Session Four

Financial Management

Ashish Pandey

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 Introduction to Duration

 You may hear two terms often : Macaulay duration and Modified Duration
 Macaulay duration is the weighted average maturity of cash flows.

FV 100
Coupon 5%
Maturity (in years) 5
Coupon Freq 1
Yield 4%

Year Month Cashflow PV PV*Year

1 12 5 4.808 4.808
2 24 5 4.623 9.246
3 36 5 4.445 13.335
4 48 5 4.274 17.096
5 60 105 86.302 431.512
104.452 475.996

Mac. Duration 4.56

Mod. Duration 4.38

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 Introduction to Duration

 Modified duration is a price sensitivity measure. It is measured as the percent change in

price per one unit (percentage point) change in yield.
 Modified Duration = -(dp/P)/dy
 Modified Duration = Macaulay duration / (1+y/m) where m is compounding frequency.
 Percentage Price Change = -1 * Modified Duration * Yield Change
 A change in the yield of +2.5% should result in a % change in the price of the bond of -4.38
* .025 = - 0.1095 (or - 10.95 %). Since the bond was initially priced at 104.45, the
estimated new price is {104.45* (1-10.955%)} or 93.01
 In continuously compounded case, both durations are equal.

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 Stocks

 Equity-holder or a stockholder of a corporation is residual owner: residual in the sense that his
claim to firm’s financial assets is after creditors have been paid in full.
 Two types of stocks: common and preferred. Preferred stock holders have claims subordinated
to debt but senior to common stockholder. Preferred stockholder also usually get paid dividend
ahead of common shareholder.
 You understand terms Authorized share capital; Issued share capital, Outstanding share capital
etc.?
 You also understand the distinction between book value of stock and market value of stock?
 Primary Offering: First time issuance of stock to public
 Secondary Offering: Not a first time issuance of stock to public
 Bid Price or Bid: The price at which a market-maker is prepared to buy stocks.
 Ask Price or Ask: The price at which a market-maker is prepared to sell stocks.
 Market Maker: A market maker is a company or an individual that quotes both a buy and a sell
price for a stock, hoping to make a profit on the bid-offer spread.
 How are shares traded? Trading Floor?

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 Valuing Stocks

 The foundation for valuation of common stock is dividend.

 P = D1/(1+r) + D2/ (1+r)2 +…….D∞ /(1+r)∞
 Let us rephrase statement a bit, though substance remain same. The foundation for valuation of
common stock is dividend and terminal value.
 Expected Return = r = (DIV1 + P1 – P0) / P0, also called market capitalization rate or cap rate.
 Price of share today = 100, expected dividend next year = 5, and expected price next year =
110. r = (5+110-100)/100 = 15%
 But how did we get next year price P1 above?
 r = (DIV1 + P1 – P0) / P0 or P0(1+r)= DIV1 + P1 or P0= (DIV1 + P1 ) / (1+r)
 So P1= (DIV2 + P2 ) / (1+r); but then how do we get P2 ? We will use a small trick of substitution
here to drive the point.
 P0= (DIV1 + P1 ) / (1+r) = (DIV1) / (1+r) + (DIV2 + P2 ) / (1+r)2 = (DIV1) / (1+r) + (DIV2) / (1+r)2 +
(DIV3) / (1+r)3 + (DIV4) / (1+r)4 + (DIV5) / (1+r)5 + …. (DIVn) / (1+r)n + Pn / (1+r)n
 So we prove statement that foundation for valuation of common stock is dividend and terminal
value. As we go further in the future, the value of term Pn / (1+r)n in present value terms keeps
on becoming lower and lower. At the extreme as n tends to infinity, we can ignore the terminal
price term and say P0 = ∑ ∝ 𝐷𝐼𝑉𝑛 /(1 + 𝑟)n .

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 Valuing Stocks
∝
 P0 = ∑ 𝐷𝐼𝑉𝑛 /(1 + 𝑟)n .
 Please note that this formula is nothing but NPV formula. We are just saying all through the
previous slide that the value of stock today is sum of all future cash flows discounted at
opportunity cost of capital. Bonds, projects, investments , stocks – everything is valued on this
fundamental principal.
 It is difficult to project individual dividend for every year in future.
 Hence, generally a simplified assumption is made that expected dividends grow at a constant
rate every year.
 If expected dividends grow at a rate ‘g’ every year, we can use the perpetuity formula as a
stream of dividends received every year.
 P0= (DIV1) / (r-g)
 Also from above, r = DIV1/P0 + g. The market capitalization rate is sum of dividend yield
(DIV1/P0) and growth rate of dividend.
 How to estimate g then. Next year dividend isn’t that difficult. Use analyst estimate or past
history of dividends.
 Two more terms: Payout Ratio and Plowback Ratio. Payout Ratio is ratio of dividends to EPS. Any
EPS not distributed in the form of dividend is reinvested in company (plowed back).
 Plowback ratio = 1- Payout ratio

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 Valuing Stocks with dividends growing at a constant rate

 If a firm’s ROE is 10%, and it reinvests 60% of its income (plowback ratio is 0.6), then the book
value of equity will increase by 6%.
 Assuming everything else constant, the earnings and dividend in the next period will also
increase by 6%.
 Above assumption of ceteris paribus has many hidden assumptions. Most importantly ones are
constant return to capital factor productivity and ability of market to absorb additional
production at the same prices. Mitigating factor can be increased economy of scale.
 Rare to find a justification that a company will continue to grow profits at the same rate
infinitely in time. At sometime, industry structure will mature leading to dip in profit margins.
Further, what about Schumpeter’s Creative Destruction theory.
 What about a company that has no growth; it reinvests nothing and pays all earning as dividend.
 P0= (DIV1) / (r-g) = EPS1 / r

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 Valuing present value of growth opportunity

 In general, we can also think of stock price as capitalized earnings under no growth policy plus
the NPV of growth opportunity.
 P0 = EPS1 / r + PVGO where PVGO = NPV1 /(r-g)
 Assume a firm which has market capitalization rate of 15%, will pay dividend of $5 in the first
year, distributes 40% of earnings and has dividend growth rate of 10%.
 P0= (DIV1) / (r-g) = 5/ (0.15-0.1) = 100
 This company has payout ratio of 0.4. It reinvests 60% of earnings and only distributes 40% of
earning. It distributed $5, hence total earnings were $12.5 (5/0.4) and it retained $7.5 for
investment.
 Price assuming no growth is 12.5/0.15 = 83.33. Can you tell me what is the ROE of this company?
 0.1/0.6 = 16.66%
 $7.5 invested in year 1 at 16.66% will deliver income of $1.25 next year.
 NPV1 = -7.5 + 1.25/0.15 = 0.833
 The value of this growing perpetuity of future growth opportunity is: 0.833/(0.15-0.1) = 16.66
 100 = 83.33 +16.66
 Note: Everything will be the same next year (year 2) except that firm will have distributed dividend of $5.5,
and would have invested $8.25 (10% growth). $8.25 invested at 16.66% will lead to income of 1.375 or
perpetuity value of 1.375/0.15 = 9.13 and hence NPV2 = -8.25 + 9.16 = 0.916. NPV2 is 10% more than NPV1.
Hence, the growing perpetuity formulae. 7
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 Nominal and Real Rate of Interest

 You may have already covered this in your Macroeconomics course

 I will just restrict myself to expression used for converting nominal cashflows to real
cashflows.
 Real Cash Flow (in period t) = Nominal Cash Flow (in period t) / (1+ inflation rate)t
 The above real cash flow is not present value; but is future value adjusted for
inflation.
 Also (1+ rnominal) = (1+ rreal) * (1+ inflation rate)

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 Concepts to be covered

 Risk– Definition

 How to measure risk and return at a portfolio level?

 Discount Rate, Hurdle Rate, Opportunity Cost of Capital, Discount Factor

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 Definition of Return and Risk

 What is risk?
 Variability of realized return from the expected return
 Illustration:
 Suppose you buy a 1 year T bill issued by the government at a yield of 8%.
 If you hold t-bill for 1 year, your realized return will be 8%. Not an iota more or less.
 Now suppose you buy stock of a company at $100 expecting it to reach price of $115
at the end 1 year (no dividend paid). But the yearend price may not be 115. It can be
105, 125 or even 90.
 Your actual realized return from holding the stock can differ substantially from your
expected return at the time of purchase.
 Stock will be a risky security, t-bill will be a risk free security in this instance.

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 Risk Definition

 What is risk?
 Variability of realized return from the expected return
 How do we mathematically express this variability?
 We do so by using standard deviation or variance as a measure of risk
 Expected Return Rmean = ΣRiPi and Std. Dev. = (Σ(Ri – Rmean)2Pi)1/2 where i indicates a return
scenario and Pi indicates probability of the scenario
Difference from Squared Prob*
Return (%) Probability expected return Difference Sq. Diff
60 0.25 40 1600 400
20 0.5 0 0 0
-20 0.25 -40 1600 400

 Expected return above is 20% and std. dev. is 28.2 [ (800)0.5]

Investment A Investment B

Expected Return .08 .24

Std. Dev .06 .08

 Which is more risky investment?

 Coefficient of variation: Risk per unit of return

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 Portfolio Return and Portfolio Risk

 Portfolio Return: Rp = ΣriAi for j ranging from 1 to n; A= proportion of investment in portfolio

 Simply the return of security multiplied by its proportion of investment in total portfolio.
 Three securities case:
Security 1 2 3
Return 0.08 0.12 0.16
Std. Deviation 0.2 0.3 0.4
Investment 100 100 200
 Portfolio Return: 0.08*(100/400) + 0.12*(100/400) + 0.16*(200/400) = 0.13
 But standard deviations are not simple additions. Std. Dev of Portfolio = (Σ ΣAj Ak σjk)1/2
 First large sum operator is for j ranging from 1 to n and second large sum operator is for k
ranging from 1 to n
 For a two security scenario (only security 1 and 2); formula will be
Variance of Portfolio = A12 σ12 + A22 σ22 + 2 A1A2 σ12 and σ12 = ρ 12 σ1 σ2 ; ρ = Correlation Coeff.
 For a three security scenario; formula will be
Variance of Portfolio = A12 σ12 + A22 σ22 + A32 σ32 + 2 A1A2 σ12 + 2 A1A3 σ13 + 2 A2A3 σ23
 As portfolio of stocks becomes bigger and bigger, the value of individual variance of a stock
diminishes and the value of covariance increases. For a 30 stock case: how many covariance
terms?
 870 covariance terms.
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 Portfolio Risk

 Covariance: Whether two variables move together? Σ(Xi – Xmean) (Yi – Ymean) /(n-1)

 Very similar to correlation coefficient except that correlation coefficient is scaled.

Security 1 2
Return 0.08 0.12
Std. Deviation 0.2 0.3
Investment 100 100

For ρ 12 being 0.5, S.D. is 0.25*0.04+0.25*0.09+2*0.25*0.5*0.06 = 0.21.

For ρ 12 being 1, S.D. is 0.25 and for ρ 12 being -1, S.D. is 0.05.
 Any correlation except a perfect correlation of 1 will decrease risk.

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 Diversification

 If investing $100 across 10 stocks is less riskier than investing $100 across 5 stocks?
 Depends on covariance – 10 stocks may be from the same industry
 Diversification has to be meaningful
 Total portfolio risk has two components:
 Systematic Risk or Market Risk: Risk due to risk factors that affect the overall market condition
(say change in corporate tax rate). There is no way to diversify this risk component (as every
stock is equally affected and hence any combination of security will not yield anything given
there is perfect correlation between Security A, Security B and Market.
 Unsystematic Risk: Risk associated with the variability of stock’s return that is not related to
movements in excess return of market as a whole (say higher tax on cigarettes). This component
of risk can be diversified.

Unsystematic
Risk
Std. Deviation

Systematic
Risk

Number of securities in portfolio

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