1

CHAPTER 10: CAPITAL BUDGETING AND

INVESTMENT CRITERIA
I) NET PRESENT VALUE METHOD
- Value of asset today is the sum of PVs of future cash flows.
- Net present value is the difference between an investment’s market value (in today’s
dollars) and its cost (also in today’s dollars). NPV measures the amount by which the value
of the firm will increase if the project is accepted.
𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝑵
𝑵𝑷𝑽 = 𝟏
+ 𝟐
+⋯+ − 𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝒄𝒐𝒔𝒕
(𝟏 + 𝒓) (𝟏 + 𝒓) (𝟏 + 𝒓)𝑵
Example: A project requires initial investment of $1,100 and is planned to last for 2 years.
Revenues and expenses for the first year is $1,000 and $500, respectively; for the second year
$2,000 and $1,000. Assume that all revenues and expenses are cash-basis and required return
is 10%. Should the company accept the project?
Cash flow of year 1 = 1,000 – 500 = 500
Cash flow of year 2 = 2,000 – 1,000 = 1,000
500 1,000
𝑁𝑃𝑉 = 1
+ − 1,100 = 181
(1 + 10%) (1 + 10%)2
- NPV Rule:
• Accept all projects with NPV > 0.
• Reject all projects with NPV < 0.
• For mutually exclusive projects, choose the project with the highest NPV.
1. Mutually exclusive projects
Example: The government is planning to extend the shipping facilities at Hai Phong port.
Option 1: Building a jetty.
Option 2: Building a port (deep enough to accommodate a larger variety of vessels).
The environmental considerations require that only one of the options be undertaken.
2

Assuming a required rate of return of 8% for both projects, which one of these mutually
exclusive projects would you recommend?
Option 1:
0.5 0.7 0.8
𝑁𝑃𝑉1 = + 2
+ − 1 = 0.6982 𝑚𝑖𝑙
1 + 8% (1 + 8%) (1 + 8%)3
Option 2:
1.3 1.3 1.3
𝑁𝑃𝑉2 = + + − 3 = 0.3502 𝑚𝑖𝑙
1 + 8% (1 + 8%)2 (1 + 8%)3
Because NPV1 > NPV2, choose the Jetty project.
2. Problems with NPV
- Company faces capital rationing (have limited fund and cannot invest in all positive NPV
projects).
2.1. Comparing projects with different lives
- When comparing two mutually-exclusive projects with different lives, it is necessary to
make comparisons over the same time period.
- So, we compare the annual equivalent (AE), or the annual annuity with the same NPV.
- The equivalent annual annuity (AE) approach calculates the constant annual cash flow
generated by a project over its lifespan if it was an annuity. The present value of the
constant annual cash flows is exactly equal to the project’s net present value (NPV).
Example: Machine A costs $3,000 and then $1,000 per annum for the next four years. Machine
B costs $6,000 and then $1,200 for the next eight years. The required rate of return for both
projects is 10%. If either of the machines wears out, the company would have to replace with
a new one. Which is the better project the company should choose? Assume that the two
projects bring the same benefits (profits) to the company.
Step 1: Calculate the NPV for each project
3

1
1−
(1 + 10%)4
𝑁𝑃𝑉𝐴 = −3,000 − 1,000 ∗ [ ] = −6,169.87
10%

1
1−
(1 + 10%)8
𝑁𝑃𝑉𝐵 = −6,000 − 1,200 ∗ [ ] = −12,401.91
10%

Step 2: Convert the NPVs for each project into an annual equivalent annuity.
𝐴𝐸𝐴 1
𝑁𝑃𝑉𝐴 = −6,169.87 = ∗ [1 − ]
10% (1 + 10%)4
<=> 𝐴𝐸𝐴 = −1,946.41
𝐴𝐸𝐵 1
𝑁𝑃𝑉𝐵 = −12,401.91 = ∗ [1 − ]
10% (1 + 10%)8
<=> 𝐴𝐸𝐵 = −2,324.66
Therefore, the company should choose machine A.
Example: P&G must decide which of the two machines it should use to produce its new line
of products – new generation of shampoo called Maxxhair. Machine A costs $100,000 has a
useful life of 4 years, and generates after-tax cash flows of $40,000 per year. Machine B costs
$65,000, has a useful life of 3 years, and generates after-tax cash flows of $35,000 per year.
Assume that the discount rate is 10% per year. Which machine P&G should buy?
1
1−
(1 + 10%)4
𝑁𝑃𝑉𝐴 = −100,000 + 40,000 ∗ [ ] = 26,794.62
10%

𝐴𝐸𝐴 1
𝑁𝑃𝑉𝐴 = 26,794.62 = ∗ [1 − ]
10% (1 + 10%)4
<=> 𝐴𝐸𝐴 = 8,452.92
1
1−
(1 + 10%)3
𝑁𝑃𝑉𝐵 = −65,000 + 35,000 ∗ [ ] = 22,039.82
10%

𝐴𝐸𝐵 1
𝑁𝑃𝑉𝐵 = 22,039.82 = ∗ [1 − ]
10% (1 + 10%)3
<=> 𝐴𝐸𝐵 = 8,862.54
P&G should buy machine B.
4

II) PAYBACK METHOD

1. Payback period
- The payback period is the amount of time required for the firm to recover its initial
investment.
• If the project’s payback period is less than the maximum acceptable payback
period, accept the project.
• If the project’s payback period is greater than the maximum acceptable payback
period, reject the project.
- Management determines maximum acceptable payback period (cut-off point).
Example: Initial investment = - $1,000
Year Cash flow Accumulated cash flow
1 $200 $200
2 400 600
3 600 1,200
Payback period = 2 2/3 years.
Example:
Projects CF0 CF1 CF2 CF3 Payback NPV (at 10%)
A -2,000 1,000 1,000 10,000 2 $7,249
B -2,000 1,000 1,000 0 2 -264
C -2,000 0 2,000 0 2 -347
What do you think about these 3 projects?
The payback period is the same for 3 projects. However, the NPVs of project B and project C
are negative. Therefore, these 2 projects should be rejected.
2. Pros and cons
- Advantages of payback period:
• Extremely simple.
• Helps prevent cash flow problems since cash is recovered as quickly as possible.
• Useful when technology changes rapidly. Cost of machinery is recovered before
new model comes out.
- Disadvantages of payback period:
• Ignores the time value of money.
• Ignores cash flows after the payback period.
• Arbitrary acceptance criteria.
5

• A project is accepted based on the payback criteria may not have a positive NPV.
III) INTERNAL RATE OF RETURN
- Internal rate of return (IRR) is the discount rate that results in a zero NPV for the project.
𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝟑 𝑪𝑭𝑻
𝑵𝑷𝑽 = 𝟎 = 𝑪𝑭𝟎 + + + + ⋯ +
𝟏 + 𝑰𝑹𝑹 (𝟏 + 𝑰𝑹𝑹)𝟐 (𝟏 + 𝑰𝑹𝑹)𝟑 (𝟏 + 𝑰𝑹𝑹)𝑻
- IRR found by computer/calculator or manually by trial and error.
- The IRR decision rule is:
• If IRR is greater than the cost of capital, accept the project.
• If IRR is less than the cost of capital, reject the project.
Example: Initial investment = - $200
Year Cash flow
1 $50
2 100
3 150
Find the IRR.
50 100 150
0 = −200 + + +
1 + 𝐼𝑅𝑅 (1 + 𝐼𝑅𝑅)2 (1 + 𝐼𝑅𝑅)3
<=> 𝐼𝑅𝑅 = 19.44%
1. Problems with IRR
1.1. Borrowing or lending
Project 0 1 IRR NPV at 10%
A -1,000 1,500 50% 363.64
B 1,000 -1,500 50% -363.64
Both projects have an IRR = 50%, but only project A is acceptable.
1.2. Multiple rates of returns
- Project will have multiple rates of returns in case of unconventional cash flows (there is
more than one negative cash flows).
Year Cash flows
0 -$252
1 1,431
2 -3,035
3 2,850
4 -1,000
- If you have more than one IRR, you cannot use any of them to make your decision.
6

1.3. Mutually exclusive projects

- The timing problem
0 1 2 IRR NPV
-5,000 8,000 0 60% 2,273
-5,000 0 9,800 40% 3,099
Despite having a higher IRR, project A is less valuable than project B.
- The scale problem
Year 0 1 IRR NPV
Small project -1 1.5 50% 0.43
Large project -100 110 10% 4.76
IRR does not take into account project scale (size).
2. NPV and IRR rules
- Usually, NPV and IRR are consistent with each other. If IRR says accept the project, then
NPV will also say accept the project.
- However, IRR can be in conflict with NPV if:
• Investing or financing decisions.
• Projects are mutually exclusive.
o Projects differ in scale of investment.
o Cash flows pattern of projects are different.
• Projects have unconventional cash flows.
- If IRR and NPV conflict, use NPV approach.
IV) PROFITABILITY INDEX METHOD
- Capital rationing: limit set on the amount of funds available for investment. Sometimes the
amount of capital that an organization can invest in long-term projects is limited.
- Solution: Management will obviously wish to select those projects that will give the
greatest return per dollar invested (highest profitability index).
- Profitability Index expresses a project’s benefits relative to its initial cost.
𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝟑 𝑪𝑭𝑻
𝑷𝑽 𝒐𝒇 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘𝒔 𝟏 + 𝒓 + (𝟏 + 𝒓)𝟐 + (𝟏 + 𝒓)𝟑 + ⋯ + (𝟏 + 𝒓)𝑻
𝑷𝑰 = =
𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝑪𝑭𝟎
- Acceptance criteria: accept a project with PI > 1.
Example: Assume you have the following information on Project X:
7

Initial investment = - $1,100

Required return = 10%
Annual cash revenues and expenses are as follows:
Year Revenues Expenses
1 $1,000 $500
2 2,000 1,000
500 1,000
𝑁𝑃𝑉 = + − 1,100 = 181
1 + 10% (1 + 10%)2
1,281
𝑃𝐼 = = 1.1645
1,100
8

CHAPTER 11: CAPITAL BUDGETING AND PROJECT

CASH FLOWS ANALYSIS
I) REVEVANT PROJECT CASH FLOWS COMPONENTS
1. Revelant and Irrelevant cash flows
1.1. Rule 1: Only incremental cash flows are relevant
a) Forget about sunk costs.
- A cost that has already been paid for, or incurred the liability to pay, and cannot be removed
(not incremental cash flow).
Example: Apple’s CEO is advocating the license of Apple’s operating system to some PC
vendors. A consultant is hired for $50,000 analyze. The consultant’s report concludes that
Apple should go ahead. The CEO thinks that the consultant’s fee should be included in the
project’s cash flows. What do you think?
This cost has been paid for and cannot be removed. The company incurred the liability to pay
for this cost prior to making the decision to accept or reject the project. Therefore, it is sunk
cost.
b) Include all opportunity costs.
- Cost that measures the opportunity that is lost or sacrificed when the choice of one course
of action requires that another course of action be given up.
- Opportunity cost = next best alternative use = most valuable alternative given up by the
firm.
Example: Paper mill bought 10 years ago for $100,000 is now used to build an apartment
complex. If the apartment complex is not build on this land, we can either sell it for $150,000
cash or we can lease it (forever) for $120,000.
The land is not “free” because we paid for it in the past. The relevant cash flow for this land
is the most valuable alternative, $150,000 so we have to include this to the incremental cash
flows.
c) Include all side effects.
- Side effects (project interactions): the presence of a new project will affect the cash flows
of the firm’s existing projects.
Example: New Highlands coffee eats up revenues of old Highland coffee at 2 blocks away
(product cannibalization).
Example: 3 years ago, the Jamestown Co. purchased some land for $1.24 million. The land is
valued at $1.32 million today. 6 years ago, the company purchased some equipment for
9

$189,000. This equipment has a current book value of zero and a current market value of
$39,900. What value should be assigned to the land and equipment if Jamestown Co. opts to
use both for a new project?
The land: 1.32 million.
The equipment: 39,900.
Relevant cost = 1,320,000 + 39,900 = 1,359,900.
Example: Blue Shoe currently sells (annually):
• 13,000 pairs of athletic shoes at $79 each.
• 4,500 pairs of dress shoes at $49 each.
The company is considering expanding its offerings to include sandals at $29 a pair, which
have the following effects:
• Increase annual athletic shoe sales by 800 pairs.
• Reduce annual dress shoe sales by 1,000 pairs.
Blue Shoe expects to sell 4,500 pairs of sandals yearly.
What amount should Blue Shoe use as the annual estimated sales revenue when it analyzes the
addition of sandals to its lineup?
Current revenue from athletic shoes = 79 * 13,000 = 1,027,000
Estimated revenue from athletic shoes = 79 * (13,000 + 800) = 1,090,200
Side effect of athletic shoes = 1,090,200 – 1,027,000 = 63,200
Current revenue from dress shoes = 49 * 4,500 = 220,500
Estimated revenue from dress shoes = 49 * (4,500 – 1,000) = 171,500
Side effect of dress shoes = 171,500 – 220,500 = - 49,000
Estimated revenue from sandals = 29 * 4,500 = 130,500
Total estimated sales revenue of sandals = 63,200 – 49,000 + 130,500 = 144,700
d) Recognize the investment in working capital, which is fully recovered at the end of
the project.
- Most projects entail an additional investment in working capital in addition to long term
assets. A project will need some amount of cash on hand to pay for expenses that arise
(before it collects $ from selling products). When project ends, receivables are collected,
inventories are sold, these activities free up the net working capital originally invested.
e) Beware of allocated overhead costs.
10

- Beware of allocated overhead costs (rent, heat, electricity). These overhead costs may not
be related to a particular project, but they must be paid for nevertheless.
1.2. Rule 2: Discount after-tax cash flows, not accounting profit
- Project evaluation is interested only in measuring cash flow when it actually occurs, not
when it accrues in an accounting sense. And tax is definitely a cash outflow, so always use
after-tax incremental cash flows.
- Depreciation itself is a non-cash expense; it is only relevant because it affects taxes.
• Therefore, tax depreciation is relevant, not book depreciation (if they differ).
• Depreciation tax deduction provides a “tax shield”.
- Assets are depreciated down to their estimated salvage values in the final year.
• Sales tax, delivery costs, and installation are regarded as part of the cost of the new
asset for depreciation purposes.
- More on depreciation method:
• Straight-line method.
• Accelerated method (reducing balance method).
• MACRS (Modified Accelerated Cost Recovery System).
- More on salvage value (market selling price):
• If SV > BV => gain on sale of assets.
• If SV < BV => loss on sale of assets.
• If SV = BV => no gain or loss.
• If an asset is later sold for an amount above (or below) its book value, there is a tax
effect.
𝑻𝒂𝒙𝒆𝒔 𝒐𝒏 𝒕𝒉𝒆 𝒔𝒂𝒍𝒆 𝒐𝒇 𝒂𝒔𝒔𝒆𝒕 = (𝑩𝒐𝒐𝒌 𝒗𝒂𝒍𝒖𝒆 − 𝑺𝒂𝒍𝒗𝒂𝒈𝒆 𝒗𝒂𝒍𝒖𝒆) ∗ 𝒕𝒂𝒙 𝒓𝒂𝒕𝒆
(Nếu Taxes là số âm => taxes paid, nếu Taxes là số dương => taxes received)
a. MACRS system
11

Property Class
Year 3-year 5-year 7-year
1 33.33% 20% 14.29%
2 44.45% 32% 24.49%
3 14.81% 19.2% 17.49%
4 7.41% 11.52% 12.49%
5 11.52% 8.93%
6 5.76% 8.92%
7 8.93%
8 4.46%

Example: Suppose we have an asset that falls in the 5-year MACRS classification and the
initial cost is $12,000. Calculate the depreciation and book value of this asset for each year.
Year Beginning book Depreciation Ending book value
value
1 $12,000 $2,400 9,600
2 9,600 3,840 5,760
3 5,760 2,304 3,456
4 3,456 1,382.4 2,073.6
5 2,073.6 1,382.4 691.2
6 691.2 691.2
b. Disposal of assets
- If the salvage value > book value, a profit/gain is made on disposal. This profit/gain is
subject to tax (excess depreciation in previous periods).
- If the salvage value < book value, the ensuing loss on disposal is a tax deduction
(insufficient depreciation in previous periods). A tax rebate will be given.
Example: In the previous example, assume that we would be able to sell the asset at the end of
year 5 for $3,000. Tax rate is 34%. Calculate the resulting taxes to be paid/received from selling
the asset. What is the CF from selling the asset at the end of year 5?
Taxes paid/received = (691.2 – 3,000) * 34% = -784.992
Net cash flows from selling asset = 3,000 – 784.992 = 2,215
c. Operating cash flow calculation
Example: Assume a project has the following estimates:
Sales = 1,500
Costs = 700
Depreciation = 600
Tax rate = 34%
12

Assume no interest is paid (interest is a financing expense – not an operating expense).

Calculate OCF for the project.
𝑶𝑪𝑭 = 𝑬𝑩𝑰𝑻 + 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 − 𝑻𝒂𝒙𝒆𝒔 (𝟏)
EBIT = Sales – Costs – Depreciation = 1,500 – 700 – 600 = 200
Since we assume no interest is paid
➔ Taxes = EBIT * tax rate = 200 * 34% = 68
OCF = EBIT + Depreciation – Taxes = 200 + 600 – 68 = 732
𝑶𝑪𝑭 = 𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆 + 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 (𝟐) (𝑏𝑜𝑡𝑡𝑜𝑚 − 𝑢𝑝 𝑎𝑝𝑝𝑟𝑜𝑎𝑐ℎ)
Since we ignore any financing expenses (interest)
➔ Project Net income = EBIT – Taxes = 200 – 68 = 132
OCF = Net income + Depreciation = 132 + 600 = 732
𝑶𝑪𝑭 = 𝑺𝒂𝒍𝒆𝒔 − 𝑪𝒐𝒔𝒕𝒔 − 𝑻𝒂𝒙𝒆𝒔 (𝟑) (𝑡𝑜𝑝 − 𝑑𝑜𝑤𝑛 𝑎𝑝𝑝𝑟𝑜𝑎𝑐ℎ)
OCF = 1,500 – 700 – 68 = 732
𝑶𝑪𝑭 = (𝑺𝒂𝒍𝒆𝒔 − 𝑪𝒐𝒔𝒕𝒔) ∗ (𝟏 − 𝑻𝒂𝒙 𝒓𝒂𝒕𝒆) + 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 ∗ 𝑻𝒂𝒙 𝒓𝒂𝒕𝒆 (𝟒)
(𝑡ℎ𝑒 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑 𝑎𝑝𝑝𝑟𝑜𝑎𝑐ℎ)
OCF = (1,500 – 700)*(1 = 34%) + 600 * 34% = 732
Example: Tan Hiep Phat buys a machine for $100,000 for its new line of products – “Dr. Thanh
super tea”.
2-year project.
Machine depreciated straight line over the project life.
EBDIT or (Sales – Costs) is $53,000 in the first year, $66,000 in the second year.
Tax rate 36%.
Assume no interest. What is the annual accounting income, and what is the annual net cash
flow?
Year 1 2
EBDIT $53,000 $66,000
Less: Depreciation (50,000) (50,000)
EBIT 3,000 16,000
Less: Taxes (1,080) (5,760)
Net income 1,920 10,240
OCF 51,920 60,240
1.3. Rule 3: Separate investment and financing decisions
13

- Projects must make sense regardless of how financed.

• Ignore all financing costs, even if the project is partially financed with debt.
• Financing side effects will be considered later.
• Interest costs are considered in the discount rate.
2. Investment valuation – step by step
- Step 1: Calculate the taxable income.
- Step 2: Calculate the cash flows.
Project CF components:
• Project operating cash flow (OCF).
• Project change in net working capital (NWC).
• Project capital spending.
- Step 3: Discount the cash flows.
- Step 4: Make decision using capital budgeting methods.
II) INVESTMENT VALUATION
Example: Suppose we have the following projections for the coming project:
Cans sold per year: 50,000
Price per can: $4
Variable cost per can: $2.5
Required return: 20%
Fixed costs per year: $12,000
Manufacturing equipment: $90,000
Project life (years): 3
Initial net working capital: $20,000
Tax rate: 34%
Assume straight-line depreciation. Evaluate the project.
Sales = 50,000 * 4 = 200,000
Variable costs = 50,000 * 2.5 = 125,000
Gross profit = 200,000 – 125,000 – 12,000 = 63,000
14

Depreciation cost per year = 90,000 / 3 = 30,000

EBIT = 63,000 – 30,000 = 33,000 = EBT because no interest expense.
Taxes = 33,000 * 34% = 11,220
Net income = 33,000 – 11,220 = 21,780
OCF = Net income + Depreciation = 21,780 + 30,000 = 51,780
Year 0 1 2 3
OCF 51,780 51,780 51,780
Changes in WC (20,000) 20,000
Capital spending (90,000)
Project CF (110,000) 51,780 51,780 71,780

51,780 51,780 71,780

𝑁𝑃𝑉 = −110,000 + + + = 10,647.69
1.12 1.122 1.123
51,780 51,780 71,780
𝑁𝑃𝑉 = 0 <=> −110,000 + + +
1 + 𝐼𝑅𝑅 (1 + 𝐼𝑅𝑅)2 (1 + 𝐼𝑅𝑅)3
<=> 𝐼𝑅𝑅 = 25.76%
III) SPECIAL CASES OF DCF ANALYSIS
1. Evaluating cost-cutting projects
Example: Melvin’s Machine Shop is considering the purchase of an automated machine which
costs $480,000. The company will depreciate this machine using straight line depreciation over
the machine’s six-year life. This machine is expected to reduce operating costs by $95,000 a
year. The applicable tax rate is 35%. What is the projected annual operating cash flow?
𝑂𝐶𝐹 = (𝑆𝑎𝑙𝑒𝑠 − 𝐶𝑜𝑠𝑡𝑠) ∗ (1 − 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 ∗ 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒
= (0 + 95,000) ∗ (1 − 35%) + 80,000 ∗ 35% = 89,750
2. Equipment replacement
Example: Should ABC replace its photocopy equipment every year, every 2 years, or every 3
years?
Cost of machine: $15,000 using straight line depreciation.
Discount rate is 12% p.a.
Salvage value is:
• $6,000 at the end of year 1.
• $3,000 at the end of year 2.
15

• $0 at the end of year 3.

Maintenance costs are:
• $1,000 in the first year.
• $2,000 in the second year.
• $3,000 in the third year.
Corporate tax rate 34%.
Assume that company revenues are unaffected by the replacement policy; and that Salvage
value (market selling price) = Book value (for calculating Depreciation)
- Cash flows if keep the machine for 1 year:

- Cash flows if keep the machine for 2 year:

16

- Cash flows if keep the machine for 3 year:

17
18

CHAPTER 6: RETURN, RISK, AND THE SECURITY

MARKET LINE
I) MEASURING RISK AND RETURN – INDIVIDUAL ASSETS
- Risk: the probability (chance) that an invetsment’s actual return will be different than
expected return. It can be more or less than expected return.
- People have different attitudes towards risk:
• Risk lover (seeker).
• Risk adverse.
• Risk neutral.
- Always there is risk return tradeoff: the higher the risk, the higher the return.
1. Measuring expected return
- Expected return: the weighted average of the distribution of possible returns.
𝑛

𝐸(𝑟) = ∑ 𝑝𝑖 𝑟𝑖
𝑖=1

Where:
pi: probability of state “i” happening.
ri: the return in state “i”.
n: number of possible outcomes/states.
Example:
State of economy pi: probability of state “i” ri: the return in state “i”
Boom 0.25 35%
Normal 0.5 15%
Recession 0.25 -5%

𝐸(𝑟) = 0.25 ∗ 35% + 0.5 ∗ 15% + 0.25 ∗ (−5%) = 15%

2. Measuring risk
- Risk is the variability of returns from expected return (how actual return deviates from
expected return).
- It is the statistical standard deviation of possible return.
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- Variance is a measure of the variation of possible rates of return (ri) from the expected
return.
𝑛

𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 (𝜎 2 ) = ∑ 𝑝𝑖 [𝑟𝑖 − 𝐸(𝑟)]2

𝑖=1

- Standard deviation is the square root of the variance.

𝑆𝑡𝑑𝐷𝑒𝑣 (𝜎) = √∑ 𝑝𝑖 [𝑟𝑖 − 𝐸(𝑟)]2

𝑖=1

3. Interpreting the standard deviation

- If we denote standard deviation for an investment 𝜎
• There is 68.28% probability that a return will fall within the expected return (+/-) 1 𝜎
• There is 95% probability that a return will fall within the expected return (+/-) 2 𝜎
• There is 99% probability that a return will fall within the expected return (+/-) 3 𝜎
Example:
State of economy Ri - R (Ri – R)2 Pi * (Ri – R)2
Boom 0.2 0.04 0.01
Normal 0 0 0
Recession -0.2 0.04 0.01

𝜎 2 = 0.02 => 𝜎 = 14.14%

Interpret 14.14% standard deviation:
• There is 68.28% probability that a return will fall within 15% (+/-) 14.14% or (0.86%;
29.14%)
• There is 95% probability that a return will fall within 15% (+/-) 2 * 14.14% or (-13.28%;
43.28%)
• There is 99% probability that a return will fall within 15% (+/-) 3 * 14.14% or (-27.42%;
57.42%)
- Conclusion: Standard deviation measures how far each possible return varies from the
mean (expected return).
• If small StdDev, then less risk.
• If large StdDev, then more risk.
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Example:
State of economy Pi Return on asset A Return on asset B
Boom 0.4 30% -5%
Bust 0.6 -10% 25%
Find the expected return, variance, and standard deviation.
Expected Return:
𝐸(𝑟)𝐴 = 0.4 ∗ 30% + 0.6 ∗ (−10%) = 6%
𝐸(𝑟)𝐵 = 0.4 ∗ (−5%) + 0.6 ∗ 25% = 13%
Variance:
𝜎𝐴 2 = 0.4 ∗ (30% − 6%)2 + 0.6 ∗ (−10% − 6%)2 = 3.84%
𝜎𝐵 2 = 0.4 ∗ (−5% − 13%)2 + 0.6 ∗ (25% − 13%)2 = 2.16%
Standard Deviation:

𝜎𝐴 = √𝜎𝐴 2 = 19.6%

𝜎𝐵 = √𝜎𝐵 2 = 14.7%
II) MEASURING RISK AND RETURN – TWO OR MORE ASSETS
1. Portfolio
- A portfolio is a collection of assets held by an investor (bond, stock, IOU, COD,…)
- The risk – return trade-off for a portfolio is measured by the portfolio’s expected return
and standard deviation, just as with individual assets.
2. Portfolio expected returns
- The expected return of a portfolio is the weighted average of the expected returns for each
asset in the portfolio.
𝑛

𝐸(𝑅𝑝 ) = ∑ 𝑤𝑗 𝐸(𝑅𝑗 )
𝑗=1

Where:
𝑤𝑗 : the proportion of fund invested in asset j

𝑛: the number of assets in the portfolio

Example: Assume 50% of portfolio in asset A and 50% in asset B.
State of economy Pi RA RB
Boom 0.4 30% -5%
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Bust 0.6 -10% 25%

What is the portfolio’s expected return?
What is the portfolio’s standard deviation?
(1) Weighted average of the expected return of each asset:
𝐸(𝑅𝐴 ) = 0.3 ∗ 0.4 + (−0.1) ∗ 0.6 = 0.06
𝐸(𝑅𝐵 ) = −0.05 ∗ 0.4 + 0.25 ∗ 0.6 = 0.13
=> 𝐸(𝑅𝑃 ) = 0.5 ∗ 0.06 + 0.5 ∗ 0.13 = 0.095
(2) Weighted average of the expected return of each state:
Return of portfolio in case economy boom:
= 0.3 ∗ 0.5 + (−0.05) ∗ 0.5 = 0.125
Return of portfolio in case economy bust:
= −0.1 ∗ 0.5 + 0.25 ∗ 0.5 = 0.075
Expected return of portfolio:
𝐸(𝑅𝑃 ) = 0.4 ∗ 0.125 + 0.6 ∗ 0.075 = 0.095
- Note that Var(RP) ≠ (0.5 * Var(RA)) + (0.5 * Var(RB))
Example:
State of economy Pi R(P)
Boom 0.4 0.125
Bust 0.6 0.075
Find the variance and standard deviation.
E(RP) = 0.095
𝑉𝑎𝑟(𝑅𝑃 ) = 0.4 ∗ (0.125 − 0.095)2 + 0.6 ∗ (0.075 − 0.095)2 = 0.0006

𝑆𝑡𝑑𝐷𝑒𝑣(𝑅𝑃 ) = √0.0006 = 2.45%

3. Conclusion
- Variance of portfolio is not weighted average of variances of individual assets.
- An equally weighted portfolio (50% in stock A and 50% in stock B) has less risk than stock
A or B held separately.
- By combining assets in a portfolio, the risks faced by the investor can significantly decrease
(diversification effect).
4. Why diversification reduces risk?
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𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 + 𝑈𝑛𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛

𝑅 = 𝐸(𝑅) + 𝑈 = 𝐸(𝑅) + 𝑠𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑝𝑜𝑟𝑡𝑖𝑜𝑛 + 𝑛𝑜𝑛 − 𝑠𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑝𝑜𝑟𝑡𝑖𝑜𝑛
- Actual total return differs from expected return because of the unexpected that occur.
- Systematic risk: that component of total risk which is due to economy-wide factors and
affects a large number of assets (uncertainties about GDP, interest rates, inflation,…)
- Non-systematic risk: that component of total risk which is unique to an asset or firm (strike,
death of CEO…)
5. Diversification and portfolio risk
- Diversification: The process of spreading investments across different assets, industries
and countries to reduce risk.
5.1. Non-systematic risk
- When stock price increases: new R&D, cost savings programs.
- When stock price decreases: strike, CEO death, lawsuits…
- If we hold only 1 stock, the value of our investment would fluctuate because of company’s
specific events. If we hold more than 1 stock, some will increase because of company’s
positive events and some will decrease because of negative events → cancel out the risk.
- Therefore, non-systematic risk is diversifiable.
5.2. Systematic risk
- Systematic risk affects almost all assets to some degree.
- No matter how many assets/securities we put in a portfolio, systematic risk just doesn’t go
away.
- So systematic risk is non-diversifiable.
5.3. The principle of diversification
- Diversification can substantially reduce the variability of returns without an equivalent
reduction in expected returns.
- This reduction in risk arises because worse than expected returns from one asset are offset
by better than expected returns from another.
- However, there is a minimum level of risk that cannot be diversified away - the systematic
risk.
5.4. Systematic risk principle
- The systematic risk principle states that the expected return on a risky asset depends only
on the asset’s systematic risk. WHY?
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• Non-systematic risk is essentially eliminated by diversification at no cost.

• Market does not reward risks that are borne unnecessarily.
- Risk premium: the excess return required from an investment in a risky asset over that
required from a risk-free asset.
5.5. Measuring systematic risk of an asset
- We do not look at the asset in isolation! Instead we measure the individual asset’s
sensitivity to the fluctuations of the overall market.
- The amount of systematic risk in an asset relative to an average asset is measured by the
beta coefficient - The expected percent change in the excess return of an asset for a 1%
change in the excess return of the market portfolio.
- Beta of average asset (market portfolio) = 1
- Beta of risk-free asset = 0
5.5.1. Beta facts
Value of beta
Interpretation
β<0 Asset generally moves in opposite direction with market.
β=0 Movement of the asset is uncorrelated with the movement of market.
0<β<1 Movement of the asset is generally in the same direction as, but less than the
movement of market.
β=1 Movement of the asset is generally in the same direction as, and about the
same amount as the movement of market.
β>1 Movement of the asset is generally in the same direction as, but more than
the movement of the benchmark.
5.5.2. Portfolio beta
- Portfolio Beta: is the weighted average of the Betas of participating securities.
III) THE CAPITAL ASSET PRICING MODEL (CAPM)
- CAPM decribes the relationship between risk and return.
- CAPM uses
• In calculating the required rate of return for an investment proposal, which then
becomes the discount rate, or cost of capital for that investment.
• Provide a way to calculate the return that market is expected to deliver for bearing
systematic risk
𝐸(𝑅𝑖 ) = 𝑅𝐹 + 𝛽𝑖 ∗ [𝐸(𝑅𝑀 ) − 𝑅𝐹 ]
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CHAPTER 9: COST OF CAPITAL

I) COST OF CAPITAL OVERVIEW
- The opportunity cost investors face for investing their funds in one business instead of
others with similar risk.
- Discount rate used to discount project CFs.
- Minimum required return needed on projects (hurdle rate).
- Components:
• Cost of equity (common stock).
• Cost of equity (preferred stock).
• Cost of debts (bank loans).
• Cost of debts (bonds).
1. The WACC equation
- WACC = the weighted average cost of possible sources of capital (Debt, Preferred stock,
Common stock) by market value.
E P D
WACC = ∗ R E + ∗ R P + ∗ R D ∗ (1 − TC )
V V V
E = market value of Common Equity
RE = cost of Common Equity
P = market value of Preferred Equity
RP = cost of Preferred Equity
D = market value of Debt
RD = cost of Debt
V = E + D + P = market value of Firm
TC = tax rate
2. Debt: can be bond and/or bank loan
2.1. Bond
- Market value = # bonds outstanding x market price per Bond
1
𝐷 1 − 𝐹𝑉
(1 + 𝑟)𝑛
= 𝐶∗[ ]+
𝑉 𝑟 (1 + 𝑟)𝑛
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C = coupon payment
r = YTM
FV = Par value (face value of the bond)
n = # periods until maturity
Note: Be careful if the bond’s coupon is paid annually or semi-annually or even quarterly…to
have the appropriate “r” and “n” and “coupon” in the formula.

- Cost of Bond: RD = YTM (converted from APR to EAR).

m
 APR 
- In which EAR = 1 +  − 1 ; m = # of compounding times during the year.
 m 
- If Bond coupon is paid annually then APR = EAR, no need to convert.
2.2. Bank loan
- Market value = Book value (assume floating interest rate for this course).
- Cost of Bank loan = current market interest rate on the loan (given).
3. Equity: can be common stock and/or preferred stock
3.1. Preferred stock
- Market value = # preferred shares outstanding x market price per preferred share.
D
- Cost of preferred stock = in which D = preferred dividend (constant); P0 = market
P0
price.
3.2. Common stock
- Market value = # common shares outstanding x market price per common share.
- Cost of common stock: 2 ways to calculate (which way to use depends on the information
given).
𝐷1
𝑅𝐸 = +𝑔
𝑃0
- In which D1 = Dividend in year 1; P0 = current stock price; g = growth rate of
dividend/stock price/earnings (constant growth case in stock valuation; assuming a
constant payout ratio)

OR using CAPM:

𝐸(𝑅𝑖 ) = 𝑅𝐹 + 𝛽𝑖 ∗ [𝐸(𝑅𝑀 ) − 𝑅𝐹 ]
- In which Rf = risk-free rate (in your problem it’s frequently referred to as the Government
bond/bill rates; (RM – Rf) = market risk premium;  E measures the level of systematic risk
of the stock.
- Note: Be very careful if the problem gives you information about Market return, which is
RM or market risk premium, which is (RM – Rf). Lots of students have this same mistake
on the test!!!