FIN312- corporate finance

DescriptionMODULE 2 – CAPITAL BUDGETING (30 MARKS)
Project X involves a new type of graphite composite in-line skate wheel. We think we can sell
6,000 units per year at a price of $1,000 each. Variable costs will run about $400 per unit, and the
product should have a four-year life. Fixed costs for the project will run $450,000 per year. We
also engaged the service of a consulting company to run a feasibility study on the project, and we
paid $250,000 for it, on top of $100,000 for R&D. Further, we will need to invest a total of
$1,250,000 in manufacturing equipment. This equipment is seven-year MACRS property for tax
purposes. In four years, the equipment will be worth about half of what we paid for it. We will
have to invest $1,150,000 in net working capital at the start. Using MS Excel spreadsheet,
combined with MS Word, prepare an analysis and a report for the NPV of the investment project.
MODULE 3 – FINANCING & CAPITAL STRUCTURE (30 MARKS)
1) An income bond holder receives interest payments only if the firm makes income. If the
firm does not make interest payments in a year, the interest is cumulated and paid in the
first year the firm makes income. A preferred stock receives preferred dividends only if
the firm makes income. If a firm does not make preferred dividend payments in a year, the
dividend is cumulated and paid in the first year the firm makes income. Are income bonds
really preferred stock? What are the differences? For purposes of calculating debt how
would you differentiate between income bonds and regular bonds?
2) You are analyzing a new security that has been promoted as equity, with the following
features:
• The dividend on the security is fixed in dollar terms for the life of the security, which
is 20 years.
• The dividend is not tax deductible.
• In the case of default, the holders of this security will receive cash only after all debt
holders, secured as well as unsecured, are paid.
• The holders of this security will have no voting rights. Based upon the description of
debt and equity in the chapter, how would you classify this security? If you were asked
to calculate the debt ratio for this firm, how would you categorize this security?
3) You have been asked to calculate the debt ratio for a firm that has the following
components to its financing mix –
• The firm has 1 million shares outstanding, trading at $ 50 per share.
• The firm has $ 25 million in straight debt, carrying a market interest rate of 8%.
• The firm has 20,000 convertible bonds outstanding, with a face value of $1000, a
market value of $1100, and a coupon rate of 5%.
Estimate the debt ratio for this firm.
4) Zycor Corporation obtains most of its funding internally. Assume that the stock has a beta
of 1.2, the riskless rate is 6.5% and the market risk premium is 6%.
a) Estimate the cost of internal equity.
b) Now assume that the cost of issuing new stock is 5% of the proceeds. Estimate the cost
of external equity.
MODULE 4 (DIVIDEND POLICY)
1. What options does a firm have to spend its free cash flow (after it has satisfied all interest
obligations)?
2. ABC Corporation announced that it will pay a dividend to all shareholders of record as of
Monday, April 2, 2012. It takes three business days of a purchase for the new owners of a share
of stock to be registered.
a) When is the last day an investor can purchase ABC stock and still get the dividend payment?
b) When is the ex-dividend day?
3. Describe the different mechanisms available to a firm to use to repurchase shares.
4. RFC Corp. has announced a $1 dividend. If RFC’s price last price cum-dividend is $50, what
should its first ex-dividend price be (assuming perfect capital markets)?
5. KMS Corporation has assets with a market value of $422 million, $36 million of which are cash.
It has debt of $186 million and 18 million shares outstanding. Assume perfect capital markets.
a) What is its current stock price?
b) If KMS distributes $36 million as a dividend, what will its share price be after the dividend is
paid?
c) If instead, KMS distributes $36 million as a share repurchase, what will its share price be
once the shares are repurchased?
d) What will its new market debt-equity ratio be after either transaction?
MODULE 5 (RISK MANAGEMENT)
6. Why might a large, multinational company choose to insure against common events, such as
vehicle accidents, but not against rare events which could cause large losses? Explain briefly.
7. “The farmer does not avoid risk by selling wheat futures. If wheat prices stay about $2.80 a
bushel, then he will actually have lost by selling wheat futures at $2.50.” Is this a fair comment?
8. List some of the commodity futures contracts that are traded on exchanges. Who do you think
could usefully reduce risk by buying each of these contracts? Who do you think might wish to
sell each contract?
9. Genentech’s main facility is in South San Francisco. Suppose that Genentech would experience a
direct loss of $450 million in the event of a major earthquake that disrupted its operations. The
chance of such an earthquake is 2% per year, with a beta of -0.5.
a) If the risk-free interest rate is 5% and the expected return of the market is 10%, what is the
actuarially fair insurance premium required to cover Genentech’s loss?
b) Suppose the insurance company raises the premium by an additional 15% over the amount
calculated in part (a) to cover its administrative and overhead costs. What amount of
financial distress or issuance costs would Genentech have to suffer if it were not insured to
justify purchasing the insurance?
MODULE 6 (INTERNATIONAL FINANCE)
10. Spot and Forward Rates: Suppose the exchange rate for the Swiss franc is quoted as SF 1.09 in
the spot market and SF 1.11 in the 90-day forward market.
a) Is the dollar selling at a premium or a discount relative to the franc?
b) Does the financial market expect the franc to strengthen relative to the dollar? Explain.
c) What do you suspect is true about relative economic conditions in the United States and
Switzerland?
11. Purchasing Power Parity: Suppose the rate of inflation in Mexico will run about 3 percent
higher than the U.S. inflation rate over the next several years. All other things being the same,
what will happen to the Mexican peso versus dollar exchange rate? What relationship are you
relying on in answering?
Module 6
International Corporate
Finance
Multinational or Global Corporation
▪ The terms multinational corporations, transnational corporations, and global
corporations are used to describe firms that operate in an integrated fashion in a
number of countries.
▪ Rather than merely buying resources from and selling goods to foreign nations,
multinational firms often make direct investments in fully integrated operations,
from extraction of raw materials, through the manufacturing process, and to
distribution to consumers throughout the world.
▪Today, multinational corporate networks control a large and growing share of
the world’s technological, marketing, and productive resources.
Why companies “go global”?
1.
To broaden their markets. After a company has saturated its home market, growth
opportunities are often better in foreign markets. Thus, such homegrown firms as Coca-Cola
and McDonald’s are aggressively expanding into overseas markets, and foreign firms such as
Sony and Samsung now dominate the U.S. consumer electronics market.
2.
To seek raw materials. Many U.S. oil companies, such as ExxonMobil, have major
subsidiaries around the world to ensure access to the basic resources needed to sustain the
companies’ primary business lines.
3.
To seek new technology. No single nation holds a commanding advantage in all
technologies, so companies scour the globe for leading scientific and design ideas. For
example, Xerox has introduced more than 80 different office copiers in the United States that
were engineered and built by its Japanese joint venture, Fuji Xerox.
Why companies “go global”?
4.
To seek production efficiency. Companies in high-cost countries are shifting production to
low-cost regions. For example, GE has production and assembly plants in Mexico, South
Korea, and Singapore; Japanese manufacturers are shifting some of their production to
lower-cost countries in the Pacific Rim.
5.
To avoid political and regulatory hurdles. For example, when Germany’s BASF launched
biotechnology research at home, it confronted legal and political challenges from the
environmentally conscious Green movement. In response, BASF shifted its cancer and
immune system research to two laboratories in the Boston suburbs. This location is attractive
not only because of its large number of engineers and scientists but also because the Boston
area has resolved many controversies involving safety, animal rights, and the environment.
6.
To diversify. By establishing worldwide production facilities and markets, firms can cushion
the impact of adverse economic trends in any single country. In general, geographic
diversification helps because the economic ups and downs of different countries are not
perfectly correlated.
Multinational vs. Domestic Market
Six major factors that complicate financial management in multinational firms:
1.
Different currency denominations. Cash flows in various parts of a multinational corporate
system will be denominated in different currencies. Hence, the effects of exchange rates
must be addressed in all financial analyses.
2.
Economic and legal ramifications. Each country has its own unique economic and legal
systems, and these differences can cause significant problems when a corporation tries to
coordinate and control its worldwide operations.
▪ For example, differences in tax laws among countries can cause a given economic transaction to have
strikingly different after-tax consequences, depending on where the transaction occurs.
▪ Differences in legal systems of host nations, such as the Common Law of Great Britain versus the
French Civil Law, complicate matters ranging from the simple recording of business transactions to the
role played by the judiciary in resolving conflicts.
▪ Such differences can restrict multinational corporations’ flexibility in deploying resources and can
even make procedures that are required in one part of the company illegal in another part.
Multinational vs. Domestic Market
3.
Language differences. The ability to communicate is critical in all business transactions, and
here U.S. citizens are often at a disadvantage because they are generally fluent only in
English, whereas European and Japanese businesspeople are usually fluent in several
languages, including English.
4.
Cultural differences. Even within geographic regions that are considered relatively
homogeneous, different countries have unique cultural heritages that shape values and
influence the conduct of business. Multinational corporations find that matters such as
defining the appropriate goals of the firm, attitudes toward risk, dealings with employees,
and the ability to curtail unprofitable operations vary dramatically from one country to the
next.
Multinational vs. Domestic Market
5.
Role of governments. In a foreign country, the terms under which companies compete, the
actions that must be taken or avoided, and the terms of trade on various transactions often
are determined not in the marketplace but by direct negotiation between host governments
and multinational corporations.
6.
Political risk. Political risk means possible adverse acts by a hostile foreign government after
an investment is made. A nation might place constraints on the transfer of corporate
resources or even expropriate assets within its boundaries. This is political risk, and it varies
from country to country. Another aspect of political risk is terrorism against U.S. firms or
executives. For example, U.S. and Japanese executives are at risk of being kidnapped in
Mexico and several South American countries.
These factors complicate financial management, and they increase the risks
faced by multinational firms. However, the prospects for high returns and
better diversification make it worthwhile for firms to accept these risks and
learn how to manage them.
International corporate finance theories:
The international financial manager has to cope with different currencies, interest rates, and
inflation rates. To produce order out of chaos, the manager needs some model of how they are
related.
Four useful theories to consider in international corporate finance:
1.
Interest rate parity theory : states that the interest differential between two countries must
be equal to the difference between the forward and spot exchange rates. In the international
markets, arbitrage ensures that parity almost always holds. There are two ways to hedge
against exchange risk: One is to take out forward cover; the other is to borrow or lend abroad.
Interest rate parity tells us that the costs of the two methods should be the same.
▪ For example: Interest rate parity theory says that the peso rate of interest covered for exchange risk
should be the same as the dollar rate. As long as money can be moved easily between deposits in
different currencies, interest rate parity almost always holds. In fact, dealers would set the forward
price of pesos by looking at the difference between the interest rates on deposits of dollars and pesos
International corporate finance theories:
2.
The expectations theory of exchange rates: tells us that the forward rate equals the
expected spot rate. In practice forward rates seem to incorporate a risk premium, but this
premium is about equally likely to be negative as positive. But on average the forward rate
and future spot rate are almost identical. It means that a company that always uses the
forward market to protect against exchange rate movements does not pay any extra for this
hedging.
International corporate finance theories:
3.
Purchasing power parity (law of one price): States that $1 must have the same purchasing
power in every country. That doesn’t square well with the facts, for differences in inflation
rates are not perfectly related to changes in exchange rates. This means that there may be
some genuine exchange risks in doing business overseas. On the other hand, a financial
manager, who needs to make a long-term forecast of the exchange rate, cannot do much
better than to assume that the real exchange rate will not change and that the changes in
the value of the currency would offset the difference in inflation rates.
International corporate finance theories:
4.
In an integrated world capital market real rates of interest would have to be the same. In
practice, government regulation and taxes can cause differences in real interest rates.
Companies can use forward markets or the loan markets to hedge transactions exposure,
which arises from delays in foreign currency payments and receipts. But the company’s
financing choices also need to reflect the impact of a change in the exchange rate on the
value of the entire business. This is known as economic exposure. Companies protect
themselves against economic exposure either by hedging in the financial markets or by
building plants overseas.


Because companies can hedge their currency risk, the decision to invest overseas does not involve
currency forecasts (separate out the investment decision from the decision to take on currency
risk). This means that the views about future exchange rates should NOT enter into the
investment decision.
There are two ways for a company to calculate the NPV of an overseas project. The first is to
forecast the foreign currency cash flows (foreign approach) and to discount them at the foreign
currency cost of capital. The second is to translate the foreign currency cash flows into domestic
currency assuming that they are hedged against exchange rate risk (home country approach).
These domestic currency flows can then be discounted at the domestic cost of capital. The
answers should be identical.
End of module 6
YANBU UNIVERSITY COLLEGE
Management Science Department
FIN 312
CORPORATE FINANCE
MODULE 2 – Part 1
Capital Investment Decisions, Project Analysis and
Evaluation
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Learning Objectives
• Define what is a project
• Characterize the dimensions in capital investment
• Identify steps in investment analysis
• Analyze the incremental cash flows in project
analysis
• Perform project analysis and evaluation for a firm
• Analyze capital investment decisions
• Use sensitivity analysis, or scenario analysis to
evaluate project risk.
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Slide 2
What is a Project?
• A capital budget lists the projects and investments that a company plans to
undertake during the coming year. To determine this list, firms analyze alternative
projects and decide which ones to accept or reject through a process called capital
budgeting.
• These decisions qualify as projects:
❖ Major strategic decisions to enter new areas of business
❖ Merger and Acquisitions of other firms
❖ New ventures within existing businesses or markets
❖ Replacement to reduce cost (renewal)
❖ Contraction projects (downsizing)
❖ Safety and environment project
❖ Decisions on how best to deliver a service that is necessary for the business to
run smoothly
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Slide 3
What is a Project? Example:
In early 2008, McDonalds Corp., the world’s leading fast food restaurant,
announced that it would add cappuccinos, lattes, and mochas to its menu of
nearly 14,000 U.S. locations over the next two years. John Betts, vice
president of national beverage strategy, described the introduction as “the
biggest endeavor for McDonald’s since our introduction of breakfast 35 years
ago.” Betts added that McDonald’s menu enhancements could add up to $1
billion in sales. The decision by McDonald’s to introduce “high-end” coffee
options to its menu represents a classic capital budgeting decision. To make
such decisions, McDonald’s relies primarily on the NPV rule. But how can
managers quantify the cost and benefits of a project like this one to compute
its NPV?
The first step in this process is to forecast the project’s revenues and costs,
and from them estimate the project’s expected future cash flows. The process
of estimating a project’s expected cash flows, which are crucial inputs in the
investment decision process will be considered in detail . Using these cash
flows, we can then compute the project’s NPV—its contribution to shareholder
value. Finally, because the cash flow forecasts almost always contain
uncertainty, we demonstrate how to compute the sensitivity of the NPV to the
uncertainty in the forecasts.
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Slide 4
Dimensions of investment decisions
1) How new projects affect other projects the firm is
considering and analyzing.
▪ While some projects are independent of the analysis of any other projects, and
thus can be analyzed separately, other projects are mutually exclusive,
– i.e., taking one project will mean rejecting other projects; in this case,
all of the projects will have to be considered together.
▪ Some projects are prerequisites for other projects down the road.
▪ Thus, projects can be categorized as falling on the continuum between prerequisites and mutually exclusive:
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Slide 5
Dimensions of investment decisions
1) Ability of the project to generate revenues or reduce costs.
▪ Decision rules for generating revenue?
✓ evaluate whether the earnings or cash flows from the projects justify the
investment needed to implement.
▪ Decision rules for cost-reduction projects?
✓ Examine whether the reduction in costs justifies the up-front investment needed for
the projects.
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Slide 6
Project Cash Flow : A First Look
▪ The effects 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 flow and then decide whether
they add value to the firm.
▪ Thus, the first step is to decide which cash flows are
relevant.
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Slide 7
Relevant Cash Flows
A relevant cash flow for a project is a change in the firm’s
overall future cash flow that comes about as a direct
consequences of the decision to take the project.
Because the relevant cash flows are defined in terms of
changes in, or increments to, the firm’s existing cash flow,
they are called the incremental cash flows associated with the
project.
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Slide 8
Incremental Cash Flows
The incremental cash flows for project evaluation consist of
any and all changes in the firm’s future cash flows that are
a direct consequence of taking the project.
Incremental earnings of a project—that is, the amount by which the firm’s
earnings are expected to change as a result of the investment decision.
Incremental cash flows is the difference between a
firm’s future cash flows with
a project and those without
the project.
Any cash flow that exists regardless of whether or not a
project is undertaken is not relevant.
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Slide 9
The Stand-Alone Principle
❑ Once we identify the effect of undertaking the proposed
project on the firm’s cash flows, we need to focus only
on the project’s resulting incremental cash flows.
❑ The Stand Alone Principle : The assumption that
evaluation of a project may be based on the project’s
incremental cash flows.
➢ We can view that project as a kind of “minifirm” with its own future
revenues and costs, its own assets, and its own cash flows.
➢ We will then be primarily interested in comparing the cash flows from this
“minifirm” to the cost of acquiring it.
➢ An important consequence of this approach is that we will be evaluating
the proposed project purely on its own merits, in isolation from any other
activities or projects.
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Slide 10
Incremental Cash Flows : In Detail
▪ Only concern with cash flows that are incremental and that
result from a project.
▪ But there are some non-incremental cash flows that should
not be included in the analysis; which include:
▪ Sunk Costs
▪ Net working capital
▪ Financing costs
➢ But what about opportunity costs?
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Slide 11
Incremental Cash Flows : In Detail
SUNK COSTS
A cost that has already been incurred and cannot
be removed and recovered.
▪ Sunk costs have been or will be paid regardless of the decision about whether or not
to proceed with the project. There are some expenses, related to a project that might
be incurred before the project analysis is done.
▪ Therefore, they are not incremental with respect to the current decision and should not
be included in its analysis.
▪ Remember: focus of capital budgeting is with future CF!
▪ For example:
▪ Expenses incurred for a test market or feasibility study to assess the potential
market for a product prior to conducting project analysis.
▪ These expenses cannot be recovered if the project is rejected, these sunk costs
are not incremental and thus should not be considered as part of investment
analysis.
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Slide 12
Incremental Cash Flows : In Detail
SUNK COSTS
For example:
▪ Research and Development (R&D)
▪ Marketing research
▪ Engineering costs
▪ Example: General Mill Company hires a financial consultant to help evaluate
whether a line of chocolate milk should be launched. Thus, the consultancy
fee is a sunk cost: it must be paid whether or not the chocolate milk line is
actually launched.
If the expenditure has already been made, we do not
consider this in the CF analysis for a capital project
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Slide 13
Incremental Cash Flows : In Detail
OPPORTUNITY
COSTS
• It requires us to give up a benefit (foregone opportunity).
• The most valuable alternative that is given up if a particular
investment is undertaken.
• The opportunity cost of using a resource is the value it
could have provided in its best alternative use.
▪ Many projects use a resource that the company already owns. Because the firm does
not need to pay cash to acquire this resource for a new project, it is tempting to assume
that the resource is available for free.
▪ However, in many cases the resource could provide value for the firm in another
opportunity or project.
▪ Because this value is lost when the resource is used by another project, we should
include the opportunity cost as an incremental cost of the project.
Opportunity costs that represent foregone CF should
be included in the CF analysis of a capital project
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Slide 14
Incremental Cash Flows : In Detail
OPPORTUNITY COSTS
▪ For example:
▪ A firm is thinking of converting an old rustic cotton mill it bought years ago for
$100,000 into condominiums complex.
▪ If the firm undertakes this project, there will be no direct cash outflow associated
with buying the old mill because it already owns it. For purposes of evaluating the
condo project, should the firm then treats the mill as “free”? The answer is no.
▪ The mill is a valuable resource used by the project. If the firm didn’t use it here, it
could do something else with it. Like what?
▪ At a minimum, the firm could sell it. Using the mill for the condo complex thus has
an opportunity cost : The firm gives up the valuable opportunity to do something
else with the mill.
▪ Therefore, the opportunity cost that we charge the project is what the mill would sell
for today (net of any selling costs) because this is the amount we give up by using
the mill instead of selling it.
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Slide 15
Incremental Cash Flows : In Detail
OPPORTUNITY COSTS
▪ Consider another example:
▪ A company purchased a piece of land several years ago for $150,000.
▪ Today the company is deciding whether or not to use the land as the location for a new
storage facility.
▪ The original outlay of $150,000 is a sunk cost and should be ignored.
▪ But the land cannot be considered “free” because the company always has an option of
using it for another purpose or selling it.
▪ Assuming the company could sell this land today at a market price of $200,000 – this would
become the opportunity cost of using the land for the storage facility.
▪ As such it should be included in the cost of the project.
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Slide 16
Incremental Cash Flows : In Detail
NET WORKING CAPITAL
▪ Normally, a project will require that the firm invest in net working capital in addition to
long-term assets.
▪ For example, a project will generally need some amount of cash on hand to pay any
expenses that arise.
▪ Also, a project will need an initial investment in inventories and account receivable (to
cover credit sales).
▪ Some financing for this will be in the form of amounts owed to suppliers (account
payable), but the firm will have to supply the balance.
▪ This balance represents the investment in net working capital.
▪ As the project winds down, inventories are sold, receivables are collected, bills are paid,
and cash balances can be drawn down.
▪ These activities will free up the net working capital originally invested.
▪ The firm supplies working capital at the beginning and recovers it toward the end.
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Slide 17
Incremental Cash Flows : In Detail
FINANCING COSTS
▪ In analyzing a proposed investment, we will not include interest paid or
any other financing costs such as dividends because we are interested in
the cash flow generated by the assets of the projects.
▪ This is because, the interest paid is a component of cash flow to
creditors, not cash flow from the assets.
▪ Any incremental interest expenses will be related to the firm’s decision
regarding how to finance the project. Here we wish to evaluate the
project on its own, separate from the financing decision.
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Slide 18
Incremental Cash Flows : In Detail
FIXED OVERHEAD EXPENSES
▪ Overhead expenses are associated with activities that are not directly
attributable to a single business activity but instead affect many different
areas of the corporation.
▪ These expenses are often allocated to the different business activities for
accounting purposes.
▪ If these overhead costs are fixed and will be incurred in any case, they
are not incremental to the project and should not be included.
▪ Only include as incremental expenses the additional overhead expenses
that arise because of the decision to take on the project.
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Slide 19
Incremental Cash Flows : In Detail
PROJECT EXTERNALITIES
▪ Project externalities are indirect effects of the project that may
increase or decrease the profits of other business activities of the firm.
▪ For instance, in the McDonald’s example, some cappuccino
purchasers would otherwise have bought an alternative beverage, like
a soft drink.
▪ When sales of a new product displace sales of an existing product, the
situation is often referred to as cannibalization or erosion.
▪ Cannibalization is a negative impact on CF of an existing product from
the introduction of a new product.
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Slide 20
Pro forma Financial Statement and Project Cash Flow
1)
PRO FORMA FINANCIAL STATEMENT
▪ A set of pro forma or projected financial statement is needed before
evaluating a proposed investment.
▪ It is a financial statement which projects future years’ operations.
▪ It is used to develop the projected cash flows from the projects.
▪ After we have the cash flows, then the value of the project can be
evaluated using the technique (NPV).
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Slide 21
Getting Started: Pro forma Financial Statement
Key ingredients in preparing the pro forma financial
statement:
▪ Estimate unit sales
▪ Estimate selling price per unit
▪ Estimate variable costs per unit
▪ Estimate fixed costs
▪ Know how much the total investment required (including any
investment in net working capital)
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Slide 22
Getting Started: Pro forma Financial Statement
Illustrations:
▪ Suppose we think we can sell 50,000 cans of shark attractant per year at a price
of $4 per can.
▪ It costs us about $2.50 per can to make the attractant, and a new product such as
this one typically has only a three-year life (perhaps because the customer base
declines rapidly). We require a 20 percent return on new products.
▪ Fixed costs for the project, including such things as rent on the production facility,
will run $12,000 per year.
▪ Further, we will need to invest a total of $90,000 in manufacturing equipment.
▪ For simplicity, we will assume that this $90,000 will be 100 percent depreciated
over the three-year life of the project.
▪ Furthermore, the cost of removing the equipment will roughly equal its actual
value in three years, so it will be essentially worthless on a market value basis as
well.
▪ Finally, the project will require an initial $20,000 investment in net working capital,
and the tax rate is 34 percent.
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Slide 23
Getting Started: Pro forma Financial Statement
Illustrations: continue
▪ First preparing the pro forma income statement.
▪ Do not deduct any interest expense since interest paid is a financing expense, not a
component of operating cash flow.
Table 1: Projected Income Statement
Sales (50,000 units at $4/unit)
$200,000
Variable costs ($2.50/unit)
125,000
$ 75,000
Fixed costs
12,000
Depreciation ($90,000/3)
30,000
EBIT
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$ 33,000
Taxes (34%)
11,220
Net income
$ 21,780
Slide 24
Getting Started: Pro forma Financial Statement
Illustrations: continue
▪ Also prepare abbreviated balance sheet that shows the capital requirements for the
projects.
Table 2: Projected Capital Requirements
Year
0
1
2
3
Net Working
Capital
$ 20,000
$ 20,000
$ 20,000
$ 20,000
Net Fixed
Assets
90,000
60,000
30,000
0
Total
Investment
$110,000
$ 80,000
$ 50,000
$ 20,000
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Slide 25
Getting Started: Pro forma Financial Statement
▪ Net working capital $20,000 each year
▪ Fixed assets $90,000 at the start of project life (year 0); they
decline by $30,000 in depreciation each year, ending up at 0.
▪ Total investment is total book value not market value.
Next step is to convert this accounting information into cash flows
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Slide 26
Project Cash Flow
2)
PROJECT CASH FLOW
▪ The cash flows from assets have three components:
1. Operating cash flow
2. Capital spending
3. Changes in net working capital
▪ To evaluate a project, we need to calculate cash flow like this:
Project cash flow = Project operating cash flow –
project change in net working
capital – project capital spending
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Slide 27
Project Cash Flow
2)
PROJECT CASH FLOW
Project cash flow = Project operating cash flow –
project change in net working
capital – project capital spending
A) Project Operating cash flow
Operating cash flow
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= earnings before interest and taxes
+ depreciation
– taxes
Slide 28
Project Cash Flow
2)
PROJECT CASH FLOW
A) Project Operating cash flow
Operating cash flow
= earnings before interest and taxes
+ depreciation – taxes
▪ Using the projected income statement in table 1
Sales (50,000 units at $4/unit)
$200,000
Variable costs ($2.50/unit)
125,000
Fixed costs
12,000
Depreciation ($90,000/3)
30,000
EBIT
© Yanbu University College
$ 33,000
Taxes (34%)
11,220
Net income
$ 21,780
Slide 29
Project Cash Flow
2)
PROJECT CASH FLOW
Given the projected income statement in Table 1, we can
now calculate the projected operating cash flow:
Table 4: Projected operating cash flow
© Yanbu University College
EBIT
$33,000
+Depreciation
+30,000
-Taxes
-11,220
Operating cash flow
$51,780
Slide 30
Project Cash Flow
2)
PROJECT CASH FLOW
Given the projected income statement in Table 1, we can
now calculate the projected operating cash flow:
Table 5: Projected total cash flow
Year
0
Operating cash flow
$ 51,780
Changes in NWC
– $ 20,000
Capital spending
– $ 90,000
Total project cash
flow
– $110,000
© Yanbu University College
1
2
$ 51,780
3
$ 51,780
+ 20,000
$ 51,780
$ 51,780
$ 71,780
Slide 31
Project Cash Flow
2)
PROJECT CASH FLOW
Next, we need to take care of the fixed asset and net
working capital requirements:
▪ Based on our balanced sheet, we know that the firm must spend $90,000 up
front for fixed assets and invest an additional $20,000 in net working capital.
▪ Thus, the immediate outflow is $110,000.
▪ At the end of project life, the fixed assets will be worthless, but the firm will
recover the $20,000 that was tied up in working capital.
▪ This will lead to a $20,000 inflow in the last year (year 3).
▪ Therefore, whenever we have an investment in net working capital, the same
amount will be recovered with opposite sign (+).
© Yanbu University College
Slide 32
Project Cash Flow and Value
3)
PROJECT CASH FLOW AND VALUE
Finally, we can finish this cash flow analysis:
Given the 20% required return for the project:
NPV
= – $110,000 + 51,780/(1.2) + 51,780/(1.2)
2
3
+ 71,780/(1.2)
= $10,648
Based on these projections, the project creates over $10,000 in
value and should be accepted.
© Yanbu University College
Slide 33
Further Adjustments to Free Cash Flow
• Other Non-cash Items
– Amortization (a charge that captures the change in
value of acquired assets – e.g. patent, copyrights,
trademarks, licences)
• Timing of Cash Flows
– Cash flows are often spread throughout the year.
• Accelerated Depreciation
– Modified Accelerated Cost Recovery System
(MACRS) depreciation
© Yanbu University College
Depreciation : MACRS
© Yanbu University College
Slide 35
Depreciation : MACRS
• The basic idea under MACRS is that every asset is assigned to a particular
class.
• An asset’s class establishes its life for tax purposes.
• Once an asset’s tax life is determined, the depreciation for each year is
computed by multiplying the cost of the asset by a fixed percentage.
▪ Example: Consider an automobile costing $12,000. Autos are normally classified as
five-year property.
© Yanbu University College
Slide 36
Further Adjustments to Free Cash Flow (cont’d)
• Liquidation or Salvage Value
Capital Gain = Sale Price − Book Value
Book Value = Purchase Price − Accumulated Depreciation
After-Tax Cash Flow from Asset Sale = Sale Price − (c  Capital Gain)
© Yanbu University College
Book Value vs Market Value
• Book value of an asset can differ substantially from its actual market value.
• Suppose we wanted to sell the car after five years. The market value is
25% of the purchase price, or 0.25 x $12,000 = $3,000.
• If we actually sold it at this price, we would have to pay tax of the difference
between the sale price of $3,000 and the book value of $691.20.
• Given tax rate is 34%; the tax liability is:
0.34 x $2,308.80 = $784.99
© Yanbu University College
Slide 38
Alternative Example 8.6
• Problem
– Plentix is considering replacing its some old equipment
that has a market value of $1 million but a book value
of only $200,000.
– If the equipment is not sold, the firm will depreciate
the remaining book value in the coming year.
– The firm’s marginal tax rate is 34%.
– How would the firm’s free cash flow be affected if the
firm keeps the equipment versus selling the old
equipment?
© Yanbu University College
Alternative Example 8.6 (cont’d)
• Solution
– If the equipment is kept, the firm will have
$200,000 of additional depreciation, which will
reduce the firm’s taxable income by $200,000.
– With a 34% marginal tax rate, this will reduce the
firm’s taxes by $200,000 x 34% = $68,000.
– Because the firm will pay $68,000 less in taxes, free
cash flow will increase by the same amount for the
year.
© Yanbu University College
Alternative Example 8.6 (cont’d)
• Solution
– If the equipment is sold, the firm receive $1 million
in cash but will have to pay taxes on the gain above
the book value, or $1 million – $200,000 =
$800,000.
– The taxes due on the sale will be $800,000 x 34% =
$272,000.
– Thus, the firm’s free cash flow will increase by
$1,000,000 – $272,000 = $728,000 for the year.
© Yanbu University College
8.5 Analyzing the Project
• Break-Even Analysis
– The break-even level of an input is the level that
causes the NPV of the investment to equal zero.
– HomeNet IRR Calculation
Table 8.7 Spreadsheet HomeNet IRR Calculation
© Yanbu University College
Sensitivity Analysis
• Sensitivity Analysis shows how the NPV varies
with a change in one of the assumptions,
holding the other assumptions constant.
© Yanbu University College
Sensitivity Analysis (cont’d)
Table 8.9 Best- and Worst-Case Parameter Assumptions
for HomeNet
© Yanbu University College
Figure 8.1 HomeNet’s NPV Under Best- and Worst-Case
Parameter Assumptions
© Yanbu University College
Scenario Analysis
• Scenario Analysis considers the effect
on the NPV of simultaneously changing
multiple assumptions.
Table 8.10 Scenario Analysis of Alternative Pricing
Strategies
© Yanbu University College
4/4/2021
MODULE 5
Risk Management
Prepared by: Ms Rohaya Shaari
5-1
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Chapter Outline
5.1 Insurance
5.2 Commodity Price Risk
5.3 Exchange Rate Risk
5.4 Interest Rate Risk
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Course Objectives
• To consider the strategies that firms use to manage and
reduce the risk borne by their investors.
• To measure role of insurance in reducing risk and
examine its pricing and potential benefits and costs for a
firm.
• To identify the ways firms can use financial markets to
offload the risks associated with changes in commodity
prices, exchange rate fluctuations, and interest rate
movements.
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5.1 Insurance
• Insurance is the most common method firms use to reduce
risk.
• Firms use insurance to protect against the unlikely event
that their real assets are damaged or destroyed by
hazards such as fires, hurricanes, accidents, and other
catastrophes that are outside their normal course of
business (property insurance)
• Other common types of insurance include:
– Business liability insurance, which covers the costs that result if
some aspect of the business causes harm to a third party or
someone else’s property.
– Business interruption insurance, which protects the firm against the
loss of earnings if the business is interrupted due to fire, accident,
or some other insured peril.
– Key personnel insurance, which compensates for the loss or
unavoidable absence of crucial employees in the firm.
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The Role of Insurance: An Example
• To understand the role of insurance in reducing risk,
consider an oil refinery with a 1-in-5000, or 0.02%, chance
of being destroyed by a fire in the next year.
• If it is destroyed, the firm estimates that it will lose $150
million in rebuilding costs and lost business.
• The risk from fire can be summarized with a probability
distribution:
E(loss) = (Pbi x loss1) + (Pbi2 x Loss2)
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The Role of Insurance: An Example
• The firm can manage the risk by purchasing insurance to
compensate its loss of $150 million.
• In exchange, the firm will pay an annual fee, called an
insurance premium, to the insurance company.
• Insurance allows the firm to exchange a random future
loss for a certain upfront expense.
• When a firm buys insurance, it transfers the risk of the loss
to an insurance company.
• The insurance company charges an upfront premium to
take on that risk.
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4/4/2021
Insurance Pricing in a Perfect Market
• When a firm buys insurance, it transfers the risk of the loss
to an insurance company.
• The insurance company charges an upfront premium to
take on that risk.
• At what price will the insurance company be willing to bear
the risk in a perfect market?
5-7
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Actuarially Fair Insurance Premium
where Pr(Loss) is the probability that the loss will occur,
E [ . ] is the expected payment if the loss occurs,
rL is the appropriate cost of capital, which depends on the risk being
insured.
Beta measures the risk:
• Beta negative – for nondiversifiable risks (earthquake, hurricane
etc)
• CAPM
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Example 1: Insurance Pricing and the
CAPM
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Example 1: Insurance Pricing and the
CAPM
5-10
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Actuarially Fair Insurance Premium
= 0.01 x $1bil
1 + 0.04
= $961,538
if beta = 0
rL = use risk-free rate 4%
Step 1: Beta loss = -2.5
Find rL using CAPM rL = rf + B(rm – rf)
rL = rf + B(rm – rf)
= 4% – 2.5(10% – 4%) = -11%
Step 2: insurance premium
= 0.1 x $1bil
1 – 0.11
= $1.124m
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Example 2: Avoiding Distress and
Issuance Costs
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Example 2: Avoiding Distress and
Issuance Costs
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Example 2: Avoiding Distress and
Issuance Costs – Solution
NPV = – cost
actuarial fair
premium
+
P(loss) x (Payment in Loss) + Extra cost
(1 + RL)
Step 1: insurance premium
= 0.1 x $150mil
1 + 0.04
if beta = 0
= $1.44m
rL = use risk-free rate 4%
NPV = -$1.44 + P(loss) x (Payment in Loss) + Extra cost
(1 + RL)
= -$1.44 + 1% x ($150m + $50m)
1.04
= -$1.44 + $1.92
= $0.48m
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5.2 Commodity Price Risk
• Many risks that firms face arise naturally as part of their
business operations.
• For many firms, changes in the market prices of the raw
materials they use and the goods they produce may be the
most important source of risk to their profitability.
• Example of Commodity :
– Natural resources (rubber, oil and gas, gold)
– Livestock or agricultural products (cattle, pork, wheat, sugar,
coffee, rice etc.)
• Example: For an airline, oil price fluctuations are clearly an
important source of risk.
• There are ways firms can reduce, or hedge, their exposure to
commodity price movements.
• Hedging involves contracts or transactions that provide the firm
with cash flows that offset its losses from price changes.
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5.2 Commodity Price Risk
A. Hedging with Vertical Integration and Storage
B. Hedging with Long-Term Contracts
C. Hedging with Futures Contracts
– Eliminating Credit Risk
– Marking to Market: An Example
• Common Mistake: Hedging Risk
• Deciding to Hedge Commodity Price Risk
• Differing Hedging Strategies
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5.2 Commodity Price Risk
A. Hedging with Vertical Integration and Storage
– Vertical integration is the merger of a firm and its supplier (or a firm
and its customer). It is a merger between non-competitors but
operate in the same supply chain.
– Because an increase in the price of the commodity raises the firm’s
costs and the supplier’s revenues, these firms can offset their risks
by merging.
– Vertical integration can add value if combining the firms results in
important synergies.
– Example:
• Boeing purchased a number of its suppliers involved in its 787 “Dreamliner”
to improve quality control and coordination, and reduce production delays.
• Japanese tire maker Bridgestone purchased a large Indonesian rubber
plantation to control its costs.
• Airlines could offset their oil price risk by merging with an oil company.
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5.2 Commodity Price Risk
B. Hedging with Long-Term Contracts
– An alternative to vertical integration or storage is a long-term supply
contract.
– Example:
• Firms routinely enter into long-term lease contracts for real
estate, fixing the price at which they will obtain office space
many years in advance. (leasing)
• Utility companies sign long-term supply contracts with power
generators.
• Steelmakers sign long-term contracts with mining firms for iron
minerals.
• Through these contracts, both parties can achieve price stability
for their product or input.
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4/4/2021
Figure 5.1 Example: Commodity Hedging
Smoothes Earnings
$23
By locking in its fuel costs through long-term supply contracts, Southwest Airlines
has kept its earnings stable in the face of fluctuating fuel prices. With a long-term
contract at a price of $23 per barrel, Southwest would gain by buying at this price
if oil prices go above $23 per barrel. If oil prices fall below $23 per barrel,
Southwest would lose from its commitment to buy at a higher price.
Reduce the firm’s earnings because paid
higher price than it should be
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Example: Hedging with Long-Term
Contracts
5-20
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Example: Hedging with Long-Term
Contracts
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Example: Hedging with Long-Term
Contracts – Solution
If price increase to $1950 (without hedging):
Step 1: Increase in Cost
= (new price – old price) x number of units
= ($1950 – $1400) x 10,000
= $5.5mil
Step 2: new EBIT = old EBIT – increase in cost
= $22m – $5.5m
= $16.5m (new EBIT reduced significantly)
If hedging with long-term contract at fixed price of $1450:
Step 1: increase in cost
Step 2: new EBIT
= (new price – old price) x number of units
= ($1450 – $1400) x 10,000
= $0.5mil
= old EBIT – increase in cost
= $22m – $0.5m
= $21.5m (new EBIT slightly reduced)
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5.2 Commodity Price Risk
• Hedging with Long-Term Contracts :
Disadvantages:
1. A long-term supply contracts are bilateral contracts negotiated by a
buyer and a seller.
– The contracts expose each party to the risk that the other party may
default and fail to live up to the terms of the contract. Thus, while
they insulate the firms from commodity price risk, they expose them
to credit risk.
2. The contracts cannot be entered into anonymously; the buyer and
seller know each other’s identity. This lack of anonymity may have
strategic disadvantages.
3. The market value of the contract at any point in time may not be
easy to determine, making it difficult to track gains and losses, and it
may be difficult or even impossible to cancel the contract if necessary.
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5.2 Commodity Price Risk
C. Hedging with Futures Contracts
– A commodity futures contract is a type of long-term contract
designed to avoid the disadvantages in hedging with long-term
contract.
– Futures contract is an agreement to trade an asset on some future
date, at a price that is locked in today.
– Futures contracts are traded anonymously on an exchange at a
publicly observed market price and are generally very liquid.
– Both the buyer and the seller can get out of the contract at any time
by selling it to a third party at the current market price.
– Futures contracts are designed to eliminate credit risk.
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4/4/2021
Figure 2: Futures Prices for Light, Sweet
Crude Oil, September 2015
$57
Agree to trade at $57
on Sept 15 for
delivery on March
2019 (3 years in
advance)
But spot rate on that
date $45
Delivery on March
2019
Price is based on
supply and
demand and
expectation of oil
price and risk
premium
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5.2 Commodity Price Risk
• Hedging with Futures Contracts: Descriptions
– Figure 30.2 shows the prices in September 2015 of futures contracts for
light, sweet crude oil traded on the New York Mercantile Exchange
(NYMEX).
– Each contract represents a commitment to trade 1000 barrels of oil at the
futures price on its delivery date.
– For example, by trading the March 2019 contract, buyers and sellers in
September 2015 agreed to exchange 1000 barrels of oil in March 2019 at a
price of $57 per barrel.
– By doing so, they were able to lock in the price they will pay or receive for
oil more than three years in advance.
– The futures prices shown are not prices that are paid today. They are prices
agreed to today, to be paid in the future.
– The futures prices are determined in the market based on supply and
demand for each delivery date. They depend on expectations of future oil
prices, adjusted by an appropriate risk premium.
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5.2 Commodity Price Risk
• Hedging with Futures Contracts: how to eliminate
default risk?
– If a buyer commits to purchase crude oil in March 2019 for $57 per barrel,
how can the seller be assured that the buyer will honor that commitment?
– If the actual price of oil in March 2019 is only $35 per barrel, the buyer will
have a strong incentive to back out and default on the contract.
– Similarly, the seller will have an incentive to default if the actual price of oil
is more than $57 in March 2019.
– Two mechanisms to prevent buyers or sellers from defaulting:
– First: traders are required to post collateral, called margin, when buying or
selling commodities using futures contracts. This collateral serves as a
guarantee that traders will meet their obligations.
– Second: rather than waiting until the end of the contract, there is daily
settlement of all profits and losses through a procedure called marking to
market. That is, gains and losses are computed and exchanged each day
based on the change in the price of the futures contract.
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Table 30.1 : Example of Marking to Market and Daily
Settlement
– Second: rather than waiting until the end of the contract, there is daily
settlement of all profits and losses through a procedure called marking to
market. That is, gains and losses are computed and exchanged each day
based on the change in the price of the futures contract.
– Parties involved in the contract pay losses or collect gains at the end of
each trading day by adjusting the margin via a clearinghouse (financial
institution).
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Table 30.1 : Example of Marking to Market and Daily
Settlement
If price increase to $34
If price decrease to $55,
buyer has lost $2 which
needs to be settled
(deducted) in her margin
account
from $32, buyer has gain
$2 which needs to be
settled (added) in her
margin account
+
+
Pay $35 on
delivery date


+
+
+
Total lost in margin $22
Process continues until delivery date
Cumulative profit/loss is sum of daily amount; always equal to the difference
between original contract price and current contract price
5-29
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5.3 Exchange Rate Risk
• Multinational firms face the risk of exchange rate
fluctuations.
• Two strategies that firms use to hedge this risk: A)
currency forward contracts and B) currency options.
• Exchange Rate Fluctuations:
A) Hedging with Currency Forward Contracts
– Cash-and-Carry and the Pricing of Currency Forwards
– The Law of One Price and the Forward Exchange Rate
– Advantages of Forward Contracts
B) Hedging with Options
– Options Versus Forward Contracts
– Currency Option Pricing
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4/4/2021
5.3 Exchange Rate Risk
• Exchange Rate Fluctuations
– an exchange rate is the market rate at which one currency can be
exchanged for another currency.
– Consider the relationship between the U.S. dollar and the euro. In
April 2008, the value of the euro (£) relative to the dollar at an
exchange rate of 0.625 euros per dollar or, equivalently:
– Like most foreign exchange rates, the dollar/euro rate is a floating
rate, which means it changes constantly depending on the quantity
supplied and demanded for each currency in the market.
– Because the supply and demand for currencies varies with global
economic conditions, exchange rates are volatile.
5-31
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Example 1: The Effect of Exchange Rate
Risk
• Fluctuating exchange rates cause a problem, known as the
importer–exporter dilemma, for firms doing business in
international markets.
• To illustrate, consider the problem faced by Manzini Cyclery, a small
U.S. maker of custom bicycles. Manzini US needs to import parts from
an Italian supplier, Campagnolo.
• If Campagnolo sets the price of its parts in euros, then Manzini faces
the risk that the dollar may fall, making euros, and therefore the parts,
more expensive.
• If Campagnolo sets its prices in dollars, then Campagnolo faces the
risk that the dollar may fall and it will receive fewer euros for the parts it
sells to the U.S. manufacturer.
5-32
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Example 1: The Effect of Exchange Rate
Risk
5-33
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11
4/4/2021
Using a Forward Contract to Lock in an
Exchange Rate (A)


Exchange rate risk naturally arises whenever transacting parties use different
currencies. One of the parties will be at risk if exchange rates fluctuate.
The most common method firms use to reduce the risk that results from
changes in exchange rates is to hedge the transaction using currency
forward contracts.
– A currency forward contract is a contract that sets the exchange rate in
advance.
– It is usually written between a firm and a bank, and it fixes a currency
exchange rate for a transaction that will occur at a future date.
– A currency forward contract specifies (1) an exchange rate, (2) an amount
of currency to exchange, and (3) a delivery date on which the exchange
will take place.
– The exchange rate set in the contract is referred to as the forward
exchange rate, because it applies to an exchange that will occur in the
future.
– By entering into a currency forward contract, a firm can lock in an
exchange rate in advance and reduce or eliminate its exposure to
fluctuations in a currency’s value.
5-34
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Example 2: Using a Forward Contract to
Lock in an Exchange Rate
5-35
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Example 2: Using a Forward Contract to
Lock in an Exchange Rate
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Hedging with Options (B)
• Currency options are another method that firms commonly use to
manage exchange rate risk.
• Currency options, give the holder the right—but not the obligation—to
exchange currency at a given exchange rate.
• Currency forward contracts allow firms to lock in a future exchange
rate; currency options allow firms to insure themselves against the
exchange rate moving beyond a certain level.
• Example:
– In December 2005, the one-year forward exchange rate was $1.20 per euro.
– Instead of locking in this exchange rate using a forward contract, a firm that will need
euros in one year can buy a call option on the euro, giving it the right to buy euros at
a maximum price.
– Suppose a one-year European call option on the euro with a strike price of $1.20 per
euro trades for $0.05 per euro.
– That is, for a cost of $0.05 per euro, the firm can buy the right—but not the
obligation—to purchase euros for $1.20 per euro in one year’s time.
– By doing so, the firm protects itself against a large increase in the value of the euro,
but still benefits if the euro declines.
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Table1. Cost of Euros ($/€) When Hedging with a
Currency Option with a Strike Price of $1.20/€ and an
Initial Premium of $0.05/€
5-38
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Figure 1. Comparison of Hedging the Exchange Rate
Using a Forward Contract, an Option, or No Hedge
The forward hedge locks in an exchange rate and so eliminates all risk.
Not hedging leaves the firm fully exposed. Hedging with an option allows
the firm to benefit if the exchange rate falls and protects the firm from a
very large increase.
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Hedging with Options: Figure 1
explanation




Compare hedging with options to the alternative of hedging with a forward
contract or not hedging at all.
If the firm does not hedge at all, its cost for euros is simply the spot exchange
rate.
If the firm hedges with a forward contract, it locks in the cost of euros at the
forward exchange rate and the firm’s cost is fixed.
As the figure 1 shows, hedging with options represents a middle ground: The
firm puts a cap on its potential cost, but will benefit if the euro depreciates in
value.
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5.4 Interest Rate Risk





Firms that borrow must pay interest on their debt. An increase in interest rates
raises firms’ borrowing costs and can reduce their profitability.
In addition, many firms have fixed long-term future liabilities, such as capital
leases or pension fund liabilities. A decrease in interest rates raises the present
value of these liabilities and can lower the value of the firm.
Thus, when interest rates are volatile, interest rate risk is a concern for many
firms.
Primary tool used to measure interest rate risk is duration.
The sensitivity of zero-coupon bonds to interest rates increases with their
maturity.
5-41
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5.4 Interest Rate Risk

For example, for a 10-year, zero-coupon bond, an increase of one percentage
point in the yield to maturity from 5% to 6% causes the bond price per $100
face value to fall from:



or a price change of (55.84 – 61.39)/61.39 = -9%.
The price of a five-year bond drops only 4.6% for the same yield change.
The interest rate sensitivity of a single cash flow is roughly proportional to its
maturity.
The farther away the cash flow is, the larger the effect of interest rate changes
on its present value.

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End of module 5
5-43
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15
YANBU UNIVERSITY COLLEGE
Management Science Department
FIN 312
CORPORATE FINANCE
MODULE 4
DIVIDEND and PAYOUT POLICY
Prepared by Ms Rohaya Shaari
© Yanbu University College
Learning Objectives
• Define cash dividends and dividend payments
• Identify different types of dividends
• Describe the trade-off between paying dividends and
retaining (reinvesting) firm profits.
• Explain the dividend irrelevance theorem
• Identify factors in setting the dividend policy
• Understand the impact of dividend payments and its payout
policy on share price
• Describe stock repurchase as an alternative to cash
dividends
• Define stock dividends and stock splits
• Establish a dividend policy for a firm
• Calculate dividend amount for different policy and assess its
implication for the value of the firm
© Yanbu University College
Slide 2
Introduction : Uses of Free Cash Flow
© Yanbu University College
Slide 3
Cash Dividends and Dividend Payment
• Dividend :
✓A payment made out of a firm’ earnings to its owners, in
the form of either cash or stock.
✓Firms are not obligated to pay dividends or maintain a
consistent policy with regard to dividends.
Payout Policy:
✓ The way a firm chooses between the alternative ways to
distribute free cash flow to equity holders
Distribution (return of capital)
✓ When a firm, instead of paying dividends out of current earnings
(or accumulated retained earnings), pays dividends from other
sources, such as paid-in-capital or the liquidation of assets
© Yanbu University College
Slide 4
Types of dividend
• Cash dividend : public companies pay regular cash dividend
four times a year
• Stock Split (Stock Dividend) : when a company issues a
dividend in shares of stock rather than cash to its shareholders
• Regular cash dividend : cash payment made by a company
during normal course of business; usually paid four times a
year
• Extra cash dividend : non-recurring dividend paid to
shareholders in addition to regular dividend; may not be
repeated in the future; rewards of prosperity (wealth)
• Special dividend : truly unusual dividend or one-time dividend
payment and won’t be repeated; rewards of loyalty
© Yanbu University College
Slide 5
Dividend-versus-Retention Trade-Offs
© Yanbu University College
Dividend Policy Trade-Offs
• If management has decided how much to invest
and has chosen the debt-equity mix, decision to
pay a large dividend means retaining less of the
firm’s profits. This means the firm will have to rely
more on external equity financing.
• Similarly, a smaller dividend payment will lead to
less reliance on external financing.
© Yanbu University College
DOES DIVIDEND POLICY MATTER TO
STOCKHOLDERS?
The importance of a firm’s dividend policy
depends on the impact of the dividend decision
on the firm’s stock price. That is, given a firm’s
capital budgeting and borrowing decisions, what
is the impact of the firm’s dividend policies on
the stock price?
© Yanbu University College
Three Views
• There are three basic views with regard to the
impact of dividend policy on share prices:
1. Dividend policy is irrelevant
2. High dividends will increase share prices
3. Low dividends will increase share prices
© Yanbu University College
View #1 (Modigliani–Miller and Dividend
Policy Irrelevance theory)
• Dividend policy is irrelevant
– The original proponents of the dividend irrelevance theory were
Merton Miller and Franco Modigliani (MM).
– They argued that the firm’s value is determined only by its basic
earning power and its business risk.
– In other words, MM argued that the value of the firm depends
only on the income produced by its assets, not on how this
income is split between dividends and retained earnings.
– In perfect capital markets, holding fixed the investment policy of
a firm, the firm’s choice of dividend policy is irrelevant and does
not affect the initial share price.
© Yanbu University College
Dividend Policy with Perfect Capital Markets
• A firm’s free cash flow determines the level of payouts that it can
make to its investors.
✓ In a perfect capital market, the type of payout is irrelevant.
✓ In reality, capital markets are not perfect, and it is these
imperfections that should determine the firm’s payout policy.
• Irrelevance implies shareholder wealth is not affected by dividend
policy (whether the firm pays 0% or 100% of its earnings as
dividends).
• There is no relationship between dividend policy and stock value.
This view is based on two assumptions:
(a) Perfect capital markets; and
(b) Firm’s investment and borrowing decisions have been made and
will not be altered by dividend payment.
© Yanbu University College
View #1
• Dividend policy is irrelevant
Perfect capital markets:
• No brokerage commission when investor buy/sell stocks
• New securities can be issued without floatation costs
• No income tax, personal tax or corporate tax
• Information is free and equally available to all investors
• There is no conflicts of interests between management and
shareholders (agency theory not exist)
• Financial distress and bankruptcy costs are non existent
• Financial leverage does not affect cost of capital (debt)
• Dividend policy has no impact on firm’s capital budgeting
(investment)
© Yanbu University College
View #1 Dividend policy is irrelevant
• Dividend policy is irrelevant
– Any shareholder can in theory construct his own dividend policy.
– For example, if a firm does not pay dividends, a shareholder who
wants a 5% dividend can “create” it by selling 5% of his stock
(homemade dividend).
– Conversely, if a company pays a higher dividend than an investor
desires, the investor can use the unwanted dividends to buy
additional shares of the company’s stock.
– If investors could buy and sell shares and thus create their own
dividend policy without incurring costs, then the firm’s dividend
policy would truly be irrelevant.
© Yanbu University College
Homemade dividend Example (1 of 2)
• Problem
– You own 1,000 shares in a firm that has historically paid
dividends at a rate of 50% of earnings per share. Although
earnings per share this year are $5, the firm has decided to
retain all of the earnings and not pay a dividend. The current
market price is $50 per share.
– How could you create a homemade dividend based on the
firm’s dividend history?
© Yanbu University College
Homemade Dividend (2 of 2)
• Solution
– Based on the firm’s history, its “normal” dividend
would have been $5 × 50% = $2.50 per share.
– To create a homemade dividend, you need to sell
enough shares to generate the desired cash flow.
– This equates to 1,000 shares × $2.50 per share =
$2,500. dividend income?
– Given a current market value of $50 per share, you
would need to sell $2,500 = 25
$50
25 shares to create the desired homemade
dividend.
© Yanbu University College
View #2 Bird-in-the-hand-theory
• High dividends increase stock value (dividend
certain)
– This position in based on “bird-in-the-hand theory,” which
argues that investors may prefer “dividend today” as it is less
risky compared to “uncertain future capital gains.”
– A return in the form of dividends is a certain, but a return in the
form of capital gains is risky.
– This implies a higher required rate for discounting a dollar of
capital gain than a dollar of dividends.
• Capital gain: profits results in disposal of capital assets such as stock,
bonds and real estates.
Bird-in-the-hand-theory
The view that dividends are more
certain than capital gains
© Yanbu University College
View #2 : Explanation
• Dividends are more predictable than capital gains because
management can control dividends, while they cannot dictate the
price of the stock.
• Thus, investors are less certain of receiving income from capital
gains than from dividend income. Therefore, shareholders prefer
dividends and are willing to accept a lower required return on
equity.
• Example: 14% return for a stock that pays dividend
• Example: 20% return for a stock that pays no dividend (high growth
stock) : high risk high required return
© Yanbu University College
View #3 Low dividend increases stock values
Taxes treatment on Dividends and Capital Gains
– Shareholders must pay taxes on the dividends they receive, and
they must also pay capital gains taxes when they sell their shares.
– Dividends are typically taxed at a higher rate than capital gains.
In fact, long-term investors can defer the capital gains tax forever
by not selling.
– Thus stocks that allow tax deferral (i.e., low dividends and high
capital gains) will possibly sell at a premium (higher price)
relative to stocks that require current taxation (i.e., high
dividends and low capital gains lower share price).
– This suggests that a policy to pay low dividends will result in a
higher stock price. That is, high dividends hurt investors, while
low dividends-high retention helps the firm’s investors.
© Yanbu University College
Some Other Explanations
• The Residual Dividend Theory
• Clientele Effect
• The Information Effect
• Agency Costs
• The Expectations Theory
© Yanbu University College
Residual Dividend Theory
• Determine the amount of equity needed for financing
– First, use retained earnings to supply this equity
– If retained earnings still available, distribute the residual as
dividends.
• Dividend Policy will be influenced by:
(a) investment opportunities or capital budgeting needs, and
(b) availability of internally generated capital (RE). Unstable dividend
Residual dividend approach
A policy under which a firm pays dividends only after
meeting its investment needs while maintaining a
desired debt–equity ratio.
© Yanbu University College
Residual Dividend Theory : Explanation
• In perfect capital markets, once a firm has taken all positive-NPV
investments, it is indifferent between saving excess cash and paying
it out.
• With market imperfections, there is a trade-off: Retaining cash can
reduce the costs of raising capital in the future, but it can also
increase taxes and agency costs.
• So under this theory, a dividend would be paid only after all
acceptable investments have been financed; and company only pay
dividend when there is cash remaining after funding all positive NPV
projects.
• Therefore, a dividend policy is totally passive in nature and can’t
affect the market price of the common stock; because investment
projects is what affect the share value.
© Yanbu University College
The Clientele Effect
• When the dividend policy of a firm reflects the tax preference of its investor
clientele.
• Individuals in the highest tax brackets have a preference for stocks that pay no or
low dividends, whereas tax-free investors and corporations have a preference for
stocks with high dividends. Lower tax bracket
• That means different groups of investors or clienteles prefer different dividend
payout policies.
• For example, retired individuals, pension funds, and university endowment funds
generally prefer cash income, so they may want the firm to pay out a high
percentage of its earnings = dividend. Such investors are often in low or even zero
tax brackets, so taxes are of no concern. Lower income investors
• Stockholders who are saving rather than spending dividends might favor the lowdividend policy: the less the firm pays out in dividends, the less these
stockholders will have to pay in current taxes. Wealthy investors
© Yanbu University College
The Clientele Effect : Explanation
• It is a belief that individuals and institutions that need current
income will invest in companies that have high dividend payouts.
• Other investors prefer to avoid taxes by holding securities that offer
only small dividend income but large capital gains (share price
higher).
• Some investors want current investment income and prefer a fixed
income stream should own shares in high–dividend payout firms.
• While some investors with no need for current investment income
such as wealthy investors (also would prefer to defer taxes), should
own shares in low–dividend payout firms.
• Thus, the companies have a “clientele” of investors.
clientele effect
The observable fact that stocks attract particular groups
based on dividend yield
and the resulting tax effects.
© Yanbu University College
The Information Effect info content, signalling
• In dividend irrelevance theory, MM assumed that everyone—investors and
managers alike—has identical information regarding a firm’s future
earnings and dividends. Information is symmetry
• In reality, however, different investors have different views on both the
level of future dividend payments and the uncertainty inherent in those
payments, and managers have better information about future prospects
than public stockholders. Information asymmetry
• Evidence shows that large, unexpected change in dividends can have a
significant impact on the stock prices.
• A firm’s dividend policy may be seen as a signal about firm’s financial
condition. Thus, high dividend could signal expectations of high earnings in
the future and vice versa.
• Stock price changes following dividend actions simply indicate that there is
important information, or signaling, content in dividend announcements.
© Yanbu University College
information content effect
The market’s reaction to a change in corporate
dividend payout.
The Information Effect : Explanation
• Investors use a change in dividend policy as a signal about the firm’s “true”
financial condition, especially its earning power.
• Corporations are reluctant to cut dividends, which implies that
corporations do not raise dividends unless they anticipate higher earnings
in the future.
• Thus, MM argued that a higher than expected dividend increase is a signal
to investors that the firm’s management forecasts good future earnings.
• Conversely, a dividend reduction, or a smaller than expected increase, is a
signal that management is forecasting poor earnings in the future.
• Some investors claim that managers have inside information about the
firm that cannot be made available to investors. The difference in
accessibility of information or information asymmetry, can result in a
lower or higher stock price.
• Dividends therefore, can become an important communication tool
because managers may have no other credible way to inform investors
about the future earnings, or to at least has no convincing way that is less
costly.
© Yanbu University College
Signaling with Payout Policy
• Dividend Smoothing
– The practice of maintaining relatively constant dividends
• Firm change dividends infrequently, and dividends are much
less volatile than earnings.
– Management believes that investors prefer stable dividends with
sustained growth.
– Management desires to maintain a long-term target level of
dividends as a fraction of earnings.
– If firms smooth dividends, the firm’s dividend choice will contain
information regarding management’s expectations of future
earnings (dividend signaling)
• Thus, firms raise their dividends only when they perceive a long-term
sustainable increase in the expected level of future earnings can be
maintained and cut them only as a last resort.
© Yanbu University College
Agency Costs
• Dividend policy may be perceived as a tool to minimize
agency costs.
• Dividend payment may require managers to issue stock to
finance new investments. New investors will be attracted
only if they are convinced that the capital will be used
profitably. Thus, payment of dividends indirectly monitors
management’s investment activities and helps reduce
agency costs, and may enhance the value of the firm.
© Yanbu University College
The Expectations Theory
• Expectation theory suggests that the market reaction does
not only reflect response to the firms actions, it also
indicates investors’ expectations about the ultimate
decision to be made by management.
• Thus if the amount of dividend paid is equal to the
dividend expected by shareholders, the market price of
stock will remain unchanged. However, market will react if
dividend payment is not consistent with shareholders
expectations.
• Thus deviation from expectations is more important than
actual dividend payment.
© Yanbu University College
The Expectations Theory : Explanation
• As the time approaches for management to announce the amount
of the next dividend, investors form expectations as to how much
the dividend will be. When the actual dividend decision is
announced, the investor compares the actual decision with the
expected decision.
• If the amount of the dividend is as expected, even if it represents an
increase from prior years, the market price of the stock will remain
unchanged. However, if the dividend is higher or lower than
expected, the investors will reassess their perceptions about the
firm and the value of the stock.
Expectation is based on past dividend decisions, current and
expected earnings, investment strategies, and financing
decisions, general economy, changes in government policy
© Yanbu University College
• In the beginning dividend consistent:
– Then if unexpectedly increase – share increase
– If unexpected decrease – share decrease
(SH will react negatively to unanticipated cut in the
dividend amount – signal the firm in trouble)
– Expected increase/decrease the same as the actual =
unchanged in the share price (sometime affecting share
price at a minimum rate)
© Yanbu University College
Slide 30
Dividend Payment Procedures
• Generally, companies pay dividend on a quarterly basis. The final
approval of a dividend payment comes from the firm’s board of
directors.
• For example:
Katz Corporation paid a $0.50 dividend per share in each quarter of
2010, for an annual dividend per share of $2.00. In common financial
term, we say that in 2010 Katz’s regular quarterly dividend was $0.50,
and its annual dividend was $2.00. In late 2010, Katz’s board of
directors met, reviewed projections for 2011, and decided to keep the
2011 dividend at $2.00. The directors announced the $2 rate, so
stockholders could count on receiving it unless the company
experienced unanticipated operating problems.
© Yanbu University College
Dividend payment procedure
The actual payment procedure is as follows:
1. Declaration date.
• The date on which the board of directors authorizes
announced the payment of a dividend.
• On the declaration date—on Thursday, November 11— the
directors meet and declare the regular dividend, issuing a
statement similar to the following:
“On November 11, 2010, the directors of Katz Corporation met
and declared the regular quarterly dividend of 50 cents per
share, payable to holders of record as of Friday, December 10,
payment to be made on Friday, January 7, 2011.”
© Yanbu University College
Actual payment procedure
2. Holder-of-record date (Date of record).
• At the close of business on the holder-of-record date,
December 10, the company closes its stock transfer books
and makes up a list of shareholders as of that date.
• When a firm pays a dividend, only shareholders on record on
this date receive the dividend.
• If Katz Corporation is notified of the sale before 5 p.m. on
December 10, then the new owner receives the dividend.
However, if notification is received after 5 p.m. on December
10, the previous owner gets the dividend check.
© Yanbu University College
Actual payment procedure
3. Ex-dividend date :
• A date, two days prior to a dividend’s record date, on or after which anyone
buying the stock will not be eligible for the dividend.
• Suppose Jean Buyer buys 100 shares of stock from John Seller on December
7. Will the company be notified of the transfer in time to list Jean Buyer as
the new owner and thus pay the dividend to her?
• To avoid conflict, the securities industry has set up a convention under
which the right to the dividend remains with the stock until two business
days prior to the holder-of-record date; on the second day before that date,
the right to the dividend no longer goes with the shares.
• The date when the right to the dividend leaves the stock is called the exdividend date. In this case, the ex-dividend date is two days prior to
December 10, which is December 8 and 9:
Dividend goes with stock: Tuesday, December 7
Ex-dividend date: Wednesday, December 8 and Thursday, December 9
Holder-of-record date: Friday, December 10
• Therefore, if Jean Buyer is to receive the dividend, she must buy the stock
on or before December 7. If she buys it on December 8 or later, John Seller
will
receive the dividend because he will be the official holder of record.
© Yanbu University
College
Actual payment procedure
4. Payment date ( Payable Date or Distribution Date)
• A date, generally within a month after the record date, on which a firm
mails dividend checks to its registered stockholders.
• The company actually pays the dividend on January 7, the payment date,
to the holders of record.
© Yanbu University College
Example: Important Dates for Microsoft’s
Special Dividend
© Yanbu University College
Stock Repurchases
• An alternative way to pay cash to investors is through a share
repurchase or buyback.
• The firm uses cash to buy shares of its own outstanding stock.
• Stock repurchases are made in one of these ways:
1. A publicly owned firm can buy back its own stock through a
broker on the open market (open market repurchase). Represent
about 95% of repurchased.
2. Tender offer: A public announcement of an offer to all existing
security holders to buy back a specified amount of outstanding
securities at a prespecified price (typically set at a 10% to 20%
premium to the current market price) over a prespecified period
of time (usually about 20 days). If shareholders do not tender
enough shares, the firm may cancel the offer, and no buyback
occurs.
© Yanbu University College
Stock Repurchases
• Stock repurchases are made in one of these ways:
3. The firm can directly purchase a block of shares from one large
holder on a negotiated basis. This is a targeted stock repurchase.
4. Greenmail: When a firm avoids a threat of takeover merger
acquisition and removal of its management by a major shareholder
by buying out the shareholder, often at a large premium over the
current market price
© Yanbu University College
Investor’s Preference:
Dividend or Stock Repurchases
• If there are no taxes, no commission when trading
stocks, and no information content assigned to a
dividend, the investor should be indifferent.
(perfect capital market)
• Investors could simply create a dividend stream by
selling stock when income is needed.
© Yanbu University College
Comparison of Dividends and Share
Repurchases
• Consider Genron Corporation. The firm’s board is meeting
to decide how to pay out $20 million in excess cash to
shareholders.
• Genron has no debt, its equity cost of capital equals its
unlevered cost of capital of 12%. = i%
• With 10 million shares outstanding, Genron will be able to
pay a $2 dividend immediately. $20m/10m = $2div
pershare
• The firm expects to generate future free cash flows of $48
million per year; thus, it anticipates paying a dividend of
$4.80 per share each year thereafter. $48m/10m = $4.80
© Yanbu University College
Alternative Policy 1: Pay Dividend with Excess
Cash (1 of 4)
• Cum-dividend
– When a stock trades before the ex-dividend date, entitling
anyone who buys the stock to the dividend
• The cum-dividend stock price of Genron will
be
Pcum = Current Dividend + PV (Future Dividends) = 2 +
© Yanbu University College
4.80
= 2 + 40 = $42
0.12
Alternative Policy 1: Pay Dividend with Excess
Cash (2 of 4)
• After the ex-dividend date, new buyers will
not receive the current dividend and the share
price and the price of Genron will be
Pex = PV (Future Dividends) =
© Yanbu University College
4.80
= $40
0.12
Alternative Policy 1: Pay Dividend with Excess
Cash (3 of 4)
Black
December 11
( Cum-Dividend)
December 12
(Ex-Dividend)
Cash
20
0
Other assets
400
400
Total market value
420
400
Shares(millions)
10
10
share price
$42
$40
© Yanbu University College
Alternative Policy 1: Pay Dividend with Excess
Cash (4 of 4)
• In a perfect capital market, when a dividend is
paid, the share price drops by the amount of the
dividend when the stock begins to trade exdividend.
© Yanbu University College
Alternative Policy 2: Share Repurchase (No
Dividend) (1 of 6)
• Suppose that instead of paying a dividend this year, Genron
uses the $20 million to repurchase its shares on the open
market.
– With an initial share price of $42, Genron will repurchase?
476,000 shares.
$20 million
= 0.476 million shares

$42 per share
– This will leave only 9.524 million shares outstanding.
• 10 million − 0.476 million = 9.524 million
Before repurchase – number repurchased Share = share
outstanding
© Yanbu University College
Alternative Policy 2: Share Repurchase (No
Dividend) (2 of 6)
• The net effect is that the share price remains
unchanged.
Blank
December 11
(before Repurchase)
December 12
(After Repurchase)
Cash
20
0
Other assets
400
400
Total market value of
assets
420
400
Shares(millions)
10
9.524
share price
$42
$42
© Yanbu University College
Alternative Policy 2: Share Repurchase (No
Dividend) (3 of 6)
• Genron’s Future Dividends
– It should not be surprising that the repurchase had no
effect on the stock price.
– After the repurchase, the future dividend would rise to
$5.04 per share.
48 million
= $5.04 per share

9.524 million shares
• Genron’s share price is
Prep =
© Yanbu University College
5.04
= $42
0.12
Alternative Policy 2: Share Repurchase (No
Dividend) (4 of 6)
• Genron’s Future Dividends
– In perfect capital markets, an open market share
repurchase has no effect on the stock price, and the
stock price is the same as the cum-dividend price if a
dividend were paid instead.
© Yanbu University College
Alternative Policy 2: Share Repurchase (No
Dividend) (5 of 6)
• Investor Preferences
– In perfect capital markets, investors are indifferent
between the firm distributing funds via dividends or
share repurchases. By reinvesting dividends or selling
shares, they can replicate either payout method on
their own. (homemade dividend)
© Yanbu University College
Alternative Policy 2: Share Repurchase (No
Dividend) (6 of 6)
• Investor Preferences
– In the case of Genron, if the firm repurchases shares
and the investor wants cash, the investor can raise cash
by selling shares.
• This is called a homemade dividend.
– If the firm pays a dividend and the investor would
prefer stock, they can use the dividend to purchase
additional shares.
© Yanbu University College
Homemade Dividends: Example 1 (1 of 2)
Problem:
Suppose Genron does not adopt the alternative policy, and
instead pays a $2 dividend per share today. Show how an
investor holding 2000 shares could create a homemade
dividend of $4.50 per share × 2000 shares = $9000 per year
on her own.
© Yanbu University College
Homemade Dividends: Example 1 (2 of 2)
Solution:
If Genron pays a $2 dividend, the investor receives $4000 in
cash and holds the rest in stock. To receive $9000 in total
today, she can raise an additional $5000 by selling 125
shares at $40 per share just after the dividend is paid.
In future years, Genron will pay a dividend of $4.80 per
share. Because she will own 2000 − 125 = 1875 shares, the
investor will receive dividends of 1875 × $4.80 = $9000 per
year from then on.
© Yanbu University College
STOCK DIVIDENDS AND STOCK
SPLITS
© Yanbu University College
Stock Dividends
• A stock dividend entails the distribution of additional
shares of stock instead of cash payment.
• A distribution of shares up to 25% of the number of shares
outstanding; issued on pro rate basis to the current
shareholders.
• While the number of common stock outstanding
increases, the firm’s investments and future earnings
prospects do not change.
Stock Dividend
A payment made by a firm to its owners in the form of stock,
diluting the value of each share outstanding.
© Yanbu University College
Stock Splits
• A stock split involves exchanging more (or less in the case
of “reverse” split) shares of stock for firm’s outstanding
shares.
• While the number of common stock outstanding increases
(or decreases in the case of reverse split), the firm’s
investments and future earnings prospects do not change.
• Stock splits and stock dividends are far less frequent than
cash dividends.
Stock Split
An increase in a firm’s shares outstanding
without any change in owners’ equity.
© Yanbu University College
Stock Dividends & Stock Splits : Explanation
• Both a stock dividend and a stock split involve issuing new
shares of stock to current stockholders.
• The investor’s percentage ownership in the firm remains
unchanged. The investor is neither better nor worse off
than before the stock split/dividend.
• On an economic basis, there is no difference between a
stock dividend and a stock split.
• For accounting purposes, the stock split has been defined
as a stock dividend exceeding 25 percent.
© Yanbu University College
Stock Dividends & Stock Splits : Explanation
• Rationale for a stock dividend or split:
1. The price of stock may not fall precisely in proportion
to the share increase; thus, the stockholders’ value is
increased.
2. If a company is encountering cash problems, it can
substitute a stock dividend for a cash dividend. Investors
will probably look beyond the dividend to determine the
underlying reasons for conserving cash.
© Yanbu University College
End of module 4
© Yanbu University College
Slide 58
YANBU UNIVERSITY COLLEGE
Management Science Department
FIN 312
CORPORATE FINANCE
MODULE 3
Financing Mix; The Capital Structure Decisions and
Long Term Financial Policy
Adapted from Damodaran’s Corporate Finance
And Berk Peter DeMarzo
© Yanbu University College
The Choices in Financing
• There are only two ways in which a business can
make money.
– The first is debt. Debt is that you promise to make
fixed payments in the future (interest payments and
repaying principal). If you fail to make those
payments, you lose control of your business.
– The other is equity. With equity, you do get whatever
cash flows are left over after you have made debt
payments.
2
© Yanbu University College
Debt versus Equity
Debt versus Equity
Fixed Claim
High Priority on cash flows
Tax Deductible
Fixed Maturity
No Management Control
Debt
Residual Claim
Lowest Priority on cash flows
Not Tax Deductible
Infinite life
Management Control
Hybrids (Combinations
of debt and equity)
Equity
3
© Yanbu University College
The Choices
• Equity can take different forms:
– For very small businesses: it can be owners investing
their savings
– For slightly larger businesses: it can be venture capital
– For publicly traded firms: it is common stock
• Debt can also take different forms
– For private businesses: it is usually bank loans
– For publicly traded firms: it can take the form of bonds
4
© Yanbu University College
Equity – common stock
• Applied to stock that has no special preference
either in receiving dividends or in bankruptcy.
• Shareholder Rights
– The value of a share of common stock in a corporation
is directly related to the general rights of shareholders.
– A corporation’s shareholders elect directors who, in
turn, hire management to carry out their directives.
– Shareholders, therefore, control the corporation
through the right to elect the directors.
– “one share, one vote” ( not one shareholder, one vote)
5
© Yanbu University College
Equity – common stock
• Other Rights
1. The right to share proportionally in dividends.
2. The right to share proportionally in assets remaining
after liabilities have been paid in a liquidation.
3. The right to vote on stockholder matters of great
importance, such as a merger. Voting usually occurs at
the annual meeting or a special meeting.
6
© Yanbu University College
Equity – common stock
• Dividends


Corporations are legally authorized to pay dividends to their shareholders.
The payment of dividends is at the discretion of the board of directors.

Some important characteristics of dividends include the following:
1.
Unless a dividend is declared by the board of directors of a corporation, it is not
a liability of the corporation. A corporation cannot default on an undeclared
dividend. As a consequence, corporations cannot become bankrupt because of
nonpayment of dividends. The amount of the dividend and even whether it is
paid are decisions based on the business judgment of the board of directors.
2.
Dividends are paid out of the corporation’s aftertax cash flow. They are not
business expenses and are not deductible for corporate tax purposes.
3.
Dividends received by individual shareholders are taxable. However,
corporations are permitted to exclude 70 percent of the dividends they receive
from other corporations and are taxed only on the remaining 30 percent.
7
© Yanbu University College
Equity – preferred stock
• Pays a cash dividend expressed in terms of dollars per
share.
• Has a preference over common stock in the payment of
dividends and in the distribution of corporation assets in
the event of liquidation.
• Preference means only that holders of preferred shares
must receive a dividend (in the case of an ongoing firm)
before holders of common shares are entitled to anything.
• The decision of the board of directors not to pay the
dividends on preferred shares may have nothing to do with
the current net income of the corporation.
• Preferred stock typically has no maturity date.
8
© Yanbu University College
Equity – preferred stock
• Stated Value
– Preferred shares have a stated liquidating value, usually $100
per share.
– For example, General Motors’ “$5 preferred,” paying an annual
dividend of $5, translates into a dividend yield of 5 percent of
stated value.
• Cumulative and Noncumulative Dividends
– A preferred dividend is not like interest on a bond.
– Dividends payable on preferred stock are either cumulative or
noncumulative; most are cumulative.
– If preferred dividends are cumulative and are not paid in a
particular year, they will be carried forward as an arrearage.
– Usually, both the accumulated (past) preferred dividends and
the current preferred dividends must be paid before the
common shareholders can receive anything.
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Debt – Corporate Long-Term Debt
• A debt represents something that must be repaid;
it is the result of borrowing money.
• When corporations borrow, they generally
promise to make regularly scheduled interest
payments and to repay the original amount
borrowed (that is, the principal).
• The person or firm making the loan is called the
creditor, or lender. The corporation borrowing the
money is called the debtor, or borrower.
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Debt – Corporate Long-Term Debt
From a financial point of view, the main differences between
debt and equity are:
1. Debt is not an ownership interest in the firm. Creditors
generally do not have voting power.
2. The corporation’s payment of interest on debt is
considered a cost of doing business and is fully tax
deductible. Dividends paid to stockholders are not tax
deductible.
3. Unpaid debt is a liability of the firm. If it is not paid, the
creditors can legally claim the assets of the firm. This
action can result in liquidation or reorganization, two of
the possible consequences of bankruptcy. Thus, one of the
costs of issuing debt is the possibility of financial failure.
This possibility does not arise when equity is issued.
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Debt – Corporate Long-Term Debt






The maturity of a long-term debt instrument is the length of
time the debt remains outstanding with some unpaid balance.
Debt securities can be short term (with maturities of one year
or less) or long term (with maturities of more than one year).
Debt securities are typically called notes, debentures, or bonds .
A bond is a secured debt, meaning that certain property is
pledged as security for repayment of the debt. In common
usage, bond refers to all kinds of secured and unsecured debt.
The only difference between a note and a bond is the original
maturity – Issues with an original maturity of 10 years or less
are often called notes. Longer-term issues are called bonds.
Long-term debt can be issued to the public or privately placed Privately placed debt is issued to a lender and not offered to the
public.
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Debt – Corporate Long-Term Debt
• Different Types of Bonds
1. Floating-rate Bonds – the coupon payments are adjustable.
2. Warrant – For a bond with warrants attached, the buyers
also receive the right to purchase shares of stock in the
company at a fixed price per share over the subsequent
life of the bond.
3. Convertible bond – can be swapped for a fixed number of
shares of stock anytime before maturity at the holder’s
option.
4. Income bonds – are similar to conventional bonds, except
that coupon payments are dependent on company
income. Specifically, coupons are paid to bondholders only
if the firm’s income is sufficient.
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Debt – Corporate Long-Term Debt
• Different Types of Bank Loans
1. Lines of Credit
• Setting the maximum amount that the bank is willing to lend to the
business. The business can then borrow the money according to its
need for funds.
• If the bank is legally obligated, the credit line is generally referred
to as a revolving line of credit or a revolver.
• As an example, imagine a revolver for $75 million with a three-year
commitment, implying that the business could borrow part or all
of the $75 million anytime within the next three years. A
commitment fee is generally charged on the unused portion of the
revolver. Suppose the commitment fee is .20% and the corporation
borrows $25 million in a particular year, leaving $50 million
unborrowed. The dollar commitment fee would be $100,000 (5
.20% 3 $50 million) for that year, in addition to the interest on the
$25 million actually borrowed.
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Debt – Corporate Long-Term Debt
• Different Types of Bank Loans
1. Syndicated Loans





Very large banks such as Citigroup typically have a larger demand for
loans than they can supply, and small regional banks frequently have
more funds on hand than they can profitably lend to existing customers.
Basically, they cannot generate enough good loans with the funds they
have available.
As a result, a very large bank may arrange a syndicated loan with a firm
or country and then sell portions of it to a syndicate of other banks.
With a syndicated loan, each bank has a separate loan agreement with
the borrowers.
The lead arranger takes the lead, creating the relationship with the
borrower and negotiating the specifics of the loan. The lead arranger
works with the participant lenders to determine shares of the loan and
generally lends the most. It also receives an up-front fee as
compensation for this additional responsibilities.
The participant lenders are typically not involved in the negotiation
process.
All lenders receive interest and principal payments.
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© Yanbu University College
Is it debt or equity?
• As a general rule, equity represents an ownership interest
and is a residual claim.
• This means that equity holders are paid after debt holders.
As a result, the risks and benefits associated with owning
debt and equity are different.
• For example, note that the maximum reward for owning a
debt security is ultimately fixed by the amount of the loan,
whereas there is no upper limit to the potential reward
from owning an equity interest.
• The distinction between debt and equity is very important
for tax purposes. So, one reason that corporations try to
create a debt security that is really equity is to obtain the
tax benefits of debt and the bankruptcy benefits of equity.
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Equity vs Debt
© Yanbu University College
Slide 17
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