Finance Final Exam Notes

Ch7. Investment Decision Rules

NPV and Stand-Alone Projects
 Stand-alone project means undertaking it does not constrain ability to take other projects
 NPV investment rule: when making an investment decision, take the alternative with the
highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today

Applying the NPV Rule

The NPV Profile and IRR

 Uncertainty regarding cost of capital

 NPV profile used which is graph that projects NPV over a range of discount rates
 IRR is the discount rate that sets the NPV of projects cash flows to zero
o Provides useful information regarding sensitivity of NPV to errors in cost of capital
 In general, difference between cost of capital and IRR is the maximum estimation error in the
cost of capital that can exist without altering the original decision

Alternative Rules versus the NPV Rule

The Internal Rate of Return Rule

 IRR Investment Rule: Take any investment opportunity where the IRR exceeds the
opportunity cost of capital. Turn down any opportunity whose IRR is less than the
opportunity cost of capital
 IRR measures the average return over the life of an investment

Applying the IRR Rule

 The IRR rule is only guaranteed to work for a standalone project if all of the projects negative
cash flows precede its positive cash flows

Pitfall 1: Delayed Investments

 When cash received upfront and expenses incurred later

o When you borrow money (which is what has occurred essentially), want lowest rate
possible
 IRR might fail by itself but useful in conjunction with NPV to determine how sensitive
investment decision is to uncertainty in cost of capital

Pitfall 2: Multiple IRR’s

 There can be as many IRR’s as the number of times the projects cash flows change sign over
time
 Even though IRR fails, two (or multiple) IRR’s are still useful as bounds on the cost of capital
Pitfall 3: Nonexistent IRR
 IRR provides no guidance when no IRR
 NPV can be always positive or always negative when no IRR exists
 Should use NPV profile to interpret IRR

The Payback Rule

 Only projects that pay back their initial investment within the payback period are undertaken
 Payback period is a specified amount of time used in the payback investment rule.
 To apply payback rule,
o Calculate payback period then accept project if less than prespecified length of time

Payback Rule Pitfalls in Practice

 Ignores projects cost of capital and time value of money
 Ignores cash flows after payback period
 Relies on ad hoc decision criteria (what is the right number of years to require for the
payback period)
 Still used due to simplicity thus for small investment decisions
 Provides budgeting information regarding length of time capital will be committed to project
 If payback period short, most projects accepted satisfy NPV

Choosing between projects

NPV Rule and Mutually Exclusive Investments
 Mutually exclusive means taking one project excludes us from taking others
 Determine highest NPV

IRR Rule and Mutually Exclusive Investments

 When projects differ in their scale of investment, timing of cash flows or their riskiness, then
their IRR’s cannot be meaningfully compared
 Differences in scale
o Because it is a return, you cannot tell how much value will actually be created
without knowing the scale of the investment
 Differences in timing
o Dollar value of earning a giving return, and therefore NPV, depends on how long
return is earned
o Earning a high annual return more valuable over long period of time than for few
days
o Longer term investments tend to benefit in terms of NPV with similar IRR’s
 Differences in Risk
o To know whether IRR is attractive, must compare to cost of capital, which
determined by projects risk
 IRR attractive for safe project may not be for risky project

The Incremental IRR

  The IRR of the incremental cash flows associated with replacing one project with another, or
changing from one decision to another
 Incremental IRR is discount rate which it becomes profitable to switch from one project to
another
 Problems with invremental IRR
o In incremental cash flows, negative cash flows may not precede positive thus IRR can
be difficult to determine or may not exist
o Indicates when profitbale to switch but not which has higher NPV
o If different cost of capital, don’t know what to compare incremental IRR to

Project Selection with Resource Constraints

Evaluating Projects with Different Resource Requirements
 Situations where choices have different resourcing needs
 If there is a fixed supply of the resource so that you cannot undertake all possible
opportunities, then the firm must choose the best set of investments it can make given the
resources it has available

Profitability Index
 Profitability index measures the NPV per unit of resource consumed
 Profitability index = NPV / resource consumed
 After computing profitability index, rank projects based on it and take all projects until
resource is consumed starting from the top
 Resource constraints may cause firm to pass up on positive-NPV projects
 Highest profitability index available from remaining projects provides useful information
regarding value of that resource to firm

Shortcomings of the Profitability Index

 For index to be completely reliable, must satisfy these:
o The set of projects taken following the profitability ranking completely exhausts the
available resource
o There is only a single relevant resource constraint

Valuing Stocks
The Dividend-Discount Model
A one-year investor
 Two potential cash flows of owning a stock
o Pay out cash to shareholders as dividend
o Selling shares at future date
 Equity cost of capital is the expected rate of return available in the market on other
investments with equivalent risk to the firms shares
¿ 1+ P1
 To buy stock, Po ≤
1+ ℜ
 ¿ 1+ P1
 To sell stock Po ≥
1+ ℜ
¿ 1+ P1
 But both must hold as two parties in sale so Po=
1+ ℜ
Dividend yields, Capital Gains, and Total Returns

 Dividend yield is percentage return investor expects from dividen

 Capital gain is amount which sale of asset exceeds purchase
 Total return is expected return of investor for 1 year investment
 Expected total return of stock should equal expected return of other investments available in
market with equivalent risk i.e. cost of capital

A multiyear Investor
The Dividend-Discount Model Equation
 Dividend-discount model values shares of a firm according to the present value of the future
dividends the firm will pay
 Model holds for any horixon N
 Thus all investors (with same beliefs) will attach the same value to the stock independent of
investment horizon
o How long they intend to hold stock and whether they collect their return in form of
dividends or capital gain is irrelevant
 If hold stock forever, the price of the stock is equal to present value of expected future
dividends

Applying the Dividend-Discount Model

 Rearranging formula shows that g equals the expected capital gain rate
 With constant expected dividend growth, the expected growth rate of share price matches
growth rates of dividends

Dividends Versus Investment and Growth

  Share price increases with current dividend level and expected growth rate
 To maximize price, increase both
o However, increase growth may require investment, and money on investment cant
be used for dividends
 Dividend payout rate is the fraction of firms earnings that the firm pays as dividends
Earningst
 Divt= ∗Dividend Payout Ratet
Shares Outstandingt
 Thus firm increase dividends by
o Increase earnings
o Increase dividend payout rate
o Decrease shares outstanding
 Assume shares fixed
 With earnings, firm can pay to investors or reinvest to increase future earnings and dividends
 Assume if no investnment, firm doesn’t grow
 Retention rate is fraction of firms current earnings that the firm retains
 Earnings growth rate = Retention rate x Return on new investment= g (if dividend payout rate
constant)
 Sustainable growth rate is rate at which a firm can grow using only retained earnings
 Cutting the firms dividends to increase investment will raise the stock price if and only if the
new investments have a positive NPV (i.e. roe > cost of capital)

Changing Growth Rates

Limitations of the Dividend-Discount Model
 Large amount of uncertainty associated with forecast of firm’s future dividends
 Forecasting dividends requires forecasting earnings, dividend payout rate, future share
count. Future earnings depend on interest expenses (which depend on how much firm
borrows), and firms share count and dividend pay out rate depend on whether firm uses
portion of earnings to repurchase shares

Total Payout and Free Cash Flow Valuation Models

Share Repurchases and the Total Payout Model
 Share repurchase is when firm uses excess cash to buy back its own stock
o More cash used for repurchases, less for dividends
o Repurchasing shares decreases share count hence increase eps and dps
 Total payout model discounts the firm total payouts to equity holders (dividends +
repurchases) then divide by number of shares to determine share price

Ch8. Fundamentals of Capital Budgeting

Forecasting Earnings
 A capital budget lists all projects company plans to undertake next period
 Capital budgeting is the process of analyzing investment opportunities to decide which to
accept
  Incremental earnings is the amount by which a firm’s earnings are expected to change as a
result of an investment decision

Revenue and Cost Estimates

 While revenues and costs occur throughout year, standard convention of listing at end of
year
 Capital expenditure is purchases of new property, plant and equipment
 Depreciation is a yearly deduction a firm makes from the value of its fixed assets (other than
land) over time according to a depreciation schedule that depends on an assets life span
 When evaluating capital budgeting decision, don’t include interest expense as related to how
financing project and aim is evaluate project on own separate from financing decision as the
appropriate cost of capital will be incorporated when calculating NPV
 Unlevered net income is net income that doesn’t include any interest expenses
 Marginal corporate tax rate is tax rate firm pays on an incremental dollar of pretax income
 As long as business earns taxable income elsewhere, can offset losses in tax elsewhere

Indirect effects on Incremental Earnings

 Opportunity costs
o The value a resource could have provided in its best alternative use
o Because this value is lost when the resource is used by another project, should
include opportunity cost as incremental cost such as rent that could’ve been earnt
on warehouse
 Project externalites
 Indirect effects of a project that may increase or decrease the profits of
other business activities of a firm
 Cannibalization is when sales of a firm’s new product displace sales of
existing products

Sunk Costs and Incremental Earnings

 Sunk cost is any unrecoverable cost for which a firm is already liable
o Have or will be paid regardless of if project taken or not
 Therefore not incremental and not included in analysis
 Overhead expenses are associated with activites that affect many different areas of
coporation
o Fixed overhead expenses not included but additional overhead expenses would be
included
 Past Research and Development expenditures
o Any money already spend is sunk cost
o Decision to continue or abandon based only on incremental costs and benefits
 Unavoidable competitive effects
o If sales likely to decline in any case as a result of new products introduced by
competitors, lost sales a sunk cost and not included in projections

Real World Complexities

 Sales, selling price and cost of production typically change over time
Determining Free Cash Flow and NPV
 Earnings accounting measure of firms performance but don’t represent real profits / cash.
Cant use earnings to pay dividends or fund new projects etc
 Free cash flow is the incremental effect of a project on available cash

Calculating Free Cash Flow from Earnings

 Earnings include non-cash charges such as dep but don’t include cost of capital investment
 CapEx and Depreciation
o Dep not a cash expense
o Don’t include in cash flow forecast, instead include actual cost of asset
 Net Working Capital
o Difference between current assets and current liabilities
o NWC = cash + inventory + receivables – payables
o Most projects require firm to invest in NWC i.e. minimum cash and inventory
balances
o Trade credit difference between receivables and payabels
o Increases in net working capital decrease free cash flow

Calculating Free Cash Flows Directly

 Depreciation tax shield is the tax savings that result from the ability to deduct depreciation

Calculating NPV

 Use appropriate cost of capital

Choosing among Alternatives

 Highest NPV

Evaluating Manufacturing Alternatives

Further Adjustments to Free Cash Flow

 Other non cash items in incremental earnings should not be included
o Add back amortization or intangible assets to unlevered net income
 Can forecast free cash flows quarterly, monthly or greater precision if required
 Liquidation or salvage value
o Assets that no longer needed can be sold
o When asset is liquidated, any gain on sale is taxed
o After-Tax Cash Flow from Asset Sale = Sale Price – t x (Sale price – book value)
 Gain on Sale = Sale Price – Book Value

Analyzing the Project

 Maximize NPV however lot of uncertainty in estimates for everything

Break-Even Analysis
 Break-even level is the level for which an investment has NPV of zero
  Break-even analysis is a calculation of the value of each parameter for which the NPV of the
project is zero
 EBIT break-even for sales is level of sales for which EBIT is zero

Sensitivity Analysis

 Sensitivity Analysis determines how the NPV varies as a single underlying assumption is
changed
 Allows us to explore the effects of errors in our NPV estimates
 By conducting sensitivity analysis, learn which assumptions most important and invest
further resources to refine
 Also reveals which aspects most crucial when managing project

Scenario Analysis
 Scenario Analysis determines how the NPV varies as number of underlying assumptions
changed simultaneously
 In reality, certain factors may affect more than one parameter

Ch10. Capital Markets and the Pricing of Risk

Risk and Return: Insights from 92 Years of Investor History
 S&P 500: firms represented leaders in respective industries and among largest firms in terms
of market value, traded on U.S. markets
 Smll stocks: bottom 20% of market caps on NYSE updated quarterly
 World portfolio: portfolio of internation stocks from all worlds major stock markets in NA,
Europe, ASisa
 Corporate bonds: long term, AAA US corporate bonds with approx. 20 year maturities
 Treasury Bills: one month US treasury bills

Common Measures of Risk and Return

Probability Distributions
 Return indicates percentage increase in value of investment per dollar initially invested in the
security

Expected Return
 Expected return is a computation for the return of a security based on the average payoff
expected, weighted average of all possible returns

Variance and Standard Deviation

 Standard deviation of return is volatility
 Std dev in same units as return
 In most situations, don’t know explicit probability distribution hence typically extrapolate
from historical data

Historical Returns of Stocks and Bonds

Computing Historical Returns
 Realized return is the return that actually occurs over a particular time period
 Realized return = dividend yield + capital gain rate
 Calculating Realized Annual Returns
o To focus on returns of single security, assume you reinvest all dividends immediately
and use them to purchase additional shares of same stock or security
 Both dividend yield and capital gain rate contribute to total realized return
 Returns are risky

Average Annual Returns

 The arithmetic average of an investment’s realized returns for each year

The Variance and Volatility of Returns

Estimation Error: Using Past Returns to Predict the Future
 To estimate cost of capital for an investment, need to determine the expected return that
investors will require to compensate them for that investment’s risk
 If distribution of past and future returns same, can look at what investors expected in past
and assume expect same in future
o However 2 flaws
 We don’t know what investors expected in past; we can only observe the
actual returns that were realised
 The average return is just an estimate of the true expected return, and is
subject to estimation error
 Limitations of expected return estimates
o Individual stocks more volatile than large portfolios
o Many only in existence for few years providing little data to estimate
o Relatively large estimation error means average return investors earned in past not
reliable estimate of security’s expected return

The Historical Tradeoff Between Risk and Return

 Investors risk averse
o Benefit they receive from increase in income smaller than personal cost of
equivalent decrease in income

The Returns of Large Portfolios

 Excess return is the difference between the average return for an investment and the
average return for a risk-free investment
 Investments with higher portfolios have rewarded investors with higher average returns
 Risker investments must offer higher average returns to compensate them for extra risk they
taking on

The Returns of Individual Stocks

 No clear relation between risk and volatility of individual stocks
o Larger stocks have lower volatility overall
o Even the largest stocks are typically more volatile than a portfolio of large stocks
Diversification in Stock Portfolios
 Independent risks are diversified in a large portfolio whereas common risk are not
 Diversification reduces risk

Firm-specific Versus Systematic Risk

 Firm-specific news is good or bad news about the company itself

 Market-wide news is news about a economy as a whole and therefore affects all stocks
 Firm specific risk is fluctuations of a stocks return due to firm specific news and are
independent risks unrelated across all stocks
 Systematic risk is fluctuations of a stocks return that are due to market-wide news
representing common risk
 When we combine many stocks in a large portfolio, the firm-specific risk for each stock will
average out and be diversified as overall good and bad news relatively constant
 Systematic risk affect all firms, therefore entire portfolio and wont be diversified
 When firms carry both types of riks, only firm specific risk diversified and volatility will
decline as more stocks added until only systematic risk remains

No Arbitrage and the Risk Premium

 Suppose return of type I firm exceeds risk free rate
o Holding portfolio of many type I, all risk diversified out and earn return above risk
free with no significant risk
 Pretty much arbitrage opportunity, borrow money at risk free and invest in large portfolio of
type I
 As more investors do this, prices for type I increase and return decreases until equal risk free
rate
 The risk premium for diversifiable risk is zero, so investors are not compensated for holding
firm specific risk
 The risk premium of a security is determined by its systematic risk and does not depend on
its diversifiable risk
 An asset that moves with the economy contains systematic risk and so requires a risk
premium

Measuring Systematic Risk

Identifying Systematic Risk: The Market Portfolio
 To determine how sensitive a stock is to systematic risk, we can look at the average change in
its return for each 1% change in the return of a portfolio that fluctuates solely due to
systematic risk
 An efficient portfolio is one that contains only systematic risk. An efficient portfolio cannot be
diversified further; there is no way to reduce the volatility of the portfolio without lowering
its expected return. When risk-free borrowing and lending is available, the efficient portfolio
is the tangent portfolio, the portfolio with the highest sharpe ratio in the economy
 Because diversification improves with the number of stocks held in portfolio, efficient
portfolio should be large
  Market portfolio is a value weighted portfolio of all shares of all stocks and securities in the
market
o Often considered S&P 500 as difficult to find data on returns of small stocks/bodns
 The beta of a security is the expected % change in its return given a 1% change in the return
of the market portfolio
o Measures the sensitivity of a security to market-wide risk factors
o Average beta in market is 1

Beta and the Cost of Capital

Estimating the Risk Premium
 The risk premium investors earn by holding market risk is the difference between the market
portfolios expected return and risk free interest rate which is the market risk premium

 If a stock has a negative beta it will have an expected return below risk free rate
 However does good in bad times so provides insurance against systematic risk of other stocks
so pay for insurance by accepting below risk free rate

The Capital Asset Pricing Model

 Capital Asset Pricing Model is an equilibrium model of the relationship between risk and
return that characterizes a security’s expected return based on its beta with the market
portfolio

Chapter 11. Optimal Portfolio Choice and the Capital Asset Pricing
Model
The Expected Return of a Portfolio
 Portfolio weights is the fraction of the total investment in a portfolio held in each individual
investment in the portfolio
 Portfolio return is weighted average of returns of investments in portfolio
 Same for expected return of portfolio

The Volatility of a Two-Stock Portfolio

 By combining stocks into a portfolio, reduce risk through diversification
 The amount of risk that is eliminated in a portfolio depends on the degree to which the
stocks face common risks and their prices move together

Determining Covariance and Correlation

  If two stock move together, covariance positive and negative if in opposite directions
 Magnitude of covariance hard to interpret as larger if stocks more volatile and larger
the more closely stocks move together
 Correlation is measure of the common risk shared by the stocks that doesn’t depend
on their volatility
 Stock returns will tend to move together if affected similarly by economic events thus
same industry tend to have higher correlation
Computing a Portfolio’s Variance and Volatility

The Volatility of a Large Portfolio

Large Portfolio Variance
 The variance of a portfolio is equal to the weighted average covariance of each stock within
the portfolio
 The variance of a portfolio is equal to the sum of of the covariances of the returns of all pairs
of stocks in the portfolio multiplied by each of their portfolio weights
 The overall variability of the portfolio depends on the total comovement of the stocks within
it

Diversification with an Equally Weighted Portfolio

 Equally weighted portfolio has same dollar amount invested in each stock

 As the number of stocks grows large, the variance of the portfolio is determined primarily by
the average covariance among the stocks
 The benefit of diversification is most dramatic initially
o Almost all benefit of diversification can be achieved with 30 stocks

Diversification with General Portfolios

  When combining stocks into a portfolio that puts positive weight on each stock, unless all of
the stocks have a perfect positive correlation of +1 with the portfolio, the risk of the portfolio
will be lower than the weighted average volatility of the individual stocks
o i.e. remove some volatility by diversifying

Risk versus Return: Choosing an Efficient Portfolio

Efficient Portfolios with Two Stocks
 an inefficient portfolio is a portfolio where another portfolio has a higher expected return
and lower volatility
 investors choose amongst efficient portfolios based on their preferences for return vs risk

The Effect of Correlation

 correlation has no effect on expected return of portfolio, has effect on volatility
 the lower the correlation, the lower the volatility as reduced due to diversification
 when correlation is 1, the volatility of the portfolio is equal to weighted average volatility of
the two stocks
 when two stocks correlation -1, possible to have portfolio with no risk

Short Sales

 long position is positive investment in security

 short positive is negative investment in a stock via a short sale
o sell a stock today that you don’t own with obligation to buy back in future
 profitable if expect stocks price to decline in future
 also profitable if you expect stock to rise as long as you invest proceeds in another stock with
higher expected return, but can greatly increase risk

Efficient Portoflios with Many Stocks

 when the set of investment opportunities increases from 2 to 3 stocks, the efficient frontier
improves
 adding new investment opportunities allows for greater diversification and improves the
efficient frontier

Risk Free Saving and Borrowing

 the ability to choose the amount to invest in risky versus risk-free securities allows us to
determine the optimal portfolio of risky securities for an investor

Investing in Risk Free Securities

  our expected return is equal to the risk free rate plus a fraction of the portfolio’s risk
premium, based on the fraction x we invested

 the volatility is only a fraction of the volatility of the portfolio

Borrowing and Buying Stocks on Margin

 buying stocks on margin is borrowing money to invest in stocks
 riskier than portfolio P itself

Identifying the Tangent Portfolio

 to earn the highest possible expected return for any level of volatility, we must find the
portfolio that generates the steepest line possible when combined with the risk free
investment
 sharpe ratio is the slope of the line, measure of reward per unit risk
 optimal portfolio to combine with risk free asset has highest sharpe ratio and is tangent to
the efficient frontier of risky investments
 tangent portfolio is portfolio with highest sharpe ratio; the point of tangency to the efficient
frontier of a line drawn from the risk free asset; the market portfolio if the CAPM holds
 combinations of the risk free asset and tangent portfolio provide the best risk and return
tradeoff available to an investor
 the tangent portfolio is efficient and, once we include the risk free investment, all efficient
portfolios are combinations of the risk free investment and the tangent portfolio. Therefore,
the optimal portfolio of risky investments no longer depends on how conservative investor is,
every investor should invest in the tangent portfolio independent of taste for risk
 the efficient portfolio is the tangent portfolio, combine with risk free to earn highest possible
return for any risk

The Efficient Portfolio and Required Returns

Portfolio Improvement: Beta and the Required Return
 if we have a portfolio p, lets see if we can increase sharpe ratio by borrowing money and
investing into investment i. if we do so, two consequences
 o Expected return: Because we are giving up the risk free return and replacing it with
i’s return, our expected return will increase by i’s excess return, E[Ri] – rf
o Volatility: we will add the risk that i has common with our portfolio (rest of risk
diversified). Incremental risk measured by SD(Ri) x Corr(Ri, Rp)
 Investing in i offers larger increase in return than we could have gotten from P alone if

 beta of investment i with portfolio P is

 The required return is the expected return of an investment necessary to compensate for the
risk

 If i’s expected return exceeds this required return, than adding more will improve
performance of portfolio

Expected Returns and the Efficient Portfolio

 As we buy shares of i, correlation (and hence beta) with portfolio increases, until expected
return equals required return
 If i’s return is less than required return, reduce holdsings of I so correlation and required
return decrease until equal expected return
 If no restrictions on buy or sell, continue to trade until expected return equals required
return
  A portfolio is efficient if and only if the expected return of every available security equals its
required return

 Thus we can determine the appropriate risk premium for an investment from its beta with
the efficient portfolio
 The efficient / tangent portfolio provides the benchmark that identifies the systematic risk in
the economy

The Capital Asset Pricing Model

The CAPM Assumptions
 Investors can buy and sell all securities at competitive market prices (without incurring taxes
and transactions costs) and can borrow and lend at the risk free rate
 Investors only hold efficient portfolios of traded securities – portfolios that yield the
maximum expected return for a given level of volatility
o Homogenous expectatinos is a theoretical situation in whall all investors have the
same estimates concerning future investment returns (in reality, similar but not the
same)
 Investors have homogenous expectations regarding the volatilites, correlations, and expected
returns of securities

Supply, Demand, and the Efficiency of the Market Portfolio

 The efficient, tangent portfolio of risky securities (the portfolio that all investors hold) must
equal the tangent portfolio

Optimal Investing: The Capital Market Line

 When the tangent line goes through the market portfolio, this is called the capital market
line

Determining the Risk Premium

  If we don’t know the expected return of a security or the cost of capital of an investment,
can use the CAPM to find it using the market portfolio as a benchmark

Market Risk and Beta

 Can convert all formulas using eff to mkt as eff = mkt
 The beta of a security measures its volatility due the market risk relative to the market as a
whole, thus captures security’s sensitity to market risk

The Security Market Line

 Linear relationship between stoxks beta and expected return
 The security market line is the line along which all individual securities should lie when
plotted according to their expected return and beta
 The distance of each stock to the right of the capital market line is due to its diversifiable risk

Beta of a Portfolio
 Weighted average of beta’s

Summary of the CAPM

 Market portfolio is efficient portfolio. Highest expected return for any voltailty is obtained by
portfolio on capital market line combining market port with risk free
 Risk premium of any investment is proportional to its beta with the market. Therefore the
relationship between risk and the required return is given by the security market line