Notes
Notes
Notes
Surplus spending unit: earns more than it spends. Surplus spenders can be individuals,
sectors, countries or even the whole economy.
- For example, an individual may provide funds to the deficit spending units
in exchange for stock ownership.
Deficit spending unit: used to describe how an economy or economic unit within an
economy has spent more than it has earned over a period of time.
- Fiscal deficits occur when a government's expenditures exceed its revenue. A
government usually borrows money (by issuing Treasury securities or similar instruments) to
fill the gap or "fund the deficit."
- During times of economic hardship, governments and municipalities are likely to run
deficits to shield the effects of a recession and to spur economic growth. Although it is very
unlikely that an economic unit will operate at a surplus all the time, a prolonged deficit will
eventually cause long-term hardship for the economy as debt levels become too high
Attempt to answer the question: How does the flow of funds help an economy
grow and develop? (HD level question, answer is not found in the textbook, but
developed through critical thinking and internet research)
Subject link: Macroeconomics, which also examines the flow of funds in an
economy.
What does the efficient flow of funds allow? We will explore this in the
workshop.
There are 3 ways for the flow of funds to occur in an economy
1. Direct transfer between surplus & deficit units.
2. Indirect transfer; using an investment bank (a type of financial intermediary)
3. Indirect transfer; using a financial intermediary
Self-study:
Which figure in Chapter 2 shows these 3 methods?
What is another term for the flow of funds used in the textbook?F
Commercial banks borrow and lend money that they hold on their balance sheets.
- They hold depositors' money in instruments such as savings accounts and CDs.
- They earn profits based on the difference in the interest rate at which they charge
borrowers and the interest rate at which they give depositors.
Investment banks match institutions who want to borrow money to institutions who want to
lend money. However, unlike commercial banks, investment banks simply intermediate these
transactions and don't hold much capital themselves.
- These transactions can be in the form of debt or equity, whereas commercial banks
generally only deal with debt.
- Investment banks are compensated on a transaction-basis rather than an interest spread.
Financial Institutions: businesses that facilitate the flow and transfer of funds by providing
intermediation.
- Authorised Deposit-taking Institutions
- banks, building societies, credit unions
Non-ADI Financial Institutions
- broker-dealers, finance companies, securitisers
- Insurers and Funds Managers
- insurance companies, superannuation and deposit funds, trusts
Financial Instruments/security: primarily types of debt & equity that are vehicles for
the flow/transfer of funds.
debt: obligation that enables the issuing party to raise funds by promising
to repay a lender in accordance with terms of a contract. Types of debt
instruments include notes, bonds, debentures, certificates, mortgages,
leases or other agreements between a lender and a borrower.
equity:
- Common stock: is one of the equity instruments issued by a public company
to raise funds from the public. The shareholders have the privilege of being entitled to
co-ownership of the company in addition to having the right to vote at the shareholders
meeting as per the proportion of shares. Besides, they also have rights to take decision
in important issues like raising capital to pay dividends and merging business.
- Convertible debenture: type of equity instrument which is similar to common
bonds, the only difference being that a convertible debenture can be converted into
common stock during the particular rates and prices mentioned in the prospectus.
Convertible debentures are quite popular for profitable returns from converted stock are
higher than those form common bonds.
- Preferred stock: equity instrument, involves shareholders participation as a
business owner as in common stock. The variation lies in that the preferred
shareholders are entitled to receive repayment of capital prior to the common
shareholders.
- Depository receipt: equity instrument which entitles the rights to reference
common bonds, ordinary debentures, and convertible debentures. Investors holding a
depository receipt get benefits as shareholders of listed companies in every respects,
be it the voting rights or financial rights in the listed companies.
-Transferable Subscription Rights (TSR): an equity instrument issued by a
company to all shareholders in proporti8on numbers of shares already held by them.
This instrument is used as evidence in shares of the company. The existing
shareholders can sell/transfer their rights to others if they do not want to exercise their
shares.
Underwriting
private placement
public offering
IPO
FINANCIAL INTERMEDIATION & DIRECT FINANCING
The flow of funds occurs through either intermediation or direct financing
Direct: Deficit and surplus units seek each other out and enact the flow of funds between
them without the use of an intermediary.
- I personally ask someone for their money.
- A Direct financing example would be Joe Schmoe borrowing $1000 from you and agreeing
to pay you back the money plus interest in some amount of time. It is agreeing to pay you
back the money plus interest in some amount of time. It is direct because there is no
guarantee that Joe will actually make true of his promise. So you may get the money back
plus interest, or Joe may take off and you never see your money again.
Attempt to understand why not all business can engage in direct financing.
FINANCIAL MARKETS
We need to be able to define and understand the markets used in finance
define all with examples
Primary market is the part of the capital market that deals with issuing of new securities. ...
In a primary market, companies, governments or public sector institutions can raise funds
through bond issues and corporations can raise capital through the sale of new stock
through an initial public offering (IPO)
-
-
Secondary market also called the aftermarket, is the financial market in which previously
issued financial instruments such as stock, bonds, options, and futures are bought and sold.
-
-
Public market is most commonly used to describe a company's shares or any other type
of financial instrument that trades in the secondary markets. In other words, any securities
that trade on an exchange and can be bought or sold by anyone in the general population
are referred to as publicly traded securities.
-
-
Private market the private equity secondary market (also often called private equity
secondaries or secondaries) refers to the buying and selling of pre-existing investor
commitments to private equity and other alternative investment funds.
-
-
Money market the trade in short-term loans between banks and other financial institutions.
-
-
Capital market the part of a financial system concerned with raising capital by dealing in
shares, bonds, and other long-term investments.
-
-
Wholesale market
- The market for the sale of goods to a retailer. That is, a wholesaler receives large
quantities of goods from a manufacturer and distributes them to stores, where they are sold
to consumers. A wholesaler is generally able to extract a better price from the manufacturer
because it buys so many good relative to an individual retailer. In theory, this enables the
retailer to sell the good at a better price for the consumer.
- The market for the sale of securities to institutional investors rather than individuals.
-
-
Retail market
- The market for the sale of goods or services to consumers rather than producers or
intermediaries. For example, a retail clothing store sells to people who will (most likely) wear
the clothes. It does not include the sale of the clothes to other stores who will resell them.
The retail market contrasts with the wholesale market.
- The market for the sale of securities to individual investors rather than institutional
investors or broker-dealers.
-
-
- Applies to financial instruments that are used to raise capital and assets that are bought as
investments.
*Critical thinking concept: A financial instrument can be both an asset and a liability.*
- if a bank gives you a home loan that is an asset for the bank (it is making money
from you) and a liability for you (you will lose money)
define
Real risk-free interest rate: The risk-free rate of return is the theoretical rate of return of an
investment with zero risk. The risk-free rate represents the interest an investor would expect
from an absolutely risk-free investment over a specified period of time. REAL?
Nominal interest rate: refers to the interest rate before taking inflation into
account. Nominal can also refer to the advertised or stated interest rate on a loan, without
taking into account any fees or compounding of interest.
Premium: The three usages of the term premium all involve payment for something that is
perceived to have value
- option premium
- bond price premium
- insurance premium
Inflation: a general increase in prices and fall in the purchasing value of money
Inflation premium: is the part of prevailing interest rates that results from lenders
compensating for expected inflation.
Default-risk premium: is the additional amount a borrower must pay to compensate the
lender for assuming default risk. A default premium is generally paid by all companies or
borrowers indirectly, through the rate at which they must repay their obligation.
Maturity-risk premium: is the amount of extra return you'll see on your investment by
purchasing a bond with a longer maturity date. Maturity risk premiums are designed to
compensate investors for taking on the risk of holding bonds over a lengthy period of time.
Liquidity-risk premium: is a premium demanded by investors when any given security
cannot be easily converted into cash for its fair market value. When the liquidity premium is
high, the asset is said to be illiquid, and investors demand additional compensation for the
added risk of investing their assets over a longer period of time since valuations can
fluctuate with market effects
WEEK TWO WHAT IS FINANCE?
The relationship between finance and investment has been introduced, so now we confirm
your understanding and apply the concept
Be able to define:
Cost of capital - how much (%) needs to be paid for debt & equity.
WACC - measure of the cost of capital, using a weighted average of debt & equity
costs.
A lower WACC is always better. (WACC = Weighted Average Cost of Capital)
- A lower the Cost of Capital, means either Ke, Kd or both are cheaper.
- A lower WACC allows the company greater choice and flexibility of assets to buy
LC EXAMPLE:
FLOW OF FUNDS
Self-study question: Commercial Vs Investment banks? This will be explored more in Topic 7
What is another term for the flow of funds used in the textbook?
Define a financial intermediary.
Define an investment bank and a commercial bank.
What is the difference? The difference will be revisited in Topic 7: Financial Institutions.
Without the flow of funds, deficit units would be unable or would have to delay their
investment/consumption.
e.g. You wish to buy a $500,000 house, have a net income of $50,000/annum but
have no savings.
Without being able to borrow money (flow of funds from surplus to deficit units), you would
have to wait 10 years to save up enough to afford the house.
With the availability of debt, if you can afford the debt repayments, you can buy the house
now. $500,000 of consumption is brought forward 10 years. This is good for the economy.
The same analogy can be applied to investment.
e.g. You need $500,000 to start a business, have a net income of $50,000/annum
but have no savings.
Without being able to borrow money (flow of funds from surplus to deficit units), you would
have to wait 10 years to save up enough to start the business.
With the availability of debt, if you can afford the debt repayments, you can start the
business now. $500,000 of investment, purchases of equipment, hiring of staff and
other economic stimulants are brought forward 10 years. This is good for the economy.
With the flow of funds, deficit units can receive from surplus units the capital needed for
consumption and investment, at their time preference The flow of funds is required for
consumption investment to efficiently occur; both of which are is vital to economic growth
because they result in employment, productivity and wage growth.
The ways for the flow of funds to occur is through direct financing and through
intermediation. With intermediation, you can finance indirectly though an investment bank or
though another financial intermediary.
BENIFETS OF INTERMEDIATION
Asset transformation turning deposits into loans
Banks do this, take your money as finance and turn it into assets by giving you a loan
with interest.
Credit risk transformation & diversification low risk deposits turned into higher risk
loans and different types of loans.
Liquidity transformation short-term debt (deposits) used to fund long-term assets (loans)
Economies of scale the larger banks are, the cheaper intermediation becomes.
BHP decides to raise capital through a new share issue. Like any capital, the new shares will
have a cost, Ke, as investors will not buy BHP shares for free.
Which of the 3 options of raising equity capital would have the lowest cost Ke?
We just examined the benefits of Direct Finance, the first of which was ...
- Saves on the cost of intermediation; hiring a 3rd party is not free.
Raising equity through an intermediary, either an investment bank (Goldman Sachs) or a fund (Future
Fund) has a cost compared to BHP selling it's shares directly to exisiting shareholders.
Financial Markets
Rate of Return
RISK FREE RATE OF RETURN
Risk in finance is defined as uncertainty of future cash flows. Most assets have risk, some
element of future uncertainty in their earnings.
- it is widely accepted that government debt (treasury bonds and bills) is a risk-free
investment; as there will always be a government to make claims on.
As all other assets in the economy have some risk, a risk-free assets provides a benchmark
for performance;
All risky assets should earn E(R) > Risk-free rate of return or Rf
Example: If you can earn 4% risk-free and earn 10% from a risky asset, 10% -
4% = 6% is what you earn for taking risk, i.e. the risk premium.
PREMIUMS
Inflation premium: rate of return added to compensate for inflation. Higher inflation = higher
inflation premium
Default-risk premium: rate of return added to compensate for default-risk (risk of a
borrower defaulting, not making, debt repayments). Higher default risk = high default-risk
premium
Maturity-risk premium: rate of return added to compensate for assets that have longer-
terms to maturity. The longer it takes to get your money back, the more risky it is.
example: a loan of 30 years will have a higher maturity-risk than a loan of 1
year.
Risk premium = E(R)Asset Rf = Total Premium for all risks taken (see in the textbook how
different premiums are added up)
PRE LOAD TWO WHAT IS FINANCE?
The relationship between finance and investment has been introduced, so now we confirm
your understanding and apply the concept
Be able to define:
Cost of capital - how much (%) needs to be paid for debt & equity.
WACC - measure of the cost of capital, using a weighted average of debt & equity
costs.
A lower WACC is always better. (WACC = Weighted Average Cost of Capital)
- A lower the Cost of Capital, means either Ke, Kd or both are cheaper.
- A lower WACC allows the company greater choice and flexibility of assets to buy
LC EXAMPLE:
FLOW OF FUNDS
Self-study question: Commercial Vs Investment banks? This will be explored more in Topic 7
What is another term for the flow of funds used in the textbook?
Define a financial intermediary.
Define an investment bank and a commercial bank.
What is the difference? The difference will be revisited in Topic 7: Financial Institutions.
Without the flow of funds, deficit units would be unable or would have to delay their
investment/consumption.
e.g. You wish to buy a $500,000 house, have a net income of $50,000/annum but
have no savings.
Without being able to borrow money (flow of funds from surplus to deficit units), you would
have to wait 10 years to save up enough to afford the house.
With the availability of debt, if you can afford the debt repayments, you can buy the house
now. $500,000 of consumption is brought forward 10 years. This is good for the economy.
The same analogy can be applied to investment.
e.g. You need $500,000 to start a business, have a net income of $50,000/annum
but have no savings.
Without being able to borrow money (flow of funds from surplus to deficit units), you would
have to wait 10 years to save up enough to start the business.
With the availability of debt, if you can afford the debt repayments, you can start the
business now. $500,000 of investment, purchases of equipment, hiring of staff and other
economic stimulants are brought forward 10 years. This is good for the economy.
With the flow of funds, deficit units can receive from surplus units the capital needed for
consumption and investment, at their time preference The flow of funds is required for
consumption investment to efficiently occur; both of which are is vital to economic growth
because they result in employment, productivity and wage growth.
The ways for the flow of funds to occur is through direct financing and through
intermediation. With intermediation, you can finance indirectly though an investment bank or
though another financial intermediary.
BENIFETS OF INTERMEDIATION
Asset transformation turning deposits into loans
Banks do this, take your money as finance and turn it into assets by giving you a loan
with interest.
Credit risk transformation & diversification low risk deposits turned into higher risk
loans and different types of loans.
Liquidity transformation short-term debt (deposits) used to fund long-term assets (loans)
Economies of scale the larger banks are, the cheaper intermediation becomes.
BHP decides to raise capital through a new share issue. Like any capital, the new shares will
have a cost, Ke, as investors will not buy BHP shares for free.
Which of the 3 options of raising equity capital would have the lowest cost Ke?
We just examined the benefits of Direct Finance, the first of which was ...
- Saves on the cost of intermediation; hiring a 3rd party is not free.
Raising equity through an intermediary, either an investment bank (Goldman Sachs) or a fund (Future
Fund) has a cost compared to BHP selling it's shares directly to exisiting shareholders.
Financial Markets
Rate of Return
RISK FREE RATE OF RETURN
Risk in finance is defined as uncertainty of future cash flows. Most assets have risk, some
element of future uncertainty in their earnings.
- it is widely accepted that government debt (treasury bonds and bills) is a risk-free
investment; as there will always be a government to make claims on.
As all other assets in the economy have some risk, a risk-free assets provides a benchmark
for performance;
All risky assets should earn E(R) > Risk-free rate of return or Rf
Example: If you can earn 4% risk-free and earn 10% from a risky asset, 10% -
4% = 6% is what you earn for taking risk, i.e. the risk premium.
PREMIUMS
Inflation premium: rate of return added to compensate for inflation. Higher inflation = higher
inflation premium
Default-risk premium: rate of return added to compensate for default-risk (risk of a
borrower defaulting, not making, debt repayments). Higher default risk = high default-risk
premium
Maturity-risk premium: rate of return added to compensate for assets that have longer-
terms to maturity. The longer it takes to get your money back, the more risky it is.
example: a loan of 30 years will have a higher maturity-risk than a loan of 1
year.
Risk premium = E(R)Asset Rf = Total Premium for all risks taken (see in the textbook how
different premiums are added up)
WEEK TWO financial regulations and markets
WHY REGULATE
free market economics: where prices for goods and services are freely set by
supply and demand without the influence of government policy or rules
- most countries do not operate under this system
- certain market players will dominate so everyone can participate
in the flow of funds and there is equal opportunity
Monetary Policy
- Control over the supply of money.
- To affect the behaviour of borrowers and lenders (i.e. the flow of funds)
- That promotes price stability, economic stability and growth through a target
level of inflation
is EXPANSIONARY or CONTRACTIONARY
- expansionary = increases the money supply
- contractionary = decrease the money supply
FUNCTIONS
- The development, implementation and supervision of prudential regulation.
- Monitoring regulated entities to ensure they are complying with relevant
legislation and prudential policies
- Advising the government on the development of regulation and legislation
affecting regulated institutions and the financial markets in which they operate.
Self-study:
CAR is introduced as a prime example of how financial regulation can
affect the flow of funds and the cost of capital.
Now that CAR has been introduced, the implications of changes in CAR will
be discussed in the Workshop. (like we explored the impact of changes in
WACC in the prior topics PBL)
There is a self-study quiz question that starts to explore the implications
of changes in CAR on the cost of capital.
This will greatly aid in our appreciation of Topic 7 and for subject
Management of Financial Institutions
ASIC
- is responsible for the enforcement of company and financial services laws. The
objective is to protect consumers, investors and creditors
- is also responsible for licensing and monitoring financial markets, financial
instruments and advisors as well as monitoring the disclosure and conduct of
Australian companies and services providers.
RESPONSIBLE FOR:
- Regulating financial markets (e.g. ASX)
- Regulating financial instruments, securities, futures and corporations
- Consumer protection in superannuation, insurance, deposit-taking and credit
- Act to enforce and give effect to the law
- Receive, process and store information that is given to ASIC
- Make information about companies and other bodies available to the public as
soon as practicable
PRIORITIES
- Assist and protect retail investors and consumers in the financial economy
- Build confidence in the integrity of Australia's capital markets
- Facilitate international capital flows and international enforcement
- Manage the domestic and international implications of the global financial
turmoil
- Lift operational effectiveness and service levels for all ASIC stakeholders
- Improve services and reduce costs by using new technologies and processes
Self-study:
Be able to identify who and what ASIC regulates.
In the workshop, we shall explore how ASIC regulation affects the flow of
funds and cost of capital.
Optional: For those interested, you can read about the enforcement of
financial rules by ASIC in the following article
http://www.abc.net.au/news/2017-03-02/westpac-home-loans-asic-court-
action/8317750
PRELOAD THREE
WEALTH, TIME & MONEY
Value Vs Price
Value is defined as the worth of an asset, the total of what the asset can earn
over the period held. The worth of an asset typically comes from net income in
the future and terminal value.
The first step in establishing value is to estimate the components of cash flow
streams (money streams) that arise from financial products and real asset
- Examples of financial products: loans, shares, bonds.
- Examples of real assets: Real estate and equipment (that represent investable,
tangible projects).
terminal value:
Most investments have a holding period.
At the end of the holding period, the asset is sold.
As the future price is uncertain, the holder of the asset can assume and hope,
that the asset value at the end of the holding period is at least received =
terminal value.
-Be able to define value, appreciate how it is different from price and be able to
articulate why value is important in the context of investment.
-What are some other factors that affect an assets price apart from value?
Hint: what did we study last topic? Hint for another factor: when you buy
things, are you always rational?
- In the Workshop, we shall clearly define how Value and Price are used to answer
important investment questions
- What price should I pay for this investment?
- What price should I sell this asset for?
Time Value of Money the time at which money is earned or paid affects its
value or cost.
central rules
1. Money can be only be combined and compared if earned at the same time
period. (as they have the same time value)
2. Calculating a Future Value (FV) given periodic growth on an investment is
called compounding. Often used to work out what capital accumulates to in the
future given re-investment of a periodic return.
- An interest bearing deposit account with a bank
- A sinking fund or investment fund which earns a periodic return and re-
invests that return. 3. Calculating a Present Value (PV) by diminishing money
earned in the future to reflect the time value of money is called discounting.
- In capital budgeting, we discount the cash flows of assets to establish PV
today so as to compare value with todays price.
- We can discount cash flows of comparable liabilities to work out the
Present Value of cost and identify which is cheaper.
math formula
FV
FV =PV ( 1+i )n PV =
(1+i )n
Self-study:
- After your self-study reading, be clear on when you use PV and FV, i.e. when do
you discount cash flows and when do you compound them? Review Slides 10 &
11 to help.
- We pre-load you with the PV and FV of single sums. The reading will also take
you through PV and FV of multiple sums/cash flows and which we shall review
and practice in the workshop.
- In the workshop, we shall guide you through the right method for solving
financial math
- Write out the formula
- Make the correct substitutions for variables
- Work out the answer.
EFFECTIVE ANNUAL INTEREST RATE (EAR) The effective return that includes
the compounding effect of the
Self-study:
Be familiar with the common frequencies of payment of financial products.
e.g. monthly, fortnightly, weekly, semi-annually, etc., and be able to
incorporate EAR into PV and FV formula.
We shall practice this in the Workshops.
Yield, Return & Discount Rates The Yield or Return of an asset is a widely
used metric for relative performance.
Earnings
Yield=
Price
discount rate is used to calculate present value. It is often the required rate of
return and that used to discount future earnings/cash flow to a present value.
This discounting or diminishing of future earnings to a lower present value
reflects and incorporates
- The time value of money.
- Inflation
- Risk (the concept of risk and how it affects the present value of future earnings
is discussed in later topics)
Self-study:
Understanding the a discount rate is diminishing future cash flows to
establish their present value is important.
Be clear on why future cash flows are worth less today. i.e. be clear on the
concept of the time value of money.
This will set you up well for understanding how the PV formula
incorporates the time value of money, risk and inflation in its formula. We
will review this in the Workshop.
PRELOAD FOUR
annuity financial math
ANNUITIES
In finance we commonly encounter situations which calls for payments of equal
amount of cash at regular intervals of time over several time periods.
- cars, business, personal, loans, insurance policies
- When valuing annuities, rather than discount/compound each cash flow
individually, as each cash flow is the same and equally spaced over time, a
single formula can be applied for easy of understanding and calculation.
ordinary annuities
Most annuities are structured so that cash payments are paid or received at the
end of each period. As this is the most common structure, these annuities are
called ordinary.
* Also known as:
- annuity in arrears
- deferred annuity
ALWAYS ASSUME CASHS FLOWS ARE
ORDINARY UNLESS OTHERWISE STATED
valuation of annuities in arrears
- Be clear on the key defining characteristics between ordinary and annuity dues
- When do cash flows start for both? When PVing either what time period is the
PV for?
- Attempt to find examples of financial instruments/securities that provide
annuity payments
- In the Workshop, we shall practice applying these formula in annuity math.
deferred annuity
Annuities that do not start in Y0 but in the future.
This methodology will be used frequently in numerous later finance subjects.
example
- An ORDINARY ANNUITY starts in 3 years from today for 4 years.
- Methodology for solving this Deferred Ordinary Annuity starting in Y3 , where n
= 4: Construct the
time line then
[ ]
1+ g n1
perpetuity
An annuity where the cash flow continues for an indefinite period
In preparation for this Topics workshop, make sure you are also
comfortable with the prior Topics Workshop LC and PBL questions.
Be practiced at drawing time lines, applying formula and
establishing the correct n and i under various investment or
liability scenarios.
If unclear, see staff in consultation to make sure you understand
the last topic as well as possible.
Calculating FV
Calculation PV
EAR (effective annual rate)
It is important to
distinguish between various types of return:
Nominal return:
- Also known as the annual percentage return (APR).
Effective return: e.g. EAR
- The return that includes the effect of compounding.
Real return.
- The return that accounts for the erosion of purchasing power due to
inflation.
Required rate of return
- The minimum return needed. WACC is an example of a RRoR.
Expected rate of return
- The anticipated/forecasted return that will be earned on an asset.
PRELOAD WEEK FIVE
financial choices and decisions (capital budgeting)
what it involves
- Estimating CFs (inflows & outflows) through a timeline.
- Assessing the riskiness of CFs.
- Determining an appropriate discount rate (typically WACC)
- Finding Payback period, NPV and IRR.
- Acceptance of project if NPV > 0 and/or IRR > discount rate (typically WACC).
PAYBACK PERIOD the amount of time it takes for the asset to recoup the
investment outlay (asset cost).
A time line is usually set up with the investment outlay as a running cost being
diminished over time by the periodic net earnings of the asset.
- The shorter the payback period, the better investment.
Example:
wacc
How do changes in WACC affect NPV?
WACC = NPV, WACC = NPV
How and why might WACC change?
- Changes in capital structure
- Changes in the cost of debt and/or cost of equity.
E D
WACC= x ke + x k d
V V
Example: A company is finances 30% of it's capital through debt. The cost of
equity is 15% and the cost of debt is 9%. What is the WACC of the company?
WACC = 30% x 9% + (1-0.3) x 15% = 13.2%
Critical Thinking Concept: For a given company, Ke > Kd
- Why? From Microeconomics, we learn about the pecking order of payments in a
company. The last two stakeholders to be paid are debt holders (capital
creditors) and finally, equity holders.
- As equity investors are paid last, or perhaps not at all, their risk is always
higher than debt capital creditors (who always have to be paid).
- So given the choice of investing in the debt or equity of a company, a rational
investor would always require a higher rate of return for the companys equity.
Hence Ke > Kd
However, as Kd < Ke, would there not be an automatic bias for company
managers to finance most of capital through cheaper debt rather than equity, so
as to lower WACC?
D E
- Yes, Ke > Kd capital structure, favouring D; where V V
D E
- V means a greater weight applied to the lower K d, V means a lesser
summary
- A capital structure favouring debt = WACC as a greater weight is applied to
the cheaper form of capital.
- However, Ke as the remaining equity holders, facing greater risk, would
required a higher return. This WACC.
D
- The opposite is also true. V = lower weight on the cheaper form of capital,
WACC, but Ke then as equity holders face less risk with less debt in the
company; WACC.
- Our above understanding of the relationship between K e, Kd and capital
structure is all that is required for BFC1001.
- These competing & offsetting forces mean there is an optimal, minimal WACC;
which is explored in Corporate Finance II.
IRR RRoR
IRR is solving for i the per period growth of capital invested in the project
In NPV, we are solving for PV, applying a discount rate, which is a required rate of
return
IRR > RRoR, accept project. IRR < RRoR, reject
PBL QUESTIONS
PBL1
PBL2
PBL3
Colgate is considering establishing a new toothpaste product which is
forecasted to have revenue in the first year of $600,000. Revenue is projected
to increase at 5% p.a., operating costs are 20% of annual revenue and the
product life is 5 years. With an initial investment of $2mil and a WACC of 12%,
should Colgate go ahead with the new product? Use NPV & IRR to justify your
answer.
PBL4
BHP is considering buying in a new iron ore mine which is forecasted to start earning
$5,000,000 of revenue in the second year of operation. Revenue is projected to increase at 10%
p.a., operating costs are 25% of annual revenue and the mine is kept for 3 years, after which it
is expected to be sold for $5mil.
Setting up the mine requires $2mil today and $4mil in the first year. 60% of BHPs capital is
financed through debt which has a cost of 8% and shareholders expect a 14% return on their
equity. Does the new iron ore mine add to shareholders wealth? Use NPV and IRR to justify
your answer.