FINM7402: Corporate Finance (Advanced)
Topic 1: Introduction & Cost of Capital
Reading: Ch.10, 11, 12
CRICOS code 00025B
Education Team
Min Zhu, PhD --- Course Coordinator & Lecturer
• Email: m.zhu@business.uq.edu.au
• Tel: 7 3346 8147
• Location: Room 321, Colin Clark Building
Tutors:
Mr Binh Minh Le Miss Lu Tang
Email: b.le@uq.edu.au Email: lu.tang@uq.edu.au
Mr Will Li
Email: will.li@uq.edu.au
CRICOS code 00025B
Textbook:
• Berk, J., and DeMarzo, P. (2020). Corporate Finance. [Global edition], 5th Edition,
Pearson Publishing.
Tutorials:
• There are no tutorials in Week 1. See the subject outline for further details.
You are expected to read a wide range of source materials and thus help
understand the topics well (see the course outline).
Textbook and Supporting Materials
CRICOS code 00025B
Course Structure
Lecture / Seminar
• Theory development seasoned with practical applications.
• Prepare with required and recommended readings (see course profile and Blackboard).
Tutorial
• Discuss solutions to tutorial questions as needed.
• Additional practical applications.
• Participation will assist in preparation for exams
CRICOS code 00025B
Summary of Assessment
Mid-semester exam (30%)
• Wednesday mid-semester exam: Aug 31 in class
• 90 minutes
• MCQs & short answer
• Topics covered: 1-4
Individual assignment (20%)
• Case study on cost of capital/valuation
• Submission by the due date (Oct 5, 2023) via Blackboard.
• Zero marks for late submission
• Topics covered: 1-4
Final exam (50%)
• Centrally administered during exam block
• 120 minutes, 10 minutes perusal
• MCQs, problem solving and short answer
• Topics covered: all with emphasis on 5-10
CRICOS code 00025B
Course Objectives & Teaching Plan
Capital Budgeting
NPV, IRR
Cost of Capital
Capital Structure
Capital Structure – MM Theory
Debt, Taxes & Financial Distress
Payout Policy
Risk Management
Financial Options
Real Options
Special Topics
Corporate Governance
Mergers & Acquisitions
Raising New Capital
CRICOS code 00025B
Tips to succeed in FINM7402
• Read the course outline carefully.
• Review the lecture note before each lecture.
• Attempt tutorial questions before the tutorial.
• Study relevant chapter/s related to each topic.
• See your tutor promptly if you’re having difficulties.
• To succeed, there is no alternative to HARD WORK.
• The course is progressive (don’t fall behind).
CRICOS code 00025B
Week1: Learning Objectives
• Overview of corporate finance as a field
• Describe the market portfolio and how it is constructed in practice.
• Describe common proxies for the market return and the risk-free rate.
• Define alpha and beta and explain how they are generally estimated.
• Estimate a company’s cost of equity using the CAPM equation
• Estimate the cost of debt, given a company’s yield to maturity, probability of default, and
expected loss rate.
• Asset beta, equity beta, levered and unlevered beta
8
CRICOS code 00025B
Corporate Finance: what is it?
9
• Broadly speaking, any decision that a business makes has financial
implications, and affects the finances of a business is a corporate finance
decision.
CRICOS code 00025B
First Principles & the Big Picture
10
CRICOS code 00025B
Corporate finance is focused on…
• Maximizing the value of the business (firm). As a result of this singular objective, we can
- Choose the right investment decision rule to use amongst a menu of such rules (NPV,
IRR, payback …)
- Determine the right mix of debt and equity for a specific business
- Examine the right amount of cash should be returned to the owners of a business and the
right amount to hold back as a cash balance.
• This certitude does come at a cost. To the extent that you accept the objective of
maximizing firm value, everything in corporate finance makes complete sense. If you don’t,
nothing will.
CRICOS code 00025B
Corporate finance is universal
• Every business, small or large, public or private, Australian or Emerging market, has to
make investment, financing and dividend decisions.
• The objective in corporate finance for all these businesses remains the same: maximizing
the value.
• While the constraints and challenges that firms face can vary dramatically across firms, the
first principles does not change.
- A public traded firm, with its greater access to capital markets and more diversified investor base,
may have much lower costs of debt and equity than a private business, but they both should look
for the financing mix that minimizes their costs of capital.
- A firm in an emerging market may face greater uncertainty, when accessing new investments, than
a firm in a developed market, but both should invest only if they believe they can generate higher
returns on their investments than they face as their respective hurdle rates.
CRICOS code 00025B
Hurdle Rate: Cost of Capital
• Also referred as cost of funds used for financing a business.
cost of equity & cost of debt
• Cost of capital represents a hurdle rate that a company must
overcome before it can generate value.
• Input in the capital budgeting process to determine whether the
company should proceed with a project. NPV analysis
13
CRICOS code 00025B
Cost of Capital: risk return model
• Since financial resources are finite, there is a hurdle that projects have to
cross before being deemed acceptable. This hurdle should be higher for
risker projects than for safer projects.
• A simple representation of the hurdle rate is as follows
Hurdle rate = riskless rate + risk premium
• The two basic questions that every risk and return model in finance tries to
answer are:
- How do you measure risk?
- How do you translate this risk measure into a risk premium?
14
CRICOS code 00025B
A good risk and return model
• It should come up with a measure of risk that applies to all assets and not
be asset-specific.
• It should clearly delineate what types of risk are rewarded and what are
not, and provide a rationale for the delineation.
• It should come up with standardized risk measures, i.e., an investor
presented with a risk measure for an asset should be able to draw
conclusions about the asset is above or below-average risk.
• It should translate the measure of risk into a rate of return that the investor
should demand as compensation for bearing the risk.
• It should work well not only at explaining past returns, but also in
predicting future expected returns.
15
CRICOS code 00025B
The Capital Asset Pricing Model
• Uses variance of actual returns around an expected return as a
measure of risk.
• Specifies that a portion of variance can be diversified away, and
that is only the non-diversifiable portion that is rewarded.
• Measure the non-diversifiable risk with beta, which is standardized
around 1.
• Translates beta into expected return
Expected rate = riskless rate + beta * risk premium
16
ri=rf +βi × (E[RMkt ]-rf )
CRICOS code 00025B
• For an investment to be risk free, i.e. to have an actual return be equal to the expected
return, two conditions have to be met
- No default risk, which generally implies that the security has to be issued by the
government. Note: not all governments can be viewed as default free.
- There can be no uncertainty about reinvestment rates, which implies that it is a zero
coupon security with the same maturity as the cash flow being analyzed.
• Definition: The risk free rate is the rate on a zero coupon default-free bond matching the
time horizon of the cash flow being analyzed.
• Practically, we use returns of Treasury Securities as proxy for risk free rate. In corporate
finance, almost everything is long term. So, using a long-term default risk free treasury
bond return as the risk free rate makes sense.
17
CAPM: Risk-free rate
CRICOS code 00025B
• Risk premium: Expected return on the market portfolio – risk-free rate
Historical premium approach: In principle, market portfolio should be the value weighted entire
universe of stocks. In practice, a stock market index return is often used as a proxy of market
performance. For example, S&P 500 index is often used as a proxy of US market performance,
S&P/ASX200 index is used as a proxy of Australian stock market performance.
Table 1: Historical Excess Returns of the S&P 500
18
CAPM: Risk premium
CRICOS code 00025B
Alternative Approach for Market Risk Premium
Using historical data has two drawbacks:
• Standard errors of the estimates are large
• Backward looking, so may not represent current expectations.
• Alternative: We can get a forward looking measure of risk premium implicit in stock
prices:
• Forecast dividends (D1) for a broad sample of existing firms (i.e. forecast market
dividend yields)
g is the long-term growth rate for all stocks obtained from analyst forecasts; D/P is the
market dividend yield
MRP = (Market Div. yield + growth) - rf
19
gr
DP
e −
= 10 





+=+= g
P
Drhenceg
P
Dr me
0
1
0
1 ;
CRICOS code 00025B
Market Risk Premium
Survey estimates
Experts are surveyed as to their estimates of the MRP going forward
Many different expert groups have been asked
 CFOs
 Financial analysts
 Academics
There is little evidence that any of these groups have expertise that is relevant to estimating
MRP
CRICOS code 00025B
The risk of an individual asset
• Use variance of actual returns around an expected return as a
measure of risk.
• Specifies that a portion of variance can be diversified away,
and that is only the non-diversifiable portion that is rewarded.
• Total Risk = Systematic risk + Unsystematic Risk
• Risk diversification: firm-specific risk can be reduced by increasing
the number of investments in your portfolio. Market-wide risk cannot.
• Measure the non-diversifiable risk with beta, which is standardized
around one.
21
CRICOS code 00025B
7/13/2023
No of assets
Total Risk
systematic risk
unsystematic risk
TOTAL RISK = SYS RISK + UNSYS RISK
Diversification
Keeping return constant
22
• Total Risk = Systematic risk + Unsystematic Risk
CRICOS code 00025B
Beta
• A measure of a security’s systematic risk, describing the amount
of risk contributed by the security to the market portfolio.
βi = Cov(Ri, Rm) / σ2m
• Cov(Ri, Rm) is a raw measure of systematic risk, can be scaled by
dividing it by the variance of the return on the market.
• This gives the asset’s beta (βi)
If beta = 1 … same risk as market portfolio
if beta > 1… riskier than market portfolio
if beta < 1 … safer than market portfolio
CRICOS code 00025B
2012
Given Rf equals 8% and E(Rm) equals 15%, what is the
required return for a project which has a Beta of 1.5?
E(Ri) = .08 + 1.5(.15 - .08) = .185 or 18.5%
[ ]E R R E R Ri f i m f( ~ ) ( ~ )= + −β
Example One
CRICOS code 00025B
Cost of Equity
Monthly Returns for Cisco Stock and for the S&P 500, 2000-2015
25
Cisco mean annual ret: r = 3.3% Volatility: σ = 9.6%
95% confidence interval: 3.3% ± 1.96 ∗ 9.6% (−15.5%, 22.1%)
CRICOS code 00025B
Cost of Equity re
• Estimate expected returns directly, i.e., using historical average
return, is too noisy to be useful.
• A more robust alternative is CAPM
26
ri=rf +βi × (E[RMkt ]-rf )
Market Risk Premium
CRICOS code 00025B
Estimating Beta
• Under the CAPM, beta reflects the systematic (market-related) risk of
owning shares in the company and cannot be diversified away.
• Betas are usually estimated using regression analysis to estimate the
relationship between returns for a particular stock and returns on the
broad market.
• Regress asset excess return (Ri – Rf) on market excess return (Rm- Rf).

• The R squared of the regression provides an estimate of the proportion
of the risk (variance) of a firm that can be attributed to market risk. The
remaining (1 – R2) can be attributed to firm specific risk.
27
( ) ( ) i f i i Mkt f iR r R r− = + − +α β ε
CRICOS code 00025B
Estimating Beta
• Decide on an estimation period
- Typically use 2 to 5 years data for the regression
- Longer estimation period provides more data, but firm change
- Shorter periods can be noisy
• Decide on return interval – daily, weekly, monthly
- Shorter intervals produce more observations, but suffer from more noise.
- Noise is created by stocks not trading and biases all betas towards one.
• Estimate returns including dividends on stock
- Return = (price_end – price _bgn + dividend)/price_bgn
• Choose a market index, and estimate returns (inclusive of dividends) on the
index for the chosen interval.
28
CRICOS code 00025B
Scatterplot of Monthly Excess Returns for Cisco Vs the S&P 500, 2000-2015
29
CRICOS code 00025B 30
• The estimate of Cisco’s alpha from the regression is not
significantly different from zero.
• Cisco CAPM beta: 1.57 -- slope of the regression
• Regression parameters are always estimated with error. The
error is captured in the standard error of the beta estimate.
• Using the standard error, 95% confidence interval (CI) for
beta: beta ± 1.96 ∗ . , is 1.3 to 1.8
• Mkt risk premium: E − = 5% Risk free rate: = 3%
• Equity cost of capital: + β ∗ E − = 10.85 % with
95% CI: (9.5%, 12%)
Cost of Equity
CRICOS code 00025B 31
• You are advising a very risky software firm on the right cost of
equity to use in project analysis. You estimate a beta of 3.0 for
the firm and the resulting cost of equity is 20%. The CFO of
the firm is concerned about the high cost of equity and wants
to know whether there is anything he can do to lower his beta.
• How do you bring your beta down?
A quick test
CRICOS code 00025B
Example: Cost of Equity
CRICOS code 00025B
Example: Cost of Equity
CRICOS code 00025B
Cost of Debt rd
Different approaches, depending on the situation, question, and purpose:
1) If the firm uses private debt (i.e., no bond price is available) use an estimate
of the yield from comparable firms with the same credit rating;
2) If the firm uses public debt, can adjust bond yield to get cost of debt.
3) Use the CAPM
In principle, we could run a CAPM regression of the excess returns of the corporate
bonds over Treasuries, on the excess return on the market.
But in practice, historical data on debt returns is often hard to obtain.
34
CRICOS code 00025B
Debt Yields Versus Returns
• Yield to maturity is the IRR an investor will earn from holding the bond to maturity and receiving
its promised payments. It overstate investors’ expected return when facing risk of default.
• Consider a one-year bond with YTM of y. For each $1 invested today, the issuer promises to pay
$(1 + y) in one year.
• Suppose the bond will default with probability p, in which case bond holders receive only $(1 + y -
L), where L is the expected loss per $1 of debt in default.
• The expected return of the bond is
rd = (1 - p)y + p(y - L) = y - pL
= Yield to Maturity – Prob(default) * Expected Loss Rate
35
CRICOS code 00025B
Annual Default Rates by Debt Rating (1983–2011)
36
The average loss rate for unsecured debt is 60%.
During average times the annual default rate for B-rated bonds is
5.5%.
The expected return to B-rated bondholders is 0.055 * 0.60 =
3.3% below the yield
Table 2: Debt Default Rates
CRICOS code 00025B
Calculating rd
Debt Betas
• Alternatively, we can estimate the debt cost of capital using the CAPM.
• Debt betas are difficult to estimate because corporate bonds are traded
infrequently.
• One approximation is to use estimates of betas of bond indices by rating
category.
37
CRICOS code 00025B
Average Debt Betas by Rating and Maturity
38
Table 3: Debt Betas
CRICOS code 00025B
Example 2
CRICOS code 00025B
Example 2 (cont’d)
CRICOS code 00025B
Exercise
• In early 2013, auto parts retailer Autozone had outstanding 10-year bonds with a yield to
maturity of 3% and a BBB rating. If corresponding risk-free rates were 1.5% and the market risk
premium is 8%, estimate the expected return of Autozone’s debt.
CRICOS code 00025B
Exercise
Solution
• Using the average estimates in Table 12.2 and an expected loss rate of 60%,
from Eq. 12.7 we have
rd = 3% - 0.5%(0.60) = 2.7%
CRICOS code 00025B
Exercise
Solution
• Alternatively, we can estimate the bond’s expected return using the CAPM and
an estimated beta of 0.10 from Table 12.3. In that case, rd = 1.5% + 0.10(8%) =
2.3%
• Both estimates are rough approximations and they both suggest that the
expected return of Autozone’s debt is below its yield-to-maturity of 3%.
CRICOS code 00025B
Cost of equity capital: , β
= + β∗ E −
Cost of debt capital: , β
= + β∗ E −
What is the cost of capital for a business (firm)?
CRICOS code 00025B
Asset cost of capital
Suppose you buy a firm with both equity and debt in its capital structure.
expected return of the firm (asset) is the weighted average of the equity
and debt returns.
Firm beta as weighted average: the beta of a firm is the weighted average
of the betas of its individual components

β: unlevered beta , asset beta
β: levered beta, equity beta
45
DEA rED
Dr
ED
Er
+
+
+
=
DEA ED
D
ED
E βββ
+
+
+
=
CRICOS code 00025B
Equity beta vs. asset beta
What is more risky? Invest in a company with
1) a lot of debt (levered)
2) little or zero debt (unlevered)
Simple relationship: higher debt (higher leverage), higher
equity beta.
The (equity) beta of a firm reflects its capital structure; thus a
function of the firm’s business risk and leverage induced
risk.
= + −
46
DEA ED
D
ED
E βββ
+
+
+
=
CRICOS code 00025B
Changing the capital structure does NOT alter the risk
inherent in the business’s cash flows; it just affects how that
risk is shared among the various claimholders.
Levered beta (equity beta) accounts for the company's
capital structure. This is the beta that is typically found on
financial websites such as Google Finance
Unlevered beta (asset beta) measures how volatile the
underlying business is without considering capital structure.
It assumes that the business is purely equity financed.
47
Equity beta vs. asset beta
CRICOS code 00025B
Cash and Net Debt
Some firms maintain high cash balances.
Cash is a risk-free asset that reduces the average risk of the firm’s
assets.
Because the risk of the firm’s enterprise value is what we’re concerned
with, leverage should be measured in terms of net debt.
Net Debt = Debt – Excess Cash and short-term investments
CRICOS code 00025B
Example 3
CRICOS code 00025B
Example 3 (cont’d)
CRICOS code 00025B
Another Example
Problem
• Apple’s market capitalization in mid-2016 was $484 billion, and its beta was 1.03. At
that same time, the company had $25 billion in cash and $69 billion in debt.
• Based on this data, estimate the beta of Apple’s underlying business enterprise.
CRICOS code 00025B
Another Example (cont’d)
Solution
$484 $69 $251.03 0
$484 $69 $25 $484 $69 $25
0.0944
U E D
U
E D
β = β + β
E+D E+D
β
−
= +
+ − + −
= 0.94