Corporate

Finance
1 Corporate Finance
IDENTIFYING & ESTIMATING PROJECT CASH
FLOW
Chapter 8 (Finance for Executives-Hawawini,
viallet-3e)
The Cash Flow Principle
The with/without Principle
Estimating Relevant Cash Flows
Various types of Costs
Sensitivity/Scenario Analysis
2 Corporate Finance
Fundamental principles guiding the
determination of a projects cash flows and how
they should be applied
Actual Cash-Flow Principle
- Cash flows must be measured at the time they
actually occur
With/without Principle
- Cash flows relevant to an investment decision
are only those that change the firms overall cash
position
- Sunlight Manufacturing Companys (SMC)
designer desk lamp project used to illustrate
approach
3 Corporate Finance
After reading this chapter, students should
understand:

The actual cash-flow principle and the
with/without principle and how to apply them
when making capital expenditure decisions.

How to identify a projects relevant and
irrelevant cash flows

Sunk costs and opportunity costs

How to estimate a projects relevant cash flows
4 Corporate Finance
5 Corporate Finance
The Actual Cash-flow Principle

Cash flows must be measured at the time they
actually occur
If inflation is expected to affect future prices and
costs, nominal cash flows should be estimated
Cost of capital must also incorporate the
anticipated rate of inflation
If the impact of inflation is difficult to determine,
real cash flows can be employed
Inflation should also be excluded from the
cost of capital
Corporate Finance 6
A projects expected cash flows must be
measured in the same currency

Nominal Cash Flow: The Cash Flow that
incorporate anticipated / expected inflation should
be estimated.

Real Cash Flow: The values of cash flows
calculated with the assumption that prices and
costs will not be effected by anticipated inflation.
7 Corporate Finance
The With/Without Principle

The relevant cash flows are only those that
change the firms overall future cash position, as
a result of the decision to invest

AKA: incremental, or differential, cash flows
Equal to difference between firms expected
cash flows if the investment is made (the
firm with the project) and its expected cash
flows if the investment is not made (the firm
without the project)
8 Corporate Finance
To illustrate the definitions of incremental,
differential cash flows and those of
relevant/irrelevant costs, unavoidable costs,
sunk costs and opportunity costs consider the
following example

Example: A person must decide whether to drive
to work or take public transportation
If he drives his monthly costs are:
Insurance costs $120
Rent on garage near apartment $150
Parking fees $ 90
Gas and car service $110
9 Corporate Finance
If he takes the train his monthly ticket costs are
$140

The cash flows with the project are (assuming
he doesnt drive his car)
CF(train): = -120 150 140 = -$410
The cash flows without the project are
(assuming he drive his car)
CF(car): = -120 150 90 110 = -470
The incremental cash flows are
CF(train) CF(car)
= -$410 - -$470 = +$60

10 Corporate Finance
The Designer Desk Lamp Project

Sunlight Manufacturing Company (SMC) is
considering a possible entrance in the designer
desk lamp market
The projects characteristics are reported in
Exhibit 8.1

SMCs financial manager must
Estimate the projects expected cash flows

Determine whether the investment is a value-
creating proposal
11 Corporate Finance
EXHIBIT 8.1a:
Data Summary of the Designer Desk Lamp Project.

ITEM CORRESPONDING UNITS OR VALUE TYPE TIMING
1. Expected annual 45,000; 40,000; 30,000; 20,000; 10,000 Revenue End of year 1 to 5
unit sales
2. Price per unit $40 first year, then rising annually at 3% Revenue End of year 1 to 5
3. Consulting $30,000 Expense Already incurred
companys fee
4. Losses on $100,000 Net cash loss End of year 1 to 5
standard lamps
5. Rental of building $10,000 Revenue End of year 1 to 5
to outsiders
6. Cost of the equipment $2,000,000 Asset Now
7. Straight-line $400,000 ($2,000,000 divided by 5 years) Expense End of year 1 to 5
depreciation expenses
8. Resale value of $100,000 Revenue End of year 5
equipment
9. Raw material cost/unit $10 the first year, then rising annually at 3% Expense End of year 1 to 5
10. Raw material inventory 7 days of sales Asset Now

12 Corporate Finance
EXHIBIT 8.1b:
Data Summary of the Designer Desk Lamp Project.
ITEM CORRESPONDING UNIT OR VALUE TYPE TIMING
11. Accounts payable 4 weeks (or 28 days) of purchases Liability Now
12. Accounts receivable 8 weeks (or 56 days) of sales Asset Now
13. Work in process and 16 days of sales Asset Now
finished goods inv
14. Direct labor cost $5 the first year, then rising annually at 3% Expense End of year 1 to 5
per unit
15. Energy cost $1 the first year, then rising annually at 3% Expense End of year 1 to 5
per unit
16. Overhead charge 1% of sales Expense End of year 1 to 5
17. Financing charge 12% of the net book value of assets Expense End of year 1 to 5
18. Tax expenses on 40% of pretax profits Expense End of year 1 to 5
income
19. Tax expenses on 40% of pretax capital gains Expense End of year 5
capital gains
20. After tax cost of 9% (see Chapter 10) Not in the
capital cash flow
13 Corporate Finance
Identifying A Projects Relevant Cash Flows
Sunk Cost
Cost that has already been paid and for which
there is no alternative use at the time when the
accept/reject decision is being made
With/without principle excludes sunk costs
from the analysis of an investment

Opportunity Costs
Associated with resources that the firm could
use to generate cash, if it does not undertake the
project
Costs do not involve any movement of cash
in or out of the firm
14 Corporate Finance
Costs Implied by Potential Sales Erosion
Another example of an opportunity cost
Sales erosion can be caused by the project, or
by a competing firm
Relevant only if they are directly related to
the project
If sales erosion is expected to occur
anyway, then it should be ignored

Allocated Costs
Irrelevant as long as the firm will have to pay
them anyway
Only consider increases in overhead cash
expenses resulting from the project
15 Corporate Finance
Depreciation Expenses
Do not involve any cash outflows
Irrelevant to an investment decision
However provides for tax savings by reducing
the firms taxable profit
These tax savings are added to the projects
relevant cash flows

Tax Expenses
If an investment is profitable, the additional tax
the firm will have to pay is a relevant cash outflow
Computed using the firms marginal corporate
tax rate
16 Corporate Finance
Tax savings from the deductibility of interest
expenses are taken into account in a projects
estimated after-tax cost of capital

Financing Costs
Cash flows to the investors, not cash flows
from the project
Are captured in the projects cost of capital
Should not be deducted from the projects
cash flow stream
Investment- and financing-related cash flows
from the designer desk lamp project are shown
in Exhibit 8.2
Corporate Finance 17
INITIAL
CASH FLOW
Investment-related cash flows $1,000 +$1,200 +$91
Financing-related cash flows +$1,000 $1,100 Zero

Total Cash Flows Zero +$100 +$91
TERMINAL
CASH FLOW
NPV at
10%
TYPE OF CASH-
FLOW STREAM
EXHIBIT 8.2:
Investment- and Financing-Related Cash-Flow Streams

Inflation
If inflation is incorporated in the cost of capital,
then it should also be incorporated in the
calculation of cash flows
Corporate Finance 18
Estimating A Projects Relevant Cash Flows
The expected cash flows must be estimated
over the economic life of the project
Not necessarily the same as its accounting
lifethe period over which the projects fixed
assets are depreciated for reporting purposes


Measuring The Cash Flows Generated By A
Project
Classic formula relating the projects expected
cash flows in period t to its expected contribution
to the firms operating margin in period t:
CF
t
= EBIT
t
(1-Tax
t
) + Dep
t
- AWCR
t
- Capex
t

Corporate Finance 19
Where:
CF
t
=

relevant cash flow
EBIT
t
= contribution of the project to the Firms
Earnings Before Interest and Tax
Tax
t
= marginal corporate tax rate applicable to
the incremental EBIT
t

Dep
t
= contribution of the project to the firms
depreciation expenses
AWCR
t
= contribution of the project to the firms
working capital requirement
Capex
t
= capital expenditures related to the
project
Corporate Finance 20
Estimating The Projects Initial Cash Outflow
Projects initial cash outflow includes the following
items:
Cost of the assets acquired to launch the project
Set up costs, including shipping and installation
costs
Additional working capital required over the first
year
Tax credits provided by the government to
induce firms to invest
Cash inflows resulting from the sale of existing
assets, when the project involves a decision to
replace assets, including any taxes related to that
sale
Corporate Finance 21
Estimating The Projects Intermediate Cash
Flows
The projects intermediate cash flows are
calculated using the cash flow formula
Estimating The Projects Terminal Cash Flow
The incremental cash flow for the last year of
any project should include the following items:
The last incremental net cash flow the project is
expected to generate
Recovery of the projects incremental working capital
requirement, if any
After-tax resale value of any physical assets acquired in
relation to the project
Capital expenditure and other costs associated with the
termination of the project
Corporate Finance 22
EXHIBIT 8.3a:
Estimation of the Cash Flows Generated by the Designer Desk Lamp
Project.
Figures in thousands of dollars; data from Exhibit 8.1
Corporate Finance 23
Corporate Finance 24
EXHIBIT 8.3b:
Estimation of the Cash Flows Generated by the Designer
Desk Lamp Project.
Figures in thousands of dollars; data from Exhibit 8.1
Corporate Finance 25
Corporate Finance 26
EXHIBIT 8.4:
Calculation of Net Present Value for SMCs Designer Desk Lamp Project.
Figures from Exhibit 8.3
Corporate Finance 27
Should SMC Launch the New Product?

The project has a positive NPV

Before making the final decision, the firm
should perform a sensitivity analysis on the
projects NPV to account for two important
elements:
SMC may not be able to raise the price of its
new lamp in steps with the inflation
SMC may incur net cash losses as a result of
a potential reduction in the sales of its
standard desk lamps
Corporate Finance 28
Sensitivity of the Projects NPV to Changes in
the Lamp Price

Even if SMC is unable to raise the price of its
lamps by the three percent expected rate of
inflation, the project is still worth undertaking
Because its NPV remains positive

Sensitivity of NPV to Sales Erosion

Before deciding whether to launch the designer
desk lamp project, SMCs managers must
determine
Corporate Finance 29
The size of the possible annual reduction in
sales and net cash flows through sales erosion
With an estimated $100,000 yearly sales
erosion, the project is no longer a value-creating
proposal
However, it can withstand some sales erosion
and still have a positive NPV

Sensitivity analysis is a useful tool when
dealing with project uncertainty
Helps identify those variables that have the
greatest effect on the value of the proposal
Shows where more information is needed
before a decision can be made
Corporate Finance 30
LONG-TERM FINANCIAL PLANNING &
GROWTH
Chapter 4 (Corporate Finance Fundamentals -RWJ-8e)
Financial Planning Models
External Financing and Growth
Internal Growth and Sustainable Growth
Operating leverage/Break-even Analysis
Chapter Objectives
Understand how to apply the percentage of sales
method.
Understand how to compute the external financing
needed to fund a firms growth.
Understand the determinants of a firms growth.
Understand some of the problems in planning for
growth.
Corporate Finance 31
What is Financial Planning?

Formulates the way financial goals are to be
achieved.

Requires that decisions be made about an
uncertain future.

Recall that the goal of the firm is to maximize the
market value of the owners equity
Corporate Finance 32
The basic policy elements of financial planning
are:

The firms needed investment in new assets.

The degree of financial leverage the firm
chooses to employ.

The amount of cash the firm thinks it is
necessary and appropriate to pay shareholders.

The amount of liquidity and working capital the
firm needs on an ongoing basis.
Corporate Finance 33
Important Questions
It is important to remember that we are working
with accounting numbers, and we should ask
ourselves some important questions as we go
through the planning process. For example:

How does our plan affect the timing and risk of
our cash flows?

Does the plan point out inconsistencies in our
goals?

If we follow this plan, will we maximise owners
wealth?
Corporate Finance 34
Dimensions of Financial Planning

The planning horizon is the long-range period
that the process focuses on (usually two to five
years).

Aggregation is the process by which the
smaller investment proposals of each of a firms
operational units are added up and treated as
one big project.

Financial planning usually requires three
alternative plans: a worst case, a normal case,
and a best case.
Corporate Finance 35
Accomplishments of Planning

Optionsfirm can develop, analyse and
compare different scenarios.

Avoiding surprises development of
contingency plans.

Feasibility and internal consistency
develops a structure for reconciling different
objectives.
Corporate Finance 36
Elements of a Financial Plan

An externally supplied sales forecast (either an
explicit sales figure or growth rate in sales).

Projected financial statements (pro-formas).

Projected capital spending.

Necessary financing arrangements.

Amount of new financing required (plug figure).

Assumptions about the economic environment.
Corporate Finance 37
ExampleA Simple Financial Planning Model

Recent Financial Statements
Income Statement Balance Sheet
Sales $100 Assets $50 Debt $20
Costs 90 Equity 30
Net Income $ 10 Total $50 Total $50

Assume that:
1. Sales are projected to rise by 25 per cent
2. The debt/equity ratio stays at 2/3
3. Costs and assets grow at the same rate as
sales

Corporate Finance 38
Pro-Forma Financial Statements

Income Statement Balance Sheet
Sales $125.00 Assets $ 62.50 Debt $25.00
Costs 112.50 Equity 37.50
Net $12.50 Total $62.50 Total $62.50

What is the plug?
Notice that projected net income is $12.50, but
equity only increases by $7.50. The difference,
$5.00 paid out in cash dividends, is the plug.
Corporate Finance 39
Percentage of Sales Approach
Some items vary directly with sales, while others
do not:

Income Statement

Costs may vary directly with sales - if this is
the case, then the profit margin is constant.
Depreciation and interest expense may not
vary directly with sales if this is the case, then
the profit margin is not constant.
Dividends are a management decision and
generally do not vary directly with sales this
influences additions to retained earnings.
Corporate Finance 40
Balance Sheet
Initially assume all assets, including fixed,
vary directly with sales

Accounts payable will also normally vary
directly with sales.

Notes payable, long-term debt and equity
generally do not vary directly with sales
because they depend on management decisions
about capital structure
The change in the retained earnings portion of
equity will come from the dividend decision.
Corporate Finance 41
ExampleIncome Statement
Sales $1 000
Costs 800
Taxable Income 200
Tax (30%) 60
Net profit $140
Retained earnings $112
Dividends $28
ExamplePro-Forma Income Statement
Sales (projected) $1 250
Costs (80% of sales) 1 000
Taxable Income 250
Tax (30%) 75
Net profit $175
Corporate Finance 42
ExampleSteps
Use the original Income Statement to create a pro-
forma; some items will vary directly with sales.
Calculate the projected addition to retained earnings
and the projected dividends paid to shareholders.
Calculate the capital intensity ratio.
ExampleBalance Sheet
Assets

Current assets ($) (% of sales)
Cash 160 16
Accounts receivable 440 44
Inventory 600 60
Total 1 200 120

Non-current assets
Net plant and equipment 1 800 180
Total assets 3 000 300
Corporate Finance 43
Liabilities and owners equity

Current liabilities ($) (% of sales)
Accounts payable 300 30
Notes payable 100 n/a
Total 400 n/a
Long-term debt 800 n/a
Shareholders equity
Issued capital 800 n/a
Retained earnings 1 000 n/a
Total 1 800 n/a
Total liabilities & owners equity 3 000 n/a
Corporate Finance 44
ExamplePartial Pro-Forma Balance Sheet
Assets
Current assets ($) Change
Cash 200 $40
Accounts receivable 550 110
Inventory 750 150
Total 1 500 $300
Non-current assets
Net plant and equipment 2 250 $450
Total assets 3 750 $750
Liabilities and owners equity
Current liabilities ($) Change
Accounts payable 375 $ 75
Notes payable 100 0
Total 475 $ 75
Long-term debt 800 0
Shareholders equity
Issued capital 800 0
Retained earnings 1 140 $140
Total 1 940 $140
Total liabilities & owners equity 3 215 $215
External financing needed 535 $535
Corporate Finance 45
ExampleResults of Model
The good news is that sales are projected to increase
by 25 per cent.

The bad news is that $535 of new financing is
required.

This can be achieved via short-term borrowing, long-
term borrowing, and new equity issues.

The planning process points out problems and potential
conflicts.

Assume that $225 is borrowed via notes payable, and
$310 is borrowed via long-term debt.
Corporate Finance 46
Plug figure now distributed and recorded within
the Balance Sheet.

A new (complete) pro-forma Balance Sheet can
now be derived.
Corporate Finance 47
ExamplePro-Forma Balance Sheet
Assets

Current assets ($) Change
Cash 200 $ 40
Accounts receivable 550 110
Inventory 750 150
Total 1 500 $300

Non-current assets
Net plant and equipment 2 250 $450
Total assets 3 750 $750
Liabilities and owners equity

Current liabilities ($) Change
Accounts payable 375 $ 75
Notes payable 325 $225
Total 700 $300
Long-term debt 1 110 $310
Shareholders equity
Issued capital 800 0
Retained earnings 1 140 $140
Total 1 940 $140
Total liabilities & owners equity 3 750 $750
Corporate Finance 48
External Financing and Growth

The higher the rate of growth in sales or assets,
the greater the external financing needed (EFN).

Growth is simply a convenient means of
examining the interactions between investment
and financing decisions. In effect, the use of
growth as a basis for planning is just a reflection
of the high level of aggregation used in the
planning process.

Need to establish a relationship between EFN
and growth (g).
Corporate Finance 49
ExampleIncome Statement

Sales $500
Costs 400
Taxable Income $100
Tax (30%) 30
Net profit $70
Retained earnings $25
Dividends $45
Corporate Finance 50
ExampleBalance Sheet

($) (% of
sales)
($) (% of
sales)
Assets Liabilities
Current assets 400 80 Total debt 450 n/a
Non-current
assets
600 120 Owners equity 550 n/a
Total assets 1000 200 Total 1000 n/a


Ratios Calculated
p (profit margin) = 14%
R (retention ratio) = 36%
ROA (return on assets) = 7%
ROE (return on equity) = 12.7%
D/E (debt/equity ratio) = 0.818

Corporate Finance 51
Growth
Next years sales forecast to be $600.
Percentage increase in sales:



Percentage increase in assets also 20 per cent.

Increase in Assets
What level of asset investment is needed to
support a given level of sales growth?

For simplicity, assume that the firm is at full
capacity. in assets be financed?
20%
$500
$100
= =
Corporate Finance 52
The indicated increase in assets required equals:
A g
where A = ending total assets from the previous period and g =
the growth rate in sales

How will the increase

Internal Financing
Given a sales forecast and an estimated profit
margin, what addition to retained earnings can be
expected?

This addition to retained earnings represents the
level of internal financing the firm is expected to
generate over the coming period.

Corporate Finance 53
The expected addition to retained earnings is:
where: S = previous periods sales
g = projected increase in sales
p = profit margin
R = retention ratio

External Financing Needed

If the required increase in assets exceeds the
internal funding available (that is, the increase in
retained earnings), then the difference is the
external financing needed (EFN).


Corporate Finance 54
EFN = Increase in Total Assets
Addition to Retained Earnings

= A(g) p(S)R (1 + g)

Increase in total assets = $1000 20%= $200

Addition to retained earnings
= 0.14($500)(36%) 1.20
= $30

The firm needs an additional $200 in new financing.
$30 can be raised internally.
The remainder must be raised externally (external
financing needed).
Corporate Finance 55
170 $
20 1 % 36 500 $ 14 0 ) 20 0 ( 1000 $
) 1 ( ) ( ) (
RE o Addition t assets in total Increase EFN
=
=
+ =
=
. . .
g R S p g A
) (
Relationship
To highlight the relationship between EFN and g:





Setting EFN to zero, g can be calculated to be
2.56 per cent.
This means that the firm can grow at 2.56 per
cent with no external financing (debt or equity).

( ) ( ) | |
( )( ) ( ) | |
g
g . % .
g R S p A R S p
+ =
+ =
+ =
975 25
%) 36 ( 500 $ 14 0 1000 $ 36 500 $ 14 0
EFN
Corporate Finance 56
Financial Policy and Growth

So far sees equity increase (via retained
earnings), debt remain constant and D/E decline.

If D/E declines, the firm has excess debt
capacity.

If the firm borrows up to its debt capacity, what
growth can be achieved?
Corporate Finance 57
Sustainable Growth Rate (SGR)

The sustainable growth rate is the growth rate a
firm can maintain given its debt capacity, ROE
and retention ratio.
( )
( ) R
R



=
ROE 1
ROE
SGR
ExampleSustainable Growth Rate
Continuing from the previous example:
| | ( )
4.82%
0.36 0.127 1
0.36) .127 0 (
SGR
=


=
Corporate Finance 58
The firm can increase sales and assets at a rate
of 4.82 percent per year without selling any
additional equity, and without changing its debt
ratio or payout ratio.

Determinants of Growth

Growth rate depends on four factors:
profitability (profit margin)
dividend policy (dividend payout)
financial policy (D/E ratio)
asset utilisation (total asset turnover).
Corporate Finance 59
If a firm does not wish to sell new equity, and its
profit margin, dividend policy, financial policy and
total asset turnover (or capital intensity) are all
fixed, then there is only one possible growth rate.
Do you see any relationship between the SGR
and the Du Pont identity?
Corporate Finance 60
ESTIMATING THE COST OF CAPITAL (WACC)
Chapter 10 (Finance for executives-Hawawini,
viallet-3e)
Estimating the cost of equity
The dividend discount model
The CAPM approach
Estimating the cost of capital of a project

Cash is not freeit comes at a price
The price is the cost to the firm of using
investors money
Cost of Capital
Return expected by the investors for the capital
they supply
Corporate Finance 61
Background
Objective of Chapter
Shows how to estimate the cost of capital to be used in
discounted cash flows models
Investors do not normally invest directly in projects
They invest in the firms that undertake projects
Challenge is to identify firms, called proxies or pure
plays
Exhibit the same risk characteristics as the project
under consideration.
After a proxy has been identified need to estimate the
return expected by the investors who hold the securities
the proxy has issued
Assume that there are only two types of securities
Straight bonds
Common shares
Corporate Finance 62
Return expected from the assets managed by a firm
must be the total of the returns expected by bondholders
and shareholders, weighted by their respective
contribution to the financing of these assets
Weighted average cost of capital or WACC
Sunlight Manufacturing Companys (SMC) desk lamp
project
Used to illustrate the case when a projects cost of
capital is the same as the firms cost of capital
Buddy's Restaurant Project
Illustrates how to estimate the projects cost of capital
when the project has a risk that differs from the risk of
the firm
After reading this chapter, students should understand:
How to estimate the cost of equity capital
How to combine the cost of different sources of
financing to obtain a projects weighted average cost of
capital
Corporate Finance 63
How to estimate the cost of debt
The difference between the cost of capital for a firm
and the cost of capital for a project

Identifying Proxy Or Pure-Play Firms
When the projects risk profile is similar to the
firms risk profile, the proxy is the firm itself
Classification systems used to select pure-plays
are far from perfect
Often trade-offs need to be made between
possible large measurement errors of a small
sample of closely comparable companies and
a larger sample of firms that are only loosely
comparable to the project

Corporate Finance 64
Estimating The Cost Of Debt
If a firm takes out a loan, the firms cost of debt
is the rate charged by the bank
If we know a sufficient amount of information
the valuation formula can be solved for the
investors required rate of return




If the firm has no bonds outstanding, its cost of
debt can be estimated by adding a credit risk
spread to the yield on government securities of
the same maturity
( ) ( ) ( ) ( )
t t+1 t+2 T
t t
D D D
+ +2
D
1 t T
k k
Coupon PMT Coupon PMT Coupon PMT Coupon PMT
Bond Price = + + + +
1+ 1+ 1+ 1+ k k
Corporate Finance 65
Since interest expenses are tax deductible, the
after tax cost of debt is the relevant cost of
debt
After-tax cost of debt
= Pre-tax cost of debt (1 - marginal corporate
tax rate)
However, the after tax cost of debt is a valid
estimator only if
The firm is profitable enough, or
A carry back or carry forward rule applies to
interest expenses
Corporate Finance 66
Estimating The Cost Of Equity:
The Dividend Discount Model
According to the dividend discount model, the
price of a share should be equal to
Present value of the stream of future cash
dividends discounted at the firms cost of equity
The dividend discount model cannot be use to
solve for the cost of equity
Unless simplifying assumptions regarding the
dividend growth rate are made
Estimating The Cost Of Equity: Dividends
Grow At A Constant Rate
Firms cost of equity is the sum of its expected
dividend yield and the expected dividend growth
rate
Corporate Finance 67
If we assume the dividend that a firm is expected
to pay next year will grow at a constant rate
forever



D
0
= 2.00, kE = 13%, g = 6%.
Constant growth model:
P
0 =
D
0
(1 + g)/ P
0
+ g


= 2(1 + 0.06)/ (0.13 0.06)
= $2.12/ 0.07 =$30.29
What is the stocks market value one year from now,
P
1
?
D
1
will have been paid, so expected dividends are D
2
,

D
3
, D
4
and so on. Thus,



1
E
0
DIV
k = +g
P
Corporate Finance 68
P
1 =
D
2
/ (kE g)
= D
0
(1 + g)^2/ (kE g)
= $2.247/ 0.07= $32.10
Find the expected dividend yield and capital gains yield during the first
year.
Dividend yield = D
1
/ P
0
= $2.12/ $30.29 = 7%
CG Yield = (^P
1
- P
0
)/ P
0
= ($32.10 $30.29) / $30.29 =6%
Estimating The Cost Of Equity: How Reliable
Is The Dividend Discount Model?
For the vast majority of companies, the simplistic
assumptions underlying the reduced version of
the dividend discount model are unacceptable
Thus, an alternative valuation approach is
needed
The capital asset pricing model or CAPM


Corporate Finance 69
Estimating The Cost Of Equity:
The Capital Asset Pricing Model
The greater the risk, the higher the expected
return
What is the nature of the risk?
How is it measured?
How does it determine the return expected by
shareholders from their investment?

Diversification Reduces Risk
A major implication of holding a diversified
portfolio of securities is that the risk of a single
stock can be divided into two components
Corporate Finance 70
Unsystematic or diversifiable risk
Can be eliminated through portfolio
diversification
Includes company-specific events such as
the discovery of a new product (positive effect)
or a labor strike (negative effect)
Systematic or nondiversifiable risk
Cannot be eliminated through portfolio
diversification
Events that affect the entire economy instead
of only one firm, such as
Changes in the economys growth rate,
inflation rate and interest rates
Corporate Finance 71
Diversification Reduces Risk
Financial markets will not reward unsystematic
risk
Because it can be eliminated through
diversification at practically no cost

Thus, the only risk that matters in determining the
required return on a financial asset is the assets
systematic risk

In other words, the required rate of return on a
financial asset depends only on its systematic
risk
Corporate Finance 72
Measuring Systematic Risk With the Beta
Coefficient
A firms systematic risk is usually measured
relative to the market portfolio
Portfolio that contains all the assets in the
world
Systematic risk of a stock is estimated by
Measuring the sensitivity of its returns to
changes in a broad stock market index
Such as the S&P 500 index
This sensitivity is called the stocks beta
coefficient
Corporate Finance 73
The Impact Of Financial Leverage On A
Stocks Beta
A firms risk depends on
Risk of the cash flows generated by the firms assets
(business risk)
Firms asset (or unlevered) beta captures its business
risk


The risk resulting from the use of debt (financial risk)
Thus, firms beta coefficient is affected by both
Firms equity beta (or levered beta) captures both
business and financial risk

( )
equity
asset
Debt
1+ 1 - tax rate
Equity
|
| =
(
(

( )
equity asset
Debt
1+ 1 - tax rate
Equity
| |
(
=
(

Corporate Finance 74
EXHIBIT 10.4:
Average Annual Rate of Return on Common
Stocks, Corporate Bonds, U.S. Government
Bonds, and U.S. Treasury Bills, 1926 to 1995.

Average
Risk
Premium
Average
Annual
Return
Type of
Investment
Corporate Finance 75
The Capital Asset Pricing Model (CAPM)

Treasury bills are the safest investment available
Usually used as a proxy for the risk-free rate
Risk premium of a security
Difference between the expected return on a
security and the risk-free rate
Market risk premium
Risk premium of the market portfolio
Since beta measures a securitys risk relative to
the market portfolio
A securitys risk premium equals the market
risk premium the securitys beta.
Corporate Finance 76
The CAPM states that the expected return on any
security is the risk-free rate, plus the market risk
premium multiplied by the securitys beta


Using The CAPM To Estimate SMCs Cost Of
Equity
Treasury bill rate is replaced by the rate on
government bonds
Since it is difficult to estimate future Treasury
bill rates
SMCs cost of equity of 12.37% is estimated
from the market risk premium of 6.2 percent and
SMCs beta of 1.06

( )
i F M F i
R = R + R - R
Corporate Finance 77
K
E, SMC
= 5.8% + (6.2%) x 1.06 = 12.37%
Estimating The Cost Of Capital Of A Firm
What is the firms cost of capital?
Minimum rate of return the project must
generate
In order to meet the return expectations of its
suppliers of capital
Assuming that a project has the same risk as the
firm that would undertake it
A firms cost of capital is its weighted average
cost of capital, or WACC
Assuming that the firm is financed by debt and
equity, its WACC is equal to
Corporate Finance 78
Weighted average of the cost of these two
means of financing
Weights equal to the relative proportions of debt
and equity used in financing the firms assets
WACC= kD (1 TC) E/(E+D) + kE E/(E+D)