Session 6 Pricing of Risk and Capital Budgeting

1. Net Present Value (NPV) Rule

a. NPV higher than 0 means good business
b. Project with higher NPV is preferable (although can develop all positive NPV the
projects)
2. Internal Rate of Return (IRR) rule
a. IRR higher than WACC means good business
3. Efficient Market
a. Efficient Market Definition:
- Market where all information is available for participant at the same time, where
prices respond immediately to available information
- No possibility to Arbitrage in Efficient Market (exploiting price difference of
similar instruments)
b. Efficient Market Hypothesis:
- A firms stock market value is determined by DCF
- Positive NPV project shall be accepted
4. Implementing NPV rule
a. Rule 1:
- Cash flow is the proper basis of capital budgeting
- Work with cash flow after taxes, not net income
b. Rule 2:
- Timing of Cash flow is Critical
- Record values when it is received or paid
- Include Net Working Capital (NWC)
o Include the first value of NWC (-NWC)
o Include the incremental NWC (-NWC)
o Include the return of NWC at the end of period (+ sum of NWC)
- Replacing of Old machine with New machine
o Sales of old machine
o Loss tax shield from depreciation of old machine
o Loss of expected salvage value
o Loss from book loss when old machine is sold
a. Book Value = Cost Accumulated Depreciation
b. Loss/Gain Tax Benefit = Tax rate x (Book Value Sale Value)
o Purchase of new machine
o Gain tax shield from deprecation
o Net saving from operating expenses
c. Rule 3:
- Only incremental Cash flow is analyzed
- Include Opportunity Cos (e.g.: Opportunity cost of selling the land is minus this
cost in Year 0)
d. Rule 4:
- Consistent in the treatment of inflation (real v nominal)
- Adjust the CF to either real or nominal only
- Adjust the Discount rate accordingly
- Adjust the Depreciation accordingly

e. Rule 5:
- Risk must be compensated (Riskier project means higher BETA & WACC)
5. Useful formula of NPV
a. FCF = (Revenue Operating Expenses Depreciation) (1- Tax Rate) + Depreciation
Change in Deferred Tax Net Working Capital Change in CAPEX; or
b. FCF = (Revenue Operating Expenses) (1 Tax Rate) + (Tax Rate x Depreciation)
Change in Deferred Tax - Net Working Capital Change in CAPEX
*Note: CAPEX shall be After Tax Value

c. Nominal CF = Real CF x (1+ Inflation Rate)^t

d. Nominal Discount Rate + 1 = (Real Discount Rate + 1) (1+Inflation Rate)
e. Depreciation = (Buy Price Salvage) / # years
*Note: According to Tax rule, declarations of depreciation values have to be in nominal
values. Therefore, calculation has to be in nominal figures first, before translates it to Real
figures

f.

Loss/Gain Tax Benefit from Book loss/gain of Old machine = [Tax Rate x (Book Value
Sale Value)] where Book Value = Cost Price

Session 7 Capital Structure and Cost of Capital

1. Modigliani Miller (MM) Proposition 1
Total value of any firm is independent of its capital structure in perfect capital market and
no taxes
2. Modigliani Miller (MM) Proposition 2:
The expected rate of return of the common stock of a levered firm increases in proportion to
the D/E ratio (where rate of increase depends on the spread between rA and rD)
3. Useful formula to Capital Structure calculation
a. Total Firm Value = Operating Income / Return on Assets
b. Value of Debt = Operating Income for Debtholders / rd
c. Value of Equity = Operating Income for Equityholders / rE
d. rE = rA + (D/E) (rA-rD)
e. rA = [D/(D+E)] x rD + [E/(E+D)] x rA
f.

Beta Assets = Unlevered Beta = [(Debt %) x (Beta of Debt)] + [(Equity %) x (Beta of

Equity)]

g. Tax Shield Saving from Debt = (Tax Rate) x (rE) x Value of Debt x AF(year,rE)
4. MM with Taxes and Cost of Financial Distress
Total PV firm = PV if all equity financed + PV tax shield PV cost of financial distress
6. Optimal Capital Structure in a world with Taxes and Cost of Financial Distress

Session 8 Cost of Capital and Valuation

WACC = (Debt %) x (1-Tax) x (rD) + (Equity %) x (rE)

Beta Assets = Unlevered Beta = [(Debt %) x (Beta of Debt)] + [(1-Tax) (Equity %) x (Beta
of Equity)]
*Note: Tax rate is NOT applicable in MM 2 world. These formula can be used in MM 2
world and assume Tax = 0

Session 9 Efficient Market

Session 10 Rising Finance for Firms

Value of share = Total value of equity / Total number of shares

Value of share = Total value of firm / Total number of shares

*Note: Assumed there is no debt

Number of new shares = Funds to be raised / new subscription price

Number of rights for new share = # of existing shares / # of new shares

Ex-rights Price = (Current Firm Value + [Newly Fund raised x % exercised]) / (# existing
shares + [# new shares x % exercised])

Value of Rights = Rights on Price Ex-rights price

Maintaining amount of fund raised with % non-exercised rights;

# of shares = New fund to raise / (issue price x estimated percentage of exercised rights)