postfile_4027 by liuhongmei

VIEWS: 29 PAGES: 419

									          Chapter 1
     Time Value of Money



•   Future value
•   Present value
•   Rates of return
•   Amortization

               CHY         1
   Time lines show timing of cash flows.


  0           1           2           3
       i%

 CF0         CF1          CF2        CF3


Tick marks at ends of periods, so Time 0
is today; Time 1 is the end of Period 1;
or the beginning of Period 2.
                    CHY                    2
Time line for a $100 lump sum
  due at the end of Year 2.

    0        1        2 Year
        i%

                     100



             CHY                3
 Time line for an ordinary
annuity of $100 for 3 years.

0         1           2     3
    i%

         100         100   100



               CHY               4
Time line for uneven CFs: -$50
  at t = 0 and $100, $75, and
   $50 at the end of Years 1
            through 3.
 0          1          2    3
      i%

-50        100         75   50



                 CHY             5
  What’s the FV of an initial
$100 after 3 years if i = 10%?
 0          1          2          3
      10%

100                            FV = ?


Finding FVs (moving to the right
on a time line) is called compounding.
                 CHY                     6
After 1 year:
    FV1 = PV + INT1 = PV + PV (i)
         = PV(1 + i)
         = $100(1.10)
         = $110.00.
After 2 years:
   FV2 = FV1(1+i) = PV(1 + i)(1+i)
       = PV(1+i)2
       = $100(1.10)2
       = $121.00.
                   CHY               7
After 3 years:
    FV3 = FV2(1+i)=PV(1 + i)2(1+i)
        = PV(1+i)3
        = $100(1.10)3
        = $133.10.
In general,

    FVn = PV(1 + i)n.


                 CHY                 8
      Three Ways to Find FVs


• Solve the equation with a regular
  calculator.
• Use a financial calculator.
• Use a spreadsheet.




                  CHY                 9
     Financial calculator: HP17BII

• Adjust display contrast: hold down CLR
  and push + or -.
• Choose algebra mode: Hold down
  orange key (i.e., the shift key), hit
  MODES (the shifted DSP key), and
  select ALG.
• Set number of decimal places to display:
  Hit DSP key, select FIX, then input
  desired decimal places (e.g., 3).
                    CHY                      10
          HP17BII (Continued)

• Set decimal mode: Hit DSP key, select
  the ―.‖ instead of the ―,‖. Note: many
  non-US countries reverse the US use of
  decimals and commas when writing a
  number.




                   CHY                     11
  HP17BII: Set Time Value Parameters

• Hit EXIT until you get the menu starting
  with FIN. Select FIN.
• Select TVM.
• Select OTHER.
• Select P/YR. Input 1 (for 1 payment per
  year).
• Select END (for cash flows occuring at
  the end of the year.)
                    CHY                      12
 Financial Calculator Solution


Financial calculators solve this
equation:



There are 4 variables. If 3 are
known, the calculator will solve
for the 4th.

               CHY                 13
Here’s the setup to find FV:


 INPUTS   3   10   -100    0
          N   I/YR PV     PMT     FV
OUTPUT                          133.10


Clearing automatically sets everything
to 0, but for safety enter PMT = 0.
       Set: P/YR = 1, END.
                   CHY                   14
          Spreadsheet Solution

• Use the FV function: see spreadsheet in
  Ch 02 Mini Case.xls.
  – = FV(Rate, Nper, Pmt, PV)
  – = FV(0.10, 3, 0, -100) = 133.10




                      CHY                   15
  What’s the PV of $100 due in
      3 years if i = 10%?
  Finding PVs is discounting, and it’s
  the reverse of compounding.

   0           1         2          3
         10%


PV = ?                             100

                   CHY                   16
Solve FVn = PV(1 + i )n for PV:




                  3
          1 
PV = $100      
          1.10 
   = $100 0.7513  = $75.13.
                 CHY              17
    Financial Calculator Solution


INPUTS   3    10               0    100
         N   I/YR      PV     PMT   FV
OUTPUT               -75.13



Either PV or FV must be negative. Here
PV = -75.13. Put in $75.13 today, take
out $100 after 3 years.
                    CHY                   18
          Spreadsheet Solution

• Use the PV function: see spreadsheet.
  – = PV(Rate, Nper, Pmt, FV)
  – = PV(0.10, 3, 0, 100) = -75.13




                      CHY                 19
      Finding the Time to Double
 0           1          2          ?
      20%


 -1                                2
     FV = PV(1 + i)n
     $2 = $1(1 + 0.20)n
  (1.2)n = $2/$1 = 2
nLN(1.2) = LN(2)
       n = LN(2)/LN(1.2)
       n = 0.693/0.182 = 3.8.
                  CHY                  20
         Financial Calculator


INPUTS        20      -1    0    2
        N    I/YR     PV   PMT   FV
OUTPUT 3.8




                    CHY               21
          Spreadsheet Solution

• Use the NPER function: see
  spreadsheet.
  – = NPER(Rate, Pmt, PV, FV)
  – = NPER(0.10, 0, -1, 2) = 3.8




                      CHY          22
      Finding the Interest Rate
0           1          2          3
     ?%


-1                                2
     FV = PV(1 + i)n
     $2 = $1(1 + i)3
 (2)(1/3) = (1 + i)
1.2599 = (1 + i)
       i = 0.2599 = 25.99%.
                 CHY                  23
         Financial Calculator


INPUTS   3             -1    0    2
         N   I/YR      PV   PMT   FV
OUTPUT       25.99




                     CHY               24
          Spreadsheet Solution

• Use the RATE function:
  – = RATE(Nper, Pmt, PV, FV)
  – = RATE(3, 0, -1, 2) = 0.2599




                     CHY           25
   What’s the difference between an
 ordinary annuity and an annuity due?

Ordinary Annuity
  0            1           2      3
       i%

              PMT         PMT    PMT
Annuity Due
  0            1           2      3
       i%

 PMT          PMT         PMT
 PV                 CHY          FV     26
What’s the FV of a 3-year
ordinary annuity of $100 at
          10%?
0          1           2          3
    10%

          100         100        100
                                 110
                                 121
                            FV = 331

                CHY                    27
           FV Annuity Formula

• The future value of an annuity with n
  periods and an interest rate of i can be
  found with the following formula:




                     CHY                     28
  Financial Calculator Formula
          for Annuities

 Financial calculators solve this
 equation:




There are 5 variables. If 4 are
known, the calculator will solve
for the 5th.
                CHY                 29
   Financial Calculator Solution


INPUTS   3    10          0    -100
         N   I/YR         PV   PMT     FV
OUTPUT                                331.00



Have payments but no lump sum PV,
so enter 0 for present value.

                    CHY                        30
          Spreadsheet Solution

• Use the FV function: see spreadsheet.
  – = FV(Rate, Nper, Pmt, Pv)
  – = FV(0.10, 3, -100, 0) = 331.00




                      CHY                 31
What’s the PV of this ordinary
          annuity?

  0            1           2     3
      10%

              100         100   100
 90.91
 82.64
 75.13
248.69 = PV
                    CHY              32
           PV Annuity Formula

• The present value of an annuity with n
  periods and an interest rate of i can be
  found with the following formula:




                     CHY                     33
   Financial Calculator Solution
INPUTS   3    10              100   0
         N   I/YR    PV       PMT   FV
OUTPUT              -248.69


Have payments but no lump sum FV,
so enter 0 for future value.



                    CHY                  34
          Spreadsheet Solution

• Use the PV function: see spreadsheet.
  – = PV(Rate, Nper, Pmt, Fv)
  – = PV(0.10, 3, 100, 0) = -248.69




                      CHY                 35
 Find the FV and PV if the
annuity were an annuity due.

 0           1           2    3
      10%


100         100         100


                  CHY             36
        PV and FV of Annuity Due
          vs. Ordinary Annuity

• PV of annuity due:
  – = (PV of ordinary annuity) (1+i)
  – = (248.69) (1+ 0.10) = 273.56
• FV of annuity due:
  – = (FV of ordinary annuity) (1+i)
  – = (331.00) (1+ 0.10) = 364.1


                       CHY             37
Switch from “End” to “Begin”.
Then enter variables to find PVA3 =
$273.55.

 INPUTS   3    10                100   0
           N   I/YR         PV   PMT   FV
 OUTPUT               -273.55


Then enter PV = 0 and press FV to find
FV = $364.10.
                      CHY                   38
Excel Function for Annuities
           Due
Change the formula to:
          =PV(10%,3,-100,0,1)
The fourth term, 0, tells the function
there are no other cash flows. The
fifth term tells the function that it is an
annuity due. A similar function gives
the future value of an annuity due:
          =FV(10%,3,-100,0,1)
                   CHY                        39
 What is the PV of this uneven
              cash
          flow stream?
   0         1    2    3      4
       10%

         100     300   300   -50
 90.91
247.93
225.39
-34.15
530.08 = PV
                 CHY               40
• Input in ―CFLO‖ register:
  CF0   = 0
  CF1   = 100
  CF2   = 300
  CF3   = 300
  CF4   = -50
• Enter I = 10%, then press NPV button to
  get NPV = 530.09. (Here NPV = PV.)


                   CHY                  41
         Spreadsheet Solution


        A        B         C     D     E
1       0        1         2     3     4
2              100         300   300   -50
3    530.09
    Excel Formula in cell A3:
       =NPV(10%,B2:E2)
                     CHY                     42
     Nominal rate (iNom)
• Stated in contracts, and quoted by banks and
  brokers.
• Not used in calculations or shown on time
  lines
• Periods per year (m) must be given.
• Examples:
  – 8%; Quarterly
  – 8%, Daily interest (365 days)



                         CHY                     43
       Periodic rate (iPer )
• iPer = iNom/m, where m is number of
  compounding periods per year. m = 4 for
  quarterly, 12 for monthly, and 360 or 365 for
  daily compounding.
• Used in calculations, shown on time lines.
• Examples:
  – 8% quarterly: iPer = 8%/4 = 2%.
  – 8% daily (365): iPer = 8%/365 = 0.021918%.




                       CHY                        44
 Will the FV of a lump sum be
     larger or smaller if we
compound more often, holding
the stated I% constant? Why?
LARGER! If compounding is more
frequent than once a year--for
example, semiannually, quarterly,
or daily--interest is earned on interest
more often.

                  CHY                      45
   FV Formula with Different
Compounding Periods (e.g., $100
   at a 12% nominal rate with
 semiannual compounding for 5
            years)  mn
                  iNom
    FVn = PV 1 +              .
                        m
                                2x5
    FV5S          1 + 0.12
           = $100         
                       2 
           = $100(1.06)10     = $179.08.

                   CHY                     46
 FV of $100 at a 12% nominal
 rate for 5 years with different
          compounding
FV(Annual)= $100(1.12)5 = $176.23.
FV(Semiannual)= $100(1.06)10=$179.08.
FV(Quarterly)= $100(1.03)20 = $180.61.
FV(Monthly)= $100(1.01)60 = $181.67.
FV(Daily) = $100(1+(0.12/365))(5x365)
          = $182.19.

                   CHY                   47
  Effective Annual Rate (EAR =
             EFF%)
• The EAR is the annual rate which causes PV to
  grow to the same FV as under multi-period
  compounding Example: Invest $1 for one year at
  12%, semiannual:
           FV = PV(1 + iNom/m)m
           FV = $1 (1.06)2 = 1.1236.
 EFF% = 12.36%, because $1 invested for one
  year at 12% semiannual compounding would
  grow to the same value as $1 invested for one
  year at 12.36% annual compounding.
                        CHY                       48
• An investment with monthly
  payments is different from one with
  quarterly payments. Must put on
  EFF% basis to compare rates of
  return. Use EFF% only for
  comparisons.
• Banks say ―interest paid daily.‖
  Same as compounded daily.

                  CHY                   49
How do we find EFF% for a nominal
    rate of 12%, compounded
          semiannually?
                   iNom m
              (
      EFF% = 1 +
                    m  )  -1
                        2

            = (1 + 0.12) - 1.0
                    2
            = (1.06)2 - 1.0
            = 0.1236 = 12.36%.

               CHY                  50
    Finding EFF with HP17BII
• Go to menu starting TVM.
• Select ICNV (for int.rate conversion).
• Select PER (for periodic compounding).
• Enter nominal rate and select NOM%.
• Enter number of periods per year and
  select P.
• Select EFF%, which returns effective rate.



                    CHY                    51
EAR (or EFF%) for a Nominal
      Rate of of 12%

EARAnnual                           = 12%.

EARQ        = (1 + 0.12/4)4 - 1     = 12.55%.

EARM        = (1 + 0.12/12)12 - 1   = 12.68%.

EARD(365) = (1 + 0.12/365)365 - 1 = 12.75%.


                       CHY                      52
Can the effective rate ever be
 equal to the nominal rate?

• Yes, but only if annual compounding is
  used, i.e., if m = 1.
• If m > 1, EFF% will always be greater
  than the nominal rate.


                   CHY                     53
  When is each rate used?


iNom: Written into contracts, quoted
      by banks and brokers. Not
      used in calculations or shown
      on time lines.




                 CHY                   54
iPer: Used in calculations, shown on
      time lines.


 If iNom has annual compounding,
 then iPer = iNom/1 = iNom.




                 CHY                   55
EAR = EFF%: Used to compare
            returns on investments
            with different payments
            per year.


(Used for calculations if and only if
dealing with annuities where
payments don’t match interest
compounding periods.)
                  CHY                   56
         Amortization


Construct an amortization schedule
for a $1,000, 10% annual rate loan
with 3 equal payments.




                CHY                  57
      Step 1: Find the required
             payments.
  0                 1                 2                 3
         10%

-1,000             PMT               PMT               PMT

 INPUTS        3        10     -1000               0
               N        I/YR     PV       PMT      FV
OUTPUT                                    402.11

                               CHY                           58
 Step 2: Find interest charge
         for Year 1.
    INTt = Beg balt (i)
    INT1 = $1,000(0.10) = $100.

Step 3: Find repayment of principal in
        Year 1.
               Repmt = PMT - INT
                     = $402.11 - $100
                     = $302.11.
                  CHY                    59
Step 4: Find ending balance
after
        Year 1.
 End bal = Beg bal - Repmt
         = $1,000 - $302.11 = $697.89.


Repeat these steps for Years 2 and 3
to complete the amortization table.

                 CHY                     60
        BEG                          PRIN    END
YR      BAL     PMT         INT      PMT     BAL

 1    $1,000   $402       $100       $302 $698
 2       698     402         70        332   366
 3       366     402         37        366     0
TOT            1,206.34     206.34   1,000


     Interest declines. Tax implications.

                      CHY                          61
     $
402.11
                    Interest

302.11

             Principal Payments



         0      1              2    3
Level payments. Interest declines because
outstanding balance declines. Lender earns
10% on loan outstanding, which is falling.
                     CHY                 62
• Amortization tables are widely used-
  -for home mortgages, auto loans,
  business loans, retirement plans,
  and so on. They are very important!
• Financial calculators (and
  spreadsheets) are great for setting
  up amortization tables.


                  CHY                    63
On January 1 you deposit $100 in an
account that pays a nominal interest
rate of 11.33463%, with daily
compounding (365 days).
How much will you have on October
1, or after 9 months (273 days)?
(Days given.)


                 CHY
    iPer = 11.33463%/365
         = 0.031054% per day.
   0               1         2          273
       0.031054%

  -100                                 FV=?


  FV273 = $1001.00031054
                                 273

        = $1001.08846 = $108.85.

Note: % in calculator, decimal in equation.
                       CHY
 iPer = iNom/m
      = 11.33463/365
      = 0.031054% per day.

INPUTS      273            -100      0
            N     I/YR         PV   PMT    FV
OUTPUT                                    108.85



           Enter i in one step.
         Leave data in calculator.
                         CHY
What’s the value at the end of
 Year 3 of the following CF
stream if the quoted interest
 rate is 10%, compounded
        semiannually?
0        1    2    3      4    5    6    6-mos.
    5%                                  periods

             100         100       100


                   CHY                       67
• Payments occur annually, but
  compounding occurs each 6 months.
• So we can’t use normal annuity
  valuation techniques.




                CHY                   68
1st Method: Compound Each
            CF
0        1    2     3     4    5    6
    5%

             100         100       100.00
                                   110.25
                                   121.55
                                   331.80

FVA3 = $100(1.05)4 + $100(1.05)2 + $100
     = $331.80.
                   CHY                  69
  2nd Method: Treat as an Annuity

Could you find the FV with a
   financial calculator?
Yes, by following these steps:

a. Find the EAR for the quoted rate:
                        2

  EAR =   (     0.10
              1+ 2     ) - 1 = 10.25%.
                  CHY                    70
b. Use EAR = 10.25% as the annual rate
in your calculator:


 INPUTS   3   10.25        0    -100
          N   I/YR         PV   PMT     FV
OUTPUT                                 331.80



                     CHY                        71
 What’s the PV of this stream?
  0         1           2     3
      5%

           100         100   100

 90.70
 82.27
 74.62
247.59
                 CHY               72
You are offered a note which pays
$1,000 in 15 months (or 456 days)
for $850. You have $850 in a bank
which pays a 6.76649% nominal rate,
with 365 daily compounding, which
is a daily rate of 0.018538% and an
EAR of 7.0%. You plan to leave the
money in the bank if you don’t buy
the note. The note is riskless.
Should you buy it?
                CHY
  iPer =0.018538% per day.

  0                365           456 days


 -850                           1,000


3 Ways to Solve:

1. Greatest future wealth: FV
2. Greatest wealth today: PV
3. Highest rate of return: Highest EFF%
                    CHY
1. Greatest Future Wealth
  Find FV of $850 left in bank for
  15 months and compare with
  note’s FV = $1,000.

   FVBank = $850(1.00018538)456
          = $924.97 in bank.

   Buy the note: $1,000 > $924.97.

                 CHY
 Calculator Solution to FV:
 iPer = iNom/m
      = 6.76649%/365
      = 0.018538% per day.

INPUTS    456            -850      0
           N    I/YR         PV   PMT    FV
OUTPUT                                  924.97



  Enter iPer in one step.
                       CHY
2. Greatest Present Wealth


  Find PV of note, and compare
  with its $850 cost:

  PV = $1,000/(1.00018538)456
     = $918.95.



                 CHY
          6.76649/365 =
INPUTS   456 .018538              0    1000
          N    I/YR         PV   PMT    FV

OUTPUT                 -918.95




 PV of note is greater than its $850
 cost, so buy the note. Raises your
 wealth.
                      CHY
3. Rate of Return

  Find the EFF% on note and
  compare with 7.0% bank pays,
  which is your opportunity cost of
  capital:
            FVn = PV(1 + i)n
         $1,000 = $850(1 + i)456

  Now we must solve for i.
                    CHY
INPUTS   456          -850    0    1000
         N        I/YR  PV   PMT   FV
OUTPUT         0.035646%
                per day


Convert % to decimal:
Decimal = 0.035646/100 = 0.00035646.

EAR = EFF% = (1.00035646)365 - 1
           = 13.89%.
                    CHY
Using interest conversion:

 P/YR = 365
NOM% = 0.035646(365) = 13.01
EFF% = 13.89


Since 13.89% > 7.0% opportunity cost,
buy the note.

                  CHY
 OVERVIEW AND
  THE COST OF
    CAPITAL
[公司理財與資金成本
       ]
     CHY    82
     I. OVERVIEW OF FINANCIAL
               MANAGEMENT
The value of any investment
  = present value of the future cash
     flows that it is expected to generate
     for the investor.
  ( 投資價值
    = 投資人預計未來現金流入的現值 )



                    CHY                  83
           經理人應該 . . .
1. Use the existing firm assets in ways that
   will maximize the cash flows that can be
   generated from them, and which are free
   to be paid to the investors 〔尋求自由現
   金流量最大〕.
2. Accelerate these free cash flows into
   nearby time periods [如果能夠早日回收, 現
   值會更高] to the extent it is feasible to do
   so, because it is the present value of the
   free cash flows that determine
   shareholder value.
                    CHY                         84
            經理人應該 . . .
3. Balance the cash flow generation potential
    of the firm against the risks that must be
    taken to achieve it. Investors know that
    some risk has to be taken to operate a
    business. However, they do not like
    management to take unwarranted risks. 〔
    避免承擔無謂的風險〕
4. Make capital budgeting decisions that will
    enhance the economic value of the firm and
    its equity shares. [適當的資本預算決策,選擇有
    利的投資方案]
                     CHY                    85
5. Minimize the firm’s cost of capital by designing
    an optimum capital structure. [適當的資本結構
    決策, 尋求低資金成本〕

6. Choose an optimal dividend policy [適當的股
    利政策] that will properly balance the following
    objectives:
   – Fund all worthwhile investment
      opportunities. [不要為發放股利犧牲好方案]
   – Maintain the optimum capital structure. [盡量
      維持最適資本結構]
   – Satisfy shareholder preferences for
      dividends versus capital gains 〔資本利得
      〕.
                       CHY                     86
B. AGENCY ISSUES〔代理人問題
             〕
•
    ~ 【利益衝突】但是經理人未必以上
    述當作之事為首要目標,而或有自利
    心
    ~ 今天大家談公司治理, 實為解決代理
    問題


            CHY           87
B. AGENCY ISSUES〔代理人問題〕
 – Managers may opt to increase their salaries and
   perquisites [經理人在意薪資津貼, 勝過如何為股東
   賺取股利], rather than increase shareholder
   dividends.
 – Managers may engage in ― empire building‖ by
   using corporate cash flow to make acquisitions
   that increase the size of the enterprise in order to
   enhance their own prestige without
   commensurately enhancing earnings. 〔利用企
   業資源, 建立自己的王國〕

                         CHY               Page 13 88
– Managers might use corporate funds to
  contribute to their favorite charities or political
  parties to enhance their own reputations at the
  expense of maximizing shareholder wealth. 〔
  利用企業資金, 參與社會, 政治活動〕
– Managers might employ various measures to
  insulate themselves from investors who are
  dissatisfied with their performance by
  recommending persons that are friendly to them
  for positions on the board of directors, enacting
  “golden parachutes,” and so forth 〔防範股東
  牽絆, 找友好者擔任董事; 制定”金降落傘” 協
  議(如果企業被併購, 將鉅額酬庸經理人)〕 CHY                        89
    C. MANAGEMENT MOTIVATION

•   Management Compensation 〔隨績效變動
    經理人薪酬; 高階員工認股權Executive
    Stock Options〕
•   Intervention 〔強有力的機構投資人
    Institutional Investors 干預經理人不當決策
    〕
•   Replacement [汰換不適任者]
•   Takeover Threats 〔如果內部制衡機制不
    彰, 併購與解聘威脅可以讓經理人不至於
    濫用企業資源或鬆懈〕
                  CHY               90
AGENCY ISSUES〔代理人問題〕
       其實又有兩類
• 經理人 (Managers) 與 股東
  (Shareholders)間 有 代理人問題

• 債權人 (Banks, Bondholders)與 股
  東 (Shareholders)間 也有 代理人問
  題

              CHY               91
 II.    THE COST OF CAPITAL
                       〔資金成本]

A. THE COST OF A FIRM’S CAPITAL
    COMPONENTS
  – Debt    〔負債〕
  – Preferred equity    [特別股]
  – Retained earnings 〔保留盈餘〕
  – Newly issued common stock[新的普通股
    有發行成本flotation costs]


                       CHY            92
    A. THE COST OF A FIRM’S
     CAPITAL COMPONENTS
•   The Cost of Debt 〔負債〕 Capital


    rafter-tax = (1-t)rD



                   CHY              93
 Example:      A firm’s bonds are rated Baa.
 Currently, new Baa bonds are being issued
 with a coupon of 7%.

 Assuming a corporate income tax rate of
 35%, what is the after-tax cost of debt capital
 for the firm?
Answer:
  rafter-tax = (1-t)rD =(1-0.35)(7%) =4.55%

[如果同時看到coupon 與Yield to Maturity, 請用
  YTM]        CHY                   94
   A. THE COST OF A FIRM’S
    CAPITAL COMPONENTS
2. The Cost of Preferred Stock [特別股]
  Capital




                  CHY                  95
Example:
      What is the cost of the preferred capital
of a firm whose currently outstanding
preferred shares pay a dividend of $4.50 per
share and the preferred shares are trading
at $60 per share?
Answer:
   rp = DIVp = $4.50 = 7.5%
         PPS    $60


                      CHY                    96
    A. THE COST OF A FIRM’S
     CAPITAL COMPONENTS
3. The Cost of Retained Earnings 〔保留
    盈餘〕(Common equity)
    a. The Capital Asset Pricing Model (CAPM)
      Approach [資本資產定價模型]:


     rCE = rF + βCS(rM – rF)

                     CHY                    97
Example:
The Acme Corporation’s common shares
have a beta of 1.2. The stock market has a
long-run expected return of 10% per year. If
the risk-free rate is 4%, estimate Acme’s
cost of retained earnings.
Answer:
   rCE = rF + βCS(rM – rF)
       = 4% + 1.2(10% -4%)
       = 11.2%

                     CHY                   98
    A. THE COST OF A FIRM’S
     CAPITAL COMPONENTS
3. TheCost of Retained Earnings 〔保留盈餘〕
(Common equity)
   b. The Dividend-Yield-Plus-Growth-
     Rate ( or Implied Return) Approach:




                  CHY                99
Example:        The Ajax Company currently (小
心 這是關鍵字)pays a dividend of $2.00 per
share on its common shares. The long-term
dividend growth rate is expected to be 5% per
year. If Ajax common shares are currently selling
at $25 per share, estimate Ajax’s cost of
retained earnings capital.


Answer:




                         CHY                        100
   A. THE COST OF A FIRM’S
    CAPITAL COMPONENTS
3. The Cost of Retained Earnings 〔保留盈
   餘〕(Common equity)
   c. The Bond-Yield-Plus-Risk-Premium
     Approach




                  CHY                101
Example:
      The XYZ Corporation’s common
shares should sell at a premium of 4%
over its long-term debt yield to compensate
for their risk. If XYZ’s long-term debt is
selling to yield 6.3%, estimate XYZ’s cost
of internal equity.
Answer:




                    CHY                   102
    A. THE COST OF A FIRM’S
     CAPITAL COMPONENTS
4. Cost of Newly Issued Common Stock
   [新的普通股 有發行成本flotation costs]
(Also Called the Cost of External Equity)




                    CHY                 103
Example:        The XYZ Corporation’s common
shares are trading at $40. The Company currently
is paying a dividend of $2.50 per share on its
common stock.

If it were to sell additional common shares, its
flotation cost 〔發行成本〕 would be 15%. If the
Company has a 4% long-term growth rate in
dividends per share, calculate its cost of newly
issued common stock (external equity).
Answer:


                        CHY                        104
 B. DETERMINING A FIRM’S
OPTIMUM CAPITAL STRUCTURE
•   The optimal capital structure (最適資本結構
    ) of a firm is defined as that mix of capital
    sources that will maximize the value of a
    firm taken as a whole.
•   One of the important issues in finance is
    how a management should determine what
    its optimal capital structure should be.
•   Once determined, this is target capital
    structure that the firm should seek to
    maintain.
                      CHY                    105
C. THE WEIGHTED-AVERAGE COST
 OF CAPITAL 〔加權平均資金成本〕
 • The firm’s weighed-average cost of capital
   (WACC) can be found using the target
   capital structure [要用目標的資本結構] and
   the component capital costs.

 • A firm’s cost of funds is called its weighted-
   average cost of capital


                       CHY                    106
                     WACC




•   The value of the company is the sum of the
    market values 【盡量用市值而非帳面值】of
    each component, while the value of the stock
    is the market value of the firm’s outstanding
    common stock.

                        CHY                         107
Example:
Consider a company with the following capital
structure:
               Capital Structure
       Book Value 帳面值 Market Value市值
Debt           $100 million     $106 million
Preferred Stock 50                52
Common Equity 350                 842
Total Invested
    Capital    $500 million       $1,000 million

                        CHY                     108
Example continued…
Some other characteristics of the company are:

•    Beta of the common stock………….1.07x
•    Expected secular growth rate ………6.0%
•    Quality of debt ……..…………………..Aa
•    Quality of preferred shares…..……….A
•    Expected Dividend yield on common
                               stock…….3.7%
•    Marginal income tax rate…………..35.0%


                       CHY                       109
Example continued…
 The prevailing financial market conditions are as
follows:

Quality          Yields on Newly Issued Bonds by Qlty
   Aaa                       6.9%
   Aa                        7.0
   A                         7.2
   Baa                       7.5
Quality          Yields on Newly Issued Preferred
                        Stocks by Quality
   A                         7.5%
   B                         8.0
   C                         8.9
Risk-free rate………………………………                     6.5%
Equity risk premium over bonds ………….           2.7
Expected return on stock market index……
                        CHY                    9.5110
Example continued…
What is the company’s weighted-average cost of
capital 〔加權平均資金成本〕?
Answer:
    From these data we can find each of the
    component costs and, subsequently, the
    weighted-average cost of capital.

   The cost of debt is 7.0% on a pretax basis, as this
   is the cost of newly issued bonds of equal quality
   (Aa rating).

   The cost of preferred stock is 7.5%, which is
   equal to the cost of newly issued preferred stocks
   of similar quality.
                       CHY                             111
                                   Continue on next page
The cost of common equity capital, which is the
cost of retained earnings, (rCE) can be calculated in
one of three ways:
•   rCE=rD+rERP=7.0% + 2.7%=9.7%*
•




•   rCE=rF+b CS(rm-rF)
       = 6.5% +1.07(9.5-6.5)
       =9.7%*
                         CHY                       112
Therefore, the weighted-average cost of capital
〔加權平均資金成本〕 of the firm under these
conditions is:




                       CHY                    113
      D. THE MARGINAL COST OF
      CAPITAL 〔加權平均資金成本〕
Example: A company’s capital structure is as
   follows:

Source Capital Structure Weight Component Cost
Debt     $400 million     50%       6%
Equity    400 million     50%      12%
                     WACCexisting = 9%

The firm must raise $100 m in new capital and
   plans to maintain its current capital structure.
   Assume that retained earnings are exhausted
   as a source of new capital.
                          CHY                       114
=>Thus, new debt in the amount of $50 m
  will be issued at an after-tax cost of 6%
  and the other $50 m will come from newly
  issued common equity.
  Because of floatation costs, new common
  shares have a cost of 14% instead of the
  12% cost of retained earnings. Under
  these conditions,
• what will be the firm’s marginal
 cost of this $100 million unit of
 capital? 〔新籌措$100Mil 資金的邊
 際成本〕
                    CHY                   115
Answer:
   The firm’s marginal cost of this last $100 million unit
   of capital is 10%, which is calculated as follows:

Source   Capital Struc.    Weight    Component     W.
                                        Cost     Cost
   Debt $50 million        50%       6% 0.5(6%) =3%
   Equity 50 million       50%      14% 0.5(14%) = 7%
                                                =10%

                           CHY                        116
    E. FACTORS AFFECTING THE
         COST OF CAPITAL
•    Factors That the Firm Can Control
    – Capital Structure 〔資本結構影響加權平均
       資金成本〕
    – Dividend Policy 〔多付股利會增加負債比率,
      影響資金成本〕
    – Investment Policy [投資於高風險方案者資金成
      本高]



                  CHY              117
THE BASICS OF CAPITAL
     BUDGETING




         CHY            118
       I. INTRODUCTION

 Capital budgeting is the process of
analyzing projects in order to decide which
ones should be undertaken.




                   CHY                   119
II. RANKING CAPITAL PROJECTS
A. FOUR METHODS AND THEIR
  CALCULATION
 1.Payback Period
 2.Discounted Payback Period
 3.Net Present Value (NPV)
 4.Internal Rate of Return (IRR)




                      CHY          120
    3. Net Present Value (NPV)
Example:
   Calculate the net present value of the above
   project whose cost of capital is 10%.
Answer:
    Year         Cash Flow        P.V. of Cash Flow
      0         $(100,000)               $(100,000)
      1           20,000                  18,182
      2           40,000                  33,058
      3           60,000                  45,079
      4           30,000                  20,490
      5           10,000                   6,209
                                         $ 23,018
                       CHY                        121
    3. Net Present Value (NPV)
•   A project whose net present value is equal to
    or greater than zero is one that is expected to
    produce a rate of return that is equal to or
    greater than the cost of capital required to
    justify it. Such a project should be undertaken.
    A project with a negative net present value is
    one that is expected to produce a rate of return
    less than the cost of capital required to justify
    it. Such a project should be rejected.

                         CHY                       122
4. Internal Rate of Return (IRR)
Example:
 What is the internal rate of return for the
 project in the previous problem?




                      CHY                      123
4. Internal Rate of Return (IRR)
Answer:
   An internal rate of return requires a trial and error
   solution. However, using the cash flow functions of a
   financial calculator, the internal rate of return can be
   quickly determined. This is shown using the following
   cash flows:
      Year          Cash Flow
      0             $(100,000)
      1                  20,000
      2                  40,000
      3                  60,000
      4                  30,000
      5                  10,000
                             CHY                              124
4. Internal Rate of Return (IRR)
Answer continued:
        HP12C                 TIBA2+
1000【CHS】【g】【CF0】   【CF】1000 【+/-】【ENTER】【↓】
200  【g】【CFj】            200 【ENTER】【↓】
400  【g】【CFj】            400 【ENTER】【↓】
600  【g】【CFj】            600 【ENTER】【↓】
300  【g】【CFj】            300 【ENTER】【↓】
100  【g】【CFj】【f】【IRR】   100 【ENTER】【IRR】【CPT】


         The answer is: 18.91%



                    CHY                 125
a. Modified Internal Rate of Return
              (MIRR)




                CHY              126
  B.    INTERPRETING THE VARIOUS
   METHODS OF RANKING PROJECT
                RETURNS
• Payback Period
• Discounted Payback Period
• Net Present Value (NPV)
 – The net present value method is generally
   regarded as the best method for ranking
   investment projects




                    CHY                    127
   3. Net Present Value (NPV)
Example:
   Three projects, each with a cost of 15%, have the
   following free cash flows:
Year       Project A Project B Project C
0    $(50,000)         $(120,000) $(20,000)
1      40,000            (50,000) 2,000
2      20,000            150,000 15,000
• 10,000           75,000     15,000
• If the projects are independent, which one(s)
   should be undertaken?
• If the projects are mutually exclusive, which
   one should be undertaken?
                       CHY                     128
   Answer:
1. The NPVS of the projects are:
Yr   NPV of Proj A        NPV of Proj B         NPV of Proj C
       @15%                @15%                  @15%
0    $(50,000)          $(120,000)                  $(20,000)
1     34,783               (43,478)                     1,739
2     15,123              113,422                     11,342
3      6,575                49,314                      9,863
     $ 6,481               $ (742)                     $2,944

  If the projects are independent, undertake Project A and C
     because both have positive NPVS.
2. If the projects are mutually exclusive, undertake Project A
     because it has the highest NPV.

                               CHY                          129
4. Internal Rate of Return (IRR)
•   If two projects are independent of each other, then
    the internal rate of return methodology will
    produce the same decision with regard to
    undertaking projects as the net present value
    method
•   if projects are mutually exclusive, the internal rate
    of return may produce a different ranking than the
    net present value method; when both the internal
    rate of return and the net present value methods
    produce “accept” decisions, the order of the
    rankings among alternative projects produced by
    the two methods can differ.

                           CHY                         130
•   When one project is more expensive
    than another (the sizes of the two
    investments differ).
•   When the timing of the cash flows differ
    such that most of the cash flows come in
    the early years for one project, while
    most of the cash flows come in the later
    years for the other project.
                     CHY                   131
    a. Modified Internal Rate of
    Return (MIRR)

• The MIRR method is better than the IRR
  method, but still inferior to the NPV
  method, for ranking capital projects.




                   CHY                132
  III. POST-AUDIT AND CAPITAL
           RATIONING
A. THE POST-AUDIT PROCESS
• Improve forecasts through employees
    learning why their original forecasts were
    missed and the employees knowing that their
    actions are being monitored.
• Improve operations through the desire of
    employees to meet their forecasts. The
    employee(s) will work harder to make sure
    operations are improving so that forecasts will
    be met.
B. CAPITAL RATIONING

                         CHY                      133
CASH FLOW ESTIMATION AND
OTHER CAPITAL BUDGETING
         TOPICS




           CHY         134
             I.      INTRODUCTION
A. CASH FLOW VS. ACCOUNTING PROFIT
B. DEFINITIONS
     a. The incremental free cash flow of a project should be calculated
     before financing costs, because the method of financing an asset’s
     purchase has no bearing on the value of the asset.
     b. The cost of capital used as the discount rate in determining the
     present value of the net free cash flows is an after-tax cost (as it is in
     the conventional WACC formulation).
     . Sunk costs are costs that would be incurred regardless of whether or
     not an investment is made in the asset or project being evaluated.
     d. Opportunity costs are cash flows that could be generated from
     assets already owned by a firm if they were not used for the target
     project.
     e. Externalities are the positive or negative changes in the cash flows
     of projects (other than the target project) that are attributable to the
     target project.
     f. Shipping and installation costs associated with a target project
     should be included as part of its incremental net free cash flows to be
                                    CHY                                   135
     analyzed.
•   Therefore, the weighted-average cost of
    capital of a firm is the proper discount rate
    at which to discount the future projected
    net free cash flows it is expected to
    generate. This implicitly assumes that the
    target project’s risk is about the same as
    the average risk inherent in a firm’s normal
    business activities.
•   Since the weighted-average cost of capital
    is used as the discount rate, the
    incremental unleveraged free cash flow of
    the project should be the variable that is
    discounted in calculating its net present
    value (NPV).
                       CHY                      136
             II. PROJECT ANALYSIS
         A. ANALYSIS OF AN EXPANSION
                  PROJECT
Example:
   A company is attempting to decide whether or not to enter the widget
   business over the next 5 year. It estimates that it could generate widget
   sales of $600,000 and earn a net income of $88,980 per year over a 5-
   year period beginning next year.
   However, to enter the widget business, an initial investment outlay of
   $512,000 will be required, of which $510,000 is for a widget-making
   machine and $2,000 is for working capital . The widget-making
   machine has a useful life of 5 years and a salvage value of $10,000.
   Management intends to depreciate it over its useful life using the
   straight-line method for both book and tax purposes. The purchase of
   the machine will be financed entirely with 7% debt.
   Management uses the accrual method of accounting for both book and
   tax purposes. The following pro forma data depicts management’s
   estimates of the annual incremental revenues, expenses, and working
   capital outlays associated with the widget business in each of the next
   5 years of operation:
                                    CHY                                 137
Example continued:
Incremental Annual Effects of the Widget Project
  Sales
                                       $ 600,000
  Direct Expenses
                                        300,000
  Depreciation
                                        100,000
  Selling Expenses and Externalities
                                         16,000
  Administrative Expenses
                                               0 (1)
  EBIT
                                       $ 184,000
  Interest Expense
                                         35,700
  Pretax Income
                                       $ 148,300
  Income Tax Expense @40%
                                         59,320
  Net Income
                                       $ 88,980
  Required Additional
        Working Capital Outlay
                                       $ 40,000 (2)
                                         CHY           138
Example continued:
(1) Administrative expenses are sunk costs
    because they would be incurred whether or not
    the widget project is undertaken. Thus they
    add no incremental cost to the widget project.

(2) The additional working capital requirements of
    the widget project must be included in the
    analysis because capital budgeting decisions
    are based on an incremental cash flow
    analysis, and not a net income analysis. The
    net increase in working capital required by the
    widget project is necessary because it will be
    used as a negative adjustment to pro forma
    net income to bring it down to cash flow.
                        CHY                       139
Example continued:
• In addition, it is assumed that a terminal-
  year cash flow will be produced in the sixth
  year consisting of $10,000 for selling the
  widget-making machine for its salvage
  value, $2,000 of closing expenses, and the
  collection of $40,000 from outstanding
  receivables and the sale of unsold
  inventory at cost.

                     CHY                    140
Example continued:
The capital structure of the Company is as
follows:

                    Capital Structure
                       Book Value Market Value
Negotiated Debt        $10,000,000 $11,000,000
Preferred Stock           5,000,000    6,000,000
Common Equity            70,000,000   83,000,000
Total Invested Capital  $85,000,000 $100,000,000


                       CHY                     141
Example continued:
• Current conditions in the financial markets
   suggest that yields on newly issued bonds and
   preferred stocks whose risks and other
   characteristics are the same as those of the
   Company are as follows:
      Bond Yields………………………..7.0%
      Preferred Stock Yields…………….6.0
• The Company’s common shares are currently
   paying a $3.00 dividend per share and are
   trading on the stock exchange at $30 per
   share. The Company is mature, with an
   expected long-term dividend growth rate of 6%
   per year.
                       CHY                    142
Example continued:
Given this inform and assuming the widget business
is similar in terms of risk to the Company’s other
product lines, answer the following questions:

•   Calculating the initial investment outlay for the
    widget project.
•   Calculate the incremental cash flows of the
    project for the operating years (Years 1-5).
•   Calculate the terminal-year cash flow (Year 6).
•   Calculate the weighted average cost of capital
    of the firm.
•   Determine whether or not the widget project
    should be undertaken.
                         CHY                       143
Answer:

1. Calculating the initial investment outlay (Year 0)
 Cost of the Widget-making Machine
                                              $510,000
 Additional Working Capital
                                                  2,000
 Initial Investment Outlay
                                              $512,000



                           CHY                          144
2. Calculating the incremental cash flows
during the operating years (Years 1-5):
The table below shows how the pro forma income and additional working capital information is used to
        determine the incremental cash flows during the operating years:
                                                          Projected            Projected
                                                          Pro Forma            (Free) Cash
                                                          Income                  Flows
Sales                                                     $600,000             $600,000
Direct Expenses                                            300,000              300,000
Depreciation                                               100,000              100,000
Selling Expenses and Externalities                           16,000              16,000
EBIT                                                     $184,000              $184,000
Interest Expense                                             35,700
Pretax Income                                             $148,300
Income Tax Expense @40%                                      59,320             73,600(40% of
        EBIT)
Net Income                                                 $ 88,980

EBIT(1-t)                                                                       $110,400
Plus: Depreciation                                                               100,000
Less: Capital Expenditures                                                             0
Less: Required Additional
       Working Capital Outlay                                                     40,000
Incremental Cash Flow in the
       Operating Years                         CHY                              $170,400        145
Notice that the calculation of the incremental
cash flow accruing to the firm from the
normal operation of the widget project is
really the (unrevealed) free cash flow to the
firm, defined as:

FCFF = EBIT(1-t) + DEPR –CAPX –ΔWC




                      CHY                   146
In performing this calculation, remember:
1. Interest expense is not counted as a cost in
   calculating this free cash flow to the firm from the
   operation of the widget business, even though it
   is counted as a cost in calculating the project’s
   net income. This is because the cost of debt
   capital is included in the firm’s weighted average
   cost of capital that will be used to discount these
   cash flows to their present value. To include the
   effects of leverage in both the cash flow
   calculation and the discount rate used to reduce it
   to NPV would count the effect of leverage twice.
                         CHY                      147
In performing this calculation, remember:
•   The income tax ―expense‖ is not the same when
    calculating the free cash flow to the firm as the actual
    income tax expense used to calculate net income. In
    the free cash flow to the firm calculation, the income
    tax ―expense‖ is computed by multiplying the income
    tax rate by EBIT, whereas the actual income tax
    expense used to determine net income is computed by
    multiplying the income tax rate by pretax income. The
    difference in the two calculations is the interest tax
    shield that is produced by financial leverage:

•   Difference in Income Tax Calculation
             = $73,600 – 59,320 = $14,280

•   Interest Tax Shield
             = t(INT) =0.40($35,700) = $14,280
                            CHY                           148
    In effect, the free cash flow to the firm calculation
    excludes the impact of the interest tax shield on a
    firm’s cash flow. This is appropriated because all of the
    effects of financial leverage are taken into account
    when the firm’s weighted average cost of capital is
    used to discount these projected cash flows to their
    present value. To include the interest tax shield effects
    of financial leverage in both the cash flow calculation
    and the discount rate used to reduce it to present
    value would count the effect of leverage twice.
•   The required additional working capital is
    counted as a cash outflow when computing
    the free cash flow to the firm, while it is not
    counted as an expense in computing net
    income.

                            CHY                           149
    3. Calculating the terminal-year cash
                flow (Year 6):
•    The cash flow accruing to the firm in the terminal year is
     as follows:
                                  Cash Flow
                                  Pretax          After-Tax
Cash from Sale of Machine        $10,000          $10,000--(1)
Plus: Cash from Collection of
     Receivables and sale of
      unsold inventory            40,000           40,000—(2)
Less: Closing expenses, net
of taxes                            2,000           1,200—(3)
Terminal-year cash flow           48,000           48,000
                             CHY                           150
(1) The machine is sold for its book value. Therefore, no
    tax is owed or saved on the transaction.

(2) The Company uses accrual accounting for book and
    tax purposes. Therefore, no tax is due when
    receivables are collected, because it was paid in prior
    years when the income on sales were reported
    Inventories were sold at cost, so no taxes are owed or
    saved at this time.

(3) Closing expense are tax deductible. Therefore, there is
    a tax savings of $800 that (presumably) can be used to
    reduce the Company’s over all tax burden for the year.
    Thus, the net closing expenses after this tax saving is:

    Net Closing Expense = $2,000(1-0.4) = $1,200

                            CHY                             151
    4. Calculating the firm’s weighted
         average cost of capital:
•    To calculate the firm’s weighted average cost
     of capital, first compute the firm’s cost of
     common equity:
     rCE =DIV1/PCS + gDIV
         =$3(1.06)/30 + 0.06 = 16.6%
•    The weighted-average cost of capital of the
     firm is, therefore:

rw = (1-t)rD (VD/ VA) + rP (VP/ VA) + rCE (VCE/ VA)
rW = (1-0.4)(0.07)(11,000,000/100,000,000)
    +0.06(6,000,000/100,000,000)
    +0.166(83,000,000/100,000,000) = 14.6%
                          CHY                         152
5. Making the capital budgeting
           decision:
The best way to make the capital budgeting
decision is to compute the net present value
(NPV) of all of the cash flows to the firm (the
initial cash outlay, the cash generated from the
project over its operating years, and the
terminal-year cash flow), using the firm’s
weighted average cost of capital as the
discount rate. If the NPV is positive, the project
should be undertaken; if it is negative, it should
not be undertaken.
                     CHY                        153
Note:
•   The cost of capital for the project is the
    weighted average cost of capital of the firm
    because this project has approximately the
    same risk that is inherent in the firm’s overall
    business. While the widget machine was
    financed entirely with 7% debt capital, this is
    not the cost of capital for the project because,
    ultimately, the firm’s capital structure must be
    rebalanced back to its target proportions of
    debt, preferred stock, and common equity.
                         CHY                       154
The table below depicts the projected cash flows over the
life of the widget project and the NPV of the project when
these cash flows are discounted to their present value
using the firm’s WACC:

    Year            Cash Flow      PV of Cash Flow @14.6%
    0               $(512,000)             $(512,000)
    1               170,400                   148,691
    2               170,400                   129,748
    3               170,400                   113,218
    4               170,400                    98,794
    5               170,400                    86,208
    6               48,800                     21,543
                                             $ 86,202
    Since the NPV of the free cash flows to the firm
    generated by the project is positive, the expected return
    on the project is greater than the firm’s cost of capital.
    Therefore, the widget project should be undertaken. 155
                              CHY
          B. ANALYZING A
       REPLACEMENT PROJECT
Example:
   A company is thinking of replacing a machine and buying
   a new one.
   •    The annual cash operating expenses associated with the current
       machine are $100,000.
   •   the machine is being depreciated by $10,000 per year (straight
       line). It has a useful life of five additional years and, if sold today, it
       could fetch $5,000 in the used machine market, which is $2,000
       below its book value.
   •   The new machine would probably be used for 5 years, at which
       time it would be fully depreciated. However, it could be sold for
       $7,000 at the end of Year 5(which is an estimate and not a
       ―salvage value‖ for purposes of computing depreciation from a tax
       perspective).
   •   The cash operating expenses required to operate the new
       machine are only $60,000 per year, but it would also require an
       additional working capital each year of $3,000. The price of the
                                     The
       new machine is $90,000. CHY firm’s cost of capital is 15% and its   156
       marginal income tax rate is 40%.
Example continued:
•     Calculate the initial investment outlay for the analysis:
      The initial investment outlay in Year 0 is the cost of the
      new machine, less the cash received from selling the old
      machine and the tax savings that accrues to the benefit of
      the Company because it sells the old machine at a loss:
                                     Cash Outlay
Cost of New Machine                     $90,000
      Less: Sale of Old Machine           5,000
Less: Tax Savings on Sale of Old
Machine                                     800【0.40×$2,000
                                                           loss】
Initial Investment Outlay               $84,200


                            CHY                           157
Example continued:
•     Calculate the operating cash flows for the
      “normal” years(1-4):
      The table below summarizes the calculation of the regular operating cash
      flows from this replacement project:

                                                            Cash Flow
After-tax reduction in cash operating costs                   $24,000 (1)
Depreciation on new machine                                   $18,000
Depreciation on old machine                                    10,000
Increase in depreciation                                       $ 8,000
Tax savings on increase in depreciation                          3,200 (2)
Less: Increase in required working capital                       3,000
Operating cash flow                                           $24,200

(1) (1-t)(100,000 –60,000) = (0.60)(40,000) = $24,000
(2) Tax Savings = t (Increase in depreciation) = 0.40($8,000) = $3,200



                                      CHY                                    158
Example continued:
3. Calculate the terminal-year cash flow (Year 5):
    The cash flows in the terminal year are the regular
    operating cash flow of $24,200 associated with the
    project and the special cash flows that occur in Year 5
    as summarized in the table below:
                                       Cash Flow
Regular operating cash flow             $24,200
Proceeds from sale of machine             7,000
Less: Tax on gain from sale of machine    2,800 (3)
Terminal-year cash flow                 $28,400

(3) Tax on gain from sale = t (Gain on sale) = 0.40($7,000) =$2,800



                                 CHY                                  159
Example continued:
4. Construct a cash flow table for the life of the new machine.
     This table should depict the cash flows resulting from the
     replacement project from Year 0 through Year 5, and calculate the
     net present value (NPV) of those cash flows.

   The cash flow for this replacement project and the NPV calculation is
    contained in the following table:

     Year            Cash Flow             PV of Cash Flow @15%
     0               $(84,200)          $(84,200)
     1                  24,200                     21,299
     2                  24,200                     18,299
     3                  24,200                     15,912
     4                  24,200                     13,836
     5                  24,200                     14,020
                                              NPV $(1,090)
Answer:
    The old machine should not be replaced because the NPV of the
    project is negative.

                                  CHY                                 160
  III. OTHER CAPITAL BUDGETING
              TOPICS
A. MAKING DECISIONS REGARDING
  PROJECTS WITH DIFFERENT USEFUL
  LIVES
• The methods described previously for
  ranking projects are applicable only if the
  projects all have the same time horizon.



                      CHY                   161
Example:
•   The management of the Gadget Manufacturing Company must
    decide which of two machines to buy in order to make one of the
    components of the gadget that they manufacture more cheaply.
•   Machine A costs $600,000 to buy and would save the
    Company $300,000 of operating costs per year. Its
    useful life is three years.
•   Machine B costs $700,000 to buy and would save the
    company $200,000 per year to operate and has a
    useful life of six years.
•   Both machines can produce the same output and
    make the same contribution to revenues every year.
    One or the other machine will be bought; it is only a
    matter of which is the cheapest to operate, all factors
    considered.
•   The company has a weighted average cost of capital of
    14%. Both machines have zero salvage value.
•   Which machine should purchased?
                               CHY                          162
answer:
1. The Equivalent Annuity (EAA) Approach
• The equivalent annual annuity is defined
  as the size of the annuity payment
  required each year of an asset’s life to
  make the present value of the operating
  cash flows equal the NPV of the asset,
  using the cost of capital for the asset as
  the discount rate. The asset with the
  algebraically highest EAA is considered to
  be the best investment.
                     CHY                   163
answer:
    1. The Equivalent Annuity (EAA) Approach
•        Applied to this problem, the EAAs for the two machines are calculated as follows, using a financial calculator. The
         annual operating cash flows generated by Machine A and Machine B and their respective present values are:


Year       Machine A                     P.V. of A                          Machine B                      P.V of B
           Operating                     Operating                          Operating                       Operating
          Cash Flows                     CF @14%                              CF                           CF @14%

    0        $(600,000)                    $(600,000)                           $ (700,000)                  $(700,000)
    1        300,000                         263,158                               200,000                     175,439
    2        300,000                         230,840                               200,000                     153,894
    3        300,000                         202,491                               200,000                     134,994
    4                                                                              200,000                     118,416
    5                                                                              200,000                     103,874
     6                                                                             200,000                      91,117
                                            $ 96,489                                                          $ 77,734




                                                         CHY                                                        164
   Machine A                   Machine B

  PV = 96,489                   PV =77,734
       n=3                       n=6
       i = 14                    i = 14
       FV = 0                    FV = 0
 EAA = PMT = $41,561      EAA = PMT = $19,990

The decision is to buy Machine A because it
has the algebraically higher equivalent annual
annuity per year.

                    CHY                         165
  公司財務研討 I
In Class Question
              P57

        CHY         166
     Other Capital Budgeting Topics
    MAKING DECISIONS REGARDING
  PROJECTS WITH DIFFERENT USEFUL
                 LIVES

• For the projects with different time horizon

• (A方案NPV 較負, 但是該機器可以用10年;

• B方案NPV 沒有那麼負, 但是只能用5年; ) . . .
                        CHY                      167
    釋例:
•   The management of the Gadget Manufacturing
    Company must decide which of two machines
    to buy in order to make one of the components
    of the gadget that they manufacture more
    cheaply.

•   Machine A costs $600,000 to buy & would
    save the Company $300,000 of operating
    costs per year. Its useful life is three years.

•   Machine B costs $700,000 to buy & would
    save the company $200,000 per year to
    operate & has a useful life of six years.
                        CHY                           168
    釋例:
•   The management of the Gadget Manufacturing
    Company must decide which of two machines
    to buy in order to make one of the components
    of the gadget that they manufacture more
    cheaply.

•   Machine A costs $600,000 to buy & would
    save the Company $300,000 of operating
    costs per year. Its useful life is three years.

•   Machine B costs $700,000 to buy & would
    save the company $200,000 per year to
    operate & has a useful life of six years.
                        CHY                           169
  釋例: [續]
• Both machines can produce the same output &
  make the same contribution to revenues every
  year. One or the other machine will be bought; it
  is only a matter of which is the cheapest to
  operate, all factors considered.
• The company has a weighted average cost of
  capital of 14%. Both machines have zero salvage
  value.
• Which machine should purchased?

                           CHY                        170
        2. The Replacement Chain
         (Common Life) Approach
•   The replacement chain (Common Life) method
    solves the problem by equalizing the lives of the
    two machines.

•   This is done by extending the life of Machine A
    until it equals that of Machine B by treating the
    problem as if Machine A 陸續接力 【 at the end of
    Year 3, 續用 Machine A . . . 】

•   In that case, the operating cash flows of the two
    machines & their associated present values would
                           CHY                      171
    appear as follows:
2. The Replacement Chain
(Common Life) Approach @ 14%
continued…
 Year   Machine A   P.V. of   Machine B              P.V of
         Operating   Machine A Operating             Machine B
         Cash Flows Operating  Cash Flows            Cash Flows

 0      $(600,000)      $(600,000)     $ (700,000)   $(700,000)
 1       300,000          263,158         200,000      175,439
 2       300,000          230,840         200,000      153,894
 3      (300,000)(*)   (202,491)          200,000      134,994
 4       300,000          177,624         200,000      118,416
 5       300,000          155,811         200,000      103,874
 6       300,000          136,767         200,000       91,117
                        $ 161,618                    $ 77,734
                                 CHY                              172
    (*) 接力點 If a new Machine A is
     purchased at the end of the third
     year, the cash flows in that year
     will be:
$300,000-600,000 = $ (300,000)

This approach leads to the decision to
 buy Machine A, because it has the
 higher net present value of its cash
 flows.          CHY                 173
Other Capital Budgeting
        Topics
THE EFFECT OF INFLATION ON
       NPV ANALYSIS
• Cost of Capital r 已經含有 EXPECTED
  INFLATION, 所以 Incremental Cash Flow
  也要考慮到未來物價上漲趨勢


                  CHY               174
CAPITAL BUDGETING RISK
       ANALYSIS

I. TYPES OF RISK
• Stand-alone Risk
• Corporate (Within-firm) Risk
• Market Risk (Beta)


                  CHY            175
 釋例 Which of the following statements
                     is true?
(A)Stand-alone risk is the best way for a conglomerate
   to analyze the risk associated with a potential new
   acquisition.

(B)Corporate risk measures do not take into account the
   principle that diversification reduces risk.

(C)Market risk affects the impact that a potential new
   project can have on the price of the stock of the firm
   that is contemplating to undertake the project.

(D) Fully diversified stockholders in a firm are more
   concerned with the corporate risk of a project that a
   company whose stock they own is undertaking than
   they are about its market risk.
                         CHY                         176
  解析:       C
A is false because corporate or market risk
  should be the way for a conglomerate to
  analyze a new acquisition since diversification
  may reduce overall risk relative to the
  acquisition’s stand-alone risk.
B is false because corporate risk does take into
  account the principle that diversification
  reduces risk.
D is false because diversified investors are
      more concerned with market risk than with
  corporate risk.
                        CHY                   177
Measuring Stand-alone Risk

Scenario Analysis
• The probabilities assigned to each scenario are
   subjective.
• ―Outlier‖ scenarios (war, famine, & pestilence),
   which represent the largest risks to the viability of
   a project, do occur from time to time.
• Yet, such scenarios are not often included in the
   analysis because they are very unlikely.
• The tendency to ignore highly improbable, yet
   very costly, scenarios results in an
   underestimation of project risk.
                         CHY                        178
Sensitivity Analysis
 NPV 結果對那個變數最敏感?

Monte Carlo Simulation
Simulating probable events & generate
  estimated returns & risk indexes
考慮到特殊事件 (Outliers)
  但是: 變數的分配要主觀認定, 且操作複
  雜

                  CHY                   179
  Measuring Market risk
THE SECURITY MARKET LINE

r = rF +β(rM-rF)

• USING A MARKET (SYSTEMATIC;
  BETA) RISK MEASURE TO
  DETERMINE THE REQUIRED
  RETURN ON A CAPITAL PROJECT
  FINANCED WITH EQUITY CAPITAL
                   CHY           180
     Using the SML to Estimate the
      Risk-Adjusted Cost of Equity
                Capital
               IRR
     Project
                     Good
                              A
                     projects


      30%                 B

                          C   Bad projects
           5%
                                             Firm’s risk (beta)
                        2.5
An all-equity firm should accept a project whose IRR
 exceeds the cost of equity capital & reject projects
 whose IRRs fall short of the cost of capital.
                                  CHY                      181
釋例 Which of the following is
  NOT an appropriate way of
 measuring stand-alone risk?
A. Sensitivity analysis. B. Scenario
  analysis.
C. Monte Carlo simulation.
D. Security market line analysis.

解析:     D   The SML approach is used to
 measure market risk.
                    CHY                182
釋例         The Greenhouse Grocery
Corporation, a large grocery store retailer, is
thinking about acquiring the Fly-by-Nite Airline
Company.

Based on the information given below, what is the
most appropriate discount rate that should be
applied to the incremental free cash flows to
equity expected to be generated by this
acquisition in order to decide whether or not this
acquisition is worthwhile?
                        CHY                    183
• Risk-free rate
      5.00%
• Expected stock market return
      10.00%
• Grocery industry market beta         0.85
• Airline industry market beta         1.50
• Greenhouse grocery’s WACC
      8.00%
• Market return on unleveraged investments
      9.00%

a.8.00%
b. 9.00%
c.9.25%               CHY                     184
d. 12.50%
解析:       D     Given the choices, the
 best one would be the return calculated
 from the security market line using the
 CAPM approach & an airline industry
 beta. Greenhouse’s WACC is
 inappropriate because an airline is an
 entirely different business from the one
 Greenhouse is in; hence the risks are
 different.

r = rF +βairlines(rM-rF)
                   CHY                      185
= 5%+1.5(10-5)=12.5%
MEASURING THE BETA OF A
  PROJECT
• The Pure Play Method ~ 找Single
  Product Company (Pure Player) 看她的
  Beta




                CHY                   186
        INCLUDING A RISK
          ADJUSTMENT
• Certainty Equivalent Approach ~ All cash
  flows not known with certainty are scaled
  down. (e.g., 都乘以0.8, 然後以rF 折現)

• Risk-Adjusted Discount Rate ~ cash flows
  not scaled down, 但是以Risk-Adjusted
  Cost of Equity Capital 折現


                     CHY                      187
  CAPITAL
STRUCTURE &
 LEVERAGE

          Page 83

    CHY             188
THE TARGET CAPITAL STRUCTURE
 ~ 以下變數Trade-off 的結果


• Business Risk (純資產的產銷風險)
• Tax Position (Tax Shield 稅盾)
• Financial Flexibility (如果有Future
  Capital Needs, Balance Sheet 必須好
  看)
• Managerial Conservatism (經理人風
  險偏好)          CHY              189
2-1 ANALYZING BUSINESS RISK
               【營業風險】
• Volatility of Sales 【營業收入波動性】
• Volatility of Resource Costs 【投入要素成本波
  動性】
• Operating Leverage 【營業槓桿】 of the
  Business (固定成本多者Degree of Operating
  Leverage 高)
Degree of Operating Leverage 【營業槓桿】
  (DOL) ~ 當Sales變動1% , EBIT變動的百分比
= %∆EBIT = 1+               CF固定成本
                         CHY          190
    %∆Sales               EBIT 息前稅前盈餘
2-2 ANALYZING FINANCIAL RISK
                 【財務風險】
• Financial leverage refers to using fixed-cost
  sources of investment capital, such as debt, to
  finance a firm.
• Financial risk is the extra risk to shareholders
  that results from using financial leverage. [買
  聯電股票的風險 >買聯電晶圓廠的風險 ]

• Financial risk can be measured by standard
  measures of financial leverage, such as the
                        CHY                    191
  Debt/Total Capital or Debt/Equity ratios.
• However, a more useful measure of financial
  leverage is the degree of financial leverage 【財
  務槓桿】( DFL),

• defined as the percent change in pretax income
  that occurs every time there is a one-percent
  change in EBIT. (DFL) can be calculated in a
  number of ways that are mathematically
  equivalent.
  ~ 當EBIT變動1% , 稅前淨利變動的百分比

                         CHY                   192
• DFL =
          %ΔPretax Income
              %ΔEBIT

= EBIT / Pretax Income

= EBIT / (EBIT-INTEREST)

                    CHY     193
     Degree of Total Leverage
           【總槓桿】
• DTL 【總槓桿】
= DOL【營業槓桿】 × DFL【財務槓桿】



• %ΔPretax Income =ΔPretax Income
                       Pretax Income
 = DOL × DFL x % ΔSales

                  CHY                  194
• %ΔEPS    = DOL × DFL x %ΔSales



• EPS2006
= EPS2005 (1 + DOL × DFL x %ΔSales)

• DOL & DFL 像是擴大器

                  CHY                 195
 The Effect of Financial Leverage
      on Earnings per Share
• [如果企業希望EPS增長] If a company expects
  its EBIT> breakeven EBIT, debt should be
  employed in its capital structure because the
  financial leverage will enhance its EPS;
• [如果企業希望EPS增長] if it expects its EBIT <
  breakeven EBIT, it should have lower debt in its
  capital structure because the financial leverage
  will result in per-share earnings being less than
  they would be if financial leverage were not
  employed.               CHY                   196
Financial Leverage財務槓桿, EPS
  每股盈餘& EBIT息前稅前盈餘
         EPS ($)
                                           D/E = 1
    3                                      Levered
  2.5                                      Firm
    2

  1.5

    1                                      D/E = 0 Un-
  0.5                                      leveraged
    0                                      Firm
 – 0.5

  –1
                                            EBIT ($ millions,
         0    0.2   0.4   0.6    0.8   1
                                            no taxes)

                                CHY                         197
• Leveraged firms 【使用負債挹注資金的
  企業】

• Unleveraged firms 【未使用負債挹注資金
  的企業】




              CHY              198
【釋例 ~ 如果旨在增加 EPS】
As a general rule:
A. Firms that expect to have low earnings before
  interest & taxes should use financial leverage in
  order to enhance their earnings per share.
B. Firms that expect to have high earnings before
  interest & taxes should use financial leverage in
  order to ↑ their EPS.
C. Leveraged firms will generate the same
  earnings per share for a given level of earnings
  before interest & taxes as unleveraged firms.
D. Unleveraged firms always generate a lower
                         CHY                   199

  earnings per share than leveraged
• 解析: B          Leveraged firms produce
  higher EPS if their EBIT is above their
  financing breakeven point & lower EPS
  if their EBIT is below their breakeven
  point.
• => A, & C, are incorrect. (D) X because
  leverage can have a positive or negative
  influence on earnings per share.

                    CHY                  200
    Real World Complications
• Cost of Debt 隨D/E 上升
• Cost of Equity 隨D/E上升
• 所以固然expects its EBIT to be greater than
  its breakeven EBIT 時, 如果增加D/E => EPS
  上升, 但是WACC 也會增加
• Common shareholder wealth is Not
  (necessarily) maximized by maximizing
  earnings or dividends per share. [畢竟企業
  目的不在極大化其EPS]
• 應該是 Maximize present value of the
                  CHY                201
  future cash flows
          CAPITAL STRUCTURE THEORIES
       A.   MODIGLIANI & MILLER’S CAPITAL
     STRUCTURE IRRELEVANCE PROPOSITION
           [MM 資本結構無關企業價值理論]
Assumptions
• There are no brokerage costs.
• There are no taxes.
• There are no bankruptcy costs.
• Investors & corporation can borrow at the same rate.
• All investors have the same information about the
  firm’s future investment opportunities as the firm’s
  management. 〔企業不需要用高負債來顯示其看好未
  來獲利〕
• EBIT is not affected by the use of debt.
                            CHY                        202
         MM with Taxes
1. The Effect of Taxes [ 實務上因
   為負債有Tax Shield 效果, 增加借
   貸可以省資金成本]

2. The Effect of Bankruptcy Costs [
   實務上破產成本驚人, 故企業不敢
   借太兇]
                CHY               203
    B. THE TRADE-OFF THEORY
• The optimal capital structure for a firm is one
  that will maximize the value of its assets (or
  minimize its weighted average cost of capital 〔最
  低之加權平均資金成本〕)

• debt is beneficial to a firm, but only up to a point.

• In contrast to the Modigliani-Miller irrelevance
  proposition, an optimal capital structure does exist
  [存在最適資本結構]. It is that mix of debt,
  preferred stock, & common equity that minimizes
  the firm’s weighted average cost of capital.
                          CHY                      204
CHY   205
CHY   206
【釋例】 The value of a firm is
enhanced when:
 A. The cost of equity capital equals a firm’s
   weighted average cost of capital.
 B. The firm’s weighted average cost of
   capital is minimized.
 C. The cost of a firm’s equity capital is
   minimized.
 D. The cost of avoiding financial distress is
   minimized.
                       CHY                       207
CHY   208
解析: (B) The value of a firm is the present
  value of its (unleveraged) free cash flows
  discounted by the firm’s WACC. This value
  is maximized when WACC is minimized.
• (C) X because the cost of equity relates to
  the value of the firm’s equity capital only &
  not the firm as a whole.
• (D) X because the cost of avoiding financial
  distress is minimized by having no debt,
  which is usually not an optimal capital
  structure
                    CHY                    209
C. SIGNALING THEORY                [訊號理論]
• 〔發行新股籌資顯示企業認為股價高於真實價
  值〕Management would want to raise capital
  by selling common equity if it believed that the
  firm’s common equity was significantly
  overvalued.

• The announcement of a stock offering is
  generally taken by the market to be a signal
  that management believes that its firm’s stock
  is overpriced relative to the firm’s future
  prospects.           CHY                    210
【融資順位理論】Pecking   Order Theory

• 有好消息的企業 :先以自有資金融資 => 短期
  債融資 =>長期債融資 =>可轉債融資 => 股票
  融資

• 有壞消息的企業 :最後才是自有資金融資 =>
  短期債融資 =>長期債融資 =>可轉債融資 =>
  股票融資

            CHY                  211
          SIGNALING THEORY
           ~ 發行股票有缺點
• It raises a firm’s marginal cost of capital, thereby
  making some projects uneconomical that would have
  been worthwhile if they could have been financed with
  less expensive debt capital. [權益資金成本比負債資金
  成本貴]
• It tends to reduce the value of the firm as investors
  downgrade their outlook for the growth rate of the
  company to correspond with what they interpret as a
  signal from management that the prospects for the
  company are really less than the market had been
  presuming. 〔發行新股籌資顯示企業認為股價高於
  真實價值〕
                          CHY                      212
    【釋例】 The static trade-off theory
differs from the Modigliani-Miller Theorem
                   in that:
A. The static trade-off theory suggests that
  financial leverage cannot enhance the value of
  a firm because of the cost associated with
  financial distress, while Modigliani-Miller
  suggests that the use of debt can enhance a
  firm’s value.
B. The static trade-off theory introduces the effect
  of the cost of avoiding financial distress〔當負
  債比率增加, 負債資金成本也上升〕, while
  Modigliani-Miller assumes that the cost of debt
  & equity capital remain unchanged even at very
  high debt-to-equity ratios.
                          CHY                   213
C. The static trade-off theory can determine
 an optimal debt-to-equity ratio that fits the
 unique circumstances of a firm, while
 Modigliani-Miller cannot define any
 uniquely optimal debt-to-equity ratio that
 fits the facts & circumstances that relate to
 a particular firm.
D. MM Theorem is more realistic than the
 static trade-off theory.


                      CHY                   214
解析:        C
• (A) X because both theories claim that firm
  value can be enhanced by using debt
  (leverage).
• (B) X because MM does not assume that
  the cost of equity capital remains
  unchanged as the debt-to-equity ratio↑.
• D is clearly incorrect.
                     CHY                   215
      Corporate Finance
    Important Equations
     The Cost of Debt Capital
          rafter-tax = (1-t)rD

The Cost of Preferred Stock Capital




                 CHY                  216
The Capital Asset Pricing Model (CAPM)
               Approach:
         rCE = rF + βCS(rM – rF)
The Dividend-Yield-Plus-Growth-Rate ( or
        Implied Return) Approach



                   CHY                217
 The Bond-Yield-Plus-Risk-Premium
             Approach
         rCE = rD+ rERP
Cost of Newly Issued Common Stock
  (Also Called the Cost of External
                Equity)




                CHY                   218
The weighted-average cost of capital
 rw = (1-t)rD (VD/ VA) + rP (VP/ VA) + rCE
                  (VCE/ VA)

 Free Cash Flow from an Expansion
               Project
  FCFF = EBIT(1-t) + DEPR –CAPX –
                 ΔWC

                   CHY                  219
Degree of Operating Leverage
   DFL = %ΔEBIT = 1+CF
          %Δsales EBIT

Degree of Financial Leverage




             CHY               220
Quantifying Total Company Risk




              CHY                221
DIVIDEND POLICY 【股利政策】

• I. Dividend 【股利】 & Cash
  Buyout [庫藏股買回]
• II.DETERMINING A FIRM’S
  OPTIMUM DIVIDEND
  POLICY 【股利政策】
                  Page 101
           CHY           222
Procedure for Cash Dividend
Payment
     25 Oct.         1 Nov.   2 Nov.       6 Nov.      7 Dec.
 …

  Declaration        Cum-      Ex-        Record      Payment
    Date            dividend dividend      Date         Date
                      Date     Date

   Declaration Date[ 宣佈日]: The Board of Directors declares a
   payment of dividends.
   Cum-Dividend Date〔含息基準日〕: The last day that the
   buyer of a stock is entitled to the dividend.
   Ex-Dividend Date 〔除息日〕: The first day that the seller
   of a stock is entitled to the dividend.
   Record Date 〔記錄日〕: The corporation prepares a list of
   all individuals believed to be stockholders as of 6 November.
                               CHY                          223
  Price Behavior around the Ex-
          Dividend Date
• In a perfect world, the stock price will fall by the
  amount of the dividend on the ex-dividend date.
           -t   …   -2   -1     0       +1      +2      …

     $P


                                                       $P - div
 The price drops by the         Ex-
 amount of the cash          dividend
 dividend                       Date
                   Taxes complicate things a bit. Empirically, the
                   price drop is less than the dividend and occurs
                   within the first few minutes of the ex-date. 224
                                CHY
   A. THREE THEORIES ON
      DIVIDEND POLICY
1. MM: Dividend Irrelevance Theory
   (MM股利無關企業價值論)


This dividend irrelevance theory suggests that
   the dividend payout ratio & dividend policy
   is irrelevant on determining the value of
   firms.


                     CHY                   225
 The Miller-Modigliani Hypothesis: Dividends
do not affect value (MM股利無關企業價值論)
  If a firm's investment policy (and hence cash flows) don't
    change, the value of the firm cannot change with
    dividend policy. Investors have to be indifferent to
    receiving either dividends or capital gains.
 - Underlying Assumptions:
 A. No tax differences between dividends & capital gains.
 B. If companies pay too much in cash, they can issue new
    stock, with no flotation costs (發行成本) to replace this
    cash.
 C. If companies pay too little in dividends, they do not use
    the excess cash for bad projects or acquisitions 〔無
    代理人問題〕.                    CHY                        226
                  MM:
d. NO Signaling Effect (沒有訊號效果)
• Many companies pay a regular cash
    dividend.
• Corporations “Smooth” Dividends.
• Dividends Provide Information to the Market
    (Signaling long-run dividend policy; 實業界
    默契: 企業不輕易變動股利, 投資人見股
    利減少即大賣)
e. Investors Can Create Homemade
    Dividends(自己發自己現金股利)
                      CHY                  227
              Homemade Dividends
                  (自己發自己現金股利)
• Bianchi Inc. stock Price=$42 about to pay a $2 cash
  dividend. [當然配息以後股價理論上會跌$2]
• Bob Investor owns 80 shares and prefers $3 cash
  dividend.
• Bob’s homemade dividend strategy:
   – Sell 2 shares ex-dividend
                      homemade dividends    $3 Dividend
Cash from dividend ($D x 80) $160                  $240
Cash from selling stock       $80                    $0
Total Cash                   $240                  $240
Value of Stock Holdings $40 × 78 股         $39 × 80 股
                         =$3,120
                               CHY          = $3,120 228
f. 高Dividend Payout %者Internal
    Growth Rate 低 [今天多拿到$
               => 未來少拿到$ ]

  Internal Growth Rate (g)
  = ROE (1-k)

    Where: ROE is the return on equity
                     (淨值報酬率).
        K is the payout ratio (股利
                   CHY               229
                             支付率).
【釋例】 An investor in a stock can
create a “homemade” dividend by:
 A. Selling off a portion of the shares owned.
 B. Buying the stock on margin.
 C. Buying futures contracts on the shares.
 D. All of the above techniques will create
   ―homemade‖ dividends.


 (A) V 賣出部份持股
                       CHY                   230
2. The Bird-in-the –Hand [
     一鳥在手] Theory
Higher Div Payout => Better




                  CHY         231
PRICE cs
= DIV1 / (r – g)
= Div Payout Ratio
  x Expected EPS at period 1
  ÷ (r – g)



                CHY            232
3. The Tax Preference Theory

 The tax preference theory suggests that
 high dividend payout policies reduce the
 value of common shares and, hence,
 the value of the firm.




                  CHY                  233
• In the presence of personal taxes:
  1. A firm should not issue stock to pay a
     dividend.

  2. Managers have an incentive to seek
     alternative uses for funds to reduce
     dividends.

  3. Personal taxes mitigate against the payment
     of dividends

                       CHY                    234
   4. A Summary of the Three
           Theories
• The bird-in-the-hand theory [一鳥在手]
  suggests that the higher the payout ratio,
  the higher will be the value of the firm &
  its common stock.
• The tax preference theory states that the
  higher the payout ratio, the lower will be
  the value of the firm & its common stock.
• The dividend irrelevance theory states
  that dividend policy has no effect on the
                      CHY
  value of the firm or its common stock. 235
  A clientele based explanation
• [意思是. ..] Investors may form
  clienteles based upon their tax
  brackets.
• Investors in high tax brackets may
  invest in stocks which do not pay
  dividends & those in low tax brackets
  may invest in dividend paying stocks.
• 倒沒有說多發現金股利不好,得看
  想要滿足甚麼樣的投資人需求
                   CHY                236
–(a) Older investors were more likely
 to hold high dividend stocks, &
–(b) Poorer investors tended to hold
 high dividend stocks




                CHY                237
  A clientele based explanation
(c) If stockholders like dividends as a source
   of current income => Higher dividends
(d) If stockholders like stable dividend levels
   => Avoid cutting dividends
(e) If stockholders like stable dividend payout
   => Maintain the target payout ratio
(f) If cash dividends serve as an Uncertainty
   resolution => Higher dividends
                     CHY                   238
【釋例】 Which of the following
theories about dividend policy is most
closely associated with the clientele
effect?
A. The bird-in-the-hand theory.
B. The tax preference theory.
C. The dividend irrelevance theory.
D. The MM theory.

• (B)Investors (clientele) in low tax brackets
  may prefer higher payout ratios than
  investors in high tax brackets.
                       CHY                   239
B. THE RESIDUAL DIVIDEND
    MODEL [2004-10-08]
• Determine the optimal capital budget.
• Based on the target capital structure,
  determine the amount of equity capital
  required to finance the optimal capital
  budget.
• To the extent possible, use internally
  generated retained earnings as the
  primary source of meeting the equity
  capital requirement.            Page 109
                   CHY                  240
• Pay dividends only to the extent that
  funds are left over after meeting the
  financing needs of the capital budget,
  taking into consideration other
  constraining factors, such as bond
  indenture constraints, preferred stock
  restrictions, the availability of cash, tax
  penalties on excess retained earnings,
  capital impairment restrictions, & so
  forth.
                    CHY                   241
• Avoid cutting dividends at all costs,
  because this sends the wrong signal to
  investors.
• Therefore, do not apply this residual
  dividend model on a year-by-year basis;
  rather, apply it over a 5-10 year time
  horizon.
• In other words, the residual dividend
  model should be used to set long-run
  target payout ratios, based on 5-10 year
  free cash flow projections.
                    CHY                 242
• A residual dividend policy:
  – Net income (projected) = $200M
  – D/E (target) = 2/3 (E/V = 60%; D/V = 40%)
  – Capital budget (planned) = $260M
  – Maximum capital spending with no outside equity:
    .60  C = $200M   C = $333.33M
  – Therefore, a dividend will be paid
  – New equity needed= .60  $260M = $156M
    New debt needed     = .40  $260M = $104M
  – Dividend = $200M - $156M = $44M
                         CHY                      243
   C. REPURCHASING COMMON
  STOCK AS AN ALTERNATIVE TO
       PAYING DIVIDENDS
1. Advantages of Repurchasing
   Common Shares [買回庫藏股票] Instead
   of Paying Dividends
a. Signaling that mgt believe the shares
   are undervalued 〔感覺便宜才會買進
   〕
b. Only the shareholders who choose to
   sell their shares are subject to a tax
                   CHY               244
c. Cash dividends, once declared, cannot
  be cut without adversely affecting the
  price of the common stocks. In contrast,
  repurchase programs can be “on and
  off” 〔自由實施〕

d. Buybacks helps shifting in a firm’s
  target capital structure policy (Debt-
  Equity Ratio UP)


                    CHY                    245
An alternative to paying additional dividends
 : Repurchasing common shares

• 【買回庫藏股票,可以拉高每股盈餘、省
  現金股利稅、有訊號效果】




                     CHY                   246
Disadvantages of Repurchasing
    Common Shares Instead of
       Paying Dividends ~
a. Buybacks may imply mgt uncertainty about the
     trend of Free Cash Flow 〔否則就發現金
     股利〕
b. The selling shareholders may not be fully
     aware of all of the implications of a buyback
     program 〔現有股東未必知道是否應該出
     售〕
c. If the firm buys back shares at an inflated
     price, it wastes money. 〔也許買價過高
     〕                   CHY                    247
   Calculating the Price Effect of a Stock
       Repurchase [買回庫藏股票會. . .]
E.g., Net Income = $150M;
• #Issued Shares = # Outstanding Shares= 50M
• Current P/E = $75/ $3 = 25x
• If the amount to be allocated = $60M
• => 800,000 shares can be repurchased

• EPS after the repurchase =
  $150M / (50M – 0.80M) = $3.05
                      CHY                    248
    每股盈餘(Earnings per Share )
  Earnings Attributable to Ordinary Shareholders
  Number of Outstanding Ordinary (Common) Shares

             淨利                 特別股利
=         Net Income -          Preferred Dividends
  Number of Issued Shares- Number of Treasury Shares
             發行數                庫藏數

 (現金股利↑時,每股盈餘會?) 不變
【Q】Would a company’s EPS increase or decrease as it
 declares & pays cash dividends?
                         CHY                    249
(股票股利↑時,每股盈餘會?) ↓
【Q】Would a company’s EPS ↑ or ↓ as it declares &
distributes stock dividends (股票股利)?

(買回庫藏股票時,每股盈餘會?) ↑
【Q】【Treasury Stock Transaction】Would a
company’s earnings per share ↑ or ↓ as it buys back
shares?

(重行賣出庫藏股票時,每股盈餘會?) ↓
【Q】【Decrease in Treasury Stocks】Would a
company’s EPS ↑ or ↓ as it resells its Treasury Stocks?
                           CHY                        250
    現金股利 (Cash Dividend) versus a 庫藏股
      買回 (Share Repurchase) 的衝擊
• Assume no taxes, commissions, or other market
  imperfections
• Consider a firm with 50,000 shares outstanding
  and the following balance sheet


                     Balance Sheet
 Cash         $ 100,000         $       0    Debt
 Other Assets   900,000          1,000,000   Equity
        Total   $1,000,000      $1,000,000   Total

                         CHY                       251
• Price per share is $20
  ($1,000,000/50,000)
  Net income is $100,000, so EPS = $2.00
  => The P/E ratio is 10

• The firm is considering;
  – 1)    paying a $1 per share cash
    dividend, or
  – 2) repurchasing 2,500 shares at $20 a
    share            CHY                    252
現金股利 (Cash Dividend) versus a 庫藏股買
   回 (Share Repurchase) 的衝擊

 • 1.Choose 現金股利 (cash dividend)
     (all stockholders get $1 per share)

                  Balance Sheet

   Cash      $ 50,000 $      0         Debt
   Other Assets900,000 950,000         Equity
      Total   $ 950,000 $ 950,000      Total


 • Price per share is $19 ($950,000/50,000)
   Net income is still $100,000, so EPS = $2.00
   The P/E ratio becomes CHY 9.5                  253
   現金股利 (Cash Dividend) versus a庫藏
    股買回 (Share Repurchase) 的衝擊

• 2.Choose 庫藏股買回 (repurchase)
    (2,500 shares are repurchased at $20 a share)

                         Balance Sheet

  Cash     $ 50,000 $        0       Debt
  Other Assets900,000 950,000        Equity
     Total $ 950,000 $ 950,000       Total


• Price per share remains $20 ($950,000/47,500)
  Net income is still $100,000, so EPS = $2.10
                                 CHY                254
  The P/E ratio is 9.5
【釋例】Repurchasing common shares (買
   回庫藏股票) is an alternative to paying
           additional dividends that:
 A. Can boost the price of the shares if
   investors interpret the purchases as a
   signal that management believes the
   shares are undervalued.
 B. Has tax advantages for high-income
   shareholders.
 C. Is disadvantageous to the Company if the
   shares are overpriced.
 D. All of the above statements are true.
                     CHY                  255
• 解析: D A stock repurchase plan can
  signal that management believes its shares
  are      undervalued.

• Repurchase plans can benefit high-income
  shareholders as the lower capital gains
  tax 【證所稅】 is paid by only the investors
  who choose to sell    their shares.

• A disadvantage of are repurchase plan is
  that the price at which the stock is
  repurchased may be too high.

                    CHY                      256
STOCK DIVIDENDS, SPLITS, &
    REVERSE SPLITS
1. Empirical Evidence ~ STOCK
   DIVIDENDS, SPLITS, & REVERSE
   SPLITS do not change the value of
   firms, nor the wealth of their
   shareholders.

2. Rationale ~ SPLITS & STOCK
   DIVIDENDS讓單價降下來, 降至
   Optimal Trading Range 以內
                 CHY                   257
   Irrelevance of Stock Dividends
              : Example
Shimano USA has 2 million shares currently
outstanding at $15 per share. The company
declares a 50% stock dividend. How many
shares will be outstanding after the dividend is
paid?
A 50% stock dividend will increase the number
of shares by 50%:
    2 million    × 1.5 = 3 million shares
                        CHY                   258
     Irrelevance of Stock Dividends
                   [Pizza 多片]
•   After the stock dividend what is the new price
    per share and what is the new value of the
    firm?
•   The value of the firm was
    2 Mil × $15 per share = $30 Mil.
•   After the dividend, the value will remain the
    same.
•   Price per share
    = $30Mil / 3Mil shares = $10 per share
                       CHY                   259
Cash Dividend Policy is Also Irrelevant
           [還記得Homemade Dividends?]
• Since investors do not need dividends to convert shares to
  cash, dividend policy will have no impact on the value of
  the firm.
• In the above example, Bob Investor began with total wealth
  of $3,360:


     After a $3 dividend, his total wealth is still $3,360:



     After a $2 dividend, and sale of 2 ex-dividend shares,his
      total wealth is still $3,360:

                                CHY                            260
    【Corporate Finance 釋例】
1. Bay Corp. generated net income of $105
million and a return on equity (ROE) of 10%
during the year-ended 2005.       Assuming a
dividend payout rate of 45% and that the ROE
above is consistent with management’s long-term
expectations, the expected sustainable growth
rate (最高可維持成長率)of dividends is:
  a. 10.0%
  b. 5.5%
  c.    2.5%
  d. 1.25%                          P121
                      CHY                   261
【擬答】(B)
    g = ROE (1 – Dividend Payout Rate)
*

    => 10%(1-45%) = 5.5%

最高內部成長率 (Internal Growth Rate) 與最
高可維持成長率(Sustainable Growth Rate)




                  CHY               262
• 1. 當企業無法 發行新股增資、也無法增加借
  貸 時 (When External Debt and Equity
  Financing = 0)
• Internal Growth Rate =
  (ROA)   × (1- Dividend Payout Ratio)
• 2. 當企業無法發行新股增資、但是她能夠增加
  借 貸 時       (When External Equity
  Financing = 0
最 高 可 維 持 成 長 率 (Sustainable Growth
  Rate) ~ Less stringent
• Sustainable Growth Rate =
(ROE) × (1- DividendCHY
                     Payout Ratio)       263
Optimal capital structure
2. Which of the following statements best describes
   the optimal capital structure?

a. The optimal capital structure is the mix of debt,
   equity, & preferred stock that maximizes the
   company’s earnings per share (EPS).
b. The optimal capital structure is the mix of debt,
   equity, & preferred stock that maximizes the
   company’s stock price.
c. The optimal capital structure is the mix of debt,
   equity, & preferred stock that minimizes the
   company’s weighted average cost of capital
   (WACC).
d. Statements b & c are correct. 【擬答】 (D) E 264
                         CHY
Leverage & capital structure
3. Which of the following is likely to encourage a
   company to use more debt in its capital
   structure?

a. An increase in the corporate tax rate.
b. An increase in the personal tax rate.
c. Changes in the bankruptcy code make
   bankruptcy less costly to corporations
d. Statements a & c are correct.

【擬答】(D)                                 P122
                      CHY                      265
Capital structure & WACC
4. Which of the following statements is most correct?

a. Since debt financing raises the firm’s financial
   risk, increasing a company’s debt ratio will always
   increase the company’s WACC.
b. Since debt financing is cheaper than equity
   financing, increasing a company’s debt ratio will
   always reduce the company’s WACC.
c. Increasing a company’s debt ratio will typically
   reduce the marginal costs of both debt & equity
   financing; however, it still may raise the
   company’s WACC.
d. None of the statements above is correct.
                         CHY
                                  【擬答】 (D) E       266
Operating & financial leverage
5. Which of the following statements is most
   correct?


a. Firms whose sales are very sensitive to
   changes in the business cycle are more
   likely to rely on debt financing.
b. Firms with large tax loss carry forwards are
   more likely to rely on debt financing.
c. Firms with a high operating leverage are
   more likely to rely on debt financing.
d. None of the statements above is correct.
                      CHY                   267
                            【擬答】(D) M
Stock repurchases
6. Which of the following statements is most correct?

a.       One advantage of stock repurchases is that
   they are generally taxed more favorably than
   dividend payments.
b.      Stock repurchases make sense if a company
   is interested in increasing its equity ratio.
c.             Stock repurchases make sense if a
   company believes that its stock is overvalued
   & that it has a lot of profitable projects to fund over
   the next year.
d.      If a company announces a 2-for-1 stock split
   & the overall value of the firm remains unchanged,
   the company’s stock price must have doubled.
                             CHY                        268
                                       【擬答】(A) E
Dividend theory
7. Which of the following statements is most
   correct?
a. The tax preference theory states that, all
   else equal, investors prefer stocks that
   pay low dividends because retained
   earnings can lead to capital gains that are
   taxed at a lower rate.
b. An increase in the cost of equity capital
   (ks) when a company announces an
   increase in its dividend per share, would
   be consistent with the bird-in-the-hand
   theory.
                     CHY                   269
c. An increase in the stock price when
   a company decreases its dividend
   is consistent with the signaling
   theory.
d. A dividend policy that involves paying
   a consistent percentage of net
   income is the best policy if the
   “clientele effect” is correct.


【擬答】(A) M
                                   P123
                   CHY                 270
Dividends & repurchases
8. Which of the following statements is most
  correct?

a. In general, stock repurchases are taxed the
   same way as dividends.
b. On average, companies send a negative signal
  to the marketplace when they announce an
  increase in their dividend.
c. In the real world, we find that dividends usually
   exhibit greater stability than earnings.
d. All statements are correct.       【擬答】(C) E
                        CHY                       271
Stock split
9. A stock split will cause a change in the total
    dollar amounts shown in which of the
    following balance sheet accounts?

a.   Cash.
b.   Common stock.
c.   Paid-in capital.
d.   Retained earnings.
e.   None of the statements above is correct.
                          【擬答】 (E) E
                       CHY                   272
NPV profiles
10. Project A & Project B are mutually exclusive
   projects with equal risk. Project A has an internal
   rate of return of 12 percent, while Project B has
   an internal rate of return of 15 percent.

The two projects have the same net present value
   when the cost of capital is 7 percent. (In other
   words, the ―crossover rate‖ is 7 percent.)
   Assume each project has an initial cash outflow
   followed by a series of inflows. Which of the
   following statements is most correct?

                          CHY                       273
CHY   274
a. If the cost of capital is 10 percent, each
   project will have a positive net present
   value.
b. If the cost of capital is 6 percent, Project B
   has a higher net present value than Project
   A.
c. If the cost of capital is 13 percent, Project B
   has a higher net present value than Project
   A.
d. Statements a & c are correct.

                        CHY                          275
                                           P124
【擬答】(D) E
     Since both projects have an IRR > the
 10% cost of capital, both will have a positive
 NPV. Therefore, statement a is true. At 6
 percent, the cost of capital is less than the
 crossover rate & Project A has a higher NPV
 than B. Therefore, statement b is false. If the
 cost of capital is 13 percent, then the cost of
 capital is greater than the crossover rate & B
 would have a higher NPV than A. Therefore,
 statement c is true.

                       CHY                         276
NPV profiles
11. O’Leary Lumber Company is considering two
  mutually exclusive projects, Project X &
  Project Y. The two projects have normal cash
  flows (an up-front cost followed by a series of
  positive cash flows), the same risk, & the
  same 10 percent WACC. However, Project X
  has an IRR of 16 percent, while Project Y has
  an IRR of 14 percent. Which of the following
  statements is most correct?



                      CHY                      277
a. Project X’s NPV must be positive.
b. Project X’s NPV must be higher than Project
   Y’s NPV.
c. If Project X has a lower NPV than Project Y,
   then this means that Project X must be a
   larger project.
d. Statements a & c are correct.




                       CHY                        278
解析:(A).IRR of Project X > weighted average cost
 of capital; therefore, the project has a positive
 net present value. Statement b is incorrect; we
 do not know where the crossover point is (if one
 exists) for these two projects. Statement c is
 also incorrect; if anything, existing information
 would suggest that Project X was the smaller
 project. In addition, the lower NPV could be the
 product of the timing of cash flows or the length
 of the project’s life.

                       CHY                      279
NPV profiles
12. Cherry Books is considering two mutually
  exclusive projects. Project A has an internal
  rate of return of 18 percent, while Project B
  has an internal rate of return of 30 percent.
  The two projects have the same risk, the
  same cost of capital, & the timing of the cash
  flows is similar. Each has an up-front cost
  followed by a series of positive cash flows.
  One of the projects, however, is much larger
  than the other. If the cost of capital is 16
  percent, the two projects have the same net
  present value (NPV); otherwise, their NPVs
  are different. Which of the following
  statements is most correct?
                         CHY                       280
                                            p125
a.If the cost of capital is 12 percent,
  Project B will have a higher NPV.
b.If the cost of capital is 17 percent,
  Project B will have a higher NPV.
c.Project B is larger than Project A.
d.Statements a & c are correct.




                     CHY                  281
【擬答】:




        CHY   282
(B) E
       Draw the NPV profiles using the information
  given in the problem. It is clear that Project A will
  have a higher NPV when the cost of capital is 12
  percent. Therefore, statement a is false. At a 17
  percent cost of capital, Project B will have a
  higher NPV than Project A. Therefore, statement
  b is true. If the cost of capital were 0, then the
  NPV of the projects would be the simple sum of
  all the cash flows. In order for statement c to be
  true, B’s NPV at a 0 cost of capital would have to
  be higher than A’s. From the diagram we see that
  this is clearly incorrect. So, statement c is false.
                            CHY                       283
NPV & IRR
13. Which of the following statements is most
    correct?
a. If a project’s internal rate of return (IRR)
    exceeds the cost of capital, then the
    project’s net present value (NPV) must be
    positive.
b. If Project A has a higher IRR than Project B,
    then Project A must also have a higher NPV.
c. The IRR calculation implicitly assumes that
    all cash flows are reinvested at a rate of
    return equal to the cost of capital.
d. Statements a & c are correct.
                      CHY               P126   284
【擬答】: (A) E
     If the projects are mutually exclusive,
 then project B may have a higher NPV
 even though Project A has a higher IRR.
 IRR is calculated assuming cash flows are
 reinvested at the IRR, not the cost of
 capital.


                     CHY                  285
NPV & IRR
14. Project A has an internal rate of return (IRR) of
   15 percent. Project B has an IRR of 14 percent.
   Both projects have a cost of capital of 12 percent.
   Which of the following statements is most correct?
a. Both projects have a positive net present value
   (NPV).
b. Project A must have a higher NPV than Project B.
c. If the cost of capital were less than 12 percent,
   Project B would have a higher IRR than Project A.
d. Statements a & c are correct.
e. All of the statements above are correct.
                           CHY                       286
【擬答】: (A) E
     Projects with IRRs > the cost of
 capital will have a positive NPV.
 Statement b is false because you know
 nothing about the relative magnitudes of
 the projects. (C) is false because the
 IRR is independent of the cost of
 capital.


                   CHY                  287
NPV, IRR, & MIRR
15. A project has an up-front cost of $100,000.
   The project’s WACC is 12 percent & its net
   present value is $10,000. Which of the
   following statements is most correct?
a. The project should be rejected since its return
   is less than the WACC.
b. The project’s internal rate of return is greater
   than 12 percent.
c. The project’s modified internal rate of return
   is less than 12 percent.
d. All of the statements above are correct.

                        CHY                       288
 【擬答】: (B) E
    If the NPV > 0, then IRR > 12%. (C)
is false; if NPV > 0, then MIRR >
WACC.




                 CHY                      289
NPV, IRR, MIRR, & payback
16. A proposed project has normal cash flows.
   In other words, there is an up-front cost
   followed over time by a series of positive cash
   flows. The project’s internal rate of return is
   12 percent & its WACC is 10 percent. Which
   of the following statements is most correct?
a. The project’s NPV is positive.
b. The project’s MIRR is greater than 10 percent
   but less than 12 percent.
c. The project’s payback period is greater than
   its discounted payback period.
d. Statements a & b are correct.
        P121
                       CHY                       290
 【擬答】: (D) E
    (A) is true because the IRR exceeds the
WACC. Statement b is also true because the
MIRR assumes that the inflows are reinvested at
the WACC, which is less than the IRR.
Statement c is false. For a normal project, the
discounted payback is always longer than the
regular payback because it takes longer for the
discounted cash flows to cover the purchase
price.
                     CHY                     291
NPV & expected return
17. Stock C has a beta of 1.2, while Stock D
   has a beta of 1.6. Assume that the stock
   market is efficient. Which of the following
   statements is most correct?
a. The required rates of return of the two stocks
   should be the same.
b. The expected rates of return of the two stocks
   should be the same.
c. Each stock should have a required rate of
   return equal to zero.
d. The NPV of each stock should equal its
   expected return.
e. The NPV of each stock should equal zero.
                       CHY                      292
【擬答】: (E) E
    If the stock is correctly priced, i.e., the
 stock market is efficient, the NPV of this
 project should be zero.




                       CHY                        293
NPV & project selection
18. Moynihan Motors has a cost of capital of 10
   percent. The firm has two normal projects of
   equal risk. Project A has an internal rate of
   return of 14 percent, while Project B has an
   internal rate of return of 12 percent. Which
   of the following statements is most correct?
a. Both projects have a positive net present
   value.
b. If the projects are mutually exclusive, the
   firm should always select Project A.
d. Statements a & b are correct
e. Statements a & b are incorrect.
【擬答】:(A) E
                      CHY                      294
IRR
19. Project A has an IRR of 15 percent. Project
    B has an IRR of 18 percent. Both projects
    have the same risk. Which of the following
    statements is most correct?
a. If the WACC is 10 percent, both projects will
    have a positive NPV, & the NPV of Project
    B will exceed the NPV of Project A.
b. If the WACC is 15 percent, the NPV of
    Project B will exceed the NPV of Project A.
                                          P128

                       CHY                     295
c. If the WACC < 18 percent, Project B will
   always have a shorter payback than Project
   A.
d. If the WACC > 18 percent, Project B will
   always have a shorter payback than Project
   A.
e. If the WACC increases, the IRR of both
   projects will decline.




                      CHY                       296
【擬答】:(B) E
     Project A’s IRR is 15%, at a WACC of 15%
 NPVA = 0; however, Project B would still have a
 positive NPV. Given the information in a, we
 can’t conclude which project’s NPV is going to
 be greater at a cost of capital of 10%. Since we
 are given no details about each project’s cash
 flows we cannot conclude anything about
 payback. Finally, IRR is independent of the
 discount rate, that is, IRR stays the same no
 matter what the WACC is.

                       CHY                      297
Post-audit
20. The post-audit is used to
a. Improve cash flow forecasts.
b. Stimulate management to improve
   operations & bring results into line with
   forecasts.
c. Eliminate potentially profitable but
   risky projects.
d. Statements a & b are correct.
【擬答】:(D) E
                     CHY                   298
NPV profiles
21. Projects L & S each have an initial cost of
  $10, followed by a series of positive cash
  inflows. Project L has total, undiscounted
  cash inflows of $16, while S has total
  undiscounted inflows of $15. Further, at a
  discount rate of 10%, the two projects have
  identical NPVs. Which project’s NPV will be
  more sensitive to changes in the discount
  rate?

                       CHY                        299
a. Project S.
b. Project L.
c. Both projects are equally sensitive to
   changes in the discount rate since their NPVs
   are equal at all costs of capital.
d. Neither project is sensitive to changes in the
   discount rate, since both have NPV profiles
   which are horizontal.
e. The solution cannot be determined unless the
   timing of the cash flows is known.

【擬答】:(B) M

                       CHY                      300
NPV profiles
22. Two mutually exclusive projects each have
  a cost of $10,000. The total, undiscounted
  cash flows for Project L are $15,000, while
  the undiscounted cash flows for Project S
  total $13,000. Their NPV profiles cross at a
  discount rate of 10 percent. Which of the
  following statements best describes this
  situation?
                                        P129

                      CHY                        301
a. The NPV & IRR methods will select the same
   project if the cost of capital is greater than 10
   percent; for example, 18 percent.
b. The NPV & IRR methods will select the same
   project if the cost of capital is less than 10
   percent; for example, 8 percent.
c. To determine if a ranking conflict will occur
   between the two projects the cost of capital is
   needed as well as an additional piece of
   information.
d. Project L should be selected at any cost of
   capital, because it has a higher IRR.
   【擬答】: (A) M            CHY                          302
NPV profiles
23. A company is comparing two mutually
   exclusive projects with normal cash flows.
   Project P has an IRR of 15 percent, while
   Project Q has an IRR of 20 percent. If the
   WACC is 10 percent, the two projects have
   the same NPV. Which of the following
   statements is most correct?
a. If the WACC is 12 percent, both projects
   would have a positive NPV.
b. If the WACC is 12 percent, Project Q would
   have a higher NPV than Project P.
c. If the WACC is 8 percent, Project Q would
   have a lower NPV than Project P.
d. All of the statements above are correct.
                      CHY                       303
【擬答】: (D) M
The diagram above can be drawn from
 the statements in this question




                 CHY                  304
NPV & IRR
24. Assume that you are comparing two mutually
   exclusive projects. Which of the following
   statements is most correct?
a. The NPV & IRR rules will always lead to the
   same decision unless one or both of the
   projects are ―non-normal‖ in the sense of
   having only one change of sign in the cash
   flow stream, that is, one or more initial cash
   outflows (the investment) followed by a series
   of cash inflows.
                                    P130

                       CHY                      305
b. If a conflict exists between the NPV & the
   IRR, the conflict can always be eliminated
   by dropping the IRR & replacing it with the
   MIRR.
c. There will be a meaningful (as opposed to
   irrelevant) conflict only if the projects’ NPV
   profiles cross, & even then, only if the cost
   of capital is to the left of (or lower than) the
   discount rate at which the crossover occurs.
d. All of the statements above are correct.

【擬答】: (C) M
                        CHY                           306
NPV & IRR
25. Which of the following statements is
  incorrect?
a.Assuming a project has normal cash
  flows, the NPV will be positive if the IRR
  is less than the cost of capital.
b.If the multiple IRR problem does not
  exist, any independent project
  acceptable by the NPV method will also
  be acceptable by the IRR method.

                     CHY                   307
c.If IRR = k (the cost of capital), then NPV =
  0.
d.NPV can be negative if the IRR is positive.
e.The NPV method is not affected by the
  multiple IRR problem.
  【擬答】 (A) M
      NPV is positive if IRR is greater than
  the cost of capital.

                      CHY                   308
NPV & IRR
26. Project J has the same internal rate of
   return as Project K. Which of the following
   statements is most correct?
a. If the projects have the same size (scale) they
   will have the same NPV, even if the two
   projects have different levels of risk.
b. If the two projects have the same risk they will
   have the same NPV, even if the two projects
   are of different size.



                        CHY                       309
c.If the two projects have the same
  size (scale) they will have the same
  discounted payback, even if the two
  projects have different levels of risk.
d. None of the statements above is
  correct.




                    CHY                     310
【擬答】(D) M
      (A) is false: The projects could easily have
 different NPVs based on different cash flows &
 costs of capital. (B): NPV is dependent upon the
 size of the project. Think about the NPV of a $3
 project versus the NPV of a $3 million project.
 Statement c is false. NPV is dependent on a
 project’s risk.


                       CHY                       311
NPV, IRR, & MIRR
27. Which of the following statements is most
   correct?
a. If a project with normal cash flows has an IRR
   that exceeds the cost of capital, then the
   project must have a positive NPV.
b. If the IRR of Project A exceeds the IRR of
   Project B, then Project A must also have a
   higher NPV.
c. The modified internal rate of return (MIRR)
   can never exceed the IRR.
d. Statements a & c are correct.
                         CHY             P131    312
【擬答】(A) M
    The IRR is the discount rate at which a
project’s NPV is zero. If a project’s IRR exceeds
the firm’s cost of capital, then its NPV must be
positive, since NPV is calculated using the firm’s
cost of capital to discount project cash flows.




                      CHY                       313
NPV, IRR, & MIRR
28. Which of the following statements is most
   correct?
a. The MIRR method will always arrive at the
   same conclusion as the NPV method.
b. The MIRR method can overcome the multiple
   IRR problem, while the NPV method cannot.
c. The MIRR method uses a more reasonable
   assumption about reinvestment rates than the
   IRR method.
d. Statements a & c are correct.

                      CHY                     314
【擬答】(C) M
MIRR & NPV can conflict for mutually
 exclusive projects if the projects differ in
 size. NPV does not suffer from the
 multiple IRR problem.




                      CHY                       315
NPV, IRR, & payback
29. Project X has an internal rate of return of
   20 percent. Project Y has an internal rate of
   return of 15 percent. Both projects have a
   positive net present value. Which of the
   following statements is most correct?
a. Project X must have a higher net present
   value than Project Y.
b. If the two projects have the same WACC,
   Project X must have a higher net present
   value.
c. Project X must have a shorter payback than
   Project Y.
d. None of the statements above is correct.
                         CHY                       316
【擬答】(D) M
    Statement a is false; the two
 projects’ NPV profiles could cross,
 consequently, a higher IRR doesn’t
 guarantee a higher NPV. Statement b is
 false; if the two projects’ NPV profiles
 cross, Y could have a higher NPV.
 Statement c is false; we don’t have
 enough information.
                   CHY                  317
IRR
30. A capital investment’s internal rate of return
a. Changes when the cost of capital changes.
b. Is equal to the annual net cash flows
    divided by one half of the project’s cost
    when the cash flows are an annuity.
c. Must exceed the cost of capital in order for
    the firm to accept the investment.
d. Is similar to the yield to maturity on a bond.
e. Statements c & d are correct.
       【擬答】(E) M                            P132

                        CHY                          318
MIRR
31. Which of the following statements is most
   correct? The modified IRR (MIRR)
   method:
a. Always leads to the same ranking decision
   as NPV for independent projects.
b. Overcomes the problem of multiple internal
   rates of return.
c. Compounds cash flows at the cost of capital.
d. Overcomes the problems of cash flow timing
   & project size that lead to criticism of the
   regular IRR method.
e. Statements b & c are correct
【擬答】(E) M
                      CHY                     319
Ranking methods
32. Which of the following statements is
   correct?
a. Because discounted payback takes account
   of the cost of capital, a project’s discounted
   payback is normally shorter than its regular
   payback.
b. The NPV & IRR methods use the same basic
   equation, but in the NPV method the discount
   rate is specified & the equation is solved for
   NPV, while in the IRR method the NPV is set
   equal to zero & the discount rate is found.
c. If the cost of capital is less than the crossover
   rate for two mutually exclusive projects’ NPV
   profiles, a NPV/IRR conflict will not occur.
                           CHY                       320
d. If you are choosing between two projects that
   have the same life, & if their NPV profiles
   cross, then the smaller project will probably
   be the one with the steeper NPV profile.
e. If the cost of capital is relatively high, this will
   favor larger, longer-term projects over
   smaller, shorter-term alternatives because it
   is good to earn high rates on larger amounts
   over longer periods.
【擬答】(B) M
Statement (B) reflects exactly the difference
   between the NPV & IRR methods.
                          CHY                             321
Project selection
33. A company estimates that its weighted
   average cost of capital (WACC) is 10
   percent. Which of the following independent
   projects should the company accept?
a. Project A requires an up-front expenditure of
   $1,000,000 & generates a net present value
   of $3,200.
b. Project B has a modified internal rate of
   return of 9.5 percent.
                                          P133


                       CHY                         322
c. Project C requires an up-front expenditure of
   $1,000,000 & generates a positive internal
   rate of return of 9.7 percent.
d. Project D has an internal rate of return of 9.5
   percent.
【擬答】(A) M
       Project A is the only project with either a
   positive NPV or an IRR that exceeds the cost
   of capital.




                        CHY                          323
Miscellaneous concepts
34. Which of the following is most correct?
a. The NPV & IRR rules will always lead to the
   same decision in choosing between mutually
   exclusive projects, unless one or both of the
   projects are ―nonnormal‖ in the sense of
   having only one change of sign in the cash
   flow stream.
b. The Modified Internal Rate of Return (MIRR)
   compounds cash outflows at the cost of
   capital.
c. Conflicts between NPV & IRR rules arise in
   choosing between two mutually exclusive
                        CHY                        324

   projects
(that each have normal cash flows) when
  the cost of capital exceeds the
  crossover rate (that is, the discount rate
  at which the NPV profiles cross).
d.The discounted payback method
  overcomes the problems that the
  payback method has with cash flows
  occurring after the payback period.
e.None of the statements above is
  correct.
【擬答】(E) M            CHY                       325
    IRR can lead to conflicting decisions with
NPV even with normal cash flows if the
projects are mutually exclusive. Cash
outflows are discounted at the cost of capital
with the MIRR method, while cash inflows are
compounded at the cost of capital. Conflicts
between NPV & IRR arise when the cost of
capital is less than the crossover rate. The
discounted payback method corrects the
problem of ignoring the time value of money,
but it still does not consider cash flows that
occur beyond the payback period.
                    CHY                          326
Miscellaneous concepts
35. Which of the following statements is most
   correct?
a. The IRR method is appealing to some
   managers because it produces a rate of
   return upon which to base decisions rather
   than a dollar amount like the NPV method.
b. The discounted payback method solves all
   the problems associated with the payback
   method.
c. For independent projects, the decision to
   accept or reject will always be the same using
   either the IRR method or the NPV method.
d. Statements a & c are correct.
       P134
                       CHY                      327
【擬答】(D) M
     The discounted payback method still
  ignores cash flows that occur after the
  payback period.
(A) 如殖利率報價




                    CHY                     328
Miscellaneous concepts         (A) M
36. Which of the following statements is most
   correct?
a. One of the disadvantages of choosing
   between mutually exclusive projects on the
   basis of the discounted payback method is
   that you might choose the project with the
   faster payback period but with the lower total
   return.
b. Multiple IRRs can occur in cases when
   project cash flows are normal, but they are
   more common in cases where project cash
   flows are nonnormal.
                       CHY                          329
c.    When choosing between mutually
exclusive projects, managers should accept all
projects with IRRs greater than the weighted
average cost of capital.
d.    Statements a & b are correct.
【擬答】(A) M
     Multiple IRRs can occur only for projects with
 nonnormal cash flows. Mutually exclusive
 projects imply that only one project should be
 chosen. The project with the highest NPV
 should be chosen.

                        CHY                      330
Miscellaneous concepts
37. Normal projects C & D are mutually exclusive.
   Project C has a higher net present value if the
   WACC is less than 12 percent, whereas
   Project D has a higher net present value if the
   WACC exceeds 12 percent. Which of the
   following statements is most correct?
a. Project D has a higher internal rate of return.
b. Project D is probably larger in scale than
   Project C.
c. Project C probably has a faster payback.
d. Statements a & c are correct.
e. All of the statements above are correct.
【擬答】(A) M               CHY                        331
【擬答】(A) M
    Sketch the profiles. From the
information given, D has the higher IRR.
The project’s scale cannot be
determined from the information given.
As C’s NPV declines more rapidly with
an increase in rates, this implies that
more of the cash flows are coming later
on. So C would have a slower payback
than D.
                  CHY                  332
NPV profiles
38. Your assistant has just completed an
  analysis of two mutually exclusive projects.
  You must now take her report to a board of
  directors meeting & present the alternatives
  for the board’s consideration. To help you
  with your presentation, your assistant also
  constructed a graph with NPV profiles for the
  two projects. However, she forgot to label the
  profiles, so you do not know which line
  applies to which project. Of the following
  statements regarding the profiles, which one
  is most reasonable?

     P135             CHY                      333
a. If the two projects have the same investment
   cost, & if their NPV profiles cross once in the
   upper right quadrant, at a discount rate of 40
   percent, this suggests that a NPV versus IRR
   conflict is not likely to exist.
b. If the two projects’ NPV profiles cross once, in
   the upper left quadrant, at a discount rate of
   minus 10 percent, then there will probably not
   be a NPV versus IRR conflict, irrespective of
   the relative sizes of the two projects, in any
   meaningful, practical sense (that is, a conflict
   that will affect the actual investment decision).

                        CHY                        334
c.If one of the projects has a NPV profile
  that crosses the X-axis twice, hence the
  project appears to have two IRRs, your
  assistant must have made a mistake.
d.Whenever a conflict between NPV &
  IRR exist, then, if the two projects have
  the same initial cost, the one with the
  steeper NPV profile probably has less
  rapid cash flows. However, if they have
  identical cash flow patterns, then the
  one with the steeper profile probably
  has the lower initial cost.
                    CHY                       335
e. If the two projects both have a
  single outlay at t = 0, followed by a
  series of positive cash inflows, & if
  their NPV profiles cross in the lower
  left quadrant, then one of the projects
  should be accepted, & both would be
  accepted if they were not mutually
  exclusive.
【擬答】(B) Diff: T
                   CHY                  336
NPV, IRR, & MIRR
39. Which of the following statements is most
   correct?
a. When dealing with independent projects,
   discounted payback (using a payback
   requirement of 3 or less years), NPV, IRR, &
   modified IRR always lead to the same
   accept/reject decisions for a given project.
b. When dealing with mutually exclusive
   projects, the NPV & modified IRR methods
   always rank projects the same, but those
   rankings can conflict with rankings produced
   by the discounted payback & the regular IRR
   methods.

                      CHY                         337
c.Multiple rates of return are possible with
  the regular IRR method but not with the
  modified IRR method, & this fact is one
  reason given by the textbook for favoring
  MIRR (or modified IRR) over IRR.
d.Statements a & c are correct.
【擬答】(C) Diff: T



                     CHY                       338
NPV, IRR, & MIRR
40. Which of the following statements is
   correct?
a. There can never be a conflict between NPV &
   IRR decisions if the decision is related to a
   normal, independent project, that is, NPV will
   never indicate acceptance if IRR indicates
   rejection.
b. To find the MIRR, we first compound CFs at
   the regular IRR to find the TV, & then we
   discount the TV at the cost of capital to find
   the PV.
c. The NPV & IRR methods both assume that
   cash flows are reinvested at the cost of
   capital. However, the MIRR method
   assumes reinvestment at the MIRR itself.
                         CHY                      339
                                            P130
d. If you are choosing between two projects
   that have the same cost, & if their NPV
   profiles cross, then the project with the
   higher IRR probably has more of its cash
   flows coming in the later years.
e. A change in the cost of capital would
   normally change both a project’s NPV & its
   IRR.

【擬答】 (A) Diff: T


                      CHY                       340
   Sketch out a NPV profile for a normal,
   independent project, which means that only
   one NPV profile will appear on the graph. If
   WACC < IRR, then IRR says accept. But in
   that case, NPV > 0, so NPV will also say
   accept. Statement d is false. Here is the
   reasoning:
1. For the NPV profiles to cross, then one
   project must have a higher NPV at k = 0 than
   the other project, that is, their vertical axis
   intercepts will be different.
2. A second condition for NPV profiles to cross
   is that one have a higher IRR than the other.
.
                        CHY                          341
3. The third condition necessary for profiles to
   cross is that the project with the higher NPV
   at k = 0 will have the lower IRR
One can sketch out two NPV profiles on a
   graph to see that these three conditions are
   indeed required.
4. The project with the higher NPV at k = 0
   must have more cash inflows, because it has
   the higher NPV when cash flows are not
   discounted, which is the situation if k = 0.


                      CHY                      342
5. If the project with more total cash inflows also
   had its cash flows come in earlier, it would
   dominate the other project--its NPV would be
   higher at all discount rates, & its IRR would
   also be higher, so the profiles would not
   cross. The only way the profiles can cross is
   for the project with more total cash inflows to
   get a relatively high percentage of those
   inflows in distant years, so that their PVs are
   low when discounted at high rates. Most
   students either grasp this intuitively or else
   just guess at the question!
                        CHY                           343
Choosing among mutually exclusive
  projects
41. Project A has an internal rate of return
  of 18 percent, while Project B has an
  internal rate of return of 16 percent.
  However, if the company’s cost of
  capital (WACC) is 12 percent, Project B
  has a higher net present value. Which
  of the following statements is most
  correct?

                     CHY                   344
a. The crossover rate for the two projects
   is less than 12 percent.
b. Assuming the timing of the two
   projects is the same, Project A is
   probably of larger scale than Project
   B.
c. Assuming that the two projects have
   the same scale, Project A probably
   has a faster payback than Project B.
d. Statements a & b are correct.
                    CHY            P131   345
【擬答】(C) Diff: T
     Draw out the NPV profiles of these two
 projects. As B’s NPV declines more rapidly
 with an increase in discount rates, this
 implies that more of the cash flows are
 coming later on. Therefore, Project A has
 a faster payback than Project B.


                    CHY                  346
Capital components
42. Which of the following statements is most
   correct?
a. In the weighted average cost of capital
   calculation, we must adjust the cost of
   preferred stock for the tax exclusion of 70
   percent of dividend income.
b. We ideally would like to use historical
   measures of the component costs from prior
   financings in estimating the appropriate
   weighted average cost of capital.


                      CHY                        347
c. The cost of a new equity issuance (ke) could
   possibly be lower than the cost of retained
   earnings (ks) if the market risk premium &
   risk-free rate decline by a substantial amount.
d. None of the statements above is correct.
【擬答】(D) M
       Unlike interest expense on debt, preferred
   dividends are not deductible, hence there are
   no tax savings associated with the use of
   preferred stock. The component costs of
   WACC should reflect the costs of new
   financing, not historical measures. The cost of
   issuing new equity is always greater than the
   cost of retained earnings.
                       CHY                       348
Capital components
43. Which of the following statements is most
   correct?
a. The cost of retained earnings is the rate of
   return stockholders require on a firm’s
   common stock.
b. The component cost of preferred stock is
   expressed as kp(1 - T), because preferred
   stock dividends are treated as fixed charges,
   similar to the treatment of debt interest.
c. The bond-yield-plus-risk-premium approach
   to estimating a firm’s cost of common equity
   involves adding a subjectively determined risk
   premium to the market risk-free bond rate.
                         CHY                     349
 d. The higher the firm’s flotation cost for new
 common stock, the more likely the firm is to
 use preferred stock, which has no flotation
 cost.
【擬答】(A) M
      Preferred stock dividends are not tax
 deductible; therefore, the cost of preferred
 stock is only kp. The risk premium in the
 bond-yield-plus-risk premium approach would
 be added to the firm’s cost of debt, not the
 risk-free rate. Preferred stock also has
 flotation costs.      CHY                       350
Cost of capital estimation
44. Which of the following statements is
   correct?
a. The cost of capital used to evaluate a project
   should be the cost of the specific type of
   financing used to fund that project.
b. The cost of debt used to calculate the
   weighted average cost of capital is based on
   an average of the cost of debt already issued
   by the firm & the cost of new debt.
                                          P131

                       CHY                      351
c. One problem with the CAPM approach in
   estimating the cost of equity capital is that if a
   firm’s stockholders are, in fact, not well
   diversified, beta may be a poor measure of
   the firm’s true investment risk.
d. The bond-yield-plus-risk-premium approach
   is the most sophisticated & objective method
   of estimating a firm’s cost of equity capital.
e. The cost of equity capital is generally easier
   to measure than the cost of debt, which
   varies daily with interest rates, or the cost of
   preferred stock since preferred stock is
   issued infrequently.
【擬答】(C) M
                         CHY                            352
Cost of equity estimation
45. Which of the following statements is
   correct?
a. Although some methods of estimating the
   cost of equity capital encounter severe
   difficulties, the CAPM is a simple & reliable
   model that provides great accuracy &
   consistency in estimating the cost of equity
   capital.
b. The DCF model is preferred over other
   models to estimate the cost of equity because
   of the ease with which a firm’s growth rate is
   obtained.              CHY                     353
c. The bond-yield-plus-risk-premium approach
   to estimating the cost of equity is not always
   accurate but its advantages are that it is a
   standardized & objective model.
d. Depreciation-generated funds are an
   additional source of capital and, in fact,
   represent the largest single source of funds
   for some firms.
【擬答】(D) M



                       CHY                          354
CAPM cost of equity estimation
46. In applying the CAPM to estimate the cost
   of equity capital, which of the following
   elements is not subject to dispute or
   controversy?
a. The expected rate of return on the market,
   kM.
b. The stock’s beta coefficient, bi.
c. The risk-free rate, kRF.
d. The market risk premium (RPM).
e. All of the above are subject to dispute.
【擬答】 (E) M               CHY                    355
CAPM & DCF estimation
47. Which of the following statements is most
   correct?
a. Beta measures market risk, but if a firm’s
   stockholders are not well diversified, beta
   may not accurately measure stand-alone
   risk.
b. If the calculated beta underestimates the
   firm’s true investment risk, then the CAPM
   method will overestimate ks.

                                         P133

                       CHY                       356
c. The discounted cash flow method of
   estimating the cost of equity can’t be used
   unless the growth component, g, is constant
   during the analysis period.
d. An advantage shared by both the DCF &
   CAPM methods of estimating the cost of
   equity capital, is that they yield precise
   estimates & require little or no judgement.
e. None of the statements above is correct.
【擬答】(A) M

                      CHY                        357
WACC
48. Which of the following statements is most
   correct?
a. The weighted average cost of capital for a
   given capital budget level is a weighted
   average of the marginal cost of each relevant
   capital component that makes up the firm’s
   target capital structure.
b. The weighted average cost of capital is
   calculated on a before-tax basis.
c. An increase in the risk-free rate is likely to
   increase the marginal costs of both debt &
   equity financing.
                       CHY                          358
d. Statements a & c are correct.
e. All of the statements above are correct.
【擬答】 (D) M
     Both statements a & c are true; therefore,
   statement d is the correct choice.
   Statement a recites the definition of the
   weighted average cost of capital.
   Statement c is correct because
• kd = kRF + LP + MRP + DRP while
   ks = kRF + (kM - kRF)b. If kRF increases
   then the values for kd & ks will increase.

                      CHY                         359
    49. Which of the following statements is correct?
a. The WACC should include only after-tax
   component costs. Therefore, the required rates of
   return (or ―market rates‖) on debt, preferred, &
   common equity (kd, kp, & ks) must be adjusted to
   an after-tax basis before they are used in the
   WACC equation.
b. The cost of retained earnings is generally higher
   than the cost of new common stock.
c. Preferred stock is riskier to investors than is debt.
   Therefore, if someone told you that the market
   rates showed kd > kp for a given company, that
   person must have made a mistake.
d. If a company with a debt ratio of 50 percent were
   suddenly exempted from all future income taxes,
   then, all other things held constant, this would
   cause its WACC to increase.
                            CHY                       360
【擬答】       (D) M
     If a firm paid no income taxes, its cost of
 debt would not be adjusted downward, hence
 the component cost of debt would be higher
 than if T were greater than 0. With a higher
 component cost of debt, the WACC would
 increase. Of course, the company would have
 higher earnings, & its cash flows from a given
 project would be high, so the higher WACC
 would not impede its investments, that is, its
 capital budget would be larger than if it were
 taxed.

                       CHY                         361
WACC
50. Which of the following statements is most
   correct?
a. An increase in flotation costs incurred in
   selling new stock will increase the cost of
   retained earnings.
b. The WACC should include only after-tax
   component costs. Therefore, the required
   rates of return (or ―market rates‖) on debt,
   preferred, & common equity (kd, kp, & ks)
   must be adjusted to an after-tax basis before
   they are used in the WACC equation.

                       CHY                         362
c. An increase in a firm’s corporate tax rate will
   increase the firm’s cost of debt capital, as
   long as the yield to maturity on the company’s
   bonds remains constant or falls.
d. Statements b & c are correct.
e. None of the statements above is correct.




                       CHY                       363
【擬答】 (E) M
      An increase in flotation costs has no effect
 on the cost of retained earnings. Since interest
 is tax deductible, while preferred & common
 dividends are not, only the cost of debt used in
 the WACC equation must be adjusted by
 multiplying by (1 - T). An increase in the firm’s
 corporate tax rate reduces the after-tax
 component cost of debt.

                        CHY                          364
Risk-adjusted cost of capital
51. If a company uses the same cost of capital
    for evaluating all projects, which of the
    following results is likely?
a. Accepting poor, high-risk projects.
b. Rejecting good, low-risk projects.
c. Accepting only good, low-risk projects.
d. Accepting no projects.
e. Answers a & b are correct.
【擬答】 (E) M
                      CHY                        365
Risk-adjusted cost of capital
52. If a typical U.S. company uses the same
   cost of capital to evaluate all projects, the firm
   will most likely become
a. Riskier over time, & its value will decline.
b. Riskier over time, & its value will rise.
c. Less risky over time, & its value will rise.
d. Less risky over time, & its value will decline.
e. There is no reason to expect its risk position
   or value to change over time as a result of its
   use of a single discount rate.
【擬答】 (A) M                                    P135

                         CHY                        366
Division WACCs & risk
53. Pearson Plastics has two equal-sized
  divisions, Division A & Division B. The
  company estimates that if the divisions
  operated as independent companies Division
  A would have a cost of capital of 8 percent,
  while Division B would have a cost of capital
  of 12 percent.

Since the two divisions are the same size,
  Pearson’s composite weighted average cost
  of capital (WACC) is 10 percent.

                      CHY                         367
    In the past, Pearson has assigned separate
hurdle rates to each division based on their
relative risk. Now, however, Pearson has
chosen to use the corporate WACC, which is
currently 10 percent, for both divisions. Which of
the following is likely to occur as a result of this
change? Assume that this change is likely to
have no effect on the average risk of each
division & market conditions remain unchanged.

                       CHY                        368
a. Over time, the overall risk of the company will
   increase.
b. Over time, Division B will become a larger part of
   the overall company.
c. Over time, the company’s corporate WACC will
   increase.
d. All of the statements above are correct.



                         CHY                       369
【擬答】 (D) M
      If the company uses the 10 percent
 WACC, it will turn down all projects with a
 return of less than 10 percent but more than 8
 percent. Thus, these ―safer‖ projects will no
 longer be taken, & the company will increase
 the proportion of risky projects it undertakes.
 Therefore, statement a is true. If Division A’s
 projects have lower returns than Division B’s
 because they have less risk, fewer & fewer
 projects will be accepted from Division A &
 more projects will be accepted from Division
 B.                    CHY                       370
     Therefore, Division B will grow & Division A
will shrink. Therefore, statement b is true. If the
company becomes riskier, then its cost of equity
will increase causing WACC to increase.
Therefore, statement c is true.




                       CHY                        371
WACC
54. An analyst has collected the following
  information regarding Christopher Co.:
• The company’s capital structure is 70 percent
  equity & 30 percent debt.
• The yield to maturity on the company’s bonds
  is 9 percent.
• The company’s year-end dividend is
  forecasted to be $0.80 a share.
• The company expects that its dividend will
  grow at a constant rate of 9 percent a year.

                                        P136
                      CHY                         372
• The company’s stock price is $25.
• The company’s tax rate is 40 percent.
• The company anticipates that it will need to
   raise new common stock this year, & total
   flotation costs will equal 10 percent of the
   amount issued.
Assume the company accounts for flotation
   costs by adjusting the cost of capital. Given
   this information, calculate the company’s
   WACC.
a. 10.41%                 b.    12.56%
c. 10.78%                 d.    13.55%
                          CHY                      373
e. 9.29%
【擬答】 (A) E
WACC = wdkd(1 - T) + wcke. kd is given =
 9%. Find ke:
 ke= D1/[P0(1 - F)] + g
 = $0.8/[$25(1 - 0.1)] + 0.09
 = 0.125556.
 WACC = (0.3)(0.09)(0.6) + (0.7)(0.125556) =
 10.41%



                     CHY                       374
55. Flaherty Electric has a capital structure that
  consists of 70 percent equity & 30 percent
  debt. The company’s long-term bonds have a
  before-tax yield to maturity of 8.4 percent.

The company uses the DCF approach to
  determine the cost of equity. Flaherty’s
  common stock currently trades at $45 per
  share. The year-end dividend (D1) is
  expected to be $2.50 per share, & the
  dividend is expected to grow forever at a
  constant rate of 7 percent a year.

The company estimates that it will have to issue
  new common stock to help fund this year’s
  projects.
                        CHY                          375
The flotation cost on new common stock issued
   is 10 percent, & the company’s tax rate is
   40 percent. What is the company’s
   weighted average cost of capital, WACC?
a. 10.73%
b. 10.30%
c. 11.31%
d. 7.48%
e. 9.89%
【擬答】 (A) E
WACC = [0.3  0.084  (1 - 0.4)] + [0.7 
   ($2.5/($45  (1 - 0.1)) + 0.07)]= 10.73%.
                     CHY                        376
WACC
56. Billick Brothers is estimating its WACC. The
  company has collected the following
  information:
• Its capital structure consists of 40 percent
  debt & 60 percent common equity.
• The company has 20-year bonds outstanding
  with a 9 percent annual coupon that are
  trading at par.
• The company’s tax rate is 40 percent.
• The risk-free rate is 5.5 percent.
• The market risk premium is 5 percent.
• The stock’s beta is 1.4.
                                          P137

                      CHY                      377
|What is the company’s WACC?
a.  9.71% b.      9.66%
c.  8.31% d. 11.18% e. 11.10%

 【擬答】 (B) E
 WACC = wdkd(1 - T) + wcks.
 ks = kRF + RPM(b)
 ks = 5.5% + 5%(1.4)
 ks = 5.5% + 7% = 12.5%.
 WACC = wdkd(1 - T) + wcks
 WACC = 0.4(9%)(1 - 0.4) + (0.6)12.5%
 WACC = 9.66%.
                       CHY              378
Agency
57. Which of the following statements is most
   correct?

a. Compensating managers with stock can
   reduce the agency problem between
   stockholders & managers.
b. Restrictions are included in credit agreements
   to protect bondholders from the agency
   problem that exists between bondholders &
   stockholders.
c. The threat of a takeover can reduce the
   agency problem between bondholders &
   stockholders.
                         CHY                   379
d. Statements a & b are correct.            P137
【擬答】: (D) E
The threat of a takeover alleviates
 the agency problem between
 managers & stockholders, not
 between       bondholders        &
 stockholders.



                CHY                   380
Agency
58. Which of the following work to reduce agency
   conflicts between stockholders &
   bondholders?

a. Including   restrictive covenants in the
   company’s bond contract.
b. Providing managers with a large number of
   stock options.
c.    The passage of laws that make it easier for
   companies to resist hostile takeovers.
d. Statements b & c are correct.


                      CHY                     381
【擬答】:(A) E
 Restrictive covenants resolve differences
 between bondholders & stockholders.




                   CHY                  382
Agency
59. Which of the following actions are likely to
   reduce       agency    conflicts   between
   stockholders & managers?
a. Paying managers a large fixed salary.
b. Increasing the threat of corporate
   takeover.
c. Placing restrictive covenants in debt
   agreements.
d. All of the statements above are correct.
                       CHY                   383
【擬答】: (B) E
Corporate takeovers are most likely to occur
 when a firm is underperforming. Managers
 who fear losing their jobs will try to
 maximize shareholder wealth. The other
 statements are false. Statement a will
 exacerbate the agency conflict, while
 statement c reduces the agency conflict
 between stockholders & bondholders.
                    CHY                    384
Agency
60. Which of the following actions are likely to
  reduce the agency problem between
  stockholders & managers?

a. Congress passes a law that severely restricts
   hostile takeovers.
b.A manager receives a lower salary but receives
   additional shares of the company’s stock.
c. The board of directors has become more vigilant
   in its oversight [ 董 事 會 盯 更 緊 ] of the
   company’s management.
d.Statements b & c are correct.
                       CHY                     385
擬答: (D) E
Statement a will serve to increase the
 agency problems by preventing
 takeovers. Both statements b & c
 will reduce agency problems.




                 CHY                     386
Financial policy & cash flows
61. Which of the following statements is most
  correct?

a. The optimal dividend policy is the one that satisfies
   the shareholders because they supply the firm’s
   capital.
b. The use of debt financing has no effect on cash
   flow or stock price.
c. The riskiness of projected cash flows depends
   upon how the firm is financed.
d. Stock price is dependent on the projected cash
   flows & the use of debt, but not on the timing of the
   cash flow stream.
【擬答】(C) M
                           CHY                       387
                                          P139
Corporate goals & control
62. Which of the following statements is
  most correct?

a.The proper goal of the financial manager
  should be to maximize the firm’s
  expected cash flow, because this will add
  the most wealth to each of the individual
  shareholders (owners) of the firm.

                     CHY                  388
b. One way to state the decision framework
  most useful for carrying out the firm’s
  objective is as follows: ―The financial
  manager should seek that combination of
  assets, liabilities, & capital that will
  generate the largest expected projected
  after-tax income over the relevant time
  horizon.‖

                   CHY                  389
c.The riskiness inherent in a firm’s
  earnings per share (EPS) depends on
  the characteristics of the projects the
  firm selects, which means it depends
  upon the firm’s assets, but EPS does
  not depend on the manner in which
  those assets are financed.



                   CHY                  390
d. Since large, publicly-owned firms are controlled by
   their management teams, & typically, ownership is
   widely dispersed, managers have great freedom
   in managing the firm. Managers may operate in
   stockhold-ers’ best interests, but they may also
   operate in their own personal best interests. As
   long as managers stay within the law, there simply
   aren’t any effective controls over managerial
   deci-sions in such situations.
e. Agency problems exist between stockholders &
   managers, & between stockholders & creditors.
                              【擬答】 (E) M

                           CHY                      391
Split
63. Which of the following statements is
   false?
a.     A good reason for a firm to initiate a
   reverse split is to get the price of the
   shares up to some minimum
   requirement for listing on a national
   exchange.
b.     Stock dividends do not change the
   value of firms, but reverse splits do
   change form value.   CHY                  392
c.       When the number of shares of a stock
     doubles because of a stock split, trading
     volume tends to increase by less than 100
     percent.

d. When a stock undergoes a reverse split,
   effective trading activity tends to increase.   〔
   平均每元交易成本降低〕



【擬答】(B)
 Stock dividends, splits, and reverse splits have
 no effect on firm value.
                         CHY                       393
Capital Structure & Leverage
64. Assume the following facts for Lowry’s
  Manufacturing        Company’s       two
  operating divisions at 20X2:
Division A: sales = $1,000,000; variable
  costs = $400,000; units sold = 10,000
Division B: sales = $ 800,000; variable
  costs = $600,000; units sold = 4,000
                                    P140

                   CHY                   394
         Based on fixed costs of $500,000
     divided    equally     between    the     two
     divisions, the pre-tax operating profit (EBIT)
     during 20X2 for Division A and Division B,
     respectively, was?

a.     Division A = $100,000, Division B = $ (300,000)
b.     Division A = $170,000, Division B = $ 100,000
c.     Division A = $600,000, Division B = $ 200,000
d.     Division A = $350,000, Division B = $ (50,000)



                            CHY                     395
【擬答】(D)
 The formula is :(sales-variable costs) – fixed
 costs;
 The altemate formula is: (per unit contribution
 margin) (units sold) – fixed costs.
 Choice D calculation:
     Division A = ($1,000,000 - $400,000) -
 $250,000 = $350,000
     Division B = ($800,000 - $600,000) -$250,000
 = $(50,000)
 Alternate Formula:
     Division A = ($100 - $40) (10,000)- $250,000
 = $350,000
     Division B = ($200 - $150)(4,000) -$250,000 =
 $(50,000)
                         CHY                     396
(A) X. These are the results if each divisions’
  fixed costs were $500,000.
(B) X. These are meaningless results.
(C) X. These are the operating profit
  excluding fixed costs.



                      CHY                    397
65. The Simpson Corporation has a
  degree of operating leverage of 2.0 and
  a degree of financial leverage of 5.0.
  Simpson’s degree of total leverage is:
a.     7.0
b.    10.0
c.    2.5
d.    0.4



                   CHY                  398
【擬答】 (B)
Degree of Total Leverage (DTL)
= Degree of Operating Leverage (DOL) ×
 Degree of Financial Leverage (DFL)

DTL = DOL × DFL = 2.0 ×5.0 =10.0




                  CHY                399
66. Which of the following is a true statement
   regarding a company’s use of debt and its impact
   on the cost of debt, the cost of equity capital, and
   the weighted-average cost of capital?
a.      The cost of equity capital increases as the
   debt-to-total capital ratio rises because the
   required return on common equity should increase
   with the higher risk.
b.     The cost of debt declines as the debt-to-total
   capital ratio increases because the credit ratings
   on the bond improve as the debt-to-total capital
   ratio increases.
c.      Beta for a stock is constant at all levels of debt-
   to-equity.
                             CHY                        400
d.     All are true.                                P141
【擬答】(A)
The cost of equity should rise as the debt-to-
  equity. In effect, the additional risk results
  in a higher beta.
(B) X. The cost of debt will likely increase as
  the debt-to-equity ratio increases. As this
  ratio increases, the firm’s credit ratings
  should fall.
(C) X. See explanation for choice ―a‖ as to
  why beta is not constant.
Choice ―d‖ is incorrect. Since both ―b‖ and ―c‖
  are incorrect, ―d‖ is incorrect.
                      CHY                     401
67. An investor in a stock can create
   his or her own dividend policy by:
a.      Selling off a portion of the shares
   owned.
b.     Buying the stock on margin.
c.      Buying futures contracts on the
   shares.
d.     All of the above techniques will
   create an investor’s own dividend
   policy.
                    CHY                   402
【擬答】                          (A)
(A) V. By selling off shares funds are
  raised as if a dividend was received.

Choice ―b‖ and ―c‖ are incorrect. These
 choices increase leverage, but do not
 constitute a dividend policy for a
 shareholder.


                  CHY                 403
68. Which statement is most correct, based
   on the clientele effect?
a.       If a company changed its dividend
   policy from a low payout ratio to a high
   payout ratio, it would likely lose its existing
   investor base (its ―clientele‖) and the price
   of the shares would fall.
b.      If a company changed its dividend
   policy from a low payout ratio to a high
   payout ratio, it would likely gain a new
   ―clientele‖ and the price of the shares
   would rise.
                       CHY                       404
c. If a company changed its dividend policy
  from a low payout ratio to a high payout
  ratio, its investor base (clientele) would
  change from growth-oriented investors to
  income-oriented investors. But, in the long
  run, there would probably be no significant
  change in the price of the shares.
d. Investors prefer that the dividend that a
  company pays be equal to the total
  amount of the free cash flow that the firm
  has generated for equity investors during
  the most recent accounting period.

                     CHY                        405
【擬答】(C) According to the clientele
 effect, a change in the dividend payout
 probably has no effect on firm or
 common stock values.
Choice ―a‖ and ―b‖ are incorrect. These
 outcomes contradict the clientele effect.
Choice ―d‖ is incorrect. Such a policy
 would produce erratic dividends, which
 investors dislike. This has nothing to do
 with the clientele effect.

                   CHY                   406
70. Proposition I of the Modigliani-Miller
   Theorem (without taxes) suggests that if two
   firms have the same total value:
a.        The one with the most debt will have the
   highest equity value.
b.        The one with the most debt will have the
   lowest equity value.
c.        The equity values of the two firms will be
   equal in spite of the fact that one firm has more
   debt than the other.
d.         The optimum capital structure would be
   one with a modest amount of debt.

【擬答】(B)                                  P142
                        CHY                      407
  The value of a firm equals the sum
of the values of the debt and equity
    portions of its capital structure.
Therefore, if the debt portion is large,
the       equity portion must be small
and vice versa.




                 CHY                   408
Modigliani-Miller Theorem (without taxes)

Proposition I 任何Debt-Equity Ratio都可以;
               Firm Value 不受影響
Proposition Cost      of Cost       of WACC不變
II            Debt不變     Equity    隨
                         Debt-Equity
                         Ratio 增 加 而
                         上升

                         CHY                409
Modigliani-Miller Theorem (with taxes)

Proposition I Debt-Equity Ratio越高越好
Proposition   Cost of    Cost of     WACC隨
Ⅱ             Debt不變     Equity隨     Debt-Equity
                         Debt-Equity Ratio增加,
                         Ratio增加     稅盾愈多 而
                         而上升         減少
Trade-off     Debt- Equity Ratio有最合適水準
Theory
Signaling     增加Equity之外部融資會有負面訊號
Theory        效果     CHY        410
71. Proposition Ⅱ of the Modigliani-Miller
   Theorem (without taxes) suggests that if
   there is no preferred stock in the capital
   structure, as a firm’s debt-to-equity ration
   increases:
 a.      Its cost of common equity capital
   decreases.
 b. Its cost of common equity capital ↑.
 c. Its cost of common equity capital remains
   constant.
 d. All of the above are possible.

                      CHY                     411
                                       P143
【擬答】 (B)
  Proposition II states that the weighted
 average cost of capital must remain
 constant across all debt-to-equity
 rations for a non-taxpaying firm => the
 cost of debt is assumed to remain
 constant over the entire range of debt-
 to-equity ratios, so in the absence of
 preferred equity, the cost of equity
 capital must increase as the debt-to-
 equity ratio rises.
                   CHY                  412
72. According to Proposition Ⅱ of the
   Modigliani-Miller Theorem (with taxes):
a.        As the debt-to-equity ratio ↑, WACC
   will remain constant.
b.       As the debt-to-equity ratio↑, WACC will
   ↑.
c.                When the capital structure is
   entirely comprised of debt, WACC = after-
   tax cost of debt capital.
d.        The value of the equity of a firm with
   100﹪debt will be zero. [有稅盾價值]
【擬答】 (C)                CHY                  413
73. Which statement is most correct?
a.          If a company changed its dividend
   policy from a low payout ratio 【股利支付
   比率】 to a high payout ratio, it would
   likely lose its existing investor base (its
   ―clientele‖) and the price of the shares
   would fall.
b.          If a company changed its dividend
   policy from a low payout ratio to a high
   payout ratio, it would likely gain a new
   ―clientele‖ and the price of the shares
   would rise.
                    CHY                    414
c.      If a company changed its dividend policy
   from a low payout ratio to a high payout ratio,
   its investor base (clientele) would change
   from growth oriented investors to income
   oriented investors but, in the long run, there
   would probably be no significant change in
   the price of the shares.
d.         Investors prefer that the dividend that a
   company pays be equal to the total amount of
   the free cash flow that the firm has generated
   for equity investors during the most recent
   accounting period.

                        CHY                        415
【擬答】 (C)
(D) X     because such a policy would
  produce erratic dividends <= 投資人現金流
  量不確定 =負面效果




                 CHY               416
Business risk        (C)      E
74. A decrease in the debt ratio will
   generally have no effect on

a.   Financial risk.
b.   Total risk.
c.   Business risk.
d.   Market risk.
e.     None of the above is correct. (It will
     affect each type of risk above.)
                      CHY                   417
75. A capital project that is undertaken
   primarily for the purpose of
   increasing sales is called:
a.     An expansion project.
b.    A replacement project.
c.     An environmental project.
d.    A remediation project.


                  CHY                  418
【擬答】 (A)
An expansion project is undertaken to
  increase sales. This sales increase can
  be accomplished by expanding into
  existing or new markets.
(B)X        A replacement project is
  undertaken      to   replace     existing
  equipment.
Choices ―c‖ & ―d‖ are incorrect. Neither of
  these are done to increase sales.
                    CHY                   419

								
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