Capital Budgeting (NPV) The difference between the market value of a project and its cost

PVCCATs

CdT 1 0.5 k S n dT

(d k ) 1 k (d k )

1
n
(1 k )

Abram Cortez (500 515 877)

NPV: PV (OCF) + PV (NCS) + PV (NWC) + PVccats

NPV(replace): PVOCF + PVNCSnew PVNCSold + PVNWCnew PVNWCold + PVCCATSnew

PVCCATSold
OCF: (s-c)(1-Tc)
(you will get PMT then input in CALC to find NCSold = Current Value + Salvage Value (What you get for selling giving
PV)
up)
NCS: - initial Cost + PV (Salvage)
NWC = -intial investment + PVrecap ( -x + x/(1+rn)
Solving for Cost of Equity RE
Cost of project = (amount to be raised) =

CAPM RE = Rf + BE (ERM RE D1 g RF)

projectcost
P
WACC = WE x RE + WD x RD x (1-Tc)
1 floatationcost
Leasing/Buying Minimizing cost by deciding to lease or buy an A/S
Criteria for Financial (Capital) Lease:
Lease transfers ownership by end of lease term

Lesee can purchase asset at below market price

Lease term is 75% life of A/S
PVLP is at least 90% of FMV At start of lease

Solving for Net Advantage to Leasing (NAL): Same as NPV

MAKE SURE IN BGN MODE!!!!

NAL = Initial Investment PVATLP PVCCATS PVSALVAGE +/- PVMaintenance

Leasing Paradox: If Lessor and lessee have the same tax rate, then there is no extra benefit or cost to leasing
GOOD REASONS FOR LEASING
Taxes reduced
May have lower tx cost
May require restrictive cov. May encumber fewer A/s than secured borrow
Finding CF from Lessors POV: Flip all signs. If they have the same tax rate then NAL is exact opposite of Lessees NAL
Capital Structure involves changing amount of leverage firm without changing the firms assets

Maximize Firm Value, minimize WACC

ROE = EBIT / EQUITY EBIT EBIT Interest

EPS = EBIT / o/s

Home Made Leverage
S/ O
New S/ O

An investor can replicate proposed borrowing by making his own D/E ratio = 1
HOMEMADE LEVERAGE ex:
(When Cap Structure doesnt change)
owner has 125 shares

This is done by selling shares in the ratio at which firm is buying back and put money in
o If firm moves 40% debt but
prefers all equity, sell 40% of
the bank (when cap changes)
shares

= unlevered ( 1 + D/E)
o
#shares
to sell = (0.4)(125)
M&M Proposition I
Prop II
o Interest CF = (#shares to sell x
No Tax: VL = VU | Vu = D + E | ALL EQUITY: RE = RANo
= WACC
Tax: Cost of Equity (RE) = RA + (RA RD) x D/E
price/share) (interest)
With Tax: VU = EBIT (1 Tc) / RU
|
VL = VU + DT
With Tax Cost of Equity (RE) = RA + (RA RD) x D/E x (1 Tc)
o Dividend CF = (shares

Firms cost of equity RE, rises as the firm relies more heavily on debt financing.
remaining)(EPS)
M&M with bankruptcy costs

Static Theory: the gain from tax shield on debt is offset by bankruptcy. An optimal capital structure exists that just balances
the additional gain from leverage (debt) against the added bankruptcy cost
o
WACC falls initially because of the tax advantage of debt beyond the point of D/E, it begins to rise because of financial
distress.
Dividend Policy
Home Made Dividends

Dividend policy is irrelevant when there are no taxes or other market imperfections

The S/H receives div > desired can reinvest. The S/H receives div < desired can sell extra shares
Alternative to paying Dividend:
1. Select addition capital budgeting proj.
2. Repurchase Shares
3. Acquire other companies
4. Purchase Financial A/S
Raising Capital
Over-Allotment: Allows syndicate to purchase 15% of the issue from issuer and also allows the issue to be oversubscribed. Provides some
protection for lead underwriter
shares offered =

total amount raised

offer price
Lockup Agreements: How long insiders must wait after an IPO

Quiet Period: 40 Calendar days. No comm.

With public.
Rights Offering:
Number of new shares to issue
= funds to raise / sub price

N # rights needed to buy 1 share

Ex-rights price
Value of right: (M-S) / (N+1)
= #old shares / #new shares = (N x initial stock price + sub price)
M = common share price during rights on
N+1
S = Sub price

Dilution: loss in value of existing shareholders (1. % ownership shares sold to public w/o rights offering
2. MV firm accepts ve NPV
3. BV and EPS MVtoBV < 1)
Public Placements
Private Placements
1. Maximizes number of buyers 2. Increases liquidity of original owners 1. Avoids costly and time consuming report process 2.avoids costly issuing
3. The Firm Can grow Quickly
3.There may be better access to info for investors
Enterprise Risk Management
Hedging: reducing firms exposure to price fluctuations. Derivative: financial A/S that represents a claim to another A/S
Forwards: Does not completely eliminate risk because both parties still face credit risk
Futures
Required an upfront cash payment and are marked-to-market on daily basis
Long an increase in settlement price leads to a GAIN
Gain/Loss = Contract Size x Change in Settlement Price

Short an increase in settlement price leads to a Loss

Cross Hedging: hedging an asset with contracts written on closely related, but not identical A/S
Basis Risk: When cross-hedging, the risk that the futures price doesnt move directly with the cash price of the hedged asset

Options and Corp Securities

Option seller = writer
Call right to buy
Put right to sell

Call Options:
Put Options:
Upper Bound: Call Price S
In the Money (ITM): S > X ITM: S < X then X S
Lower Bound: Call Price S X or 0 greater of two
Out the Money (OTM): S < OTM
X
S>X=0

Option Value = Intrinsic Value (LB) + Time Value

Prices are higher for options with the same strike price but longer expirations

Call options with strikes less than the current price are worth more than corresponding puts
Five Factors that determine Option Value
S(+) = C(+) and P(-) X(+) = C(-) and P(+)Time to expire(+) = C(+) and P(+) Rf(+) = C(+) and P(-) Variance of return(+) = C(+) and P(+)
Hedging with options:

Unlike forwards and futures, options allow the buyer to hedge their
downside risk, but still participate in upside potential

Exchange rate risk with options: Buying Puts is less risky than
selling calls
Warrants

Like a call options issued by corp with other securities to reduce

yield

Warrants can be detached from the orginal securities and sold

separately

Warrants affect value of firm