Professional Documents
Culture Documents
Finance - Notes
Finance - Notes
$2,000
$1,768.62 •
30-year bond
$1,500
$500 • $502.11
Interest
5% 10% 15% 20% rates
Time
to
Maturity
Interest
Rate
1
Year
Value of a Bond with a 10% Coupon Rate for Different Interest Rates and Maturities
30
Years
5%
$1,047.62
Time to Maturity
$1,768.62
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%
10%
$916.67
1,000.00 1,000.00
$502.11
This
table
shows
prices
u15%
nder
different
interest
rate
scenarios
for
10%
coupon
956.52 671.70bonds
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
bond’s
value,
but
the
1-‐year
bond’s
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
bond’s
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
bond’s
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
bond’s
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
bond’s
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
not”…limits
or
prohibits
actions
that
the
company
may
take.
§ A
positive
covenant
is
a
“thou
shalt”…it
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
investor’s
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
holder’s
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%(1–T)=6%
.
.
.
T
=
25%
Chapter
9
-‐
Stock
Valuation
ß
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
firm’s
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
ܸܫܦଵ ଵ െ ܲ
݁݀ ݊ݎݑݐ݁ݎൌ ݎൌ
ܲ
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:
ܸܫܦଵ § Price
ଵ
=
P0
=
Div/r
-‐
g
ܲ ݁ܿ݅ݎൌ ܲ ൌ • g
=
the
growth
rate
in
dividends
(capital
gains
yield)
ͳ • ݎr
=
the
required
return
on
the
stock
o The
constant
growth
stock
equation
can
be
rearranged
to
obtain
an
expression
for
the
tailed calculation of expected
the Price return
Po0 n
we
the
need
stock
ato s
follows:
ure stock prices and dividends: § Expected
return
=
r
=
Div1/P0
+
g
§ 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.
ܸܫܦଵ ܸܫܦଶ ଵ next
year
=
earnings
this
year
+
retained
earnings
x
return
on
݁ ൌ ܲ ൌ § Earnings
ͳݎ ሺͳ retained
ݎሻଶ 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 Dividend
growth
the rate
=
g
=
RR
x
ROE
o get the present value and that present o ROE
value =
Net
Income/Equity
=
(Net
Income/Sales)
x
(Sales/Assets)
x
he intrinsic value of the stock. This (Assets/Equity)
model
s far in the future as we want. If we call the Ratio
=
1-‐
Payout
Ratio
o Retention
§ Payout
Ratio
=
Dividends/Earnings
et a general formula to calculate
• Differential
Growth
P 0 :
o Assume
that
dividends
will
grow
at
different
rates
in
the
foreseeable
future
and
then
will
ୌ grow
at
a
constant
rate
thereafter
o
ܸܫܦTo
௧value
ܲு
a
Differential
Growth
Stock,
we
need
to:
ܲ ൌ
ሺͳ §ݎሻ estimate
୲ ሺͳ fݎuture
ሻ dividends
in
the
foreseeable
future
ୌ
௧ୀଵ § 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, the
period
appropriate
H could discount
be rate
The value of shares o A
Differential
of common Growth
stock,Example
like
§ r
=
12%
(investors’
required
return)
instrument, is often understood as the present
§ g1
=
g2
=
g3
=
8%;
g4
=
g5
=
...
=
4%
uture returns. The value § D of0
=a
$stock
2
is equal to
payments discounted §at the D1
=rate
$2
x
1of return
.08
that
=
$2.16,
D2
=
$2.33,
D3
=
$2.52
§ Imagine
receive on other securities with equivalent t hat
y ou
a re
at
t=3
looking
forward
cks do not have a fixed maturity; • D4
=
$2.52
theirx
1cash
.04
=
$2.62
• 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
ஶ The
price
of
a
share
of
common
stock
to
the
investor
is
equal
to
the
ܸܫܦ௧ present
value
of
all
the
expected
future
dividends
ܿ݁ ൌ ܲ ൌ
ሺͳ ݎሻ୲ Div
=
the
dividend
paid
at
year’s
end
௧ୀଵ
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
firm’s
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
firm’s
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
firm’s
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
firm’s
policy
growth
actually
destroys
firm
value.
o Under
what
conditions
would
the
firm’s
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
ß
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
Normal
.30
-‐.12
.30
-‐
.175
=
.125
-‐.12
-‐
.055
=
-‐.175
.125
=
2 -‐.1752
=
.015625
.030625
Boom
.50
.09
.50
-‐
.175
=
.325
.09
-‐
.055
=
.035
.325
=
2 .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
company’s
expected
return
given
previously
Step
3
Multiply
each
deviation
by
itself
to
make
it
positive
Step
4
Calculate
the
variance
.
.
.
Variance
=
the
expected
value
of
(the
security’s
actual
return
–
the
security’s
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:
σp²
=
The
term
in
the
upper
left
WA²σA²
+
WB²σB²
+
2(WAWBσAσBρAB)
involves
the
variance
of
Example:
Calculate
portfolio
variance
Asset
A
Portfolio
variance
=
σ²
=
0.6²
*
The
term
in
the
lower
8.66²
+
0.4²
*12²
+
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:
σ
=
√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
security’s
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
aren’t
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
it’s
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
)
don’t
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
it’s
underpriced,
they’ll
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.