Review of Valuation

& Other Topics

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Basic Review
Goals: You should be familiar with . . .

CAPM and other asset-pricing models

Metrics to Evaluate Projects

Financial Statements

M&M

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1. Capital Asset Pricing Model (CAPM)

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PAUSE, THINK, and ANSWER!

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 QUESTION:
A Way to Motivate CAPM

 Do you (or would you) hold insurance (like

property)?

 This financial product loses money for you on

average!

 Why hold an asset with an expected negative

return?It is a loss on investment. Clearly
every investor wants to avoid negative
returns.In some cases, negative returns on i
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 QUESTION:
Another way to think of CAPM
 Suppose have two firms: Firm A and Firm B
 They have the same expected cash flows
going forward, but Firm A does better in
good times and Firm B does better in bad
times

 Which firm’s stock should trade at a higher

price today?

 Which firm offers the higher expected return

in the future?
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ANSWER: A Way to Motivate CAPM
 Insurance loses money for the customer on
average (another way of saying the
insurance companies are profitable!)
 Despite the negative expected return, people
still demand insurance
 Key insight: Payoffs from the insurance
company differ dramatically depending on
what is happening to your wealth (i.e., you
are paid money after a big decline in your
wealth!)
 This is why people value insurance!

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 Another way to think of CAPM
 Suppose have two firms: Firm A and Firm B
 They have the same expected cash flows going
forward, but Firm A does better in good times
and Firm B does better in bad times
 Which firm’s stock should trade at a higher price
today? Which firm offers the higher expected
return in the future?
 A simple answer is that the expected cash flows of the two
firms are the same, so they should have the same value
today and the same expected returns in the future
 CAPM says that Firm B is more valuable to investors
(thus, it will have a higher value today and lower
expected/required returns in the future)

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 The Capital Asset
Pricing Model (CAPM)
Equation

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Capital Asset Pricing Model (CAPM)
 The CAPM determines the expected return of
a stock:

E ri   rRF   i E rMkt   rRF 

E ri   rRF   i E rMkt   rRF 

 The expected return depends linearly on the
systematic risk of the asset:
Cov rMkt , ri 
i 
Var rMkt 
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CAPM & required returns

 The expected risk premium of an asset varies
in direct proportion to its beta

 In other words, risk premium demanded by

investors is proportional to the marginal
contribution of a stock to the risk of the
market portfolio (the stock’s beta).

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Validity of CAPM
 CAPM best known model of risk-return

 Captures idea that investors should be

rewarded for undertaking risks, but only
systematic risk

 In reality, how well has CAPM performed in

predicting returns over time?

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Validity of CAPM (Cont.)

 Test this by estimating CAPM each year and
forming portfolios based on magnitude of
beta (portfolio #1 has 10% of NYSE stocks
with lowest betas, portfolio #10 has 10% of
NYSE stocks with the highest betas)

 Then see how actual average risk premiums

vary across the portfolios.

 Fisher Black did this test from 1931-1991.

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 Success – the CAPM Works!

 No wonder CAPM papers written in mid 1960s!

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Fama & French (2004) Test

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When it Rains it Pours for the CAPM

 Beta only somewhat predicts stock returns,

less so today than in earlier years.

 CAPM not only predicts what SHOULD

predict returns, but also what should NOT
predict returns.
 Nothing else should predict returns!

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Book-to-Market Predicts Returns!

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Small–Firm Effect

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 Small-Firm Effect in Stock Returns
 Size is based on the market cap of a firm’s stock
 Sample is annual stock returns 1927-2014

Source: Kenneth R. French Data Library (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html) 19

 CAPM Betas of the Ten Size Portfolios

Source: Kenneth R. French Data Library (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html) 20

 Small-Firm Effect (risk-adjusted)

Source: Kenneth R. French Data Library (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html) 21

Well-Documented Market Anomalies

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Defending CAPM
 Market index should theoretically contain all risky
investments (financial and real assets – even human
capital) and not just common stocks, measurement
error in “RHS variable” of regression

 Perhaps firm size and market-to-book anomalies due

to “data mining,” and are just chance results that will
not continue

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 Macro-announcement days (a-days)
 Average excess returns for 50 beta-sorted portfolios, 1964-2011

Source: Appendix Figure 1 from p. 196 of Savor, Pavel and Mungo Wilson, 2014, “Asset Pricing: A Tale of Two 24
Days,” Journal of Financial Economics, Vol. 113(2), p. 171-201.
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Alternative Model of Risk-Return

 Arbitrage Pricing Theory (APT)

Return = a + b1(rfactor 1) + b2(rfactor 2) + . . . + noise

 What are common factors people use in

practice?

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2. Metrics to Evaluate Projects

Payback period

Book rate of return

Internal rate of return-discount rate at which NPV

equals to zero

Why NPV rule leads to best investment decisions

Why NPV>0?

What do CFOs Use? CFOs use NPV in assessing

the effectiveness of the investment.
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Payback Period Rule

 The payback period of a project is the
number of years it takes before the
cumulative forecasted cash flow
equals/exceeds the initial investment.

 Only projects that recover their initial

investment within a specified cutoff date are
undertaken.

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Payback Period Rule

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Book Rate of Return

 NPV rule just depends on cash flows of
project and opportunity cost of capital

Shareholders pay attention to book measures of

profitability, so managers may care how project will affect
book return.

 Book rate of return = book income / book

assets on prospective assets firm is
considering acquiring

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Internal Rate of Return

 Internal rate of return (IRR):
discount rate that makes NPV = 0

 To solve for IRR for a project lasting T years, solve for

IRR in the following equation:

NPV = 0 =
C0 + C1/(1+IRR) + C2/(1+IRR)2 + . . . + CT/(1+IRR)T

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Positive NPV & Economic Rents

How can we tell the difference between
forecasting error and actual positive NPV
opportunities?

Basic microeconomics: in long-run equilibrium

assets will earn their opportunity cost of capital
 future projects have NPV = 0

Profits that exceed the opportunity cost of capital

are known as economic rents.
 Persistent rents due to some degree of market power

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Positive NPV & Economic Rents

 To believe project has NPV > 0 have to
believe in source of economic rents
(have to believe asset is more productive in your hands
than in your close competitor’s)

 Where do we find NPV projects (economic

rents)?
1. economies of scale
2. economies of scope
3. first-mover advantage (exploit learning curve)
4. patent (gov’t protection)
5. differentiation of products and services
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 What return-risk method
do CFOs use when need
to calculate discount
rates for projects?
Source for all subsequent figures and tables:
Graham, John R. and Campbell R. Harvey, 2001,
“The theory and practice of corporate finance:
Evidence from the field,” Journal of Financial
Economics, Vol. 61, p. 187-243.
 Graham and Harvey (2001) Survey
 Survey of 392 Chief Financial Officers (CFOs)

Source: Figure 2 of Graham, John R. and Campbell R. Harvey, 2001, “The theory and practice of corporate finance: 34
Evidence from the field,” Journal of Financial Economics, Vol. 61, 187-243.
 Graham and Harvey (2001) Survey
 What percent of surveyed CFOs use the
CAPM when estimating cost of equity capital
(392 surveyed)?

Source: Figure 1 Panel H of Graham, John R. and Campbell R. Harvey, 2001, “The theory and practice of corporate 35
finance: Evidence from the field,” Journal of Financial Economics, Vol. 61, 187-243.
Graham and Harvey (2001) Survey

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 Survey – Breakdown by Firm Type

Source: Table 3 of Graham, John R. and Campbell R. Harvey, 2001, “The theory and practice of corporate finance: 37
Evidence from the field,” Journal of Financial Economics, Vol. 61, 187-243.
 One More Breakdown!

Score of 0 (never) to 4 (always) is recorded for each CFO and then averaged for the
particular firm type (also report % that answered 3-4 in first column, i.e., answered
almost always or always)
Source: Table 3 of Graham, John R. and Campbell R. Harvey, 2001, “The theory and practice of corporate finance: 38
Evidence from the field,” Journal of Financial Economics, Vol. 61, 187-243.
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3. Financial Statements
Primary Financial Statements

Balance Sheet

Income Statement

Statement of Cash Flow

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Balance Sheet
Assets Liabilities and Shareholders’ Equity

Current assets: Current liabilities:

Cash & short-term securities Accounts payable
Accounts Receivable Short-term debt (due in one year)
Inventory Accrued expenses
Total current assets Total Current Liabilities

Fixed (long-term) assets: Long-term liabilities:

Property, plant, and equipment (net) Long-term debt
Investments
Other assets Total Liabilities

Shareholders equity:
Total Assets Common equity (paid in)
Retained earnings

Total liabilities and shareholders’ equity

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Income Statement

Earnings per share:

Basic: net income / shares of common stock outstanding
Diluted: this measure of EPS is adjusted for stock options and
convertible debt

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Statement of Cash Flows

Cash flows divided into three parts:

1. Operating activity
(income from business)
2. Investing activities
(financial investments, and investment in property, plant,
& equipment)
3. Financing activities
(issuance of stocks and bonds, dividend payments,
repurchase of stock)

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4. Modigliani & Miller

Irrelevance of dividend policy and capital
structure

Key assumptions:
 No taxes
 No transaction cost
 No signaling
 Investors and firms can borrow at same rate

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