1

Topic 1: Basics of cash flow valuation, and personal finance

applications
Professor Camelia Kuhnen, MBA 771 – Financial Tools

Outline:

1. Course Overview
2. Time Value of Money. The Law of One Price.
3. Special Cash Flow Streams: Perpetuities, Annuities, Growing Perpetuities and Growing
Annuities
4. Applications to Personal Finance on Paper and in Excel
5. Compound Interest: Annual Percentage Rate (APR) And Effective Annual Rate (EAR)
6. Changing Interest Rates Over Time: Refinancing A Fixed Rate Mortgage

1. Course Overview
Main theme: Financial decision making for firms and for investors

In deciding which projects to take on firms worry about the cash flows from the
projects:
1. How large are are the expected cash flows?
2. At what times do the cash flows arrive? Cash flows that occur earlier are more valuable.
3. How risky are those cash flows? Risky cash flows are worth less than safe cash flows.

It is possible (to a first approximation) to decide which projects to take on without discussing
the method of financing, since investors get a fair deal (i.e., what they give equals what they
expect to receive from the firm).
 3

2. Time Value of Money

The key idea behind the Time Value of Money is that we can move cash flows through
time by looking at market interest rates. Money now is better than money later. If you have
it now, you can invest it.

Future value:
Moving money forward in time (also called “compounding” the cash flow).
You do this by investing, i.e. lending.

Present value:
Moving money backward in time (also called “discounting” the cash flow).
You do this by borrowing, or equivalently, selling off the future cash flow today.
To move money forward or backward in time we use an interest rate, denoted r.
Also called the discount rate, cost of capital, or opportunity cost of capital.

Example: I lend you 1 today. The interest rate is 7%. You repay 1.07 in a year.
PV FV

Future Value
Definition: You have an amount P today. The Future Value (FV) of P is the amount
you will have at some point in the future if you invest P today.

Assume you have 100, and can invest at 8% per year:

The value in 1 year is: $100 × 1.08 = $108.
After 2 years: $100 × 1.08 × 1.08 = $100 × 1.082 = $116.64
After n years: $100 × 1.08n

In general the future value (in n years of a cash flow P today) is:
FV = P × (1 + r) × · · · × (1 + r)
= P × (1 + r)n

Example: A bank pays 4% per year on a 2-year CD and you deposit 10,000.

FV = 10, 000 × (1 + 0.04)2 = $10, 816.

 5

Present Value
Definition: You have an amount F at some future date. The Present Value (PV) of F is
the amount that one would need to invest today to have F at the future point in time.

Example: With an interest rate of 6% what is the PV of 100, received one year from now?
$100
PV × (1.06) = $100 ⇐⇒ PV = = $94.34
1.06

Example (later arrival of cash flow): With an interest rate of 6% what is the PV of
100, received two years from now?

$100
PV × (1.06)2 = $100 ⇐⇒ PV = = $89.00
1.062

F
In general the present value (of a cash flow F in n years) is: PV = (1+r)n

The PV will equal what you can sell F for today. Present value is market value!

Multiple Cash Flows

Basic principle: To calculate the total PV or FV of a set of cash flows, just add up the
PVs or FVs of the individual cash flows. This illustrate the Law of One Price: Equivalent
investment opportunities (i.e., those with identical cash flows) must have the same market price.
Arbitrage opportunities exist in the rare situations when the Law of One Price does not
hold. In such instances it is possible to make a profit without taking any risk.
Example of the importance of the time value of money: Vaccine
- Don’t sum cash flows as is because TVM would be
A drug company is considering developing a vaccine. ignored.
Strategy A: Date: 0 1 2 3 - For Strat B: 350 at t2 & t3 are different - t2 is more valuable
because the sooner money comes to you, the more valuable.
Cash Flows: -400 200 200 200 - All cash flows must be brought to the same time period.
- A higher NPV adds more value to a firm.
Strategy B: - FV is PV compounded -> FV = PV*(1+r)^3
Date: 0 1 2 3
Cash Flows: -400 -100 350 350

Which strategy creates the most value? We cannot just add up the cash flows – cash flows
early are more valuable. What should we do instead?
 7

Example (adding up PV’s): Vaccine (continued)

Assume that the interest rate is r = 5%.

Strategy A: Date: 0 1 2 3 PV = 200 / (1.05) = 190.5

Cash Flows: -400 200 200 200 PV = 200 / (1.05)^2 = 181.4

Present Value: -400 190.5 181.4 172.8
PV = 200 / (1.05)^3 = 172.8
NPV 144.6
“NPV” means net present value. It’s often used instead of PV to indicate that some of the
cash flows are negative.

Strategy B: Date: 0 1 2 3
Cash Flows: -400 -100 350 350
Present Value: -400 -95.2 317.5 302.3
NPV 124.6

The firm should choose strategy A.

3. Valuing Special Cash Flow Streams

a. Perpetuity (e.g., console bonds issued by the UK
government)
Definition: A perpetuity is a cash flow stream that provides an identical cash flow of C
at the end of each period, forever. The cash flows from a 1 perpetuity look like this:
1.5

1
Cashflow

0.5
...
0

0 1 2 3 4 5 6 7 8 9 10 11 12
Time

Even though the sum of the payments of a perpetuity is infinite, the value is not. As long
as the interest rate is positive, the discounted value of the payments will be finite.

C C C C
Present value: P V = 1+r + (1+r) 2 + (1+r)3 + ... = r

Important: The formula gives the PV as of 1 period before the first cash flow. For example,
if the first cash flow is at t=1, the PV is as of t=0. The same applies to the next formulas
(growing perpetuity, annuity, growing annuity).
 9

b. Growing Perpetuity (e.g., dividends from a stock)

Definition: A growing perpetuity provides a cash flow of C at the end of this period,
with subsequent cash flows growing at a rate of g each period. Cash flows from a 1 growing
perpetuity look like this for g = 5%:
- The more money that comes to you sooner,
the more valuable it is.
1.5

...
Cashflow

0.5

0 1 2 3 4 5 6 7 8 9 10 11 12
Time

2
Present value: P V = C
1+r + C(1+g)
(1+r)2
+ C(1+g)
(1+r)3
C
+ ... = r−g , when r − g > 0. If cash flows start after t = 0

What if the first payment occurs today (at time 0) rather than in a year?
! "
C(1+g)2 C(1+g)3 C(1+g)2
P V = C + C(1+g)
1+r + (1+r) 2 + (1+r) 3 + ... = (1 + r) C
1+r + C(1+g)
(1+r) 2 + (1+r) 3 + ... C
= (1 + r) r−g If cash flows start at t = 0

Difference between Perpetuity & Annuity is that A has finite years. 10

c. Annuity (e.g., car loan or mortgage payments)

Definition: An annuity provides an identical cash flow of C each period, starting at the
end of this period and lasting for n periods. The cash flows for a 1 annuity look like this:

1.5

1
Cashflow

0.5

0 1 2 3 4 5 6 7 8 9 10 11 12
Time

# $
C 1
Present value: P V = r 1 − (1+r) n .

= C/r - (1/(1+r)^n) * C/r

TV of 1st Discount it back t6 value of the

perpetuity 6 periods to t0 delayed perpetuity

NB: When discounting,

you divide
 11

d. Growing Annuity Eg. Salaries

Definition: A growing annuity provides a cash flows of C at the end of this period, with
subsequent cash flows growing at a rate of g each period, and lasting for n periods.
The cash flows look like this for C = $1 and g=5%:
NB: nper function in excel requires
-ve sign.
1.5
Cashflow

0.5

0 1 2 3 4 5 6 7 8 9 10 11 12
Time

# % 1+g &n$
C
Present value: P V = r−g 1− 1+r .

n
What if r = g? Then PV = C × 1+r .

PV = C/(r-g) - 1/(1+r)^n * [C(1+g)^m] / [r-g]

Discount it Value of delayed growing

Value at t0 of
perpetuity that starts to
growing perpetuity
pay at t7.

12

4. Applications to Personal Finance on Paper and in Excel

What can you implement in Excel?

Excel has canned functions for annuities, but not for perpetuities, growing perpetuities, or
growing annuities. For those cash flow streams, just type the relevant formula into a cell.

Excel uses the following equation to work with annuities:

PMT PMT PMT FV
0 = PV + + 2
+ ··· + n
+ .
(1 + r) (1 + r) (1 + r) (1 + r)n
where
n =number of payments
r =interest rate per payment period
P V =(-) present value (principal)
F V =future value (face value).
P M T =constant periodic payment amount.

Feed in 4 of the inputs and it calculates the other!

This is done using the Excel functions PV, FV, PMT, NPER, RATE. Make sure either PV
or PMT is negative when using NPER.
 13

Example (annuity, find P V ): An insurance company is selling an annuity of 10,000 per

year for 20 years. What is the market price if r = 5%? Payments are made at the end of each
year.
' (
1 1
PV = C × 1−
r (1 + r)n
' (
1 1
= 10, 000 × × 1−
0.05 1.0520
= 10, 000 × 12.46 = 124, 622.1
In Excel: = P V (r%, n, P M T, F V, type) = P V (5%, 20, −10000). Note: ”type” is 0 if the 1st
payment occurs at t=1 (default option), or 1 if the 1st payment occurs at t=0.

Example (loan, find C): A car loan of 20,000 comes with a 12% annual interest rate
over 5 years. The borrower makes annual payments at the end of each year. What are the
payments?
' (
1 1
PV = C × 1−
r (1 + r)n
' (
1 1
20, 000 = C × 1−
0.12 (1.12)5
= C × 3.60
Hence C = 5, 548.19. In Excel: = P M T (r%, n, P V, F V, type) = P M T (12%, 5, −20000).

14

Example (bank deposits, find F V ): How much will you have in the bank in 5 years if,
starting in a year, you deposit 1,000 each year, and you earn 5%/year?
F V = P V × (1 + r)n
' (
1 1
= C× 1− × (1 + r)n
r (1 + r)n
' (
1 1
= 1, 000 × 1− × (1.05)5
0.05 (1.05)n
= $5, 525.63
In Excel: = F V (r%, n, P M T, P V, type) = F V (5%, 5, −1000)

@t=5 - Has 4 years to compound.

1000 1000 1000 1000 1000

0 1 2 3 4 5
1000 * (1.05)^4
Sum of these
1000 * (1.05)^3
gives the
1000 * (1.05)^2 same value as
1000 * (1.05)^1 FV formula
1000 * (1.05)^0
 15

Example (pension planning, find C): A pension fund manager must fund a 10M
obligation due in 10 years. What annual contributions are needed? Suppose r = 5%.
F V = P V × (1 + r)n
' (
1 1
= C× 1− × (1 + r)n
r (1 + r)n
' (
1 1
10M = C × 1− × (1.05)10
0.05 (1.05)10
= C × 12.58.
Hence
10M
C= = 0.795M : He must invest 795 thousand each year.
12.58
In Excel: = P M T (r%, n, P V, F V, type) = P M T (5%, 10, 0, −10000000)

C C C C FV of growing annuity = $10M

0 1 2 3 10

16

Example (paying off a loan, find n): An entrepreneur borrows 300,000 today. The
interest rate is 8%. If the entrepreneur makes annual payments of 45,000 per year, how many
years will it take to repay the loan?
' (
1 1
PV = C × 1−
r (1 + r)n
PV × r 1
= 1−
C (1 + r)n
1 PV × r
n
= 1−
(1 + r) C
PV × r
ln(1) − n × ln(1 + r) = ln(1 − )
C
ln(1 − P VC×r )
n = −
ln(1 + r)
ln(1 − 300,000
45,000 × 0.08)
= −
ln(1.08)
= 9.90 years.
In Excel: = N P ER(r%, P M T, P V, F V, type) = N P ER(8%, −45000, 300000)
 17

5. Compound Interest: Annual Percentage Rate (APR) And

Effective Annual Rate (EAR) Effective Annual Yield - what you
actually pay
With compound interest you earn interest on your interest. The compounding
interval tells you how frequently interest is accumulated.
What if interest is assigned twice per year, or each month, or each day, rather than just at
the end of the year?
Calculate the interest rate per compounding period. From then on, our formulas
work as usual. Take APR and divide it by the number of compounding intervals to get effective
interest rate.
Example: A bank offers a one-year CD paying a 6% annual percentage rate (APR),
compounded semi-annually. You invest 10,000. How much do you have in a year? In two
years?
6%
This means that the interest rate per six-month period is: 2 = 3%.

At the end of the year you have: 10, 000 × (1 + 0.03)2 = 10, 000 × 1.0609 = 10, 609.
You earn an effective annual rate (EAR) of 6.09%. 6.09 increase for every dollar.

After two years, you will have: 10, 000 × (1.03)4 = $11, 255. $10k compounded at 3% each month for
This could also be calculated as: 10, 000 × (1.0609)2 = $11, 255. 4 times, that is, after 2 years.

18

Concepts:
Compounding intervals per year, k: How many times per year interest is assigned.

Annual percentage rate, APR: Not interesting in itself, but allows you to compute
the interest rate per compounding period. By definition:
rAP R
Interest rate per compounding period = .
k

Effective annual rate, EAR: The interest rate you really earn per year, taking account
of interest on interest. Also called annual percentage yield (APY) or effective annual yield
(EAY). Calculated as follows:
1 + EAR = (1 + Interest rate per compounding period)k .
Or equivalently:
# rAP R $k
1 + EAR = 1 + .
k
Once you have the EAR, it works like any annual return: After after t years you have
# rAP R $tk
(1 + EAR)t = 1 + .
k
 C C C
PV = C + C + ……. + C
(1+r) (1+r)^2 (1+r)^60

19
0 1 2 …….. 60
Example (car loan): You purchase a car for 20,000 with 5,000 down and the remaining
15,000 financed at an APR of 10% compounded monthly over 5 years.

Suppose you make monthly payments. What are the monthly payments? What effective
annual rate do you pay?
The value of the payments today is the PV. The PV of the
Interest rate per month= rAPk R = 10%
12 = 0.83%.
annuity has to be equal to the price of the car less the
amount downpaid.
Your payment stream is an annuity with:
n = 5 × 12 = 60 payments

r = 0.83% The interest rate must match the frequency of the cash flows. (The effective
interest rate for the compounding period)
P V = $15, 000

A monthly payment C of:

) *
1 1 10%
PV = C × 1− ⇐⇒ C = PMT( , 60, −15000) = $318.71
r (1 + r)n 12

We get that: 1 + EAR = (1 + 0.83%)12 =⇒ EAR = (1 + 0.83%)12 − 1 = 10.47% > 10%

Paying more than 10% APR due to the monthly compounding.

Banks will advertise the APR rate for credit cards, but the EAR for savings accounts to
make it look more attractive.
0.83% 0.83% 0.83% 0.83%
$1 + some effective interest
rate amount.
20
1 2 3 4 11 12

Harder: What if you only make quarterly payments? Compounding is still monthly.
To use the annuity formula we need a quarterly interest rate

The interest rate per month is unchanged – we did not change the compounding frequency.
How much interest do you earn in a quarter?
(1 + Interest rate per month)3 = (1 + 0.83%)3 = 1.02521
- r is different because it has to match the frequency of cash flow
so the interest rate per quarter is 2.52%.
over the length of the window.
Your payment stream is an annuity with: - The interest doesn’t change.
n = 5 × 4 = 20 payments.

r =2.52% - The only time you can divide APR by some number is when it is the
number of compounding intervals. So in this case, k remains as 12.
P V = $15, 000

A quarterly payment C of:

) *
1 1
PV = C × 1− ⇐⇒ C = PMT(2.52%, 20, −15000) = $964.11. > (3*318.71)
r (1 + r)n
- There is a greater payment because interest is accrued on months where there were no cash flows.
- The investor has nothing to reinvest, therefore you have to repay a greater amount.
 C C C

0 1 2 3 …. 6 ……. 20

Monthly to Quarterly
Need to know how to discount quarterly
0.83 0.83 0.83
cash flows.

0 1 2 3
Effective quarterly rate:

(1 + 0.83%)^3 = 1 + EQR
EQR

If EQR (not a standard term - quarterly) is given:

eg. EQR = 5%

EMR EMR EMR

0 1 2 3 …. 6

EQR

1 + EQR = (1 + EMR)^3 Because there are 3 months every quarter.

so EMR = (1+5%)^1/3 - 1

For 6 months (semi-annually) -> The quarterly rate (EQR) is compounded twice.

(1 + EQR)^2 = 1 + ESR
ESR = (1 + 5%)^2 -1

From effective monthly to semi-annually:

1 + ESR = (1 + EMR)^6 There are 6 periods.

 21

How important is the compounding frequency? Let rAP R =5%:

k Value of 1 in a year EAR - If k increases then EAR will increase.
Semi-annually 2 1.050625 5.0625%
Monthly 12 1.051162 5.1162%
Daily 365 1.051268 5.1268%
Hourly 8,760 1.051271 5.1271%

Continuous compounding is just the limit of this: limk→∞(1 + rAP R /k)k = erAP R
The value of a dollar at the end of one year, invested at an APR of rAP R , continuously
compounded is: erAP R = exp(rAP R )
e ≈ 2.71828 (the base of the natural logarithm).
One dollar invested at 5% continuously compounded yields e0.05 = 1.051271 dollars at the
end of a year.
In two years the dollar grows to: 1.0512712 = e0.05 × e0.05 = e2×0.05 = e0.10 = 1.10517.

22

6. Changing Interest Rates Over Time:

Refinancing A Fixed Rate Mortgage

Take-aways:
How to calculate mortgage payments.
How to break mortgage payments up into interest and principal.
How to find the principal owed at any point in time.
Refinancing decisions: How to deal with cases where market interest rates change over time
– when to use the ”old” and the ”new” interest rate.

You buy an 800,000 home with a 20% down payment. You borrow the remaining 640,000 by
taking out a 30-year mortgage with a 6% APR, monthly compounding and monthly payments.
C C C
1. Compute the monthly payment:
Annuity:
n = 30 × 12 = 360
r = 6%
12 = 0.5% per month
P V = 640,000 hence: 0 1 2 ……. 360
C = P M T (0.5%, 360, −640000) = 3,837.12
 23

2. Let’s break your first and second payment up into interest and principal.
It = Pt−1 × r is interest paid in month t
Rt = C − It is principal repaid in month t
Over time, more money goes towards the principle instead of interest

P0 = 640,000 Interest Paid

I1 = 640,000 × 0.5%= 3,200

R1 = 3,837.12- 3,200= 637.12 $
P1 = 640,000 - 637.12= 639,362.88
I2 = 639,362.88 × 0.5%= 3,196.81
Principle Paid
R2 = 3,837.12- 3,196.81= 640.31
Months

3. How much do you still owe (i.e. what’s the remaining principal) after 5 years?
Interpretation: You can get out of your current mortgage by paying the lender the
remaining principal today.

Method 1 (slow): Keep going as we did above. Principal still owed=Amount borrowed
minus principal repaid so far (see Excel)= P0 − R1 − R2 − R3−...

Method 2 (fast): Principal still owed=PV of remaining payments at contract interest

rate

24

Using Method 2, the principal still owed at t = 60: We need to compare the PVs given the new interest rate.

# $
C 1
Pt = r 1 − (1+r) n−t = P V (0.5%, 300, −3837.12) = 595,547.88.
Important: We used 6% for all our calculations. We never needed to know how interest
rates for new mortgages have changed since you bought the house – this is not relevant
as long as you stick with your current mortgage. It is relevant for deciding whether you
should stick with your current mortgage!
4. After 5 years of payments, mortgage rates drop from 6% to 5% for a 30-year loan. You will
have to pay 2,000 in fees to refinance (loan application fees, recording fees, title insurance,
etc.). Assume you would add these costs to the new mortgage. Should you refinance?
Refinancing means that you pay off your current lender what is owed (the remaining
principal) by taking out a new mortgage (from the same or another lender).
I set it up so you will take out another 30-year loan if you refinance. Therefore, we
cannot just compare the monthly payments in the two scenarios (different number of
payments). Instead, calculate the PV of the monthly payments in the two scenarios.
 25

If you refinance: We need to find the value of the cash flows from the old lender as of today.
The size of your new mortgage is: 595,547.88 + 2,000= 597,547.88.

The PV of the payments on new mortgage is also 597,547.88.

You can calculate the PV of the payments on the new mortgage by first working out
your new monthly payment and then discounting them back – but you already know
the answer! Just to check:
– We can obtain the new monthly payment: C = P M T ( 5%
12 , 360, −597, 547.88) = 3,207.77

– The PV# of the new

$ monthly payments, using the going market interest rate is:
PV= r 1 − (1+r)n =PV( 5%
C 1
12 , 360, -3207.77)= 597,547.88

– The PV will equal the amount borrowed since you used the annuity PV formula
to calculate the payment (C), then used the exact same formula to discount the
payments to get their PV!

Important: We used 5% for all our calculations.

3837 + ……….. + 3837
= $656k
[1+(5%/12) [1+(5%/12)^300
- We use the new rate because we want to know the PV today using today’s interest rate.
- The initial lender doesn’t want the borrower to pre-pay because they wouldn’t get back the same value of C. In this case, he’d
need someone to pay 656k to get the same C as the previous customer - They don’t like refinancing because they can’t
generate the same cash flow.
- If you aren’t staying in a home long enough then refinancing doesn’t make sense (5 months min.)

26

So should you refinance? This is the only place it gets tricky to keep track of what
interest rate to use where.
If you do not refinance, you owe P60 = 595,547.88 on your current mortgage (from (3),
calculated using 6% in all our calculations).
You can get out of this mortgage, by paying exactly this amount. But, if you don’t,
you expect to pay 3,837.12 per month for 25 years. The market value of this cash flow
stream now that the market interest rate is 5% is: = P V ( 5%
12 , 300, −3837.12) = 656,378.50.

Conclusion:

You should refinance, because the value of your payments to your lender (whoever they
are, depending on the scenario you consider) is 656,378.50 if you do not refinance, and
597,547.88 if you refinance.
 27

The principles we applied:

Calculate loan payments using the contract interest rate (6% for the old mortgage, 5%
for the new mortgage).
You find the principal still owed by discounting the remaining payments using the
contract interest rate.
The only tricky part is the PVs (i.e. the market values) of a set of payments. You
calculate those using the going market interest rate. We did this for both the new and
old mortgage payments when we wanted their PV.

5. Would your answer to (4) change if you expected to sell your house shortly (tomorrow,
say)? What will you owe your lender after selling your house?

If you do not refinance you will owe your current lender: 595,547.88

If you refinance you will owe your new lender: 597,547.88

Conclusion: In this case, you should not refinance, because you do not have time to
benefit from the low interest rate.

Topic 2: Bonds
Professor Camelia Kuhnen, MBA 771 – Financial Tools

Outline:
1. Bond basics:
(a) What is a bond? How do you calculate the return?
(b) Types of bonds. Why are fixed-rate bonds risky?

2. Bond valuation: Price=PV of expected coupon and principal payments

(a) Zero coupon bonds and the zero-coupon yield curve
(b) Coupon bonds
(c) Valuing project cash flows using the zero-coupon yield curve

3. Price sensitivity to yield curve shifts: duration analysis

4. Duration matching (immunization against interest rate risk)
 2

1. Bond basics
(a) What is a bond?
A bond is a security issued to raise money from investors today in exchange for a specified
stream of promised future payments.
• Payments are made until a final repayment date, called the maturity date.
The remaining time from today to the maturity date is called the term of the bond.

• Bonds typically make two types of payments to investors:

– Coupons, C: The promised interest payments are called coupons.
– Face Value, F: The principal or face value of the bond is a notional amount
used to compute the coupons. In addition, the investor receives the face value of the
bond at maturity.

• The coupon rate determines the amount of each coupon payments.

– The coupon rate is expressed as an APR. The size of each coupon payment is
Coupon Rate × Face Value
C= . = APR / k
Number of Coupon Payments per Year

• In the US, coupon payments are typically annual or semi-annual.

C C C
3

Examples:
0 6m 12m 10y
• A coupon bond with an 8% coupon rate, a face value of F=$1,000, a maturity of 10 years,
and semi-annual coupon payments pays
You get this bond today by paying a price at time 0.
8% × $1, 000
C= = $40
2
at t=1,2,...,20 (where t=1 is 6 months from the date of issue, and t=20 is 10 years from
the date of issue) and an additional $1,000 at t=20.

• A zero-coupon bond with a face value of F=$1,000 and a maturity of 10 years pays $1,000
10 years from the date of issue.

What is the return on a bond?

• If you hold it from t to t + 1:

+ve return if time
Pt+1 − Pt Ct+1
between t & t+1 +
has increased bcz + P,-t . Pt
+,-.
of cap. gain/appreciation.
Return from capital gain + Return from coupon payments
If t + 1 is the maturity date, then replace Pt+1 by Principalt+1.
 4

(b) Types of bonds

• Treasuries: Bonds issued by the US Federal Government. Considered default-free.
Treasury bills – Initial maturity<1 year. Are zero-coupon bonds.
Treasury notes and bonds – Initial maturity≥1, ≤30 years. Are coupon bonds. When gov wants to raise money

These come with some risk because the company may not have money down the
• Corporates: Issued by corporations. road to repay in the future.
Commercial paper – Initial maturity<270 days. Are zero-coupon bonds.
Corporate bonds – Initial maturity≥270 days. Are typically coupon bonds.

• Municipal bonds: Issued by US municipalities

• Agency and GSE-backed mortgage pools (mortgage backed securities)

Played important role in 2008 financial crisis. They look like coupon bonds but they aren’t risk-free.

• Credit rating agencies (Moody’s, S&P, Fitch) provide ratings such as Aaa, Aa, A, Baa, Ba,
B, Caa, Ca, C etc.
• The ratings reflect the estimated default probability and the estimated recovery rate
for the security in default.
AAA - very small chance of defaulting, that is, the payments will arrive to buyer exactly as promised and on time.
Probability decreases as alphabet increases.

5
Government is safest because they can always print
Why are fixed-rate bonds risky? more money to repay loans.

1. Cash flow news: Takes several forms for bonds:

• Default risk: You may not get the promised coupon payments or principal payments.
• Inflation risk: Relevant for nominal bonds – you may not be able to buy much with
the nominal payments.
2. Discount rate news: If discount rates go up unexpectedly and you sell the bond prior
to maturity, the price you can sell at will be lower than expected.
Value of a bond today (price people are willing to pay) is the value today of the promised cash flows of the bond. It’s the
cash flows from the future discounted back depending on when in the future the cash flows arrive. If interest rates go up then
the price today of a bond is going to fall because the discounted value of its future cash flows is now a lower number because
you’re dividing that future cash flow by 1 + higher int. rate than before. So the price of a bond changes are int. rates move around
& value of bond portfolio will move.
 6

2. Bond valuation
(a) Zero coupon bonds and the zero-coupon yield curve F

Consider a j-year zero coupon bond with a face value of $F:

0 Bj j
• It pays F dollars j years from now. The price is the PV of this cash flow. Denote the price
by Bj . you expected to get from it

• Therefore, once you observe the price, you can infer what interest rate the market is using
for cash flows that arrive j years from now! It is called the yield to maturity on the
j-period zero coupon bond and is denoted yj .

Price of a j-period zero coupon bond with face value F :

) *1/j
F F
Bj = j ⇐⇒ yj = Bj
− 1.
discounting it back (1 + yj )
• If you buy the bond at the price Bj today and hold it to maturity, you earn an annual
return equal to yj . IRR - investment in buying the bond ; the one discount rate that if applied to all the cash flows of an
investment including the purchase price will set the NPV of buying the asset to be equal to zero.
• The yield to maturity is simply the internal rate of return to buying the bond (the
rate that sets the NPV of buying the bond to zero): −Bj + F j = 0.
(1+yj )
This is the int. rate that the market requires. If the government wants to borrow money over the next j years then the market
demands an annual interest rate of yj.

• The convention for most bonds is to report prices per 100 units of face value. Then
) *1/j
100 100 Eg. j = 3 ; B3 = $92, that is, the price paid today to
Bj = j
⇐⇒ yj = − 1. get $100 in the future.
(1 + yj ) Bj

y3 = [(100/92) ^ 1/3] - 1 = 2.83%

Constructing the zero-coupon yield curve from STRIPS prices:

• The most commonly know zero-coupon bonds are U.S. Treasury STRIPS. Prices of
these STRIPS are reported, for example, in the Wall Street Journal. The prices are
reported as price per 100 dollars of face value.

• The plot of the yield on zero coupon bonds as a function of the time to maturity j is the
(zero coupon) yield curve or term structure.
If the government needs to borrow money over
Yield the next 1 year
Yield (annual int rate) for longer maturities are higher
because the lender doesn’t get their money back for a
long time. And the lender needs to be compensated
for higher risk.

Maturity
 8

What drives the yield curve?

• The level of the yield curve: Determined by the real interest rate (fairly stable over time)
and inflation (less stable over time)

• The slope of the yield curve: Related to the higher risk of long bonds relative to short
bonds

• The twists and turns of the yield curve: Related to the business cycle.

The bond market is good at predicting recessions.

C C 9
C

(b) Coupon Bonds

Price Pj 0 1 2 j
Consider a j-year coupon bond with a face value of $F and annual coupon payments of $C:
• It pays C dollars each year (t=1,2,...,j) and an additional F dollars j years from now.
• The price is the present value of this cash flow. Denote the price by Pj .
• Suppose you have already calculated the zero-coupon yield curve. Then you know how to
discount each of the cash flows and price the coupon bond.

Price of a j-year coupon bond with face value F and annual coupon payments C
C C C C +F PV of coupon + face value
Pj = + 2
+ ... + j−1
+
B1 = 100/(1+y1)
(1 + y1) (1 + y2) (1 + yj−1) (1 + yj )j
or expressed directly in terms of the zero-coupon bond prices Since the yield curve is not flat, we have to use
1/(1+y1) = B1/100 different annual cash flow rates.
B1 B2 Bj−1 Bj
Pj = C × +C × + ... + C × + (C + F ) × .
100 100 100 100
PV of cash flows to be received at t=1
If this relationship between zero-coupon bond prices and the coupon bond price was not satis-
fied, there would be an arbitrage opportunity.
 10

Example: You are given the opportunity to purchase a 5 year coupon bond with an annual
coupon rate of 10% and a face value of $1000. Also you know the following from the market
for Treasury STRIPS:

Years to Maturity 1 2 3 4 5
Bj STRIPS Prices 98 95 92 89 85 Price of zero-coupon bond
yj STRIPS Yields 0.0204 0.0260 0.0282 0.0296 0.0330

What is the most that you would pay for the coupon bond?
100 100 100 100 1100
Price = P V = + 2
+ 3
+ 4
+ = $1, 309
(1.0204) (1.0260) (1.0282) (1.0296) (1.0330)5
or equivalently
98 95 92 89 85
Price = P V = 100 × + 100 × + 100 × + 100 × + 1100 × = $1, 309
100 100 100 100 100

11

Calculating the yield to maturity y of a coupon bond:

The yield to maturity, y, is again defined as the internal rate of return to buying the bond. It
is given by the equation:
C C C C +F
Pj = + + ... + + .
(1 + y) (1 + y)2 (1 + y)j−1 (1 + y)j

Example: Find the yield to maturity of the 5 year coupon bond with an annual coupon rate
of 10% and a face value of $1,000. This coupon bond has a price of $1,309.
100 100 100 100 1100
$1, 309 = + 2
+ 3
+ 4
+ 1. $B < $F — Discount: Yield Above
(1 + y) (1 + y) (1 + y) (1 + y) (1 + y)5 2. $B = $F — Par: Yield Equal
which using the IRR (or solver function) in Excel gives y = 3.21%. 3. $B > $F — Premium: Yield Below

• Terminology: When the bond price is lower than/equal to/higher than the face value we
say that the bond trades at a discount/at par/at a premium, respectively. When this
happens the yield is above/equal to/below the coupon rate.
Coupon IRR is an approx of how investment will grow and therefore a rough estimate of how good your investment is.
Since it is an approximation we can’t use yields from coupon bonds to come up with yield to maturity rates.
 12

Important:
• The yield to maturity on a zero coupon bond corresponds to the annual return you earn if
you hold it to maturity.

• The yield to maturity on a coupon bond is only an approximation to the annual

return you will earn if you hold the coupon bond to maturity. Why?
– The IRR is only the same as the annual return if we are able to reinvest any intermediate
cash flows at a return equal to the IRR.

• Since the yield on the coupon bond does not correspond to a rate at which you can borrow
or lend at any horizon it is not useful for discounting!
– For valuation we need the yields on the zeros.

13

(c) Valuing cash flows using the zero-coupon yield curve

Example: Suppose that you are considering an investment in a project that generates the
following cash flows with perfect certainty:

Date 1 2 3 4
Cash Flow 50 100 100 50

You also know the discount bond prices:

Maturity Date 1 2 3 4
Bj 98 95 92 88
yj 0.0204 0.0260 0.0282 0.0325

What would you be willing to pay for this project?

 14

Method I (use prices of zero coupon bonds):

B1 B2 Bn
P V = C1 × + C2 × + ... + Cn ×
100 100 100
98 95 92 88
= 50 × + 100 × + 100 × + 50 × = 280
100 100 100 100

Method II (use yields to maturity of zero coupon bonds):

C1 C2 Cn
PV = + 2 + ... +
1 + y1 (1 + y2) (1 + yn)n
50 100 100 50
= + 2
+ 3
+ = 280
1.0204 1.0260 1.0282 1.03254

15

3. Price sensitivity to yield curve shifts: Duration analysis

Consider the following bond mutual funds:
• Vanguard Long-Term Treasury Fund (VUSTX)

• Vanguard Short-Term Treasury Fund (VFISX)

We can easily find information about each fund: fund total net assets, number of bonds, average
maturity, average duration, etc.

• Which fund is riskier? Which fund will decline in price most, in percentage terms, if interest
rates increase from one day to the next?

Answer: The riskier fund is VUSTX because it has a higher duration .

If you knew all the bonds these funds own, then for each of the two funds you could calculate
the PV of all cash flows from coupons and principal payments at both yield curves and see
how they differ under the two interest rate scenarios (current and post rate hike). Often you
don’t know all the bonds. Even if you do, you may be fine with an approximate answer. The
duration of the each fund gives you a simple way to understand which fund is most sensitive
to changes in interest rates.
 16

• For simplicity, we’ll consider only cases where the yield curve is flat and shifts up/down
from one level to another.

Definition: The duration of a security that pays cash flows C1, C2, ..., CT is:
P V (C1) P V (C2) P V (CT )
D=1× +2× + ··· + T × .
P V (C1, C2, ..., CT ) P V (C1, C2, ..., CT ) P V (C1, C2, ..., CT )
Note that the PV of all the cash flows, P V (C1, C2, ..., CT ), is just the price of the security.

Result: The sensitivity of the price of a security to changes in the yield curve
is approximately given by
D
% Change in value of security ≈ − × Change in yield (in % points)
1+y
where y is the level of the yield curve before any changes.

100
Intuition: Think of the formula for the price of zero coupon bonds: Bj = (1+y) j . The
duration of a j-year zero coupon bond is just j. The result then simply formalizes the idea that
the higher is j, the more the PV or price moves when the yield changes since there are more
years of discounting.

17

Example, zero coupon bond: Consider a 20-year zero coupon bond with $1,000 face
value. Currently the yield curve is flat at 5%. What is the duration of this bond? If interest
rates fall to 4.5%, how much will its price change?
• The duration is D = 20 years. The percentage price change is:
20
% Change in Bond Price ≈ − × (−0.5%) = 9.52%.
1.05
Example, coupon bond: Consider a 2-year 8% coupon bond with face value $1,000. The
yield curve is flat at 5%. What is this bond’s duration? By how much will the price of this
bond change if the yield curve moves up by 1 percentage point?

Time (horizon) 1 2
Cash flow $80 $1080
PV of cash flow (at r = 5%) $76.19 $979.59
$76.19 $979.59
Weight = PV/Total PV Weight on horizon i $1,055.78 = 0.0722 $1,055.78 = 0.9278

• The current price of the bond is $76.19 + $979.59 = $1, 055.78.

• The duration of the bond is the value weighted average of the horizons of its cash flows:
D = 1 × 0.0722 + 2 × 0.9278 = 1.9278
• If the yield curve moves up by 1 percentage point, the price of this bond will change by
approximately − 1.9278
1.05 × 1% = −1.836%.
 18

Duration of a portfolio:
• If you have a portfolio, you could calculate all the cash flows and apply the standard
duration formula. However, if you have the duration of each of the assets (and liabilities)
in the portfolio, it is easier to use the following expression.

• The duration of a portfolio is a value-weighted (portfolio-weighted) average of the

durations of the assets (and liabilities) in the portfolio.
) * ) *
Value(Security1) Value(Security2)
DPortfolio = DSecurity 1× +DSecurity 2× +· · ·
Portfolio Value Portfolio Value

– If a security is a liability, the portfolio weight for that security will be negative.
– The duration of a portfolio of assets and liabilities can be greater than the maturity of
all the individual securites held. It can also be negative!

– The percentage change in the portfolio in response to a yield curve shift is as above:
Dportf olio
% Change in portfolio value ≈ − × Change in yield (% points).
1+y

19

Duration facts:

1. Maturity: A longer maturity increases the duration of a bond (for given coupon rate and
yield).

2. Coupon rate: A higher coupon rate decreases the duration of a bond (for a given yield
and maturity).
• Intuition: More weight on the earlier dates – “on average” cash flows arrive sooner the
higher the coupon rate.
• The duration of a coupon bond is always less than its maturity. The duration of a
zero-coupon bond is just the maturity.

3. Yield: A higher yield decreases the duration of a bond (for given coupon rate, maturity).
• Intuition: In present value terms, the later cash flows matter less when yields are higher.
The weights on the later cash flows are smaller.
 20

4. Duration matching (immunization against interest rate risk)

Duration matching is a term for adding or subtracting assets or liabilities to your portfolio
so as to make the duration of the portfolio equal to zero, i.e., to immunize the portfolio to
interest rate risk. Other terms for this process are hedging and immunization.

Example: Suppose that you are the CEO of a bank. The bank’s balance sheet looks like this
(all values are market values) and someone has been nice and calculated the duration of each
of the assets and each of the liabilities:
Market Value ($M) Duration (Years)
Assets, A
Cash 10 0
Auto loans 120 2
Mortgages 170 8
300 ?
Liabilities, L
Checking and savings accounts 120 0
CDs 90 1
Long-term debt 75 12
285 ?
Equity=A-L 15 ?

21

1. What is the duration of assets, of liabilities, and of equity?

10 120 170
DA = ×0+ ×2+ × 8 = 5.33 years
300 300 300
120 90 75
DL = ×0+ ×1+ × 12 = 3.47 years
285 285 285
A L 300 285
DE = DA−L = × DA − × DL = × 5.33 − × 3.47 = 40.67 years.
E E 15 15
2. You want to shorten the assets in order to set the duration of equity to zero (i.e. immunize
equity from shifts in the yield curve). Suppose you sell some of the mortgages and hold the
proceeds in cash. How many of the mortgages should you sell (in market value terms)?
• What asset duration do we need?
A L 300 285
DE = DA−L = × DA − × DL = × DA − × 3.47 = 0 ⇐⇒ DA = 3.30.
E E 15 15
• Denote by X the dollar amount of mortgages sold. Then
10 + X 120 170 − X
DA = ×0+ ×2+ × 8 = 3.30 ⇐⇒ X = 76.3M.
300 300 300
 1

Topic 3: Stocks
Professor Camelia Kuhnen, MBA 771 – Financial Tools

Outline:
1. Stock basics: What is a stock? How do you calculate the return?
2. Stock valuation: The Dividend Discount Model (DDM)
(a) The general principle: Price=PV of expected dividends
(b) The Gordon growth model, constant growth version
(c) The Gordon growth model, two-stage version
(d) Approaches to terminal values and when to use P/E ratios for valuation
3. Additional insights from the Gordon growth model:
(a) When is growth good for shareholders?
(b) Understanding the present value of growth opportunities

1. Stock basics
What is a stock? How do you calculate the return?
• Stockholders are the owners of a company. Stockholders earn the cash flows left over
after the company has met its obligations to employees, suppliers, taxes, debt holders etc.

• The company (on shareholders’ behalf) decides how much of this to pay out this year as a
dividend and how much to retain inside the company. That is:

Earnings = Dividends + Retained Earnings.

The amount kept inside the company is invested in new projects or to grow existing business.
This enables growth, i.e. higher earnings and thus higher dividends in the future.

• As a stockholder you therefore get the following cash flows:

– A stream of (hopefully growing) dividends while you own the stock (and cash from
stock repurchases)
– A cash flow upon sale, which (hopefully) ensures you a capital gain.
 3

• Between time t and time t+1 the total return to a share of stock is:
Pt+1 − Pt DIVt+1
+
+ P ,-t . + P ,-t .

Return from capital gain (capital gain rate) + Return from dividends (dividend yield)
This is the realized return. The expected return could have been different.

• You can either buy stocks in the primary market at an initial public offering (IPO) or
seasoned equity offering (SEO).
– These shares are bought directly from the issuer and raise capital for the firm.

• Or, you can buy stocks in the secondary market for shares.
– These shares are bought from existing shareholders. These trades do not raise capital
for the firm.
– The principal secondary markets for shares in the US are the NYSE and NASDAQ.

2. Stock valuation: The Dividend Discount Model

(a) The general principle: Price=PV of expected dividends
Starting point: The price of a stock is set such that the stock’s expected return equals that
of other stocks with similar risk.

Implication: Price=PV of expected future dividends.

Example: In one year firm ABC is expected to pay dividends of DIV1 = 5 and trade at
P1 = 50. The return investors expect to earn on stocks with risk similar to ABC’s risk is
r∗ = 0.10.
• Then the price today P0 must be set so that
P1 − P0 DIV1 P1 + DIV1 55
+ = r∗ ⇐⇒ P0 = ∗
= = $50.
P0 P0 1+r 1.1
The price today (P0) is the PV of the expected payoff in a year, discounted at the rate r∗.

• Why must this hold? If ABC’s stock price was $49.50, then you could expect a return of
P1 − P0 DIV1 50 − 49.50 5
+ = + = 0.111.
P0 P0 49.50 49.50
Seeing this, investors would sell other stocks in this risk class and rush to buy ABC, thus
pushing up ABC’s stock price (to $50). Conversely if ABC’s stock price was above $50.
 5

• But how do investors set P1? Investors expect the price at time 1 to be set the same
way as the price at time 0, i.e. as the PV of the expected payoff at time 2
# $
P2 +DIV2
P2 + DIV2 DIV1 + P1 DIV 1 + 1+r ∗ DIV1 DIV2 P2
P1 = ⇐⇒ P0 = = = + +
1 + r∗ 1 + r∗ 1 + r∗ 1 + r∗ (1 + r∗)2 (1 + r∗)2
so P0 is also the PV of expected payoffs from holding ABC for 2 years!

• What if we go out T years?

/T
DIVt PT
P0 = +
t=1
(1 + r ∗ )t
(1 + r∗)T

• If we let T go to infinity, then

/∞
DIVt
P0 = .
t=1
(1 + r∗)t
Eliminating the PT term reflects an assumption that, if we look out far enough, the PV of
the future dividends the firms stock price represent at that time is tiny (when discounted
back to today) in comparison to the PV of the dividends we will receive before then.

• Bottom line: This is how you should value a stock, regardless of how long you
intend to hold it. If you sell the share, the purchaser buys it for the PV of its future
dividends from then on.

(b) The Gordon growth model – constant growth version

The Gordon growth model is a simple model for forecasting dividends and valuing
them to get the stock price. It relies on the general principles that earnings are either:
(a) Paid out as dividends, or
(b) Retained in the firm to generate growth in capital (tangible and intangible) and thus growth
in future earnings and dividends.

The model makes some simplifying assumptions:

1. The firm is expected to live forever and is financed only with equity (i.e. has no debt).
2. The firm’s profitability, measured by return-on-equity is constant over time.
3. A constant fraction of earnings is paid out as dividends. The rest is reinvested.
4. The firm invests out of retained earnings only (called internal financing). No new shares
are issued. No shares are repurchased.
5. The firm’s cost of capital will remain constant at r, where r > g.

Under these (restrictive) assumptions we will show that dividends will be a growing perpe-
tuity and the stock price will be Pt = DIV t+1
r−g .
 7

The mechanics of the model:

1. You start out the year at time t with a known amount of capital.
• BEt, book equity per share: We will call it book equity, but think of it more
precisely as the replacement cost of all the firm’s tangible and intangible capital.
2. You run the firm using this capital (plus some employees) and generate some earnings:
• ROE, return on equity: Cash flow (per share) generated by capital, net of main-
taining productive capacity, as a percentage of book equity per share (BE).

• EPSt+1, earnings per share: The total cash flow that is available (per share) to
be paid out as dividends or to be reinvested in the firm, net of maintaining the the
company’s productive capacity. Often computed as Net Incomet/Shares Outstandingt.
EPSt+1 = ROE × BEt.

3. You decide how much to pay out and how much to reinvest:
• POR, payout ratio: Fraction of earnings paid out in the form of dividends.
DIVt+1 = POR × EPSt+1.

• PBR, plowback ratio: Fraction of earnings reinvested (retained) in the firm.

New capital boughtt+1 = PBR × EPSt+1.

• P OR + P BR = 1 since no new capital is raised and no shares repurchased.

4. At the end of the year, you have more capital:
BEt+1 = BEt + PBR × EPSt+1 = BEt + PBR × ROE × BEt
BEt+1 − BEt
⇐⇒ = PBR × ROE.
BEt
5. So next year you have more earnings and more dividends:
EPSt+2 = ROE × BEt+1 : Same growth rate as book equity
DIVt+2 = POR × EPSt+2 : Same growth rate as earnings and book equity
6. So the growth rates of book equity, earnings, and dividends are all equal and
given by
g = PBR × ROE.
Shortcut! Often you can get analyst forecasts for the growth rate.

In sum: Dividends are a growing perpetuity, so the stock price is

DIVt+1 POR × EPSt+1 POR × ROE × BEt
Pt = = =
r−g r−g r − PBR × ROE
(and it will also grow at rate g).
 9

Note that if we observe Pt we can use the formula to infer the expected return:
DIVt+1
r= + g.
Pt

Example: Fledgling Inc. has book equity per share of $36. It has ROE of 18% and is expected
to pay out 30% of its earnings each year as a dividend. If investments with a similar level of
risk have discount rates of 14% what is the stock price of Fledgling Inc?

DIV1 POR × EPS1 POR × ROE × BE0 0.3 × 0.18 × 36

P0 = = = = = $138.57.
r−g r−g r − PBR × ROE 0.14 − 0.7 × 0.18

Note: If we want the value of all the equity, just multiply P0 by the number of shares out-
standing, or (easier) just use total earnings and total book equity for EPS and BE in the above
formulas.

10

(c) The Gordon growth model – two-stage version

Suppose now that the conditions for the Gordon growth model are not met, because profitability
and thus growth will change over time. Suppose that growth is unusually high or low until
some time T, and then stabilizes and is constant (at glate) thereafter. Then use the general
formula from earlier :
/ T
DIVt PT
P0 = +
t=1
(1 + r) t
(1 + r)T
• PT is the usual expression from the standard Gordon growth model
DIVT +1
PT =
r − glate
with glate = P BRlate × ROElate,
and DIVT +1 = P ORlate × EP ST +1 = P ORlate × ROElate × BET .

• If growth is constant and equal to gearly up to time T , then dividends for the first T years
are a growing annuity with gearly = P BRearly × ROEearly . In that case:
0 ) *T 1 ' (
DIV1 1 + gearly 1 DIVT +1
P0 = 1− +
r − gearly 1+r (1 + r)T r − glate
where DIV1 = P ORearly × EP S1.
 11

Example: Find the time 0 stock price of a firm for which:

• From year 1 through 8, ROE = 15% and PBR = 80%.
• From year 9 on, ROE = 10% and PBR = 40%.
• BE0 = $50. r = 10%.
Step 1: Work out the growth rate for year 1 to 8, gearly , and the growth rate
from year 9 on, glate.
gearly = P BRearly × ROEearly = 0.8 × 0.15 = 0.12
glate = P BRlate × ROElate = 0.4 × 0.10 = 0.04

Step 2: Work out the PV of DIV1,...,DIV8

DIV1 = P ORearly × EP S1 = P ORearly ×!ROEearly × BE 0 = 0.2 × 0.15 × 50 =$1.5/share
1.5
% 1+0.12 &8"
P V of DIV1, DIV2, ..., DIV8 = 0.1−0.12 × 1 − 1+0.10 = $11.63

Step 3: Work out P8

BE8 = (1 + gearly )8 × BE0 = (1 + 0.12)8 × 50 = $123.80
DIV9
P8 = r−g = 0.6×0.1×123.80
0.10−0.04 = $123.80. Why BE8 = P8? Because ROE = r from t=8 on.
late

Step 4: Work out P0

$123.90
P0 = $11.63 + (1+0.10) 8 = $69.38. Why P0 > BE0 ? Because ROE > r for the first 8 years,
hence the firm is running its capital stock profitably.

12

(d) Approaches to terminal values and when to use P/E ratios

for valuation
The price at the start of the stable growth period is often called the terminal value.
We calculated it using the standard (one-stage) Gordon growth model, but it is common to
investigate the sensitivity of the result to the approach used. A popular alternative is to use
P/E ratios for mature firms in the industry. Then
PT = (P/E)mature × EP ST .
Pt Pt
Definitions: Current price-earnings ratio: EP St . Forward price-earnings ratio: EP St+1 where
EP St+1 is a forecast.
In the one-stage Gordon growth model, the forward price-earnings ratio is
Pt POR POR
= =
EPSt+1 r − g r − PBR × ROE

It’s common to call stocks with high P/E ratios growth stocks and stocks with low PE-ratios
value stocks. In practice there are lots of stocks with high P/E ratios and low growth (i.e.,
low PBR) and conversely. The terminology forgets the role of ROE.

Using P/E ratios of other firms to value a company’s stock: When can we use
this approach?
 13

3. Additional insights from the Gordon growth model

(a) When is growth good for shareholders?
The payout ratio is a decision variable! You should choose it to make Pt as big possible. A
lower payout ratio leads to higher growth g, but is that always good for the stock price? No!
That is, what is the price per
Example: ROE = 5% forever, r = 8%, BE0 = 20, Payout Ratio = 100%. What is P0? share of the firm
EPS @ t1
DIV1 P OR×ROE×BE0 1×0.05×20 1 Since the growth rate,
P0 = r−g = r−P BR×ROE = 0.08−0×0.05 = 0.08 = $12.50/share. Note that g = 0×0.05 = 0%. which is driven by the
Because the profitability number and the
payout ratio is 100% payout policy, is constant,
What if the payout ratio is decreased to 50%? What is P0 then? (retain all earnings) then the dividend is a
growing perpetuity.

P0 = DIV
r−g =
1 P OR×ROE×BE0
r−P BR×ROE = 0.5×0.05×20
0.08−0.5×0.05 = 0.5
0.055 = $9.09/share. Note that in this case
g = 0.5 × 0.05 = 2.5%.

Bottom line: Increasing the growth rate is bad when ROE < r. This is because the firm is
investing at a lower rate of return than what investors can get elsewhere. In fact, management
should shut down this firm, sell its assets for $20/share, and make shareholders better off by
$20 − $12.50 = $7.50/share.
The firm is worth more being shut down, because then you’d get the value of its capital stock (which is $20 book equity).

14

Example: ROE = 10% forever, r = 8%, BE0 = 20, Payout Ratio = 100%. What is P0?

1×0.1×20 2
P0 = 0.08−0×0.1 = 0.08 = $25/share. Note that g = 0 × 0.1 = 0%.

What if the payout ratio is decreased to 50%? What is P0 then?

0.5×0.1×20 1
P0 = 0.08−0.5×0.1 = 0.08−0.05 = $33.33/share. Note that here g = 0.5 × 0.1 = 5%.

Bottom line: Increasing the growth rate is good when ROE > r. In general, management
should consider raising external capital to the point where the ROE on marginal investment
is driven down to r.
 15

(b) Understanding the present value of growth opportunities

How much of the price of a stock is due to growth opportunities (PVGO)?
• Using the Gordon growth model: Calculate the price twice, with and without growth, and
compare. In the good growth example, PVGO=$33.30-$25.00=$8.33/share.

• In the one-stage Gordon growth model you can calculate the PVGO in one step as:
This tells us how much of the value this
company has in the market is driven by their EPSt+1 Value of the firm’s dividends
growth opportunities. PVGO = Pt − Cashflow/r (that is, val of perp)
r
Price per share of a firm today
where Pt the price with growth. Why? if they decided not to grow
anymore (all dividends, no RE)
– If the firm chose a plowback ratio of zero, it would have no growth, and Pt = EPS
r
t+1
.

– If ROE>r the firm will not chose a plowback ratio of zero. We will observe a price
above EPSt+1/r and the difference is the present value of growth opportunities, PVGO.

• In the one-stage Gordon growth model you can also calculate the PVGO as:
How ROE compares the the cost of capital. If +ve then# $
the firm should grow, if -ve then is worth more if it ROE − 1 × PBR × EPS
stops growing. r t+1
PVGOt = .
r−g
– Why? The firm grows by plowing back earnings. The NPV of plowing back earnings

16

at t + 1 is (−investment) + (PV of extra earnings from investment):

) *
ROE × PBR × EPSt+1 ROE
NPVt+1 = −PBR×EPSt+1 + = − 1 ×PBR×EPSt+1
r r
The NPV’s of plowing back earnings grow at rate g (since earnings do), so they are a
growing perpetuity. Therefore, PVGOt= NPV t+1
r−g .

– Note that the IRR to investing is just the ROE!

• If you observe the market price, and assuming the one-stage Gordon growth model frame-
work is reasonable, you can back out the market’s perception of the PVGO.

Example: Amazon.com vs. other retail firms

 1

Topic 4: Options
Professor Camelia Kuhnen, MBA 771 – Financial Tools

Outline:
1. Option basics
2. Option payoffs at expiration
3. Put-Call Parity
4. Factors affecting option prices
5. Exercising options early
6. Equity as a call option
7. Black-Scholes formula for pricing call options: Intuition

1. Option basics
An option contract gives its owner the right, but not the obligation, to buy or sell an asset at
a fixed price at some future date. A call option gives the owner the right to buy the asset.
A put option gives the owner the right to sell the asset.

Details of option contracts:

• Exercising the option: enforcing the agreement to buy or sell the asset at the agreed-upon
price.

• Strike price or exercise price: price at which option holder buys or sells the asset
when the option is exercised.

• American options: holder may exercise the option on any date up to and including a
final date called the expiration date.

• European options: holder may exercise the option only on the expiration date, and not
before.
Note: American/European terminology has nothing to do with the geographical location
where these options are traded.
 3

2. Option payoffs at expiration

Call value at expiration: C = max(S − K, 0)

Put value at expiration: C = max(K − S, 0)

 5

Q: What are the payoffs at expiration for the parties that sold calls or puts?

A: The mirror images of the payoffs of the buyers, or holders, of calls or puts.

Profit from holding a Call option to expiration

 7

Profit from holding a Put option to expiration

3. Put-Call Parity

Figure 2: Payoff if buy zero-cpn Bond with face-value K and a

Figure 1: Payoff if buy Stock and a Put Call
 9

Since the payoffs at expiration from these two strategies are the same, the Law of One Price
implies that prices of European calls and puts must be such that the following relationship,
known as put-call parity, holds:

S + P = P V (K) + C

where S = stock price, P = put price, K = strike price and C = call price.

10

4. Factors affecting option prices

All else equal:

lower higher
If Strike Price K is higher: Call price C is , Put price P is .

higher lower
If Stock Price S is higher: Call price C is , Put price P is .

higher
If Stock Price S is more volatile: Call price C and put price P are .

If Exercise Date is further in the future: American options are worth more. Not necessarily
true for European options. Think about two comparisons: (1) Compare a 6-month Ameri-
can option with a 1-year American option. The right to delay exercising the option is worth
something; (2) Compare a 6-month European call option with a 1-year European call option
on a stock that will pay a dividend in 8-months. The latter won’t allow you to get this dividend.
 11

5. Exercising options early

It is never optimal to exercise an American call option on a non-dividend paying stock. You are
always better off selling the call. This is because the price of any call option on a non-dividend
paying stock exceeds its intrinsic value, which is what you get if you immediately exercise, i.e.,
S − K. Proof: C = S + P − P V (K) ≥ (S − K + P ). So you will never exercise an American
call on a non-dividend paying stock early. As a result, the price of such an American call is
equal to the price of the Euro call with the same parameters.

It may be optimal to exercise early an American put option on a non-dividend paying stock, in
certain situations: e.g., when the put is deep in the money, which happens if the firm is near
bankruptcy, so S is close to 0. Then, you are better off exercising the American put early, get
(almost) K, which is the maximum payoff from the put, and invest it.

For American options on dividend-paying stocks the right to exercise calls or puts early is
generally valuable. This is easier to see for calls. There is a trade-off between the benefits of
waiting to exercise the call option and the loss of dividend caused by waiting before exercising
the call.

12

6. Equity as a call option

Application of options to corporate finance: Equity is a call option on the assets of the firm,
with the strike price equal to the value of the debt outstanding.

E.g. Consider a firm that must pay

$100 Million (face value) to debt hold-
ers at the end of the year. Re-
call that equity holders are residual
claimants, that is, they get whatever
is left (if anything) after debt holders
are paid. It turns out equity is a call
on the firm’s assets (i.e., overall cash
flows) with strike=$100 Million, the
face value of debt.

What types of investments do equity holders prefer, then? Riskier ones or safer ones?
 13

7. Black-Scholes formula for pricing call options: Intuition

Black-Scholes Price of a Call Option on a Non-Dividend Paying Stock:

C = S × N (d1) − P V (K) × N (d2)

where S = current price of the stock, T = number of years left to expiration, K = exercise
price, σ = annual volatility (standard deviation) of the stock return, P V (K) = present value
(price) of a zero-coupon bond that pays K on the expiration date of the option, N (d)√= the
probability that a normally distributed variable is less than d , and d1 = ln[S/P
√
V (K)]
+ σ 2 T and
√ σ T
d2 = d1 − σ T .

Next: Intuition for this formula, and applications.

Topic 5: Risk, diversification, and optimal portfolios

Professor Camelia Kuhnen, MBA 771 – Financial Tools

Outline:
1. The Cost of Capital for Risky Projects
2. What Risks do Investors Care About?
3. Understanding Diversification – Two Risky Assets
4. Understanding Diversification – Many Risky Assets
5. Portfolios of a Riskless Asset and One Risky Asset
6. Optimal Portfolio Choice With a Riskless Asset and Two or More Risky Assets
7. Equilibrium: The Mean-Variance Efficient Portfolio=The Market Portfolio
 2

1. The Cost Of Capital For Risky Projects

In the capital budgeting/project choice exercises we have done so far we have sidestepped the
question of where to get the discount rate, or cost of capital, when the cash flows from the
project are risky. We need it to calculate the NPV.

• The cost of capital has two components:

Cost of capital = Risk-free interest rate + Risk premium
– The risk-free interest rate is the cost of capital for projects with riskless cash flows
– Risk Premium is the premium for risk investors require to invest in projects with risky
cash flows.

• We already know how to find the appropriate risk-free interest rate:

– The yield on zero coupon bonds of appropriate maturity.

• To find the risk premium we’ll need to understand what risk investors
care about

It turns out that you cannot evaluate project risk, without thinking about what else
investors hold in their portfolio
• Investors care about the overall average return and risk of their portfolio
• Need to figure out how much extra risk the project introduces into the portfolio
• This will depend on how the return on the project comoves with the return on the assets
investors already hold!

Therefore we need to figure out what smart investors hold in their portfolio!
• Smart investors diversify
• What exactly do smart investors hold?
• If this is how smart people invest, then what is the firm’s cost of capital?

Bottom line:
• Learn how to form an optimal investment portfolio (Investor).
• Learn how to calculate the cost of capital for risky projects (Manager).
 4

2. What Risks do Investors Care About?

For individual stocks expected returns are NOT proportional to standard deviations (or
total risk)!

Why not?
• The expected return on a stock is not determined by the total risk of the
stock (the standard deviation)
• It is determined by the part of the risk investors cannot diversify away – the undiversi-
fiable risk (also called systematic risk or market risk and captured by β).
– The risk premium for diversifible risk (also called unsystematic risk or firm-specific
risk) is zero!
– We will need to understand diversification to be more precise about this!

• This implies that you don’t get paid extra to be poorly diversified! You just get more risk!
 6

3. Understanding Diversification – Two Risky Assets

• When we combine two (or more) risky assets into a portfolio, the risk of the portfolio will
depend on the variance of each security, but also on the covariance of the returns.

• The covariance of two returns is the expected product of the deviations of the
two returns from their means:
n
/
cov(rA, rB ) = σA,B = E[(rA − E(rA))(rB − E(rB ))] = pj × (rA,j − E(rA))(rB,j − E(rB ))
j=1

• We can estimate the covariance based on a set of T years of historical data:

T
1 /
Estimate of Covariance = (rA,t − rA,t)(rB,t − rB,t)
T − 1 t=1
Excel: Use the COVAR function, but multiply the result by T/(T-1) (Excel wrongly
divides by T, not T-1).

• A useful way to rescale the covariance is to compute the correlation – it is always between
1 and -1:
cov(rA, rB )
corr(rA, rB ) = ρA,B =
σA σB
Excel: Use the CORREL function.

Risk and Return of a Portfolio of Two Risky Assets

• xA and xB are the fractions of the value of portfolio p that is invested in asset A and B,
respectively. With two assets, xB = (1 − xA).
• The realized return on portfolio p is:

r p = x A · rA + x B · rB

• The expected return on portfolio p is:

E(rp) = xA · E(rA) + xB · E(rB )

• The variance of the portfolio is:

σp2 = x2AσA2 + x2B σB2 + 2xAxB cov(rA, rB )
or, since ρAB = cov(rA, rB )/(σA · σB ),

σp2 = x2AσA2 + x2B σB2 + 2xAxB ρAB σAσB .

2
• The standard deviation of the portfolio is: σp = σp2.
 8

Example: At the beginning of this month you invest $30K in Microsoft (MSFT) stock and
$50K in Johnson & Johnson (JNJ) stock. Suppose that:
• The expected the monthly return is 1.2% for MSFT and 0.5% for JNJ.
• The standard deviation of monthly returns is 11.6% for MSFT and 6.5% for JNJ.
• The correlation of the returns on the two stocks is 0.18.

What is the expected monthly return on your portfolio?

30 50
E(rp) = xA · E(rA) + xB · E(rB ) = · 1.2% + · 0.5% = 0.7625%
30 + 50 30 + 50
What is the variance and the standard deviation of our portfolio?
σp2 = x2AσA2 + x2B σB2 + 2xAxB ρAB σAσB =
= 0.3752 · 0.1162 + 0.6252 · 0.0652 + 2 · 0.375 · 0.625 · 0.18 · 0.116 · 0.065 = 0.004179

√
so the standard deviation is 0.004179 = 0.0646 or 6.46% per month, less than either of
the two stocks’ standard deviations! (How is this possible?)

Suppose the realized returns for this month turn out to be 5.48% for MSFT and -1.93% for
JNJ. What is the realized return on your portfolio?
rp = xA · rA + xB · rB = 0.375 · 5.48% + 0.625 · (−1.93%) = 0.85%.

Possible combinations of expected returns

and return standard deviations
Objective: Combine risky assets A and B to form a portfolio P. For various combinations of
A and B, plot E(rp) against σp.
• We’ll calculate E(rp) and σp for many portfolios, defined by the weights xA and xB .
E(rp) = xA · E(rA) + xB · E(rB )
2
σp = x2AσA2 + x2B σB2 + 2xAxB ρAB σAσB

• One portfolio gives one point on the line. The line will be called the minimum variance
frontier (also sometimes called the mean variance frontier).

• As an example we will assume that we can trade in asset A and asset B with these features:
E(rA) = 25%, σA = 75%.
E(rB ) = 8%, σB = 25%.

• Notice that the variance of the portfolio also depends on the correlation between the two
securities. To develop intuition for how correlation affects the risk of the possible portfolios,
we will derive the minimum variance frontier under several different assumptions:
ρAB = 1, ρAB = 0.5, ρAB = 0, ρAB = −0.5, ρAB = −1.
 10

• To construct the minimum variance frontier for a given value of ρAB , calculate the expected
returns and return standard deviations for many different portfolios of A and B.
• In Excel, for ρAB = 0.5:
xA xB σp E(rp )
0 1 0.250 0.080
0.05 0.95 0.258 0.089
0.1 0.9 0.270 0.097
0.15 0.85 0.286 0.106
0.2 0.8 0.304 0.114
0.25 0.75 0.325 0.123
0.3 0.7 0.347 0.131
0.35 0.65 0.371 0.140
0.4 0.6 0.397 0.148
0.45 0.55 0.423 0.157
0.5 0.5 0.451 0.165
0.55 0.45 0.479 0.174
0.6 0.4 0.507 0.182
0.65 0.35 0.537 0.191
0.7 0.3 0.566 0.199
0.75 0.25 0.596 0.208
0.8 0.2 0.626 0.216
0.85 0.15 0.657 0.225
0.9 0.1 0.688 0.233
0.95 0.05 0.719 0.242
1 0 0.750 0.250

• Examine the row for portfolio P where assets A and B each represent half the value of the
portfolio, i.e., xA = 0.5 and xB = 0.5, to see how E(rp) and σp are obtained. The expected
return of portfolio
√ P is E(rp) = 0.5 · 25% + 0.5 · 8% = 0.165, and the standard deviation
of P is σp = 0.52 · 0.752 + 0.52 · 0.252 + 2 · 0.5 · 0.5 · 0.5 · 0.75 · 0.25 = 0.451.

11

The Role of Correlation

If we plot the two last columns against each other, we get the minimum variance frontier. I
have included all five of them (for the different values of the correlation) in one picture.
 12

Bottom line:
1. For ρA,B = 1 there is is no diversification benefit. Then
σp2 = x2AσA2 + x2B σB2 + 2xAxB σAσB = (xAσA + xB σB )2 , and σp = xAσA + xB σB
so the portfolio standard deviation is simply the weighted average of the standard devia-
tions of the two assets.

2. For ρA,B = 0.5 there is a diversification benefit. The portfolio standard deviation is
now less than the weighted average of the standard deviations of the two assets. Thus by
diversifying you can get less risk for the same expected return or higher expected return
for the same risk. The diversification benefit is even bigger for ρA,B = 0, ρA,B = −0.5,
and especially for ρA,B = −1.

3. For ρA,B = −1 it is even possible to get a risk of zero:

σp2 = x2AσA2 + x2B σB2 − 2xAxB σAσB = (xAσA − xB σB )2 , and σp = xAσA − xB σB
which is zero for xA/xB = σB /σA = 1/3, i.e. xA = 0.25 and xB = 0.75.

13

Extending the Minimum Variance Frontier to Allow for

Shorting
For ρA,B = 0.5
 14

4. Understanding Diversification – Many Risky Assets

We have seen that by holding a portfolio of risky assets, rather than just one risky asset, we
can reduce risk. This is true as long as the returns have a correlation less than one. Let’s:
• Illustrate the power of diversification with real data and in very well diversified portfolios.
• Show why it is covariances (or, equivalently, correlations) that drive the extent of diversi-
fication possible.
• Understand diversifiable risk and undiversifiable risk.

Consider a portfolio with n risky assets. xi is the proportion of wealth invested in asset i.

The return on the portfolio is:

n
/
rp = x 1 r1 + x 2 r 2 + · · · + x n r n = x i ri
i=1

The expected return on the portfolio is:

n
/
E(rp) = x1E(r1) + x2E(r2) + · · · + xnE(rn) = xiE(ri)
i=1

15

What is the variance of the portfolio return? It is not just a function of the variances!

For n = 2 (where σ1,2 denotes Cov(r1, r2)).

2 /
/ 2
σp2 = x21σ12 + x22σ22 + 2x1x2σ1,2 = xixj σi,j .
i=1 j=1

For any n:
n /
/ n n
/ n /
/ n
σp2 = xixj σi,j = x2i σi2 + xixj σi,j
i=1 j=1 i=1 i=1 j=1
i,=j

Note that there are n variance terms and n × (n − 1) = n2 − n covariance terms. For n large,
there are a lot more covariance terms!

Let’s rewrite the variance formula in a more intuitive way. To be able to do this, consider the
case of equal-weighted portfolios of stocks (xi = xj = 1/n). Then

n
/ n /
/ n ) */
n ) */ n
n /
1 1
σp2 = x2i σi2 + xixj cov(ri, rj ) = σi2 + cov(ri, rj )
i=1 i=1 j=1
n2 i=1
n2 i=1 j=1
i,=j i,=j
) * ) *
1 n − 1
= σ2 + cov → cov as n gets large.
n n
 16

where σ 2 and cov are the average variance and covariance of the securities:
) */ n /n / n
2
1 2 1
σ = σ cov = cov(ri, rj )
n i=1 i n(n − 1) i=1 j=1
i,=j

Only the average covariance matters for very well diversified portfolios.

In NYSE data:
• The average (annual) return variance is σ 2 = 0.492.
• The average (annual) covariance between stocks is cov = 0.037. Since the average covari-
ance is positive, even a very well diversified portfolio of stocks will be risky.

17

• Plotting the portfolio standard deviation against the number of stocks in the portfolio:
Diversifiable and Systematic Risk (Average NYSE Stock
0.55
Annual Return Standard Deviation

0.5

0.45

0.4

0.35

0.3

0.25

0.2

0.15
0 5 10 15 20 25
Number of Securities in Porfolio

• The part of risk that can be diversified away we call the diversifiable, firm-specific,
idiosyncratic or unsystematic risk.

• The risk of the well diversified portfolio is called undiversifiable or systematic risk or
market risk – it is the part of risk you cannot get rid of.
 18

5. Portfolios of the Riskless Asset and One Risky Asset

Consider a portfolio p consisting of one risky asset and a riskless asset.
• Risky asset (A): Expected return: E(rA). Standard deviation: σA. We invest a fraction
xA in this asset.

• Riskless asset (f ): Expected return (=realized return): E(rf ) = rf . Standard devia-

tion σf = 0. We invest a fraction xf = 1 − xA in this asset.

The realized return on portfolio p is:

r p = x A · r A + x f · rf
The expected return on portfolio p is:
E(rp) = xA · E(rA) + xf · rf = rf + xA · (E(rA) − rf ) (1)
The variance of the portfolio is:
σp2 = x2AσA2 + x2f σf2 + 2xAxf ρA,f σAσf = x2AσA2
since σf =0 and ρA,f = 0. The standard deviation of the portfolio is:
σp = xA σA . (2)

19

The Capital Allocation Line

Objective: Plot the possible combinations of expected returns and return stan-
dard deviations for different combinations of the assets.
E(rp) = xA · E(rA) + xf · rf = rf + xA · (E(rA) − rf )
σp = xA σA .
• This is the same exercise as we did to derive the minimum variance frontier earlier. The
resulting line just has a different name when it involves the riskless asset.

Example:
• Risky asset, A: E(rA) = 0.25, σA = 0.75. Portfolio share xA.
• Riskless asset, f: rf = 0.03. Portfolio share xf = 1 − xA.

Fraction of Fraction of Standard Deviation of Expected

Portfolio in A Portfolio in f Portfolio Return Portfolio Return
xA xf σp E(rp )
0 1 0 0.03
0.25 0.75 0.1875 0.085
0.5 0.5 0.375 0.14
0.75 0.25 0.5625 0.195
1 0 0.75 0.25
1.25 -0.25 0.9375 0.305

Third row: E(rp) = 0.03 + 0.5 · 0.22 = 0.14. σp = 0.5 · 0.75 = 0.375.
 20

The Capital Allocation Line

The graph of the CAL shows all risk-return combinations possible from a portfolio of one risky
asset and the riskless asset:

• Where in the graph would a very risk averse investor’s portfolio plot? Where would a less
risk averse investor’s portfolio plot?

21

We can derive a direct expression for the CAL:

To get the direct relation between the expected return and the standard deviation of the
σ
portfolio, isolate xA = σ p and substitute it into E(rp):
A

σp
E(rp) = rf + xA · (E(rA) − rf ) = rf + · (E(rA) − rf )
' ( σ A
E(rA) − rf
= rf + σp
σA
RewardA
Expected Return = Risk-free rate + · Riskp
RiskA
The reward to risk ratio, called the Sharpe ratio is the return premium per unit of risk.
The Sharpe ratio on the US stock market index is about 0.5 based on historical data – you get
about 0.5% more expected return per 1% extra standard deviation you are willing to accept.

Example: For our example the capital allocation line is

' (
0.25 − 0.03
E(rp) = .03 + σp .
0.75
The Sharpe ratio on asset A is 0.22/0.75=0.293.
 22

6. Portfolio Choice with Two or More Risky Assets

and the Riskless Asset

Suppose we can trade in a riskless asset with rf = 0.03 and risky assets B and C, where,

Asset E(r̃) σ
B 10% 20%
C 15% 30%

and ρBC = 0.5. We calculate the minimum variance frontier for the two risky assets exactly as
we did before:
Minimum−Variance Frontier
0.18

0.16
C
0.14
Expected Return

0.12
Assets B & C

0.1 B

0.08

0.06

0.04

0.02
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5
Return Standard Deviation

23

Now consider portfolios of either the riskless asset plus asset B, or the riskless asset plus asset
C. The two possible capital allocation lines are:
Minimum−Variance Frontier
0.18

0.16
C
0.14
Expected Return

0.12
Assets B & C

0.1 B

0.08

0.06

0.04

0.02
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5
Return Standard Deviation

However, why restrict ourselves to portfolios of the riskless asset and B or C alone? What is
the optimal portfolio of risky assets to combine with the riskless asset?
 24

Minimum−Variance Frontier
0.18

0.16
C
0.14

Expected Return
MVE Portfolio
0.12

0.1 B

0.08

0.06

0.04

0.02
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5
Return Standard Deviation

• We call this portfolio of B and C the Mean-Variance Efficient or MVE portfolio of

risky assets. It is also sometimes called the tangency portfolio. It is this the only
portfolio of these two risky assets we would ever hold!
• In combination with the riskless asset, it provides the optimal capital allocation line,
i.e. the one with the highest slope, or Sharpe Ratio). Portfolios on the optimal CAL
are efficient portfolios.

25

Calculating the Weights of the MVE Portfolio

• In the case of two risky assets we can find the MVE portfolio in Excel using Solver.
What we are looking for is the portfolio with the highest Sharpe ratio.

• Example, continued: (spreadsheet on course page)

– The MVE consists of 50% invested in B and 50% invested in C. This is not always the
case – the optimal mix of B and C will change with the means, standard deviations
and correlation of B and C!

– E(rM V E ) = 0.125, σM V E = 0.218, Sharpe ratioM V E = 0.436.

• It turns out that the calculation of the weights of the MVE portfolio is pretty complicated,
once there are three or more risky assets.

• We will not compute the weights in this course. For the case with 3 or more risky assets
we will focus only on finding the desired mix of the riskless asset and the MVE portfolio,
not finding the MVE portfolio weights.
 26

Formulas for Efficient Portfolios

Once we have found the MVE then the expected return and standard deviation for portfolios
on the optimal capital allocation line follow the general principles for capital allocation
lines. For a portfolio p which combines f and MVE:

Return (realized return):

rp = xrM V E + (1 − x) rf
Expected return:
E(rp) = xM V E · E(rM V E ) + xf · rf = rf + xM V E · (E(rM V E ) − rf )
Variance:
σp2 = x2M V E σM
2
VE
Standard deviation:
σ p = xM V E σM V E .

Direct relation between the expected return and the standard deviation of the portfolio:
' (
E(rM V E ) − rf
E(rp) = rf + σp
σM V E
This is the formula for the optimal capital allocation line, CAL.

27

Example: Suppose you are investing $10,000 between three assets: stock B, stock C, and
the riskless asset f. Find the portfolio p with σp = 10% and the highest possible
expected return.
• Efficient portfolios combine the riskless asset and the MVE portfolio of risky assets.
• Solve for fraction invested in MVE using formula for the efficient portfolio standard devia-
tion: σp = xM V E ·σM V E ⇒ 0.1 = xM V E ·0.218 ⇒ xM V E = 0.459, xf = 1−xM V E = 0.541

• The expected return on this portfolio is: E(rp) = xM V E · E(rM V E ) + xf · rf = 0.459 ·

0.125 + 0.541 · 0.03 = 0.0736
E(r )−r
• The Sharpe ratio of portfolio p is: SR = σp p f = 0.0736−0.03
0.10 = 0.436. Notice that this is
the same as for the MVE portfolio of risky assets.

• How is our $10,000 divided between the three assets?

0.541 × $10000 = $5412 is invested in the riskless asset and 0.459 × $10000 = $4588 is
invested in the MVE portfolio of risky assets, of which 0.5 × $4588 = $2294 is invested in
B, and 0.5 · $4588 = $2294 is invested in C.
 28

Example: Suppose you are investing $10,000 between three assets: stock B, stock C, and
the riskless asset f. Find the portfolio p with E(rp) = 0.10 and the lowest possible
standard deviation.

• Efficient portfolios combine the riskless asset and the MVE portfolio of risky assets.

• Solve for the fraction invested in MVE using the formula for the efficient portfolio’s expected
return
E(rp) = xM V E · E(rM V E ) + xf · rf = rf + xM V E · (E(rM V E ) − rf )
0.10 = 0.03 + xM V E · (0.125 − 0.03) ⇐⇒ xM V E = 0.737
and thus xf = 1 − xM V E = 0.263

• The standard deviation for this portfolio is:

σp = xM V E σM V E = 0.737 · 0.218 = 0.161.

• Notice that we have constructed a portfolio with the same expected return as stock B, but
a lower standard deviation.

29

Efficient Portfolios with Many Assets

• The optimal mix of risky assets (the MVE) is again the same for everyone, no matter what
their tolerance for risk.

• The formulas for efficient portfolios are exactly as for the case with two risky (and a riskless)
assets.

• Efficient portfolios (those on the optimal capital allcoation line) will again invest a fraction
xM V E in the MVE portfolio of risky assets and a fraction xf = 1 − xM V E if the riskless
asset.

• The more risk averse investors invest a higher fraction of their wealth in the riskless asset,
but everyone agrees that these are the only two funds they want to invest in.

• Bottom line: Investors should control the risk of their portfolio not by reallocating
among risky assets, but through the split between risky and riskless assets.

This all assumes that investors have the same estimates of means, standard deviations, and
covariances. If some have “private information” about an asset they might want to de-
viate from our above portfolio recommendations (their MVE will differ from the one we have
calculated).
 30

7. Equilibrium: The Mean-Variance Efficent Portfolio

=The Market Portfolio
Risky portfolio in demand: The MVE portfolio of risky assets.
Risky portfolio supplied: The (value-weighted) market portfolio of risky assets.
Equilibrium: Asset prices must adjust to ensure that MVE=Market.

Implication: All investors should only hold combinations of the market and the risk-free
asset. This may explain the increased popularity of index funds!

What is the value-weighted market portfolio of risky assets?

• The portfolio of all risky securities held in proportion to their market value. Its return is:
N
/ total dollar value of security i
rm = x i ri where xi =
i=1
total dollar value of all risky securities

• In theory, the market portfolio should include all securities that investors hold, not just
stocks. I.e., stock, risky bonds, real-estate, human capital, international stocks etc.

• However, in practice we typically simplify and use a market portfolio of U.S. stocks as a
market proxy: The S&P 500 Index.

31

• The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry
group representation. It is a value weighted index, with each stock’s weight in the index
proportionate to its market value (stock price times number of shares outstanding).

• To get the S&P 500 return each day, S&P multiplies the weights for each of the 500 stocks
by the stock returns. Weights change each day as relative stock prices rise and fall.

• The S&P 500 Index return is a good proxy for the overall US equity market return, since
the index covers about 75% of the market (in terms of $ value).
 32

The Capital Market Line (CML)

In equilibrium, every investor faces the same optimal CAL, namely the one that goes through
the market portfolio of risky assets
) *
E(rm) − rf
E(rp) = rf + σp
σm
Capital Market Line
0.13

0.12

0.11 C

0.1 B
Expected Return

0.09 Market Portfolio

A
0.08

0.07

0.06 D

0.05

0.04
Risk−Free Asset
0.03
0 0.05 0.1 0.15 0.2 0.25 0.3
Return Standard Deviation

This optimal CAL is called the Capital Market Line (CML). It gives us the set of
efficient portfolios. These portfolios are combinations of the riskless asset and the market
portfolio of risky assets. The formulas for efficient portfolios are as before (plug in m for MVE).

33

Example: Suppose you currently have your entire portfolio of $100,000 invested in the stock
of McDonalds (E(rM cD = 10%, σM cD = 25%). The risk free rate is rf = 3% and the expected
excess return on the market is E(rm) − rf = 8%. The standard deviation of the market is
σm = 20%.
• Find an efficient portfolio with the same expected return and the smallest possible risk
(standard deviation).
 34

• Graph your results in the mean-standard deviation diagram

Topic 6: The Capital Asset Pricing Model (CAPM)

Professor Camelia Kuhnen, MBA 771 – Financial Tools

Outline:
1. Understanding the CAPM
(a) Intuition
(b) Regression approach: Decomposing return and return variance
(c) β of a portfolio
2. Implementing the CAPM
(a) Estimating β
(b) What riskless rate, what equity premium to use in the CAPM formula
3. Alpha (α) and market efficiency
 2

1. Understanding the CAPM

a. Intuition
• The return that investors require is solely driven by the covariance of the stock’s
return with the market.

• The general formula

Cost of capital (i.e. required return) = Risk-free interest rate + Risk premium
will now be more precise:
E(ri) = rf + βi (E(rm) − rf ) The CAPM
where i denotes security i (or project i).

• E (rm) − rf measures the premium for taking on market risk.

• βi measures how similar the stock’s return is to that of the market.

• Crucial: Betas can be estimated fairly accurately based on just a few years of data =⇒
Using the CAPM is preferable for estimating the cost of capital.
Better than using historical average returns for this asset (or similar assets).

How does this relate to our work so far?

We have looked at the problem of how to select a portfolio, given that we know what the
expected returns, return variances, and return covariances are.

We showed that smart investors diversify:

• Diversification leads to a reduction in portfolio risk (standard deviation), without a reduc-
tion in expected return.
• But even portfolios that are very well diversified are not riskless – some risk is undiversifiable
(i.e. systematic).
• We considered the risk of an equal-weighted market portfolio.

We then showed more precisely what smart investors do:

• They invest in a combination of the riskless asset and a particularly good well-diversified
portfolio of the risky assets called the mean-variance efficient portfolio (MVE).
• The MVE is generally not an equal-weighted portfolio. We argued that in equilibrium it
would be the value-weighted market portfolio of the risky assets.
 4

Implication for the cost of capital (i.e. expected return) on a particular asset
– a stock, or a project:.
• Smart investors are well-diversified and some of the risk cancels out once the asset is
included in a well-diversified portfolio. The cost of capital is determined by the undiver-
sifiable risk of the asset.
• We measure undiversifiable risk by beta, estimated from a regression of the excess
return of the security on the excess return of the risky asset portfolio investors hold, i.e.
the value-weighted market portfolio of risky assets.

The basic assumptions made in the CAPM:

• Investors care about their wealth at the end of the period; trade off expected returns and
standard deviations; can borrow and lend at the risk free rate; all have the same information
and faces the same minimum variance frontier for risky assets. And we can measure the
return to what investors’ perceive as the relevant market portfolio (probably the most
restrictive assumption – remember human capital, real estate etc.)
Then Market=MVE and we can estimate beta and implement the CAPM.

The CAPM model is the main method used in practice to calculate the cost
of capital for firms.

b. Regression Approach: Decomposing Return and Return

Variance Into Diversifiable vs. Undiversifiable Risk
Regression equation:
ri,t − rf,t = αi + βi(rm,t − rf,t) + %i,t
ri,t − rf,t: Dependent variable. What we are trying to explain.
rm,t − rf,t: Independent variable. What we are trying to explain it with.
αi is the constant term (or “intercept”).
cov(ri,t ,rm,t )
βi is the slope of the line of best fit. It’s just a rescaled version of covariance: βi = σm2 .

• βi(rm,t − rf,t): The part of ri,t − rf,t that is “explained” by the market return
– This is the undiversifiable (=systematic=market) component.
– Variance of this component: βi2σm
2
.
– Securities with large β’s are more subject to economy-wide risk and they contribute
more to the risk of your overall portfolio.

• %i,t: The part of ri,t − rf,t that is not explained by the market return
– This represents the diversifiable (=unsystematic=firm specific=idiosyncratic)
2
component. Variance of this component: σ%,i .
 6

– The more volatile %i,t is, the more important is firm specific risk.

• The total return variance for asset i is

σi2 = βi2σm
2 2
+ σ%,i

• CAPM: Only the systematic component is priced: E(ri) = rf + βi(E(rm) − rf )

2
– βi drives the expected return, σ%,i does not! Why? The %’s average to zero across assets
in a well-diversified portfolio – smart investors do not hold any firm specific risk.
– The CAPM also states that the αi should be zero: Take expectations on both sides of
the regression equation. You get the CAPM formula if αi=0.

• The R2 value of the regression measures what fraction of the total variation in an asset’s
excess return can be explained by movements in the market excess return.
Explained Variance Systematic Risk β 2σ2 β 2σ2
Ri2 = = = 2 2i m 2 = i 2m
Total Variance Total Risk βi σm + σ%,i σi
The R2 is also equal to the square of the correlation between the assets excess return and
the market excess return: ρ2i,m.

c. What Is The β Of A Portfolio?

The beta of a portfolio is the value-weighted average of the betas of the assets in the portfolio.
βp = x1β1 + x2β2 + · · · + xnβn
Example: What is the beta of a portfolio on the capital market line?
βp = xmβm + xf βf = xm · 1 + xf · 0 = xm
Example: You hold $70,000 of Nike stock and $30,000 of Microsoft stock. Assume that
βN IKE = 0.69 and βM SF T = 1.26. What is the beta of your portfolio?
βp = xN IKE × βN IKE + xM SF T × βM SF T = 70% · 0.69 + 30% · 1.26 = 0.861
Assume that the risk free rate is 3.9% and the expected return on the market is 9.9%. What
is the expected return of your portfolio?
E[rp] = rf + βp[E(rm) − rf ] = 0.039 + 0.861 · (9.9% − 3.9%) = 0.0907
Find a new, efficient portfolio that has the same expected return and a lower standard deviation.
E[rpnew ] = rf + xm(E[rm] − rf ) → 0.0907 = 0.039 + xm · 0.06 → xm = 0.861, xf = 0.139
Why do we find that xm = βp? Because we imposed E(rp) = E(rpnew ), which implies (from
the CAPM) that βp = βpnew . But βpnew = βf xf + βmxm = 0 + 1 · xm = xm. Hence, βp = xm.
 8

2. Implementing the CAPM: E(ri) = rf + βi(E(rm) − rf )

a. Estimating β
What data is used for estimating beta?
1. Use excess returns for the regression: ri,t − rf,t = αi + βi(rm,t − rf,t) + %i,t.
If you omit the riskless rate you’ll get almost the same beta (but not a meaningful alpha).
2. How many years of data should you use? What data frequency?
• Betas are not constant over time. Why not?
Common to use five years of monthly data or a couple of years of weekly data.
• Don’t use daily or hourly data if the company is not traded very frequently.
3. What market index? What riskless rate?
• Common to use the S&P500 index.
Using the Wilshire 5000, the NYSE Composite Index, or even the full index of all
NYSE, NASDAQ and AMEX firms will give fairly similar beta estimates.
• Could consider a broader definition of the market, e.g. a world stock index (MSCI).
• Common to use 30-day Treasury bill returns for the time series of riskless rates when
estimating beta.

b. What Riskless Rate, What Equity Premium?

Riskless rate (at start of CAPM formula):
• Today’s yield, y: You want the expected return going forward from today. It is not
meaningful to use the historical average return on riskless assets (why?).
– Note: The rf is different for the beta estimation (uses time series of historical returns)
and the number in the first part of the CAPM formula (latest yield).

• What maturity? This depends on the cash flows from the project (or security) in focus.
It is common to use the yield on 10-year, 20-year or 30-year bonds (though often
coupon bonds are used rather than zeros).

• Ideally, you’d calculate a whole schedule of CAPM-cost’s of capital, one for each maturity.
In practice, most firms just use one cost of capital.
 10

Equity premium:
• It is common to estimate this based on the average in a sample of historical data for
the return of stocks over the return of bonds, rM − rf .
– What bond returns? Of similar duration to the duration of the bonds whose yield
is used to proxy for today’s riskless rate.

– What sample length? Often the full historical sample is used (around 7%). Even
then the confidence interval is quite wide.

• But is the past a good guide to the future? We could back out a forward-looking
value for the expected return on the market from the Gordon growth model:
DIV1
E(rm) = + g.
P0
For a dividend yield around 2% and g equal to expected long-run nominal GDP growth
of about 6% (3% real plus 3% inflation), this gives E(rm) = 0.08. Current long yields are
around 3%. That implies an equity premium of about 5%.

11

3. Alpha (α) and market efficiency

The difference between an asset’s actual expected return and what something with its beta
should return according to the CAPM is called the asset’s alpha:
αi = E(ri) − [rf + βi (E(rm) − rf )]
• αi is expected return over and above the required compensation for risk. If the CAPM is
true, alphas are zero.

• You estimate the alpha as the realized average return on the asset, minus the benchmark
for what something with this beta should have returned according to the CAPM:
αi = ri − [rf + βi(rM − rf )]
= ri − [(1 − βi)rf + βirM ]
= ri − [realized average return on a portfolio with xf = (1 − βi) and xm = βi]
= ri − [realized average return on something with similar beta that’s easy to do]
Excel actually does this for you: It is the intercept from the CAPM regression.

• Crucial tool in performance evaluation of mutual funds and hedge funds.

 12

Example: You are trying to decide whether or not to invest in an actively managed mutual
fund (fund i). You have data on the last 10 years of the mutual fund’s returns (after fees). Over
the 10 years the fund’s average annual return was 17% with a β of 1.3. Over the same period
the average realized return on the market was 13% and the risk free rate was 4%.

Based on past performance, what is your best estimate of the alpha for fund i?

αi = 0.17 − [0.04 + 1.3 × (0.13 − 0.04)] → αi = 0.013 = 1.3%

Given the positive alpha, you may decide to invest in the fund.
• I would only do this if the standard error of the alpha estimate is low, so the alpha is
statistically significantly different from zero. Running the CAPM regression will
give you both the alpha estimate and its standard error.

• Even then, you should only invest a small fraction of your wealth in the fund,
not 100%! Why not?
Market efficiency discussion: mutual fund and hedge fund performance statistics, sources
of abnormal returns.

Topic 7: Cost of capital for project valuation: Capital structure

and differences across business units
Professor Camelia Kuhnen, MBA 771 – Financial Tools

Outline:
1. The Capital Budgeting Process When Cash Flows Are Risky
2. Estimating Project Betas:
(a) The Steps Involved
(b) Practical Issues:
- Debt Betas In Practice
- Firms With Multiple Divisions
3. Putting It All Together: Practice Example
 2

1. The Capital Budgeting Process When Cash Flows Are Risky

What determines the cost of capital for a risky project? The beta of the return
on the project
• Not the standard deviation of the return on the project.
• Not the beta of the firm’s other business if the new project differs from that business.
• Not the capital structure used to finance the project if capital markets are perfect.
But accounting for capital structure will play a key role in beta estimation.
Suppose we have perfect capital markets:
• The firm’s financing decisions for the project does not change the overall cash flows from
the project (this will not be true in the presence of taxes, or bankruptcy costs).
• Investors and firms can trade the same set of securities at the same prices with no trans-
actions costs.

Modigliani-Miller’s Proposition I: In perfect capital markets, the NPV of a

project (or firm) does not depend on how the project is financed.
• In MBA 772 you will consider the tax-advantage of debt finance and bankruptcy
costs. Then the method of finance does affect the cash flows from the project. You will
derive an optimal capital structure.

Does capital structure (the mix of equity and debt financing) affect anything
in a perfect capital market? Yes, the presence of debt makes equity riskier!
• Debt holders have a senior claim over equity: Debt holders get paid first and equity
holders get whatever is left over – equity is a residual claim. This forces equity holders
to bear a disproportionately high share of the systematic risk of the firm’s cash flows.

• To compensate for the extra systematic risk, equity holders will require higher expected
returns, but the overall cost of capital for the project (or firm) does not change.
 4

Understanding the effect of capital structure on the risk of equity:

• The cash flows from the project are split between equity holders and debt holders, so the
value of the project equals the market value of the equity plus the market value of the debt:
Value (V) = Equity (E) + Debt (D) .
The value of the project comes from the value of its assets, so this can also be written as
Assets (A) = Equity (E) + Debt (D) .

• The β of the firm’s assets is a weighted average of the βs of the components:

%E & %D &
βA = V βE + V βD
where βE and βD are the beta’s of the equity and of the debt, respectively. This follows
from the firm being a portfolio made up of the equity and debt of the firm. Note that
D
E E 1 D D
= = and = = E D.
V E+D 1+ D
E
V E+D 1+ E
We can rewrite the formula for asset beta to see that in the presence of debt

βE = βA + D
E (βA − βD )

Thus equity risk (βE ) equals “business risk” (βA) plus “financial risk” (leverage-
induced risk) D
E (βA − βD ).

• The cost of capital for the project (or firm) (= E(rA)) is a weighted average of the expected
return on equity and on debt:

E(rA) = VE E(rE ) + D
V E(rD )

Solving for the expected return on equity:

E(rE ) = E(rA) + D
E [E(rA ) − E(rD )]

This result is called Modigliani-Miller’s Proposition II: Increasing D/E increases

E(rE ), and possibly E(rD ), but the weights E/V and D/V change leaving E(rA) unaffected!

Example: Your firm operates in the fast food industry. Your firm has D = $240M , E =
$960M . You have estimated that βE = 0.7 and βD = 0 and that rf = 4%, E(rM ) − rf = 5%.
Using the CAPM, what is the appropriate cost of capital for projects in your firm?
• To compute the cost of capital for your firm we need to compute the asset beta:
E D 960 240
βA = βE + βD = × 0.7 + × 0 = 0.56.
V V 960 + 240 960 + 240
Using the CAPM we can compute the appropriate discount rate for your firm:
E(rA) = rf + βA [E(rm) − rf ] = 0.04 + 0.56 × 0.05 = 0.068.
 6

• An equivalent way to compute the cost of capital for your firm is to start by calculating
the expected return to both your firm’s debt and equity:
E(rE ) = rf + βE [E(rm) − rf ] = 0.04 + 0.7 × 0.05 = 0.075
E(rD ) = rf + βD [E(rm) − rf ] = 0.04 + 0 × 0.05 = 0.04.
The cost of capital for your firm is then:
E D
E(rA) = E(rE ) + E(rD ) = 0.8 × 0.075 + 0.2 × 0.04 = 0.068.
V V

Question: Could you lower your cost of funds by increasing the firms debt to equity ratio to
1? Suppose that this did not change the beta of your firm’s debt.
• After the change your firm’s debt to equity ratio will be 1 which implies: VE = D
V = 0.5.
The increase in leverage will raise the beta of your firm’s equity:
E D
βA = βE + βD ⇐⇒ 0.56 = 0.5 × βE + 0.5 × 0 ⇐⇒ βE = 1.12.
V V
• So the expected return to your firm’s equity must increase to:
E(rE ) = rf + βE [E(rm) − rf ] = 0.04 + 1.12 × 0.05 = 0.096.

• Is the weighted average cost of capital changed? No:

E D
E(rA) = E(rE ) + E(rD ) = 0.5 × 0.096 + 0.5 × 0.04 = 0.068.
V V

2. Estimating A Project’s Beta

a. The Steps Involved
1. Find a comparable firm (or better, a collection of firms to increase estima-
tion precision) whose business consists of projects similar to ours, and which are publicly
traded (so you can get data). If the project is similar to our firm’s existing business, our
firm itself can be included in this set of firms.
2. Estimate the equity betas of these comparable firms using regressions. Also estimate
debt betas if the firms have enough debt that it is risky.
3. For each firm, calculate the asset beta or firm beta, using the equity betas, debt betas,
and capital structure.
4. Use an average of the comparables’ asset betas as an estimate of your project beta.
5. From this estimated project beta, calculate a discount rate using the CAPM, and discount
the expected cash flows to get the NPV.
 8

b. Practical Issues
Debt Betas in Practice
Debt betas are harder to estimate than equity betas.
• In principle, we could run a CAPM regression of the excess returns of the corporate bonds
over Treasuries, on the excess return on the market.
• But historical data on debt returns is often hard to obtain. The debt may not even be
publicly traded.

In practice, here is what you can do:

1. If the cash flows to debt are approximately riskless, assume the debt beta is zero.
• The debt is not really riskless because of “duration” risk, but in the CAPM the com-
pensation for such risk is already reflected in our measure of rf which (as discussed
last week) should be the yield of a Treasury bond with maturity (or more precisely,
duration) similar to that of the project.
2. If the cash flows to debt are not approximately riskless, then you can use the yield
on the corporate bonds and the security market line to back out the debt beta.
• But calculate the yield from the expected, not the promised cash flows.

Using Firms With Multiple Divisions

What if you cannot find a comparable firm, but you can find one that has a division which is
comparable to your project?

Example: Construction Tools and Office Products

• You have been asked to determine the cost of capital for office products.

• Firm X has two divisions. One division produces office products and the other produces
construction tools. You have run a CAPM regression on the firm’s equity and estimated a
it to have a beta of 1.2. The value of the firm’s construction tool division is $2.5B and the
total value of the firm is $4B.

• You have also identified another firm, firm Y, which only produces construction tools. You
have run a CAPM regression and found that firm Y’s equity has a beta of 1.5.

• Both firms are 100% equity financed. The risk free rate is 3%, the expected excess return
on the market is 5%.

What is the appropriate discount rate to use for new projects involving office products?
 10

Step 1: Firm X’s asset beta is a weighted average of the asset betas for construction tools
(CT) and office products (OP):
VCT CT VOP OP
βA = β + β
V A V A
We know that:
• βA = 1.2, from firm X’s equity beta, since firm X has no debt.

• βACT = 1.5, from firm Y’s equity beta, since firm Y has not debt and only produces
construction tools.
VCT 2.5 VOP 1.5
• V = 4 = 0.625 and V = 4 = 0.375.

Therefore:
VCT CT VOP OP
βA = β + β
V A V A
1.2 = 0.625 × 1.5 + 0.375 × βAOP ⇐⇒ βAOP = 0.7.

Step 2: Using the CAPM to estimate the cost of capital for office products projects we then get:

E(rOP ) = rf + βAOP [E(rm) − rf ] = 0.03 + 0.7 × 0.05 = 0.065.

11

3. Putting It All Together: Practice Example

Example: You are the CFO of a major pharmaceutical firm. You are evaluating a proposal
for a new project which would use genetic engineering methods to develop new drugs for the
treatment of tuberculosis.
• Starting up this project would require a single initial investment of $240 million today, and
no additional investment.

• You estimate the expected cash flows from the project would be zero in years 1-6. In year
7, the expected cash flow would be $15 million, and the expected cash flows would then
grow from this level at a rate of 6% forever.

• The riskfree rate is 5%/year, and the expected return on the market is 10%/year. You
should assume that the CAPM holds. You should also ignore taxes. All cashflows and
discount rates are in nominal terms.

You identify two firms whose only projects are genetic engineering projects equivalent in risk
to the project you are analyzing. These two firms (call them firm A and firm B) have equity
betas of 1.2 and 1.5, debt betas of 0.2 and 0.4, and debt-to-equity ratios of 0.55 and 1.5. Your
firm’s beta is 1.6, and your firm is entirely equity financed. The table below summarizes this
information:
 12

Firm: A B
Debt/Equity Ratio 0.55 1.5
Equity β 1.2 1.5
Debt β 0.2 0.4

Question: Do you accept the project?

Strategy: Use these comparable firms to estimate the project beta for genetic engineering.
Get the cost of capital from the CAPM and discount the expected cash flows.

Step 1: Estimate the asset betas for each of the comparable firms:
3 4 3 4 ) * ) *
D
F irmA 1 E 1 0.55
βA = βE + βD = 1.2 + 0.2 = 0.8452
1+ D
E 1+ D E
1 + 0.55 1 + 0.55
) * ) *
F irmB 1 1.5
βA = 1.5 + 0.4 = 0.84
1 + 1.5 1 + 1.5

Step 2: Estimate the project beta for genetic engineering as the average of the asset betas
from our two comparables:

1
βAGen.Eng. = [0.8452 + 0.84] = 0.8426
2

13

Step 3: Use the estimate for βAGen.Eng. to compute the cost of capital for genetic engineering
projects using the CAPM.

E(rGen.Eng.) = rf + βAGen.Eng. [E(rm) − rf ] = 0.05 + 0.8426 × 0.05 = 0.0921.

Step 4: Discount the cash flows.

The expected cash flows which begin in year 7 are a growing perpetuity. The present value of
these cash flows at time 6 is:
C7 $15M
P V6 = = = $466.87M
r − g 0.0921 − 0.06
The present value of these cash flows at t = 0 is:
P V6 $466.87M
P V0 = 6
= = $275.139M
(1 + r) (1 + 0.0921)6

Hence the NPV of the project is:

N P V0 = $275.139 − $240M = $35.139M.
So your firm should take this project!
 14

Example, continued: Now, suppose that you can’t identify a firm with a single project
similar to the genetic engineering project you are analyzing. However, you do identify two
purely equity financed firms C and D.
• Firm C has two divisions. Division 1 has a genetic engineering project equivalent in risk
to your new project and no other projects. Division 2 has a high-volume drug-production
project very different in risk. The market values of Divisions 1 and 2 are $100 Million and
$600 Million, respectively, and the equity beta of firm C is 1.5.

• Firm D has a single division with a high-volume drug-production project equivalent in risk
to Firm C’s second division. Firm D has an equity beta of 1.6.

Question: In this scenario, estimate your project’s beta and determine its NPV.

Strategy: We want to estimate the beta for genetic engineering projects and then use this
to estimate our cost of capital. We will use the beta of firm D to help infer what the beta of
firm’s C genetic engineering project must be. Note that both comparable firms are 100% equity
financed so we don’t need to unlever the equity beta for either.

15

Step 1: Use firm C’s asset beta, and information for firm D, to estimate the project beta for
genetic engineering.

VGen.Eng Gen.Eng. VDrugs Drugs

βAF irmC = βA + βA
V V
• βAF irmC = βEF irmC = 1.5, since firm C is 100% equity financed.

• βADrugs = βEF irmD = 1.6, since firm D is 100% equity financed and works only on high
volume drug production.
Therefore,
100 Gen.Eng. 600
1.5 = β + 1.6 ⇐⇒ βAGen.Eng. = 0.9.
700 A 700

Step 2: Use our estimate of the beta for genetic engineering projects to compute the cost of
capital using the CAPM.
E(rGen.Eng.) = rf + βAGen.Eng. [E(rm) − rf ] = 0.05 + 0.9 × 0.05 = 0.095.
 16

Step 3: Discount the cash flows (same as before but with new estimate of discount rate).

The expected cash flows which begin in year 7 are a growing perpetuity. The present value of
these cash flows at time 6 is:
C7 $15M
P V6 = = = $428.57M
r − g 0.095 − 0.06

The present value of these cash flows at t = 0 is:

P V6 $428.57M
P V0 = = = $248.621M
(1 + r)6 (1 + 0.095)6

Hence the NPV of the project is:

N P V0 = $248.621M − $240M = $8.62M.

So your firm should take this project (although our assessment of the NPV has fallen).