CHAPTER - 1

1-1
What long-term investments should the firm undertake?
The starting point for financial decision making involves identifying investments that will increase the value of
the firm and therefore the wealth of shareholders. Companies typically have a range of possible investments to
choose from and use capital budgeting to choose between them. In the case of Apple, the company perceived
that there would be sufficient demand for a new tablet computer the iPad. This decision involved projecting
future cash flows from sales and performing a cost-benefit analysis to determine whether the project would
increase the value of the company.
How should the firm raise money to fund those investments?
Companies usually have a range of options in terms of raising capital. These include borrowing money from
banks, issuing debt securities and issuing shares. The development and production of a major new product such
as the iPad requires significant up-front investment, and Apple used a variety of sources to raise the necessary
capital.
How can the firm best manage its cash flows as they arise in its day-to-day operations?
Once the product was launched, there would have been significant cash inflows from sales, along with
continuing outflows of cash from ongoing development and marketing expenses. Working-capital management
involves making sure there is sufficient cash and inventory for day-to-day operations, and projecting and
managing cash flows so that obligations can be met in a timely fashion and surplus cash is invested
productively.
1-2

The main advantages of a company as the dominant form of business organisation are limited liability
of owners, and division of ownership into shares, allowing ease of transfer of ownership. These
advantages have enabled companies to pool the funds of large numbers of individual investors.
Companies are more easily able to raise additional funding from external investors (or lenders) in the
capital markets.

1-3
The goal of the financial manager is to maximise shareholder wealth by maximising the value of
ordinary shares. The market value of the firms shares reflects the value of the firm as seen by its owners. The
shareholders are the legal owners of the firm and the financial manager is engaged as their agent to manage the
firms finances in their interest. Maximising share price and hence shareholder wealth is not only in their
interest, but also provides the most productive use of societys resources. One of the difficulties of achieving
this goal is that share prices frequently fluctuate, and often for no apparent reason. The solution is to make
financial decisions which should, all else being equal and in the long run, maximise share price.
Another difficulty is the agency problem, whereby managers sometimes have a conflict of interest.
Sometimes financial decisions might benefit the manager and not shareholders. An example is focusing
on short-term profit at the expense of long-term value. One way to combat this problem is by designing
remuneration packages for managers which tend to align their interests with those of shareholders, such
as bonuses based on long-term share price.

1-4

Almost any financial decision that involves cash flows at different points in time implicitly involves the
time value of money. Making an investment such as buying shares, purchasing a major asset such as a
house or a car, or deciding to spend money on a university education involves a short-term cash
outflow that will hopefully result in future cash inflows. The concept of the time value of money
requires us to compare the value of the cash inflows with the value of the outflows, and because the
cash flows occur at different points in time, adjustments need to be made for the time value of money in
order to make a valid comparison.

1-5

Principle 1 suggests that you should only invest money in a risky investment if the expected return on
the investment is greater than for a less risky investment. The amount of additional expected return
should be proportional to the extra risk being taken on.

1-6

Principle 4 suggests the costs and benefits of any financial decision must be weighed up in terms of
incremental cash flows. The decision to reduce your working hours has cost $10,000 per annum. The
value of the decision is based on the extra cash flow that will be received in the future as a result of
enhanced career and job promotion prospects. The decision will be a good one in financial terms if
those extra cash flows exceed $10,000 per year.

1-7

Companies can improve their competitive position through:

Product differentiation: Differentiating your products from those of competitors enables you to charge
a premium, because customers no longer base their decisions on price alone. This can be done through
quality and service, advertising, patents or product innovation.
Creating a cost advantage: This can be achieved through economies of scale, experience or location
advantage, among others. If you can produce at a lower cost than your competitors, you can maintain a
competitive advantage.

1-8

Globalisation has resulted in opportunities and challenges. Businesses are more easily able to source
labour and materials internationally, often resulting in cost savings. But it also means that businesses in
many different industries are faced with low-cost competitors.

1-9

The answer to this question will vary from person to person. Increasing unemployment because of
reduced economic growth in Australia (and a recession in most countries) can affect individuals and
families when jobs are lost. Many investors in some financial products have lost their investments but,
more broadly, anyone with direct share investments or retirement savings which include investments in
shares has seen a reduction in the value of their investments. Those close to retirement may see a
significant reduction in their standard of living post-retirement because of the reduction in the value of
their investments.

CHAPTER-4
4.1 The time value of money (TVM) concept is based on the idea that a dollar received today is worth more than the same
dollar received a year from now (or at any future date). The TVM exists because there are investment opportunities on
money; that is, we can place our dollar received today in a savings account and one year from now have more than a dollar.
(In other words, receiving a dollar today is worth more than receiving just one dollar in the future.)
The TVM concept is of vital importance in finance as it forms the basis for much financial decision making. For a
typical investment project, initial cash outflows are known with some certainty, however, future cash inflows from
operations are less certain. Understanding the concept of a time value of money provides for consistency in the
assessment as to whether an investment project should proceed in order to maximise the wealth of business
owners, the present value of future cash inflows would need to exceed the initial cash outflows. Where there are
competing projects, the project providing the greatest net cash inflow (after taking into consideration the time value
of money) should be selected.
TVM concepts are equally applicable when borrowing money. A dollar repaid in the future is worth less (costs less)
than a dollar borrowed today. So, the cost of borrowing cannot be based on comparing dollar payments that occur
at different times. Instead, a suitable interest rate must be used to properly assess the cost of borrowing.
4-2.

Compounding and discounting are inverse processes of each other. In compounding, money is moved
forward in time, while in discounting money is moved back in time. This can be shown mathematically
in the compounding or FV equation:
n
FVn PV 1 i
1/ 1 i

We can derive the discounting (PV) equation by multiplying each side of this equation by
PV FVn / 1 i

.
FVn PV 1 i

We know that

which gives

4-3.

. Thus, an increase in i will increase the value of the right-hand side of

the equation and so increase FVn. Similarly, an increase in n will increase FVn.
4.6.

Continuous compounding occurs when interest is earned on previously earned interest and principal and this
happens as frequently as theoretically possible continuously. Continuous compounding occurs when the
number of compounding periods in a year (m in the equation below) are taken to the limit (that is, m approaches
infinity):
mt
FVn PV 1 j / m

where t is the number of years and so the number of compounding periods is

n=mt
Although it is difficult to conceptualise the notion of infinite compounding, mathematically workable outcomes
are obtained in the form of the following equation which is used to solve relevant problems that involve
continuous compounding:

FVt PVe jt

where e is approximately equal to 2.71828; t is the number of years (t can be non-integer). This equation can be
rearranged to solve for the PV.
CHAPTER 7
7-l

Working capital is usually defined as the firms investment in current assets. Net working capital
(NWC) refers to the difference between the firms current assets and its current liabilities, as shown by
the equation:
NWC = Current assets Current liabilities

7-2

Other things remaining the same, the greater the firms investment in current assets, the greater its
liquidity. The firm may choose to invest additional funds in cash and/or marketable securities as a
means of increasing its liquidity (which reduces the risk of illiquidity). However, these asset
investments earn little or no return. Therefore, the firm can reduce its risk of illiquidity only by
reducing its overall return on invested funds and vice versa.

7-3

Advantages and disadvantages of short-term debt (compared to long-term debt):

Advantages
The interest rate is usually lower for short-term debt (that is, if the term structure of interest rates is
upward-sloping).
Funds are borrowed only when they are needed and can be repaid, typically without much penalty,
when no longer required.
Disadvantages
Short-term debts must be repaid sooner; hence, there is a greater risk of illiquidity.
Interest costs on short-term debts vary from year to year, whereas long-term debt agreements may
lock in the cost of funds to the firm (if at a fixed rate). Hence, greater uncertainty (risk) may
follow from taking out short-term debt.

7-4

The hedging principle involves matching the maturities of the sources of financing (of the firms assets)
with the useful lives of the assets. To implement the hedging principle, the firm must use long-term
sources of funds to finance the permanent asset investments that are not financed by spontaneous
sources (payables), and also finance with short-term sources of funds all the temporary asset
investments that are not funded by spontaneous sources of financing.

7-8

(i)
(ii)
(iii)

2/10, net 30 means that a 2% discount is offered for payment within 10 days or the full amount
is due in 30 days.
4/20, net 60 means 4% discount within 20 days, full amount 60 days.
3/15, net 45 means 3% within 15 days, full amount 45 days.

CHAPTER-8
8-1

The cash-flow process refers to the flow of funds through the business, from the time of their initial
receipt until their ultimate disposition. Over the long run, accounts receivable collections provide for the
largest regular source of cash in the typical manufacturing company. Payment of accounts payable, payroll
expenses and the distribution of income to the owners (cash dividends) are the major forms of cash
disbursal.
Other sources of cash for a company may include receipts from the sale of assets, raising additional debt,
issuing new stock or sale of securities. While these are important sources of cash to a company, the
proceeds are not available on a regular basis. Major capital expenditure programs, new company
acquisitions and inventory stockpiling are examples of irregular disbursals of cash outside the normal
course of everyday business.

8-2

The three dominant motives for holding cash and near-cash balances are:
(1) the transactions motive
(2) the precautionary motive, and
(3) the speculative motive.
Transactions balances allow the firm to make payments that arise in the ordinary course of undertaking
business. Precautionary balances provide a buffer stock of liquid assets that can be drawn on if unexpected
demands for cash arise. Speculative balances permit the firm to take advantage of future profit-making
situations.

8-4

(1)
(2)
(3)

Choosing among various methods available for speeding up cash receipts, slowing down cash
payments, and providing for more effective control over cash outflows.
Splitting the firms liquid asset holdings among cash and marketable securities.
Choosing the appropriate marketable securities mix.

(2)
(3)
(4)

Processing float: this represents the time needed for the company to process the firms
remittances and get them ready for deposit at their financial institution.
Transit float: this represents funds tied up because of the time necessary for deposited amounts to
clear through the commercial banking system and become clear funds to the firm.
Disbursing float: this refers to funds available in the firms current account due to the time
needed for a payment remittance to clear through the banking system. This aspect of float is
opposite in effect to the previous three types of float.

8-13

A credit agency or bureau has specialised skills in assessing the creditworthiness of a potential future
debtor. Using such a service may reduce credit risk and reduce the possibility of making an incorrect
lending decision. There is obviously a fee for using such services, which must be weighed up against the
possible benefits. It is possible that the use of such a service could more than pay for itself by avoiding
poor lending decisions and consequential bad debts, whilst ensuring as many customers with good credit
ratings are retained as possible.

8-14

The returns associated with a more liberal credit policy come from the fact that extending credit to weaker
customers or liberalizing the trade credit terms will probably increase sales, resulting in a greater gross
profit.
The risks involved largely result from the increased possibility of extending credit that add to collection
costs with a portion of credit sales eventually becoming bad debts. In such a situation it is feasible that the
total costs of a more liberal credit policy will exceed their total benefits.

8-16

Yes. The stock of cash carried by a firm is simply a special type of inventory. In terms of uncoupling the
various operations of the firm, the purpose of holding cash is to make the payment of bills independent of
the collection of accounts due.

8-17

In order to effectively control the investment in inventory, the firm must:

(1) determine the optimal order size for the inventory item given its expected usage, carrying costs
and ordering costs, and
(2) determine how low inventory should be allowed to be depleted before it is reordered.

CHAPTER - 9
9-2

Data has been compiled on the actual returns and standard deviations of the Australian share-market
accumulation index and for government bonds over the 25-year period from 1984 to 2010. This data has
shown that investors historically have received greater returns for greater risk-taking, with an investment
in the share market providing significantly higher returns than that of government bonds. Investments in
both shares and government bonds have provided returns that, on average, consistently exceeded the
inflation rate. Over the period of the survey, equity investors, on average, received a risk premium of
just under 2% p.a. for their additional level of risk exposure in comparison to a risk-free investment in
government bonds. Their level of risk, however, is also greater, as measured by the standard deviation
of returns. Both of these observations are consistent with Principle 1.

9-3

The impact of inflation is to reduce real rates of return to investors as inflation erodes the purchasing
power of the nominal returns. For a given nominal rate of return it can be seen that the higher the rate
of inflation the lower will be the real rate.

9-5

The fall in the NABs share price is largely non-systematic or firm specific as the risk factor i.e. loss
from unauthorized option trading only affected the NAB. However, there might also be an element of
systematic risk given the weakness of the market. Therefore, a large component of the fall in share price
was attributable to non-systematic risk while a small component of the fall could be explained by a weak
market that reduced the prices, on average, of all shares in the market.

9-6

(a)

The investor's required rate of return is the minimum rate of return necessary to attract an investor
to purchase or hold a security.

(b)

Risk is the potential variability in returns on an investment. Thus, the greater the uncertainty as to
the exact outcome, the greater is the risk. Risk may be measured in terms of the standard
deviation or by the variance, which is simply the standard deviation squared.

(c)

A large standard deviation of returns indicates greater riskiness associated with an investment.
However, whether the standard deviation is large relative to the returns has to be examined with
respect to other investment opportunities. Alternatively, probability analysis is a meaningful
approach to capture a greater understanding of the significance of a standard deviation figure.

(a)

Unsystematic (unique) risk is the variability in a firm's share price that is associated with the
specific firm and is not the result of some broader influence. An employee strike at a company is
an example of unsystematic risk.

(b)

Systematic risk is the variability in a firm's share price that is the result of overall market or
economic influences. The sub-prime crisis was an example of systematic risk, because it was
largely universal in its effect in share markets around the world. An unexpected change in
interest rates announced by the Reserve Bank of Australia is also an example of systematic risk.

9-7

9-8

Beta is a measure of the responsiveness of a firm's returns as compared to market returns under the
assumption of full diversification. It takes into account the relative riskiness of the share's returns and is
expressed as a number whereby movements in market returns are assigned a value of one. It is used to
calculate the investor's required rate of return by its inclusion into the CAPM, which expresses the
required rate of return in terms of the risk free rate and the beta-adjusted market risk premium.

9-9

The security market line is a graphical representation of the risk-return trade off that exists in the market.
The line indicates the minimum acceptable rate of return for investors given a specific level of risk.
Since the security market line results from actual market transactions, the relationship not only
represents the risk-return preferences of investors in the market but also represents the investors
available opportunity set.

9-10

The beta for a portfolio is equal to the weighted average of the individual share betas, weighted by the
percentage invested in each share.

9-16

The CAPM provides us with a tool to calculate the required rate of return on a risky financial asset. The
most important underlying assumption of the CAPM is that only systematic risk is priced (i.e. investors
are not rewarded for bearing non-systematic risk as this can be effectively diversified away). Hence the
required rate of return on a financial asset is determined by its systematic risk. The CAPM postulates
that the required rate of return on a risky asset is made up of a risk-free rate and a risk premium where
the risk premium is determined by beta. An asset with a beta of 0 has no systematic risk, with its
required rate of return not 0, but instead, equal to the risk-free rate.
CHAPTER -10

10-1

Book value is the assets historical value and is represented on the balance sheet as the actual cost
minus depreciation. Liquidation value is the amount that could be realised if the asset were sold
individually and not as part of a going concern. Market value is the observed value for an asset in
the marketplace where buyers and sellers negotiate a mutually acceptable price. Intrinsic value is
the present value of the assets expected future cash flows discounted at an appropriate discount rate
that reflects risk.

10-2

The first two factors affecting asset value (the asset characteristics) are the assets expected cash
flows and the riskiness of these cash flows. The third consideration is the investors required rate of
return. The required rate of return reflects the investors risk-return preference. As investors will
require a high rate of return from an asset with very risky (uncertain) future cash flows, the asset
will have a low intrinsic value.

10-3

The relationship is inverse. As the required rate of return increases, the value/price of the security
decreases, and a decrease in the required rate of return results in a value/price increase.

10-4

The value of a security is equal to the present value of cash flows to be received by the investor.
Hence, the terms value and present value have the same meaning in this context.

10-5

(a)

The par value is the amount stated on the bond documentation to be paid to the holder of the
bond on the bonds maturity date. This value does not change and, therefore, is completely
independent of the market value. However, the market value will change when the required
rate of return changes to reflect changing risk due to economic conditions and factors within
the firm.

(b)

The coupon interest rate determines the fixed amount the bond investor will receive each
coupon payment period equal to the coupon rate x par value. As such, the coupon interest
rate is constant throughout the life of the bond. On the other hand, the bondholders required
rate is equivalent to the investors required rate of return, and will change as investor
attitudes towards the risk of investing in the bond change.

10-6

The two types of return that holders of ordinary shares receive include dividend income and capital
gains. The amount of dividend income received by ordinary shareholders is variable and is
dependent on the amount of after-tax company profits and the discretion of the companys board of
directors. As ordinary shareholders also participate in the growth in the value of the company, their
second source of return is capital gains from appreciation of the companys share price.

10-7

The investors required rate of return is the discount rate that equates the present value of future
cash flows expected from the security with the price they are prepared to pay for the security. As
such, the required rate of return is similar to the internal rate of return for capital-budgeting
problems and, without access to a financial calculator or appropriate computer program, this rate
has to be determined by trial and error using the interpolation process.

10-8

The expected rate of return is the rate of return that may be expected from purchasing a security at
the prevailing market price. Thus, the expected rate of return is the rate that equates future cash
flows with the actual selling price of the security in the market. For the marginal investor who is
willing to pay the ruling market price (but no more) for a security, the expected rate of return is
equal to the required rate of return.

10-9

(a)

EPS (Earnings Per Share) is the amount of the companys after-tax profit for a period
expressed on a per share basis. EPS is usually computed by dividing annual after-tax profit
by the number of ordinary shares on issue. EPSis linked to share price via the Price-Earnings
Ratio (PER). If the share price is $P and EPS is $E, then the PER is simply $P/$E. In other
words, the PER is nothing more than the arithmetic outcome of dividing the observed share
price by the observed EPS.

(b)

Use of the PER is limited by the fact that it is strictly an arithmetic outcome of the observed
share price and so it is not really a comprehensive theory of how that share price was
formed.
However, some financial analysts use the (observed) PER as a way of predicting share price.
They argue, for example, that if the firms PER is, say, 30 and a prediction for EPS next year
is $1, then the share price at the end of next year is predicted to be $30. Thus, such analysts
are asserting that EPS drives the share price and so a firm with growing earnings per share
will also have growth in the share price.
Analysts do not necessarily believe that the PER is static. They argue that, other things being
equal, a company that incurs increased risk will suffer a decline in the PER. This is actually a
way of saying that investors will pay less for shares in a riskier company, other things being
equal. Alternatively, if two companies have equal earnings but one benefit from growth
while the other is static, the growing company will have a higher PER. This too is a way of
saying that investors will pay more for a share in a growing company, other things being
equal. However, it can again be argued that such analysis of the PER is merely the outcome
of predictions and observations about share price movements, rather than a theory of what
brings about the formation of those share prices.

CHAPTER 14
14-1

The cost of capital is the minimum rate of return that the firm must be earn on its investments in order to
satisfy the rates of return required by the firms investors. Stated differently, the cost of capital is the rate
of return from the firms investments that will leave the price of the companys ordinary shares
unchanged. The cost of capital is a function of the investors required rate of return, the costs incurred in
issuing new securities and the proportions (weight) of each source of capital used by the firm. Depending
on the firms taxation category, the cost of capital can be calculated as a before-tax or after-tax value.

14-2

Two objectives may be given for determining a companys cost of capital:

(1)

The financial management objective is to maximize shareholder wealth. Assuming that everything
else remains constant, a company can increase the value (price) of its ordinary shares by lowering
its cost of capital. Thus, the company would prefer the capital mix that provides an outcome of the
lowest cost of capital. However, measuring the cost of capital for various financial structures is
quite difficult in practice.

(2)

The cost of capital is used as the minimum acceptable rate of return from capital investments.
Projects that are expected to generate a rate of return above this minimum will have a positive net
present value Therefore, value of the firm (and its shares) will be maximised by accepting all
projects where the net present value is positive when discounted at the firms cost of capital.

14-3

All types of capital, including debt, preference shares, retained earnings and new ordinary equity,
should be incorporated into the cost of capital computation, with the relative importance of a particular
source being based upon its market value proportion of financing to be provided.

14-4

General economic conditions and factors that are determined at the firm level have a direct impact upon
a companys cost of capital. General economic conditions such as the demand and supply of funds in
the economy, as well as the existing inflationary pressures, determine the rate of return required on a
riskless investment and therefore the cost of each source of capital. In addition, the marketability of a
firms securities is not completely within the control of management. Although the firms managers can
take actions that will increase or decrease this marketability, certain factors within the overall
marketplace can influence the ability to market a security.
Regarding decisions that can be made by management which affect the firms cost of capital, both
business and financial risk influence the risk premium required by investors. Therefore, as management
increases the risk within the firm, resulting from particular investment decisions or by changing the
firms financial mix, investors will change their required rate of return in response to the change in the
perceived risk of their investment.

14-5

It is only appropriate to use the cost of capital as the hurdle (discount) rate to evaluate investment
opportunities that are of similar risk to the existing assets within the firm and where the firms financial
risk its debt-to-equity structure is constant. In other words, new investments will be a part of the
firms existing business and will be financed in the same manner as past investments. In reality these
assumption are quite restrictive, and the cost of capital will need to be adjusted (up or down) to evaluate
projects that will significantly change the risk of the firm.
Also, to compute the cost of equity capital via the dividend valuation model, we must make two
simplifying assumptions. The dividend-earnings relationship is assumed to be relatively constant and
the growth rate of the firms dividends is also assumed to be constant. It is important to recognise that
although these assumptions often fail to be satisfied in practice, they are needed to be able to estimate
the firms cost of equity, which is an integral part of the cost of capital calculation.

14-6

(a)

Taxation category 1: As any income tax paid by these companies is credited to shareholders via
imputation (franking) credits that the shareholders can fully utilise, the companys cost of capital
and capital-budgeting evaluation should made on a before-tax basis.

Taxation category 2: For companies subject to a classical tax system of double taxation and
sole trader/partnership firms, cost of capital and capital-budgeting evaluation should be made on
an after-tax basis.
Taxation category 3: For companies in between taxation categories 1 and 2, the relevant tax rate
is the effective company tax rate. As this rate is a function of the degree to which shareholders
can utilise imputation credits, the effective tax rate will vary from company to company and will
be somewhere between zero (taxation category 1) and the company tax rate (taxation category
2). The cost of capital and capital-budgeting evaluation for taxation category 3 companies
should be on an after-effective-company tax basis.
(b)

A company will have to pay bankers and other financial advisers significant commissions and fees to
assist the company to make a new bond or share issue. There are also other costs of issue such as legal
and accounting fees, and stationery costs. As the total amount of these costs can be quite substantial,
the net amount of capital the company receives from the new issue of bonds or shares will be
significantly less than indicated by the issue price. The return required by investors is based on the
issue price they pay. However, as the company only receives a net amount of the issue price, every
dollar invested in projects must earn a higher return to be able to pay the investors required rate of
return. This is why the inclusion of issues costs via the net price results in a higher cost of capital.

CHAPTER 16
16-1

(a)

Financial structure: the mix of all items that appear on the liability and equity side of the
companys balance sheet.

(b)

Capital structure: the mix of long-term funds used by the firm.

(c)

Optimal capital structure: the mix of long-term funds that will minimize the composite cost of
capital for raising a given amount of funds.

(d)

Debt capacity: the maximum proportion of debt that the firm can include in its capital structure
and still maintain its lowest composite cost of capital (optimal capital structure).

16-2

The objective of capital-structure management is to determine the mix of long-term sources of finance to

be used by the firm that will maximize the value of the firm for its owners (i.e. share price for a company).

16-8

It makes sense for financial managers to be familiar with the business cycle because financial market
and product market conditions can change abruptly during the cycle. This means that company policies
and decisions may differ over different phases (say, expansion or contraction) of the cycle. For
example, profits and cash flows will tend to decline during an economic downturn, so the firm may
then want to use more modest levels of debt when assessing its capital structure.

16-9

Financial managers clearly favor the use of internally generated equity funds provided by retained
earnings in the financing of capital budgets.
CHAPTER 15

15-1

Business risk is reflected in the variability of the firms stream of earnings before interest and
taxes (EBIT). One measure of business risk is the coefficient of variation in the firms
expected level of EBIT. Business risk is the residual effect of the: (1) firms operating cost
structure, (2) product demand characteristics and (3) intra-industry competitive position. The
firms asset structure is the primary determinant of its business risk.
Financial risk can be identified by its two key attributes: (1) the added risk of insolvency
assumed by the ordinary shareholder when the firm chooses to use financial leverage, and (2)
the increased variability in the stream of earnings available to the firms ordinary shareholders.
The principal distinguishing feature between business risk and financial risk as a cause of the
variability in the firms earnings stream is that business risk relates to operational and industry
issues whereas financial risk is primarily based on the proportion of debt finance used by the
firm.

15-2

Financial leverage occurs when a portion of the firms assets is financed with securities requiring
payment of fixed cash flows to investors. The firm uses financial leverage if preference shares are
present in the capital structure because preference shares requires the company to pay a fixed dividend
amount to preference shareholders. Ordinary shares is the main source of financing which does not
create financial leverage because the amount of ordinary dividends can be varied by the companys
Board of Directors.

15-3

Operating leverage occurs when the firm has fixed operating costs in its cost structure. When operating
leverage is present, any percentage fluctuation in sales will result in a greater percentage fluctuation in
EBIT.

15-4

The most important shortcomings of break-even analysis are:

The cost-volume-profit relationship is assumed to be linear over the entire range of output.

All of the firms production is assumed to be saleable at the fixed selling price.

The sales mix and production mix is assumed constant.

The level of total fixed costs and the variable cost to sales ratio is held constant over all output
and sales ranges.
15-5

Total risk exposure is reflected by combined leverage and is the result of the firms use of both operating
leverage and financial leverage. The firms total risk is caused by business risk and financial risk. A
company that is normally exposed to a high degree of business risk may manage its financial leverage in
such a way as to minimise financial risk. Alternatively, a firm that enjoys a stable EBIT over time (i.e.
low operating risk) might reasonably elect to use a high degree of financial leverage.
Reducing total risk exposure reduces the overall variability in the firms earnings stream, however, this
is potentially at the cost of a decrease in earnings per share (EPS) and also the rate of return provided to
shareholders.

15-6

By taking the degree of combined leverage of 3 times the sales change of negative 15%, the earnings per
share available to the firms ordinary shareholders will be expected to decline by 3 x 15% = 45%.

15-7

As the sales of a firm increase, two things occur that bias the cost and revenue functions toward a
curvilinear shape. Firstly, sales will increase at a decreasing rate. As the market approaches saturation,
the firm must cut its price to generate further sales revenue.
Secondly, as production approaches capacity, inefficiencies occur that result in higher labour and
material costs. Furthermore, the firms operating system may have to bear higher administrative and
fixed costs. The result is higher per unit costs as production output increases.

15-8

The decision to use financial leverage by the firm affects both the level and variability of the EPS
flowing to the ordinary shareholders. EBITEPS analysis deals only with the level (amount) of EPS
available under a given financing plan. The variability in the EPS stream associated with the plan is
ignored. EBITEPS analysis thus disregards the riskiness inherent in a particular financing alternative,
which has been identified as a significant weakness in the adoption of this approach as a decisionmaking tool for the objective of maximising shareholder wealth.

CHAPTER-17
17-1

The dividend payout ratio indicates the amount of dividends paid relative to the earnings available to
ordinary shareholders. It is measured by dividend per share (DPS) divided by earnings per share (EPS).

17-2

A companys net profits can be used to pay dividends and/or to finance new investments. As a higher
proportion of profits are paid out as dividends, retained earnings available for reinvestment are reduced.
Conversely, as a larger amount of profits are retained, the profits available for payment of dividends to
shareholders are reduced. Management aims to find the dividend payout that will maximise shareholder
wealth, whilst recognizing that shareholders are likely to have divergent interests including
capital/income requirements.

17-3

(a)

In a perfect market, there are no brokerage commissions, no issue costs, no taxes, no information
content assigned to a particular dividend policy, no liquidation costs, and free information is
available to every investor.

(b)

A companys dividend policy is irrelevant in a perfect market. Management may choose between
retaining profits and paying dividends without affecting the share price and shareholder wealth.
Therefore, the only wealth-creating activity in a perfect market comes from the companys
investment decisions.

17-4

The existence of issue costs eliminates the indifference between financing by internal capital (i.e.
retained earnings) and by issuing new shares. Financing investment through retained earnings will be
preferred to avoid issue costs. If no other perfect market assumptions have been relaxed, new shares
would be issued only after the company has invested all of its internally generated funds.

17-5

(a)

According to the residual-dividend theory, the company only pays dividends if there are still
profits/retained earnings available after being used to finance all acceptable investments.

(b)

This theory may not be feasible in the short term because the year-to-year variability in dividend
payments is undesirable. The theory can be used in the long term if management forecasts the
companys financing needs for several years. A target dividend payout ratio for this planning
horizon can be established that will distribute the residual profits smoothly over this period.

17-6

Tax on dividend income is paid when the dividend is received by the shareholder, while tax on capital
gains is deferred until the shares are actually sold. In addition, there are concessional tax rates available
on capital gains that are not applicable to dividend income.

17-7

Company law prevents a company from paying dividends from its capital. Restrictions in debt and
preference share contracts may also limit dividends. These contract provisions may stipulate that
dividends are not to be paid from profits before the repayment of debt. Also, the provisions may require
that a certain amount of working capital must be maintained by the company. Finally, if any preference
dividends remain unpaid, a provision may restrict the payment of dividends on ordinary shares.

17-8

Dividends are paid with cash. If there is little or no cash available, the company will be unable to pay
dividends regardless of the amount of the companys current and retained profits.

17-9

For many companies, maintaining voting control is very important. Issuing new shares is unattractive to
these companies if it results in a dilution of the control of current shareholders. Financing by debt and
from company profits will be preferred. Thus, the companys growth is limited to the amount of debt
capital available as well as the companys ability to generate profits that can be retained.

17-10

(a)

Company managers are reluctant to change dividends without being confident that the change is
reflected in the companys long-term earnings prospects. This is why most managers avoid a
change in dividends in response to temporary fluctuations in earnings, and are especially
reluctant to make a dividend cut. They would prefer instead to develop a gradually increasing
dividend series over time. This approach is consistent with a stable-dollar dividend policy. The
smoothing of the dividend stream is undertaken in an effort to minimise the effects of other types
of company reversals.

(b)

Investors also prefer a stable-dollar dividend policy because they perceive a change in the
dividend payment to reflect managements view of the companys long-term earning prospects.
Also, many investors rely upon dividends for current income, and this need is best satisfied by a
relatively stable dividend.

17-11

(a)

Australian resident shareholders who can effectively utilize the value of imputation (franking)
credits to offset their own tax liabilities tend to be better off if they receive high payouts of
franked dividends now, rather than receiving capital gains later. Note that this argument is one
that is tax driven. In practice, companies need to consider their overall policies when paying
dividends.

(b)

No. The payment of franked dividends is given first priority. Funds for projects can then be
financed from remaining retained funds (if any), debt and new equity issues. Many companies
have been able to reduce the actual outflow of cash when paying franked dividends by using
dividend reinvestment schemes.

17-12

Dividend reinvestment schemes enable shareholders to forego the receipt of dividends in cash in
exchange for using the dividend amount to purchase shares in the company (often at a discount below
the current market price). These schemes enable companies to provide franking credits to shareholders
and yet retain the cash that would otherwise be paid out in dividend cheques.

17-13

The declaration date is the date that the dividend is formally authorised by the board of directors.
Investors recorded as owning shares on the date of record are paid the declared dividend. The exdividend date is five clear days prior to the record date. This date is set by the stock exchange as the
date when the right of ownership to the dividend is terminated.

17-14

A shareholder will benefit only if the price of the share does not fall in proportion to the number of new
shares issued. In such circumstances shareholder wealth will be increased. An advantage to the
company is the conservation of cash for investment opportunities.

17-15

There are many benefits claimed to arise for a company which repurchases its own shares, such as:
By reducing the number of shares, EPS will increase which, in theory, should result in a
corresponding increase in the company share price.
Modifying the target capital structure (perhaps to increase financial leverage, by raising debt to
purchase the shares). Particular benefits may arise if debt was seen to be relatively cheap.
Potential disadvantages for a company which repurchases its own shares include:
Unfair discrimination between shareholders.
Increasing the risk of the companys failure because overall capital is reduced.

CHAPTER 18
18-1 There are a number of reasons why a corporate bond issue might appeal to a large company. A large
company with a good debt rating can prospectively tap financial markets directly without having to borrow
from intermediaries, thus having the potential to reduce the cost of funds. Another reason is that a bond issue
may be free from the greater restrictions that would be imposed if a loan was borrowed with restrictive
covenants.

A private placement has the potential to be easier to arrange than a public issue and to be less costly because
many of the issue costs may be avoided. On the other hand, a lack of marketability might necessitate investors
being offered a higher interest rate to compensate for the lesser liquidity. Legally, corporate bonds mostly are
long-term promissory notes and so rely on the good standing of the issuer rather than on formal legal security of
the kind associated with secured debt. Investors (buyers of the bonds) therefore want some independent
assessment of this standing, such as is provided by debt ratings agencies. These ratings, however, are provided
only for large companies, who undergo considerable scrutiny to obtain a rating. Small companies generally have
to rely on borrowings from intermediaries, as they lack the necessary financial standing to directly access
financial markets.
18-2 The bond issuer may incur costs such as advisers fees, legal fees, accounting fees and underwriting
costs. In addition, an agent or broker may be engaged to sell the issue to investors. The effect of such fees is that
the cost of the issue is more than the interest rate offered to the investor (the investors yield). However, the
non-interest costs can be incorporated into the interest rate by adjusting the bond cash flows. In particular,
upfront fees reduce the proceeds of the issue in much the same way as costs of a new share issue. In effect,
these fees reduce the PV of the issue in the hands of the issuer, which has the mathematical effect of increasing
the implied interest rate. Looking at the five financial math variables in pricing a bond, PV, i, n, PMT and FV,
the last three of these are fixed or given at the time of issue (n = time to maturity; PMT = coupon interest
payment; FV = maturity value) and so, if PV is reduced, i must increase.
18-4 By issuing a bond to raise long-term finance, a company bypasses financial intermediaries such as the
banks that make term loans. In effect, the bond issuer borrows directly in the financial markets from primary
investors, and so saves on the costs of intermediation (such as a banks margin between the rate it pays investors
and the rate it must charge borrowers in order to make a satisfactory profit. It has been estimated that this
margin is around two per cent). Furthermore, some issuers can raise funds in overseas markets and save on costs
in local markets. However, only large companies that have obtained a (satisfactory) bond rating are acceptable
to investors. This excludes the majority of Australian companies, which are not of sufficient size or standing
by world standards.
18-5 The yield spread is the interest rate (yield) premium that is observed in the financial markets for a lowrated bond over a high-rated bond. The yield spread varies with changing economic conditions. The yield
spread is indicative of the yield on a low-rated bond, which in turn is the starting point in determining the bond
issuers overall cost of raising new funds.

CHAPTER 13

13-1

The objective of project risk analysis is to explore the risks associated with projected cash flows and to
incorporate those risks into the evaluation of projects. This is critical because estimates that are overly
optimistic could result in the acceptance of loss-making projects, while estimates that are overly
pessimistic could result in a company passing up worthwhile projects. Both of these mistakes are costly
to shareholders. Incorporating risk into the analysis takes into account the possible variability of future
cash flows and is designed to reduce the likelihood of these errors occurring.

13-2

The payback-period criterion is frequently used as a rough risk-screening device to eliminate projects
whose returns do not materialise until later years. In this way, the earliest returns are emphasised which,
in all likelihood, are less risky.

13-3

The primary difference between the certainty-equivalent approach and the risk-adjusted discount-rate
approach is how the adjustment for risk is incorporated into the calculations. The certainty-equivalent
approach penalises or adjusts downwards the value of the expected annual cash flows, while the riskadjusted discount rate leaves the cash flows at their expected value and adjusts the required rate of
return, i, upwards to compensate for added risk. In either case, the NPV of the project is being adjusted
downwards to compensate for additional risk. An additional difference between these methods is that the
risk-adjusted discount rate assumes that risk increases over time and that cash flows occurring later
should be more severely penalised. The certainty-equivalent method, on the other hand, allows each cash
flow to be treated individually according to the finance managers subjective view of risk.

13-5

Generally speaking, the beta of the firm can be used as a measure of systematic risk for the project if the
project has the same systematic risk as the firm; that is, the cash flows of the project will be affected by
the same macroeconomic factors as does the firm. When it is believed that the systematic risks of the
firm and the project differ, it is not appropriate to use the firms beta as a measure of systematic risk for
the project. In that circumstance, a proxy will be needed to estimate the beta of the project. A proxy can
be another company that is assessed to have a similar risk pattern to the project. For many publicly
traded firms, this information can be obtained as proxy.

13-6

Sensitivity analysis is performed by changing key variables that will affect the NPV of a project (i.e.
changing one key variable at a time, keeping others constant) and assessing the effect on the NPV. The
purpose is to investigate the sensitivity of the projects NPV and hence the accept/reject decision to
such changes, and to determine which variables will have the most impact. This then allows more effort
to be expended on firming up the estimates for those variables in order to reduce risk. Unlike
sensitivity analysis, which involves changing one variable at a time, scenario analysis involves changing
a number of variables in order to estimate the NPV based on a particular scenario (i.e. a particular set of
values for those variables). Examples of possible scenarios include base case, best case and worst
case.

CHAPTER 21
21-1

Risk management entails identifying the various risks the firm faces and establishing guidelines for
dealing with those risks.

21-2

The most common sources of risk affecting a firms cash flows are:
Demand risk: Fluctuations in product or service demand driven by competitive forces and the state
of the economy.
Commodity risk: Price fluctuations in commodities that are essential to the firms core business.
Country or political risk: Risks arising from political unrest or unfavorable government
interference if the company does business in foreign countries.
Operational risk: Cost overruns related to the firms operations.
Foreign-exchange risk: Variability of cash flows resulting from changes in the exchange rate
between Australia and countries in which the firm does business.

21-3

A forward contract is an agreement between two parties for an asset to be sold in the future, at a price
agreed to when the contract is entered into. It differs from an exchange-traded futures contract in that it
is flexible and can be customized to meet the needs of the parties. A futures contract, on the other hand,
is standardized in terms of the underlying commodities that are available to be the subject of futures
contracts, the size of the contract and the settlement date and settlement terms.
Other differences include:
Ease of cancellation: It is very difficult to get out of a forward contract. This can only be done
with the agreement of the other party and, if the reason is because the price of the commodity has
changed in such a way that it is not in your interest to honor the contract, it will probably cost
money to get out of the contract. It is very easy to enter into, modify or cancel a futures position.
To cancel your position, you only need to buy the contracts that you have sold, or sell the contracts
that you have bought, and the exchange will offset the two sets of contracts and close out your
position.

21-4

21-5

21-6

Exchange of cash flow at the beginning of the contract: There is no exchange of cash when a
forward contract is entered into, but both parties to a futures contract must deposit money into a
margin account to enable the exchange to manage default risk.
Default risk: Both parties are potentially subject to credit risk or default risk, depending on what
happens to the price of the commodity between the date the contract is entered into and the
settlement date. There is no default risk for buyers or sellers of futures contracts; the exchange
takes on all default risk and manages that risk with margin accounts.

Limitations on the use of forward contracts to construct a hedge against price risk:
The fact that both parties are potentially subject to default risk.
It is sometimes unavoidable that strategic information needs to be shared with the other party to
the contract. If the parties could remain anonymous, this could avoid a strategic disadvantage.
The market value of forward contracts is not easily determined because there is no secondary
market in which these instruments are traded.
Organized futures exchanges address these limitations, in that:
The parties to a futures contract are not subject to default risk. The exchange takes on all default
risk and manages that risk with margin accounts.
Parties to a futures contract remain anonymous.
Because of the standardisation of futures contracts, a liquid secondary market is able to develop in
which the market value of the contracts can be observed.
Commodity and financial futures are the same apart from the type of item specified in the contract; that
is, the item to be delivered. With a commodity future, the item to be delivered is an article of commerce,
such as soybeans or wheat, while with a financial future the item to be delivered is a financial instrument
such as a certificate of deposit or Eurodollars.
The essential aim of a hedge using interest-rate futures is to manage interest-rate risk. While the
contracts are known as interest-rate futures, the contracts obligate transactions on debt instruments
whose value depend on interest rate. A long position in interest-rate-futures contracts obligates the
holders to buy the debt instruments. As a result, a long position is entered into to hedge against a fall in
interest rate. A short position, on the other hand, is to hedge an increase in interest rate.