably than cash dividends for tax purposes.

Disadvantages of Share Repurchases
signal negative information about the firm’s future growth and investment opportunities
the provincial securities commission may raise questions about the intention
share repurchase may not qualify the investor for a capital gain

Borrowing to Pay Dividends
Is this legal? is it possible to do?
Yes
the firm must have the ability and capacity to borrow
the firm must have sufficient retained earnings to allow it to pay the dividend
the firm must have sufficient cash on hand to pay the cash dividend
the firm must NOT have agreed to any limitations on the payment of dividends under the bond indenture.
Why?
A possible answer is to signal to the market that the board is confident about the firm’s ability to sustain cash dividends into the future.

CHAPTER 22 – Dividend Policy
22 – 59
Assets: Liabilities:
Cash 10 Long-term Debt 0
Fixed Assets 140 Common Stock 50
Retained Earnings 100
Total Assets $150 Total Claims $150

After Borrowing…before cash dividend:
Assets: Liabilities:
Cash 60 Long-term Debt 50
Fixed Assets 140 Common Stock 50
Retained Earnings 100
Total Assets $200 Total Claims $200
Before Borrowing:
0% Debt
25% Debt
Borrowing to Pay Dividends
An Example

59

CHAPTER 22 – Dividend Policy
22 – 60
Assets: Liabilities:
Cash 60 Current liabilities 50
Fixed Assets 140 Long-term Debt 50
Common Shares 50
Retained earnings 50
Total Assets $200 Total Claims $200

After Cash Dividend payment of $50
Assets: Liabilities:
Cash 10 Long-term Debt 50
Fixed Assets 140 Common Stock 50 Retained earnings 50
Total Assets $150 Total Claims $150
After Dividend Declaration…before date of payment.
50% Debt
33% Debt
Borrowing to Pay Dividends
An Example …

60

The foregoing example illustrates:
it is possible for a firm with ‘borrowing capacity’ to borrow funds to pay cash dividends.
this is not possible if the lenders insist on restrictive covenants that limit or prevent this from occurring.
the cash for the dividend must be present in the cash account.
payment of dividends reduces both the cash account on the asset side of the balance sheet as well as the retained earnings account on the ‘claims’ side of the balance sheet.
in the absence of restrictions, it is possible to transfer wealth from the bondholders to the stockholders. (Bondholders in this example may have thought their firm would have only a 25% debt ratio….after the dividend the debt ratio rose to 33% and the equity cusion dropped from 75% to 66%.)
Borrowing to Pay Dividends
An Example

61

Summary and Conclusions
In this chapter you have learned:
About the different types of dividends including, regular and special cash dividends, stock dividends, and share repurchases.
M&M’s dividend irrelevance argument and the real world factors such as transactions costs, taxes, clientele effects and signalling tend to favour real-world dividend relevance
Tax motives and other reasons explain why firms might want to repurchase their shares.

Concept Review Questions
Define four important dates that arise with respect to dividend payments.
Past year Qs

Leasing
Types of Leases
The Basics
A lease is a contractual agreement between a lessee and lessor.
The agreement establishes that the lessee has the right to use an asset and in return must make periodic payments to the lessor.
The lessor is either the asset’s manufacturer or an independent leasing company.

Operating Leases
Usually not fully amortized. This means that the payments required under the terms of the lease are not enough to recover the full cost of the asset for the lessor.
Usually require the lessor to maintain and insure the asset.
Lessee enjoys a cancellation option. This option gives the lessee the right to cancel the lease contract before the expiration date.

Financial Leases
The exact opposite of an operating lease.
Do not provide for maintenance or service by the lessor.
Financial leases are fully amortized.
The lessee usually has a right to renew the lease at expiry.
Generally, financial leases cannot be cancelled, i.e., the lessee must make all payments or face the risk of bankruptcy.

Sale and Lease-Back
A particular type of financial lease.
Occurs when a company sells an asset it already owns to another firm and immediately leases it from them.
Two sets of cash flows occur:
The lessee receives cash today from the sale.
The lessee agrees to make periodic lease payments, thereby retaining the use of the asset.

Leveraged Leases
A leveraged lease is another type of financial lease.
A three-sided arrangement between the lessee, the lessor, and lenders.
The lessor owns the asset and for a fee allows the lessee to use the asset.
The lessor borrows to partially finance the asset.
The lenders typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default by the lessee.

Accounting and Leasing
In the old days, leases led to off-balance-sheet financing.
In 1979, the Canadian Institute of Chartered Accountants implemented new rules for lease accounting according to which financial leases must be “capitalized.”
Capital leases appear on the balance sheet—the present value of the lease payments appears on both sides.

Accounting and Leasing
Balance Sheet
Truck is purchased with debt
Truck $100,000 Debt $100,000
Land $100,000 Equity $100,000
Total Assets $200,000 Total Debt & Equity $200,000
Operating Lease
Truck Debt
Land $100,000 Equity $100,000
Total Assets $100,000 Total Debt & Equity $100,000
Capital Lease
Assets leased $100,000 Obligations under capital lease $100,000
Land $100,000 Equity $100,000
Total Assets $200,000 Total Debt & Equity $200,000

Capital Lease
A lease must be capitalized if any one of the following is met:
The present value of the lease payments is at least 90-percent of the fair market value of the asset at the start of the lease.
The lease transfers ownership of the property to the lessee by the end of the term of the lease.
The lease term is 75-percent or more of the estimated economic life of the asset.
The lessee can buy the asset at a bargain price at expiry.

Taxes and Leases
The principal benefit of long-term leasing is tax reduction.
Leasing allows the transfer of tax benefits from those who need equipment but cannot take full advantage of the tax benefits of ownership to a party who can.
If the CCRA (Canada Customs and Revenue Agency) detects one or more of the following, the lease will be disallowed.
The lessee automatically acquires title to the property after payment of a specified amount in the form of rentals.
The lessee is required to buy the property from the lessor.
The lessee has the right during the lease to acquire the property at a price less than fair market value.

The Cash Flows of Leasing
Consider a firm, ClumZee Movers, that wishes to acquire a delivery truck.
The truck is expected to reduce costs by $4,500 per year.
The truck costs $25,000 and has a useful life of five years.
If the firm buys the truck, they will depreciate it straight-line to zero.
They can lease it for five years from Tiger Leasing with an annual lease payment of $6,250.

The Cash Flows of Leasing
Cash Flows: Buy
Year 0 Years 1-5
Cost of truck –$25,000
After-tax savings 4,500×(1-.34) = $2,970
Depreciation Tax Shield 5,000×(.34) = $1,700
–$25,000 $4,670
Cash Flows: Lease
Year 0 Years 1-5
Lease Payments –6,250×(1-.34) = –$4,125
After-tax savings 4,500×(1-.34) = $2,970
–$1,155

Cash Flows: Leasing Instead of Buying
Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = –$5,825

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The Cash Flows of Leasing
Cash Flows: Leasing Instead of Buying
Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = –$5,825
Cash Flows: Buying Instead of Leasing
Year 0 Years 1-5
–$25,000 $4,670 –$1,155 = $5,825
However we wish to conceptualize this, we need to have an interest rate at which to discount the future cash flows.
That rate is the after-tax rate on the firm’s secured debt.

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NPV Analysis of the Lease-vs.-Buy Decision
A lease payment is like the debt service on a secured bond issued by the lessee.
In the real world, many companies discount both the depreciation tax shields and the lease payments at the after-tax interest rate on secured debt issued by the lessee.
The various tax shields could be riskier than lease payments for two reasons:
The value of the CCA tax benefits depends on the firm’s ability to generate enough taxable income.
The corporate tax rate may change.

NPV Analysis of the Lease-vs.-Buy Decision

NPV Buying Instead of Leasing
Year 0 Years 1-5
-$25,000 $4,670 – $1,155 = $5,825
There is a simple method for evaluating leases: discount all cash flows at the after-tax interest rate on secured debt issued by the lessee. Suppose that rate is 5-percent.
NPV Leasing Instead of Buying
Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = -$5,825

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77

Reasons for Leasing
Good Reasons
Taxes may be reduced by leasing.
The lease contract may reduce certain types of uncertainty.
Transactions costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset.
Bad Reasons
Leasing and accounting income
100% financing

Summary and Conclusions
There are three ways to value a lease.
Use the real-world convention of discounting the incremental after-tax cash flows at the lessor’s after-tax rate on secured debt.
Calculate the increase in debt capacity by discounting the difference between the cash flows of the purchase and the cash flows of the lease by the after-tax interest rate. The increase in debt capacity from a purchase is compared to the extra outflow at year 0 from a purchase.
Use APV (presented in the appendix to this chapter).
They all yield the same answer.
The easiest way is the least intuitive.

why investors should establish portfolios
This is neatly captured in the old saying ‘don’t put all your eggs in one basket’.

The logic
The logic is that an investor who puts all of their funds into one investment risks everything on the performance of that individual investment. A wiser policy would be to spread the funds over several investments (establish a portfolio) so that the unexpected losses from one investment maybe offset to some extent by the unexpected gains from another.

EXPECTED RETURN
Investors receive their returns from shares in the form of dividends and capital gains/ losses.

formula
The formula for calculating the annual return on a share is:
Annual return = D 1 + (P1 – P 0)/P0
where:
D1 = dividend per share
P1 = share price at the end of a year
P0 = share price at the start of a year.

Example
Suppose that a dividend of 5p per share was paid during the year on a share whose value was 100p at the start of the year and 117p at the end of the year:
Annual return =
5 + (117 – 100)/100 × 100 = 22%

dividend yield and capital gain
The total return is made up of a 5% dividend yield and a 17% capital gain. We have just calculated a historical return, on the basis that the dividend income and the price at the end of year one is known .

The future expected return
Calculating the future expected return is a lot more difficult because we will need to estimate both next year ’s dividend and the share price in one year ’s time. Analysts normally consider the different possible returns in alternate market conditions and try and assign a probability to each.

Example 1 shows the calculation of the
expected return for A plc.
The current share price of A plc is 100p and the estimated returns for next year are shown .

The investment in A plc is risky.
Risk refers to the possibility of the actual return varying from the expected return, ie the actual return may be 30% or 10% as opposed to the expected return of 20%.

Required return
The required return consists of two elements,
which are:
Required return = Risk-free return + Risk premium

Risk-free return
The risk-free return is the return required by investors to compensate them for investing in a risk-free investment.

The risk-free return compensates investors for inflation and consumption preference, ie the fact that they are deprived from using their funds while tied up in the investment.
The return on treasury bills is often used as a surrogate for the risk-free rate.

Risk premium
Risk simply means that the future actual return may vary from the expected return.
If an investor undertakes a risky investment he needs to receive a return greater than the risk-free rate in order to compensate him.
The more risky the investment the greater the compensation required.
This is not surprising and it is what we would expect from risk averse investors.

The Barclay Capital Equity Gilt Study 2003
The Barclay Capital Study calculated the average return on treasury bills in the UK from 1900 to 2002 as approximately 6%.
It also calculated that the average return on the UK stock market over this period was 11%.
Thus if an investor had invested in shares that had the same level of risk as the market, he would have to receive an extra 5% of return to compensate for the market risk.
Thus 5% is the historical average risk in the UK.

The required return calculation
Suppose that Joe, the investor believes that the shares in A plc are twice as risky as the market and that the use of long-term averages are valid.
Calculate the required return

The required return may be calculated as follows:
Required return of A plc = Risk free + Risk premium
16% = 6% + (5% × 2)
Thus 16% is the return that Joe requires to compensate for the perceived level of risk in A plc, i.e. it is the discount rate that he will use to appraise an investment in A plc.

THE NPV CALCULATION
Suppose that Joe is considering investing £100 in A plc with the intention of selling the shares at the end of the first year.
Assume that the expected return will be 20% at the end of the first year.
Given that Joe requires a return of 16% should he invest?

THE NPV CALCULATION
Cash flows year 0 (100), year end 120
Discount factor – 16%, year 0 = 1, year 1= 0.862
(100) 103
NPV=3

Decision criteria:
accept if the NPV is zero or positive.
The NPV is positive, thus Joe should invest.
A positive NPV opportunity is where the expected return more than compensates the investor for the perceived level of risk, i.e. the expected return of 20% is greater than the required return of 16%.

An NPV calculation compares the expected and required returns in absolute terms.

Calculation of the risk premium
Calculating the risk premium is the essential component of the discount rate.
This in turn makes the NPV calculation possible.

To calculate the risk premium, we need to be able to define and measure risk.

THE STUDY OF RISK
The definition of risk that is often used in finance literature is based on the variability of the actual return from the expected return.
Statistical measures of variability are the variance and the standard deviation (the square root of the variance).

The variance and standard deviation of the returns.
Example 1 – A plc,
Market conditions [Actual return Probability – expected return]2
Boom [30 – 20]2 0.1 10
Normal [20 – 20]2 0.8 0
Recession [10 – 20]2 0.1 10
Variance σ2 20
Standard deviation σ = 4.47

The variance
The variance of return is the weighted sum of squared deviations from the expected return.
The reason for squaring the deviations is to ensure that both positive and negative deviations contribute equally to the measure of variability.
Thus the variance represents ‘rates of return squared’.

The standard deviation
Standard deviation is the square root of the variance, its units are in rates of return.
As it is easier to discuss risk as a percentage rate of return, the standard deviation is more commonly used to measure risk.

A choice of investing in either A plc or Z plc,
Shares in Z plc have the following returns and associated probabilities:
Probability Return %
0.1 35
0.8 20
0.1 5

A choice of investing in either A plc or Z plc,
Let us then assume that there is a choice of investing in either A plc or Z plc, which one should we choose?
To compare A plc and Z plc, the expected return and the standard deviation of the returns for Z plc will have to be calculated.

Calculation
The expected return is: (0.1) (35%) + (0.8)(20%) + (0.1) (5%) = 20%
The variance is: = σ2, z = (0.1) (35% – 20%)2 + (0.8) (20% – 20%)2 + (0.1) (5% – 20%)2 = 45%
The standard deviation is: = σz = 6.71%

Summary table
Investment Expected return Standard deviation
A plc 20% 4.47%
Z plc 20% 6.71%
Given that the expected return is the same for both companies, investors will opt for the one that has the lowest risk, ie A plc.

The decision
The decision is equally clear where an investment gives the highest expected return for a given level of risk.
However, these only relate to specific instances where the investments being compared either have the same expected return or the same standard deviation.
Where investments have increasing levels of return accompanied by increasing levels of standard deviation, then the choice between investments will be a subjective decision based on the investor ’s attitude to risk.

RISK AND RETURN ON TWO-ASSET
PORTFOLIOS
So far we have confined our choice to a single investment. Let us now assume investments…
The risk-return relationship will now be measured in terms of the portfolio’s expected return and the portfolio’s standard deviation.
Information about four investments: A plc, B plc, C plc, and D plc.

Assumption
Assume that our investor, Joe has decided to construct a two-asset portfolio and that he has already decided to invest 50% of the funds in A plc.
He is currently trying to decide which one of the other three investments into which he will invest the remaining 50% of his funds.

The expected return of a two-asset portfolio
The expected return of a portfolio (Rport) is simply a weighted average of the expected returns of the individual investments.

Return on investments (%)
Market conditions Probability A plc B plc C plc D plc
Boom 0.1 30 30 10 10
Normal 0.8 20 20 20 22.5
Recession 0.1 10 10 30 10
Expected return 20 20 20 20
Standard deviation 4.47 4.47 4.47 4.47

E.g. 3 – Return on investments (%)
Market Conditions A plc B plc Portfolio A + B
Boom 30 30 30
Normal 20 20 20
Recession 10 10 10

Portfolio Expected Return calculation
Rpor t = x.RA + (1 – x).RB
x = the proportion of funds invested in A
(1 – x) = the proportion of funds invested in B
RA + B = 0.5 × 20 + 0.5 × 20 = 20
RA + C = 0.5 × 20 + 0.5 × 20 = 20
RA + D = 0.5 × 20 + 0.5 × 20 = 20

Portfolio Expected Return
Given that the expected return is the same for all the portfolios, Joe will opt for the portfolio that has the lowest risk as measured by the portfolio’s standard deviation.

The standard deviation of a two-asset portfolio
We can see that the standard deviation of all the individual investments is 4.47%.
Intuitively, we probably feel that it does not matter which portfolio Joe chooses, as the standard deviation of the portfolios should be the same (because the standard deviations of the individual investments are all the same).

The standard deviation of a two-asset portfolio
However, the above analysis is flawed, as the standard deviation of a portfolio is not simply the weighted average of the standard deviation of returns of the individual investments but is generally less than the weighted average.

So what causes this reduction of risk?
What is the missing factor?
The missing factor is how the returns of the two investments co-relate or co-vary, i.e. move up or down together. There are two ways to measure co variability.
The first method is called the covariance and the second method is called the correlation coefficient.
Before we perform these calculations let us review the basic logic behind the idea that risk may be reduced depending on how the returns on two investments co-vary.

Portfolio A+B – perfect positive correlation
The returns of A and B move in perfect lock step, (when the return on A goes up to 30%, the return on B also goes up to 30%, when the return on A goes down to 10%, the return on B also goes down to 10%), ie they move in the same direction and by the same degree.

Example 3.
This is the most basic possible example of perfect positive correlation , where the forecast of the actual returns are the same in all market conditions for both investments and thus for the portfolio (as the portfolio return is simply a weighted average).

Example 3.
Hence there is no reduction of risk. The portfolio’s standard deviation under this theoretical extreme of perfect positive correlation is a simple weighted average of the standard deviations of the individual investments:
σpor t (A,B) = 4.47 × 0.5 + 4.47 × 0.5
= 4.47

Portfolio A+C – perfect negative correlation
The returns of A and C move in equal but opposite ways (when the return on A goes up to 30%, the return on C goes down to 10%,
when the return on A goes down to 10%, the return on C goes up to 30%). See Example 4.

EXAMPLE 4-Return on investments (%)
Market Conditions A plc C plc Portfolio A + C
Boom 30 10 20
Normal 20 20 20
Recession 10 30 20

Portfolio A+C – perfect negative correlation
This is the utopian position, i.e. where the unexpected returns cancel out against each other resulting in the expected return. If the forecast actual return is the same as the expected return under all market conditions, then the risk of the portfolio has been reduced to zero.
This is the only situation where the portfolio’s standard deviation can be calculated as follows:
σport (A,C) = 4.47 × 0.5 – 4.47 × 0.5 = 0

EXAMPLE 5
Market Conditions A plc D plc Portfolio A + D
Boom 30 10 20
Normal 20 22.5 21.25
Recession 10 10 10

Market conditions
The forecast actual return is the same as the expected return under normal market conditions and almost the same under boom market conditions (20 v 21.25).
Therefore, we can say that the forecast actual and expected returns are almost the same in two out of the three conditions.

Market conditions
This compares with only one condition when there is perfect positive correlation (no reduction of risk) and all three conditions when there is perfect negative correlation (where risk may be eliminated).
Therefore, when there is no correlation between the returns on investments this results in the partial reduction of risk.

Measuring co-variability
Co-variability can be measured in absolute terms by the covariance or in relative terms by the correlation coefficient.

The covariance
A positive covariance indicates that the returns move in the same directions as in A and B.
A negative covariance indicates that the returns move in opposite directions as in A and C.
A zero covariance indicates that the returns are independent of each other as in A and D.

The correlation coefficient
Using the covariance formula, we can easily determine the formula for the correlation coefficient.
ρA,B = Cov a,b/σaσb
The correlation coefficient as a relative measure of co-variability expresses the strength of the relationship between the returns on two investments.
It is strictly limited to a range from -1 to +1. See Example 6.

Reality
In reality, the correlation coefficient between returns on investments tends to lie between 0 and +1.
It is the norm in a two-asset portfolio to achieve a partial reduction of risk (the standard deviation of a two-asset portfolio is less than the weighted average of the standard deviation of the individual investments).

Reality
Therefore, we will need a new formula to calculate the risk (standard deviation of returns) on a two -asset portfolio. The formula will obviously take into account the risk (standard deviation of returns) of both investments but will also need to incorporate a measure of co-variability as this influences the level of risk reduction .

The formulae for the standard deviation of
returns of a two-asset portfolio
Version 1
Version 2

Summary table
Investment Expected return (%) Standard deviation (%)
Port A + B 20 4.47
Port A + C 20 0.00
Port A + D 20 3.16

Summary
A + C is the most efficient portfolio as it has the lowest level of risk for a given level of return.
Perfect negative correlation does not occur between the returns on two investments in the real world, ie risk cannot be eliminated, although it is useful to know the theoretical extremes.
However, as already stated, in reality the correlation coefficients between returns on investments tend to lie between 0 and +1.

Investments in different industries
Indeed, the returns on investments in the same industry tend to have a high positive correlation of approximately 0.9, while the returns on investments in different industries tend to have a low positive correlation of approximately 0.2.
Thus investors have a preference to invest in different industries thus aiming to create well diversified portfolio, ensuring that the maximum risk reduction effect is obtained.

Initial understanding
Based on our initial understanding of the risk-return relationship, if investors wish to reduce their risk they will have to accept a reduced return. However, portfolio theory shows us that it is possible to reduce risk without having a consequential reduction in return.

Initial understanding
This can be proved quite easily, as a portfolio’s expected return is equal to the weighted average of the expected returns on the individual investments, whereas a portfolio’s risk is less than the weighted average of the risk of the individual investments due to the risk reduction effect of diversification caused by the correlation coefficient being less than +1.

By investing in just two investments we
can reduce the risk
We can see from Portfolio A + D above where the correlation coefficient was zero, that by investing in just two investments we can reduce the risk from 4.47% to just 3.16% (a reduction of 1.31 percentage points).
Imagine how much risk we could have diversified away, had we created a large portfolio of say 500 different investments or indeed 5,000 different investments.

10 KEY POINTS TO REMEMBER
1 The expected return on a share consists of a dividend yield and a capital gain/loss in percentage terms.
2 The required return on a risky investment consists of the risk-free rate (which includes inflation) and a risk premium.
3 Total risk is normally measured by the standard deviation of returns (σ).

KEY POINTS TO REMEMBER
4 Portfolio theory demonstrates that it is possible to reduce risk without having a consequential reduction in return, i.e. the portfolio’s expected return is equal to the weighted average of the expected returns on the individual investments, while the portfolio risk is normally less than the weighted average of the risk of the individual investments.

KEY POINTS TO REMEMBER
5 The extent of the risk reduction is influenced by the way the returns on the investments co-vary. Co-variability is normally measured in the exams by the correlation coefficient.
6 In reality, the correlation coefficient between returns on investments tend to lie between 0 and +1. Thus total risk can only be partially reduced, not eliminated.

KEY POINTS TO REMEMBER
7 A portfolio’s total risk consists of unsystematic and systematic risk.
However, a well-diversified portfolio only suffers from systematic risk, as the unsystematic risk has been diversified away.
8 An investor who holds a well-diversified portfolio will only require a return for systematic risk. Thus their required return consists of the risk-free rate plus a systematic risk premium.

KEY POINTS TO REMEMBER
9 Investors who have well-diversified portfolios dominate the market.
Thus the market only gives a return for systematic risk.
10 The preparation of a summary table and the identification of the most efficient portfolio (if possible) is an essential exam skill.

Revision –Investment analysis
Explain the usefulness of financial derivatives to business organization?
What is the difference between money market and capital market?
What is meant by market portfolio?
Define Security Market Line (SML)?
What is the advantage of using margin facility in share trading to an investor?

Revision –Exam style questions
Which security is an example of a hybrid security?
A. Ordinary share
B. Commercial paper
C. Bond
D. Convertible share

Revision –Investment analysis
The share of Medex Ltd. is currently trading at $3.35. You expect the share price to go up to $3.80 in the next few days.
What type of order would you give to your broker to purchase the shares now?
A. Margin order
B. Market order
C. Stop-loss order
D. Limit order

Revision –Investment analysis
Which is the definition for an optimal portfolio?
A. The portfolio that has the lowest risk.
B. The portfolio that gives the best set of returns.
C. The portfolio that has the best set of returns within its specific risk level.
D. The portfolio that comprises of assets that are risk-free.

Revision –Investment analysis
Assuming a portfolio has 3 assets. How many variances and co-variances need to be calculated to compute the portfolio risk?
A. The number of variance is 3 and the number of covariance is also 3.
B. The number of variance is 6 and the number of covariance is 3.
C. The number of variance is 3 and the number of covariance is 6.
D. The number of variance is 6 and the number of covariance is also 6.

Revision –Investment analysis
A share has a beta of 1.1. The risk-free rate is 2.5% and the return on the market is 12%. The estimated return for the share is 14%.
Based on the Capital Asset Pricing Model (CAPM), what should an investor do?
A. Sell the share because the required return is 9.95%.
B. Sell the share because the required return is 16.5%.
C. Buy the share because the required return is 11.5%.
D. Buy the share because the required return is 12.95%.

Revision –Investment analysis
On 13 October 2010, Mr. Aik bought 2,000 shares of Zee Ltd. (Zee) at $3 per share. He receives a dividend of $0.06 per share on 15 December 2010 and later sold the shares for $3.30 per share on 29 December 2010.
 
Based on this information, how much is the dividend yield and capital gain of Zee’s shares?

Revision –Investment analysis
You have a portfolio consisting of 30% of Share Ae and the balance in Share Be. The beta coefficient of Share Ae and Share Be are 0.7 and 1.5 respectively. The risk-free rate is 4% and the expected market return is 12%.
What is your portfolio’s expected return?

Revision –Investment analysis
Mr. Kasim, an investor wishes to construct a portfolio consisting of 40% index share and 60% risk-free asset. The return on the risk-free asset is 2% and the expected return on the index share is 10%. If the standard deviation of returns on the index share is 8%, what is the expected standard deviation of the portfolio?

VALUATION PROCESS
There are two approaches to evaluate security. They are:
(a) Top to Bottom Approach
(b) Bottom Up Approach

Two approaches
In the Top to Bottom Approach, we begin by analysing the economy followed by the industry and then proceed to the firms in the industry.
In the Bottom Up Approach, analysts will try to identify firms that are undervalued. These firms were chosen without taking into account the economic situation and environment.

The basic valuation model
In the basic valuation model, we will look at:
(a) the Discounted Dividend Model
(b) the Constant Growth Model
(c) the Relationship between Share Price and Growth
(d) Multistage Growth

Discounted Dividend Model
In the Discounted Dividend Model, the share price is calculated by finding the present value of the predicted dividend and the predicted selling price of the share.

Constant Growth Model
If there is a rise in the dividend, the Discounted Dividend Model (formula 5.6) will have to be adjusted. For example, let’s assume the dividend of the company rise at a rate of 5% per year. So, if we take 3 years ahead, the dividend will be:
D1 = 0.50(1.05) = 0.525
D2 = 0.525(1.05) = 0.55125 or 0.05(1.05)2
D3 = 0.55125 (1.05) = 0.579 or 0.05(1.05)3

Constant Growth Model
Generally, the situation above is the same as:
D1 = D0(1+g)
D2 = D1(1+g) or D0 (1+g)2
D3= D2(1+g) or D1(1+g)3
Note: g is the growth rate.

PRICE EARNING (PE) RATIO MODEL
This model is also known as the earnings multiplier model. This is because the PE ratio is also known as the earning multiplier

ECONOMIC ANALYSIS
The prospect and future of a firm depends on the economic situation and business environment where the firm operates. Sometimes, the environment plays a great role on the performance of a firm.
In the evaluation of share prices, we have to evaluate the following economic and industrial situations:
(a) World Environment
(b) Domestic Economy
(c) Government Policy

INDUSTRY ANALYSIS
A simple definition of industry would be where a group of firms run the same business.
The purpose of industrial analysis is to understand the characteristics and structure of an industry.
There is a relationship between the character and structure of the industry with earnings that can be generated by firms in the industry.
In addition, a good firm usually is in a healthy and growing industry.

Sales Level and Industry Life Cycle

Competitive Structure in Industry
We can complete the industry analysis by examining the competitive structure of an industry.
The competitive structure can give insight into the earning of firms in the industry. The tighter the competition, the harder it will be for firms to get or maintain high profit.

Michael Porter, 5 forces model

COMPANY ANALYSIS
The objective of company analysis is to examine the nature and characteristics of a company.
SWOT analysis
It also involves examining the financial affairs of that company and determining the quality of its earnings.

Company analysis – 3 main financial statements
There are 3 main financial statements. They are:
(a) Balance Sheet which is a statement of the company’s assets, liabilities and stockholders’ equity.
(b) Income Statement which provide a summary of operating results.
(c) Statement of Cash Flows which provide a summary of cash flow and events that caused the cash position to change.

Financial statements

To increase earnings
There are two main strategies that a company can use in order to increase earnings.
They are:
Low Cost Strategy
Differentiation Strategy

Low Cost Strategy
Through this strategy the company endeavors to increase earnings by controlling costs.
This is only done when there is no opportunity to increase the price of the product.

Through this strategy the company will maintain its pricing policy, being confident that customers will not stop buying its products as it is perceived to be different and maybe of high quality.

Differentiation Strategy

Porters Generic Strategies

Fixed Income Security
A bond is a fixed income security which promises the investor a fixed stream of income for a specific time period.

CHARACTERISTICS OF BONDS
Maturity Period
Maturity Value
Coupon Rates
Floating Rate
Zero-coupon Bonds
Embedded Options

A floating rate indicates that the coupon rate may change according to the current interest rate. This current interest rate is dependent on the state of the economy.
Floating Rate

Embedded Options
Embedded options are specific characteristics stipulated in the bond indentures. These characteristics may include the option to call the bond at an earlier date before maturity.
Another type of option is when bonds can be converted to equity.
The latter is known as convertible bonds.

RISKS ASSOCIATED WITH BONDS
Interest Rate Risks
Reinvestment Risks
Redemption Risks (or Risk of a Call)
Default Risks
Inflation Risks
Liquidity Risks

BOND PRICING
The price/value of a bond is the present value of the expected cash flow from the bond.

The expected cash flows are the coupon payments and the face value.
These cash flows are then discounted at the required rate of return. This rate of return is normally called the yield of the bond.

Yield
This yield will depend vastly on the present market interest rate.
The present market interest rate will consider the risk-free rate of return and compensate its investor for the expected inflation.
Depending on the risk structure of the bond, the investor will also be compensated for additional risks faced throughout the life of the bond.
These risks may include liquidity, default or call risk which are normally specific to the security and firms.

Example
For example, a three-year RM1,000 bond with 10% coupon rate with a yield of 8% will have a value of:
Calculate…
Bond value = Present value of coupons + Present value of face value

Yield to Maturity
The rate of return earned from investing in bonds until the bond matures is termed as yield to maturity. Yield to maturity is also viewed as the promised rate of return accruing to investors.
However, investors can only expect the promised
return only if:
-the probability of the issuer defaulting in payment is zero; and
-the bond cannot be called before maturity.

Current Yield and Holding period return
The current yield of a bond is just the coupon payment divided by the price.
The holding period return equals income earned over a period (including capital gains or losses) as a percentage of the bond price at the start of the period.
The return can be calculated for any holding period based on the income generated over that period.

VOLATILITY IN BOND PRICES
The most important factor that influences the value of the bond is the market interest rate, which directly influences the yield that an investor is looking for.
Changes in this interest rate will affect the changes in the prices of bonds referred to as the volatility of bond prices.

Bond Prices Move Inversely with Interest
Rates
Generally, the price of bonds will move counter cyclical to the movements in interest rates. In other words, if the price of bonds has a tendency to fall, then it may be due to the upward movements of interest rates in the market.
Go through the exmple.

Volatility of Bond Prices for Longer Term
Maturity Bonds
Bonds with longer maturity periods, experience a more volatile price movement.
Table 7.1 shows that the rate of change in price is higher for a ten-year bond compared to a one-year bond.
Observe also that the rate of change in price reduces at a decreasing rate as the maturity period increases given the same level of interest rate.

Modified Duration
Modified duration is used to estimate the sensitivity of bond price as a result of a change in interest rates. It is calculated as:
Use the formula…
Where D* is the Macaulay Duration, i is the yield and n is the number of times the coupon rate is paid in a year.

If a bond is sold at RM1,000, and has Macaulay Duration of 5 years with a yield of 8% and pays the coupon twice in a year.
Calculate the modified duration.
Macaulay duration, named for Frederick Macaulay who introduced the concept, is the weighted average maturity of a bond
Modified Duration = Macaulay Duration /( 1 + y/n), where y = yield to maturity and n = number of discounting periods in year ( 2 for semi – ann pay bonds )

BOND PORTFOLIO MANAGEMENT
Investors can put their money in more than one bond to create a bond portfolio.
There are two types of management strategies namely the passive and active.
a) Passive Strategy;
-Buy and Hold Strategy
-Index Strategy
b) Active Strategy

Active Strategy
There are 4 sources of active management strategies namely:
Interest Rates Forecasting
Choosing a Sector
Movements Between Sector
Choosing a ‘Wrongly’ Priced Bond

Active Bond Management
In an active bond portfolio management, there is always a need to change the portfolio of bonds. A bond manager may have to switch from one sector to another, or from one bond to another. Sometimes there is no need to actually buy and sell bonds. Instead the manager can just enter a swap.
A swap is an exchange between one bond with another.
Go through the examples of swap…

Liability Funding Strategy
Apart from maximising profits given a specific level of risk, investments in bonds provide a buffer against contingent claims.
An insurance company for example, receiving premiums must be able to pay its customers’ claims at the end of the life of the insurance. This does not include any unexpected claims made by the clients.

Derivatives
This topic explains derivative securities: forward contracts, futures, and both call and put options.
Among the most innovative and most rapidly growing markets to be developed in recent years are the markets for financial futures and options. This is known as Derivative market.
Futures and options trading are designed to protect the investor against interest rate risks, exchange rate risks and price risks.
A derivative security is a financial contract written on an underlying asset.

Derivatives (Definition)
A financial instrument whose characteristics and value depend upon the characteristics and value of an underlier, typically a commodity, bond, equity or currency.
Example;
Basics Four:
1. Forward
2. Future
3.Option
4. Warrents& Convertibles.
Complex
1. Swap
2. Exotics

Use of derivatives
hedging or risk management
speculate or strive for enhanced returns
price discovery – insight into future prices of commodities

The underlying asset
The underlying asset may be a share, Treasury Bill, foreign currency or even another derivative security.
Go through the examples…
Two types of derivative security, futures and options are actively traded on organized exchanges.
These contracts are standardized with regard to description of the underlying asset, the right of the owner, and the maturity date.

Not standardized contracts
Forward contracts, on the other hand, are not standardized; each contract is customized to its owner, and they are traded in what is called the inter-bank market.
Options can be found embedded in other securities, convertible bonds and extendible bonds being two such examples.
A convertible bond contains a provision that gives an option to convert the security into common share. As extendible bond contains a provision that gives an option to extend the maturity of the bond.

A forward contract and A futures contract
A forward contract is an agreement to buy or sell a specified quantity of asset at a specified price, with delivery at a specified time and place.
A futures contract is an agreement to buy or sell a specified quantity of an asset at a specified price, and at a specified time and place.
This part of the definition of a futures contract is identical to that of a forward contract. But futures contracts differ from forward contracts in four important ways.

The differences are
(a) Futures contracts allow participants to realise gains or losses on a daily basis, while forward contracts are cash settled only at delivery.
(b) Futures contracts are standardised with respect to the quality and the quantity of the asset underlying the contract, the delivery date or period, and the delivery place if there is physical delivery. In contrast, forward contracts are customised on all these dimensions to meet the needs of the two counterparties.

The differences are
Futures contracts are settled through a clearing house. The clearing house acts as a middleman. This minimises credit risk as the second party to a futures contract is always the clearing house.
Futures markets are regulated, while forward contracts are unregulated.
Now let’s look at an example of a futures contract.

Example
Sugar cane or wheat or cotton farmers may wish to have contracts to sell their harvest at a future date to eliminate the risk of change in price by that date.
There are commodity futures and financial futures.

Clearing House
This intervention of the clearing house means that the futures market has no counterparty risk.
If A plans to buy futures and B plans to sell futures, both parties will refer to the clearing house to fulfil their intentions. The clearing house is thus the counter party to every contract.
In this case, B is not the counter party to A.

Meaning of options:
An option is the right, but not the obligation to buy or sell something on a specified date at a specified price. In the securities market, an option is a contract between two parties to buy or sell specified number of shares at a later date for an agreed price.

Call and Put Option
An option to buy anything is known as a CALL while an option to sell a thing is called a PUT. Options trade in an organized market but, large percentage of it is traded over the counter (i.e. privately).
Note that this is just an option. That means it is a right and not an obligation.
Strike price: Price specified in the options contract is known as the strike price or exercise price.

Call option
Call option that gives the right to buy in its contract gives the particulars of
The name of the company whose shares are to be bought.
The number of shares to be purchased.
The purchase price or the exercise price or the strike price of the shares to be bought.
The expiration date, the date on which the contract or the option expires.

Put option
Put option gives its owner the right to sell (or put) an asset or security to someone else.
Put option contract contains:
The name of the company shares to be sold.
The number of shares to be sold.
The selling price or the striking price.
The expiration date of the option.

Basis with respect to maturity

Novation
The substitution of a new contract for an old one; or the substitution of one party in a contract with another party.
The replacement of existing debt or obligation with a new one.

SWAPS (Meaning)
Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts.
Types of Swaps
(1).Interest Rate Swaps.
(2).Currency Swaps.
(3).Commodity Swaps.
(4).Equity Swaps.

Commonly used swaps
Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.
Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

Options Moneyness
Options moneyness refers to a situation of whether it is profitable or not when we initiate the contract.
Moneyness is always viewed from the buyer or the long position viewpoint and not from the seller’s
view point.
Further, moneyness is obtained by comparing the exercise price with the spot value of the underlying asset.

Difference between Options and Futures
Contracts
Only the sellers (not the buyer) are obliged to buy or sell. The buyer of options need not buy or sell the underlying. In the futures contract, the buyers and sellers are obliged to buy or sell.
Thus, the main advantage of options is where the holder or the buyer of options will benefit from an upside benefit while limiting a downside loss.

Difference between Options and Futures
Contracts
The buyer of options must pay a fee or the price of the options to the seller to get the right. In the futures contract, there is no exchange of money when the contract is initiated.
The buyer of the options will decide on the price of the options to buy (for call options) or to sell (for put options) but can take the opportunity if the price of the options is low. In the futures contract, the price is already fixed and the parties to the contract cannot obtain profit or suffer losses from any price movement.

The Binomial Pricing Model
In this model, we will use a riskless portfolio (S – C) where we buy a unit of the underlying asset and sell a call option on the asset.
We further assume that there are only two possible states, market goes up or market goes down.

The assumptions used in this model
(a) There are no market frictions.
(b) Market participant entails no counterparty risk.
(c) Markets are competitive.
(d) Market participants prefer more wealth to less.
(e) There are no arbitrage opportunities.

The Black-Scholes Model
The Black-Scholes model for pricing put (p) and call (c) options is as follow:
Formula..
N(d1), N(d2), = the cumulative probability density. The value for N(.) is obtained
from a normal distribution that is tabulated in most statistics textbooks.
c = European call option price p
P = European put option price
S0 = Share price today
ST = Share price at option maturity
K = Strike price
T = Life of option
R = Risk-free rate for maturity T with cont comp
σ = Volatility of stock price

Topic 9
Mutual Fund Investment and Performance
Measurement

INTRODUCTION
This topic discusses another alternative approach to investment.
In this topic we will mainly discuss investment in mutual funds.
These mutual funds are basically portfolios that are managed by professional financial service organisations.
There are various kinds of funds available in the market.
To manage the portfolio, they will need to go through a process.
Finally, we will discuss performance evaluation of investments.

PROCESS OF PORTFOLIO MANAGEMENT

Asset Classification
Go through table 9.1 Asset Classification

INVESTORS’ OBJECTIVES
As we mentioned earlier, there are many investors with different risk tolerance.
Therefore, each major group of investors will have different portfolios that suit their needs.
The easiest way to determine an investors profile is by their age.
Table 9.1: Investors Needs Categorised According to Age

MUTUAL FUNDS: PROFESSIONALLY
MANAGED INVESTMENT PORTFOLIOS
A mutual fund is a financial service that collects money from shareholders and invests those funds on their behalf in a diversified portfolio of securities.

Characteristics of a Fund
An open-end fund is a type of fund where investors can buy shares from the fund.
A close-end fund is a fund where the number of shares is fixed. Investors can buy these shares initially from the fund, but they cannot sell it back to the fund.

Types of Funds
A growth fund’s specific objective is price appreciation. They target securities that will have long-term growth and capital gains and less on securities that give dividends or income.
Because of this, growth fund is risky. This type of fund is suitable for investors between the age group of 25 to 40. Their objective is to accumulate capital.

Types of Funds
Income funds emphasise on current income. They will invest in securities that provide stable income. Shares that provide high dividends are normally the
favourite choice as well as established blue chip companies.
They however do hold a few growth shares. Apart from shares, these types of funds also invest in
bonds.
The investment is less risky than growth shares.

Types of Funds
Index fund is a portfolio that replicates the combination of shares in an index.
For example the KLCI contain 100 shares, with predetermine weight for each share.
A portfolio can be built to replicate that index and use the same 100 shares and weights.

PERFORMANCE EVALUATION
Sharpe’s Measure
Sharpe’s Differential Return
Treynor’s Measure
Treynor’s Differential Return

Revision
1. Calculate the price of a bond with a per value of $1000 to be paid in ten years, a coupon rate of 10%, and a required yield of 12%. Assume that coupon payments made annually to bond holders and that the next coupon payment is expected in six months.
Calculate bond price…
2. Bond investors are exposed to interest rate risk and redemption risk.
Explain these risks…

Revision
What do you understand by the term top-down security analysis?
What is the consequence of an increase in interest rates?
What is the consequence of an increase in inflation?
What type of stocks the constant growth-model is best suited for?
Define an expansionary economic policy?

Revision
List some of the popular tools for technical analysis?
What is the implication of random walk hypothesis?
Describe the term “efficient market” ?
Briefly explain the main objectives of technical analysis?
Write the difference between ‘bond at a premium’ and ‘bond at a discount’?

Revision
What makes the bond prices to be most volatile?
Explain zero coupon bond?
What do you understand by the term T-Bill?
Explain what is a passive bond portfolio strategy with some examples?
Explain what is an active bond portfolio strategy with some examples?

Revision
What is an immunization strategy?
What is forward contract?
What is the main difference between future contract and forward contract?
How does a call option differ from a put option?
What is growth fund?

Revision
1. If XYZ Ltd. has a price earnings (P/E) ratio of 10 and an earnings per share (EPS) of $0.90, what is the current price of the share?
A. $11.11 per share.
B. $17.07 per share.
C. $09.00 per share.
 
D. $19.35 per share

Revision
2. A common stock is expected to pay a $0.85 annual dividend next year. If the dividends are expected to grow at 5% annually and the current stock price is $8.50, what is the required rate of return of the stock?
A. 15.00%
 
B. 8.91%
 
C. 10.73%
D. 11.38%

Revision
3. The constant-growth dividend valuation model is best suited for what type of stocks?
A. Stocks of new or emerging companies.
 
B. Small-cap stocks within growing industries.
 
C. Stocks of mature, dividend-paying companies.
D. Stocks of cyclical companies. 

Revision
4. Which one describes the point-and-figure approach in technical analysis?
 A. A point-and-figure chart depicts all of the closing prices of a stock over a period of time.
B. A point-and-figure chart consists of columns of X’s and O’s.
C. A typical bar chart uses vertical bars to show the closing price as well as the change in price from the previous day.
D. A sell signal occurs when prices break through a resistance line on a chart pattern.

Revision
5. If the market is strong-form efficient, what types of information will be reflected in the stock price?
 
A. Only historical information.
B. Only the information related to events that have already occurred.
 
C. All publicly known information related to past events and announced future events.
D. All information including both public and private.

Revision
6. Which one signals a strong market?
A. A greater number of advancing stocks than declining stocks and a greater volume of declining stocks than advancing stocks
B. A greater number of advancing stocks than declining stocks and a greater volume of rising stocks than declining stocks
C. A greater number of declining stocks than advancing stocks and a greater volume of rising stocks than declining stocks
D. A greater number of declining stocks than advancing stocks and a greater volume of declining stocks than advancing stocks

Revision
7. If investors can use past share prices to predict the future prices of the share, what does this indicate?
A. The security market is weak-form efficient
B. The security market is semi-strong efficient
C. The security market is strong-form efficient
D. The security market is inefficient

Revision
8. If you expect market interest rates to rise, what type of bonds should you purchase?
A. Short term, low coupon bonds.
B. Short term, high coupon bonds.
 
C. Long term, low coupon bonds.
 
D. Long term, high coupon bonds.

Revision
9. What is the current price of a bond if its par value is $1,000, coupon rate of 6% and pays interest semi-annually, matures in 10 years and has a yield-to-maturity of 7.1325%?
A.$567
B.$920
C.$1,030
D.$1,080

Revision
10. What does the duration of a bond measure?
A. The sensitivity of bond price against interest rate.
B. The average return of a bond.
C. The relationship between bond price and money supply.
D. The movement of bond price in response to changes in foreign exchange rate.

Revision
11. A $1,000 par value, 6% annual coupon bond matures in 3 years. The bond is currently priced at $993.35 and has a yield to maturity of 6.25%.
What is the duration of this bond?
A.1 year
B.2.67 years
C.2.83 years
D.2.89 years

Revision
12.What is the expression for put-call parity?
A.Stock price + Call Price = Put Price + Risk Free Bond Price
B.Stock price + Put Price = Call Price + Risk Free Bond Price
C.Put price + Call Price = Stock Price + Risk Free Bond Price
D.Stock price – Put Price = Call Price + Risk Free Bond Price

Revision
13. A stock currently sells for $15 per share. Assume that a call option on the stock with an exercise price $15.50 currently sells for $2.50.
 
What is the terminology used to describe this situation?
A.In-the-money
B.Out-of-the-money
C.At-the-money
D.Break-even point

Revision
14Ali owns a portfolio that has a standard deviation of 13%, a beta of 1.05, and a total return of 10.5%. The risk-free rate is 4% and the overall market return is 9.8%.
What is the value of Sharpe’s measure for Ali’s portfolio?
A.0.05
B.0.06
C.0.50
D.0.81

Revision
15.A portfolio has a total return of 10.5%, a beta of 0.72 and a standard deviation of 6.3%. Assume that the risk free rate is 3.8% and the market return is 12.4%.
What is Jensen’s measure of this portfolio’s performance?
A. 4.3%.
B. 7.9%.
C. 9.3%.
D. 0.5%

1996199719981999200020012002200320042005Average
%%%%%%%%%%
BCE4.693.422.521.411.073.153.994.084.294.443.31
Celestica Inc.00000000000.00
CIBC3.673.072.853.373.172.93.483.283.313.573.27
Cott Corporation0.230.530.5400000000.13
Kinross Gold Corporation00000000000.00
TransAlta Corporation6.225.164.525.355.594.064.925.735.884.515.19
Yellow Pages Income Fund7.347.097.22
Table 22-1 S&P/TSX 60 Index Dividend Yields
Sheet1

Table 22-1 S&P/TSX 60 Index Dividend Yields

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Average
% % % % % % % % % %

BCE 4.69 3.42 2.52 1.41 1.07 3.15 3.99 4.08 4.29 4.44 3.31
Celestica Inc. 0 0 0 0 0 0 0 0 0 0 0.00
CIBC 3.67 3.07 2.85 3.37 3.17 2.9 3.48 3.28 3.31 3.57 3.27
Cott Corporation 0.23 0.53 0.54 0 0 0 0 0 0 0 0.13
Kinross Gold Corporation 0 0 0 0 0 0 0 0 0 0 0.00
TransAlta Corporation 6.22 5.16 4.52 5.35 5.59 4.06 4.92 5.73 5.88 4.51 5.19
Yellow Pages Income Fund 7.34 7.09 7.22

0
1
P
D
0
0
1
P
P
P
–
Income Level
$25,000$50,000$75,000$100,000
British ColumbiaDividends2.526.1915.6920.04
Capital gains12.4515.5818.8520.35
AlbertaDividends3.638.0313.8313.83
Capital gains12.6316.0018.0018.00
OntarioDividends0.008.2420.7420.74
Capital gains10.6515.5821.7121.71
QuebecDividends5.9515.4226.0626.06
Capital gains14.3719.1922.8622.86
Nova ScotiaDividends0.008.7517.0519.06
Capital gains12.0218.4821.3422.63
Table 22-3 Individual Tax Rates (%) on Dividends and Capital Gains
Sheet1

Table 22-3 Individual Tax Rates (%) on Dividends and Capital Gains

Income Level $25,000 $50,000 $75,000 $100,000
British Columbia Dividends 2.52 6.19 15.69 20.04
Capital gains 12.45 15.58 18.85 20.35
Alberta Dividends 3.63 8.03 13.83 13.83
Capital gains 12.63 16.00 18.00 18.00
Ontario Dividends 0.00 8.24 20.74 20.74
Capital gains 10.65 15.58 21.71 21.71
Quebec Dividends 5.95 15.42 26.06 26.06
Capital gains 14.37 19.19 22.86 22.86
Nova Scotia Dividends 0.00 8.75 17.05 19.06
Capital gains 12.02 18.48 21.34 22.63

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Corporate Finance

Objectives of the Course
On successful completion of this course, you should be able to:
Identify the purpose and relevance of Corporate Finance;
Explain the use of a variety of advance capital budgeting techniques;
Discuss the importance of risk and return in Corporate Finance;
Discuss the process determining the capital structure and dividend policy;
Apply financial derivatives in risk management; and
Discuss factors that affect shareholders’ wealth.

Topic 1: Value and Capital Budgeting
Net Present Value
How to Value Bonds and Stocks
Some Alternative Investment Rules
Net Present Value and Capital Budgeting
Risk Analysis, Options and Capital Budgeting

Topic 2: Risk and Return
Capital Market Theory: An Overview
Return & Risk: The Capital Asset Pricing Model (CAPM)
An Alternate View of Risk and Return: The Arbitrage Pricing Theory
Risk, Cost of Capital, and Capital Budgeting

Topic 3: Capital Structure and Dividend Policy
Corporate Financing Decisions and Efficient Capital Markets
Long-Term Financing: An Introduction
Capital Structure: Basic Concepts
Capital Structure: Limits to the Use of Debt
Valuation and Capital Budgeting for the Levered Firm
Dividend Policy: Why Does It Matter?

Topic 4&5: Long-Term Financing & Derivatives
Issuing Securities to the Public
Long-Term Debt
Leasing
Topic 5: Options, Futures, and Corporate Finance
Options and Corporate Finance: Basic Concepts -Warrants and Convertibles , Derivatives and Hedging Risk

Research!
Research is the art of seeing what everyone else has seen, and doing what no-one else has done.

The Time Value of Money
Which would you rather have — $1,000 today or $1,000 in 5 years?
Obviously, $1,000 today.
Money received sooner rather than later allows one to use the funds for investment or consumption purposes. This concept is referred to as the TIME VALUE OF MONEY!!

Why TIME?
NOT having the opportunity to earn interest on money is called OPPORTUNITY COST
Remember, one CANNOT compare numbers in different time periods without first adjusting them using an interest rate.

Compound Interest
When interest is paid on not only the principal amount invested, but also on any previous interest earned, this is called compound interest.
FV = Principal + (Principal x Interest)
= 2000 + (2000 x .06)

Future Value
If you invested $2,000 today in an account that pays 6% interest, with interest compounded annually, how much will be in the account at the end of two years if there are no withdrawals?
FV1 = PV (1+i)n = $2,000 (1.06)2 = $2,247.20
FV = future value, a value at some future point in time
PV = present value, a value today which is usually designated as time 0
i = rate of interest per compounding period
n = number of compounding periods

Future Value Example
John wants to know how large his $5,000 deposit will become at an annual compound interest rate of 8% at the end of 5 years.
FVn = PV (1+i)n FV5 = $5,000 (1+ 0.08)5 = $7,346.64

Present Value
Since FV = PV(1 + i)n.
PV = FV / (1+i)n.
Discounting is the process of translating a future value or a set of future cash flows into a present value.

Present Value Example
Joann needs to know how large of a deposit to make today so that the money will grow to $2,500 in 5 years. Assume today’s deposit will grow at a compound rate of 4% annually.
Calculation based on general formula: PV0 = FVn / (1+i)n
PV0 = $2,500/(1.04)5 = $2,054.81

Finding “n” or “i” when one knows PV and FV
If one invests $2,000 today and has accumulated $2,676.45 after exactly five years, what rate of annual compound interest was earned?

Annuities
An Annuity represents a series of equal payments (or receipts) occurring over a specified number of equidistant periods.
Examples of Annuities Include:
Student Loan Payments
Car Loan Payments
Insurance Premiums
Mortgage Payments
Retirement Savings

Dividend Policy
Learning Objectives
Important Terms
Mechanics of Dividend Payments
Cash Dividend Payments
M&M’s Dividend Irrelevance Theorem
The “Bird in the Hand” Argument
Dividend Policy in Practice
Relaxing the M&M Assumptions
Stock Dividends and Stock Splits
Share Repurchases
Summary and Conclusions

Dividend Policy
What is It?
Dividend Policy refers to the explicit or implicit decision of the Board of Directors regarding the amount of residual earnings (past or present) that should be distributed to the shareholders of the corporation.
This decision is considered a financing decision because the profits of the corporation are an important source of financing available to the firm.

Types of Dividends
Dividends are a permanent distribution of residual earnings/property of the corporation to its owners.
Dividends can be in the form of:
Cash
Additional Shares of Stock (stock dividend)
Property
If a firm is dissolved, at the end of the process, a final dividend of any residual amount is made to the shareholders – this is known as a liquidating dividend.

Dividends a Financing Decision
In the absence of dividends, corporate earnings accrue to the benefit of shareholders as retained earnings and are automatically reinvested in the firm.
When a cash dividend is declared, those funds leave the firm permanently and irreversibly.
Distribution of earnings as dividends may starve the company of funds required for growth and expansion, and this may cause the firm to seek additional external capital.

Corporate Profits After Tax
Retained Earnings
Dividends

Dividends versus Interest Obligations
Interest
Interest is a payment to lenders for the use of their funds for a given period of time
Timely payment of the required amount of interest is a legal obligation
Failure to pay interest (and fulfill other contractual commitments under the bond indenture or loan contract) is an act of bankruptcy and the lender has recourse through the courts to seek remedies
Secured lenders (bondholders) have the first claim on the firm’s assets in the case of dissolution or in the case of bankruptcy
Dividends
A dividend is a discretionary payment made to shareholders
The decision to distribute dividends is solely the responsibility of the board of directors
Shareholders are residual claimants of the firm (they have the last, and residual claim on assets on dissolution and on profits after all other claims have been fully satisfied)

Dividend Payments
Cash Dividend – Payment of cash by the firm to its shareholders.
Ex-Dividend Date – Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend.
Record Date – Person who owns stock on this date received the dividend.

Mechanics of Cash Dividend Payments
Declaration Date
this is the date on which the Board of Directors meet and declare the dividend. In their resolution the Board will set the date of record, the date of payment and the amount of the dividend for each share class.
when CARRIED, this resolution makes the dividend a current liability for the firm.
Date of Record
is the date on which the shareholders register is closed after the trading day and all those who are listed will receive the dividend.
Ex dividend Date
is the date that the value of the firm’s common shares will reflect the dividend payment (ie. fall in value)
‘ex’ means without.
At the start of trading on the ex-dividend date, the share price will normally open for trading at the previous days close, less the value of the dividend per share. This reflects the fact that purchasers of the stock on the ex-dividend date and beyond WILL NOT receive the declared dividend.
Date of Payment
is the date the cheques for the dividend are mailed out to the shareholders.

Dividend Policy
Dividends, Shareholders and the Board of Directors
There is no legal obligation for firms to pay dividends to common shareholders
Shareholders cannot force a Board of Directors to declare a dividend, and courts will not interfere with the BOD’s right to make the dividend decision because:
Board members are jointly and severally liable for any damages they may cause
Board members are constrained by legal rules affecting dividends including:
Not paying dividends out of capital
Not paying dividends when that decision could cause the firm to become insolvent
Not paying dividends in contravention of contractual commitments (such as debt covenant agreements)

Dividend Reinvestment Plans (DRIPs)
Involve shareholders deciding to use the cash dividend proceeds to buy more shares of the firm
DRIPs will buy as many shares as the cash dividend allows with the residual deposited as cash
Leads to shareholders owning odd lots (less than 100 shares)

Firms are able to raise additional common stock capital continuously at no cost and fosters an on-going relationship with shareholders.

Dividend Payments
Stock Dividends
Stock dividends simply amount to distribution of additional shares to existing shareholders
They represent nothing more than recapitalization of earnings of the company. (that is, the amount of the stock dividend is transferred from the R/E account to the common share account.
Because of the capital impairment rule stock dividends reduce the firm’s ability to pay dividends in the future.

Dividend Payments
Stock Dividends
Implications
reduction in the R/E account
reduced capacity to pay future dividends
proportionate share ownership remains unchanged
shareholder’s wealth (theoretically) is unaffected
Effect on the Company
conserves cash
serves to lower the market value of firm’s stock modestly
promotes wider distribution of shares to the extent that current owners divest themselves of shares…because they have more
adjusts the capital accounts
dilutes EPS
Effect on Shareholders
proportion of ownership remains unchanged
total value of holdings remains unchanged
if former DPS is maintained, this really represents an increased dividend payout

Dividend Payments
Stock Dividends
ABC Company
Equity Accounts
as at February xx, 20×9
Common stock (215,000) $5,000,000
Retained earnings 20,000,000
Net Worth $25,000,000
The company, on March 1, 20×9 declares a 10 percent stock dividend when the current market price for the stock is $40.00 per share.
This stock dividend will increase the number of shares outstanding by 10 percent. This will mean issuing 21,500 shares. The value of the shares is:
$40.00 (21,500) = $860,000
This stock dividend will result in $860,000 being transferred from the retained earnings account to the common stock account:

Dividend Payments
Stock Dividends
After the stock dividend:
ABC Company
Equity Accounts
as at March 1, 20×9
Common stock (236,500) $5,860,000
Retained earnings 19,140,000
Net worth $25,000,000

The market price of the stock will be affected by the stock dividend:
New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36
The individual shareholder’s wealth will remain unchanged.

Cash Dividend Payments
The Macro Perspective
Aggregate after-tax profits run at approximately 6% of GDP but are highly variable
Aggregate dividends are relatively stable when compared to after-tax profits.
They are sustained in the face of drops in profit during recessions
They are held reasonably constant in the face of peaks in aggregate profits.

Aggregate Dividends and Profits

Cash Dividend Payments
The Macro Perspective – Question
Why are dividends smoothed and not matched to profits?
The companies chosen here illustrate the dramatic differences between companies:
Some pay no dividends
Some pay consistent cash dividends representing substantial yields on current shares prices
The highest yields are found in the case of Income Trusts and large stable ‘blue-chip’ financials and utilities

Cash Dividend Payments
Dividend Yields

Modigliani and Miller’s Dividend Irrelevance Theorem
The value of M&M’s Dividend Irrelevance argument is that in the end, it shows where value can be created with dividend policy and why.

M&M’s Dividend Irrelevance Theorem
Assumptions
No Taxes
Perfect capital markets
large number of individual buyers and sellers
costless information
no transaction costs
All firms maximize value
There is no debt

M&M’s Dividend Irrelevance Theorem
Residual Theory of Dividends
The Residual Theory of Dividends suggests that logically, each year, management should:
Identify free cash flow generated in the previous period
Identify investment projects that have positive NPVs
Invest in all positive NPV projects
If free cash flow is insufficient, then raise external capital – in this case no dividend is paid
If free cash flow exceeds investment requirements, the residual amount is distributed in the form of cash dividends.

M&M’s Dividend Irrelevance Theorem
Residual Theory of Dividends – Implication
The implication of the Residual Theory of Dividends are:
Investment decisions are independent of the firm’s dividend policy
No firm would pass on a positive NPV project because of the lack of funds, because, by definition the incremental cost of those funds is less than the IRR of the project, so the value of the firm is maximized only if the project is undertaken.
If the firm can’t make good use of free cash flow (ie. It has no projects with IRRs > cost of capital) then those funds should be distributed back to shareholders in the form of dividends for them to invest on their own.
The firm should operate where Marginal Cost equals Marginal Revenue as seen in Figure on the following slide:

CHAPTER 22 – Dividend Policy
22 – 38
M&M’s Dividend Irrelevance Theorem
Internal Funds, Investment, and Dividends
FIGURE

$11,976 Million
Rate of Return

WACC
Internal Funds Available
OPTIMAL INVESTMENT
$177,607 Million

MC=MR

38

The “Bird-in-the-Hand” Argument
M&M’s Assumptions Relaxed
Risk is a real world factor.
Firm’s that reinvest free cash flow, put that money at risk – there is no certainty of investment outcome – those forfeit dividends that are reinvested…could be lost!
Remember the two-stage DDM?

The “Bird-in-the-Hand” Argument
M&M’s Assumptions Relaxed
Myron Gordon suggests that dividends are more stable than capital gains and are therefore more highly valued by investors.
This implies that investors perceive non-dividend paying firms to be riskier and apply a higher discount rate to value them causing the share price to fall.
The difference between the M&M and Gordon arguments are illustrated in Figure 2 on the following slide:
M&M argue that dividends and capital gains are perfect substitutes

CHAPTER 22 – Dividend Policy
22 – 41
The “Bird-in-the-Hand” Argument
M&M versus Gordon’s Bird in the Hand Theory

FIGURE 2

Gordon
OPTIMAL INVESTMENT
M&M

41

The “Bird-in-the-Hand” Argument
M&M versus Gordon’s Bird in the Hand Theory
Conclusions:
Firms cannot change underlying operational characteristics by changing the dividend
The dividend should reflect the firm’s operations through the residual value of dividends

Dividend Policy in Practice
Firms smooth their dividends
Firms tend to hold dividends constant, even in the face of increasing after-tax profit
Firms are very reluctant to cut dividends

Relaxing the M&M Assumptions
Welcome to the Real World!
Dividends and Signalling
Under conditions of information asymmetry, shareholders and the investing public watch for management signals (actions) about what management knows.
Management is therefore very cautious about dividend changes…they don’t want to create high expectations (this is the reason for extra or special dividends) that will lead to disappointment, and they don’t want to have investors over react to negative earnings surprises (the sticky dividend phenomenon)
(The Signalling Model is explained in Figure 3 found on the next slide.)

Relaxing the M&M Assumptions
The Signalling Model
FIGURE 3
et
$
1 2 3 Time

et*
dt*
dt

45

Relaxing the M&M Assumptions
Welcome to the Real World!
Agency Theory
Investors are wary of senior management so they seek to put controls in place.
There is a fear that managers may waste corporate resources by over-investing in low or poor NPV projects.
Gordon Donaldson argued this is the reason for the pecking order managements tend to use when raising capital
Shareholders would prefer to receive a dividend and then have management file a prospectus, justifying investment in projects and the need to raise the capital that was just distributed as a dividend.
Shareholders are prepared to pay those additional underwriting costs as an agency cost incurred to monitor and assess management.

46

Relaxing the M&M Assumptions
Welcome to the Real World!
Taxes and the Clientele Effect
Table (on the following slide) illustrates that different classes of investors face different tax brackets
Preference for dividends versus capital gains income depends on the province of residence and taxable income level leading to tax clienteles.
High income earners tend to prefer capital gains (there is an additional tax incentive for such individuals in that they can choose the timing of the sale of their investment…remember only ‘realized’ capital gains are subject to tax
Low income earners tend to prefer dividends
Conclusion – firm’s should not change dividend policy drastically since it upsets the existing ownership base.

48

Relaxing the M&M Assumptions
Taxes

49

Share Repurchases
Simply another form of payout policy.
An alternative to cash dividend where the objective is to increase the price per share rather than paying a dividend.
Since there are rules against improper accumulation of funds, firms adopt a policy of large infrequent share repurchase programs.

Share Repurchases
reasons for use:
Offsetting the exercise of executive stock options
Leveraged recapitalizations
Information or signalling effects
Repurchase dissident shares
Removing cash without generating expectations for future distributions
Take the firm private.

Disadvantages of Share Repurchases
they are usually done on an irregular basis, so a shareholder cannot depend on income from this source.
if regular repurchases are made, there is a good chance that Revenue Canada will rule that the repurchases were simply a tax avoidance scheme (to avoid tax on dividends) and will assess tax
there may be some agency problems – if managers have inside information, they are purchasing from shareholders at a price less than the intrinsic value of the shares.

Methods of Share Repurchases
tender offer:
this is a formal offer to purchase a given number of shares at a given price over current market price.
open market purchase:
the purchase of shares through an investment dealer like any other investor
this is not designed for large block purchases.
private negotiation with major shareholders
In any repurchase program, the securities commission requires disclosure of the event as well as all other material information through a prospectus.

Repurchase Example
Current EPS
= [total earnings] / [# of shares] = $4.4 m / 1.1 m = $4.00
Current P/E ratio
= $20 / $4 = 5X
EPS after repurchase of 100,000 shares
= $4.4 m / 1.0 = $4.40
Expected market price after repurchase:
= [p/e][EPSnew] = [5][$4.40] = $22.00 per share

Effects of A Share Repurchase
EPS should increase following the repurchase if earnings after-tax remains the same
a higher market price per outstanding share of common stock should result
stockholders not selling their shares back to the firm will enjoy a capital gain if the repurchase increases the stock price.

Advantages of Share Repurchases
signal positive information about the firm’s future cash flows
used to effect a large-scale change in the firm’s capital structure
increase investor’s return without creating an expectation of higher future cash dividends
reduce future cash dividend requirements or increase cash dividends per share on the remaining shares, without creating a continuing incremental cash drain
capital gains treated more favourably than cash dividends for tax purposes.

Disadvantages of Share Repurchases
signal negative information about the firm’s future growth and investment opportunities
the provincial securities commission may raise questions about the intention
share repurchase may not qualify the investor for a capital gain

Borrowing to Pay Dividends
Is this legal? is it possible to do?
Yes
the firm must have the ability and capacity to borrow
the firm must have sufficient retained earnings to allow it to pay the dividend
the firm must have sufficient cash on hand to pay the cash dividend
the firm must NOT have agreed to any limitations on the payment of dividends under the bond indenture.
Why?
A possible answer is to signal to the market that the board is confident about the firm’s ability to sustain cash dividends into the future.

CHAPTER 22 – Dividend Policy
22 – 59
Assets: Liabilities:
Cash 10 Long-term Debt 0
Fixed Assets 140 Common Stock 50
Retained Earnings 100
Total Assets $150 Total Claims $150

After Borrowing…before cash dividend:
Assets: Liabilities:
Cash 60 Long-term Debt 50
Fixed Assets 140 Common Stock 50
Retained Earnings 100
Total Assets $200 Total Claims $200
Before Borrowing:
0% Debt
25% Debt
Borrowing to Pay Dividends
An Example

59

CHAPTER 22 – Dividend Policy
22 – 60
Assets: Liabilities:
Cash 60 Current liabilities 50
Fixed Assets 140 Long-term Debt 50
Common Shares 50
Retained earnings 50
Total Assets $200 Total Claims $200

After Cash Dividend payment of $50
Assets: Liabilities:
Cash 10 Long-term Debt 50
Fixed Assets 140 Common Stock 50 Retained earnings 50
Total Assets $150 Total Claims $150
After Dividend Declaration…before date of payment.
50% Debt
33% Debt
Borrowing to Pay Dividends
An Example …

60

The foregoing example illustrates:
it is possible for a firm with ‘borrowing capacity’ to borrow funds to pay cash dividends.
this is not possible if the lenders insist on restrictive covenants that limit or prevent this from occurring.
the cash for the dividend must be present in the cash account.
payment of dividends reduces both the cash account on the asset side of the balance sheet as well as the retained earnings account on the ‘claims’ side of the balance sheet.
in the absence of restrictions, it is possible to transfer wealth from the bondholders to the stockholders. (Bondholders in this example may have thought their firm would have only a 25% debt ratio….after the dividend the debt ratio rose to 33% and the equity cusion dropped from 75% to 66%.)
Borrowing to Pay Dividends
An Example

61

Summary and Conclusions
In this chapter you have learned:
About the different types of dividends including, regular and special cash dividends, stock dividends, and share repurchases.
M&M’s dividend irrelevance argument and the real world factors such as transactions costs, taxes, clientele effects and signalling tend to favour real-world dividend relevance
Tax motives and other reasons explain why firms might want to repurchase their shares.

Concept Review Questions
Define four important dates that arise with respect to dividend payments.
Past year Qs

Leasing
Types of Leases
The Basics
A lease is a contractual agreement between a lessee and lessor.
The agreement establishes that the lessee has the right to use an asset and in return must make periodic payments to the lessor.
The lessor is either the asset’s manufacturer or an independent leasing company.

Operating Leases
Usually not fully amortized. This means that the payments required under the terms of the lease are not enough to recover the full cost of the asset for the lessor.
Usually require the lessor to maintain and insure the asset.
Lessee enjoys a cancellation option. This option gives the lessee the right to cancel the lease contract before the expiration date.

Financial Leases
The exact opposite of an operating lease.
Do not provide for maintenance or service by the lessor.
Financial leases are fully amortized.
The lessee usually has a right to renew the lease at expiry.
Generally, financial leases cannot be cancelled, i.e., the lessee must make all payments or face the risk of bankruptcy.

Sale and Lease-Back
A particular type of financial lease.
Occurs when a company sells an asset it already owns to another firm and immediately leases it from them.
Two sets of cash flows occur:
The lessee receives cash today from the sale.
The lessee agrees to make periodic lease payments, thereby retaining the use of the asset.

Leveraged Leases
A leveraged lease is another type of financial lease.
A three-sided arrangement between the lessee, the lessor, and lenders.
The lessor owns the asset and for a fee allows the lessee to use the asset.
The lessor borrows to partially finance the asset.
The lenders typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default by the lessee.

Accounting and Leasing
In the old days, leases led to off-balance-sheet financing.
In 1979, the Canadian Institute of Chartered Accountants implemented new rules for lease accounting according to which financial leases must be “capitalized.”
Capital leases appear on the balance sheet—the present value of the lease payments appears on both sides.

Accounting and Leasing
Balance Sheet
Truck is purchased with debt
Truck $100,000 Debt $100,000
Land $100,000 Equity $100,000
Total Assets $200,000 Total Debt & Equity $200,000
Operating Lease
Truck Debt
Land $100,000 Equity $100,000
Total Assets $100,000 Total Debt & Equity $100,000
Capital Lease
Assets leased $100,000 Obligations under capital lease $100,000
Land $100,000 Equity $100,000
Total Assets $200,000 Total Debt & Equity $200,000

Capital Lease
A lease must be capitalized if any one of the following is met:
The present value of the lease payments is at least 90-percent of the fair market value of the asset at the start of the lease.
The lease transfers ownership of the property to the lessee by the end of the term of the lease.
The lease term is 75-percent or more of the estimated economic life of the asset.
The lessee can buy the asset at a bargain price at expiry.

Taxes and Leases
The principal benefit of long-term leasing is tax reduction.
Leasing allows the transfer of tax benefits from those who need equipment but cannot take full advantage of the tax benefits of ownership to a party who can.
If the CCRA (Canada Customs and Revenue Agency) detects one or more of the following, the lease will be disallowed.
The lessee automatically acquires title to the property after payment of a specified amount in the form of rentals.
The lessee is required to buy the property from the lessor.
The lessee has the right during the lease to acquire the property at a price less than fair market value.

The Cash Flows of Leasing
Consider a firm, ClumZee Movers, that wishes to acquire a delivery truck.
The truck is expected to reduce costs by $4,500 per year.
The truck costs $25,000 and has a useful life of five years.
If the firm buys the truck, they will depreciate it straight-line to zero.
They can lease it for five years from Tiger Leasing with an annual lease payment of $6,250.

The Cash Flows of Leasing
Cash Flows: Buy
Year 0 Years 1-5
Cost of truck –$25,000
After-tax savings 4,500×(1-.34) = $2,970
Depreciation Tax Shield 5,000×(.34) = $1,700
–$25,000 $4,670
Cash Flows: Lease
Year 0 Years 1-5
Lease Payments –6,250×(1-.34) = –$4,125
After-tax savings 4,500×(1-.34) = $2,970
–$1,155

Cash Flows: Leasing Instead of Buying
Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = –$5,825

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The Cash Flows of Leasing
Cash Flows: Leasing Instead of Buying
Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = –$5,825
Cash Flows: Buying Instead of Leasing
Year 0 Years 1-5
–$25,000 $4,670 –$1,155 = $5,825
However we wish to conceptualize this, we need to have an interest rate at which to discount the future cash flows.
That rate is the after-tax rate on the firm’s secured debt.

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NPV Analysis of the Lease-vs.-Buy Decision
A lease payment is like the debt service on a secured bond issued by the lessee.
In the real world, many companies discount both the depreciation tax shields and the lease payments at the after-tax interest rate on secured debt issued by the lessee.
The various tax shields could be riskier than lease payments for two reasons:
The value of the CCA tax benefits depends on the firm’s ability to generate enough taxable income.
The corporate tax rate may change.

NPV Analysis of the Lease-vs.-Buy Decision

NPV Buying Instead of Leasing
Year 0 Years 1-5
-$25,000 $4,670 – $1,155 = $5,825
There is a simple method for evaluating leases: discount all cash flows at the after-tax interest rate on secured debt issued by the lessee. Suppose that rate is 5-percent.
NPV Leasing Instead of Buying
Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = -$5,825

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77

Reasons for Leasing
Good Reasons
Taxes may be reduced by leasing.
The lease contract may reduce certain types of uncertainty.
Transactions costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset.
Bad Reasons
Leasing and accounting income
100% financing

Summary and Conclusions
There are three ways to value a lease.
Use the real-world convention of discounting the incremental after-tax cash flows at the lessor’s after-tax rate on secured debt.
Calculate the increase in debt capacity by discounting the difference between the cash flows of the purchase and the cash flows of the lease by the after-tax interest rate. The increase in debt capacity from a purchase is compared to the extra outflow at year 0 from a purchase.
Use APV (presented in the appendix to this chapter).
They all yield the same answer.
The easiest way is the least intuitive.

Capital Structure
capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities.
A firm’s capital structure is then the composition or ‘structure’ of its liabilities.
In reality, capital structure may be highly complex and include dozens of sources.
An optimal capital structure: maximizes the value of the firm.
The impact of capital structure on value depends upon the effect of debt on:
WACC
FCF

Modigliani-Miller theorem,
The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value.
perfect capital market;
-no transaction or bankruptcy costs;
-perfect information
– firms and individuals can borrow at the same interest rate;
-no taxes;
-and investment decisions are not affected by financing decisions.

Capital structure in the real world
The theories below try to address some of these imperfections, by relaxing assumptions made in the M&M model.
1. Trade-off theory – bankruptcy cost Vs. Tax benefit but it (doesn’t explain differences within the same industry).
2. Pecking order theory -companies prioritize their sources of financing (from internal financing to equity) / costs of asymmetric information
3. Agency Costs – Underinvestment problem / Free cash flow management issues

Capital structure Ratios
Capital structure ratios compare a company’s debt and its equity.
Debt and equity are the two methods companies acquire capital. Debt refers to money borrowed, while equity refers to money invested or earned.
Financial ratios that measure capital structure include
the debt-to-equity ratio
the ratio of fixed assets to long-term liabilities.
Gearing ratio
EPS and PE ratio
Capital gearing ratio = (Capital Bearing Risk) : (Capital not bearing risk)

Factors to be considered
Debt ratios of other firms in the industry.
Pro forma coverage ratios at different capital structures under different economic scenarios.
Lender and rating agency attitudes
(impact on bond ratings).
Reserve borrowing capacity.
Effects on control.
Type of assets: Are they tangible, and hence suitable as collateral?
Tax rates.

why investors should establish portfolios
This is neatly captured in the old saying ‘don’t put all your eggs in one basket’.

The logic
The logic is that an investor who puts all of their funds into one investment risks everything on the performance of that individual investment. A wiser policy would be to spread the funds over several investments (establish a portfolio) so that the unexpected losses from one investment maybe offset to some extent by the unexpected gains from another.

EXPECTED RETURN
Investors receive their returns from shares in the form of dividends and capital gains/ losses.

formula
The formula for calculating the annual return on a share is:
Annual return = D 1 + (P1 – P 0)/P0
where:
D1 = dividend per share
P1 = share price at the end of a year
P0 = share price at the start of a year.

Example
Suppose that a dividend of 5p per share was paid during the year on a share whose value was 100p at the start of the year and 117p at the end of the year:
Annual return =
5 + (117 – 100)/100 × 100 = 22%

dividend yield and capital gain
The total return is made up of a 5% dividend yield and a 17% capital gain. We have just calculated a historical return, on the basis that the dividend income and the price at the end of year one is known .

The future expected return
Calculating the future expected return is a lot more difficult because we will need to estimate both next year ’s dividend and the share price in one year ’s time. Analysts normally consider the different possible returns in alternate market conditions and try and assign a probability to each.

Example 1 shows the calculation of the
expected return for A plc.
The current share price of A plc is 100p and the estimated returns for next year are shown .

The investment in A plc is risky.
Risk refers to the possibility of the actual return varying from the expected return, ie the actual return may be 30% or 10% as opposed to the expected return of 20%.

Required return
The required return consists of two elements,
which are:
Required return = Risk-free return + Risk premium

Risk-free return
The risk-free return is the return required by investors to compensate them for investing in a risk-free investment.

The risk-free return compensates investors for inflation and consumption preference, ie the fact that they are deprived from using their funds while tied up in the investment.
The return on treasury bills is often used as a surrogate for the risk-free rate.

Risk premium
Risk simply means that the future actual return may vary from the expected return.
If an investor undertakes a risky investment he needs to receive a return greater than the risk-free rate in order to compensate him.
The more risky the investment the greater the compensation required.
This is not surprising and it is what we would expect from risk averse investors.

The Barclay Capital Equity Gilt Study 2003
The Barclay Capital Study calculated the average return on treasury bills in the UK from 1900 to 2002 as approximately 6%.
It also calculated that the average return on the UK stock market over this period was 11%.
Thus if an investor had invested in shares that had the same level of risk as the market, he would have to receive an extra 5% of return to compensate for the market risk.
Thus 5% is the historical average risk in the UK.

The required return calculation
Suppose that Joe, the investor believes that the shares in A plc are twice as risky as the market and that the use of long-term averages are valid.
Calculate the required return

The required return may be calculated as follows:
Required return of A plc = Risk free + Risk premium
16% = 6% + (5% × 2)
Thus 16% is the return that Joe requires to compensate for the perceived level of risk in A plc, i.e. it is the discount rate that he will use to appraise an investment in A plc.

THE NPV CALCULATION
Suppose that Joe is considering investing £100 in A plc with the intention of selling the shares at the end of the first year.
Assume that the expected return will be 20% at the end of the first year.
Given that Joe requires a return of 16% should he invest?

THE NPV CALCULATION
Cash flows year 0 (100), year end 120
Discount factor – 16%, year 0 = 1, year 1= 0.862
(100) 103
NPV=3

Decision criteria:
accept if the NPV is zero or positive.
The NPV is positive, thus Joe should invest.
A positive NPV opportunity is where the expected return more than compensates the investor for the perceived level of risk, i.e. the expected return of 20% is greater than the required return of 16%.

An NPV calculation compares the expected and required returns in absolute terms.

Calculation of the risk premium
Calculating the risk premium is the essential component of the discount rate.
This in turn makes the NPV calculation possible.

To calculate the risk premium, we need to be able to define and measure risk.

THE STUDY OF RISK
The definition of risk that is often used in finance literature is based on the variability of the actual return from the expected return.
Statistical measures of variability are the variance and the standard deviation (the square root of the variance).

The variance and standard deviation of the returns.
Example 1 – A plc,
Market conditions [Actual return Probability – expected return]2
Boom [30 – 20]2 0.1 10
Normal [20 – 20]2 0.8 0
Recession [10 – 20]2 0.1 10
Variance σ2 20
Standard deviation σ = 4.47

The variance
The variance of return is the weighted sum of squared deviations from the expected return.
The reason for squaring the deviations is to ensure that both positive and negative deviations contribute equally to the measure of variability.
Thus the variance represents ‘rates of return squared’.

The standard deviation
Standard deviation is the square root of the variance, its units are in rates of return.
As it is easier to discuss risk as a percentage rate of return, the standard deviation is more commonly used to measure risk.

A choice of investing in either A plc or Z plc,
Shares in Z plc have the following returns and associated probabilities:
Probability Return %
0.1 35
0.8 20
0.1 5

A choice of investing in either A plc or Z plc,
Let us then assume that there is a choice of investing in either A plc or Z plc, which one should we choose?
To compare A plc and Z plc, the expected return and the standard deviation of the returns for Z plc will have to be calculated.

Calculation
The expected return is: (0.1) (35%) + (0.8)(20%) + (0.1) (5%) = 20%
The variance is: = σ2, z = (0.1) (35% – 20%)2 + (0.8) (20% – 20%)2 + (0.1) (5% – 20%)2 = 45%
The standard deviation is: = σz = 6.71%

Summary table
Investment Expected return Standard deviation
A plc 20% 4.47%
Z plc 20% 6.71%
Given that the expected return is the same for both companies, investors will opt for the one that has the lowest risk, ie A plc.

The decision
The decision is equally clear where an investment gives the highest expected return for a given level of risk.
However, these only relate to specific instances where the investments being compared either have the same expected return or the same standard deviation.
Where investments have increasing levels of return accompanied by increasing levels of standard deviation, then the choice between investments will be a subjective decision based on the investor ’s attitude to risk.

RISK AND RETURN ON TWO-ASSET
PORTFOLIOS
So far we have confined our choice to a single investment. Let us now assume investments…
The risk-return relationship will now be measured in terms of the portfolio’s expected return and the portfolio’s standard deviation.
Information about four investments: A plc, B plc, C plc, and D plc.

Assumption
Assume that our investor, Joe has decided to construct a two-asset portfolio and that he has already decided to invest 50% of the funds in A plc.
He is currently trying to decide which one of the other three investments into which he will invest the remaining 50% of his funds.

The expected return of a two-asset portfolio
The expected return of a portfolio (Rport) is simply a weighted average of the expected returns of the individual investments.

Return on investments (%)
Market conditions Probability A plc B plc C plc D plc
Boom 0.1 30 30 10 10
Normal 0.8 20 20 20 22.5
Recession 0.1 10 10 30 10
Expected return 20 20 20 20
Standard deviation 4.47 4.47 4.47 4.47

E.g. 3 – Return on investments (%)
Market Conditions A plc B plc Portfolio A + B
Boom 30 30 30
Normal 20 20 20
Recession 10 10 10

Portfolio Expected Return calculation
Rpor t = x.RA + (1 – x).RB
x = the proportion of funds invested in A
(1 – x) = the proportion of funds invested in B
RA + B = 0.5 × 20 + 0.5 × 20 = 20
RA + C = 0.5 × 20 + 0.5 × 20 = 20
RA + D = 0.5 × 20 + 0.5 × 20 = 20

Portfolio Expected Return
Given that the expected return is the same for all the portfolios, Joe will opt for the portfolio that has the lowest risk as measured by the portfolio’s standard deviation.

The standard deviation of a two-asset portfolio
We can see that the standard deviation of all the individual investments is 4.47%.
Intuitively, we probably feel that it does not matter which portfolio Joe chooses, as the standard deviation of the portfolios should be the same (because the standard deviations of the individual investments are all the same).

The standard deviation of a two-asset portfolio
However, the above analysis is flawed, as the standard deviation of a portfolio is not simply the weighted average of the standard deviation of returns of the individual investments but is generally less than the weighted average.

So what causes this reduction of risk?
What is the missing factor?
The missing factor is how the returns of the two investments co-relate or co-vary, i.e. move up or down together. There are two ways to measure co variability.
The first method is called the covariance and the second method is called the correlation coefficient.
Before we perform these calculations let us review the basic logic behind the idea that risk may be reduced depending on how the returns on two investments co-vary.

Portfolio A+B – perfect positive correlation
The returns of A and B move in perfect lock step, (when the return on A goes up to 30%, the return on B also goes up to 30%, when the return on A goes down to 10%, the return on B also goes down to 10%), ie they move in the same direction and by the same degree.

Example 3.
This is the most basic possible example of perfect positive correlation , where the forecast of the actual returns are the same in all market conditions for both investments and thus for the portfolio (as the portfolio return is simply a weighted average).

Example 3.
Hence there is no reduction of risk. The portfolio’s standard deviation under this theoretical extreme of perfect positive correlation is a simple weighted average of the standard deviations of the individual investments:
σpor t (A,B) = 4.47 × 0.5 + 4.47 × 0.5
= 4.47

Portfolio A+C – perfect negative correlation
The returns of A and C move in equal but opposite ways (when the return on A goes up to 30%, the return on C goes down to 10%,
when the return on A goes down to 10%, the return on C goes up to 30%). See Example 4.

EXAMPLE 4-Return on investments (%)
Market Conditions A plc C plc Portfolio A + C
Boom 30 10 20
Normal 20 20 20
Recession 10 30 20

Portfolio A+C – perfect negative correlation
This is the utopian position, i.e. where the unexpected returns cancel out against each other resulting in the expected return. If the forecast actual return is the same as the expected return under all market conditions, then the risk of the portfolio has been reduced to zero.
This is the only situation where the portfolio’s standard deviation can be calculated as follows:
σport (A,C) = 4.47 × 0.5 – 4.47 × 0.5 = 0

EXAMPLE 5
Market Conditions A plc D plc Portfolio A + D
Boom 30 10 20
Normal 20 22.5 21.25
Recession 10 10 10

Market conditions
The forecast actual return is the same as the expected return under normal market conditions and almost the same under boom market conditions (20 v 21.25).
Therefore, we can say that the forecast actual and expected returns are almost the same in two out of the three conditions.

Market conditions
This compares with only one condition when there is perfect positive correlation (no reduction of risk) and all three conditions when there is perfect negative correlation (where risk may be eliminated).
Therefore, when there is no correlation between the returns on investments this results in the partial reduction of risk.

Measuring co-variability
Co-variability can be measured in absolute terms by the covariance or in relative terms by the correlation coefficient.

The covariance
A positive covariance indicates that the returns move in the same directions as in A and B.
A negative covariance indicates that the returns move in opposite directions as in A and C.
A zero covariance indicates that the returns are independent of each other as in A and D.

The correlation coefficient
Using the covariance formula, we can easily determine the formula for the correlation coefficient.
ρA,B = Cov a,b/σaσb
The correlation coefficient as a relative measure of co-variability expresses the strength of the relationship between the returns on two investments.
It is strictly limited to a range from -1 to +1. See Example 6.

Reality
In reality, the correlation coefficient between returns on investments tends to lie between 0 and +1.
It is the norm in a two-asset portfolio to achieve a partial reduction of risk (the standard deviation of a two-asset portfolio is less than the weighted average of the standard deviation of the individual investments).

Reality
Therefore, we will need a new formula to calculate the risk (standard deviation of returns) on a two -asset portfolio. The formula will obviously take into account the risk (standard deviation of returns) of both investments but will also need to incorporate a measure of co-variability as this influences the level of risk reduction .

The formulae for the standard deviation of
returns of a two-asset portfolio
Version 1
Version 2

Summary table
Investment Expected return (%) Standard deviation (%)
Port A + B 20 4.47
Port A + C 20 0.00
Port A + D 20 3.16

Summary
A + C is the most efficient portfolio as it has the lowest level of risk for a given level of return.
Perfect negative correlation does not occur between the returns on two investments in the real world, ie risk cannot be eliminated, although it is useful to know the theoretical extremes.
However, as already stated, in reality the correlation coefficients between returns on investments tend to lie between 0 and +1.

Investments in different industries
Indeed, the returns on investments in the same industry tend to have a high positive correlation of approximately 0.9, while the returns on investments in different industries tend to have a low positive correlation of approximately 0.2.
Thus investors have a preference to invest in different industries thus aiming to create well diversified portfolio, ensuring that the maximum risk reduction effect is obtained.

Initial understanding
Based on our initial understanding of the risk-return relationship, if investors wish to reduce their risk they will have to accept a reduced return. However, portfolio theory shows us that it is possible to reduce risk without having a consequential reduction in return.

Initial understanding
This can be proved quite easily, as a portfolio’s expected return is equal to the weighted average of the expected returns on the individual investments, whereas a portfolio’s risk is less than the weighted average of the risk of the individual investments due to the risk reduction effect of diversification caused by the correlation coefficient being less than +1.

By investing in just two investments we
can reduce the risk
We can see from Portfolio A + D above where the correlation coefficient was zero, that by investing in just two investments we can reduce the risk from 4.47% to just 3.16% (a reduction of 1.31 percentage points).
Imagine how much risk we could have diversified away, had we created a large portfolio of say 500 different investments or indeed 5,000 different investments.

10 KEY POINTS TO REMEMBER
1 The expected return on a share consists of a dividend yield and a capital gain/loss in percentage terms.
2 The required return on a risky investment consists of the risk-free rate (which includes inflation) and a risk premium.
3 Total risk is normally measured by the standard deviation of returns (σ).

KEY POINTS TO REMEMBER
4 Portfolio theory demonstrates that it is possible to reduce risk without having a consequential reduction in return, i.e. the portfolio’s expected return is equal to the weighted average of the expected returns on the individual investments, while the portfolio risk is normally less than the weighted average of the risk of the individual investments.

KEY POINTS TO REMEMBER
5 The extent of the risk reduction is influenced by the way the returns on the investments co-vary. Co-variability is normally measured in the exams by the correlation coefficient.
6 In reality, the correlation coefficient between returns on investments tend to lie between 0 and +1. Thus total risk can only be partially reduced, not eliminated.

KEY POINTS TO REMEMBER
7 A portfolio’s total risk consists of unsystematic and systematic risk.
However, a well-diversified portfolio only suffers from systematic risk, as the unsystematic risk has been diversified away.
8 An investor who holds a well-diversified portfolio will only require a return for systematic risk. Thus their required return consists of the risk-free rate plus a systematic risk premium.

KEY POINTS TO REMEMBER
9 Investors who have well-diversified portfolios dominate the market.
Thus the market only gives a return for systematic risk.
10 The preparation of a summary table and the identification of the most efficient portfolio (if possible) is an essential exam skill.

The Efficient Market Hypothesis
What is Efficient Market?

A market where there are large numbers of rational profit maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants.

The Efficient Market Hypothesis
Efficient Market Hypothesis
• Securities prices always fully reflect all available, relevant information about the security.

Note the key words of the definition: “always,” “fully,” and “information.”
• Two important questions – What is all available information? – What does it mean to “Reflect all available information?”

The Efficient Market Hypothesis
All available information
• Past Price : Weak Form
• All public information : Semi Strong Form – Past price, news etc..
• All information including inside information : Strong Form

Forms of the EMH
Weak Information Set
The relevant information is historical prices and other trading data such as trading volume.
If the markets are weak form efficient, use of such information provides no benefit “at the margin.”
Semi-strong Information set :
The relevant information is “all publicly available information, including past price and volume data.”
If the markets are semi-strong form efficient, then studying past price and volume data & studying earnings and growth forecasts provides no net benefit in predicting price changes at the margin.

Forms of the EMH
Strong information set:
The relevant information is “all information” both public and private or “inside” information.
If the markets are strong form efficient, use of any information (public or private) provides no benefit at the margin.
SEC Rule 10b-5 limits trading by corporate insiders, (officers, directors and major shareholders). Inside trading must be reported.

Forms of the EMH
Relationships between forms of the EMH

Revision –Investment analysis
Explain the usefulness of financial derivatives to business organization?
What is the difference between money market and capital market?
What is meant by market portfolio?
Define Security Market Line (SML)?
What is the advantage of using margin facility in share trading to an investor?

Revision –Exam style questions
Which security is an example of a hybrid security?
A. Ordinary share
B. Commercial paper
C. Bond
D. Convertible share

Revision –Investment analysis
The share of Medex Ltd. is currently trading at $3.35. You expect the share price to go up to $3.80 in the next few days.
What type of order would you give to your broker to purchase the shares now?
A. Margin order
B. Market order
C. Stop-loss order
D. Limit order

Revision –Investment analysis
Which is the definition for an optimal portfolio?
A. The portfolio that has the lowest risk.
B. The portfolio that gives the best set of returns.
C. The portfolio that has the best set of returns within its specific risk level.
D. The portfolio that comprises of assets that are risk-free.

Revision –Investment analysis
Assuming a portfolio has 3 assets. How many variances and co-variances need to be calculated to compute the portfolio risk?
A. The number of variance is 3 and the number of covariance is also 3.
B. The number of variance is 6 and the number of covariance is 3.
C. The number of variance is 3 and the number of covariance is 6.
D. The number of variance is 6 and the number of covariance is also 6.

Revision –Investment analysis
A share has a beta of 1.1. The risk-free rate is 2.5% and the return on the market is 12%. The estimated return for the share is 14%.
Based on the Capital Asset Pricing Model (CAPM), what should an investor do?
A. Sell the share because the required return is 9.95%.
B. Sell the share because the required return is 16.5%.
C. Buy the share because the required return is 11.5%.
D. Buy the share because the required return is 12.95%.

Revision –Investment analysis
On 13 October 2010, Mr. Aik bought 2,000 shares of Zee Ltd. (Zee) at $3 per share. He receives a dividend of $0.06 per share on 15 December 2010 and later sold the shares for $3.30 per share on 29 December 2010.
 
Based on this information, how much is the dividend yield and capital gain of Zee’s shares?

Revision –Investment analysis
You have a portfolio consisting of 30% of Share Ae and the balance in Share Be. The beta coefficient of Share Ae and Share Be are 0.7 and 1.5 respectively. The risk-free rate is 4% and the expected market return is 12%.
What is your portfolio’s expected return?

Revision –Investment analysis
Mr. Kasim, an investor wishes to construct a portfolio consisting of 40% index share and 60% risk-free asset. The return on the risk-free asset is 2% and the expected return on the index share is 10%. If the standard deviation of returns on the index share is 8%, what is the expected standard deviation of the portfolio?

VALUATION PROCESS
There are two approaches to evaluate security. They are:
(a) Top to Bottom Approach
(b) Bottom Up Approach

Two approaches
In the Top to Bottom Approach, we begin by analysing the economy followed by the industry and then proceed to the firms in the industry.
In the Bottom Up Approach, analysts will try to identify firms that are undervalued. These firms were chosen without taking into account the economic situation and environment.

The basic valuation model
In the basic valuation model, we will look at:
(a) the Discounted Dividend Model
(b) the Constant Growth Model
(c) the Relationship between Share Price and Growth
(d) Multistage Growth

Discounted Dividend Model
In the Discounted Dividend Model, the share price is calculated by finding the present value of the predicted dividend and the predicted selling price of the share.

Constant Growth Model
If there is a rise in the dividend, the Discounted Dividend Model (formula 5.6) will have to be adjusted. For example, let’s assume the dividend of the company rise at a rate of 5% per year. So, if we take 3 years ahead, the dividend will be:
D1 = 0.50(1.05) = 0.525
D2 = 0.525(1.05) = 0.55125 or 0.05(1.05)2
D3 = 0.55125 (1.05) = 0.579 or 0.05(1.05)3

Constant Growth Model
Generally, the situation above is the same as:
D1 = D0(1+g)
D2 = D1(1+g) or D0 (1+g)2
D3= D2(1+g) or D1(1+g)3
Note: g is the growth rate.

PRICE EARNING (PE) RATIO MODEL
This model is also known as the earnings multiplier model. This is because the PE ratio is also known as the earning multiplier

ECONOMIC ANALYSIS
The prospect and future of a firm depends on the economic situation and business environment where the firm operates. Sometimes, the environment plays a great role on the performance of a firm.
In the evaluation of share prices, we have to evaluate the following economic and industrial situations:
(a) World Environment
(b) Domestic Economy
(c) Government Policy

INDUSTRY ANALYSIS
A simple definition of industry would be where a group of firms run the same business.
The purpose of industrial analysis is to understand the characteristics and structure of an industry.
There is a relationship between the character and structure of the industry with earnings that can be generated by firms in the industry.
In addition, a good firm usually is in a healthy and growing industry.

Sales Level and Industry Life Cycle

Competitive Structure in Industry
We can complete the industry analysis by examining the competitive structure of an industry.
The competitive structure can give insight into the earning of firms in the industry. The tighter the competition, the harder it will be for firms to get or maintain high profit.

Michael Porter, 5 forces model

COMPANY ANALYSIS
The objective of company analysis is to examine the nature and characteristics of a company.
SWOT analysis
It also involves examining the financial affairs of that company and determining the quality of its earnings.

Company analysis – 3 main financial statements
There are 3 main financial statements. They are:
(a) Balance Sheet which is a statement of the company’s assets, liabilities and stockholders’ equity.
(b) Income Statement which provide a summary of operating results.
(c) Statement of Cash Flows which provide a summary of cash flow and events that caused the cash position to change.

Financial statements

To increase earnings
There are two main strategies that a company can use in order to increase earnings.
They are:
Low Cost Strategy
Differentiation Strategy

Low Cost Strategy
Through this strategy the company endeavors to increase earnings by controlling costs.
This is only done when there is no opportunity to increase the price of the product.

Through this strategy the company will maintain its pricing policy, being confident that customers will not stop buying its products as it is perceived to be different and maybe of high quality.

Differentiation Strategy

Porters Generic Strategies

Fixed Income Security
A bond is a fixed income security which promises the investor a fixed stream of income for a specific time period.

CHARACTERISTICS OF BONDS
Maturity Period
Maturity Value
Coupon Rates
Floating Rate
Zero-coupon Bonds
Embedded Options

A floating rate indicates that the coupon rate may change according to the current interest rate. This current interest rate is dependent on the state of the economy.
Floating Rate

Embedded Options
Embedded options are specific characteristics stipulated in the bond indentures. These characteristics may include the option to call the bond at an earlier date before maturity.
Another type of option is when bonds can be converted to equity.
The latter is known as convertible bonds.

RISKS ASSOCIATED WITH BONDS
Interest Rate Risks
Reinvestment Risks
Redemption Risks (or Risk of a Call)
Default Risks
Inflation Risks
Liquidity Risks

BOND PRICING
The price/value of a bond is the present value of the expected cash flow from the bond.

The expected cash flows are the coupon payments and the face value.
These cash flows are then discounted at the required rate of return. This rate of return is normally called the yield of the bond.

Yield
This yield will depend vastly on the present market interest rate.
The present market interest rate will consider the risk-free rate of return and compensate its investor for the expected inflation.
Depending on the risk structure of the bond, the investor will also be compensated for additional risks faced throughout the life of the bond.
These risks may include liquidity, default or call risk which are normally specific to the security and firms.

Example
For example, a three-year RM1,000 bond with 10% coupon rate with a yield of 8% will have a value of:
Calculate…
Bond value = Present value of coupons + Present value of face value

Yield to Maturity
The rate of return earned from investing in bonds until the bond matures is termed as yield to maturity. Yield to maturity is also viewed as the promised rate of return accruing to investors.
However, investors can only expect the promised
return only if:
-the probability of the issuer defaulting in payment is zero; and
-the bond cannot be called before maturity.

Current Yield and Holding period return
The current yield of a bond is just the coupon payment divided by the price.
The holding period return equals income earned over a period (including capital gains or losses) as a percentage of the bond price at the start of the period.
The return can be calculated for any holding period based on the income generated over that period.

VOLATILITY IN BOND PRICES
The most important factor that influences the value of the bond is the market interest rate, which directly influences the yield that an investor is looking for.
Changes in this interest rate will affect the changes in the prices of bonds referred to as the volatility of bond prices.

Bond Prices Move Inversely with Interest
Rates
Generally, the price of bonds will move counter cyclical to the movements in interest rates. In other words, if the price of bonds has a tendency to fall, then it may be due to the upward movements of interest rates in the market.
Go through the exmple.

Volatility of Bond Prices for Longer Term
Maturity Bonds
Bonds with longer maturity periods, experience a more volatile price movement.
Table 7.1 shows that the rate of change in price is higher for a ten-year bond compared to a one-year bond.
Observe also that the rate of change in price reduces at a decreasing rate as the maturity period increases given the same level of interest rate.

Modified Duration
Modified duration is used to estimate the sensitivity of bond price as a result of a change in interest rates. It is calculated as:
Use the formula…
Where D* is the Macaulay Duration, i is the yield and n is the number of times the coupon rate is paid in a year.

If a bond is sold at RM1,000, and has Macaulay Duration of 5 years with a yield of 8% and pays the coupon twice in a year.
Calculate the modified duration.
Macaulay duration, named for Frederick Macaulay who introduced the concept, is the weighted average maturity of a bond
Modified Duration = Macaulay Duration /( 1 + y/n), where y = yield to maturity and n = number of discounting periods in year ( 2 for semi – ann pay bonds )

BOND PORTFOLIO MANAGEMENT
Investors can put their money in more than one bond to create a bond portfolio.
There are two types of management strategies namely the passive and active.
a) Passive Strategy;
-Buy and Hold Strategy
-Index Strategy
b) Active Strategy

Active Strategy
There are 4 sources of active management strategies namely:
Interest Rates Forecasting
Choosing a Sector
Movements Between Sector
Choosing a ‘Wrongly’ Priced Bond

Active Bond Management
In an active bond portfolio management, there is always a need to change the portfolio of bonds. A bond manager may have to switch from one sector to another, or from one bond to another. Sometimes there is no need to actually buy and sell bonds. Instead the manager can just enter a swap.
A swap is an exchange between one bond with another.
Go through the examples of swap…

Liability Funding Strategy
Apart from maximising profits given a specific level of risk, investments in bonds provide a buffer against contingent claims.
An insurance company for example, receiving premiums must be able to pay its customers’ claims at the end of the life of the insurance. This does not include any unexpected claims made by the clients.

Derivatives
This topic explains derivative securities: forward contracts, futures, and both call and put options.
Among the most innovative and most rapidly growing markets to be developed in recent years are the markets for financial futures and options. This is known as Derivative market.
Futures and options trading are designed to protect the investor against interest rate risks, exchange rate risks and price risks.
A derivative security is a financial contract written on an underlying asset.

The underlying asset
The underlying asset may be a share, Treasury Bill, foreign currency or even another derivative security.
Go through the examples…
Two types of derivative security, futures and options are actively traded on organized exchanges.
These contracts are standardized with regard to description of the underlying asset, the right of the owner, and the maturity date.

Not standardized contracts
Forward contracts, on the other hand, are not standardized; each contract is customized to its owner, and they are traded in what is called the inter-bank market.
Options can be found embedded in other securities, convertible bonds and extendible bonds being two such examples.
A convertible bond contains a provision that gives an option to convert the security into common share. As extendible bond contains a provision that gives an option to extend the maturity of the bond.

A forward contract and A futures contract
A forward contract is an agreement to buy or sell a specified quantity of asset at a specified price, with delivery at a specified time and place.
A futures contract is an agreement to buy or sell a specified quantity of an asset at a specified price, and at a specified time and place.
This part of the definition of a futures contract is identical to that of a forward contract. But futures contracts differ from forward contracts in four important ways.

The differences are
(a) Futures contracts allow participants to realise gains or losses on a daily basis, while forward contracts are cash settled only at delivery.
(b) Futures contracts are standardised with respect to the quality and the quantity of the asset underlying the contract, the delivery date or period, and the delivery place if there is physical delivery. In contrast, forward contracts are customised on all these dimensions to meet the needs of the two counterparties.

The differences are
Futures contracts are settled through a clearing house. The clearing house acts as a middleman. This minimises credit risk as the second party to a futures contract is always the clearing house.
Futures markets are regulated, while forward contracts are unregulated.
Now let’s look at an example of a futures contract.

Clearing House
This intervention of the clearing house means that the futures market has no counterparty risk.
If A plans to buy futures and B plans to sell futures, both parties will refer to the clearing house to fulfil their intentions. The clearing house is thus the counter party to every contract.
In this case, B is not the counter party to A.

Settlement Price
A futures contract is marked-to-market each day. When each trading is closed, the exchange will establish the closing price, which is the settlement price.
This settlement price is used to compute the investor’s position, whether a loss or a gain compared to the initial settlement price agreed upon at the inception of the contract.

Daily Margin
When a person enters into a futures contract, the individual is required to deposit funds in an account with the broker.
This account is called the margin account.
The exchange sets the minimum amount of margin required, but brokers can increase the margin if they feel that the risk of the investors’ default is increased.
This margin account may earn interest or may not earn interest.
The economic role of the margin account is to act as collateral to minimise the risk of default by either party in the futures contract.

Basis
The difference between the futures price and the spot price is known as the basis.
Basis t = F(t, T) -S(t).

Basis with respect to maturity

Using Futures for Hedging
Futures are usually used to hedge our investment or lock the price of the underlying asset.
Thus with hedging, we can construct a portfolio consisting of assets on both the spot and the derivatives markets.
It is important to understand that in the spot market, we are dealing with the price risk whereas in the futures market, we are faced with the basis risk.
Hedging is easier to understand by using examples

An options contract
An options contract is a contract where the writer (or seller) of the options gives the right to the buyer of the options, but not an obligation, to buy (call options) or sell (put options) to the writer ‘something’ (or the underlying) at a specified price, during a specified period (or specific time).

Options Moneyness
Options moneyness refers to a situation of whether it is profitable or not when we initiate the contract.
Moneyness is always viewed from the buyer or the long position viewpoint and not from the seller’s
view point.
Further, moneyness is obtained by comparing the exercise price with the spot value of the underlying asset.

Difference between Options and Futures
Contracts
Only the sellers (not the buyer) are obliged to buy or sell. The buyer of options need not buy or sell the underlying. In the futures contract, the buyers and sellers are obliged to buy or sell.
Thus, the main advantage of options is where the holder or the buyer of options will benefit from an upside benefit while limiting a downside loss.

Difference between Options and Futures
Contracts
The buyer of options must pay a fee or the price of the options to the seller to get the right. In the futures contract, there is no exchange of money when the contract is initiated.
The buyer of the options will decide on the price of the options to buy (for call options) or to sell (for put options) but can take the opportunity if the price of the options is low. In the futures contract, the price is already fixed and the parties to the contract cannot obtain profit or suffer losses from any price movement.

The Binomial Pricing Model
In this model, we will use a riskless portfolio (S – C) where we buy a unit of the underlying asset and sell a call option on the asset.
We further assume that there are only two possible states, market goes up or market goes down.

The assumptions used in this model
(a) There are no market frictions.
(b) Market participant entails no counterparty risk.
(c) Markets are competitive.
(d) Market participants prefer more wealth to less.
(e) There are no arbitrage opportunities.

The Black-Scholes Model
The Black-Scholes model for pricing put (p) and call (c) options is as follow:
Formula..
N(d1), N(d2), = the cumulative probability density. The value for N(.) is obtained
from a normal distribution that is tabulated in most statistics textbooks.
c = European call option price p
P = European put option price
S0 = Share price today
ST = Share price at option maturity
K = Strike price
T = Life of option
R = Risk-free rate for maturity T with cont comp
σ = Volatility of stock price

Topic 9
Mutual Fund Investment and Performance
Measurement

INTRODUCTION
This topic discusses another alternative approach to investment.
In this topic we will mainly discuss investment in mutual funds.
These mutual funds are basically portfolios that are managed by professional financial service organisations.
There are various kinds of funds available in the market.
To manage the portfolio, they will need to go through a process.
Finally, we will discuss performance evaluation of investments.

PROCESS OF PORTFOLIO MANAGEMENT

Asset Classification
Go through table 9.1 Asset Classification

INVESTORS’ OBJECTIVES
As we mentioned earlier, there are many investors with different risk tolerance.
Therefore, each major group of investors will have different portfolios that suit their needs.
The easiest way to determine an investors profile is by their age.
Table 9.1: Investors Needs Categorised According to Age

MUTUAL FUNDS: PROFESSIONALLY
MANAGED INVESTMENT PORTFOLIOS
A mutual fund is a financial service that collects money from shareholders and invests those funds on their behalf in a diversified portfolio of securities.

Characteristics of a Fund
An open-end fund is a type of fund where investors can buy shares from the fund.
A close-end fund is a fund where the number of shares is fixed. Investors can buy these shares initially from the fund, but they cannot sell it back to the fund.

Types of Funds
A growth fund’s specific objective is price appreciation. They target securities that will have long-term growth and capital gains and less on securities that give dividends or income.
Because of this, growth fund is risky. This type of fund is suitable for investors between the age group of 25 to 40. Their objective is to accumulate capital.

Types of Funds
Income funds emphasise on current income. They will invest in securities that provide stable income. Shares that provide high dividends are normally the
favourite choice as well as established blue chip companies.
They however do hold a few growth shares. Apart from shares, these types of funds also invest in
bonds.
The investment is less risky than growth shares.

Types of Funds
Index fund is a portfolio that replicates the combination of shares in an index.
For example the KLCI contain 100 shares, with predetermine weight for each share.
A portfolio can be built to replicate that index and use the same 100 shares and weights.

PERFORMANCE EVALUATION
Sharpe’s Measure
Sharpe’s Differential Return
Treynor’s Measure
Treynor’s Differential Return

Revision
1. Calculate the price of a bond with a per value of $1000 to be paid in ten years, a coupon rate of 10%, and a required yield of 12%. Assume that coupon payments made annually to bond holders and that the next coupon payment is expected in six months.
Calculate bond price…
2. Bond investors are exposed to interest rate risk and redemption risk.
Explain these risks…

Revision
What do you understand by the term top-down security analysis?
What is the consequence of an increase in interest rates?
What is the consequence of an increase in inflation?
What type of stocks the constant growth-model is best suited for?
Define an expansionary economic policy?

Revision
List some of the popular tools for technical analysis?
What is the implication of random walk hypothesis?
Describe the term “efficient market” ?
Briefly explain the main objectives of technical analysis?
Write the difference between ‘bond at a premium’ and ‘bond at a discount’?

Revision
What makes the bond prices to be most volatile?
Explain zero coupon bond?
What do you understand by the term T-Bill?
Explain what is a passive bond portfolio strategy with some examples?
Explain what is an active bond portfolio strategy with some examples?

Revision
What is an immunization strategy?
What is forward contract?
What is the main difference between future contract and forward contract?
How does a call option differ from a put option?
What is growth fund?

Revision
1. If XYZ Ltd. has a price earnings (P/E) ratio of 10 and an earnings per share (EPS) of $0.90, what is the current price of the share?
A. $11.11 per share.
B. $17.07 per share.
C. $09.00 per share.
 
D. $19.35 per share

Revision
2. A common stock is expected to pay a $0.85 annual dividend next year. If the dividends are expected to grow at 5% annually and the current stock price is $8.50, what is the required rate of return of the stock?
A. 15.00%
 
B. 8.91%
 
C. 10.73%
D. 11.38%

Revision
3. The constant-growth dividend valuation model is best suited for what type of stocks?
A. Stocks of new or emerging companies.
 
B. Small-cap stocks within growing industries.
 
C. Stocks of mature, dividend-paying companies.
D. Stocks of cyclical companies. 

Revision
4. Which one describes the point-and-figure approach in technical analysis?
 A. A point-and-figure chart depicts all of the closing prices of a stock over a period of time.
B. A point-and-figure chart consists of columns of X’s and O’s.
C. A typical bar chart uses vertical bars to show the closing price as well as the change in price from the previous day.
D. A sell signal occurs when prices break through a resistance line on a chart pattern.

Revision
5. If the market is strong-form efficient, what types of information will be reflected in the stock price?
 
A. Only historical information.
B. Only the information related to events that have already occurred.
 
C. All publicly known information related to past events and announced future events.
D. All information including both public and private.

Revision
6. Which one signals a strong market?
A. A greater number of advancing stocks than declining stocks and a greater volume of declining stocks than advancing stocks
B. A greater number of advancing stocks than declining stocks and a greater volume of rising stocks than declining stocks
C. A greater number of declining stocks than advancing stocks and a greater volume of rising stocks than declining stocks
D. A greater number of declining stocks than advancing stocks and a greater volume of declining stocks than advancing stocks

Revision
7. If investors can use past share prices to predict the future prices of the share, what does this indicate?
A. The security market is weak-form efficient
B. The security market is semi-strong efficient
C. The security market is strong-form efficient
D. The security market is inefficient

Revision
8. If you expect market interest rates to rise, what type of bonds should you purchase?
A. Short term, low coupon bonds.
B. Short term, high coupon bonds.
 
C. Long term, low coupon bonds.
 
D. Long term, high coupon bonds.

Revision
9. What is the current price of a bond if its par value is $1,000, coupon rate of 6% and pays interest semi-annually, matures in 10 years and has a yield-to-maturity of 7.1325%?
A.$567
B.$920
C.$1,030
D.$1,080

Revision
10. What does the duration of a bond measure?
A. The sensitivity of bond price against interest rate.
B. The average return of a bond.
C. The relationship between bond price and money supply.
D. The movement of bond price in response to changes in foreign exchange rate.

Revision
11. A $1,000 par value, 6% annual coupon bond matures in 3 years. The bond is currently priced at $993.35 and has a yield to maturity of 6.25%.
What is the duration of this bond?
A.1 year
B.2.67 years
C.2.83 years
D.2.89 years

Revision
12.What is the expression for put-call parity?
A.Stock price + Call Price = Put Price + Risk Free Bond Price
B.Stock price + Put Price = Call Price + Risk Free Bond Price
C.Put price + Call Price = Stock Price + Risk Free Bond Price
D.Stock price – Put Price = Call Price + Risk Free Bond Price

Revision
13. A stock currently sells for $15 per share. Assume that a call option on the stock with an exercise price $15.50 currently sells for $2.50.
 
What is the terminology used to describe this situation?
A.In-the-money
B.Out-of-the-money
C.At-the-money
D.Break-even point

Revision
14Ali owns a portfolio that has a standard deviation of 13%, a beta of 1.05, and a total return of 10.5%. The risk-free rate is 4% and the overall market return is 9.8%.
What is the value of Sharpe’s measure for Ali’s portfolio?
A.0.05
B.0.06
C.0.50
D.0.81

Revision
15.A portfolio has a total return of 10.5%, a beta of 0.72 and a standard deviation of 6.3%. Assume that the risk free rate is 3.8% and the market return is 12.4%.
What is Jensen’s measure of this portfolio’s performance?
A. 4.3%.
B. 7.9%.
C. 9.3%.
D. 0.5%

1996199719981999200020012002200320042005Average
%%%%%%%%%%
BCE4.693.422.521.411.073.153.994.084.294.443.31
Celestica Inc.00000000000.00
CIBC3.673.072.853.373.172.93.483.283.313.573.27
Cott Corporation0.230.530.5400000000.13
Kinross Gold Corporation00000000000.00
TransAlta Corporation6.225.164.525.355.594.064.925.735.884.515.19
Yellow Pages Income Fund7.347.097.22
Table 22-1 S&P/TSX 60 Index Dividend Yields
Sheet1

Table 22-1 S&P/TSX 60 Index Dividend Yields
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Average
% % % % % % % % % %
BCE 4.69 3.42 2.52 1.41 1.07 3.15 3.99 4.08 4.29 4.44 3.31
Celestica Inc. 0 0 0 0 0 0 0 0 0 0 0.00
CIBC 3.67 3.07 2.85 3.37 3.17 2.9 3.48 3.28 3.31 3.57 3.27
Cott Corporation 0.23 0.53 0.54 0 0 0 0 0 0 0 0.13
Kinross Gold Corporation 0 0 0 0 0 0 0 0 0 0 0.00
TransAlta Corporation 6.22 5.16 4.52 5.35 5.59 4.06 4.92 5.73 5.88 4.51 5.19
Yellow Pages Income Fund 7.34 7.09 7.22

0
1
P
D
0
0
1
P
P
P
–
Income Level
$25,000$50,000$75,000$100,000
British ColumbiaDividends2.526.1915.6920.04
Capital gains12.4515.5818.8520.35
AlbertaDividends3.638.0313.8313.83
Capital gains12.6316.0018.0018.00
OntarioDividends0.008.2420.7420.74
Capital gains10.6515.5821.7121.71
QuebecDividends5.9515.4226.0626.06
Capital gains14.3719.1922.8622.86
Nova ScotiaDividends0.008.7517.0519.06
Capital gains12.0218.4821.3422.63
Table 22-3 Individual Tax Rates (%) on Dividends and Capital Gains
Sheet1

Table 22-3 Individual Tax Rates (%) on Dividends and Capital Gains
Income Level $25,000 $50,000 $75,000 $100,000
British Columbia Dividends 2.52 6.19 15.69 20.04
Capital gains 12.45 15.58 18.85 20.35
Alberta Dividends 3.63 8.03 13.83 13.83
Capital gains 12.63 16.00 18.00 18.00
Ontario Dividends 0.00 8.24 20.74 20.74
Capital gains 10.65 15.58 21.71 21.71
Quebec Dividends 5.95 15.42 26.06 26.06
Capital gains 14.37 19.19 22.86 22.86
Nova Scotia Dividends 0.00 8.75 17.05 19.06
Capital gains 12.02 18.48 21.34 22.63

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WACC Example:

A fi

r

m is considerin

g

a new project which would be similar in terms of risk to its existing projects

.

The firm needs a discount rate for evaluation purposes. The firm has enough cash on hand to provide the necessary equity financing for the project. Also, the firm:
· has

1

,

0

00,000 common shares outstanding
· current price $

11

.

25

per share

· next year’s dividend expected to be $1 per share

· firm estimates dividends will grow at 5% per year after that

· flotation costs for new shares would be $0.10 per share

· has 150,000 preferred shares outstanding

· current price is $9.50 per share

· dividend is $0.95 per share

· if new preferred are issued, they must be sold at 5% less than the current market price (to ensure they sell) and involve direct flotation costs of $0.25 per share

· has a total of $10,000,000 (par value) in debt outstanding. The debt is in the form of bonds with 10 years left to maturity. They pay annual coupons at a coupon rate of 11.3%. Currently, the bonds sell at 106% of par value. Flotation costs for new bonds would equal 6% of par value.

The firm’s tax rate is 40%. What is the appropriate discount rate for the new project?

Solution:

Market value of common

=

11.25(1000000) =
$11,250,000

Market value of preferred = 9.50(150000) =
$1,425,000

Market value of debt = 10000000(1.06) =
$10,600,000

Total value of firm =

$23,275,000

Cost of common:

(Note: floatation costs ignored for common equity because cash on hand is enough to finance the project.)

1389

.
0

05

.
0
25
.
11
1
g

P

Div

r
1
=

+

=
+
=

Cost of preferred:

1083
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25
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0
)
05
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0
1
(
50
.
9
95
.
0
P
net
Div
r
=
–
–
=
=

Cost of debt:
Net price = 106% – 6% = 100% of par value
Net price = par
Therefore, cost of debt = coupon rate
r = 11.3%
Therefore:

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23275000
1425000
1389
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11250000
WACC
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