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298 Final Equations

The document provides definitions and equations for key concepts in finance and investment analysis, including: 1) Stock valuation equations that relate stock price to future dividends, growth rates, and interest rates. 2) Formulas for price-earnings ratio, systematic risk, expected and realized rates of return, variance, and the security market line. 3) Methods for calculating net present value, internal rate of return, weighted average cost of capital, profitability index, correlation, and portfolio variance.

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Kevin Gellenbeck
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97 views

298 Final Equations

The document provides definitions and equations for key concepts in finance and investment analysis, including: 1) Stock valuation equations that relate stock price to future dividends, growth rates, and interest rates. 2) Formulas for price-earnings ratio, systematic risk, expected and realized rates of return, variance, and the security market line. 3) Methods for calculating net present value, internal rate of return, weighted average cost of capital, profitability index, correlation, and portfolio variance.

Uploaded by

Kevin Gellenbeck
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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298 Final Equations

Stock Value Po = D1 + D2 + (D3+D4/(r-g)) (1+r) (1+r)2 (1+r)3


Po price today D1 future dividend D4+ constant growth dividend r period interest rate g growth rate

Price Earnings Ratio P/E = Price EPS


EPS = earnings per share Low P/E = low future growth High P/E = high future growth

Systematic Risk = am m2

If >1, sensitive to market fluctuations. = systematic risk am = covariance m2 = variance

Rate of Return r = D1 + [E(P1) - P0] P0

Expected Return E(X) = [x*Pr(x)]


= sum of x = possible return Pr(x) = chance of that return

Security Market Line E(rp) = rf + [E(rm) - rf]

r rate of return Po price today D1 any dividends received E(P1) P0 change in price

Realized Rate of Return(ROR) FV = PV(1+ROR)n


FV future value PV present value ROR realized rate n number of periods

Functions of Variables f = a*X E(f) = a*E(x) f2 = a2*x2 f = a*x Variance x2 = E(X2)-E(X)2 = E(X-Xexp)2 = (x-xexp)Pr(x)
x2 = variance Xexp = expected value of X Pr(X) = probability of X

Expected return according to market activity. Use CML to find best weight of portfolio mixed with market for higher return & lower .

r 1 higher = buyer P
If r < E(r) compared with , overpriced, sell. If r > E(r), underpriced, buy.

Net Present Value


NPV = initial cost + PV of future cash flows If >0, accept. If <0 reject. If near 0, justify.

Capital Market Line Equation CML = p(rm-rf) + rf m E(rp) = wmE(rm) + (1-wm)rf


p = wmm (because f = 0) p2 = wm2m2 If p>m, borrow at rf. If p<m, lend at rf.

Internal Rate of Return


0 = C0 + C1 + C2 + (1+IRR) (1+IRR)2 C = future cash flow IRR = internal rate of return r = cost of capital Rate that creates an NPV = 0. If IRR>r, accept. Easy to understand. Beware non-conventional cash flows.

Covariance xy = E(X*Y) E(X)E(Y) = E[(X-Xexp)(Y-Yexp)] = (x-xexp)(y-yexp)Pr(x|y)


xy = covariance Xexp = expected value of X = sum of Pr(x|y) = probability of x and y

WACC =

(D/V)rd + (Ep/V)rp + (Ec/V)rc

Profitability Index
PV of future revenues PV of future costs If >1.00, accept. Good for capital rationing with limited cash.

Correlation xy = xy xy

xy = correlation xy = covariance x = standard deviation

V = total value of firm D = total debt rd = cost of debt = yield to maturity Ep = total preferred shares rp = required preferred return Ec = total common shares rc = required share return (find with stock price & dividends) Apply WACC to new projects

Payback Method
# years until initial costs are covered *if recovered part-way through year, use fraction of that years total revenue If > cutoff (set internally), than accept. Easy to understand. Ignores time value of money. Ignores future cash flows.

Portfolio Variance p2 = wx2x2 + wy2y2 + 2wxwyxy


wx = weight of X x2 = variance of X xy = covariance

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