Accounting and Finance for Managers, Jan24 Edition

MBA564

Mark Shackleton

Lancaster University Management School

2023/24
M.Shackleton (LUMS) MBA564 Jan 2024 2 / 146
Learning objectives

The course treats the principal topics in Accounting and Finance of concern to the general
manager and financial decision makers. These include Net Present Values and related financial
measures, risk and return, valuation of equity and debt, market efficiency and its implications
and some personal finance (valuing education). It aims to do this with a minimum of
mathematics although an understanding of these issues does require some formulae. At the
end of this module students will be able to:-
Apply discounting to value simple corporate and personal finance situations
Produce the relevant firm or salary cashflows to feed into such calculations
Understand in broad terms, the factors present in risk return trade-offs
Use simple risk return formulae to produce an appropriate risk adjusted discount factor
Discuss market efficiency and its implications for financial policy
View investments through a sustainability (ESG) lens.

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Pre–reading/Moodle Quiz Assessments (25%)

Assets, liabilities and networth

Fractions of assets and liabilities
Annual salary and net savings
More percentages
Bank balance calculations
Calculating % return on investments
Payback on MBA year
Discounting, present value and rates of return
Set text: The Finance Book, Warner and Hussain.
Distinction level grade given for bona fide attempt to complete all quizzes

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Group coursework presentations (50%), Weds Jan 24th 2024, 1-4:30pm

With you company groups choose a company and email me before Nov. A US company
with well defined/notable stock market reactions on newsworthy days! I have Boeing
(Tesla is reserved, competing demands, but other choices on first come basis). Firms
operating with or failing to meet environmental standards/protection often have newsworthy
events or reaction to COVID Mar 2020. Find daily stock price history inc. dividends and the
US index and calculate two return series; one for your stock and one for your index (I will help
with WRDS/CRSP data). Produce a wealth time series graph and an x,y scatter graph of
returns on your stock (y axis) against returns on the market (x axis). This forms the basis for
a regression to determine a slope/risk coefficient (see separate document). Aim for a 15 min
presentation with a dozen ppt slides (max). Instant feedback, from the audience will be
provided. Delayed and more considered feedback will be given later (out of 50) on your group
written ppt/pdf reports to be submitted at noon on Weds 24th, 1pm before the
presentations start.

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Individual Exam (25%), Friday 26th Jan 2024

Location TBC with invigilators

Financial calculator app required
30 questions in two parts for 75 marks in total.
Qs1–10 NPV style questions for 15 marks. One mark for the answer and 0.5 for showing
the workings or the calculator inputs.
Qs11-30 short answer questions for 3 marks a piece, 60 total. Each is a statement
relating to matters raised or discussed in the course.
You must Agree or Disagree with each short statement by writing A (Agree) or D
(Disagree) clearly on your answer sheet against the question numbers Qs11–30
Next to that, you should also write a sentence (or two) explaining why you Agree (A) or
Disagree (D) with that statement in the context of this course.

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20 Agree/Disagree Questions, 3 marks max each

3 marks are given for a well articulated argument, consistent with the course materials
and discussion
2 marks or 1 mark are given for partial answers or straight statements of facts from the
course
No marks are given for incorrect answers or correct answers that do not relate to that
statement
Agree or Disagree may not have a global “right” answer. If you wish to bring in other
views, full marks can be given for unexpected material/opinions not from the course.
You may Agree (A) and Disagree (D) by providing TWO SEPARATE statements one
marked A and one D in different paragraphs. In that case the mark for that question will
be best of both once the rules above are applied.

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Course outline

Course Outline: 1 What is Finance?

Markets for capital and financial discipline

Financial intermediaries
Ownership and control
Regulation and government
The financial system
The composition of financial markets
The role of finance in the economy
Historical rates of asset return and returns

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Course outline

2 Time value of money and discounted cashflow analysis

Compounding, from discrete to continuous

Net present values (NPV) and the time value of money
Annuities, perpetuities and amortising flows
Time value of money and discounted cashflow analysis
Internal rate of return (IRR)
Exchange rates and inflation
Present value/equivalent annual cost of equipment
Why NPV instead of IRR, payback or other?

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Course outline

3 Life cycle financial planning

Your investment/consumption decision

Valuing your education
Present value of gains from study
Relevant cash flows for decision making
Project cashflows: How to analyse investment projects
Profit/Loss Statements
Cash Flow Statements
Balance sheets

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Course outline

4 Principles of asset valuation

The law of one price “no arbitrage”

Information and security prices
Efficient markets hypothesis, beating the marker
Cognitive biases, random walks

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Course outline

5 Risk and return

Covariance and regression to the market

Two asset portfolio
Diversification and rewards for risk
The security market line
Firm valuation
Using company reports and accounts, ratios etc.
Financial planning & forecasting
Managing liquidity
Dividends and growth
Allocating the cost of capital

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Course outline

6 Corporate Finance and capital structure

Market values of items

Enterprise value
Environmental Social and Governance (ESG)
Discussion & course summary review

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Why study finance?

Why study finance?

Expand your mind!

Manage your personal resources
Deal with the business world
Pursue interesting and rewarding career opportunities
Make informed choices as a citizen, influence the business impact on the planet
The Financial System allocates scarce resources over time where cost and benefits are:-
Spread out in time (investment required before realisation of returns)
Not known in advance (return realisation is uncertain)
Unfortunately, the majority of natural resources lie outside its scope, and are treated as
“externalities”!

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Why study finance?

Difference between finance and economics?

Economics shows how today’s goods and services are allocated through a price mechanism
In the markets for any two goods, there are limited production possibilities
Aggregate preferences for the two tell us the relative worth of the two as determined in a
market where consumers are free to chose
More frequently, a common numeraire is used to express prices, money in today’s terms
Thus each commodity has a price which reflects its worth to consumers
Competition should drive prices toward long run marginal cost and there should be no
economic rents (abnormally large profits).

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Why study finance?

Finance shows how..

Future uncertain return are allocated between investors through expected returns.
Future:– markets for money today and tomorrow with limited possibilities; some prefer
today, some tomorrow, we allow them to trade by lending money
Aggregate preferences determine the relative value of money today/tomorrow, both
commodities have a price but their rate of exchange is called an interest rate.
Competitive markets for borrowing and lending should mean that financial markets offer a
fair return
Uncertain:– also a market for certain returns and uncertain returns; some prefer
certainty, others uncertainty
Preferences will determine the relative price of certain returns compared to uncertain
returns
Competitive markets for investment should mean that the financial markets should offer a
fair return on risk (need to define risk carefully later).
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Why study finance?

Financial Objectives; Personal, Corporate & Social

Personal: Maximise your future wealth while still sleeping well at nights (too much risk
may cause personal bankruptcy)
Corporate & Managerial: Maximise the value of the firm on behalf of the owners (ditto).
However, accounting and finance are Social systems. They have largely ignored
externalities to date, but now social norms are making it hard for firm’s to profit at the
expense of the environment.

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Why study finance?

Financial Discipline and Social License

Companies that thrive and prosper will attract more resources: credit, labour, managers,
equity and debt capital.
Companies that perform poorly will be starved of resources and will be subject to
takeover.
More shareholders will try to sell the firm’s stock pushing the acquisition price to a
competitor down.
Firm’s that lose their social license will be subject to divestment and de–listing, they
will lose access to large capital markets.
Environmental, Social and Governance (ESG) metrics have come to the forefront in the
recent years.

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Why study finance?

Separation of ownership & control

Asset ownership used to demand that control was exerted by owners; sole proprietor or
partnerships (it was difficult to get someone to mind the business for you)
The arrival of the joint stock company allowed separation of ownership from control
and new enterprises were formed that specifically had investors who did not manage
This allowed people without capital to manage, managers to specialise (or specialist
managers to be hired) and owners to diversify (invest in many businesses)
The resulting form of the firm is more efficient but how they survive the next 100 years of
corporate evolution is anybody’s guess.
ESG investing is driving investment and lending decisions.

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Why study finance?

Principals and Agents in a system

Principals are those who ultimately own an interest in a firm. All firm ownership can be
tracked down to individuals (via intermediaries) in the end
Agents are those to whom the principals delegate control. These include firm managers
(on behalf of owners) and all government officials (for all)
Even though it is more efficient to delegate the managerial role, it is not without its
incentive problems
Private and family held firms chose not to have outside ownership, they must rely more
on internal financing
Next Table shows the most important parties in a modern financial system and the flows
of money and services that link them

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Why study finance?

Interactions
1.People 2.Comps 3.Banks 4. Funds 5.Insurers 6.Govt.
a.Interest Insurance Personal
1 Trade Labour Investment
2.Deposits Premia Taxes
a.Interest Corporate
2 Wages Trade Dividends Dividends
b.Deposits Taxes
a.Loans a.Loans a.Dividends a.Loans Corporate
3 Trade
b.Interest b.Interest b.Interest b.Interest Taxes
Retirement Equity a.Equity Inv. Equity Investment
4 Trade
Benefits Invest. b.Deposits Investment Taxes
Insurance Equity 1.Interest Bond
5 Dividends Trade
Benefits Invest. b.Deposits Investment
Bond
6 Services Services Services Services -
Interest

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Why study finance?

Adam Smith’s invisible hand

Acting in a self interested manner can promote overall good for society (welfare) e.g.
Buying low cost goods promotes efficient producers who waste less
Investing in stocks with good prospects promotes efficient projects selection
A good educator might align their interest with yours through rankings
BUT beware of market failures and externalities (e.g. climate)
Not all goods and services could/should be traded in markets, e.g. defence. Healthcare
and primary education are public as well as private goods. Consumption of narcotics
imposes costs on others, gambling is also addictive to certain individuals.
Not everyone values a pension sufficiently to save for one; policies change and pensions
are becoming a private not public concern.
Smith also wrote about the negative externalities of the day, education and the role of
govts. He would write about the climate today.

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Why study finance?

Incentive problems
Separating different interests makes things more efficient but e.g. for insurance moral
hazard exists because purchasing insurance reduces incentives for the insured to prevent
against loss
Adverse selection exists where the amount of information that two parties have differs
(say a buyer and a seller) causing some sellers or some buyers to be disadvantaged or
excluded
Although charged with representing the principals best interests, the agent has incentives
of his own and therefore may not pursue the strategy that is best for the principal
This is known as the principal agent problem, a perfect contract (1st best) is impossible
so principal agent contracts are compared to 2nd best.
Insurers are starting to refuse to cover some environmental risks, not only are they hard to
price and costly to settle, but they are subject to moral hazard.
When it comes to managing the environment, we are all principals and agents and
insurance is not possible!
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Why study finance?

M.Shackleton (LUMS) MBA564 Jan 2024 24 / 146

Why study finance?

Financial markets

Deposits, short term certificates (CDs), money market accounts are less than one year
investments with rates of return known at the beginning. If the issuer wont default, we
treat these rates of return as being risk free.
Bonds, term fixed rate loans are long lived investments. Despite having a fixed rate of
interest, they can fluctuate in value due to shorter term rate changes e.g. if locked into a
10% fixed rate bond when rates rise to 15%, your investment falls in value. Because short
term interest rates fluctuate, longer term bond prices also change.
Equity claims on limited liability firms represent the (residual) share or stock value of a
stake in a firm. Value is returned to the investor by the payment of dividends and by
capital appreciation driven by higher future dividends, both of which are uncertain,
therefore equity returns are far from riskless.
N.B. the Covid–19 impact and bounce compared to the dot.com bubble and great
financial crisis of 2008.
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Why study finance?

From returns r to a wealth index W

N.B. rates of return are percentages % = 100 and therefore normally less than one,
10% = 0.10, 20% = 0.20 etc. (only 100% = 1!)
Often set the initial wealth to W0 = 100 $ units (arbitrary)
Given a total return over a year of 10% the closing wealth will be a multiple of
1 + 10% = 1.1 of the initial wealth, W1 = 110
Given a total return over a year of r01 % the closing wealth will be a multiple of 1 + r01 of
the initial wealth
W1 = (1 + r01 ) W0
Repeat for W2 from W1 etc. from r12

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Why study finance?

From index to returns

If the end of period one wealth W1 = 110 then the return from period zero is the gain
divided by the initial investment 10% = 110−100
100 = 110
100 − 1

W1 − W 0 W1
r01 = = −1
W0 W0
W1
1 + r01 =
W0
Repeat for r12 etc. from W2 ,W1 . We will see that for stocks with dividends, W1 /W0 can
be thought of as (P1 + D01 ) /P0 and therefore the % return on wealth invested in stocks
is the same if one or a million stocks are held.
W0 W1 W2 W3
↘ ↗ ↘ ↗ ↘ ↗
1 + r01 1 + r12 1 + r23

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Why study finance?

Calculation of mean of returns r

Get or calculate returns, r01 , r12 ...rN−1,N etc. and add them up

N
X
r01 + r12 + ... + rN−1,N = rt−1,t = r0,N
t=1

Divide by the number of observations N to get the mean return (in %) which has a label
of r (r bar)
r0,N
r=
N

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Why study finance?

Calculation of standard deviation of returns σ

N
X
(r01 − r )2 + (r12 − r )2 + (rN−1,N − r )2 = (rt−1,t − r )2
t=1

Subtract means (r01 − r ) , (r12 − r ) ... (rN−1,N − r ) , square (r01 − r )2 , (r12 − r )2 ...
(rN−1,N − r )2 add to get total Variance (which has units %% or %2 ). Divide by number
of observations (less 1 for required for r )
N
1 X
Variance = σ =2
(rt−1,t − r )2 = StDev2
N −1
t=1

Standard Deviation has same units as return (%), often labelled σ (sigma). Performed on
returns r not W (mean wealth levels are not useful in finance).

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Why study finance?

Distribution of returns

Future assets returns are random, not forecastable!

Markets are Efficient if they react to new, news which by definition is unpredictable.
First guess, normally distributed (bell shape)
This is the most common distribution in nature, there are statistical reasons why it crops
up repeatedly
Many coin tosses will yield a normal distribution for the number of heads & the sample
mean from any distribution will be normally distributed
It is convenient to work with mathematically (r , σ), however it is possible to reject that
returns are normally distributed (they have fat tails).
It is harder to reject that markets have no day to day correlation etc. Unpredictability
remains the null hypothesis that all would like to reject.

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Why study finance?

Present values

With a rate of r % per annum, just as we say that $1 today is worth $1 + $r = $ (1 + r )

next year, we can calculate the equivalent of $1 next year in today’s terms, it is $1/(1 + r )

today next year

$1 today $1 $ (1 + r )
$1 −1
$1 next year 1+r = $1 × (1 + r ) $1

$1 $1 $1
I.e. 1+r today will grow to 1+r (1 + r ) = $1 next year so 1+r is called today’s present
value of $1 next year.
For two years we can say that $1 today is worth $ (1 + r ) (1 + r ) = $1 + $2r + $r 2 in two
years time with a present value of $1/ (1 + r )2
For a cashflow coming N years into the future the result can be generalised to $ (1 + r )N
and the present value that would grow to $1 over N years is $1/ (1 + r )N

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Why study finance?

Examples

An IOU (I owe you) of $100 dated for next year is worth (bankable) only $90.91 = 100
1.1 if
interest rates are 10% pa
On retirement in 30 years you may need $250,000 but this only has a present value of
$24, 844 = $250,000
1.0830
if investments return 8% p.a.
Purchase $10,000 car and sell for $5,000 in three years; depreciation (negative growth) is
1
5,000 3
10,000 − 1 = −20.63% p.a. (leasing cost greater than 20% p.a. of value).
The price of used cars in Europe rose more than 25% during the pandemic year!

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Time value of money

Time value of money, discounted cashflows

Compounding requires products like 1.1 × 1.1 × 1.1; the y x button simplifies 1.15 = 1.1
y x 5 = 1.6105 which is the Future Value (FV ) of the Present Value (PV ) 1.0 after 5
years (N) with an interest rate of 10% (r or I /Y )
1
Discount factors invert (reciprocal) growth rates, five year discount factor 1.1 −5
5 = 1.1
= 1.1 y x −5 = 0.6209, 1 unit due in five years time (FV ) has a PV today of 0.6209.
If the inflow is in 10 years the PV is only 1.1 y x (−10) = 0.3855; the further ahead a
fixed cashflow is, the less it is worth now
8% over 45 years gives a growth factor of 1.08 y x 45 = 31.92, however
9% over 45 years gives a growth factor of 1.09 y x 45 = 48.33
Over longer horizons, small return differences make a difference

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Time value of money

The rule of 72 (70, or 69)

How many years does it take an asset or investment to double in value? It depends on the
investment return but there is a useful rule of thumb for the two (see Luca Pacioli [9] who also
documented double entry bookkeeping).
Number of years N times the rate of return r is approx 72, i.e. N × r = 72 (%)
e.g. if r = 10%, N ≈ 7.2 (in fact 1.17.2 = 1.99)
or if r = 1%, N ≈ 72 (in fact 1.0172 = 2.05) etc.
for (1 + r )N = 2 the natural log of (1 + r )N is approximately rN and ln 2 ≈ 0.69
so rN ≈ ln 2 = 0.69 or 70% or 72% which also divides by three

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Time value of money

If the bank says 10% for deposits and lets you chose the Compounding

Compounding Calculation Closing value

Annual 1 + 0.10 $110.00
Semi–Annual (1 + 0.05)2 $110.25
Monthly (1 + 0.10/12)12 $110.471
Daily (1 + 0.10/365)365 $110.5156
times a year (1 + 0.10/n)n
n → ∞ continuous limn→∞ (1 + 0.10/n)n = e 0.1 $110.5171..

Euler’s constant e = 2.71828.. is more important in Finance than π = 3.14159.. It is the basis
of Natural Logs (above).

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Time value of money

But the bank fixes the annual effective rate and reduces the rate as you
increase the compounding

Compounding Frequency Calculation Closing value

Annual 1 (1.1 − 1)
1
= 10.0% $110.00
Semi–Annual 2 (1.1) 2 − 1 = 9.76% $110.00
1

Monthly 12 (1.1) 12 − 1 = 9.57% $110.00
1

Daily 365 (1.1) 365 − 1 = 9.53% $110.00
1

n times a year n (1.1) n − 1
n → ∞ continuous loge 1.1 = ln 1.1 = 9.53% $110.00

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Time value of money

Compound returns
If an account pays interest at 10% p.a., $110 will be left at the end for every $100
deposited. How about if the 10% is calculated (pro rata) every 6 months and interest
earns more interest thereafter? The answer is $110.25 which is $100×1.052 .
Harder to calculate quarterly, monthly etc. but maths can calculate every second of the
day etc. Table above shows increasing compounding. It is 100e 0.1 = 110.5171 which is a
series limit (or take large n). Euler’s constant e = 2.71828.. is a special number in growth
theory and the basis of natural logarithms. Sometimes we assume that interest and other
flows are compounded continuously (not periodically) so the $1 account year end has e r .
Continuous returns lead the investment to grow with e r each year; after N years the
investment is worth e r e r ...e r N times or (e r )N = e rN and the present value that leads to
$1 at the end of N years is $1/e rN = e −rN .
We call the factor by which present money is less valuable than future money, the
discount factor. For continuous compounding it is just e −rN while for discrete
compounding it is (1 + r )−N for small rates r or short times N these two are roughly the
same.
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Time value of money

BAII plus: Calculator Purpose and Settings

e.g.? How much will FV be N years in the future, if invest −PV now at a % rate of i/Y while
drawing off N constant annual payments of PMT at the end of each year?
(Clear memory: 2nd, MEM, 2nd, CLR WORK (or TVM), CE/C clears display only).
First, set display to 3 dec. places: 2nd, FORMAT, 3, ENTER, 2nd, QUIT.
2nd BGN, 2nd SET toggles to END for arrears (not advance).
2nd, P/Y, 1, ENTER, 2nd, QUIT changes default 12 monthly to annual 1.
N.B. PV investment is mostly negative; 50 then +/− (bottom, not right −) for −50.
Now you can enter four of the five NPV numbers and calculate the last with CPT.

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Time value of money

;
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Time value of money

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Time value of money

Calculator maps N forecast PMTs & FV to a PV using i

e.g. Figure
N number of PMT s / years between PV and FV 5
i (or Y ) the rate of interest per period (year) 50(%)
PV the initial/first, present value or investment −$20
PMT payment per period (no growth, N of them) $10
FV final/closing (yr N) one off payment (above final PMT ) $20
Set BAII Plus calculator options to assume that PMT payments come at the end of each
period & that i/Y is quoted/applied once per year (factory settings give wrong answers).
When i/Y comes from the others, it is known as the Internal Rate of Return or IRR, there
is one IRR for every sign change in cash flows.

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Time value of money

NPVs
These five buttons can be used to perform a range of TVM calculations: PV e.g.
100
computing ? gives 68.06 as the PV of a FV of 100 ( 1.08 5)

N i PV PMT FV
5 8 ? 0 100
FV e.g. computing ? gives 110.20 as the FV of a PV of 75 (75 × 1.085 )
N i PV PMT FV
5 8 75 0 ?
i e.g. computing ? gives 5.922% as the i that turns a PV of 75 into a FV of 100
1
(i = 100
75
5
− 1). We require the outflow FV and the inflow PV to be of different sign
because one is an investment and the other is a return.
N i PV PMT FV
5 ? −75 0 100
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Time value of money

Annuities (FV = 0)
These are periodic and even flows from now until some specified future time when they
stop
Examples include pension payments (with a fixed termination date) and mortgage
payments

PMT PMT PMT PMT

PV = + 2
+ 3
... +
1+i (1 + i) (1 + i) (1 + i)N
N
X PMT
=
t=1
(1 + i)t

N i PV PMT FV
10 10 ? 10 0

gives −61.445 for the PV

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Time value of money

Zero Coupon Debt (PMT = 0)

This is a debt instrument with a one time repayment of principal at maturity

Examples include some corporate debt and zero interest repayment loans
FV
PV =
(1 + i)N

N i PV PMT FV
10 10 ? 0 100
gives −38.554 for the PV

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Time value of money

Coupon Debt

This is debt which not only repays a principal on maturity but also pays (annual) regular
coupons in-between
Most corporate debt is of this form and an interest only mortgage would require
repayment of principal at loan maturity
Coupon debt can be synthesised from an Annuity and a Zero Coupon Bond. 10 years at
10% gives −100 for the PV ! (Why do you think this is? Are you surprised?)

PMT PMT PMT PMT FV

PV = + 2
+ 3
... + N
+
1+i (1 + i) (1 + i) (1 + i) (1 + i)N
N
X PMT FV N i PV PMT FV
= t +
t=1
(1 + i) (1 + i)N 10 10 ? 10 100

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Time value of money

Perpetuities (N → ∞)

These are periodic and even flows from now with no final payment e.g. some UK
Government Debt and (preferred) stock with constant dividend.

PMT PMT PMT

PV = + 2
+ ... =
1+i (1 + i) i

Shown using algebra, or finessed by setting N high (999 in which case FV does not
matter)
N i PV PMT FV 10
or PV = 0.1 = 100
999 10 ? 10 X
Think about a $100 bank account earning 10% p.a., you can draw $10 from it each year
leaving the principal untouched.

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Time value of money

Forward start perpetuities and annuities

These are valued at the forward time as a perpetuity and then brought back to the
present using a further discount factor
PMT PMT 1 PMT
PV = 0 + 0 + ... N+1
+ N+2
... = N
(1 + i) (1 + i) (1 + i) i

The annuity between now and N is worth the difference between the current and forward
N + 1 start perpetuity
!
PMT 1 PMT PMT 1
PV = − = 1−
i (1 + i)N i i (1 + i)N

M.Shackleton (LUMS) MBA564 Jan 2024 47 / 146

Time value of money

Growing perpetuities (i ′ = i − g = yield)

Periodic flows growing at g = 3% p.a. (no FV ) valued with required rate i = 10%
(growth g is also the capital gain, it can be negative but can’t exceed i). E.g. stocks
with growing dividends with PV =

PMT PMT (1 + g ) PMT (1 + g )2 PMT 10

+ 2
+ 3
... = = = 142.86
1+i (1 + i) (1 + i) i −g 0.07

Equivalent to flat annuity using a net (positive) rate i ′ of i less growth g . Use N = 999
as infinite (then FV is irrelevant, can use any X since X /(1 + i)999 → 0 but set X = 0).

N i′ PV PMT FV
10
999 10 − 3 = 7 ? 10 0 or PV = 0.07 = 142.86
(999 i = 10 ? 10, 10.3.. 0)

M.Shackleton (LUMS) MBA564 Jan 2024 48 / 146

Time value of money

Gordon model [4]..

.. has share price PV = P0 , expected total return i & prospective end of year dividend
PMT = D1 (growing yearly after). Divide annual/end divs by current observed price to
give prospective div. yield, equal to total rate of return i less the expected capital gain g .
PMT D1
Dividend Yield is y = = =i −g
PV P0
Or total required return equals the current div yield and expected capital gain (yield is
observable but total return depends on promised growth)

PMT
Required Return i = + g = Dividend Yield + Expected Capital Growth
PV
P1 + D 1 P0 (1 + g ) + D1 D1
P0 = = ⇒ P0 =
1+i 1+i i −g
M.Shackleton (LUMS) MBA564 Jan 2024 49 / 146
Time value of money

Internal rate of return i solves for NPV = 0

For given cashflows PMT , FV and an amount required to purchase them PV , the rate of
return i that sets the discounted sum equal to the purchase price is called the Internal
Rate of Return (IRR). Setting i = IRR makes the Net Present Value zero.

Net Present Value = Present Value of PMTs and FV less PV

For the examples the IRR = i is 10% (treating the growing perpetuity as flat, the IRR is
7%, but adding the growth rate of 3% makes it a 10% rate of return also).
For given investment PV and N future cashflows PMTs and capital repayments FV (N
years away) the IRR (i) is a measure of the average annual rate of return over the N years.
It is also the rate of return required to clear an account that borrows PV at time zero,
repaying the account with N payments of PMT followed by a final payment of PV .

M.Shackleton (LUMS) MBA564 Jan 2024 50 / 146

Time value of money

Summary

type N i PV PMT FV IRR

solves fori
Annuity 10 ? −61.44 10 0 PV = 1 − 1 N PMT i
(1+i)
FV
Coupon debt 10 ? −100.00 10 100 ditto +
(1+i)N
1
FV N
Zero coupon 10 ? −38.56 0 100 i = PV −1
PMT
Perpetuity 999 ? −100.00 10 X i = PV
Growing perp. 999 ? −142.86 10(1st) X i = PMT
PV + g

M.Shackleton (LUMS) MBA564 Jan 2024 51 / 146

Time value of money

Net present value NPV , (single) IRR and required rates

Present value benefit of future cashflows PMTs, FV net of investment expense −PV ;
required rate i can be above or below the forecast IRR in which case:-

i > IRR ⇐⇒ NPV < 0 : forecast rate less than required, overvalued
i = IRR ⇐⇒ NPV = 0 : forecast rate equal to required, fairly valued
i < IRR ⇐⇒ NPV > 0 : forecast rate greater than required, undervalued

A 10 year 10% coupon bond with a PV of 100 and IRR of 10% is fair if i = 10%. If
another investor thought required rate i = 5% they would pay up to 138.61 for the bond.
Conversely if a third investor had a required rate of i = 15%, they would only pay 74.91.
In competitive markets some investors buy, some abstain; we assume that benefit is driven
down to cost, at the margin NPV = 0. This allows us to take the price PV and flows
PMT , FV and infer the promised or forecast return from the IRR.

M.Shackleton (LUMS) MBA564 Jan 2024 52 / 146

Time value of money

NPVs in different currencies

You cannot directly compare the price of goods in different currencies and so it is with
NPVs. A car may be ¥1, 000, 000 or $10, 000 but the units are different. When taking
NPVs in different currencies the rates of interest and discounts will differ too, e.g. a
project requires $10,000 but could be situated in Japan where it gives ¥575,000 pa or in
the US where it gives $6,000 both for five years. Required rates of return are 4% in ¥
and 6% in $ and the exchange rate is $0.01 = 1¥

N i PV PMT FV =⇒ NPV
5 6% $25, 274 $6, 000 0 $15, 274
¥2, 559, 798 × 0.01 ¥$ −$10, 000
5 4% ¥2, 559, 798 ¥575, 000 0
= $15, 597

The NPV is higher from investing in Japan (but not if you use N = 5, i = 6%,
PMT = ¥575, 000)
M.Shackleton (LUMS) MBA564 Jan 2024 53 / 146
Time value of money

Inflation

Investment returns must be positive to induce investors to save (what strategy could you
adopt if they were negative?) but they must also beat the inflation rate or people will
chose to hold physical assets instead (which appreciate at the inflation rate). The real
rate of return is often used to indicate the rate of return net of inflation and is
calculated from the nominal rate and the inflation rate

Nominal rate = Real Rate + Inflation Rate

(Required rate = Dividend Yield Rate + Div Growth Rate)

A real coupon rate coupled with inflation indexation is the same as a nominal. We would
expect positive real rates if investors are willing to hold financial assets instead of physical
assets and the nominal rate of interest is normally above the rate of inflation in a country.

M.Shackleton (LUMS) MBA564 Jan 2024 54 / 146

Time value of money

Inflation 2
As part of their anti inflation programme, governments now offer inflation linked bonds
which pay a small real rate of interest on a balance that increases with inflation. If
inflation rises their debt becomes more expensive to service, investors who are concerned
about inflation buy them.
Interest rates are different in different countries principally because inflation is different in
different countries
Both real and nominal analysis are consistent (but mixing real flows with nominal
discount rates and vice versa is wrong). Both require an inflation assumption but in
different places (see Table on next page).

year PV 0 PMT 1 PMT + FV 2 N i FV

real −142.86 10 10 + 142.86 2 7 142.86 × 1.002
nom −142.86 10 10.3 + 151.56 2 10 142.86 × 1.032 + 0.3

M.Shackleton (LUMS) MBA564 Jan 2024 55 / 146

Time value of money

Inflation Summary

Discount Rate
Real = 10 − 3 = 7% Nominal = 10%
✓ correct value × understates value
Real
Cash dont inflate flows, 0% dont inflate flows, 0%
0% infl
reduce reqd rate 7% reqd rate 10%
× overstates value ✓ correct value
Nominal
Flows inflate flows 3% inflate flows 3%
3% infl
reduce reqd rate 7% reqd rate 10%
Table: Real and Nominal Analysis

M.Shackleton (LUMS) MBA564 Jan 2024 56 / 146

Time value of money

Which currency forecasts (if any) to use?

If markets have different return to risk, there may be relative risk premia between
currencies but these can change sign.
Currency “parity” relations have strong consequences for international capital budgeting,
namely that projections based on proprietary forecasts are questionable and subject to
arbitrage; are you in the operating or currency forecasting game?
The only “forecasts” that are objective are those embedded in forward and futures market
prices since they are arbitrage free. To translate at any other rate is dangerous, moreover
the market neutral forecasts can be locked in by hedging.
Foreign flows can either be foreign discounted and spot exchanged, forward hedged and
domestic discounted or unhedged and domestic discounted; all else equal these have the
same expected payoff but different risks.

M.Shackleton (LUMS) MBA564 Jan 2024 57 / 146

Time value of money

Investment criteria

Payback: the time taken for the cum. cashflow −PV , PMT , PMT .. to become positive
(−100, 10, 10... has a 10 year payback); fast (low years) paybacks are preferred

(−) PV
Years Payback =
PMT
1
Pay Back = PMT
−PV is very similar to the IRR in this case (which would be exactly 10% for
this perpetuity), high IRRs are preferred
However both are scale independent (no information about the project size), NPV does
and is a preferred measure when comparing (high NPV preferred to low). With mutually
exclusive projects, this avoids turning down a large but marginally profitable opportunity
at the expense of a small but highly profitable project.

M.Shackleton (LUMS) MBA564 Jan 2024 58 / 146

Life cycle financial planning

Life-cycle financial planning

Total Assets $k $k Total Liabilities

Cash/Investments Bank Overdraft
Car $60k Personal Loans
House Mortgage
Other –$60k Net Worth
Table: Net Worth of an Individual

Your net worth is defined by what you own less what is owed, like an accounting balance
(see Table Although a useful start point for defining personal finance, this only represents
the past/current situation and can’t say what the future holds for our finance.
How to save to secure a prosperous retirement? Assumptions: age 35, retirement 65,
death 80, current savings and asset nil, income $30,000 (after tax) constant in real terms
(no promotions) with real asset return of 3%.
M.Shackleton (LUMS) MBA564 Jan 2024 59 / 146
Life cycle financial planning

Replacement rule
Assuming you want 75% of your salary on retirement from age 65 to 80 we need a PV
age 65 that will produce an annuity of $22,500
N i PV PMT FV
15 3 $268, 604 $22, 500 0

Must produce this as FV over the next 30 years with 3% real returns
N i PV PMT FV
30 3 0 $5, 646 $268, 604

A salary on retirement of $22, 500 requires saving $5, 646pa over 30 years if real rates of
return are 3%. About 19%! Try it with your own inputs (you may have savings/debts in
which case decrease/increase the PV in the second calculation from zero since). Don’t be
tempted to increase the real rate of return too much, more return requires taking more
risk!
M.Shackleton (LUMS) MBA564 Jan 2024 60 / 146
Life cycle financial planning

Constant consumption
How about choosing a replacement rate that leaves your salary net of saving the same?
Assume that the salary net of saving is C . The amount saved for each of the first 30 years
is $30, 000 − C . One dollar saved each year is worth $47.58 in 30 years time
N i PV PMT FV
30 3 0 $1 $47.58
so $C pa will yield $47.58× ($30, 000 − C)
The amount drawn each year form the retirement account is C for each year of 15 one
dollar a year has a PV of
N i PV PMT FV
15 3 $11.94 $1 0
so that C dollars a year requires a lump sum of $11.94×C. Now solve for C
$47.58× (30, 000 − C) = $11.94×C
C = $23, 982
M.Shackleton (LUMS) MBA564 Jan 2024 61 / 146
Life cycle financial planning

Income and Human Capital

45 30
X C X Income of 30, 000
t = t ⇐⇒ C ∗ 24.52 = $30k ∗ 19.60
t=1
(1 + r ) t=1
(1 + r )

C solves an equation (calcs. (45, 3, −24.52, 1, 0) , (30, 3, −19.60, 1, 0)); present value of
45 consumption years is equal to the PV of 30 labour income years, these are known as
Permanent Income and Human Capital. Adding PV (Financial Capital) , the market
value of investments..

PV (Human Capital) + PV (Financial Capital) = PV (Permanent Income)

The more human or financial capital, the higher your permanent consumption. The
“budget constraint” can be expanded to include a Bequest B; with Fin Capital = W0 and
labelling income Y , if T is the number of years of life and R the numbers of years to
retirement (See Table 3)
M.Shackleton (LUMS) MBA564 Jan 2024 62 / 146
Life cycle financial planning

Income and Human Capital 2

PV income $k $k PV outgoings 45 years
Net financial wealth 0 $588k 45 consumption years ($23.98k)
30 work years ($30k) $588k 0 Bequest
Table: PV Balance for a student about to start work

N i PV PMT FV
30 3 −$588k $30k 0
45 3 −$588k $24k 0
15 3 −$286k $23.98k 0

PV income $k $k PV outgoings 15 years

Net financial wealth $286k $286k 15 consumption years ($23.98k)
Work income (nil) 0 0 Bequest
Table: PV Balance for a worker about to retire
M.Shackleton (LUMS) MBA564 Jan 2024 63 / 146
Life cycle financial planning

M.Shackleton (LUMS) MBA564 Jan 2024 64 / 146

Life cycle financial planning

M.Shackleton (LUMS) MBA564 Jan 2024 65 / 146

Life cycle financial planning

M.Shackleton (LUMS) MBA564 Jan 2024 66 / 146

Life cycle financial planning

Income and Human Capital 3

You can increase your per annum consumption C if you...

Have higher income Y
Lower your childrens’ bequest B
Raise your real rate of return r (but risk)
Lengthen time to retirement R
Shorten retirement (lower T − R)
Have more initial wealth W0 . This may be negative (borrowing) as its possible to borrow
limited amounts against your future human capital, however this capacity declines with
age.1

1
UK’s Student Loan Company has extended £200billion to over 6 million students repayable through a
graduate tax (9% of earnings over £25k). Balances increase at 3–6% p.a. but are written off after 40 years (a
graduate tax). More akin to an equity position in the student’s human capital than a (defaultable) loan.
M.Shackleton (LUMS) MBA564 Jan 2024 67 / 146
Life cycle financial planning

Valuing education

Why are you sitting here studying finance? You can either treat education as consumption
(like a long, expensive but hopefully enjoyable movie which may not increase your wealth
or income) or as an investment good which reaps valuable returns in years to come.
What benefits might you expect from studying? Increased employment opportunities,
greater job flexibility and satisfaction. In short you expect this costly study (which
reduces your W0 or makes it more negative if you are already in debt) to increase your
human capital and your expected consumption or bequest.
By how much might income have to increase to make a years study a profitable
(NPV > 0) activity? Explicit study costs may be about $30,000 for the year, on top of
that you have given up your job so you have an opportunity cost of not working for the
year (say $30,000). Consumption costs over the year can be ignored, you would have had
to be housed (pay rent), eat, drink and socialise anyway.

M.Shackleton (LUMS) MBA564 Jan 2024 68 / 146

Life cycle financial planning

Valuing education 2
If Human Capital depends on 30 years income we need an investment of $60,000 to pay
off with a real return of 3%. Only need a base salary rise of $3, 061 on $30,000 (and
subsequent indexation to be based on the levels2 ). Take heart, this is about 10% while
studies show that students increase their salary by more than this.
N i PV PMT FV
30 3 −$60, 000 $3, 061 0
25 3 0 −$13, 700 $500, 000
Conclusion? Studying is great value, it can increase your Human Capital by more than it
costs! Corollary? Business Schools are not charging enough for their courses! In
competitive markets the price of any good rises to its marginal benefit ;-)
An MBA is the $60k icing on your personal $500k cake, think about those that have
invested in you over the 25 or so prior years to this point.
2
Consumption saving of $2,447 over 45 years pays for an MBA (45, 3, −$60k, ?, 0) so does lowering career
risk and HC rate to 2.27% (30, ?, −$648k, $30k, 0).
M.Shackleton (LUMS) MBA564 Jan 2024 69 / 146
Life cycle financial planning

The Function of Financial Statements

Who are the stakeholders in a firm who need information, what do they need?
Profit and Loss
What has been earned over a period
To record the change in economic value of the firm
Balance sheet
What is owned and what is owed
To record the cumulated economic value of the firm
Cashflow statement
What cash changes have occurred over a period
To record the cash changes of the firm
The three main Financial Statements are linked

M.Shackleton (LUMS) MBA564 Jan 2024 70 / 146

Life cycle financial planning

Market versus Book values

All three accounting statements are based on accounting rules: accountants produce book
values
Market values, however, are based on willingness to pay and may be very different to
book values: financial market valuations produce these!
If the market value fell beneath the book value, it could be possible to buy the company
for its break up value.

M.Shackleton (LUMS) MBA564 Jan 2024 71 / 146

Life cycle financial planning

Returns to shareholders versus return on book equity

Shareholder returns are determined by dividend distributions and capital gains

Return on book equity is determined by accounting profit divided by accounting book
value
The latter can be systematically higher than the former if book values lag market values
Both forms of calculation are affected by leverage, i.e. the borrowing ratio.

M.Shackleton (LUMS) MBA564 Jan 2024 72 / 146

Life cycle financial planning

Ratio analysis

Ratios are useful for analysing the historical performance of a firm, either over time or
across firms.
Ratios help with working capital management, which is like sunk capital (JIT and KanBan
measures to reduce it produce value).
Ratios are not however forward looking like equity values
Ratios (public info.) may help determine the risk metrics and expected rate of return on a
firm, but the Efficient Market Hypothesis says that there will still be uncertainty centered
on the private info.

M.Shackleton (LUMS) MBA564 Jan 2024 73 / 146

Life cycle financial planning

Examples of investment ideas

Launch a new line of business (increase assets)

Replace existing plant with more efficient plant (replace assets)
Spend money closing a loss making subsidiary (decrease assets)
Even if they do not necessarily increase book assets, all three involve sinking cash now in
order to gain a future expected benefit

M.Shackleton (LUMS) MBA564 Jan 2024 74 / 146

Life cycle financial planning

Which cashflows?

Estimate the cashflows without the investment. Estimate the cashflows with the
investment, then take the difference
This will yield only future, differential, cashflows, profit and non–cash items, past and
sunk costs will be excluded
e.g. you know that investing in your business education will be profitable, however NPV
cares about cash and the timing of cashflows.
Also you invested considerable time, effort and money in researching this education before
undertaking this course. However until you decided to actually come, you could have
changed you mind. Therefore these sunk costs should not have affected your decision
after they had been incurred, they were an option you purchased without the obligation
to proceed.

M.Shackleton (LUMS) MBA564 Jan 2024 75 / 146

Life cycle financial planning

Profit statement

USD million
Sales (4,000 @ $5,000) 20.0
Seven year project to sell 4,000 units p.a. @ Cost of Sales (4,000 @ $3,750) −15.0
$5,000 each (marginal cost of $3,750 each), Gross Margin 5.0
the annual P/L will look like this Table Note SalesGenAdmin −3.1
that there is no debt so apart from depreciation Depreciation −0.4
there is no tax shield and this unlevered entity Profit before Tax 1.5
is fully taxed. We will also assume a cost of Tax @ 40% −0.6
financing without specifying how it is financed. Profit after Tax (Net Income) 0.9
Also since this project winds up at zero, no Dividend/payout −1.3
terminal value assumption is required. Retentions −0.4
Table: Profit statement for each of the seven years
of operation (USD million)
M.Shackleton (LUMS) MBA564 Jan 2024 76 / 146
Life cycle financial planning

Balance sheets
The year by year balance sheet (in $M) is shown in a Table

Year End 0 1 2 3 4 5 6 7
Fixed Assets 2.8 2.4 2.0 1.6 1.2 0.8 0.4 0.0
Working Capital 2.2 2.2 2.2 2.2 2.2 2.2 2.2 0.0
Total Assets 5.0 4.6 4.2 3.8 3.4 3.0 2.6 0.0

Owners Interest 5.0 4.6 4.2 3.8 3.4 3.0 2.6 0.0
Profit / Loss p.a. 0.9 for each of the seven years p.a.
Dividends p.a. –1.3 for each of the seven years p.a.

Total Liability 5.0 4.6 4.2 3.8 3.4 3.0 2.6 0.0
Table: Evolution of the Balance Sheet over the seven years of operation USD million

M.Shackleton (LUMS) MBA564 Jan 2024 77 / 146

Life cycle financial planning

Free cash flows

Year 0 0–1 1–2 2–3 3–4 4–5 5–6 6–7
Capital exp. −2.8 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Working capital −2.2 0.0 0.0 0.0 0.0 0.0 0.0 2.2
Total investment −5.0 0.0 0.0 0.0 0.0 0.0 0.0 2.2

Op prof bef tax 1.5 1.5 1.5 1.5 1.5 1.5 1.5
Non cash items 0.4 0.4 0.4 0.4 0.4 0.4 0.4
Total op cashflow 1.9 1.9 1.9 1.9 1.9 1.9 1.9
Taxes −0.6 −0.6 −0.6 −0.6 −0.6 −0.6 −0.6
Distributed divs −1.3 −1.3 −1.3 −1.3 −1.3 −1.3 −1.3
Change in cash 0.0 0.0 0.0 0.0 0.0 0.0 0.0

1.3+
Project cashflow −5.0 1.3 1.3 1.3 1.3 1.3 1.3
2.2
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Life cycle financial planning

Cash flow calculation

Cashflow = Revenue − Cash Expenses − Taxes (20 − 15 − 3.1 − 0.6 = 1.3)

or = Revenue − Total Expenses − Taxes + Non Cash Expenses
= Net Income + Non Cash Expenses (0.9 + 0.4 = 1.3)

These reconcile P/L with balance sheets in Table & have IRR of 21.9%. Using all equity
unlevered discount rate Ru = 15% (last section shows levered rate Rl ), they have NPV
(PV − I ) of $1.236M = $6.236M − $5M (but negative $0.3M @ 24%).

N i PV PMT FV
7 21.9% −5.000 1.3 2.2
7 15.0% −6.236 1.3 2.2
7 24.0% −4.703 1.3 2.2

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Life cycle financial planning

M.Shackleton (LUMS) MBA564 Jan 2024 80 / 146

Life cycle financial planning

Future share performance

If a shareholder injects $5M, when investment is made the equity is worth $6.236M
(capitalised gain is difference between original & new 15% equity IRR)
It has prospective (year end) $1.3M dividend yielding 20.8%, however capital declines.
Paying out a higher rate than it earns (firm IRR is 15% @ $6.236M), it is subject to a
first year capital loss of g7 = −5.8%
In a year after the first dividend of $1.3M is paid, the remaining PV is P6 = $5.871M but
its prospective yield increases to 22.1%; so has the next capital loss g6 = −7.1%. Last
growth g1 is from P1 = $3.043 to P0 = $2.200 i.e. –27.7% when company is liquidated.
Over the years this continues but the total return on the shares is always i = 15%
In reality the share price will change because actual cashflows differ from forecast,
required rates (15% & risk) change too and because real companies start new project and
stop old ones all the time which can create or destroy value.

M.Shackleton (LUMS) MBA564 Jan 2024 81 / 146

Life cycle financial planning

Future share performance 2

Stern Stewart & Co. created the concept of Economic Value Added (EVA ©), if the firm
just meets the cashflow forecasts embedded in the stock market valuation, it just earns
enough on its stock market capital but does not add any further value.
P
years left i PV = PN PMT FV DN−1 /PN gN = PN−1
N
−1
N=7 15% 6.236 1.3 2.2 20.8% −5.8%
6 15% 5.871 1.3 2.2 22.1% −7.1%
5 15% 5.452 1.3 2.2 23.8% −8.8%
4 15% 4.969 1.3 2.2 26.2% −11.2%
3 15% 4.415 1.3 2.2 29.4% −14.4%
2 15% 3.777 1.3 2.2 34.4% −19.4%
1 15% 3.043 1.3 2.2 42.7% −27.7%
0 2.200

M.Shackleton (LUMS) MBA564 Jan 2024 82 / 146

Life cycle financial planning

Ranking projects with different lives

If we have to chose between competing projects (expand operations under plan 1 or plan
2) and both plans have the same life, there is no problem. We can simply chose the one
with the greatest NPV (PV − I )
However there is a problem if the projects have different lives say 5 & 10 years, effectively
one NPV will represent the present value cost/benefit of 5 years operation while the
other will represent 10 years of operation and will therefore probably be bigger!
The concept of equivalent annual cost or annualised capital cost takes care of this for
us. We assume that the shorter project is repeated until its final time horizon matches the
longer (or they are both are repeated indefinitely if their lives have no common
denominator). Assume that both machines save the same amount p.a.

M.Shackleton (LUMS) MBA564 Jan 2024 83 / 146

Life cycle financial planning

Ranking projects with different lives 2

A machine with a five year life costs $2M, its annualised capital cost at 10% is
$0.528M while the machine with a ten year life costs $4M, its annualised capital cost at
10% is $0.651M. Two five year machines (one after the other) are preferred because the
annual capital charge is lower that way. If the machines had different benefits, they could
be included in the computation in order to evaluate a net annual capital charge.

N i PV PMT FV
5 10 $2M $0.528M 0
10 10 $4M $0.651M 0

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Life cycle financial planning

Inflation & Capital Budgeting

Again to repeat, if future cashflows are stated in real terms then a real rate must be used.
If future cashflows are stated in nominal terms then a nominal rate must be used.
The two should not be mixed!
You can go between the two if real coupons apply in arrears on the initial uninflated sum
when:-
Real Coupon (arrears) = Nominal Coupon − Inflation
which is like
Div Yield = Required Return − Growth in Divs

M.Shackleton (LUMS) MBA564 Jan 2024 85 / 146

Principles of asset valuation

Principles of asset valuation

In economics the law of one price says that competition will drive the price of identical
goods to the same level
In finance this law is enforced through arbitrage an activity pursued by speculators or
other investors seeking to purchase something for less than its intrinsic value and sell it
for more
Physical goods (foods, equipment etc.) can be difficult to arbitrage (buy in one location
and sell in another) because of transaction costs
Financial assets (stocks, bonds, currencies) are easy to arbitrage, if they sold for different
prices in different locales, it would be easy to exploit price differentials

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Principles of asset valuation

Measures of value

Accounting book value involves conservatism so understate value

Lower of cost or net realisable value plus accrued profits less distributions
Earnings multiples, price/earnings (P/E ) and earnings per share (EPS)
P
P/E = EPS with EPS = $2 and an industry P/E = 10 one estimate of the share price
would be $20
Cashflow models from company and public information, analysts forecasts and all other
available information
Lay out all future cash flows and take an NPV using a required rate of return (interest
rate)
Ask around others for their opinion, guess!
Look at the price at which others are prepared to trade, this is the market value. Market
to book ratios are normally greater than one and can easily exceed 5!
M.Shackleton (LUMS) MBA564 Jan 2024 87 / 146
Principles of asset valuation

Efficient markets hypothesis

EMH says prices reflect information known by market participants, else those with better
information would exploit it! Fama [1], [2] proposed three forms.
Weak form: Investors can’t earn excess returns from trading rules based on historical
prices or returns; past price info is irrelevant in achieving excess returns but superior
public or private info can still profit.
Semi-strong form: Investors can’t earn excess returns from trading rules based on
publicly available info. (inc. annual reports) but those with superior private info.
(insiders) can profit.
Strong form: Investors can’t earn excess returns using any info (i.e. including private
insiders who we ban from trading).
The information sets are nested: Strong ⊂ Semi ⊂ Weak.

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Principles of asset valuation

Random walks (have uncorrelated changes)

One consequence of the EMH is that when markets fully anticipate all available
information they appear to follow a random walk, Samuelson [10] was one of the first
academics to show this.
New (unanticipated) information arrives randomly so that in efficient markets prices
follow random walks. e.g.
Asset prices go up if unexpected news is good and down if unexpected news is bad (e.g.
unexpected change in interest rates, fall in seasonally adjusted employment, change in
anticipated monetary policy and inflation etc.).
Go up if a head is tossed, go down if a tail is tossed in a repeated game (if the coin is
unbiased, no matter how far ahead we look we expect – on average – to be where we are
now).
However markets have an upward drift to compensate investors for the variability they
must endure.
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Principles of asset valuation

Is it possible to beat the market?

Sure! Somebody is doing it every day, it is just that it is not the same guy every day and
we can’t say in advance who will do it (i.e. it could be like winning the lottery)! The
existence of big winners (and losers) does not contravene efficiency, only if there were
repeat winners might we get interested. Darwinian selection takes care of the repeat
losers.
In efficient markets on average you get a return to compensate for the risk (we have yet
to define risk), i.e. your expected return is fair
After the risks are realised, you may or may not have been lucky and out or
underperformed the market, this does not mean that it was not a fair bet when you
invested. In efficient markets, it should not be possible to consistently beat the market.
However, many believe in correlation over time and that the 2008 crash was pre-visible!

M.Shackleton (LUMS) MBA564 Jan 2024 90 / 146

Principles of asset valuation

Efficient Market Hypothesis: EMH debate

EMH says:–
Prices reflect underlying or consensus value which changes with news
Prices walk randomly since unanticipated news by definition is random
The positive market risk premium persuades investors to hold the risky market instead of
the riskless bank account
EMH does not say:–
Prices are un–caused, they are caused by new (hopefully not fake) news items
There is no upward trend in the market: markets drifts up by a market return Rm greater
than the risk free rate Rf
All shares have the same expected return, different risk firms offer different rates of return
Investors should throw darts to select stocks (however, a broad investment portfolio does
allow diversification).
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Principles of asset valuation

Market efficiency debate: Apophenia

Why are there disbelievers ?

There are optical illusions, mirages and apparent patterns in stock prices. Our brains
have developed to detect patterns, however there are no “patterns” in random walks!
Truth can be less interesting than fiction, after 218 episodes of the X-Files, there were
probably no aliens!
Hubris, overestimation of one’s abilities and Confirmation Bias
From past data, there has been marginal evidence to reject efficiency (seasonality, insider
trading) but these results against EMH don’t persist.
Market efficiency is now a null hypothesis everyone is trying to reject; that’s how science
works!

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Risk and return

Risk and return

Haven’t said where discount/required rates like project’s 15% come from. All like higher
expected returns but financial investors do not like high dispersion (risk). Portfolio risk
and return pioneered by Markowitz [6] and Capital Asset Pricing Model (CAPM) of
Sharpe [11], Lintner [5] which relates the expected return on a stock to the overall market.
How to measure the sensitivity of a stock’s return against the market? Use linear
regression; correlation and slope are related but distinct concepts 3 . Some stocks
outperform the market by going up more when the market goes up (and conversely when
down) this is beta β. Some stocks may be able to go up even if the market does not go
up (or even if the market goes down) this is alpha α.
N.B. the return series we used for wealth, had dividends re-invested but they form part of
the return (look at CRSP without divs.).
D1 + P1 − P0
r01 = = % div yield + % capital gain
P0
3
https://en.wikipedia.org/wiki/Pearson correlation coefficient
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Risk and return

Stock r , market R; correlation and slope

For stock r and market R past returns, we can calculate their means (r , R) and standard
deviations (σr , σR ) but their dependence is captured by Covariance
N
1 X
Cov (r , R) = (rt−1,t − r ) Rt−1,t − R = ρσr σR
N −1
t=1

or their correlation coefficient ρ (rho, between -1 and +1) is

Cov (r , R)
ρ=
σr σR
and the final regression variable is the slope β (stock betas between 0 and 2)
Cov (r , R) ρσr σR
Slope of r on R is β = =
Var (R) σR2

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Risk and return

Beta regression example

E.g. generate N = 500 points that follow a unit slope β = 1 for a stock r with typical
exposure to R. Random variables N (0, 1) have a mean of 0 and s.d. of 1, i.e. zero mean and
1% per day standard deviation (generated in Excel using NORMSINV (RAND())).

rt = 1 × Rt + εt stock return r = 1 × market return R + idiosyncratic news ε

Rt ∼ N (0, 1) the market return is normally distributed with R, σR = 0, 1
εt ∼ N (0, 1) stock specific news ε is also normally distributed with 0, 1
Cov (Rt , εt ) = 0 stock specific news market uncorrelated – idiosyncratic

The stock r has higher total risk σr than R because it carries market risk σR = 1% and stock
specific risk σidio = σε = 1%.
The total risk σr could be between 0% and 2% depending on the correlation between R, ε but
if these are uncorrelated σr = 1.41% and σr2 = 2. Note that r , ε are correlated with ρ = 0.71
but not perfectly due to R.
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Risk and return

Beta regression example

Visually, consider the residual sum of squares from a regression model:-
σr
1
↗↑ σidio = 1 − ρ2 2
σr
→
σsystem
=
βσR

σr2 = σsystem
2 2
= β 2 σR2 + 1 − ρ2 σr2

+ σidio
1
2%2 = 1%2 + 1%2 = 12 1%2 + 2%2
2
total sum regression sum error sum
= +
of squares of squares of squares

sample theoretical
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Risk and return

If β became important what happened to α?

Alpha α corresponds to the intercept of the slope line of a regression of excess stock
returns against the excess market return. The cumulative idiosyncratic news should
average zero, therefore for very small risk free rate Rf (or daily returns)

r = α+β×R
Expect [r ] = β × R
Expect [α] = 0

Using historical data, this can be tested by looking at sample α’s for systematic deviation
from 0; in an efficient market they should be zero. Fund and investment managers who
claim to add value are all seeking α.

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Risk and return

Diversification

Weight two unit beta stocks 12 , 21 in portfolio p: Regression slope of sum is sum of
regression slopes & portfolio beta is average beta, e.g. for r , r ′
1 1 1
r = R + ε & r ′ = R + ε′ so p = R + ε′ = R + ε + ε′

(R + ε) +
2 2 2
With uncorrelated stock specific news Cov(ε, ε′ ) = 0, portfolio variance is
σp2 = σR2 + 14 1 + 14 1 = 1.5 & σp = 1.22% lower than 1.41% on both.
For three 13 stocks, result is σp2 = σR2 + 19 1 + 91 1 + 19 1 = 1.33 so σp = 1.15%. As the
number of stocks (four gives 1.12%) becomes large σp → σR = 1% a fully diversified
portfolio carrying market risk only (βp = 1 too).
Investing in all stocks according to market capitalisation (not equally) gives market
index fund. This passive fund does not require any re–balancing trades to keep its
weights (neither does it take active bets).
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Risk and return

Risk return trade-off

When we diversify our portfolio across groups of stocks with similar (not unit) betas, this
reduces the idiosyncratic risk, produces a portfolio that more closely tracks βp × R but
with β ̸= 1.
A portfolio centred on utilities (energy firms) with βp < 1
Typical industrial portfolio with βp = 1
A high tech portfolio with βp > 1.
Historically, higher risk has generated higher returns, with a risk return trade–off that
matches that of the overall market. How much risk should we take?
Will this vary over the course of our life and our changing investment needs?

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Risk and return

Asset allocation

This is the theoretical basis behind the Capital Asset Pricing Model.
All identical, risk averse investors end up holding a (linear) combination of the risk free
asset Rf and the market portfolio R (known as two fund separation), all efficient
portfolios reside on a security market line (SML).
Efficient portfolios have all their idiosyncratic risk diversified away.
Alternatively we could invest in a fraction of the market index fund and a fraction of the
risk free rate (σRF = 0), say 50:50

1 1 1
p= (R + Rf ) where βp = and σp = σR
2 2 2
This can be done with any fraction 20:80 to 80:20 to produce an SML with betas of 0.2
to 0.8 resp. If you can borrow at the risk free rate, it can also produce betas of 1.2 and
1.4 (e.g. 120 invested 20 borrowed).
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Risk and return

Market risk premium

For risk free Rf and expected return on market R, the risk premium is RP = R − Rf . We
care about the expected (future) premium but historically (CRSP 2023) we had:-

Inflation Bills Bonds Int stocks US stocks

Return p 2.9 3.7 5.1 7.8 9.8
Risk σp 4.0 3.4 8.4 21.7 19.8

Some debate, so state your assumptions! To keep it simple, I use those below: a stock
beta of β, the expected stock return r is given by

Rf = 3%, RP = 7%, R = 10% i.e. r = 0.03 + 0.07 × β

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Risk and return

Valuation examples Apple

Founded by Steve Jobs and Steve Wozniak in 1976 to make personal computers (rival to
IBMs). Went public in 1980, it has had four splits (including a 7:1 so now 56 for each
original).
It went through a period of decline 1991-97 but was restructured and became successful
again with the IPhone in 2007. Dec 2023 market cap 3tr$.
Dividends were re–instated in 2012 since when they have increased CAGR by about 9%
p.a. its div yield is 0.50%
Managed to produce positive alpha for several consecutive years, i.e. it has outperformed
its cost of capital
Apple has a beta about 1.3 so i ≈ 12.1% looking forward so long term dividends growth
is about 11.6% p.a. implied

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Risk and return

Microsoft

1975 start by HBS leavers Bill Gates & Paul Allen, buying DOS (Disk Operating System)
which with Windows dominated the IBM compatible desktop PC market
Listed in 1986, it paid no stock dividend until 2003, but large gains during that time with
nine stock splits (2:1 or 3:2 for a factor increase of 288). Mkt Cap 2.7tr$. Div yield of
0.8%.
Now valued at more than $1trillion, it has created three billionaires and more than 10,000
millionaires. Consistent large cash reserves, currently ˜$130billion.
Android Operating Systems have come to dominate so new growth by acquisition
(LinkedIn & Skype, $26bn & $8bn)
Since 2003, div yielded between DY = 1% − 3% but payout has grown by g = 11.8% p.a.
Microsoft has a beta β of ˜0.90 (used to be much higher) & capital cost of about
i = 9.3% so seems fairly valued with steady state growth (9.3%-0.8% = 8.5% implied).

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Risk and return

Nvidia

Market cap 1.23$trn, beta of 1.7, cost of equity capital

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Risk and return

Saudi Aramco
Founded in 1933 as California Arabian Standard Oil Company, then 1944
Arabian-American Oil Company, 1988 Saudi Arabian Oil Company
World’s largest proven crude oil reserves (more than all majors combined, 270 billion
barrels @ $40/barrel), second largest oil producer (after Rosneft). 2018 net revenues of
$111.1billion, committed to making total dividend payments of $75billion p.a.
As part of 2030 diversification strategy, the Saudi Govt is seeking to sell shares in
Aramco; first on the local Tadawul, later on an international exchange for potential
$2trillion total valuation (double Google, Apple, Amazon, Microsoft etc.).
Suppose international $ investors hold the CAPM with 5% + 5% beliefs, consider Exxon
and Shell which have betas close to 0.9 against the US markets.
Prospective oil stock returns r = 5% + 0.9 ∗ 5% = 9.5%; this required return comes from
dividend yield & growth. The yield on Shell was about 6% and is 5% on Exxon, this
implies dividend growth of 3.5 − 4.5% (lower than historical average).
A $2trillion valuation for Aramco with $75bn of divs would imply a yield of only 3.75%,
lower than other oil majors.
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Risk and return

Factor investing

Investment managers do not bet the ranch on a small number of stocks

Instead they develop expertise in managing a specific sector or risk factor; here are some
Small or unlisted stocks (these have higher beta and outperform)
Value (high yield) v growth (zero yield but high capital gains)
Momentum; despite market efficiency, this is viewed as a strategy
They have different responses to the macroeconomic environment so appeal to different
investor groups at different times
Environment, Social and Governance investing is emerging as an important consideration
for investors who care about climate change
There is a debate about whether investing in stocks with good ESG scores helps or
hinders your investment performance.

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Risk and return

Linearity of r in β
different market allocations $k
Stocks Betas port i port ii port iii port iv
Risk free 0.0 $4 $1 –$1 $0
Utility 0.5 $3 $2 $2 –$2
Typical stock 1.0 $2 $3 $3 $0
Growth/high tech 1.5 $1 $4 $4 $4

Portfolio value $10 $10 $8 $2

β weighted sum $5 $10 $10 $5
Portfolio beta βp 0.50 1.00 1.20 2.50
Table: Weighting betas with market values

Since returns are linearly related to betas, the weighted average beta in portfolio p be
expressed in terms of component betas of assets each also on the SML.
M.Shackleton (LUMS) MBA564 Jan 2024 107 / 146
Corporate Finance and capital structure

Firm valuation

Now that we have an understanding or how risk and return go together, we can use the CAPM
to look at theoretical valuation of the components of firm value. The aim is to use finance
rules to produce a Market Value balance sheet. This will differ from a Book Value Balance
sheet which is constructed using Accounting rules. Both methods have their place but they
may produce similar or dissimilar results.

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Corporate Finance and capital structure

Book value balance sheet

Book values are the lower of cost or net realisable value and can be presented in net or gross
formats (see Table for example of gross format). The sheet must balance due to accounting
identities.
Total Assets Total Liabilities
Cash and Marketable Securities Current Interest and Tax
Raw Materials Creditors
Finished Stock Senior Loans and Debt
Debtors Junior Debt and Preferred Equity
Intangible Assets Shareholders Equity
Fixed Assets Retained Profit
Table: Typical Book Value Balance Sheet (Gross Format)

The amount of cash, materials and credit given in normal business less the amount of credit
taken is called the working capital requirement (WCR) and is capital that the firm requires to
operate.M.Shackleton
This is (LUMS)
separate to the capital required to purchase operating assets,
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Jan 2024
Corporate Finance and capital structure

“Off Balance Sheet” items

Often assets are contracted for via a lease where regular payments (rather than outright
purchase) are made. Subcontracting & outsourcing (e.g. rent v. buy) are other examples of a
firms activities that do not enter the book value balance sheet but enter firm value implicitly
though the cash flows. Intangibles & growth options, Brands, Research and Development,
strategic options and joint ventures are all off the accounting balance sheet as well but on the
market value balance sheet so long as their cash flows are anticipated. Other off balance sheet,
Hedge Instruments, Contingent liabilities, non recourse lending, option like investments and
the government’s tax slice.

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Corporate Finance and capital structure

Market values; Cash

The Market value is given by the discounted (present) value of future expected cashflows, i.e.
(net) present value of future cashflows. Consider a cash interest account that pays an interest
rate r , on an amount I invested, the cashflow at the end of the year is (1 + r ) I . The present
value is still I because the NPV formula includes cashflows on top and discount rates beneath

(1 + r ) I
PV (Cash) = I = (1)
(1 + r )

Thus for cash the book value equals the market value!4 This is not necessarily true of other
marketable securities, it depends how the accounting treats the changes in their market value.
4
This is true not matter what liquidiation time is chosen, the longer the time the higher the cashflow, in just
the right proportion to offset the discounting

(1 + r )T I
=I
(1 + r )T

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Corporate Finance and capital structure

Debtors & Creditors

Debtors are due within the year, say at the year end (exactly when depends on the terms of
trade) so the present (market) value will actually be less than the book value

D or C
PV (Debtors or Creditors) = < D or C
(1 + r ′ )t<1

Raw materials and stock could be valued on its expected sale, invoice and final payment date
less the cash flows required to get it to the point of sale.

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Corporate Finance and capital structure

Other assets

Intangibles assets are difficult to value (wrapped into residual equity claims) but fixed assets
can be if their (potential) sale value or cashflow benefits are known.

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Corporate Finance and capital structure

Debts and loans

Companies can issue loans or bonds as they are known. Once issued bonds with fixed terms
will have a value that can fluctuate away from their issue and book value as the interest rate
and credit they offer becomes more or less attractive compared to other bonds in issue. The
present value is simply the sum across all future interest payments c per bond, for a three year
bond with principal

Expect [c1 ] Expect [c2 ] Expect [100 ∗ 1ND + c3 ]

PV (Loan) = + +
1 + rd (1 + rd )2 (1 + rd )3

and is sensitive to the current rate of interest. If there are m bonds in issue the total market
value of the debt is D = mL and the total interest rate expense is C = mc.
The book value however remains at 100 per bond excluding the interest due within the year
(c1 , c2 per bond etc. which goes under current liabilities), unless the bond is partly or fully
repaid in which case the book value of the bond is adjusted accordingly. There are some
special cases for the valuation of bonds and some income streams.
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Corporate Finance and capital structure

Equity

The book value accounts record the initial amount of equity contributed by shareholders, any
further amount contributed by new issue and the amounts earned by but not distributed to
shareholders over the course of the years (retained profit/loss). This contrasts starkly with the
equity’s market value and can often be different by a factor of 10! Using the dividend growth
model of Gordon [3] with a constant growth rate for dividends of g and infinite horizon

d1 d1 (1 + g ) d1
P0 = + 2
... =
1 + re (1 + re ) re − g

d1 is the next year end dividend per share, if there are N shares in issue the total dividend
expense is Nd1 and the market value of Equity is E = NP. Book equity B typically remains
lower, even though augmented by retained profit because it still does not look at future
growth, only what has been contributed or accumulated.

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Corporate Finance and capital structure

Book values and EVA surplus

For all equity financing, even if book value grows at the same rate as market value of equity,
share price P0 differs from its book value B0 . Suppose firm earning e1 exceed the (g growth)
divs d1 , the sum not distributed e1 − d1 increases book value B1 − B0 . If this is the same
growth, then gB0 = e1 − d1 and firm share price P0 is a book value B0 and present value of
perpetual residual income e1 − re B0 .
d1 e1 − gB0 e1 − re B0 re B0 − gB0 e1 − re B0
P0 = = = + = + B0 .
re − g re − g re − g re − g re − g
Market value of equity P0 is premium to book value B0 , due to capitalised residual income
e1 − re B0 with growth. Or goodwill P0 − B0 (firm worth P0 can only be recognised in
acquirer’s accounts at B0 ) is capitalised residual income. If EVA = e1 − re B0 is positive, then
the share price exceeds book value. If not then goodwill is negative, liquidate the firm!

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Corporate Finance and capital structure

Market value balance sheet

Market value of assets Market value of liabilities

Debt: D = mL
Assets: A (Beer: B, Chips: C )
Equity: E = nP
Table: Market value balance sheet

Now the market values of Equity and Debt (which depend on m, n bonds L, shares P) can be
added to infer the enterprise value A = mL + nP of the assets (net of creditors, i.e. fixed
assets and working capital requirement). In practice since the market price of the debt is not
always available, it is usually necessary to estimate it from the book value debt. This cannot
be not too bad, especially if the firm is far from default, but this is not an approach we would
wish to take for equity. Note that this example is without tax until the end of this section.

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Corporate Finance and capital structure

Reconciling asset/liabilities returns

Consider operation of this firm with assets of value A over one period followed by liquidation
without growth. For a given current asset value of A = 100 and an expected operating cash
flow (or profit ignoring investment, cash flow timings etc. in a one period world) of πa = 9,
the expected return on assets is
πa
Ra = = 9%
A
N.B. this is consistent with the NPV rule

NPV (Assets) = Discounted (constant) value plus cash

A + πa
A = NPV (A) =
1 + Ra
πa πa
Ra = or perpetuity of =A
A Ra

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Corporate Finance and capital structure

Two assets
πa could be the sum of flows (profits without tax) from two different business lines: B (beer)
and C (chips) with individual flows πb , πc and current values B, C

πa = πb + πc
A = B +C

Assume some values

B = 50 : πb = 3.5 : C = 50 : πc = 5.5
then the expected rates of return on the individual assets themselves can be defined &
calculated
πb 3.5
Rb = = = 7%
B 50
πc 5.5
Rc = = = 11%
C 50
M.Shackleton (LUMS) MBA564 Jan 2024 119 / 146
Corporate Finance and capital structure

Weighted average return on assets

Mathematically this relationship gives the total asset return as a weighted average of the two
sub-asset returns

πa = πb + πc (2)
Ra A = Rb B + Rc C
B C 50 50
Ra = Rb + Rc = 7% + 11% = 9%
A A 100 100
where BA and CA are the weights attached to the two individual expected rates of return Rb , Rc .
This relationship holds for portfolios of stocks and any other (long lived) investments as well
as physical assets, i.e. expected returns are linear in components.

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Corporate Finance and capital structure

Return to liability holders; debt

If the asset flow is not entirely attributable to one class of owners, how is the operational flow
divided up between these liability holders? If the debt holders are promised interest payments
of πd = 1.5 on their (current) face value of Debt D = 25 their expected return is

πd 1.5
Rd = = = 6%
D 25
This might be close to the risk free rate (say 5%) or it might be above it if there is a chance
that the interest and loan cant be repaid.

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Corporate Finance and capital structure

Equity

This leaves an expected return attributable to (equity) shareholders

πe = πa − πd = 9 − 1.5 = 7.5 on a (current) value of E = A − D = 75 which corresponds to
an expected return of
πe 7.5
Re = = = 10%
E 75
The return to equity holders is less certain than the return to debtholders (almost certain) so
Re > Rd .

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Corporate Finance and capital structure

Weighted average cost of capital

The capital structure is 25% debt and 75% equity so the weighted expected return (asset
return) is a quarter that of the return to debt holders and three quarters that of the return to
equity holders

πa = πd + πe
1 3
9% = 6% + 10%
4 4
Thus the weighted average cost of capital (across debt and equity) is given by WACC

Ra A = Rd D + Re E (3)
D E
Ra = Rd + Re
A A
where it is the market value (not book value) of debt and equity that must be used to
weight the expected returns (since expected returns are returns on market investments).
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Corporate Finance and capital structure

Leverage

Again the expected returns operator is seen to be linear in its components and the return on
equity is a linear (but leveraged) function of return on assets less return to debt where new
weights are used EA , − D
E (N.B. these still sum to one)

E +D D D
Re = Ra − Rd = Ra + (Ra − Rd )
E E E
4 1
10% = × 9% − × 6%
3 3
N.B. The weighted average asset return is also the same WACC. Thus without tax, leverage
should not affect return Ra and if leverage does not affect the cost of debt (return to
debtholders) Rd , Re can be made arbitrarily large through the choice of extreme leverage!

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Corporate Finance and capital structure

Extreme leverage or no leverage

For small debt, Rd is close to Rf but for extreme leverage, debtholders own all of the firm and
bear all of the risk of the assets E → 0 ⇐⇒ Rd → Ra . In absence of taxes, market
imperfections (incentive, info problems, transaction costs etc.) firm value is independent of
leverage; otherwise investors put together a portfolio of firm debt and equity to earn excess
returns. It is the asset value A and return Ra that are the points from which liability values are
derived.
When dealing with a corporation tax rate τ, we presume (as in section 3) that projects are
unlevered with no tax shield i.e. πu = (1 − τ ) πa having unlevered cost of equity Ru = Ra .
From this perspective the cost of debt is subsidized and the levered cost of equity Rl increases
more slowly than the formula on the last page.
D
Rl = Re = Ra + (1 − τ ) (Ra − Rf )
E

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Corporate Finance and capital structure

Earnings per share and other measures

How can assets be partitioned without affecting total value if “higher earnings per share” are
favoured? Consider two possible firm structures (identical assets worth 100, no tax).
75/25 E/D Flow Value Yield or return
Asset Flow/Value 9 100 9%
Debt Interest/Value 1.5 25 6%
Equity Dividend/Value 7.5 75 10%
75 shares in issue 0.10 /share 1.0 /share

50/50 E/D Flow Value Yield or return

Asset Flow/Value 9 100 9%
Debt Interest/Value 3 50 6%
Equity Dividend/Value 6 50 12%
50 shares in issue 0.12 /share 1.0 /share
M.Shackleton (LUMS) MBA564 Jan 2024 126 / 146
Corporate Finance and capital structure

Earnings manipulation

Repurchasing 25 units of equity by issuing 25 units of debt has increased the per share figure
from 0.10 per share to 0.12; is this good? Value has not changed because the asset cashflows
remain unaltered and the share price has not changed because the required yield has gone up!
The share risk return profile is different, now there is more chance that the firm value will fall
below the debt value (equivalently that the profit will fall below the interest expense).
What is really required to add value to a firm’s share price is to increase the per share dividend
while keeping the gearing constant, because this usually involves hard work on the asset side
(trimming costs, increasing revenues etc.) slick financial managers are less keen, as a quick fix
it is easy to just increase the gearing.

M.Shackleton (LUMS) MBA564 Jan 2024 127 / 146

Corporate Finance and capital structure

Value additivity

This statement that the firm value is independent of the capital structure comes from
Modigliani and Miller [7] [8], it is also a statement of linear valuation. The Modigliani Miller
proposition is true for NPV valuation because the NPV rule is linear in its components5 .

A = NPV (πa ) = NPV (πb + πc ) = NPV (πb ) + NPV (πc ) = B + C

9 3.5 + 5.5 3.5 5.5
100 = = = + = 50 + 50
9% 9% 7% 11%

5
Note that the values 3.5/9% = 38.89 and 5.5/9% = 61.11 still add to 100 but have no meaning.
M.Shackleton (LUMS) MBA564 Jan 2024 128 / 146
Corporate Finance and capital structure

Weighted Average Cost of Capital (WACC)

In absence of taxes and bankruptcy costs, the WACC remains constant. As the leverage rises,
both the cost of equity and the cost of debt will rise! However because the cost of debt is
always lower than the return on assets, the weighted average can remain the same. These
prospective returns are consistent with a market risk premium the same as that of the equity,
i.e. 5%, i.e. 5% on top of a risk free rate of 5% and all assets lie on the security market line.

item Rf Rd Rb Ra Re = Rm Rc
ex.ret 0.05 0.06 0.07 0.09 0.10 0.11
beta 0.00 0.20 0.40 0.80 1.00 1.20

Ri = Rf + (Rm − Rf ) βi

M.Shackleton (LUMS) MBA564 Jan 2024 129 / 146

Corporate Finance and capital structure

Firm value and WACC with tax

When corporate taxes are levied, it is typically after the interest expense has been deducted
giving a relative advantage to debt. With no debt (the example in section 3 with
Ra = Re = Ru = 15% had no debt), the unlevered value of the firm U is 1 − τ of A where τ is
the corporate tax rate.
(1 − τ ) πa
U= = (1 − τ ) A
Ru
When debt D is used to replace some E , the (net) value of the firm V = D + E goes up
because interest is extracted before tax. This is because (without default) there is a present
value tax shield of τ D. This can be made manifest by applying a new post tax WACC
Rv < Ru to the same after tax unlevered flow (1 − τ ) πa

(1 − τ ) πa
V = >U
Rv

M.Shackleton (LUMS) MBA564 Jan 2024 130 / 146

Corporate Finance and capital structure

Cost of capital with taxes

This WACC is lowered to take into account the subsidised cost of debt but must allow for the
levered cost of equity, where Rl is a levered cost of equity.
D E
Rv = Rd (1 − τ ) + Rl
V V
D
Rl = Ru + (1 − τ ) (Ru − Rf )
E

M.Shackleton (LUMS) MBA564 Jan 2024 131 / 146

Corporate Finance and capital structure

Limitations

This analysis works for low levels of leverage; in this case the cost of debt is close to the
risk free rate, the chance of default is low and the tax shield is considered safe.
As the amount of debt increases, these will no longer be true; the cost of debt will rise
and the tax shield will be less secure because in default, there will be no subsidy to debt
compared to the unlevered firm (which cannot default).
Also many firms will lose extra value in default if their assets are sold at a time of failure
(fire sales).
In practice, these bankruptcy costs and loss of tax shield means that the WACC
presented will start to increase again. This means that there is an optimal level of debt,
beyond which firm value is destroyed. Unfortunately many firms only discover this point
after the fact.

M.Shackleton (LUMS) MBA564 Jan 2024 132 / 146

Corporate Finance and capital structure

Global population (OurWorldinData)

M.Shackleton (LUMS) MBA564 ;

Jan 2024 133 / 146
Corporate Finance and capital structure

Births and deaths data over 60 years (OurWorldinData)

M.Shackleton (LUMS) MBA564 Jan 2024 134 / 146

Corporate Finance and capital structure

Absorption/reflection of Sun’s rays global ◦

C temp

M.Shackleton (LUMS) MBA564 Jan 2024 135 / 146

Corporate Finance and capital structure

Absorption and ◦ C from parts per million ppm CO2

M.Shackleton (LUMS) MBA564 Jan 2024 136 / 146

Corporate Finance and capital structure

Emissions data over 60 years (OurWorldinData)

;
M.Shackleton (LUMS) MBA564 Jan 2024 137 / 146
Corporate Finance and capital structure

Social Licence to Operate (SLO): 7, 12 ,13

M.Shackleton (LUMS) MBA564 Jan 2024 138 / 146

Corporate Finance and capital structure

The emissions “tap”, carbon “level” & net zero

33 billion tons CO2 annual emissions lifts ppm by 3 each year (0.03 ◦ C)

M.Shackleton (LUMS) MBA564 Jan 2024 139 / 146

Corporate Finance and capital structure

Emissions pledges, (UNEP)

M.Shackleton (LUMS) MBA564 Jan 2024 140 / 146

Corporate Finance and capital structure

Greenhouse gas emissions: Scope 2, 1 & 3

2 Indirect: Purchased,
1 Direct: Emissions from 3 Indirect: All other emissions
acquired energy (elec., steam,
operations owned or controlled in company’s value chain up &
heating, cooling) consumed by
by the reporting company. down stream (embodied).
company.

M.Shackleton (LUMS) MBA564 Jan 2024 141 / 146

Corporate Finance and capital structure

The greening of finance

Pollutants are felt by all; it is difficult to tax CO2 globally

Moved from Friedman (fiduciary) to Freeman (stakeholder) view
Finance & Accounting activities enhance “social licence” & trust e.g.
Insurance firms are declining to cover some climate risks
Responses vary: risk as financial (limit/trade) or risk as an opportunity?
Engagement: If investors actively lobby a firm, its policies may change
Divestment: If investors sell, a firm’s funding cost rises, but it survives
M&A: “Green” acquisitions and “brown” divestitures (to whom?)
Half of global business not listed/regulated on exchanges (private/govt.)

M.Shackleton (LUMS) MBA564 Jan 2024 142 / 146

Corporate Finance and capital structure

JM Keynes, on stock markets adapted for greenest (1936)

“It is not a case of choosing those [firms] that, to the best of one’s judgment, are really the
greenest, nor even those that average opinion genuinely thinks the greenest. We have
reached the third degree where we devote our intelligences to anticipating what average
opinion expects the average opinion to be.” General Theory of Employment, Interest & Money.
M.Shackleton (LUMS) MBA564 Jan 2024 143 / 146
Corporate Finance and capital structure

US Stock Market sector composition over 200 years

Markets have winning & losing segments but are resilient

Capital returns, preferences change, oil and gas are falling, brown businesses consolidating
Energy sectors such as solar power & green hydrogen emerging
M.Shackleton (LUMS) MBA564 Jan 2024 144 / 146
Corporate Finance and capital structure

This process of creative destruction is the essential

fact about capitalism.

It is what capitalism consists of and what every

capitalist concern has to live with.

Joseph Schumpeter: Capitalism, Socialism &

Democracy, 1942.

M.Shackleton (LUMS) MBA564 Jan 2024 145 / 146

Corporate Finance and capital structure

Does Financing change the world? (Yale/Beinecke)

“Bearer” bond (transferrable) issued by Dutch Water Board to finance dike improvements
“1,000 Carolus Guilders of 20 Stuivers a piece” paying 5% interest (reduced to 2.5%).
It has no end date (perpetual) and has been serviced since 1648.

M.Shackleton (LUMS) MBA564 Jan 2024 146 / 146

Corporate Finance and capital structure

E. F. Fama.
Efficient capital markets: A review of theory and empirical work.
Journal of Finance, 25:383–417, 1970.
E. F. Fama.
Efficient capital markets II.
Journal of Finance, 46(5):1575–1617, 1991.
M. Gordon.
Security and a financial theory of investment.
Quarterly Journal of Economics, 74(3):472–492, 1960.
M. J. Gordon and E. Shapiro.
Capital equipment analysis: The required rate of profit.
Management Science, 3(1):102–110, 1956.
J. Lintner.

M.Shackleton (LUMS) MBA564 Jan 2024 146 / 146

Corporate Finance and capital structure

The valuation of risk assets and the selection of risky investments in stock portfolios and
capital budgets.
Review of Economics and Statistics, 47:13–37, 1965.
H. M. Markowitz.
Portfolio selection.
Journal of Finance, 7, 1952.
M. H. Miller and F. Modligliani.
The cost of capital, corporation finance and the theory of investment.
American Economic Review, 48:261–297, 1958.
F. Modligliani and M. H. Miller.
The cost of capital, corporation finance, and the theory of investment.
American Economic Review, 48(June):261–297, 1958.
L. Pacioli.
Particularis de computis et scripturis.
Summa de arithmetica, 181(44):472–492, 1494.
M.Shackleton (LUMS) MBA564 Jan 2024 146 / 146
Corporate Finance and capital structure

P. A. Samuelson.
Proof that properly anticipated prices fluctuate randomly.
Industrial Management Review, 6(Spring):41–49, 1965.
W. F. Sharpe.
Capital asset prices: A theory of market equilibrium under conditions of risk.
Journal of Finance, 19(3):425–442, 1964.

M.Shackleton (LUMS) MBA564 Jan 2024 146 / 146