FINANCIAL MANAGEMENT

Chapter 1 The Corporation

Learning Objectives Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

1. Identify the basic forms of business

organisation;
2. Identify the key financial decisions faced
by the financial managers
3. Understand the rationale of firms’ goal of
maximisation of shareholders’ wealth;
4. Understand the nature of the Stock
Market.
2
5. Emerging Issues
 Forms of Key Goal of Stock Issues

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A review on: Business
Organisati
on
Financial
Decisions
Firms &
Corporatio
ns
Market Arising

The Four Types of Firms

¨ Sole Proprietorship

¨ Partnership

¨ Limited Liability Company

¨ Corporation

3
 Legal forms of business Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising

organisation Organisati
on
Decisions Corporatio
ns

¨ Sole proprietorship
¤ A business owned by a single individual, unlimited
liability, limited access to capital, lack of continuity,
constraints of various skills.

¤ Advantages
n Easy to create

¤ Disadvantages
n Unlimited personal liability
n Limited life
n Difficult to transfer ownership

4
 Legal forms of business Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising

organisation Organisati
on
Decisions Corporatio
ns

¨ Partnership
¤ An association of two or more individuals joining
together as co-owners to operate a business for
profit, joint responsibility, involves partnership
agreement, better access of capital/skills, continuity
of business?
¤ All partners are personally liable for all of the firm’s
debts. A lender can require any partner to repay all of
the firm’s outstanding debts.
¤ The partnership ends with the death or withdrawal of
any single partner.

5
 Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
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The Four Types of Firms (cont'd)

¨ Partnership
¤ Advantages: limited protection of owners’ personal
assets; more sources of equity & expertise.
¤ Disadvantages: hard to dissolve, shared control & profit.

¤ Limited Partnership has two types of owners.

n General Partners
n Have the same rights and liability as partners in a
“regular” partnership (personally liable for firm’s debt obligations.)
n Typically run the firm on a day-to-day basis
n Limited Partners
n Have liability limited to their investment
n Have no management authority and cannot legally be involved in
the managerial decision making for the business
n The limited partner’s interest is transferable
6
 Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

The Four Types of Firms (cont'd)

¨ Limited Liability Company (LLC)
¤ All owners have limited liability (not personally
liable) but they can also run the business.

¤ Can be private or public companies.

¤ Known as PLC in UK.

7
 Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

The Four Types of Firms (cont'd)

¨ Corporation
¤ A legal entity separate from its owners
n Has many of the legal powers as individuals have, such as the
ability to enter into contracts, own assets, and borrow money

n The corporation is solely responsible for its own obligations. Its

owners are not liable for any obligation the corporation enters
into.

n An entity that legally functions separately and apart from its

owners, limited liability, good access of capital/skills, separation
of management and ownership, ownership is dictated by the
shareholdings and is transferable.

8
 Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

The Four Types of Firms (cont'd)

¨ Corporation
¤ Advantages: protects personal assets, no
shareholder liability for business, greater access
to sources of funds.

¤ Disadvantages?

¤ Formation
n Corporations must be legally formed. A legal
document is created on formation of the corporation.

9
 Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

The Four Types of Firms (cont'd)

¨ Corporation
¤ Ownership
n Represented by shares of stock
n Owner of stock is called
n Shareholder
n Stockhoder
n Equity Holder
n Sum of all ownership value is called equity.
n There is no limit to the number of shareholders, and
thus the amount of funds a company can raise by
selling stock.
n Owner is entitled to dividend payments.

10
 Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

Legal forms of business organisation

Comparison of organisational forms
Consider:
¤ Organisation requirements and costs
¤ Liability of owners
¤ Continuity of business
¤ Transferability of ownership
¤ Management control
¤ Ease of capital raising
¤ Income taxes
 Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

Textbook Example 1.1

 Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

Textbook Example 1.1 (cont'd)

 Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

Ownership versus Control of Corporations

¨ Corporate Management Team
¤ In a corporation, ownership and direct control are
typically separate.
¤ Board of Directors
n Elected by shareholders
n Have ultimate decision-making authority

¤ Chief Executive Officer (CEO)

n Board typically delegates day-to-day decision making
to CEO.

14
Figure 1.2 Organizational Chart of a
Forms of Key Goal of Stock Issues

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Typical Corporation Business
Organisati
on
Financial
Decisions
Firms &
Corporatio
ns
Market Arising

15
 Forms of Key Goal of Stock Issues

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Organisati Decisions Corporatio
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Financial Management
16

¨ How people in corporations make financial

decisions?

¨ Financial decisions?
¤ Where, when, what, how much, how…etc.
¤ Mostly concern with three decisions: Investment
decisions, Financing decisions and cash for
treasury management decisions.
¤ With one goal…
Ownership versus Control of Corporations
Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

¨ Financial Manager
¤ Responsible for:
n Investment Decisions
n Financing Decisions
n Cash (Treasury) Management or Dividend Decisions

17
 Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
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The Role of the Financial Manager

18

¨ Capital budgeting: decide which L-T assets to

acquire;
¨ Financing: decide how to pay for S-T and L-T
assets,
¨ Cash for Treasury Management: ensure
sufficient cash on hand to meet its day-to-day
obligations, or
¨ Dividend decision: decide on the payout of
dividend.
Cash Flows Between the Firm and
Its Stakeholders and Owners
Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
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(Parrino et al., 2012)

How the Financial Manager’s Decisions
Affect the Balance Sheet Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

(Parrino et al., 2012)

 Ownership versus Control of Corporations
Forms of Key Goal of Stock Issues

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(cont'd) Business
Organisati
on
Financial
Decisions
Firms &
Corporatio
ns
Market Arising

¨ Goal of the Firm

¤ Shareholders will agree that they are better off if
management makes decisions that maximizes the
value of their shares.
¤ Maximisation of shareholders’ wealth; or firm’s
value.

21
Goal of the firm Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

Profit maximisation?
Problems:
¤ Timing of returns, eg.
¤ Uncertainty of returns, (risk vs return,
opportunity cost of capital) eg.
¤ Impact on the society as a whole?
The Goal of the Firm
Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

¨ Maximizing Profit…
¤ Accounting profit differs from cash flows
¤ Profit earned may not equal cash received
n Cash not received can’t be used to pay bills
¤ The strategy ignores the timing of future cash
flows
¤ The strategy ignores the risks associated with
having to wait for cash flows
The Goal of the Firm
Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

¨ Maximizing Shareholders’ Wealth…

¤ Future cash flows are considered
¤ The timing of future cash flows is considered

¤ The risks associated with having to wait to for

cash flows are considered
The Goal of the Firm Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

¨ Its All About Cash flow!

¤ Positive residual cash flow may be paid to firm
owners as dividends or invested in the firm
¤ The larger the positive residual cash flow, the
greater the value of a firm
¤ Negative residual cash flow – over the long run -
leads to bankruptcy or closing a business
Goal of the firm Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

Maximisation of shareholder
wealth?

How do we measure it?

Goal of the firm Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

Maximisation of
shareholder wealth?
The maximisation of the
refers to
price/market value of the existing
ordinary shares which owned by
the ultimate owners - who affects
the movement of share prices.
Goal of the firm Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

Maximisation of shareholder
wealth?

This goal is consistent with:

¤ Maximising firm value
¤ Maximising share value

BUT…its not without its difficulties!

 Ownership versus Control of Corporations
Forms of Key Goal of Stock Issues

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(cont'd) Business
Organisati
on
Financial
Decisions
Firms &
Corporatio
ns
Market Arising

¨ Ethics and Incentives within Corporations

¤ Agency Problems
n Managers may act in their own interest rather than in
the best interest of the shareholders.

n One potential solution is to tie management’s

compensation to firm performance. (may encourage
risk-taking)

n How should performance be measured?

29
 Ownership versus Control of
Corporations (cont'd) Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

¨ CEO Performance
If a CEO is performing poorly:
¤ shareholders can express their dissatisfaction by selling their
shares. This selling pressure will drive the stock price down.
or

¤ shareholders could pressure the board to reappoint a new CEO.

(eg: Disney’s Michael Eisner, Hewlett Packard’s Carly Fiorina)
¤ Hostile Takeover
n Low stock prices may entice a Corporate Raider to buy enough stock
so they have enough control to replace current management. The
stock price will rise after the new management team “fixes” the
company.

30
 Ownership versus Control of Corporations
(cont'd) Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

¨ Corporate Bankruptcy
¤ Debt holders vs equity holders

¤ Reorganization

¤ Liquidation

31
The Stock Market Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

¨ The stock market provides liquidity

to shareholders.
¤ Liquidity
n The ability to easily sell an asset for close to the price
you can currently buy it for
n Why is it important?

32
The Stock Market (cont'd)
Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
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¨ Public Company
¤ Stock is traded by the public on a stock exchange.

¨ Private Company
¤ Stock may be traded privately.

33
The Stock Market (cont'd)
Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
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¨ Primary Markets
¤ When a corporation itself issues new shares of
stock and sells them to investors, they do so on
the primary market.

¨ Secondary Markets
¤ After the initial transaction in the primary market,
the shares continue to trade in a secondary
market between investors.

34
The Stock Market (cont'd)
Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

¨ Largest Stock Markets

¤ New York Stock Exchange (NYSE)
n Market Makers/Specialists
n Each stock has only one market maker

¤ NASDAQ
n Does not meet in a physical location
n May have many market makers for a single stock

¤ Bid Price versus Ask Price

n Bid-Ask Spread
n Transaction cost

35
Getting A Stock Price Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
on ns

The stock price is the market price of a stock. Using the Bursa
Malaysia website you can view the price for any listed stock.

Getting a Price:
There are many places you can find market news, eg:
¨ The financial section of the daily newspapers
¨ Bursa Malaysia Website. (www.bursamalaysia.com)
¨ Your broker website may have an up-to-date list of stock
prices
¨ Your telephone company may be able to send you market
updates via your mobile phone (source:www.bursamalaysia.com)
 The Essence of Share Prices Forms of Key Goal of Stock Issues

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Business Financial Firms & Market Arising
Organisati Decisions Corporatio
37 on ns

¨ What is the importance of share prices?

¨ Why are the news focused heavily on the
movement of the share prices?
¨ What are the factors that driving the changes
in the share prices?
 The World Markets
38
Recap for Bonds Valuation
 Recap of TVM
40 Back to the Fundamental

Future Value
 Compounding and Discounting

¨ Translate $1 today into its equivalent in

the future (COMPOUNDING).
Today Future

FV=?

¨ Translate $1 in the future into its

equivalent today (DISCOUNTING).
Today Future

PV=?
 Future Value
42

PV = -100 FV = 106

0 1
Future Value (FV) = PV (1 + i) t
= 100 (1+0.06)1 = RM 106

Calculator Solution:
P/Y = 1 I=6 N = 1 PV = -100 FV = RM106
 Future Value
43

PV = -100 FV = 133.82

0 5
Future Value (FV) = PV (1 + i) t
= 100 (1+0.06)5 = RM 133.82

Calculator Solution:
P/Y = 1 I = 6 N = 5 PV = -100 FV = RM133.82
 Future Value
44

PV = -100 FV = 133.82

0 5
Mathematical Solution:
FV = PV (FVIF i, n )
FV = 100 (FVIF 6%, 5 ) (use FVIF table, or)
FV = PV (1 + i)n
FV = 100 (1.06)5 = RM133.82
 Future Value
45

PV = -100 FV = 134.69

0 20
Future Value (FV) = PV (1 + i/m) mxn
= 100 (1+0.06/4)(4x5) = 134.69

Calculator Solution:
P/Y = 1 I = 1.5 N = 20 PV = -100 FV = 134.69
 Future Value
46

PV = -100 FV = 134.89

0 20
Future Value (FV) = PV (1 + i/m) mxn
= 100 (1+0.06/12)(12x5) = 134.89

Calculator Solution:
P/Y = 1 I = 0.005 N = 60 PV = -100 FV =
134.89
 Present Value
47
 Present Value - single sums
If you receive $100 one year from now, what is the
PV of that $100 if your opportunity cost is 6%?
48

PV = ?? FV = 100

0 1
Present Value (PV) = FV/(1+i)t = 100/(1.06)1 = 94.34

Calculator Solution:
P/Y = 1 I = 6 N = 1 FV = 100 PV = -
94.34
Present Value - single sums
If you receive $100 five years from now, what is the PV
of that $100 if your opportunity cost is 6%?
49

PV = ?? FV = 100

0 5
Present Value (PV) = FV/(1+i)t = 100/(1.06)5 = 74.73

Calculator Solution:
P/Y = 1 I = 6 N = 5 FV = 100 PV = -74.73
50 Mathematical Solution:

PV = FV (PVIF i, n )
PV = 100 (PVIF 6%, 5 ) (use PVIF table)
PV = FV / (1 + i)n
PV = 100 / (1.06)5 = 74.73
Present Value of $1
n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091
2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264
51 3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209
6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645
7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835 0.5470 0.5132
8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820 0.5403 0.5019 0.4665
9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241
10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855
11 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3875 0.3505
12 0.8874 0.7885 0.7014 0.6246 0.5568 0.4970 0.4440 0.3971 0.3555 0.3186
13 0.8787 0.7730 0.6810 0.6006 0.5303 0.4688 0.4150 0.3677 0.3262 0.2897
14 0.8700 0.7579 0.6611 0.5775 0.5051 0.4423 0.3878 0.3405 0.2992 0.2633
15 0.8613 0.7430 0.6419 0.5553 0.4810 0.4173 0.3624 0.3152 0.2745 0.2394
16 0.8528 0.7284 0.6232 0.5339 0.4581 0.3936 0.3387 0.2919 0.2519 0.2176
17 0.8444 0.7142 0.6050 0.5134 0.4363 0.3714 0.3166 0.2703 0.2311 0.1978
18 0.8360 0.7002 0.5874 0.4936 0.4155 0.3503 0.2959 0.2502 0.2120 0.1799
19 0.8277 0.6864 0.5703 0.4746 0.3957 0.3305 0.2765 0.2317 0.1945 0.1635
20 0.8195 0.6730 0.5537 0.4564 0.3769 0.3118 0.2584 0.2145 0.1784 0.1486
21 0.8114 0.6598 0.5375 0.4388 0.3589 0.2942 0.2415 0.1987 0.1637 0.1351
22 0.8034 0.6468 0.5219 0.4220 0.3418 0.2775 0.2257 0.1839 0.1502 0.1228
23 0.7954 0.6342 0.5067 0.4057 0.3256 0.2618 0.2109 0.1703 0.1378 0.1117
24 0.7876 0.6217 0.4919 0.3901 0.3101 0.2470 0.1971 0.1577 0.1264 0.1015
25 0.7798 0.6095 0.4776 0.3751 0.2953 0.2330 0.1842 0.1460 0.1160 0.0923
30 0.7419 0.5521 0.4120 0.3083 0.2314 0.1741 0.1314 0.0994 0.0754 0.0573
40 0.6717 0.4529 0.3066 0.2083 0.1420 0.0972 0.0668 0.0460 0.0318 0.0221
50 0.6080 0.3715 0.2281 0.1407 0.0872 0.0543 0.0339 0.0213 0.0134 0.0085
60 0.5504 0.3048 0.1697 0.0951 0.0535 0.0303 0.0173 0.0099 0.0057 0.0033
52
The Time Value of Money

Compounding and
Discounting
Cash Flow Streams

0 1 2 3 4
53
Annuities
¨ Annuity: a sequence of equal cash
flows, occurring at the end of each
period.

0 1 2 3 4
 Examples of Annuities:
54

¨ If you buy a bond, you will

receive equal semi-annual
coupon interest payments over
the life of the bond.
¨ If you borrow money to buy a
house or a car, you will pay a
stream of equal payments.
Future Value – annuity
If you invest $1,000 each year at 8%, how much
would you have after 3 years?
55

FV?

1000 1000 1000

0 1 2 3

FV = (PMT) (1 + i)n - 1
i
= (1,000) (1.08)3 - 1 = 3,246.40
.08
 :FV = PMT (FVIFA i, n )
56
FV = 1,000 (FVIFA .08, 3 ) (use FVIFA
table)
= 1,000 x 3.2464 = RM 3,246.40
Sum of an Annuity of $1 for n years
n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
2 2.0100 2.0200 2.0300 2.0400 2.0500 2.0600 2.0700 2.0800 2.0900 2.1000
3 3.0301 3.0604 3.0909 3.1216 3.1525 3.1836 3.2149 3.2464 3.2781 3.3100
4 4.0604 4.1216 4.1836 4.2465 4.3101 4.3746 4.4399 4.5061 4.5731 4.6410
5 5.1010 5.2040 5.3091 5.4163 5.5256 5.6371 5.7507 5.8666 5.9847 6.1051

Calculator Solution:
P/Y = 1 I = 8 N = 3 PMT = -1,000
Solve for FV = RM 3,246.40
 Sum of an Annuity of $1 for n years
n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
57 1 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
2 2.0100 2.0200 2.0300 2.0400 2.0500 2.0600 2.0700 2.0800 2.0900 2.1000
3 3.0301 3.0604 3.0909 3.1216 3.1525 3.1836 3.2149 3.2464 3.2781 3.3100
4 4.0604 4.1216 4.1836 4.2465 4.3101 4.3746 4.4399 4.5061 4.5731 4.6410
5 5.1010 5.2040 5.3091 5.4163 5.5256 5.6371 5.7507 5.8666 5.9847 6.1051
6 6.1520 6.3081 6.4684 6.6330 6.8019 6.9753 7.1533 7.3359 7.5233 7.7156
7 7.2135 7.4343 7.6625 7.8983 8.1420 8.3938 8.6540 8.9228 9.2004 9.4872
8 8.2857 8.5830 8.8923 9.2142 9.5491 9.8975 10.2598 10.6366 11.0285 11.4359
9 9.3685 9.7546 10.1591 10.5828 11.0266 11.4913 11.9780 12.4876 13.0210 13.5795
10 10.4622 10.9497 11.4639 12.0061 12.5779 13.1808 13.8164 14.4866 15.1929 15.9374
11 11.5668 12.1687 12.8078 13.4864 14.2068 14.9716 15.7836 16.6455 17.5603 18.5312
12 12.6825 13.4121 14.1920 15.0258 15.9171 16.8699 17.8885 18.9771 20.1407 21.3843
13 13.8093 14.6803 15.6178 16.6268 17.7130 18.8821 20.1406 21.4953 22.9534 24.5227
14 14.9474 15.9739 17.0863 18.2919 19.5986 21.0151 22.5505 24.2149 26.0192 27.9750
15 16.0969 17.2934 18.5989 20.0236 21.5786 23.2760 25.1290 27.1521 29.3609 31.7725
16 17.2579 18.6393 20.1569 21.8245 23.6575 25.6725 27.8881 30.3243 33.0034 35.9497
17 18.4304 20.0121 21.7616 23.6975 25.8404 28.2129 30.8402 33.7502 36.9737 40.5447
18 19.6147 21.4123 23.4144 25.6454 28.1324 30.9057 33.9990 37.4502 41.3013 45.5992
19 20.8109 22.8406 25.1169 27.6712 30.5390 33.7600 37.3790 41.4463 46.0185 51.1591
20 22.0190 24.2974 26.8704 29.7781 33.0660 36.7856 40.9955 45.7620 51.1601 57.2750
Present Value - annuity
What is the PV of RM 1,000 at the end of each of the
next 3 years, if the opportunity cost is 8%?
58

PV? 1000 1000 1000

0 1 2 3
Present Value (PV) = C1 C2 C3
(1 i )1 (1 i ) 2 (1 i ) 3
=
1,000 1,000 1,000
(1 0.08)1 (1 0.08) 2 (1 0.08) 3

= RM 2, 577.10
 Mathematical Solution:
59 PV = PMT (PVIFA i, n )
PV = 1,000 (PVIFA 8%, 3 ) (use PVIFA table)
= 1,000 x 2.5771 = RM 2,577.10
Present Value of an Annuity of $1 for n years

n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091
2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.8080 1.7833 1.7591 1.7355
3 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730 2.6243 2.5771 2.5313 2.4869
4 3.9020 3.8077 3.7171 3.6299 3.5460 3.4651 3.3872 3.3121 3.2397 3.1699
5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908

Calculator Solution:
P/Y = 1 I = 8 N = 3 PMT = -1,000
Solve for PV = RM 2,577.10
 Present Value of an Annuity of $1 for n years

n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
60
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091
2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.8080 1.7833 1.7591 1.7355
3 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730 2.6243 2.5771 2.5313 2.4869
4 3.9020 3.8077 3.7171 3.6299 3.5460 3.4651 3.3872 3.3121 3.2397 3.1699
5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908
6 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173 4.7665 4.6229 4.4859 4.3553
7 6.7282 6.4720 6.2303 6.0021 5.7864 5.5824 5.3893 5.2064 5.0330 4.8684
8 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098 5.9713 5.7466 5.5348 5.3349
9 8.5660 8.1622 7.7861 7.4353 7.1078 6.8017 6.5152 6.2469 5.9952 5.7590
10 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601 7.0236 6.7101 6.4177 6.1446
11 10.3676 9.7868 9.2526 8.7605 8.3064 7.8869 7.4987 7.1390 6.8052 6.4951
12 11.2551 10.5753 9.9540 9.3851 8.8633 8.3838 7.9427 7.5361 7.1607 6.8137
13 12.1337 11.3484 10.6350 9.9856 9.3936 8.8527 8.3577 7.9038 7.4869 7.1034
14 13.0037 12.1062 11.2961 10.5631 9.8986 9.2950 8.7455 8.2442 7.7862 7.3667
15 13.8651 12.8493 11.9379 11.1184 10.3797 9.7122 9.1079 8.5595 8.0607 7.6061
16 14.7179 13.5777 12.5611 11.6523 10.8378 10.1059 9.4466 8.8514 8.3126 7.8237
17 15.5623 14.2919 13.1661 12.1657 11.2741 10.4773 9.7632 9.1216 8.5436 8.0216
18 16.3983 14.9920 13.7535 12.6593 11.6896 10.8276 10.0591 9.3719 8.7556 8.2014
19 17.2260 15.6785 14.3238 13.1339 12.0853 11.1581 10.3356 9.6036 8.9501 8.3649
20 18.0456 16.3514 14.8775 13.5903 12.4622 11.4699 10.5940 9.8181 9.1285 8.5136
 Chapter 6
Valuing Bonds

61
Chapter Outline
6.1 Bond Cash Flows, Prices, and Yields
6.2 Dynamic Behavior of Bond Prices
6.3 Corporate Bonds

62
Learning Objectives
1. Identify the cash flows for both coupon bonds and
zero-coupon bonds, and calculate the value for each
type of bond.
2. Calculate the yield to maturity for both coupon and
zero-coupon bonds, and interpret its meaning for
each.
3. Given coupon rate and yield to maturity, determine
whether a coupon bond will sell at a premium or a
discount; describe the time path the bond’s price will
follow as it approaches maturity, assuming prevailing
interest rates remain the same over the life of the
bond.

63
Learning Objectives
4. Illustrate the change in bond price that will occur as
a result of changes in interest rates; differentiate
between the effect of such a change on long-term
versus short-term bonds.
5. Calculate the price of a coupon bond using the Law
of One Price and a series of zero-coupon bonds.

64
Learning Objectives
8. Discuss the relation between a corporate bond’s
expected return and the yield to maturity; define
default risk and explain how these rates incorporate
default risk.
9. Assess the creditworthiness of a corporate bond
using its bond rating; define default risk.

65
 Recap: The Law of One Price
66

¨ In competitive markets, securities or portfolios

with the same (future)cash flows must have the
same price.
¨ Price of a security = PV of CFs

¨ The __value___of an asset to the firm or its

investors is determined by its competitive
_______. The benefits and costs of a decision
should be evaluated using these market prices
to increase the ___________ of the firm.
 Bond
67

¨ A ___________(investment opportunity) sold

be governments and corporations to raise
money from investors today in exchange for
the promised future payments.
¨ Fixed income securities
¨ Pay fixed interest
 6.1 Bond Cash Flows, Prices, and Yields

¨ Bond Terminology
Bond Certificate
n States the terms of the bond
Maturity Date
n Final repayment date
Term
n The time remaining until the repayment date
Coupon/coupon interest
n Promised interest payments

68
6.1 Bond Cash Flows, Prices,
and Yields (cont'd)
¨ Bond Terminology
Face Value
n Notional amount used to compute the interest
payments, AKA par value or maturity value.

Coupon Rate
n Determines the amount of each coupon payment,
expressed as an APR

Coupon Payment

Coupon Rate Face Value

CPN
Number of Coupon Payments per Year
69
Zero-Coupon Bonds

¨ Zero-Coupon Bond
¤ Does not make coupon payments
¤ Always sells at a discount (a price lower
than face value), so they are also called pure
discount bonds
¤ Treasury Bills are U.S. government zero-
coupon bonds with a maturity of up to one
year.

70
Zero-Coupon Bonds (cont'd)

¨ Suppose that a one-year, risk-free, zero-

coupon bond with a $100,000 face value has
an initial price of $96,618.36. The cash flows
would be:

¤ Although the bond pays no “interest,” your

compensation/opportunity cost is the difference
between the initial price and the face value.
71
Zero-Coupon Bonds (cont'd)

¨ Yield to Maturity
¤ The discount rate that sets the present value
of the promised bond payments/ cash flows
equal to the current market price of the bond.
n Price of a Zero-Coupon bond

FV
P
(1 YTM n ) n

72
Zero-Coupon Bonds (cont'd)
¨ Yield to Maturity
¤ For the one-year zero coupon bond:
100,000
96,618.36
(1 YTM 1 )

100,000
1 YTM 1 1.035
96,618.36

n Thus, the YTM is 3.5%.

n What does this mean?

73
Zero-Coupon Bonds (cont'd)
¨ Yield to Maturity
¤ For the one-year zero coupon bond:Under the law of one price,
the competitive market risk-
100,000 free interest rate is 3.5%,
96,618.36 hence all 1-yr risk-free
(1 YTM 1 ) investment must earn 3.5%.

100,000
1 YTM 1 1.035
96,618.36
n Thus, the YTM is 3.5%.
n What does this mean?
n Given the expected future cash flows as
$100,000 in a year time, the 3.5% represents the
return of the investment in this bond!
74
Zero-Coupon Bonds (cont'd)

¨ Yield to Maturity
¤ Yield to Maturity of an n-Year Zero-Coupon
Bond
1
FV n
YTM n 1
P

75
Textbook Example 6.1

76
Textbook Example 6.1 (cont'd)

YTM1 = (P1-P0)/P0
Or (100-96.62)/96.62 = 3.50%

77
Alternative Example 6.1

¨ Problem
¤ Suppose that the following zero-coupon bonds
are selling at the prices shown below per $100
face value. Determine the corresponding yield
to maturity for each bond.
Maturity 1 year 2 years 3 years 4 years

Price $98.04 $95.18 $91.51 $87.14

78
Alternative Example 6.1 (cont'd)

¨ Solution:

YTM (100 / 98.04) 1 0.02 2%

YTM (100 / 95.18)1/2 1 0.025 2.5%
YTM (100 / 91.51)1/3 1 0.03 3%
YTM (100 / 87.14)1/4 1 0.035 3.5%

79
Zero-Coupon Bonds (cont'd)

¨ Risk-Free Interest Rates

¤ A default-free zero-coupon bond that matures
on date n provides a risk free return over the
same period. Thus, the Law of One Price
guarantees that the risk-free interest rate
equals the YTM on such a bond.
¤ Risk-Free Interest Rate with Maturity n

rn YTM n
80
Zero-Coupon Bonds (cont'd)

¨ Risk-Free Interest Rates

¤ Spot Interest Rate
n Another term for a default-free, zero-coupon yield

¤ Zero-Coupon Yield Curve

n A plot of the yield of risk-free zero-coupon bonds as
a function of the bond’s maturity date

81
Coupon Bonds
¨ Coupon Bonds
¤ Pay face value at maturity
¤ Pay regular coupon interest payments

¨ Treasury Notes
¤ U.S. Treasury coupon security with original
maturities of 1–10 years
¨ Treasury Bonds
¤ U.S. Treasury coupon security with original
maturities over 10 years
82
Textbook Example 6.2

83
Textbook Example 6.2 (cont'd)

84
Coupon Bonds (cont'd)
¨ Yield to Maturity
¤ The YTM is the single discount rate that equates the
present value of the bond’s remaining cash flows to
its current price.

¤ Yield to Maturity of a Coupon Bond (computing the

YTM)
1 1 FV
P CPN 1
y (1 y) N (1 y) N
85
 Bond valuation
Using Formula:

S
n
PV = CPN + CPN + FV
t=1
(1 + YTM)t (1 + YTM)n

Using Financial Tables:

Vb = $I x PVIFARb,n + $M x PVIFR ,n b

86
 Bond valuation
87

1. Estimate the expected future Cfs;

2. Determine the required rate of return
(discount rate, reflects risk);
3. Compute the present value of the future CFs.
(how much the asset is worth?)
6.2 Dynamic Behavior of Bond Prices
¨ Discount
¤ A bond is selling at a discount if the price is
_________ the face value.
¨ Par
¤ A bond is selling at par if the price is equal to the
face value.
¨ Premium
¤ A bond is selling at a premium if the price is
_____________ the face value.

88
Discounts and Premiums
¨ If a coupon bond trades at a discount, an
investor will earn a return both from receiving
the coupons and from receiving a face value
that exceeds the price paid for the bond.
¤ If a bond trades at a discount, its yield to maturity
will exceed its coupon rate.

89
Discounts and Premiums (cont'd)
¨ If a coupon bond trades at a premium it will
earn a return from receiving the coupons but
this return will be diminished by receiving a face
value less than the price paid for the bond.
¨ Most coupon bonds have a coupon rate so
that the bonds will initially trade at, or very
close to, par.

90
Discounts and Premiums (cont'd)
Table 8.1 Bond Prices Immediately After a Coupon Payment

91
Valuing a Coupon Bond
Using Zero-Coupon Yields
¨ The price of a coupon bond must equal the
____present value_______ of its coupon payments
and face value.
¤ Price of a Coupon Bond
PV PV (Bond Cash Flows)
CPN CPN CPN FV
L
1 YTM 1 (1 YTM 2 ) 2 (1 YTM n ) n

100 100 100 1000

P $1153
1.035 1.042 1.0453
92
Coupon Bond Yields

¨ Given the yields for zero-coupon bonds, we

can price a coupon bond.
100 100 100 1000
P 1153
(1 y) (1 y)2 (1 y )3

100 100 100 1000

P $1153
1.0444 1.04442 1.04443

93
 6.4 Corporate Bonds
¨ Corporate Bonds
¤ Issued by corporations

¨ Credit Risk
¤ Risk of default

94
Corporate Bond Yields

¨ Investors pay less for bonds with ___credit

risk______ than they would for an otherwise
identical default-free bond.
¨ The yield of bonds with credit risk will be
higher than that of otherwise identical default-
free bonds.

95
Corporate Bond Yields (cont'd)
¨ No Default
¤ Consider a 1-year, zero coupon Treasury Bill with
a YTM of 4%.
n What is the price?
1000 1000
P $961.54
1 YTM 1 1.04

96
Corporate Bond Yields (cont'd)

¨ Certain Default
¤ Suppose now bond issuer will pay 90% of
the obligation.
n What is the price?
900 900
P $865.38
1 YTM 1 1.04

97
Corporate Bond Yields (cont'd)

¨ Certain Default
¤ When computing the yield to maturity for a
bond with certain default, the promised rather
than the actual cash flows are used.
FV 1000
YTM 1 1 15.56%
P 865.38

900
1.04
865.38

98
Corporate Bond Yields (cont'd)

¨ Certain Default
¤ The yield to maturity of a certain default bond
is not equal to the expected return of investing
in the bond. The yield to maturity will always be
higher than the expected return of investing in
the bond.

99
 Are U.S. Treasuries and FD really
Default-free securities?
100

¨ Risk free = ___zero_____ chance of default;

¨ How certain that the investors’ expectation are
met in the past?
¨ In the late 2011, Standard & Poor downgraded
the rating of U.S. government bonds.
¨ Can bank(s) fails?
Bond Ratings

¨ Investment Grade Bonds

¨ Speculative Bonds
¤ Also known as Junk Bonds or High-Yield
Bonds

101
 Table 6.4 Bond Ratings

102
 Table 6.4 Bond Ratings (cont’d)

103
104

Source: https://countryeconomy.com/ratings/malaysia
105
 Chapter 9
Valuing Stocks
 Learning Objectives
1. Calculate the NPV of uneven cash flows and perpetuities
2. Calculate the total return of a stock, given the dividend payment,
the current price, and the previous price.
3. Use the dividend-discount model to compute the value of a
dividend-paying company’s stock, whether the dividends grow at a
constant rate starting now or at some time in the future.
4. Given the retention rate and the return on new investment,
calculate the growth rate in dividends, earnings, and share price.
5. Describe circumstances in which cutting the firm’s dividend will
raise the stock price.
Learning Objectives (cont'd)
6. Assuming a firm has a long-term constant growth rate after
time
N + 1, use the constant growth model to calculate the
terminal value of the stock at time N.
7. Compute the stock value of a firm that pays dividends as
well as repurchasing shares.
8. Use the discounted free cash flow model to calculate the
value of stock in a company with leverage.
9. Use comparable firm multiples to estimate stock value.
Stock valuation

What does stock price indicates?

´It reflected changes in investor

expectations regarding the value of the

cash flows that ownership of stocks
would entitle them to receive.
´Eg: 4% decline.
Stock Valuation
¨ One of the approach used to develop a
stock-valuation model;
¨ to compare the value estimate from the
model with the market price.
 Ordinary Shares
¨ Ordinary shareholders are residual
claimants on the income and assets of the
company.
¨ Voting rights are often important.
¨ Book value is the accounting value of equity
as shown in the firm’s balance sheet.
¨ Market value is the total value of the firm, as
determined in the market place.
Ordinary Shares — Dividends

¨ Dividends are cash payments made half-

yearly to shareholders.
¨ Dividends are at the discretion of the
company; can be very volatile.
¨ Dividend yield is the income component of a
share’s return (D/P).
¨ Payout ratio is the ratio of dividends to
earnings (D/E).
Ordinary Shares — Dividends

´ A share purchased on/after the ex-dividend

date does not have dividend entitlements.
´ Prior to the ex-dividend date is the cum-rights period.

´ A share dividend is a payment to the owners in shares

(instead of cash).
 Common Stock vs Preferred Stock
Common Stock
¨ an equity share with voting rights

¨ represents the basic ownership claim in a

corporation
¨ the most common type of equity security

Preferred Stock
¨ An equity share in a corporation

¨ Entitles to claim before the stock holders in

the event of bankruptcy
¨ No voting rights
DIVIDEND DISCOUNT MODEL
 The Dividend Discount Model
¨ A One-Year Investor
¤ Potential Cash Flows
n Dividend
n Sale of Stock (Capital Gain)
¤ Timeline for One-Year Investor

¤ Since the cash flows are risky (uncertainty), we

must discount them at the equity cost of capital.
 Equity Cost of Capital?
It is the expected return of other investments available in the market
with equivalent rise to the firm’s shares.

Do You understand?
 The Dividend Discount Model (cont'd)
¨ A One-Year Investor
Div1 P1
P0
1 rE

¤ If the current stock price were less than this

amount- P0, investors are expected to rush in
and buy it, driving up the stock’s price.
¤ If the stock price exceeded this amount, selling
it would cause the stock price to fall quickly.
¤ Why?
 Dividend Yields, Capital Gains and
Total Returns
Total return of stock investment (1 yr):

Div1 P1 Div1 P1 P0
rE 1
P0 P0 P0
{ {
¨ Dividend Yield Dividend Yield Capital Gain Rate
¨ Capital Gain
¤ Capital Gain Rate
¨ Total Return

¤ Dividend Yield + Capital Gain Rate

n The expected total return of the stock should equal
the expected return of other investments available
in the market with equivalent risk.
 Alternative Example 9.1
¨ Problem
¤ 3M (MMM) is expected to pay dividends of $1.92
per share in the coming year.
¤ You expect the stock price to be $85 per share at
the end of the year.
¤ Investments with equivalent risk have an expected
return of 11%.
¤ What is the most you would pay today for 3M
stock?
¤ What dividend yield and capital gain rate would
you expect at this price?
 Alternative Example 9.1 Solution
Div1 P1 $1.92 $85
P0 $78.31
(1 rE ) (1 .11)

Div1 $1.92
Dividend Yield 2.45%
P0 $78.31
P1 P0 $85.00 $78.31
Capital Gains Yield 8.54%
P0 $78.31

Total Return = 2.45% + 8.54% = 10.99% ≈ 11%

 Total return
¨ The expected return for investor for one
year;
¨ or the expected total return of the stock =
the expected return of ___other_______
investments available in the market with
equivalent risk.
 A Multi-Year Investor
¨ What is the price if we plan on holding the stock for two years?

Div1 Div2 P2
P0 2
1 rE (1 rE )
 The Dividend-Discount Model Equation
¨ What is the price if we plan on holding the stock for N years?

Div1 Div2 DivN PN

P0 L
1 rE (1 rE ) 2 (1 rE ) N (1 rE ) N

¤ This is known as the Dividend Discount Model.

n Note that the above equation holds for any horizon N. Thus all
investors (with the same beliefs) will attach the same value to
the stock, independent of their investment horizons.
 The Dividend-Discount Model Equation
(cont'd)
Div1 Div2 Div3 Divn
P0 L
1 rE (1 rE ) 2 (1 rE )3 n 1 (1 rE ) n

¨ The __price____ of any stock is equal to the

____present value______of the expected future
dividends it will pay.
¨ Can it be summarised?
 Zero-Growth Dividend Model
¨ Dividends have a growth rate of zero, thus, the
dividend payment pattern remains constant
over time

Div1 = Div2 = Div3 = …= Div∞ = Divn

Div1 Div2 Div3 Divn
P0 L
1 rE (1 rE ) 2 (1 rE )3 n 1 (1 rE ) n

P0 = D/R
 Applying the Discount-Dividend Model

¨ Constant Dividend Growth

¤ The simplest forecast for the firm’s future dividends
states that they will grow at a constant rate, g, forever.
 Applying the Discount-Dividend Model
(cont'd)
¨ Constant Dividend Growth Model

Div1
P0
rE g
Div1
rE g
P0
¨ The value of the firm depends on the current dividend level, the cost of equity,
and the growth rate.

¨ The expected dividends are a constant growth perpetuity, i.e. div grow at a
constant, g, forever.
 The Maximisation of firms’ Share
price
Div1
P0
rE g
-To maximise its share price, firms need to inc. both Div1
and g.
-But it involves trade-off: constraints of funds – investment
for higher growth vs paying higher div.
 Alternative Example 9.2
¨ Problem

¤ AT&T plans to pay $1.44 per share in dividends in

the coming year.
¤ Its equity cost of capital is 8%.
¤ Dividends are expected to grow by 4% per year in
the future.
¤ Estimate the value of AT&T’s stock.
Alternative Example 9.2 - Solution

Div1 $1.44
P0 $36.00
rE g .08 .04
 Dividends Versus Investment and Growth

¨ A Simple Model of Growth

¤ Dividend Payout Ratio

n The fraction of earnings paid as dividends each year

Dividend per shr:

Earnings t
Divt Dividend Payout Ratet
Shares Outstanding
1 4 4 4 2 4 4 43t
EPSt
 Dividends Versus Investment and Growth
(cont'd)
¨ A Simple Model of Growth

¤ Assuming the number of shares outstanding is

constant, the firm can do few things to
__increase_______ its dividend:
n Increase its earnings (net income)
n Increase its dividend payout rate
n It can decrease its shares outstanding (buyback)

Earningst
Divt Dividend Payout Ratet
Shares Outstanding
1 4 4 4 2 4 4 43t
EPSt
 Dividends Versus Investment and Growth
(cont'd)
¨ A Simple Model of Growth
¤ A firm can do one of two things with its earnings (Dividend
decisions):
n It can __pay____ them out to investors.
n It can retain and ____reinvest_____ them.

g Retention Rate Return on New Investment

 Dividends Versus Investment and Growth
´ Profitable Growth (cont'd)
´ Ifa firm wants to increase its share price,
should it cut its dividend and invest more, or
should it cut investment and increase its
dividend?
´ The answer: it depend on the profitability of
the firm’s investments.
´ Cutting the firm’s dividend to increase
investment will raise the stock price if, and
only if, the new investments have a
_____positive NPV________
 Alternative Example 9.4
¨ Problem
Dren Industries is considering expanding into a
new product line. Earnings per share was $5 this
year and are expected to grow annually at 5%
without the new product line but growth would
increase to 7% if the new product line is
introduced. To finance the expansion, Dren would
need to cut its dividend payout ratio from 80% to
50%. If Dren’s equity cost of capital is 11%, what
would be the impact on Dren’s stock price if they
introduce the new product line? Assume the
equity cost of capital will remain unchanged.
 Formula Without With New
New Project
Project
EPS1 EPS0 (1+g) 5(1 +0.05) 5(1 +0.07)
= 5.25 = 5.35

Dividend EPS1 x 5.25 x 80% 5.35 x 50%

(D1) DPO = 4.20 = 2.675
Stock Price D1/ (re –g) 4.2/(0.11 – 2.675/(0.11-
(P0) 0.05) 0.07)
= $70 = $66.875
 Changing Growth Rates
¨ We cannot use the constant dividend growth model to value a stock if the
growth rate is not constant.

¤ For example, young firms often have very high

initial earnings growth rates. During this period
of high growth, these firms often retain 100% of
their earnings to exploit profitable investment
opportunities. As they mature, their growth
slows. At some point, their earnings exceed
their investment needs and they begin to pay
dividends.
Changing Growth Rates (cont'd)
¨ Although we cannot use the constant dividend
growth model directly when growth is not
constant, we can use the general form of the
model to value a firm by applying the constant
growth model to calculate the future share price
of the stock once the expected growth rate
stabilizes.
 Changing Growth Rates (cont'd)

DivN 1
PN
rE g

¨ Dividend-Discount Model with Constant Long-Term Growth

Div1 Div2 DivN 1 DivN 1

P0 L
1 rE (1 rE ) 2 (1 rE ) N (1 rE ) N rE g
Textbook Example 9.5 (p.261)
Textbook Example 9.5 (cont'd)
Textbook Example 9.5 (cont'd)
 Limitations of the Dividend-Discount Model
Div1 Div2 DivN PN
P0 L
1 rE (1 rE ) 2 (1 rE ) N (1 rE ) N
¨ There is a tremendous amount of uncertainty associated
with forecasting a firm’s dividend growth rate and future
dividends (inc. firm’s earnings, div. payout ratio etc).
¨ Small changes in the assumed dividend growth rate can
lead to large changes in the estimated stock price.
¨ Cannot be used when g > re
¨ Limited to firms that pay dividends
 Total Payout and Free Cash Flow Valuation
Models
¨ Share Repurchases and the Total Payout Model
¤ Share Repurchase
n When the firm uses ____excess______ cash to buy back its own stock
(to replace div payout)
¤ Implications for the Dividend-Discount Model
n The more cash the firm uses to repurchase shares, the less it has
available to pay dividends.
n By repurchasing, the firm decreases the number of shares outstanding,
which increases its earnings per share and dividends per share.

Total Payout Model

PV (Future Total Dividends and Repurchases)

PV0
Shares Outstanding 0
Textbook Example 9.6 (p.264)
Textbook Example 9.6 (cont'd)
 DISCOUNTED FREE CASH FLOW
METHOD

¨ Free cash flow (FCF) represents the cash that a

company is able to generate after laying out the
money required to maintain or expand its asset
base.
¨ It allows a company to pursue opportunities that
____enhance______ shareholder value, i.e. to
develop new products, make acquisitions, pay
dividends and reduce debt.
¨ A negative FCF may not be bad since a company
can be making large investments for its L-T return.
 The Discounted Free Cash Flow Model
¨ Discounted Free Cash Flow Model

¤ Determines the __________ of the firm to all

investors, including both equity and debt holders
Enterprise Value Market Value of Equity Debt Cash

¤ The enterprise value can be interpreted as the net

cost of acquiring the firm’s equity, taking its cash,
paying off all debt, and owning the unlevered
business.
¨ Valuing the Enterprise
The Discounted Free Cash Flow Model
(cont'd)

6 4Unlevered
44 7Net4Income
4 48
Free Cash Flow EBIT (1 c) Depreciation
Capital Expenditures Increases in Net Working Capital
¤ Free Cash Flow (FCFt): Cash flow available to pay both
debt holders and equity holders
¤ Discounted Free Cash Flow Model
V0 PV (Future Free Cash Flow of Firm)
VEquity = VFirm –VDebt V0 Cash 0 Debt 0
P0
Shares Outstanding 0
 The Discounted Free Cash Flow Model
(cont'd)
¨ Implementing the Model
¤ Sincewe are discounting cash flows to both
equity holders and debt holders, the free cash
flows should be discounted at the firm’s
weighted average cost of capital, rwacc If the
firm has no debt, rwacc = rE.
 The Discounted Free Cash Flow Model
(cont'd)
¨ Implementing the Model
FCF1 FCF2 FCFN VN
V0 L
1 rwacc (1 rwacc ) 2 (1 rwacc ) N (1 rwacc ) N

FCFN 1 1 g FCF
VN FCFN
rwacc g FCF (rwacc g FCF )

¤ Often, the terminal value is estimated by assuming

a constant long-run growth rate gFCF for free cash
flows beyond year N, so that:
Textbook Example 9.7(p.266)
Textbook Example 9.7 (cont'd)
Textbook Example 9.7 (cont'd)
 The Discounted Free Cash Flow Model
(cont'd)
´ Connection to Capital Budgeting
´ The firm’s free cash flow is equal to the sum of the free cash flows
from the firm’s current and future investments, so we can interpret the
firm’s enterprise value as the total NPV that the firm will earn from
continuing its existing projects and initiating new ones.
´ The NPV of any individual project represents its contribution to the
firm’s enterprise value. To maximize the firm’s share price, we should
___accept________ projects that have a positive NPV.
Figure 9.1 A Comparison of Discounted
Cash Flow Models of Stock Valuation
Valuation Multiples
¨ Valuation Multiple

¤ A ratio of firm’s value to some measure of the

firm’s scale or cash flow
¨ The Price-Earnings Ratio

¤ P/E Ratio
n Share price divided by earnings per share (EPS)
n When you buy a stock = buying the rights to entitle for the firm’s future
earnings.
 Alternative Example 9.9

¨ Problem
¤ Best Buy Co. Inc. (BBY) has earnings per share
of $2.22.
¤ The average P/E of comparable companies’ stocks
is 19.7.
¤ Estimate a value for Best Buy using the P/E as a
valuation multiple.
 Alternative Example 9.9

¨ Solution
¤ The share price for Best Buy is estimated by
multiplying its earnings per share by the P/E of
comparable firms.
¤ P0 = $2.22 × 19.7 = $43.73
The basic process of valuation
 3 basic steps in determining the
value of an asset (using the formula):
1: Estimate the amount and timing of future CFs
= Ct ;

2: Determine the investor’s required rate of return

(R) = Rf + RP;
3: Calculate the intrinsic value, V/PV = The
intrinsic/present value of expected future CFs
discounted at the R.
Back to Basic:
1: the risk-return ______________: we won’t
take on additional risk unless being
compensated with additional return;

2: The time value of money: a dollar received

today is worth more than a dollar receive in
the future;

3: Cash – not profits – is king.

 Stock Valuation Techniques:
The Final Word
¨ No single technique provides a final answer regarding a stock’s true value.
All approaches require assumptions or forecasts that are too uncertain to
provide a definitive assessment of the firm’s value.

¤ Most real-world practitioners use a combination of

these approaches and gain confidence if the
results are consistent across a variety of methods.
 Stock Valuation
´ Stock prices ___________ all the time-
sometimes dramatically
´ Eg: Flash Crash
´ The May 6, 2010 Flash Crash also known as
The Crash of 2.45pm, the 2010 Flash Crash or
just simply, the Flash Crash, was a United
States stock market crash on May 6, 2010 in
which the Dow Jones Industrial Average
plunged about 900 points—or about nine
percent—only to recover those losses within
minutes.
Making sense of news
Local news
´ KUALA LUMPUR: The Malaysian ringgit hit a new 13-
year high of 3.0345 in intra-day trading yesterday
before ending trade at 3.036. (the star, 8th Feb 2011)

´ Malaysia's ringgit hit a near six-year low on Tuesday

after the government adjusted its economic targets to
cope with sliding oil prices, … the ringgit fell as much
as 0.9 percent to 3.6030 per dollar, its weakest since
April 2009.(the star, Tuesday, 20 January 2015)

´ How should you respond to this news?

 Making sense of news
Local news

¨ …The overall health effects of a changing climate

are likely to be overwhelmingly negative. Climate
change affects the fundamental requirements for
health such as clean air, safe drinking water,
sufficient food and secure shelter. ……Infections
and diseases are expected to worsen with the
extreme weather conditions likely to be
experienced by the country in the next few years
(The Star, 8th Feb 2011)
¨ How should you respond to this news?
Making sense of news
…“Many companies involved in commodities
trading also need to know the changes in the
weather condition to help them predict
commodity prices,” he said.
The weather forecast is even more important
for oil companies and fishermen.

¨ Studying investments will help you to

understand how to use information to make
personal financial decisions.
¨
Investment strategy
Passive
¤ Determine initial investment proportions in
assets and asset classes
¤ Make few changes over time
¨ Active
¤ Change proportions and or assets in an effort
to make higher profits
¤ The more information efficient the market is,
the less likely profits are available from
frequent portfolio adjustments
 Factors Affecting the Process
¨ Uncertainty in ex post returns dominates the decision process.
¨ Foreign financial assets.
¨ How ___________ are financial markets in processing new
information?
¨ Institutional investors are important.
 The Great Unknown
¨ The realised return on any risky asset is often
different from the expected return.
¨ All investors are affected by uncertainty.
¨ No returns are guaranteed.
¨ A thorough understanding of the basic principles of
investing allows investors to cope intelligently
The Global Investments Arena
¨ Existence of ‘around-the-clock’ investing
opportunities.
¨ Opportunities exist to increase returns, reduce risk, or
both.
¨ Existence of emerging markets.
 The Rise of the Internet
¨ Revolutionised the flow of investment information.
¨ Dramatically lowered commission rates for individual
investors.
 Institutional Investors
¨ Manage funds far greater in value than individual
investors.
¨ Trade ‘over-the-counter’ privately in sizeable portions.
¨ Most are buy-and-hold strategists.
 Quote of the lecture:
¨ Most smart investors put enough money in savings products to cover
an emergency and invest the balance so as to _________ returns.
To determine which investments are appropriate for you, you need to
know how much money you can invest in depending on the current
situation of your life.
Chapter 10 (Part 1)
Capital
Markets and
the Pricing of
Risk
Learning Objectives

1. Define a probability distribution, the mean, the

variance, the standard deviation, and the volatility.
2. Compute the realized or total return for an
investment.
3. Using the empirical distribution of realized returns,
estimate expected return, variance, and standard
deviation (or volatility) of returns.
4. Use the standard error of the estimate to gauge the
amount of estimation error in the average.
Learning Objectives

5. Discuss the volatility and return characteristics of

large stocks versus large stocks and bonds.
6. Describe the relationship between volatility and
return of individual stocks.
7. Define and contrast idiosyncratic and systematic
risk and the risk premium required for taking each
on.
8. Define an efficient portfolio and a market portfolio.
Learning Objectives

9. Discuss how beta can be used to measure the

systematic risk of a security.
10. Use the Capital Asset Pricing Model to calculate
the expected return for a risky security.
11. Use the Capital Asset Pricing Model to calculate
the cost of capital for a particular project.
12. Explain why in an efficient capital market the cost
of capital depends on systematic risk rather than
diversifiable risk.
 Do you know that:
Understanding indices:
¨ A stock market is a single number calculated
from the prices of __many________ stocks;
¨ It is used as ___benchmarks ________ of
stock performance for portfolios like mutual
funds;
¨ Some investment funds (index funds)
manage their portfolio in order to mirror
(track) the performance of stock market
index;
Do you know that:
¨ Similar to CPI (represents a broad measure of
changes in retail prices);
¨ Used as a tool to measure the
_performance________ of a group of stocks from
a market;
¨ Being part of an index is a __status____ symbol
for companies.
¨ Bursa Malaysia indices are calculated using the
market capitalisation weighted method (total value
of the listed companies based on current mkt
price).
Rates of return
¨ Historical return
The return that an asset has already
produced over a specified period of time
¨ Expected return
The return that an asset is expected to
produce over some future period of time
¨ Required return
The return that an investor requires an
asset to produce if he/she is to be a
future investor in that asset
Rates of return
¨ Nominal
The actual rate of return paid or earned
without making any allowance for inflation
¨ Real
The nominal rate of return adjusted for
the effect of inflation
¨ Effective
The nominal rate of return adjusted for
more frequent calculation (or
compounding) than once per annum
 10.1 A First Look at Risk and Return
Which one do you perceive to have higher risk?
Higher return?
10.2 Common Measures of Risk and Return
¨ Probability Distributions
¤ When an investment is risky, there are different
returns it may earn. Each possible return has
some likelihood (probability) of occurring. This
information is summarized with a probability
distribution, which assigns a probability, PR ,
that each possible return, R , will occur.
Figure 10.2 Probability Distribution of
Returns for BFI

Assume BFI stock currently trades for $100 per share.

In one year, there is a 25% chance the share price will be $140, a 50% chance it will be
$110, and a 25% chance it will be $80.

(140-100)/100 = (P1-P0)/P0
Figure 10.2 Probability Distribution of
Returns for BFI

Expected return: (0.4)(0.25__)+(0.1)(0.5)+(___-0.2__)(0.25)=0.1 or 10%

Calculating expected returns (example)

State of Probability Return

economy P A B

Recession 0.20 4% -10%

Normal 0.50 10% 14%
Boom 0.30 14% 30%

Expected return is just a weighted average

R* = P(R1) x R1 + P(R2) x R2 + … + P(Rn) x Rn
Case study

State of Probability Return

economy P A B

Recession 0.20 4% -10%

Normal 0.50 10% 14%
Boom 0.30 14% 30%

Company A
R* = P(R1) x R1 + P(R2) x R2 + … + P(Rn) x Rn
RA* = 0.2 x 4% + 0.5 x 10% + 0.3 x 14% = 10%
Case study

State of Probability Return

economy P A B
Recession 0.20 4% -10%
Normal 0.50 10% 14%
Boom 0.30 14% 30%

Company B
R* = P(R1) x R1 + P(R2) x R2 + … + P(Rn) x Rn
RB* = 0.2 x -10% + 0.5 x 14% + 0.3 x 30% = 14%
 Based only on your
expected return
calculations, which
company share would
you prefer?

Company A Company B
Expected return 10% 14%
Have you
considered
RISK?
Risk
¨ How to measure risk
Variance, standard deviation,
beta

¨ How to reduce risk

Diversification

¨ How to price risk

Security market line, CAPM, APM
For a Treasury security, what is the required rate of
return?

Required Risk-free
rate of = rate of
return return

Reason:
Treasury securities are free of default risk
For a company security, what is the required rate of
return?

Required Risk-free
Risk
rate of = rate of + premium
return return

How large a risk premium should we require

to buy a corporate security?
What is risk?
¨ The possibility that an ____actual____ return will
differ from our __expected________ return

¨ Uncertainty in the distribution of possible

outcomes
Risk
¨ Referring to the __variability________ of

the actual return from the expected return.

¨ The quantifiable likelihood of loss or less

than expected return. Examples

¨ Statistical measures of variability are the

variance and the standard deviation.

20
1
Uncertainty in the distribution of possible outcomes

Company 1 Company 2

0.5 0.2

0.4 0.15
0.3
0.1
0.2
0.05
0.1
0 0
4 8 12 -10 -5 0 5 10 15 20 25 30
return (%) return (%)
How do we measure risk?
¨ General idea: Share’s price range over the
past year
¨ More scientific approach: Share’s standard
deviation of returns
¨ Standard deviation is a measure of the
dispersion of possible outcomes
¨ The greater the standard deviation, the
greater the uncertainty, and therefore, the
greater the risk
Variance
¨ Average value of squared deviations from mean.

¨ The weighted sum of squared deviations from the

expected return.
¨ A measure of volatility.

Standard Deviation
¨ Square root of the variance.

¨ A measure of volatility.

¨ More commonly used to measure risk.

20
4
Standard deviation – probability data

n
s = S ( R - R*
i =1
i ) 2 P( Ri )
Case study

n
s = Si =1
( Ri - R* )2 P( Ri )
Company A
( 4% - 10% )2 ( 0.2 ) = 7.2
( 10% - 10% )2 ( 0.5 ) = 0.0
( 14% - 10% )2 ( 0.3 ) = 4.8
Variance = s2 = 12.0
Standard deviation = Ö12.0 = 3.46%
Case study

n
s = S
i =1
( Ri - R* )2 P( Ri )
Company B
( -10% - 14% )2 ( 0.2 ) = 115.2
( 14% - 14% )2 ( 0.5 ) = 0.0
( 30% - 14% )2 ( 0.3 ) = 76.8
Variance = s2 = 192.0
Standard deviation = Ö192.0 = 13.86%
Case study summary

Share A Share B

Expected return 10% 14%

Standard deviation 3.46% 13.86%

Case study

Which share would you prefer?

How would you decide?
Remember the trade-off!
Return

Which share do you

prefer?
It depends on your
tolerance for risk!

Risk
Portfolios

Combining
several
securities Can Risk ¯¯
in a portfolio

How does this work?

 Returns

Pe
rfe
co ct __
re rre __
mo la __
Two-share portfolio

ve tion __
sr
isk
B
A

Portfolio

Time
Simple diversification

perfectly
_no___ effect
___positively_____
on risk
correlated

Investing in If
two securities securities
to reduce risk are

Perfect
perfectly diversification.
_negatively__ risk is
correlated minimised
Portfolio risk
Depends on:
¨ _Proportion_ of funds invested in each asset
¨ The risk associated with each asset in the portfolio
¨ The relationship between each asset in the
portfolio with respect to risk
Questions
If you owned a
share of every
stock traded on Would you have
the Bursa eliminated all
Malaysia, of your risk?
would you be
diversified?
NO!
Consider stock
market
YES! “crashes”!
 Risk and diversification
¨ Diversifiable risk
¤ Firm-specific risk
¤ Company-unique Can be eliminated
risk by diversification
¤ Unsystematic risk

¨ Non-diversifiable risk
¤ Market-related risk Cannot be
¤ Market risk eliminated by
¤ Systematic risk diversification
Possible causes of risk

Market risk Firm-specific risk

¨ Unexpected changes in ¨ A company’s labour force
interest rates goes on strike
¨ Unexpected changes in ¨ A company’s top
economic conditions management dies in a
¤ Tax changes plane crash
¤ Foreign competition ¨ A huge oil tank bursts and
¤ Overall business cycle floods a company’s
¨ Unexpected war production area
How much diversification?

Almost all possible gains

from diversification are
Portfolio risk

achieved with a carefully

Diversifiable risk
chosen portfolio of 20
shares

Nondiversifiable risk

1 20 No of different shares
Level of market risk

Do some firms
have more Example
market risk Interest rate changes
than others? affect all firms, but which
would be more affected:
a) Retail food chain
b) Commercial bank
YES
Risk and return

ä Investors are only

compensated for
A need to
accepting market risk
measure
ä Firm-specific risk market
should be diversified risk for a
away firm
Beta:
A measure of market risk
A measure of: ¨ For the market: Beta = 1
¨ A firm with Beta _=__1
¨ How an individual
has average market risk.
share’s returns vary with
market returns It has the same volatility
as the market
¨ The ¨ A firm with Beta __>__1 is
“__sensitivity_______”
more volatile than the
of an individual share’s
returns to changes in the market
market ¨ A firm with Beta __<__ 1
is less volatile than the
market
Beta:
A measure of market risk

¨ Beta-the slope of the characteristic line – a

measure of firm’s mkt risk, even after a
portfolio has been diversified;
¨ It is this risk – and only risk – that matters for
any investors who have diversified;
¨ __Defensive__ stock: beta < 1, on avg less
risky than the market;
¨ _Offensive _ stock: beta > 1, on avg more
risky than the market.
Chapter 10 (Part 2)
Capital Markets
and the Pricing
of Risk
Calculating beta (Beta shows the avg movement of of
XYZ price in response to mkt index)

Company XYZ return (%)

Market
index
return
(%)
Characteristic line Beta = slope of
characteristic
line
Calculating Beta

Βj = ρjm x σj/σm ,
Βj = beta of security j;
ρjm = correlation coefficient between returns on
security j and the mkt;
σj = std dev of returns on securities j;
σm = std dev of returns on mkt return.
 Required rate of return

Required Risk-free
Risk
rate of = rate of +
premium
return return
An te nta re
ra co k p
inv of r in a miu
on

es etu _ m
ly ris

to rn __
r’s
re sho ___

Market risk Firm-specific

qu uld

+
ire

premium risk premium

d
_
Graphing this relationship

Required SML
rate of
return

Market
11%
return
Known as the
_______
Risk-free
rate of 4%
return

0 1 Beta
The CAPM Model
SML: Security market line

•The SML is a relationship between the required rate of return and Beta - the
measure of ______

CAPM: Capital Asset Pricing Model

•The return on the FBMKLCI (Kuala Lumpur Composite Index) on the Bursa Malaysia
is a good approximation for the ____________

•Treasury securities (or FD) are as close to riskless as possible. i.e. Beta = ______
The CAPM equation

Rj = Rf + bj ( Rm – Rf )
where
Rj = the required return on security j
Rf = the risk-free rate of interest
bj = the beta of security j
Rm = the return on the market index
 Example
Suppose the Treasury bond rate is 4%, the average return on
the All Ords Index is 11%, and XYZ has a beta of 1.2.
According to the CAPM, what should be the required rate of
return on XYZ shares?

Rj = Rf + bj ( Rm – Rf ) Rj = 4 + 1.2 x ( 11 – 4 )
= 12.4%
Here:
Rf = 4%
Rm = 11%
bj = 1.2
CAPM theory

Theoretically,
Required every security SML
rate of should lie ____
return the SML

11%

If a security is on the
SML, then investors are
4% being _____
compensated for risk

0 1 Beta
CAPM theory

If a security is
Required above the SML, SML
rate of it is _______
return

11%

If a security is
below the SML, it
4% is ________

0 1 Beta
 Criticisms of the CAPM

Technical issues
¨ Return on the market Theoretical issue
¤ Is this observable? Is it realistic to think
¤ Use of _____ data that the risk of an
¨ Risk free rate of return asset can be
Re d an too
accurately reflected
use
¤ Best proxy? ma d l
by only _____
ins imp
¨ Beta variable of market
a ort
Measurement issues sensitivity?
wi an
¤ de t
¤ Changes over time
ly
 Expected Return
¨ Expected (Mean) Return
¤ Calculated as a weighted average of the possible
returns, where the weights correspond to the
probabilities.
Expected Return E R P
R R
R

E RBFI 25%( 0.20) 50%(0.10) 25%(0.40) 10%

 Variance and Standard Deviation
¨ Variance - The expected squared deviation from the mean

2 2
Var (R) E R E R R
PR R E R
¨ Standard Deviation- The square root of the variance

SD( R) Var ( R)
Both measures of the risk of a probability distribution
 Variance and Standard Deviation (cont'd)
¨ For BFI, the variance and standard deviation are:

Var RBFI 25% ( 0.20 0.10)2 50% (0.10 0.10)2

25% (0.40 0.10)2 0.045

SD( R) Var ( R) 0.045 21.2%

¨ Volatility = Standard Distribution

¨ The standard deviation is easier to interpret because it is

in the same units as the returns themselves.
 Alternative Example 10.1
¨ Problem
¤ TXU stock is has the following probability distribution:

Probability Return
.25 8%
.55 10%
.20 12%

¤ What are its expected return and standard deviation?

 Alternative Example 10.1 (cont’d) -
Solution
Expected Return
n E[R] = (.25)(.08) + (.55)(.10) + (.20)(.12)
n E[R] = 0.020 + 0.055 + 0.024 = 0.099 = 9.9%

Standard Deviation
SD(R) =√ [(.25)(.08 – .099)2 + (.55)(.10 – .099)2 +
(.20)(.12 – .099)2]
= √ [0.00009025 + 0.00000055 + 0.0000882]
= √ 0.000179 = .01338 = 1.338%
10.3 Historical Returns of Stocks and
Bonds

¨ Computing Historical Returns

¤ Realized Return
n The return that actually occurs over a particular time
period. Pt+1
Divt 1 Pt 1 Divt 1 Divt 1 Pt
Rt 1 1
Pt Pt Pt
Dividend Yield Capital Gain Rate
10.3 Historical Returns of Stocks and
Bonds (cont'd)

¨ Computing Historical Returns

¤ If you hold the stock beyond the date of the first
dividend, then to compute your return you must
specify how you invest any dividends you receive
in the interim. Let’s assume that all dividends are
immediately reinvested and used to purchase
additional shares of the same stock or security.
 10.3 Historical Returns of Stocks and
Bonds (cont'd)

¨ Computing Historical Returns

¤ If a stock pays dividends at the end of each
quarter, with realized returns RQ1, . . . ,RQ4 each
quarter, then its annual realized return, Rannual, is
computed as:
1 Rannual (1 RQ1 )(1 RQ 2 )(1 RQ 3 )(1 RQ 4 )
Alternative Example 10.2

¨ Problem:
¤ What were the realized annual returns for Ford
stock in 1999 and in 2008?
Date Price ($) Dividend ($) Return Date Price ($) Dividend ($) Return
12/31/1998 58.69 12/31/2007 6.73 0
1/31/1999 61.44 0.26 5.13% 3/31/2008 5.72 0 -15.01%
4/30/1999 63.94 0.26 4.49% 6/30/2008 4.81 0 -15.91%
7/31/1999 48.5 0.26 -23.74% 9/30/2008 5.2 0 8.11%
10/31/1999 54.88 0.29 13.75% 12/21/2008 2.29 0 -55.96%
12/31/1999 53.31 0 -2.86%
 Alternative Example 10.2 - Solution

¨ Solution
¤ We compute each period’s return using Equation.
For example, the return from December 31, 1998 to
January 31, 1999 is:
61.44 0.26
1 5.13%
58.69
¤ We then determine annual returns:
R1999 (1.0513)(1.0449)(0.7626)(1.1375)(0.9714) 1 7.43%
R2008 (0.8499)(0.8409)(1.0811)(0.440) 1 66.0%
 Alternative Example 10.2 - Solution

¨ Solution
¤ Note that, since Ford did not pay dividends during
2008, the return can also be computed as:

2.29
1 66.0%
6.73
 Average Annual Return (Portfolio)
T
1 1
R R1 R2 L RT Rt
T T t 1

The average annual return for the S&P 500 from 1999-2008 is:
1
R (0.210 0.091 0.119 0.221 0.287
10
0.109 0.109 0.158 0.055 0.37) 0.7%
 Estimation Error: Using Past Returns to
Predict the Future

¨ We can use a security’s historical average

return to estimate its actual expected return.
However, the average return is just an estimate
of the expected return.
 Estimation Error: Using Past Returns to
Predict the Future (cont'd)
¨ Standard Error of the Estimate of the Expected
Return
SD(Individual Risk)
SD(Average of Independent, Identical Risks)
Number of Observations

¨ 95% Confidence Interval

Historical Average Return (2 Standard Error)
Taking a Global Perspective

¨ Investing today is more sophiscated and more

international.
¨ Investors now search for ‘good’ companies,
regardless of their location.
¨ Investment in foreign securities can be very
rewarding but also potentially very risky.
 Diversification in Stock
Portfolios

¨ Firm-Specific Versus Systematic Risk

¤ Firm Specific News
n __good____ or ___bad___ news about an individual
company

¤ Market-Wide News
n News that affects all stocks, such as news about
the economy
Impact of the Market

¨ Market risk is the single most important risk

affecting the price movement of ordinary
shares.
¤ Particularly true for a diversified portfolio
of ordinary shares.
¤ Accounts for 90% of the variability in a
__diversified______ portfolio’s return.
¨ Investors buying foreign shares face market
risk of the economies in which the companies
operate.
Portfolio Risk and Diversification

sp %
35 Portfolio risk

20
Market Risk
0
10 20 30 40 ...... 100+

Number of securities in portfolio

 Required Rate of Return
¨ Minimum expected rate of return needed to
induce investment.
¨ Given risk, a security must offer some minimum
expected return to persuade/compensate an
investor purchase it.
¨ RRR = __RF____ + ___Risk
Premium________
¨ Investors expect the risk free rate as well as a
risk premium to compensate for the
__Additional_____ risk assumed. Eg.
Components of the Required Rate of
Return
¨ RF = Real rate of return + Inflation premium
¤ Real rate of return is the basic exchange rate in
the economy.
¤ Nominal risk free rate must contain a premium
for expected __inflation________.
¨ The risk premium:
¤ Reflects all uncertainty in the asset.
Understanding the Required Rate of
Return
¨ Different financial assets have different
required rates of return.
¨ Different securities within a particular asset
class will have different required rates of
return.
¨ The level of required rate of return changes
over time (e.g. with changes in
_inflationary__ expectations or changes in
risk premiums).
The Risk-Return Trade-off
 Diversification in Stock Portfolios
¨ _____________ Risk • ____________ Risk
¤ Independent Risks
– Common Risks
n Due to firm-specific
news • Due to market-wide news
n Also known as: – Also known as:
n Firm-Specific Risk » Systematic Risk
n Idiosyncratic Risk » Undiversifiable Risk
n Unique Risk
» Market Risk
n Unsystematic
Risk
n Diversifiable Risk

In a portfolio, only firm specific risk can be diversified.

 Effects of Covid-19
¨ Restructuring
¨ The significant disruption to operations caused by the
coronavirus outbreak in certain regions may prompt
companies to think about diversifying their geographic
concentration of suppliers, operations, personnel, or
inventory.
¨ A company would only record a restructuring liability when
an event has occurred that creates a present obligation. A
commitment to a plan, in and of itself, typically does not
create a present obligation. Many costs, including relocation
costs, cannot be accrued before they are actually incurred.
¨ The accrual of employee severance and contract
termination costs is complex and should be based on the
specific facts and circumstances.
 Diversification in Stock Portfolios
¨ Firm-Specific Versus Systematic Risk
¤ Consider two types of firms:
n Type S firms are affected only by systematic
risk. There is a 50% chance the economy will
be strong and type S stocks will earn a return
of 40%; There is a 50% change the economy
will be weak and their return will be –20%.
Because all these firms face the same
systematic risk, holding a large portfolio of
type S firms will not diversify the risk.
 Diversification in Stock Portfolios
(cont'd)

¨ Firm-Specific Versus Systematic Risk

n Type I firms are affected only by Firm
specific risks. Their returns are equally likely
to be 35% or –25%, based on factors
specific to each firm’s local market. Because
these risks are firm specific, if we hold a
portfolio of the stocks of many type I firms,
the risk is diversified.
10.6 Diversification in Stock Portfolios
(cont'd)

¨ Firm-Specific Versus Systematic Risk

¤ Actual firms are affected by both market-wide
risks and firm-specific risks. When firms carry
both types of risk, only the unsystematic risk will
be diversified when many firm’s stocks are
combined into a portfolio. The volatility will
therefore decline until only the systematic risk
remains.
Figure 10.4 The Empirical Distribution of Annual
Returns for U.S. Large Stocks (S&P 500), Small Stocks, Corporate
Bonds, and Treasury Bills, 1926–2008
Figure 10.6 Historical Volatility and Return for 500
Individual Stocks, by Size, Updated Quarterly, 1926–2005
Textbook Example 10.6
Type S Firm : SYSTEMATIC RISK ONLY

Expected return = 0.5 (40%) + 0.5(- 20%) = 10%

Standard Deviation/Volatility :

NOT DIVERSIFIABLE
Type I Firm : FIRM SPECIFIC RISK ONLY

Expected return = 0.5 (35%) + 0.5(- 25%) = 5%

Standard Deviation/Volatility :

DIVERSIFIABLE
 Volatility of Portfolios of Type S
and I Stocks

Systematic risk
only

Systematic
+
Firm Specific Risk

Firm specific
risk only
Asian Financial Crisis 1997

¨ The Asian financial crisis was a period of

financial crisis that gripped much of Asia
beginning in July 1997, and raised fears of a
worldwide economic meltdown due to financial
contagion.
Countries most affected by the Asian
Financial Crisis in 1997
Flash Crash 2010

¨ The May 6, 2010 Flash Crash also known the

Flash Crash, was a United States stock
market crash on May 6, 2010 in which the Dow
Jones Industrial Average plunged about 1000
points—or about nine percent—only to recover
those losses within minutes. It was the second
largest point swing, 1,010.14 points, and the
biggest one-day point decline, 998.5 points, on
an intraday basis in Dow Jones Industrial
Average history.
Background:

¨ On May 6, US stock markets opened down

and trended down most of the day on worries
about the debt crisis in Greece. At 2:42 pm,
with the Dow Jones down more than 300
points for the day, the equity market began to
fall rapidly, dropping more than 600 points in 5
minutes for an almost 1000 point loss on the
day by 2:47 pm. Twenty minutes later, by
3:07 pm, the market had regained most of the
600 point drop.
 No Arbitrage and the Risk Premium

¨ Arbitrage opportunity: Any situation in which it

is possible to make a profit without taking any
_risk_____ or making any investment. Eg. Borrow
@ Rf to invest.

¨ Arbitrage exists as a result of market

___inefficiencies_______; it provides a
mechanism to ensure prices do not deviate
substantially from fair value for long periods of
time.
 No Arbitrage and the Risk Premium

¨ The risk premium for diversifiable risk is

__zero____, so investors are not
compensated for holding firm-specific risk
(unsystematic risk/unique risk).
¤ If the diversifiable risk of stocks were
compensated with an additional risk premium,
then investors could buy the stocks, earn the
additional premium, and simultaneously diversify
and eliminate the risk.
 No Arbitrage and the Risk Premium
(cont'd)
¤ By doing so, investors could earn an additional
premium ___without____ taking on additional risk.
This opportunity to earn something for nothing
would quickly be exploited and eliminated.
Because investors can eliminate firm-specific risk
“for free” by diversifying their portfolios, they will
not require or earn a reward or risk premium for
holding it.
No Arbitrage and the Risk Premium
(cont'd)

¨ The risk premium of a security is determined

by its systematic risk and does _not____
depend on its diversifiable risk.
¤ This implies that a stock’s volatility, which is a
measure of total risk (that is, systematic risk plus
diversifiable risk), is not especially useful in
determining the risk premium that investors will
earn.
 No Arbitrage and the Risk Premium
(cont'd)

¨ Standard deviation is not an appropriate

measure of risk for an individual security.

¨ There should be no clear relationship between

volatility and average returns for individual
securities. Consequently, to estimate a
security’s expected return, we need to find a
measure of a security’s systematic risk.
Textbook Example 10.7
Textbook Example 10.7 (cont'd)
 Measuring Systematic Risk

¨ Efficient Portfolio
¤ A portfolio that contains only systematic risk
There is no way to reduce the volatility of the
portfolio without lowering its expected return.
¨ Market Portfolio
¤ An efficient portfolio that contains all shares and
securities in the market
n The S&P 500 is often used as a ___proxy______ for
the market portfolio.
10.7 Measuring Systematic Risk (cont'd)

¨ Sensitivity to Systematic Risk: Beta (β)

¤ The expected percent change in the excess return of a
security for a 1% change in the excess return of the
market portfolio.
n Beta differs from volatility. Volatility measures total risk
(systematic plus unsystematic risk), while beta is a
measure of only systematic risk.
Textbook Example 10.8
¨ Change of return in the market portfolio
= 47% - (-25%) = 72%

¨ Changes in return in Type S firm = 40% - (-

20%) = 60%
βS = Δ Return of Firm = S 60%/72% =
Δ Market Return0.833%

• Firm I has only firm specific risk à No

systematic risk
• à βI = 0
 10.7 Measuring Systematic Risk (cont'd)

¨ Interpreting Beta (β)

¤ A security’s beta is related to how ___sensitive______ its
underlying revenues and cash flows are to general economic
conditions. Stocks in cyclical industries are likely to be more
sensitive to systematic risk and have higher betas than stocks
in less sensitive industries.
Cyclical industry: an industry that is sensitive to the business
cycle, such that revenues are generally higher in periods of
economic prosperity and expansion, and lower in periods of
economic downturn and contraction. Eg?
 Beta and the Cost of Capital
¨ Estimating the Risk Premium
¤ Market risk premium
n The market risk premium is the reward investors expect
to earn for holding a portfolio with a beta of 1.

Market Risk Premium E RMkt rf

Capital Asset Pricing Model :
E R Risk-Free Interest Rate Risk Premium
rf (E RMkt rf )
 Alternative Example 10.9

¨ Problem
¤ Assume the economy has a 60% chance of the
market return will 15% next year and a 40%
chance the market return will be 5% next year.
¤ Assume the risk-free rate is 6%.
¤ If Microsoft’s beta is 1.18, what is its expected
return next year?
 Alternative Example 10.9 - Solution

¨ Solution
¤ E[RMkt] = (60% × 15%) + (40% × 5%) = 11%
¤ E[R] = rf + β ×(E[RMkt] − rf )
¤ E[R] = 6% + 1.18 × (11% − 6%)
¤ E[R] = 6% + 5.9% = 11.9%
Bull vs Bear in Wall Street
Recap: Some important terminologies

¨ Risk: The potential variability in future cash flows. Can be

measured by the ____________ of the expected return.
¨ Risk premium: The additional ________ expected for
assuming risk.
¨ Yield to maturity: The rate of ________ the investor will
earn if a bond is held to maturity.
¨ Historical return: The return earned on a past investment.
¨ Expected rate of return: The arithmetic mean or average
of all possible outcomes where those outcomes are
__________ by the probability that each will occur.
Terminologies (Continued)
¨ Beta: The relationship between an investment’s
returns and the market returns. This is a
relative measure of the investment’s
___________ risk.
¨ Covariance: The statistical measure of the
degree of co-movement between two asset
returns. It essentially measures the tendency of
the two stocks to ‘_______’. A positive
covariance between two stock returns
suggested that as one return goes up the other
tends to go up as well, and vice versa.
Terminologies (Continued)

¨ Correlation coefficient: A standardised measure of

covariance. While covariance can theoretically
take on any value, the ____________ takes on
values between -1 and 1.
¨ Required rate of return: The _________ rate of
return necessary to attract an investor to purchase
or hold a security. It is also the discount rate that
equates the present value of the cash flows with
the value of the security.
¨ Efficient portfolios: Portfolios with a higher level of
return for the same level of risk, or a lower level of
risk for the same level of return.
Chapter 11
Optimal
Portfolio
Choice and the
Capital Asset
Pricing Model
 Chapter Outline
11.1 The Expected Return of a Portfolio
11.2 The Volatility of a Two-Stock Portfolio
11.3 The Volatility of a Large Portfolio
11.4 Risk Versus Return: Choosing an Efficient Portfolio
11.5 Risk-Free Saving and Borrowing
11.6 The Efficient Portfolio and Required Returns
11.7 The Capital Asset Pricing Model
11.8 Determining the Risk Premium
 Learning Objectives
1. Given a portfolio of stocks, including the holdings in each stock
and the expected return in each stock, compute the following:
a. portfolio weight of each stock
b. expected return on the portfolio
c. covariance of each pair of stocks in the portfolio
d. correlation coefficient of each pair of stocks in the portfolio
e. variance of the portfolio
f. standard deviation of the portfolio
2. Compute the variance of an equally weighted portfolio, using
equation 11.12.
3. Describe the contribution of each security to the portfolio.
Learning Objectives (cont'd)

4. Use the definition of an efficient portfolio from Chapter 10 to

describe the efficient frontier.
5. Explain how an individual investor will choose from the set of
efficient portfolios.
6. Describe what is meant by a short sale, and illustrate how short
selling extends the set of possible portfolios.
7. Explain the effect of combining a risk-free asset with a portfolio of
risky assets, and compute the expected return and volatility for
that combination.
8. Illustrate why the risk-return combinations of the risk-free
investment and a risky portfolio lie on a straight line.
 Learning Objectives (cont'd)
9. Calculate the beta of investment with a portfolio.
10. Use the beta of a security, expected return on a portfolio, and the
risk-free rate to decide whether buying shares of that security will
improve the performance of the portfolio.
11. Use the risk-free rate, the expected return on the efficient portfolio,
and the beta of a security with the efficient portfolio to calculate the
risk premium for an investment.
12. List the three main assumptions underlying the Capital Asset
Pricing Model.
13. Explain why the CAPM implies that the market portfolio of all risky
securities is the efficient portfolio.
14. Compare and contrast the capital market line with the security
market line.
15. Define beta for an individual stock and for a portfolio.
11.1 The Expected Return of a Portfolio

¨ Portfolio Weights
¤ The Fraction of the total investment in the
portfolio held in each individual investment in the
portfolio
n The portfolio weights must add up to 1.00 or 100%.
Value of investment i
xi
Total value of portfolio
 11.1 The Expected Return of a Portfolio
(cont'd)

¨ The return on the portfolio, Rp , is the weighted

average of the returns on the investments in
the portfolio, where the weights correspond to
portfolio _weights_______.
Rp= X1R1+x2r2 +…+ XnRn = sum of Xi Ri

n
E(Rp ) wi Ri
i 1

Value of investment i
xi
Total value of portfolio
 Alternative Example 11.1
¨ Assume that you buy 400 shares of ABC Bhd at
$20 per share and 100 shares of XYZ Bhd at
$25. If ABC’s share price goes up to $ 22 and
XYZ’s share price falls to $23, what is the new
value of the portfolio, and what return did it
earn? After the price change, what are the new
portfolio weights?
 Alternative Example 11.1 - Solution

¨ Solution :
¨ Initial investment = (400 x 20) + (100 x 25) =
$10,500
¨ Current value of portfolio :
(400 x $22) + (100 x $23) = $11,100
¨ Return of Portfolio = ($11,100 - $10,500)/10,500 =
5.7%

New portfolio weights :

¨ ABC : (400 x $22)/11,100 = 79.28%
¨ XYZ : (100 x $23)/11,100 = 20.72%
 11.1 The Expected Return of a Portfolio
(cont'd)

¨ The expected return of a portfolio is the

weighted average of the expected returns of
the investments within it.
E RP E i
xi Ri i
E xi Ri i
xi E Ri
or
n
E(Rp ) wi Ri
i 1
Alternative Example 11.2

¨ Problem
¤ Assume your portfolio consists of $25,000 of Intel stock and
$35,000 of ATP Oil and Gas.
¤ Your expected return is 18% for Intel and 25% for ATP Oil
and Gas.
¤ What is the expected return for your portfolio?
Alternative Example 11.2 - Solution
Assume your portfolio consists of $25,000 of Intel stock and $35,000 of ATP Oil and Gas.
Your expected return is 18% for Intel and 25% for ATP Oil and Gas. What is the expected return for
your portfolio?

Total Portfolio = $25,000 + 35,000= $60,000

Portfolio Weights
n Intel: $25,000 ÷ $60,000 = 0.4167
n ATP: $35,000 ÷ $60,000 = 0.5833
Expected Return
n E[R] = (0.4167)(0.18) + (0.5833)(0.25)
n E[R] = 0.075006 + 0.145825 = 0.220885 =
22.1%
11.2 The Volatility of a Two-Stock
Portfolio
Combining Risks
Table 11.1 Returns for Three Stocks, and Portfolios of
Pairs of Stocks
Volatility
1/2 RN + 1/2 RW
Year %
A B = ((A) -10%) C= (B)2
2003 15.00 5.00 25.00
2004 25.50 15.50 240.25
2005 7.00 (3.00) 9.00
2006 (3.50) (13.50) 182.25
2007 (3.50) (13.50) 182.25
2008 19.50 9.50 90.25

Average Return 10.00 729

T
1 2
Var (R ) Rt R
T 1 t 1

Variance = 1/(6-1) X 729 =145.8

Standard Deviation = √145.8 = 12.08 %

 11.2 The Volatility of a Two-Stock
Portfolio (cont'd)
¨ Combining Risks
¤ By combining stocks into a portfolio, we reduce
risk through ______________.
¤ The amount of risk that is eliminated in a portfolio
depends on the degree to which the stocks face
common risks and their prices move together.

Is diversification good for investors?

 Determining Covariance and Correlation

¨ To find the risk of a portfolio, one must know the

degree to which the stocks’ returns move
___________.

¨ Covariance
¤ The expected product of the deviations of two
returns from their means
¤ Covariance between Returns Ri and Rj
Cov(Ri ,R j ) E[(Ri E[ Ri ]) (R j E[ R j ])]
 Determining Covariance and Correlation
(cont'd)
§ If the covariance is _________, the two
returns tend to move together

§ If the covariance is _________, the two returns

tend to move in opposite directions.

Estimation of covariance from historical data:

1
Cov(Ri ,R j ) (Ri ,t Ri ) (R j ,t Rj )
T 1 t
 Determining Covariance and Correlation
¨ Correlation
(cont'd)
¤ A measure of the common risk shared by stocks that
does not depend on their volatility
Cov(Ri ,R j )
Corr (Ri ,R j )
SD (Ri ) SD (R j )
The correlation between two stocks will always be between
____ and ____.
 Textbook Example 11.3

For single stock holding:

Covariance = Variance Correlation = 1

For single stock holding:

Covariance = Variance Correlation = 1

 Computing the Covariance and
Correlation Between Pairs of Stocks

Table 11.1 Returns for Three Stocks, and Portfolios of

Pairs of Stocks
Computing the Covariance and Correlation Between Pairs of Stocks
Table 11.3 Historical Annual Volatilities
and Correlations for Selected Stocks
 Alternative Example 11.5

¨ Problem
¤ Using the data from Table 11.3, what is the
covariance between General Mills and Ford
Motors?

Cov( RGeneral Mills , RFord ) Corr ( RGeneral Mills , RFord )SD( RGeneral Mills ) SD( RFord )
(0.07)(0.18)(0.42) .005292
 Computing a Portfolio’s Variance
and Volatility

¨ For a two security portfolio:

Var (RP ) Cov(RP ,RP )
Cov(x1R1 x2 R2 ,x1R1 x2 R2 )
x1 x1Cov(R1 ,R1 ) x1 x2Cov(R1 ,R2 ) x2 x1Cov(R2 ,R1 ) x2 x2Cov(R2 ,R2 )

¤ The Variance of a Two-Stock Portfolio

Var (RP ) x12Var (R1 ) x22Var (R2 ) 2 x1 x2Cov(R1 ,R2 )
2 2 2 2
= √ + + 2 ,
Textbook Example 11.6
Table 11.3 Historical Annual Volatilities
and Correlations for Selected Stocks
Table 11.3 Historical Annual Volatilities
and Correlations for Selected Stocks
Textbook Example 11.6 (cont'd)
2 2 2 2
= √ + + 2 ,
Alternative Example 11.6

¨ Problem
¤ Continuing with Alternative Example 11.2:
n Assume the annual standard deviation of returns is
43% for Intel and 68% for ATP Oil and Gas.

¤ If the correlation between Intel and ATP is .49,

what is the standard deviation of your
portfolio?
 Alternative Example 11.6 (cont’d)
2 2 2 2
=√ + + 2 1,2
¨ Solution
Or Equation 11.9.

SD(RP ) x12Var (R1 ) x22Var (R2 ) 2 x1 x2Cov(R1 ,R2 )

SD(RP ) (.4167)2 (.43)2 (.5833)2 (.68)2 2(.4167)(.5833)(.49)(.43)(.68)

SD(RP ) (.1736)(.1849) (.3402)(.4624) 2(.4167)(.5833)(.49)(.43)(.68)

SD(RP ) .0321 .1573 .0696 0.259 .5089 50.89%

 11.3 The Volatility of a Large Portfolio

¨ The variance of a portfolio is equal to the

weighted average covariance of each stock
with the portfolio:
Var (RP ) Cov(RP ,RP ) Cov i
xi Ri ,RP i
xi Cov( Ri ,RP )

¤ which reduces to:

Var (RP ) i
xi Cov( Ri ,RP ) i
xiCov( Ri , j x j R j )

i j
xi x j Cov( Ri ,R j )
Diversification with an Equally Weighted
Portfolio of Many Stocks

¨ Equally Weighted Portfolio

¤ A portfolio in which the same amount is invested
in each stock

¨ Variance of an Equally Weighted Portfolio

of n Stocks
1
Var ( RP ) (Average Variance of the Individual Stocks)
n
1
1 (Average Covariance between the Stocks)
n
 Risk Versus Return:
Choosing an Efficient Portfolio
¨ Efficient Portfolios with Two Stocks

¤ Identifying Inefficient Portfolios

n In an inefficient portfolio, it is possible to find
another portfolio that is better in terms of both
expected return and volatility.

¤ Identifying Efficient Portfolios

n Inan efficient portfolio there is no way to
reduce the volatility of the portfolio
without lowering its expected return.
 11.4 Risk Versus Return:
Choosing an Efficient Portfolio (cont'd)

¨ Efficient Portfolios with Two Stocks

¤ Consider a portfolio of Intel and Coca-Cola

Expected Returns and Volatility for Different Portfolios of Two Stocks

Figure 11.3 Volatility Versus Expected Return for
Portfolios of Intel and Coca-Cola Stock
Figure 11.3 Volatility Versus Expected Return for
Portfolios of Intel and Coca-Cola Stock
Portfolios with at least 20% in Intel stock are
efficient (the red part of the curve).
Efficient portfolios: there are no other portfolio
of the two stocks that offers a higher exp.
return with lower volatility. Investors’
preference is subject to risk appetite.
11.4 Risk Versus Return:
Choosing an Efficient Portfolio (cont'd)

¨ Efficient Portfolios with Two Stocks

¤ Consider investing 100% in Coca-Cola stock. As
shown in on the previous slide, other portfolios—
such as the portfolio with 20% in Intel stock and
80% in Coca-Cola stock—make the investor
better off in two ways: It has a higher expected
return, and it has lower volatility. As a result,
investing solely in Coca-Cola stock is inefficient.
Textbook Example 11.9
Figure 11.3 Volatility Versus Expected Return for
Portfolios of Intel and Coca-Cola Stock
The Effect of Correlation

¨ Correlation has no effect on the expected return of a

portfolio. However, the __________ of the portfolio will
differ depending on the correlation.
¨ The ______ the correlation, the lower the volatility we
can obtain. As the correlation decreases, the volatility of
the portfolio falls.
CHAPTER 11 (PART 2)
OPTIMAL
PORTFOLIO CHOICE AND THE
CAPITAL ASSET PRICING MODEL
 A one-minute recap:
Covariance and Correlation

§ If the covariance is positive, the two returns

tend to move ______

§ If the covariance is negative, the two returns

tend to move in _______ directions.
 A 0ne-minute recap:
Covariance and Correlation
¨ Correlation
¤ A measure of the common risk shared by stocks that
does not depend on their volatility
Cov(Ri ,R j )
Corr (Ri ,R j )
SD (Ri ) SD (R j )
The correlation between two stocks will always be between –1
and +1.
The Effect of Correlation

¨ Correlation has no effect on the expected

return of a portfolio. However, the volatility of
the portfolio will differ depending on the
correlation.
¨ The lower the correlation, the lower the volatility we can
obtain. As the correlation decreases, the volatility of the
portfolio falls.
 Correlation
338

¨ Used to quantify the strength of the

relationship between two stocks;
 Returns

Pe
rfe
co ct n
re rre ega
mo la
ve tion tive
sr
isk
B
A

Portfolio

Time
Two-share portfolio (A 1-min Recap)
 Short Sales

¨ Long Position
¤ A positive investment in a security

¨ Short Position
¤ A negative investment in a security
¤ In a short sale, you _______a stock that you do
not ____ and then buy that stock back in the
future. Low/High?

¤ Short selling is an advantageous strategy if you

expect a stock price to ______ in the future.
340 Low/High?
 Risk Versus Return:
Choosing an Efficient Portfolio (cont'd)
¨ Efficient Portfolios with Two Stocks
¤ Consider a portfolio of Intel and Coca-Cola

Expected Returns and Volatility for Different Portfolios of Two Stocks

341
 Textbook Example 11.10

buy sell

342
 Textbook Example 11.10 (cont'd)

343
 What is your choice?

344
 Comparisons and The choice

345
 Adding one more stock in the portfolio?
346

¨ The Third stock?

¨ Much lower portfolio risk…
 Risk Versus Return: Many Stocks

¨ The efficient portfolios, those offering the highest

possible ______________ for a given level of
____________, are those on the northwest edge
of the shaded region, which is called the efficient
frontier for these three stocks.
¤ In this case none of the stocks, on its own, is on the
efficient frontier, so it would not be efficient to put all
our money in a single stock.
¤ In general, adding new investment opportunities
allows for greater diversification and improves the
efficient frontier.

347
Figure 11.8 Efficient Frontier with Ten
Stocks Versus Three Stocks
 “ Diversification provided a “free lunch” –
the opportunity to reduce risk without
sacrificing expected return.…. By computing
the efficient frontier for a set of securities.”
(Berk & DeMarzo, 2011)

Harry Markowitz
349
(born in 1927)
 Figure 11.8 Efficient Frontier with Ten
Stocks Versus Three Stocks

350
 11.5 Risk-Free Saving and Borrowing

¨ Risk can also be reduced by investing a portion

of a portfolio in a risk-free investment, like T-Bills.
However, doing so will likely reduce the expected return.
¨ On the other hand, an aggressive investor who
is seeking high expected returns might decide
to borrow money to invest even more in the
stock market.

351
 Investing in Risk-Free Securities

¨ Consider an arbitrary risky portfolio and the

effect on risk and return of putting a fraction of
the money in the portfolio, while leaving the
remaining fraction in risk-free Treasury bills.

¤ The expected return would be:

E [RxP ] (1 x)rf xE[RP ]
rf x (E[RP ] rf )

352
 Investing in Risk-Free Securities (cont'd)

¨ The standard deviation of the portfolio would

be calculated as:
SD[RxP ] (1 x) 2Var (rf ) x 2Var (RP ) 2(1 x)xCov(rf ,RP )

x 2Var (RP ) 0
xSD(RP )

¤ Note: The standard deviation is only a fraction of

the volatility of the risky portfolio, based on the
amount invested in the risky portfolio.

353
 Borrowing and Buying Stocks on Margin

¨ Buying Stocks on Margin

¤ Borrowing money to invest in a stock.
¤ A portfolio that consists of a short position in the
risk-free investment is known as a levered
portfolio. Margin investing is a risky investment
strategy.

354
 Textbook Example 11.13

355
 Textbook Example 11.13 (cont'd)

356
 Expected Returns
and the Efficient Portfolio

¨ Expected Return of a Security

eff
E[ Ri ] ri rf i (E[ Reff ] rf )

¤ A portfolio is efficient if and only if the expected

return of every available security ________ its
required return.

357
 11.7 The Capital Asset Pricing Model

¨ The Capital Asset Pricing Model (CAPM)

allows us to identify the efficient portfolio of
______________ without having any
knowledge of the expected return of each
security.
¨ Instead, the CAPM uses the optimal choices
investors make to identify the efficient portfolio
as the market portfolio, the portfolio of all
stocks and securities in the market.

358
 The CAPM Assumptions

¨ Three Main Assumptions

¤ Assumption 1
n Investors can buy and sell all securities at competitive
market prices (without incurring taxes or transactions
costs) and can borrow and lend at the risk-free interest
rate.

359
 The CAPM Assumptions (cont'd)

¨ Three Main Assumptions

¤ Assumption 2
n Investors hold only ______________ of traded
securities—portfolios that yield the ________
expected return for a __________ level of volatility.

360
 The CAPM Assumptions (cont'd)

¨ Three Main Assumptions

¤ Assumption 3
n Investors have homogeneous expectations
regarding the volatilities, correlations, and expected
returns of securities.
n Homogeneous Expectations
n All investors have the same/identical estimates concerning
future investments and returns.

361
 Supply, Demand, and the Efficiency of
the Market Portfolio
¨ Given homogeneous expectations, all investors will
demand the same efficient portfolio of risky securities.
¨ The combined portfolio of risky securities of all investors
must equal the efficient portfolio.
¨ Thus, if all investors demand the efficient portfolio, and
the supply of securities is the market portfolio, the
demand for market portfolio must equal the supply of the
market portfolio.

362
 Optimal Investing: The Capital Market
Line

¨ When the CAPM assumptions hold, an optimal

portfolio is a combination of the risk-free
investment and the market portfolio.
¤ When the tangent line goes through the market
portfolio, it is called the capital market line
(CML).

363
 11.8 Determining the Risk Premium

¨ Market Risk and Beta

¤ Given an efficient market portfolio, the expected
return (required) of an investment is:
Mkt
E[Ri ] ri rf i (E[RMkt ] rf )
1 4 4 4 2 4 4 43
Risk premium for security i

¤ The beta is Volatility

defined as:
of i that is common with the market
6 4 4 4 4 7 4 4 4 48
Mkt SD(Ri ) Corr (Ri ,RMkt ) Cov(Ri ,RMkt )
i i
SD(RMkt ) Var (RMkt )
364
 Textbook Example 11.16

365
 Textbook Example 11.16 (cont'd)

366
 Textbook Example 11.17

367
 Textbook Example 11.17 (cont'd)

368
 The Security Market Line

¨ There is a linear relationship between a stock’s

______ and its expected return (See figure on
next slide). The security market line (SML) is
graphed as the line through the risk-free
investment and the market.
¤ According to the CAPM, if the expected return
and beta for individual securities are plotted, they
should all fall along the SML.

369
 Figure 11.12 The Capital Market Line
and the Security Market Line

370
 The Security Market Line (cont'd)

¨ Beta of a Portfolio
¤ The beta of a portfolio is the weighted average beta
of the securities in the portfolio.

Cov(RP ,RMkt ) Cov i

xi Ri ,RMkt Cov(Ri ,RMkt )
P x
i i
xi i
Var (RMkt ) Var (RMkt ) Var (RMkt ) i

371
 Textbook Example 11.18

372
 Textbook Example 11.18 (cont’d)

373
 374

CAPM

Advantages Disadvantages
¨ It considers only ______ ¨ Values needed to be
risk, hence reflecting a assigned for risk-free rate
reality for most ________ (not fixed, may changes
investors; daily), market return(can
¨ It provides a theoretically-
be –ve) and beta(not
derived relationship constant).
between __________ and
systematic risk;
¨ A better method in
providing discount rates for
use in investment
appraisal than WACC.
 Summary of the Capital Asset
Pricing Model

¨ The market portfolio is the efficient portfolio.

¨ The risk premium for any security is
proportional to its __________ with the
market.
¨ The CAPM provides a ___________ level of
return required by investors.

375
CHAPTER 12

Estimating the Cost of Capital

Chapter Outline
12.1 The Equity Cost of Capital
12.2 The Market Portfolio
12.3 Beta Estimation
12.4 The Debt Cost of Capital
12.5 A Project’s Cost of Capital
12.6 Project Risk Characteristics and Financing
12.7 Final Thoughts on the CAPM

377
Learning Objectives
1. Estimate a company’s cost of capital using the
CAPM equation for the Security Market Line.
2. Describe the market portfolio and how it is
constructed in practice.
3. Discuss the attributes of a value-weighted portfolio.
4. Describe common proxies for the market return
and the risk-free rate.
5. Define beta and explain how it can be generally
estimated.

378
Learning Objectives
6. Compare the use of average return versus beta and
the SML to estimate cost of equity capital.
7. Estimate the cost of debt, given a company’s yield to
maturity, probability of default, and expected loss rate.
8. Discuss the difference between the yield to maturity
and the cost of debt when there is low versus high
default risk.
9. Calculate the cost of debt given a company’s debt
beta, the risk free rate, and the market risk premium.

379
Learning Objectives
10. Illustrate the use of comparable companies’
unlevered betas or unlevered cost of capital to
estimate project cost of capital.
11. Discuss the advantages of using several companies’
betas to estimate a project beta.
12. Define operating leverage and discuss its influence
on project risk.
13. Calculate the weighted average cost of capital.
14. Discuss strengths and weaknesses of the CAPM.

380
Financial structure The mix of all funds sources that
appear on the B/S

Balance sheet

Current Current

Financial structure
assets liabilities

Debt and
preference
Fixed shares
assets
Shareholders’
equity
Capital structure (the long-term sources of funds
used by firms.)

Balance sheet

Current Current
assets liabilities

Debt and
preference

structure
shares

Capital
Fixed
assets
Shareholders’
equity
Why is capital structure important?
¨ Leverage
Higher financial leverage means potentially higher
returns to shareholders, but higher risk
(financial distress) due to higher interest payments

¨ Cost of capital
Each source of finance has a ________cost. Capital
structure affects the cost of capital

¨ Optimal capital structure

The structure that _______the firm’s cost of capital and
______ firm value (shareholders’ wealth)
 Why is capital structure important?
384

¨Capital structure theory:

Apply the cost of capital concept, and examines
the effects of financial leverage on the overall
__________to firms.
 What is the cost of capital?
385

¨ Joe Knight:“It is the return expected by those

who provide capital for the business.” (Author
of HBR tools & co-founder and owner of
www.business-literacy.com).

¨ Equity holders and debt holders

¨ Often calculated and used to determine the
discount rate (with cushion); subject to risk
appetite
¨ Example
 Cost of Capital
386

¨ To understand:
1) Firms need to ensure that it has sufficient
cash flows to pay costs of (debt/equity) capital
provided by investors.

2) Investors require to earn a return ( debt/equity

finance) from their capital once contributed into
the firm.
The cost of capital

¨ For investors: the rate of return on a security is

a benefit of investing
¨ For financial managers that same rate of return
is a cost of raising funds
¨ The cost of raising funds is the firm’s cost of
capital
 Cost of capital
388

¨ to evaluate individual investments;

¨ to assess the risk of a company’s

equity.
 Cost of capital
389

¨ “Cost of capital” is also referred to as

n weighted cost of capital
n weighted average cost of capital
n cost of finance/funds
n required rate of return of finance
n hurdle rate for new investments
n discount rate for evaluating a new
investment
The cost of capital cont’d

¨ The minimum rate that a company must earn on

investment projects in order to satisfy the required rates
of return of its investors

¨ The rate of return on investments that leaves the price of

the firm’s ordinary shares unchanged
The cost of capital cont’d

Financing decisions

The choice of rate

has a significant
Cost of capital effect on estimates
of a project’s or a
company’s value.

Which long-term
projects should a
company invest?
Investment decisions
DCFs and
NPV
 The effect of cost of capital
392

¨ Too high?
¨ Reject valuable opportunities
¨ Competitors

¨ Too low?
¨ Will almost commit resources to projects that
will erode profitability
¨ Destroy shareholder value.
How can a firm raise capital?

¨ By selling
¤ Bonds
¤ Preference shares

¤ Ordinary shares

¨ Each offers a rate of return to investors

¨ These returns are costs to the firm
¨ “Cost of capital” actually refers to the
weighted cost of capital
 Cost of Capital
394 ¨ It serves as the linkage between its financing
and investment decisions;

¨ It is the hurdle rate (minimum required return

on an investment necessary to cover all costs
associated with a project) that must be
achieved to increase _________

¨ Also known as firm’s required rate of return, the

hurdle (discount) rate for new investments, the
discount rate for evaluating a new investment,
and the firm’s opportunity cost of funds.
 12.1 The Equity Cost of Capital
395

¨ The rate of equity capital that can be raised

AND
¨ The rewards expected by shareholders in
exchange for their capital.

¨ Can be estimated using Div1

P0
rE g
1) the dividend growth model

2) ______
12.1 The Equity Cost of Capital
¨ The Capital Asset Pricing Model (CAPM) is a practical
way to estimate.
¨ The cost of capital of any investment opportunity equals
the expected return of available investments with the
same beta.
¨ The estimate is provided by the Security Market Line
equation: r =r + (E[R ]-r )
i f i Mkt f

Risk Premium for Security i

¨ Investors will require a risk premium comparable to what

they would earn taking the same__________.
396
 12.1 The Equity Cost of Capital
397

¨ How much of the premium is right?

¨ Market risk premium: E(rm) – Rf? And
¨ How risky is the specific investment compared
to the market: ᵝi ? Eg.
 Textbook Example 12.1

398
 Textbook Example 12.1 (cont'd)

399
12.2 The Market Portfolio
¨ Constructing the market portfolio
¨ Market Capitalization
¤ The total market value of a firm’s outstanding
shares
MVi (Number of Shares of i Outstanding) (Price of i per Share) Ni Pi

400
12.2 The Market Portfolio (cont’d)
¨ Value-Weighted Portfolio
¤ A portfolio in which each security is held in
proportion to its market capitalization

Market Value of i MVi

xi
Total Market Value of All Securities j
MV j

401
Value-Weighted Portfolios
¨ A value-weighted portfolio is an equal-
ownership portfolio; it contains an equal
fraction of the total number of shares
outstanding of each security in the portfolio.
¨ Passive Portfolio
¤ A portfolio that is not rebalanced in response to
price changes

402
 Market Indexes
¨ Report the value of a particular portfolio of
securities.
¨ Examples:
¤ S&P 500
n A value-weighted portfolio of the 500 largest U.S.
stocks
¤ Wilshire 5000
n A value-weighted index of all U.S. stocks listed on the
major stock exchanges
¤ Dow Jones Industrial Average (DJIA)
n A price weighted portfolio of 30 large industrial stocks

403
12.2 The Market Portfolio

¨ Most practitioners use the S&P 500

(includes 500 out of more than 7,000
companies, but it includes the largest stocks
(70%) of US market capitalization. Hence,
used as the market proxy, even though it is
not actually the market portfolio.

404
The Market Risk Premium
¨ Determining the Risk-Free Rate
¤ The yield on U.S. Treasury securities
¤ Surveys suggest most practitioners use 10 to 30
year treasuries

¨ The Historical Risk Premium

¤ Estimate the risk premium (E[RMkt]-rf) using the
historical average excess return of the market
over the risk-free interest rate

405
12.3 Beta Estimation
¨ Estimating Beta from Historical Returns
Recall, beta is the expected percent change in the
excess return of the security for a 1% change in the
excess return of the market portfolio.
Beta reflects the sensitivity of each stocks to the
general performance of the economy (market).
The appropriate measure of risk for well-diversified
investor.
Consider Cisco Systems stock and how it changes
with the market portfolio.
406
 Figure 12.1 Monthly Returns for Cisco
Stock and for the S&P 500, 1996–2009

407
 Figure 12.2 Scatterplot of Monthly Excess Returns
for Cisco Versus the S&P 500, 1996–2009

408
12.3 Beta Estimation (cont'd)
¨ Estimating Beta from Historical Returns
¤ As the scatterplot on the previous slide shows,
Cisco tends to be up when the market is up, and
vice versa.
¤ We can see that a 10% change in the market’s
return corresponds to about a 20% change in
Cisco’s return.
n Thus, Cisco’s return moves about two for one with the
overall market, so Cisco’s beta is about 2.

409
12.3 Beta Estimation (cont'd)
¨ Estimating Beta from Historical Returns
¤ Beta corresponds to the slope of the best-fitting
line in the plot of the security’s excess returns
versus the market excess return.

410
12.4 The Debt Cost of Capital
¨ Refers to the cost of capital that a firm must pay
on its debt.

¨ Debt Yields
¤ Yield to maturity (YTM) is the IRR an investor will earn
from holding the bond to maturity and receiving its
promised payments.
¤ If there is little risk the firm will default, yield to maturity
is a reasonable estimate of investors’ expected rate of
return.
¤ If there is significant risk of default, yield to maturity will
overstate investors’ expected return.

411
Table 12.2 Annual Default Rates by Debt
Rating (1983–2008)

412
12.4 The Debt Cost of Capital (cont’d)
¨ The average loss rate for unsecured debt is 60%.

¨ According to Table 12.2, during average times the

annual default rate for B-rated bonds is 5.2%.

¨ So the expected return to B-rated bondholders

during average times is 0.052X0.60=3.1% below
the bond’s quoted yield.
¨ Prob(default) x Exp. Loss Rate

413
12.5 A Project’s Cost of Capital
¨ A project’s cost of capital cannot be determined
by cost of capital (since a new project is not
publicly traded security)
¨ All-equity comparables
¤ Find an all-equity financed firm in a single line of
business that is comparable to the project.
¤ Use the comparable firm’s equity beta and cost of
capital as estimates
¨ Levered firms as comparables

414
 Figure 12.3 Using a Levered Firm as a
415
Comparable for a Project’s Risk
12.5 A Project’s Cost of Capital (cont’d)

¨ Asset (unlevered) cost of capital

¤ Expected return required by investors to hold the
firm’s underlying assets.
¤ Weighted average of the firm’s equity and debt
costs of capital
E
¤ Evaluating the potential costDof a capital project,
rU
=
by measuring the
r
cost E
of
+ the
rD
project in a debt-free
E+D E+D
scenario.
WACC=weke+wdkd+wpkp
WACC=ko=ke (only for all-Equity firms)
416
12.5 A Project’s Cost of Capital (cont’d)

¨ Asset (unlevered) beta

E D
βU = βE + βD
E+D E+D

417
Textbook Example 12.5

418
Textbook Example 12.5 (cont’d)

419
Textbook Example 12.5 (cont’d)

420
Cash and Net Debt
¨ Some firms maintain high cash balances
¨ Cash is a risk-free asset that reduces the
average risk of the firm’s assets
¨ Since the risk of the firm’s enterprise value is
what we’re concerned with, leverage should be
measured in terms of net debt.

Net Debt = Debt – Excess Cash and short-term investments

421
The Weighted Average Cost of Capital

¨ Weighted Average Cost of Capital (WACC)

E E
rwacc = rE + rD ( 1-τC )
E+D E+D

¨ Given a target leverage ratio:

D
rwacc =rU - τC rD
E+D

422
 How does rwacc compare with rU?
423
The unlevered cost of capital (pretax WACC):
¨ It is the exp. Return investors will earn holding the
firm’s assets;
¨ Used to evaluate an all-equity financed project
(same risk);

WACC:
¨ The eff. A-T cost of capital to the firm.

¨ Int. expenses is tax deductible, hence WACC <

exp. Return of the firm’s assets.
¨ Used to evaluate a project with the same risk and
same financing as the firm.
Textbook Example 12.9

424
Textbook Example 12.9 (cont’d)

425
12.7 Final Thoughts on the CAPM

¨ There are a large number of assumptions

made in the estimation of cost of capital
using the CAPM.
¨ How reliable are the results?

426
12.7 Final Thoughts on the CAPM
(cont’d)
¨ The types of approximation are no different from those
made throughout the capital budgeting process. Errors in
cost of capital estimation are not likely to make a large
difference in NPV estimates.
¨ CAPM is practical, easy to implement, and robust.
¨ CAPM imposes a disciplined approach to cost of capital
estimation that is difficult to manipulate.
¨ CAPM requires managers to think about risk in the correct
way.

427
 Chapter 14
CAPITAL STRUCTURE
IN A PERFECT MARKET
 Chapter Outline
14.1 Equity versus Debt Financing
14.2 Modigliani-Miller I: Leverage, Arbitrage, and
Firm Value
14.3 Modigliani-Miller II: Leverage, Risk, and the
Cost of Capital
14.4 Capital Structure Fallacies
14.5 MM: Beyond the Propositions

429
 Learning Objectives
1. Define the types of securities usually used by
firms to raise capital; define leverage.
2. Describe the capital structure that the firm
should choose.
3. List the three conditions that make capital
markets perfect.
4. Discuss the implications of MM Proposition I, and
the roles of homemade leverage and the Law of
One Price in the development of the proposition.

430
 Learning Objectives (cont'd)
5. Calculate the cost of capital for levered equity
according to MM Proposition II.
6. Illustrate the effect of a change in debt on
weighted average cost of capital in perfect capital
markets.
7. Calculate the market risk of a firm’s assets using
its unlevered beta.
8. Illustrate the effect of increased leverage on the
beta of a firm’s equity.

431
 Learning Objectives (cont'd)
9. Compute a firm’s net debt.
10. Discuss the effect of leverage on a firm’s expected
earnings per share.
11. Show the effect of dilution on equity value.
12. Explain why perfect capital markets neither create
nor destroy value.

432
 Why capital structure matters?
433

“It doesn’t matter whether a company is big or

small. Capital structure matters. It always has
and always will.”
Michael
Miliken
 Why capital structure matters?
434

Balance Sheet
Assets Liabilities & Equity

-The role of financial markets

 14.1 Equity Versus Debt Financing
¨ Capital Structure
¤ The relative proportions of debt, equity, and other
securities that a firm has outstanding
¤ A mix of a company's long-term debt, specific short-term
debt, common equity and preferred equity. The capital
structure is how a firm finances its overall operations and
growth by using different sources of funds.
¤ Debt comes in the form of bond issues or long-term notes
payable,
¤ while equity is classified as common stock, preferred stock
or retained earnings.

435
 Equity and Debt
436

¨ Firms may choose to raise capital via:

¤ Equity only;

¤ Equity and Debt.

 Financing a Firm with Equity
¨ You are considering an investment opportunity.
¤ For an initial investment of $800 this year, the
project will generate cash flows of either $1400 or
$900 next year, depending on whether the
economy is strong or weak, respectively. Both
scenarios are equally likely.

437
 Table 14.1 The Project Cash Flows
• You are considering an investment opportunity.
▫ For an initial investment of $800 this year, the project will generate
cash flows of either $1400 or $900 next year, depending on
whether the economy is strong or weak, respectively. Both scenarios
are equally likely.

438
 Financing a Firm with Equity (cont'd)

¨ The project cash flows depend on the overall

economy and thus contain market risk. As a
result, you demand a 10% risk premium over
the current risk-free interest rate of 5% to
invest in this project.
¨ What is the NPV of this investment
opportunity?

439
 Financing a Firm with Equity (cont'd)

¨ The cost of capital for this project is 15%.

The expected cash flow in one year is:
¤ (0.5)($1400) + (0.5)($900) = $1150.

¨The NPV of the project is:

$1150
NPV $800 $800 $1000 $200
1.15

440
 Financing a Firm with Equity (cont'd)

¨ If you finance this project using only equity, how

much would you be willing to pay for the project?

$1150
PV (equity cash flows) $1000
1.15
n If you can raise $1000 by selling equity in the firm, after
paying the investment cost of $800, you can keep the
remaining $200, the NPV of the project NPV, as a profit.

441
 Financing a Firm with Equity (cont'd)

¨ Unlevered Equity
¤ Equity in a firm with no debt

¨ Because there is no debt, the cash flows of the

unlevered equity are equal to those of the
project.

442
 Table 14.2 Cash Flows and Returns for
Unlevered Equity

443
 Financing a Firm with Equity (cont'd)

¨ Shareholder’s returns are either 40% or –

10%.
¤ The expected return on the unlevered equity is:
n (0.5)(40%) + (0.5)(–10%) = 15%.
n Because the cost of capital of the project is 15%,
shareholders are earning an appropriate return for
the risk they are taking.

444
 Financing a Firm with Debt and Equity

¨ Suppose you decide to borrow $500 initially, in

addition to selling equity.
¤ Because the project’s cash flow will always be enough
to repay the debt, the debt is risk free and you can
borrow at the risk-free interest rate of 5%. You will owe
the debt holders:
n $500 × 1.05 = $525 in one year.

¨ Levered Equity
¤ Equity in a firm that also has debt outstanding
¤ Promised payments to debt holders must be made
before any payments to equity holders are distributed.

445
 Financing a Firm
with Debt and Equity (cont'd)

¨ Given the firm’s $525 debt obligation, your

shareholders will receive only $875 ($1400 –
$525) if the economy is strong, and $375 ($900
– $525) if the economy is weak.

446
 Table 14.3 Values and Cash Flows for
Debt and Equity of the Levered Firm

447
 Financing a Firm
with Debt and Equity (cont'd)

¨ What Price E should the levered equity sell

for?

¨ Which is the best capital structure choice

for the entrepreneur?

448
 Financing a Firm
with Debt and Equity (cont'd)

¨ Modigliani and Miller argued that with perfect

capital markets, the total value of a firm should
not depend on its capital structure.
¤ They reasoned that the firm’s total cash flows still
equal the cash flows of the project, and therefore
have the same present value.

449
The Value of the Firm

The value of the firm is determined by the profitability (NOI) & business risk,
NOT capital structure.
 Financing a Firm
with Debt and Equity (cont'd)

¨ Because the cash flows of the debt and

equity sum to the cash flows of the project,
by the Law of One Price the combined
values of debt and equity must be $1000.
¤ Therefore, if the value of the debt is $500, the
value of the levered equity must be $500.
n E = $1000 – $500 = $500.

451
 Financing a Firm
with Debt and Equity (cont'd)

¨ Because the cash flows of levered equity

are smaller than those of unlevered equity,
levered equity will be at a lower price ($500
versus $1000).
¤ However, you are not worse off. You will still raise
a total of $1000 by issuing both debt and levered
equity. Consequently, you would be indifferent
between these two choices for the firm’s capital
structure.

452
 The Effect of Leverage on Risk and
Return
¨ Leverage increases the risk of the equity of a
firm.
¤ Therefore, it is inappropriate to discount the cash
flows of levered equity at the same discount rate of
15% that you used for unlevered equity. Investors in
levered equity will require a higher required return to
compensate for the increased risk.
¤ A higher or lower discount rate to reflect increasing
risk?

453
 Table 14.4 Returns to Equity with and
without Leverage

454
 Table 14.4 Returns to Equity with and
without Leverage

Unlevered Equity Levered Equity

Returns 40% or -10% 75% or -25%

Expected return 15% 25%

455
 The Effect of Leverage on Risk and Return
(cont'd)
¨ The returns to equity holders are very different
with and without leverage.
¤ Unlevered equity has a return of either 40% or –
10%, for an expected return of 15%.
¤ Levered equity has higher risk, with a return of
either 75% or –25%.
n To compensate for this risk, levered equity holders
receive a higher expected return of 25%.

456
 The Effect of Leverage
on Risk and Return (cont'd)

¨ The relationship between risk and return can

be evaluated more formally by computing the
sensitivity of each security’s return to the
systematic risk of the economy.

457
 Table 14.5 Systematic Risk and Risk Premiums for
Debt, Unlevered Equity, and Levered Equity

458
 The Effect of Leverage
on Risk and Return (cont'd)

¨ Because the debt’s return bears no

systematic risk, its risk premium is zero.
Why?

459
 The Effect of Leverage
on Risk and Return (cont'd)
¨ In summary:
¤ In the case of perfect capital markets, if the
firm is 100% equity financed, the equity
holders will require a 15% expected return.
¤ If the firm is financed 50% with debt and 50%
with equity, the debt holders will receive a
return of 5%, while the levered equity holders
will require an expected return of 25%
(because of their increased risk).

460
 The Effect of Leverage
on Risk and Return (cont'd)
¨ In summary:
¤ Leverage increases the risk of equity even
when there is no risk that the firm will default.
n Thus, while debt may be cheaper, its use raises the
cost of capital for equity. Considering both sources
of capital together, the firm’s average cost of capital
with leverage is the same as for the unlevered firm:
(0.5)5%+(0.5)25%=15%.

461
 14.2 Modigliani-Miller I: Leverage,
Arbitrage, and Firm Value
¨ The Law of One Price implies that leverage
will not affect the total value of the firm.
¤ Instead, it merely changes the allocation of
cash flows between debt and equity, without
altering the total cash flows of the firm.

462
 14.2 Modigliani-Miller I: Leverage,
Arbitrage, and Firm Value (cont'd)
¨ Modigliani and Miller (MM) showed that this result
holds more generally under a set of conditions referred
to as perfect capital markets:
¤ Investors and firms can trade the same set of securities at
competitive market prices equal to the present value of their
future cash flows.
¤ There are no taxes, transaction costs, or issuance costs
associated with security trading.
¤ A firm’s financing decisions do not change the cash flows
generated by its investments, nor do they reveal new
information about them.

463
 14.2 Modigliani-Miller I: Leverage,
Arbitrage, and Firm Value (cont'd)

¨ MM Proposition I:
¤ In a perfect capital market, the total value of a
firm is equal to the market value of the total
cash flows generated by its assets and is not
affected by its choice of capital structure.

464
 MM and the Law of One Price

¨ MM established their result with the

following argument:
¤ In the absence of taxes or other transaction
costs, the total cash flow paid out to all of a
firm’s security holders is equal to the total cash
flow generated by the firm’s assets.
n Therefore, by the Law of One Price, the firm’s
securities and its assets must have the same total
market value.

465
 Homemade Leverage
¨ Homemade Leverage
¤ When investors use leverage in their own portfolios
to adjust the leverage choice made by the firm.
¤ Used as a substitute for the use of leverage by the
firm.

¨ MM demonstrated that if investors would prefer

an alternative capital structure to the one the
firm has chosen, investors can borrow or lend
on their own (assume at the same rate as the
firm) and achieve the same result.

466
 Homemade Leverage (cont'd)

¨ Assume you use no leverage and create an

all-equity firm.
¤ An investor who would prefer to hold levered
equity can do so by using leverage in his own
portfolio.

467
 14.3 Modigliani-Miller II: Leverage, Risk,
and the Cost of Capital
468

If the firm can borrow at the risk-free rate, isn’t debt a

cheaper and better source of capital than equity?
 14.3 Modigliani-Miller II: Leverage, Risk,
and the Cost of Capital
469

If the firm can borrow at the risk-free rate, isn’t debt a cheaper and better
source of capital than equity?

-Although debt does have a lower cost of capital than equity, the cost
cannot be considered in isolation.
-Debt increases the risk and therefore the cost of capital of the firm’s
equity.
-Leverage increases EPS (due to higher risk), shareholders will demand a
higher return.
-In the end, the savings from the lower cost of debt are exactly offset by a
higher cost of equity, and hence no net savings for the firm.
 14.3 Modigliani-Miller II: Leverage, Risk, and
the Cost of Capital (cont'd)

¨ Leverage and the Equity Cost of Capital

¤ The cash flows from holding unlevered equity
can be replicated using homemade leverage by
holding a portfolio of the firm’s equity and debt.

470
 14.3 Modigliani-Miller II: Leverage, Risk, and
the Cost of Capital (cont'd)

¨ Leverage and the Equity Cost of Capital

¤ The return on unlevered equity (RU) is related to
the returns of levered equity (RE) and debt (RD):

E D
RE RD RU
E D E D

471
 14.3 Modigliani-Miller II: Leverage, Risk, and
the Cost of Capital (cont'd)
¨ Leverage and the Equity Cost of Capital

¤ Solving for RE:

n The levered equity return equals the unlevered

return, plus a premium due to leverage.
n The amount of the premium depends on the amount of
leverage, measured by the firm’s market value debt-
equity ratio, D/E.

472
 14.3 Modigliani-Miller II: Leverage, Risk, and
the Cost of Capital (cont'd)

¨ Leverage and the Equity Cost of Capital

¤ MM Proposition II:
n The cost of capital of levered equity is equal to the
cost of capital of unlevered equity plus a premium
that is proportional to the market value debt-equity
ratio.
n Cost of Capital of Levered Equity
D
rE rU (rU rD )
E

473
 14.3 Modigliani-Miller II: Leverage, Risk, and
the Cost of Capital (cont'd)
¨ Leverage and the Equity Cost of Capital
¤ Recall from above:
n If the firm is all-equity financed, the expected return
on unlevered equity is 15%.
n If the firm is financed with $500 of debt, the
expected return of the debt is 5%.

474
 14.3 Modigliani-Miller II: Leverage, Risk, and
the Cost of Capital (cont'd)

¨ Leverage and the Equity Cost of Capital

¤ Therefore, according to MM Proposition II, the
expected return on equity for the levered firm
is: 500
rE 15% (15% 5%) 25%
500

475
 Textbook Example 14.4

476
 Textbook Example 14.4 (cont'd)

477
 Capital Budgeting and the
Weighted Average Cost of Capital

¨ If a firm is unlevered, all of the free cash

flows generated by its assets are paid out to
its equity holders.
¤ The market value, risk, and cost of capital for
the firm’s assets and its equity coincide and,
therefore:
rU rA

478
 Capital Budgeting and the Weighted Average
Cost of Capital (cont'd)

¨ If a firm is levered, project rA is equal to the

firm’s weighted average cost of capital.
¤ Unlevered Cost of Capital (pretax WACC)
Fraction of Firm Value Equity Fraction of Firm Value Debt
rwacc
Financed by Equity Cost of Capital Financed by Debt Cost of Capital
E D
rE rD
E D E D

rwacc rU rA

479
 Capital Budgeting and the Weighted
Average Cost of Capital (cont'd)
¨ With perfect capital markets, a firm’s WACC is
independent of its capital structure and is
equal to its equity cost of capital if it is
unlevered, which matches the cost of capital
of its assets: rWACC=Ko=Ke
¨ Debt-to-Value Ratio
¤ The fraction of a firm’s enterprise value that
corresponds to debt.

480
 Capital Budgeting and the Weighted Average
Cost of Capital (cont'd)

¨ With no debt, the WACC is equal to the

unlevered equity cost of capital.
¨ As the firm borrows at the low cost of
capital for debt, its equity cost of capital
rises. The net effect is that the firm’s WACC
is unchanged.

481
 Textbook Example 14.5

482
 Textbook Example 14.5 (cont'd)

483
 Why is capital structure important?
¨ Leverage
Higher financial leverage means potentially higher
returns to shareholders, but higher risk
(financial distress) due to higher interest payments

¨ Cost of capital
Each source of finance has a different cost. Capital
structure affects the cost of capital

¨ Optimal capital structure

The structure that minimises the firm’s cost of capital
and maximises firm value (shareholders’ wealth)
The Use of Debt
Essentially,
the change of financing mix (capital structure)
lower Ko and higher Po

Where, debt = interest exp. = tax shield

= shareholders’ wealth
Conclusion?
Can/should a company maximise its share
price and shareholders wealth by having a
capital structure of 99.9% of
Why not 100% debt?
¨ Costs associated with financial distress (can outweigh tax
shield adv.)
¤ Financing becomes difficult to obtain
¤ Customers leave due to uncertainty
¤ Possible restructuring or liquidation costs if bankruptcy (pressured
by creditors) occurs
¤ Debtors seize control
¤ Equity is wiped out, and
¤ The firm collapse
¨ Agency costs (costs to protect debt-holders)
¤ Managers act on behalf of shareholders not debt-holders:
potential conflict of interest (conflict betw. Shareholders & debt
holders).
¤ Debt covenant costs: managers need monitoring
 488

SO…
Too much debt is BAD!!!
In Reality

Moderate position
Moderate position
¨ Interest expenses are allowable tax deductions
¨ Tax deductible interest is called the tax shield
¤ Results in the cost of debt finance being even cheaper
than the cost of debt in both extreme positions
¨ However, the probability that a firm will fail
increases with the level of financial leverage
¤ Therefore: liquidation costs become important
Capital structure management in practice

Decisions are more complex than indicated in the

moderate view because:
¤ Firms tend to maintain spare debt capacity
¤ No distinction between internal and external funds
¤ Short -to medium-term borrowing is preferred to longer-
term borrowing
¤ Timing of equity and debt issues based on market
conditions is a key consideration
¤ Family-controlled companies are concerned with diluting
ownership
Pecking order theory
¨ Investment opportunities tend to drive a
company’s dividend policy
¨ Order of financing:
¤ Internally generated funds
¤ Issue of debt securities
¤ Issue of convertible securities
¤ Issue of equity securities
¨ Implication:
¤ Observed leverage ratios will reflect the cumulative
financing needs of companies over time
 Chapter 17

Payout Policy
Chapter Outline

17.1 Distributions to Shareholders

17.2 Comparison of Dividends and Share
Repurchases
17.3 The Tax Disadvantage of Dividends
17.6 Signaling with Payout Policy
Learning Objectives
1. List two ways a company can distribute cash
to its shareholders.
2. Describe the dividend payment process and
the open-market repurchase process.
3. Discuss the effect of dividend payment or
share repurchase in a perfect world.
4. Assuming perfect capital markets, describe
what Modigliani and Miller (1961) found
about payout policy.
 Free Cash Flow
¨ The cash flow available for distribution among
all the securities holders of an organization.
¨ Firms often need to decide on the use of FCF
generated by its investments.
¨ Firms of _________may have different
preferences over the use of the FCF. Example.
¨ FCF is important: allows a company to pursue
opportunities that enhance _________. Eg:
develop new products, make acquisitions, pay
dividends and reduce debt.
Free Cash Flow
¨ Some think that FCF provides a clearer view on
the firms’ ability in generating profit.
¨ Is negative FCF bad for firms?
¨ Payout policy: the way a firm chooses
between the alternatives.
Free Cash Flow

¨ Free cash flow is important because it allows a

company to pursue opportunities that enhance
shareholder value. Without cash, it's tough to
develop new products, make acquisitions, pay
dividends and reduce debt. FCF is calculated as:

¨ EBIT(1-Tax Rate) + Depreciation & Amortization - Change in

Net Working Capital - Capital Expenditure
 Figure 17.1 Uses of Free Cash Flow

Source of funds Use of Funds

Share issue + _____ + Cash = Dividend + _________

Payout Policy

¨ The overall policy concerning the distribution

of ______ from a firm to its stockholders.

Dividend
¨ Something of value distributed to a firm’s

stockholders on a pro-rata basis (in proportion

to the percentage of the firm’s shares that they
own).
 Dividend Distribution Procedure

¨ Declaration Date
¤ The date on which the board of directors
authorizes (_______) the payment of a dividend

¨ Record Date
¤ When a firm pays a dividend, only shareholders
_______on this date receive the dividend.
 Dividend Distribution Procedure

¨ Ex-dividend Date
¤ A date, two days prior to a dividend’s record
date, ________which anyone buying the stock
will not be eligible for the dividend

¨ Payable Date (Distribution Date)

¤ A date, generally within a month after the record
date, on which a firm mails dividend checks to its
registered stockholders
 Figure 17.2
Important Dates for Microsoft’s Special
Dividend

Share price is expected to fall on ex-dividend date

 Methods of Dividend Payout
¨ Regular cash dividend
- A cash dividend that is paid a regular basis. Typically
quarterly

¨ Extra Dividend
¤ A dividend paid at the same time as a regular cash
dividend to distribute additional value.
 Methods of Dividend Payout
¨ Special Dividend
¤ A one-time dividend payment a firm makes, which
is usually much larger than a regular dividend

¨ Stock Split (Stock Dividend)

¤ When a company issues a dividend in shares of
stock rather than cash to its shareholders
Share Repurchases
¨ An alternative way to pay cash to investors is through a share
repurchase or buyback.
¤ The firm uses cash to buy shares of its own outstanding stock.
Three possible ways for share repurchase

1) Tender Offer
A public announcement of an offer to all existing
security holders to buy back a specified amount of
outstanding securities at a pre-specified price
(typically set at a 10%-20% premium to the current
market price) over a pre-specified period of time
(usually about 20 days)
If shareholders do not tender enough shares, the firm
may cancel the offer and no buyback occurs
 Share Repurchases (cont'd)
1.2) Dutch Auction
¤ A share repurchase method in which the firm lists
different prices at which it is prepared to buy
shares, and shareholders in turn indicate how
many shares they are willing to sell at each price.
The firm then pays the lowest price at which it can
buy back its desired number of shares.

2) Targeted Repurchase
¤ When a firm purchases shares directly from a
specific (major) shareholder
¤ Purchase price (at premium/discount) is negotiated
directly with the seller
 Share Repurchases (cont'd)
3) Open Market Repurchase
¤ When a firm repurchases shares by buying shares
in the open market
¤ Open market share repurchases represent about
95% of all repurchase transactions.
¤ Need to oblige the SEC guidelines, and not to
appear to manipulate the price.
17.2 Comparison of Dividends and
Share Repurchases

¨ Consider Genron Corporation. The firm’s

board is meeting to decide how to pay out $20
million in excess cash to shareholders.
¨ Genron has no debt, its equity cost of capital
equals its unlevered cost of capital of 12%.
Alternative Policy 1: Pay Dividend with
Excess Cash

¨ With 10 million shares outstanding, Genron

will be able to pay a $2 dividend immediately.
¨ The firm expects to generate future free cash
flows of $48 million per year, thus it anticipates
paying a dividend of $4.80 per share each
year thereafter.
 Alternative Policy 1: Pay Dividend with Excess Cash
(cont'd)

¨ Cum-dividend
¤ When a stock trades before the ex-dividend date,
entitling anyone who buys the stock to the
dividend

¨ The cum-dividend price of Genron will be

4.80
Pcum Current Dividend PV (Future Dividends) 2 2 40 $42
0.12
Alternative Policy 1: Pay Dividend with Excess Cash
(cont'd)

¨ After the ex-dividend date, new buyers will not

receive the current dividend and the share
price and the price of Genron will be
4.80
Pex PV (Future Dividends) $40
0.12
Alternative Policy 1: Pay Div with Excess Cash (cont'd)
Computing the share price via a simple mkt value B/S
Alternative Policy 1: Pay Dividend with Excess Cash
(cont'd)

¨ In a perfect capital market, when a dividend is

paid, the share price drops by the amount of
the dividend when the stock begins to trade ex-
dividend.
¨ Otherwise, arbitrage opportunities arises.
Cum-Div (Dec 11) Ex-Div (Dec 12)
Share price $42 $40
Div - $2
Total Value $42 $42
Alternative Policy 2: Share Repurchase
(No Dividend)

¨ Suppose that instead of paying a dividend this

year, Genron uses the $20 million to
repurchase its shares on the open market.
¤ With an initial share price of $42, Genron will
repurchase 476,000 shares.
n $20 million ÷ ______ per share = 0.476 million shares

¤ This will leave only 9.524 million shares

outstanding.
n ________ − 0.476 million = 9.524 million
 Dividend Irrelevancy
Share Repurchase (No Dividend)

¨ The net effect is that the share price remains

unchanged.
 Dividend Irrelevancy
Share Repurchase (No Dividend)

¨ The net effect is that the share price remains

unchanged.
Alternative Policy 2: Share Repurchase (No
Dividend) (cont'd)

¨ Genron’s Future Dividends

¤ It should not be surprising that the repurchase
had not effect on the stock price.
¤ After the repurchase, the future dividend would
rise to $5.04 per share.
n $48 million ÷ 9.524 million shares = $5.04 per share
n Genron’s share price is
5.04
Prep $42
0.12
Alternative Policy 2: Share Repurchase (No
Dividend) (cont'd)

¨ Genron’s Future Dividends

¤ In perfect capital markets, an open market share
repurchase has no effect on the stock price, and
the stock price is the same as the cum-dividend
price if a dividend were paid instead.
Alternative Policy 2: Share Repurchase (No
Dividend) (cont'd)

¨ Investor Preferences
¤ In perfect capital markets, investors are indifferent
between the firm distributing funds via dividends
or share repurchases. By reinvesting dividends or
selling shares, they can replicate either payout
method on their own. Eg: homemade dividend
Alternative Policy 2: Share Repurchase (No
Dividend) (cont'd)

¨ Investor Preferences
¤ In the case of Genron, if the firm repurchases
shares and the investor wants cash, the investor
can raise cash by selling shares.
n This is called a homemade dividend.

¤ If the firm pays a dividend and the investor would

prefer stock, they can use the dividend to
purchase additional shares.
Alternative Policy 3:
High Dividend (Equity Issue)

¨ Suppose Genron wants to pay dividend larger

than $2 per share right now, but it only has $20
million in cash today.
¤ Thus, Genron needs an additional $28 million to
pay the larger dividend now. To do this, the firm
decides to raise the cash by selling new shares.
Alternative Policy 3: High Dividend (Equity Issue)
(cont'd)

¨ Given a current share price of $42, Genron

could raise $28 million by selling 0.67 million
shares.
¤ $28 million ÷ $42 per share = 0.67 million shares
n This will increase the total number of shares to 10.67
million.
Alternative Policy 3: High Dividend (Equity Issue)
(cont'd)

¨ The new dividend per share will be

$48 million
$4.50 per share
10.67 million shares

¨ And the cum-dividend share price will be

4.50
Pcum 4.50 4.50 37.50 $42
0.12

¨ Again, the share value is unchanged!

Modigliani–Miller
and Dividend Policy Irrelevance

¨ There is a trade-off between current and future

dividends.
¤ If Genron pays a higher current dividend, future
dividends will be lower.
¤ If Genron pays a lower current dividend, future
dividends will be higher.
Table 17.1 Genron’s Dividends per Share Each
Year Under the Three Alternative Policies

Policy 1:Pay out all cash as div.;

Policy 2:Share Repurchase (No Div);
Policy 3:Larger Div (Issue new equity).
 Modigliani–Miller and Dividend Policy
Irrelevance (cont'd)
¨ MM Dividend Irrelevance

¤In perfect capital markets,

holding fixed the investment
policy of a firm, the firm’s
choice of dividend policy is
________ and does _____
affect the initial__________.
Modigliani–Miller and Dividend Policy
Irrelevance (cont'd)
¨ In perfect capital markets, buying and selling
equity and debt are _________ transactions.
¨ Hence, no effect on firm’s value.
¨ Any choice of leverage by a firm can be
replicated by investors using homemade
leverage.

¨ Hence, the firm’s choice of capital

structure is irrelevant.
Dividend Policy
with Perfect Capital Markets

¨ A firm’s free cash flow determines the level of

payouts that it can make to its investors.
¤ In a perfect capital market, the type of payout is
irrelevant.
¤ In reality, capital markets are not perfect and it is
these imperfections that should determine the
firm’s payout policy.
17.3 The Tax Disadvantage of Dividends

¨ Taxes on Dividends and Capital Gains

¤ Shareholders must pay taxes on the dividends
they receive and they must also pay capital gains
taxes when they sell their shares.
¤ Dividends are typically taxed at a higher rate than
capital gains. In fact, long-term investors can
defer the capital gains tax forever by not selling.
17.6 Signaling with Payout Policy

¨ Dividend Smoothing
¤ The practice of maintaining relatively constant
dividends
n Firm change dividends infrequently and dividends are
much _______ than earnings.
17.6 Signaling with Payout Policy (cont'd)

¨ Research has found that

¤ Management believes that investors prefer
______ dividends with sustained growth.
¤ Management desires to maintain a long-term
target level of dividends as a fraction of earnings.
n Thus, firms raise their dividends only when they
perceive a long-term sustainable increase in the
expected level of future earnings, and ___ them only
as a last resort.
Dividend Signaling

¨ Dividend Signaling Hypothesis

¤ The idea that dividend changes reflect
_________ about a firm’s future ___________
n If firms smooth dividends, the firm’s dividend choice
will contain ___________ regarding management’s
expectations of future earnings.
Dividend Signaling (cont'd)
¨ When a firm increases its dividend, it sends a
__________ signal to investors that
management expects to be able to afford the
higher dividend for the foreseeable future.
¨ When a firm decreases its dividend, it may
signal that management has given up hope
that earnings will rebound in the near term and
so need to reduce the dividend to save cash.
Dividend Signaling (cont'd)

¨ While an increase of a firm’s dividend may

signal management’s optimism regarding its
future cash flows, it might also signal a lack of
investment opportunities.
¨ Conversely, a firm might cut its dividend to
exploit new _________investment
opportunities.
¤ In this case, the dividend decrease might lead to
a positive, rather than negative, stock price
reaction.
Signaling and Share Repurchases

¨ Share repurchases are a credible signal that the shares

are____________, because if they are over-priced a
share repurchase is costly
for current shareholders.
¤ If investors believe that managers have better information
regarding the firm’s prospects and act on behalf of current
shareholders, then investors will react favorably to share
repurchase announcements.
Practical considerations in setting a
Dividend Payout

1. Over the long term, how much does the

company’s level of earnings (CFs from
operations) exceed its investment
requirements? How _________is this level?

2. Does the firms have enough financial

reserves to maintain div payouts in periods
when earnings are down/investment
requirements are up?
 Practical considerations in setting a
Dividend Payout

3. Does the firm have sufficient __________to

maintain dividends if unforeseen circumstances
wipe out its financial reserves when earnings
are down?
4. Can the firm quickly raise capital if necessary?
5. If the company chooses to finance dividends by
selling equity, will changes in the number of
stockholders have implications for ______ of
the company?
The End
CHAPTER 23
RAISING EQUITY CAPITAL
Chapter Outline

23.1 Equity Financing for Private Companies

23.2 The Initial Public Offering
Learning Objectives
1. Describe four ways in which a private company can raise outside
capital.
2. Discuss the effects of a company founder selling stock to an
outsider.
3. Identify the two main exit strategies used by equity investors in
private companies.
4. Define an initial public offering, and discuss their advantages and
disadvantages.
5. Distinguish between primary and secondary offerings in an IPO.
6. Describe typical methods by which stock may be sold during an
IPO; discuss risks for parties involved in
each method.
Learning Objectives (cont'd)
7. Evaluate the role of the underwriter in an IPO.
8. Describe the IPO process, including the methods underwriters use
to value a company before its IPO.
Issues on Firms’ Financing
¨ Firms raise capital to acquire the productive
assets needed to grow and remain profitable.

¨ To raise money, a firm can borrow, sell equity,

or both.
Issues on Firms’ Financing
¨ The sourcing of capital depends on factors
such as the state of the firms in its life cycle, its
expected cash flows, and its risk
characteristics.

¨ The goal is to raise the amount of money

necessary at the ______ possible cost.
As is true of all firms, both Apple and
Facebook were initially funded with
private capital, including money
contributed by the founders of these
firms.
23.1 Equity Financing
for Private Companies
¨ The initial capital that is required to start a
business is usually provided by the
entrepreneur and their immediate family.
¨ Often, a private company must seek outside
sources that can provide additional capital for
growth.
¤ It is important to understand how the infusion of
outside capital will affect the control of the
company.
Sources of Funding

¨ Angel Investors
¤ Individual Investors who buy equity in small
private firms
n Contributes a relatively large amount of capital to the
newly established firms;
n Receive sizable equity share;
n May bring expertise to the firm;
n Finding angels is typically difficult.
Sources of Funding (cont'd)

¨ Venture Capital Firm

¤ A limited partnership that specializes in raising
money to invest in the private equity of young
firms

¨ Venture Capitalists
¤ One of the general partners who work for and run
a venture capital firm for limited partners
Sources of Funding (cont'd)

¨ Venture capital firms offer limited partners

advantages over investing directly in start-ups
themselves as angel investors.
¤ Limited partners are more diversified.
¤ They also benefit from the expertise of the
general partners.
Sources of Funding (cont'd)

¨ The advantages come at a cost.

¤ General partners usually charge substantial fees.
n Most firms charge 20% of any positive return they
make.
n They also generally charge an annual management fee
of about 2% of the fund’s committed capital.
Sources of Funding (cont'd)
¨ Private Equity Firms
¤ Similarly to a venture capital firm, but invests in the equity
of existing private firms rather than start-up companies.

¤ Initiate their investment by finding a publicly traded firm

and purchasing the outstanding equity,

¤ taking the company private in a transaction called a

leveraged buyout (LBO). In most cases, the private
equity firms use debt as well as equity to finance the
purchase.

¤ LBO: The acquisition of another company using a

significant amount of borrowed money (bonds or loans) to
meet the cost of acquisition.
Sources of Funding (cont'd)

¨ Institutional Investors
¤ Institutional investors such as pension funds,
insurance companies, endowments, and foundations
are active investors in private companies
n Institutional investors may invest directly in private firms
or they may invest indirectly by becoming limited partners
in venture capital firms.
Sources of Funding (cont'd)

¨ Corporate Investor
¤ A corporation that invests in private companies
¤ Also known as Corporate Partner, Strategic
Partner, and Strategic Investor
n While most other types of investors in private firms are
primarily interested in the financial returns of their
investments, corporate investors might invest for
corporate strategic objectives, in addition to the
financial returns.
Outside Investors

¨ Preferred Stock
¤ Preferred stock issued by mature companies
usually has a preferential dividend and seniority in
any liquidation and sometimes special voting
rights.
¤ Preferred stock issued by young companies has
seniority in any liquidation but typically does not
pay regular cash dividends and often contains a
right to convert to common stock.
Outside Investors (cont'd)

¨ Convertible Preferred Stock

¤ Preferred stock that gives the owner an option to
convert it into common stock on some future date
¤ The most popular hybrid securities are preference
shares and convertible notes.
Ordinary Shares

¨ Claim on income (residual claimant);

¨ Claim on assets;
¨ Voting rights;
¨ Limited liability;
¨ Pre-emptive rights
23.2 The Initial Public Offering

¨ Initial Public Offering (IPO)

¤ The process of selling stock to the public for the
first time
Advantages and Disadvantages
of Going Public
¨ Advantages:
¤ Greater liquidity
n Private equity investors get the ability to diversify.
n Eg: flexibility for existing shareholders; more straightforward
trading.

¤ Better access to capital

n Public companies typically have access to much larger amounts of
capital through the public markets.
n Gain access to an entirely new, deep and liquid source of capital
for any future needs.
n To achieve optimal capital structure
Advantages and Disadvantages
of Going Public
¨ Advantages:
¤ Branding event
n Worldwide media coverage through financial mkts.
n Fin. Reports written to further inc. the co. profile.
n Inc. in firms’ visibility, mkt shr & competitive position.

¤ Others
n Enhanced stock-based benefits for employees; public
currency for acquisitions.
Advantages and Disadvantages
of Going Public (cont'd)
¨ Disadvantages:
¤ The equity holders become more widely dispersed
(ownership concentration).
n This makes it difficult to monitor management.

¤ The firm must satisfy all of the requirements of

public companies (eg: financial disclosure,
requirements on boards of directors…)
n SEC filings, Sarbanes-Oxley, etc.
Table 23.3 Largest Global Equity Issues,
2008
Types of Offerings

¨ Underwriter
¤ An investment banking firm that manages a
security issuance and designs its structure
Types of Offerings (cont'd)

¨ Primary and Secondary Offerings

¤ Primary Offering
n New shares available in a public offering that raise
new capital

¤ Secondary Offering
n Shares sold by existing shareholders in an equity
offering
The Mechanics of an IPO

¨ Underwriters and the Syndicate

¤ Lead Underwriter
n The primary investment banking firm responsible for
managing a security issuance

¤ Syndicate
n A group of underwriters who jointly underwrite and
distribute a security issuance
The Mechanics of an IPO (cont'd)

¨ SEC Filings
¤ Registration Statement
n A legal document that provides financial and other
information about a company to investors prior to a
security issuance

¤ Preliminary Prospectus (Red Herring)

n Part of the registration statement prepared by a
company prior to an IPO that is circulated to investors
before the stock is offered
The Mechanics of an IPO (cont'd)

¨ SEC Filings
¤ Final Prospectus
n Part of the final registration statement prepared by a
company prior to an IPO that contains all the details of
the offering, including the number of shares offered
and the offer price
 Chapter 27
Short-Term
Financial Planning
Chapter Outline
27.1 Forecasting Short-Term Financing Needs
27.2 The Matching Principle

570
Learning Objectives
1. Show how future cash flow forecasts allow a company
to determine whether it has a cash flow surplus or
deficit, and whether it is a long- or short-term
imbalance.
2. Discuss the recommendations of the matching principle
with respect to long- and short-term needs for funds.
3. Describe three types of bank loans, and how they may
be used for short-term cash needs.
4. Identify the factors that affect the effective annual rate
of a bank loan.

571
 Short-Term Financial Planning
572
¨ It is important for companies to forecast their cash
flows to determine their S-T financing needs.

¨ Steps involved:
¨ 1) forecast the firm’s future CFs, i.e. surplus or
cash deficit?
¨ 2) determine if the gap is temporary or
permanent?
¨ 3) match the needs with the appropriate
financing means.
 Working-Capital Management
573
Current Assets
¤ Cash,marketable securities,
inventory, accounts receivable.
Long-Term Assets
¤ Equipment, buildings, land.

Risk-Return Trade-off:
Current assets earn low returns,
but help reduce the risk of
illiquidity.
 Working-Capital Management
574
Current Liabilities
¤ Short-termnotes, accrued expenses,
accounts payable.
Long-Term Debt and Equity
¤ Bonds, preferred stock, common
stock.

Risk-Return Trade-off:
Current liabilities are less expensive,
but increase the risk of illiquidity.
 Projected Financial Statements for Springfield Snowboards, 2013, Assuming Level Sales

575
27.1 Forecasting Short-Term Financing
Needs
¨ Firms require short-term financing for
¤ Seasonalities
¤ Negative cash flow shocks
¤ Positive cash flow shocks

576
Seasonalities
¨ For many firms, sales are seasonal.
¤ When sales are concentrated during a few months,
sources and uses of cash are also likely to be
seasonal.

577
 Projected Financial Statements for Springfield
Snowboards, 2013, Assuming Seasonal Sales
Assume that 20% of sales occur during the first quarter, 10% during each of
the second and third quarters, and 60% of sales during the fourth quarter.

578
Negative Cash Flow Shocks
¨ Occasionally, a company will encounter
circumstances in which cash flows are temporarily
negative for an unexpected reason, creating a short-
term financing needs.
¨ In the Springfield example, assume that during April
2013, management learns that some manufacturing
equipment has broken unexpectedly.
¤ It will cost an additional $1,000,000 to replace the
equipment.
n The impact is shown on the following slide.
n Note: The original assumption of level sales is used.

579
 Projected Financial Statements for Springfield Snowboards, 2013,
Assuming Level Sales and a Negative Cash Flow Shock

580
Positive Cash Flow Shocks
¨ Now assume that during the first quarter of 2013,
Springfield announces a deal where it will be the
exclusive supplier to a new major customer, leading
to an overall sales increase of 20% for the firm.
¨ The increased sales will begin in the second quarter.
¨ As part of the deal, Springfield has agreed to a one-
time expense of $500,000 for marketing.
¨ An extra $1 million in capital expenditures is also
required during the first quarter to increase production
capacity.

581
Positive Cash Flow Shocks (cont'd)

¨ The sales growth will also affect Springfield’s

required working capital.
¨ The new cash flow forecasts are shown on the
following slide.

582
 Projected Financial Statements for
Springfield Snowboards, 2013, Assuming Level Sales
and a Growth Opportunity

583
27.2 The Matching Principle

¨ Matching Principle
¤ States that a firm’s short-term needs should be
financed with short-term debt and long-term needs
should be financed with long-term sources of
funds
¤ Also known as Tenure Matching

584
Permanent Working Capital

¨ Permanent Working Capital

¤ The amount that a firm must keep invested in its
short-term assets to support its continuing
operations
n The matching principle suggests that the firm should
finance this permanent investment in working capital
with long-term sources of funds.

585
 Permanent Working capital
586

¨ Refers to the minimum amount of all current

assets that is required at all times
¨ To ensure a minimum level of uninterrupted
business operations.
¨ This part of the working capital being a
permanent investment needs to be financed
through long-term funds.
Temporary Working Capital
• The difference between the actual level of short-
term working capital needs and its permanent
working capital requirements
¤ The matching principle suggests that the firm should
finance this temporary investment in working capital
with short-term sources of funds.

587
 Temporary Working Capital
588
¨ It varies with the volume of operations, it fluctuates
with the scale of operations.
¨ The additional working capital required from time to
time over and above the permanent or fixed working
capital.
¨ Production/sales fluctuates and resulting in different
working capital needs. Seasons and off-seasons.
¨ Hence, as seasons vary, temporary working capital
requirement moves up and down.
¨ It can be financed through short term funds like

current liabilities.
 Projected Levels of Working Capital for Springfield
Snowboards, 2013, Assuming Seasonal Sales

The minimum level of working capital, $2,125,000, can be thought of as the firm’s
permanent working capital.

589
Temporary Working Capital (cont'd)

¨ The difference between this minimum level and

the higher levels in subsequent quarters
reflects Springfield’s temporary working capital
requirements.
¤ For example, in 2013Q3, the temporary working
requirements are $3,300,000.
n $5,425,000 – $2,125,000 = $3,300,000

590
 Financing Policy Choices
¨ Aggressive Financing Policy
¤ Financing part or all of a firm’s permanent working capital
with short-term debt
¤ One risk of an aggressive financing policy is funding risk.
¤ Funding Risk
n The risk of incurring financial distress costs should a firm not
be able to refinance its debt in timely manner or at a
reasonable rate

¨ Conservative Financing Policy

¤ Financing all of a firm’s permanent working capital with
long-term debt.
591
THE END