Chapter 1 -- An Overview of Financial Management

 Cash flows between capital markets and firm’s operations

 Corporate life cycle
 The goal of a firm
 Capital allocation process
 Financial securities
 Financial markets and institutions
 Interest rates
 The stock market and stock returns
 Global economic crisis
 Agency problem
 Career opportunities in finance

 Cash flows between capital markets and firm’s operations

(2) (1)
Firm’s Capital
Operation Financial (4a) Markets
(Real Assets) Managers (Financial
(3) (4b) Assets)

(1) Cash raised by selling financial assets (for example, issuing stocks, bonds, and
preferred stocks, etc.) in financial markets
(2) Cash invested in firm’s operations and used to purchase real assets (for
example, taking good projects)
(3) Cash generated from firm’s operations and returned to financial managers
(4a) Cash reinvested in firms’ operations (retained earnings for reinvestment)
(4b) Cash returned to investors (interest payments or dividends)

Financing decisions vs. investment decisions: raising money vs. allocating money
Activity (1) is a financing decision
Activity (2) is an investment decision
Activities (4a) and (4b) are financing decisions

The role of a financial manager

Forecasting and planning of firms’ financial needs
Making financing and investment decisions
Coordinating with other departments/divisions
Dealing with financial markets
Managing risks

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 Finance includes three areas
(1) Financial management: corporate finance, which deals with decisions related
to how much and what types of assets a firm needs to acquire (investment
decisions), how a firm should raise capital to purchase assets (financing
decisions), and how a firm should do to maximize its shareholders wealth (the
goal of a firm) - the focus of this class

(2) Capital markets: study of financial markets and institutions, which deals with
interest rates, stocks, bonds, government securities, and other marketable
securities. It also covers Federal Reserve System and its policies.

(3) Investments: study of security analysis (fundamental and technical), portfolio

theory, market analysis, and behavioral finance

 Corporate life cycle

Starting from a proprietorship; growing to partnership; expanding to a corporation
Proprietorship: an unincorporated business owned by one individual
Advantages:
Easy and inexpensive to form
Subject to less government regulations
Lower income taxes

Disadvantages:
Unlimited personal liability
Limited lifetime of business
Difficult to raise capital

Partnership: an unincorporated business owned by two or more people

Advantages vs. disadvantages: similar to those of proprietorship, in general

Corporation: a legal entity created by a state

Advantages:
Limited liability
Easy to transfer the ownership
Unlimited lifetime of business
Easy to raise capital

Disadvantages:
Double taxation (at both corporate and individual levels)
Cost of reporting

S Corporation: a form of organization that allows small business to be taxed as

proprietorship or partnership (to avoid corporate taxes)

Restrictions: no more than 100 shareholders; for small and privately owned firms

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 The goal of a firm
To maximize shareholder’s wealth (or firm’s long-run value)

Why not profit or EPS maximization?

Profit maximization sometimes ignores timing and risk of cash flows
EPS maximization sometimes can be manipulated or misleading

Intrinsic value and market price of a stock

Intrinsic value is an estimate of a stock’s “fair” value (how much a stock should be
worth)

Market price is the actual price of a stock, which is determined by the market
conditions, including demand and supply of the stock in the market

When the intrinsic value of a stock is higher than the market price of the stock, we
say that the stock in the market is under-valued (under-priced)
For example, if the intrinsic value for a stock is $26 and the market price is $25,
then the stock is under-valued.

When the intrinsic value of a stock is lower than the market price of the stock, we
say that the stock in the market is over-valued (over-priced)
For example, if the intrinsic value for a stock is $30 and the market price is $32,
then the stock is over-valued.

When the intrinsic value of a stock is equal to the market price of the stock, we say
that the stock in the market is fairly priced (the stock is in equilibrium)

Stock market in equilibrium: when all the stocks in the market are in equilibrium
(i.e. for each stock in the market, the market price is equal to its intrinsic value)
then the market is in equilibrium

 Capital allocation process

The process of capital flows from those with surplus capital to those who need it

Figure 1-1: Capital Allocation Process

Three types of transfer

(1) Direct transfer: a business sells its security directly to investors
(2) Indirect transfer through an investment bank: a business sells its security to an
investment bank, which in turn sells the same security to individual investors
(3) Indirect transfer through a financial intermediary: a financial intermediary
obtains funds from investors by offering its own securities and uses funds to buy
other business securities

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 Financial securities
Debt securities (long term vs. short term)
Money market securities: mature in less than a year; less risky and highly liquid
(T-bills, for example)
Capital market securities: mature in more than a year and more risky (corporate
bonds, for example)

Equity securities: claims on firm’s income and assets upon a residual value
(stocks, for example)

Derivative securities: whose values depend on the values of underlying assets

(options, futures, and swaps, for example)

Table 1-1: Major Financial Instruments

Securitization: a process whereby banks, S&Ls, and mortgage firms would

originate mortgages and then sell them to investment banks (e.g. Fannie Mae),
which would bundle them into packages and use them as collateral for bonds that
could be sold to individual investors, pension funds, insurance companies, and
other institutional investors

 Financial markets and institutions

Physical asset market vs. financial asset markets
Physical asset markets are markets for real (or tangible) assets
Financial asset markets are markets for financial (or intangible) assets - focus of
this class

Money markets vs. capital markets

Money markets are markets for short-term and highly liquid debt securities (less
than one year)
Capital markets are markets for intermediate and long-term debt securities and
stocks (one year or longer)

Primary markets vs. secondary markets

Primary markets are markets for issuing new securities
Secondary markets are markets for trading existing securities

Spot markets vs. futures markets

Spot markets are markets for immediate delivery
Futures markets are markets for future delivery even though the deal is made
today

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Private markets vs. public markets
Private markets: transactions are negotiated directly between two parties
Public markets: standardized contracts are traded on organized exchanges

Derivative markets: for derivative securities

Financial institutions
Investment banks (investment banking houses): specialized in underwriting and
distributing new securities, such as Merrill Lynch (acquired by BOA)

The role of investment banks: underwriting

Design securities with features that are attractive to investors
Buy these securities from the issuing firm
Resell these securities to individual and institutional investors

Public offering vs. private placement

Public offering: security offering to all investors
Private placement: security offering to a small number of potential investors

Commercial banks: provide basic banking and checking services, such as BOA

Financial service corporations: large conglomerates that combine different

financial institutions into a single corporation, such as Citigroup

S&Ls, credit unions

Life insurance companies

Pension funds

Mutual funds: sell themselves to investors and use funds to invest in securities

Exchange traded funds (ETFs): mutual funds but traded like stocks

Hedge funds: similar to mutual funds with few restrictions

Why do we need financial markets?

Bring borrowers who need capital and lenders with extra capital together to
exchange needs

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 Interest rates
Cost of borrowing money

Interest rate = risk-free rate + risk premiums

Fundamental factors that affect interest rates

Production opportunities
Time preference for consumption
Risk
Inflation

Economic conditions and policies that affect interest rates

Fed policy
Federal budget deficit
Business activity
International activities, including exchange rate

 The stock market and stock returns

Organized markets vs. over-the-counter (OTC) markets

Organized markets (exchanges) have physical locations, such as NYSE

OTC markets are connected by computer network with many dealers and brokers,
such as NASDAQ (National Association of Securities Dealers Automated
Quotation System)

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 Auction markets vs. dealer markets
Organized markets are auction markets: trade through a specialist
OTC markets are dealer markets: trade with dealers
ECN (electronic communications network): trade between investors

IPO markets: markets for initial public offerings

Stock market transactions (three types)

(1) Trading outstanding (existing) shares takes place in a secondary market
(2) Selling additional shares by a publicly owned firm takes place in a primary
market
(3) Selling shares to the public for the first time by a privately owned firm takes
place in a primary market (IPO market)

Stock market returns

Expected return: return expected to be realized, which is always positive
Realized return: actual return received, which can be either positive or negative

Measuring stock market performance: DJIA, S&P 500 index, NASDAQ index

Figure 1-4: S&P 500 Stock Index Performance

Realized stock market returns and risks, 1926 - 2007

Types of Stocks Average Return Standard Deviation (Risk)
Small-stocks 17.1% 32.6%
Large-stocks 12.3% 20.0%
Long-term corporate bonds 6.2% 8.4%
Long-term government bonds 5.8% 9.2%
U.S. Treasury bills 3.8% 3.1%

Positive risk-return relationship: the higher the risk, the higher the average return

 Global economic crisis

Globalization of mortgage market securitization (bad mortgage-backed debt going
around the world)
Sub-prime mortgage meltdown (do not require income documents, interest only
loans, no down payments, etc., all fuel the real estate bubble)
Liquidity crisis (after bubble bursts, homeowners can no longer afford to make
payments, banks face shortage of cash, which causes liquidity crisis)

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 Agency problem
A potential conflict of interest between two groups of people

Stockholders vs. managers

Instead of shareholders’ wealth maximization, managers may be interested in
their own wealth maximization

Align the interests

Performance shares and executive stock options (positive)
Threat of firing and hostile takeover (negative)

Stockholders vs. bondholders

Stockholders prefer high-risk projects for higher returns
Bondholders receive fixed payment and therefore prefer lower risk projects

 Career opportunities in finance

Banking
Investments
Insurance
Corporations
Government

 Exercise
Read Summary
Questions: 1-9

8
 Chapter 2 -- Financial Statements, Cash Flow, and Taxes
 Financial statements and reports
 Basic financial statements
 Free cash flow
 MVA and EVA
 Income taxes

 Financial statements and reports

Annual report: report issued annually to shareholders that contains:

(1) Verbal statements: explain what happened and why; offer future prospects

(2) Financial statements:

Balance sheet
Income statement
Shareholder’s equity statement (retained earnings statement)
Cash flow statement

Importance of financial statements and reports

To investors: valuable information regarding the firm (present and future)
To managers: for internal control and financial planning

 Basic financial statements

(1) Balance sheet: statement of a firms’ financial position at a point in time

Cash & marketable securities Accounts payable (A/P)

Accounts receivable (A/R) Accrued wages and taxes (Accruals)
Inventory Notes payable
------------------------------------ -------------------------------------
Current assets Current liabilities
+ + Total liabilities
Net fixed assets Long-term debt
+ +
Other assets Common equity (c/s and R/E)
------------------------------------ --------------------------------------
Total assets = Total liabilities and equity

Note: Current liabilities + long-term debt = total liabilities (total debt)

Common equity (Shareholder’s equity) = total assets - total liabilities
Common equity = common stock (c/s) + retained earnings (R/E)

Note: retained earnings are cumulative, assuming no preferred stocks

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Working capital: refers to current assets

Net working capital = current assets - current liabilities

Net operating working capital (NOWC) = current assets - (current liabilities -

notes payable)

Market value vs. book value

Market value = the actual market price
Book value = (common equity) / (# of shares outstanding)

Table 2-1: MicroDrive Inc. Balance Sheets

(2) Income statement: report summarizing a firm’s revenues, expenses, and

profits during a reporting period

Sales
- Operating cost except depreciation and amortization
-------------------------------------------------------------------
EBITDA
- Depreciation and amortization
----------------------------------------------------
Earnings before interest and taxes (EBIT)
- Interest expenses
----------------------------------
Earnings before Tax (EBT)
- Income tax
----------------------------------
Net income (NI)

NI can be used for cash dividend and/or retained earnings, assuming no preferred
stocks

Commonly used terms:

Earnings per share (EPS) = NI / N, where N = number of shares outstanding
Dividend per share (DPS) = cash dividend / N
Book value per share (BVPS) = (common equity) / N
Cash flow per share (CFPS) = (NI + Depreciation + Amortization) / N

Dividend payout ratio = cash dividend / NI

Retention ratio = retained earnings / NI
Dividend payout ratio + Retention ratio = 1

Table 2-2: MicroDrive Inc. Income Statements

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 (3) Shareholder’s equity statement
Last year’s end balance
Add this year’s R/E = NI - Common stock cash dividend
This year’s end balance

Table 2-3: MicroDrive Inc. Shareholder’s Equity Statement

(4) Cash flow statement: report showing how things affect the balance sheet and
income statement will affect the firm’s cash flows

It has four sections: operating, long-term investing, financing activities, and

summary on cash flows over an accounting period

Table 2-4: MicroDrive Inc. Cash Flow Statement

 Free cash flow

Accounting profit vs. cash flow
Accounting profit is a firm’s net income reported on its income statement.

Net cash flow is the actual net cash that a firm generates during a specified period.

Net cash flow = NI + depreciation and amortization

Free cash flow: amount of cash available for payments to all investors, including
stockholders and debt-holders after investments to sustain ongoing operations

FCF = EBIT*(1-T) + depreciation and amortization – (capital expenditures +  in

net working capital)

Net operating profit after taxes (NOPAT) = EBIT*(1-T)

Use of FCF:
Pay interest to debt-holders
Retire debt (pay off some of the debt)
Pay dividend to shareholders
Repurchase shares
Invest in other assets

Use FCF to value a firm

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 MVA and EVA
MVA stands for market value added, which is the excess of the market value of
equity over its book value

EVA stands for economic value added, which is the excess of net operating profit
after tax (NOPAT) over capital costs

Example 1: $500 million of common equity, stock price is $60 per share, market
value added is $130 million. How many shares are outstanding?
Answer: (500 +130)/60 = 10.5 million shares

Example 2: Shareholders’ equity is $35,000,000, number of shares outstanding is

2,000,000 shares, and stock price is $30 per share, what is MVA?
Answer: market value of stock = 30*2,000,000 = $60,000,000
MVA = 60,000,000 - 35,000,000 = $25,000,000

 Income taxes
Progressive tax rate system: the tax rate is higher on higher income

Taxable income: gross income minus exceptions and allowable deductions as set
forth in the Tax Code or the income that is subject to taxes

Marginal tax rate: the tax rate applicable to the last dollar made
Average tax rate: taxes paid divided by total taxable income

Personal income tax:

Interest income: taxed as ordinary income
Dividend income: was taxed as ordinary income (currently is taxed at a maximum
of 15%, will increase after 2012)
Capital gains (short-term, less than a year): taxed as ordinary income
Capital gains (long-term, more than a year): taxed at a maximum of 15% (will
increase after 2012)
Capital losses are tax deductible up to $3,000 or to offset capital gains

Equivalent pre-tax yield vs. after tax return

Equivalent pre-tax yield = tax-free return / (1 – T)
After tax return = before tax return (1 – T)

Example: suppose your marginal tax rate is 28%. Would you prefer to earn a 6%
taxable return or 4% tax-free return? What is the equivalent taxable yield of the
4% tax-free yield?
Answer: 6%*(1-28%) = 4.32% or 4% / (1-28%) = 5.56%
You should prefer 6% taxable return because you get a higher return after tax,
ignoring the risk.

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Corporate income tax:
Interest income is taxed as ordinary income
Interest expenses are tax deductible
Dividend income is 70% tax-exempt (70% dividend exclusion)
Dividend paid is not tax deductible
Capital gains are taxed as ordinary income
Capital losses can only offset capital gains (carry back for 3 years or carry
forward for 5 years)
Operating losses can offset taxable income (carry back for 2 years or carry
forward for 20 years)
Deprecation: plays an important role in income tax calculation - the larger the
depreciation, the lower the taxable income, the lower the tax bill

Depreciation methods:
Straight-line method
Double-declining balance method
Modified accelerated cost recovery system (MACRS)

Example 1: The projected taxable income for ABC formed in 2010 is indicated in
the following table. The tax rate for ABC is 40%.
Year Taxable income
2010 ($15,000,000)
2011 10,000,000
2012 10,000,000
2013 (8,000,000)
What is the tax liability for ABC in 2011, 2012, and 2013 respectively?

Answer
For 2011: it will have no taxes due and there will be $5,000,000 loss to carry over
to 2012;
For 2012: it will have $5,000,000 taxable income and it should pay $2,000,000 in
taxes;
For 2013: it will have no taxes due; it will receive a refund of $2,000,000 and it
will have $3,000,000 loss to carry over to 2014

Example 2: Corporate tax calculation

Sales $4,500,000
OC excluding depreciation (3,000,000)
Depreciation (1,000,000)
Operating income $ 500,000
Interest income 10,000
Dividend income $10,000 3,000 (because 70% exclusion)
Interest payment (200,000)
Capital gains 20,000
Total taxable income $ 333,000

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 Corporate Tax Rates
Corporate Income Base Tax Rate Average Rate
$ 0- 50,000 $ 0 15% 15.0%
$ 50,000 - 75,000 7,500 25% 18.3%
$ 75,000 - 100,000 13,750 34% 22.3%
$ 100,000 - 335,000 22,250 39% 34.0%
$ 335,000 - 10,000,000 113,900 34% 34.0%
$10,000,000 - 15,000,000 3,400,000 35% 34.3%
$15,000,000 - 18,333,333 5,150,000 38% 35.0%
Over $18,333,333 6,416,667 35% 35.0%

Total tax = 22,250 + (333,000 - 100,000) * (0.39) = $113,120

Marginal tax rate = 39%; Average tax rate = (113,120 / 333,000) = 33.97%

If the firm’s taxable income is $335,000, what is the firm’s tax liability? What is
the marginal tax rate? What is the average tax rate?

Answer
Total tax = $113,900
Marginal tax rate = 39%
Average tax rate = 34.0%

 Exercise
Read Summary
Questions 1-8
ST-1
Problems: 2, 4, 8, and 13

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 Chapter 3 -- Analysis of Financial Statements
 Financial ratio analysis
 Trend analysis, common size analysis, and percentage change analysis
 Benchmarking
 Du Pont equations
 Limitations in ratio analysis
 Looking beyond the numbers

 Financial ratio analysis

Evaluating a firm’s financial statements to predict the firm’s future performance

(1) Liquidity ratios: show a firm’s ability to pay off short-term debt (the
relationship of a firm’s cash and other current assets to its current liabilities)

Current ratio = current assets / current liabilities

Quick ratio (acid test ratio) = (current assets – inventory) / current liabilities

Questions:
Is it always good to have very high current and quick ratios?
What will happen if they are very low?
Why would you like to keep current and quick ratios close to industry averages?

(2) Asset management ratios: measure how effectively a firm manages its assets

Inventory turnover = sales / inventory

Days Sales Outstanding (DSO) = account receivables / average daily sales

Fixed asset turnover = sales / net fixed assets

Total asset turnover = sales / total assets

Firms want to increase turnover ratios and want to keep DSO as low as possible

(3) Debt management ratios: show how the firm has financed its assets as well as
the firm’s ability to pay off its long-term debt (how effectively a firm uses
debt)

Using debt has tax benefit (interest payments on debt are tax deductible). On the
other hand, too much debt increases the risk of being bankruptcy.

Debt ratio = total debt / total assets

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 Times interest earned (TIE) = operating income (EBIT) / interest expenses
The higher the TIE, the better the performance

(4) Profitability ratios: show how profitable a firm is operating and utilizing its
assets (show the combined effects)

Operating profit margin = EBIT / sales

Net profit margin = net income / sales

Return on assets (ROA) = net income / total assets

Basic earnings power (BEP) = EBIT / total assets

Return on equity (ROE) = net income / common equity

The higher the returns, the better the performance

(5) Market value ratios: relate stock price to earnings and book value and show
what investors think about the firm and its future prospects

Price / earnings ratio (P/E ratio) = price per share / earnings per share

Market / book ratio = market price / book value

 Trend analysis, common size analysis, and percentage change analysis

Trend analysis: analyzing a firm’s financial ratios over time to estimate the
likelihood of improvement or deterioration in its financial conditions

Figure 3-1: MicroDrive Inc. ROE over Time

Common size analysis: all income statement items are divided by sales (as a
percentage of sales) and all balance sheet items are divided by total assets (as a
percentage of total assets) to facilitate comparisons of balance sheets and income
statements over time and across companies

Figures 3-2 and 3-3: MicroDrive Inc. Common Size Income Statement and
Balance Sheet

Percentage change analysis: calculate growth rates for all income statement items
and balance sheet accounts relative to a base year to see how a firm is doing

Figure 3-4: MicroDrive Inc. Percentage Change Analysis

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 Benchmarking
The process of comparing a particular company with a set of benchmark
companies (or the industry)

Table 3-2: MicroDrive Inc. Financial Ratios

 Du Pont equations
ROA = net income / total assets = (net income / sales) * (sales / total assets)
= profit margin* total assets turnover

In order to increase ROA, firms can try to improve profit margin and/or total asset
turnover

ROE = net income / common equity

= (net income / sales)* (sales / total assets) * (total assets / common equity)
= profit margin * total assets turnover * equity multiplier

In order to increase ROE, firms can try to improve profit margin and/or total asset
turnover and/or equity multiplier

Example 1 (Problem 3-8)

Given ROA = 3%, ROE = 5%, total assets turnover = 1.5x
Questions:
What is profit margin? Answer = 2%
What is debt ratio? Answer = 40%

Example 2
Given ROE was 3% last year; management developed a plan to raise debt ratio to
60% with interest charges of $300,000; it expects EBIT of $1,000,000 on sales of
$10,000,000 and a total asset turnover of 2; marginal tax rate is 34%
Question:
What should be new ROE?
Answer: NI = (1,000,000 – 300,000) * (1 – 0.34) = $462,000
Profit margin = NI / Sales = 462,000 / 10,000,000 = 4.62%
Debt ratio = 60% = 3/5, then EM = 5/2
New ROE = profit margin * total asset turnover * EM = 4.62%*2*(5/2) = 23.1%

 Limitations in ratio analysis

Different divisions in different industries
Industry average
Accounting methods
Inflation
Window dressing
Seasonality

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 Beyond the numbers
Tied to one customer?
Tied to one product?
Rely on one supplier?
Operations overseas?
Competition?
Future products?
Legal issues?

 Exercise
Read summary
ST-1
Problems: 3, 4, 6, and 11
Group Mini Case

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 Chapter 4 -- Time Value of Money
 Time line
 Future value (FV) and present value (PV)
 Future value annuity (FVA) and present value annuity (PVA)
 Perpetuity
 Uneven cash flows
 Semiannual and other compounding periods
 Amortization
 Applications

 Time line
Time line: an important tool used to show timing of cash flows
50 50 50 50
0 1 2 3 4 …
-100
Cash outflows vs. cash inflows: cash outflows are negative and cash inflows are
positive

 Future value (FV) and present value (PV)

FV: the amount to which a cash flow will grow over a given number of periods
Compounding: an arithmetic process of determining the final value of a cash flow
or a series of cash flows when compound interest is applied

Example: if PV = -$100, I/YR = 5%, N = 3 years, PMT = 0, FV = $115.76

Figures 4-1 and 4-2: Future Value Calculation, Interest Rates, and Time Periods

PV: the value today of a future cash flow

Discounting: a process of finding the present value of a cash flow or a series of
cash flows from the future

Example: if FV = $115.76, I/YR = 5%, N = 3 years, PMT = 0, PV = -$100

Figures 4-3 and 4-4: Present Value Calculation, Interest Rates, and Time Periods

Finding the number of years and interest rates

Example: how long will it take to double your money if interest rate is 6%,
compounded annually? N = 11.90 years
Example: if you want to double your money in 10 years, what should be the
annual interest rate? I/YR = 7.18%

Rule of 72: to double your money, I/YR*N = 72 (approximation)

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 Future value annuity (FVA) and present value annuity (PVA)
Annuity: a series of equal payments for a number of specified periods

Two types of annuities

Ordinary annuity: an annuity with payments made at the end of each period
Annuity due: an annuity with payments made at the beginning of each period

-100 -100 -100

0 1 2 3 Annuity due

-100 -100 -100

0 1 2 3 Ordinary annuity

Note: your calculator has two modes (END for ordinary annuities and BGN for
annuity dues) to deal with different types of annuities. Most often, you use END
mode to deal with ordinary annuities.

FVA: the future value of an annuity for a number of specified periods

For an ordinary annuity

Example: if PV = 0, PMT = -$100, I/YR = 5%, N = 3 years, FVA = $315.25
(using END mode)

Figure 4-5: Future Value Annuity (FVA)

For an annuity due

Example: if PV = 0, PMT = -$100, I/YR = 5%, N = 3 years, FVA = $331.01
(using BNG mode)

Or FVAdue = FVAordinary *(1+I/YR) = $315.25*(1 + 0.05) = $331.01

PVA: the present value of an annuity over a number of periods

Example: if FV = 0, N = 3, I/YR = 5%, and PMT = -$100, PVA = $272.32 (using

END mode)

If it is an annuity due, PVA = $285.94 (using BGN mode)

Or PVAdue = PVAordinary*(1+I/YR) = $272.32*(1 + 0.05) = $285.94

Finding annual payments (PMT), periods (N), and interest rates (I/YR)
Example: you have $15,000 student loan and you want to reply it in next 5 years.
The first payment will be made at the end of the year. The annual interest rate is
4%. What should be your annual payment? PMT = $3,369.41
In the above question, what is your annual payment if the first payment is made
today? PMT = $3,239.81
Example: you win a lottery and face two choices. You can receive a lump sum of
$100,000 today or you will receive $5,000 per year in next 30 years, starting from

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 today. What is the annual interest rate embedded? I/YR = 3.08%

Growing annuities: an annuity that grows at a constant rate

 Perpetuity
Annuity that lasts forever

Present value of a perpetuity = payment / interest rate = PMT / (I/YR)

 Uneven cash flows

A series of cash flows that varies in amount from one period to the other

(1) An annuity plus one additional final payment

1,000
100 100 100 100 100
0 1 2 3 4 5

If I/YR = 5%
FV = FVAordinary + 1,000 = 552.56 + 1,000 = 1,552.56
PV = PVAordinary + PV of 1,000
= 432.95 + 783.53 = 1,216.48

Alternative: PMT = 100, FV = 1,000, N = 5, I/YR = 5%, then PV = 1,216.48

(2) Irregular cash flows

100 300 300 300 500
0 1 2 3 4 5

If I/YR = 12%, then PV = 1,016.35 and FV = 1,791.15 (using CF function)

Naïve way to deal with uneven cash flows: deal with one cash flow at a time

Figures 4-7 and 4-8: PV and FV of Irregular Cash Flows

Solving for I/YR (IRR) with irregular cash flows (using cash flow function)

Figure 4-9: IRR on Uneven Cash Flows

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 Semiannual and other compounding periods
Annual compounding: interest payment is calculated once a year
Semiannual compounding: interest payment is calculated twice a year
Other compounding periods: quarterly, monthly, daily, and continuously, etc.

Effective rate = (1 + i / m)m - 1, where i is the nominal annual rate and m is the
number of compounding (for example, for quarterly compounding, m = 4)

Example: suppose you have $1,000 to invest and are choosing among banks A,
B, and C. Each bank offers the following nominal annual rate and compounding
method.

Bank A: 7% compounded annually

Bank B: 6.9% compounded quarterly
Bank C: 6.8% compounded daily

Question: which bank would you like to choose?

Answer: you should choose Bank B because
Effective rate (Bank A) = 7%
Effective rate (Bank B) = 7.08%
Effective rate (Bank C) = 7.04%

Note: If all three banks offer the same annual rate, which bank should you
choose?
Answer: Bank C. Why? Because it offers the highest effective rate

 Amortization
Amortized loan: a loan that is repaid in equal payments over its lift

Example: amount borrowed = $100,000; N = 5 years; I/YR = 6%;

PMT = $23,739.64

Figure 4-11: Loan Amortization Schedule

 Applications
Bond and stock valuations (will be covered later)

Example: saving for your dream car

Your dream car costs $50,000 now and the price will increase by 4% per year.
The interest rate is 6% per year. How much should you save every year (in same
amount) in next four years (each deposit will be made at the end of the year) to
buy the car in 4 years? How much should you save every month in next four years
to buy the car, assuming each deposit is made at the end of each month?

22
 Answer:
Step 1: price of the car in four years = 58,492.93
(PV = -50,000, I/YR = 4%, N = 4, PMT = 0, FV = 58,492.93)
Step 2: for annual deposit, FV = 58,492.93, I/YR = 6%, N = 4, PV = 0, and solve
for PMT to get PMT = $13,370.99
Step 3: for monthly deposit, FV = 58,492.93, I/YR = 6% / 12 = 0.5%, PV = 0,
N = 4*12 = 48, solve for PMT = 1,081.24

Example: saving for your retirement

Suppose you save $100 a month for 10 years, starting from age 20, and invest the
money in a mutual fund for an average return of 12% per year (1% per month,
compounded monthly). How much will you have when you reach 60? At what age
will you become a millionaire?

Answer:
Step 1: value of mutual funds when you are 30 years old
PMT = -100, I/YR = 1%, N =120, PV = 0, FV = 23,003.87
Step 2: money you will have when retiring
PV = -23,003.87, I/YR = 1%, N = 360, PMT = 0, and solve for FV
FV = $826,981
Step 3: when FV reaches 1 million
PV = -23,003.87, I/YR = 1%, PMT = 0, FV = 1,000,000, solve for
N = 379.09
379.09 / 12 = 31.59 years
When you are about 62 years old you will become a millionaire.

 Exercise
Read Summary
ST-1, ST-2, and ST-3
Problems: 21, 23, 28, and 33

23
 Chapter 5 -- Bond Valuation and Interest Rates
 Who issues bonds
 Characteristics of bonds
 Bond valuation
 Important relationships in bond pricing
 Bond rating
 The determinants of market interest rates
 Term structure of interest rates and yield curves
 What determines the shape of yield curves

 Who issues bonds

Bond: a long-term debt

Treasury bonds: issued by the federal government, no default risk

Agency bonds: issued by federal government agencies

Municipal bonds (munis): issued by state and local governments with some default
risk - tax benefit

Corporate bonds: issued by corporations with different levels of default risk

Mortgage bonds: backed by fixed assets

Debenture: not secured by a mortgage on specific property

Subordinated debenture: have claims on assets after the senior debt has been paid
off

Zero coupon bonds: no interest payments (coupon rate is zero)

Junk bonds: high risk, high yield bonds

Eurobonds: bonds issued outside the U.S. but pay interest and principal in U.S.
dollars

International bonds

24
 Characteristics of bonds
Claim on assets and income

Par value (face value, M): the amount that is returned to the bondholder at
maturity, usually it is $1,000

Maturity date: a specific date on which the bond issuer returns the par value to the
bondholder

Coupon interest rate: the percentage of the par value of the bond paid out annually
to the bondholder in the form of interest

Coupon payment (INT): annual interest payment

Fixed rate bonds vs. floating rate bonds

Zero coupon bond: a bond that pays no interest but sold at a discount below par

For example, a 6-year zero-coupon bond is selling at $675. The face value is
$1,000. What is the expected annual return? (I/YR = 6.77%)

1000
0 1 2 3 4 5 6
-675

Indenture: a legal agreement between the issuing firm and the bondholder

Call provision: gives the issuer the right to redeem (retire) the bonds under
specified terms prior to the normal maturity date

Convertible bonds: can be exchanged for common stock at the option of the
bondholder

Income bonds: pay interest only if it is earned

Sinking fund provision: requires the issuer to retire a portion of the bond issue
each year

Indexed bonds: interest payments are based on an inflation index

Required rate of return: minimum return that attracts the investor to buy a bond;
It serves as the discount rate (I/YR) in bond valuation

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 Bond valuation
Market value vs. intrinsic (fair) value

Market value: the actual market price, determined by the market conditions

(1) Intrinsic value: present value of expected future cash flows, fair value

M
INT INT INT INT
0 1 2 3 ... N

N
INT M
VB    , where INT is the annual coupon payment, M is the
t 1 (1  rd ) (1  rd ) N
t

face value, and rd is the required rate of return on the bond

Annual and semiannual coupon payments using a financial calculator

Example: a 10-year bond carries a 6% coupon rate and pays interest annually. The
required rate of return of the bond is 8%. What should be the fair value of the
bond?
Answer: PMT = 60, FV = 1,000, I/YR = 8% (input 8), N = 10, solve for
PV = -$865.80

What should be the fair value if the bond pays semiannual interest?
Answer: PMT = 30, FV = 1,000, I/YR = 4% (input 4), N = 20, solve for
PV = -$864.10

Should you buy the bond if the market price of the bond is $910.00?
No, because the fair value is less than the market price (the bond in the market is
over-priced)

Discount bond: a bond that sells below its par value

Premium bond: a bond that sell above its par value

(2) Yield to maturity (YTM): the return from a bond if it is held to maturity

Example: a 10-year bond carries a 6% coupon rate and pays interest

semiannually. The market price of the bond is $910.00. What should be YTM for
the bond?
Answer: PMT = 30, FV = 1,000, PV = -$910.00, N = 20, solve for I/YR = 3.64%
YTM = 3.64%*2 = 7.28%

26
 (3) Yield to call: the return from a bond if it is held until called

Example: a 10-year bond carries a 6% coupon rate and pays interest

semiannually. The market price of the bond is $910.00. The bond can be called
after 5 years at a call price of $1,050. What should be YTC for the bond?
Answer: PMT = 30, FV = 1,050, PV = -$910.00, N = 10, solve for I/YR = 4.55%
YTC = 4.55%*2 = 9.10%

(4) Current yield (CY) = annual coupon payment / current market price

Example: a 10-year bond carries a 6% coupon rate and pays interest

semiannually. The market price of the bond is $910.00. What is CY for the bond?
Answer: CY = 60/910 = 6.59%

 Important relationships in bond pricing

(1) The value of a bond is inversely related to changes in the investor’s
present required rate of return (current interest rate); or
As interest rates increase, the value of a bond decreases

Interest rate risk: the variability in a bond value caused by changing

interest rates
Interest rate price risk: an increase in interest rates causes a decrease in
bond value
Interest reinvestment risk: a decrease in interest rates leads to a decline in
reinvestment income from a bond

(2) If the required rate of return (or discount rate) is higher than the coupon
rate, the value of the bond will be less than the par value; and
If the required rate of return (or discount rate) is less than the coupon rate,
the value of the bond will be higher than the par value

(3) As the maturity date approaches, the market value of a bond approaches
its par value

(4) Long-term bonds have greater interest rate risk than short-term bonds

(5) The sensitivity of a bond’s value to changing interest rates depends not
only on the length of time to maturity, but also on the pattern of
cash flows provided by the bond (or coupon rates)

Figure 5-2: Time Path of the Value for Different Bonds

Figure 5-4: Value of Long- and Short-Term Bonds at Different Interest Rates

27
 Bond rating
Importance: firm’s credit

Moody’s and S&P provide bond ratings

AAA
AA
A Investment-grade bonds
BBB
BB
B Junk bonds
.

Table 5-1: Bond Rating, Default Risk, and Yields

Criteria to consider
Financial ratios: for example, debt ratio and interest coverage ratio
Qualitative factors: for example, contract terms, subordinated issues, etc.
Other factors: for example, profitability ratios and firm size

 Bond markets
OTC markets
Quotes: quoted as a % of par value of $100, minimum tick (minimum price
movement) is 1/32

Invoice price = quoted price + accrued interest

0 182 days

62 days 120 days remaining until next coupon

Suppose annual coupon is $60 ($30 in 6 months) and the quoted price is 95:16 (or
$95.500 for $100 face value)

Invoice price = 955 + (62/182)*30 = $965.22 = 955.00 + 10.22

where $955 is the quoted price and $10.22 is the accrued interest

 The determinants of interest rates

The quoted (nominal) interest rate on a debt security is composed of a real risk-
free rate, r*, plus several risk premiums

Risk premium: additional return to compensate for additional risk

Quoted nominal return = r = r* + IP + DRP + MRP + LP

where r = the quoted, or nominal rate on a given security
r* = real risk-free rate

28
 IP = inflation premium (the average of expected future inflation rates)
DRP = default risk premium
MRP = maturity risk premium
LP = liquidity premium

and r* + IP = rRF = nominal risk-free rate (T-bill rate)

Examples

 Term structure of interest rates and yield curves

Term structure of interest rates: the relationship between yields and maturities

Yield curve: a graph showing the relationship between yields and maturities

Normal yield curve (upward sloping)

Abnormal yield curve (downward sloping)
Humped yield curve (interest rates on medium-term maturities are higher than
both short-term and long-term maturities)

Term to maturity Interest rate Interest rate (%)

1 year 0.4%
5 years 2.4%
10 years 3.7%
30 years 4.6%
Years to maturity

Figure 5-5: T-bond Yield Curves on Different Dates

 What determines the shape of yield curves

Term structure theories
(1) Expectation theory: the shape of the yield curve depends on investors’
expectations about future interest rates (inflation rates)

Forward rate: a future interest rate implied in the current interest rates

For example, a one-year T-bond yields 5% and a two-year T-bond yields 5.5%,
then the investors expect to yield 6% for the T-bond in the second year.

(1+5.5%)2 = (1+5%)(1+X), solve for X(forward rate) = 6.00238%

Approximation: (5.5%)*2 - 5% = 6%
(2) Liquidity preference theory: other things constant, investors prefer to make
short-term loans, therefore, they would like to lend short-term funds at lower rates

Implication: keeping other things constant, we should observe normal yield

curves

29
 Example: expected inflation this year = 3% and it will be a constant but above 3%
in year 2 and thereafter; r* = 2%; if the yield on a 3-year T-bond equals the 1-year
T-bond yield plus 2%, what inflation rate is expected after year 1, assuming MRP
= 0 for both bonds?
Answer: yield on 1-year bond, r1 = 3% + 2% = 5%; yield on 3-year bond,
r3 = 5% + 2% = 7% = r* + IP3; IP3 = 5%; IP3 = (3% + x + x) / 3 = 5%, x = 6%

Example: Given r* = 2.75%, inflation rates will be 2.5% in year 1, 3.2% in year 2,
and 3.6% thereafter. If a 3-year T-bond yields 6.25% and a 5-year T-bond yields
6.8%, what is MRP5 - MRP3 (For T-bonds, DRP = 0 and LP = 0)?
Answer: IP3 = (2.5%+3.2%+3.6%)/3=3.1%; IP5 = (2.5%+3.2%+3.6%*3)/5=3.3%;
Yield on 3-year bond, r3=2.75%+3.1%+MRP3=6.25%, so MRP3=0.4%;
Yield on 5-year bond, r5=2.75%+3.3%+MRP5=6.8%, so MRP5=0.75%;
Therefore, MRP5 - MRP3 = 0.35%

Example: bond X has 20 years to maturity, a 9% annual coupon, and a $1,000

face value. The required rate of return is 10%. Suppose you want to buy the bond
and you plan to hold the bond for 5 years. You expect that in 5 years, the yield to
maturity on a 15-year bond with similar risk will be priced to yield 8.5%. How
much would you like to pay for the bond today?
1,000
90 … 90 90 90 90
0 1 … 5 6 … 19 20

PV5 =1,041.52 (I/YR=8.5%, PMT=90, N=15, FV=1,000)

PV0 = 987.87 (I/YR=10%, PMT=90, N=5, FV=1,041.52)

Answer:
Step 1: figure out what should be the fair value of the bond after 5 years (PV 5)
Step 2: figure out what should be the fair value of the bond now (PV0)

 Exercise
Read Summary
ST-1
Problems: 2, 4, 6, 10, and 21

30
 Chapter 6 -- Risk, Return, and CAPM

 Investment returns
 Risk
 Expected rate of return and standard deviation
 Return on a portfolio and portfolio risk
 Beta coefficient - market risk
 Relationship between risk and return

 Investment returns
Dollar return vs. rate of return

If you invested $1,000 and received $1,100 in return, then your dollar return is
$100 = 1,100 - 1,000 and your rate of return = 10% = (1,100 - 1,000) / 1,000

Rate of return is a better measure

 Risk
The chance that some unfavorable event will occur

Stand-alone risk vs. market risk

Stand-alone risk: risk of holding one asset measured by standard deviation
Market risk: risk of holding a well-diversified portfolio measured by beta

 Expected rate of return and standard deviation

Probability distribution: a list of possible outcomes with a probability assigned to
each outcome

Figures 6-1, 6-3 and 6-4: Probability Distributions

Expected rate of return: the rate of return expected to be realized that is positive

Variance and standard deviation: statistical measures of variability (risk)

^ n
Expected rate of return = 
r  Pi ri
i 1
n ^
Variance =  = 2
 P (r  r )
i 1
i i
2
and Standard deviation =   2

Figure 6-2: Expected Return Calculation

31
 Figure 6-5: Standard Deviation Calculation
Coefficient of variation (CV) = standard deviation / expected rate of return,
which measures the risk per unit of expected return

Probability ranges for a normal distribution: confidence intervals

Figure 6-6: Probability Ranges

Using historical data to estimate average return and standard deviation

Figure 6-7: Average and Standard Deviation Calculation using Excel

 Return on a portfolio and portfolio risk

Expected return on a portfolio: the weighted average of the expected returns on
the assets held in the portfolio
^ N ^
rp   wi ri
i 1

For example, the expected rate of return on stock A is 10% and the expected rate
of return on stock B is 14%. If you invest 40% of your money in stock A and 60%
of your money in stock B to form your portfolio, the expected rate of return on
your portfolio will be 12.4% = (0.4)*10% + (0.6)*14%

Portfolio risk
As you increase the number of securities in a portfolio, the portfolio total risk
decreases - diversification effect

Figure 6-12: Effects of Portfolio Size on Portfolio Risk

Total risk = firm’s specific risk + market risk

Total risk = diversifiable risk + non-diversifiable risk

Total risk = un-systematic risk + systematic risk

Why can portfolios reduce risk?

Because some of the risks can be averaged out (or can be offset)

International diversification: portfolio risk can be further reduced if international

stocks are included in the opportunity set

32
 Beta coefficient - market risk
Sensitivity of an asset (or a portfolio) with respect to the market or the extent to
which a given stock’s returns move up and down with the stock market

Plot historical returns for a firm along with the market returns (S&P 500 index,
for example) and estimate the best-fit line. The estimated slope of the line is the
estimated beta coefficient of the stock, or the market risk of the stock.
 COVi , M
 i  i  i,M 
M  M2

Figure 6-15: Estimating GE’s Beta

Portfolio beta: weighted average of individual securities’ betas in the portfolio

N
 p   wi  i
i 1

For example, if the beta for stock A is 0.8 and the beta for stock B is 1.2 and you
invest 40% of your money in stock A and 60% of your money in stock B to form
your portfolio, then the beta of your portfolio will be 1.04 = (0.4)*0.8 + (0.6)*1.2

 Relationship between risk and rates of return

Required rate of return: the minimum rate of return necessary to attract an investor
to purchase or hold a security

Market risk premium: the additional return over the risk-free rate needed to
compensate investors for assuming an average amount of risk (market risk)
RPM  rM  rRF

For example, if the required rate of return on the market is 11% and the risk-free
rare is 6% then the market risk premium will be 5%

Risk premium for a stock: the additional return over the risk-free rate needed to
compensate investors for assuming the risk of that stock
RPi  ri  rRF

For example, if the required rate of return on a stock is 15% and the risk-free rate
is 6% then the risk premium for that stock will be 9%

Why is the risk premium for the stock higher than that of the market? Because the
stock carries a higher risk than the market

33
 Capital Asset Pricing Model (CAPM)

ri  rRF  ( rM  rRF )  i , where ri is the required rate of return on stock i; rRF is the
risk-free rate; (rm – rRF) is the market risk premium;  i is the market risk for
stock i; and (rm – rRF)  i is the risk premium for stock i

Security market line (SML): a line that shows the relationship between the
required return of a stock (portfolio) and the market risk of the stock (portfolio)

Figure 6-16: SML

Overvalued vs. undervalued securities

If the actual (expected) return lies above the SML, the security is undervalued
If the actual (expected) return lies below the SML, the security is overvalued

Example: a stock has a beta of 0.8 and an expected rate of return of 11%. The
expected rate of return on the market is 12% and the risk-free rate is 4%. Should
you buy the stock?

Answer: required rate of return for the stock (using CAPM) is

4% + (12% - 4%)*(0.8) = 10.4% < 11% (expected rate of return)
The stock is under-valued

The impact of inflation: a parallel shift in SML

Figure 6-17: Shift in SML by an Increase in Interest Rates

Change in risk aversion: the slope of SML gets steeper

Figure 6-18: Shift in SML by an Increase in Risk Aversion

 Exercise
Read Summary
ST-1 and ST-2
Problems: 5, 7, 8, 9, 10 and 11

34
Example: given the information about stocks X, Y, and Z below (X, Y, and Z
are positively but not perfectly correlated), assuming stock market equilibrium:

Stock Expected Return Standard Deviation Beta

X 9.00% 15% 0.8
Y 10.75% 15% 1.2
Z 12.50% 15% 1.6

Fund Q has one-third of its funds invested in each of the three stocks and the risk-
free rate (rRF) is 5.5%

a. What is the market risk premium?

Applying CAPM to stock X and using the formula ri  rRF  (rM  rRF )  i
9.00% = 5.50% + (rM - rRF)*0.8, solve for rM - rRF = 4.375%

b. What is the beta of Fund Q?

 Q = (1/3)*(0.8) + (1/3)*(1.2) + (1/3)*(1.6) = 1.20

c. What is the expected (required) rate of return on Fund Q?

Applying CAPM to Fund Q, rQ = 5.50% + (4.375%)*1.2 = 10.75%

d. What would be the standard deviation of Fund Q (>15%, =15%, or <15%)?

It should be less than 15% due to diversification (since X, Y, and Z are
positively but not perfectly correlated)

35