Financial Management_MGT201

7th Week of Lectures

Lecture 19 to 22
Important Notes

Explanation noted by me has shown with & symbols.

Lecture No 19:

6 Dec 2015_Tuesday_ 2:13pm 3:02pm

 RISKS: Its very important to understand this concept. Coz its very helpful in
investment decisions.
 Risk: Its game of Fate or Chance. It is the subject of philosophy not
management.

What is Risk?

• Definition of Investment Risk

– Chinese Definition of Risk: Danger plus Opportunity

– UNCERTAINTY, variability, spread, or volatility in the expected

future Value (Cash Flows) or Returns

– The wider the Range of Possible Outcomes that can occur in future,
the greater the Risk or Uncertainty.

• Types of Risk:

– Stand Alone Risk (or Single Investment Risk)

– Portfolio Risk (or Collection of Investments Risk )

• Diversifiable Risk – random risk specific to one company, can
be virtually eliminated

• Market Risk - uncertainty caused by broad movement in

market or economy. More significant.

• Causes of Risk

can be Company-Specific or General – Cash Losses, Debt, Inflation,

Economy, Politics, War, .… Fate !

• Measurement of Risk is Subjective

– Standard Deviation, Variance, Beta, etc.

– Depends on exactly what KIND OF RISK and Return you are

measuring:

• Stand Alone Risk or Portfolio Risk?

• Market Risk or Diversifiable Risk?

• Stock Price Risk or Earnings Risk?

– Depends on TIME HORIZON OR DURATION

• Investing in Stocks over 1 Year or over 30 Years?

Risk – Concepts:
• Fundamental Rule of Risk & Return: No Pain - No Gain. Investors will not
take on additional Market Risk unless they expect to receive additional
Return. Most investors are Risk Averse.

• Diversification: Don’t put all your eggs in one basket. Diversification can
reduce risk. By spreading your money across many different Investments,
Markets, Industries, Countries you can avoid the weakness of each. Make
sure that they are Uncorrelated so that they don’t suffer from the same
bad news.
 Diversification is very important. Coz, it reduce the level of risk.
 Bull Market: iski hasoosiat ye hai k bull apnay enemies ko seengo say upper
uthata hai. So, jab market price barhti increase hoti hai to we will say Bull
market.
 Bear Market: bear famous from pulling a person down. Jab stock market
girti hai to isay bear market kehtay hein.

Payoff Table & Expected ROR:

Formula:

• Expected ROR of Investment in Stock

– Most Likely or Weighted Average or Mean ROR Rate of Return < r >

– Expected ROR = < r > = sigma pi ri .

= p1(r1) + p2(r2) + p3(r3)

= 0.3(40%) + 0.4(10%) + 0.3(-20%)

= 12% + 4% - 6% = 10%

Lecture No 20:

7 Dec 2015_Tuesday_ 2:55pm 3:38pm

Important points which are noted by me…

 Choose the project with lowest risk (standard deviation) and more rate of
return.
 The higher the level of risk for share then the lower the market price that
share and higher the expected rate of return for that share.(its imp to
understand this concept)
I mostly concerned from PPT and lectures for this lesson.
Lecture No 21:

9 Dec 2015_Friday_ 7:20pm 8:26pm

Today will learn calculation of Return and Risk with probability.

Important points which are noted by me…

Recap: Risk and return

 The objective in risk to maximize the Return and Minimize the Risk.
 What causes Risk? Risk is caused by the distribution or uncertainty in the
possible number of outcomes that taken place.
Means agr Ksi cheez ka outcome fix nahi hai to wahan risk ka element
shamil ho jata hai.

• Risk: Arises because of Uncertainty, Volatility, Spread - Many Possible

Outcomes (pi) for Expected Rate of Returns (ri)

– Measured using Standard Deviation or Variance

– Risk = Std Dev = = ( r i - < r i > )2 p i . = “Sigma”

Formula is not printed right here. so, concern PPT.

Portfolio Risk & Return -

Collection of Investments:

• Portfolio is a Collection of Multiple Investments. Portfolios may have 2 or

more stocks, bonds, other securities and investments or a mix of all. We
will focus on Stock Portfolios.

• Risk is Relative: The RISK from investing in Stock of Company ABC usually
DECREASES as you MAKE MORE INVESTMENTS in Other Stocks of Different
Unrelated Companies.
• Diversification: Investing in many Different Shares and Bonds and Projects
of Different Companies in Different Countries can reduce risk. DIVERSIFIED
PORTFOLIOS CAN REDUCE RISK.

• Portfolio Risk & Return: What matters is the Overall Risk & Return on the
entire Portfolio (or Collection) of Investments. The Risk & Return of an
Individual Investment in a Stock or Bond should be seen in terms of its
Incremental Effect on the Overall Portfolio.

• Investment Rule: Investor will try to Maximize Portfolio Return and

Minimize Portfolio Risk. Investor will NOT take on Additional Portfolio Risk
UNLESS compensated with Additional Portfolio Return.

Types of Risks for a Stock:

• 2 Types of Stock-related Risks which cause Uncertainty in future

possible Returns & Cash Flows: Total Stock Risk = Diversifiable
Risk + Market Risk

• Diversifiable Risk

– Known as Company-Specific or Unique or or Non-Systematic

Risk

Wo risk jo ksi aik company tk mehdood hai. Non systematic

risk kehlata hai.

– Its Caused with Random events associated with Each

Company whose stocks you are investing in ie. Winning
major contract, losing a court case, successful marketing
campaign, losing a charismatic CEO,…
– Diversifiable Risk can be reduced using Diversification. The
bad random events affecting one stock will offset the good
random events affecting another stock in your portfolio.

• Market Risk

– Known as Non-Diversifiable or Systematic (Country-wide)

or Beta Risk

– Associated with Macroeconomic or Socio-Political or Global

events that systematically affect Stock investments in every
Stock Market in the country ie. Inflation, Macro Market
Interest Rates, Recession, and War.

Is caused by large events such as the macroeconomics,

general market interest’s rate or inflation of a country.

– Market Risk can NOT be reduced by Diversification.

Portfolio Rate of Return:

• Portfolio Expected ROR Formula:

rP * = r1 x1 + r2 x2 + r3 x3 + … + rn xn .

r1 represents the expected return

x1 represents the weight of Investment/Value of investment

Portfolio Return – Example:

• Suppose that you hold a Portfolio of 2 Stock Investments:

Value of Investment (Rs) Exp Individual Return (%)

– Stock A 30 20

– Stock B 70 10

– Total Value = 100

• Expected Portfolio Return Calculation:

rP * = rA xA + rB xB

= 20%(30/100) + 10%(70/100)

= 6% + 7%

= 13%

xA is value of investment / total value of investment

“2 Stock” Investment Portfolio Risk:

• Portfolio Risk is generally NOT the weighted average risk of the Individual
Investments. In fact, it is usually LESS.

• 2 Stock (Investment) Portfolio Risk Formula:

p = XA2 A
2
+XB2 B
2
+ 2 (XA XB A B AB )

Correct formula see in the PPT and Handout. Here symbols are not appearing.

Definition of Terms:

XA is Investment A’s weight in the total value of the Portfolio.

A is Investment A’s Individual Risk (or standard deviation).

AB is the Correlation Coefficient that measures the correlation in the returns of

the two investments. Last term is a Covariance term.
Question:

Where from 0.5 came? However, formula and values are ending with
braces.
Lecture No 22:

12 Dec 2015_Monday_ 12:35pm 1:56pm

Portfolio Risk & Return Recap:

• Portfolio is a Collection of Investments in different Stocks, Bonds, other

Securities or a mix of all.

• Objective is to invest in Different Un-Correlated Stocks in order to minimize

Overall Risk … & Maximize Portfolio Return

• 2 Types of Stock Risk:

– Total Stock Risk = Diversifiable + Market Risk

Diversification means expanding the number of investments

which cover different kinds of stocks.
Market Risk can’t be diversifying.
– 7 Stocks are a good number for diversification. 40 Stocks are enough
for Minimizing Total Risk

• Calculating Expected 2-Stock Portfolio Return & Risk

– Expected Portfolio Return = rP * = xA rA + xB rB

– Portfolio Risk is generally NOT a simple weighted average.

• Interpreting 2-Stock Portfolio Risk Formula:

p = XA2 A 2 +XB2 B 2 + 2 (XA XB A B AB )
• Correlation Coefficient ( AB or “Ro”)
– Risk of a Portfolio of only 2 Stocks A & B depends on the Correlation
between those 2 stocks. The value of Ro is between -1.0 and +1.0
– If Ro = 0 then Investments are Uncorrelated & Risk Formula
simplifies to Weighted Average Formula.
– If Ro = + 1.0 then 2 Investments are Perfectly Positively Correlated
and Diversification does NOT reduce Risk.
– If Ro = - 1.0 then Investments are Perfectly Negatively Correlated
and the Returns (or Prices or Values) of the 2 Investments move in
Exactly Opposite directions. In this Ideal Case, All Risk can be
Diversified away.
– In Reality, Overall Ro for most Stock Markets is about Ro = + 0.6.
This means that increasing the number of Investments in the
Portfolio can reduce some amount of risk but NOT all risk !

Important Conclusion: Must Remember:

 If Correlation Coefficient Ro = +1.0 then it can’t reduce the Risk in

Diversification.
 If Ro = -1.0 then it can possible entirely eliminate the company specific
Risk from the portfolio.
 There is direct relationship between the portfolio risk and portfolio return.
 Keep Remember: Using the Matrix approach, if you add up all the terms
then you will come up with VARIANCE of the portfolio.
And In order to calculate exact STANDARD Deviation you simply need to
take Square root of the Variance. In other word you take the square root of
all of the different terms inside those boxes added up.

Lecture Winding Up Important Points:

Matrix approach to calculating the portfolio risk.

In matrix approach we set up a simple matrix that dimensions are
nxn. Where n represent the numbers of stocks in portfolio and this
is very simple logic that you can apply to portfolio any size.
Keep in mind, this matrix approach clarifies very important concepts
which is that when you add a new share/stock to an existing
portfolio then the risk that stock brings with it is the Market Risk
and that Market Risk effects that stocks itself. And it also affects the
risks of the other stock in portfolio.
Point to remember that adding a new stock to an existing portfolio
is that fully diversifiable for example if your portfolio already have
different share and fully diversify then adding a new share not add
anyway to the company specific risk. Because that is eliminated. The
only contribution of the new share will be the Market Risk.

NOTE:
Couldn’t take Last lectures (35 to 45), make it by urself.
I just noted roughly. So, If you find any mistake in notes anywhere then kindly
must make Correction and Share on forum with file name. However, students
could get that correction while download these files.
Regards!
Malika Eman.
Financial Management_MGT201

8th Week of Lectures

Lecture No 23 to 25

Final Term Important Notes

Explanation noted by me has shown with & symbols.

Lecture No 23:

06 Dec 2015_Friday_8:35pm 9:06pm

Recap of Portfolio Risk & Return:

• Total Risk = Diversifiable Risk(unique or company specific risk) + Market

Risk(systematic risk)

• Total Stock Return = Dividend Yield + Capital Gain Yield

• 7 Stocks are a good number for diversification. 40 Stocks are enough for
eliminating Company Risk & Minimizing Total Risk

 If u invest many stocks which are not correlated to each other than it is
possible to reduce overall risk for your investments as a whole. We call
these investments different stocks a portfolio or a Collection of stocks.

• 2-Stock Portfolio’s Expected Return = rP * = xA rA + xB rB

• Interpreting 2-Stock Portfolio Risk Formula:

 We will read this formula as,

Sigma p = square root of the variance, Xa square Sigma a square + Xb
square Sigma b square + 2 multiply by Xa Xb Sigma A Sigma b Row ab.

•
3-Stock Portfolio Risk Formula
3x3 Matrix Approach

Stock A Stock B Stock C

Stock XA2 A2 XA XB A B AB XA XC A C AC

A
Stock XB XA B A BA XB2 B
2
XB XC B C BC

B
Stock XC XA C A CA XC XB C B CB XC2 C
2

C
 Sigma and Covariance mathematical signs are not showing in formula.
So, consult lecture 23, PPT no 3 for complete picture.
• To compute the Portfolio Variance for a 3-Stock Portfolio, just add up all the terms in every box.
To compute the Portfolio Risk (Standard Deviation), simply take the Square Root of the Variance.
You can extend this Matrix Approach to calculate the Risk for a Portfolio consisting of any
number of stocks.

• Terms in Boxes on Diagonal (Top Left to Bottom Right) are called “VARIANCE” terms associated
with individual magnitude of risk for each stock.

• Terms in all other (or NON-DIAGONAL) Boxes are called “COVARIANCE” terms which account for
affect of one stock’s movement on another stock’s movement.

• Matrix for Calculating Portfolio Risk:

Covariance Terms (Non-Diagonal Boxes) measures

(1) Magnitude of movement (Standard Deviation) and

(2) Closeness of movement (Correlation Coefficient) between any two
stocks in the portfolio.

• 3-Stock Portfolio Risk Formula: Use 3x3 Matrix Approach which is

extendible to any n-sized Portfolio.

• Efficient Portfolio Maps: Efficient Portfolios with Risk-Return values that

match Theoretical Probability estimates.

• If 2-Stock Portfolio with Negative Correlation then Characteristic Reverse

Envelope or “Hook Shaped” Efficient Frontier Curve. Possible to increase
Returns and at same time reduce Risk !!!

 It is ideal, coz the main objective is to maximize the return and minimize
the risk.
 This hook shaped curve shows visually that responsible to reduce the
risk and at the same time increase the returns.

• Covariance Term represents tendency of any 2 stocks to move together.

CML & Optimal Mix for a Portfolio:

• T-Bill Portfolio (or Risk-Free Portfolio): Assume that it is available to

EVERY INVESTOR to Borrow and/or Lend Money at the same interest rate
rRF . Investors would prefer to Invest in Risk-Free T-Bill Portfolio whenever
its Coefficient of Variation ( = Risk / Expected Return) is better than their
own Portfolio’s. Whenever Stock Portfolio’s return is less than rRF then
Investors will switch to the T-Bill Portfolio.

• Point of Tangency of the CML Line (which starts at the Risk Free Return on
the Y-axis) and the Efficient Frontier is the Optimal Mix for the Portfolio. For
example 50% Stock A, 30% Stock B, and 20% Stock C.

• According to the Portfolio Theory, Efficient Portfolios are Fully Diversified

and they must lie on the CML Line.
 It’s very important to remember that according to the portfolio theory,
CML line represent the combination of all possible efficient and fully
diversified portfolios in the market.

• CML Equation : rP* = rRF + [(rM - rRF) / σM] σP

 Short term means..

rRF= risk free rate of return
rM = expected rate of return for the market of all possible stock
σM = risk of the market
σP = risk of stock portfolio

 The Portfolio theory is based on probability and the whole issues arise
because the expected future rate of return of the stocks is not certain
and there are many possible different future expected rate of returns
that are possible and there is perhaps a probability or likely hood attach
to with of each possible outcomes.

Portfolio Return, Risk, & Beta:

• The Expected Return on an Investment in a Common Share is not

guaranteed or certain. The Price and Dividend can vary so we can guess
what the Possible future Returns (or Outcomes) might be and assign
probabilities to each.
• Uncertainty about Future Expected Return on Investment gives rise to
Probability Distribution of Possible Outcomes. This gives rise to a Spread
of Possible Future Returns which is a measure of the Risk or Uncertainty or
Standard Deviation.

 The distribution of possible outcomes for the expected rate of return

gives rise to a variance and a spread and the risk would define as
standard deviation which is the simply the Square root of the variance.
• When you mix many Investments in the form of a Combination or Portfolio
then the relative Weightage or Fraction of each investment will affect the
Overall Portfolio Expected Return and Risk. Furthermore, the individual risk
of every investment affects the risk of every other investment in the
portfolio!

 When we talk about expected return on single stock then we are saying
that it is the combination of the dividend yield and capital gain yield

 When we talk about expected return on portfolio then we can use the
expected rate of return for each of the stock in that portfolio and give it
a proportional amount weighted based on the faction of the investment
in a particular stock compare to total value of the portfolio.

Market Risk & Portfolio Theory:

• Rational Investors keep a Diversified Portfolio (of at least 7 and ideally

more than 40 Different Un-correlated Stocks).

• When a New Stock is added to the Diversified Portfolio, that New Stock has
an Incremental Contribution to the Risk and Return of the Portfolio.

• The New Portfolio Risk and Return can be re-calculated after adding the
New Stock’s Return & Standard Deviation into the Formulas.

• Only Kind of Risk which a new stock adds to a fully Diversified Portfolio is
Market Risk.

 If the correlation between the different stocks in negative or even if

coefficient correlation is zero then the Risk Return profile or Graph takes
on a Hook shaped curve.
Hook shaped curve allow exactly our main objective. Reduce overall
portfolio Risk and same time increase the rate of return. Which is ideal.
 If the correlation between the different stocks in positive then Risk
Return Relationship is that a way continuous monotonic function which
is continuously rising as the expected return rises. Risk is also rises with
this. [This is the fundamental concept in Risk and Return.]

Beta Concept & CAPM:

• Beta: Tendency of a Stock to move with the Market (or Portfolio of all

Stocks in the Stock Market). Building Block of CAPM.

 Beta measures how much the price or rate of return of a particular stock
moves relatively to the movement of the overall market or stock
exchange.

• Stock Risk vs Stock Beta:

– Stock Risk: statistical Spread of possible Returns (or Volatility) for

that Stock

 We use standard deviation for the stock Risk and standard deviation
measures the spread or the range of different future expected rate of
returns for that particular stock.

– Sock Beta: statistical Spread of possible Returns (or Volatility) for

that Stock RELATIVE TO THE MARKET IE. SPREAD (or Volatility) OF
THE FULLY DIVERSIFIED MARKET PORTFOLIO OR INDEX.

 Stock beta is measuring the Risk or volatility movement in the stock

price or in the stock rate of return relatively to the market.
 The beta is concerned with the market.
 Beta Coefficients vary in value. Generally speaking the beta is more
stocks is anywhere between 0.5 to 1.5 2.O. But beta theoretically have
negative values.

• Beta Coefficients of Individual Stocks are published in “Beta Books” by

Stock Brokerages & Rating Agencies
• CAPM: Capital Asset Pricing Model. Developed by Professors Sharpe &
Markowitz. Won Nobel Prize in 1990.

 CAMP model is not perfect theory. It have certain assumptions.

• Market Risk is the only risk that is relevant to a Rational Investor with a
Diversified Portfolio of Investments. The Company Specific (or Unique)
Risk is Diversified Away ! Market Risk is measured in terms of the Standard
Deviation (or Volatility) of the Market Portfolio or Index.

 Only kind of Risk which a new stock adds to a fully diversified portfolio is
market risk.
 The Company Specific (or Unique) Risk is Totally Diversified Away if we
invest in 40 different uncorrelated stocks.

– Every Stock Market develops an Index comprising of a weighted

average of the highest-volume shares in that market. This Index
represents the relative strength of that Stock Exchange and is
considered to be close to a Totally Diversified Portfolio. In reality,
no such Portfolio exists anywhere in the world. For example the
Karachi Stock Exchange has the KSE 100 Index.

Summary:

 Whenever stock Portfolio’s return is less than r then investors will

RF

switch to the T-Bill Portfolio.

 According to the portfolio theory, efficient portfolios are fully diversified
and they must lie on the CML Line.
CML Equation:
r *=r + [ (r - r ) / Sigma M] Sigma P
P RF M RF

 Rational Investors keep a Diversified Portfolio (of at least 7 and ideally

more than 40 Different Un-correlated Stocks).
 Market only offers you a price or an extra return based on the market
risk component of the particular stock.
 The Company Specific (or Unique) Risk is Totally Diversified Away if we
invest in 40 different uncorrelated stocks.
 Only kind of Risk which a new stock adds to a fully diversified portfolio
is market risk.
 Beta is useful measure of risk coz, it accounts for the contribution of
stocks risk relative to the overall market.
- The value of beta can be negative & positive. But most of the
time it is positive.
- Beta value is published in Beta Books.
- When we are calculate the beta value we compare the extent
to which the price of stock moves compared to the movement
in the overall market. Then we can measure the movement
overall market by using the stock market index. Which is
developed for most stocks markets around of the world.
Lecture No 24:

10 Dec 2015_Wednesday_1:10am 2:07am

Recap previous lecture concepts:

Beta Concept & CAPM:

BETA: Tendency of a Stock to move with the Stock Market as a whole.

BETA: Market Risk Portion of Total Risk. It is the Building Block of CAPM.

Total Risk = Diversifiable Risk + Market Risk

Total Stock Return = Dividend Yield + Capital Gain Yield

Stock Beta Coefficients:

• Meaning of Beta for Share ABC in Karachi Stock Exch (KSE)

– If Share A’s Beta = +2.0 then that Share is Twice as risky (or volatile)
as the KSE Market ie. If the KSE 100 Index moved up 10% in 1 year,
then based on historical data, the Price of Share B would move up
20% in 1 year.

– If Share B’s Beta = +1.0 then that Share is Exactly as risky (or volatile)
as the KSE Market

– If Share C’s Beta = +0.5 then that Share is only Half as risky (or
volatile) as the KSE Market

– IF you could find a Share D with Beta = -1.0 then that share would be
exactly as volatile as the KSE Market BUT in the OPPOSITE WAY ie. If
the KSE 100 Index moved UP 10% then the price of the Share D
would move DOWN by 10% !

• The Beta of most Stocks ranges between + 0.5 and + 1.5

• The Average Beta for All Stocks = Beta of Market = + 1.0 Always.

 Rate of return is on Y axis. And return on the market x axis.

 Start * refers to the Expected part of the rate of return.
 The slope of the line represents the beta coefficient.
Slope = Beta = Δ Y / Δ X = % Δ rA* / % Δ rM*
= A =Risk Relative to Market = (rA* - rRF) / (rM* - rRF)
 Alpha refers to Company Specific Risk.
 rA* refers Expected Return on stock A.
 rM* refers Expected Return on Market.


Calculating Portfolio Beta (CAPM):

There are two ways of calculating portfolio beta
• Analyze Historical Data for Portfolio Returns and Market Index Returns like in
the case of Stock Beta, plot Least Squares Fit Line, and compute Portfolio Line
Slope or Beta directly.
• Use the Published Data for Individual Stock Betas from the “Beta Book”
Portfolio beta can be calculated as the sample weighted average of the stock
beta’s in that portfolio.
 Portfolio Beta = β P = X A β A + XB β B + XC βC +…..
In the formula
 βA represents the Beta (or Market Risk) of Stock A.
 XA represents the Weight of Stock (fractional value of investment in A to
total
portfolio value).

• Portfolio Beta (or Market Risk) Formula is a Simple Weighted Average

UNLIKE the Portfolio Risk Formula !
P = X +X + 2 (XA XB ABAB )
See this formula clearly in handout page 105.

Portfolio Beta – Example:

• Complete 2-Stock Investment Portfolio Data:
Value Exp Return (r*) Tot Risk Beta
– Stock A Rs 30 20% 20% 2.0
– Stock B Rs 70 10% 5% 0.5
Total Value =Rs 100 Correlation Coefficient = + 0.6
• Portfolio Mean Expected Return = 13% = rP*
• Portfolio Risk (Total) = 8.57% = P (relative to rP*)
• Portfolio Beta = XaBa + XbBb = (30/100)(2.0) + (70/100)(0.5) = 0.6 + 0.35 =
+0.95 = P (relative to Market Risk or Volatility)
– Means that the Portfolio of A & B is slightly LESS RISKY than the
Totally Diversified KSE 100 Market Portfolio whose Beta = +1.0

Take Exercises from handout for 2 and 3 stock investment on pg 105.

Required Rate of Return (CAPM):

• Required ROR vs Expected ROR

– Expected ROR (r*): The Most Likely (or Mean) ROR expected in the
future. Calculated using Weighted Average Formula and
Probabilities (what we have been calculating so far).

 It is the rate of return that is Expected in the future base on the

likelihood of the possible outcomes and probability attach to them.

– Required ROR (r): Minimum Return that Investors Require from the
Stock to invest in it. Varies from individual to individual. Based on
perceived Risk relative to the Market and Psychological Risk Profile
of each Investor and Opportunity Cost of Capital. Average Required
ROR for all Rational Investors in an Efficient Market can be Estimated
using the CAPM Theory: Beta and Risk Free Rate of Return.

 However the Required Rate of Return is quite subjective and personal to

the investors. Coz, this is the rate of return that the investors required
based on what? Based on his personal or individual risk preference and
risk profile, based on his personal opportunity cost of capital.
 Required rate of return or the opportunity cost of capital varies to
another person. Coz, every individual has the different preference for
taking risk.
 However, required rate of return can be linked to the Beta Risk. why’s
that? Coz, based on the portfolio theory and the capital asset pricing
model there is directly relationship between risk and return. Means if
they will take risk they will get extra amount of return.

– Total Rate of Return (ROR) for Single Stock = Dividend Yield +

Capital Gain. GORDON’S FORMULA FOR COMMON STOCK PRICING
OR VALUATION USES REQUIRED RETURN. r = DIV/Po + g. In
Efficient Markets, Price of Stocks is based on Market Risk (or Beta).
– How can we calculate the Required Return from the Beta which is a
measure of Risk ?
– Based on the SML (Security Market Line) which is the most
important part of the CAPM and is Often Challenged by Critics of
CAPM.

 SML is very important and critical part of CAMP.

 If the combination of Risk & Return for any stock does not lie on the SML
then that stock is not efficiently price.

SML Linear Equation for the Required Return of any Stock A:

rA = rRF + (rM - rRF ) β A .

In the above equation
 rA = Return that Investors Require from Investment in Stock A.
 rRF = Risk Free Rate of Return (ie. T-Bill ROR).
 rM = Return that Investors Require from Investment in an Average Stock
(or the Market Portfolio of All

Stocks where β M = + 1.0 always). β A = Beta for Stock A. (rM - rRF )

β A = Risk Premium or Additional Return in Excess of Risk Free ROR to
compensate the Investor for the additional Risk.

Lecture No 25:

12 Dec 2015_Thursday_10:46pm pm

Recap Previous Lecture:

Important points:
 Capital asset pricing model is grounded on the fundamental principle
that the rate of return for a stock and to be more accurate the quite rate
of return on a stock is directly proportional to the risk premium.
 Risk premium is the term dependent upon the market risk alone and not
the total risk.
 Beta of the stock tendency of the stock price to move with the market.
 On the graph representation, Y axis is the expected return for the stock
and on X axis we have expected return from the stock market index.
 Stock Beta measures the Risk of a Stock RELATIVE TO THE MARKET.
 Other way of the calculate risk is standard deviation.
 Stock Beta measures the Risk of a Stock Relative to the market.
Beta Stock A = % Δ rA* / % Δ rM* = Slope of Regression Line. Regression
Line uses Experimental Data.
 The formula that relates beta of the stock to the standard deviation is as
follows,
Beta Stock A = Covariance of Stock A with Market / Variance of Market
= σ A σ M  AM / σ 2 M
(Covariance Formula based on Probability & Statistical Portfolio Theory)
Links Stock Beta
(Market Portion of Risk) to Stock Standard Deviation (Total Single Stock
Risk).

Simplified formula:
= σ A  AM / σ M = market risk

Formulas symbols are not showing here correctly, so, concern for correct
formulas from handout or PPT. pg 110.
σ A = 30% (Stock A’s Total Risk or Standard Deviation)
σ M = 20% (Stock Market Index Standard Deviation or Risk)
 AM = + 0.8 (Correlation between Stock A and the Market Index)
Theoretical Beta – Example:
See this example in handout or PPT.

 We can collect the data on expected return movements on stocks and

compare that to the expected return movements in the stock market index.
 If we can’t use conveniently collect data on expected returns then we use
historical data.
 Total risk = market risk + company specific risk.
 This company specific risk is diversifiable component of risk that can be
remove.
 Company specific risk/diversifiable risk associated with random events in
life of the company is in some way proportional to the vertical distance
between an actual data point and point of on state line that passes through
data points.
 If a stock is fully diversified portfolio which has successfully eliminated all of
the company specific risk.

=========
Lec 15:51, PPT 6, handout 111…left..
Again start 2:10pm
=========

Definition of Total Risk in term of Variances:

Variances are also a measure of Risk. Because variance is nothing other than the
standard deviation squared.
 Standard deviation as the representative of the risk.

TOTAL VARIANCE RISK Formula:

• Total Risk of Stock A in terms of Variance ( = Std Dev 2 )
– Total Risk = Market Risk + Random Specific Unique Risk
A2 = A2 M2 + A-Error2
Here,
 A2(Sigma A square)Is representative of Random Error/Company
specific Risk.
 A2 M2(Beta A Square, Sigma M square)Is representative of
Market Risk
 A-Error2(Beta A Square, Sigma M square)Is representative of Total
Risk

Example:
Concern for exercise PPT slide 7, or handout page 112

Security Market Line (SML) Cornerstone of C.A.P.M:

• Straight Line Model for Beta Risk and Required Return. Similar to the
Relationship for the 2-Stock Portfolio with Ro>0.
 Security market Line provides the relationship between the Beta/Market
Risk and the Required Rate of Return for the particular Stock.
• Beta Risk is Directly Proportional to Required Return. The Investors
require an extra Return which exactly compensates them for the extra Risk
of the Stock relative to the Market.
 Required Rate of Return is different from Expected Rate of Return.
 Expected Rate of Return can be calculated using Probability and the
forecasted returns for the particular stocks using the weighted average
formulas.
 Required rate of return is a function of individual and very subjective and it
depends on the individual investors and personal risk profile.

• SML Linear Equation for the Required Return of any Stock A:

rA = rRF + (rM - rRF )  A .

Terms:
rA = Return that Investors Require from Investment in Stock A.
rRF = Risk Free Rate of Return (ie. T-Bill ROR).
rM = Return that Investors Require from Investment in an Average Stock (or
the Market Portfolio of All Stocks
where
 M = + 1.0 always).
A = Beta for Stock A. (rM - rRF )
A = Risk Premium or Additional Return Required in Excess of Risk Free ROR to
compensate the Investor for the Additional Market Risk of the Stock.

 Risk Premium is the extra rate of return that is required above the risk free
rate of return in order to compensate the investors for the additional
market risk of the stock that the yield taking on.
 Price of stock depend on the market risk of stock.

Required Rate of Return,

Risk Premium & Market Risk:

• SML Model for Efficient Markets establishes a Straight Line relationship (or
Direct Proportionality) between a Stock’s Required ROR and its Risk
Premium.
• rA = rRF + (rM - rRF ) A
• A Stock’s Risk Premium depends on its Market Risk Portion (and NOT the
Total Risk)
• In Efficient Markets, Market Price of a Stock is based on Required Return
which depends on Risk Premium which depends on Stock’s Market Risk
Component (and NOT the Total Risk).

SML - Numerical Example:

• Calculate the Required Rate of Return for Stock A given the following data:
– A = 2.0 (ie. Stock A is Twice as Risky as the Market)
– rM = 20% pa (ie. Market ROR or ROR on a Portfolio consisting of All
Stocks or ROR on the “Average Stock”)
– rRF = 10% pa (ie. T-Bill ROR)
• SML Equation (assumes Efficient Stock Pricing, Risk, Return)
rA = rRF + (rM - rRF ) A.
= 10% + (20% - 10%) (2.0) = 30%

• Interpretation of Result:
– Investors Require a 30% pa Return from Investment in Stock A. This
is higher than the Market ROR because the Stock (Beta = 2.0) is
Riskier than the Market (Beta = 1.0 always).
– If Required Return (30%) is Higher than Expected Return (20%) it
means that Stock A is Unlikely to Achieve the Investors’ Requirement
and Investors will NOT invest in Stock A.

NOTE:
Couldn’t take Last lectures (35 to 45), make it by urself.
I just noted roughly. So, If you find any mistake in notes anywhere then kindly
must make Correction and Share on forum with file name. However, students
could get that correction while download these files.
Regards!
Malika Eman.
Financial Management_MGT201

9th Week of Lectures

Lecture No 26 to 28

Final Term_ Important Notes

Explanation noted by me has shown with & symbols.

Lecture No 26:

13 Dec 2016_Friday_4:08pm 5:10pm

Recap of Beta, Market Risk, and Required Return (SML):

• Theoretical Beta of a Stock:

Beta Stock A = Covariance of Stock A with Market / Variance of Market
= σ A σM  AM / σ 2 M = σA AM/ σM

 Variance of market means standard deviation of the market squared.

• Theoretical Market Risk of a Stock (Standard Dev):

Market Risk of Stock A = A σ M = σ A AM
Extent to which Actual Stock Return Data lies on Regression Line
Total Risk = Market Risk + Random Company Specific Risk

 Market Risk = Total Risk of stock without Company specific risk is an ideal
case.

• Security Market Line (SML) and Required Rate of Return (rA)

rA = rRF + (rM - rRF ) A.
In Efficient Markets, Stock Price (and Value) depends on Required Return
which depends on Market Risk (not the Total Risk)

 Cornerstone of the pricing theory is SML Equation which represents with

straight Line.
 SML equation allow us to use the value that we have calculated Beta and
from that calculate the required rate of return of the stock.

What is the risk premium?

 Risk premium=rA-rRF……..Required Rate of Return – Risk free rate of
return
 It is directly proportion to market risk of stock.

Security Market Line(SML):

 SML exist for only the efficient markets/perfect capital markets.
 Rational investor will eliminate the company’s specific risk and the total risk
of the company will be equal to the market risk of the company.
- Means according to the Capital asset pricing theory, ksi bhi
efficient market mein sab stocks k Risks and Returns
combinations, Security Market Line pr paye jaen gay. Coz,
efficient market mein rational investor (sensible investors)
paye jatay hein, jinho nay bht say stocks mein investment ki
hoti hai(which is called ‘Portfolio’). Which has eliminated the
company specific risk. Then Stock mein baqi bach Janay wala
Risk ‘Market Risk’ kehlata hai. Which is calculated via Beta.

 SML Line is an ideal case and in efficient marketers all the stocks lie on the
SML Line.
 If Risk and Return combination of any stock is above SML it means that it is
the offering higher rate of return as compare to efficient stock.
 If any stock is lying below the SML line the price will come down. It will
offer as much as potential as the efficient stock offers.
 Risk free mein inflation risk already included hai.

Share Price Valuation: Application of SML (CAPM):

• The Most Important Application is to Share Price Valuation which we

discussed in the Previous Part of this Course.
• Common Share Price Valuation (Gordon’s Formula for Perpetual
Investment with Constantly Growing Dividends):
Po = DIV1 / (rCE - g)
rCE = REQUIRED Rate of Return on Investment in Common Equity or Stock
DIV1 = represents forecasted dividend of the coming year.
‘g’ = represents constant growth rate.

• Combining Gordon’s Share Price Formula with the SML Equation from
CAPM Theory :
rA = rRF + (rM - rRF ) A = rCE
Po* = DIV1 / [ (rRF + (rM - rRF ) A ) - g]

NPV Calculations & Capital Budgeting:

Application of SML (CAPM):

• NPV (and PV) Calculation which is the Heart of Investment Criteria and
Capital Budgeting uses REQUIRED Rate of Return (and NOT Expected ROR)
– This is why Share Pricing also uses Required Rate of Return because
Share Price was derived from the PV Equation for Dividend Cash
Flows.
• We can apply our Probabilistic Risk Analysis to Entire Companies or Real
Projects or Assets and focus on the Volatility or Uncertainty of their Net
Cash Flows. We can compare that to the Volatility of the Cash Flows of the
Industry that the Company is a part of to come up with a Beta Coefficient
for the Assets of a Company as a whole. We can then use the Asset Beta to
calculate the Overall Required Rate of Return for a Company (ie. All Assets -
both Equity and Debt).

Risk & Return - Must Consider BOTH

• Spent the First Part of this Course on Valuation (or Calculating NPV and PV)
which are measures of Return. We were ignoring Risk and origins of
Required ROR.
• Spent the Second Part of this Course Applying the PV Concept to Valuing or
Pricing Bonds (Debt) and Shares (Equity). Again we ignored Risk and origins
of Required ROR.
• Part 3 of the Course Introduced Risk and how it determines the Required
Return used in NPV and Share Price Formulas.
• In Perfect Markets and Efficient Markets where Rational Investors have
Diversified Away ALL Company Specific Risk, Value (and Stock Price)
depends on Required Return which depends on Market Risk (and not Total
Risk).
• In most Real Markets where Investors are not fully Diversified, Total Risk is
important. It can be calculated using the Sigma (Standard Deviation)
Formulas, probabilities, and Expected Return.
• Total Risk and Expected Return must BOTH be considered in Comparing
Investments.
• Market Risk and Required Return are related to one another in Efficient
Markets according to the SML Equation. Required Return depends on the
Individual Investor’s Psychological Risk Profile and Opportunity Cost of
Capital.

Final Notes on Betas:

• Stock Beta vs Real Asset Beta
– Objective in FM is to Maximize STOCK holders’ (or Owners’) Wealth
• Negative Side Effect - Treasury Managers of Listed
Corporations in USA and Europe spend too much time
manipulating Stock Prices.
– Real Assets have Risky Revenue Cash Flows:
• Asset Beta = Revenue Beta x [1 + PV(Fixed Costs)/PV(Assets)]

• A Stock’s Beta or Risk Relative to the Market can change with time
– if the Company’s business operations or environment chang, its
responsiveness to the Market can alter ie. If it buys another business,
implements a Total Quality Management program, makes an R&D
technological discovery, takes on Debt, etc.

Notes on Measuring Uncertainty:

• Standard Deviation vs Beta
– For Example, Oil Drilling Companies: possible to have High Standard
Deviations in Forecasted Earnings and Returns but Low Betas or
Stock Price volatility relative to Market
• Volatility vs Risk
– Seasonal or macro volatility in Earnings does NOT necessarily signify
Risk BUT High Stock Price volatility does signify Risk.
Lecture No 27:

13 Dec 2016_Friday_7:20pm 8:37pm

This Lecture is Only Summaries of Previous Lecture 23 to 26.

 Term representation
- X is represent the Refraction of the stock.
- Σ is represent the Standard Deviation.
- roIs the correlation coefficient between 2 stocks A & B.

 Correlation coefficient is measured of the tendency of the 2 stocks to move

together to prices to move together.
- If move together EXACTLY then Correlation coefficient is +1.0.
- If move together EXACTLY opposite direction then Correlation
coefficient is -1.0.
- And In case of no relationship, then Correlation coefficient is
0.
 For more than 2 stocks, Risk Matrix is used.
 Hook shaped curve is very important to understand that its possible to add
other stock in existing portfolio then increase overall return of the portfolio
but decrease the Risk of the portfolio. And its ideal. Coz, its main objective
of portfolio theory that maximize Return and Minimize the Risk.

Criticisms of CAPM & Alternatives:

– Weakness in SML:
• Not All Investors are rich or well-informed enough to hold Fully
Diversified Portfolios therefore Market Risk (and Betas) are
NOT the only relevant factor in estimating Required Return
and Stock Prices. Other Efficient Market Assumptions.
• Taxes and Brokerage Costs that affect Investor’s analysis and
estimation of Returns have been ignored
– Weakness in CML:
Not All Investors are influential enough to be able to Borrow at
the T-Bill Rate. Generally the Borrowing Rate is higher than
the Lending Rate.
– Fama & French:
CAPM ignores 2 important determinants of Higher Required
ROR (1) smaller firms and (2) Low Market-to-Book Ratio.
– Arbitrage Pricing Model:
Accounts for several factors that affect risk ie. Tax, inflation, oil
price, ...

Financial Management Applications of Risk-Return Theory (CAPM):

• Practical Real Asset Investment Decisions and Capital Budgeting

– The most important NPV (and PV) Equations uses REQUIRED ROR
(and NOT Expected ROR)
• Actual Share Pricing and Investment in Securities
– Gordon’s Formula for Share Pricing uses PV of Dividends which uses
REQUIRED ROR

Common Life Applications of Risk and Return Theory:

• Concepts of Risk & Return Theory have Wide Practical Applications that
require a Creative Mind.
– Expected Value or Expected ROR or Expected Payoff
– Total Risk or Standard Deviation (based on Spread or Range of
Breadth of Possible ROR outcomes) = Unique + Market Risk
– Systematic (or Market or Nondiversifiable) Risk (= Beta A x Sigma M).
Individual Risk relative to Market or Industry.
• Think Out of the Box:
– Social Cost-Benefit Analysis of Power Plant.
• Environmental and Village Relocation Risk, Uncertain Savings
– Court Case Payoff: Claims & Penalties
• Uncertain likelihood of success and Opponent, Uncertain
Payoff
– Likelihood of War: Capability & Intent (Game Theory)
• Magnitude of Capability vs Uncertainty of Intent

Lecture No 28:

13 Dec 2016_Friday_8:40pm pm

This Lecture will introduced Capital Structure and Corporate Financing.

Points which Already Studied, Just Review:

 2 main sources to raise money, i- Debt ii- Asset

Recap of Financial Markets:

• Capital Markets
- Stock Exchange (listed shares, unit trusts, TFC)
• Money Markets (Short-term liquid debt market)
- Bonds
• Government of Pakistan: FIB, T-Bill
• Private Sector: Corporate Bonds, Debentures
- Call Money, Inter-bank short-term and overnight lending
- Loans, Leases, Insurance policies, Certificate of Deposits (CD’s)
- Badlah (money lending against shares), Road-side money
lenders
• Real Assets Markets
- Cotton Exchange, Gold Market, Kapra Market
- Property (land, house, apartment, warehouse)
- Computer hardware, Used Cars, Wheat, Sugar, Vegetables,etc.
Debt and Equity Markets:
• Equity Markets and Institutions
– Stock Exchanges
– Private Placements
– Private Equity Investments
– Venture Capital
– Islamic Finance
• Debt Markets and Institutions
– Bond Markets
– Money Markets & Call Markets
– Bank Loans & Certificate of Deposits (CD’s)
• Project Financing
• Running Finance or Working Capital Finance
– Hypothecation and Pledge Financing for Inventory
Purchase
• Bridge Financing
– Mortgage Financing
– Lease Financing
– Insurance and Credit Card

“Efficient Markets” Assumption:

• We assume that Financial Markets are Quick and Prices are Right.
 Mean whatever information or knowledge about any company/stock/bond
is available to one investor, is also avail to other investors. In other words
knowledge and information spread quickly. So, it’s called Quick market.

• There are Lots of Rational Investors in every Financial Market. They are all
well-informed and act quickly on information related to the companies’
operations, finances, risk and return.
• So Prices of Securities like Stocks and Bonds adjust (equilibrate) quickly to
new information. Pricing by the Market is Efficient and Accurate.
• Observed Market Price are Accurate reflection of Fair Price (or Theoretical
Price based on Investors’ NPV calculations).
• All Stocks have Optimal Risk-Return Combinations, ie. All Stocks lie right
ON the SML Line !

Securities:

• Securities: pieces of legal contractual paper that represent claim against

assets
- Direct Claim Securities:
• Stocks: equity paper representing ownership,
shareholding. Appears on Liabilities side of Balance
Sheet
-stocks also called shares.
• Bonds: debt paper representing loan or borrowing.
- Bonds also called interest.
o When you are Issuing Bonds (ie. Borrowing
money) then the Value of Bonds appears under
Liabilities side (as Long Term Debt) of Balance
Sheet.
o If you are Investing (or buying) Bonds of other
companies then their Value appears under Assets
side (as Marketable Securities) of Balance Sheet.
• Value of Direct Claim Security is directly tied to the value of the underlying
Real Asset.

New Topic Introduction

Capital Structure:
• Definition: The Mixture or Proportion of Debt Capital and Equity Capital is
known as the Capital Structure.

• Most Firms keep a Mix of Both Debt and Equity Capital. In other words
most Firms raise money from both Stock holders(or Shareholders) and
Bondholders (and Banks).

• This Financial Policy Decision is taken by the CEO, CFO, and Board of
Directors

 Means Decisions regarding how much percentage of total capital to have as

Debt and how much percentage of total capital to have as Asset is made by
the chief executive officer, board of directors and chief Financial Officer.

• Capital Structure can Change With Time depending on Firm’s Financing

needs and strategy.

o Some Projects like Power Plants and Cement are so Capital Intensive
and large that initially the sponsors need Debt Capital
Coz, machinery, plants ect ki price bht high honay ki wjay say invest
zyada krna parti hai that’s y owners have no choice but to raise
most capital through Debt.
o When a Running Business reaches maturity, some owners prefer to
fix the Ratio of Debt to Equity at 20/80 and only for Running
Finance.
Ye bht common hai specially when the interest rate in a country has
become high.
o Some Muslim Businessmen use 100% Equity Capital only (No Debt).

16:55 stop, PPt slide 9, handout 123

Again start from Wednesday, 18 january..

• Firms try to attract Debt and Equity Investors to invest their Capital (or
money).
• Firms claim that they are SAFE and PROFITABLE investments. Therefore,
Firms try to Get Investment Capital (or money) at the LOWEST possible
Cost of Capital.
• Remember that whenever you Borrow or Rent or Buy anything (cycle,
house, money), it Costs You Money in the form of a Rental, Interest or
Mark-up, Installment, etc.
– Stockholders (Equity owners) expect to receive Dividends
– Bondholders (Debt Holders and Banks) expect to receive Interest

Cost of Capital & Required ROR:

• Required ROR (or Opportunity Cost) %
– CAPM Theory (SML for Efficient Markets) & NPV
– Minimum ROR required to attract investor into buying a Security (ie.
Stock or Bond …)
– Opportunity Cost: Investor Sacrifices the ROR available from the 2nd
best investment.
• Cost of Capital %
– Weighted Average Cost of Capital (WACC)
– Combined costs of all sources of financing used by Firm (ie. Debt and
Equity)
– WACC is Similar to Required ROR BUT Takes into account some
Practical Factors:
• TAXES: Interest Payments are P/L Expenses and NOT Taxed.
• TRANSACTION COSTS: Brokerage, Underwriting, Legal, and
Flotation Costs incurred when a Firm issues Stocks or Bond
Securities

WACC %
Weighted Average Cost of Capital:
• Assume that Firm markets 3 Types of Financial Products (or Securities or
Instruments) to attract Investors’ Capital.
– Bonds (Debt): Cost = Coupon Interest
– Common Shares (Equity): Cost = Variable Dividend
– Preferred Shares (Hybrid Equity): Cost = Fixed Dividend
• The Firm Issues a Security or Financial Instrument to the Investor and
Receives Capital (or Money) in exchange. The Firm has to pay a “Rental
Cost” for using the Investors’ Capital.
• WACC % = Weighted % Cost of Debt + Weighted % Cost of Common
Equity + Weighted % Cost of Preferred Equity = rDxD + rExE + rPxP
• WACC must take Taxes & Transaction Costs into account.

 When company invest the money it must earn a higher rate of return than
the WACC.

NOTE:
Couldn’t take Last lectures (35 to 45), make it by urself.
I just noted roughly. So, If you find any mistake in notes anywhere then kindly
must make Correction and Share on forum with file name. However, students
could get that correction while download these files.
Regards!
Malika Eman.
Financial Management_MGT201

10th Week of Lectures

Lecture No 29 to 31

Final Term_ Important Notes

Explanation noted by me has shown with & symbols.

Lecture No 29:

19 January 2016_Thursday_5:02pm 6:50pm with break 20 min

 The Mixture or Proportion of Debt Capital and Equity Capital are known as
the Capital Structure.
 A key building block and concept of capital structure which is known as
Weighted Average Cost of Capital or known as the WACC.

Previous lecture discussed,

 2 way to raising money

i) in the form of Equity ii) in form of Debt

 Objective of a company is to minimize the cost at which it raises the Capital.

 Objective of a company is to get the financing or capital at lower possible
costs. And company do this as marketing by itself as firms have very low
risk and very high profitability.
 WACC is similar to the concept ROR(Required Rate Of Return).

Lecture29 start from here..

 WACC is generally applied to entire company or firms not just a particular

company or stock or particular bond.
 When talked about WACC, we include 3 instruments in it,
i)Debt (Bond) ii) preferred stock iii) common stock
 WACC is slightly different from Required Rate Of Return. Coz, WACC takes
into account some real world and practical consideration such as the
impact of taxes and transaction costs/floatation costs associated with
issuing selling and marketing financial securities like stocks and bonds.
 WACC %:
WACC = rDxD + rExE + rPxP

Weighted % Cost of Bond (Debt):

rD XD . Where
rD is the Average Rational Investors’ Required ROR for investing in the Bond.
XD is the Weight or Fraction of Total Capital value raised from
Bonds = Bond Value / Total Capital
Weighted % Cost of Common Equity
o rE XE . Where
rE is the Average Rational Investors’ Required ROR for investing in
Common Share.
XE is Weight or Fraction of Total Capital raised from Common Equity.
Note that rE is Not the WACC and Not the ROE (=NI / common stock)
Weighted % Cost of Preferred Equity
o rP XP . Where
rP is the Average Rational Investors’ Required ROR for investing in
Preferred Share.
XP is Weight or Fraction of Total Capital raised from Preferred Equity.

Weighted Cost of Debt:

• Weighted Cost of Debt % = rD XD .

• Required ROR for Debt

– Bond YTM = Interest Yield + Capital Gain Yield = Expected (or

Theoretical) ROR. It becomes Required ROR when you use Actual
Observed Market Price of Bond as PV in the Bond Pricing Formula.
• Cost of Debt Capital = rD

– Practically speaking, Bonds are Issued (or sold) in the Market at a

Premium (above Par Value) or Discount (below Par Value). AND,
the Issuance of Bonds has Transaction Costs. These transaction costs
include Legal, Accounting, and Marketing and Sales fees. Both these
are factored into the Market Price of the Bond used in PV Formula
to calculate the Pre-Tax Cost of Debt Capital = rD* . So, rather than
using Market Price of Debt, use the NET PROCEEDS = Market Price –
Transaction Costs

– Finally, Debt becomes less Costly because Additional Interest

creates a new form of Tax Saving or Tax Shield.

– After Tax Cost of Debt = rD = rD* ( 1 - TC ) where TC is the Marginal

Corporate Tax Rate on the Net Income of the Firm.

 Its very important point that the interest that a company pays to a
bondholder or the interest pays to a bank is tax deductible.

Weighted Cost of Preferred Equity:

• Weighted Cost of Preferred Equity % = rP XP .

• Required ROR for Preferred Equity

– Use the Perpetuity Formula for Perpetual Investment & Constant Div

– PV = Present Price = Po= DIV1 / r . So r = DIV1 / Po. If you use the

Actual Observed Market Price for Po then r = Required ROR

 Po (P not) is referred to market Price.

• Cost of Preferred Equity Capital = rP

– Practically speaking, the process of Legally Structuring, Printing, and

Marketing Preferred Share Certificates costs money in the form of
Flotation Costs (including Brokerage and Underwriting Fees). These
Costs are factored directly into the PV or Observed Market Price.

– PV = Net Proceeds = Market Price - Flotation Costs

– Preferred Stock Dividends are paid out from Net Income AFTER
TAXES. So they are NOT Tax Deductible (unlike Bond Interest
Payments).

 Bonds there is tax saving associating payments but In case of preferred

Equity there is no tax saving. WHY? Because whatever dividend is paid to
the preferred equity holders, is paid after calculation to the net income.
Therefore, the is no tax saving attach to it.
 Required Rate of Return is Common Equity.

Weighted Cost of Common Equity

 There are 2 approaches to calculate Required Rate of Return or Common

Stock as following,
i) Dividend Growth Model: Gordon Formula (simplified PV Formula)
ii) CAPM (SML Equation) Assuming Efficient Markets

Cost of Capital & Required ROR:

• Required ROR (or Opportunity Cost) %

– CAPM Theory (SML for Efficient Markets) & NPV

– Minimum ROR required to attract investor into buying a Security (ie.

Stock or Bond …)

– Opportunity Cost: Investor Sacrifices the ROR available from the 2nd
best investment.

• Cost of Capital %
– Weighted Average Cost of Capital (WACC)

– Combined costs of all sources of financing used by Firm (ie. Debt and
Equity)

– Similar to Required ROR BUT Takes into account some Practical

Factors:

• TAXES: Interest Payments are P/L Expenses and NOT Taxed.

• TRANSACTION COSTS: Brokerage, Underwriting, Legal, and

Flotation Costs incurred when a Firm issues Stocks or Bond
Securities

Summary of Formulas
Total risk= market risk + company specific risk
s 2 + b 2s 2 + s 2
NPV Bond Pricing Equation:
Bond Price = PV = C1/ (1+rD) + C2 (1+rD) 2 + C3 / (1+rD) 3 +….. + PAR
/ (1+rD) 3

Gordon’s Formula for Share Pricing:

rCE = (DIV 1 / Po) + g = Dividend Yield + Capital Gains Yield
SML Equation (CAPM Theory)
r = rRF + Beta (rM - rRF)

 Required Rate of Return formulated in the capital asset pricing

model is based on ideal model which is based on efficient market
with there is no taxes or transaction costs.
Lecture No 30:

19 January 2016_Thursday_7:05pm 8:01pm

 Capital structure is an area of financial management where we decide what

the distribution of debt and equity should be within a company or a firm.
 This is important decision and it is part of financial policy that is made by
the chief executives and board of directors of the companies.

Debt vs Equity
From FIRM’s Point of View:

• Need Capital to Start a New Business or to Expand Operations

• Capital can be raised in basically 2 ways. Look at each from FIRM’S (or
Company’s) Point of View:

– Issuing Debt (or Leverage)

• Advantages of Issuing Debt:

– Limited fixed Interest payment - no share in profits

– Limited Life

– Interest Payment is an Expense ie. Tax Deductible

– Can Improve (or Amplify) the Return on Equity (ROE)

• Disadvantages

– Debt adds to Company-specific Risk

– If company doesn’t pay Interest, it can be closed down

– Issuing Equity (generally Common Equity or Ownership)

• Advantages of Issuing Equity:

– Not required to pay fixed regular Dividends

• Capital Structure is a Firm’s Mix of Debt & Equity

Risks Faced by FIRM:

• Total Stand-Alone Risk of a STOCK (from Risk and CAPM Theory).

– Stock’s Total Stand Alone Risk = Diversifiable + Market

– Company-specific Risk: Unique, Diversifiable

– Market Risk: Systematic, Not Diversifiable

• Total Stand-Alone Risk of a FIRM (New)

– Firm’s Total Stand Alone Risk = Business + Financial

– Business Risk: Risk of All Assets & Operations (without debt).

Includes Both Company-Specific (or Diversifiable) & Market Risks.

– Financial Risk: Additional Risk faced by Common Stockholders if Firm

takes Debt. Pure Debt-related Risk.

 When common stock holders/shareholders find out a company is taking on

more loans/debt demands in a higher require rate of return. Means they
expect higher dividend.

Financial Risk – Concept

INVESTOR’S Point of View:

• Suppose Firm ABC had a Capital Structure of 100% Common Equity. Then
the Management and Board of Directors of Firm ABC then decides to
Reduce Half of the Equity and take a Loan (or Debt) instead. This affects
the distribution of Risk & Return to the Common Equity holders (or
Owners).
– In other words, the Management of Firm ABC has added a New Kind
of Investor. The Debt Holder faces almost no risk because he is
“guaranteed” the Interest payment at all costs whether or not the
Firm is making profit or whether or not the Equity Owners are paid
Dividend. Debt Holders eat away at the Owners’ (or Equity
Holders’) money at almost no risk.

– So, naturally, the RISK faced by Equity Holders INCREASES because

same Business Risk is now shouldered by Fewer Equity Shares. Risk
per Share Increases. Generally Speaking, Increasing Debt Shifts
More Risk Upon the Shareholders. Therefore REQUIRED ROR
demanded by the Common Equity Holder also INCREASES (based on
CAPM Theory)

Firm’s Total Stand Alone Risk

Uncertainty in ROA & ROE:

• Firm’s Total Stand Alone Risk measured by the Uncertainty or Fluctuations

in Possible Outcomes for Firm’s Future Overall ROR.

• If Business has Debt & Equity (ie. LEVERED FIRM):

– Firm’s Overall ROR = ROA = Return on Assets = Return to Investors /

Assets = (Net Income + Interest) / Total Assets

– Note: Total Assets = Total Liabilities = Debt + Equity

• If Business is 100% Equity (or UN-LEVERED FIRM) No Debt and No Interest.

– Firm’s Overall ROR = Net Income / Total Assets. For 100% Equity
Firm, Total Assets = Equity. So Overall ROR = Net Income / Equity =
ROE! Note: Net Income is also called Earnings.

– Note: ROE Does NOT Equal rE (Required Rate of Return). ROE is

Expected Book Return on Equity. Used in Stock Valuation Formula
to calculate “g” & “PVGO”

– Fluctuations in ROE = “Basic Business Risk”

• Review Financial Accounting Ratios

Basic Business Risk

(Not Considering Debt):

• Causes of High “Basic Business Risk” or Uncertainty or Volatility or

“Instability” or “Shocks”

– Large changes in Customers’ Demand (seasonality)

– Unstable Selling Price (unstable markets and retailers)

– Uncertainty in Input Costs (raw material, labor, utilities)

– Inability of Management to Change Operational Tactics and Strategy

to Meet Changing Environment

• Ineffective Price Stabilization

• Poor Product R&D and Planning

– High Operating Leverage (OL)

– Many other causes.

 The HIGHER the operating leverage of a company the GREATER business

Risk.

Operating Leverage (OL):

• Formula: OL = Fixed Costs / Total Costs

• Concept: High OL Increases Risk: Customer Demand Falls but Fixed Costs
remain High. So, Small Decline in Sales Can Cause Large Decline in ROE.

• Fixed Costs Across Different Industries:

– Plant, Machinery, Equipment ie. Power Plant, Cement, Steel, Textile

Spinning

– New Product Development, R&D Costs ie. Pharma, Auto, IT

– Highly Specialized & Skilled Workers ie. IT

• OL used in Capital Budgeting & Capital Structuring Decisions

 What is Leverage? Leverage is something that allows a small force to create

a large facts.
 A small change in the quantity of sales or the amount of the product that a
company sales can have on the earnings of the company.
 Formula: OL = Fixed Costs / Total Costs

Operating Leverage Application to Capital Structure:

• Applications to Capital Structure

– Example of 2 Types of Cement Manufacturing Technologies:

Different OL’s has 2 Impacts:

• Different Risks so Different Betas (CAPM Approach to Cost of

Equity Capital), Different WACC’s for 2 Technologies. Affects
Choice of Capital Mix (or Capital Structure)

• Different Fixed Costs, Different EBIT & NI, Different ROE’s so

Different Dividend Growth Rates “g,” (Gordon-Dividends
Approach to Cost of Equity Capital). So Different WACC’s.
Affects Choice of Capital Mix.

Lecture No 31:

19 January 2016_Thursday_ 8:01pm

Recap of Business Risk & OL:

• Total Risk Faced by FIRM

– Total Risk = Business Risk + Financial Risk

– Business Risk (from Operations except Debt)

• Uncertainty & Fluctuations in Prices & Costs. Specific & Market

Causes.

• Higher Operating Leverage (OL = Fixed Cost / Total Cost)

causes:

– Higher Breakeven Point

– Higher but Riskier Expected Return on Equity <ROE>

– Financial Risk

• Created when Firm takes Loan or Debt or issues Bonds – this is

Financial Leverage (FL = Debt / Total Assets = D / (D+E))

 A small decrease in the sales can be large decrease on ROE. It’s the concept
of Leverage.
 Any changes or any variation in ROE is a measure of Risk of that firm.

_ Application of Operating Leverage to capital budgeting:

o Different OLs, Different Breakeven points, Different Risks, Different RORs.

So, different discount rates, Affect computation of NPV investments
criterion.
o Breakeven Point: Quantity of sales at which EBIT = 0 therefore ROE = 0.
o EBIT = Op revenue – Op costs = Op revenue – variable costs- fixed costs =
PQ – VQ – F.
Where
P = Product Price
Q = Quantity or # of Units sold
V = Variable Cost
F = Fixed Cost
So, if EBIT = 0 then PQ – VQ – F = 0
o Breakeven Quantity Q = F / (P - V)

 Variable costs are the costs which ups and downs with the sale. However,
fixed are just fixed which is not changed.
 Breakeven point is the point Operating Revenue is equal to Operating
Costs. In other word EBIT is equal to Zero.

Financial Leverage (FL) &

Operating Leverage (OL):

• Effect of Financial Leverage & Operating Leverage on Risk & Return (as
measured by ROE) are Similar.

– High Operating Leverage: OL = Fixed Cost / Total Cost. High Fixed

Costs so small changes in Quantity Sold cause larger changes in Net
Income & ROE

• Risky if Firm’s Sales < Breakeven Point BUT

• Multiplies Increase in Mean ROE when Sales > Breakeven

 We visualize Operating leverage on the costs verses sales graph and there
are 2 major effects,
i) High operating Leverage: means Greater reduction in the EBIT. In
other word high Operating Leverage means a GREATER chance to
lose.
ii) 2ndly high operating leverage shifts the breakeven point into the
right in other words increases the minimum number of units that
need to be sold for in order to a company to its total costs.
iii) High Financial Leverage:
– High Financial Leverage: FL = Debt / Total Assets = D / (D+E). High
Debt & Interest Payments so small changes in EBIT cause large
changes in Net Income & ROE

• Risky if Firm’s Overall Return is low and can NOT pay Interest
on time BUT

• Multiplies Increase in Mean ROE and Total Return (to Equity &
Debt Holders) when Firm’s Overall Return is Higher than Cost
of Debt

Operating Leverage Application to Capital Budgeting:

(Attachment from Lecture No. 30 – Insert After Slide No. 2 Lecture No. 31)

 Higher rate of return means higher WACC.

 With higher WACC, higher the Risk.
 ROE: means Return On Equity.
- ROE = Net Income / Equity = NI/E
- Financial Accounting Ratio
 ROR: Required Rate of Return.
- Re = (DIV1/Po) + g(Gordon’s Formula for share price)
- Market and Risk – Oriented Financial Management
Parameter. Depends on investors risk profile and market
risk (Beta). Linked to CAMP theory.
 ROA: Return On Assets.
- Is a financial ratio
- ROA = Total Return / Total assets = (Net Income
+Interest ) / (Debt + Equity) = (NI +int) / (D + E)

Financial Leverage (Debt) Increases ROE Risk:

• Increase in Debt Increases Chances of Net Loss if EBIT falls and Firm can
NOT make Interest Payment.

Financial Leverage = FL = Debt / Total Assets = D / (D+E)

• Increase in Debt Increases Uncertainty in ROE. Range or Spread of Possible
future values of ROE increases. Risk faced by Common Stock Holders
Increases.

• Total Stand Alone Risk of Firm = Business Risk + Financial Risk

– Total Stand Alone Risk = Standard Deviation of ROE of Levered Firm

– Business Risk = Standard Deviation of ROE for Un-levered Firm

Financial Leverage (FL) &

Operating Leverage (OL):

• Effect of Financial Leverage & Operating Leverage on Risk & Return (as
measured by ROE) are Similar.

– High Operating Leverage: OL = Fixed Cost / Total Cost. High Fixed

Costs so small changes in Quantity Sold cause larger changes in Net
Income & ROE

• Risky if Firm’s Sales < Breakeven Point BUT

• Multiplies Increase in Mean ROE when Sales > Breakeven

– High Financial Leverage: FL = Debt / Total Assets = D / (D+E). High

Debt & Interest Payments so small changes in EBIT cause large
changes in Net Income & ROE

• Risky if Firm’s Overall Return is low and can NOT pay Interest
on time BUT

• Multiplies Increase in Mean ROE and Total Return (to Equity &
Debt Holders) when Firm’s Overall Return is Higher than Cost
of Debt

 Small changes in the EBIT can be very LARGE changes in the ROE.
 Financial Risk created By Debt.

I mostly concerned this lecture from PPT n Video.

NOTE:
Couldn’t take Last lectures (35 to 45), make it by urself.
I just noted roughly. So, If you find any mistake in notes anywhere then kindly
must make Correction and Share on forum with file name. However, students
could get that correction while download these files.
Regards!
Malika Eman.
Financial Management_MGT201

11th Week of Lectures

Lecture No 32 to 34

Final Term_ Important Notes

Explanation noted by me has shown with & symbols.

Lecture No 32:

23 January 2016_Monday_9:17pm 12:03pm with chunks of breaks..

Recap of WACC, Business Risk, & Leverage:

 WACC % = rD XD + rE XE + rP XP .
(Debt + Common Equity + Preferred Equity)
- Where “r” is ACTUAL COST which can be calculated from
REQUIRED ROR after accounting for Taxes & Transaction Costs.
- Equity Capital: If Not Enough Retained Earnings then Equity Capital
must be financed by New Stock Issuance which is more costly.

 We calculate required rate of return (ROR) for a bond using the

bond pricing equation Present Value (PV) and solving it by try and
error for the R value. We did this when we calculating the yield to
maturity YTM that the case for debt.
 required rate of return (ROR) for Equity we use Gordon formula
for Common Equity in order to calculate Required Rate of Return.
 There are 2 ways to generate new Equity;
i) we can use either retained earnings which are the saving that
the company has accumulated over its life in the form of net
income that has been collected in the history of the company.
ii) Or you can issue new stock/ new Common Equity.
Naturally if company does not have an enough retained
earnings then it has to issue new stock.
The Disadvantage with issuing new stock is, that it is Time
consuming and it is costly.

 Total Risk Faced by FIRM

- Total Risk = Business Risk + Financial Risk
Standard Deviation of ROE (Levered Firm ABC) = Standard
Deviation (if Firm ABC is Un-Levered) + Financial Risk (from Debt)\

 Risk of a stock = Diversifiable risk + Market risk

 Total Risk or Standalone Risk is same thing.
 ROE Risk is used to calculate overall rate of return for a firm.
 Unlevered firm is the firm which is 100% Equity and no debt
 Business Risk is the Risk that caused by the assets operation business
itself and there is both a specific aspect to the risk as well market risk.

- Business Risk (from Operations except Debt)

Uncertainty & Fluctuations in Prices & Costs. Specific & Market
Causes.
Higher Operating Leverage (OL = Fixed Costs / Total Costs)
Higher Mean ROE WHEN FIRM’S SALES >
BREAKEVEN POINT
Higher Fixed Costs means Higher Breakeven Point and More
Chances of Operating Loss. Risk of Large Drop in Return on
Equity <ROE> so Higher Risk.

 The higher the operating leverage of a firm the higher its Business
Risk and large fall in the ROE (Return On Equity).
 Leverage concept means magnification. It amplifies in largest the
effects.
 Effect is: Small change in the sales of a company can lead to a very
large change in the operating profit or loss and very large change
In the Return On Equity (ROE).

- Financial Risk (from Debt, Bonds, or Loan)

Created when you take Loan or Debt or Financial Leverage (FL =
Debt / (Debt + Equity)
Financial Risk = Std Dev of ROE (Levered) - Std Dev of ROE (Un-
levered)
Example: If Total Risk = 30% and Business Risk = 20% then
Financial Risk = 30% - 20% = 10%
 Causes of financial risk are debt when a firm takes on loans and
accessible amount on borrowing it is more prone to financial risk.

 Leverage concept means magnification. It amplifies in largest the

effects.
Effect is: Small change in the EBIT or earnings before interest or
taxation can lead to a very large change or effect on ROE of the firm.

Financial Leverage Concept:

• Created when you take Loan or Debt or Financial Leverage (FL).

• Financial Leverage (%) =Debt /Total Assets =D/A = Debt / Debt + Equity =
D / (D+E)

• If Firm has Rs 1000 of Total Assets and Rs 500 Debt then it has 50%
(=50/1000) Financial Leverage

• Practically, Firms increase Financial Leverage by:

– Issuing New Debt (ie. Taking New Loans and Increase Debt) OR

– Replacing Equity with New Debt ( Increasing Debt AND DECREASING

EQUITY too)

Financial Leverage
Impact on Risk & Return of Firm:

• Financial Leverage (or Debt Financing) Generally Increases Overall Risk &
Return of a Firm:

• Increases Return (Mean ROE):

– When EBIT /Total Assets > Interest Cost then Financial Leverage is
Good. Small Increase in EBIT can create much LARGER Increase in
ROE.

– If Equity (and number of shares) Reduced then Return (NI) per Share
Increases
• Increases Risk (Standard Deviation in ROE): Fixed Interest Dues so Higher
Chances of Losses, No Dividends for Shareholders. Possibility of Large Drop
in ROE. Possibly Default. More Risk Transferred to Stockholders.

– If Equity (and number of shares) Reduced then Risk per Share

Increases.

Capital Structure Theory:

• Financial Leverage (FL = D / (D+E)):

– Increases Overall Return (Mean ROE) when EBIT/Total Assets >

Interest (or Cost of Debt then Leverage is Good because small
Increase in EBIT causes much LARGER Increase in ROE.

– Increases Overall RISK (Standard Deviation of ROE) of FIRM.

Leverage will always MAGNIFY or AMPLIFY a small change in EBIT
into a LARGER change in ROE.

• Fundamental Principle in Risk-Return: Rational Investors in Efficient

Markets will only take Extra Risk if they are Compensated by Sufficient
Extra Return.

• Should the Management of a Firm undertake Financial Leverage? If So,

then how much Debt should a Firm have?

– Answer provided by Capital Structure Theory

 How do we know financial leverage is Good or not?

Answer is Capital Structure Theory…

Modigliani - Miller:
Fathers of Corporate Finance

• “Cost of Capital, Corporate Finance, and The Theory of Investment” -

Revolutionary Article Published by Professors Modigliani & Miller in
American Economic Review in June 1958. Won Nobel Prize.
• “Pure M-M” (or Modigliani-Miller) Model - IDEAL CASE:
– Major Assumptions:
No Taxes, No Bankruptcy Costs, Efficient Markets, Equal
Information Available to All Investors
 But these assumptions are not true in real world. The conclusion of
Modigliani and Miller is not correctly accurate but they give us very
important inside to impact of debt and capital structure on the value of
firm on investments decisions.

– Major Conclusions:
• Capital Structure has NO AFFECT on VALUE of a
FIRM! Capital Structure is Irrelevant!
 Under this ideal condition conclusion is
correct..

• It does NOT matter how a firm finances its

operations, how much debt it has because it
has NO bearing on a Firm’s Overall Value as
calculated using NPV!
 This is only true under the ideal conditions
and assumptions of mod and miller made.
Naturally its ideal situation that applies in real
world theory.

• Corporate Financing & Capital Structure

Decisions have no bearing on Investment (or
Capital Budgeting) Decisions.
 This is assumption that is going by…

• Capital Budgeting can be carried out without

knowing the exact Capital Structure of a Firm -
you can assume 100% Equity (Un-levered)
Firm.
Modified MM - With Taxes

The first change or modification that made by the mod and miller theory was to
include the effects of taxes.

• Modigliani-Miller (With Corporate Tax)

- In most countries, a FIRM’s Interest Payments to Bond Holders are
NOT Taxed. But Dividend Payments to Equity Holders are Taxed.
- Based on CORPORATE TAXES, FIRMS should prefer to raise
Capital using DEBT Financing.

 These modifications are done by themselves (Mod and miller).and

conclusion came up with is that, the most countries around the world
cooperate the tax or tax the company have to pay by the government
favors the raising of capital form of debt. WHY??
 Coz, the interest rate that the companies pay on debt is tax deductible.
 Therefore, interest represents tax saving or tax shield or tax shelter.
 Whereas the Equity and dividends paid on Equity do not lead to any
Tax saving as far as tax goes.
 So, from the companies or firms point of view there is a saving
associated with capital that raise in form of debt or loan.
 So, firms based on tax cooperation’s would prefer issue debt rather
than Equity.

• Merton-Miller (With Personal Tax)

- In most countries, INVESTORS pay a higher Personal Income Tax on
Interest Income from Bonds than on Dividend Income from Equity (or
Stocks).
- Based on PERSONAL TAXES, INVESTORS should prefer to
invest in STOCKS (or Equity).

 In most countries around the world, individual investors pay more

personal tax on income from debt in the form of interest then they do
on income in the form of capital gains equity or in the form of
dividend income from equity.
 So, from Investors point of view they would prefer to give or invest
their money in Equity.
 Now, this is a difference which capital is better depending on whether
you’re looking at the firm cooperative taxes or looking at the
individual investors and personal taxes.
• Uncertain Conclusion: Difficult to determine Net Effect. But, practically
speaking, Corporate Tax Effect is generally stronger so Based on Taxes
alone, Firms should prefer Debt.

 The NET RESULT of this opposing we see is that when we see

both tax Cooperate Tax and Personal Tax into consideration the NET
EFFECT is generally speaking, it is better for firm to issue debt in
terms of taxes because the tax saving from the interest payments are
more important than the Tax saving for the investors from the income
from equity.

Lecture No. 33_ Capital Structure

27 January 2016, Friday

Miller Modigliani- MM Theory

& Other Theories

Recap of WACC, Business Risk, & Leverage

WACC % = rD XD + rE XE + rP XP . (Debt,Common Equity,

Preferred Equity)
Where “r” is ACTUAL COST which can be calculated from
REQUIRED ROR after accounting for Taxes & Transaction
Costs.
Use Net Proceeds (NP = Market Price – Transaction
Costs) instead of Market Price (Po) when calculating rD
and rE.
Two ways to calculate Cost of Equity rE: (1) Use
Gordon’s Formula: rE = (DIV 1 / Po) + g or (2) Use
CAPM Theory: rE = rRF + (rM – rRF) x Beta
Equity Capital: If Not Enough Retained Earnings then Equity
Capital must be financed by New Stock Issuance which is more
costly.

Total Risk Faced by FIRM

Total Stand Alone Risk of Firm = Business Risk + Financial Risk
Standard Deviation of ROE (if Firm is Levered) = Standard
Deviation of ROE (if Firm is Un-Levered) + Financial Risk
(from Debt)
Note: Stand Alone Risk of Stock = Diversifiable (or Company
Specific) Risk + Market Risk

 A firm has 2 general ways to raise equity.

It either converted retained earnings which are basically saving of
income that has been collected over the years. And convert that
into common equity and issue common shares against it OR
company can issue fresh equity. And sale common stock in open
market.

 Business Risk (from Operations and Assets but not Debt)

Uncertainty & Fluctuations in Prices & Costs. Specific &
Market Causes.
 Higher Operating Leverage (OL= Fixed Costs / Total
Cost)
 Bunsiness risk is associate with the fluctuation and
changes in the prices and costs associated with the
operation of a business.
 Business risk increases with Operating Leverage.
 Leverage is the phenomena that magnifies or larges
effects.
 Operating Leverage in larges its effects of changings in
sales. So, a small changes in sales can lead to a large
change in the earnings of the company OR in the ROE
(Return On Equity) for the shareholders.
 Operating Leverage = Fix costs / Total Cost.

- Good when FIRM’S SALES > BREAKEVEN

POINT. Small increase in sales can lead to large
increase in ROE.
 Operating Leverage can be good or bad. It’s like a knife.
You can use a knife in good way or in a negative way.
Similarly, Operating Leverage is good provided that the
firm has a healthy amount of sales. If the sales of the firm
are HIGHER than Breakeven Point the Operating
Leverage can be beneficial. Coz, small increases in sales
can lead to large increases in the return equity in the
shareholders.

- Bad if Sales < Breakeven Point. Higher Fixed Costs

means Higher Breakeven Point and More Chances of
Operating Loss. Risk of Large Drop in Return on
Equity <ROE> so Higher Risk.
 When operating leverage increases the average point of
equity it also increases the overall amount of RISK. Coz, it
is in larges the effect of sales on Return On Equity and
whenever there is larger in its effects and larger spread of
variation then Risk Increases.

Financial Risk (from Debt, Bonds, or Loan ie. Leverage)

Created when you take Loan or Debt or Financial Leverage
(FL = Debt / (Debt + Equity))
• Financial Risk is created when you take Loan or Debt or Issue Bonds ie.
Financial Leverage (FL). FL = Debt / (Debt + Equity). FL magnifies small
changes in EBIT (and sales) into large changes in ROE.
• Financial Risk = Standard Deviation of ROE (if Firm is Levered) - Standard
Deviation of ROE (if Firm is Un-levered)
• Financial Leverage (Debt Financing)
– FL =Debt / Total Assets =D/ A = Debt / (Debt+Equity) =D/(D+E)
– Good if it Increases Overall Return (Mean ROE) when EBIT/Total
Assets > Interest (or Cost of Debt then Leverage is Good because
small Increase in EBIT causes much LARGER Increase in ROE.
– Bad when it Increases Financial Risk and therefore the Overall RISK
(Standard Deviation of ROE) of FIRM. Leverage will always MAGNIFY
or AMPLIFY a small change in EBIT into a LARGER change in ROE.

 Financial Risk is created by Debt. When a company

takes loan or when it takes or borrows money it takes on
Financial Risk.
 Financial Risk is Proportional to Financial Leverage.
 Financial Leverage is defined as the ratio of the debt to
the total asset of the company. In other words, (FL = Debt
/ (Debt + Equity))
 Financial Leverage also have a Magnifying effects.
 And in this case small changes in the earning or EBITS of
company can lead to a large changes in the ROE for the
shareholders.
 Financial Leverage either Good or Bad depending on the
health of the company.
 If the company is healthy and overall returns measured by
EBIT / Total Assets > cost of debt or interest then
Financial Leverage can be POSITIVE OR can be
helpful.
 In this case small increase in EBIT can lead to large
increase in the ROE. However, increase in financial
Leverage not only increase the ROE it also increases the
RISK or uncertainty in the ROE. It increases the Standard
Deviation to the ROE as well.

Modigliani - Miller:
Fathers of Corporate Finance
 “Cost of Capital, Corporate Finance, and The Theory of
Investment” - Revolutionary Article Published by Professors
Modigliani & Miller in American Economic Review in June
1958. Won Nobel Prize later.
 Financial leverage goes to increase the average ROE for
the shareholders but it increases the RISK. So, question is,
Is Leverage/Debt is good or bad? And how much it is
good or bad?
 To answer of this question starting talking about Capital
Structure Theory.

 “Pure M-M” (or Modigliani-Miller) Model – Case of an

IDEAL FINANCIAL WORLD:
- Major Assumptions of Pure MM Theory: No
Taxes, No Bankruptcy Costs, Equal Information,
Efficient Markets
 They assumed a world where no taxes, no bankruptcy
costs and all of the investors and shareholders and
managers in the market has same amount of information.
These are major assumption which they made. Therefore,
the results are not exactly accurate.
 They were aware of these effects. But they have
important consequences and understanding impact of
the capital structure in debt on investment decisions and
the value of firm.

- Major Conclusions of Pure MM Theory:

 According to Pure MM Theory, Capital Structure has
NO AFFECT on VALUE of a FIRM ! It only affects
the way a Firm decides to distribute or split its cash
outflows between the Equity Holders and the Debt
Holders.
 Capital Structure or amount of debt or borrowing that a
firm takes has absolutely no impacts on the VALUE of a
FIRM b. In other words, whether the firms has 10% debt
or 90% debt on capital structure
 According to the MM theory based on IDEAL condition
has no bearing on the value of firm. And this result was
surprising to us we just said that increasing debt and value
of risk of a firm.
 MM Theory said that Amount of firm has no bearing on
the valuation of that firm based on the NPV formula. How
can this be??
 Well, according to this theory, the value of a firm is
derived from
 Value of a firm/ value of a real assets(working assets) that
are in operation or in business that value, that fair value or
the intrinsic value is based on the future cash flows that is
generated by this real assets.

 It does NOT matter how a firm finances its operations,
how much debt it has because is has NO bearing on a
Firm’s Overall Value of Firm
- Value of Firm can be calculated using NPV
Formulas from Capital Budgeting
- Value of Firm = Price of One Share x Number
of Shares Outstanding
 According to Pure MM Theory, Corporate Financing &
Capital Structure Decisions have no bearing on
Investment (or Capital Budgeting) Decisions.
 Capital Budgeting can be carried out without knowing
the exact Capital Structure of a Firm - you can assume
100% Equity (Un-levered) Firm when analyzing Project
Investment Decisions and Capital Budgeting.
MM theory was not implementing on the real world cases, where taxes
are exists, not every investor are rational/smart and not everybody have
equal knowledge in the corporate.
So, changes had to happened by MM in their theory.
1st modification was with taxes.

1_ Modified MM - With Taxes

• Modigliani-Miller (With Corporate Tax)

– In most countries, a FIRM’s Interest Payments to Bond
Holders are NOT Taxed. Therefore, Interest Expenses
(shown on P/L Statement) provide Tax Shield or Tax
Shelter. However, Dividend Payments to Equity Holders
ARE Taxed.
– Based on CORPORATE TAXES, FIRMS should prefer to raise
Capital using DEBT Financing.
 Most countries around the world, the corporate tax that firms and
companies pay to the government favor DEBT rather than
EQUITY. WHY? Coz, whenever a firm takes on debt the interest
rate that paid is Tax Deductible. Firms do not pay tax on the
interest that the pay to the bondholders or to the landers. This is
a tax saving.
 Company raises capital through debts then it saves tax because
of the interest payments that is mixed. Which is known as tax
shield or tax shelter.
 However, if the company issues equity and it pays dividends then
those dividends are not tax deductible. So, there is no tax
advantage associative with the dividends that a company pays to
its shareholder.
 Therefore, according to the Corporate Tax Law around the world,
company could prefer to raise money through debt rather than
equity.

• Merton-Miller (With Personal Tax)

– In most countries, INVESTORS pay a higher Personal
Income Tax on Interest Income from Bonds than on
Dividend Income from Equity (or Stocks).
– Based on PERSONAL TAXES, INVESTORS should prefer to
invest in STOCKS (or Equity).
 In this case, the individual person have to pay personal taxes. So,
in such case situation become inverse.
 Individual investors of firm receives income form of interest from
investments on debt then it pays a HIGHER personal income tax.
Then on the income that is received in the form of dividend from
equity. In other words, personal taxes in most countries around
the world for interest income is HIGHER than the personal tax on
dividend income from equity or capital gains which is increases
the price of the share.
 So, according to the personal tax laws most individual investors
would prefer to invest their money in equity.

• Impact of Taxes is Uncertain: Difficult to determine Net Effect of Taxes

on Optimal Capital Structure. But, practically speaking, Corporate Tax
Effect is generally greater and so Based on Taxes alone, Firms should
prefer to raise capital in the form of Debt.
 Impact on personal tax and corporate tax are contradictory to each
other.
 The net effect in generally is that Corporate taxes are more
important and generally taking on both corporate and personally
taxes into consideration. Companies would buying large prefer to
raise money in the form of debt.

2_ Modified MM - With Bankruptcy Cost

• Bankruptcy: when a Firm is forced to close down because of

continual Losses and Net Cash Outflows, or Default on
Interest Payments.
• Bankruptcy Costs Real Money - Companies Do Not Die in
Peace ! Fees paid to Lawyers and Accountants, possible
penalties and Legal Claims by Suppliers, Buyers, & Partner
Firms, and Loss on Sale of Assets because Firm is forced to
quickly Liquidate its Assets and repay the Debt Holders (such
as Banks) first.
• Even the THREAT or RUMOR of Bankruptcy can create
problems for a Firm. Suppliers refuse to supply raw materials
and cancel Trade Credit facilities. Banks demand higher
Interest Rates. Customers cancel Purchase Orders so sales
fall.
• If Firm is EXCESSIVELY LEVERAGED (or has a Lot of Debt) then
there is a HIGHER Chance of Bankruptcy.
• For Certain Types of Firms, Debt is More Likely to Cause
Bankruptcy:
– Firms with High Operating Leverage or high Fixed Costs
– Firms with Non-Liquid Assets that are difficult to sell
quickly for cash
– Firms whose EBIT (or Earnings) Fluctuate a Lot

Tradeoff Theory of Capital Structure

With Tax & Bankruptcy
 Trade off theory Is mix and couple of changes in the Pure
MM theory by taking into the consideration both taxes and
bankruptcy.

• Decision regarding how much Debt (or Financial Leverage) is

based on Tradeoff between the Advantage of Debt &
Disadvantage of Debt.
– Advantage of Debt over Equity: Interest Payments
are Not Taxed. Known as Interest Tax Saving or Tax
Shield or Tax Shelter
– Disadvantage of Too Much Debt: Firm becomes
more Risky so Lenders and Banks Charge Higher
Interest Rates and Greater Chance of Bankruptcy
• When 100% Equity Firm adds a Small Amount of Debt, the
Value of its Stock Goes Up at first because Total Return
Increases.
Total Return = Net Income (paid to Equity Holders) + Interest
(paid to Debt Holders).
But if the Firm keeps adding too much debt then the Chance
of Bankruptcy will Offset the Initial Benefit and the Stock
Value will Fall.
 As a firm gradually increases the percent of debt capital
structure. So, as the firm become more and more
Leveraged.
• Value of Firm = Price of One Share x Number of Shares
Outstanding
 It’s the rough calculation for the value of firm.

• A range for the Optimal Capital Structure or Debt/Equity Mix

can be calculated in theory. This is where the Firm has
Maximum Value and Minimum WACC. Practically speaking it
varies across industries and companies. Optimal D/E can
range from 20/80 to 70/30 and keeps changing with time
depending on the firm’s financial health and growth
strategy.
 Trades off theory tells us there is some optimal or best
capital structure there is some value or percentage that is
ideal for particular firm at the particular time.

Signaling Theory of Capital Structure

Improvement on Tradeoff Theory
• Signaling Theory: Practically speaking, NOT all Investors have equal
amount of information. A Firm’s Owners & Managers (Insiders) know more
about it than Ordinary Outside Investors.
• Signaling Theory: “Insiders (Managers & Owners) Know Better”
– When Firm’s Future genuinely looks Good (ie. High
forecasted Cash Flows, Earnings, NI, ROE…) then Managers
will Choose to raise financing through Debt (or Bonds or
Loan) because they do not want to share the Financial Gain
with More Shareholders. Rather They Prefer to Take On
Debt and pay a small interest to the Debt Holders. There is
almost no risk of Default.
– When Firm’s Outlook looks Bad, then Managers will
Choose to raise capital by Issuing Equity (or Stock) to be
able to share the Likely Losses amongst more Shareholders
(Owners). If they took Debt and couldn’t repay it, they
might Default and be forced to go Bankrupt.
 Managers know better kab debt lena hai kab equity. Coz, he see
real picture of the financial environment within a corporation
rather than an out sider.
 So, based on the real picture he can assume better that next 2,3
years mein lose hoga ya company will go to up in growth. Agr
company k up Janay ki indications paye ga to who debt lay ga.
however, shareholder na honay ki wjay say profit k liay zyada
shareholders nahi hongay.
 Or agr he feels company will go down till next some year..he will
take equity. However, shareholders ki tadad zyada ho or company
ka lose zyada say zyada shareholders mein divide ho jaye.

Signaling Theory – Conclusions:

• Practically speaking, Firms should maintain LESS Leverage

than the Optimal Level from Tradeoff Theory.
• Firms Should Save Some Reserve Debt Financing Capacity in
case they find a Great Project or Investment Opportunity.
They should finance the Project using Debt for 2 reasons:
– they don’t have to share the Financial Gains with
more shareholders AND
– they give the Right Signal to the Market of Investors
about the good health of their Firm !
– Debt Financing brings Financial Discipline and
tighter cash control on some Managers that waste
Shareholders’ money
• News of New Equity Financing: Signals bad news. Investors
will sell stock and Market Price (Po) of Stock will fall.
Therefore, Required ROR ( r = DIV/Po + g) will Rise and WACC
will Increase. Now more difficult for Projects and Investments
to meet this Firm’s Capital Budgeting Criterion by showing
t
positive NPV (= Sum of {Cash Flows / (1+r) }.

 A firm that is healthy decide to issue new equity, then it

can force a situation there by it increases its
WACC(Weighted Average Cost of Capital) and its is force
to reject projects that are good but that do not meet its
minimum required rate of return criteria based on the
WACC.

Lecture No. 34

12:35pm, 29 January 2016, Sunday

Recap of WACC & Firm Risk:
• WACC % = rD XD + rE XE + rP XP . 3 Basic Forms of Raising Capital: D=Debt,
E=Common Equity, & P=Preferred Equity. Uses Required ROR’s adjusted by
Taxes and Transaction Costs. “x” represent fractions of MARKET VALUES of
Debt or Equity. Should NOT use the Book Values from Financial Statements
used in Financial Accounting.
– Two Ways to Raise Equity Capital: (1) Retained Earnings which is
cheap way to raise equity AND (2) New Stock Issue which is more
costly
– Two Ways to Calculate rE (Required ROR on Equity): (1) Gordon’s
Formula for Stock Pricing : rE = (DIV1/Po) + g AND (2) CAPM Theory /
SML : rE = rRF + (rM – rRF)Beta
• Total Stand Alone Risk of Firm = Business Risk + Financial Risk
• Business Risk = Standard Deviation of ROE of Un-levered Firm
– Operating Leverage (OL) = Fixed Cost / Total Cost. OL increases
Business Risk. Small Change in Sales Causes Large Change in
Operating Income & ROE. OL can be Good when Sales > Breakeven.
 Operating leverage can be good provided that companies’ sales
are higher than breakeven points.
 In any case operating leverage will generally always increase the
level of risk.

• Financial Risk = Total Risk for Levered Firm - Business Risk

– Financial Leverage = Market Value of Debt / Market Value of Total
Assets = D / (D+E): FL increases Financial Risk. Small Change in EBIT
Causes Large Change in ROE. FL can be Good when EBIT/Assets >
Interest.
– Leverage Rises. Financial Distress & Higher chance of Bankruptcy.
Banks charge Higher Interest Rates. Higher Cost of Debt. Higher
Risk. Higher Beta. Higher Required Return on Equity ( rE ). Higher
Cost of Equity.

 Capital structure ki ibteda WACC(Weighted Average Cost of

Capital) say ki jo k bht basic concept hai.
 Jab ksi or country say koi real asset(tangible, pen glasses or any
kind of touchable thing) apni country mein lai jati hai purchase kr
k to mind mein uski average cost hi hoti hai. Then we want to
purchase same thing with high cost than average cost.
 Same like companies and firms sarmaya jama krti hein investors
say, chahay wo debt holders hon ya stockholders company k, jab
koi firm sarmaya akhatha kr rhi hoti hai to then usko ye hisab
lagana hota hai k whats the Price of that thing/real asset which
it have to pay? And this one is the basic Question. Jahan bhi who
company sarmaya laga rhi hai uski rate of return is say zyada honi
chahiaye otherwise there is no benefit.

NOTE:
Couldn’t take Last lectures (35 to 45), make it by urself.
I just noted roughly. So, If you find any mistake in notes anywhere then kindly
must make Correction and Share on forum with file name. However, students
could get that correction while download these files.
Regards!
Malika Eman.