CORPORATE FINANCE II
Teaching and learning strategies
4 hours weekly classes to impart knowledge and
define the scope of coverage for self-study.
➢2 hour lecturer
➢2 hour exercises and seminar
Assessment
• Participation: 10%
• Mid-term test 1: 15%
• Mid-term test 2: 15%
• Final exam: 60%
Materials
Learning Materials
• Text book: Corporate Finance (10th Edition) by Ross,
Westerfield, Jaffe. McGraw-Hill, 2013.
ISBN: 978-0-07-803477-0
• Lecture notes and in-class materials
• Readings (if available) will be provided before each lecture.
Lecturer
Ms. Mai Tran (PhD):
CORPORATE FINANCE:
3 main areas of concern
Capital Structure
Where will the firm
get the financing to
pay for its
investments?
Capital Budgeting
What long-term
investments should
the firm take?
Working Capital
Management
How should the firm
manage its everyday
financial activities?
Content Overview
Chapter 1. Cost of Capital
Chapter 2. Capital Structure
Chapter 3. Capital Budgeting
Chapter 4. Dividend and Other Payouts
Chapter 5. Short-term finance and Cash Management
Chapter 6. Credit and Inventory Management
Learning Schedule
TOPIC
TIMING
Readings
Chapter 1. Cost of Capital
Session 1 + 2
Chapter 13
Chapter 2. Capital Structure
Session 3 + 4*
Chapter 15, 16, 17
Chapter 3. Capital Budgeting
Session 5 + 6 + 7*
Chapter 18
MID-TERM TEST 1
Session 8
Chapter 4. Dividend and Other Payouts
Session 9
Chapter 19
Chapter 5. Short term Financing and Cash Management
Session 10 + 11*
Chapter 26, 27
Chapter 6. Credit and Inventory Management
Session 12 + 13+ 14* Chapter 28
MID-TERM TEST 2
Session 15
Revision
Session 16
Chapter 1
COST OF CAPITAL
Key Concepts and Skills
• Know how to determine a firm’s cost of equity capital
• Understand the impact of beta in determining the
firm’s cost of equity capital
• Know how to determine the firm’s overall cost of
capital
• Understand the impact of flotation costs on capital
budgeting
Where Do We Stand?
• Corporate Finance I on capital budgeting focused on
the appropriate size and timing of cash flows.
• Corporate Finance II discusses the appropriate
discount rate when cash flows are risky.
Chapter Outline
1.
The Cost of Equity Capital
2.
Estimation of Beta
3.
Determinants of Beta
4.
The Dividend Discount Model Approach
5.
Cost of Fixed Income Securities
6.
The Weighted Average Cost of Capital
Part 1.
Cost of Equity Capital
1. The Cost of Equity Capital
Firm with
excess cash
Pay cash dividend
Shareholder
invests in
financial asset
A firm with excess cash can either pay a dividend
or make a capital investment
Invest in project
Shareholder’s
Terminal Value
The discount rate of a project should be the expected return
on a financial asset of comparable risk.
Why???
The Cost of Equity Capital
• From the firm’s perspective, the expected return is
the Cost of Equity Capital (CAPM model):
R s = RF + (R M − RF )
• To estimate a firm’s cost of equity capital, we need to
know three things:
1.
The risk-free rate, RF
2. The market risk premium, RM - RF
Cov (Ri , RM )
= i,M
3. The company beta, i =
2
Var(RM )
M
Example
Example
Suppose you estimate that Harmony’s stock (HMN) has a
volatility of 20% and a beta of 1.25. A similar process for Lovely
stock (LVL) yields a volatility of 30% and a beta of 0.55. Which
stock carries more total risk? Which has more market risk? If the
risk-free interest rate is 3% and you estimate the market’s expected
return to be 8%, calculate the equity cost of capital for Harmony
and Lovely. Which company has a higher cost of equity capital?
Solution
Given Harmonay’s estimated beta of 1.25, we expect the price for HMN’s stock to
move by 1.25% for every 1% move of the market. Therefore, HMN’s risk premium will
be 1.25 times the risk premium of the market, and HMN’s equity cost of capital
rHMN = 3% + 1.25 * (8% - 3%) = 3% + 6.25% = 9.25%
Similar explanation for the LVL:
rLVL = 3% + 0.55 * (8% - 3%) = 3% + 2.75% = 5.75%
Example
Suppose Alpha Air Freight is an all-equity firm with a beta of 1.21.
Further suppose the market risk premium is 9.5 percent, and the risk-free rate is 5 percent.
Alpha Air Freight is considering the following non–mutually exclusive projects: (given the
cost of $100).
Project
Project’s
Beta
Project’s
Expected
Cash Flows
Next Year
A
1.21
$140
B
1.21
120
C
1.21
110
Project’s
Internal
Rate of
Return
Project’s NPV
When Cash
Flows Are
Discounted
at 16.495%
Accept or
Reject
Example
Suppose Alpha Air Freight is an all-equity firm with a beta of 1.21.
Further suppose the market risk premium is 9.5 percent, and the risk-free rate is 5 percent.
Alpha Air Freight is considering the following non–mutually exclusive projects:
Project
Project’s
Beta
Project’s
Expected
Cash Flows
Next Year
Project’s
Internal
Rate of
Return
Project’s NPV
When Cash
Flows Are
Discounted
at 16.495%
Accept or
Reject
A
1.21
$140
40%
$20.2
Accept
B
1.21
120
20
3
Accept
C
1.21
110
10
-5.6
Reject
The Risk-Free Rate
• Treasury securities are close proxies for the risk-free rate.
• The CAPM is a period model. However, projects are long-lived. So,
average period (short-term) rates need to be used.
• The historic premium of long-term (20-year) rates over short-term
rates for government securities is in the range of 1-2%.
• So, the risk-free rate to be used in the CAPM could be estimated as
2% below the prevailing rate on 20-year treasury securities.
Part 2.
Estimation of Beta
2. Estimation of Beta
Beta of a security is the standardized covariance of a security's return
with the return on the market portfolio.
Market Portfolio - Portfolio of all assets in the economy. In practice, a
broad stock market index, such as the S&P 500, is used to
represent the market.
Beta - Sensitivity of a stock’s return to the return on the market
portfolio.
Estimation of Beta
Cov(Ri ,RM )
=
Var(RM )
•
Problems
•
1. Betas may vary over time.
2. The sample size may be inadequate.
are influenced by changing financial leverage and business risk.
3. Betas
Solutions
–
–
–
Problems 1 and 2 can be moderated by more sophisticated statistical
techniques.
Problem 3 can be lessened by adjusting for changes in business and financial
risk.
Look at average beta estimates of comparable firms in the industry.
Monthly return for Cisco stock and for the SP500, 2000-2015
Scatterplot of Monthly Excess Returns for Cisco Versus the S&P 500, 2000–2015