~~

~"
". ......"...",
~
~

Note: The use of programmable calculators and PDAs are prohibited during mid-terms and final exams

TIME VALUE OF MONEY

All fonnulas in this section are expressed in tenns of $1 or some periodic cash flow C
Future value of$l or C $1 *FVr,1 $1 * (I +r)' or C(1 + r)'

Future value of $1 or size C annuity $I*FVA r,l= $1*[(I+r}1 -I] or C[(I+r}t -I]
I
Present value of $1 or C $1*PVr,1 $1 *_1_ or C -­
(I + r )1 (I + r Y

Present value of$l or size C annuity $I*PVA r,l =

"r~1 o'f~

Present value of a growing annuity of size C =

r-g
C[I (1+l+rg)']
Present value of$l or size C perpetuity
$1
or
c
r r

Annual percentage rate (APR) Rate per period (denoted by r) * Compounding Periods per year (denoted by m)

Effective annual rate (EAR)

VALUATION OF BONDS & STOCKS

Let: Bo = current price of a bond, r = bond required return, C = annual coupon, F = face value, n = years to maturity

Current price of an annual coupon bond Bo = C * PVA"n + F * PV"n or c h2~l +F[_Ir 1

r (I + r

Current price ofa semiannual coupon bond Bo = ~ * PVA'/2,2n + F* PV,/2,2n or

Yield to Maturity = The interest rate y such that: Bo = C * PVAy,n + F * PVy,n

AnnuatCoupon + [ (Facevatue-Price)]

.
Maturity
Yield to Maturity Approximation: YTM "" -------r,...,-----=------:-=;-'-----~=-
[(Price + F;cevatue)]

Investment rate of return = total income/investment

(I + NominalInterestRate)

Real interest rate = -'----,,------------:---'­

(1 + Inflation Rate )

Let: Po,P, = current stock price, stock price in one period, r = stock expected return, Do,D, = current dividend, dividend in one period

Stock expected return = expected dividend yield + expected capital appreciation

D, + (J~ -Po)
Po
Constant growth (g) dividend discount model: Po =~= Do(l+g)
r-g r-g
 Zero growth (g=0) dividend discount model: Po =!3...
r r
INVESTMENT CRITERIA
Let: CFt = cash flow in year t, r opportunity cost of capital, 10 = initial investment, n = project life

• Ordinary Payback is the value ofT such that: CF, +CF2 +... +CFT =/0

CF,
• Discounted Payback is the value ofT such that
CF2
(I + r)' + (I + r l + ... +
CFT
(J + r r = 10

Net Present Value: NPV CF, CF2 CF.

= (I+r)' + (1+r)2 + ... + (1+r)· 10
CF, CF2 CF.
• Internal Rate of Return - Find IRR such that:
(I + IRR)' + (1 + IRRY + ... + (1 + IRR)·

• Profitability Index = ~~ =[(IC::

Y
+ (1C::)2 + .•. + (lC:;r ]/0
• Book (accounting) rate of return: Average book rate of return = (average annual net income )/(average annual book value of assets)

CAPITAL BUDGETING
Let: OI = Operating Income = Sales - Costs of goods sold, C = capital cost of an asset in year 0, d = CCA rate, Tc = corporate tax rate,
k = discount rate, S = salvage value

PV of After tax Operating Income = (I: k)' (1- ~ )01, + (I +Ik Y(1- ~ )012 + ... + (I +Ik r (1- ~ )01.
• PV ofperpetual tax shield with salvage value in yearn = [(~~d)]*[(I+;~) ] - (I +Ik r [(:~d)]
• PVOfallchangesinNetWorkingCapital=lJNWCo + -1(),lJNWC, + _ )2 lJNWC2+ ... + _
I ( I)( lJNWC.
I+k l+k I+k'

PVO! AfterTax )+(Pvo!perpetual)_[PVO! Allchanges]+_l_S_1

• NPV ( Operating Income TaxShield inNWC (I+k)" 0

• Equivalent annual cost EAC (pVofaU costs)/(Presentvalue of annuity factor)

RISK & RETURN

Let:x" X2 = investment proportion in asset 1, asset 2, E(R.) portfolio expected return, 0'. portfolio standard deviation, 0', ,0'2 = return standard
deviation for asset I, asset 2, CORR 12 = correlation between returns for assets 1 and 2

Expected return for a single asset given n past historical realized returns Expected return for a single asset given k possible states ofthe economy,

R"R2,..·,R. : conditional returns and their probabilities:

E(R)= p,R, + P2RZ + ... + p.R.

Variance of returns for a single asset given n past historical realized Variance for a single asset given k possible states of the economy,
returns Rl'R2 , ••• ,R.: conditional returns and their probabilities:
(j2 p,[R, -E(R)Y + P2[R2 _E(R))2 + ... + p.[R. -E(R)f

• Expected return ofa portfolio ofj assets: E Rp

• u,,=.J x;u;+ xjuj+ 2XIXICORR I2 u/Ul
• CAPM: E(R,)= Rj + p,lE(RM)- Rj 1

COST OF CAPITAL

• Dividend Growth Model: Note: Where appropriate, g may be estimated as a:

RE=DJ+ g D.(l+g)+ I) Compound rate
Po Po g 2) Average (Aritlnnetic) rate
Shareholders required return 3) Retention ratio X Return on Retained Earnings = Retention ratio *
ROE
Next period's projected
dividend =(retained earnings)*( earnings )
earnings shareholders equity
g Constant growth rate
 SML Approach: RE=R/+[Rm-R/JPE D
• Cost of Preferred Stock
Risk-free rate Po
Return on the market portfolio D Fixed dividend
The systematic risk ofthe asset Po Price per share ofthe preferred stock
Market risk premium
After tax Cost of Debt RD = Yield ( J- Tc) Tc = Corporate tax rate

Weights: V=E+D JOO%=(EIV )+(DIV)

V Market value ofthe firm consisting of the market value of equity plus debt
EIV, DI V Market value ofequity fmancing, Market value of long-term debt financing

WACC (f)XRE+(f)XRD( I-Te)

LEVERAGE & CAPITAL STRUCTURE

% A in EPS EBIT
• Degree of Financial Leverage (DFL)
% A in EBIT EBIT -Interest
• Indifference EBIT When EPS under debt or equity financing are equal
EPS = ( EBIT - Interest) ( I - t < ) - Preferred Share Dividends
# of common shares
Vu, VL Value of the unlevered, levered firm
EBIT Perpetual operating income
R~ Required return on equity (un levered firm)
EL ,DL Market value of equity (levered firm), debt (levered firm)
R. Required rate of return on the firm's assets
Ru Unlevered cost of capital

MM Proposition I MM Proposition II
No Tax EBIT
Vu VL +DL RE = R. + (R. - RD)~
'E
With Tax VL Vu + TeD
R" =Ru +(Ru -RD)D(I-TJ
E

Equity beta:

OPTIONS
So ' SI Current Stock Price, Stock Price at Expiration (in one period)
S; , Si Stock Price at Expiration in the Up State, Stock Price at Expiration in the Down State
Co , CI Current Value ofa CalJ Option, Value ofthe Call Option at Expiration
E Exercise price on the option
Rj Risk-free rate and
number of time periods

tion can fmish out-of-the-mone :

Co =AC,
- ­ [ So -S,- ( I \r ],smceS
. AS, C S-
o = - ­ 0 + ! -r---,­
AS, 1+ R j J AC,