Chapter

1 - Introduction to Corporate Finance

Balance Sheet Model of the Firm
Fixed assets are those that will last a long time, such as buildings.
o Firms assets are broken down into current (short lives, typically less than a year) and fixed
(last a long time)
o Fixed assets can be tangible (machinery, buildings) or intangible (patents, trademarks)
Current assets comprises those that will have short lives, such as inventory.
Firms options for financing (raising money) are debt or equity (stock)
o Debts or liabilities can be current or long-term (doesnt have be paid within a year)
o Shareholders equity is residual, leftover value between value of assets and firms debt
Finance focuses on 3 questions:
1. In what long-lived assets should the firm invest?
a. Capital budgeting the process of making and managing expenditures on long-
lived assets.
2. How can the firm raise cash for required capital expenditures?
a. Capital structure the portions of the firms financing from current and long-
term debt and equity.
3. How should short-term operating cash flows be managed?
a. Net working capital current assets minus current liabilities.

The Corporate Firm
A sole proprietorship is a business owned by one person.
1. The sole proprietorship is the cheapest business to form.
2. A sole proprietorship pays no corporate income taxes.
3. The sole proprietorship has unlimited liability for business debts and obligations.
4. The life of the sole proprietorship is limited by the life of the sole proprietorship.
5. Because the only money invested in the firm is the proprietors, the equity money that can
be raised by the sole proprietor is limited to the proprietors personal wealth.
Any two or more people can get together and form a partnership.
o Partnerships fall into two categories: (1) general partnerships and (2) limited partnerships.
In a general partnership all partners agree to provide some fraction of the work and
cash and to share the profits and losses.
General partners have unlimited liability for all debts.
General partnership is terminated when a general partner dies or withdraws.
Limited partnerships permit the liability of some of the partners to be limited to the
amount of cash each person has contributed to the partnership.
Limited partnerships usually require that (1) at least one partner be a
general partner and (2) the limited partners do not participate in managing
the business.
o Partnerships are usually inexpensive and easy to form.
o It is difficult for a partnership to raise large amounts of cash.
o Income from a partnership is taxed as personal income to the partners.
o Management control resides with the general partners.
o The disadvantages are (1) unlimited liability, (2) limited life of the enterprise, and (3)
difficultly of transferring ownership. These three disadvantages lead to (4) difficultly in
raising cash.
The articles of incorporation must include the following:
1. Name of the corporation.
2. Intended life of the corporation (it may be forever).

3. Business purpose.
4. Number of shares of stock that the corporation is authorized to issue, with a statement of
limitations and rights of different classes of shares.
5. Nature of the rights granted to shareholders.
6. Number of members of the initial board of directors.
The potential separation of ownership from management gives the corporation several
advantages over proprietorships and partnerships.
1. Because ownership in a corporation is represented by shares of stock, ownership can
readily be transferred to new owners.
2. The corporation has unlimited life.
3. The shareholders liability is limited to the amount invested in the ownership shares.
Firms are often called joint stock companies, public limited companies, or limited liability
companies, depending on the specific nature of the firm and the country of origin.

Goal of Financial Management
To create and sustain maximum value for the firm's owners
o Value is a function of the amount, timing, and riskiness of expected cashflows
Possible financial goals:
o Survive.
o Avoid financial distress and bankruptcy.
o Beat the competition.
o Maximize sales or market share.
o Minimize costs.
o Maximize profits.
o Maintain steady earnings growth.
Goal of financial management: maximize the current value per share of the existing stock.
Corporate finance the study of the relationship between business decisions, cash flows, and the
value of the stock in the business.

How to Create Value
Create value if the value today of the steam of net cashflows to be generated by a transaction
exceeds the cost of the transaction
o To create sustainable value, we must:
Respect ethical and legal boundaries
Focus on amount, timing, and riskiness of cashflows
Consider social responsibilities
Manage agency relationships
How do financial managers create value?
1. Try to buy assets that generate more cash than they cost.
2. Sell bonds and stock and other financial instruments that raise more cash than they cost.
Allocational Efficiency
o Assets end up in the hands of those who can use them most productively
Market (informational) efficiency
o Security prices quickly and accurately reflect all relevant information
o Three degrees of market (informational) efficiency: weak, semi-strong, strong
o Implications for managers
Price adjustments reveal markets assessment of managerial decisions
No value added if you can do-it-yourself
No sustainable financial illusions

The Agency Problem and Control of the Corporation

The relationship between stockholders and management is called an agency relationship.
Agency problem the possibility of a conflict of interest between the principal and the agent.
o One person (principal) engages another person (agent) to perform some duty on the
principals behalf
o Involves delegating some decision-making authority to the agent
Agency costs refers to the costs of the conflict of interest between stockholders and management.
An important mechanism by which unhappy stockholders can replace existing management is
called a proxy fight.
In general, a stakeholder is someone other than a stockholder or creditor who potentially has a
claim on the cash flows of the firm.

Competing and/or Complementary Models
Behavioral hypothesis
o Psychological biases affect financial markets
o Markets are driven by fear and greed
o Consider cognitive biases: overconfidence, overreaction, and representative bias
Adaptive markets hypothesis
o Reconciles efficient markets and behavioral theories
o Applies principles of evolution to financial markets


Chapter 3 Financial Statement Analysis and Financial Models

Sources of Financial Information
Accounting based (book values) info that already happened; past info to predict future value
o Traditional uses of accounting based financial information
Common-size statements are standardized and used to compare companies
Income statements express each value as a percentage of sales
Balance sheet s- express each value as a percentage of total assets
Ratio analysis
o Ratios that primarily use accounting-based financial information
Liquidity
Profitability
Asset utilization (turnover)
Leverage
o Ratios that combine accounting based and market-based financial information
Dividend
Valuation
Market based (market values) uses values today and builds in expectations of future value
o Money markets
o Capital markets
o Derivatives markets

Financial Ratios (using accounting based financial info)
Measures of earnings
o Earnings before interest expense and taxes (EBIT) total operations revenues
operating expenses
Measure of operating cash flow and doesnt take into account differences in earnings
from a firms capital structure

o Earnings before interest, taxes, depreciation, and amortization (EBITDA) EBIT +

depreciation + amortization
Short-term solvency ratios as a group are intended to provide information about a firms
liquidity, and these ratios are sometimes called liquidity measures.
o Current ratio: current assets/current liabilities
How well can a company cover its short term liabilities
Measure of short-term liquidity: higher ratio means a firm is more liquid though
could also be inefficient use of cash and short-term assets
Usually have current ratio of at least 1
o Quick ratio: (current assets-inventory)/current liabilities
Removes inventory because its 2 steps away from being money so is less liquid than
other assets
o Cash ratio: cash/current liabilities
Long-term solvency ratios are intended to address the firms long-run ability to meet its
obligations or, more generally, its financial leverage; sometimes called financial leverage ratios or
just leverage ratios
o Total debt ratio: (total assets-total equity)/total assets
How much of firms financing is debt; tells for every $1 in assets, how much debt
does the firm have
o Debt-equity ratio: total debt/total equity
o Equity multiplier: total assets/total equity
Turns out to be 1 plus the debt to equity ratio because total assets in numerator is
just total debt + total equity
o Times interest earned (TIE): EBIT/interest (Not discussed in class)
Also known as interest coverage ratio, indication of how well company can cover its
interest obligations
o Cash coverage ratio: EBITDA/interest (Not discussed in class)
Used because EBIT (in TIE) isnt really a measure of cash you have to pay interest
since amortization and depreciation have been deducted. This take into account
how much cash is actually available to pay interest
Asset management or utilization ratios describe how efficiently, or intensively, a firm uses its
assets to generate sales.
o Inventory turnover: COGS/Inventory
How many times in a year does a firm sell off its entire inventory
Generally, higher the ratio is, the better (as long as firm isnt running out of stock)
o Days sales in inventory: 365 days/inventory turnover
Length of time inventory is held before being sold
o Receivables Turnover: sales/accounts receivables
How many times in a year a firm collects its outstanding credit
o Days Sales in Receivables: 365 days/receivables turnover
On average, how long it takes for a firm to receive cash from its credit sales
Also called average collection period
o Total Asset Turnover: Sales/total assets
Big picture ratio: for every dollar of assets, how much you generate in sales
Profitability measures
o Profit margin: net income/sales
How much goes to be bottom line, for every dollar in sales, how much ends up as net
income
o EBITDA margin: EBITDA/Sales

Looks more at actual cash flows than net income does since it doesnt include taxes
or effect of capital structure.
o Return on Assets (ROA): Net income/total assets
How much profit is made for each dollar of assets
o ROE = Net Income/Equity = (Net Income/Sales) x (Sales/Assets) x (Assets/Equity)
How much profit is made for each dollar in equity; tells how firm is benefiting
shareholders

Financial Ratios Using Market-Based and Accounting-Based Information
Valuation ratios
o Price-earnings ratio: price per share/earnings per share
Shares sell for __ times earnings (blank equals PE ratio)
Measure of how much investors are willing to pay per dollar of current earnings
Usually higher PE is an indication of high prospects for future growth
o Market-to-Book ratio: Market value per share/book value per share
Compares market value of firms investments to their cost
o Market capitalization: price per share x shares outstanding
Total cost of all shares of the firm
o Enterprise value: Market cap + market value of interest bearing debt cash
Measure of how cost of buying all shares of a firm and paying off the debt
o Enterprise Value Multiple: EV/EBITDA
Estimates value of a firms total business rather than just value of equity
Dividend ratios
o Dividend yield: dividend/stock price
Dividend a shareholder receives as a percentage of investment
o Payout ratio: dividends/net income
Percentage of net income paid out as dividends
Complement to payout ratio is retention ratio: (net income-
dividends)/dividends
Amount of net income that is retained in the firm

Dupont Identity (ROE Decomposition)
Return on Equity = Net Income/Equity . . . can be broken down into: (Net Income/Sales) x
(Sales/Assets) x (Assets/Equity)
o This is profit margin * total asset turnover * equity multiplier and is known as the DuPont
Identity
DuPont Identity means that ROE is affected by operating efficiency (profit margin), asset use
efficiency (Total asset turnover) and financial leverage (equity multiplier)
The Du Pont Identity tells us that ROE is affected by three things:
1. Operating efficiency (as measured by profit margin).
2. Asset use efficiency (as measured by total asset turnover).
3. Financial leverage (as measured by the equity multiplier).

Sources of Market-Based Information
Money markets short term investments and loans
o Interest rates need to reflect expected inflation so should be at least as much as inflation
rate
o Consumer price index how much overall prices have changed in the US
o Federal funds rate rate govt. targets when Fed Reserve adjusts interest rates
Capital markets

o Longer term assets/liabilities with maturities more than a year

o Includes stock market: major US indices are:
Dow Jones: average of 30 stocks of major companies (McDs, Dupont, Coke)
S&P 500 50 large companies provides broader measure of markets
Nasdaq smaller companies, usually tech, pharmaceutical, biotech, etc.
Indices indicate growth or decline within the particular type of companies listed on
it
Derivatives markets
o Derivative something whose value is derived from something else such as a stock option
(value is based on value of the actual stock)
o Two types of options put and call
Put right to sell an asset at a fixed price (value increases if stock goes down)
Call right to buy an asset as a fixed price (value increases as stock value goes up)

Chapter 3 - Financial Modeling

Important Concepts
Financial planning models use pro forma financial statements
Allows you to see where company will go in the future

Applications of Financial Models
Valuation (firms, securities, projects)
Restructuring
Justification for whether a change makes sense for a company
o If the company were to change its policy, what would it look like versus what it would look
like under its current plan
Planning

Outcome of Financial Modeling
Identification of how much financing the firm will need, when it will be needed, and where it will
come from
What problems are solvable and whether they are worth the costs of solving them

Short-Term Modeling Process
Estimate cash receipts
Estimate cash disbursements
Specify desired cash balance
Identify cash deficits/surpluses
Specify needed financing (if deficit) or short-term investment (if surplus)
Short term modeling with percentage of sales approach (items increase at same rate as sales)
o Separate income statement and balance sheet items into those that vary with sales and
those that do not and establish a sales forecast
o Income statement:
Project sales/costs: assume costs are the same percentage of sales as current year
Project dividend payment
o Balance sheet
Project sales, then project items that vary with sales (such as inventory) using
current percentage of sales

Capital intensity ratio is total assets/total sales and tells you amount needed
to generate $1 in sales. Therefore you can calculate how much total assets
need to increase based on sales forecast
Liabilities such as accounts payable will vary with sales, notes payable and
long term debt will not
For items that dont vary with sales, initially write in same amount as current year
Determine if there is a difference between projected assets and liabilities and if
external financing is needed.
Determine method of external financing to use and examine how chosen method
(long term borrowing, short term, new equity) may affect financial ratios

Long-Term Modeling Process
Forecast sales
Define relation between sales and other account balances
Specify dividend policy
o Dividend yield = dividend / stock price
o Percentage of Sales Approach
Dividend payout ratio = Cash dividends/Net income
Retention ratio = net income dividend / net income
Estimate external financing needed (EFN)
o Long-term company financial planning makes use of financial statements. External
financing needed (EFN) is a forecast of the external financing a company will need based on
sales forecasts, or the external financing a company will need to finance forecasted sales.
The formula to determine external financing needs (EFN) is:
EFN = ((assets/sales) X sales) - ((spontaneous liabilities/sales) X sales)
- (PM X projected sales X (1 - d)) . . . Where:
o sales = the projected change in sales in dollar amount.
o Spontaneous liabilities = liabilities that change with changes in
sales; listed on financial forms as accounts payable.
o PM = Profit margin ratio = net income/sales
o d = dividend payout ratio = cash dividends/net income
o Example: The most recent financial statements for a firm are as follows:
Income Statement


Balance Sheet
Sales

25,800
Assets 113,000
Debt
20,500
- Costs

16,500



+Equity
92,500
Taxable Income
9,3000
Total 113,000
Total
113,000
- Taxes (34%)
3,162
Net Income
6,138
o Assets and costs are proportional to sales. Debt and equity are not. A dividend of $1,841.40
was paid, and Martin wishes to maintain a constant payout ratio. Next years sales are
projected to be $30,960. What external financing is needed?
An increase of sales to $30,960 is an increase of:
Sales increase = ($30,960 25,800) / $25,800 = .20 or 20%
Assuming costs and assets increase proportionally, the pro forma financial
statements will look like this:
Pro forma income statement

Pro forma balance sheet
Sales
30,960.00
Assets 135,600
Debt 20,500.00
Costs
19,800.00



Equity 97,655.92
EBIT
11,160.00
Total 135,600
Total 118,155.92
Taxes (34%) 3,794.40

Net income 7,365.60

The payout ratio is constant, so the dividends paid this year is the payout ratio from
last year times net income, or:
Dividends = ($1,841.40 / $6,138)($7,365.60) = $2,209.68
The addition to retained earnings is:
Addition to retained earnings = $7,365 2,209.68 = $5,155.92
And the new equity balance is:
Equity = $92,500 + 5,155.92 = $97,655.92
So the EFN is:
EFN = Total assets Total liabilities and equity
EFN = $135,600 118,155.92 = $17,444.08

Sustainable Growth
Internal growth rate = ROA X b/1 ROA X b
Sustainable growth rate the maximum rate of growth a firm can maintain without
increasing its financial leverage (ROE x b/1 ROE x b)
o ROE = Net Income/Equity = (Net Income/Sales) x (Sales/Assets) x (Assets/Equity)
A firms ability to sustain growth depends explicitly on the following four factors:
1. Profit margin: an increase in profit margin will increase the firms ability to generate funds
internally and thereby increase its sustainable growth.
2. Dividend policy: A decrease in the percentage of net income paid out as dividends will
increase the retention ratio.
3. Financial policy: An increase in the debt-equity ratio increases the firms financial leverage.
4. Total asset turnover: An increase in the firms total asset turnover increases the sales
generated for each dollar in assets.
If a firm does not wish to sell new equity & its profit margin, dividend policy, financial policy, &
total asset turnover (or capital intensity) are all fixed, then there is only one possible growth rate.


Chapter 26 - Short-Term Finance and Planning

What types of questions fall under the general heading of short-term finance?
1. What is a reasonable level of cash to keep on hand (in a bank) to pay bills?
2. How much should the firm borrow in the short term?
3. How much credit should be extended to customers?

Tracing Cash and Net Working Capital
Net working capital = working capital management
o Basic balance sheet identity is:
Net working capital + Fixed assets = Long-term debt + Equity
Net working capital = (Cash + Other current assets) Current liabilities
Substitute net working capital into basic balance sheet identity and you get:
Cash = long-term debt + equity + current liabilities current assets
other than cash fixed assets
o This indicates that to increase cash you either increase liabilities (long term or short term
debt), increase equity, or decrease an asset (sell of inventory or building)
Activities that increase cash are called sources of cash
o Conversely, to decrease cash, decrease liabilities (pay off debt), decrease equity (buy back
stock), or increase an asset (purchase something)
Activities that decrease cash are called uses of cash

Activities That Increase Cash sources of cash

o Increasing long-term debt (borrowing over the long-term)
o Increasing equity (selling some stock)
o Increasing current liabilities (getting a 90-day loan)
o Decreasing current assets other than cash (selling some inventory for cash)
o Decreasing fixed assets (selling some property)
Activities That Decrease Cash uses of cash
o Decreasing long-term debt (paying off a long-term debt)
o Decreasing equity (repurchasing some stock)
o Decreasing current liabilities (paying off a 90-day loan)
o Increasing current assets other cash (buying some inventory for cash)
o Increasing fixed assets (buying some property)

The Operating Cycle and the Cash Cycle
Operating cycle is length of time it takes to acquire inventory, sell it, and collect for it. 2 parts:
o Inventory period the time it takes to acquire and sell the inventory.
o Accounts receivable period the time it takes to collect on the sale.
The cash cycle is the number of days that pass before we collect the cash from a sale, measure
from when we actually pay for the inventory (different from operating cycle because you may not
pay for purchase of inventory at the time you acquire it)
o Accounts payable period period of time between receiving inventory & paying for it
o Cash cycle = operating cycle accounts payable period
The cash flow time line presents the operating cycle and the cash cycle in graphical form.
o Inventory turnover = Cost of goods sold/Average inventory
o Inventory period = 365 days/Inventory turnover
o Receivables turnover = Credit sales/Average accounts receivable
o Receivables period = 365 days/Receivables turnover
o Operating cycle = Inventory period + Accounts receivable period
o Payables turnover = Cost of goods sold/Average payables
o Payables period = 365 days/Payables turnover
o Cash cycle = Operating cycle Accounts payable period

Some Aspects of Short-Term Financial Policy
The policy that a firm adopts for short-term finance will be composed of at least two elements:
1. The size of the firms investment in current assets: This is usually measured relative to the
firms level of total operating revenues.
2. The financing of current assets: measured as the proportion of short-term to long-term debt
Flexible short-term financial policies include:
1. Keeping large balances of cash and marketable securities.
2. Making large investments in inventory.
3. Granting liberal credit terms, which results in a high level of accounts receivables.
Restrictive short-term financial policies are:
1. Keeping low cash balances and no investment in marketable securities.
2. Making small investments in inventory.
3. Allowing no credit sales and no accounts receivable.
Costs that rise with the level of investment in current assets are called carrying costs.
Costs that fall with increases in the level of investment in current assets are called shortage costs.
o There are two kinds of shortage costs:
1. Trading, or order, costs: Order costs are the costs of placing an order for more cash
(brokerage costs) or more inventory (production setup costs).

2. Costs related to safety reserves: These are the costs of lost sales, lost customer
goodwill, and disruption of production schedules.
A growing firm can be thought of as having a permanent requirement for both current assets and
long-term assets. This total asset requirement will exhibit balances over time reflecting
1. a secular growth trend,
2. a seasonal variation around the trend, and
3. unpredictable day-to-day and month-to-month fluctuations.
Several considerations must be included in a proper analysis:
1. Cash reserves: flexible financing strategy implies surplus cash & little short-term borrowing.
2. Maturity hedging: Most firms finance inventories with short-term bank loans and fixed
assets with long-term financing.
3. Term structure: Short-term interest rates are normally lower than long-term interest rates.

Cash Budgeting
Financial manager can identify short-term financial needs and how much borrowing is needed
Cash outflow - cash disbursements are four basic categories
1. Payments of accounts payable: payments for goods or services, such as raw material.
2. Wages, taxes, and other expenses: This category includes all other normal costs of doing
business that require actual expenditures.
3. Capital expenditures: These are payments of cash for long-lived assets.
4. Long-term financing: This category includes interest and principal payments on long-term
outstanding debt and dividend payments to shareholders.

The Short-Term Financial Plan
Financing options include (1) unsecured bank balancing, (2) secured borrowing, (3) other sources.
A noncommitted line of credit is an informal arrangement that allows firms to borrow up to a
previously specified limit without going through the normal paperwork.
Committed lines of credit are formal legal arrangements and usually involve a commitment fee
paid by the firm to bank.
Compensating balances are deposits the firm keeps with the bank in low-interest or non-
interest-bearing accounts.
Under accounts receivable financing, receivables are either assigned or factored.
As the name implies, an inventory loan uses inventory as collateral. Some common types are:
1. Blanket inventory lien: The blanket inventory lien gives the lender a lien against all the
borrowers inventories.
2. Trust receipt: Under this arrangement, the borrower holds inventory in trust for the lender.
3. Field warehouse financing: In field warehouse financing, a public warehouse company
supervises the inventory for the lender.
Commercial paper consists of short-term notes issued by large, highly rated firms.
A bankers acceptance is an agreement by a bank to pay a sum of money.


Chapter 4 - Time Value of Money

Basic Valuation
0
1
2
t
Value
C1
Ct
Ct
PV = [C1/(1 + r)1] + [C2/(1 + r)2] + + [Ct/(1 + r)t]
PV = present
C = cash
r = required rate of
t = time
value
flow
return


Review from Accounting
Future value of a single amount
o Assume that you invest $100 today at 6%, how much will you have after 10 years?
100 X (1.06)10 = 179.08
Present value of a single amount
o Assume that you will need $120 four years from now and can invest at 5% (annual
compounding), how much must you invest today to reach your goal?
120/(1.05)4 = 98.72
Present value of an annuity
o Assume that you will need $100 one year from today and another $100 two years from
today. Assume you can invest at 10%. How much must you invest today to reach your goal?
(100/(1.10)1) + (100/(1.10)2) = 173.55
Compound Semiannually
o Assume that you will need $120 four years from now and can invest at 5% compounding
semiannually, how much must you invest today to reach your goal?
2.5% 8 periods
120/(1.025)8 = 98.49

Cash Flow Valuation
Value of Any Claim
o Present value of expected cash-flows from assets in place discounted at an appropriate
required return + value of strategic (real) options
Important Concepts
o Understand how the timing of cashflows affects value
o Determine the present and future value of various types of cashflows
Future Value (FV) or Compound Value
o The value that an amount of cash will grow to over a specific length of time at an
appropriate rate of return with an assumption of compounding interest that is reinvested
each year; the bracketed part is the future value interest factor
FVT = Co * (1 + r)T
T = time
C = cashflow amount
r = annual interest = required return
FV1 = 1,100 * (1.10)1 = 1,210
FV5 = 1,100 * (1.10)5 = 1,772
Example (one period): A firm is considering investing in a piece of land that costs
$85,000. They are certain that next year the land will be worth $91,000, a sure $6000
gain. Given that the guaranteed interest rate in the bank is 10%, should the firm
undertake the investment in the land?
At the interest rate of 10%, the $85,000 would grow to: (1 + .10) x $85,000 =
$93,000 next year. This would be $2500 more than the $91000 she would
gain from investing in the land. Therefore she should not invest in the land.
Example (multi-period): You put $500 in a savings account that earns 7%
compounded annually. How much will you earn in 3 years?
Interest on interest = $500 x 1.07 x 1.07 x 1.07 = $500 x (1.07)3 = $612.52
Example (finding the rate): You won $10,000 and you want to buy a car in five years.
The car will cost $16,105 at that time. What interest rate must you earn to be able to
afford the car?
The ratio of purchase price to initial cash is: $16,105/$10,000 = 1.6105.
Thus, you must earn an interest rate that allows $1 to become $1.6105 in five

years. $10,000 x (1 + r)5 = $16,105 where r is the interest rate needed to

purchase the car. Because $16,105/$10,000 = 1.6105, we have: (1 + r)5 =
1.6105 and r = 10%
Present Value of an Investment
o The value today of future cash-flows discounted at an appropriate rate of return
o PV = CT/(1 + r)T
C = cash flow at date 1
r = the required rate of return or discount rate
o Example: A firm is considering investing in a piece of land that costs $85,000. They are
certain that next year the land will be worth $91,000, a sure $6000 gain. Given that the
guaranteed interest rate in the bank is 10%, should the firm invest in the land?
Calculate the present value of the sale price next year as:
Present value = $91000/1.10 = $82727.27.
Because the present value of next years sales price is less than this years purchase
price of $85,000, present value analysis also indicates that she should not
recommend purchasing the land.
o Example: You will receive $10,000 three years from now. You can earn 8 percent on your
investments, so the appropriate discount rate is 8 percent. What is the present value of your
future cash flow?
PV = $10,000 x (1/1.08)3 = $10,000 x .7938 = $7,938
o Discounting = the process of calculating the present value of a future cash flow.
o Present value factor = the factor used to calculate the present value of a future cash flow
What is the exact cost or benefit of a decision?
o Net Present Value of an Investment = -Cost + PV
o NPV = PV of future cash flows minus present value of the cost of the investment
o Net present value of a cash flow = -C0 + (C1/(1 + r)) + (C2/(1 + r)2) + . . . + (CT/(1 + r)T)
Compounding Interest Rate
o Compounding an investment m times a year provides end-of-year wealth of: C0(1 + r/m)m
C0 is the initial investment
r is the stated interest rate (annual interest rate w/o considering compounding)
o Example: What is the end-of-year wealth if you receive a stated annual interest rate of 24
percent compounded monthly on a $1 investment?
$1(1 + .24/12)12 = $1 x (1.02)12 = $1.2682. The annual rate of return is 26.82
percent. Due to compounding, the annual interest rate is greater than the stated
annual interest rate of 24 percent.
o Future vale of compounding: FV = C0(1 + r/m)mT
Example: You are investing $5,000 at a stated interest rate of 12 percent per year,
compounded quarterly, for five years. What is your wealth at the end of five years?
$5,000 x (s + .12/4)4x5 = $5,000 x (1.03)20 = $5000 x 1.8061 = $9,030.50

Simplifications Four Cash Flow Steams
1. Perpetuity
o Series of cashflows of the same amount which continue for indefinite number of periods
o Constant stream of cash flow without end
o PV of Perpetuity = C1/r
C1 = cashflow one year from today
r = annual interest rate = required return
g = annual growth rate of the cashflow
o Example: An insurance company is trying to sell you an investment policy that will pay you
and your heirs $20,000 per year forever. If the required rate of return on this investment is 6.5

percent, how much will you pay for the policy? Suppose the policy costs $340,000; at what
interest rate would this be a fair deal?
This cash flow is = perpetuity. To find the PV of a perpetuity, we use the equation:
PV = C/r = $20,000/.065 = $307,692.31
To find the interest rate that equates the perpetuity cash flows with the PV of the
cash flows. Using the PV of a perpetuity equation:
PV = C / r $340,000 = $20,000 / r
We can now solve for the interest rate as follows:
r = $20,000 / $340,000 = .0588 or 5.88%
2. Growing Perpetuity
o Series of cashflows over an indefinite number of periods which increase each period by a
constant percentage
o PV of Growing Perpetuity = C1/(r g)
C1 = cashflow one year from today
r = annual interest rate = required return
g = annual growth rate of the cashflow
o Example: You expect the first annual cash flow on your technology to be $215,000, received 2
years from today. Subsequent annual cash flows will grow at 4 percent in perpetuity. What is
the present value of the technology if the discount rate is 10 percent?
This is a growing perpetuity. The present value of a growing perpetuity is:
PV = C / (r g)
PV = $215,000 / (.10 .04) = $3,583,333.33
It is important to recognize that when dealing with annuities or perpetuities, the
present value equation calculates the present value one period before the first
payment. In this case, since the first payment is in two years, we have calculated the
present value one year from now. To find the value today, we simply discount this
value as a lump sum. Doing so, we find the value of the cash flow stream today is:
PV = FV / (1 + r)t
PV = $3,583,333.33 / (1 + .10)1 = $3,257,575.76
3. Annuity
o Series of cashflows of the same amount for each of a fixed number of periods
o Example: An investment offers $4,300 per year for 15 years, with the first payment occurring
1 year from now. If the required return is 9%, what is the value of the investment? What
would the value be if payments occurred for 40 yrs? 75 yrs? Forever?
To find the PVA, we use the equation: PVA=C({1[1/(1+r)]t }/r)
PVA @ 15 yrs: PVA = $4,300{[1 (1/1.09)15 ]/.09} = $34,660.96
PVA @ 40 yrs: PVA = $4,300{[1 (1/1.09)40 ]/.09} = $46,256.65
PVA @ 75 yrs: PVA = $4,300{[1 (1/1.09)75 ]/.09} = $47,703.26
PV = C/r
PV = $4,300/.09 = $47,777.78
Notice that as the length of the annuity payments increases, the present value of the
annuity approaches the present value of the perpetuity.
The present value of the 75-year annuity and the present value of the perpetuity
imply that the value today of all perpetuity payments beyond 75 years = $74.51.
o Example: You are planning to save for retirement over the next 30 years. To do this you will
invest $700/month in a stock account and $300/month in a bond account. The return on
stock is expected to be 10%, and the bond account will pay 6%. When you retire, you will
combine your money into an account with an 8% return. How much can you withdraw each
month from your account assuming a 25-year withdrawal period?

We need to find the annuity payment in retirement. Our retirement savings ends at
the same time the retirement withdrawals begin, so the PV of the retirement
withdrawals will be the FV of the retirement savings. So, we find the FV of the stock
account and the FV of the bond account and add the two FVs.
Stock: FVA = $700[{[1 + (.10/12) ]360 1} / (.10/12)] = $1,582,341.55
Bond: FVA = $300[{[1 + (.06/12) ]360 1} / (.06/12)] = $301,354.51
Total saved at retirement is: $1,582,341.55 + 301,354.51 = $1,883,696.06
Solving for the withdrawal amount in retirement using the PVA equation gives us:
PVA = $1,883,696.06 = C[1 {1 / [1 + (.08/12)]300} / (.08/12)]
C = $1,883,696.06 / 129.5645 = $14,538.67 withdrawal per month
o Timing of Annuity Payments
Ordinary annuity (or annuity in arrears) = first of annual cash-flows occur one
period from now
Annuity due (or annuity in advance) = 1st of annual cashflow occurs immediately
Deferred annuity = annuity starting more than one year in the future
4. Growing Annuity
o Series of cash-flows for fixed number of periods which increase each period by a constant
percentage rather than infinite cash flows like growing perpetuity
o Example: Your job pays once per year. Today you received your salary of $60,000 and you
plan to spend all of it. However, you want to start saving for retirement beginning next year.
One year from today you will begin depositing 5% of your annual salary in an account that
will earn 9% per year. Your salary will increase at 4% per year throughout your career. How
much will you have on the date of your retirement 40 years from today?
Since your salary grows at 4 percent per year, your salary next year will be:
Next years salary = $60,000 (1 + .04) = $62,400
This means your deposit next year will be:
Next years deposit = $62,400(.05) = $3,120
Since salary grows at 4%, the deposit will also grow at 4%. We can use the PV of a
growing perpetuity equation to find the value of deposits today. Doing so, we find:
PV = C {[1/(r g)] [1/(r g)] [(1 + g)/(1 + r)]t}
PV = $3,120{[1/(.09 .04)] [1/(.09 .04)] [(1 + .04)/(1 + .09)]40}
PV = $52,861.98
Now, we can find the future value of this lump sum in 40 years. We find:
FV = PV(1 + r)t
FV = $52,861.98(1 + .09)40 = $1,660,364.12
This is the value of your savings in 40 years

Deferred Annuity Example
Example: Kevin wishes to retire 3 years from now. When he retires, he will require $100,000 per year for the
next 5 years to cover living expenses. The 1st $100,000 cashflow will occur at the end of his 1st year of
retirement. The other annual $100,000 cashflows will occur at the end of each subsequent year of his
retirement. He plans to fully deplete his personal savings by the end of his 5th year of retirement since his
pension will begin 5 years after he retires. Kevin expects an annual return of 15%. He plans to make 2
deposits into an investment account: $125,000 one year from now and $150,000 three years from now. Will
these investments be sufficient to meet his retirement goals?
Today 0 1
2 3
4
5
6
7
8

+125
+150 -100
-100 -100 -100
-100
Value of $125 from today: 125[1/1.151) = 108.7 At the end of year 3: 100[1 (1/1.155) / .15 = 335
Value today of $150: 150(1/1.153) = 98.6





3
335(1/(1.15) ) = - 220.4 . . . we dont have enough to cover this


Chapter 8 Interest Rates and Bond Valuation

Bond Features and Prices
When a corporation or government wishes to borrow money from the public on a long-term basis,
it usually does so by issuing or selling debt securities that are generically called bonds.
Bonds = promise by a borrower to pay specified interest payments and/or specified principal
amount at maturity (normally an interest-only loan).
o Example: a corporation wants to borrow $1,000 for 30 years and that the interest rate on
similar debt issued by similar corporations is 12 percent. the corporation thus pays .12
$1,000 = $120 in interest every year for 30 years. At the end of 30 years, the corporation
repays the $1,000.
The $120 regular interest payments that the corporation promises to make are
called the bonds coupons (the stated interest payments made on a bond).
Because the coupon is constant and paid every year, the type of bond we are
describing is sometimes called a level coupon bond.
The principal amount of a bond that is repaid at the end of the term is the bonds
face value or par value.
As in the example, this par value is usually $1,000 for corporate bonds, and a
bond that sells for its par value is called a par bond.
The annual coupon divided by the face value is called the coupon rate on the bond,
which is $120/1,000 = 12%; so the bond has a 12 percent coupon rate.
The number of years until the face value is paid is the bonds time to maturity.
A corporate bond would frequently have a maturity of 30 years when it is
originally issued, but this varies.
Once the bond has been issued, the number of years to maturity declines as
time goes by.

Bond Values and Yields
Value of a bond fluctuates
o Cash flows from a bond stay the same because the coupon rate and maturity date are
specified when it is issued.
o When interest rates rise, the present value of the bonds remaining cash flows declines, and
the bond is worthless; when interest rates fall, the bond is worth more.
To determine the value of a bond on a particular date, we need to know the number of periods
remaining until maturity, the face value, the coupon, and the market interest rate for bonds
with similar features.
o This interest rate required in the market on a bond is called the bonds yield to maturity
The market interest rate that equates a bonds present value of interest payments
and principal repayment with its price
Market-based required rate of return as determined by current market conditions
and bond's risk; the cost of the debt
Frequently, we know a bonds price, coupon rate, and maturity date, but not its YTM.
Example: suppose we were interested in a six-year, 8% coupon bond. A broker
quotes a price of $955.14. What is the yield on this bond?
o The price of a bond can be written as the sum of its annuity and lump-
sum components. With an $80 coupon for 6 years and a $1,000 face
value, this price is:
$955.14 = $80 (1 1/(1 + r)6)/r + $1,000/(1 + r)6 where r is the
unknown discount rate or yield to maturity.

o We have one equation and one unknown, but we cannot solve it for r
explicitly; so, we must use trial and error. Use what you know about
bond prices and yields:
The bond has an $80 coupon and is selling at a discount. We thus
know that the yield is greater than 8%.
o If we compute the price at 10%:
Bond value = $80 (1 1/1.106)/.10 + $1,000/1.106 = $80
(4.3553) + $1,000/1.7716 = $912.89
o At 10%, the value we calculate is lower than the actual price, so 10% is
too high. The true yield must be somewhere between 8% and 10%. Plug
and chug to find the answer.
Try 9%, which is, in fact, the bonds YTM.

The Present Value of a Bond = The Present Value of the Coupon Payments (an annuity) + The
Present Value of the Par Value or Face Amount (time value of money)
Example: A bank issues a bond with 10 years to maturity. The bank's bond has an annual coupon of $56.
Suppose similar bonds have a yield to maturity of 5.6 percent. Based on our previous discussion, the bank's
bond pays $56 per year for the next 10 years in coupon interest. In 10 years, the bank pays $1,000 to the
owner of the bond. What would this bond sell for?
Cash Flows
Year
0
1
2
3
4
5
6
7
8
9
10
Coupon

$56
$56
$56
$56
$56
$56
$56
$56
$56
$56
Face Value
-
-
-
-
-
-
-
-
-
-
$1000

$56 $56
$56
$56
$56
$56
$56
$56
$56
$56
$1056
The bank's bond's cash flows have an annuity component (the coupons) and a lump sum (the face value
paid at maturity). We thus estimate the market value of the bond by calculating the present value of these
two components separately and adding the results together.
First, at the going rate of 5.6%, the present value of the $1,000 paid in 10 years is:
PV = $1,000/1.05610 = $1,000/1.7244 = $579.91
Second, the bond offers $56 per year for 10 years, so the present value of this annuity stream is:
Annuity PV = $56 (1 1/1.05610)/.056 = $56 (1 1/1.7244)/.056 = $56 7.5016 = $420.09
We can now add the values for the two parts together to get the bonds value:
Total bond value = $579.91 + 420.09 = $1,000.00
If a bond has (1) a face value of F paid at maturity, (2) a coupon of C paid per period, (3) t periods to
maturity, and (4) a yield of r per period, its value is:
Bond value = C (1 1/(1 + r)t)/r + F/(1 + r)t

Three Ways to Sell a Bond

PAR
Discount
Premium
Price
Sold for face value
Sold for < face value
Sold for > face value
Investor Equals coupon rate
Higher return than coupon rate
Less return than coupon rate
Example Consider a bond selling Consider a bond selling in 2005 for
Consider a bond selling in 2005
for $10,000 with an
$10,000 with an annual coupon
for $10,000 with an annual
annual coupon
payment of $1,000. What is the
coupon payment of $1000.
payment of $1,000.
coupon rate? $1,000/$10,000 = 10% What is the coupon rate?
Similar types of bonds
$1,000/10,000 = 10%
are also offering
Suppose in 2006, the same bond

interest payments of
yields only 8% interest payments
Now suppose that in 2006, the
$1,000 a year. What is annually. What is the coupon
same bond yields an insane 15%
the coupon rate?
payment? 8% x 10,000 = $800/yr.
in interest payments annually.

$1,000/$10,000 =
10%. Since similar
bonds are also
offering a 10%
interest rate, this
bond is sold at the
original price of
$10,000 (at Par).

Which one would you prefer buying?
At 10% or 8% coupon rate? Since the
value of the bond (cash flows
produced) has depreciated from
$1000/yr to $800/yr, this bond will
have to be sold at a cheaper price
(or at DISCOUNT).

What is the coupon payment?

15% x 10,000 = $1500/yr.

Since the value of the bond has
appreciated from $1000/yr to
$1500/yr, this bond will have
to be sold at a PREMIUM price
(higher than its original value).

Semi-annual Bond Valuation
Example: In practice, bonds issued in Canada usually make coupon payments twice a year. So, if an
ordinary bond has a coupon rate of 8%, the owner gets a total of $80/year, but this $80 comes in 2
payments of $40 each. Suppose we were examining such a bond. The yield to maturity is quoted at
10%. Bond yields are quoted like APRs; the quoted rate is equal to the actual rate per period
multiplied by the number of periods. With a 10% quoted yield and semi-annual payments, the true
yield is 5% per 6 months. The bond matures in 7 years. What is the bonds price? What is the effective
annual yield on this bond?
o The bond would sell at a discount because it has a coupon rate of 4% every 6 months when
the market requires 5% every 6 months. So, if our answer exceeds $1,000, we know that
we made a mistake.
o To get the exact price, we calculate the present value of the bonds face value of $1,000 paid
in 7 years. This 7 years has 14 periods of 6 months each. At 5% per period, the value is:
Present value = $1,000/1.0514 = $1,000/1.9799 = $505.08
o The coupons can be viewed as a 14-period annuity of $40 per period. At a 5% discount rate,
the present value of such an annuity is:
Annuity present value = $40 (1 1/1.0514)/.05 = $40 (1 .5051)/.05 = $40
9.8980 = $395.92
o The total present value gives us what the bond should sell for:
Total present value = $505.08 + 395.92 = $901.00
o To calculate the effective yield on this bond, note that 5% every 6 months is equivalent to:
Effective annual rate = (1 + .05)2 1 = 10.25%
The effective yield, therefore, is 10.25%.

Bond Spread
Bid price = what a dealer is willing to pay
Asked price = what a dealer is willing to take for it
Difference between the two = bid-ask spread


Summary: Most bonds are issued at par with the coupon rate set equal to the prevailing market
yield or interest rate. This coupon rate does not change over time. The coupon yield, however, does
change and reflects the return the coupon represents based on current market prices for the bond.
The yield to maturity is the interest rate that equates the present value of the bonds coupons and
principal repayments with the current market price (i.e., the total annual return the purchaser would
receive if the bond were held to maturity). When interest rates rise, a bonds value declines. When
interest rates are above the bonds coupon rate, the bond sells at a discount. When interest rates fall,
bond values rise. Interest rates below the bonds coupon rate cause the bond to sell at a premium.

In-Class Example
Solve for Danaher bond prices
P0 = C[(1 - (1/(1 + r)T)/r] + FT/(1 + r)T
C = 5.625% x $1000 = $56.25
T = 7 years
F = $1000
r = 3.827%
1108.61 = 56.25[(1 - (1/(1 + 1.03827)7)/0.03827] +
1000/(1 + 1.03827)7
Danaher's bond price is 1108.61 or 110.86% of face value


Summary of Bond Valuation
I. FINDING THE VALUE OF A BOND:
II. FINDING THE YIELD ON A BOND:


Bond value = C (1 1/(1 + r)t)/r + F/(1 + r)t
Given a bond value, coupon, time to maturity,
C = the coupon paid each period
and face value, it is possible to find the implicit
r = the rate per period
discount rate or YTM by trial and error only. To
t = the number of periods
do this, try different discount rates until the
F = the bonds face value (always assume 1000) calculated bond value equals the given value.
Example: Youre looking at two bonds identical in every way except for their coupons and, of course, their
prices. Both have 12 years to maturity. The first bond has a 10% coupon rate and sells for $935.08. The
second has a 12% coupon rate. What do you think it would sell for?
Because the 2 bonds are similar, they are priced to yield about the same rate. Begin by calculating
the yield on the 10% coupon bond. A little trial and error reveals that the yield is actually 11%:
o Bond value = $100 (1 1/1.1112)/.11 + $1,000/1.1112 = $100 6.4924 + $1,000/3.4985 =
$649.24 + 285.84 = $935.08
With an 11% yield, the second bond sells at a premium because of its $120 coupon. Its value is:
o Bond value = $120 (1 1/1.1112)/.11 + $1,000/1.1112 = $120 6.4924 + $1,000/3.4985 =
$779.08 + 285.84 = $1,064.92

Using Excel to Solve the Price of a Bond Problem
Example: Suppose the settlement date of a bond you purchased is November 30, 2001; the maturity
date of the bond is December 31, 2028; the bond has a coupon rate of 6.25% and interest is paid
semi-annually; the face value of the bond is $1000; and actual days per month/year is used for the
day-count basis (not 30/360). Suppose investors currently want an 8.3% return for this type of bond.
What price should they be willing to pay?
o To use Excel, you will first go to the Function Wizard. The Function you are going to use is
in the function category of FINANCIAL and is PRICE.
o To use the PRICE function, you need to complete the following:
SETTLEMENT is the settlement date.
You have to type in DATE(2001, 11, 30)
Click the Tab key (not the <Enter> key).
This gives you the number of days from 1/1/1900.
MATURITY is the maturity date.
You have to type in DATE(2028, 12, 31). Click the Tab key.
This gives you the number of days from 1/1/1900.
RATE is the coupon rate.
You type in .0625. Click the Tab key.
YIELD is the desired yield to maturity (or current market rate of interest).
You type in .083. Click the Tab key.

REDEMPTION is the redemption value per $100 of value

You type in 100 since you will not be given more than $100 per $100 of face
value (even if the face value of the bond is $1000); click the Tab key.
FREQUENCY is how often interest is paid; 2 for semi-annual and 1 for annual.
You type in 2 (the default) since interest is paid semi-annually; click Tab key.
BASIS Type of day-count basis to use: 0 means 30/360, 1 is actual/actual, etc.
Type in 1; click the Tab key.
Click on FINISH
The answer is 78.02187. This means that investors are only willing to pay me
78.02 per 100. For a $1000 bond (multiply by 10), investors will only pay me
$780.22. Investors are only willing to pay about $780 for a bond with a
$1000 face value. Why? Because the coupon rate is below the desired yield to
maturity sought by investors.
o If you know the PRICE investors are willing to pay and want to calculate the desired Yield
to Maturity, go to the Function Wizard and use the YIELD function. Everything is the same
except, instead of (4) YIELD, you will see PR (PRICE). Type in the price per $100.
Thus, if investors are paying, say, $850 for a $1000 bond, you type in 85.

Zero-Coupon Bond
Most bonds pay interest semi-annually until maturity, when the bondholder receives the par value
of the bond back; zero coupon bonds pay no interest, but are sold at a discount to par value, which
is paid when the bond matures.
How do zero coupon bonds make money then if they don't pay interest?
o A zero coupon bond must be offered at a price that is much lower that its stated face value.
Investment dealers engage in bond stripping when they sell the principal and coupons separately.
Example: Suppose the DDB Company issues a $1,000 face value 5-year stripped (zero coupon)
bond. The initial price is set at $497. It is straightforward to check that, at this price, the bonds
yield 15% to maturity. The total interest paid over the life of the bond is $1,000 497 = $503.
For tax purposes, the issuer of a stripped bond deducts interest every year even though no
interest is actually paid; the owner must also pay taxes on interest accrued each year, even though
no interest is actually received, making zero-coupon bonds less attractive to taxable investors
Zero-coupon bonds are still a very attractive investment for tax-exempt investors with long-term
dollar-denominated liabilities because the future dollar value is known with relative certainty.
The most famous example of a zero-coupon bond: the US T-bill (or Treasury bill).

Inflation and Interest Rates
Real Rate of Interest
o Interest rates or rates of return that have been adjusted for inflation.
o This is the pure cost of money, assuming no change in purchasing power
o The percentage change in your buying power (how much you can buy with your dollars)
Nominal Rate of Interest
o Interest rates or rates of return that have not been adjusted for inflation.
o Percentage change in the number of dollars you have
o Increase or decrease in purchasing power
The Fisher Effect
o The relationship between nominal returns, real returns, and inflation.
o A rise in the rate of inflation causes the nominal rate to rise just enough so that the real rate
of interest is unaffected because people know that with inflation comes uncertainty about
what you money can buy; so, a demand in the increase of the nominal interest rate is
necessary to ensure purchasing power parity

1 + R = ( 1 + r ) x ( 1 + h)
R = nominal rate
r = real rate
h = expected inflation rate
Exact
R = r + h + rh
Approximation
R = r + h
o Example: We require a 10% real return & expect inflation to be 8%. Whats the nominal rate?
Exact
R = (1.1)(1.08) 1 = .188 = 18.8%
Approximation
R = 10% + 8% = 18%
Because the real return and expected inflation are relatively high, there is significant
difference between the actual Fisher Effect and the approximation.
o Example: If investors require a 10 percent real rate of return, and the inflation rate is 8
percent, what must be the approximate nominal rate? The exact nominal rate?
The nominal rate is approximately equal to the sum of the real rate and the inflation
rate: 10% + 8% = 18%.
From the Fisher effect, we have: 1 + R = (1 + r) (1 + h) = 1.10 1.08 = 1.1880
Therefore, the nominal rate will actually be closer to 19%.

Risk to Bondholders
Interest-Rate (Maturity) Risk
o Sensitivity of bond prices to changes in market interest rates
o Amount of interest-rate risk is affected by: time to maturity and coupon rate
Default Risk
o Corporate bonds have default risk which is why you have higher returns
o Government bonds do NOT have default risk but this is correlated in the yield to maturity
which is usually low
Reinvestment Rate Risk
o Uncertainty concerning rates at which cash flows can be reinvested
o Short-term bonds have more reinvestment rate risk than long-term bonds
o Cash flows may be reinvested in the future at lower interest rates
o Long-Term Bonds: higher price risk, lower reinvestment rate risk
o Short-Term Bonds: lower price risk, higher reinvestment rate risk
Liquidity Risk
o Investors prefer liquid assets to illiquid ones, so they demand a liquidity premium on top of
all the other premiums we have discussed.
o A liquidity premium is the portion of a nominal interest rate or bond yield that represents
compensation for lack of liquidity.
o As a result, all else being the same, less liquid bonds will have higher yields than more
liquid bonds; more liquid bonds will generally have lower required returns
o Anything else that affects the risk of the cash flows to the bondholders, will affect the
required returns
Expropriation (Agency) Risk
o Legal implications that may impact receiving receipts from bond
o Based on conflict of interest between stockholders and bondholders
o Managers (agents of stockholders) may take actions that benefit stockholders at the
expense of bondholders


Interest Rate Risk
Interest rate risk = the risk that arises for bond owners from fluctuating interest rates (market
yields); how much interest risk a bond has depends on how sensitive its price is to interest rate
changes; this sensitivity depends on 2 things: 1) the time to maturity and 2) the coupon rate.
Keep the following in mind when looking at a bond:
1. All other things being equal, the longer time to maturity, the greater the interest rate risk.
Longer-term bonds have greater interest rate sensitivity.
A large portion of a bonds value comes from the $1,000 face amount.
: Valuation of Future Cash Flows
The present value of this amount isnt greatly affected by a small change in interest
rates if it is to be received in one year.
If
it is to
be received in 30 years, even a small change in the interest rate can have a
Interest
Rate
Risk
ffect oowners
nce it ifrom
s compounded
30 years.
The risk thatsignificant
arises for ebond
fluctuatingfor
interest
rates (market yields) is called

The
p
resent
v
alue
o
f
t
he
f
ace
a
mount
b
ecomes
m
uch
more
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ith a is
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itswprice
to
bond
as sensitivity
a result. directly depends on two things: the time to maturity and
interest rate term
changes.
This
the
rate.
Keepbthe
following
inlower
mind twhen
looking
at athe
bond:
2. coupon
All other
things
eing
equal, the
he coupon
rate,
greater the interest rate risk.
Bonds
with lequal,
ower the
coupons
ave time
greater
interest the
rate
risk. the interest rate risk.
1. All other
things being
longerhthe
to maturity,
greater

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o
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ond
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epends
o
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resent
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o
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i
ts
coupons
and
the
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2. All other things being equal, the lower the coupon rate, the greater the
interest
rate
risk.
value of the face amount.
We illustrate the first of these two points in Figure 7.2. As shown, we compute and plot
If two bonds with different coupon rates have the same maturity, the value of the
prices under different interest rate scenarios for 10 percent coupon bonds with maturities of
with tNotice
he lower
is of
proportionately
more
dependent
on the
face afor
mount
one year andone
30 years.
howcoupon
the slope
the line connecting
the
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steeper
1
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b
e
r
eceived
a
t
m
aturity;
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s
a

r
esult,
a
ll
o
ther
t
hings
b
eing
e
qual,
i
ts
v
alue
the 30-year maturity than it is for the one-year maturity. This tells us that a relatively small
fluctuates
ore alead
s interest
rates change.
in the bonds value. In comparison,
change in interest
ratesm
could
to a substantial
change
the one-year
bonds
price
is
relatively
insensitive
to
interest
rate
changes.
The bond with the higher coupon has a larger
cash
flow early in its life, so its value is
less sensitive to changes in the discount rate.
e 7.2
Value of a Bond with a 10% Coupon Rate for Different Interest Rates and Maturities
te risk and

aturity

Bond
values

$2,000
$1,768.62

30-year bond

$1,500

$1,000

$1,047.62

1-year bond

$916.67
$502.11

$500

5%

10%

15%

Interest
rates

20%

Time to Maturity
Value of a Bond with a 10% Coupon Rate for Different Interest Rates and Maturities
Interest Rate
1 Year
30 Years
5%
$1,047.62
$1,768.62
Time to Maturity
10%
$1,000.00
$1,000.00
Interest Rate
1 Year
30 Years
15%
$956.52
$671.70
5%
$1,047.62
$1,768.62
20%
$916.67
$502.11
10%
1,000.00
1,000.00
956.52
671.70
This table shows prices u15%
nder different interest rate
scenarios for 10% coupon
bonds with maturities of
20%

916.67

502.11

1 year & 30 years. Notice how the slope of the line connecting the prices is much steeper for the 30-year
maturity than it is for the 1-year maturity. A small change in interest rates could lead to a substantial
change in the bonds value, but the 1-year bonds price is relatively insensitive to interest rate changes.


Duration Statistic
Measures rate of change in bond price caused by a change in interest rates
Most widely used duration statistics: Macaulay Duration and Modified Duration
Any coupon bond is actually a combination of pure discount bonds. Example, a five-year, 10 percent coupon
bond, with a face value of $100, is made up of five pure discount bonds:
1. A pure discount bond paying $10 at the end of Year 1.
2. A pure discount bond paying $10 at the end of Year 2.
3. A pure discount bond paying $10 at the end of Year 3.
4. A pure discount bond paying $10 at the end of Year 4.
5. A pure discount bond paying $110 at the end of Year 5.
Because the price volatility of a pure discount bond is determined only by its maturity, we would like to
determine the average maturity of the 5 pure discount bonds that make up a 5-year coupon bond. This leads
us to the concept of duration. We calculate average maturity in 3 steps for the 10% coupon bond:
1. Calculate present value of each payment using the bonds yield to maturity.
Year
Payment
Present Value of Payment by Discounting at 10%
1
$10
9.091
2
$10
8.264
3
$10
7.513
4
$10
6.830
5
$110
68.302
Total

$100.000
2. Express PV of each payment in relative terms by calculating the relative value of a single
payment as the ratio of the PV of the payment to the value of the bond (which is $100). The
bulk of the relative value, 68.302%, occurs at Date 5 when the principal is paid back.
Year
Payment Present Value of Payment Relative Value = PV of Payment Value of Bond
1
$10
9.091
$9.091/$100 = 0.09091
2
$10
8.264
8.264/$100 = 0.08264
3
$10
7.513
7.513/$100 = 0.07513
4
$10
6.830
6.830/$100 = 0.0683
5
$110
68.302
68.302/$100 = 0.68302
Total

$100.000
$100.000/$100 = 1.00000
3. Weigh the maturity of each payment by its relative value.
1 year 0.09091 + 2 years 0.08264 + 3 years 0.07513 + 4 years 0.06830 + 5 years 0.68302 = 4.1699
years = the effective maturity of the bond (duration)
Duration is an average of the maturity of the bonds cash flows, weighted by the present value of each
cash flow. The duration of a bond is a function of the current interest rate. A 5-year, 1% coupon bond has
a duration of 4.8742 years. Because the 1% coupon bond has a higher duration than the 10% bond, the
1% coupon bond should be subject to greater price fluctuations. The 1% coupon bond receives only $1 in
each of the first 4 years. Thus, the weights applied to Years 1 through 4 in the duration formula will be
low. Conversely, the 10% coupon bond receives $10 in each of the first 4 years. The weights applied to
Years 1 through 4 in the duration formula will be higher. In general, the percentage price changes of a
bond with high duration are greater than the percentage price changes for a bond with low duration.

Bond Ratings Investment Quality

Bond ratings are based largely on analyses of five groups of financial ratios:
1. Coverage - Measures of earnings to fixed costs, such as times interest earned and fixed-charge
coverage; low or declining figures signal possible difficulties.
2. Liquidity - Measure of ability to pay amounts coming due, such as current and quick ratios.
3. Profitability - Measures rates of return on assets and equity; higher profitability reduces risks.
4. Leverage - Measures debt relative to equity; excess debt suggests difficulty in paying obligations.
5. Cash flow to debt - Measures cash generation to liabilities.

Contractual Characteristics of Long-Term Bonds
Call Option
o Gives corporation the option to repurchase the bond at a specified price before maturity
o Corporate bonds are usually callable.
o Call provisions may have tax advantages to both bondholders and the company if the
bondholder is taxed at a lower rate than the company.
Because the coupons are a deductible interest expense to the corporation, if the
corporate tax rate is higher than that of the individual holder, the corporation gains
more in interest savings than the bond-holders lose in extra taxes.
o Callable bonds have higher rates than non-callable bonds.
Generally, the call price is more than the bonds stated value (that is, the par value).
o The difference between the call price and the stated value is the call premium.
The call premium may also be expressed as a percentage of the bonds face value.
The amount of the call premium usually becomes smaller over time.
Protective Covenant
o A protective covenant is that part of the indenture or loan agreement that limits certain
actions a company might otherwise wish to take during the term of the loan.
o Covenants are designed to reduce the agency costs faced by bondholders.
o By controlling company activities, protective covenants reduce the risk of the bonds.
o Two types: negative covenants and positive (or affirmative) covenants.
A negative covenant is a thou shalt notlimits or prohibits actions that the
company may take.
A positive covenant is a thou shaltit specifies an action that the company agrees
to take or a condition the company must abide by.
Seniority (Priority)
o Preference in position over other lenders; some debt is subordinated.
o In the event of default, holders of subordinated debt must give preference to other
specified creditors, meaning the subordinated lenders are paid off from cash flow and asset
sales only after the specified creditors have been compensated

o Debt cannot be subordinated to equity.

Security (Collateral)
o Debt securities classified by the collateral & mortgages used to protect the bondholder
Collateral is a general term that, strictly speaking, means securities (for example,
bonds and stocks) pledged as security for payment of debt.
o Bonds frequently represent unsecured obligations of the company.
A debenture is an unsecured bond, where no specific pledge of property is made.
Sinking Fund
o Bonds can be repaid at maturity, at which time the bondholder receives the stated or face
value of the bonds, or they may be repaid in part or in entirety before maturity.
o Early repayment in some form is more typical and is often handled through a sinking fund
(an account managed by the bond trustee for the purpose of repaying the bonds0
o From an investors viewpoint, a sinking fund reduces the risk that the company will be
unable to repay the principal at maturity.
o Since it involves regular purchases, a sinking fund improves the marketability of the bonds.
Conversion Option
o A convertible bond can be swapped for a fixed number of shares of stock anytime before
maturity at the holders option.
Put Option
o A put bond allows the holder to force the issuer to buy the bond back at a stated price.
o As long as the issuer remains solvent, the put feature sets a floor price for the bond.
o The reverse of the call provision.

Tax Treatment of Interest on Corporate Debt
Tax deductible to issuer
Taxable to all investors

Government Bonds
Treasury Securities
Federal government debt
T-bills pure discount bonds with original maturity of one year or less
T-notes coupon debt with original maturity between one and ten years
T-bonds coupon debt with original maturity greater than ten years

Municipal Securities
Debt of state and local governments
Varying degrees of default risk, rated similar to corporate debt
Interest received is tax-exempt at the federal level
o Example: A taxable bond has a yield of 8% and a municipal bond has a yield of 6%. If you are
in a 40% tax bracket, which bond do you prefer?
8%(1 - .4) = 4.8%
o The after-tax return on the corporate bond is 4.8%, compared to a 6% return on the
municipal. At what tax rate would you be indifferent between the two bonds?
8%(1T)=6% . . . T = 25%

Chapter 9 - Stock Valuation NOT ON TEST

The Present Value of Common Stocks
Common stock represents equity, an ownership position, in a corporation.
Important characteristics of common stock:
1. Residual claim: common stockholders have claim to firms cash flows and assets after all
obligations to creditors and preferred stockholders are met
2. Limited liability: common stockholders may lose their investments, but no more
3. Voting rights: Common stockholders are entitled to vote for the board of directors and on
other matters.
As compared with bond valuation, stock valuation is more complex because:
1. The future cash flows are not certain. In case of bonds we have certain payments but in
case of common stock, the dividends are not predictable.
2. The investment has no maturity.
3. The rate of return cannot be easily determined.
Like bond valuation, stock valuation centers around the time value concept of future cash flows
With bonds, future cash flows were coupon payments; with common stock, these are dividends
The value of shares of common stock, like any other financial instrument, is often understood as
the present value of expected future returns.
Common stocks do not have a fixed maturity; their cash payments consist of an indefinite stream
of dividends.

Techniques of Common Stock Valuation
Discounted Cashflow (DCF)
Method of Comparable (Use of Multiples)

Discounted Cashflow Valuation
Free Cashflow Models
o Operating Cash Flow - Capital Expenditures
Dividend Discount Models (DDM)
o A stock can be valued by discounting its dividends
o Make one of three simplifying assumptions about pattern of future dividends
Zero Growth
Constant Growth
g = Growth Rate in Dividends
Div0 = Dividend Just Paid
Div1 = Dividend to be Paid in 1 Period
Div1 = Div0(1 + g)
Example: If a dividend is $2 today (D0) and the expected growth rate is 5%,
then D5 = D0 x (1.05)5 = $2 x 1.276 =$2.55
Non-Constant Dividend Growth
Dividends grow at varying rates and then ultimately grow at a constant or
zero rate at a specific point in the future

Three Types of Dividend Discounting Models
Zero Growth
o If a firm does not grow at all, meaning that all earnings are paid out as dividends, the
expected return is also equal to the earnings per share divided by the share price
Price = P0 = Div1/r = EPS1/r
This just an application of the perpetuity formula

 

Constant Growth
o It may be reasonable to assume that the dividends of a mature company will grow at a
you can changeconstant
the formula
using given
rate, g, forever
o If the cash
ds and price calculating
theflows
pricegrow
P0: at a constant rate forever, this is simply a growing perpetuity
o As long as g < r, the present value at the rate r of dividends growing at the rate g is:
= P0 = Div/r - g
Price

g = the growth rate in dividends (capital gains yield)

  
r = the required return on the stock
o The constant growth stock equation can be rearranged to obtain an expression for the
expected
return
the need
stock ato
s follows:
tailed calculation of
the Price
Po0 n we
Expected return = r = Div1/P0 + g
ure stock prices and dividends:
The expected return = the dividend yield (DIV1/P0) + the dividend growth rate
o The hard part is to estimate g, the expected rate of dividend growth.

 next year = earnings this year + retained earnings x return on

  
 Earnings
retained

earnings
1 + g = 1 + retention ratio (ratio of retained earnings to earnings) x ROE
With these to formulas we can define the dividend growth rate (g) as:
osophy is just a method of discounting
the rate = g = RR x ROE
Dividend growth
o get the present value and that present
o ROE value
= Net Income/Equity = (Net Income/Sales) x (Sales/Assets) x
(Assets/Equity)
he intrinsic value of the stock. This
model
o
Retention
s far in the future as we want. If we call the Ratio = 1- Payout Ratio
Payout Ratio = Dividends/Earnings
et a general
formula
to
calculate
P
:
0
Differential Growth
o Assume that dividends will grow at different rates in the foreseeable future and then will

grow at a constant rate thereafter

o
To value
a Differential
Growth Stock, we need to:


estimate
future
dividends in the foreseeable future

estimate the future stock price when the stock becomes a constant growth stock
compute the total present value of the estimated future dividends and stock price at
do not expire of old age,
H could
be rate
the period
appropriate
discount
o A Differential
Growth
Example
The value of shares
of common
stock,
like
r = 12% (investors required return)
instrument, is often understood as the present
g1 = g2 = g3 = 8%; g4 = g5 = ... = 4%
uture returns. The value
of0 =a $stock
is equal to
D
2
payments discounted at the
return
that
D1 =rate
$2 x 1of
.08
= $2.16,
D2 = $2.33, D3 = $2.52

Imagine
t
hat
y
ou
a
re
a
t t=3 looking forward
receive on other securities with equivalent
D4 = $2.52
.04 = $2.62
cks do not have a fixed maturity;
theirx 1cash
P3 = $2.62 / (.12 - .04) = $32.75
of an indefinite stream
of dividends.
P0 = 2.16/1.12 + 2.33/1.122 + 35.27/1.123 = $28.89
ent value
of a common stock is
Calculating the Present Value of a Common Stock Investment

The price of a share of common stock to the investor is equal to the

present value of all the expected future dividends

  
Div = the dividend paid at years end

R = the appropriate discount rate for the stock

Growth Rate of Dividends
An estimate of the growth rate of dividends is needed for the dividend discount model
o Estimate of the growth rate is g = Retention Ratio x Return on Retained Earnings (ROE)

o As long as the firm holds its ratio of dividends to earnings constant, g represents the
growth rate of both dividends and earnings
The price of a share of stock can be viewed as the sum of its price (under the assumption that the
firm is a "cash cow") plus the per share value of the firm's growth opportunities.
o A company is termed a cash cow if it pays out all of its earnings as dividends.
o The formula for the value of a share is = EPS/R + NPVGO
EPS = Div (where EPS is earnings per share and Div is dividends per share)
The NPVGO is the NPV of the investments that the firm will make in order to grow.
Net present value of growth opportunities = NPVGO = NPV1/r-g
Negative NPV projects lower the value of the firm.
o Projects with rate of returns below discount rate have a negative NPV.
Example: A shipping corporation expects to earn $1 million per year in perpetuity if it undertakes no
new investment opportunities. There are 100,000 shares of stock outstanding, so earnings per share
equal $10 ($1,000,000/100,000). The firm will have an opportunity at date 1 to subsequent period by
$210,000 (for $2.10 per share). This is a 21% return per year on the project. The firm's discount rate
is 10%. What is the value per share before and after deciding to accept the marketing campaign?
o The value of a share of the company before the campaign (when firm acts as a cash cow):
EPS/R = $10/.1 = $100
o The value of the marketing campaign as of date 1 is:
-$1,000,000 + $210,000/.1 = $1,100,000
o Because the investment is made at date 1 and the first cash inflow occurs at date 2. We
determine the value at date 0 by discounting back one period as follows:
$1,100,000/1.1 = $1,000,000
o Thus, NPVGO per share is $10($1,000,000/100,000); the price per share is:
EPS/R + NPVGO = $100 + $10 = $110

Growth in Earnings
Both the earnings and dividends of a firm will grow as long as the firm's projects have positive
rates of return.
Earnings are divided into two parts: dividends and retained earnings
Most firms continually retain earnings in order to create future dividends
Do not discount earnings to obtain price per share since part of the earnings must be reinvested
Only dividends reach the stockholders and only they should be discounted to obtain share price.
Two conditions must be met in order to increase value
o Earnings must be retained so that projects can be funded
o The projects must have positive net present value
Example: A new firm will earn $100,000 a year in perpetuity if it pays out all its dividends. However,
the firm plans to invest 20% of its earnings in projects that earn 10% per year. The discount rate is
18%. Does the firms investment policy lead to an increase or decrease in the vale of the firm?
o The policy reduces value because the rate of return on future projects of 10% is less than
the discount rate of 18%. In other words, the firm will be investing in negative NPV
projects, implying that the firm would have had a higher value at date 0 if it simply paid all
of its earnings out as dividends.
o Is the firm growing? Yes, the firm will grow over time, either in terms of earnings or in
terms of dividends. The annual growth rate of earnings is:
g = retention rate x return on retained earnings = .2 x .10 = 2%
Since earnings in the first year will be $100,000, earnings in the second year
will be $100,000 x 1.02 = $102,000, earnings in the third year will be
$100,000 x (1.02)2 = $104,040 and so on.

Because dividends are a constant proportion of earnings, dividends must

grow at 2% per year as well.
o Since the firms retention ratio is 20%, dividends are (1 20%) = 80%
of earnings. In the 1st year of the new policy, dividends will be (1 2)
x $100,000 = $80,000. Dividends next year will be $80,000 x 1.02 =
$81,600. Dividends the following year will be $80,000 x (1.02)2 =
$83,232 and so on.
o In conclusion, the firms policy of investing in negative NPV projects produces 2 outcomes.
First, the policy reduces the value of the firm.
Second, the policy creates growth in both earnings and dividends.
o In other words, the firms policy growth actually destroys firm value.
o Under what conditions would the firms earnings and dividends actually fall over time?
Earnings and dividends would fall over time only if the firm invested in projects with
negative rates of return.

Price-Earnings Ratio
The earnings-price ratio = EPS1/P0 = r x [1 - (NPVGO/P0)]
Companies with significant growth opportunities are likely to have high PE ratios
Low -risk stocks are likely to have high PE ratios
Firms following conservative accounting practices will likely have high PE ratios
A firm's price-earnings ratio is a function of 3 factors
1. The per-share amount of the firm's valuable growth opportunities
2. The risk of the stock
3. The type of accounting method used by the firm


Chapter 10 - Risk and Return

Dollar Returns
There are 2 components to a return on your investment
o Income component = the dividend you receive
o Capital gain (or loss) = part of the return required to maintain investment of the company
Example: You purchased 100 shares of stock at the beginning of the year at a price of $37 per share.
Your total investment then was: C0 - $37 x 100 - $3,700
o Suppose that over the year the stock paid a dividend of $1.85 per share. During the year,
then, you received income of:
Dividend = $1.85 x 100 = 185
o At the end of the year the market price of the stock is $40.33 per share. Because the stock
increased in price, you had a capital gain of:
Capital Gain = ($40.33 - $37) x 100 = $333
If the price of the company's stock had dropped in value to $34.78:
Capital Loss = ($34.78 - $37) x 100 = -$222
o The total dollar return on your investment is the sum of the dividend income and the
capital gain or loss on the investment:
Total dollar return = Dividend income + Capital gain (or loss)
The total dollar return of the initial example is:
Total dollar return = $185 + $333 = $518
o If you sold the stock at the end of the year, your total amount of each would be the initial
investment plus the total dollar return. In this example you would have:
Total cash if stock is sold = initial investment + total dollar return

Total cash if stock is sold = 3,700 + $518 = $4,218

This is the same as the proceeds from the sale of stock plus the dividends
Stock Proceeds + Dividends = $40.33 x 100 + $185 = $4,033 + $185 = $4,218

Percentage Returns
Example: You purchased 100 shares of stock at the beginning of the year at a price of $37 per share.
The dividend paid during the year on each share was $1.85.
o The percentage income return (dividend yield) is:
Dividend yield = Divt + 1 / Pt = $1.85/$37 = .05 = 5%
o The capital gain (or loss) is the change in the price of the stock divided by the initial price
Letting Pt + 1 be the price of the stock at year-end, we can compute the capital
gain as follows: Capital Gain = (Pt + 1 - Pt) / -Pt
Capital Gain = ($40.33 - $37) / $37 = $3.33 / $37 = .09 = 9%
o Combining these two results, we find that the total return on the investment in the
company's stock over the year, which is labeled Rt+1, was:
Rt + 1 = Divt + 1 / Pt + (Pt + 1 - Pt) / Pt = 5% + 9% = 14%

Holding Period Returns
Average compound return per year over a particular period = (1 + R1) x (1 + R2)...(1 + Rt)
o Rt is the return in year t (expressed in decimals); the value you would have at the end
of year T is the product of 1 plus the return in each of the years
Example: if the returns were 11%, -5%, and 9% in a 3-year period, an investment of $1 at the
beginning of the period would be worth:
o (1 + R1) x (1 + R2) x (1 + R3) = ($1 + 0.11) x ($1 - 0.05) x ($1 + 0.09) = $1.11 x $.95 x $1.09
= $1.15 15% is the total return at the end of 3 years, including the return from
reinvesting the first year dividends in the stock market for 2 more years and reinvesting
the 2nd year dividends for the final year

Average Stock Returns and Risk-Free Returns
Excess return on the risky asset = the difference between risky returns and risk-free returns
Equity risk premium = the average excess return on common stocks; the additional return from
bearing risk

Risk Statistics
Risk = uncertainty that actual return will differ from expected (pro forma or forecasted) return
Standard deviation = measures the dispersion of potential returns about the expected return;
measure of total risk
Variance = most common measure of variability or dispersion
o Example: The return on common stocks are (in decimals) .1370, .3580, .4514, and -.0888,
respectively. The variance of the sample is computed as follows:
Variance = (1 / T-1) x [(individual return1 - average return)2 + (individual
return2 - average return)2 + (individual return3 - average return)2 +
(individual return4 - average return)2]
Variance = .0582 = (1 / 3) x [(.1370 - .2144)2 + (.3580 - .2144)2 + (.4514 -
.2144)2 + (-.0888 - .2144)2]
standard deviation = the square root of .0582 = .2412 or 24.12%
Sharpe Ratio = Return to Level of Risk Taken = Risk Premium of Asset / Standard Deviation
o Example: The Sharpe ratio is the average equity risk premium over a period of the time
divided by the standard deviation. From 1926 to 2008, the average risk premium for large-

company sticks was 7.9% while the standard deviation was 20.6%. The Sharpe ratio of this
sample is computed as:
Sharpe ratio = 7.9% / 20.6% = .383
o The Sharpe ratio is sometimes referred to as the reward-to-risk ratio where the reward is
the average excess return and the risk is the standard deviation

Arithmetic Versus Geometric Averages
Geometric average return answers the question: "what was your average compound return per
year over a particular period?"
o Tells you what you actually earned per year on average, compounded annually
o Useful in describing historical investment experience
o Example: Suppose a particular investment had annual returns of 10%, 12%, 3%, and -9%
over the last 4 years. The geometric average return over this 4 year period is calculated as:
o Geometric average return = [(1 + R1) x (1 + R2) x . . . x (1 + RT)]1/T - 1
o Geometric average return = (1.10 x 1.12 x 1.03 x .91)1/4 - 1 = 3.66%
o Four steps to this formula:
1. Take each of the T annual returns R1, R2, . . . , RT and add 1 to each (after
converting them to decimals)
2. Multiply all the numbers from step 1 together
3. Take the result from step 2 and raise it to the power of 1/T
4. Subtract 1 from the result of Step 3; the result is the geometric average return
Arithmetic average return answers the question: "what was your return in an average year over
a particular period?"
o Your earnings in a typical year; an unbiased estimate of the true mean of the distribution
o Useful in making estimates for the future
o Example: suppose a particular investment had annual returns of 10%, 12%, 3%, and -9%
over the last 4 years. The average arithmetic return is (.10 + .12 + .03 - .09)/4 = 4.0%


Chapter 11 The Capital Asset Pricing Model

Expected Return and Variance
State of the
Rate of Return
Deviation from Expectation Return
Squared Value of
Economy
Deviation

Supertech Slowpoke Supertech: Expected Slowpoke:
Supertech Slowpoke
Returns
Returns
Return = 0.175
Expected Return =
(RAt)
(RBt)
0.055
Depression
-.20
.05
-.20 - .175 = -.375
.05 - .055 = -.005 -3752 =
-.0052 =
.140625
.000025
Recession
.10
.20
10 - .175 = -.075
.20 - .055 = .145
-.0752 =
.1452 =
.005625
.021025
2
Normal
.30
-.12
.30 - .175 = .125
-.12 - .055 = -.175 .125 =
-.1752 =
.015625
.030625
2
Boom
.50
.09
.50 - .175 = .325
.09 - .055 = .035
.325 =
.0352 =
.105625
.001225
Step 1 Calculate the expected return
Supertech Example: (-.20 + .10 + .30 = .50)/4 = .175 = 17.5%
Slowpoke Example: (.05 + .20 - .12 + .09)/4 = .055 = 5.5%
Step 2 For each company, calculate the deviation of each possible return from the companys expected
return given previously

Step 3
Step 4

Multiply each deviation by itself to make it positive

Calculate the variance . . . Variance = the expected value of (the securitys actual return
the securitys expected return)2
Step 5 Calculate the standard deviation by taking the square root of the variance
Calculating Covariance and Correlation
Product of the deviations = (the return of company A in the specific state of the economy the expected
return on security A) x (the return of company B in the specific state of the economy the expected
return on security B)
Calculate the average value of the four states. This average is the covariance. If the two returns are
positively related to each other, the covariance will be positive. If they are negatively related to each
other, the covariance will be negative. If they are unrelated, the covariance should be zero.
To calculate the correlation, divide the covariance by the standard deviation of both of the two securities.

Individual Securities
Expected return
o Return that an individual expects a stock to earn over the next period
Variance and standard deviation
o Way to assess the volatility of a security's return
Covariance and correlation
o Returns on individual securities are related to one another
o Covariance = statistic measuring the interrelationship between two securities
Positive correlation
o Stocks move in line with one another
Perfect Negative Correlation
o Stocks move opposite of each other
Zero Correlation
o Return on security A is completely unrelated to the return on security B
Return and Risk for Portfolios
o Portfolio theory analyzes investors asset demand given asset returns.
o Portfolio risk depends on risk of individual assets and the correlation of returns between
the pairs of assets in the portfolio
o The market portfolio is the portfolio of all risky assets traded in the market.
o Consider:
The relationship between the expected returns on individual securities and the
expected return on a portfolio made up of these securities
The relationship between the standard deviations of individual securities, the
correlation between these securities, and the standard deviation of a portfolio made
up of these securities
Expected return on portfolio
o The expected return on a portfolio is a weighted average of the expected returns on the
individual securities
o Example: The expected returns on 2 securities are 17.5% and 5.5%. The expected return on a
portfolio of these two securities alone can be written as:
Expected return on portfolio = (percentage of the portfolio in company A x 17.5%) +
(percentage of portfolio in company B x 5.5%)
o If an investor with $100 invests $60 in company A and $40 in company B, the expected
return on the portfolio can be written as:
Expected return on portfolio = .6 x 17.5% + .4 x 5.5% = 12.7%
Effect of Diversification
o Portfolio risk reduced by combining assets that are less than perfectly positively correlated


Portfolio Variance
Portfolio variance formula: p =
The term in the upper left
WAA + WBB + 2(WAWBABAB)
involves the variance of
Example: Calculate portfolio variance
Asset A
Portfolio variance = = 0.6 *
The term in the lower
8.66 + 0.4 *12 + 2*( 0.6 * 0.4
right corner involved the
* 0.7 * 8.66 * 12) = 84.96
variance of Asset B.
Standard deviation is equal
The other two boxes
the square root of the
contain the term

variance: = 84,96 = 9.22
involving the covariance.

Systematic Risk
A risk that influences a large number of assets
Systematic risk is overall market risk
For a diversified portfolio, all the risk is systematic
Reward for bearing risk depends only on asset's systematic risk
Use beta to measure systematic risk
Beta indicates how the return on an individual asset moves relative to return for the entire market

Unsystematic Risk
A risk that influences a single asset or small group of assets
Unsystematic risk is unique specific risk

Relationship Between Risk and Expected Return Capital Asset Pricing Model (CAPM)
The expected return on a security is positively (and
linearly) related to the securitys systematic risk beta.
o Beta indicates how the return on an asset moves
relative to return for the entire market
o Higher betas = more sensitive to the market.
Equity market premium is the difference between the
expected return on market and risk-free rate
o Because the average return on the market has
been higher than the average risk-free rate over
long periods of time, the equity market premium
is presumably positive



Chapter 13 Risk, Cost of Capital, and Capital Budgeting


Discount When Cash Flows are Risky
A firm with excess cash can either pay a dividend or make a capital expenditure
Because stockholders can reinvest the dividend in risky financial assets, the expected return on a
capital budgeting project should be at least as great aa the expected return on financial asset of
comparable risk
The expected return on any asset is dependent on its beta
o How to Estimate the Beta of a Stock
Employ regression analysis on historical terms
Both beta and covariance measure the responsiveness of a security to movements in the market
Correlation and bets measure different concepts

Beta is the slope of the regression line

In a project with beta risk equal to that of the firm, if the firm is unlevered, the discount rate of the
project is equal to RF + B x (RM - RF)
o RM is the expected return on the market portfolio
o RF is the risk-free rate
o In words, the discount rate on the project is equal to the CAPM's estimate of the
expected return on security
The beta of a company is a function of a number of factors including:
o Cyclicality of revenues
o Operating leverage
o Financial leverage
If project's betas differ from that of the firm, discount rate should be based on the project's beta

Chapter 14 - Efficient Capital Markets and Behavioral Challenges

3 ways to create valuable financing opportunities
o Fool investors - sell securities at higher values if investors have overly optimistic view
o Reduce costs/increase subsidies different securities have different tax advantages so
minimize taxes and other costs
o Create a new security new security that is distinct may attract investors who are willing
to pay extra for security that fits their needs
Efficient capital market stock prices fully and immediately reflect all available info.
o Efficient market hypothesis: since prices immediately reflect info, investors can only get
a normal rate of return. The market adjusts before an investor can trade on info
o Firms will receive fair value (present value) for securities they sell
Foundations of market efficiency theory by Andrei Shleifer
o Rationality investors are rational and will evaluate prices of stocks in rational way
o Independent deviations from rationality emotion may cause over- or under- valuation
o Arbitrage professionals evaluation and trading of stocks will overrule out any irrational
ones caused by amateurs causing efficient markets
Professionals willing to buy and sell different but substitute securities and generate
profits (ex. GM v Ford)
o Behavioral finance says these theories may not old in the real world because:
People arent really rational
People make decisions based on representativeness (make decisions based on
insufficient data, limited sample) and conservatism (too slow to adjust beliefs fo
new information)
Arbitrate strategies may have too much risk to eliminate market inefficiencies
Cognitive biases such as overconfidence, overreaction affect market prices
Allocational efficiency states that assets will go to those who can utilize them the best
3 theories of market efficiency
o Weak form assessment of stocks prices is based on fully incorporating past stock prices
o Semistrong form market incorporates all publicly available info into price of a stock
o Strong form market incorporates all known information (public or private) into price of a
stock, even if its only known to one individual
Adaptive markets reconcile market efficiency and behavioral theories
o Apply principles of evolution to financial markets greater competition for information in
market means information of more vital and necessary for survival in market
o Therefore, competition for information makes markets more efficient

Implications of market efficiency for managers the market is generally efficient enough see
through any choices made by managers and price stock fairly
o Choices in accounting practices (ex. Straight line vs accelerated depreciation ) dont
generally affect stock price provided accounting numbers are not fraudulent (ex: Enron)
o Timing of equity managers who believe stock is overprice will issue equity. If they believe
its underpriced, theyll wait to issue stock.
Studies have shown that SEOs (seasoned equity offerings) lead to higher stock
returns in period after SEO though this is not the same for IPOs.
Firms are also more likely to repurchase stock if they feel its undervalued and
evidence suggests stock returns of repurchasing firms are abnormally high after
repurchase occurs
o Speculation can occur if firms believe interest rates will rise or fall (firm will borrow
today is rates will rise), or firms may speculate and issue debt in foreign currencies if they
believe interest rates will change.