1.1 - 1.4 Risk and Return, Bonds, Stock

1.
1 RISK AND RATES OF

RETURN
1.1 RISK AND RATES OF RETURN
1.1.1 Risk and Return Fundamentals
1.1.2 Different types of return
1.1.3 Risk and Return of a Single Asset
1.1.4 Risk and Return of Portfolio
1.1.5 Correlation, diversification
1.1.6 Capital Asset Pricing Model (CAPM) and
Security Market Line (SML)
1.1.7 Efficient Market Hypothesis
FIVE BASIC PRINCIPLES OF
FINANCE
• #1: Money has a Time Value
• #2: There is a Risk-Return Trade-off
• #3: Cash Flows are the source of Value
• #4: Market Prices reflect Information
• #5: Individuals Respond to Incentives
RISK AND RETURN
• Risk- measure of the uncertainty

surrounding the return that an
investment will earn OR the variability
of returns associated with a given
asset
• (Total) Return-the total gain or loss

experienced on an investment over a
given period of time
RISK-RETURN TRADE-OFF
• Historical data shows that investors usually earn higher
rates of return on riskier investments
notalways
• Risks are not always rewarded; Investors “expect” to
realize a higher return but higher return is not guaranteed
• 5 common types of investments: Treasury bills- Treasury
bonds- Corporate bonds- stocks of large companies-
stocks of small firms arranged in terms of riskiest: lowest to highest risk
A. Government-issued (Bureau of Treasury) = Risk-free

1. Treasury Bills (1yr or less)
2. Bonds (more than a year) - longer so riskier
B. Stocks of Companies
TYPES OF RETURN
1.Realized return
2.Average return
3.Real return
4.Expected return
REALIZED RETURN
• Total gain or loss on an investment
• Combined effect: (1) cash flow and (2) capital gain/loss which
pertains to changes in value over the period
• Can be expressed in amount or percentage over the holding
period
• Cash Return (in amount) = Ending Price + Cash distribution or
dividends – Beginning price
• Rate of return (%) can be computed as follows
Capital Gain/Loss -> Purchase Price vs. Selling Price
where: CFt= cashflow (interest or dividends) received during period

Pt= ending price or value of asset
Pt-1= beginning price or value of asset
CALCULATING REALIZED RETURN
ACYFMG bought an investment at the start of the year
for a total price of P100,000. During the year, the
investment distributed cash amounting to P5,000. At the
end of the year, ACYFMG sold the investment for
P101,600. Realized return can be computed as follows:
Cash return = 101,600 + 5,000 – 100,000 = 6,600

Rate of return= 6,600/100,000 = 6.6% (for holding
period) goodfor 1 year
(5,000 + 101,600) / 100,000 = 6.6%
AVERAGE RETURN
• Two types of average return
• Arithmetic average - simple average or sum set of
returns divide by their number. Applicable if
succeeding period is equal the period of historical
returns
• Geometric or compound return- rate of return
earned on an investment that incorporates
consideration for the effects of compound interest.
Applicable if succeeding period is not equal historical
period and for multi-period horizon
End
Price
BegPrice
COMPUTING AVERAGE RETURN
ACYFMG bought an investment 2 years ago worth
P10,000. The said investment is valued at P11,500 at the
end of year 1 and P11,155 at the end of year 2.
Arithmetic and geometric average return can be
calculated as follows:
r1 = (11,500-10,000)/10,000 = 15%
r2 = (11,155- 11,500)/11,500 = -3%
Arithmetic Ave.= (15% + -3%)/2 = 6%
Geometric Ave.= [(1+15%) x (1+ -3%)]1/2-1 = 5.62%
r terms
= (11,155/10,000)1/2 -1 = 5.62%
REAL RETURN
o Real rate of return- nominal rate adjusted for inflation or
other factors (taxes and fees); it reflects the additional
purchasing power gained on of the investment
o Nominal or quoted rate of return- basic return
generated by an investment without adjusting for inflation
and other factors
o Fisher effect model: relationship between the nominal
rate, the anticipated rate of inflation and the real rate
(1+nominal) = (1+real) (1+inflation)
o Real = [(1+nominal)/ (1+ inflation)] -1 derived
o Inflation premium( IP)= nominal rate – real rate derived
NOMINAL VS. REAL RETURN
oCompute for ACYFMG’s real return on its
investment earning 12% if inflation is 2% during
the year. What is the inflation premium?
Theinvestmentearned
oReal = [(1+12%) /(1+2%)]-1 = 9.8% youa 9.801 withthe
samepurchasingpower
oInflation premium= 12% - 9.8% = 2.2%
Gadditionalreturn to
coverforinflation
EXPECTED RETURN
• Three approach of computing expected return:
Probabilistic ,historical and risk-based
• Weighted average of possible returns, where
weights are determined by the probability that it
occurs Historical = ave. of historical returns
• Expected Rate of Return= (Rate of Return 1 x

Probabilty of Return 1) + (Rate of Return 2 x
Probabilty of Return 2)+…+ (Rate of Return n x
Probabilty of Return n)
CALCULATING EXPECTED RETURN
Calculate ACYFMG’s expected return worth P50,000
with the following estimates:
Outcome Probability Yearend
Selling Price
Good 30% P57,500
Fair 50% 51,000
Poor 20% 44,750
ILLUSTRATIVE: Types of Return
Using the expected return, you decided to invest your P500,000 in an investment. The
expected return was calculated based on the following probable ending values after one
year: 30% 575,000
35% 525,000
35% 485,000
After a year, the investment is valued at P 515,000. Since the actual return for year 1
falls short of your expectation, you decided to continue your investment for another
year. At the end of year 2, you sold your investment at its market value of P 546,000.
Calculate the following:

201 a.) expected return
9.201b.) realized return for the two-year period
4.511 c.) arithmetic average of your historical return for the two-year period
4.501d.) geometric average of your historical return for the two-year period
e.) If inflation was 2% annually for 2 years, compute the real return on year 1, year 2
and over the 2-year period. E1 0.9801 EL 3.94 E3 4.96
RISK PREFERENCES
Three categories to describe how investors respond to risks:
- Assume this if problem is silent

- Represent the Risk Return Trade-off
Risk Averse – Risk Neutral- Risk Seeking-

investor require investors choose investors prefer
an increased the investment investments with
return as with the higher greater risk even
compensation return regardless if they have
for an increase in of its risk lower expected
risk return
ILLUSTRATION:
RISK PREFERENCES
return
• Luigi: I will take a card from PILE A
200014
Pile A +400 +400 +600 +600 soo
PILE B
• Peach: I will take a card from
200014
Pile B +0 +0 +1,000 +1,000 soo
• Mario: I will take a card. I

don’t mind which pile I take
one from
ILLUSTRATION: RISK PREFERENCES
variabilityofReturns
PileA PileB
PILE A aim
• Luigi: I will take a card from
+400 +400 +600 +600 Pile A (risk averse)
PILE B
• Peach: I will take a card from
+0 +0 +1,000 +1,000 Pile B (risk seeking)
• Mario: I will take a card. I
don’t mind which pile I take
one from (risk neutral,
indifferent since both piles have
same expected return)
RISK ASSESSMENT
• Two approaches: Scenario Analysis and Probability

Distribution
• 1. Scenario analysis- uses several possible alternative
outcomes (scenarios) to obtain sense of the variability
among returns
• 2. Probability distribution- Model that relates
probabilities to the associated outcomes
• Probability- chance that a given outcome will occur
Probability distribution
• A bar chart is the simplest type of probability distribution;

shows only a limited number of outcomes and associated
probabilities for a given event. The wider the riskier as it covers more area = more variability
condensed Intterdskier
sincemore
varied
toassess which
PROBABILITY DISTRIBUTION asset is riskier
or not
• A continuous probability distribution is a probability

distribution showing all the possible outcomes and
associated probabilities for a given event.
The wider the riskier as it covers more area = more variability
lessRisk
riskier
morevariable
RISK MEASUREMENT
• Relates risk to the volatility of an investment or
variability of returns
• Asset’s or investment’s risk can be measured
through:
• 1. Range
• 2. Standard deviation if the problem is silent
• 3. Coefficient of variation
• 4. Beta
RISK MEASUREMENT: RANGE
Range- measure asset’s risk by subtracting
return associated with pessimistic outcome from
return associated with optimistic outcome
Asset B is riskier because

wider range
highest - lowest return Higher

917 2301 RISK
1390
17
I
RISK MEASUREMENT: SD
• Variance (σ2) = [(rate of return 1 – expected
return)2x probability of return 1]+[(rate of return 2
– expected return)2x probability of return
2]+…+[(rate of return n – expected return)2x
probability of return n]
• Standard deviation = squareroot of variance
• Example: Compute for the standard deviation of ACYFMG’s
P50,000 investment:
Outcome Probability Rate of Return
Good 30% 15%
Fair 50% 2%
Poor 20% -10.5%
• Expected return = 3.4%

• If probabilities are unknown, analysts use historical

data to estimate standard deviation using the
formula below:
• Using excel: =stdev(r1,r2,r3…rn)

15 3
ACYFMG bought an investment 2 years ago worth
P10,000. The said investment is valued at P11,500 at
the end of year 1 and P11,155 at the end of year 2.
Calculate standard deviation using historical
returns.
Arithmetic average return = 6% 2 because we only have 2 returns
Variance: [(15%-6%)2 + (-3% - 6%)2]/ (2-1) = 0.0162

Standard deviation: squareroot of 0.0162 = 12.73%
RISK MEASUREMENT: CV
• Coefficient of Variation (CV) – measure of relative
dispersion that is useful in comparing risks (standard
deviations) of assets with differing expected returns
• Standard deviations of investments with different
expected returns are not comparable
• A higher coefficient of variation means that an

investment has more volatility relative to its
expected return riskier
Comparing risks of investments
Using previous examples (50,000 investment and

10,000 investment), we can compute their CV to
determine which has higher risk.
P50,000 investment: 8.94%/ 3.4% = 2.63
P10,000 investment: 12.73%/6% = 2.12

ILLUSTRATIVE: Risk Measurement
Using the expected return, you decided to invest your P500,000 in an investment. The
expected return was calculated based on the following probable ending values after one
year: 30% 575,000
35% 525,000
35% 485,000
After a year, the investment is valued at P 515,000. Since the actual return for year 1
falls short of your expectation, you decided to continue your investment for another
year. At the end of year 2, you sold your investment at its market value of P 546,000.
Calculate the following:

a.) standard deviation of the expected return
b.) standard deviation of your historical return
c.) coefficient of variation of the expected return
d.) coefficient of variation of your historical return
• In real-world situations, the risk of any
single investment would not be viewed
independently of other assets. New
investments are evaluated based on their
impact to an investor’s portfolio of assets
• Investment portfolio is a combination of
INVESTING IN A several individual investments (marketable
PORTFOLIO AND securities, bonds, stocks, etc.) based on
DIVERSIFICATION one’s risk preference and investment
objective
• Portfolio can be less risky than the
average risk of its individual investments in
the portfolio due to Diversification
A 2019 study of 150 PSE companies used
financial ratios to determine optimal
portfolio. Back-test results show that
portfolio selection using a combination of
INVESTING IN A n number of favorable financial ratio
PORTFOLIO AND
trend is not only superior to the
DIVERSIFICATION
portfolio selection using only one financial
ratio trend but also outperforms the
market portfolio. (Mercado et al., 2019)
Diversification
! Diversification- reduction in risk that comes about
STDEV
by combining two or more risky assets into a

portfolio where the individual assets are less than
minimum for diversification
perfectly positively correlated

! There is diversification benefits if we combine
investments whose return does not move together
! Correlation coefficient- a measure of the degree to
which that variation in one variable is related to the
variation in another (ranges -1 to +1)
DIVERSIFICATION Correlation Coefficient
Correlation Diversification Benefits

between
investment
Diversification benefits returns nodiversification
or
will be greater when
perfectly positively correlated
+1 No benefit
correlations are low or 0.0 Substantial benefit
negative -1 Maximum benefit.
perfectly negatively correlated
Abestto Indeed, the
unsystematic risk of
find portfolio can be reduced
to zero.
INTERNATIONAL DIVERSIFICATION
• The inclusion of assets from countries with business cycles that are not highly correlated
with the local country’s business cycle reduces the portfolio s responsiveness to market
movements.
• Over shorter periods such as a year or two, internationally diversified portfolios may
perform better or worse than domestic portfolios
• Over long periods, internationally diversified portfolios tend to perform better (meaning
that they earn higher returns relative to the risks taken) than purely domestic portfolios.
you cannot control if international
a nationwide
Ifthere's
event allstocks
willbeaffected
out if youdiversify
SYSTEMATIC AND UNSYSTEMATIC RISK
• Total risk of an investment consist of two parts:

UNSYSTEMATIC SYSTEMATIC
• Total risk = Diversifiable risk + Nondiversifiable risk

UNSYSTEMATIC / FIRM-SPECIFIC
• Diversifiable risk- is the portion of an asset’s risk

that is attributable to firm-specific or random can be controlled
by the firm
causes; can be eliminated thru diversification

SYSTEMATIC / MARKET RISK
• Nondiversifiable risk- is the portion of the asset’s

inflation
war risk attributable to market factors that affect all
CANNOT be
controlled by
fir,m
firms; cannot be eliminated through diversification

Countessthruinternationaldiversification
You cannot bring your STDEV to 0 because there
always systemtic risk
DIVERSIFICATION AND UNSYSTEMATIC RISK
• Diversifiable- aka unsystematic, unique, firm-specific or
ex. scandals & corruption = can be controlled by the firm e.g. by appointing a verified person or hide the
idiosyncratic risk
scandal through media
• Non-diversifiable –aka systematic or market-wide risk

is declines aryougag
Totalrisk
declining P more investments
but it only
pertains
Remainthesameregardless
investments
of your
MEASURING NONDIVERSIFIABLE RISK
• Using investment’s beta coefficient (β) response to the
M
• Beta-measures the extent to which a particular market
investment’s returns vary with the returns of the
market portfolio
• Market portfolio is an optimally diversified portfolio
that includes all risk investments/ assets in the market
• Beta of market portfolio is 1.00 whereas Beta or risk-
free investment is 0.0
• In practice, β is estimated as the slope of a straight line
calculated using rise over run
GRAPHICAL
DERIVATION
OF BETA
FOR ASSETS
R AND S
INTERPRETING BETA COEFFICIENT
positive
negative
CALCULATING BETA
1. Using Graph: compute for slope (Rise over run)
LEGEND
2. Using Covariance or Correlation Formula: rm market

ri orra asset
• Covariance and correlation measures how

two stocks move together
EXAMPLE: CALCULATING BETA
Using the graph below, calculate Beta of Asset A and Asset B
Asset Return %
EXAMPLE: 32
28
Asset B
CALCULATING 24
20
b = slope = 1.33
Asset A
BETA 16
12
b = slope = .75
8
4
0 Market
-16 -12 -8 -4 -4 0 4 8 12 16 20 Return
-8
-12
• To estimate beta, the “rise over run” method can be used:

• Taking the points shown on the graph:
DY 12 - 9 3 DY 26 - 22 4
Beta A = = = = 0.75 Beta B = = = = 1.33
DX 8 - 4 4 DX 13 - 10 3
With a higher beta of 1.33, Asset B is more risky. Its return will move 1.33 times for each one
point the market moves. Asset A’s return will move at a lower rate, as indicated by its beta
coefficient of 0.75.
A financial calculator with statistical functions can be used to perform linear regression analysis. The
beta (slope) of line A is 0.79; of line B, 1.379.
Let's assume the investor also wants to calculate the beta of

Tesla Motors Inc. (TSLA). Based on data over the past five
years, TSLA and market return have a covariance of 0.032, and
the variance of market return is 0.015.
• Beta of TSLA =0.032 / 0.015 = 2.13

• Therefore, TSLA is theoretically 113% more volatile than the
market return.
An investor is looking to calculate the beta of Apple Inc.
(AAPL). Based on data over the past five years, the correlation
between AAPL, and market return is 0.83. AAPL has a standard
deviation of returns of 23.42% and market return has a
standard deviation of returns of 32.21%.
•Beta of AAPL = 0.83 x (0.2342 / 0.3221) = 0.6035

• In this case, Apple is considered less volatile than the
market as its beta of 0.6035 indicates that the stock
theoretically experiences 40% less volatility than the market.
EXPECTED RETURN FOR PORTFOLIOS
• Portfolio’s return = weighted average of the

expected rates of returns of the individual
investments
• Portfolio weights (w) = amount invested in a

security divided by Total portfolio investment
EXPECTED RETURN FOR PORTFOLIOS
(CONT’D)
Suppose ACYFMG would be investing on the
following securities:
• 50,000 on Stock A with 15% E(R)
• 10,000 on Stock B with 10% E(R)
• 15,000 on Stock C with 12% E(R)
Expected return of the portfolio would be computed as:
= [15% x (50/75)] + [10% x (10/75)] + [12% x (15/75)]
=13.73%
Weights: A= 67%; B=13%; C=20%
PORTFOLIO RISK
• Using standard deviation of portfolio and not
weighted average of standard deviations
• Difference is due to effects of diversification
Asif portfolio
asset
is asingle
CALCULATING PORTFOLIO RISK
If ACYFMG invest half of its excess cash in each of the two common
stocks below
Expected Return Standard Deviation
Common Stock A 15% 8%
Common Stock B 20% 18%
about
Correlation 0.3
Coefficient
10
foster
versification
notjust
adding
lookinto
also comelatrin
Its portfolio risk can be computed as follows: their
ahalf ofthe 2 w
asset as invested
=squareroot of [ (0.5 x 0.08 ) + (0.52 x 0.182) + (2 x 0.5 x 0.5 x 0.3
2
x 0.08 x 0.18)]
decreaseisduetodiversification
=10.89% (vs. 13% if weighted average was used)
Covariance Covariance
CALCULATING PORTFOLIO
RISK
! If correlation of coefficient (ρ) is not given, we can
calculate standard deviation of a portfolio using
historical returns of the portfolio and applying the
following formula:
! Historical returns of the portfolio can be computed

using weighted average historical returns of the
assets in the portfolio
CALCULATING PORTFOLIO BETA
• Portfolio Beta-measures the systematic risk

of the portfolio
• Calculated using the weighted average of the
Betas of the individual investments contained
in the portfolio
CALCULATING PORTFOLIO BETA
ACYFMG hold a portfolio with the following securities:
Percent of
Security Portfolio Beta Return
X Corporation 20% 1.35 14%
Y Corporation 35% 0.95 10%
Z Corporation 45% 0.75 8%
The expected return and beta for the portfolio can be computed as
follows:
Portfolio return: (20% x 14%) + (35% x 10%) + (45% x 8%) = 9.9%
Portfolio beta: (20% x 1.35) + (35% x 0.95) + (45% x 0.75) = 0.94
Illustrative: Portfolio return, SD and beta
Tiffany is considering building an investment portfolio containing two
stocks, ALT and ESC. ALT will represent 40% of the value of the portfolio,
and ESC will account for the the 60%.
Security Return SD Beta

ALT 9% 15.1% 0.73
ESC 21% 36% ?
6.20 (a) Calculate portfolio expected return

23.561(b) Determine portfolio standard deviation if correlation of ALT’s return
and ESC’s return is 0.2
1.61 (c) Compute for ESC’s beta if its correlation with market return is 1.25
and market return’s standard deviation is 28%.
1.26
(d) What is the portfolio beta?
MODERN PORTFOLIO THEORY
• Efficient portfolio- a portfolio that

maximizes return for a given level
mustlower of risk
dont
thanthisthe • Modern Portfolio Theory (MPT),
also called "portfolio theory" or
"portfolio management theory“, is
an investment theory by Harry
Markowitz. MPT suggests that it is
possible to construct an "efficient
frontier" of optimal portfolios
MODERN PORTFOLIO
THEORY
• MPT suggests that it is not enough to look at
the expected risk and return of one
particular stock. It quantifies the
benefits of diversification, also known as
not putting all of your eggs in one basket.
• Capital Market Theory builds upon the
Markowitz portfolio model. It tries to
explain and predict the progression of
capital markets over time on the basis of the
one or the other mathematical model such as
the Capital Asset Pricing Model.
CAPITAL ASSET PRICING MODEL (CAPM)
• Capital Asset Pricing Model (CAPM) model- links

risk and return for all assets
• Using the beta coefficient to measure
nondiversifiable risk
• CAPM assumes that investors choose to hold the
market portfolio
• Per CAPM, relevant risk of an investments relates to
how the investment contributes to the risk of this
market portfolio
CAPM
• Risk-based approach of computing expected return
• Two parts: risk-free rate of return and risk premium
the asset
• Risk Premium= Difference between the returns of

riskier investment and the less risky investment
• The risk premium of Investment A (10% return)
over Investment B (8% return) is 2%
CAPM
• Using the beta coefficient and market risk premium
to measure nondiversifiable risk, CAPM pricing
equation:
Market (risk) premium
Asset j’s or Company’s (risk) premium

ESTIMATING EXPECTED RETURN (CAPM)
Security I has a beta of 1.3, the risk-free rate is 4%, and

the expected return on the market is 11%. The CAPM
expected return for Security I can be computed as
follows:
E(r) = 4% + 1.3(11% - 4%) = 13.1%
Market risk premium is 7% while that of Security I is 9.1%
ESTIMATING EXPECTED RETURN (CAPM)
ACYFMG invested P25,000 in Stock A (β=1.5) and
additional P75,000 in Stock B (β=1.75). Compute for
expected return of your portfolio using CAPM if risk-free
rate of 2% and expected market return of 8%.
CAPM E(r) of A = 2% + 1.5(8%-2%) = 11%
CAPM E(r) of B = 2% + 1.75(8%-2%) = 12.5%
Portfolio beta = (1.5 x 25/100) + (1.75 x 75/100)= 1.6875
Portfolio E(r) = (11% x 25/100) + (12.5% x 75/100) OR
= 2% + 1.6875(8%-2%) =12.125%
ILLUSTRATIVE: ESTIMATING EXPECTED
RETURN (CAPM)
Kendall invested P1,000,000 to set up the following portfolio
one year ago
Stock Cost Beta at purchase
L34 P 500,000 0.90
M78 170,000 1.85
N90 330,000 1.22
At the time Kendall made her investments, investors were

estimating that the market return for the coming year would
be 15% and risk-free rate would have an average of 4%.
Calculate the CAPM return of each stock and that of the
portfolio.
CAPM: STOCK OVER/UNDERVALUATION
Comparing CAPM required return and expected return of a
stock, we can assess whether a stock is overvalued or
undervalued
E(R) < CAPM (r),

stock is overvalued
E(R) > CAPM (r),

stock is undervalued
CAPM: STOCK OVER/UNDERVALUATION
E(R) < CAPM (r),
stock is overvalued
E(R) > CAPM (r),

stock is undervalued
Assume that the risk free rate is 5% and the expected market return is
15%. Stock A, with beta of 0.7, is currently valued at P100 today and
is expected to increase by P10 and pay P5 dividends.
CAPM return = 5% + 0.7 (15%-5%) = 12%
Expected return =( 5 + 110 – 100)/ 100 = 15%; stock A is undervalued
For the stock to be fairly valued according to CAPM, the price would
have to be 125/share (5 + 10 / 12% = 125).
CAPM AND SECURITY MARKET LINE
• Investments with same systematic risk (beta) will
have the same CAPM return
• Investors will require a higher rate of return on
investments with higher systematic risks (beta)
• When CAPM is depicted graphically, it is called the
• SML – graph that reflects the required return in
the market place for each level of nondiversifiable
risk (beta)
SECURITY MARKET LINE
Stock is
undervalued
where,
intercept - risk
free rate
slope- market risk

premium
stock is
overvalued
INFLATION ON SML
Changes in inflationary expectations affect the risk-free rate of
return resulting to SML shifting upward/downward
RISK AVERSION ON SML
Slope of SML reflects the degree of risk aversion of investors in the
market place. Increasing risk avoidance will result to a steeper SML.
RISK AND RETURN: THE CAPM (CONT.)
• Risk-return tradeoff is clearly represented in SML

• CAPM assumes there is a linear relationship between
risk and return and that return should increase with
risk
• The CAPM relies on historical data; therefore, the
required returns specified by the model should be used
only as rough approximations.
• The CAPM also assumes markets are efficient.
• States that securities prices accurately
reflect future expected cash flows and
are based on all information available to
investors
• An efficient market is a market in which
all the available information is fully
EFFICIENT incorporated into the prices of the
MARKET securities and the returns the investors
HYPOTHESIS earn on their investments cannot be
(EMH) predicted. Because of this, it is
impossible for an investor to
consistently earn high rates of return
without taking substantial risk
EFFICIENT MARKET HYPOTHESIS (EMH)
• Degree of market efficiency
• Weak- reflects past market information
• Semi-strong- reflects past and present public
information
• Strong- reflects all information, including
private information
• In general, markets are expected to be at least
weak-form and semi-strong form efficient.
1.1 RISK AND RATES OF RETURN
1.1.1 Risk and Return Fundamentals
1.1.2 Different types of return
1.1.3 Risk and Return of a Single Asset
1.1.4 Risk and Return of Portfolio
1.1.5 Correlation, diversification
1.1.6 Capital Asset Pricing Model (CAPM) and
1.1.7 Efficient Market Hypothesis
Questions and clarifications?
END OF 1.1
• 1.2.1 Application of Time Value of Money
• 1.2.2 Valuation: The Basic Process
• 1.3.1 Types of Bonds

• 1.3.2 Bond Valuation
• 1.3.3 Bond Yields
• 1.3.4 Convertible Bond
• #1: Money has a Time Value
• #2: There is a Risk-Return Trade-off
• #3: Cash Flows are the source of Value
• #4: Market Prices reflect Information
• #5: Individuals Respond to Incentives
• P1,000,000 today or after 5 years? Which has
more value?
• Will your answer change if the choice is
P1,000,000 today or P1,200,000 after 5 years?
• Is P200,000 worth the 5 years?
• Time value is based on the belief that a peso
today is worth more than a peso to be received
at some future date. It assist managers in making
decisions for cash flows involving different time
periods
TWO VIEWS OF TIME VALUE
PV Present
Value FV Future
Value
value today of a cash value of a cash flow

flow in the future today at a future
• Known item- future date
cash flow – Know item- current
• Process of cash flow
computing the PV- – Process of
discounting computing the FV-
compounding or
projecting
PATTERNS OF CASH FLOW
Lump Sum–single cash flow either currently

held or expected at a future date
Annuity- stream of equal periodic cash flows

Ordinary annuity- occurs at the end of each period (commonly used)
Annuity due- occurs at the beginning of each period
Mixed Stream- series of unequal cash flows reflecting no

particular pattern
TIMELINE DEPICTING CASH FLOW
Future
Value
PROJECTING/
COMPOUNDING
-P1,020,000 P10,000 P10,000 P10,000 P10,000 P980,000
0 1 2 3 4 5
DISCOUNTING
Present
Value
TYPES OF TIME VALUE
TIME VALUE
Future value
Lump Sum Annuity Mixed Stream
Ordinary
Due
Present Value
Lump Sum Annuity Mixed Stream Perpetuity
Ordinary Level
Due Growing
TYPES OF TIME VALUE
TIME VALUE
Future value
Ordinary
Due
Present Value
Ordinary Level
Due Growing
Concept of compound interest
• Projecting/compounding- process of computing
future value
• There are two ways to apply interest over the
principal:
– Simple interest- interest paid only on the initial principal of
an investment
– Compound interest- interest earned on both principal and
on interest earned in previous period (commonly used)
• Example: P2,000,000 earning 10% per year under a 5-
year time deposit. Maturity value applying:
(1) Simple interest: 2,000,000 + (2,000,000 x 10% x 5) = 3,000,000
(2) Compound interest: 2,000,000 x (1+10%)5 =3,221,020
G FVLumpsum
Formula elements
• FV – future value or terminal value
• PV – present value
• r – interest rate or opportunity cost per period
(typically 1 year)
• n – number of periods invested (typically
years)
• CFt – cash flow at the end of period t
• t - period number (1,2,3….n)
• CF – annuity’s annual payment
• g – constant annual growth rate
• m – number of times compounded per year
FUTURE VALUE
Definition Formula Example: Compute
for the FV of the
following CF if
Interest is 12%
Lump Sum Value of a single P2,000,000 after 3
amount in the future years
Ordinary Value of equal cash P10,000 every end
Annuity flows made every end of the year for 3
of the period in the years
future
Annuity Value of equal cash P10,000 every
Due flows made every beginning of the
beginning of the year for 3 years
period in the future
Mixed Value of unequal cash cash flows: year 1 =
Stream flows in the future P15,000; year 3 =
P7,500
– Lump sum: 2M x 1.123 = 2,809,856
– Ordinary annuity: 10,000 x [(1.123 -1)/12%] = 33,744
– Annuity Due: 33,744 x 1.12 = 37,793.28
– Mixed Stream: (15,000 x 1.122) + 7,500 = 26,316

cashflowx strate
Compounding more frequently than annually
• For: Semiannual, Quarterly, monthly, weekly or daily
• Modify FV equation by dividing the interest rate (r) by
the number of times compounded per year (m) and
multiplying the period (n) by m.
Example: P1,000,000 compounded monthly for 2 years,

assuming a 12% interest rate:
=1M x 1.0124 =1,269,734.65
APR vs. EAR
Annual Percentage Rate (APR)- aka simple, nominal, quoted or
stated interest rate
APR-the interest paid or earned in one year without compounding. It
is equivalent to r if expressed in annual terms; otherwise, use
equation below if r is expressed in period shorter than a year
Effective Annual Rate (EAR) aka annual percentage yield – the

annual compounded rate; return earned or paid over a 12-month period
taking compounding into account
Example: APR and EAR of interest of 3% per quarter compounded

quarterly is
APR: 3% x 4 = 12%;
EAR: 1.034 – 1 = 12.5509%
Continuous Compounding
Compounding interest literally all the time. Equivalent

to compounding interest an infinite number of times
per year.
We use exponential function as follows:
Example: P1,000,000 compounded continuously at

12% interest rate for 2 years:
= 1,000,000 x e(12%x2) = 1,271,249.15

Continuous EAR: e12%-1 = 12.7497%
TYPES OF TIME VALUE
TIME VALUE
Future value
Ordinary
Due
Present Value
Ordinary Level
Due Growing
PRESENT VALUE
for the PV of the
following CF if
Interest is 12%
Lump Sum Value today of single 2,000,000 to be

future cash flow received after 3
years
Ordinary Value today of equal P10,000 every end
Annuity cash flows every end of the year for 3
of the period years
Annuity Value today of equal P10,000 every

Due cash flows every beginning of the
beginning of the year for 3 years
period
PRESENT VALUE
for the PV of the
following CF if
Interest is 12%
Mixed Value today of cash flows: year 1 =

stream unequal cash flows to P15,000; year 3 =
be made in the P7,500
future
Level an annuity with P10,000 every year
Perpetuity constant level of with no maturity
payments that
continues forever
(n=∞)
Growing perpetuity in which P10,000 growing
Perpetuity the payments grow at 0.5% every year with
a constant rate from no maturity
period to period over
time
• Lump sum: 2M / 1.123 = 1,423,560.50
• Ordinary annuity: (10,000/12%) x [1-(1/1.123)] =

24,018.31
• Annuity Due: 24,018.31 x 1.12 = 26,900.51
• Mixed Stream: (15,000/1.12) + (7,500/1.123)= 18,731.21
• Level perpetuity: 10,000/12% = P83,333.33

• Growing perpetuity: 10,000/(12%-0.5%) = 86,956.52
• P1,000,000 today or after 5 years? Which has
more value?
• Will your answer change if the choice is
P1,000,000 today or P1,200,000 after 5 years?
• Is P200,000 worth the 5 years?
• Compute for PV or FV assuming prevailing
interest rate of 6%
COMMON APPLICATIONS OF
TIME VALUE FORMULA
1. Regular deposits needed to accumulate a future

sum- using FV of an annuity equation
2. Periodic payments in Loan amortization- using PV of

an annuity equation
3. Determining interest or growth rate- using FV of a

lump sum equation
COMMON APPLICATIONS OF
TIME VALUE FORMULA
4. Determining unknown number of periods-

using FV of a lump sum equation
Rule of 72- is a simplified way to determine how long an

investment will take to double, given a fixed annual rate of
interest. By dividing 72 by the annual rate of return, investors
can get a rough estimate of how many years it will take for
the initial investment to duplicate itself.
Rule of 72
7219
Exercise: Application of Time
Value
A small beach house in Palawan now

costs P25 million. Inflation is
expected to cause this price to
increase at 3.5% per year over the
next 7 years before Liam and Jane
retire from successful careers in real
estate. How large an equal annual
end-of-year deposit must be made
into a time deposit account paying
an annual rate of interest of 12% in
order to buy the beach house upon
retirement?
o Valuation- process that links risk and return to determine
worth of asset
o Value of any asset is the present value of all future cash
flows it is expected to provide over the relevant time
period
v0 = Value of the asset at time zero

CFT = cash flow expected at the end of year t
r = appropriate required return (discount rate)
n = relevant time period

Steps:
1. Estimate amount and timing of cash flow
2. Estimate appropriate discount rate
3. Calculate price using present value
0 1 2 3 4 5 6 7 8 9 10
1.3 Bond Valuation
Bond
-A long-term (10 year or more) debt
instrument indicating that the issuer
has borrowed certain amount of
money and promises to repay in the
future under clearly defined terms
claims on debt (like bonds) are honored

before those of preferred and common
stock
o Bond indenture- a legal document that specifies
both the rights of the bondholders and the
duties of the issuing corporation
o Par value or face value or principal- stated
amount that the firm is to repay upon the
maturity date
o Bond premium (discount)- the amount by which
a bond sells above (or below) its par value
McGrawUs
Inn
Principalstem
o Coupon or interest rate- percentage of a bond’s

par value that will be paid annually (typically in two
equal semiannual payments), as interest silent annually
o Maturity date- date on which the bond issuer must
repay the principal or par value to the bondholder
o Bond rating- credit rating given to a bond,
providing an indication of creditworthiness of the
bond
o Recovery rate- % of principal or interest that is
owed that a bondholder will end up receiving if the
bond defaults
• Restrictive or protective covenants- provisions in
bond indenture that place operating and financial
constraints on the borrower
– positive covenants- requirements that borrower
must do/ meet as long as bonds remain
outstanding
• Sinking fund provision- restrictive covenant that requires the
systematic retirement of bonds prior to their maturity
– Negative covenants- requirements that borrower
must not do
cites causes of accounting
woes (April 18, 2018)
The changes prompted the downward revision of profits by almost P2 billion over
two years.
The restatement also had an impact on when 2GO’s long-term debt became due.
Most of its debt is owed to the BDO Unibank Inc., controlled by 2GO shareholder
SM Investments Corp.
As of the end of last year, long-term debt amounting to P731.3 million and P2.7
billion for 2017 and 2016, respectively, were reclassified into current liabilities. This
means they are due in the next 12 months. These were reclassified because 2GO no
longer complied with its debt covenants
Source: https://business.inquirer.net/249360/2go-cites-causes-accounting-
woes#ixzz6UyUQcTrT
• Conversion feature- allows bondholders to
change each bond into a stated number of shares
of common stock
• Call provision- gives the issuer the opportunity to
repurchase bonds at a stated call price prior to
maturity
• Stock purchase warrants- instrument the give
their holders the right to purchase a certain
number of shares of issuer’s common stock at a
specified price over a certain period of time
Example: In 2020, RB Corp. issued 40,000 15-year 10%
semi-annual coupon bond with a face value of
P1,000 for P 993.
Determine the following elements:

a.
4010001000 Total par value
10 b. Coupon interest payment per bond
c. Maturity date
d. Bond premium or discount (per bond)
o By Issuer
1.Corporate bonds- a bond issued by a corporation.
2.Municipal bonds- issued by local government and
municipalities to help finance public projects (schools,
highways, bridges, prisons, etc.)
3.Treasury bonds- issued through Bureau of Treasury
department as direct obligation of the Republic of the
Philippines
4.Agency bonds- issued by specific government agencies to
be used for certain projects
o By Issuer
4.Eurobonds- bond issued by an international
borrower and sold to investors in countries with
currencies other than the currency in which the
bonds is denominated (e.g. US company issuing
dollar-denominated bond in the Philippines)
5.Foreign bond- issued by foreign corporation or
government and is denominated in investor’s home
currency (e.g. Japanese company issuing peso-
denominated bond in the Philippines)
o By Features
7. Fixed-rate bonds- coupon payments are fixed in amount
over the bond’s life
8. Floating-rate or variable rate bonds- have interest rates that
adjust up or down depending on movements of an
agreed upon benchmark, such as treasury rate or IBCL
– Interbank Call Loan (IBCL) rates- rate of loans among
banks for periods not exceeding 24 hours to cover
reserve deficiencies
9. Income bonds- payment of interest is required only when
earnings are available
10. Zero or low-coupon or pure discount bonds- issued with
no or very low coupon payments and sold at large
discount from par
o By Features (cont’d)
11. Debentures- Unsecured bonds
12. Subordinate Debenture (Unsecured bonds) – Claims
are not satisfied until those of the creditors holding
certain (senior) debts have been fully satisfied
13. Junk (high-yield) bonds- high-risk debt that has a
below-investment-grade bond rating (rated Ba/BB or
lower)
14. Mortgage bonds- bond secured by real estate or buildings
15. Collateral Trust bonds –secured by stock and/or bonds that are
owned by issuer. Collateral is usually 25% to 35% greater
than bond value
16. Equipment Trust Certificates- used to finance new equipment
or “rolling stock”. It is a type of leasing where trustee buys
the asset with funds raised through sale of trust certificates
and then lease it to the firm. Title for the equipment is held
in trust for the holders until the debt is paid off (final lease
payment is made).
17. Term bonds- bonds which mature on a single date
18. Serial or installment bonds- bonds which mature in
portion over several different dates during its term or
life.
19. Amortizing bond- bonds that are paid off in equal periodic
payments with those payments including part of the
principal (par value) along with the interest payments
20. Non-amortizing bonds- bonds that are paid-off with
periodic interest payments first and the principal to be
paid on maturity date
21. Convertible bonds- debt securities that can be converted
into a issuer’s stock at a pre-specified price
22. Exchangeable (Mandatory) bonds- investors have option
(or are required) to convert into CS of another company
other than issuer
23. Callable bonds- issuer has right to repurchase in the
future at a predetermined price
24. Putable bonds- investors can sell bonds back to issuer at a
predetermined price
25. Premium bond- bond that is selling above its par value
26. Discount bond- bonds that sell at a discount below par
value
27. Extendible notes- short maturities, typically 1-5 years, that
can be renewed for a similar period at the option of the
holders
o Value is equal to the present value of the contractually
promised principal and interest payments (the cash
flows) discounted back to the present using the market’s
required return, aka yield to maturity (YTM), on similar
risk bond
o Price = PV of coupons + PV of principal
using excel: =pv(rate,nper,pmt,fv)
Note: excel would normally result in negative amount to denote as
cash outflow
o Using PV of mixed stream or combination of annuity and
lump sum
o Bond pricing equation:
1
1− 1
1 + 234 !
!"#$ %&'() = +#,)-)., + 5-6#768&'
234 1 + 234 !
80 x i Tat 5135723
Premium bond if:
Price > Face Value
Coupon > YTM
Discount bond if:

Price < Face value
Coupon < YTM
nets nets
NR
farce
NR E
masnabilimonamura mashabilimo
ngmahal
DISCOUNT
interest expense increase
Amortization increase Amortization increase t
ACYFMG just issued a 10-year 15% coupon bond. The face
value of the bond is P1,000 and the bond makes annual
coupon payments. If the required return on the bond is
10%, what is the bond’s price?
Premium
18 12
1
1− 1
1 + 234 !
!"#$ %&'() = +#,)-)., + 5-6#768&'
234 1 + 234 !
Value of the bond can be computed as follows:

P0 = P150 x {[1-(1 /(1+10%)10)] /]10%} + [P1,000 /(1+10%)10
= 1,307.23
Using excel: =pv(10%,10,150,1000) =-1,307.23 =1,307.23
Note: excel would normally result in negative amount to denote as
cash outflow
Heartilly Inc. recently issued bonds that mature in 15 years.
They have a par value of P1,000 and an annual coupon of
5.7%. If the current market interest rate is 7%, at what
price should the bonds sell?
1
1− 1
1 + 234 !
!"#$ %&'() = +#,)-)., + 5-6#768&'
234 1 + 234 !
Non-annual coupon
o For bonds paying coupon for a period of less than
one year, we need to adjust the bond-pricing
framework by:
o Dividing annual interest by m
o Dividing YTM or annual required return by m
o Multiplying period (n) by m
1
1−
+#,)-)., 1 + 4563/ !"# 1
!"#$ %&'() = + 9-:#;:<&'
/ (4563/ ) 1 + 4563/ !"#
where: m- number of interest payment period per

year
Non-annual coupon
BK just issued a 10-year 15% coupon bond. The face value
of the bond is P1,000 and the bond makes semiannual
coupon payments. If the required return on the bond is
10%, what is the bond’s price?
Price of the bond can be computed as follows:

= 75 x {1-[1 /(1+ 5%)20] / 5%} + [1,000 /(1+ 5%)20]
= P1,311.56
Using excel: =pv(5%,20,75,1000) = -1,311.56 =1,311.56

Current or coupon yield- measure of a bond’s cash return for
the year
Yield to maturity (YTM)- compound annual rate of return

earned on a debt security purchased on a given day and
held to maturity
Yield to call (YTC)- rate of return that investors earn if they
buy a callable bond and hold it until it is called back. If lower
than YTM, investors would expect bonds to be called.
Holding period yield (HPY)- compound annual return earned
by the investor over the holding period for the bond; same
calculation of YTM except for period and ending value
o YTM is the discount rate that makes present value of the
bond’s promised interest and principal equal to the bond’s
observed market price
o Using same equation but solve for YTM using trail and error
approach* and interpolation
1
1− 1
1 + 234 !
!"#$ %&'() = +#,)-)., + 5-6#768&'
234 1 + 234 !
*Note: Check price if premium and discount first to determine starting point.
Then, start in the middle of the applicable range and then increase/decrease YTM to
decrease/increase calculated bond value
negativeG form
o Using excel: =rate(nper,pmt,pv,fv) MPVwouldhavetobenegative
where: pv is considered as outflow so indicate negative sign
Interpolation
• Is a method of determining the more exact rate
between a range or interval of rates
1. Find the difference in net present value (or PV factor) between the
range
2. Find the absolute difference (i.e., ignore a plus or minus sign)
between the desired PV (calculated PV factor) and the present value
(or PV factor) for the lower rate
3. Divide the value from Step 2 by that found in Step 1 to get the
percent total distance across the range attributable to the desired or
calculated value.
4. Multiply the percent found in Step 3 by the interval width over which
interpolation is being performed.
5. Add the value found in Step 4 to the interest rate associated with the
lower end of the interval.
Consider a four-year bond that promises a coupon rate of 8%
and has a principal (par value) of P1,000. Further assume the
bond is currently trading for P950. What is the current yield?
What is the yield to maturity on this bond (hint: 8% - 12%)?
Current yield can be computed as follows:

(8% x 1,000)/ 950 =8.42%
YTM can be computed as follows:

Solve for x: 80*{[1-(1 /(1+ x)4)] /]x} + [1,000 /(1+ x)4] = 950
Excel: =rate(4,80,-950,1000)
YTM can be computed using trial and error as follows:
Note that it is selling at a discount bond, hence YTM > 8%
Price at 10%:= 80 x {[1-(1 /(1+ 10%)4)] /]10%} + [1,000 /(1+ 1=%)4] =
936.6027
Price at 9%: = 80 x {[1-(1 /(1+ 9%)4)] /]9%} + [1,000 /(1+ 9%)4] = 967.6028
9% YTM 10%
|______________|_______________|
967.6028 950 936.6027
|_____17.6028_____| |
|_______________31.0001___________|
YTM= 9% + [1% x (17.6028/31.0001)] = 9.57%

• Bond’s YTM can be separated into benchmark
and yield spread
1. Benchmark rates- usually the risk-free rate or YTM of
similar maturity Treasury bond
2. Credit or Yield spread - difference in yield of one
instrument from another
• Credit or yield spread usually expressed in basis
points where 100 basis points (bps) equals 1
percent 100bps 1
• Yield spread is the risk premium component of
the YTM which increases as maturity increases
and bond ratings decline
difference
treasury Yield
1
625
6.25 1.254
6.25 375
625 2.50
YTM: Non-annual coupon
For bonds paying coupon for a period of less than
one year, the YTM computed using the equation
will be the YTM for period only (YTMperiod):
!"#$ %&'()
1
+#,)-)., 1− !"# 1
1 + 456<)-:"$
= + 9-:#;:<&' !"#
/ 456$%&'() 1 + 456<)-:"$
where: m - number of interest payment per year
Or using excel: =rate(nper,pmt,pv,fv)

where: pv is considered outflow so indicate negative sign
Simple annualized yield or bond equivalent yield (BEY)-
annualized yield/return which does not take into account
reinvestment of CFs during the year
YTMannual=YTMperiod x m
Effective annualized yield (EAY) or effective annual return

(EAR)- annualized yield/return taking into account the
reinvestment of CFs during the year
YTMannual=(1 + YTMperiod)m - 1
where m is the number of periods in a year or number of times compounded
in a year
Non-annual coupon
DM Corporation just issued a P1,000 5-year 10% coupon
bond that makes quarterly coupon payments. The bond’s
market price is P954.53.
YTMperiod is computed as follows:

Find YTM: 954.53= 25 x {1-[1 /(1+ YTM)20] / YTM} +
[1,000 /(1+ YTM)20]
Or using excel: =rate(20,25,-954.53,1000) =2.80%
Current yield: 100/954.53 = 10.48% or 0.1048
Simple annual yield: 2.80% x 4 = 11.20%
Effective annual yield or EAR: (1+2.80%)4 -1 = 11.68%
Morelli Corporation is planning to issue a 10-year
8% semiannual coupon bond with a par value of
P1,000. A similar risk 10-year bond currently sell
for P1,053.20. This bond pays annual coupon of
P90 and have a par value of P1,000. Compute for
the following:
a. YTM to use in pricing Morelli’s bond
b. Price of Morelli’s bond
c. Current yield of Morelli’s bond
d. Effective annualized yield
o YTC is the discount rate that makes present value of the
bond’s interest payment (period up to call date) and call
price equal to the bond’s observed market price. Using
same equation but make adjustments as follows:
o Revise period up to call date
o Use call price instead of principal
1
1− 1
1 + 23: "
!"#$ 9&'() = +#,)-)., + :&'' 8-67)
23: 1 + 23: "
where: t – is the number of interest payment period

up to call date
Consider a four-year callable bond that promises a
coupon rate of 8% and has a principal (par value)
of P1,000. Further assume the bond is currently
trading for P950. Compute for YTC if the bonds can
be called after 3 years from issuance at a price of
P990.
YTC is 9.70% computed as follows:

Solve for x: 80*{[1-(1 /(1+ x)3)] /]x} + [990 /(1+ x)3] = 950
Excel: =rate(3,80,-950,990)
o HPY is the discount rate that makes present value of the
bond’s interest (during holding period) and selling price
equal to the bond’s purchase price. Using same equation
but make adjustments as follows:
o Revise period to holding period
o Use purchase price
o Use selling price instead of principal
1
1− 1
1 + <52 "
5(-7ℎ&.) 8-67) = +#,)-)., + =)''6#> 8-67)
<52 1 + <52 "
where: t – is the number of interest payment period while holding the

bond
Consider a four-year bond that promises a coupon
rate of 8% and has a principal (par value) of P1,000.
Further assume the bond is currently trading for
P950. Compute for the HPY if you hold the bonds for
two years and sell it for P975.
HPY is 9.68% computed as follows:

Solve for x: 80*{[1-(1 /(1+ x)2)] /]x} + [975 /(1+ x)2] =
950
Excel: =rate(2,80,-950,975)
o 1. The value of the bond is inversely related to changes
in the market’s required rate or yield to maturity
YIM
discount rate
Higher lower
Discount Bond
value
o 2.The market value of a bond will be less than
the par value if the market’s required yield to
maturity is above the coupon interest rate and
will be valued above par value if the market’s
required yield to maturity is below the coupon
interest rate Discount Premium
YIM NM M C NM
Face sellingPrice Face a sellingPrice
o 3. As the maturity date approaches, the market value
of a bond approaches its par value (pull to par effect)
4. Long-term bond price fluctuate more when interest
rate change than do short-term bond price
o Long-term bonds have greater interest-rate risk
than short-term bond
o Interest-rate risk – variability in a bond’s value
caused by changing interest rates
o An increase in market required return for a
discount bond, would mean investor receiving
below-market coupon for longer period than
that of a shorter-term bond
Compute for the bonds’ prices at both 10% and 14% market
rate
a.A 10 year 8% bond with P1,000 par value
b.A 10-year 12% bond with P1,000 par value
c.A 20-year 12% bond with P1,000 par value
PV = P1,000 At 10% At 14% Change

10-year 8% P877.11 P687.03 -P190.08 (-22%)
10-year 12% P1,122.89 P895.68 -P227.21 (-20%)
20-year 12% P1,170.27 P867.54 -P302.92 (-26%)
o Term structure of interest rates- (positive)
relationship between the maturity and interest
rates (such as rate of return bonds with similar
level of risk)
o Yield curve- graphical depiction of term structure

of interest rates
Yield curves
(a) Normal yield curve-
upward-sloping yield curve
indicates that long-term a longertermbond is more
interest rates are generally Yield to sensitive torates
higher than short-term Maturity

interest rates bond
demand
precession sinvestors
termsensitive
bonds
shorter (a)
gingermorerates
(b) Inverted yield curve- be
willtomarket
downward-sloping yield
curve indicates that short-
(c)
term interest are generally implants.si
higher than long-term ntgiesehighen
a
interest necessionging (b)
(c) Flat yield curve- indicates Time to Maturity
that interest rates do not
vary much at different
maturities
• Hybrid Security – a form of debt and equity
financing that possesses characteristics of
both debt and equity financing
• Example: Preferred stock, Convertible
securities and Bonds with attached stock
purchase warrants
• Derivative Security – A security that is neither
debt nor equity but derives its value from an
underlying asset that is often another security
• Example: Options or detached stock warrants
Convertible Securities and
warrants
• Motives of issuing convertible securities and warrants

– Deferred common stock financing
– Use as a “sweetener” for financing
– Fewer restrictive covenants
– Raise cheap funds temporarily
• Option of the holder to convert or exercise

sweetener
• They give investors the chance to experience attractive
bondholders
capital gains while taking less risk resulting to a market
premium
Effect on EPS
• If converted or exercised, would dilute

(lower) EPS
• Basic EPS-calculated without regard to any
contingent securities
• Diluted EPS- calculation under the
assumption that ALL contingent securities
are converted and exercised, and are
therefore common stock
pincreasesOsout
A bond that can be changed into a specified
number of shares of common stock
1. Straight bond value- price at which it would sell in
the market without the conversion feature;
equals present value of interest and principal
discounted at a rate the firm would have to pay
on a nonconvertible bond
2. Conversion value- market price of common stock
into which the security can be converted
• Conversion ratio- ratio at which a convertible security
can be exchanged for common stock
• Conversion price- per-share price paid for common
stock as the result of conversion
3. Market value- price at which the convertible bond

is selling in the market; likely to be greater than
straight value or conversion value
• Market premium is the amount by which market value
exceeds the higher of conversion or straight value
G floorPriceof
theBond
f
straight conversion conversion
straight conversion straight
Queenify Company has an outstanding issue of
convertible bonds with a P1,000 par value. These
bonds are convertible into 60 shares of common stock.
They have a 10% coupon and a 5-year maturity. A
straight bond could have been sold at par with an 8%
stated interest rate. The market price of the stock and
bond is P25/share and P1,650, respectively.
Compute for conversion ratio, conversion price,
conversion value, straight bond value, market
premium.
If market price of the stock is P15/ share, what is the
market premium.
Conversion ratio 60 (given)
Conversion Price P16.67

(P1,000 / 60)
Conversion Value P1,500
(60 x P25)
Straight bond value P1,079.85
(using 8% to discount)
Market premium P150
(1,650- 1,500)
Market premium P420.15
(if CS price is 15/share) (1650-1,079.85)
Greyluxe Manufacturing is considering issuing
10-year, 8% annual coupon, P1,000 face value
convertible bonds at a price of P983 each.
Each bond is convertible into 20 shares of
common stock. If the bonds were not
convertible, investors would require an annual
yield of 10%. The stock's current price is P45.
Determine the market premium of the bond.
• 1.2.1 Application of Time Value of Money
• 1.2.2 Valuation: The Basic Process
• 1.3.1 Types of Bonds

• 1.3.2 Bond Valuation
• 1.3.3 Bond Yields
• 1.3.4 Convertible Bond
Questions or clarifications?
luation
tock Va
1.4 S
1.4 Stock Valuation
1.4.1 Features and Types of Preferred
Stock
1.4.2 Preferred Stock Valuation
1.4.3 Characteristics of Common Stock
1.4.4 Common Stock Valuation
1.4.5 Growth rate calculation
1.4.6 Convertible preferred stock
1.4.7 Stock purchase warrants
Equity Securities
An instrument that signifies an ownership position
(called equity) in a corporation, and represents a
claim on its proportional share in the corporation's
assets and profits.
Compared to debt securities (bonds), riskier but

has higher return on average
Two types:
Preferred Stock and
Common Stock
Bonds Preferred Common
Claim priority 1st (legal) 2nd 3rd (residual)
Income Interest Regular Dividends and/
dividends* or capital gain
Voice in None None Voting rights

management
Tax treatment Tax- Non Non deductible
InterestExpense deductible deductible
Risk to investors Low Medium High
Maturity Fixed None** None

Classification Liability Equity Equity
Restrictive covenants Can include Can include None
*Cumulative PS requires all past unpaid PS dividends be paid before

CS dividends are declared
** Some PS requires that money be set aside to regularly retire PS
issue, in effect resulting in a maturity date
Preferred Stock
Preferred stockholders are promised a fixed
periodic dividend, which is stated either as a
percentage or as a peso amount.
Preferred stock gives its holders certain
privileges that make them senior to common
stockholders.
Preferred stock is often considered quasi-debt

because, much like interest on debt, it specifies
a fixed periodic payment (dividend); but unlike
debt in that it has no maturity date.
Types of Preferred Stock
Par-value preferred stock is preferred stock with a
stated face value that is used with the specified
dividend percentage to determine the annual dollar
dividend.
No-par preferred stock is preferred stock with no
stated face value but with a stated annual dollar
dividend.
Cumulative preferred stock is a preferred stock for
which all passed (unpaid) dividends in arrears, along
with the current dividend, must be paid before
dividends can be paid to common stockholders.
Noncumulative preferred stock is preferred stock for
which passed (unpaid) dividends do not accumulate.
Types of Preferred Stock
a participating preferred stock is one that provide
additional dividends in the event that the company
meets certain financial goals (meets profit target)
a non-participating preferred stock is one that

provides a fixed rate/ dividend regardless of
financial performance
A callable preferred stock is one that allows the

issuer to retire the shares within a certain period
time and at a specified price.
A convertible preferred stock allows holders to

change each share into a stated number of shares
of common stock.
Stock Valuation
Using Basic Valuation Model, Value or price of a stock is
the present value of the entire dividend stream the
stock will pay in the future, this is specifically known as
the Discounted Dividend Model
1. Estimate amount and timing of dividends

2. Evaluate risk & determine investor’s or market’s
required return on the stock
3. Calculate the present value of dividend stream
Preferred Stock Valuation
¡ Preferred Stock (PS)- fixed cash flows without maturity,
hence, PV of a level perpetuity will be used
¡ Market’s required yield is typically estimated using the
dividend yield of similar shares of PS in the financial market
¡ Preferred stock valuation equation:
PPS = Dps/ rps

where: PPS – price of the PS today
Dps – dividend amount per period
rps - required return on the PS
PS Valuation
ACYFMG has preferred stock outstanding. It pays a
semiannual dividend of P11. If the next dividend is paid
six months from now and a similar preferred stock
currently sells at P80 with an annual dividend of P10,
what should be the value of the ACYFMG preferred
stock?
Market’s required return can be computed as:
rps= dividend yield= 10/80 = 12.5%
ACYFMG’s PS value is P176 computed as follows:
= 11/ (12.5%/2)
Exercises: PS valuation
a. Beryl Inc. has an outstanding issue of perpetual
preferred stock with an annual dividend of P55
per share. If the required return on this
preferred stock is 11.3%, at what price should
the stock sell?
b. Skyrim's preferred stock pays a dividend of P13

per quarter. If the price of the stock is P400,
what is its nominal annual rate of return? What is
the effective annual rate of return?
Common Stock
sometimes called capital stock, is the standard ownership
share of a corporation
Authorized shares are the shares of common stock that a

firm s corporate charter allows it to issue.
Outstanding shares are issued shares of common stock
held by investors, this includes private and public investors.
Treasury stock are issued shares of common stock held by
the firm; often these shares have been repurchased by the
firm.
Issued shares are shares of common stock that have been
put into circulation.
Issued shares = outstanding shares + treasury stock
Voting Rights
Elect board of directors (BOD)
Approve any change in corporate charter (e.g. new

stock issuance or merger)
Proxy- voting in which a designated party is provided

with temporary power of attorney to vote for the signee
at the corporation’s annual meeting
Two commonly used voting procedures:

Majority voting- each share of stock allows the shareholder one
vote, and each position on the BOD is voted on separately
Cumulative voting-each share of stock allows the shareholder a
number of votes equal to the number of directors being
elected. Shareholder can cast his/her all votes for a single
candidate or split them among the various candidates
Voting Rights
A proxy battle is an attempt by a nonmanagement
group to gain control of the management of a firm
by soliciting a sufficient number of proxy votes.
Supervoting shares is stock that carries with it

multiple votes per share rather than the single vote
per share typically given on regular shares of
common stock.
Nonvoting common stock is common stock that

carries no voting rights; issued when the firm
wishes to raise capital through the sale of common
stock but does not want to give up its voting control.
Agency Problem/ Costs
Agency Problem- managers may put their personal
interests ahead of the firm’s owners if their incentives
are not properly aligned with those of firm’s
stockholders
Managers avoid unpleasant tasks such as taking on less
profitable projects that they personally like, not reducing
number of employees as needed, avoiding very risky
projects that may jeopardize their jobs
Agency costs are difficult to quantify but can be seen in
stock prices e.g. stock price increase for removal on
ineffective management team
Common Stock Valuation
the Intrinsic Value of a share of common stock is
equal to the present value of all future cash flows
(discounted dividends model)
Same with PS, no maturity

More complex since there is no fixed cash flow
stream (variable and uncertain)
Dividend is based on 1) profitability of the firm
and 2) management’s decision to pay dividends
or retain earnings for growth
Three models to dividend valuation:
(1) Zero Growth- assumes a constant, non-growing
dividend stream (using PV of a level perpetuity)
Note: Forward (or expected) Dividend Yield = D1/ P0

(2) Constant Growth (Gordon Growth Model)- dividend
will grow at a constant rate, PV of a growing
perpetuity
where r >g
D1=D0 x (1+ g)
Variable or supernormal Growth - dividend initially
have a rapid growth before a stable one
Present value calculation is divided into two

periods, the fast-growth period and the stable-
growth period following it.
ACYFMG just paid a P1.57 dividend and investors
expect the same dividend each year forever. If the
required return on the stock investment is 12%,
price of the stock today should be P13.08 computed

as follows:
=1.57/12%
If investors expect that dividend to grow by 5% each

year forever. Price of the stock today would be
P23.55 computed as follows:
= (1.57 x 1.05)/ (12% - 5%)

Mightee Juice (MJ), Inc. is not paying a
dividend right now, but is expected to pay a
P21 dividend two years from now. If the
required return on the stock investment is
9%, what should be the price of MJ stock
today?
Zero-Growth: Assuming MJ will the pay the same
amount of dividends in subsequent years.
Constant Growth: Investors expect that dividend
to grow by 4% every year forever.
ACYFMG recently paid a P2 annual dividend. The
company is projecting that its dividends will grow
by 18% next year, 15% annually for the next two
years after, and 5.5% annually thereafter. If the
required rate of return is 10%, ACYFMG common
stock current intrinsic value is P61.71 computed
as:
D1= 2 x 1.18 = 2.36

D2= 2.36 x 1.15 = 2.714
D3= 2.714 x 1.15 = 3.1211
ACYFMG discounted dividend computation can be
analyzed using a timeline as follows:
0 1 2 3 4
@ 5.5%
2.36 2.714 3.1211 3.2927605
2.36/1.1
2.714/1.12
3.1211/1.13
73.17245556
=[3.2927605/
(10%-5.5%)]
73.17245556/1.13
CJ, Inc. just paid a P20 dividend. The
company is expected to pay a P22 dividend
next year and a P24 dividend two years
from now. Starting year 3, dividends are
expected to grow at 2% forever. If investors
require a return of 10% on the investment,
how much is the current intrinsic value of
CJ stock?
Interpretation: overvalued
or undervalued
Comparing the computed intrinsic value of a stock
and its current stock price, we can assess whether
a stock is overvalued or undervalued
Stock price>intrinsic
value, stock is
overvalued
Stock price<intrinsic
value, stock is
undervalued
A study on constant
growth model reveals…
that the predicted values using the constant growth
dividend discount model (DDM) were not
significantly different from the actual values.
Therefore, the constant growth DDM is a reliable
model to predict the common stock prices among
the 15 companies listed in the PSE. (Gacus &
Hinlo, 2018)
(historical) Growth rate
we can calculate historical annual growth rate using FV
of a lump sum equation as follows:
D0 – most recent dividend paid

D-n – oldest dividend paid
n – number of periods from D-n to D0
(historical) Growth rate
ACYFMG paid the following per share dividend
for the past 5 years:
2019 P2.00
2018 1.95
2017 1.89
2016 1.83
2015 1.80
The historical growth rate can be computed as:
= (2/1.80)1/4-1 = 2.67%
Growth Rate calculation
(using ROE and RR)
Growth rate depends on many factors such as
new investments, return on equity (ROE), and
proportion of earnings reinvested
Using ROE and RR, we can calculate growth rate

as follows:
Required rate of return
Determined by two key factors
Level of interest rates in the economy
Risk of firm’s stock
We can calculate required return using
CAPM equation:
Illustrative:
Growth Rate Required Rate of Return
ACYFMG is expected to pay P3 dividend per share
out of its current earnings of P1,000,000 to its
100,000 common shares outstanding. Such dividend
is expected to grow at a constant rate. Portion of the
firm’s earnings will be invested into a new project
which is expected to cause the risk of the firm, as
measured by the stock’s risk premium, to increase
immediately from 8% to 12%. Currently, the risk-free
rate is 5%. On the other hand, the new project is
expected to also increase the firm’s ROE to 14%.
what should be the price of ACYFMG stock today?
Illustrative:
ACYFMG’s growth rate is 9.8% calculated as follows:
= [1- (3/10)] x 14%
Required return on ACYFMG’s stock is 17%
= 5% + 12%
Therefore, ACYFMG stock’s price today is:
3/ (17% - 9.8%) = P41.67

Exercise:
Stellar Company earned P174,000 net income for
the year just ended. 20% of this earnings will be
retained by the firm to fund its future projects. The
treasury bond and market currenly yields 8% and
16% return, respectively. Stellar’s strategy is a bit
conservative with an estimated beta of 0.15.
Stellar’s stockholders’ equity balance is P3,000,000
with 20,000 common stock outstanding. Compute
for: (a) growth rate, (b) required return, and (c) the
intrinsic value Stellar’s stock.
Other CS Valuation Approach
If the firm doesn’t pay dividends or if it is
difficult to estimate the dividend amount and
when it will be paid, we can use different
valuation approach such as:
Free Cash Flow model
Book value model
Liquidation value model
P/E Ratio Valuation model (Relative Valuation
Model)
Free Cash Flow Approach:
1. Discount free cash flow (FCF) to determine total
enterprise value
2. Deduct value of debt and preferred shares from the total

value to obtain Value of common stock
Vcs= Vc-Vd-Vps
OR Discount free cash flow to equity (FCFE) to determine
total equity value
3. Divide value of common stock by number of shares
outstanding to determine price per share
Free Cash Flow Valuation Approach
An analyst seeks to determine the value of Bulldog
Industries. After careful research, the analyst believes
that free cash flows for the firm will be P80 million in
next year and will grow at 10% for years 2 and 3. The
free cash flows will grow at a rate of 5% after year 3.
The market value of Bulldog Industries debt and
preferred stock is P940 million. The firm has 50 million
shares of stock outstanding. If the firm has a required
return of 10%, the equity value of the firm’s stock is
805.45M or 16.109 per share computed as follows:
= P1,745.45M less P940M

VC: (80M/1.1) + (88M/1.12) + (96.8M/1.13) + {(1/1.13) x
[(96.8M x 1.05)/(10% - 5%)]} = 1,745.45M
Book value- amount per share of common stock that would
be received if all of the firm’s assets were sold for their
book value and proceeds remaining after paying all
liabilities (including PS) were divided among common
stockholders.
This method lacks sophistication and can be criticized on
the basis of its reliance on historical balance sheet data.
It also ignores the firm s expected earnings potential and
generally lacks any true relationship to the firm s value in
the market
At year-end, Flip Fashion’s balance sheet has P6 million
total assets, P4 million total liabilities, P500,000 preferred
stock and 100,000 common shares outstanding . Book
value per common stock is P15 per share [(6M – 4M –
500,000)/ 100,000]
Liquidation value- amount per share of common stock that
would be received if all of the firm’s assets were sold for their
current market value and proceeds remaining after paying all
liabilities (including PS) were divided among common
stockholders.
This measure is more realistic than book value because it is

based on current market values of the firm s assets. However,
it still fails to consider the earning power of those assets.
At year-end, Flip Fashion’s balance sheet has P6 million total

assets, P4 million total liabilities, P500,000 preferred stock and
100,000 common shares outstanding . Upon investigation, the
assets can be sold for only P5.25 million today. The liquidation
value per common stock is P7.50 per share
= (5.25M – 4M – 500,000)/100,000
Price/ earnings (P/E) ratio or earnings multiplier or relative
valuation approach- price per share divided by
company’s earnings per share.
Value of CS can be calculated by multiplying the firm s
expected earnings per share (EPS1) by the average
price/earnings (P/E) ratio for the industry.
P0= (P/E) x EPS1

If an investor estimate that Flip Fashion will earn P2.50
per share next year and finds that the P/E ratio for firms
in the same industry to average 7x. The firm’s share
value today is P17.50
= 7 x 2.50
Reason Defer common
stock financing
less leveraged
Convertible Preferred stock
A preferred stock that can be changed into a stated
number of shares of common stock.
General features:
1. Conversion ratio- ratio at which a convertible security can
be exchanged for common stock
2. Conversion price- per-share price paid for common stock
as the result of conversion
1. Straight PS value- price of a nonconvertible PS

2. Conversion (stock) value- value of the convertible security
by multiplying conversion ratio by the current market price
of common stock
Market Premium- the amount by which the market value
exceeds the straight or conversion value
Convertible Preferred stock
A firm has outstanding convertible preferred stock
with a P50 par value which is convertible at a
price of P25 per share of common stock. The
current market price of a share of common stock
and convertible preferred stock is P45 and P110,
respectively.
Conversion ratio 2
(P50/ 25)
Conversion Value P90
(2 x P45)
Market premium P20
110-90
Stock Purchase Warrants
an instrument that gives its holder the right to purchase
certain number of shares of common stock at a
specified price over a certain period of time
Key characteristics
1. Exercise (or option) price- price at which holders can
purchase a specified number of shares of common
stock
2. Detachable- can sell the warrant without selling the
security
3. Implied price- price effectively paid for each warrant
attached to a security
=price of bonds with warrants less straight bond value
Key characteristics (cont’d)
4. Theoretical value (TVW)- expected price of a
warrant
TVW = (Pcs- E) x N
where: Pcs- price of CS, E- exercise price,
N –number of shares of common stock obtainable with
one warrant
Combination of positive investor expectation and
leverage opportunities results to warrant premium,
which is the difference of market value of warrant and
its theoretical value
Fast Forwarder (FF) purchased a warrant for P15 allowing it
to buy two shares of ACYFMG common stock at P28 per
share. The common stock price per share is P30.
1. Exercise price = P28 (given)
2. Theoretical value of the warrant is P4 [(30-28) x 2]
3. Market premium of the warrant is P11 (15 – 4)
4. FF’s gain if stock price goes up to P50 is P29 {[(50-28)x2]-
15}
5. FF’s loss if stock price declines to P25 is P15 (cost of the
warrant only because FF would not exercise the warrant)
1.4 Stock Valuation
1.4.1 Features and Types of Preferred
Stock
1.4.2 Preferred Stock Valuation
1.4.3 Characteristics of Common Stock
1.4.4 Common Stock Valuation
1.4.5 Growth rate calculation
1.4.6 Convertible preferred stock
1.4.7 Stock purchase warrants
End of 1.4
Questions or clarifications?
Prepare for Quiz 1 (1.1 – 1.4)

Check
ledge
Know
KC: True or False
T 1) The realized return of a share of stock refers to its dividend

yield plus or minus percentage increase in price.
F 2) When investors view a bond as riskier than other bonds in the
market, its market required return will decrease and the bond’s
price will increase
F 3) Straight bond value is the minimum price at which the
convertible bond can be traded.
T 4) It is more appropriate to use geometric average return than
arithmetic average in determining expected return for a multi-
period horizon.
F 5) Starting to invest early for retirement reduces the benefits of
compound interest.
KC: True or False
6) A portfolio that combines two assets whose returns

have a correlation coefficient of +1 cannot reduce the
portfolio’s overall risk
7) Two firms with the same expected dividend and growth
rate must also have the same stock price.
8) A well-diversified portfolio eliminates systematic risk;
hence, CAPM does not reward investors for taking on
diversifiable risk.
9) Prices of short-term bond are much more sensitive to
changes in interest rates than long-term bond prices.
10) In accordance with the the risk-return trade-off
principle, riskier investment will always earn higher return
than a less risky investment.
KC: Multiple Choice
11) Stocks A and B have the same price and are in equilibrium,
but Stock A has the higher required rate of return. Which of the
following statements is CORRECT?
OA If Stock A has a lower dividend yield than Stock B, its growth rate
must be higher than Stock B's.
B Stock A and stock B must have the same dividend yield
OCD Stock A must have a higher dividend yield than Stock B

If Stock A has a lower dividend yield than Stock B, its growth rate
must be lower than Stock B
KC: Multiple Choice
12.) If coupon rate is _______ required rate of return, the

bonds are traded at ____.
lower than equal to higher than
A a premium a discount par
B par a premium a discount
C a premium par a discount
D a discount par a premium
KC: Multiple Choice
13.) You plan to analyze the value of a potential investment by
calculating the sum of the present values of its expected cash flows.
The cash flows are in the form of 10-year annuity, and they total to
P100,000. Which of the following would lower the calculated value
of the investment?
A You learn that the total amount cash flows should only be
P80,000 hence annuity amount is P8,000 rather than P10,000
B the discount/interest rate decreases
C the total amount of cash flows remains the same, but more of
the cash flows are received in the earlier years and less are
received in the later years.
D the total amount of cash flows remains the same, but annuity
lasts for only 5 rather than 10 years, hence that each payment is
for P20,000 rather than for P10,000.
KC: Multiple Choice
14) Which asset would the risk-neutral financial manager

prefer?
Asset A Asset B Asset C Asset D

Return 11.5% 10.5% 12% 12.25%
Range 6% 3% 8% 7%
A Asset A
B Asset B
C Asset C
D Asset D
KC: Multiple Choice
15.) Zach’s investment portfolio is composed of 50% treasury

bond, 30% stock C and 20% stock N. The portfolio beta can
computed as:
A (30% x βc) + (20% % x βn)
B (60% x βc) + (40% % x βn)
C Squareroot of [(βc2 x 0.3) + (βn2 x 0.2) ]
D (50% x 1.0) + (30% x βc) + (20% % x βn)
KC: Multiple Choice
16.) Strikes, lawsuits, regulatory actions, and increased

competition are all examples of ____ risk; while war, inflation,
and the condition of the foreign markets are all examples of
___ risk.
A Unsystematic, firm-specific
B Systematic, non-diversifiable
C Diversifiable, systematic
D Market-wide, unsystematic
KC: Multiple Choice
17) To convert realized return from cash amount to

percentage, simply divide total cash return by:
A Holding period
B Beginning price
C Ending price
D Cash flow received during the investment
KC: Multiple Choice
18) Connor Inc. issued a 10-year bond that will pay annual
interest provided it generated a net income for the year. The
interest is set at 5% above the prevailing treasury bond rate.
What type of bond is this?
A Floating rate, debenture bond

B Floating-rate, income bond
C Pure-discount, debenture bond
D Pure-discount, income bond
KC: Multiple Choice
19.) Efficient market hypothesis states that securities prices

reflects information. If the degree of market efficiency is semi-
strong, which of the following information are reflected in the
price:
A Past information
B Past information and present public information
C Past information and present private information
D Present information, both public and private
KC: Multiple Choice
20.) A decrease in ____ would result to an increase in the price

of a bond.
A yield to maturity
B face value
C coupon amount
D None of the above
KC: Problem solving
21.) You are offered a zero-coupon bond with a P1,000 face value
and 5 years left to maturity. If the required return on the bond is 12%,
what is the most you should pay for this bond?
22.) Your bank has agreed to loan you P300,000 if you agree to
pay a lump sum of P570,000 in five years. What annual rate of
interest will you be paying?
23) Jackman Industries just paid a dividend of P1.32. Analysts

expect the company's dividend to grow by 30% next year, by 10% in
Year 2, and at a constant rate of 5% in Year 3 and thereafter. The
required return on this low-risk stock is 9.00%. What is the best
estimate of the stock's current market value?
KC: Problem solving
24.) You must estimate the intrinsic value of Noe Technologies'

stock. The free cash flow next year is expected to be P27.5
million, and it is expected to grow at a constant rate of 7.0% a
year thereafter. The company's cost of capital is 10.0%, it has
P125 million of long-term debt & preferred stock outstanding,
and there are 15 million shares of common stock outstanding.
What is the firm's estimated intrinsic value per share of
common stock ?
25.) A new bank recently advertised the following claim: Invest

your money with us at 15%, compounded annually, and we
guarantee to double your money sooner than you imagine.
Ignoring taxes, how long would it take to double your
money?
KC: Problem solving
26.) An investment advisor has recommended a

P500,000 portfolio containing assets J, K, and R; ;
P100,000 will be invested in asset J, with an expected
annual return of 15%; P150,000 will be invested in asset
K, with an expected annual return of 9%; and P250,000
will be invested in asset R, with an expected annual
return of 11%. The expected annual return of this portfolio
is:
27.) Three years from now, Walter will purchase a laptop

computer that will cost P42,500. Assume that Walter can
earn 8% (compounded quarterly) on his money. How
much should he set aside today for the purchase?
Knowledge Check
28. An investor has P1,000 that she is interested in
investing in ABC stock, which is currently selling for P15
per share. ABC’s warrants are selling for P13.50 per
warrant. Each warrant entitles the holder to purchase
three shares of ABC’s common stock for P11 per share.
The warrant premium is
29. A bond currently trades at P985 on the secondary
market. The bond has 10 years until maturity and pays
an annual coupon at 9.5% of face value. The face value
of the bond is P1,000. What is the coupon yield for this
bond?
30. You own a P1,000 bond that pays a 15% coupon semi-
annually coupon. The bond has 5 years to maturity. If
the required return on the bond suddenly increases
from 14% to 16%, then what is the percentage increase
(decrease) in value for the bond?
31. Blue Irons (BI) purchased 100 shares of Pleroo, Inc.
common stock for P23 per share one year ago.
During the year, Pleroo, Inc. paid cash dividends of
P6.50 per share. The stock is currently selling for
P27 per share. If BI sells all of his shares of Pleroo,
Inc. today, what rate of return would he realize?
32. If you were to invest P12,000 for two years, while
earning 6% compound interest, what is the total
amount of interest that you will earn?
33. If Dividend next year is = P2.95, growth rate (which
is constant) is 4.7%, and Price today is P26, what is
the stock's expected dividend yield for the coming
year?
34. Your credit card carries a 1.5% monthly percentage
rate, compounded monthly. What is the (a) annual
stated rate? (b) effective annual rate?
35. Asset Y has a beta of 0.89. The risk free rate of
return is 7%, while the return on the market portfolio
of assets is 16%. The asset’s risk premium is:
KC: Long Problem
Encore is an international retailer of casual-wear. Jordan
Ellis, the founder, believes that the company can
maintain a constant annual growth rate in dividends per
share of 6% in the future, or possibly 8% for the next 2
years, and then 6% thereafter. Ellis based his estimates
on expansion into European and Latin American markets.
Venturing into these markets was expected to cause the
risk of the firm, as measured by the risk premium on its
stock, to increase immediately from 8.8% to 10%.
Currently, the risk-free rate is 6%.
KC: Long Problem
In preparing the long-term financial plan, Encore’s CFO has
assigned a junior financial analyst to evaluate the firm’s current
stock price, asking him to consider the conservative predictions of
securities analysts and the aggressive predictions of the company
founder, Jordan Ellis.
Industry P/E ratio 5.45
Projected NI next year 19,800,000
Price of CS 40.00
Book value of CS 60,000,000
No. of CS outstanding 2,500,000
Most recent CS dividend 4.00
KC: Long Prob
a. What is the Encore’s stock value per share using the book
value approach?
b. What is the Encore’s stock value per share using the relative
valuation approach?
c. What is the current required return for Encore stock? What
will be the new required return for Encore stock assuming
that they expand into European and Latin American markets
as planned?
d. If the securities analysts are correct and there is no growth in
future dividends, what will be the value per share of the
Encore stock? (Note: use the new required return on the
company s stock here)
e. If Jordan Ellis s predictions are correct, what will be the value
per share of Encore stock if the firm maintains a constant
annual 6% growth rate in future dividends? (Note: Continue to
use the new required return here.)
f. If Jordan Ellis s predictions are correct, what will be the value
per share of Encore stock if the firm maintains a constant
annual 8% growth rate in dividends per share over the next 2
years and 6% thereafter?

1.1 - 1.4 Risk and Return, Bonds, Stock

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1.1 - 1.4 Risk and Return, Bonds, Stock

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1.

1 RISK AND RATES OF

• Risk- measure of the uncertainty

• (Total) Return-the total gain or loss

A. Government-issued (Bureau of Treasury) = Risk-free

where: CFt= cashflow (interest or dividends) received during period

Cash return = 101,600 + 5,000 – 100,000 = 6,600

• Expected Rate of Return= (Rate of Return 1 x

Calculate the following:

- Assume this if problem is silent

Risk Averse – Risk Neutral- Risk Seeking-

• Mario: I will take a card. I

• Two approaches: Scenario Analysis and Probability

• A bar chart is the simplest type of probability distribution;

• A continuous probability distribution is a probability

Asset B is riskier because

highest - lowest return Higher

• Expected return = 3.4%

• If probabilities are unknown, analysts use historical

• Using excel: =stdev(r1,r2,r3…rn)

Arithmetic average return = 6% 2 because we only have 2 returns

Variance: [(15%-6%)2 + (-3% - 6%)2]/ (2-1) = 0.0162

• A higher coefficient of variation means that an

Using previous examples (50,000 investment and

P50,000 investment: 8.94%/ 3.4% = 2.63

P10,000 investment: 12.73%/6% = 2.12

Calculate the following:

by combining two or more risky assets into a

perfectly positively correlated

Correlation Diversification Benefits

• Total risk of an investment consist of two parts:

• Total risk = Diversifiable risk + Nondiversifiable risk

• Diversifiable risk- is the portion of an asset’s risk

causes; can be eliminated thru diversification

• Nondiversifiable risk- is the portion of the asset’s

firms; cannot be eliminated through diversification

• Non-diversifiable –aka systematic or market-wide risk

1. Using Graph: compute for slope (Rise over run)

2. Using Covariance or Correlation Formula: rm market

• Covariance and correlation measures how

• To estimate beta, the “rise over run” method can be used:

Let's assume the investor also wants to calculate the beta of

• Beta of TSLA =0.032 / 0.015 = 2.13

•Beta of AAPL = 0.83 x (0.2342 / 0.3221) = 0.6035

• Portfolio’s return = weighted average of the

• Portfolio weights (w) = amount invested in a

! Historical returns of the portfolio can be computed

• Portfolio Beta-measures the systematic risk

Security Return SD Beta

6.20 (a) Calculate portfolio expected return

• Efficient portfolio- a portfolio that

• Capital Asset Pricing Model (CAPM) model- links

• Risk Premium= Difference between the returns of

Market (risk) premium

Asset j’s or Company’s (risk) premium

Security I has a beta of 1.3, the risk-free rate is 4%, and

L34 P 500,000 0.90

M78 170,000 1.85

N90 330,000 1.22

At the time Kendall made her investments, investors were

E(R) < CAPM (r),

E(R) > CAPM (r),

E(R) > CAPM (r),

slope- market risk

Effective Annual Rate (EAR) aka annual percentage yield – the

Example: APR and EAR of interest of 3% per quarter compounded

Compounding interest literally all the time. Equivalent