Business Finance

🧭 Overview

🧠 One-sentence thesis

The financial manager's role is to make three critical decisions—investment, financing, and dividend—that together should maximize shareholder welfare while balancing social responsibility.

📌 Key points (3–5)

• Three core decisions: investment (what to invest in), financing (how to fund it), and dividend (how to distribute profits).
• Business structures differ in liability and taxation: sole traders and partnerships have unlimited liability and single taxation; companies have limited liability but face double taxation.
• Financial objective evolution: the goal has shifted from simply maximizing share price to maximizing welfare, which includes social and environmental responsibility.
• Common confusion: maximizing revenue or profit ≠ maximizing shareholder wealth; share price incorporates future expectations and is the better target.
• Five fundamental concepts: time value of money, firm value, risk aversion, market efficiency, and agency relationships underpin all financial decisions.

🏢 Business structures and their trade-offs

🧑‍💼 Sole trader

A sole trader is an individual who runs and owns the business alone.

Advantages:

• Easy to start; least regulated by ASIC (Australian Securities and Investments Commission).
• Single owner keeps all profits.
• Income taxed once as personal income (no double taxation).

Disadvantages:

• Unlimited liability: if the business has debt or incurs losses, the owner must pay from personal wealth.
• Limited to owner's life unless sold.
• Capital limited to owner's personal wealth, restricting growth.
• Difficult to sell ownership interest.

🤝 Partnership

Two or more people combine their funds to set up a business.

Advantages:

• Shared management responsibility among owners.
• More knowledge and capital available.
• Relatively easy to start.
• Income taxed once as personal income.

Disadvantages:

• Unlimited liability (varies by partnership type):
  • General partnership: all partners have unlimited liability.
  • Limited partnership: general partners have unlimited liability; limited partners (passive investors) have liability capped at their contribution.
  • Incorporated limited partnership: limited liability for most, but at least one general partner has unlimited liability.
• Dissolves when one partner dies or wishes to sell.
• Difficult to transfer ownership.

🏛️ Company

According to the 2001 Corporations Act, a company is a separate legal entity.

Key distinction: Unlike sole traders and partnerships, a company is a legal entity separate from its owners.

Advantages:

• Limited liability: if you invest $400 (20 shares × $20) in Company A and it goes bankrupt with $1 billion in debt, your loss is only $400—lenders cannot recover debt from your personal wealth.
• Unlimited life (does not dissolve with owner changes).
• Separation of ownership and management: owners hire managers to run the business.
• Easy transfer of ownership by selling shares.
• Easier to raise capital through initial public offerings (IPOs).

Disadvantages:

• Double taxation: dividends are paid from after-tax earnings and are not tax-deductible.
• Agency issues: because owners and managers are separate, managers may act opportunistically to maximize their own wealth rather than shareholders' wealth (this problem does not exist in sole traders or partnerships where owners are managers).

🔍 How to distinguish the three structures

Feature	Sole Trader	Partnership	Company
Legal entity	No	No	Yes (separate legal entity)
Liability	Unlimited	Unlimited (varies by type)	Limited
Taxation	Once (personal income)	Once (personal income)	Twice (corporate + dividend)
Ownership transfer	Difficult	Difficult	Easy (sell shares)
Agency issues	None (owner = manager)	None (owners = managers)	Yes (owners ≠ managers)

💼 Three critical financial decisions

💰 Investment decisions (Capital budgeting)

Long-term decisions about what investments or projects the company should take on.

• What it means: deciding what type of assets to invest in; the starting point of any business.
• Why it matters: all marketing, strategy, and operations flow from the decision to invest in a product or service.
• Example: Facebook's decision to buy WhatsApp, or Disney planning to invest in a theme park in Rio.
• Related concept: working capital management—managing day-to-day finances of the firm.

🏦 Financing decisions (Capital structure)

Deciding the funding source for investment decisions.

• Two broad sources: debt (loans from banks or selling bonds) and equity (selling shares to investors).
• The question: should the company use debt, equity, or a mix of both?
• Example: if Disney builds a theme park in Rio, how will it fund the construction—through bank loans, issuing bonds, selling shares, or a combination?

💵 Dividend decisions

Deciding how much profit to distribute to shareholders vs. reinvest in the business.

• The trade-off: profit can be returned to owners or retained for reinvestment.
• Example: Facebook earns profit from WhatsApp—how much is reinvested in the business vs. returned to shareholders?

🎯 Financial and overall objectives

📈 Why not maximize revenue, minimize costs, or maximize profit?

Objective	Why it's insufficient
Maximize revenue	Ignores costs incurred by the firm.
Minimize costs	Could mean not investing in new opportunities, leading the company to go out of business.
Maximize profit	Accounting profit can be manipulated by changing accounting rules (e.g., Facebook boosted earnings by $934 million by changing how it accounts for employee stock options).

📊 Maximize share price (traditional financial objective)

The purpose of a company is to make money for its owners; maximizing current share price increases owners' wealth.

• Why it works: share price incorporates expectations about the company's future (this idea is used in Topic 5 Share Valuation).
• For non-public firms: the equivalent is maximizing owners' equity.

🌍 Revised overall objective: Maximize welfare

• Why the shift?: regulators now impose social responsibility requirements; customers and investors care about society and the environment.
• Evidence:
  • 2021 global consumer insights pulse survey: 55% of customers chose sustainable products to protect the environment.
  • Eco-friendly consumers are concentrated in Asia-Pacific (Philippines, Indonesia, Vietnam, Egypt, UAE) and aged 23–32.
• UN's 17 Sustainable Development Goals: corporations can contribute to good health, gender equality, responsible consumption, climate action, life below water, life on land, etc.
• Long-term outcome: investors invest in socially responsible firms → higher share price in the long run (supported by academic research by Oliver Hart and Luigi Zingales).

Don't confuse: maximizing welfare does not replace the financial objective; it supports maximizing share price by attracting investors and customers who value responsibility.

🧩 Five fundamental concepts in finance

⏰ Time value of money

A dollar is worth more today than tomorrow because it can be invested today to earn a return.

• Example: invest $100 in 2022 at 10% interest → get $110 in 2023. If receiving money in 2023, you are better off getting $110 than $100.

🏢 Value of firm (Enterprise value)

The sum of the market value of debt and the market value of equity.

• Perspective: calculated from the viewpoint of investors who want to invest in the company.
• Why managers care: higher firm value attracts more investors.
• (You will learn valuation concepts in Topics 4 and 5.)

🎲 Risk aversion

Rational investors prefer more money to less and do not like to take risk; they require higher returns to invest in riskier assets.

• Rational investor behavior: given the same level of return, choose the less risky investment.
• Example comparison (both have average payoff of $100):
  • Alternative 1: 50% chance of $200, 50% chance of $0.
  • Alternative 2: 90% chance of $0, 10% chance of $1,000.
  • Rational investors choose Alternative 1 because it is less risky.

📡 Market efficiency

Investors, managers, and regulators have access to the same information; rational investors process it and make decisions; stock prices reflect all available information.

• Example: In early January 2019, Apple cut its revenue outlook due to slowing demand in China → Apple shares fell 7.8%.
• Sequence: announcement → rational investors receive and process information → sell shares → price adjusts.

💹 Asset pricing

The return (or price) of an asset is determined by its riskiness.

Two types of risk:

• Systematic risk (market risk): related to macroeconomics (interest rates, inflation, etc.).
• Unsystematic risk (company-specific risk): labor strikes, fraud, etc.

Key principle: the market prices only systematic risk; it does not price unsystematic risk.

🤝 Agency relationship

Exists when owners hire managers to run the business (true for companies, not sole traders or partnerships).

Agency conflict/issue:

• Arises when managers act opportunistically to maximize their personal benefit rather than shareholders' benefit.
• Examples: Enron collapse, Lehman Brothers collapse, Royal Commission into misconduct in Australia's financial industry (bad banking behavior).

How to fix agency conflict:

• Align interests: tie a portion of manager's compensation to firm performance.
• Independent directors: have directors with no close family ties to the CEO on the board.
• Regulation: firms face lawsuits if they fail to comply.
• Corporate culture: integrity, ethics, doing the right thing, collaboration, employee safety—strong culture reduces agency issues.

Don't confuse: agency issues exist only in companies (where owners ≠ managers), not in sole traders or partnerships (where owners = managers).

🧭 Overview

🧠 One-sentence thesis

Rational investors demand higher returns for higher risk, and finance provides tools to measure both return (holding period and expected return) and risk (variance and standard deviation) for individual assets and portfolios to support investment decisions.

📌 Key points (3–5)

• Foundation assumption: Investors are rational—they prefer more money to less and less risk to more, creating a positive relationship between risk and return.
• Two types of return measures: holding period return (backward-looking, based on actual outcomes) vs. expected return (forward-looking, based on probabilities of future outcomes).
• Risk is measured by variability: variance and standard deviation quantify how much actual returns deviate from expected returns.
• Common confusion: when probabilities are given (future scenarios), use probability-weighted formulas; when historical data is given (equal probability), use simple average formulas.
• Portfolio thinking: investors hold collections of assets, so portfolio return is a weighted average of individual returns, but portfolio risk depends on weights, individual risks, and correlations between assets.

💡 Core assumptions about investors

💡 Investor rationality

Investor rationality: Investors are rational. This means they prefer more money to less and less risk to more, all else equal.

• This assumption leads to the conclusion that ex-ante risk-return is positively related: higher the risk, higher the return.
• Investors are assumed to be risk-averse return-seekers.
• They will require higher returns to invest in riskier assets and accept lower returns on less risky assets.
• They seek to reduce risk while attaining desired return, or increase return without exceeding maximum acceptable risk.

🔍 Three types of investors

The excerpt distinguishes three investor types by their attitude toward risk:

Type	Definition	Behavior
Risk-neutral	Utility not affected by risk	Focuses only on expected return when choosing investments
Risk-averse	Demands compensation for risk	Requires higher expected returns to take on more risk
Risk-seeking	Derives utility from high risk	May give up some expected return to be exposed to additional risk

• Standard assumption in finance theory: all investors are risk-averse.
• Don't confuse: risk-averse does not mean refusing all risk; it means viewing risk as undesirable but acceptable if compensated with sufficient return—a trade-off.

📊 Measuring return

📊 What return means

Return is the net dollar gain or loss of an investment over a specified time period.

• Rate of return is expressed as a percentage of the investment's initial cost.
• It is calculated by determining the percentage change from the dollar value at the beginning of the period until the end.

💵 Dollar returns

Total dollar return = income from investment + capital gain (loss) due to change in price

Example: You bought a bond for $950 one year ago, received two coupons of $30 each, and can sell the bond for $975 today.

• Income = $30 + $30 = $60
• Capital gain = $975 – $950 = $25
• Total dollar return = $60 + $25 = $85

📈 Percentage returns (holding period return)

It is generally more intuitive to think in terms of percentage rather than dollar returns:

• Dividend yield = income / beginning price
• Capital gains yield = (ending price – beginning price) / beginning price
• Total percentage return = dividend yield + capital gains yield

Note: the 'dividend' yield is just the yield on cash flows received from the security (other than the selling price).

Shortcut: Total percentage return = total dollar return / beginning price.

Example: You bought a share for $35 in 2015, received dividends of $1.25, and the share is now selling for $40 in 2022.

• Dollar return = $1.25 + ($40 – $35) = $6.25
• Dividend yield = $1.25 / $35 = 3.57%
• Capital gains yield = ($40 – $35) / $35 = 14.29%
• Total percentage return = 3.57% + 14.29% = 17.86% (or $6.25 / $35 = 17.86%)

🔮 Expected returns (forward-looking)

Expected returns are based on the probabilities of possible "future" outcomes. This is measured in the context of the future.

• When probabilities are given (different scenarios): multiply each possible return by its probability and sum them.

• Example: Shares CCC and TTT in three states (Boom 0.3, Normal 0.5, Recession 0.2):

  • E(R_CCC) = 0.3×0.15 + 0.5×0.10 + 0.2×0.02 = 9.9%
  • E(R_TTT) = 0.3×0.25 + 0.5×0.20 + 0.2×0.01 = 17.7%

• When historical data is given (equal probability): use the simple average of past returns.

• The excerpt notes: 'expected' means 'average' if the process is repeated many times. The 'expected' return does not have to be a possible return.

• Annualize expected returns so you can compare the performance of different securities available in the market.

📉 Measuring risk

📉 What risk means

Risk is there whenever investors are not certain about the outcome of an investment.

• Risk is measured by variance or standard deviation.
• Essentially, it means by how much a particular return deviates from an expected return (average return).

🧮 Variance

When probabilities are given: use probability-weighted squared deviations from the mean.

Example: Variance of CCC and TTT shares:

• Variance of CCC = 0.3×(0.15 – 0.099)² + 0.5×(0.10 – 0.099)² + 0.2×(0.02 – 0.099)² = 0.00209
• Variance of TTT = 0.3×(0.25 – 0.177)² + 0.5×(0.20 – 0.177)² + 0.2×(0.01 – 0.177)² = 0.007441

When historical data is given (equal probability): use the formula for population variance or sample variance.

• The excerpt distinguishes population variance from sample variance (the latter uses n-1 in the denominator).
• Annualize the variance so you can interpret it as risk per annum.

📏 Standard deviation

This is another measure of risk. It is just the square root of variance.

• It is easier to interpret than variance because it is measured in the same unit as the return (%).
• Annualize the standard deviation so you can interpret it as risk per annum.

💰 Risk premium

Risk premium is how much compensation you have to pay to investors to get them to invest in equity as a class of asset.

• Risk premium = average equity return – risk-free rate (government bond rate).
• Example: If average return of CCC is 9.9% and TTT is 17.7%, and risk-free rate is 4.15%:
  • Share CCC: 9.9 – 4.15 = 5.75%
  • Share TTT: 17.7 – 4.15 = 13.55%

🔔 Using normal distribution for decisions

🔔 What is normal distribution

The normal distribution is a symmetric, bell-shaped frequency distribution. It is completely defined by its mean and standard deviation.

• The excerpt assumes that returns are normally distributed.
• The probability on the left hand side is 50% and on the right hand side is 50%. The total area is 100% or 1.
• The normal distribution shows all possible return outcomes.
• The mean return is the central point of the distribution (proxy for expected return).
• The standard deviation is the average deviation from the mean (proxy for total risk).

📊 How investors use it

Investors use mean, standard deviation of returns, and normal distribution to make investment decisions.

• Once you know the normal distribution rule, you can apply these rules, mean, and standard deviation to measure the probability if return is going to be positive, negative, or within a range of returns.
• Assuming investors are rational, the mean is a proxy for expected return and the standard deviation is a proxy for total risk.

⚖️ Risk-return trade-off

⚖️ The positive relationship

There is also a trade-off between risk and return. Higher the risk, higher the return.

Example:

• When you buy a government bond, you get a return of about 2.5% (short term government bond rate).
• If you invest in a real estate stock, you may get a return of 6% or 7%, but there is high risk involved.
• If the market for real estate stock does not do well, you may lose all your money.
• In case of an Australian government bond, there is no such risk.
• Note that there is a positive relation between risk and return.

🎯 Risk of individual assets vs portfolios

• The risk of an individual asset is summarized by the standard deviation (or variance) of returns.
• Investors usually invest in a number of assets (a portfolio) and will be concerned about the risk of their overall portfolio.
• You need to consider how individual asset risks will interact to provide you with overall portfolio risk.

🗂️ Portfolio return and risk

🗂️ What is a portfolio

A portfolio is a collection of assets.

• An asset's risk and return are important in how they affect the risk and return of the portfolio.
• The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation.
• The concept is similar to how you measure risk and return of individual assets.

⚖️ Portfolio weights

Portfolio weights represent the proportion of total investment in each asset.

Example: You have $15,000 to invest and purchased:

• $2,000 of CCC → Weight = $2,000 / $15,000 = 13.33%
• $3,000 of KKK → Weight = $3,000 / $15,000 = 20.00%
• $4,000 of NNN → Weight = $4,000 / $15,000 = 26.67%
• $6,000 of BBB → Weight = $6,000 / $15,000 = 40.00%

Remember: the sum of weights of a portfolio is always 100% or 1.

📈 Portfolio expected return

The expected return of a portfolio is the weighted average of the expected returns of the individual assets in the portfolio.

Example: Given expected returns CCC 19.69%, KKK 5.25%, NNN 16.65%, BBB 18.24%:

• E(R_P) = 0.133×19.69% + 0.2×5.25% + 0.267×16.65% + 0.4×18.24% = 15.41%

Alternative method: If portfolio return and probabilities are given for different states of the economy, you can find the expected return by finding the portfolio return in each possible state and computing the expected value as you did with individual securities.

📉 Portfolio variance (two-asset case)

It is complicated to compute portfolio variance of a 4-asset portfolio. For MAF203, focus only on a two-asset portfolio.

Portfolio (comprising two assets) risk depends on:

• The proportion of funds invested in each asset (w)
• The riskiness of the individual assets (σ²)
• The relationship between each asset in the portfolio with respect to risk, correlation (ρ)

Two-asset portfolio variance formula includes:

• Squared weights times individual variances
• Plus a term involving both weights, both standard deviations, and the correlation

🔗 Relationship measures

Covariance:

• Describes the relationship between two variables.
• Positive if both variables move together in the same direction.
• Negative if both variables move in the opposite direction.

Correlation coefficient:

• Another measure of the strength of a relationship between two variables, very similar to covariance.
• Equal to the covariance divided by the product of the assets' standard deviations.
• Simply a standardization of the covariance, bounded by the range +1 to –1.
• Correlations are measured in percentage, so easier to interpret than covariance.

Example: Portfolio of two stocks:

• Stock CCC: $50,000, standard deviation 20%
• Stock BBB: $100,000, standard deviation 10%
• Correlation: 0.85
• Total portfolio value: $150,000
• Weight CCC = 33.3%, Weight BBB = 66.7%
• Variance = (33.3%² × 20%²) + (66.7%² × 10%²) + (2 × 33.3% × 20% × 66.7% × 10% × 0.85) = 1.64%
• Standard deviation (portfolio risk) = square root of 1.64% = 12.81%

🧑‍🤝‍🧑 Individual risk tolerance

• Each individual has their own level of risk tolerance.
• Some people are naturally more inclined to take risk and will not require the same level of compensation as others.
• Individual risk preferences also change through time.
• Example: You may be willing to take more risk when you are young and without a family, but once you start a family, your risk tolerance may drop.

🧭 Overview

🧠 One-sentence thesis

Financial markets reward investors only for bearing systematic risk (which cannot be diversified away), not for unsystematic risk (which can be eliminated through diversification), and this relationship is formalized through the Capital Asset Pricing Model (CAPM).

📌 Key points (3–5)

• Portfolio diversification reduces total risk by combining assets whose returns do not move perfectly together, but cannot eliminate systematic risk.
• Systematic vs unsystematic risk: only systematic risk (measured by beta) earns a return premium; unsystematic risk can be diversified away and earns no reward.
• CAPM and the Security Market Line (SML) describe the linear relationship between an asset's expected return and its beta (systematic risk).
• Common confusion: more total risk (standard deviation) does not mean higher expected return—only systematic risk (beta) determines expected return in a diversified portfolio.
• Efficient portfolios and the Capital Market Line (CML) show how combining a risk-free asset with an optimal risky portfolio expands investment opportunities.

🎯 Portfolio diversification fundamentals

🎯 What diversification means

Portfolio diversification means investing in several different asset classes or sectors.

• It is not simply holding many assets; holding 50 real-estate shares is not diversified.
• True diversification requires spreading investments across different industries or asset classes.
• Example: owning 50 shares spanning 20 different industries achieves diversification.

🛡️ The principle of diversification

The purpose of diversification is to substantially reduce the variability of returns without an equivalent reduction in expected returns.

• How it works: worse-than-expected returns from one asset are offset by better-than-expected returns from another.
• Limitation: there is a minimum level of risk (the systematic portion) that cannot be diversified away.
• Don't confuse: diversification reduces total risk but cannot eliminate all risk.

📊 Correlation and risk reduction

The degree of risk reduction depends on correlation between asset returns:

Correlation (r)	Meaning	Risk reduction
r = +1	Perfectly positive correlated	No risk reduction
0 < r < 1	Less than perfectly positive	Some risk reduction
r < 0	Negatively correlated	More risk reduction

• The lower the correlation between assets, the greater the diversification benefit.
• For a diversified portfolio, risk depends largely on the covariances between assets, not individual asset variances.

🗑️ Diversifiable risk

Diversifiable risk: the risk that can be eliminated by combining assets into a portfolio; also known as unsystematic, unique, or asset-specific risk.

• If you hold only one asset or assets in the same industry, you expose yourself to risk you could diversify away.
• This type of risk should be eliminated through proper diversification.

🔬 Systematic vs unsystematic risk

🧮 Total risk decomposition

Total risk = Systematic risk + Unsystematic risk

• Standard deviation of returns measures total risk.
• For well-diversified portfolios, unsystematic risk is very small, so total risk ≈ systematic risk.

⚠️ Systematic risk and the reward principle

One fundamental concept of finance is that there is a reward for bearing risk, but no reward for bearing risk unnecessarily.

• Key insight: there is no reward for bearing unsystematic risk because it can be diversified away.
• The expected return on a risky asset depends only on that asset's systematic risk.
• Investors can achieve diversification easily by investing in mutual funds and ETFs.

📏 Measuring systematic risk with beta

Asset's beta (systematic risk) measures the risk of an asset relative to the market as a whole.

Beta interpretation:

Beta value	Meaning
Beta = 1	Same systematic risk as the overall market
Beta < 1	Less systematic risk than the market
Beta > 1	More systematic risk than the market

🆚 Total risk vs systematic risk example

Consider two securities:

Security	Standard Deviation	Beta
CCC	25%	1.50
KKK	30%	0.97

• Which has more total risk? KKK (30% standard deviation > 25%)
• Which has more systematic risk? CCC (beta 1.50 > 0.97)
• Which should have higher expected return? CCC (higher beta means higher expected return)

Don't confuse: higher total risk does not automatically mean higher expected return—only systematic risk (beta) determines expected return.

🧺 Portfolio beta

Portfolio beta is the weighted average of individual asset betas:

Portfolio beta = (weight₁ × beta₁) + (weight₂ × beta₂) + ... + (weightₙ × betaₙ)

Example calculation:

• Security CCC: weight 0.133, beta 1.685
• Security KKK: weight 0.2, beta 0.195
• Security NNN: weight 0.267, beta 1.161
• Security BBB: weight 0.4, beta 1.434
• Portfolio beta = 0.133(1.685) + 0.2(0.195) + 0.267(1.161) + 0.4(1.434) = 1.147

📈 Portfolio performance measurement

🎯 Performance appraisal approach

Investors need to measure portfolio risk and then compare performance against a benchmark with the same risk.

Portfolio performance may differ from the benchmark due to:

• Asset allocation
• Market timing
• Security selection
• Random influences

📊 Sharpe ratio

The Sharpe ratio measures excess return per unit of total risk.

Sharpe ratio = (average portfolio return - average risk-free rate) / standard deviation of portfolio returns

• Measures reward per unit of total risk (standard deviation).
• Compare the portfolio's Sharpe ratio to the benchmark's Sharpe ratio.

📉 Treynor ratio

The Treynor ratio measures excess return per unit of systematic risk.

Treynor ratio = (average portfolio return - average risk-free rate) / portfolio beta

• Measures reward per unit of systematic risk (beta).
• Compare the portfolio's Treynor ratio to the benchmark's Treynor ratio.
• Don't confuse: Sharpe uses total risk (standard deviation); Treynor uses systematic risk (beta).

💰 Capital Asset Pricing Model (CAPM) and Security Market Line (SML)

🏛️ The pricing of risky assets

What determines expected return on an individual asset?

• Risky assets are priced such that there is a relationship between returns and systematic risk.
• Investors need to be sufficiently compensated for taking on investment risks.

Core principle: The capital market will only reward investors for bearing risk that cannot be eliminated by diversification.

• Unsystematic risk can be diversified away → no reward.
• Systematic risk cannot be diversified away → earns a higher expected return.

📐 The CAPM equation

In equilibrium, the expected return on a risky asset is given by the Security Market Line (SML):

Expected return on asset i = Risk-free rate + Beta of asset i × (Expected market return - Risk-free rate)

Or in notation: E(Rᵢ) = Rբ + βᵢ × [E(Rₘ) - Rբ]

• Rբ = risk-free rate
• βᵢ = beta of asset i (measures risk relative to the market)
• E(Rₘ) = expected return on the market portfolio
• [E(Rₘ) - Rբ] = market risk premium

The covariance term is the only explanatory factor specific to asset i.

🔧 Implementing the CAPM

The three components can be obtained as follows:

Component	How to obtain
Rբ (risk-free rate)	Yield of government security with same term as the proposed project
βᵢ (beta)	Source time series data on rates of return; use market model to estimate beta
E(Rₘ) (expected market return)	Calculate average return in share market index over long period and deduct Rբ, OR estimate market risk premium directly

🧪 Tests and extensions of CAPM

Early evidence: supportive of CAPM.

Roll's critique (1977): The market portfolio (theoretically all assets in the economy) is unobservable in practice; tests can only determine whether the market portfolio used is efficient.

Later findings: Factors other than beta were shown to explain returns.

Conclusion: CAPM is a useful tool when thinking about asset returns, despite limitations.

🔬 Fama-French three-factor model

Fama and French (1992, 1995) found:

• No support for CAPM alone.
• Support for firm size, leverage, P-E ratio, book-value-to-market-value (BV/MV).

Three-factor model includes:

1. CAPM market factor
2. Small minus large portfolio factor (SML)
3. High minus low market-to-book portfolio (HML)

• Empirically robust and supported by Australian data.
• Limitation: difficult economic interpretation—why do company size and BV/MV explain asset returns?
• Extension: Carhart (1997) added a fourth factor called momentum (companies with high/low returns in past 3–12 months have high/low returns in next 3–12 months).

🌐 Capital Market Line (CML) and efficient portfolios

🗺️ The efficient frontier

The efficient frontier is the set of all feasible portfolios that can be constructed from a given set of risky assets.

A portfolio is efficient if:

• No other portfolio has a higher return for the same risk, OR

• No other portfolio has a lower risk for the same return.

• The efficient frontier is determined on the basis of dominance.

• Investors are diverse, so each may prefer a different point along the efficient frontier.

• The efficient frontier is a graph showing the trade-off between risk (standard deviation on x-axis) and return (expected return on y-axis).

• The curve starts at the lowest standard deviation and rises to the highest expected return.

🚀 The Capital Market Line (CML)

The CML represents the efficient set of all portfolios that provides the investor with the best possible investment opportunities when a risk-free asset is available.

How it works:

• Combining the efficient frontier with a risk-free asset expands the opportunity set for investors.
• Results in a new efficient frontier—the Capital Market Line.
• The CML links the risk-free asset with the optimal risky portfolio (M).

Investors can vary portfolio riskiness by changing weights in the risk-free asset and portfolio M.

CML equation:

Expected return = Risk-free rate + [(Expected market return - Risk-free rate) / Market standard deviation] × Portfolio standard deviation

• This changes return according to the CML as investors adjust their risk exposure.

📚 Appendix: Market efficiency concepts

🎲 Expected vs unexpected returns

Realized returns = Expected component + Unexpected component

• Realized returns are generally not equal to expected returns.
• The unexpected return can be positive or negative at any point in time.
• Over time, the average of the unexpected component is zero.

📰 Announcements and news

Announcements contain:

• An expected component
• A surprise component

Key insight: It is the surprise component that affects a share's price and return.

• This is observable when share prices move on unexpected announcements or earnings surprises.

🏦 Efficient markets

Efficient markets are a result of investors trading on the unexpected portion of announcements.

• The easier it is to trade on surprises, the more efficient markets should be.
• Efficient markets involve random price changes because you cannot predict surprises.

Efficient capital markets: share prices are in equilibrium or are "fairly" priced.

• You should not be able to earn "abnormal" or "excess" returns.
• Efficient markets do not imply investors cannot earn a positive return—they can earn returns based on systematic risk.

🔍 What makes markets efficient?

• Many investors research the capital market.
• As new information arrives, it is analyzed and trades are made.
• Prices should reflect all available public information.
• Important: If investors stop researching, the market will not be efficient.

Consequences of wider information availability and lower transaction costs:

• Markets become more volatile.
• Easier to trade on "small" news instead of just big events.
• Not all available information is reliable—research is still necessary.

❌ Common misconceptions about efficient markets

Misconception 1: "Efficient markets mean you cannot make money."

• Reality: On average, you will earn a return appropriate for the risk undertaken; there is no bias in prices that can be exploited for excess returns.

Misconception 2: "Market efficiency protects you from wrong choices."

• Reality: Efficiency will not protect you if you do not diversify—you still should not "put all your eggs in one basket."

Misconception 3: "Claims of superior performance are easy to verify."

• Reality: If markets are semi-strong form efficient, the ability to consistently earn excess returns is unlikely.

📊 Three forms of market efficiency

🔒 Strong form efficiency

Prices reflect all information, including public and private.

• If strong form efficient, investors could not earn abnormal returns regardless of information possessed.
• Empirical evidence: markets are not strong form efficient; insiders could earn abnormal returns.

📖 Semi-strong form efficiency

Prices reflect all publicly available information including trading information, annual reports, press releases, etc.

• If semi-strong form efficient, investors cannot earn abnormal returns by trading on public information.
• Implies that fundamental analysis will not lead to abnormal returns.
• Empirical evidence: some shares (larger, more closely followed) are semi-strong form efficient; small, thinly traded shares may not be, but liquidity costs may eliminate abnormal returns.

📉 Weak form efficiency

Prices reflect all past market information such as price and volume.

• If weak form efficient, investors cannot earn abnormal returns by trading on market information.
• Implies that technical analysis will not lead to abnormal returns.
• Empirical evidence: markets are generally weak form efficient.
• Don't confuse: technical analysis not leading to abnormal returns doesn't mean you won't earn fair returns—efficient markets imply you will earn fair returns.

🧭 Overview

🧠 One-sentence thesis

Bond valuation depends on discounting future cash flows at market interest rates, and bond prices move inversely with interest rates while being influenced by duration, term structure, and multiple risk factors that determine coupon rates.

📌 Key points (3–5)

• What a bond is: a debt security where the issuer borrows money and promises to pay periodic interest (coupon) and repay principal (face value/par value) at maturity.
• How bonds are valued: by discounting known future cash flows (coupons and principal) at the market interest rate (yield to maturity) and summing the present values.
• Inverse price-rate relationship: bond prices fall when interest rates rise, and vice versa; longer-term and lower-coupon bonds are more sensitive to rate changes.
• Common confusion—discount vs premium bonds: if yield to maturity is above the coupon rate, the bond trades at a discount (below face value); if yield to maturity is below the coupon rate, it trades at a premium (above face value).
• Duration as a risk measure: duration estimates how much a bond's price will change for a given interest rate change, and it is used to manage interest rate risk through immunisation strategies.

💼 What bonds are and how they trade

💼 Definition and structure

A bond is a debt security where borrowers issue bonds to raise money from investors willing to lend them money for a certain amount of time.

• When you buy a bond, you are lending to the issuer (government, municipality, or corporation).
• The issuer promises:
  • Periodic interest payments (the coupon)
  • Repayment of the principal (also called face value or par value) at maturity.

🏦 Bond market characteristics

• Bond markets are primarily over-the-counter (OTC) with dealers connected electronically.
• There are extremely large numbers of bond issues, but generally low daily volume in single issues.
• This makes getting up-to-date prices difficult, especially for small company bonds.
• Exception: government securities have more transparent pricing.
• Reported trading volume does not capture total activity due to off-exchange transactions.

🏷️ Bond classifications and types

🏷️ Classification by registration and security

Classification	Description
Registered or bearer	Ownership recorded vs. physical possession
Collateral	Secured by financial securities
Mortgage	Secured by real property (land or buildings)
Notes	Unsecured debt

🔒 Seniority and security

• Secured bonds: less risky because income from the security is used to pay them off first.
• Unsecured bonds: no specific collateral backing.

📊 Bond ratings and information asymmetry

• Bond issuers pay rating agencies tens of thousands of dollars to receive a rating, even though the rating could be less favourable than expected.
• Why? There is agency cost and information asymmetry between bond issuer and buyer; a bond rating mitigates this asymmetry.
• Investment grade bonds:
  • High grade: Moody's Aaa / S&P AAA (extremely strong capacity to pay); Moody's Aa / S&P AA (very strong).
  • Medium grade: Moody's A / S&P A (strong, but more susceptible to changes); Moody's Baa / S&P BBB (adequate, adverse conditions have more impact).
• Speculative bonds (junk):
  • Low grade: Moody's Ba, B / S&P BB, B (capacity to pay may degenerate).
  • Very low grade: Moody's C and below / S&P C and below (income bonds with no interest paid, or in default).

🌪️ Special bond types

Type	Feature	Coupon rate implication
Catastrophe bonds	Issued by property/casualty companies; bondholders may lose payments if claims reach a threshold for a single disaster	Higher coupon rate
Income bonds	Coupon payments depend on corporate income; if earnings are insufficient, interest is not owed	Higher coupon rate
Put bonds	Bondholder can force the company to buy back the bond prior to maturity	Lower coupon rate

💰 Bond valuation mechanics

💰 Core valuation principle

Financial assets such as bonds are valued by discounting the known future cash flows at the market interest rate and adding the resultant present values of the future cash flows.

• Coupon is also known as yield (in the sense of the bond's stated rate).
• Yield to maturity (YTM) is the market return of similar bonds—the discount rate used in valuation.

🧾 Valuing a zero-coupon bond (bill)

Example: You want to borrow $100,000 for 180 days. 180-day bills trade at a yield of 4.25%. What amount do you receive today?

• Daily rate = 0.0425 ÷ 365 = 0.00011
• Rate for 180 days = 0.00011 × 180 = 0.0209
• Price = $100,000 / (1 + 0.0209) = $97,947.14

Formula: Price of a zero-coupon bond = Face value / (1 + rate for the period)

📉 Valuing a discount bond with annual coupons

Example: Coupon rate 10%, face value $1,000, 5 years to maturity, YTM 11%.

• Price = PV of annuity + PV of lump sum
• Price = 100 × [1 – 1/(1.11)⁵] / 0.11 + 1,000 / (1.11)⁵
• Price = 369.59 + 593.45 = $963.04

Why it's a discount bond: YTM (11%) > coupon rate (10%), so price < face value.

📈 Valuing a premium bond with annual coupons

Example: Coupon rate 10%, face value $1,000, 20 years to maturity, YTM 8%.

• Price = 100 × [1 – 1/(1.08)²⁰] / 0.08 + 1,000 / (1.08)²⁰
• Price = 981.81 + 214.55 = $1,196.36

Why it's a premium bond: YTM (8%) < coupon rate (10%), so price > face value.

📐 Bond pricing theorems and interest rate relationships

📐 Three key theorems

Theorem 1: Bond prices are inversely related to interest rate movements. As interest rates decline, bond prices rise; as interest rates rise, bond prices decline.

Theorem 2: For a given change in interest rates, the prices of long-term bonds will change more than short-term bonds.

Theorem 3: For a given change in interest rates, the prices of lower coupon bonds change more than the prices of higher coupon bonds.

🔄 Relationship between YTM, coupon rate, and bond price

Condition	Result	Bond type
YTM = coupon rate	Face value = bond price	Par bond
YTM > coupon rate	Face value > bond price	Discount bond
YTM < coupon rate	Face value < bond price	Premium bond

Mechanical reason: Present values decrease as discount rates (YTM) increase. If YTM is above the coupon, the present value (price) must fall below face value.

Intuitive reason: If a new bond with the same risk offers a 9% coupon (YTM = 9%), you would pay more for it than for an old bond with an 8% coupon. Since the new bond is priced at $1,000, the 8% bond must sell for less than $1,000.

Return decomposition: Return = "dividend yield" (coupon rate) + capital gains yield. If coupon rate is 8% and YTM is 9%, capital gains yield must be approximately 1%, which requires the bond to sell below face value.

⚠️ Interest rate risk

Interest rate risk: the chance that interest rates will change in the future, thereby changing the value of an asset.

• In bond valuation, interest rate risk means the bond's value will change due to changes in prevailing interest rates.
• When interest rates rise, existing bonds with lower rates decrease in value (investors can get higher returns elsewhere).
• When interest rates fall, existing bonds with higher rates increase in value (investors pay a premium for higher returns).
• Why it matters: Bond value is the present value of future cash flows discounted at an interest rate; as rates change, the discount rate changes, affecting present value.

🛡️ Risks even for "risk-free" bonds

Risk-free bonds (e.g., US Treasury or Reserve Bank of Australia bonds) still face:

• Interest rate risk: value changes with rate movements.
• Inflation risk: inflation erodes purchasing power of future cash flows.
• Liquidity risk: difficulty selling or buying at a fair price.
• Reinvestment risk: when the bond matures, the investor may not find a similar investment with the same return; if rates have fallen, reinvestment yields will be lower.

🌡️ Inflation, interest rates, and the Fisher effect

🌡️ Inflation and interest rate relationship

• Inflation: the rate at which the general level of prices for goods and services is increasing.
• High inflation → central banks may increase interest rates to slow economic growth and reduce demand, which helps reduce inflation.
• Low inflation → central banks may decrease interest rates to stimulate growth and encourage borrowing and spending.
• Inverse relationship: as inflation increases, interest rates tend to increase; as inflation decreases, interest rates tend to decrease.
• However, the relationship is not always straightforward; economic growth, monetary policy, and global events also play a role.

📐 The Fisher effect

The Fisher effect defines the relationship between real rates, nominal rates, and inflation: (1 + R) = (1 + r)(1 + h) where R = nominal rate, r = real rate, h = expected inflation rate.

Approximation: R = r + h

• The approximation works well with "normal" real rates and expected inflation.
• If expected inflation is high, there can be a substantial difference.

Example: You require a 10% real return and expect 8% inflation. What is the nominal rate?

• Exact: R = (1.1)(1.08) – 1 = 0.188 = 18.8%
• Approximation: R = 10% + 8% = 18%
• Because both the real return and expected inflation are relatively high, there is a significant difference.

Historical context:

• Late 1997–early 1998: deflation concerns → lower nominal rates and higher real rates (consistent with Fisher effect).
• Around 2008: opposite situation occurred.

📊 Term structure of interest rates (yield curve)

📊 What the term structure is

The term structure of interest rates (yield curve): the relationship between the yield on bonds of different maturities.

• It is a graph showing interest rates for different periods, from short-term to long-term bonds.

📈 Yield curve shapes

Shape	Description	Implication
Normal	Upward-sloping; long-term yields higher than short-term	Investors expect compensation for holding bonds longer
Inverted	Downward-sloping; long-term yields lower than short-term	May signal economic slowdown or recession expectations
Flat	Yields similar across maturities	Interest rates unlikely to change in near future

🔍 Factors influencing the yield curve

• Inflation expectations
• Economic growth expectations
• Monetary policy decisions
• Market demand for different types of bonds

🧩 Why term structure and default risk matter for valuation

• Term structure determines the interest rate (discount rate) paid on a bond; longer-term bonds typically have higher yields.
• Risk of default: the possibility that the issuer will be unable to make payments on time or in full; reflected in the bond's credit rating.
• When valuing a bond:
  • The term structure is used to determine the appropriate discount rate.
  • The risk of default is used to adjust cash flows to reflect the possibility of partial or total loss.
• Both factors significantly impact bond value and must be considered by investors.

⏱️ Duration and interest rate sensitivity

⏱️ What duration measures

Duration: a financial metric used to measure the sensitivity of a bond's price to changes in interest rates.

• Duration takes into account both the amount and timing of a bond's cash flows.
• It measures the average time it takes for an investor to receive the bond's cash flows, weighted by the present value of each cash flow.
• Duration is expressed in years.

📉 How duration estimates price changes

• Duration provides a rough estimate of how much a bond's price will change in response to a 1% change in interest rates.
• Example: A bond with a duration of 5 years:
  • If interest rates increase by 1%, the bond's price is expected to decrease by approximately 5%.
  • If interest rates decrease by 1%, the bond's price is expected to increase by approximately 5%.

🛡️ Duration and immunisation

Immunisation: an investment strategy used to minimize interest rate risk by matching the portfolio's duration with the investor's investment horizon.

• Goal: structure a portfolio so that cash flows are timed to coincide with the investor's expected future cash needs.
• How it works:
  • If interest rates are expected to increase, sell bonds with longer durations and buy bonds with shorter durations to reduce overall duration.
  • If interest rates are expected to decrease, sell bonds with shorter durations and buy bonds with longer durations to increase overall duration.
• Benefit: provides a degree of protection against interest rate changes while still allowing the investor to receive expected cash flows.
• Limitation: immunisation does not completely eliminate interest rate risk; unexpected rate changes can still impact portfolio value.

📐 Duration and interest elasticity

The interest elasticity of a bond's price is proportional to its duration.

• Different bonds have different interest elasticities (sensitivity to rate changes).
• Duration has a tight link with interest rate elasticity and price response.

Formula for percentage change in bond price: For small, discrete changes in interest rates and bond prices: Percentage change in bond price ≈ –Duration × Change in interest rate

(The negative sign reflects the inverse relationship between price and interest rates.)

🎯 Factors that affect bond coupon rates

🎯 Five key risk factors

1. Interest rate risk: the risk that interest rates will change, affecting bond value.
2. Marketability of bonds: the ability of an investor to sell securities quickly at a low transaction cost.
   • If companies issue low marketability bonds, they must increase coupon rates to compensate.
3. Default risk: the possibility of failure on the borrower's part to repay debt or meet interest payments.
   • If companies issue bonds with high default risk, they must increase coupon rates to compensate investors for additional risk.
4. Call provisions: a call provision gives the issuing company the option to purchase the bond at a pre-determined price (call price); the investor must sell at that price.
   • If bonds have call provisions, the company must compensate the investor with a higher coupon.
5. (Implicit from earlier sections) Inflation risk, liquidity risk, and reinvestment risk also influence required coupon rates, though not explicitly listed in this section.

🔄 Summary table

Risk factor	Effect on coupon rate
Low marketability	Higher coupon
High default risk	Higher coupon
Call provision present	Higher coupon
Interest rate risk	Varies; higher risk → higher coupon

Don't confuse: Coupon rate is set at issuance to compensate for various risks; yield to maturity is the market's required return on similar bonds and is used to value the bond in the secondary market.

🧭 Overview

🧠 One-sentence thesis

Share valuation uses discounted cash flow models or market-based comparisons to determine the present value of a company's equity, whether public or private, by forecasting future dividends or comparing to similar firms.

📌 Key points (3–5)

• Two main valuation approaches: discounted cash flow (DCF) methods value shares by present value of expected future dividends; market-based methods use industry comparisons like P/E ratios.
• Ordinary vs preference shares: ordinary shares represent basic ownership with voting rights but lowest priority; preference shares get fixed dividends and priority in liquidation but no voting rights.
• Growth share paradox: companies that pay no current dividends can still have value because investors expect future dividends or capital gains from eventual sale.
• Common confusion: preference shares are legally equity but behave like bonds—they pay fixed dividends with after-tax dollars and often have sinking funds, blurring the line between debt and equity.
• When to use market-based valuation: apply relative valuation (P/E multiples) when firms are new with no dividend history, pay no dividends, or are private and not traded.

🏢 Types of companies and equity securities

🏢 Public vs private companies

Public companies:

• Shares are traded on stock markets (e.g., Australian Stock Exchange).
• Ownership is dispersed among thousands of investors.
• Secondary markets provide marketability and fair pricing.
• Active secondary markets lower funding costs for new debt or equity issues.

Private companies:

• Shares are not traded publicly.
• Ownership is concentrated among a small group of investors.
• Same valuation tools apply despite lack of market trading.

📜 Ordinary shares

Ordinary shares represent a basic ownership claim in a company.

• Voting rights: owners vote on important matters (board elections, capital budgets, mergers).
• Dividend uncertainty: no guaranteed dividend payments.
• Priority: lowest priority claim on assets in insolvency.
• Limited liability: shareholders' legal liability is limited.
• Example: if a company goes bankrupt, ordinary shareholders are paid last, after all creditors and preference shareholders.

📜 Preference shares

Preference shares represent ownership interest with preferential treatment over ordinary shares in certain matters.

• Fixed dividends: dividend payments are fixed obligations, similar to bond interest, but paid with after-tax dollars.
• Priority: preference shareholders have priority over ordinary shareholders for dividends and asset claims in liquidation.
• No voting rights: preference share owners cannot vote on company matters.
• Perpetuity classification: legally classified as perpetuities with no maturity, though most modern issues have sinking funds requiring mandatory retirement schedules.
• Convertibility: sometimes convertible into ordinary shares.
• Credit ratings: often have ratings similar to bonds.
• Don't confuse: legally equity, but economically behave like bonds due to fixed payments and priority structure.

🔄 Secondary market types

🔄 Broker markets

• Brokers charge a commission to bring buyers and sellers together.
• Provide extensive contacts and price information that individual investors cannot economically duplicate.
• Commission is less than the cost of direct search, incentivizing investors to use brokers.

🔄 Dealer markets

• Dealers hold inventories of securities they own.
• Provide continuous bidding by buying (bid) and selling (ask) from inventory.
• Earn profit from the price difference (spread) between bid and ask.
• Example: NASDAQ is a dealer market.
• Electronic communications networks provide additional price information, increasing marketability and competition.

🔄 Auction markets

• Buyers and sellers confront each other directly and bargain over price.
• Example: ASX originally operated as an 'open out-cry' market; NYSE uses specialists at designated posts.
• The auctioneer (specialist) acts as dealer and represents public customer orders.

💰 Discounted cash flow valuation

💰 Why shares are harder to value than bonds

Three key challenges:

• Uncertain cash flows: size and timing of dividend payments are less certain than bond coupon payments.
• True perpetuities: ordinary shares have no final maturity date.
• Unobservable return: rate of return on ordinary shares cannot be observed directly, unlike bond yields.

💰 General dividend valuation model

The price of a share is the present value of all expected future dividends.

• The formula makes no assumption about when the share will be sold.
• Does not assume any specific pattern for future dividends (e.g., constant growth).
• The dividend in the numerator is always for one period later than the price being computed (present value calculation).
• Why it works: underlying share value is determined by the market's expectations of the company's future cash flows.
• In efficient markets, share prices change constantly as new information is discounted into the market price.

💰 One-period, two-period, and perpetuity models

One-period model:

• Value equals present value of next dividend plus end-of-period share price.
• Example: MMM Ltd expected to pay $2 dividend in one year and sell for $14; with 20% required return, price = (14 + 2) / 1.2 = $13.33.

Two-period model:

• Two one-period models tied together.
• Example: MMM held two years with dividends of $2 and $2.10, final price $14.70; PV = 2/1.2 + (2.10 + 14.70)/(1.2)² = $13.33.

Perpetuity model:

• Series of one-period models tied together.
• Theoretically sound but not practical—number of dividends could be infinite.
• Example: MMM held three years yields the same PV of $13.33, showing that price equals present value of all future dividends regardless of holding period.

🌱 Growth share pricing paradox

Growth shares: shares of companies whose earnings are growing at above-average rates and are expected to continue.

• Fast-growing companies typically pay no dividends during the growth phase.
• Management reinvests earnings in high-return opportunities.
• The paradox: common sense suggests shares that never pay cash are worthless.
• Resolution: these companies will eventually pay dividends in the distant future; if internal investments succeed, share price should rise significantly, allowing investors to sell at much higher prices.
• Example: an investor buys a growth company share paying no dividends now but expects the company to pay large dividends in 10 years after successful expansion.

🌱 Three dividend growth patterns

Pattern	Description
Zero growth	Dividend payments remain constant over time (growth rate = 0)
Constant growth	Dividends grow at a constant rate
Mixed growth	Dividends have one payment pattern then switch to another

🌱 Constant-growth model mechanics

Example calculation:

• Firm's share sells for $10.50.
• Just paid $1 dividend; dividends expected to grow at 5% per year.
• Required return: R = [1(1.05)/10.50] + 0.05 = 15%.
• Dividend yield: 1(1.05)/10.50 = 10%.
• Growth rate: g = 5%.

Critical constraint: the constant-growth model yields invalid solutions whenever dividend growth rate equals or exceeds discount rate (g ≥ R).

• If g > R, present value of dividends gets bigger rather than smaller, implying a company grows very fast forever (unrealistic).
• Don't confuse: this is a mathematical limitation, not a statement about real company growth potential.

📊 Market-based valuation methods

📊 When to use relative valuation

Three scenarios where DCF is impractical:

1. New firms: no history to calculate future dividends.
2. Non-dividend-paying firms: firms pay no dividends.
3. Private firms: not traded in stock markets, so no market price observable.

In these cases, apply relative valuation: value assets based on how similar assets are currently priced in the market.

📊 P/E ratio method

P/E ratio: share price to earnings ratio, measuring price per dollar of earnings.

Steps for relative valuation:

1. Identify comparable assets and obtain market values.
2. Convert market values into standardized values (price multiples).
3. Compare the standardized value for the asset being analyzed to standardized values for comparable assets.

Application:

• Calculate the average P/E ratio for firms in the industry.
• Multiply the firm's earnings per share (EPS) by the industry average P/E ratio to estimate share price.
• Formula: Share price = EPS × Industry average P/E ratio.
• Example: if industry average P/E is 12 and a private firm's EPS is $2, estimated share price = 2 × 12 = $24.

📈 Financial ratios for company health

📈 Why ratios matter

• Financial ratios are calculated from financial statement variables.
• Allow better comparison through time (trend analysis) or between companies.
• Ask: what does the ratio measure and why is that information important?
• Ratios must be observed over time to get a meaningful sense of the measure.

📈 Long-term solvency (leverage) ratios

Debt/Asset ratio:

• Measures how much of total assets are financed with debt.
• Example: Debt/Asset = 52% means the firm finances about 52% of its assets with debt.

Debt/Equity ratio:

• Measures the relative proportion of debt and equity in the business.
• Example: Debt/Equity = 2.5 means if the firm has $1 equity, it has $2.50 of debt (debt is 2.5 times equity).

📈 Interest coverage ratio

• Measures the ability of the firm to service its debt.
• Higher ratio = better ability to pay interest.
• Formula: EBIT (Earnings Before Interest and Taxes) / Interest expense.
• Example: Coverage ratio = 6 means the company generates earnings 6 times the amount of interest it must pay on debt.
• Key insight: higher debt is acceptable as long as the company generates enough cash to pay interest.

📈 Profitability ratios

Three key profitability measures:

Ratio	Measures	Interpretation
Profit/Revenue	Profit per $1 of revenue	Higher = better profitability
Profit/Asset	Profit per $1 of assets	Firm's ability to generate profit from assets
Profit/Equity	Profit per $1 of equity	Return to equity holders

📈 Benchmark and growth ratios

Price/Earnings ratio:

• Measures the price of the asset per $1 of earnings it generates.
• Price in numerator is the share price.
• Used to measure relative performance of firms in the industry.

Market value/Book value ratio:

• Measures growth opportunities of the firm.
• Higher ratio = better growth prospects.
• Example: Ratio = 15 means market value of share has grown 15 times the book value of the share.

🧭 Overview

🧠 One-sentence thesis

Net Present Value (NPV) is the preferred capital budgeting method because it accounts for the time value of money, considers all cash flows, and directly measures how much value a project adds to the firm in dollar terms, making it most consistent with shareholder wealth maximization.

📌 Key points (3–5)

• What capital budgeting is: a systematic process to evaluate major projects or investments by analyzing whether they will increase firm value by generating more cash inflows than their cost.
• Two families of methods: non-discounted methods (Payback Period, ARR) ignore the time value of money; discounted methods (NPV, IRR) discount future cash flows back to present value.
• NPV vs IRR: both are discounted methods, but NPV gives a dollar value of wealth added, while IRR gives a rate of return; NPV is preferred when they conflict.
• Common confusion: IRR can mislead when cash flows are unconventional or projects are mutually exclusive, because it assumes reinvestment at the IRR rate rather than the cost of capital.
• Why it matters: capital investments involve large cash outlays and are hard to reverse, so choosing the right evaluation technique directly affects firm value and business risk.

🏗️ What is capital budgeting and why it matters

🏗️ Definition and purpose

Capital budgeting is a process a business undertakes to evaluate potential major projects or investments.

• It helps management systematically analyze business opportunities to decide which are worth undertaking.
• The goal is to select projects that will increase the value of the company.
• A project creates value if it generates more cash inflows than its cost.

⚠️ Why these decisions are critical

• Capital investments involve substantial cash outlays.
• Once made, they are not easily reversed.
• The projects a firm invests in will determine its business risk.
• Example: A hotel company deciding to invest in a casino could alter its riskiness by entering a new line of business.

📂 Types of capital projects

📂 Three classifications

Type	Description	Example
Independent	Cash flows are unrelated; accepting or rejecting one does not affect the other.	A computer manufacturer wants to install a printer plant and new air conditioning systems—both can be funded.
Mutually exclusive	Accepting one automatically prevents the other; they typically perform the same function.	A firm owns land large enough for either a shoe plant or a steel plant—choosing one excludes the other.
Contingent	One project's acceptance depends on another; can be optional or mandatory.	Optional: Intel bundles a gaming system with a new computer. Mandatory: A power plant must invest in pollution control to meet environmental standards.

🔍 How to distinguish

• Independent: "Can we do both?" → Yes.
• Mutually exclusive: "Can we do both?" → No, only one.
• Contingent: "Does this project require another to happen first?" → Yes.

🚫 Non-discounted cash flow methods

🚫 Key characteristic

These methods do not involve discounting future net cash flows back to time 0—they ignore the time value of money.

⏱️ Payback Period

The payback period is the amount of time required for an investment to generate net cash flows to cover the initial cost of the investment.

How to calculate:

1. Identify the number of years before the cost is fully recovered.
2. Add the relevant fraction of the year in which total cost is recovered.

Example: Initial investment is $70,000. Cash inflows: Year 1 = $30,000; Year 2 = $30,000; Year 3 = $20,000; Year 4 = $15,000.

• Cumulative at end of Year 2: –$10,000 remaining.
• Payback period = 2 + (10,000 / 20,000) = 2.5 years.

Decision rule: Accept if payback period is below a pre-specified threshold (e.g., 5 years).

Why it can mislead:

• Consider three mutually exclusive projects (all cost $50 million):
  • Project AAA: payback 2 years; total inflows $50 million.
  • Project CCC: payback 3 years; total inflows $650 million.
• Payback method chooses AAA, but CCC generates far more cash and likely increases firm value the most.
• No economic rationale links payback to shareholder wealth maximization.

Advantages:

• Simple to understand.
• Measures liquidity (how quickly cash is recovered).
• Can serve as a risk indicator (faster recovery = less risky).
• Encourages capital conservation.

Disadvantages:

• Ignores time value of money.
• Ignores cash flows beyond the payback period.
• Ignores risk (volatility, uncertainty).
• Subjective determination of acceptable payback period.

📊 Accounting Rate of Return (ARR)

ARR is a measure of an investment's profitability, calculated as: Average net profit divided by Average book value of investment.

How to calculate:

• Average net profit = sum of net profits over project life / number of years.
• Average book value = (initial investment + ending book value) / 2.
• ARR = (Average net profit / Average book value) × 100%.

Example: Initial investment $240; Year 1 net profit $105, Year 2 net profit $30.

• Average net profit = (105 + 30) / 2 = $67.50.
• Average book value = (240 + 0) / 2 = $120.
• ARR = 67.50 / 120 = 37.5%.

Decision rule: Accept if ARR > management's target rate of return.

Advantages:

• Simple measure.
• Uses readily available accounting data.
• Focuses on profitability.
• Takes a long-term view over the investment's entire life.
• Considers non-cash items (depreciation, amortization).

Disadvantages:

• Ignores time value of money.
• Relies on historical accounting data, which may not reflect current or future conditions.
• Ignores cash flows (timing and amount).
• Ignores risk.
• Subjective (useful life, salvage value estimates vary).

✅ Discounted cash flow methods

✅ Key characteristic

These methods do involve discounting future net cash flows back to time 0—they account for the time value of money.

💰 Net Present Value (NPV)

NPV estimates the amount by which the benefits (cash inflows) from a project exceed the cost of the project in present value (dollar) terms.

Formula: NPV = PV of cash inflows – PV of cash outflows.

Core principle: A dollar received in the future is worth less than a dollar received today because of the opportunity cost of not investing that money today.

Steps to calculate NPV:

1. Identify the investment project.
2. Estimate all cash flows (initial investment, inflows, outflows).
3. Determine the discount rate (usually the cost of capital).
4. Calculate the present value of each cash flow: PV = Cash flow / (1 + discount rate) raised to the power of the number of years.
5. Sum up all present values.
6. Compare NPV to zero.

Decision rule: Accept if NPV is positive; reject if NPV is negative.

Example: Project costs $300,000; generates $80,000 net cash flow per year for 4 years, plus $30,000 salvage in Year 5; discount rate 15%.

• NPV = –300 + 80/(1.15) + 80/(1.15)² + 80/(1.15)³ + 80/(1.15)⁴ + 110/(1.15)⁵
• NPV = –300 + 69.57 + 60.49 + 52.60 + 45.74 + 54.69 = –$16.91 (i.e., –$16,910).
• Decision: Reject (negative NPV).

Advantages:

• Accounts for time value of money.
• Provides a precise measure of profitability in dollar terms.
• Considers all cash flows over the project's life.
• Incorporates the cost of capital.
• Allows for scenario analysis.

Disadvantages:

• Requires accurate cash flow forecasts (hard to predict future with certainty).
• Relies on subjective assumptions (e.g., discount rate).
• Ignores non-monetary factors (regulatory changes, market conditions).
• Doesn't account for project size.
• May not fully consider all risks (delays, cost overruns).

📈 Internal Rate of Return (IRR)

IRR is the discount rate that makes the present value of the project's future net cash inflows equal to the cost of the project—the actual rate of return for the project.

Formula: Set NPV to zero and solve for the discount rate: –Initial cash flow + Cash flow Year 1 / (1 + IRR) + Cash flow Year 2 / (1 + IRR)² + … = 0.

How to calculate:

• Choose a discount rate and substitute into the NPV equation.
• If NPV is negative, the guessed rate is too high; if positive, too low.
• Narrow the range until NPV ≈ 0.
• (In practice, use Excel's IRR function.)

Example: Initial investment –$2,000; cash inflows $1,000, $2,000, $2,000, $1,000 over 4 years.

• By trial and error, IRR ≈ 73.08%.

Decision rule: Accept if IRR > required rate of return (cost of capital).

Interpretation example: Project A has IRR of 15%; cost of capital is 10%.

• Since 15% > 10%, accept the project.

Advantages:

• Intuitive appeal to managers (expressed as a percentage rate).
• Similar logic to NPV (both discount cash flows).

Disadvantages:

• Can produce multiple solutions with unconventional cash flows (e.g., negative cash flow at the end).
• Assumes cash flows are reinvested at the IRR, not the cost of capital—this can lead to accepting projects that should be rejected.
• Can conflict with NPV when projects are mutually exclusive.

⚖️ NPV vs IRR: when they agree and when they conflict

⚖️ When they agree

NPV and IRR will always agree on accept/reject decisions when:

• Projects are independent, and
• Cash flows are conventional (initial outflow, then all positive inflows).

⚠️ When they disagree

NPV and IRR can produce different decisions if:

• A project has unconventional cash flows (e.g., negative initial, positive middle, negative final).
• Two or more projects are mutually exclusive.

🔄 Unconventional cash flows

• Future cash flows can be both positive and negative.
• IRR technique can provide more than one solution, making results unreliable.
• Do not use IRR for projects with unconventional cash flows.

🔀 Mutually exclusive projects

• The NPVs of two projects may intersect at a certain discount rate (the crossover point).
• Depending on whether the required rate of return is above or below this crossover point, the ranking of projects will differ.
• Example: At low discount rates, Project A may have higher NPV; at high rates, Project B may have higher NPV.

💡 Reinvestment rate assumption

Method	Reinvestment assumption	Implication
IRR	Cash flows reinvested at the IRR	Can overstate project attractiveness; may accept projects that should be rejected
NPV	Cash flows reinvested at the cost of capital	More realistic; consistent with actual opportunity cost

🏆 Final verdict

• While IRR has intuitive appeal (output as a rate), it has critical problems.
• NPV decisions are consistent with the goal of shareholder wealth maximization.
• NPV shows the dollar amount by which a project is expected to increase the value of the company.
• When NPV and IRR conflict, always go with NPV.
• For these reasons, NPV method should be used to make capital budgeting decisions.

🔑 Key takeaways for practice

🔑 Choosing the right method

• Non-discounted methods (Payback, ARR): simple but ignore time value of money; useful for quick screening or liquidity checks, not for final decisions.
• Discounted methods (NPV, IRR): account for time value of money; NPV is superior for decision-making.

🔑 Common pitfalls to avoid

• Don't confuse: Payback period measures speed of recovery, not profitability.
• Don't confuse: ARR uses accounting profit, not cash flows.
• Don't confuse: IRR is a rate, NPV is a dollar value—they measure different things.
• Don't rely on IRR alone when cash flows are unconventional or projects are mutually exclusive.

🔑 Why NPV is preferred

• It provides a direct measure of value added to the firm.
• It uses the cost of capital as the discount rate, reflecting the firm's actual opportunity cost.
• It avoids the reinvestment rate problem of IRR.
• It handles unconventional cash flows and mutually exclusive projects correctly.

🧭 Overview

🧠 One-sentence thesis

Capital budgeting Part II extends project evaluation by teaching how to calculate incremental cash flows correctly, assess project risk through sensitivity and scenario analysis, and allocate limited capital using profitability index ranking.

📌 Key points (3–5)

• Core skill: Calculate project cash flows by identifying only incremental cash flows—those that occur (or don't occur) solely because the project is accepted.
• Three critical adjustments: Ignore sunk costs, include opportunity costs, and account for side effects when computing incremental cash flows.
• Common confusion: Financing costs (interest, dividends) should not appear in cash flows because they are already reflected in the discount rate—including them causes double counting.
• Risk analysis: Sensitivity analysis changes one variable at a time to find which inputs most affect NPV; scenario analysis examines NPV under different economic conditions.
• Capital rationing: When funds are limited, rank projects by profitability index (PI) and select the bundle that maximizes total NPV within the budget constraint.

💰 Why project cash flows matter

💰 Cash flows as the foundation of capital budgeting

Project cash flow: the outflow and inflow of money from the project to the firm.

• Cash inflows (revenue) are positive; cash outflows (expenditures) are negative.
• Net cash flow = all cash inflows minus all cash outflows.
• Cash flows are the required input for NPV, IRR, and payback period techniques (all except ARR).

🎯 NPV's three-step process

NPV analysis depends entirely on accurate cash flow estimation:

1. Identify and estimate the net cash flows associated with the project.
2. Identify an appropriate discount rate that reflects the project's riskiness.
3. Discount the net cash flows using that rate to calculate NPV.

• NPV tells managers how much better or worse off the company is in current dollar terms from undertaking the project.

🔍 Calculating incremental cash flows

🔍 The incremental principle

Incremental cash flows: the additional cash flows that occur as a result of taking on a project.

• Ask: "Will this cash flow occur only if the project is accepted?"
  • Yes → include it (it is incremental).
  • No → exclude it (it will occur anyway).
  • Part of it → include only the part that occurs because of the project.

🚫 Sunk costs (ignore them)

Sunk costs: unavoidable cash outflows incurred in the past that are no longer relevant to whether a project should be undertaken.

• Why ignore: They have already been spent and cannot be recovered, regardless of the project decision.
• Example: A $10,000 marketing study was already paid. A project costs $125,000 and yields $75,000/year for 2 years at 10% discount rate.
  • Incorrect (including sunk cost): NPV = -$135,000 + $75,000/(1.1) + $75,000/(1.1)² = -$4,800 → reject.
  • Correct (excluding sunk cost): NPV = -$125,000 + $75,000/(1.1) + $75,000/(1.1)² = $5,200 → accept.
• Don't confuse: Just because money was spent doesn't mean it affects the project's incremental value.

💸 Opportunity costs (include them)

Opportunity cost: the dollar value of the alternative use of resources that must be given up to undertake the new project.

• If a resource could be used elsewhere, the foregone benefit is a real cost of the new project.
• Example: Machinery currently leased out for $3m/year will be used in a project yielding $20m/year for 2 years, costing $30m (10% discount rate).
  • Incorrect (ignoring opportunity cost): NPV = -$30m + $20m/(1.1) + $20m/(1.1)² = $4.7m → accept.
  • Correct (including lost lease income): NPV = -$30m + $17m/(1.1) + $17m/(1.1)² = -$0.5m → reject.
  • ($17m = $20m revenue minus $3m lost lease income per year.)

🔗 Side effects (include them)

Side effects: positive or negative cash flows that occur in other parts of the business as a result of taking on the new project.

• Example: A new product may reduce sales of an existing product (negative side effect) or increase sales of a complementary product (positive side effect).
• Include these impacts in the incremental cash flow calculation.

🚫 Financing costs (exclude them from cash flows)

• Financing costs = interest expense (debt) and dividend payments (equity).
• Key rule: Financing costs are reflected in the discount rate (required rate of return), so do not include them in cash flows—doing so causes double counting.
• The required rate of return already represents the return needed to satisfy providers of capital.

📊 Tax effects on cash flows

📊 Taxation overview

• Taxation is a cash outlay that reduces project cash flows.
• Depreciation and other tax-deductible expenses provide a "tax shield" (reduce taxable income, thus reduce taxes paid).
• Gains or losses on asset sales affect taxes paid.

🏭 Productive assets: book gains and losses

• Book value = purchase price minus accumulated depreciation.
• Gain on sale = salvage value (sale price) minus book value.
• Tax on gain = gain × tax rate.

Example: Machine purchased for $1m, 10-year life, straight-line depreciation ($100,000/year). After 7 years:

• Book value = $1m - (7 × $100,000) = $300,000.
• Salvage value = $350,000.
• Gain = $350,000 - $300,000 = $50,000.
• Tax (30% rate) = $50,000 × 0.30 = $15,000.

Situation	Tax impact
Salvage value > book value	Gain on sale → pay tax
Salvage value < book value	Loss on sale → tax rebate (tax shield)

• Note: Depreciation is used when calculating book gain/loss on productive assets.

🏢 Investment assets: capital gains and losses

• Capital gain = sale price minus purchase price.
• Tax on capital gain = capital gain × marginal tax rate.

Example: Investment apartment purchased for $1m in 2016, sold for $1.3m in 2020:

• Capital gain = $1.3m - $1m = $300,000.
• Tax (40% rate) = $300,000 × 0.40 = $120,000.

Situation	Tax impact
Sale price > purchase price	Capital gain → pay tax
Sale price < purchase price	Capital loss → no rebate, but can offset other capital gains

• Note: Depreciation is not used when calculating capital gain/loss on investment assets.

🧮 Free cash flow (FCF) formula

🧮 The stand-alone principle

Stand-alone principle: evaluate the cash flows from a project independently, as if the project were a stand-alone company with its own revenue, expenses, and investment requirements.

• Free Cash Flow (FCF) = Net Cash Flow (NCF) in this context.

🧮 FCF calculation formula

FCF = (Revenue - Operating Expenses - D&A) × (1 - t) + D&A - Cap Exp - Increase in WC

Equivalently: FCF = (Revenue - Operating Expenses) × (1 - t) + D&A × t - Cap Exp - Increase in WC

Where:

• Operating Expenses = all expenses except depreciation and amortization (D&A).
• D&A = Depreciation and Amortization.
• t = tax rate.
• Cap Exp = Capital Expenditure.
• Increase in WC = Increase in Current Assets minus Increase in Current Liabilities.

Exclude interest expense from operating expenses because it is a financing cost, not an operating cost.

🔁 Why add back D&A?

• Depreciation is not a real cash flow—it's a book entry.
• However, depreciation provides a tax shelter (reduces taxable income), creating tax savings.
• The formula subtracts D&A to calculate taxable income, then adds it back because no actual cash left the firm.

📦 Why subtract increase in working capital?

Working Capital (WC): cash employed to run day-to-day operations (e.g., money tied up in inventory).

• Increase in WC = more cash is employed (tied up) → cash outflow.
• Decrease in WC = less cash is employed (freed up) → cash inflow.
• Example: A new machine increases operating efficiency, requiring $10,000 more inventory (a current asset) → treat the $10,000 increase as an outflow.

🗂️ Three components of project cash flows

🗂️ The three parts for NPV calculation

1. Initial Investment (Year 0)
2. Operating FCF (all years except Year 0)
3. Terminal Cash Flow (final year only)

🏁 Initial Investment (Year 0)

Components:

1. Cost of project = Purchase Price + any additional Capital Expenditure.
2. Net Working Capital contributions (increase in net working capital).
3. Sale price of replaced (old) asset, if any, adjusted for tax implications.

Example: New machine costs $100,000, installation $10,000, additional inventory $15,000, old machine sold for $20,000 (book value $10,000):

Item	Amount
Cost of Machine	-$110,000
Increase in WC	-$15,000
Sale of Old Machine	+$20,000
Tax on sale of Old Machine	-$3,000
Initial Investment	-$108,000

🔄 Operating FCF

• These are the operating cash flows that occur during all years except Year 0.
• Use the FCF formula for each operating year.

Example (truck for plumbing business, 10-year life):

Item	Amount
Revenue	$50,000
Less Cash Op Expenses	-$30,000
Less Depreciation & Amort	-$2,500
EBIT	$17,500
Less Tax @ 30%	-$5,250
NOPAT	$12,250
Plus Depreciation & Amort	+$2,500
Less WC increase	-$3,000
Net Cash Flow (FCF)	$11,750

🏁 Terminal Cash Flow (Final Year)

• The terminal year includes unique cash flows that occur only in the last year.
• Normal operating FCF still occurs in the last year as well.

Terminal CF components:

1. Salvage (sale) value of the project asset (e.g., machine).
2. Tax effect on the sale/salvage of the asset.
3. Recovery of Working Capital (assume 100% recovery at project end).

Example: New machine salvage value $20,000 after 10 years (fully depreciated), initial WC increase was $15,000:

Item	Amount
Salvage Value (New Machine)	+$20,000
Tax on Sale of New Machine	-$6,000
Recovery of Working Capital	+$15,000
Terminal Cash Flow	+$29,000

🎲 Analyzing project risk

🎲 Two main risk analysis methods

1. Sensitivity analysis: examines how NPV changes when one variable changes at a time.
2. Scenario analysis: examines how NPV changes under different economic scenarios (multiple variables change together).

📈 Sensitivity analysis

Sensitivity analysis: examines the sensitivity of results (e.g., NPV, IRR) to changes in individual variables.

Steps:

1. Compute NPV using most likely values of all variables.
2. Change the value of one variable (e.g., sales volume) and recompute NPV.
3. Reinstate the original value of that variable.
4. Change the value of another variable (e.g., discount rate) and recompute NPV.
5. Repeat for all variables.
6. Tabulate all results.
7. Identify the most sensitive variables (those causing the largest NPV changes).
8. Explore what the company can do to improve estimation or reduce uncertainty for those variables.

Example tables:

Sales Growth vs. NPV:

Sales Growth	NPV
-5%	125.36
0%	134.99
+5%	145.27
+10%	156.20

Discount Rate vs. NPV:

Discount Rate	NPV
5%	185.26
10%	156.20
15%	132.95
20%	114.14

🌦️ Scenario analysis

Scenario analysis: examines whether results change under alternative scenarios (states of the world).

• A scenario describes how a set of project inputs might differ under different economic conditions.
• By comparing the range of NPVs across scenarios, you understand the uncertainty (risk) associated with the project.

Example:

Economy	Sales Growth	Discount Rate	Expense (%)	NPV
Good	10%	15%	40%	161.28
Average	0%	10%	50%	134.99
Bad	-5%	5%	60%	116.15

• Don't confuse: Sensitivity analysis changes one variable at a time; scenario analysis changes multiple variables together to reflect coherent economic states.

💼 Capital rationing

💼 What is capital rationing?

Capital rationing: the process of identifying the bundle of projects that creates the greatest total value when the company does not have enough money to invest in all available positive-NPV projects.

• Goal: choose the set of projects that generates the greatest value per dollar invested in a given period.

📊 Profitability Index (PI)

Profitability Index (PI) = NPV / Initial Investment

• PI measures the value created per dollar invested.
• Formula: PI = (Present Value of Future Cash Flows) / Initial Investment = 1 + (NPV / Initial Investment).

📋 Capital rationing steps

1. Calculate the PI for each project.
2. Rank projects from highest PI to lowest PI.
3. Select projects starting at the top of the list:
   • Choose the project with the highest PI.
   • Work down the list, selecting the next highest PI project that fits within the total capital available (budget).
4. Repeat until the bundle with the highest total NPV is identified.

💡 Example

Company has $10,000 to invest:

Project	Year 0	Year 1	Year 2	NPV @ 10%	PI
A	-$5,000	$5,500	$6,050	$5,000	2.0
B	-$3,000	$2,000	$3,850	$2,000	1.67
C	-$3,000	$4,400	$0	$1,000	1.33
D	-$2,000	$1,500	$1,375	$500	1.25

Solution: Choose A, B, and D.

• A + B + D = $5,000 + $3,000 + $2,000 = $10,000 (fits budget).
• Total NPV = $5,000 + $2,000 + $500 = $7,500.
• C is not chosen even though its PI (1.33) is higher than D's (1.25), because there is not enough capital remaining after selecting A and B.

🧭 Overview

🧠 One-sentence thesis

Capital structure—the mix of debt and equity a firm uses—affects firm value through tax benefits, financial distress costs, agency conflicts, and information asymmetry, with the optimal structure balancing these trade-offs across the firm's life cycle.

📌 Key points (3–5)

• What capital structure is: the mix of debt and equity financing used by a company to fund its operations and investments.
• Core tension: debt provides tax benefits but increases financial distress risk; equity avoids fixed obligations but is more expensive and dilutes ownership.
• MM's insight: in perfect markets capital structure is irrelevant, but real-world imperfections (taxes, bankruptcy costs, agency costs, information asymmetry) make it matter.
• Common confusion: debt is "cheaper" than equity, but increasing debt raises the required return on equity, so the overall cost of capital (WACC) does not automatically fall—this is the core of MM Proposition 2.
• Practical guidance: firms follow a pecking order (internal funds → debt → equity) and adjust capital structure as they mature through their life cycle.

💼 Debt vs Equity: Core characteristics

💰 What is equity financing?

Equity financing: issuing ordinary shares (common stock) to investors, typically through an initial public offering (IPO), in exchange for capital.

Key characteristics of equity:

Feature	Description
Residual claim	Shareholders receive dividends only after all other obligations (suppliers, employees, lenders, taxes) are met; in liquidation, they claim what remains after all debts are paid.
Tax treatment	Dividends are not tax-deductible—the firm receives no tax benefit from equity finance.
Maturity	Infinite—shares do not mature; the company is never obligated to redeem them.
Control	Shareholders have voting rights (one vote per share) and can elect directors, exerting control over management.
Risk and return	Shareholders face the highest risk, so they expect the highest return.

Advantages of equity (from the firm's perspective):

• No obligation to pay dividends (discretionary).
• No maturity date—no forced redemption.
• Higher equity proportion lowers perceived risk for lenders, reducing interest rates on debt.

Disadvantages of equity:

• Issuing new shares dilutes existing ownership and control.
• Higher transaction costs (prospectus, underwriting fees) than borrowing.
• Dividends are not tax-deductible.

🏦 What is debt financing?

Debt financing: a contract in which the borrower promises to pay future cash flows (interest and principal) to the lender.

Key characteristics of debt:

Feature	Description
Legal claim	Lenders have a high-priority claim; if the borrower defaults, lenders can seize pledged assets or take legal action.
Tax treatment	Interest expense is tax-deductible, providing a tax shield (e.g., 30% tax rate × $1M interest = $300k tax saving).
Maturity	Fixed—debt must be repaid on a specified date (e.g., 10-year bond matures in 10 years).
Control	Lenders have no direct control over operations as long as the firm meets its obligations, but they have potential control if the firm defaults (can appoint administrators, liquidate the company).

Don't confuse: "No direct control" does not mean "no influence"—lenders can impose covenants and take over if the firm defaults.

📊 Comparison table

Dimension	Equity	Debt
Payment obligation	Discretionary (dividends)	Mandatory (interest & principal)
Tax benefit	None	Tax-deductible interest
Maturity	Infinite	Fixed date
Control	Voting rights	No direct control (unless default)
Risk to holder	Highest	Lower (priority claim)
Cost to firm	Higher expected return	Lower expected return (but fixed obligation)

🏢 Sources of external financing

🌐 Equity sources

🎯 Initial Public Offering (IPO)

• What it is: a company invites the public to subscribe for shares for the first time, "floating" or "going public" to raise equity capital.
• Minimum requirements (ASX example): at least 300 shareholders, each subscribing at least $2,000 (minimum $600,000 raised).

Advantages of an IPO:

1. Access to capital for growth: easier to raise large amounts and to conduct future seasoned offerings.
2. Liquidity: creates a secondary market where shareholders can sell shares.
3. Currency for acquisitions: shares can be used to acquire other companies.
4. Higher profile: media and analyst attention increases credibility.
5. Institutional investment: transparency and liquidity attract institutional investors.
6. Independent valuation: market generates a valuation based on available information.
7. Employee alignment: shares can be used for employee remuneration, aligning interests with company goals.
8. Reassurance: rigorous due diligence and ongoing compliance improve perception of strength.

Considerations (possible disadvantages):

1. Susceptibility to market conditions: share price affected by factors beyond the firm's control (economic conditions, industry events).
2. Under-pricing: IPO shares are typically sold below fair value; existing shareholders lose value. Example data: US 18.8%, Australia 11.9%–25.6%, China 137.4%.
3. Disclosure and reporting: higher governance standards, investor relations, and management time required.
4. Short-term focus: pressure to meet quarterly profit targets may distract from long-term value.
5. Media exposure: heightened scrutiny requires management.
6. Costs and fees: listing fees, prospectus costs, underwriting fees (4–7% of funds raised). Example: 10 million shares → $70k initial listing fee, $25k annual fee.
7. Reduced control: selling shares cedes control to outside shareholders.

🔒 Private Equity (PE)

Private equity: securities issued to investors that are not publicly traded, including family, friends, and private equity funds.

Two main types:

1. Venture Capital (VC): funding for smaller, riskier companies with strong growth potential; useful when capital needs are too small or uncertain for an IPO.
2. Acquisition of mature public companies: a group of investors purchases 100% of a listed company and de-lists it ("privatisation").

Four sub-types of PE:

1. Start-up financing: for businesses <30 months old, to develop products.
2. Expansion financing: to manufacture and sell products commercially.
3. Turnaround financing: for companies in financial difficulty.
4. Management buyout (MBO): management team purchases the business with PE fund assistance.

Key features:

• Illiquid: no public trading; investors commit funds for 5–10 years.
• Investment size: typically $500k–$20M.
• Target: businesses with good growth prospects, capable and honest management.
• Exit strategy: increase company value, then sell for a profit.

🏦 Debt sources

⏱️ Short-term debt (maturity ≤12 months)

Sources: banks, finance companies, investment banks, credit unions.

Types:

• Non-marketable: e.g., bank overdraft (no secondary market).
• Marketable: e.g., commercial paper (also called promissory note):
  • Unsecured promise to pay face value on a specified future date.
  • Maturity: 30–180 days.
  • Issued only by blue-chip companies and governments.
  • Sold at a discount to face value; also called "one-name paper" (only the borrower promises payment).
  • Can be resold in the secondary market.

📅 Long-term debt (maturity >12 months)

Types:

• Loans: from banks and financial intermediaries, often asset-backed (e.g., mortgages secured by property).
• Marketable securities: debentures, unsecured notes, corporate bonds.

📏 Measuring capital structure

📐 Definition and formula

Capital structure: the mix of debt and equity finance used by a company.

Optimal capital structure: the debt/equity mix that maximises the value of the company.

Firm value identity:

• Value of Firm (V) = Value of Debt (D) + Value of Equity (E)
• Capital = Equity (E) + Debt (D) = Firm value (V)

📊 Leverage ratios

Two main measures of financial leverage (gearing):

1. Debt-to-equity ratio: D / E
2. Debt-to-capital ratio: D / V

Higher debt → higher financial leverage.

🔍 Interest coverage ratio

Interest coverage ratio = (measure of earnings) / Interest expense

• Determines how easily a company can pay interest on outstanding debt.
• Lower ratio → company is more burdened by debt.
• Ratio ≤1.5 → ability to meet interest expenses is questionable.

⚠️ Debt and risk

Two types of risk:

1. Business risk: faced by all businesses (even 100% equity-financed); caused by:

   • Changes in technology
   • Consumer taste
   • Market competition
   • Government regulation

2. Financial risk: additional risk from using debt:

   • Expected return on equity increases
   • Variability of returns to shareholders increases
   • Trade-off: higher leverage → higher expected return but also higher risk

Don't confuse: Business risk exists regardless of capital structure; financial risk is added only when the firm uses debt.

🧪 Theories of capital structure

🏛️ Modigliani and Miller (MM) analysis

🔬 Perfect markets assumptions

MM's model assumes perfect capital markets:

1. Companies and individuals can borrow at the same interest rate.
2. No taxes.
3. No liquidation costs.
4. Fixed investment policies—investment decisions are independent of financing decisions.

📜 MM Proposition 1

MM Proposition 1: The market value of a firm is independent of its capital structure.

Core logic:

• Changing the debt/equity ratio changes how net operating income is divided between lenders and shareholders, but does not change total firm value.
• Two companies with the same assets but different capital structures are perfect substitutes and should have the same value.
• Investors will not pay a premium for shares of levered companies because they can create home-made leverage by borrowing personally.
• Home-made leverage is a perfect substitute for corporate leverage.

Key mechanism: The substitutability between corporate debt and personal debt.

📜 MM Proposition 2

MM Proposition 2: The cost of equity of a levered firm equals the cost of equity of an unlevered firm plus a financial risk premium, which depends on the degree of financial leverage.

WACC formula for a levered firm:

• WACC = (E/V) × R_E + (D/V) × R_D
  • R_E = cost of equity of a levered firm
  • R_D = cost of debt

Cost of equity for a levered firm:

• R_E = R_U + (R_U − R_D) × (D/E)
  • R_U = cost of equity of an unlevered firm

Interpretation:

• As leverage (D/E) increases, the required return on equity (R_E) increases exactly in line with the increase in available return.
• "Cheaper" debt is offset by the higher return required by equity holders due to increased risk.
• Therefore, WACC remains constant regardless of capital structure.

Don't confuse: Debt has a lower required return than equity, but adding debt raises the required return on equity, so the overall WACC does not fall in perfect markets.

🎯 Why MM matters

• MM shows what does not matter in perfect markets (capital structure is irrelevant).
• By implication, if capital structure does matter in the real world, the reasons must lie in market imperfections: taxes, financial distress, agency costs, information asymmetry.

🌍 Relaxing perfect market assumptions

💸 Company income taxes

• Tax benefit of debt: Interest is tax-deductible, so debt increases after-tax cash flows to investors.
• Implication of MM Proposition 1 with taxes: A company should borrow as much as possible to reduce its tax bill to zero (an extreme conclusion).

Value of levered firm with taxes:

• V_L = V_U + (tax benefit of debt)

💥 Financial distress costs

Financial distress: a situation where a company's financial obligations cannot be met, or can be met only with difficulty.

Indirect costs (attempting to avoid bankruptcy):

• Lost sales and reduced operating efficiency.
• Stakeholders (customers, suppliers, employees) behave in ways that disrupt operations and reduce value.
• Managerial time diverted to averting failure (less attention to product quality, employee safety).

Direct costs (bankruptcy itself):

• Fees for accountancy, legal work, liquidator.

Value of levered firm with taxes and distress:

• V_L = V_U + (tax benefit of debt) − (present value of financial distress costs)

⚖️ Trade-off theory (Static theory)

• Managers choose capital structure by trading off the benefits and costs of debt.
• Increase debt until the marginal benefit (tax shield) equals the marginal cost (expected distress costs).
• This point is the optimal capital structure, which maximises firm value.

Example: A firm increases debt to capture tax benefits, but stops before distress costs become too large.

🤝 Agency costs

🏦 Agency costs: shareholders vs debtholders

Agency costs: costs arising from potential conflicts of interest between parties in contractual relationships.

Sources of conflict (ways management may transfer wealth from lenders to shareholders):

1. Claim dilution: Issue new debt that ranks higher than existing debt, reducing the value of old debt.
2. Dividend payout: Significantly increase dividends, decreasing assets and increasing debt riskiness.
3. Asset substitution: Undertake risky (even negative-NPV) investments; if successful, shareholders capture most gains; if they fail, lenders bear most losses. Total firm value falls, but equity value rises at the expense of debt value.
4. Underinvestment: Reject positive-NPV, low-risk projects when debt is very risky; shareholders may not want to contribute new capital because the benefits would go mostly to lenders.

Don't confuse: Asset substitution and underinvestment are opposite problems—one is taking too much risk, the other is taking too little—but both arise from conflicts between shareholders and debtholders.

👔 Agency costs: shareholders vs managers

Jensen's free cash flow theory:

• When a profitable but declining company generates high cash flows but has few good investment projects, managers may waste funds on poor investments.
• Solution: Pay out free cash flows to investors (dividends or buybacks) to avoid misuse by managers.

📡 Information asymmetry and the pecking order theory

🪜 Pecking order theory

Pecking order theory: Managers choose the "least expensive" capital first, then move to increasingly costly capital.

Order of preference:

1. Internally generated funds (e.g., retained earnings)
2. Debt
3. Equity

Rationale (Myers):

• Information asymmetry: managers have more information than outside investors.
• If managers believe shares are undervalued, they issue debt (to avoid selling cheap equity).
• If managers believe shares are overvalued, they issue equity (to take advantage of high prices).
• Investors understand this signal, so equity issuance is interpreted as bad news → equity is the most expensive source of capital.

Evidence:

• In the US and Australia, most investment by non-financial companies is financed from internal cash flows, followed by debt, then equity.
• Exception: high-growth companies have investment needs exceeding cash flows, so they depend heavily on equity issues.

🌱 Firm life cycle and capital structure

📈 Life cycle stages and financing patterns

Firm life cycle: the different stages a company goes through as it grows and matures over time.

Relationship between life cycle and capital structure:

Life cycle stage	Typical capital structure	Reason
Young/start-up	Heavy reliance on equity (venture capital, angel investors)	No track record, few assets for collateral, high uncertainty
Mature/established	Balanced mix of debt and equity, greater emphasis on debt	Stable revenue, assets for collateral, proven financial performance → creditworthy
Decline	Heavier reliance on debt	Equity financing difficult to obtain; debt used to maintain operations and fund investments

Summary: Young firms rely on equity; established firms shift toward debt; declining firms depend on debt because equity is hard to raise.

Don't confuse: The shift toward debt as firms mature is not because debt becomes "better," but because the firm becomes more creditworthy and equity becomes harder to justify (lower growth opportunities).

🧭 Overview

🧠 One-sentence thesis

Cost of capital is the minimum return a company's investors require given the firm's risk, and it serves as the hurdle rate for evaluating new investments of similar risk.

📌 Key points (3–5)

• What cost of capital represents: from investors' perspective it is the required rate of return (RRR); from management's perspective it is the cost of obtaining funds (interest, dividends, capital gains).
• How market prices reflect cost: current security prices embed the market's required return—higher required return means lower price for the same future cash flows.
• WACC calculation: weighted average cost of capital combines cost of debt (adjusted for tax benefit) and cost of equity, weighted by market values.
• Common confusion: firm-wide WACC vs. project-specific cost of capital—firm WACC is appropriate only when the project has similar risk and financing structure to the overall firm.
• Why it matters: WACC is used as the discount rate (hurdle rate) for capital budgeting decisions.

💰 What cost of capital means

💰 Dual perspectives on cost of capital

Cost of capital: the minimum return a company's investors (equity and debt holders) need to earn given the company's riskiness; equivalently, the required rate of return (RRR) of the investors.

From the investors' viewpoint:

• It is what they require to compensate for the risk of investing in the company.
• It is their opportunity cost—what they could earn elsewhere on investments of similar risk.

From management's viewpoint:

• It is what the company must provide (pay as interest, dividends, and/or capital gains) to obtain funds.
• It is the average cost of funds the company must offer to raise capital now.
• The excerpt emphasizes: "returns and costs are mirror images of each other."

📉 How market prices reveal cost of capital

The current price of a security reflects the return the market requires from it.

The logic:

• For a given amount of future cash inflows, if the required return is higher, the price must be lower.
• Conversely, if you observe the current price and know the expected cash flows, you can calculate the required return.

Example from the excerpt:

• A share pays $5 per year in perpetuity.
• If the market requires 10% return, the price is $50 (using perpetuity model).
• If the market requires 20% return, the price is $25.
• If the share is trading at $50 and pays $5, the required return is 10%.

Don't confuse: The price is not arbitrary; it adjusts so that the return equals what the market requires for that level of risk.

🧮 Calculating WACC

🧮 What WACC is

Weighted Average Cost of Capital (WACC): the weighted average of required returns (weighted by market value) on debt and equity.

• From investors' perspective: weighted average of required returns.
• From management's perspective: average cost of funds.
• WACC is the opportunity cost for the company's investors as of today.
• It is used as the discount rate (hurdle rate) for evaluating investments in new assets of similar risk.

🔢 Steps to calculate WACC

The excerpt outlines the following steps:

1. Identify sources of funding (debt, ordinary shares, preference shares).
2. Calculate or identify cost of each funding source.
3. Adjust interest cost for tax benefit: interest payments are tax-deductible, so the after-tax cost of debt = pretax cost × (1 − tax rate). Ordinary and preference shares do not get this tax benefit.
4. Calculate proportion (weight) of each funding source using market values.
5. Multiply weight by cost for each source, then sum to get WACC.

📊 Capital structure weights example

From the excerpt:

Item	Market Value	Weight
Equity (E)	$500 million	51.28%
Debt (D)	$475 million	48.71%
Total (V)	$975 million	100%

• Weight of E = $500 / $975 = 51.28%
• Weight of D = $475 / $975 = 48.71%

💡 Intuitive cost of capital example

From the excerpt:

Source	$ Value	Rate Required	$ Return
Debt	$8 million	10%	$0.8 million
Equity	$2 million	15%	$0.3 million
Total	$10 million		$1.1 million

• Cost of capital = $1.1 million / $10 million = 11%

This is a weighted average: the company must generate at least 11% return to satisfy both debt and equity investors.

💳 Cost of debt

💳 Estimating current cost of debt

• Use the current cost of debt, not past cost.
• The current cost is estimated using yield to maturity from bond valuation (the market interest rate used for pricing bonds).
• If the company has multiple types of debt, calculate a weighted average of the costs of each.

🏦 Tax benefit of debt

• Interest payments are tax-deductible.
• After-tax cost of debt = pretax cost × (1 − tax rate).
• This tax shield reduces the effective cost of debt.
• Don't confuse: Equity (ordinary and preference shares) does not receive this tax benefit.

📈 Cost of equity

📈 What cost of equity is

Cost of equity: the minimum rate of return required (RRR) by a company's shareholders, given its riskiness.

• It is a weighted average of the costs of different types of shares the company has outstanding.
• Market information is used to estimate it.

🔬 Method 1: Capital Asset Pricing Model (CAPM)

The excerpt describes the CAPM approach:

Steps:

1. Estimate the beta of the shares using historical data (or use publicly available betas).
2. Determine the current risk-free rate (recommended: yield on long-term Treasury security, e.g., 10-year government bonds, because equity is a long-term claim).
3. Determine the expected market risk premium.
4. Substitute into the CAPM equation.

Practical issues:

• Risk-free rate: use long-term rate to reflect long-term inflation expectations and the cost of long-term investment.
• Beta: for publicly traded shares, use regression analysis or publicly available betas. For non-public shares, identify a comparable company in the same business with similar debt, or use an industry average beta.
• Market risk premium: the excerpt references an external source (Damodaran's website) that updates equity risk premiums by country annually.

🌱 Method 2: Constant-growth dividend model

From Topic 5 (share valuation):

• When dividends are expected to grow at a constant rate, rearrange the constant-growth model to solve for the required return.
• This method uses the current share price, expected dividend, and growth rate.

🎯 Preference shares

• Preference shares have characteristics that allow use of the perpetuity model.
• Rearrange the pricing equation for preference shares to find the cost of preference equity.
• CAPM can also be used to estimate the cost of preference equity.

🔧 Factors affecting WACC

🔧 Cost of debt factors

• Interest rate on loans and bonds: determined by the firm's credit rating.
• Bond rating: whether the firm's bonds are investment grade (BBB or above) or junk (below BBB) affects the interest rate and thus the cost of capital.

🔧 Cost of equity factors (CAPM)

If CAPM is used, WACC is affected by:

• Risk-free rate
• Systematic risk (beta)
• Market risk premium

🔧 Cost of equity factors (dividend growth model)

If the dividend growth model is used, WACC is affected by:

• Dividends
• Share price
• Growth rate of dividends

🏢 Firm WACC vs. project-specific cost of capital

🏢 When to use firm WACC for a project

The excerpt emphasizes that a firm is a collection of projects, and the firm's cost of capital reflects the weighted average risk of all projects.

Use the firm's WACC to evaluate an individual project when:

1. The project has the same risk level as the overall firm's operations: the cost of capital reflects the firm's risk, so if the project's risk is similar, the firm's WACC is appropriate.
2. The project's financing structure matches the firm's overall financing structure: if the project uses the same mix of debt and equity as the firm, the firm's WACC applies.
3. The project is expected to generate similar returns as the firm's other investments: if the project's expected returns are comparable to the firm's existing investments, the firm's WACC is suitable.

Don't confuse: Using firm WACC for a project with different risk or financing structure will lead to incorrect accept/reject decisions. Projects with higher risk than the firm should use a higher discount rate; projects with lower risk should use a lower rate.

🏢 Adjusted Present Value (APV) method

The excerpt introduces an alternative method:

APV method: an alternative way of calculating WACC that considers the specific financing structure of a project and adjusts the cost of capital accordingly.

Basic idea:

• First, calculate the value of a project assuming all-equity financing (the "unlevered value" or "base-case value").
• Then add the present value of any tax shields or other financing benefits from using debt.
• Sum these to get the total project value.
• Calculate the WACC for the levered project using this adjusted value.

When to use APV:

• When a project has a unique financing structure.
• When the financing structure changes over time.
• APV allows more accurate reflection of a project's specific risk and return profile.

🔑 Key takeaways

🔑 Cost of capital as hurdle rate

• WACC is the discount rate used for capital budgeting.
• It represents the opportunity cost of capital for the firm's investors.
• Projects must earn at least the WACC to be acceptable (for projects of similar risk).

🔑 Tax shield on debt

• Interest is tax-deductible, reducing the effective cost of debt.
• This makes debt financing cheaper than equity, all else equal.
• The tax benefit is incorporated into WACC by using after-tax cost of debt.

🔑 Market values, not book values

• WACC weights are based on market values of debt and equity, not book values.
• Market values reflect current investor expectations and required returns.

🔑 Matching risk and discount rate

• The firm's WACC is appropriate only for projects with similar risk and financing structure.
• For projects with different risk profiles, adjust the discount rate accordingly or use the APV method.

🧭 Overview

🧠 One-sentence thesis

Payout policy—the decision of whether and how much to distribute to shareholders—is a critical managerial choice that affects both firm value and capital structure, with its importance and optimal form shaped by market imperfections, taxes, signaling effects, and agency costs.

📌 Key points (3–5)

• Why payout matters: it signals financial health, meets shareholder expectations for returns, and can affect financing decisions and firm value (through dividend discount models).
• Forms of payout: cash dividends (regular and special), share buybacks, dividend reinvestment plans, and bonus shares—each with different tax and flexibility implications.
• Competing theories: Modigliani & Miller argue payout is irrelevant in perfect markets, while De Angelo & De Angelo emphasize "full payout" of free cash flows; real-world factors (taxes, transaction costs, agency costs) make payout policy important.
• Common confusion—dividend vs. share price: bonus shares and share splits increase the number of shares but do not change total shareholder wealth (value per share falls proportionately).
• Tax systems matter: Australia's imputation system (franking credits) eliminates double taxation of dividends, unlike classical systems, making dividends more attractive to Australian investors.

💰 Why payout decisions are important

💰 Three uses of profit

When a company earns profit, it faces three options:

• Reinvest in the business (fund new projects).
• Distribute to shareholders as dividends (payout).
• Hold as loose cash.

The payout decision is one of three major managerial decisions (alongside investment and financing).

📡 Signaling financial health

By paying regular dividends, firms can signal their financial well-being.

• If a firm is not in good health, it cannot sustain regular dividends.
• Consistent dividends communicate stability and positive prospects to the market.

🤝 Meeting shareholder expectations

• Shareholders provide capital with the expectation of receiving returns—either as payouts or capital gains.
• Payout policy directly affects shareholder satisfaction and the firm's ability to attract investors.

🔗 Link to firm value and capital structure

• Payout affects financing decisions: distributing profit reduces internal funds available, potentially increasing reliance on debt or external equity.
• Firm value is tied to dividends through dividend discount models (constant, constant growth, supernormal growth), so payout policy influences share price.

🧩 Forms of payout

💵 Regular cash dividends

The most common form of dividend is the regular cash dividend, which is a cash dividend that is paid on a regular basis.

• In Australia, dividends are typically paid semi-annually.
• Management sets the regular dividend at a level it expects to maintain long-term, barring major changes in the company's fortunes.
• Why set it conservatively: management dislikes reducing dividends because it sends a bad signal about future prospects.

🎁 Special dividends

• Paid when a company generates high profit in a specific period (not expected to recur).
• Allows management to distribute extra cash without committing to a higher regular dividend.
• Example: Woolworths paid a special dividend of $0.45 in fiscal year 2021.

🔄 Share buybacks (repurchases)

In a share buy-back (or share repurchase), the company buys some of the issued shares back from shareholders.

Key differences from dividends:

• Shareholders can choose not to participate.
• Reduces the number of shares outstanding (in Australia, bought-back shares must be cancelled).
• Profit to shareholders is treated as capital gains (taxed at a lower effective rate—50% of income tax in Australia).

Methods of buyback:

• On-market: company buys shares from the market at market price.
• Equal access: offered to all shareholders on a pro-rata basis; shareholders must apply.
• Selective: offered only to select groups (targeted).
• Employee share scheme: only for employees holding shares under such schemes.
• Minimum holding: buys back small, unmarketable parcels to reduce administration costs.

Advantages:

• Flexibility: shareholders choose when to receive distribution (and when to pay tax).
• Management can cut back or end buybacks at any time (more flexible than dividends).
• Capital gains historically taxed at lower rates than dividends.

🔁 Dividend reinvestment plans (DRPs)

A dividend reinvestment plan (DRP) gives shareholders the option of receiving new shares at a small discount, instead of cash dividends.

• Shareholders are deemed to have received the cash dividend and are taxed on it.
• They receive franking credits that can offset tax liability.
• Allows compounding of investment without transaction costs.

🎉 Bonus shares and share splits

When a company issues bonus shares, it distributes new shares on a pro-rata basis to existing shareholders.

• The number of shares increases, but the value per share falls proportionately.
• Total shareholder wealth is unchanged (theoretically).

Example: A company worth $11,000 with 10,000 shares ($1.10 each) issues a 10% bonus (1,000 new shares). Now 11,000 shares exist, each worth $1.00 ($11,000 ÷ 11,000). A shareholder with 100 shares worth $110 now has 110 shares worth $110—no change in wealth.

Share splits: similar to bonus issues but involve a larger multiple (e.g., 2-for-1 split). Theoretically, no value is added.

Don't confuse: bonus shares and splits do not increase wealth; they only change the number of shares and price per share.

📅 Dividend payment process

📅 Four key dates

Date	What happens
Announcement (declaration) date	Board of directors passes a resolution to pay dividend; announces amount per share and other dates. Share price often changes due to signaling.
Ex-dividend date	First date the share trades without rights to the dividend. Buy before this date → receive dividend; buy on or after → no dividend. Share price usually drops by the dividend amount (plus franking credits).
Record date	Date on which an investor must be a shareholder of record (officially listed) to receive the dividend. Typically three days after ex-dividend date (time needed to update shareholder list).
Payment date	Shareholders of record actually receive the dividend (by cheque or direct transfer).

Key distinction: the ex-dividend date precedes the record date because it takes time (normally 3 working days) to update the shareholder list.

Terminology:

• Cum dividend: share trading with the right to receive the dividend (before ex-dividend date).

🏦 Dividend imputation in Australia

🏦 Classical vs. imputation tax systems

System	How it works	Result
Classical (e.g., US, UK pre-1987 Australia)	Company profits taxed at corporate rate t_c; dividends taxed again at shareholder's personal rate t_p.	Double taxation: shareholder receives (1 – t_c) × (1 – t_p) from each dollar of profit. Capital gains often taxed at lower rates, so dividends are disadvantaged.
Imputation (Australia since July 1987)	Company tax paid is used as a franking credit to offset shareholder's tax liability.	Dividends effectively taxed only once at the shareholder's personal tax rate.

🧾 How franking credits work

Franked dividend: a dividend paid out of Australian company profits on which company tax has been paid and which carries a franking credit for the income tax paid by the company.

Franking credit: a credit for Australian company tax paid which, when distributed to shareholders, can be offset against their personal tax liability.

Example: Company earns $100 profit before tax. Corporate tax rate is 30%, so after-tax profit is $70. Company pays $70 as dividend. Shareholder receives:

• $70 cash dividend
• $30 franking credit (tax already paid by company, sitting with the tax office)
• Total dividend income: $100 (grossed-up dividend)

Tax treatment by shareholder's marginal rate:

Shareholder's tax rate	Income tax owed on $100	Franking credit	Net effect
10%	$10	$30	$20 refund (excess credit)
30%	$30	$30	$0 (no payment or refund)
50%	$50	$30	$20 additional tax to pay

Key insight: franked dividends are tax-free to Australian residents if their marginal tax rate equals the corporate rate. Lower-rate taxpayers get refunds; higher-rate taxpayers pay additional tax.

Limitation: profits earned and taxed offshore do not carry franking credits.

📊 Measuring and determining payout

📊 Two measures of dividend distribution

Dividend payout ratio:

Dividend payout = Dividend ÷ Net income

• Measures the percentage of earnings the company pays in dividends.
• Limitation: what if net income is negative? (Ratio becomes meaningless.)

Dividend yield:

Dividend yield = Dividend per share ÷ Share price

• Measures the return an investor can make from dividends alone.
• Useful for comparing income-generating potential across stocks.

🧭 Determinants of payout policy

Other financial decisions (investment and financing):

• If the company finances expenses and investments from earnings, it will pay less in dividends.

Signaling effect:

• Higher dividends signal positive future performance and stable cash flow.
• If the company is profitable and generates positive cash flow, it has funds to pay dividends.

Dividend clientele (shareholder characteristics):

• When shareholders prefer current dividend income over capital gains (e.g., retirees), the company may pay dividends regularly.
• Conversely, high-tax-rate investors prefer capital gains (which can be deferred).

Future economic indications:

• If future sales and earnings are stable and predictable, the company is more likely to pay a higher percentage of earnings as dividends.
• Unpredictable earnings lead to more conservative payout policies.

Firm life cycle:

Stage	External financing need	Internal financing need	Capacity to pay dividends
Introductory/start-up	High but constrained	Negative or low	None (cash flow is negative)
Growth	High	Negative	None (high investment needs)
High growth	High	Low	Very low (cash used to fund potential investments)
Mature growth	Moderate (low investment opportunities)	High	High (cash flows realized from past investments)
Decline	Moderate (low investment opportunities)	High	High (cash flows continue)

Key pattern: early-stage firms retain earnings to fund growth; mature firms have stable cash flows and can afford consistent dividends.

🧪 Theories of payout policy

🧪 Modigliani & Miller (MM): Payout irrelevance

Core claim: In a perfect capital market, dividend payout policy has no effect on shareholder wealth; firm value is determined solely by the earning power of its assets.

Assumptions:

• Investment plan and borrowing decisions are fixed.
• Perfectly competitive capital market: no taxes, transaction costs, flotation costs, or information costs.
• Rational investors: prefer more wealth; indifferent between cash dividends and increases in share value.

Logic:

• If a firm increases dividends (and investment/borrowing are fixed), it must issue new shares to fund the payout.
• If dividends are reduced, surplus cash is used to repurchase shares.
• Dividend policy is a trade-off between higher/lower dividends and issuing/repurchasing shares.
• Shareholders can "manufacture" any dividend they want by selling shares (homemade dividends) at no cost.

Conclusion: payout policy does not change shareholder wealth. Net cash paid to investors is a residual—the difference between profits and investments. Companies can adjust payouts by changing the number of shares on issue.

🧪 De Angelo & De Angelo (DD): Full payout is important

Core claim: MM's theorem is correct given the assumptions, but the concept of "full payout" is a more logical starting point for understanding payout policy.

Full payout policy: the full present value of a company's free cash flow should be paid out to shareholders.

Free cash flows: cash flows in excess of those required to fund all available projects that have a positive NPV.

Key distinction: DD separate investment value (from selecting good projects) from distribution value (from ensuring investors receive the greatest possible present value of distributions).

Managers' two jobs:

1. Selecting good investment projects (investment value).
2. Ensuring that, over the life of the enterprise, investors receive a distribution stream with the greatest possible present value (distribution value).

Implication: if a company retains part of its free cash flow (instead of paying it out), company value can be changed. Therefore, both investment policy and payout policy are important.

Don't confuse: MM and DD agree under perfect markets but support different payout policies. DD emphasize that retaining free cash flows (beyond what is needed for positive-NPV projects) destroys value.

🌍 Real-world factors that make payout policy important

🌍 Transaction costs and dividend clienteles

Transaction costs:

• In theory, shareholders can create "homemade dividends" by selling shares or reinvest unwanted dividends by buying more shares.
• In reality, buying and selling incur brokerage fees and other transaction costs.
• Investors requiring regular income prefer shares that pay regular dividends (avoiding the need to sell shares repeatedly).

Dividend clienteles:

Imperfections in the capital market lead to 'dividend clienteles'—different classes of investors with different preferences for current income; a firm will attract a clientele of investors suited to its dividend policy.

Examples:

• A company with no/low dividends attracts investors with adequate income from other sources (e.g., high earners who prefer capital gains and want to avoid transaction costs from reinvesting dividends).
• A company with stable high dividends attracts investors requiring regular income (e.g., retirees) who avoid transaction costs that would arise if they had to sell shares for income.

Tax-driven clienteles:

• High-tax-rate shareholders prefer low dividends and capital gains (which can be deferred and are taxed at lower rates).
• Low-tax-rate shareholders (or those with franking credit benefits) may prefer dividends.

🌍 Flotation costs

• If a company pays dividends and retained profits are insufficient for investment needs, it must raise funds externally.
• External financing involves substantial costs: prospectus preparation, underwriter's fees, loan establishment fees.
• Flotation costs provide an incentive to restrict dividends and preserve shareholder wealth by using internal funds.

🌍 Behavioral factors and catering theory

Behavioral factors:

• Investors are not always rational.
• Sometimes investors prefer dividends; other times they prefer increases in share value.
• If investors are willing to pay more for dividend-paying companies, arbitrage will not prevent these companies from having higher share prices.

Catering theory:

Managers cater to investor demand—pay dividends when investors place higher value on dividends; don't pay dividends when investors place higher value on increases in value of shares.

• Managers adjust payout policy in response to changes in investor demand for dividends.

🌍 Information signaling effects

Asymmetric information:

• Managers usually have better information about the company's prospects than shareholders.
• If this affects dividend decisions, then changes in dividends convey management's "inside" information about future cash flows.

Evidence:

• Share price changes around dividend announcements are positively related to the change in the dividend.
• The announcement provides the occasion for a price change but is not the cause—the cause is the information conveyed.

DD's interpretation:

• This supports the importance of payout policy: investors value securities only for the payouts they are expected to provide.
• Higher share prices follow announcements of higher payouts because investors update their expectations of future distributions.

🌍 Agency costs and corporate governance

Two ways higher dividends reduce agency costs:

Greater accountability:

• Higher dividends force the company to raise capital externally.
• External financing requires providing information to investors, underwriters, and others, who scrutinize the company at relatively low cost.
• This increases monitoring of managers, making them more likely to act in shareholders' interests.

Avoid overinvestment:

• Where firms have free cash flows (FCF), managers may retain cash and overinvest to increase the size of the company (and their own power and remuneration).
• New projects may have negative NPVs, reducing shareholder wealth.
• This argument is particularly relevant to mature firms with fewer investment opportunities.
• Shareholders are better off if management pays out FCFs as dividends.

Empirical evidence:

• Lie (2000) and Grullon, Michaely, and Swaminathan (2002) found that increased payouts signal reduced opportunity to overinvest.
• Firms with excess cash relative to industry norms that pay out have positive excess returns.
• The market welcomes payouts because it believes managers cannot be relied upon to invest retained funds profitably.
• Firms with limited investment opportunities exhibit bigger abnormal returns to payout announcements.

📋 Types of payout policies

📋 Residual dividend policy

Pay out as dividends any profit that management does not believe can be invested profitably.

• No fixed payout percentage is set.
• Dividends are the residual after funding all positive-NPV projects.
• Implication: dividends will fluctuate with investment opportunities and profits.

📋 Stable (progressive) dividend policy

A target proportion of annual profit to be paid out as dividends.

Example: If profit in Year 1 is $10 million and the target is 10%, dividends paid = $1 million. If profit in Year 2 is $20 million (and this is a sustainable increase) and the target is 10%, dividends paid = $2 million.

• Provides predictability for investors.
• Management adjusts dividends gradually in response to sustainable changes in earnings.

📋 (Third policy not fully described in excerpt)

The excerpt mentions "three payout policies" but only describes two in detail. The third is not elaborated.