1.+CFP Study+Guide v2.0

Corporate Finance and
Planning
STUDY GUIDE
v2.0
CORPORATE FINANCE AND PLANNING
Copyright © 2019 Kaplan Higher Education Academy (KHEA). All rights reserved.
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Kaplan Desired Graduate Attributes
Through the reading of this module, Kaplan Higher

Education Academy (KHEA) intends to: Ability to communicate well: Graduates will
recognise the importance and value of communication
• Instill in students the value of lifelong and self- in the learning and professional environment. This
directed learning by stimulating intellectual attributed is demonstrated when students:
curiosity, creative and critical thinking and an
awareness of cultural diversity; • Create and present knowledge, arguments and
• Assist students in developing professional ideas confidently and effectively using a variety of
attributes, ethical values, social skills and methods and technologies;
strategies that will nurture success in both their • Recognise the wide range of possible audiences
professional and personal lives; for information and respond with communication
• Foster integrity, commitment, responsibility and a strategies appropriate to those audiences; and
sense of service to the community; • Work collaboratively with people from diverse
• Prepare students to meet the ever-changing backgrounds and be aware of the different roles
needs of their communities both now and in the of team members and to function within that team.
future; and
• Promote innovative and effective teaching. Independent and reflective practitioner
• Graduates will be able to work independently and
be self-directed learners with the capacity and
Culminating from these institutional values and
motivation for continued professional learning and
educational goals, Kaplan Higher Education
development; and
Academy’s Desired Graduate Attributes are:
• They will be able to critically reflect on their own
Inquiry and criticality: Graduates will be able to practice and evaluate and understand current
critically collect, evaluate and apply information and capacity and further development needs
data in order to make decisions in a wide variety of
professional situations. This attribute is demonstrated Embedded within the desired graduate attributes are
when students: the following skills:
• Conduct research.
• Undertake, evaluate and apply appropriate • Analyse, organise and present data and
research, theories, concepts and tools to information.
investigate problems and find solutions;
• Think and read critically.
• Exercise critical thinking and independent
• Make an oral presentation.
judgement to assess situations and determine
solutions; and • Intellectual curiosity and awareness of culture and
diversity.
• Have an informed respect for the principles,
methods, values and boundaries of their profession • Develop professional ethos and practice that will
and the capacity to question these. foster success in career and life.
• Meet the ever changing needs of communities
Ethicality and discernment: Graduates will be able to now and in the future.
assess situations and respond in an ethically, socially
and professionally responsible manner. This attributed
is demonstrated when students:
• Act responsibly, ethically and with integrity in their

profession;
• Hold personal values and beliefs and participate
in the broad discussion of these values and beliefs
while respecting the views of others;
• Understand the broad local and global economic,
political, social and environmental systems and
their impact as appropriate to their discipline and
profession; and
• Acknowledge personal responsibility for their own
judgments and behaviour
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Table of Contents
Kaplan Desired Graduate Attributes ii

Table of Contents iii
About this module iv
Scheme of Work vi
Assessment Matters viii
Topic 1
Introduction to Finance 1
Topic 2
Business Organizations 7
Topic 3
Time Value of Money (Part 1) 15
Topic 4
Time Value of Money (Part 2) 27
Topic 5
Capital Budgeting Evaluation Techniques 38
Topic 6
Capital Budgeting Cashflow Estimation 56
Topic 7
Working Capital Management 70
Topic 8
Working Capital – Financing Policies & Cash Budgeting 79
Topic 9
Capital Structure – Valuation, Cost of Capital 87
Topic 10
Capital Structure – WACC, M&M, Information Asymmetry 96
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About this module
Corporate Finance and Planning is an Overview of Learning Resources

introductory module in finance for the students
to learn and understand the key principles in Recommended reading:
finance. This module is designed to give the
student knowledge of the fundamental Stephen A. Ross, Randolph W. Westerfield,
principles of finance, including the time Bradford D. Jordon (latest Edition) Essentials of
value of money, financial budgeting, choosing Corporate Finance, McGraw-Hill Irwin
financial sources (capital structure) and working
capital management. The module seeks to Foundations of Finance: The Logic and Practice
develop skills relevant for decision making in of Financial Management
contemporary business settings. Fifth Edition. Prentice Hall.
Arthur J. Keown, John D. Martin, J. William

Petty, II, David F. Scott, Jr. Brealey, R. A.,
Module Learning Outcomes
Myers, S. C. & Marcus, A.J. (latest international
edition). Fundamentals of Corporate Finance.
Upon successful completion of this module,
USA: Irwin-McGraw Hill.
the student should be able to:
• Describe the history of international business
Gitman, L. J., Juchau, R. H. & Flanagan, J.
and how this has resulted in the modern
Principles of Managerial Finance (international
global trade environment
edition.). : Edison Wesley.
• Compare and contrast the financial
implications of the various legal entireties Peirson, G., Brown, R., Easton, S. & Howard, P.
available to structure an organisation Business Finance (international edition.). Hong
• Calculate and analyse the fundamentals of Kong: McGraw Hill.
investment analysis and the time value of
money
• Evaluate investments using various capital Other sources:
budgeting techniques
• Calculate and analyse an organisation’s day See Proquest database linked to your Elearn
to day financial decisions and its working LMS homepage. The National Library Board
capital management on North Bridge Road (databases are for
• Calculate a company's weighted average Singaporean/PR only)
cost of capital and evaluate the determinants
of a company's optimal capital structure
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Instructions to Students
How to use this study guide

Activity Sheets
This study guide consists of written notes that
form the main treatise of the subject matter of It is imperative that you sincerely attempt all the
this module. You are strongly advised to study activities in class and document your responses
these notes carefully and thoroughly, as well faithfully. These activity sheets are specially
as, examine the sources that have been cited. designed to scaffold your learning; working
through the tasks is an integral part of
Written quiz and examination will not test beyond developing the desired skills.
the scope of the contents found in the study guide.
However, in order to fully address the Also, by making your thinking visible through the
assessment requirements of the assignment, you activity sheets, it is then possible for your lecturer
will need to research beyond the confines of the to provide you with growth producing feedback
study guide. Nevertheless, the materials herein so that you may improve your performance or
are still a sound basis from which to build the have your doubts clarified.
assignment.
Further supporting materials
The study guide is supplemented by the following:
• Reproduced PowerPoint slides used by the

lecturers
• Activity sheets
PowerPoint Slides
The PowerPoint slides are meant for the lecturers

to signpost the flow of the lesson and for you to
have a visual focus when in class. Outside of
class, they can also serve to help you recall the
activities that took place during the respective
lessons so that you might be reminded of key
learning points.
However, the PowerPoint slides must NOT

replace the need for you to read the written
notes in the study guide. The slides alone are
INSUFFICIENT for you to gain the necessary
understanding of the subject matter. As such,
they will NOT prepare you adequately for the
various summative assessment components.
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Scheme of Work
LESSON TOPICS
1 01 Overview of Financial Management
• Introduction to finance
• Different branches of finance
• Why study finance
• Topics in corporate finance: capital budgeting, capital structure, working capi-
tal management
2 01 Overview of Financial Management
• Different types of business organisations
• Agency conflict
• Financial markets: primary and secondary
3 02 Time Value of Money
• Simple interest
• Compound interest: future value, present value, rate, time: relations between
different pararmeters
4 02 Time Value of Money Applications
• FV of multiple cash flows
• PV of multiple cash flows
5 03 Capital Budgeting
• Overview of capital budgeting
• NPV using the sample project
• Payback period using the sample project
• Profitability Index using the sample project
• IRR calculations (using trial and error method) using the sample project
• MIRR
• Cross over rate
7 Quiz
• Defining the cash flows that are used for capital budgeting
• Calculating the cash flows for capital budgeting using the Shark Attractant
project example
• Scenario analysis and sensitivity analysis using the example in the study
guide
10 04 Working Capital Management
• Overview of working capital management
• Calculating the cash equation in the study guide
11 04 Working Capital Management – Operating Cycle
• Calculating the operating cycle using the example
• Flexible and restrictive policy
• Carry and shortage costs
• Cash budget using the example of Fun Toys
12 05 Capital Structure
• Overview of capital structure
• Valuation of bonds and shares
• Different types of capital available and their features
• Calculating the WACC using the example
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13 05 Capital Structure
• The effect of financial leverage using the Trans Am Corporation example
• M&M Capital Structure Theories
• Information Asymmetry – Capital Structure, Credit Markets, Venture Capital
14 Module Consolidation
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Assessment Matters
Assessment Overview Important Policies
Assessment 1: Continuous Penalties for Plagiarism

Assessment (Quiz) Plagiarism in any form is not tolerated by
Weighting: 20% Kaplan Higher Education Academy (KHEA).
That said, direct quotations and general
Assessment 2: Individual Assignment similarities of common terms and language
Weighting: 30% mean the E-Learn LMS will often pick up every
small similarity so the likelihood of a Turnitin
Assessment 3: Written Exam Similarity report recording a result of 0% is
Weighting: 50% unrealistic. After all, no technology is perfect
and there is the need for some direct quotation
(provided you reference using APA
guidelines, of course) and to use commonly
accepted terms and language.
TOP TIP:
The surest way to succeed is to ensure all work
is correctly referenced. Keep a copy of the
Kaplan Higher Education Academy (KHEA)
Academic Works and APA Guide handy
when you are typing your assignments and
use it to guide you as to correct referencing,
citation and other aspects of academic writing.
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Topic 1a Introduction to Finance
Learning Objectives
Provide an overview of the main function of Finance and its four main areas
At the end of this topic, students should be able to:

• Define the nature and function of Finance
• Explain the purpose of Investments and give relevant examples
• Explain the purpose of Financial Institutions and give relevant examples
• Explain the purpose of International Finance and give relevant examples
• Explain the purpose of Corporate Finance and give relevant examples
An Introduction to Finance
Finance assists businesses and individuals to decide when to buy / sell and what to
buy / sell. The economic objective of any financial decision is to make the organization
and its shareholders wealthier.
Some misunderstand finance to be about buying stocks or investing in lucrative

projects. However, wealth creation is much more than that. The main areas of a
financial manager is in evaluating investments and financing arrangements, along with
maximizing the economic value of existing assets. By generating the needed
information, the financial manager plays a vital role in helping decision-makers arrive
at the right conclusion.
This module is the introduction to the study of finance and financial management.
Although this may be the first formal study of the subject, your everyday life (investing
your money, lending / borrowing money) may have already endowed you with an
intuitive sense of finance.
In this first and introductory topic, we will learn about finance activities and the main
areas of finance.
The 4 Main Areas of Finance
We often divide finance into four main areas:

1. Investments
2. Financial Institutions
3. International Finance
4. Corporate Finance or Business Finance
Investments
When we engage in investment activities, our focus is on evaluating whether a

certain asset can bring us the return we desire. The nature of assets can be financial
(e.g. shares) or physical (e.g. property). By evaluating the asset and trying to price it
accurately, we are able to tell if an investment is fairly valued or not, thus increase the
probability of achieving our desired return.
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This helps us look at the potential risk and returns that are associated with the assets
and what is the best mix of assets to hold.
Students specializing in the area of investments have various career opportunities

such as being a stock broker, a portfolio manager and a security analyst.
Financial Institutions
Financial Institutions are businesses that deal in financial matters. The Bank is the
most common financial institution that we often deal with. Some other institutions are
insurance companies and pension fund companies. Financial Institutions employ
people to perform a large variety of finance related tasks.
The following is an elaboration of the roles of different Financial Institutions
Depository Institutions
Such institutions are primarily funded by the taking in of deposits and the making of
loans.
- Commercial Banks: Banks receive deposits from institutions and individuals.
They can use the deposits to make loans and invest in instruments such as
government bonds.
- Savings & Loans Associations: While being similar to banks in the taking of
deposits, the Savings & Loans Associations were mostly restricted to making
loans for residential purposes only. However, with deregulation, the range of
loans possible have increased and Savings & Loans Associations compete with
Commercial Banks for the same business.
- Credit Unions: These are small cooperative lending institutions that collect
deposits from their members and make consumer loans. The members of such
credit unions often have a pre-existing relationship, for example, they may all
work for the same company or may all be of the same ethnic group.
Contractual Savings Institutions

These institutions, such as pension funds or insurance companies, issue contracts
and receive funds at fixed intervals. Based on statistical analysis, they are able to
predict the timing and amount of cash payments. This means that unlike Depository
Institutions, they do not have to be very concerned about liquidity and sudden
withdrawal of funds.
- Life Insurance Companies: Insurance policies will receive a fixed premium

from customers. The company will then invest these premiums into instruments
such as stocks, bonds and mortgages.
- Pension Funds and Government Retirement Funds: Such funds receive

contributions from workers and their employers. The funds then invest it in
stocks, bonds and other vehicles such as private equity.
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Investment Intermediaries
- Finance Companies: Raising funds by issuing equity or debt, Finance

Companies then lend such funds to consumers (individuals and companies)
who wish to make large purchases. It is common for a large firm to create a
Finance Company so as to provide financing for its products.
For example, Caterpillar, a firm that sells expensive industrial equipment, has
a Financing Company, Cat Financial. Customers who intend to purchase
millions of dollars worth of equipment can turn to Cat Financial for assistance.
(Caterpillar, 2019)1
- Mutual Funds: By selling shares to individuals or institutions, Mutual Funds

then use the money to purchase portfolios of stocks and bonds. Its size allows
it to enjoy economies of scale when purchasing stocks and bonds, a benefit
which it can pass on to the individual investors. It also assists individuals in
constructing and purchasing diversified portfolios, something which they might
not be capable of doing by themselves.
- Hedge Funds: They are similar to mutual funds, in that they seek investment
from individuals and institutions. However, such funds do not have the ordinary
Joe as the target profile. Hedge Funds require minimum investment that may
range from USD$100,000 to USD$1,000,000, or more. Because Hedge Funds
only target sophisticated investors, they are also subject to much less
governmental regulation as it is assumed that sophisticated investors are aware
of the relevant risks.
Hedge Funds invest in stocks, bonds, currencies and derivatives. They

usually take on significant debt so as to magnify returns.
- Investment Banks: While called a bank, Investment Banks do not have the
ability to collect deposits and make loans on them. Investment banks typically
provide the service of helping a company issue shares, via an Initial Public
Offer, or bonds.
An Initial Public Offer (IPO) is when a company desires to issue shares to the
public and the shares are then freely traded on a stock exchange. The money
received from the issue of the shares will go to the company and it will use the
money for various purposes such as expansion or to pay off debt.
Advice is needed on the pricing of the shares, price it too high and the public
will not buy it. However, if the price is too low, the company has not maximized
the possible investment amount from the public and has sold its shares too
cheaply, thus damaging the pre-IPO investors.
Investment Banks provide advisory and underwriting services on such issues,

thus earning fees on them. An underwriting service is to guarantee the success
1
Caterpillar (2019), Caterpillar Brands: Cat Financial
Retrieved from: https://www.caterpillar.com/en/brands/cat‐financial.html
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of such issues for the client, acting as an “insurance policy” of sorts and earning
fees based on that.
Investment Banks also feature prominently as dealmakers and advisors for

Mergers and Acquisitions. For example, a company may wish to acquire
another. In order to do so, advice is needed on the price to offer and how to
raise the needed funds for the acquisition. With some mega acquisitions being
worth billions of dollars, good advice is vital.
Interestingly, Investment Banks also provide advice to firms that are being
acquired. They will give advice to help such firms get the best offer possible, to
the benefit of existing shareholders.
International Finance
International Finance deals with all the other areas of finance on a more global basis.
It adds the multinational aspect of the finance activities. Some areas of International
Finance are:
Foreign Exchange Markets
When investing overseas, it is unavoidable for foreign currencies to be used. For

example, a French company that expands and sells its products in India, will have to
deal extensively in the Indian Rupee. If the Indian Rupee strengthens against the Euro,
the receipts from sales would be worth more to the French company. If the Indian
Rupee weakens, the receipts from sales would be worth less.
A company will thus seek to find ways to manage the risk of exchange rates moving
unfavorably as such movements affect the value of the overseas projects.
Prominent concepts to understand how exchange rates move are the

- Law of One Price
- Purchasing Power Parity
- Interest Rate Parity
International Interest Rates and Credit Markets
When investing overseas, a relevant consideration is the raising of the needed funds
to do so. There are 3 basic ways, each with its own set of unique considerations.
Borrowing on the example of the French company that is investing in India, the 3 basic
ways are:
1) The French firm could raise funds in France and export the funds to India.
- As the interest payments for such funds will be in Euros, this method could
pose some risks if the Indian Rupee weakens. The Indian project’s profits, when
converted to Euros, may be insufficient to cover the cost of funds in France.
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2) The French firm could raise funds in the foreign country where the project is
focused on, India.
- As the interest payments for the funds will be in Indian Rupees, it will be
matched by the project cashflows. Foreign exchange risk is thus eliminated.
However, the interest rates in the foreign country may not be a favorable one.
3) The French firm could raise funds in a third country where the cost of funds is
the lowest. For example, it could raise money in the United States.
- While helping the French firm enjoy low interest rates, this raises similar
risks as (1), whereby a weakening of the Indian Rupee against the US Dollar
may lead to the Rupee receipts from the project being unable to cover the US
Dollar cost of funds.
Corporate Finance
Corporate Finance relates to the making of decisions for a company, in the key areas
of Capital Budgeting, Capital Structure and Working Capital Management.
Corporate Finance is the study of ways to answer the three important questions:
1. What should the firm decide upon for long-term investments?
2. For such investments, how would the financing be attained?
3. On an everyday basis, how should financial activities of the firm be managed?
The first question concerns with the process of planning and managing a firm’s long
term investments and is termed as Capital Budgeting.
• Examples: What areas should the firm invest in, should old equipment be
replaced with newer equipment?
The second question concerns how the firm obtains the financing it needs to support
its long-term investments. A firm’s Capital Structure refers to the mixture of debt and
equity that is maintained by the firm.
• Examples: What are the most costly sources of funds, is there an ideal mix of
debt and equity? Also, where and when should the firm raise financing?
The third question concerns the Working Capital Management. The working capital
management refers to the firm’s short-term assets and liabilities (e.g. inventories and
payables)
• Examples: How much goods and inventory should the company hold, what
credit policy is best, where will the firm get its short-term financing?
We will look at each of them in detail during our study of the Corporate Finance
module.
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The other potential areas that Corporate Finance touches on are:
• Marketing
A poorly marketed financial instrument can mean that a company is unable to raise
funds or achieve its goals. Examples of key marketing needs are promoting a
company during its IPO or in marketing its bonds issue.
• Accounting
In large companies, accountants only handle the financial reporting aspects.
Financial management is left to the finance department. For smaller companies,
an accountant may have to take up this dual function.
• Management
Business strategy – getting an understanding of the strategic aims of a firm and
how a careful management of cashflow can aid the achievement of such aims.
• Personal Finance
Helps to make financial decisions that will be very important to us personally.
A Finance 101 course is generally provided for all business undergraduates. This is
because a basic understanding of finance is needed so as to ensure all within an
organization can effectively communicate. This is akin to how business
undergraduates need a Marketing 101 or Management 101 module.
A student equipped with the concepts of finance will be able to better handle everyday
business tasks such as creating a cost- benefit analysis or a map of decision making
pathways. As a private individual, they can use the concepts to better make financial
actions so as to attain to financial independence and security.
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Topic 1b Business Organizations
Learning Objectives
Provide an understanding of various forms of business organizations, their

goals and agency costs.
At the conclusion of this topic, you should be able to:

• Differentiate between sole proprietorships, partnerships and corporations
• Identify and explain the main goal of a firm
• Explain and illustrate the concept of “Agency Costs” within a firm
Corporate Organizations
It is an exciting venture to start a business. Often, a person usually starts a company
and focuses on the organization chart. This is what an organization chart can look like
for an established company.
Corporate Organization Chart
In the context of our discussion, the most relevant function will be Finance. This is
usually headed by the Chief Financial Officer (CFO) or Vice President (VP) of Finance.
Such a role is typically filled by someone with both an accounting and finance skill-set,
since the position has responsibility for both the Treasury and Controller functions in
a company.
Prior to giving thought to the organization chart of a company, it is worth to consider if

a company is the best form of business organization. Aside from a company, there are
other forms of business organization such as sole proprietorships and partnerships.
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We normally categorize businesses into: corporations/companies, partnerships

and proprietorships. Over time, due to evolving needs, a business may change from
one form to another. A common transition being from a proprietorship to a company.
As each profile contains its advantages and disadvantages, businessmen give much
thought on which is the most appropriate for the entity.
Sole Proprietorship
A sole proprietorship is a business owned by an individual. It is the simplest and the

least complicated business organization. It requires the least amount of formal
documentation. There are more proprietorships than any other types of business
organizations.
The advantage of a sole proprietorship is that the owner makes all the decisions and
keeps all the profits. All business income is taxed as personal income. There is no
distinction between personal and business income.
Most critically, the owner has unlimited liability for business debts. While this may have
no relevance during good times, it becomes a grave issue during bad times. Should
the business fail and owe debts to its creditors, the creditors will be able to seize the
personal assets of the owner to pay off the debts.
A simple example follows:
Tom invested $100,000 to start a sole-proprietorship that deals with computer

hardware. When his business failed, he owed the suppliers $300,000. As assets, the
business had valuable computer hardware which can be easily sold in the market for
$80,000.
The suppliers will seize the computer hardware worth $80,000 and then look to Tom’s
personal assets for the remaining $220,000. Tom may have his car, home and other
valuable assets seized so as to pay off the $220,000.
The business is limited to the owner’s life. When the owner dies, so does the business.
If so desired, the owner can sell the entire business to another owner. The ability to
raise capital directly depends on the owner’s networks and ability to find funds.
(IRAS, 2019)2
2
Inland Revenue Authority of Singapore (2019, Dec 2) Basic Guide for Self-Employed Persons.
Retrieved from https://www.iras.gov.sg/irashome/Businesses/Self‐Employed/Learning‐the‐basics/Basic‐Guide‐for‐Self‐Employed‐
Persons/
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Partnership
A partnership is a business owned jointly by two or more individuals. The partnership

agreements spell out the percentage of ownership and the level of participation. It also
spells out how the business will distribute the profits and losses.
Partners can be general partners or limited partners.
General partnership – all partners will share in profits or losses. In the event of a bad
situation, all partners will hold unlimited liability for all the debts of the partnerships.
Due to the unlimited liability, written agreements are vital.
Limited partnership – one or more general partners run the business and have
unlimited liability. A limited partner’s liability will not go beyond his investment to the
partnership, however, they are unable to be involved in the running of the business.
Limited partners cannot be actively involved in the business or else they may be
deemed general partners.
It must be noted that for a general partnership, unlimited liability applies to all partners.
For a limited partnership, it will apply only to the general partner(s).
The advantages and disadvantages of a partnership are basically same as that of a

proprietorship.
The common features between sole proprietorship and partnership are:

1. The owners have unlimited liability
2. The business has a limited life span
3. Transferring ownership interests is difficult
Limited Liability Partnership (LLP)
A recent creation is the Limited Liability Partnership (LLP). It has the flexibility of a
partnership but, like a corporation, it is a separate legal entity. Partners will not be held
personally liable for the debts incurred.
To illustrate how similar it is to a company, an LLP is able to do things such as

 Sue and be sued in its name
 Buy, hold and sell property in its name
 Have a common seal in its name
(ACRA, 2019)3
3
Accounting and Corporate Regulatory Authority (2019, Dec 2) Understanding LLPs.
Retrieved from https://www.acra.gov.sg/how‐to‐guides/registering‐a‐llp/understanding‐llps
KHE-LCD-SGD-00250 9
Corporation
A corporation is a legal entity, separate from its owners. To establish a business as

a corporation, the business must file articles of incorporation and a set of bylaws in the
state in which it resides.
The articles of incorporation include the name of the business, the intended life, its
intended purpose, the number of shares that can be issued etc. The bylaws are the
rules describing how the corporation regulates its own business.
The structure of the corporation separates the owners and managers of the firm.
1) The owners (shareholders) elect the Board of Directors

2) The Board of Directors then selects the executives and managers of the
company.
As a result of the separation of ownership and management, the ownership can be

readily transferred. But it also leads to a conflict called the agency conflict, which will
be discussed further later.
The corporation borrows money in its own name, so the owners have limited liability
for the firm’s debt.
The relative ease of transferring ownership, the limited liability of business debts and
the unlimited life of the business are the reasons why corporations are superior when
it comes to raising cash.
Corporate profits are taxed twice. Corporations are separate legal entity, so they must
pay taxes. Also, the money paid out to the owners is taxed again as the income to the
owners. This is double taxation.
With this understanding of a corporation, one now can understand why an LLP is said
to have the purpose of operating and being taxed like a partnership but retaining
limited liability for its owners like a corporation. This was discussed in the previous
page.
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The Goal of the Firm
Many mistakenly assume that the goal of the firm is to maximize profit. However, that
is an imprecise goal. What profit do we hope to maximize – short term or long term?
Accounting profits or cashflow?
The goal to maximize profits may lead management to take certain unsustainable
actions such as severe cost cutting, which may boost profits now, but lead to low
growth later.
In Financial Management, the goal is to maximize the current value per share.
Phrased differently, it is to maximize the market value of the existing owners’
equity.
This is known as Wealth Maximization.
As share prices reflect future cash flows, this means the firm has to keep an eye
on the future, as it makes its decisions. This encourages it to think long term.
This does not mean that the firms should do “anything” to maximize shareholder
wealth. It is important to note that unethical behavior does not ultimately benefit
owners.
Agency Issue
The relationship between an owner and the manager is called the agency relationship.
The manager, in this context, is known as the “agent” while the owner is known as the
“principal”.
The conflict of interest between the owner and the manager is called the “agency
conflict”. A business agent is entrusted with the management of the owner’s business
and assets. He is supposed to represent and act in the best interests of the owner.
However, it has been often observed that agents tend to act in their own best interest
rather than the best interest of the owners. The managers may incur expenses that do
not add value to the business but make their own lives more comfortable.
For example, if a CEO decides to incur the company expense of a luxury car as
personal transportation, he may argue that it is for the benefit of the company as the
CEO represents the company. For him to arrive at business events in a luxury car
could thus convey an image of strength and reliability, benefitting the firm.
However, if the CEO incurs the company expense to purchase five luxury cars for
transportation, one for each day of the week, it would be clear that it does not add
value to the firm. Rather, it seems to be for the personal comfort and advantage of the
CEO. This is an agency conflict and the wasteful expenses are known as “agency
costs”.
Shareholders are aware of this issue and they often place measures to monitor and
influence the behavior of management. Such measures will consume resources, such
costs are also called “agency costs”.
Some agency costs to monitor and influence the behavior of management:

1) Hiring external auditors to ensure the financial statements that management
provides are accurate
2) Having disclosure requirements such as the quarterly reporting of financial
statements
3) Providing incentives to managers, such as stock options and bonuses, so that
managers start to think and act like shareholders
Stockholders technically have control of the firm and, if dissatisfied, can remove
management. However, this is easier said than done.
Stakeholders of a Company
Stakeholders are other groups, besides stockholders, that have an interest

in the firm and potentially have claims on the firm’s cash flows. Stakeholders
can include creditors, employees, customers and the community in which the company
operates it.
'Sarbanes-Oxley Act Of 2002 - SOX' is an act passed by U.S. Congress in 2002 to

protect investors and stakeholders from the possibility of fraudulent accounting
activities by corporations. The Sarbanes-Oxley Act (SOX) mandated strict reforms to
improve financial disclosures from corporations and prevent accounting fraud. (United
States Government Publishing Office, 2002)4
This was enacted in response to the accounting scandals in the early 2000s. Scandals
such as Enron, Tyco, and WorldCom shook investor confidence in financial statements
and required an overhaul of regulatory standards. This is intended to strengthen
protection against accounting fraud and claims by senior management of having no
knowledge of misdeeds.
Because of its extensive requirements, compliance with the SOX is very costly to
publicly traded firms. Many public firms have chosen to “go dark” which means that
their shares will not be traded in the major stock markets, in which case the Act does
not apply. Many firms choose to go public outside the US as the cost savings from
avoiding SOX are enormous.
(CFO Magazine, 2018)5
Interactions of a Firm and the Financial Markets
A firm has many 2-way interactions with the financial markets.
4
United States Government Publishing Office, 2002 July 30. Public Law 107-204.
https://www.govinfo.gov/content/pkg/PLAW-107publ204/pdf/PLAW-107publ204.pdf
5
CFO Magazine, 2018 Aug 13. 16 Years Later, SOX Compliance Continues to Evolve.
Retrieved from https://www.cfo.com/auditing/2018/08/16-years-later-sox-compliance-continues-to-evolve/
For example, a typical process will be

1) The firm receives investment funding (debt or equity) from the financial markets
2) It uses such funding to invest in productive assets.
3) The productive assets generate a return
4) The firm uses the return to pay investors in (1) via dividends and interest
payments. It also uses the return to invest in additional assets, which can
generate even more returns for investors.
The following is a graphical representation of the 2-way interactions between the firm
and the market.
Cash Flows Between the Firm and the

Financial Markets
The financial markets can be segmented into primary markets and secondary markets.
Primary market: the market in which NEW securities are sold by the company.
Such a sale can be done by public offerings or private placements.
Secondary market: the market where EXISTING securities that have already been
issued are traded between investors.
The stock exchanges, such as the New York Stock Exchange, and the over-the-
counter market, such as NASDAQ, are part of the secondary market.
Dealer Market versus Auction Markets:
Dealer Market:
• One with several traders, called market makers, who maintain an inventory in
securities they trade and provide prices at which they stand ready to buy (bid)
and sell (ask) the securities.
NASDAQ is an example of a dealer market.
Auction Market:
• Generally, it has a physical location where buyers and sellers are matched by
a broker, with little dealer activity. A stock that trades on an exchange is said to
be “listed.”
NYSE is an example of the auction market.
Topic 2a Time Value of Money (Part 1)
Learning Objectives
To be able to execute the needed computations for Time Value of Money.

• Compute simple interest and compound interest
• Compute the future value of an investment that is made today
• Compute the present value of cashflows to be received in the future
.
Introduction to Time Value of Money
One of the most important concepts in the field of finance is the: Time Value of Money
(TVM).
Money is said to have a time value as long as it can be invested at some positive rate
of return. Concepts such as future value, present value and compound interest are all
part of the time value of money.
Imagine your relatives opened a savings account for you on the exact day you were
born. It had an initial deposit of $10,000 and is for a college education. The account
will increase at 5% per year and you are able to withdraw the money only on your 18th
birthday. While you were growing and maturing over the eighteen-year period, so was
your account. On your eighteenth birthday, the account had about $24,000 in it.
How did it happen?
In this topic of TVM, we will look at how the money in the college fund grew. We will
see that the interest rate that we can earn means that time adds value to our invested
money. The higher the interest rate or longer we wait, the more money we will have in
the account.
This also means that $1 now, can become worth much more later. This is because the
$1 now can be placed into an investment account and grow over time. Based on that
concept, a person will always prefer to receive $1 now (as he can then immediately
grow it) instead of receiving $1 later.
The ability to calculate the value of money at different points in time is the key to
understanding the material ahead as well as making financial choices for your future.
Understanding Timelines
It is a good practice to draw a timeline to understand the concept of TVM. It makes the
problems simpler. A timeline is simply a graph of cash flows associated with the
problem.
Time Line for a $100 Lump Sum due at the

End of Year 2.
0 1 2 Year
r%
100
Money in the present (i.e. today) is put at Time 0. Cash flow at the end of 2 years will
be put in time period 2 as shown above.
Payments (cash outflows) are taken to be negative and receipts (cash inflows) are
taken to be positives.
If a cash flow is said to be received in a certain year, we usually consider the cash
flows to be received at the end of the period. So if we say that a person received cash
in year 4, we will just assume he received it at the end of year 4.
Lecture Exercise:
Assume one period is one year.
Draw the timeline for a person who received
• $500 now.
• $800 in Year 1
• $600 in Year 2
• $900 in Year 3
• $400 in Year 4
Basic Definitions in Time Value of Money

• Future Value (FV)
- The amount an investment now will be worth after one or more periods
in the future.
For example, if you invested $1,000 now for the next 5years, how much will it be worth
5 years later? That amount is the Future Value.
• Present Value (PV)

- The current value of future cash flows discounted at the appropriate
discount rate
- It is the value at “Time 0” on a timeline
For example, if you expect to receive $2,000 in 10 years time, how much will it be
worth now? That amount is the Present Value.
• Interest Rate (r)

- Usually expressed as a decimal or percentage
- This is the amount you can earn if you invest your money. This rate is
very important in time value of money.
It is also known as the

• Discount rate
• Cost of capital
• Opportunity cost of capital
• Required return
For example, if you are offered an return of 5% / per year by a bank, that can be your
interest rate or discount rate.
• Time period (t)

- This refers to the time frame we have in mind.
For example, if you have an investment opportunity that requires you to commit your
money for 7 years, that is your time period.
Assuming one time period is 1 year, “t” will equal to “7”.
Putting the Basic Definitions Together
The time value of money refers to a dollar in hand today is worth more than a dollar in
future, because we can invest today’s dollar in an interest-bearing account that grows
in value over time.
Imagine your relatives opened a savings account for you on the exact day you were
born. It had an initial deposit of $10,000 and is for a college education. The account
will increase at 5% per year and you are able to withdraw the money only on your 18th
birthday. While you were growing and maturing over the eighteen-year period, so was
your account. On your eighteenth birthday, the account had about $24,000 in it.
Remember this example, how would the banker speak to your parents on the day you
were born?
Banker: The current deposit of $10,000 is said to be the Present Value (PV) as that
is what the investment is worth now.
When your child grows up, the Future Value (FV) is the amount to which the current
deposit will grow over time when it is placed in an interest paying account. $24,000 is
the Future Value (FV).
5% is the annual interest rate (r) and the time periods (t) equals to 18.
Simple and Compound Interest
• Simple interest
- Interest earned only on the original principal (i.e. the original amount
invested).
• Compound interest
- Interest earned on both the principal and on interest received
- “Interest on interest” – this refers to how previous interest received would
itself, earn interest when you reinvest them.
Simple Interest – Example 1
a) Suppose you invest $100 at a rate of 10% per annum. What is the future value
of your investment in one year?
Interest = 100(0.10) = 10
Value in one year

= Principal + interest
= 100 + 10 = 110
For a simple interest, interest is earned only on the principal.
The interest is given as the product of Principal, Rate and Time:
Interest = Principal x Rate x Time = P x R x T

Final Amount = Principal + Interest
In this example, Principal = $100; Rate = 10% = 0.1; Time = 1 year = 1
Interest for one year = 100 (0.1) (1) = $10

Total amount at the end of one year = Principal + Interest = $100 + $10 = $110
b) Suppose you leave the money in for an additional year. How much will you
have two years from now?
Interest for two years = 100 (0.1) (2) = $20

Total amount at the end of one year = Principal + Interest = $100 + $20 = $120
For compound interest, the total amount after the end of the first period will be same
as that of the simple interest. But after that, and interest will be earned on interest too
and so the total amount will be more that that can be earned in a simple interest.
The outcome will be different from Simple Interest. Let us examine an example of
Compound Interest.
Compound Interest– Example 1
a) Suppose you invest $100 at a rate of 10% per annum. What is the future value
of your investment in one year?
Interest = 100 (0.10) = 10

Value in one year = 100 + 100 (0.1) = 110
a) Suppose you leave the money in for an additional year. How much will you
have two years from now?
Interest = 110 (0.10) = 11

Value in two years = 110 + 11 = 121
a) What will be the value after three years?

Interest = 121 (0.10) = 12.10
Value in three years = 121 + 12.10 = 133.10
We can see that compound interest earns us more than simple interest. This is the
power of being able to earn interest on the previous interest.
Compound Interest – General Formula

Lets look at the same example, from a slightly different angle and try to derive the
general formula for compound interest.
Suppose you invest $100 at 10% per year.
Value in one year

= 100 + 100 (0.1) = 110
= 100(1 + 0.1) = 110
Value in two years

= 110 + 110 (0.1) = 121
= 110( 1 + 0.1) = 121
or
= 100 ( 1 + 0.1)(1 + 0.1) = 121

= 100 ( 1 + 0.1)2 = 121
• Consider the prior example

- FV with simple interest method
= 100 + 10 + 10 = 120
- FV with compound interest method
=100(1.10)2 = 121.00
- The extra 1.00 comes from the interest of .10(10) = 1.00 earned on the
first interest payment
For the previous example, the extra 1.00 ($121 - $120) comes from the interest
of .10(10) = 1.00 earned on the first interest payment.
As the time period for investing increases, the effect of compounding becomes greater
i.e. the differences between the total amounts earned will be much more if invested at
a compound rate of return as compared to a simple interest.
Future Value: Important Relationship 1
If we examine the formula that FV = PV (1 + r)t

For a given interest rate:
- The longer the time period,
- The higher the Future Value
Phrased another way, for a given “r”, as “t” increases, FV increase
At a constant interest rate, the future value of a sum of money will increase as the time
period increases. Future value and time period are said to have a positive or direct
relationship.
Future Value: Important Relationship 2
If we examine the formula that FV = PV (1 + r)t

For a given time frame:
- The higher the interest rate,
- The higher the future value
Phrased another way, for a given “t”, as “r” increases, FV increases
If a sum of money is invested for a given time period, the Future Value will increase
as the rate increases. Future value and rate are said to have a positive or direct
relation.
The graph shows the future value of $1 invested now. For example, if the return is
20%, the $1 will become close to $3 in 5 years. If the return is 15%, the $1 will become
around $2 in 5 years.
Notice the positive relationship of FV and time as rate and PV are kept constant.
The graph also shows the positive relationship of FV and rate if the time period and
PV are kept constant.
Quick Quiz: Future Value
• What is the difference between simple interest and compound interest?

Suppose you have $500 to invest and you believe that you can earn 8% per year
over the next 15 years.
- How much would you have at the end of 15 years using compound
interest?
- How much would you have using simple interest?
Present Values
While both the future value and present value are important concepts, it can be argued
that present value is more important as it shows what something is worth now. If I am
aware of how much it is worth now, I can decide how much to invest in it now.
For example, if an investment product is worth $1,000 now, I would be able to decide
to buy it for $1,000 now.
When we try to find the present value of a future cashflow, the process is called
“discounting”.
The discounting process helps us find:

• The current value of future cash flows discounted at the appropriate discount
rate
• The current value is at t=0 on a timeline
It answers the questions:

- How much do I have to invest today to have some amount in the future?
- What is the current value of an amount to be received in the future?
Present Value = the value now for an amount to be received in the future
- Why is it worth less than the future value?
- Opportunity cost
- Risk & Uncertainty
- Discount Rate = ƒ (time, risk)
Present Values
FV = PV(1 + r)t
• Rearrange to solve for PV
PV = FV / (1+r)t
PV = FV(1+r )-t
• “Discounting” = finding the present value of one or more
future amounts.
Using the same basic equation of FV = PV(1 + r)t, , we can find the PV of a sum of
cash flow. The present value formula is thus:
PV = FV/(1 + r)t
or
PV = FV(1 + r)-t
As a reminder, the process of finding the PV is called “discounting” and the rate that
is used in discounting is called the “discount rate”.
We use this concept of discounting quite often in the area of finance. The value of any
asset is said to be the Present Value (PV) of all expected future cash flows from the
asset. Therefore, we find the PV of the cash flows to find out the value or price of any
asset now. This concept is used in investments.
Present Value: Example 1
What’s the PV of $100 due in 3 years if r = 10%?

Finding PVs is discounting, and it’s the reverse of compounding.
Formula: PV = FV(1+r)-t = 100(1.10)-3 = $75.13
In conclusion, the $100 received in 3 years’ time is only worth $75.13 now.
Topic 2b Time Value of Money (Part 2)
Learning Objectives
To be able to execute the needed computations for Time Value of Money.

• Compute the present value of cash to be received at a future date
• Compute the return on an investment
• Compute the number of periods that equates a present value and a future
value, given an interest rate.
• Be able to compute the future value of multiple cash flows
• Be able to compute the present value of multiple cash flows
A Quick Recap On Present Value
Present Value = the value now for an amount to be received in the future
When future cashflows are placed into the discounting process, the present value of
the cashflows will emerge.
Present Value: Important Relationship 1
FV
PV=
Examining the PV formula of (1+r)t
For an interest rate that is given and unchanged:

- The longer the time period, the lower the present value
For a given “r”, as “t” increases, “PV” decreases
At a constant interest rate, the Present Value of a sum of money will decrease as the
time period increases. Present Value and time period are said to have a negative
or inverse relation.
To help us comprehend the above, let us try a sample question.

What is the present value of $500 to be received
i) in 5 years?
ii) In 10 years?
The discount rate is 10%.
5 years: PV = 500/(1.10)5 = 310.46 , (1.10)5 = 1.6105

10 years: PV = 500/(1.10)10= 192.77 , (1.10)10 = 2.5937
With the 10 years present value being lower than the 5 years present value, it is clear
from this worked example that the longer the time period, the lower the present value.
Present Value: Important Relationship 2
FV
PV=
Examining the PV formula of (1+r)t
For a time period that is given and unchanged:

- The higher the interest rate, the lower the present value
For a given “t”, as “r” increases, “PV” decreases
If a sum of money is invested for a given time period, the present value will decrease
as the rate increases. Present value and rate are said to have a negative or inverse
relation.
To help us comprehend the above, let us try a sample question.

What is the present value of $500 received in 5 years if the interest rate is
i) 10%?
ii) 15%?
10%: PV = 500/(1.10)5 = 310.46

15%: PV = 500/(1.15)5 = 248.59
This may be slightly counter-intuitive at first, but the present value with a higher interest
rate (15%) is smaller. However, when it is considered that we are saying “At a 15%
interest rate, I only need to invest $248.59 now, so as to receive $500 in 5 years”, it
now looks reasonable.
The graph shows the negative relation of PV and time as rate and FV are kept
constant. The graph also shows the negative relation of PV and rate if the time period
and FV are kept constant.
Quick Quiz
What is the relationship between (i) present value and (ii) future value?
Suppose you need $15,000 in 3 years.

• If you can earn 6% per annum, how much do you need to invest today?
• If you could invest the money at 8%, would you have to invest more or less
today than at 6%? How much more/less?
Manipulating the Formula to Solve for a Specific Variable
PV = FV / (1 + r)t
There are four parts to this equation

- PV, FV, r and t
- Know any three and you can solve for the fourth
• Be sure and remember the sign convention
• +CF = Cash INFLOW -CF = Cash OUTFLOW
Find the Rate

Sometimes, the problem may provide the PV, FV and t. It then requires us to solve for
“r”.
Manipulating the formula, the solution for the implied rate is given as:
r = (FV / PV)1/t – 1
If you are required to find out what rate is the investment offering, you would need to
find “r”
Discount Rate – Example 1

You are looking at an investment that will pay $1200 in 5 years if you invest $1000
today. What is the implied rate of interest?
By manipulating the formula, we can see that

r = (1200 / 1000)1/5 – 1 = .03714 = 3.714%

Suppose you are offered an investment that will allow you to double your money in 6
years. You have $10,000 to invest. What is the implied rate of interest?

Suppose you have a 1-year old son and you want to provide $75,000 in 17 years
towards his college education. You currently have $5,000 to invest. What interest rate
must you earn to have the $75,000 when you need it?
Quick Quiz
What are some situations in which you might want to compute the implied interest
rate?
Suppose you are offered the following investment choices:

a) You can invest $500 today and receive $600 in 5 years. The investment is
considered low risk.
b) You can invest the $500 in a bank account paying 4% annually.
What is the implied interest rate for the first choice and which investment should you
choose?
Finding the Number of Periods (t)
PV = FV / (1 + r)t
There are four parts to the above equation
- PV, FV, r and t
- Know any three and you can solve for the fourth
 FV 
ln PV 
The solution for the time period (t) is given as : t =
ln(1+ r)
Imagine that “r” is given and you have to find how long it will take a certain PV to reach
the desired FV. What is the time period? We are thus needing to find “t”.
Let us consider this worked example to understand the process of finding “t”.
You want to purchase a new car and you are willing to pay $20,000. If you can invest
at 10% per year and you currently have $15,000, how long will it be before you have
enough money to pay cash for the car?
Formula Solution:
- FV/PV = 20,000/15,000 = 1.333

- ln(1.333) = 0.2877
- ln(1.10) = 0.0953
- t = 0.2877/0.0953 = 3.0189 years
It will take 3.02 years for $15,000 to amount to $20,000 if invested at a rate of 10%
per annum
Quick Quiz
When might you want to compute the number of periods?
Suppose you want to buy some new furniture for your family room. You currently have
$500 and the furniture you want costs $600. If you can earn 6%, how long will you
have to wait so as to get the amount you need?
Solving for Multiple Cashflows

As we have understood the techniques of discounting, we are now able to apply the
same technique to multiple cashflows.
We will use worked examples for this teaching point.
Future Value: Multiple Cash Flows - Example 1

At the end of every year, you will be able to deposit $4,000 in your bank account that
pays 8% interest. You plan to make deposits for the next 3 years and then stop. You
currently have $7,000 in the account.
- How much will you have in 3 years?
- How much will you have in 4 years?
Future Value: Multiple Uneven Cash Flows

Solution 1 – Formulas & Time Line
0 1 2 3 4
8%
$7,000.00 $4,000.00 $4,000.00 $4,000.00
$4,000.00
4000*(1.08) = $4,320.00
4000*(1.08)^2 = $4,665.60
7000*(1.08)^3 = $8,817.98
$21,803.58
* (1.08) = $23,547.87
Future Value: Multiple Cash Flows - Example 2
If you deposit $100 in one year, $200 in two years and $300 in three years.
How much will you have in three years at 7 percent interest?
How much will you have in three years at 7 percent interest?
Future Value: Multiple Uneven Cash Flows

Solution 2 – Formulas & Time Line
TIMELINE
0 1 2 3 4 5
7%
$100.00 $200.00 $300.00
$300.00
200*(1.07) = $214.00
100*(1.07)^2 = $114.49
$628.49
Total interest = $628.49-600=28.49
* (1.07)^2 = $719.56
Present Value: Multiple Cash Flows – Example 1

You are offered an investment that will pay
- $200 in Year 1,
- $400 the next year,
- $600 the following year, and
- $800 at the end of the 4th year.
You can earn 12% on similar investments.

What is the most you should pay for this investment?
Present Value: Multiple Cash Flows

Solution 1
0 1 2 3 4
Time
(years)
200 400 600 800

178.57
= 1/(1.12)2 x
318.88
= 1/(1.12)3 x
427.07
= 1/(1.12)4 x
508.41
1,432.93
Present Value: Multiple Cash Flows - Example 2

You are considering an investment that will pay you $1,000 in the 1st year, $2,000 in
the 2nd year and $3,000 in the 3rd year.
If you want to earn 10% on your money, how much would you be willing to pay?
Present Value: Multiple Cash Flows

Solution 2
▪ PV = $1,000 / (1.1)1 = $ 909.09

▪ PV = $2,000 / (1.1)2 = $1,652.89
▪ PV = $3,000 / (1.1)3 = $2,253.94
▪ PV = $4,815.92
Topic 3a Capital Budgeting Evaluation Techniques
Learning Objectives
To be able to identify a capital budgeting project and evaluate the financial

acceptability of the project.

• Select the right criteria for the evaluation of a capital budgeting project
• Execute the evaluation of a capital budgeting project using the Net Present
Value method
• Execute the evaluation of a capital budgeting project using the Payback
method.
• Execute the evaluation of a capital budgeting project using the Internal Rate of
Return method.
• Execute the evaluation of a capital budgeting project using the Profitability
Index method.
• Weigh the advantages and disadvantages of each evaluation technique and
select the most appropriate one for the task.
Introduction to Capital Budgeting
Capital Budgeting is the process of planning and managing a firm’s long-term

investments. Long term projects are those with lives that extend over a year. It could
even extend longer than the firm’s normal business operating cycle. We call long term
decisions as the capital budgeting decisions and view them as having long term effects
that we cannot easily reverse or that we can change only at a great cost. It involves
planning, appraising, comparing and selecting of a firm’s long-term projects.
Examples of such long-term decisions can be determining the number of

manufacturing facilities that a firm should operate, whether the firm should launch a
new product or whether the firm should enter a new market.
We can make three key observations about the capital budgeting decisions:
• A capital budgeting decision is typically a go or no-go decision on a product,
service, facility or activity of a firm. We either accept or reject a proposal
• A capital budgeting decision will require sound estimates of the timing and the
amount of cash flow for the proposal
• The capital budgeting model has a predetermined accept or a reject criterion.
First, capital budgeting is about making decisions. Second, the appropriate future cash
flows are a necessary input into all capital budgeting decisions.
We will study capital budgeting decision in two parts. In this first part, we will assume
that we have the appropriate estimate of future cash flows so that we can examine the
various decision-making models. For the second part, we will explore how to estimate
the cash flows.
Why Must Capital be Budgeted?
Because money is always limited, companies must be careful to choose projects that
are feasible and profitable. Firms use the projected cash flows to filter only those ideas
that they deem most likely to grow into money-making or money-saving projects. If
there are alternatives and only one can be selected, the firm must identify and accept
the most beneficial among all the projects.
Capital budgeting is concerned with making the best investment choices and is the
heart of corporate finance. We will study several different models that can help a
company determine whether it should accept or reject a project. A “project” can be
anything from a new machine to a new factory. We apply decision-making criteria to
answer the question, “Is it worthwhile?”
What Criteria Should We Use For Making Decisions?
While it may not be possible to find an evaluation technique that perfectly meets all
the criteria for decision making, we can find which one most closely meets it. To do
so, lets understand the various criteria.
1) Cashflows
- Does the method use accounting profits or cashflows? Accounting profits
can be manipulated and is not as reliable as cashflows.
- If it uses cashflows, does it consider all the cashflows? That will help it to
evaluate the full life of the project.
2) Time Value of Money

- Since $1 now is worth more than $1 later, is Time Value of Money
considered when evaluating such long term projects?
3) Risk-adjusted
- Since every project may have different risk, is the method capable of
factoring the different risks in each project?
4) Ranking of Projects
- Will this method be able to rank projects of varying sizes, allowing us to
identify which is the best one?
5) Value Added to the Firm

- Will this method be able to show the value added to the firm, upon
acceptance of the project?
In the workplace, there are 4 general decision models that meet the above criteria in
differing degrees.
We will look at four decision models:
• Net present value (NPV)
• Payback period
• Profitability index (PI)
• Internal rate of return (IRR)
Thereafter, we will weigh the valuation techniques by considering the advantages and
disadvantages of each model.
Net Present Value

An investment is worth undertaking if it creates value for its owners. We create value
by identifying an investment that is worth more than it costs us to acquire.
Net Present Value (NPV) is the difference between the investment’s market value and
its cost.
We use the discounted cash flow valuation to find out the NPV of an investment. The
discounted cash flow valuation is the process of valuing an investment by discounting
its future cash flows.
NPV of an investment is the present value of all benefits (cash inflows) minus the
present value of all costs (cash out flows).
NPV = PV of all benefits – PV of all costs

The steps in an NPV calculation are
Step 1: Estimate the expected future cash flows.
Step 2: Estimate the required return for projects of this risk level.
Step 3: Find the present value of the cash flows and subtract the initial investment to
arrive at the Net Present Value.
NPV is represented in a formula with the following:
Instead of memorizing the formula, a worked example can show how straightforward
it is to apply NPV.
Sample Project Data

You are looking at a new project and have estimated the following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120
Year 2: CF = 70,800
Year 3: CF = 91,080
Your required return for assets of this risk is 12%.
Note: This project will be the example for all further discussions in this topic.
What is the NPV of the Sample Project?

This is a three year project.
This project requires an initial investment (cash outflow) of $165,000.

This cash outflow is shown as -$165,000 in Year 0 (i.e. today)
The project will generate cash flows for three years. It will bring in a cash inflow of
$ 63,120 after one year. This is shown as a +$63,120 in Year 1. Similarly, it shows
that the project will generate a cash flow of $70,800 in Year 2 and $91,080 in Year 3.
The firm requires a return of 12% on this project. We will use 12% as the discount rate
for finding the PV for the future cash flows.
Now that we understand the question, we start to discount all the Cashflows to find
NPV.
Notice how every single cashflow is discounted to present value. Net Present Value
then adds them all up to a final figure of $12,627.41. We have found the Net Present
Value.
Does the NPV show that we should accept the Sample Project?
• NPV is a direct measure of how well this project will meet the goal of
increasing shareholder wealth.
The NPV Decision Rule is simple,
 If NPV is positive, accept the project. It is expected to add value to the firm
and increase the wealth of the owners.
 If NPV is negative, reject the project. It is expected to reduce value within the
firm and decrease the wealth of owners.
Since the project’s NPV is $12,627.41, it is positive and should be accepted.
Does NPV meet the needed criteria?

NPV is a superior method and meets all desirable criteria
- Considers all cashflows
- Considers time value of money
- Adjusts for risk
- Can rank mutually exclusive projects
- Directly related to increase in the value of the firm
It is the dominant method; if there are contradictions with other methods, NPV always
prevails.
NPV and Mutually Exclusive Projects

Two projects are independent if the acceptance of one project has no bearing on the
acceptance or rejection of the other project.
Some projects however are mutually exclusive projects. With mutually exclusive
projects, picking one project eliminates the possibility of picking the other project.
Examples of mutually exclusive projects:
• A firm needs to buy only one machine in the coming year.
• A company plans to build a shopping complex or a residential complex on a

piece of land that it owns. By using the land for one project, the other project is
no longer viable because it is missing a necessary component - the land.
Firms have constraints on their capital and can take on only a limited number of
projects.
The NPV model is an economically sound model when comparing several projects
across a wide variety of products, services and activities under capital constraint.
Projects are ranked from most desirable to least desirable based on their NPV.
The greater is the project’s NPV, the greater is the profit for taking the project.
Because more money is better, we choose the largest “bag of money”.
So for mutually exclusive projects, we choose the project with the greatest positive
NPV.
Payback Method
The payback period is the amount of time required for an investment to generate the
cash flows needed to recover the initial cost. This model answers one basic
question, “How soon will I recover my initial investment?”
It simply calculates at what point in time the company recovers its initial cash outflow
with its future cash inflow.
Based on the payback rule, an investment is acceptable if its calculated payback

period is less than some pre-specified number of years. This pre-specified number of
years is decided by management and is termed as the cut-off period of the project.
Accept the project if

Payback period < cut off period
Sample Project Data

Year 0: CF = -165,000
Year 1: CF = 63,120
Year 2: CF = 70,800
Year 3: CF = 91,080
What is the payback period?

A cumulative cashflow table can be created to help determine payback.
Capital Budgeting Project
Year CF Cum. CFs

0 $ (165,000) $ (165,000)
1 $ 63,120 $ (101,880)
2 $ 70,800 $ (31,080)
3 $ 91,080 $ 60,000
Payback = year 2 +
+ (31080/91080)
Payback = 2.34 years
The project requires an initial investment of $165,000. For the first two years, the cash
inflows are expected to be $63,120 and $70,800.
This totals to: $63,120 + $70,800 = $133,920.
We still need $31,080 to recover the initial investment of $165,000. This can be
recovered in the third year. As the cash flows in the third year is $91,080, we only need
a part of the third year to recover $31,080.
So the payback period is 2 years + 31,080/91,080 = 2.34 years.
Should we accept the project based on the payback period?

Acceptance on the project depends on the cut-off period. This period is not mentioned
in the question.
If we assume that management wishes for its projects to pay back within 3 years, the
cut-off period will then be 3 years. This project pays back in 2.34 years, making it less
than 3 years and thus acceptable.
However, if we assume that management wishes for its projects to pay back within 2
years, the cut-off period will then be 2 years. This project pays back in 2.34 years,
making it more than 2 years and thus unacceptable.
Weighing the Payback Method

The Payback method is known for its advantages of:
1) Easy to understand
2) Adjusts for uncertainty of later cash flows
3) Biased towards liquidity
However, it has significant disadvantages, making it suitable for deep analysis.

1) Ignores the time value of money
2) Requires an arbitrary cutoff point
3) Ignores cash flows beyond the cutoff date
4) Biased against long-term projects, such as research and development,
and new projects
Due to its nature, companies often use it as a screen for dealing with a myriad of minor
investment decisions that they have to make. Many companies use payback period
for small dollar decisions.
Profitability Index
The Profitability Index method measures the benefit per unit cost, based on the time
value of money. A profitability index of 1.1 implies that for every $1 of investment, we
create an additional $0.10 in value, benefits thus exceed costs.
Decision Rule
If PI > 1.0 → Accept Project
If PI < 1.0 → Reject Project
This method can be very useful in situations of capital rationing.
Sample Project Data

Year 0: CF = -165,000
Year 1: CF = 63,120
Year 2: CF = 70,800
Year 3: CF = 91,080
What is the Profitability Index of the Sample Project?

The formula to calculate the Profitability Index is
Essentially, it is the PV of Cash Inflows divided by the Initial Investment.
PI = [63,120/(1.12)1 + 70,800/(1.12)2 + 91,080/(1.12)3] / 165,000

PI = 177,627.41 / 165,000
= 1.077
As the PI >1, we will accept the project.
Weighing the Profitability Index Method

Its advantages are
- Closely related to NPV, generally leading to identical decisions
- Considers all CFs
- Considers TVM
- Easy to understand and communicate
- Useful in capital rationing
Its disadvantage is that it occasionally conflicts with the NPV method and can lead to
incorrect decisions for mutually exclusive projects.
The following will show how a conflict can occur.
In this scenario, we have Project A and Project B. Notice that Project B requires a
much larger cash outflow at Time 0. When initial outflows are vastly different between
projects, the Profitability Index may conflict with the NPV method.
PI for A = 15,000/10,000 = 1.5

NPV for A = 15,000 – 10,000 = $5,000
PI for B = 125,000/100,000 = 1.25

PV for B = 125,000 – 100,000 = 25,000
Based on PI, we should select Project A as its NPV is higher than that of B.
Based, on NPV, we should select Project B as its NPV is higher.
So, PI may differ from NPV in ranking the projects. In this scenario, we will choose the
Project B as NPV is the superior method.
Internal Rate of Return

The most popular alternative to the NPV for the capital budgeting decisions is the
internal rate of return (IRR). This is the discount rate that produces a zero NPV. Or the
specific discount rate at which the present value of the cost (the investment or the
cash outflow) equals to the present value of the future benefits (cash inflows).
IRR rule states that we should accept the projects in which the IRR exceeds the
project’s required return.
Decision Rule
If IRR > Required Return → Accept Project
Unlike NPV, IRR is a rate rather than a dollar amount. This may explain its popularity
as we are prone to speak of returns as a percentage rather than in terms of dollars,
such as “I made a 10% return on my $100 investment” rather than “I made $10.”
Sample Project Data

Year 0: CF = -165,000
Year 1: CF = 63,120
Year 2: CF = 70,800
Year 3: CF = 91,080
What is the IRR of the Sample Project?

When using a Financial Calculator, it is possible to find IRR.
Without a Financial Calculator or computer software, IRR has to be found with trial
and error.
For this sample project, we will try to input the values of required return r, and find out
the values of NPV. We try this out with different values of “r” such that a particular “r”
makes the NPV to zero. This value of “r” is taken as the IRR of the project.
If IRR is higher than our required return, we will accept the project.
Calculating IRR for our project,
If we take the required return as 16%, we get NPV as +$380.83
If r = 17%, NPV = -$2,463.25
So if NPV has to be zero, IRR is in between 16% and 17%.
If we try out different values of r, we will get that at r = 16.13%, NPV is very close to 0.
So, we take the IRR as 16.13%.
NPV Profile
The project’s NPV at different interest rates is called the NPV profile. It shows the
range of interest rates where the project is acceptable and the range of interest rates
where the project is not acceptable. The x-axis is the discount rates and the y-axis is
the NPV in $.
The intercept on the x-axis is the discount rate at which NPV is zero and is the IRR of
the project.
Weighing IRR
IRR is very popular in practice. This is probably because it fills a need that NPV does
not. In analyzing investments, we seem to prefer talking about the rates of returns
rather than the dollar values. IRR appears to provide a simple way of communicating
information about a proposal.
Also, IRR does not require you to have an appropriate discount rate while NPV does.
Under certain circumstances, IRR may have a practical advantage over the NPV. We
can’t estimate the NPV unless we know the appropriate discount rate, but we can still
estimate the IRR.
The major disadvantage of IRR is that if cash flows is not standard, there is a possibility
of multiple IRRs. Also, based of IRRs the ranking of the projects might differ as
compared to those based on NPV rankings. So IRR criteria may not be suitable for
mutually exclusive projects. Finally, IRR has a flawed reinvestment assumption.
We will look in details at these issues in the next paragraphs.
IRR vs NPV
Although it has its benefits, IRR can’t be the primary decision criteria. NPV is still
superior.
NPV and IRR will generally give the same decision. But sometimes there is conflict in
the decisions. Two such scenarios are:
• Non-conventional cash flows where the cash flow sign changes more than
once.
• Mutually exclusive projects where the initial investment may be substantially

different or where the timings of cashflows may be substantially different.
Non-conventional cash flows mean the sign of the cash flows changes more than once
or the cash inflow comes first and outflows come later. If this occurs, you will have
multiple internal rates of return. This is problematic for the IRR rule, however, the NPV
rule still works correctly.
Take an example of a restaurant that requires a large initial investment to get the
operations going. It has positive cash flows for a few years. It then expands or updates
facilities during a particular future year. This will cause a negative cash flow or an
investment for that year. The following years return to positive cash flows again. When
we apply the IRR to such a series of non-standard cash flow, we have the potential of
more than one IRR solution.
IRR Problems – Example 1

Suppose an investment will cost $90,000 initially and will generate the following cash
flows:
- Year 1: 132,000
- Year 2: 100,000
- Year 3: -150,000
The required return is 15%.
Should we accept or reject the project?
Notice that the unconventional cashflows result in 2 IRR answers of 10.11% and
42.66%. This is a flaw in the IRR method as it is illogical for an investment to have two
IRRs.
This is the NPV profile for the non-conventional project that we have just looked at.
Looking at the profile, we know that we should accept the project if the required return
is in between 10.11% and 42.66%.
The Flawed Reinvestment Assumption

When cash inflows are received in Year 1, 2 , 3 and so on, the models have to
assumed that such inflows are reinvested.
• IRR assumes reinvestment at IRR.
• NPV assumes reinvestment at the firm’s weighted average cost of capital
(opportunity cost of capital)
- More realistic
- NPV method is best
• NPV should be used to choose between mutually exclusive projects.
IRR Problems – Example 2
The required return for both projects is 10%. Which project should we accept and why?
This is a simple example of two mutually exclusive projects that result in conflicting
signals from NPV and IRR.
Based on IRR, we will choose Project B as its IRR is higher. But if the required return
is 10%, we will choose Project A because at 10%, NPV of Project A is higher than that
of Project B.
Due to the superiority of NPV, we will also decide based on it. We will choose Project
A.
If we plot the NPV profile for the two projects, we will see that it crosses at 11.8%. This
is the cross over rate at which the NPV of the two projects are equal.
The reasons for the NPV profile cross overs are:
Size (scale) differences:

• Smaller project frees up funds sooner for investment.
• The higher the opportunity cost, the more valuable these funds, so high
discount rate favours small projects.
Timing differences:
• Project with faster payback provides more CF in early years for reinvestment.
• If discount rate is high, early CFs are especially good
NPV directly measures the increase in value to the firm.

IRR is unreliable in the following situations:
• Non-conventional cash flows
• Mutually exclusive projects
Whenever there is a conflict between NPV and another decision rule, always use
NPV.
Modified Internal Rate of Return (MIRR)
To address some of the problems that crop up with IRR, it is often proposed that a
modified version is used. There are several ways to calculate the MIRR – Modified
Internal Rate of Return but the idea is to modify the cash flows first and then calculate
the IRR with the modified cash flows.
Executives clearly prefer IRR yet it has shortcomings. MIRR – Modified Internal Rate
of Return, controls for these problems.
MIRR is a better choice than IRR if a rate of return metric is preferred as it does not
suffer from the multiple rates of return problems.
How to Calculate MIRR

There are two possible methods:
1. Discounting Approach = Discount future outflows to present and add to CF0
2. Reinvestment Approach = Compound all CFs , except the first one, forward to the
end.
MIRR Method 1: The Discounting Approach – The idea is to discount all negative
cash flows back to the present using the discount rate and add them to the initial cost.
Then calculate the IRR. Because only the first modified cash flow is negative, there
will be only one IRR.
Method 1: Discounting Approach

R= 20%
Yr CF ADJ MCF
0 -60 -69.4444 -129.44444
1 155 155
2 -100 0
IRR= 19.74%
MIRR Method 2: The Reinvestment Approach – We compute all cash flows (positive
or negative), except the first out, to the end of the project and then calculate the IRR.
We are “reinvesting” the cash flows and not taking them out until the very end.
Capital Budgeting in Practice

It is common among large firms to employ a discounted cash flow technique such as
IRR or NPV along with payback period. It is suggested that this is one way to resolve
the considerable uncertainty over future events that surrounds the estimation of NPV.
Even though the Payback method should not be used to make the final decision, we
should consider the project very carefully if it suggests rejection. There may be more
risk than we have considered or we may want to pay additional attention to our cash
flow estimations. Sensitivity and scenario analysis can be used to help us evaluate our
cash flows.
The fact that payback is commonly used as a secondary criteria may be because short
paybacks allow firms to have funds sooner to invest in other projects without going to
the capital market.
Conclusion: All Methods Have Its Value
As shown in the table above, each method has its unique value proposition. So while
NPV is the superior method, we do not only use NPV, but round out our analysis with
the various measures.
Topic 3b Capital Budgeting Cashflow Estimation
Learning Objectives
To be able to correctly define and calculate the cashflows within a long-term

capital budgeting project

• Correctly identify and define the cashflows of a long term capital budgeting
project
• To correctly calculate and discount the cash flows for capital budgeting using
the Shark Attractant project example
• To reasonably create scenario analysis and sensitivity analysis for a capital
budgeting project
The Importance of Cashflows
A major metric of a company’s health and its prospects for a long life is how much
cash flow it can generate. Managing a stream of money in and out of a business
enterprise is critical to its success. It doesn’t necessary matter how much profit you
have projected on paper because you cannot spend profits.
What is the difference between profits and cash flows?

Profits are accounting measure of performance during a specific period of time.
Cash flow is the actual inflow or outflow of money. One way to think about cash flow
is to match it with your personal bank account.
Consider a case of a business that has had a very profitable year and has earned $1
million in profits. Can it distribute this $1 million to its owners (via dividends)? Maybe
it can, maybe it cannot. It could if it had $1 million in cash at the end of the year. But it
may have reinvested some of the cash in inventory or paid off some of its debts,
leaving its cash account balance to near zero. In the second case, it cannot pay $ 1
million to its owners.
The opposite can be true. A business could lose money and still pay dividends. A
company could show a loss for the operating period but have generated positive cash
flow for the business, or it could have considerable cash from the previous period,
enabling it to issue dividends to its owners. For example, if the company had a large
depreciation expense during the period- a non-cash expense- the income statement
could show a loss for the period. The cash account however may have grown enough
during the same period so that there would be sufficient cash on hand for a dividend
payment.
In this topic, we will examine how to measure and predict cash flows. We will see that
the timing and the amount of cash flows are critical to business decisions, business
growth and ultimately to business success.
Good business decisions start with understanding how the timing and the amount of
cash flows affect the viability of the project. Without understanding the project’s cash
flows, the potential for poor decisions and failure is high.
Relevant Cashflows
Not all cashflows are relevant for consideration.
The effect of taking a project is to change the firm’s overall cash flows today and in the
future. To evaluate a proposed investment, we must consider these changes in the
firm’s cash flows and then decide whether or not they add value to the firm. The first
and most important step is to decide which cash flows are relevant and which are not.
Relevant cash flows are the cash flows that occur (or don’t occur) because a project
is being started. If a cash flow will occur, regardless of whether we start the project or
not, that cash flow is not relevant.
Incremental cash flows are the movements in the future cash flows that are directly
due to taking the project. Once is able to discern such cashflows by comparing a firm’s
future cash flows (i) with the project and (ii) without the project.
The Stand-Alone Principle is viewing projects as “a company by itself” with its own
revenues, costs and assets. This allows us to isolate the investment and evaluate it
separately from the other business within the firm.
Which Cashflows Will Be Relevant?

We are concerned with only those cash flows that are incremental and that results
from the project. We will look at some of the cash flows and decide whether they are
incremental or not and so whether they should be considered in an investment
decision.
1. Sunk Cost is a cash flow already paid or accrued. This cannot be recouped
and so should not be considered in an investment decision. An example can be
the cost of a consultant to evaluate whether the product should be launched or
not. This cost is a sunk cost because it will have to be paid whether or not the
product is launched.
2. Opportunity Costs is any cash flow foregone or lost by taking one

project/action rather than another. It is the “next best” alternative that is given
up if a particular investment is undertaken. This applies to any asset or resource
that has value if sold rather than used. A good illustration of this is the use of
land or buildings that are already under the firm’s ownership. While rental need
not be paid anymore, it should be observed that the use of this assets is not
“free”. If the firm did not use the asset, it could be sold. Therefore, the use of
the asset means we lost the chance to sell the asset and get the sales price.
That loss is an opportunity cost.
3. Side Effects: When a company has multiple products and investments, a new
investment may affect the others. It could either be beneficial or detrimental to
the others. Such impact can be shown in the cashflows.
a. An illustration of a beneficial side effect is when you construct in modern

logistics facility for a new project. The other existing products can
experience cost savings by utilizing this logistics facility too. The cost
savings of the existing products will be an incremental cashflow to the
new project.
b. An illustration of a detrimental side effect is cannibalism, where the new
product reduces the sales of existing products (e.g. iPhone 11 and
iPhone 8)
4. Changes in Net Working Capital (NWC): Operating cash flow derived from the
income statement assumes all sales are cash sales (instead of credit sales) and
that the COGS was paid in cash (instead of credit purchases) during that period.
By looking at changes in NWC, we can adjust for the difference in cash flow
timing that results from accounting conventions. Most projects will require an
increase in NWC initially as we build inventory and receivables.
New projects often require additional investments in inventory, cash and

receivables. Such working capital investments need to be factored in the cash
flow for the project if they are not offset by changes in payables (which they
usually are not). Later, as projects end, this investment is often recovered.
5. Financing Costs, although relevant, are not shown in the cash flows of the
project evaluation. This is because they are already included into the discount
rate.
We do not ignore interest expense (or any other financing expense, for that
matter); rather, we are only evaluating asset-related cash flows. Interest
expense is a financing cost, not an operating cost. It is chiefly a reflection of
capital structure and it is usually not an important factor when determining the
value of a project.
6. Taxes will change with the introduction of a new project. This is due to how the
project will impact the firm’s taxable income. This means that we have to factor
in taxes and consider the cashflows after tax.
Pro Forma Cashflows and Financial Statements

The phrase “Pro Forma” refers to future projections/forecasts. Pro forma financial
statements are the financial statements projecting future years’ operations.
These future cashflows will then be discounted to find the value of the project or
business, now.
Cash Flow Refresher:
• Operating Cash Flow (OCF):

OCF = EBIT + Depr – Taxes
OCF = NI + Depr (if no interest expense)
• Cash Flow From Assets:
CFFA = OCF – NCS –ΔNWC
NCS = Net capital spending
We will aim to create a full set of cashflows and discount them, using the Shark
Attractant Project.
Shark Attractant Project

Project Details
Estimated annual sales 50,000 cans
Sales price per can $4.00
Cost per can $2.50
Estimated project life 3 years
Fixed costs $12,000/year

Initial equipment cost $90,000
• 100% depreciated over 3 year life
Investment in NWC $20,000

Tax rate 34%
Cost of capital 20%
The Shark Attractant project has a 3-year life.
Capital budgeting analysis may assign a finite life to a project even if it is an acquisition
or project that is expected to continue indefinitely. Assigning a finite life, implies that
at the conclusion of the project, the company returns everything to pre-project status
– net working capital invested is recovered and all fixed assets purchased are sold for
their salvage value.
Step 1 – Create a Pro Forma Financial Statement
We prepare the pro forma statement for the given project. The assumption is that the
net income is the same for all three years of the project.
Sales = 50,000 x $4 = $200,000
Variable Cost (VC) = 50,000 x $2.50 = $125,000
Note that net fixed assets decline each year by the amount of that year’s depreciation.
Depreciation on a straight line basis is given as $90,000/3 =$30,000 for each of the
three years.
Step 2 – Show the Projected Cash Flows
OCF = EBIT + depreciation – taxes = 33,000 + 30,000 – 11,220 = 51,780; or

OCF = NI + depreciation = 21,780 + 30,000 = 51,780
Change in Net Working Capital (NWC)

We have a net investment in NWC of $20,000 at the beginning (Year 0). We get the
investment back at the conclusion of the project when we collect on our receivables,
sell our inventory and pay off our creditors.
All investments in net working capital are recovered (reversed) in the final year of a
project.
Capital Expenditure is done at the beginning of the project for the purchase of the
equipment. Therefore, it is treated as a negative cash flow (cash outflow) at time 0.
Step 3 – Discount the Projected Cash Flows; Find NPV
As we discount the cashflows, we arrive at a Net Present Value of $10,647.69.

Since NPV is positive, we accept the project.
Also, the IRR is 25.76%, which is higher than the cost of capital (required return) of
20%. Therefore, IRR would also recommend that the project is accepted.
Operating Cash Flows: Tax Shield

Interestingly, the Operating Cashflow (OCF) in Shark Attractant of $51,780 can also
be derived using the tax shield approach.
OCF = (Sales – Costs) (1 – T) + Deprec * T
OCF = (200,000-137,000) x 66% + (30,000 x .34)
OCF = 51,780
This approach is particularly useful when choosing between pieces of equipment
where the depreciation tax shield and after-tax operating costs are the major cash
flows.
Operating Cash Flows: Net Working Capital

To support higher sales, we usually increase our accounts receivable and inventory
levels. With the higher inventory levels, accounts payable is likely to correspondingly
increase. However, the cash flows associated with these increases do not appear on
the income statement when they occur.
This is due to the matching principal, where the cost of inventory is not reflected until
it is actually sold and revenue is recorded when goods are sold. The receipt or
payment of cash for this activities are not considered.
If the cash flows associated with these accounts aren’t on the income statement, they
would not be part of operating cash flow. So, similar to fixed assets, we have to
consider changes in NWC separately.
By looking at the changes in Net Working Capital, we can discern the increased
investment in receivables and inventory that are necessary for the project. As Net
Working Capital also covers account payables, we also examine the increase in our
payable accounts that partially pays for the investment in inventory and receivables.
An elaboration of changes in NWC is shown below:
• Sales is recorded when made, regardless of when cash is received
- Cash in = Sales - ΔAR
• Cost of goods sold is recorded when the goods are sold, regardless of whether the
suppliers had been paid
- Cash out = COGS - ΔAP
Operating Cash Flows: Depreciation

Depreciation is a non-cash deduction. However, depreciation affects taxes, which are
a cash flow. The relevant depreciation expense is the depreciation that will be claimed
for tax purposes. Consequently, we need to understand how the IRS requires
depreciation to be computed.
Straight-Line depreciation:
A method of computing amortization (depreciation) by dividing the difference between
an asset's cost and its expected salvage value by the number of years it is expected
to be used.
Modified Accelerated Cost Recovery System (MACRS depreciation):

• Most assets are required to be depreciated using MACRS.
• Each asset is assigned to a specific property class and depreciation is figured
based on the percentages provided in Table below.
• Note that assets are depreciated to zero. The mid-year convention causes
depreciation expense to be taken in one more year than specified by the
property class, i.e., 3-year MACRS has four years of depreciation.
MACRS Table
Year 3-year 5-year 7-year 10-year
1 0.333 0.200 0.143 0.100
2 0.445 0.320 0.245 0.180
3 0.148 0.192 0.175 0.144
4 0.074 0.115 0.125 0.115
5 0.115 0.089 0.092
6 0.058 0.089 0.074
7 0.089 0.066
8 0.045 0.066
9 0.065
10 0.065
11 0.033
Computing Depreciation and Tax

• Depreciation tax shield = DT
Where, D = depreciation expense and T = marginal tax rate
• Straight-line depreciation
D = (Initial cost – Salvage Value) / number of years
• MACRS
Depreciate → 0
Recovery Period = Class Life

1/2 Year Convention
Multiply percentage in table by the initial cost
At the end of the project, all fixed assets are sold for their salvage value. If the selling
price (SP) is greater than the asset’s book value (BV), then tax is owed on the gain.
Conversely, if an asset is sold for less than its book value, tax is recovered.
Net Salvage Cash Flow (NSCF) = SP - (SP-BV)(T)

Where, SP = Selling Price, BV = Book Value and T = Tax Rate
Worked Example – Depreciation

A car is purchased for $12,000. It is expected to be a 5-year property and the marginal
tax rate = 34%. It is depreciated using MACRS.
• If the asset is sold at End of Year 5 for $3,000:

NSCF = 3,000 - (3000 - 691.20)(.34) = $2,215.01
= $3,000 – 784.99 = $2,215.01
• If it sold at End of Year 2 for $4,000:

NSCF = 4,000 - (4000 - 5,760)(.34) = $4,598.40
= $4,000 – (-598.40) = $4,598.40
Evaluating NPV Estimates

Computing an NPV is putting a market value on uncertain future cash flows. Projecting
the future involves the potential for error. Major errors can come from biases and
omissions.
Estimated cash flows are expectations, or averages, of possible cash flows, not exact
figures.
There are two main reasons for positive NPVs: (1) we have a good project, or (2) we
have done a bad job of estimating NPV.
Similarly, a negative computed NPV might be reflective of a bad project, or of a bad

job of estimating NPV.
Forecasting risk is the danger of making a bad (value destroying) decision because of
errors in projected cash flows. This risk is reduced by systematically investigating
common problem areas.
Sources of Value: The first and best guard against forecasting risk is to keep in mind
that positive NPVs are economic rarities in competitive markets. In other words, for a
project to have a positive NPV, it must have some competitive edge – be first, be best,
be the only. Supporters of a project should be able to articulate WHY a project creates
value – why the NPV is positive.
Successful investments are those investments that involve creating, preserving, and
even enhancing competitive advantages that serve as barriers to entry. The following
are project characteristics associated with positive NPVs.
1) Economies of scale
2) Product differentiation
3) Cost advantages
4) Access to distribution channels
5) Favorable government policy
Scenario Analysis
Scenario Analysis is one of the basic forms of “what if” analysis. Scenario analysis is
a process of analyzing possible future events by considering alternative possible
outcomes. What we do is investigate the changes in our NPV estimates that result
from asking questions like: “what if unit sales should be projected at 5,500 units instead
of 6,000 units.”
There are a number of possible scenarios we should consider. A good place to start
is with the worst case scenario. This will tell us the minimum NPV of the project. While
we are at it, we will go ahead and determine the other extreme, the best case scenario.
This will put an upper bound on our NPV.
Best-case/Worst-case scenarios is putting lower and upper bounds on cash flows.

Common exercises include poor revenues/high costs and high revenues/low costs.
Note that a thorough scenario analysis starts with Base-case/Worst-case/Best-case
and then expands from there.
To give a sense of what Scenario Analysis can look like, the following example is
given.
To get the worst case scenarios, we assign the least favourable value to each item.
This means low values to items such as unit sold and price per unit and high values
for costs. We do the reverse for the best case scenarios.
After sorting out the variables that may change, we then create a discounted cashflow
statement on the various scenarios.
With the given information, we can calculate the net income and cash flows under
each scenario.
In the given example, what we learn under the worst scenario is that the cash flow is
still positive at $24,490 but the NPV is -$111,719. Since the project costs $200,000
we stand to lose a little more than half of the investment under the worst case scenario.
The best case offers an attractive return of 41%.
There are an unlimited number of scenarios that we could examine. The difficulty is
that no matter how many different scenarios we run through, all we can learn are
possibilities, some good some bad. Beyond that we do not get any guidance as to
what to do. Scenario analysis can thus be useful in telling us what can happen and in
helping us gauge the potential for disaster, but it does not tell us whether or not to take
the project.
Scenario analysis assumes perfectly correlated inputs. i.e. all “bad” values occur
together and all “good” values occur together. This is not always true.
Sensitivity Analysis
Sensitivity Analysis is a variation of scenario analysis. It is useful in pinpointing the
areas where forecasting risk is especially severe. It is the investigation of what
happens to NPV or IRR when only one variable is changed.
To conduct a sensitivity analysis, hold all variable projections constant except one;
alter that one, and determine how sensitive NPV is to the change. The objective is to
identify which variables are subject to the highest forecasting risk so that additional
resources can be focused on ensuring that the forecasts for those variables are as
realistic as possible.
Below are the strengths and weaknesses of the sensitivity analysis.
• Strengths
o Provides indication of stand-alone risk.
o Identifies dangerous variables.
o Gives some breakeven information.
• Weaknesses
o Does not reflect diversification.
o Says nothing about the likelihood of change in a variable.
o Ignores relationships among variables.
Capital Rationing
Capital rationing is the situation that exists if the firm has positive NPV projects but
cannot obtain the necessary financing.
Capital budgeting rules are distorted when soft or hard rationing occur.
• Soft rationing is when there are funds available but there is self-imposed
rationing, usually by top-level decision-makers within the firm. It often occurs
for administrative reasons that have little or nothing to do with value
maximization.
• Hard rationing, the complete lack of funds, is often associated with market
imperfections or financial distress.
Why does capital rationing occur? In theory, it shouldn’t. In a perfect world, managers
who invest only in positive-NPV projects will take shareholders’ dollars at time t, and
invest them to create more dollars at time (t+n).
Rational shareholders will, therefore, be willing to supply funds, as long as the
benefit is enough to compensate for the risk undertaken.
However, managers can’t convey total information about future projects to suppliers
of capital for fear of disclosing confidential information to competitors (information
asymmetry). And managers have incentives to misrepresent a project’s potential
(moral hazard). As a result, shareholders may hold back funds (or demand higher
required returns). Hence, capital rationing occurs.
Topic 4a Working Capital Management
Learning Objectives
To understand an overview of working capital management and the cash cycle

• Identify and explain the components of Net Working Capital
• Compute and explain the Operating Cycle
• Compute and explain the Cash Cycle
Introduction to Working Capital Management
The most important difference between the short-term and long-term finance is the
timing of the cash flow. Short-term financial decisions typically involve cash flows that
occur within a year or less.
We might view short-term finance generally, and working capital management

specifically, as less important than capital budgeting or the risk-return relationship. But
managing the short term finances of a firm are extremely important.
First, discussions with CFOs quickly lead to the conclusion that, as important as capital
budgeting and capital structure decisions are, they are made less frequently, while the
day-to-day complexities involving the management of net working capital (especially
cash and inventory) consume tremendous amounts of management time.
Second, while it is obvious that poor long-term investment and financing decisions will
adversely impact firm value, poor short-term financial decisions will impair the firm’s
ability to remain operating.
Finally, working capital decisions can also have a major impact on firm value.
Working Capital: The Accounting Equation
Working Capital management is all about managing the current assets and current
liabilities in such a way so as to improve the company’s flow of funds. This strategy
focusses on maintaining efficient levels of both current assets and current liabilities so
that a company has greater cash inflow and cash outflow. It is not only the amount of
cash flow that is important but also the timing of the cash flow.
Net Working Capital (NWC) = Current Assets – Current Liabilities
The ultimate goal of cash management is to have sufficient cash – but not too much –
on hand to meet business obligations in a timely and appropriate manner.
Defining Cash in Terms of Other Elements
Net working capital + Fixed assets = Long-term debt + Equity

Net working capital = Cash + Other current assets – Current liabilities
Substituting NWC into the first equation and rearranging;
Cash = Long-term debt + Equity + Current Liabilities – Other current assets –

Fixed assets
Sources and Uses of Cash
Sources of Cash are the activities that increase cash. Cash can be increased by the
following ways:
• Increase in long-term debt account (borrowed money)
• Increase in equity accounts (issued stock)
• Increase in current liability accounts (borrowed money from suppliers)
• Decrease in current asset accounts, other than cash (sold current assets)
• Decrease in fixed assets (sold fixed assets)
Uses of Cash are the activities that decrease cash. Cash can be decreased by the
following ways:
• Decrease in long-term debt account (repaid loans)
• Decrease in equity accounts (bought stock or paid dividends)
• Decrease in current liability accounts (repaid suppliers or short-term creditors)
• Increase in current asset accounts, other than cash (bought current assets)
• Increase in fixed assets (purchased fixed assets)
The Operating Cycle
Operating cycle is the average time required (a) acquiring inventory, (b) selling it and
(c) collecting for it.
Operating cycle = inventory period + accounts receivable period
The inventory period is the time to acquire and sell inventory.

The accounts receivable period (average collection period) is the time to collect on
sales
Example – Operating Cycle
Imagine a firm with the following information:
Days Activity
0 Acquire inventory on credit
30 Pay for inventory
60 Sell inventory on credit
105 Collect on sale
Operating cycle has two parts.

The first part is the time it takes to acquire and sell inventory. In the example, the 60
days, is called the inventory period.
The second part is the time it takes to collect on sales, 45 days in our example. [105
days – 60 days]. This is called the accounts receivable period or receivables period.
The Operating Cycle is the sum of the two periods:
Operating cycle = Inventory period + Accounts receivable period

= 60 days + 45 days = 105 days.
To calculate the Operating Cycle looks extremely easy as the Inventory period and
Accounts receivable period is provided.
How do we calculate those?
Inventory Period and Accounts Receivable Period
• Operating cycle = Inventory period + Accounts receivable period
• Inventory period = 365 / Inventory turnover

- Inventory turnover = Cost of Goods Sold /Average Inventory
The inventory period shows the average time it takes to sell inventory.
• Accounts receivable period = 365 / Receivables turnover

- Accounts receivable turnover = Credit sales/Average accounts
receivable
The accounts receivable period shows the average time it takes to collect money from
your customers.
The Cash Cycle
The Cash Cycle is the average time between cash payments to suppliers and cash
received from customers. This is an important figure as it shows how long we need
to finance the inventory and receivables.
Cash Cycle = Operating cycle – Accounts payable period
The accounts payable period is the time between receipt of inventory and payment.
Payables period = 365/payables turnover
• Payables turnover = Cost of goods sold / average payables
The graphical representation above shows the cash flow timeline and the short-term
operating activities of a typical manufacturing firm.
The operating cycle is the time period between inventory purchases until the receipt
of cash from customers.
The cash cycle is the time between payment for inventory and the receipt of cash from
customers.
A company would prefer to take as long as possible before paying bills. Accounts
payable is often viewed as “free credit;” however, the cost of granting credit is built into
the cost of the product.
Note that the operating cycle begins when inventory is purchased and the cash cycle
begins with the payment of accounts payable.
Operating and Cash Cycle - Example 1
Item Beginning Ending Average

Inventory $200,000 $300,000 $250,000
Accounts Receivable $160,000 $200,000 $180,000
Accounts Payable $75,000 $100,000 $87,500
Net Sales $1,150,000
Cost of Goods Sold $820,000
With the above, calculate the Operating Cycle and the Cash Cycle for the firm.
Step 1 – Recall the relationships between the formulas
Operating Cycle = Inventory Period + Accounts Receivables Period
Inventory Period = 365/Inventory Turnover
Accounts Receivables Period = 365/Receivables Turnover

= Average Collection Period
Cash Cycle = Operating Cycle – Accounts Payable Period
Accounts Payable Period = 365/Payables Turnover
Step 2 – Calculate the Inventory, Receivables and Payables Period
Inventory period
- Average inventory = (200,000+300,000)/2 = 250,000
- Inventory turnover = 820,000 / 250,000 = 3.28 x
- Inventory period = 365 / 3.28 = 111 days
Receivables period
- Average receivables = (160,000+200,000)/2 = 180,000
- Receivables turnover = 1,150,000 / 180,000 = 6.39 x
- Receivables period = 365 / 6.39 = 57 days
Accounts Payable Period = 365 / payables turnover

- Payables turnover = COGS / Average AP
- PT = 820,000 / 87,500 = 9.4 x
- Accounts payables period = 365 / 9.4 = 39 days
Step 3 – Calculate the Operating and Cash Cycle; Interpret Them
Inventory period = 111 days

Receivables period = 57 days
Operating Cycle = 111 + 57 = 168 days
*Note that we are assuming that all sales are credit sales.
So, on average it takes 168 days from the day we receive the inventory from our
suppliers, to the day we have sold it and collected on the sale.
Payables period = 39 days

Operating cycle = 168 days
Cash cycle = 168 – 39 = 129 days
Inventory and receivables must be financed for 129 days.
A positive cash cycle, like our example, means that inventory is paid for before it is
sold and the cash from the sale is collected. In this situation, a firm must finance the
current assets until the cash is collected from the customer.
Methods to Manage the Operating Cycle
It is observed that a company can improve its operating cycle by
• Reduce receivable period (days)

• Reduce inventory period (days)
• Increase payable period (days)
Receivables Management
A company’s credit management policy should help it maximise its expected profits.
This means to reduce the funds tied up in debtors, ensuring customers pay promptly,
or even earlier, and minimise the incidence of bad debts. To operate a good debtor
policy, a company needs to ensure the following systems are in place:
Establishing credit policy
As part of the management of accounts receivable, a company must establish a credit

policy. This policy will be influenced by:
• demand for the company's products

• competitors' terms
• risk of irrecoverable debts
• financing costs
• costs of credit control.
A firm must establish a policy for credit terms given to its customers. Ideally the firm
would want to obtain cash with each order delivered, but that is impossible unless
substantial settlement (or cash) discounts are offered as an inducement. It must be
recognised that credit terms are part of the firm's marketing policy. If the trade or
industry has adopted a common practice, then it is probably wise to keep in step with
it.
Credit assessment
To minimise the risk of irrecoverable debts occurring, a company should investigate

the creditworthiness of all new customers immediately and should continue to assess
existing customers periodically.
Information for assessing creditworthiness may come from a variety of sources, such
as bank references, trade references, competitors, published information, credit
reference agencies. company sales records or credit scoring.
Obviously, the benefits of providing credit must always be greater than the cost
involved. There is no point, therefore, in the company purchasing an expensive report
from a credit reference agency for a small credit sale.
Credit control
After giving credit, the company has to regularly monitor the customer to ensure that
the agreed terms are met. An aged debtor analysis is usually done so as to help the
company keep track of their receivables and isolate which customers are requiring
corrective attention.
As part of the credit control system, customers would be promptly sent invoices and
statement of accounts. Some companies have automated this feature to ensure a
consistent delivery of such documents. Finally, customers who are in arrears would
appear on a list that does not allow them to take further credit.
Collection of amounts due
While most customers will settle their accounts on time, there will be a minority that
delays payment. Company policy and guidelines should be set for the needed
procedures and actions, if customers pay late. Sometimes, this could involve legal
action at a certain stage. The goal is to minimize the chances of a debt going into
default due to a lack of proper attention given.
Offering early settlement discounts
Cash discounts may encourage early payment, but the cost of such discounts must
be less than the total financing savings resulting from lower debtors’ balances, any
administrative or financial savings arising from shorter debtor collection periods, and
any benefits from lower bad debts.
Factoring
Factoring companies offer a range of services, including:
1. Debt administration. A factor can take over the administration of sales invoicing
and accounting for a client company and collect debts and chase slow payers on
behalf of this client.
2. Credit insurance. A factor can take on the bad debts that may arise through non-
payment by the client’s customers. This is also known as non-recourse factoring.
3. Advance. The factor can offer a cash advance against the security of debtors. Note
that the amount of the advance is usually a percentage of the value of the
outstanding sales invoices, i.e. receivables.
Factoring is particularly useful to small businesses that need help with managing their
debtors. However, the services come at a cost. The factor charges a fee for debt
administration and credit insurance services, which is usually a percentage of the
client company’s credit sales. Interest is charged on the advance made and can be
more expensive than interest on overdraft. Hence a cost-benefit analysis is important.
MANAGEMENT OF INVENTORY
It should be clearly seen that if a smaller amount of stock is ordered each time, the
inventory will be lower, and the inventory period will be correspondingly lower.
The control of stock may be analyzed into three parts:

- Models, such as economic order quantity (EOQ), can be used to decide the
optimum order size for stocks which will minimize the costs of ordering stocks plus
stockholding costs.
- If discounts for bulk purchases are available, it may be cheaper to buy stocks in
large order sizes so as to obtain the discounts.
- Uncertainty in the demand for stocks and / or the supply lead time may lead a
company to decide to hold buffer stocks (thereby increasing its investment in
working capital) in order to reduce or eliminate the risk of ‘stock-outs’ (running out
of stock).
MANAGEMENT OF ACCOUNTS PAYABLE
It may be possible to delay payment to creditors in respect of materials and overheads

in an attempt to reduce the operating cycle.
This may, however, damage relationships with suppliers and affect the credit
reputation of the business. This might be significant for a new business. There is also
a need to evaluate the benefits of discounts for early settlement.
Topic 4b Working Capital – Financing Policies & Cash Budgeting
Learning Objectives
To understand the different options for financing working capital and the
creation of a cash budget.

• Explain the spectrum of policies available for financing, with the extremes being
Flexible and Restrictive policies.
• Discuss the advantages and disadvantages of the various financing policies.
• Accurately create a cash budget based on sales forecasts
Financing of Working Capital
The short term financing policies can be flexible or restrictive. These two policies are
the extremes. Most companies will be somewhere in between.
Flexible policy requires high levels of current assets relative to sales and relies
relatively more on long- term financing
-Keep large cash and securities balances (lower return, but cash is available for
emergencies and unexpected opportunities)
-Keep large amounts of inventory (higher carrying costs, but lower shortage cost
including lost customers due to stock-outs)
-Liberal credit terms, resulting in large receivables (greater probability of default from
customers and usually a longer receivables period; leads to an increase in sales)
Advantages
• No difficulty meeting short-term obligations due to the large amount of cash

kept in the current account.
• Cash available for emergencies
• Minimal shortage/stock out costs as there is a large amount of finished

inventory at hand, allowing quick deliveries to the customers.
Disadvantages
• Liquid securities lead to lower returns. Compared to investing the cash in other
longer term investments that can yield attractive returns, spare cash in the bank
earns very low interest.
• Financing short-term assets with long term debt is an expensive solution.

Generally, long term debt is viewed as riskier by the lender due to the longer
time horizon. As such, the lender is likely to charge a higher interest rate,
compared to short term debt.
Clearly, a flexible policy is favoured by companies with a conservative, risk averse

outlook.
Restrictive policy requires low levels of current assets relative to sales and relies
relatively more on short -term financing
-Keep low cash and securities balances (may be short of cash in emergencies or
unable to take advantage of unexpected opportunities; higher return on long- term
assets)
-Keep low levels of inventory (high shortage costs, particularly bad in industries
where there are plenty of close substitutes that customers can turn to; lower carrying
costs)
-Strict credit policies, or no credit sales (may substantially cut sales level; reduces
cash cycle and need for financing)
Advantages
• Higher returns on long term assets as spare cash is quickly invested into such
assets.
• Lower carrying costs as little inventory is carried. Smaller warehousing

expenses, obsolescence costs.
• Short term liabilities, which is what is relied upon, can be decreased more easily
in case of economic downturn. This is in comparison to long term liabilities.
Disadvantages
• Less liquidity for emergencies. If an emergency strikes, a lack of cash may force
the company to resort to very expensive means of financing.
• Higher shortage/stock-out costs. If there is an unexpected spike in demand, the

company may be caught with shortages and stock-outs.
Clearly, a restrictive policy is favoured by companies with an aggressive, risk taking

outlook.
Carrying Costs and Shortage Costs
Carrying costs are the costs that rise with the increase in the level of investment in
the current assets.
In general, carrying costs is the cost to “support” or “carry” a current asset. For
example, the warehousing costs associated with storing inventory. Or the opportunity
cost of being unable to invest in long-term projects as money is tied up to support the
accounts receivables.
Shortage costs are the costs that fall with the increase in the level of investment in
the current assets. They are incurred when the investment in the current assets is low.
There are two types of shortage costs:
• Trading and order costs – commissions, set-up, paperwork

• Stock-out costs – lost sales, business disruptions, unhappy customers
In this context, total cost is the sum of carrying costs and shortage costs.
An optimal credit policy is where the total cost is minimized.
To further develop this concept, we explore the effects of extending credit (increasing
Accounts Receivable). As shown in the graph, the more credit extended, the higher
the costs of “carrying” it.
However, if too little credit is extended, many customers will go to another supplier
instead, leading to the cost of lost sales (opportunity costs). The correct credit policy
is where the total cost curve is minimized.
Other Factors When Considering Financing Policies
Ideally, we could always finance short-term assets with short-term debt and long-term
assets with long-term debt and equity. However, this is not always feasible.
What is the most appropriate amount of short term borrowing? Several considerations
must be included in a proper analysis:
• Cash reserves
Having reserves will allow a company to take advantage of unexpected opportunities
that come its way. This is especially useful in industries that are volatile and where
business opportunities emerge due to financial distress from weaker parties. Such
possibilities are lesser in stable industries.
However, having too much liquid investments carry the problem of low returns. Placing
money in the bank will yield very low returns and hurt the firm’s overall returns. This
can lead to shareholder dissatisfaction.
• Maturity hedging
As discussed above, it is logical to match the maturity of the liabilities with the maturity
of the assets.
This would mean using long-term debt to finance fixed assets and permanent current
assets. Short term debt or current liabilities will be used to finance temporary current
assets.
The manager will be wary of financing long-term assets with short-term debt due to
the refinancing risk. When the short-term debt matures and requires renewal, there is
the risk of the bank demanding a different interest rate or even refusing to renew the
loan.
• Relative interest rates

As current assets tend to have a low return, it is not always appropriate to use long
term debt to finance it.
This is because long term debt tends to have a higher interest rate compared to short
term debt. However, do note that this is just generally true and there are exceptions.
Choosing the Best Policy
While a “best” policy would really depend on the risk appetite and outlook of a firm, a
good policy can be found by considering a firm’s
Permanent current assets

- A constant, minimum level of current assets in the firm.
- This is usually made up of minimum stock and cash levels that
management had decided upon.
Temporary current assets

- Additional current assets added when sales are expected to increase on
a seasonal basis.
Based on its considerations, a firm may even place its confidence in a “compromise
policy”, where it borrows short-term to meet peak needs and maintains a cash reserve
for emergencies. A slight blend of flexible and restrictive stances.
Cash Budget
The cash budget is a schedule of projected cash receipts and disbursements.
The purpose of a cash budget is to

- Identify short-term needs and opportunities
- Identify when short-term financing may be required
How a cash budget works

1) Identify sales and cash collections
- A Cash Budget requires sales forecasts for a series of periods. We also need
to know the average collection period on receivables to determine when the
cash from sales is received.
2) Identify various cash outflows.

- The other cash flows in the cash budget are generally based on the sales and
production estimates.
3) Subtract outflows from inflows and determine if there is spare cash for investing
or deficits that need financing.
A full worked example will show how a cash budget is created.
Cash Budget – Example 1
As the accountant for Fun Toys, you are tasked to prepare the cash budget for the
upcoming quarters.
• Expected sales by quarter (millions)

▪ Q1: $200; Q2: $300; Q3: $250; Q4: $400
• Beginning Accounts Receivables = $120 million
• Collections
= Beginning receivables + ½ x Current Quarter Sales
• Accounts payable = 60% of sales, paid in Quarter itself.
• Wages, taxes, and other expenses = 20% of sales
• Interest and dividends = $20 million per Q
• Major expansion planned for Q2 costing $100 million
• Beginning cash balance = $20 million (Management needs a minimum cash

balance of $10 million)
Create a cash budget for Fun Toys, from Quarter 1 to Quarter 4.
Step 1 – To Calculate the Cash Collections and Disbursements
Step 2 – To Aggregate Cash Collections/Disbursements to See Ending Balances
From the balances, it is clear whether there is a surplus (making investments possible)
or there is a deficit (making financing required).
Conclusion on Fun Toys
Beginning in Q2, Fun Toys will have a cash deficit which must be covered. By planning
early, Fun Toys is able to source for the most economical and appropriate form of
financing.
In the absence of early planning, Fun Toys may only discover its deficit at the last
moment and seek emergency financing, which is onerous and costly.
Sales are forecasts and could be much better or worse. Therefore, there should be
expectations on things being different and a plan to handle them.
Topic 5a Capital Structure – Valuation, Cost of Capital
Learning Objectives
To understand the composition of capital structure and the valuation of key

financial instruments.

• Discuss the two key components of capital structure - debt and equity
• Carry out an accurate valuation of coupon bonds and zero-coupon bonds
• Carry out an accurate valuation of shares and preference shares based on
cashflows
• Carry out an accurate valuation of shares and preference shares based on
market comparables
Introduction to Capital Structure
A firm’s capital structure refers to the specific mixture of long-term debt and equity that
the firm uses to finance its operations. This topic concerns how the firm obtains the
financing it needs to support its long-term investments.
We have looked at the two of the main topics in Corporate Finance: Capital Budgeting
and the Working Capital Management.
In this section we will look at the next important topic, Capital Structure.
This deals with two important questions:

• How much should the firm borrow
• What are the least expensive sources of funding
The expenses associated with the raising of long-term financing can be considerable,
so different possibilities should be carefully evaluated.
We will be looking at the two main sources of financing for the firm: debt and equity.
A firm’s choice of how much debt it should have relative to equity is known as the
capital structure decision. A firm’s capital structure is a reflection of its borrowing
policy. We will see that debt is a double edge sword which when used properly can be
very beneficial to the firms.
The cost of financing for a firm is measured as its weighted average cost of capital
(WACC). This is the minimum return a company needs to earn to satisfy all its
investors.
Debt and Bonds
Companies have a choice to finance with either debt or equity. Almost all publicly
traded companies use a combination of both to raise funds for business projects.
Debt is raised by taking out loans and selling bonds to investors.

Equity financing, however, is created when companies choose to issue shares and
sell them to investors more interested in the growth and success of the company
than in earning interest on a loan.
One of the important ways of raising funds is by issuing bonds.

A bond is the public debt of a corporation or government entity. It is a type of borrowing.
Basic Bond Definitions
Bonds are frequently referred to as “fixed income securities” since, in their most basic
form; they provide a fixed stream of coupon payments until maturity.
Coupon payment is the interest payment. Coupon payments are typically made in
cash.
Principal/par value is what is paid to the investor on maturity of the bond.
Do note that the coupon payment is based on the Par Value of the bond instead of the
Market Value of the bond. So if a bond’s Par Value is $1,000 and the coupon rate is
6%, the coupon paid will be $60. It does not matter that the Market Value of the bond
might be $1050.
Bond Valuation
A typical bond is valued based on its 2 cashflows

1) Coupon payments
2) Face value/redemption value at the end
A discount rate (not to be confused with Coupon rate) will be used to discount the
cashflows. By adding all the present value of cash inflows, we can see how much a
bond is worth now.
Bond Valuation – Example 1
Kaplan Ltd issued a coupon bond that has a face value of $1,000 and gives an annual
coupon of 8%. The bond will last for 30 years.
The appropriate discount rate is 10%.
What is the value of the bond?
Value of Bond
= $80 (PVIFA10%, 30) + $1,000 (PVIF10%, 30)
= $80 (9.427) + $1,000 (.057)
= $754.16 + $57.00 = $811.16.
Bond Valuation – Example 2
Kaplan Ltd issued another coupon bond that has a face value of $1,000 and gives an
annual coupon of 5%. The bond will last for 10 years.
The appropriate discount rate is 4%.
What is the value of the new bond?
Value of Bond
= $50 (PVIFA4%, 10) + $1,000 (PVIF4%, 10)
= $50 (8.111) + $1,000 (0.6756)
= $405.54 + $675.60 = $1,081.14
Perpetual Bonds
Perpetual Bonds give out a stream of coupons that never ends. It is valued as a
perpetuity.
Q: What is the value of a 5% Perpetual Bond with face value of $100 and with the
discount rate of 8%?
Ans:
Cashflow of Perpetual Bond = 5% x $100 = $5

Value of Perpetuity = Cashflow / Discount rate
Value of Perpetuity = $5 / 0.08 = $62.50
The perpetual bond is worth $62.50.
Zero-coupon Bonds
Zero-coupon Bonds do not give out coupons. They are purchased at a discount and
redeemed at Face Value.
Q: What is the value of a zero-coupon bond with face value of $1,000 and maturity of
5 years? Assume a discount rate of 8%.
Ans:
Value = Cashflow x (1+r)-n

Value = $1,000 x (1+8%)-5
Value = $680.58
Equity or Stocks
The other important way of raising finances is by equity. Equity financing is created
when companies choose to issue shares and sell them to investors more interested in
the growth and success of the company than in earning interest on a loan.
A share is a type of security that signifies ownership in a corporation and represents

a claim on part of the corporation's assets and earnings.
There are two main types of shares: common and preference. Common shares
usually entitle the owner to vote at shareholders' meetings and to receive dividends.
Preference shares generally does not have voting rights but has a higher claim on
assets and earnings than the common shares. For example, owners of preference
shares receive dividends before common shareholders and have priority in the event
that a company goes bankrupt and is liquidated.
A holder of stock (a shareholder) has a claim to a part of the corporation's assets

and earnings. In other words, a shareholder is an owner of a company. Ownership is
determined by the number of shares a person owns relative to the number of
outstanding shares. For example, if a company has 1,000 shares of stock
outstanding and one person owns 100 shares, that person would own and have
claim to 10% of the company's assets
Share Valuation
There are 3 methods to value a share
1) Based on cashflows
2) Based on market comparables
3) Based on asset value
Valuing a share is a challenging exercise, with no single method being able to give a
conclusive valuation. Industry professionals usually use multiple methods and then
arrive a reasonable valuation based on them.
The two most common methods are to value a share based on its cashflows and its
market comparables. Valuing a share based on its assets is lesser used as many
companies now have significant intangible assets (e.g. brand name, intellectual
property) that are not reported on its Financial Statements, making such a valuation
method very difficult.
Share Valuation - Cashflows
When we value a share based on its cashflows, we acknowledge that the relevant
cashflows are
1) Dividends
2) Sale value of shares
However, assuming that the investor wishes to hold the share for the long term, there
will then be no sale value. We can thus value it solely based on its dividends.
Valuing a share based on the present value (PV) of dividends received is known by
the Dividend Valuation model.
Dividend Valuation Model
Valuing a share based on its future dividends is a simple procedure. We will take all
its dividends and discount it to today. That is how much the share is worth now.
The discount rate used is the investors’ required return, which in turn is based on the
riskiness of the share.
However, what if the dividends are to be received for the long term (ie to infinity)?
Another set of calculations must be introduced.
Constant Growth Model
If a share will be held for the long term, we may also assume that we receive dividends
forever. In order to discount this never-ending stream of dividends, we use the
Constant Growth Model. This model allows the factoring of a constant growth rate for
the dividends, which is reasonable as the company is likely to continue growing over
time.
The Constant Growth Model also allows for a scenario where no growth is expected.
In this case, the growth factor will just be adjusted to zero.
Share Valuation – Example 1
Musol Ltd has just paid a dividend of $1.00 per share. It has announced that it intends
to grow the dividend by 3% per year.
Assuming a discount rate of 11%, what is the value of Musol Ltd’s share?
Ans: $12.875
Preference Share Valuation
As preference shares are similar to both shares and bonds, it is not surprising that we
can value it based on the prior methods learnt.
If the preference share is paying dividends and will not be redeemed, we can value
it just like a common share and use the Dividend Valuation Model.
If the preference share is to be eventually redeemed, that makes it similar to a bond

that pays coupons and is redeemed. We can then just value it likewise.
Preference Share Valuation – Example 1
Musol Ltd has just paid a dividend of $1.00 per preference share. It has announced
that it intends to grow the dividend by 3% per year. Assuming a discount rate of 11%,
what is the value of Musol Ltd’s preference share?
Ans: $12.875
Preference Share Valuation – Example 2
Vital Ltd has 6% preference shares that will be redeemed by the company in 3 years,
at par of $100.
Assuming a discount rate of 11%, what is the value of Vital Ltd’s preference share?
Ans: PV of dividends + PV of par value

$14.66 + 73.12 = $87.78
Share Valuation – Market Comparables
The market comparables method is using real-life information within the stock market
to value the share.
Similar companies will be selected and analyzed for ratios such as

- Price / Earnings: This is the ratio when dividing the Share Price by the Earnings
per Share.
- Price / Book: This is the ratio when dividing the Share Price by the Book Value
per Share
- Price / Sales: This is the ratio when dividing the Share Price by the Sales $ per
Share
When the ratios for such companies are calculated, we will then assume that our target
company will have the similar ratios too. So if a similar company has a P/E of 10X, we
will assume our target company has a P/E of 10X.
Usually, adjustments will also be made to factor in the uniqueness of our target firm.
For example, if the target firm has better growth prospects than similar companies, we
may adjust the P/E ratio upwards to 12 or 13.
Market Comparables – Example 1
NuKid wishes to sell its shares to new investors. Currently, it has Earnings per Share
of $2. Its closest competitor has a P/E ratio of 10.
Based on the P/E comparables, what would NuKid’s share price be around?
Ans: $20
A Comparison: Debt vs Equity
Debt:
• Debt means obligation.
• The company who borrows money from the investors to raise the capital is
obliged to the pay coupons at finite intervals and pay back the principal
amount at the end of tenure.
• Raising capital using debt is a burden to the Company as they have to pay
the interest at fixed times (e.g. monthly, semi-annually).
• Coupon or interest is earned by the investors.
• Returns are periodic and almost fixed.
Equity:
• Equity means ownership.
• Anyone who owns equity is part owner of that company. A shareholder,

especially a controlling one, has influence over the decisions within a
company.
• Raising capital using equity means that the company issues shares. Unlike
debt, the company needs not pay a fixed amount to the shareholders.
• The shareholder earns a return when the company issues dividends (it
happens when the company wants to share the profit to their
shareholders).Returns are only when selling of share happens or dividends
are issued. Returns are not fixed.
Cost of Capital – The Basics
“Cost of capital”, “required return”, and “discount rate” are different phrases that all
refer to the opportunity cost of using capital in one way, as opposed to alternative
financial market investments of the same systematic risk. Cost of Capital is the
required return from an investor’s point of view. From the firm’s point of view, this same
return is the cost of capital.
The total cost of capital will be a blend of the costs of various components of the firm’s
capital structure.
The cost to a firm for capital funding = the return to the providers of those funds
- The return earned on assets depends on the risk of those assets

- A firm’s cost of capital indicates how the market views the risk of the
firm’s assets
- A firm must earn, at the minimum, the required return to compensate

investors for the financing they have provided
- The required return is the same as the appropriate discount rate
A good estimate of the cost of capital is required for:

• Good capital budgeting decisions – neither the NPV rule nor the IRR rule can
be implemented without knowledge of the appropriate discount rate
• Financing decisions – the optimal/target capital structure minimizes the cost of
capital
Cost of Equity & Debt
Cost of equity is the cost that the company incurs to raise funds using equity financing
and the cost of debt is the cost that the company incurs to raise funds using debt
financing.
Two major methods for determining the cost of equity

-> The Dividend Growth Model
-> The Capital Asset Pricing Model (CAPM)
Topic 5b Capital Structure – WACC, M&M, Information Asymmetry
Learning Objectives
To be able to discuss and calculate WACC. To understand Capital Structure

theories and Information Asymmetry in the context of Finance.

• Accurately identify the components and derive the Weighted Average Cost of
Capital
• Understand the impact of leverage on returns of a firm
• Discuss Miller & Modigliani’s three cases on Capital Structure
• Explain Information Asymmetry in the context of Capital Structure, Credit
Markets and Venture Capital
Weighted Average Cost of Capital
Using the individual costs of each component of capital calculated, the WACC
combines them into a weighted average.
The Capital Structure Weights

E = market value of the firm’s equity = no. of outstanding shares x price per share
D = market value of the firm’s debt = no. of bonds x price per bond
V = combined market value of the firm’s equity and debt = E + D
The market value of the firm’s assets = market value of liabilities + market value of
equity.
*be careful not to use the book value, market value is a superior figure.
The weights to be used in the WACC formula are the percentages of the firm financed
by each component.
Firms can use different types of capital to finance its activities. Some firms use
common shares and debt and some add preferred shares as a third form of capital.
We will look at an example where the firm is using three types of capital: common
shares, preferred shares and debt.
How to Calculate WACC
WACC – overall return the firm must earn on its assets to maintain the value of its
stock. It is a market rate that is based on the market’s perception of the risk of the
firm’s assets.
After tax cash flows require an after tax discount rate. Let TC denote the firm’s marginal
tax rate. Then the weighted average cost of capital is:
WACC – Example 1
Giogio Ltd has the following financial information and is trying to derive its WACC.
Some partial workings were done by your senior.
What is the WACC of Giogio Ltd?
Answer:
Using of WACC for Project Discounting
Can WACC be used for discounting all projects? What if a project is in a war-torn
country while another is in a peaceful, developed nation?
If we ignore the differing risks in the project, this would be our outcome.
Here, WACC is 15% and blindly applied to all projects, regardless of the risk. This is
unreasonable as the WACC should be adjusted for the respective risks.
If we adjust the WACC with the relevant risks, this is the new outcome.
We see that Project A was the project in the war-torn country. It had high risk and
needed a return of 20%. Project C was in a peaceful, developed country, thus needing
a return of only 10%, corresponding to the low risk. Based on this adjustment, we now
reject Project A and accept Project C.
The WACC is the overall return the firm must earn on its existing assets to maintain
the value of its stock. The WACC is also the required return on any investment by the
firm that has essentially the same risk as existing operations.
The WACC reflects the risk of the firm’s existing assets, as a whole. So the firm/s
WACC is the appropriate discount rate only if the proposed investment is a replica of
the firm’s existing operations.
Capital Structure and Leverage
A firm’s choice of how much debt it should have relative to equity is known as the
capital structure decision. A firm’s capital structure is a reflection of its borrowing
policy.
Leverage is the amount of debt used to finance a firm's assets. A firm with significantly
more debt than equity is considered to be highly leveraged.
Most companies use debt to finance operations. By doing so, it can invest in business
operations without increasing its equity. For example, if a company is formed with an
investment of $5 million from investors, the equity in the company is $5 million - this is
the money the company uses to operate. If the company uses debt financing by
borrowing $20 million, the company now has $25 million to invest in business
operations and more opportunities to increase value for shareholders.
Leverage helps both the investor and the firm to invest or operate. However, it comes
with greater risk. If an investor uses leverage to make an investment and the
investment moves against the investor, his or her loss is much greater than it would've
been if the investment had not been leveraged - leverage magnifies both
gains and losses. In the business world, a company can use leverage to try to
generate shareholder wealth, but if it fails to do so, the interest expense and credit risk
of default destroys shareholder value.
A firm can choose any capital structure that it wants thus setting its debt equity ratio.
A firm could issue some bonds and use the proceeds to buy back some stocks, thereby
increasing the debt equity ratio. Alternatively, it could issue stock and use the money
to pay off some debt, thereby reducing the debt equity ratio. An activity that alters the
firm’s existing capital structure is called “restructuring”.
Such capital structuring decisions can have important implications for the value of the
firm and its cost of capital.
WACC is the weighted average cost of various components of the firm’s capital
structure. The value of the firm is maximized when the WACC is minimized. Thus
we want to choose such a capital structure that will minimize the WACC. Such a capital
structure is called the optimal capital structure for the firm. This is also called the firm’s
target capital structure.
Trans Am Corporation – Example 1
The Trans Am corporation currently has no debt in its capital structure. The firm is
considering a restructuring that would involve a 50% debt financing.
The current and the proposed capital structures are presented in Table 1.
To investigate the impact of capital structuring, we will compare the firm’s current
capital structure to the proposed capital structure under three scenarios. The
scenarios reflect different assumptions about the firm’s EBIT (earnings before interest
and taxes). Under the expected scenario, EBIT is $1 million. In the recession scenario,
the EBIT falls to $500,000 and in the expansion scenario, the EBIT rises to $1.5 million.
The impact of leverage on the EPS and the ROE can be seen in Table 2.
Notice to changes due to the taking of debt.
Variability in ROE
- Current: ROE ranges from 6.25% to 18.75%
- Proposed: ROE ranges from 2.50% to 27.50%
Variability in EPS
- Current: EPS ranges from $1.25 to $3.75
- Proposed: EPS ranges from $0.50 to $5.50
The variability in both EPS and ROE is much larger under the proposed capital
structure. This illustrates how financial leverage acts to magnify gains and losses to
the shareholders.
Break-Even EBIT for Trans Am Corp
To take a closer look at the effect of proposed restructuring, we plot the EPS against
the EBIT for the current and the proposed capital restructuring.
We see that the slope of the line with the capital restructuring is steeper. This tells us
that the EPS is more sensitive to the change in EBIT because of the financial leverage
employed.
Another observation to make is that the lines intersect. At that point the EPS is exactly
the same for the two capital structures. This is called the break-even point.
• If we expect EBIT to be greater than the break-even point, then leverage is

beneficial to our stockholders
• If we expect EBIT to be less than the break-even point, then leverage is
detrimental to our stockholders
EPS = for both Capital Structures
EBIT EBIT − 400,000

=
400,000 200,000
 400,000 
EBIT =   (EBIT − 400,000 )
 200,000 
EBIT = 2  EBIT − 800,000
EBIT = $800,000
800,000
EPS = = $2.00
400,000
Conclusions from Trans Am Corp Example
1. The effect of leverage depends on EBIT

- When EBIT is higher, leverage is beneficial
2. Under the “Expected” scenario, leverage increases ROE and EPS
3. Shareholders are exposed to more risk with more leverage

ROE and EPS more sensitive to changes in EBIT
Capital Structure Theory
Nobel Laureates Franco Modigliani and Merton Miller published the first works
attempting to relate a firm’s capital structure with firm value.
• M&M Proposition I states that the value of the firm (size of the pie) is not related
to how the firm is financed (how the pie is divided).
• M&M Proposition II states that the cost of equity depends on 3 factors: the
required return on the firm’s assets, the firm’s cost of debt and the firm’s debt-
equity ratio.
Capital Structure Theory: Three Special Cases

• Case I = no corporate or personal taxes and no cost to bankruptcy
• Case II = Corporate taxes; no personal taxes and no cost to bankruptcy
• Case III = Corporate taxes and costs to bankruptcy; no personal taxes
Case 1
Case I (no corporate or personal taxes and no cost to bankruptcy)

– Propositions I and II
• M&M Proposition I – without corporate taxes and bankruptcy costs, the firm
cannot affect its value by altering its capital structure.
• M&M Proposition II – a firm’s cost of equity capital is a positive linear function
of its capital structure (still assuming no taxes)
Let’s look at the cost of equity (RE) in terms of cost of debt and the total cost of the
firm:
WACC = RA = (E/V) RE + (D/V) RD
RE = RA + (RA – RD)(D/E)
As more debt is used, the return on equity increases, but the change in the proportion
of debt versus equity just offsets that increase, and the WACC does not change.
The main point with Case I is that it doesn’t matter how we divide our cashflows
between our stockholders and bondholders; the cashflow of the firm doesn’t change.
Since the cash flow doesn’t change, and we haven’t changed the risk of existing
cashflows, the value of the firm doesn’t change.
Here are the graphical illustrations of the M&M Propositions.
With Case I it doesn’t matter how we divide our cash flows between our stockholders
and bondholders; the cash flow of the firm doesn’t change and the WACC doesn’t
change.
M&M Proposition II shows that the firm’ cost of equity can be broken down into two
components. The first component RA is the required return on the firm’s overall assets
and it depends on the nature of the firm’s operating activities. The risk inherent in a
firm’s operations is called the business risk of the firm’s equity.
Business risk is the risk inherent in a firm’s operations; it depends on the systematic
risk of the firm’s assets and it determines the first component of the required return on
equity, RA
Financial risk is the extra risk to stockholders that results from debt financing; it
determines the second component of the required return on equity, (RA – RD)(D/E)
Case 2
Case II = Corporate taxes; no personal taxes and no cost to bankruptcy
Debt has two distinguishing features:

• Interest paid on debt is tax deductible
• Failure to meet debt obligation can lead to bankruptcy
We will consider taxes for Case II and the bankruptcy only in Case III.
As interest payment is tax-deductible, it reduces net income but increases cash flow.
CFFA = EBIT – taxes (depreciation expense is the same in either case, so it will not
affect CFFA on an incremental basis)
*CFFA is the Cash Flow From Assets.
Case 2 - Example
Unlevered Levered
U L
EBIT 1,000 1,000
Interest 0 80
Taxable Income 1,000 920
Taxes (30%) 300 276
Net Income 700 644
CFFA 700 724
From simple comparisons, we see the Interest Tax Shield is $24 per year.
The table shows the impact of corporate taxes on net income and cash flow on Firms
U (unlevered = no debt) and Firm L (levered).
The interest tax shield is the tax savings arising from the tax deductibility of interest. It
is the key benefit of borrowing over issuing equity.
If we assume perpetual debt, which makes the computations easier, then the present
value of interest tax savings = D(RD)(TC) / RD = D x TC
Annual interest tax savings = D x (RD) x (TC)
We also assume constant perpetual cash flows to the firm. This is done for simplicity,
but the ultimate result is the same even if you use finite cash flows that vary.
Working out the mathematics,
Annual interest tax shield

▪ Tax rate x interest payment
▪ $1,000 in 8% debt = $80 in interest expense
▪ Annual tax shield = .30($80) = $24
Present value of annual interest tax shield

▪ Assume perpetual debt
▪ PV = $24 / .08 = $300
▪ PV = D(RD)(TC) / RD = D*TC = $1,000(.30) = $300
Graphical Representation of Case 2
Value of an unlevered firm, VU = EBIT(1 – TC)/RU; where RU is the cost of capital for
an all equity firm (unlevered).
Value of a levered firm, VL = VU + D x TC
M&M Proposition I with taxes implies that a firm’s WACC decreases as the firm relies
more heavily on debt financing.
WACC = (E/V) x RE + (D/V) x RD x (1-TC)
M&M Proposition II with taxes implies that a firm’s cost of equity rises as the firm
relies more heavily on debt financing.
RE = RU + (RU – RD ) x (D/E) x (1-TC)
The amount of leverage in the firm increased, and the cost of equity increased, but the
overall cost of capital decreased.
Therefore, Case 2 advocates for an unlimited uptake of debt, so as to maximize the

tax shield.
Case 3
Herein, the bankruptcy costs related to the taking of debt is considered.
First, we explain bankruptcy cost. Direct bankruptcy costs are the legal and
administrative expenses directly associated with bankruptcy. Generally, these costs
are quantifiable, measurable and significant.
Indirect bankruptcy costs are hard to measure, and generally take the form of lost
revenues, opportunity costs, etc.
Examples include:
• difficulties hiring and retaining good people
• lost sales
• low employee morale
• inability to purchase goods on credit
Financial distress is the direct and indirect costs of avoiding bankruptcy.
Case III = Corporate taxes and costs to bankruptcy; no personal taxes
As the debt-equity ratio increases the probability of bankruptcy increases.

As this probability increases, expected bankruptcy costs increase.
At some point the advantages of debt are outweighed by the potential of
bankruptcy.
In other words,
p D/E ratio →p probability of bankruptcy
p bankruptcy probability →p expected bankruptcy costs
At some point, the additional value of the interest tax shield will be offset by the
expected bankruptcy costs.
At this point, the WACC will start to increase as more debt is added and the value of
the firm will start to decrease.
Graphical Representation of Case 3
Optimal Capital Structure is where the Maximum firm value occurs. In turn, this is
where WACC is minimized.
M&M’s Case 3 can be called the “Static Theory of Capital Structure”

-Firms borrow because tax shields are valuable
-Borrowing is constrained by the costs of financial distress
-The optimal capital structure balances the incremental benefits and costs of
borrowing.
Conclusion on M&M Theories of Capital Structure
The static model is not capable of identifying a precise capital optimal structure, but it
does point out two of the most relevant points:
Taxes – the higher the firm’s tax rate, the more important are tax shields
Financial distress – the lower the risk of distress, the more likely a firm is to borrow
funds
In theory, the static model of capital structure described here applies to multinational
firms as well as to domestic firms. That is, the multinational firm should seek to
minimize its global cost of capital by balancing the (a) debt-related tax shields across
all of the countries it operates in against (b) global agency and bankruptcy costs.
Among other things, however, this assumes that worldwide capital markets are well-
integrated and that foreign exchange markets are highly efficient. In such an
environment, financial managers would seek the optimal global capital structure. In
practice, of course, the existence of capital market segmentation, differential taxes and
regulatory frictions make the determination of the global optimum much more difficult
than the theory would suggest.
Empirical Observations of Capital Structure
Differences according to Cost of Capital 2008 Yearbook by Ibbotson Associates, Inc.
Lowest levels of debt
- Computers = 5.31%
- Drugs = 6.76% debt
Highest levels of debt
- Cable television = 61.84%

- Airlines = 56.30% debt
No two firms have identical capital structures. It has been observed that there is a wide
variation across industries, ranging from essentially no debt for drugs and computer
companies to relatively higher debt usage in airlines and cable television industries.
Information Asymmetry in Finance
Information asymmetry in finance occurs when one party has inadequate information
on the other party, making it difficult to decide if he should transact or not. (Mishkin,
2018)1
For example, shareholders could be unsure if they should rely on the assurances of
management and invest further in a company. As shareholders do not know the
detailed operations of the company, they will be uncertain if the company is really
worth investing.
Likewise, an insurance company, not knowing a person’s true health condition, has to
think carefully about whether to extend insurance to that person.
When people face uncertainty, they may choose to withdraw from the transaction,
leading to negative outcomes.
Information Asymmetry – Capital Structure
Akerlof (1970)2 spoke of the “lemons problem”, whereby buyers in the second-hand
car market are only willing to pay an average price for a car, as they are unable to truly
assess if a car is of good quality.
This will then mean that sellers with truly high-quality cars are unwilling to sell their
cars for an “average” price. While those with inferior cars, will be happy to sell it off at
1
Mishkin, A. and Eakins, S. (2018) Financial Markets and Institutions. (Ninth Edition, pp.181) United Kingdom, Pearson.
2
Akerlof, G. (1970) The Market for ‘Lemons’: Quality, Uncertainty and the Market Mechanism. Quarterly Journal of Economics
84 : 488-500
the “average” price. This creates a market which functions poorly, as most of the
supply of cars will be of inferior quality, thus discouraging buyers from entering.
A similar issue plagues the financial system and affects the capital structure of a firm.
With investors demanding an “average” return as they can’t assess if the firm is really
good, it then leads to high-quality firms being unwilling to seek investment at “average”
prices. They will hope for “below average” prices so as to reflect their quality and low-
risk. However, investors are unwilling to engage and thus, a capital transaction may
not occur.
This leads to inferior companies aggressively entering the market so as to try and
issue investments at an “average” price. Given their condition, they should be paying
“above average” returns to investors and thus, an “average” price motivates them to
enter the market. (Mishkin, 2018)3
Information Asymmetry – Credit Markets
The credit markets refer to the market where companies and governments issue debt
to the public. The issued debts can be in the form of investment-grade bonds, junk
bonds and commercial paper.
With every company having the incentive to claim to be investment grade and
investors not having the information to decide on its accuracy, information asymmetry
thus becomes apparent.
There are ways to overcome information asymmetry

1) Private firms, such as rating agencies like Standard & Poor’s, gather
information on a firm and analyze them. They then sell it to subscribers who
wish to make more accurate decisions.
2) Governments have recognized the ill effects of information asymmetry and try
to reduce it be regulating that credit market participants undergo independent
audits and disclose the needed information. (Mishkin, 2018) 4
Information Asymmetry – Credit Rating Agencies
Credit rating agencies, such as Standard & Poor’s and Moody’s, were criticized for
helping cause the Great Financial Crisis. This is because they had accepted large fees
to give advice to companies who wanted to structure financial instruments in a way
that gets a good credit rating. After providing the advice, these agencies then changed
roles into rating the financial instruments, leading to a clear conflict of interest. It is
likely that they would give a good rating for an instrument which they had helped
structure.
This led to financial instruments entering the market with good credit ratings, yet
having much higher risk within them. (Mishkin, 2018) 5
3
Mishkin, A. and Eakins, S. (2018) Financial Markets and Institutions. (Ninth Edition, pp.182) United Kingdom, Pearson
4
Mishkin, A. and Eakins, S. (2018) Financial Markets and Institutions. (Ninth Edition, pp.183-184, 216) United Kingdom,
Pearson.
5
Mishkin, A. and Eakins, S. (2018) Financial Markets and Institutions. (Ninth Edition, pp.183-184, 216) United Kingdom,
Pearson.
Information Asymmetry – Venture Capital
Start-ups are unable to raise funds from conventional sources (such as banks) due to
information asymmetry. Banks are unable to gain the needed information to assess
the creditworthiness of the start-up. Most start-ups have no track record and are often
engaged in difficult to understand areas such as the likes of cryptocurrency,
cybersecurity or biotechnology,
As such, banks will choose to abstain from engaging with such companies.
Venture Capital (VC) enters to fund such companies, in hope of a high return.
VCs work to overcome the information asymmetry by

- Taking an equity interest. This allows them to have influence and more
information on the company.
- Getting seats on the Board of Directors and even having an operational role.
They may actively attempt to add value to a company by joining in the
operations. This gives them even more information on the state of the start-up.
- Disbursing funds in stages. By disbursing funds only when milestones are met,
they increase their exposure only when further information is available. The
achieving of a milestone is valuable information to show the viability of a firm.
If such milestones are not met, the VC can cut his funding.
(Mishkin, 2018) 6
6
Mishkin, A. and Eakins, S. (2018) Financial Markets and Institutions. (Ninth Edition, pp.585-586) United Kingdom,
Pearson.

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Corporate Finance and

Kaplan Desired Graduate Attributes

Through the reading of this module, Kaplan Higher

• Act responsibly, ethically and with integrity in their

Kaplan Desired Graduate Attributes ii

About this module

Corporate Finance and Planning is an Overview of Learning Resources

Arthur J. Keown, John D. Martin, J. William

How to use this study guide

Further supporting materials

The study guide is supplemented by the following:

• Reproduced PowerPoint slides used by the

The PowerPoint slides are meant for the lecturers

However, the PowerPoint slides must NOT

Assessment Overview Important Policies

Assessment 1: Continuous Penalties for Plagiarism

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Topic 1a Introduction to Finance

At the end of this topic, students should be able to:

Some misunderstand finance to be about buying stocks or investing in lucrative

The 4 Main Areas of Finance

We often divide finance into four main areas:

When we engage in investment activities, our focus is on evaluating whether a

Students specializing in the area of investments have various career opportunities

The following is an elaboration of the roles of different Financial Institutions

Contractual Savings Institutions

- Life Insurance Companies: Insurance policies will receive a fixed premium

- Pension Funds and Government Retirement Funds: Such funds receive

- Finance Companies: Raising funds by issuing equity or debt, Finance

- Mutual Funds: By selling shares to individuals or institutions, Mutual Funds

Hedge Funds invest in stocks, bonds, currencies and derivatives. They

Investment Banks provide advisory and underwriting services on such issues,

Investment Banks also feature prominently as dealmakers and advisors for

Foreign Exchange Markets

When investing overseas, it is unavoidable for foreign currencies to be used. For

Prominent concepts to understand how exchange rates move are the

International Interest Rates and Credit Markets

The other potential areas that Corporate Finance touches on are:

Topic 1b Business Organizations

Provide an understanding of various forms of business organizations, their

At the conclusion of this topic, you should be able to:

Corporate Organization Chart

Prior to giving thought to the organization chart of a company, it is worth to consider if

We normally categorize businesses into: corporations/companies, partnerships

A sole proprietorship is a business owned by an individual. It is the simplest and the

A simple example follows:

Tom invested $100,000 to start a sole-proprietorship that deals with computer

A partnership is a business owned jointly by two or more individuals. The partnership

Partners can be general partners or limited partners.

The advantages and disadvantages of a partnership are basically same as that of a

The common features between sole proprietorship and partnership are:

Limited Liability Partnership (LLP)

To illustrate how similar it is to a company, an LLP is able to do things such as

A corporation is a legal entity, separate from its owners. To establish a business as

1) The owners (shareholders) elect the Board of Directors

As a result of the separation of ownership and management, the ownership can be

The Goal of the Firm

This is known as Wealth Maximization.

Some agency costs to monitor and influence the behavior of management: