Chapter 1 – Basic concepts of

finance
 Financial decisions of firms
• First: strategic planning; the first decision any firm
must make is what businesses it wants to be in
• Second: capital budgeting; the step that the firm
has to do to choose machinery, equipment, plant,
and so on
• Third: capital structure; the firm can issue stock,
bond, … and borrow loans from bank
• Fourth: working capital; the firm needs to decide
the working capital
 Working capital
• Working capital = current assets – current liabilities
• Working capital ratio = current assets/current liabilities
– If this ratio is less than 1: not good
– If this ratio is higher 1: good (1.2 to 2 is perfect)
– If this ratio is higher 2: not good
• Cash
• Account receivables
• Inventory
• Account payables
 Three types of business
organizations
• The legal forms of business organization fall
into three categories:
– The sole proprietorship
– The partnership
– The corporation
 The sole proprietorship
• Owned by a single individual
• Forming a sole proprietorship is very easy, low cost,
fewer regulations.
• It is very difficult to transfer ownership (-)
• who is entitled to all the firm’s profits and who is
also responsible for all the firm’s debt (unlimited) (-)
• Limited access to outside sources of financing (-)
• Personal taxes
• Limited Liability Company (LLC)
 Partnership
• General partnership
– Owned by two or more persons
– who are entitled to all the firm’s profits and who
are also responsible for all the firm’s debt
(unlimited)
– Limited access to outside sources of financing
– Personal taxes
• Limited Liability Partnership (LLP)
 Partnership (cont.)
• Limited partnerships
– There are two classes of partners: general and limited
– The general partner actually runs the business and
faces unlimited liability for the firm’s debts, while the
limited partner is only liable up to the amount the
limited partner invested.
– It is difficult to transfer ownership of the general
partner’s interest in the business; However, the
limited partner’s shares can be transferred to another
owner
 Corporation
• There are too many owners
• The owners’ liability is confined to the amount
of their investment in the company (limited)
• The life of the business is not tied to the status
of the investors
• The ease of raising capital and they can easily
sell their stock
• Double taxation
Separation of ownership and management

• There are at least five reasons

– The firm needs professional managers
– The firm needs a pool of many investors
– The investor need to diversify its capital
– The managers know better about information
– The separation benefits the learning curve
 The goal of the financial manager
• A firm has several goals: revenue, profit,
market-share, etc…
• Because the shareholders are their true
owners, companies commonly have a
principle goal described as maximizing
shareholder wealth, which is achieved by
maximizing the stock price.
 Agency problem
• Managers often face situations where their own
personal interests differ from the interests of
shareholders
• The conflict of interest between the stockholders
and the managers of a firm as an agency problem
• When the managers have little or no ownership in
the firm, they are less likely to work energetically
for the company’s shareholders
 Agency problem (cont.)
• The managers will have an incentive to enrich
themselves: luxury corporate jets, expensive
corporate apartments, or resort vacations.
• To turn down projects that have an element of
risk in order to avoid jeopardizing their jobs
• Debt may be the cheapest source of financing,
but managers might want to avoid debt
financing
 Agency problem (cont.)
• Compensation plans can be put in place that
reward managers when they act to maximize
shareholder wealth (shareholder)
• The board of directors can actively monitor
the actions of managers
• Auditors, bankers, and credit agencies monitor
the firm’s performance
• Takeover threat
Chapter 6
The Analysis of Investment Projects
The Net Present Value (NPV)
Investment Rule
 The NPV rule is to invest if the proposed project’s NPV
is positive. n
CFt
NPV (k ) = 
t = 0 (1 + k )
t

 t: time
 k: cost of capital
 Example:

Year 0 1 2 3
Net cash -$100,000 50,000 40,000 30,000
flow
The Net Present Value (NPV)
Investment Rule (cont.)
 Calculation of NPV of the previous example
Year Cash flow Present value of Cumulative
cash flow at 8% present
per year value
0 -$100,000 -100,000 -100,000
1 50,000 46,296 -53,703
2 40,000 34,293 -19,410
3 30,000 23,814 4,404

 NPV = $4,404.82
Estimating a Project’s Cash Flows
 There are two alternative ways to compute the cash
flow:
1. Cash flow = revenue – cash expenses – taxes.
2. Cash flow = revenue – total expenses (fixed costs +
variable costs) – taxes + noncash expenses
(depreciation).
= Net income + noncash expenses
(depreciation).
Estimating a Project’s Cash Flows
(cont.)
 Forecasting
Sales cash flow for the$20,000,000
PC 1,000perproject
year
Fixed costs $3,500,000 per year
- Depreciation - $400,000 per year
Variable costs $15,000,000 per year
Total annual operating costs $18,500,000 per year
Annual operating profit $1,500,000 per year
Corporate income tax at40% $600,000 per year
After-tax operating profit $900,000 per year
(net income)
 Cash flow = $900,000 + $400,000 = $1,300,000
Cost of Capital
 Cost of capital and opportunity cost of capital are the
same meaning. (how to choose cost of capital is in
chapter 16).
 However, cost of capital includes another meaning, it
is the risk-adjusted discount to use in computing a
project’s NPV.
 The standard way of dealing with uncertainty about
future cash flow is to use a larger discount rate.
Cost of Capital (cont.)
 The risk of a particular project may be different from
the risk of the firm’s existing assets.
 The risk that is relevant in computing a project’s cost
of capital is the project’s cash flow and not the risk of
the financial instruments (stock, bond, etc.) the firm
issues to finance the project.
 The cost of capital should reflect only the market –
related risk of the project (its beta, chapter 13).
Fixed cost and variable cost
 A fixed cost is a cost that does not change with an
increase or decrease in the amount of goods or services
produced ( rent, advertising, insurance and office
supplies)
 Variable costs are dependent on production output.
They rise as production increases and fall as
production decreases (direct material costs, direct
labor costs, packaging costs)
 Break – Even Point of the project
 The break – even point represents sales volume that
the NPV of the project would be zero.
 Example (p.180):
PVPMT ( PTM ,15%,7) + PVFV ($2,2million,15 %,7) − $5million = 0
PMTPV ($4,172 ,939 ,15 %,7) = $1,003,009
 Cash flow = net profit + depreciation.
0.6(1,250 Q − 3,500 ,000 ) + 400 ,000 = 1,003,000
 Q = 3,604 units per year
Contribution Margin Ratio (CM
Ratio)
The CM ratio is calculated by dividing the total
contribution margin by total sales.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit CM Ratio
Sales (500 bicycles) $ 250,000 $ 500 100%
Less: Variable expenses 150,000 300 60%
Contribution margin 100,000 $ 200 40%
Less: Fixed expenses 80,000
Net operating income $ 20,000

$100,000 ÷ $250,000 = 40%

Break-even in unit Sales:
Formula Method

Unit sales to attain Fixed expenses

=
the target profit CM per unit

$80,000
Unit sales =
$200
Unit sales = 400
Break-even in Dollar Sales:
Formula Method
Now, let’s use the formula method to calculate the
dollar sales at the break-even point.

Dollar sales to Fixed expenses

=
break even CM ratio

$80,000
Dollar sales =
40%
Dollar sales = $200,000
Analyzing Cost Reducing Projects
 Example: a firm is considering an investment proposal
to automate its production process to save on labor
costs.
 It invests $2 million and net cash flow will increases
$600,000 in each of the five subsequent years.
 NPV? (r = 10%).
 Analyzing Cost Reducing Projects
(cont.)
 Cash flow with and without investment in labor saving
equipment
Without With investment Difference due
investment to investment
Revenue $5,000,000 $5,000,000 0
Labor costs 1,000,000 300,000 -700,000
Other cash expenses 2,000,000 2,000,000 0
Depreciation 1,000,000 1,400,000 400,000
Pretax profit 1,000,000 1,300,000 300,000
10
Income tax (33 0) 333,333 433,333 100,000
3
After-tax profit 666,667 866,667 200.000
Net cash flow (after-tax 1,666,667 2,266,667 600,000
profit + depreciation)
 Analyzing Cost Reducing Projects
(cont.)
 The cash flow of this project
Year 0 1 2 3 4 5
Cash flow - 600,000 600,000 600,000 600,000 600,000
2,000,000
 NPV of this project is:

NPV = PVPMT ($0.6million,10%,5) − $2million

= $274,472
 Conclusion: this is worthwhile investment.
Projects with Different Lives
 In the previous example of labor saving equipment
that there are two different types of equipment with
different economic lives. The longer-lived equipment
requires twice the initial outlay but lasts twice as long.
 There are two ways to compare the projects with
different economic lives
1. To assume the shorter lived project will be replaced at
the end with the same equipment. Both alternatives
will then have the same expected life of 10 years, then
NPV can be computed and compared.
Projects with Different Lives (cont.)
2. To use a concept of annualized capital cost (easier
approach). This is the annual cash payment that has
a present value equal to initial outlay.
 Example:
- Project 1 (shorter live, 5 years)

- Project 2 (longer live, 10 years)

PMTPV ($2million,10 %,5) = $527 ,595
PMTPV ($4million,10 %,10 ) = $650 ,982 .
Ranking Mutually Exclusive
Projects
 The internal rate of return (IRR) is the discount rate
that makes the present value of the future cash inflows
equal to the present value of the cash outflows.
 The IRR is exactly the interest rate at which the NPV is
equal to zero.
 Example:

$100
$75 =
(1 + i ) 5
i = 5.92%
Ranking Mutually Exclusive
Projects (cont.)
 NPV is the most important indicator to rank the
project instead of IRR.
 To rank projects according to their IRR may be
inconsistent with the objective of maximizing
shareholder value.
 The reason is a project’s IRR is independent of its
scale.
Inflation and Capital Budgeting
 There are two correct ways of computing NPV.
1. Use nominal cost of capital to discount nominal cash
flow.
2. Use real cost of capital to discount real cash flow.
Chapter 8 – Valuation of Known
Cash Flows: Bonds
Overview of corporate debt
 The corporation can borrow the capital from the
bankers (private debt – short term) or from issuing the
bond (public debt – long term)
 Smaller firms raise debt capital almost by borrowing
from banks while large firms borrow from banks and
issue bonds.
Basic bond features
 Bond indenture: a legal documentation shows right
and responsibility of the bondholders and the firms
(issuers).
 Claim on assets and income: these claims stands
before of these of the firms’ shareholders.
 Par or face value: face value of T-Bills, T-Notes, and T-
Bonds is $1,000.
Basic bond features (cont.)
 Coupon rate (fixed interest rate): T-Notes and T-Bonds
pay interest twice per year. T-Bills don’t pay interest.
 Maturity and repayment of principal: T-Bills is less
than 1 year, T-Notes is from 2 to 10 years, and T-Bonds
is usually 30 years. (Treasury Inflation Protected
Security – TIPS, with 5, 10, and 15 years; fixed coupon)
 Call provision and conversion feature: for corporate
bonds only.
Valuing corporate debt (bond)
 Step1: Determine cash flow - the amount and timing if
the interest and principal payment
 Step2: Estimate the appropriate discount rate on a
bond of similar risk. (the discount rate is the return
the bond will yield if it is held to maturity and all bond
payments are made)
 Step3: compute the present value
 bond value = PV of interest + PV of principal
Step1: Determine cash flow
 Example:
 Bond of ABC, face value is $1,000, coupon rate is 8% per
year (paid semiannually), and maturity is 5 years.
Step2: Estimate the appropriate
discount rate
 We have to find a bond with similar risk and maturity
to compute the market’s required yield to maturity
(YTM)
 Calculate the market’s required YTM
int erest1 int erestn principal
Bondprice = + ... + +
(1 + YTM ) 1
(1 + YTM ) (1 + YTM ) n
n
Step3: compute the present value
 Semiannual interest payment
 1 
1 − YTM 2 n 
(1 +
int erest  
)
Bondvalue =  2 
2  YTM 
 2 
 
 
 1 
+ principal
YTM 2 n 
 (1 + ) 
 2 
Step3: compute the present value
(cont.)
 Example (bond value or bond price)

 1 
1 − (1 + 0.0375) 2 x 20 
Bondvalue = ($85 / 2)  
 0.0375 
 
 1 
+ $1,000 2 x 20 
= $1,102.75
 (1 + 0.0375) 
Step3: compute the present value
(cont.)
 Annual

 1 
1 − (1 + YTM ) n 
Bondvalue = int erest 
 YTM 
 
 1 
+ principal n
 (1 + YTM ) 
Using Present Value Factor to Value
Known Cash Flows
 The formula for the present value of an ordinary
annuity of PMT for n period and an interest rate of i
1 − (1 + i) − n
PVPMT ( PMT , i, n) = PMT
i
 For example:
1 − (1 + 0.06) −3
PVPMT ($100,6%,3) = $100 = $267.3
0.06
 If the interest rate increases from 6% to 7%

PVPMT ($100 ,7%,3) = $262 ,43

Using Present Value Factor to Value
Known Cash Flows (Cont.)
 A change in market interest rate causes a change in the
opposite direction in the market value of all
consisting contracts promising fixed payments in the
future.
Pure Discount Bonds
 Pure discount bonds (zero-coupon bonds) are
bonds promise a single payment of cash at the
maturity date (face value or par value) .
 Example 1: we have one-year pure discount bond with
face value $1,000 and a price of $950.
 Example 2: we have two-year pure discount bond with a
face value $1,000 and a price of $880.
Pure Discount Bonds (cont.)
 The yield (interest rate) on the pure discount bonds is
the annualized rate of return.
FV
PVFV ( FV , i, n) =
(1 + i) n
 Example:

$1,000
$880 =
(1 + i ) 2
i = 6.60%
Pure Discount Bonds (cont.)
 Example: you have a cash flow of payments (three year
payment, $100 each) with different interest rates for
each PMT:
Maturity Price per $100 of Yield (one year)
face value
1 year $95 5.26%
2 years $88 6.66%
3 years $80 7.72%

$100 $100 $100

PV = + 2
+ 3
= $263
1.0562 1.0660 1.0772
Pure Discount Bonds (cont.)
 When the yield curve is not flat (when the observed
yields are not the same for all maturities) the correct
procedure for valuing a contract or securities
promising a stream of known cash payment is to
discount each of the payment at the rate
corresponding to a pure discount bond of its maturity
and then add the resulting individual payments
values.
Coupon Bonds, Current Yield, and
Yield to Maturity
 Coupon bonds are bonds that pay coupon (fixed
periodic payment of interest) and face value at the
maturity.
 Coupon rate is the interest rate applied to the face
value to compute the coupon payment.
 Example: cash flows for 10%, $1.000 coupon bond

year 0 1 2 3 4 5 6
100 100 100 100 100 100
1,000
Coupon Bonds, Current Yield, and
Yield to Maturity (cont.)
 Bond pricing principle 1: par bonds;
 If a bond’s price equals its face value, then its yield
equals its coupon rate.
 Par bonds are coupon bonds with the market price
equals to their face value. In this case, its yield is the
same as its coupon rate.
 Example: a bond maturing in one year, coupon rate is
10%, face value is $1,000; the current price is $1,000. Its
yield is 10% that equals coupon rate.
Coupon Bonds, Current Yield, and
Yield to Maturity (cont.)
 Bond pricing principle 2: premium bonds.
If a coupon bond has a price higher than its face value,
its yield to maturity is less than its current yield, which
is in turn less than its coupon rate.
 Often the price of a coupon bond and its face value are
not the same. The reason is the change of the interest
rate of the economy.
 For example: the interest rate of the economy
decreases; the price of a bond is higher than its face
value.
Coupon Bonds, Current Yield, and
Yield to Maturity (cont.)
 Premium bond: when the bond’s price is higher than
its face value.
 Example: one-year 10% coupon bond (face value is
$1,000) was issued as 20-year maturity bond 19 years
ago. Its market price is $1,047.02.
 Current yield = coupon / price
 Example: current yield = $100/$1,047.02=9.55%.
Coupon Bonds, Current Yield, and
Yield to Maturity (cont.)
 The yield to maturity when bond maturity is one year.
Yield to maturity = (coupon + face value – price) /
price.
 Example:
Yield to maturity = ($100 + $1,000 -$1,047.02) / $1,047.02 =
5%
 The YTM is the discount rate that makes the PV of the
bond’s stream of promised cash PMTs equal to its
price.
Coupon Bonds, Current Yield, and
Yield to Maturity (cont.)
 The yield to maturity when bond maturity is greater
than one year.

, n) = PVPMT ( PMT , YTM , n)

PVBond ( PMT , FV , YTMYTM
+ PVFV ( FV , YTM , n)
n
PMT FV
= +
t =1 (1 + YTM ) n
(1 + YTM ) n
Coupon Bonds, Current Yield, and
Yield to Maturity (cont.)
 Example: you buy two-year 10% coupon bond with a
face value of $1,000, current price of $1,100. What is its
yield?
 Current yield = coupon/price = 100/1,100 = 9.09%
 YTM?
100 100 1,000
1,100 = + +
(1 + YTM ) (1 + YTM ) (1 + YTM ) 2
2

YTM = 4.65%
 For a premium bond: YTM < Current yield <
coupon rate
Coupon Bonds, Current Yield, and
Yield to Maturity (cont.)
 Bond pricing principle 3: discount bonds.
If a coupon bond has a price lower than its face value,
its YTM is greater than its current yield, which is in
turn greater than its coupon rate.
 For example: the interest rate of the economy
increases; the price of a bond is lower than its face
value.
Coupon Bonds, Current Yield, and
Yield to Maturity (cont.)
 Example: a bond with 4% coupon rate maturing in two
years, face value is $1,000. Its current price is $950.
What is its yield?
 Current yield= coupon/price = $40/$950 = 4.21%
 YTM? $40 $40 $1,000
$950 = + +
1 + YTM (1 + YTM ) (1 + YTM ) 2
2

YTM = 6.76%

 For discount bonds: YTM > current yield > coupon

rate.
Why Yields for the Same Maturity
May Differ
 The effect of the coupon rate: when the yield curve
is not flat, bonds of the same maturity with different
coupon rates have different yields to maturity.
 The effect of default risk and taxes.
 If default risk of bond increases, its price decreases and
its yield increases.
 If tax of bond increases, its price decreases and its yield
increases.
Why Yields for the Same Maturity
May Differ (cont.)
 The other effects on bond yields:
 Callability: the feature gives the issuers the right to
redeem it before the maturity date. (the bond that has
this feature is called callable bond).
 Callability causes a bond to have lower price.
 Convertibility: the feature gives the bondholder the right
to convert the bond into a prespecified number of share
of common stock. (the bond that has this feature is
called convertible bond).
 Convertibility causes a bond to have higher price.
Behavior of Bond Prices over Time
 The effect of passage of time:
 Any discount bond’s price rises with the passage of time
and any premium bond’s price decreases with the
passage of time.
 This is because eventually bonds mature, and their
price must equal their face value at maturity.
Behavior of Bond Prices over Time
(cont.)
 The effect of changes in market interest rate.
 When market interest rate increases, the bond’s price
decreases.
 When market interest rate decreases, the bond’s price
increases.
Chapter 9 – Valuation of
Common Stocks
New York stock exchange listing
 IBM: US International Business Machines Corp.
 06/2/06. 13:16 New York. Currency: USD; Industry:
computer.

Price Change %chang Bid Ask Open Volume

e
79.360 -1.330 -1.648 N.A N.A 80.50 4,499,600
High Low 52-week 52 week Low 1-year
High 06/28/05 return
11/29/05
80.560 79.150 89.94 73.45 3.682%
New York stock exchange listing
(cont.)
 Divided yield = annualized dividend / stock price.
 Example: $2/$80 = 2.5%
 Price / earning ratio (P/E) = stock price / annualized
earning per share
 Example: $80/$4 = 20
Dividend Discount Model (DDM)
 DDM is defined as any model that computes the value
of a share of stock as the present value of its expected
future cash dividends.
 The risk – adjusted discount rate or market
capitalization rate (k) is the expected rate of return
that investors require in order to invest in the stock.
The Discount Dividend Model
(DDM)(cont.)
 Example: ABC stock has an expected dividend per
share D1, of $5, and the expected ex-dividend price at
the end of the year, P1, is $110.

D1 + P1 − P0
k=
P0
D1 + P1
P0 =
1+ k
5 + 110
p0 = = $100
1.15
The Discount Dividend Model
(DDM)(cont.)
 If the investor intends to hold the stock until the
second year, the offered price, Po, is:
D2 + P2
P1 =
1+ k
D2 + P2
D1 +
D +P 1+ k
P0 = 1 1 =
1+ k 1+ k
D D +P
P0 = 1 + 2 22
 The general 1 + k of(1the
formula + k ) DDM


D1 D2 Dt
P0 = + + ... + 
(1 + K ) (1 + K ) 2
t =1 (1 + K ) t
The Discount Dividend Model
(DDM)(cont.)
 Conclusion: the price of a share of stock is the present
value of all expected future dividends per share,
discounted at the market capitalization rate.
The Discount Dividend Model
(DDM)(cont.)
 The constant growth rate of dividend
D1
P0 =
K −g
 g: the constant growth rate of dividend
 Example: ABC’s dividends per share are expected to
grow at a constant rate of 10% per year. The present
value of the price of this perpetual stream of dividends
is:

5
P0 = = $100
0.15 − 0.10
Implication of the constant-
growth-rate DDM
1. If g=zero, then the valuation formula reduces to the
formula for the present value of a perpetuity.

P0 = D1 K
2. The higher the value of g, the higher the value of
stock. The model is valid only if g is less than k.
Implication of the constant-
growth-rate DDM (cont.)
3. The stock price is expected to grow at the same rate as
dividend.
D2
P1 =
k−g
D2 = D1 (1 + g )
D1 (1 + g )
P1 = = P0 (1 + g )
(k − g )
P1 − P0
=g
P0
Earning and investment
opportunity
 This is another way (instead of DDM) to compute the
firm’s value.
Dividendt = earningt + netnewinvestmentt
  
Dt Et It
P0 =  = −
t =1 (1 + k ) t
t =1 (1 + k ) t
t =1 (1 + k ) t

 If earning is perpetuity

E1
P0 = + NPVoffutureinvestment
k
Earning and investment
opportunity (cont.)
 Example: ABC firm with earning per share is $15; It pay
all of its earning out as dividends. Its capitalization is
15%. The ABC stock price is:
P0 = $15 / 0.15 = $100
 If this firm reinvests 60% of its earning each year into
new investment that yields 20% per year(it will pay out
only 40% of $15 as dividend). The new ABC stock price
is:
Earning and investment
opportunity (cont.)
 We have D $6
P0 = = = $200
k − g 0.15 − 0.12
 g = earning retention rate x rate of return on new
investment = 60% x 20% = 12%.
 To summary: growth per se doesn’t add value. What
adds value is the opportunity to invest in projects that
can earn rates of return in excess of the required rate,
k.
A reconsideration of the
price/earning multiple approach
 Stocks that have relatively high P/E ratios because
their future investments are expected to earn rates of
return in excess of the market capitalization rate are
called growth stocks.
 It is not growth per share that produces a high P/E
ratio, but rather the presence of future investment
opportunities that are expected to yield a rate of return
greater than the market’s required risk-adjusted rate
(k).
Does dividend policy affect
shareholder wealth?
 Dividend policy in frictionless environment.
In 1961, Modigliani and Miller (M&M) proved that in
frictionless environment (no taxes, no costs of issuing
new shares, or repurchasing existing shares, a firm’s
dividend policy can have no effect on the wealth of its
current shareholders.
 In the real world, there are a number of friction that
can cause dividend policy to have an effect n the
wealth of the shareholders.
Does dividend policy affect
shareholder wealth? (cont.)
 Cash dividend and share repurchases:
 There are two ways a corporation can distribute cash to
its shareholders: by paying cash dividend or by
repurchasing the company’s shares in the stock
market.
 In a frictionless environment, these two policies don’t
impact on the wealth of shareholders.
Does dividend policy affect
shareholder wealth? (cont.)
 Original balance sheet

Assets Liability and

shareholders’ equity
Cash $2 million Debt $2 million
Other assets $10 million Equity $10 million
Total $12 million Total $12 million

 Number of shares outstanding: 500,000

 Price per share : $20
Does dividend policy affect
shareholder wealth? (cont.)
 Balance sheet after payment of cash dividend

Assets Liability and

shareholders’ equity
Cash $1 million Debt $2 million
Other assets $10 million Equity $9 million
Total $11 million Total $11 million

 Number of shares outstanding: 500,000

 Price per share : $18
Does dividend policy affect
shareholder wealth? (cont.)
 Balance sheet after share repurchase

Assets Liability and

shareholders’ equity
Cash $1 million Debt $2 million
Other assets $10 million Equity $9 million
Total $11 million Total $11 million

 Number of shares outstanding: 450,000

 Price per share : $20
Does dividend policy affect
shareholder wealth? (cont.)
 Stock splits and stock dividend.
 These activities don’t distribute cash to shareholders,
they increase the number of shares of stock
outstanding.
 In a frictionless environment, these activities don’t
impact on the wealth of shareholders.
Does dividend policy affect
shareholder wealth? (cont.)
 Balance sheet after stock dividend

Assets Liability and

shareholders’ equity
Cash $2 million Debt $2 million
Other assets $10 million Equity $10 million
Total $12 million Total $11 million

 Number of shares outstanding: 550,000

 Price per share : $18.18
Dividend in the real world
 In the real world, there are a number of frictions that
can cause dividend policy to have an effect on the
wealth of shareholders.
 There are a number of frictions: taxes, regulations, the
cost of external finance, and the informational content
of dividend.
Chapter 11 – Hedging, Insuring,
and Diversifying
Using forward and futures
contracts to hedge risk
 Forward contract exchanges some item in the future
in a prearranged price (forward price) between two
parties.
 The price for immediate delivery of the item is called
the spot price.
 No money is paid in the present by either to the other.
Using forward and futures
contracts to hedge risk (cont.)
 The face value of the contract is the quantity of the
item specified in the contract times the forward price.
 The party who agrees to buy the specified item is said
to take a long position, and the party who agrees to sell
the item is said to take a short position.
Using forward and futures
contracts to hedge risk (cont.)
 A futures contract is essentially a standardized
(quantity, delivery time) forward contract that is
traded on some organized exchanges.
 It is convenient to have standardized futures contracts
instead of forward contracts.
 The futures exchange operates as an intermediary
matching buyers and sellers.
 Most of the futures contracts are settled in cash
(speculation).
Futures Contracts
 Standardizing Features
 Contract Size
 Delivery Month
 Daily resettlement
 Minimizes the chance of default
 Initial Margin
 About 4-10% of contract value
 Cash or T-bills held in a street name at your
brokerage
Selected Futures Contracts
Contract Contract Size Exchange
Agricultural
Corn 5,000 bushels Chicago BOT
Wheat 5,000 bushels Chicago & KC
Cocoa 10 metric tons CSCE
OJ 15,000 lbs. CTN
Metals & Petroleum
Copper 25,000 lbs. CMX
Gold 100 troy oz. CMX
Unleaded gasoline 42,000 gal. NYM
Financial
British Pound £62,500 IMM
Japanese Yen ¥12.5 million IMM
Eurodollar $1 million LIFFE
Wall Street Journal Futures Price Quotes
Highest price that day
Lifetime Open
Open High Low Settle Change High Low Interest
Highest and lowest prices over the lifetime of the contract.
Corn (CBT) 5,000 bu.; cents per bu.
July 179 180 178¼ 178½ -1½ 312 177 2,837
Sept 186 186½ 184 186 -¾ 280 184 104,900
Dec 196 197 194 196½ -¼ 291¼ 194 175,187

TREASURY BONDS (CBT) - $1,000,000; pts. 32nds of 100%

Sept 117-05 117-21 116-27 117-05 +5 131-06 111-15 647,560
Dec 116-19 117-05 116-12 116-21 +5 128-28 111-06 13,857
Opening price Closing price Daily Change
DJ INDUSTRIAL AVERAGE (CBOT) - $10 times average
Sept 11200 11285 11145 11241 -17 11324 7875 18,530
Dec 11287 11385 11255 11349 -17 11430 7987 1,599
Lowest price that day
Expiry month Number of open contracts
Hedging foreign exchange risk with
swap contracts
 A swap contract consists of two parties exchanging
(swapping) a series of cash flows at specified intervals
over a specified period of time.
 Most swap contracts involve the exchange of
currencies, and interest rates.
25.7 Swaps Contracts
 In a swap, two counterparties consent to a
contractual arrangement wherein they agree to
exchange cash flows at periodic intervals.
 There are two types of interest rate swaps:
 Single currency interest rate swap
 “Plain vanilla” fixed-for-floating swaps are often just called
interest rate swaps.
 Cross-Currency interest rate swap
 This is often called a currency swap; fixed for fixed rate debt
service in two (or more) currencies.
25.7 Swaps Contracts
 In a swap, two counterparties consent to a
contractual arrangement wherein they agree to
exchange cash flows at periodic intervals.
 There are two types of interest rate swaps:
 Single currency interest rate swap
 “Plain vanilla” fixed-for-floating swaps are often just called
interest rate swaps.
 Cross-Currency interest rate swap
 This is often called a currency swap; fixed for fixed rate debt
service in two (or more) currencies.
Hedging shortfall risk by matching
assets and liabilities
 The insurance companies and financial intermediaries
can hedge their liabilities in the financial markets by
investing in assets that match the characteristics of
their liabilities.
 For example: if a saving bank has customer liabilities
that are short-term deposits an interest rate that
floats, the appropriate hedging instrument is a
floating-rate bond.
Insuring versus hedging
 There is a fundamental difference between insuring
and hedging. When you hedge, you eliminate the risk
of loss by giving up the potential for gain, when you
insure, you pay a premium to eliminate the risk of loss
and retain the potential of gain.
Basic features of insurance
contracts
 Exclusions and caps:
 Exclusions are losses that might seem to meet the
conditions for coverage under the insurance contract but
are specifically excluded.
 Caps are limits placed on compensation for particular
losses covered under an insurance contract.
 Deductible is an amount of money that the insured
party must pay out of his or her own resources before
receiving any compensation from the insurer.
Deductibles creates incentives for insured party to
control their losses.
Basic features of insurance
contracts (cont.)
 Copayment means that the insured party must cover a
fraction of the loss.
 Copayment are similar to deductibles in that the
insured party winds up paying part of the losses. The
difference is in the way the partial payment is
computed and in the incentives created for the insured
party to control loss.
Financial guarantee
 Financial guarantee are insurances against credit risk,
which is the risk that other party to a contract into
which you have entered will default.
 For example: credit card.
Caps and floor of interest rates
 Interest rate risk depends on one’s perspective –
whether you are a borrower or lender.
 If you are a depositor (lender), an interest rate
insurance policy for you would take for of an interest-
rate floor, which means a guarantee of minimum
interest rate.
 If you are a borrower, an interest rate insurance policy
for you would take for of an interest-rate cap, which
means a guarantee of maximum interest rate.
Option as insurance
 An option is the right to either purchase or sell
something at a fixed price in the future.
 There are many kinds of option: commodity options,
stock and bond options, foreign exchange options, etc.
 There is a special set of terms associated with option
contracts:
 A option to buy the specified item at a fixed price is a
call; a option to sell is a put.
Option as insurance (cont)
 The fixed price specified in an option contract is called
the option’s strike price or exercise price.
 The date after which an option can no longer be
exercised is called expiration date or maturity date.
 Put option on stocks protect against losses from a
decline in stock price.
 Put option on bonds provide insurance against losses
stemming from either source of risk (default risk and
risk-free interest rate).
22.2 Call Options
 Call options gives the holder the
right, but not the obligation, to buy
a given quantity of some asset on or
before some time in the future, at
prices agreed upon today.
 When exercising a call option, you
“call in” the asset.
Call Option Profits
60
Option profits ($)

40 Buy a call

20
10

20 40 50 60 80 100 120
–10 Stock price ($)
–20

Exercise price = $50; option premium = $10

–40
22.3 Put Options
 Put options gives the holder the
right, but not the obligation, to sell a
given quantity of an asset on or
before some time in the future, at
prices agreed upon today.
 When exercising a put, you “put” the
asset to someone.
Put Option Profits
60
Option profits ($)

40

20
10
Stock price ($)
20 40 50 60 80 100
–10
Buy a put
–20

–40 Exercise price = $50; option premium = $10

22.1 Options
 An option gives the holder the right, but not the
obligation, to buy or sell a given quantity of an asset on (or
before) a given date, at prices agreed upon today.
 Exercising the Option
 The act of buying or selling the underlying asset
 Strike Price or Exercise Price
 Refers to the fixed price in the option contract at which the
holder can buy or sell the underlying asset
 Expiry (Expiration Date)
 The maturity date of the option
Options
 European versus American options
 European options can be exercised only at expiry.
 American options can be exercised at any time up to expiry.
 In-the-Money
 Exercising the option would result in a positive payoff.
 At-the-Money
 Exercising the option would result in a zero payoff (i.e.,
exercise price equal to spot price).
 Out-of-the-Money
 Exercising the option would result in a negative payoff.
The diversification principle
 The diversification principle states that by
diversifying across risky assets people can sometimes
achieve a reduction in their overall risk exposure with
no reduction in their expected return.
 Diversification with uncorrelated risks

n
E ( X ) =  Pi X i
i =1
The diversification principle (cont.)
 The part of the portfolio volatility that can be
eliminated by adding more stocks is the diversifiable
risk, and the part that remains no matter how many
stocks are added is called non-diversifiable risk.
 If an event occurs that affects many firms, such as
unanticipated downturn in general economic
condition, then many stocks can be affected. The risk
of loss stemming from such event is called market
risk.
The diversification principle (cont.)
 An event occurs that affects only one firm (lawsuit,
strike). This risk can be diversified away, it is called
firm-specific-risk.
Diversification and cost of
insurance
 The more diversified are the risks in a portfolio of a
given size, the less it will cost to insure the portfolio’s
total value against a loss.
Chapter 12 – Portfolio
Opportunities and Choices
The process of personal portfolio
selection
 It is a process to decide how much to invest in stocks,
bonds, securities, and other assets).
 The life cycle: in portfolio selection the best strategy
depends on an individual’ personal circumstances
(age, family status, occupation, income, wealth, etc.).
 Time horizons: when you decide your portfolio, you
have to choose the length of time of your plan.
The process of personal portfolio
selection (cont.)
 Risk tolerance:
 It is one’s attitude toward risk; it shows how much one
can handle risk.
 It depends on one’s characteristics: age, family status,
job status, wealth, etc.
 It is a major factor of portfolio selection.
 The role of professional asset managers
 Most people rely on the investment advisor or buy the
finished products from the financial intermediaries for
their portfolio selection.
The trade off between expected
return and risk
 The goal of the professional portfolio manager is to
find the portfolio that offers the investors the highest
expected rate of return for any degree of risk.
 Portfolio optimization is often done as a two step
process: 1/. Find the optimal combination of risky
assets, and 2/. Mix this optimal risky-asset portfolio
with the riskless asset.
The trade off between expected
return and risk (cont.)
 The riskless asset is defined as a security that offers a
perfectly predictable rate of return in term of the unit
of account selected for analysis and the length of the
investor’s decision horizon.
 Usually, the U.S. government bond is preferred as the
riskless asset.
Combining the riskless asset and a
single risky asset
 The portfolio’s expected return to the proportion
invested in the risky asset.

E (r ) = rf + wr ( E (rs ) − rf )
 ( E (rs ) − rf ): risk premium.
 E(r): the expected return on the portfolio.
 W(r): the proportion is allocated to the risky asset.
 E (rs ): the expected return on the risky asset.
 r f : the riskless rate.
Example
E (r ) = 0.06 + w(0.14 − 0.06)
ifE(r ) = 0.09
w = 0.375
Combining the riskless asset and a
single risky asset (cont.)
 The portfolio standard deviation to the proportion
invested in the risky asset.
 =  r wr
  r: the standard deviation of the risky asset.
 The relation between E(r) and σ

E (rs ) − rf
E (r ) = rf + 
s
Examples
 The standard deviation of the portfolio is:

 =  r wr = 0.2 x0.375 = 0.075

 The relation between the portfolio expected return
and its standard deviation:

E (r ) = 0.06 + 0.4
The systematic risk (non-
diversifiable risk)
 The systematic risk impacts almost all of the
investments.
 This is the common element of investment returns
that causes the returns to be correlated.
 The returns of some investments are more sensitive to
systematic risk than those of other investments
 This risk contributes to the standard deviation of the
large diversified portfolio
The unsystematic risk (diversifiable
risk)
 The return of an investment changes because of a
specific event of the investment
 This risk contributes almost nothing to the standard
deviation of the large diversified portfolio
Portfolio efficiency
 An efficient portfolio is defined as the portfolio that
offers the investors the higher possible expected rate of
return at a specified level of risk.
 Portfolio with two risky assets or
one riskless asset and one risky
asset
 The expected rate of return (E(r)):
E (r ) = wE (r1 ) + (1 − w) E (r2 )
 The variance
(: )
2

 = w  + (1 − w)  + 2w(1 − w) 1, 2 1 2
2 2 2
1
2 2
2

 This equation is a more general form of one previous

equation. When the asset 2 is riskless, then .
2 = 0
Portfolio with two risky assets
(cont.)
 The expected return of the portfolio of two risky assets
is independent of the correlation between the pair of
assets.
 The standard deviation of the portfolio of two risky
assets is dependent of the correlation between the pair
of assets.
 The optimal combination of risky
assets
 The optimal combination of risky asset is a
portfolio of risky assets that then mixed with the
riskless asset to achieve the most efficient portfolio.
 The formula for finding portfolio proportion (two risky
assets)

( E (r1 ) − rf ) 22 − ( E (r2 ) − rf ) 1, 2 1 2

w1 =
( E (r1 ) − rf ) 22 + ( E (r2 ) − rf ) 12 − ( E (r1 ) − rf + E (r2 ) − rf ) 1, 2 1 2

w2 = 1 − w1
Selecting the preferred portfolio
 There is a single portfolio of the two risky assets (we
assume that we have a two risky-asset-portfolio) that it
is best to combine with the riskless asset. We call this
particular risky portfolio, which corresponds to the
tangency point T in the Figure 2.1, the optimal
combination of risky assets. The preferred portfolio is
always some combination of this tangency portfolio
and the riskless asset.
Portfolio of many assets
 We use two step method of portfolio construction
similar to the one used in the previous section
 First, we consider portfolio constructed from the risky
assets only.
 Second, we find the tangency portfolio of risky assets to
combine with the riskless asset.
 The efficient portfolio frontier is the set of
portfolios of risky assets offering the highest possible
expected rate of return for any given standard
deviation.
Chapter 13 – Capital Market
Equilibrium
The capital asset pricing model
(CAPM)
 CAPM is used to determine a theoretically appropriate
required rate of return of an asset (stock)


E (rj ) = rf +  j E (rM ) − rf 
 E ( r ): the expected return on the capital asset
j
r
 f: the risk-free rate
E (rM ): the expected return of the market portfolio (S&P
500)
( )
 E ( r ) − r : the market premium
M f
CAPM (cont.)
 E (r ) − r : the risk premium
j f

 Equation of β
 jM
cov(rj , rM )
j = = 2
var(rM ) M
 http://www.investopedia.com/articles/financial-
theory/09/calculating-beta.asp
 Example: the β of stock ABC is 1.1, the current risk free rate
is 0.06 per year, the market risk premium is 0.08 per year.

E (rABC ) = 0.06 + 1.1(0.08) = 0.148 = 14 .8%
The security market line (SML)
E(r)
SML

Beta
The security market line (SML)
(cont.)
 The straight line relationship between the beta and
expected return is called the SML
 The SML is simply a graphical representation of the
CAMP
The capital asset pricing model in
brief
 A portfolio that holds all assets in proportion to their
observed market value is called market portfolio
(S&P 500 – a real example of market portfolio).
 Depending on their risk aversion, investors hold
different mixes of risk-free and risky assets, but the
relative holdings of risky assets are the same for all
investors.
Capital market line (CML)
 The CML’s formula:
E (rM ) − rf
E (rj ) = rf + j
M

 The expected return of portfolio j depends on standard

deviation (risk level) of portfolio j, risk free rate, the
market premium, and standard deviation of the
market portfolio.
Determinants of the risk premium
on the market portfolio
E (rM ) − rf = A 2
M

 E (rM ) − rf : the risk premium of the market portfolio.

  2
: the variance of the market portfolio.
M
 A: the degree of risk aversion of the holder of wealth.
Beta and risk premium on
individual securities
 Formula of beta (β):  j ,M
j = 2
M
  j, M: the covariance between the return on security j
and the return on the market portfolio.
 The risk premium of any asset is equal to its beta times
the risk premium on the market portfolio (the
security market line – SML).

E (rj ) − rf =  j ( E (rM ) − rf )
Beta and risk premium on
individual securities (con.)
 The beta provides a proportional measure of the
sensitivity of a security’s realized return to the realized
return on the market portfolio.
 Any portfolio that lines on the CML has beta equal to
the fraction of the portfolio invested in the market
portfolio.
Using the CAPM in portfolio
selection
 The CAPM implies that the market portfolio of risky
assets is an efficient portfolio; the investors therefore
follow a simple portfolio strategy:
 Diversify your holdings of risky assets in the proportions
of the market portfolio, and
 Mix this portfolio with the risk free asset to achieve a
desired risk-reward combination.
Using the CAPM in portfolio
selection (cont.)
 In practice, the market portfolio used in measuring the
performance of portfolio managers is a well-diversified
portfolio of stocks rather than the true market
portfolio of all risky assets.
 Indexing is a strategy of performance benchmark.
Because portfolio used as proxy for the market
portfolio often has the same weights as well-known
stock marker indexes such as the S&P 500.
Valuation rates of return
 The CAPM is also used to find discount rate in the
discounted cash flow.
 The CAPM is also used in capital budgeting decisions
of firms.
Chapter 16 – Financial structure
of the firm
Internal versus external financing
 There are two sources of capital: internal and external
financing
 Internal financing: retained earning, accounts
receivable, etc.
 External financing: stock, bond, etc.
Equity financing
 Equity is a claim to the residual that is left over after all
debts have been paid
 There are three types of equity claims: common stock,
stock option, preferred stock.
 Common stock confers on its holder the residual claim
to the corporation’s assets
 Stock option gives the holder the right to buy common
stock at a fixed exercise price in the future
Equity financing (cont.)
 Preferred stock gives the holder a right to receive a
promised dividend that is received before the firm
pays the dividend to the common stock
Debt financing
 Debt financing includes accounts payable, loans,
bonds,, leases, pensions.
 Secured debt: the corporation pledges a particular
asset (collateral) to as security for the debt
 Long-term lease looks like to buy an asset with debt
secured by the leased asset
 The difference between the secured bond and the lease
is who bears the risk associated with the residual market
value of the leased asset at the end of the term of the
lease
Pension liability
 Pension plans are defined into two types: defined
contribution and defined benefit
 Defined contribution is regular contribution of the
employee. This accumulated money, the employee will
receive it back in retirement.
 Defined benefit is contribution of the employer to the
employee in retirement. Usually, this money depends
on the years of service for the employer
Modigliani–Miller theorem
 This theorem states that the firm’s value doesn’t
depend on the capital structure (full equity or mix
between equity and debt)
 Assumptions:
 No income taxes
 No transactions costs of issuing debt or equity
 Investors can borrow on the same term as the firm
 The various shareholders of the firm are able to resolve
any conflicts of the interest among themselves
Modigliani–Miller theorem (cont.)
 Without taxes:
 Proposition I:
VU = VL

 VU: value of unlevered firm

 V L: Value of levered firm
 Proposition II

D
rE = rO + (rO − rD )
E
Modigliani–Miller
r
theorem (cont.)
E
 is the required rate of return on equity, or cost of
equity

rOis the company unlevered cost of capital (ie assume
no leverage)
 rDis the required rate of return on borrowings, or cost
of debt
 D/E is the debt to equity ratio
Modigliani–Miller theorem (cont.)
 With taxes
 Proposition I
VL = VU + TC D

 TCis the tax rate

 D is the value of debt
Modigliani–Miller theorem (cont.)
 Proposition II
D
rE = rO + (rO − rD )(1 − TC )
E
rE
 is the required rate of return on equity, or cost of levered
equity = unlevered equity + financing premium.
rO
 is the company cost of equity capital with no leverage
(unlevered cost of equity, or return on assets with D/E = 0)

rDis the required rate of return on borrowings, or cost of debt
 D/E is the debt-to-equity ratio
 is the tax rate
TC
Reducing taxes
 Corporate tax rate is 34%
 Breakdown of values of claims for Nodebt and Somedebt

Claimant Nodebt Somedebt

Creditors 0 $40 million
Shareholders $66 million $39.6 million
Government tax $34 million $20.4 million
Total $100 million $100 million

 Market value of Somdebt = Market value of Nodebt +

PV of interest tax shield
Reducing costs because of
subsidies
 Some firms can receive the subsidies in term of debts if
the firms invest into some special fields
 If the firms invest in these special fields, they would
take the subsidized debts and decrease the costs.
Costs of financial distress
 The costs relate to the firm’s bankruptcy. The higher
the debt level, the more the costs of bankruptcy.
 The firm needs to balance between the costs of
financial distress and the benefit of tax shield to
choose a reasonable rate between the debt and the
equity.
Dealing with agency problem
 The agency problem is conflict between the manager
and the shareholders.
 To increase the debt to equity ratio can decrease the
agency problem
Dealing with conflict between
creditors and shareholders
 When the debt to the equity ratio is high, the manager
can take the risky projects. The creditors bear all risk
while the shareholders get all of the incremental
upside potential for gain
 To decrease the debt to the equity ratio can limit this
conflict
Chapter 4 - Allocating Resources
Over Time
Compounding
 Simple interest and compound interest.
 Interest earned on interest already paid is called
compound interest.
 Future value (FV)
 Example:

FV = $1,000 x(1 + i ) n
 i: the interest rate
 n: the number of years
Compounding (cont.)
 In general , for any present value invested, the future
value factor is given by:

FV = $1,000 x(1 + i ) n

 i : the interest rate for each period.

 n : the number of period.
The Frequency of Compounding
 Annual Percentage Rate (APR) is interest rate on
loans and saving accounts are usually stated.
 Because the frequency of compounding can differ, it is
important to calculate Effective Annual Rate (EFF).

 m: the number of compounding periods per year

APR m
EFF ( APR, m) = (1 + ) −1
m
 0.06 2
EFF (6%,2) = (1 + ) − 1 = 6.09%
2
Present Value and Discounting
 Present value factor (present value)
FV
PVFV ( FV , i, n) =
(1 + i) n
 FV: the future value
 i: the periodic interest rate (discount rate)
 n: the number of compounding periods
 Calculating present values is called discounting
Present Value and Discounting
(Cont.)
 Discounting with compounding
FV
PVm ( FV , APR , n, m) =
APR mn
(1 + )
m
 m: the number of compounding period per year.
 Example:

$500
PVm ($500 ,10 %,5,2) = = $306 ,96
10 % 10
(1 + )
2
Present Value and Discounting
(Cont.)
 The continuous discounting case
− APR.n
PVcon = FV .e
 Example:

1
− 0.10
PV = $10,000.e 2
= $9,512.29
Alternative Discounted Cash Flow
Decision Rules
 The Net Present Value (NPV) is the difference
between the present value of all future cash inflows
minus the present value of all current and future cash
outflows.
 Accept a project if its NPV is positive. Reject a project
if its NPV is negative.
 Opportunity cost of capital is the rate we could earn
somewhere else if we don’t invest in the project under
evaluation.
Alternative Discounted Cash Flow
Decision Rules (cont.)
 Future value rule: to invest in the project if its future
value is greater than the future value that will obtain in
the next best alternative.

FV = PV (1 + i ) n

 Internal rate of return (IRR): accept an investment

if its return is greater than the opportunity cost of
capital.
Multiple Cash Flow
 In some projects, there are more than one cash flow.
To calculate NPV of these projects, we have to calculate
NPV for each cash flow and add them together.
Annuities
 Annuities are essentially a series of fixed payment
required from you or paid to you at a specified
frequency over the course of a fixed time period.
 If the cash flows start immediately; it is called
immediate annuity.
 If the cash flows start at the end of the current period
rather than immediately; it is called ordinary
annuity.
Annuities (cont.)
 Future value of annuity
 Ordinary annuity
(1 + i ) − 1
n
FV =  payment / period
i
 Example: to save $100 each year for the next three years
(at the end of each year), how much will you have
accumulated at the end of that time if the interest rate is
10% per year?
(1 + 0.1) − 1 3
FV = x$100 = $331
0.1
Annuities (cont.)
 Immediate annuity ($1 per year)
(1 + i ) − 1
n
FV = (1 + i )
i
 Example: to save $100 each year for the next three years
(at the beginning of each year), how much will you have
accumulated at the end of that time if the interest rate is
10% per year?

(1 + 0.1)3 − 1
FV = x$100(1 + 0.1) = $364
0.1
Annuities (cont.)
 Present value of an− nordinary annuity
1 − (1 + i )
PV =  payment / period
i

 Example: how much you have to put into a fund

earning an interest rate of 10% per year to be able to
take out $100 per year for the next three years?

−3
1 − (1 + 0.1)
PV = x$100 = $248
0.1
Annuities (cont.)
 Buying an annuity
 What implied interest rate is the insurance company paying
you?
 How long must you live for the annuity to be worthwhile?
 Example: For a cost of $10,000, the insurance company will
pay you $1,000 per year for the rest of your life ( you are 65
years old now). If you can earn 8% in a bank account, and
you can live until age 80; it is worth buying this annuity,
and what implied interest rate is insurance company
paying you? (PV=$8,559.48; i=5.56, N=20 years)
Annuities (cont.)
 Taking a mortgage loan
 What is the amount of the monthly payment?
 Which loan is the better deal?
 Example: mortgage loan is $100,000; 30 years or 360
payments. If the interest rate is 12% per year. What is
the monthly payment? ($1,028).
 Another bank offers 15 year mortgage loan or 180
payments with monthly payment of $1,100. Which loan
is the better deal? (i =10.84%)
Perpetual Annuities
 A perpetuity is a stream of cash flows (annuities) that
lasts forever (preferred stocks). The PV of an ordinary
perpetuity annuity:
C
PV =
i
 C: the periodic payment.
 Example: a preferred stock pays a fixed cash dividend each
period and never mature.
 A preferred stock offers cash dividend $10 per year and it is
selling at $100 per share. What is the yield of this stock?
Perpetual Annuities (cont.)
 Growth perpetuity is a perpetuity that grows at a
constant rate (investing in a property).
C1
PV =
i−g
 g: the growth rate
 You want to invest into a property that gives you $1,000
at the first year and it grows 4% per year in perpetuity.
How much do you offer? (discount rate is 9%).
(PV=$20,000).
Perpetual Annuities (cont.)
 Investing in preferred stock
 What is the yield of preferred stock?
 Investing in common stock
 How much should you be wiling to pay for the stock?
Loan Amortization
 Loan amortization is the process of paying off a loan’s
principal gradually over its term.
 Part of each payment is interest on the outstanding
balance of the loan and part of repayment of principal.
Amortization schedule for 3-year loan at 9%

year Beginning Total Interest Principal Remaining

balance payment paid paid balance
1 $100,000 39,505 9,000 30,505 69,495
2 69,495 39,505 6,255 33,251 36,244
3 36,244 39,505 3,262 36,244 0
Total 118,516 18,516 100,000
Amortization schedule for a-month
loan at 1% per month
Month Beginning Total
balance payment
Interest
paid
Principal
paid
Remainin
g balance
1 $1,000 88.85 10 78.85 921.15
2 921.05 88.85 9.21 79.64 841.51
3 841.51 88.85 8.42 80.43 761.08
4 761.08 88.85 7.61 81.24 679.84
5 679.84 88.85 6.80 82.05 597.79
6 597.79 88.85 5.98 82.87 514.91
7 514.91 88.85 5.15 83.70 431.21
8 431.21 88.85 4.31 84.54 346.67
9 346.67 88.85 3.47 85.38 261.29
10 261.29 88.85 2.61 86.24 175.05
11 175.05 88.85 1.75 87.10 87.96
12 87.96 88.85 0.88 87.97 0
Total 1,066.20 66.20 1,000
Interest rate and Time Value of
Money
 In any time value of money calculation, the cash flows
and the interest rate must be dominated in the same
currency.
Inflation and Discounted Cash Flow
Analysis
 Real rate of interest = (nominal interest rate – rate of
inflation)/ (1 + rate of inflation).
 Example: (0.08 – 0.05) / (1 + 0.05) = 0.0286 or 2.86%
 Nominal interest rate is the rate dominated in in dollar
or in some other currency.
 Real interest rate is dominated in units of consumer
goods.
 With continuous compounding:
 Real interest rate = nominal interest rate – inflation rate.
Inflation and Discounted Cash Flow
Analysis (cont)
 Inflation and future values.
 Example: real future value of $100 with real interest rate
of 2.857% per year in 45 years.
Re alFV = $100 x1.02857 45
= $355
 Inflation and present value.
 Example: you want to buy a car four years from now; its
current price is $10,000. interest rate is 8% per year; and
inflation rate is 5% per year. How much do you save
today?

$12,115
PV = 4
= $8,934
1.08
Inflation and Discounted Cash Flow
Analysis (cont)
 Saving for college (p.136)
Tax and Investment Decision
 Rule: invest so as to maximize the net present value of
your after tax cash flows.
 After-tax interest rate= (1-tax rate)x before-tax interest
rate
 Example: you put $1,000 into a bank account with a
interest rate of 8% per year. Suppose that you pay 30% in
taxes on any interest that you earn.
 After-tax interest rate =(1-0.3)x8% = 5.6%
Part III – Valuation Models.
Chapter 7 – Principles of Market
Valuation.
The Relation between an Asset’s
Value and Its Price
 An asset’s fundamental value as the price well –
informed investor must pay for it in free and
competitive market.
 There can be a temporary difference between the
market price of an asset and its fundamental value.
 It is good practice to assume that the price is an
accurate reflection of value.
Value Maximization and Financial
Decisions
 The financial decision can rationally be made purely
on the basic of value maximization, regardless of the
strangers’ risk preferences or expectations about the
future.
The Law of One Price and Arbitrage
 The law of one price states that in a competitive
market, if two assets are equivalent, they will tend to
have the same market price.
 The law of one price is enforced by a process called
arbitrage, the purchase and immediate sale of
equivalent assets in order to earn a sure profit from a
difference in their prices.
Arbitrage and the Price of Financial
Assets
 The Law of one price and arbitrage also applies for
financial assets.
 The law of one price is the most fundamental
valuation principle in finance.
 Sometimes the law of one price doesn’t hold, because
something is interfering with the normal operation of
the competitive market (no two distinct assets are
identical all respects).
Interest Rate and the Law of One
Price
 Competition in financial markets ensures that not only
the prices but also that interest rates on equivalent
assets are the same.
Exchange Rate and Triangular
Arbitrage
 For any three currencies that are freely convertible in
competitive markets, it is enough to know the
exchange rate between any in order to know the third.
 Example of triangular arbitrage
Valuation Using Comparables
 The process of valuation requires that we find assets
comparable to the one whole value we want to estimate
and make adjustments about which differences have a
bearing on their value to investors.
 The point is that even when the force of arbitrage
cannot be relied on to enforce the law of one price, we
still rely on its logic to value assets.
Valuation Models
 The quantitative method used to infer an asset’s value
from information about the prices of other comparable
assets and market interest rates is called a valuation
model.
 Example: valuing share of stock
 Estimated value of a share of XYZ stock = XYZ earning
per share x (industry average price/ earning multiple)
($2 x 10 = $20).
Accounting Measures of value
 The value of an asset or liability on the balance sheet
or other financial statements often differ from the
asset’s current market value because accountants
usually measure assets by their original cost.
 The value of the asset on the balance sheet is called the
asset’s book value.
The Efficient Markets Hypothesis
(EMH)
 The efficient market hypothesis is the proposition that
an asset’s current price fully reflects all publicly
available information about future economic
fundamentals affecting the asset’s value.
 Example: stock exchange
Part IV – Risk Management and
Portfolio Theory.
Chapter 10- Principles of Risk
Management.
What is risk?
 Risk is uncertainty that affects people’s welfare.
 Risk aversion: risk – averse people prefer the lower-
risk alternative for the same cost.
Risk management
 Risk management is a process of formulating the
benefit-cost trade-offs of risk reduction and deciding
on the course of action to take.
 If you face a particular type of risk because of your job,
business, you are said to have a risk exposure.
 Speculators are investors who take positions that
increase their exposure to certain risk in the hope
increasing their wealth. In contrast, hedgers take
position to decreases exposures.
Risk and economic decisions.
 Risk facing households:
 Sickness, disability, and death.
 Unemployment risk.
 Consumer-durable asset risk.
 Liability risk.
 Financial-asset risk.
 Risks facing firms:
 Production risk.
 Price risk of outputs.
 Price risk of inputs.
The risk management process.
 The risk management process is a systematic attempt
to analyze and deal with risk. The process can be
broken down into five steps:
 Risk identification.
 Risk assessment.
 Selection of risk management techniques.
 Implementation.
 Review.
The risk management process
(cont.)
 Risk assessment is the quantification of the costs
associated with the risks.
 The firms need to rely on the professional investment
advisors: insurance companies, mutual funds, etc.
The risk management process.
(cont.)
 There are four basic techniques available for reducing risk:
 Risk avoidance.
 Loss prevention and control (diversification).
 Risk transfer (the financial system has a popular role) .
 Hedging
 Forward contract

 Future contract

 Option

 Swap

 Insurance
 Risk retention (small risk).
Three dimensions of risk transfer.
 There are three dimensions of risk transfer: hedging,
insuring, and diversifying.
 Hedging is an action taken to reduce one’s exposure to
a loss also causes one to give up of the possibility of a
gain.
 For example a farmer signs a contract to sell the crop in
advance; this farmer decreases the loss when the price
decreases but he (or she) also gives up benefit if the
price increases.
Three dimensions of risk transfer
(cont.)
 Insuring means paying a premium (the price paid for
the insurance) to avoid risk.
 For example a farmer pays a premium to an insurance
company to insure his (or her) crop because of bad
weather.
Three dimensions of risk transfer
(cont.)
 There is a fundamental difference between hedging
and insuring. When you hedge, you eliminate the risk
of loss by giving up the potential for gain. When you
insure, you pay a premium to eliminate the risk of loss
and retain the potential for gain.
Three dimensions of risk
transfer.(cont.)
 Diversifying means holding similar amounts of many
risky assets instead of concentrating all of your
investment in only one.
 Diversifying thereby limits your exposure to the risk of
any single asset. Diversification also decreases the rate
of return.
 In order to diversify, the risks must be less than
perfectly correlated with each other.
Three dimensions of risk
transfer.(cont.)
 Diversifying can carry out by the individual investors
directly in the market, or by the firm, or by a financial
intermediary (for example mutual funds).
Institutions for risk management
 Insurance companies, future markets, stock markets,
banks, etc. are examples of institutions whose primary
economic function is to transfer and manage risk.
 The products of these institutions are securities,
deposits, future, option, and swap contracts.
 These institutions help to transfer risk and encourage
economic efficiency.
Institutions for risk management
(cont.)
 Two key categories of factors limiting the efficient
allocation of risks are transaction cost and incentive
problems.
 Transaction cost are cost of establishing, running
institutions, writing, and enforcing contracts.
 Incentive problems include moral hazard and adverse
selection.
Probability distribution of returns
 The expected rate of return (the mean) is defined as
the sum over all possible return outcomes of each
possible rate of return multiply by the respective
probability of its happening.

State of Rate of return Rate of return Probability

economy of stock B of stock A
Strong 50% 30% 0.20
Normal 10% 10% 0.60
Weak -30% -10% 0.2
Probability distribution of returns
(cont.)
 The expected rate of return is defined as the sum
over all possible outcomes of each possible rate of
return multiply by the respective probability of its
happening.
E (r ) = P1r1 + P2 r2 + ... + Pn rn
n
E (r ) =  Pi ri
i =1

- E(A) = (0.2x30%) + (0.6x10%) + (0.2x-10%) = 10%

- E(B) = (0.2x50%) + (0.6x10%) + (0.2x-30%) = 10%
Standard deviation as a measure of
risk
 The statistic that is used most widely in finance to
quantify and measure the volatility of a stock
probability distribution of return is standard
deviation.
n
=  i i
P (
i =1
r − E ( r )) 2

 A = 0.2(30% − 10%)2 + 0.6(10% − 10%)2 + 0.2(−10% − 10%)2

 A = 12.65%
 B = 0.2(50% − 10%)2 + 0.6(10% − 10%)2 + 0.2(−30% − 10%)2
 B = 25.30%
Standard deviation as a measure of
risk (cont.)
 The rate of return can be virtually any number, the
distribution of stock return is a continuous
probability distribution (normal distribution).

probabili
ty

Return
Standard deviation as a measure of
risk (cont.)
 Confidence interval is a certain range of value within
which the actual return on the stock in the next period
will fall with a specified probability.
 With a normal distribution:
 One standard deviation on either side of the mean has a
probability of 68%.
 Two standard deviation has a probability of 95%.
 Three standard deviation has a probability of 99%.
Standard deviation as a measure of
risk (cont.)
 Example: a stock with expected return of 10%, and a
standard deviation of 20%. If it is normal distributed.
 95% of the actual return of this stock falls into two
standard deviation confidence interval of: 10% +(2x20%)
= 50% and 10% -(2x20%) = -30%.