How does a company grow money? 1) Debt 2) Equity 3) Retained Profits. Who finances?

1) Stockholders (get
dividends) 2) creditors (get interests). Companies can raise cash to finance their investment activities by All else being equal… 1) a bond with longer maturity has a higher relative price change (%) than one with a shorter
selling/issuing securities to financial markets: 1) bonds, if they’re debt 2) stocks, if they’re equity (2 ways of maturity, when YTM changes – the cash flows will be more eroded by time 2) a lower coupon bond has a higher
getting money from a stock: 1) dividends - how much I will receive at the end of the year for the stock 2) relative price change (%) than a higher coupon rate, when YTM changes.
appreciation – increase price of stocks, then we can sell them and gain the difference).
VALUING STOCKS 1) an asset’s value is determined by the PV of its future cash flows 2) a stock has 2 types
Notes: 1) As the creditors are paid sooner, of cash flows:
SALES their risk is smaller. 2) If we have too much
debt, EBIT goes up (increase interests) and
1) Dividends – the Dividend Growth Model

-COGS we’ll be working to pay our debts. 3) COGS –

costs of goods sold; SGA – administrative
costs; Dep. – depreciation and amortization;
- Perpetuity zero growth

GROSS PROFIT Int. – interests on our debt; retained

earnings – profit that we reinvest in the
company.
- Perpetuity constant growth
- Differential growth (≠rates → g1,g2)

-SGA TIME VALUE OF MONEY 1) An euro is worth

g = retention ratio x return on retained earnings (ROE – historical return on equity)
retention ratio = retained earnings / net income
more today that it will tomorrow (due to expected return (r) = dividend yield (DIV1 / P0) = earnings per share – price ratio (EPS1 / P0)
EBITDA inflation and interest rates) 2) a higher risk
needs a higher interest 3) when we consider 2) Capital gains – selling stocks
an investment we have to factor in our
-Dep. alternatives (opportunity costs – our 2 nd best

EBIT
alternative) 4) we have to perform all
calculations at the same point in time (in
order to compare them)… so we have:
capital now x (1 + int.rate) = PV x (1 +
-Int. 1) FUTURE VALUE (compounding) r)t RISK & RETURNS
1) Total return = Dividend income (%) + Capital Gain (%) (Pt+1 – Pt)/Pt
- if the compound is semiannual, we
divide the r by 2 - r=interest 2) Holding period returns (total return for any given interval of time)  e.g. 3 years returns: 11%, -5%, 9%
EBT rate=opportunity cost HPR = 1€ x (1+r1) x (1+r2) x 1+r3) =
= 1€ x (1,11) x (-1,05) x (1,09)

-Taxes 2) PRESENT VALUE (discounting) 1 Security (1 single asset)

- average/expected return – describes the past annual returns on the stock market over a period of time

NET INCOME Mean = r = (r1 + … + rt) / T

-Dividends if…
- variance/standard dev. – characterizes the distribution of returns relative to the expected return and its risks
1security 2 securities Var(portfolio)
Retained Earnings (when the PV is calculated for a period
later
than the preceding the one
in which the 1st cash flow occurs) capital one year from now / (1 + int.rate) = FV
r)t P0 = ∑ Divt / (1 + r)
(expected) Return = (expected) Profit / Investment
costs=(1+r)
PV = expected cash flow / opportunity t
NPV = PV – initial investment (if negative, the project is not worth undertaking)
P = ∑ [ Div x (1+g )t-1 / (1 + 0 1 1
INFLATION 10% may seem like a good return, but we have to consider the effects of inflation (if it is 20%...
10% of AIR would be bad).
r) ] t
Rr = real interest rate Rn = nominal interest rate i = inflation rate
- Real cash flow must be discounted at real int. rate; nominal cash flow at nominal int. rate;
either approach will yield the same NPV
SD = √variance (always
BONDS are a form of debt (it is a certificate showing that the borrower owes a specific sum; if I lent money to a positive)
company, it will issue me a bond and will pay me a certain interest, and at the end will give me back the money I
T = number of years for
lent). TYPES:
1) pure discount bond (or zero d.b.) – pays no coupon rate, only a single payment at a fixed future
date (a treasury bill or T-bill is a pure d.b. of government that will mature in 1 year or less and is
risk-free)
Var/=(1(1+/r)N)
P0 = [ Div1 / (1 + r)1 ] + [ Div 1 x var + (1
] … = Div
1
future expectations
(for past data, use T-1) When N→∞ variance
Rr = (1 + Rn) / (1 + i)] –
Diversified Portfolio (contribution of each

1 Total risk of individua

security to the expected return on risk of the
portfolio)

P0 = Div / (r – g) (var)
growing pe
PV = F / (1 + r)t BETA –
stock’s sensitivity to changes in the value of the market portfolio. Only about systematic risk! Everything that has
to do with the market (e.g. new drug patented or CEO leaving are under unsystematic risk)
2) level-coupon bond – offers regular cash payments, not just at maturity but also at regular times in between
(these regular payments = coupons)

βi = cov (ri, rM) / σ2 (rM)

PV0 = C1 / r x
[ 1 – (1 / (1 + - covariance (how 2 assets move together) growing annuity
σAB = cov (rA, rB) = expe
r)t ] + [ F / (1 + - correlation (standardized measure for
covariance (-1 to 1) but with correlation we
cannot know which asset causes the change of the other 1) +1 both returns on stock A and B are higher/lower

r) t ] than each respective average at the same time, 2) -1 one has a higher than average return when the other has
a lower than average return and vice-versa, 3) 0 the return on security A is completely unrelated to the return

3) consols (perpetuity) – have no final maturity date and never stop paying a coupon PV6 = x on security B.

PV = C / r  PV1 ρAB = ρBA

Whenever the coupon rate = interest rate, then the bond’s present value = its face value.
(bond is traded at its face value=principal): = PV6 / CAPM (Capital Asset Pricing Model – this model enables an individual asset to be priced relative to all other
assets in the market)
1) when coupon rate = YTM, price = face value
2) when coupon rate > YTM, price > face value
3) when coupon rate < YTM, price < face value (1 + r)6
 r = rF + β x (rM – rF)
Expected return = risk free + beta x (expected
return on the market – risk free)
- we’re only taking the systematic risk so this should be the minimum return we’d get (for an efficient asset, there
is no diversifiable risk, therefore total risk is systematic risk
- CAPM predicts that the risk premium should increase in proportion to beta, so that the returns of each portfolio
should lie on the upward-sloping security market line.
- if the volatility is high, the beta tends to be higher, so we will demand a higher return

PVreturn
= [ C1 / (1 + y) ] + [ C2/ (1 + y) ] + … (y = YTM. It will worth if y >
SML
rMr) -rF =rrM
F (security market line)
= Mkt risk premium
β
CAPITAL STRUCTURE Decisions about the CS of a firm involve the selection of the sources of financing and
the proportions of debt and equity

MODIGLIANI-MILLER
1) Without taxes… the value of a company would depend only on the profitability of its assets
- Proposition I: VL = VU (levered, company with debt = unlevered, company without debt)
Leverages add no value to the investor; V = value of firm
- Proposition II: RS = RO + B/S x (RO – RB) R0 = cost of capital for an ALL-EQUITY firm (R0 = RWACC)
RWACC = [ B/(B+S) x RB ] + [ S/(B+S) x RS ] RB = cost of debt (bonds)
RS = cost of equity (stock)

1) With taxes
- Proposition I: VL = VU + TCB (TCB = present value of all tax shield) – stands for a firm with perpetual debt

- Proposition II: RS = RO + B/S x (1 – TC) x (RO – RB) (1 – TC) is the tax shield

Examples:

INFLATION, nominal/real interest rate of return

When the bank quotes you a 10% interest rate, it is quoting a nominal interest rate, which tells you how rapidly
Invest Current Receive Period 1 Result
your money will grow.
10% (certain)
1+rnominal = (1 + rreal) x (1 + inflation rate)
$ 1,000 $ 1,100 nominal rate of
return
BONDS Invest Current Expected real value of period 1 receipts Result
Jun 2001 you invested in a 7% 2006 bond with coupon rate=7% and face value of $1,000. (this means each year, If inflation rate is 6%...
until 2006, you’ll receive an interest payment of 0,07x1,000=$70). In May 2006 the bond matures and they pay 3,774% expected
$ 1,000 $ 1,037.74 (=1,100/1,06)
you the $1,000. Other identical bonds offered at the summer of 2001 a return of 4,8%. (2002: 70$; 2003: 70$; real rate of return
2004: 70$; 2005: 70$; 2006: 70 + 1,000$) What is the PV of these payoffs?
1) PV= (70/1,048) + (70/1,048)2 + (70/1,048)3 + (70/1,048)4 + (1,070/1,048)5 = 1,095.77$
2) as annuity… PV = 70/0,048 x [ 1 – (1 / (1+0,048) 5)] + 1000/(1+0,048)5= 1,095.77$
Knowing that PV = 1,095.77$, what is the return the investors expect? Bond’s YTM=? Use the formula
introducing the PV and calculating the r.

If… the bond yields fall to 2%, our price will rise to:
PV = (70/1,02) + (70/1,02)2 + (70/1,02)3 + (70/1,02)4 + (1,070/1,02)5 = 1,235.67$
If… the bond yields jump to 10%, our price will fall to:
PV= (70/1,10) + (70/1,10)2 + (70/1,10)3 + (70/1,10)4 + (1,070/1,10)5 = 886.28$

- the higher the interest rate the investors demand, the less they will be prepared to pay for the bond.
- when the cash flows last for many years, the effect of change in YTM is greater
- if the bond makes coupon payments semiannually, we’ll receive $35 per 6months instead of $70 per year. If the
bond is quoted as semiannually compounded yields, the YTM = 4,8 / 2 = 2,4$ per 6months, instead of 4,8% per
year. So… PV = (35/1,024) + (35/1,024)2 + (35/1,024)3 + (35/1,024)4 + (1,035/1,024)5 = 1,096.77$

DIVIDENDS
Current price/share = 100$ = P0 / Expected price end of year = 110$ = P1 / Expected dividend per share = 5$ = DIV
Expected Return = r = (DIV1 + P1 – P0) / P0 = (5 + 110 – 100) / 100 = 0.15 = 15% (market capitalization rate)

If we’re given investors’ forecast of dividend (5$) and price (110$) and the expected return (15%) offered by other
equally risky stocks, we can predict today’s price: Price = P0 = (DIV1 + P1) / (1 + r) = (5 + 100) / 1.15 = $100

How do we know that $100 is the right price? Because no other price could survive in competitive capital
markets. What if P0 were above $100? The stock would offer an expected rate of return that was lower than
securities of equivalent risk. Investors would shift their capital to the other securities and in the process would
force down the price of the stock. If P0 were less than $100, the stock would offer a higher rate of return than
comparable securities; investors would rush to buy, forcing the price up to $100.

If the investors are looking today for dividends of $5.50 in year 2 and a subsequent price of $121, that would
imply a price at the end of year 1 of P1 = (DIV2 + P2) / (1 + r) = (5.50 + 121) / 1.15 = $110

VARIANCE
Suppose that 65 percent of your portfolio is invested in the shares of Coca-Cola and the remainder is invested in
Reebok. You expect that over the coming year Coca-Cola will give a return of 10% and Reebok 20%. The expected
return on your portfolio is simply a weighted average of the expected returns on the individual stocks.
Expected portfolio return = (0.65 x 10) + (0.35 x 20) = 13.5%
Calculating the risk of your portfolio: In the past the standard deviation of returns was 31.5% for C-C and 58.5%
for Reebok. You believe that these figures are a good forecast of the spread of possible future outcomes but we
need to calculate the variance:
Porfolio variance = [(0.65)2 x (31.5)2] + [(0.35)2 x (58.5)2] + 2x(0.65 x 0.35 x 1 x 31.5 x 58.5) = 1,676.9 (assuming cov=1)
Standard deviation = √1,676.9 = 41% or 35% of the way between 31.5 and 58.5. Coca-Cola and Reebok don’t
move in perfect lockstep.