CORPORATE FINANCE

CORPORATE FINANCE

Learning Goals &Topics to be
covered
i. 4 PRINCIPLES OF FINANCE
ii. THE OBJECTIVE OF CORPORATE FINANCE AND ETHICS
iii. CORPORATE GOVERNANCE AND ETHIC
iv. LEGAL FORMS OF BUSINESS ORGANIZATION
v. Corporation’s Management Decisions
vi. AGENCY PROBLEMS – ASYMMETRIC INFORMATION
© 2012 Pearson Prentice Hall. All rights reserved. 1-3
© 2012 Pearson Prentice Hall. All rights reserved. 1-4
What is Finance?
Finance can be defined as the science and art of managing money.
If we trace the origin of finance, there is evidence to prove that it is
as old as human life on earth. The word finance was originally a
French word. In the 18thcentury, it was adapted by English
speaking communities to mean “the management of money.”
Today, finance is emerged into an academic discipline of greater
significance and organized as a branch of Economics.
Finance is also the study of how and under what terms savings
(money) are allocated between lenders and borrowers. Finance is
concerned with the process institutions, markets, and instruments
involved in the transfer of money among and between
individuals, businesses and government.
Why you should study Finance
https://online.hbs.edu/blog/post/why-studyfinance
© 2012 Pearson Prentice Hall. All rights reserved. 1-5
… what is Finance?
At the personal level, finance is concerned with
individuals’ decisions about how much of their
earnings they spend, how much they save, and how
they invest their savings.
• In a business context, finance involves the same
types of decisions: how firms raise money from
investors, how firms invest money in an attempt to
earn a profit, and how they decide whether to
reinvest profits in the business or distribute them
back to investors as dividends.
© 2012 Pearson Prentice Hall. All rights reserved. 1-6
The 4 Principles of
Finance
1. Money Has a Time Value (TVM)
2. Risk-Return Trade-off
3. Cash Flows Are The Source of Value
4. Market Prices Reflect Information (EMH)
PRINCIPLE 1: Money Has a Time Value.
A dollar received today is more valuable than a
dollar received in the future.
– We can invest the dollar received today to earn
interest. Thus, in the future, you will have more
than one dollar, as you will receive the interest on
your investment plus your initial invested dollar.
PRINCIPLE 2: There is a RiskReturn Trade-off.
We only take risk when we expect to be
compensated for the extra risk with additional
return.
Higher the risk, higher will be the expected
return.

PRINCIPLE 3: Cash Flows Are The Source of
Value.
Profit is an accounting concept designed to
measure a business’s performance over an
interval of time.
Cash Flow (CF) is the amount of cash that can
actually be taken out of the business over this
same interval.
Profits versus Cash
It is possible for a firm to report profits but have
no cash.
For example, if all sales are on credit, the firm
may report profits even though no cash is
being generated.
Incremental Cash Flow
Financial decisions in a firm should consider
“incremental cash flow”, Δ(CF), i.e. the
difference between the cash flows the
company will produce with the potential new
investment it’s thinking about making and what
it would make without the investment.
CF(if Invest) – CF (if NO Invest)=Δ(CF)
PRINCIPLE 4: Market Prices Reflect
Information.
Investors respond to new information by buying and selling their
investments.
The speed with which investors act and the way that prices
respond to new information determines the efficiency of the
market. In efficient markets, this process occurs very quickly.
As a result, it is hard to profit from trading investments on
publicly released information.
PRINCIPLE 4: Market Prices Reflect
Information. (cont.)
Investors in capital markets will tend to react
positively to good decisions made by the firm
resulting in higher stock prices.
Stock prices will tend to decrease when there is
bad information released on the firm in the
capital market.
PRINCIPLE 4: Market Prices
Reflect Information.
EMH posits that in competitive financial markets
asset prices reflect the dispersed information
that is relevant to assets’ value, and thus,
market prices are aggregators of the publicly
available information in the market. Therefore,
no investor is able to beat the market and earn
abnormal profits, above the average market
returns at least in theory.
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The objective in Managerial and Corporate Finance, according
to the main international textbooks
Van Horne: “In this book, we assume that the objective of the firm is
to maximize its value to its stockholders”
Brealey & Myers: “Success is usually judged by value: Shareholders
are made better off by any decision which increases the value of
their stake in the firm… The secret of success in financial
management is to increase value.”
Copeland & Weston: The most important theme is that the objective
of the firm is to maximize the wealth of its stockholders.”
Brigham and Gapenski: Throughout this book we operate on the
assumption that the management’s primary goal is stockholder
wealth maximization which translates into maximizing the price of
the common stock.
© 2012 Pearson Prentice Hall. All rights reserved. 1-17
In traditional Corporate Finance …
In traditional corporate finance, the objective in
decision making is to maximize the value of the firm.
A narrower objective is to maximize stockholder
wealth. When the stock is traded and markets are
viewed to be efficient, the objective is to maximize
the stock price.
All other goals of the firm are intermediate ones
leading to firm value maximization, or operate as
constraints on firm value maximization.
Hillier et.al. “Corporate
Finance”
“The purpose of the firm is to create value for
the owner, who may or may not be the manager
of the firm”.
Shareholder interests
Prof Mervyn King said at the 15th BEN-Africa
Conference (November 2016, Stellenbosch, South
Africa):
“I realized long ago that the primacy of shareholders
could not be the basis in the rainbow nation“ (= multiculturalism).
The corporate governance theory of shareholder
primacy holds that shareholder interests should have
first priority relative to all other corporate
stakeholders.
Shareholder Primacy
Definition: Shareholder primacy is a shareholder-centric form of corporate
governance that focuses on maximizing the value of shareholders before considering
the interests of other corporate stakeholders, such as society, the community,
consumers, and employees.
Reference:
1). https://corpgov.law.harvard.edu/2019/08/22/so-long-to-shareholder-primacy/
“So Long to Shareholder Primacy”, Posted by Cydney Posner, Cooley LLP,
on Thursday, August 22, 2019, HARVARD LAW SCHOOL.
2). https://www.forbes.com/sites/dennisjaffe/2021/02/24/from-shareholder-primacyto-stakeholder-primacy-how-family-businesses-lead-the-way/?sh=3573711221ed
“From Shareholder Primacy To Stakeholder Primacy: How Family
Businesses Lead The Way”, Forbes, 4 Feb 2021.
1-21
Company’s responsibility
The doctrine of shareholder’s primacy is criticized for
being at odds with corporate social responsibility and
other legal obligations because it focuses solely on
maximizing shareholder profits.
According to the Wall Street Journal (WSJ, April 15,
2010):
“Ethics teaching should not just be about refraining
from cheating and corruption but recognizing that a
company has responsibility beyond its shareholders
wallets to employees, community, customers and the
environment”.
Contracts
Prof Vermaelen (INSEAD, 26 December 2008) adopts the old
view (1972, 1976) that “a company should be considered as
a nexus of contracts between various stakeholders. All
contracts have explicit and implicit characteristics,” (L.
Zingales, JoF, 2000). For example, the debt contract has a
large number of explicit terms such as maturity, interest rate,
seniority, covenants, collateral, and so on. However,
shareholders have a largely implicit contract. … In a
capitalist economy it is reasonable to assume that
shareholders have an implicit contract that the management
will maximize their interests. So, I believe that respect for
such implicit contracts is an ethical responsibility”.
Discussion: Implicit Contracts
Consider, for instance, a firm with the reputation of
rewarding employees on the basis of their contribution to
the firm, regardless of their value in the marketplace.
Counting on this reputation, the employees will make
investments that are different from those they would have
made in the marketplace.
Discussion: how is the reputation of that firm affected by
the outcome of employees’ investments?
1-24
Organizational Value
1). If these investments are indeed valuable and could
not have been elicited with an explicit contract, the
firm’s reputation adds value: it represents an
organizational asset.
2). If these investments are wasteful, the firm’s
reputation will destroy value; it represents an
organizational liability.
3). The firm, thus, can be worth more or less than the
sum of its parts, with the difference being the net of
value of organizational assets and liabilities.
1-25
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Goal of the Firm:
What About Stakeholders?
• Stakeholders are groups such as employees, customers,
suppliers, creditors, owners, and others who have a direct
economic link to the firm.
• A firm with a stakeholder focus consciously avoids
actions that would prove detrimental to stakeholders. The
goal is not to maximize stakeholder well-being but to
preserve it.
• Such a view is considered to be “socially responsible.”
2
7
Shareholders
and Investors
(millions)
Public
Corp.
Management
of the Firm
Regulators
(SEC)
Consumers and
Suppliers
The Press
& Mkt Partic.
Auditors
& Creditors
The
Board
The nexus of contracts between various stakeholders
and the (management of the) Firm
Management deals with daily operations, while
Governance is a set of policies and business processes that set the
way that the organization’s business is run. And includes the
underlying ethics of a corporation.
Poor management (PM) and Weak Gov (WG) can affect governance
Weak governance (WG) undermines the financial and
operational performance of a corporation
Weak governance affects investors’ faith in the company.
As a consequence, PM and WG affect share prices and the Value of the firms.
Management vs. Governance
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Governance and Agency:
Corporate Governance
• Corporate governance refers to the rules, processes, and
laws by which companies are operated, controlled, and
regulated.
• It defines the rights and responsibilities of the corporate
participants such as the shareholders, board of directors,
officers and managers, and other stakeholders, as well as
the rules and procedures for making corporate decisions.
• The structure of corporate governance was previously
described in Figure 1.1.
CIPE ©
2008
3
0
Corporate Governance Business Ethics
CORE VALUES
• Transparency
• Fairness
• Accountability
• Responsibility
Structure of decision-making Guide for behavior
Questions we would like to answer
in this course:
1. How financial markets determine asset prices?
2. How corporations make financial decisions?
• Investments:
– What projects to invest in?
• Financing:
– How to finance a project?
• Payout:
– What to pay back to shareholders?
• Risk management:
– What risk to take or to avoid and how?
© 2012 Pearson Prentice Hall. All rights reserved. 1-31
Function of Financial Manager
Operations
(plant,
equipment,
projects)
Financial
Manager
Financial
Markets
(investors)
1a.Raising
funds 2.Investments
3.Cash from
operational
activities
4.Reinvesting
1b.Obligations
(stocks, debt
securities)
5.Dividends or
interest
payments
Finance function – managing the cash flow
© 2012 Pearson Prentice Hall. All rights reserved. 1-33
Legal Forms of Business
Organization
• A sole proprietorship is a business owned by one person and operated for his or
her own profit. The sole proprietorship is not a legal entity. It simply refers to a
person who owns the business and is personally responsible for its debts
(disadvantage). Taxation is quite simple. The income earned by a sole
proprietorship is income earned by its owner.
• A partnership is a business owned by two or more people and operated for
profit.
• A corporation is an entity created by law. Corporations have the legal powers of
an individual in that it can sue and be sued, make and be party to contracts, and
acquire property in its own name.
• It might be the case that a simple family business may end up with a large public
limited liability company (corporation) with many shareholders.
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Table 1.1 Strengths and Weaknesses of the
Common Legal Forms of Business Organization
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Goal of the Firm:
Maximize Profit?
Profit maximization may not lead to the highest possible share price
for at least three reasons:
1. Timing is important—the receipt of funds sooner rather than later is preferred
2. Profits do not necessarily result in cash flows available to stockholders
3. Profit maximization fails to account for risk
Which Investment is Preferred?
Which Investment is Preferred in
terms of the profit maximization?
In terms of the profit maximization goal, Valve would
be preferred over Rotor because it results in higher
total EPS over the 3-year period.
. But what about risk? Which one is riskier?
. Which one would you prefer if timing (liquidity) is
important to you?
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© 2012 Pearson Prentice Hall. All rights reserved.
1-37
Rotor Valve (A-A5)^2 (B-B5)^2
1.4 0.6 0.217778 0.16
1 1 0.004444 0
0.4 1.4 0.284444 0.16
0.933333 1 0.253333 0.16 variance
0.503322 0.4 standard deviation
average EPS
Which Investment is Preferred in terms of
Risk? A-Rotor or B-Valve?
Coefficient of Variation (CV)
The coefficient of variation, CV, is a measure of spread
that describes the amount of variability of data relative
to its mean. It has no units and as such, we can use
it as an alternative to the standard deviation to
compare the variability of data sets that have different
means.
CV(x)=S(x)/x̄
Where S(x) is the standard deviation of a variable x,
and x̄ is the mean (or average) value of the variable.
© 2012 Pearson Prentice Hall. All rights reserved. 1-38
Coefficient of variation:
interpretation and usefulness
The coefficient of variation (COV) is the ratio of the standard deviation of a data set to
the expected mean. Investors use it to determine whether the expected return of the
investment is worth the degree of volatility, or the downside risk, that it may experience
over time.
The coefficient of variation is helpful when using the risk/reward ratio to select
investments. For example, an investor who is risk-averse may want to consider assets
with a historically low degree of volatility relative to the return, in relation to the overall
market or its industry. Conversely, risk-seeking investors may look to invest in assets
with a historically high degree of volatility.
 An investor can calculate the coefficient of variation to help determine whether an
investment’s expected return is worth the volatility it is likely to experience over time.
 A lower ratio suggests a more favorable tradeoff between risk and return.
 A higher ratio might be unacceptable to a conservative or “risk-averse” investor.
1-39
Range = max – min
1-40
Alternative
Invetsment
Year 1 Year 2 Year 3 a). SUM b). Range c). TVM
A 21000 15000 10000 46000 11000 A
B 20000 25000 21000 66000 5000
C 9000 15000 21000 45000 12000
D 17000 15000 19000 51000 4000
a). An investor seeking to profir maximazation would choose the investment with the higher final
value over the 3 years. In the above example, she would choose investment B with 66,000 aed
b). An investor who is risk-averse would choose the investment with the lower risk. There are
various risk measures such as variance, standard deviation, coefficient of variation and range.
Range is the difference between the highest expected cash flow and lowest expected
cash flow for each investment alternative. The higher the value of the Range, the higher the risk
of the investment. Hence, a risk-averse investor would choose the investment with the lowest
value of range. In this example, a risk-averse investor would prefer investment D with 4,000 aed range.
c). If an investor is looking for an investment with the higher expected cash flow the first year (first
principle of finance TVM) she would choose investment A or investment D. However, investment A’s first
year expected cash flow is 21,000 aed, higher that investment’s D 17,000 aed. Therefere, she would
choose investment A.
Year
Marginal Cost-Benefit Analysis
Marginal Cost-Benefit Analysis is the primary
economic principle used in Corporate Finance
according to which financial decisions should be
made and actions taken only when the added
benefits exceed the added costs.
Take a decision IF added benefits > the added
costs
Figure 1.1 Corporate Organization
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Governance and Agency:
Government Regulation
• Government regulation generally shapes the corporate
governance of all firms and requires from them to diffuse
all relevant information relating to their performance.
• During the recent decade, corporate governance has
received increased attention due to several high-profile
corporate scandals involving abuse of corporate power
and, in some cases, alleged criminal activity by corporate
officers.
© 2012 Pearson Prentice Hall. All rights reserved. 1-44
Governance and Agency:
The Agency Issue
• A principal-agent relationship is an arrangement in
which an agent acts on the behalf of a principal. For
example, shareholders of a company (principals) elect
management (agents) to act on their behalf.
• Agency problems arise when managers place personal
goals ahead of the goals of shareholders.
• Agency costs arise from agency problems that are borne
by shareholders and represent a loss of shareholder
wealth.
© 2012 Pearson Prentice Hall. All rights reserved. 1-45
The Agency Issue:
Management Compensation Plans
• In addition to the roles played by corporate boards,
institutional investors, and government regulations,
corporate governance can be strengthened by ensuring
that managers’ interests are aligned with those of
shareholders.
• A common approach is to structure management
compensation to correspond with firm performance.
© 2012 Pearson Prentice Hall. All rights reserved. 1-46
The Agency Issue:
Management Compensation Plans
• Incentive plans are management compensation plans that
tie management compensation to share price; one example
involves the granting of stock options.
• Performance plans tie management compensation to
measures such as EPS or growth in EPS. Performance
shares and/or cash bonuses are used as compensation
under these plans.
Short-term and long-term
Decisions
1.1 What is Corporate Finance?
1.2 The Goal of Financial Management
(Decisions made to achieve the goal)
1.1 Capital Budgeting
Corporate Finance addresses the
following three questions:
1. What long-term investments should the firm
choose? CAPITAL BUDGETING
CB is used to describe the process of making
and managing expenditures on long-term
assets.
1.1 Capital Structure
2. How can the firm raise cash for required
capital expenditures? CAPITAL
STRUCTURE.
CS represents the proportions of the firm’s
financing from current and long-term debt and
equity.
1.1 Net Working Capital
3. How should short-term operating cash flows
be managed? NET WORKING CAPITAL.
NWC is the management of the mismatching
between the timing of cash inflows and cash
outflows. NWC is defined as Current Assets
minus Current Liabilities.
Balance Sheet Model of the Firm
Fixed Assets
1 Tangible (e.g.
machinery,
equipment)
2 Intangible
(e.g. patents,
trademarks)
Current Assets
(short-term
assets)
Total Value of Assets:
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt
Total Firm Value to Investors:
The Capital Budgeting Decision
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt
What long-term
investments
should the firm
choose?
The Capital Structure Decision
How should the
firm raise funds
for the selected
investments?
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt
Short-Term Asset Management
How should
short-term assets
be managed and
financed?
Net
Working
Capital
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Corporation’s Management
Decisions
Capital budgeting
– What long-term investments or projects should the
business take on?
Capital structure
– How should we pay for our assets?
– Should we use debt or equity?
Working capital management
– How do we manage the day-to-day finances of the
firm?
Risk Management
– Use of derivative securities
Example
• Current Assets: AED 50 billion
• Current Liabilities: AED 40 billion
• Non-Current Assets:
• Tangible: AED 40 billion
• Intangible: AED 0.5 billion
• THEN:
• NWC = 50 – 40 = AED 10 billion
• Total Value of Assets = 50 + 40 + 0.5 = AED 90.5 bil.
• Total Value of firm to investors = 40 + Shareholders Equity
(=90.5 – 40 = 50.5, that is the Residual Claim)
Corporate Securities as Contingent
Claims on Total Firm Value
The basic feature of a debt is that it is a
promise by the borrowing firm to repay a
fixed dollar amount of by a certain date.
The shareholder’s claim on firm value is
the residual amount that remains after the
debtholders are paid.
If the value of the firm is less than the
amount promised to the debtholders, the
shareholders get nothing.
“The shareholder’s claim on firm value is the residual
amount …”: Example
For example, a firm might be having several factors
engaged directly or indirectly in production, such as
laborers, suppliers, bondholders, shareholders, etc.
The firm owes definite amounts to factors like
laborers, suppliers, etc. in order to compensate them
for the services provided. After making payment to all
other parties, the shareholders might be receiving
payment in the end, i.e., they might be receiving the
residual amount. Therefore, in this case, the
shareholders will be considered as the residual
claimants.
© 2012 Pearson Prentice Hall. All rights reserved. 1-58
Debt and Equity as Contingent Claims
$F
$F
Payoff to
debt holders
Value of the firm (X)
Debt holders are promised $F.
If the value of the firm is less than $F, they
get the whatever the firm if worth.
If the value of the firm
is more than $F, debt
holders get a
maximum of $F.
$F
Payoff to
shareholders
Value of the firm (X)
If the value of the
firm is less than $X,
share holders get
nothing.
If the value of the firm
is more than $F, share
holders get everything
Algebraically, the bondholder’s above $F.
claim is: Min[$F,$X] Algebraically, the shareholder’s
claim is: Max[0,$X – $F]
Combined Payoffs to Debt and Equity
$F
$F
Combined Payoffs to debt holders
and shareholders
Value of the firm (X)
Debt holders are promised $F.
Payoff to debt holders
Payoff to shareholders
If the value of the firm is less than
$F, the shareholder’s claim is:
Max[0,$X – $F] = $0 and the debt
holder’s claim is Min[$F,$X] = $X.
The sum of these is = $X
If the value of the firm is more than
$F, the shareholder’s claim is:
Max[0,$X – $F] = $X – $F and the
debt holder’s claim is:
Min[$F,$X] = $F.
The sum of these is = $X
Questions: After studying these slides you should
be able to answer the following questions …
Q1. Present and discuss the 4 principles in Finance (simple reference 20%
of the grade).
Q2. (a) What is the priority of a Manager seeking Profit maximization as the
goal of the firm? (b) Why Profit maximization as the goal of the firm is not
ideal? (c) Which investment’s characteristics should be taken into
consideration by a financial manager when evaluating decision alternatives
or potential actions? (d) What is the goal of business ethics
Q3. (a) Define Corporate Governance. (b) What are the consequences of a
poor management and a weak governance to the value of the firm?
© 2012 Pearson Prentice Hall. All rights reserved. 1-61
Questions …
Q4. A financial manager must choose between four alternative investments: 1, 2, 3,
and 4. Each investment costs $35,000 and is expected to provide earnings over a
three-year period as described below.
Y-1 Y-2 Y-3
Investment 1: 21,000; 15,000; 6,000;
Investment 2: 20,000; 15,000; 20,000;
Investment 3: 9,000; 20,000; 19,000; and
Investment 4: 7,000; 14,000, 9,000.
Based on the profit maximization goal, the financial manager would choose
……………., while based on the time value of money, the manager should choose
……………. If the manager is risk-averse which investment should avoid …………
and which one to choose …….
© 2012 Pearson Prentice Hall. All rights reserved. 1-62
Questions …
Q5. (a) Define agency problems and name two special
cases. (b) Define Agency costs.
Q6. A firm has just ended its calendar year making a
sale in the amount of $150,000 of merchandise
purchased during the year at a total cost of
$112,500. Although the firm paid in full for the
merchandise during the year, it has yet to collect at
year end from the customer. Calculate the net profit
and cash flow from this sale for the year.
© 2012 Pearson Prentice Hall. All rights reserved. 1-63
Questions.
Q7. Define Capital Budgeting, Capital Structre and Newt Working
Capital
Q8. Given the following information
Current Assets: AED 50 billion
Current Liabilities: AED 40 billion
Non-Current Assets:
Tangible: AED 40 billion
Intangible: AED 0.5 billion
Calculate, the Net Working Capital, the Total Value of Assets, the
Shareholders equity and the Total Value of firm to investors.
© 2012 Pearson Prentice Hall. All rights reserved. 1-64
Agency Problems and
Asymmetric Information
Principles of Managerial Finance
Asymmetric Information: Adverse Selection
and Moral Hazard
• Asymmetric information occurs when one party to a transaction has
more information than the other. We focus on two specific forms:
• Adverse selection
• Moral hazard
• The analysis of how asymmetric information problems affect
behavior is known as agency theory.
Asymmetric Information: Adverse Selection and Moral Hazard
• Adverse Selection
1. Occurs when one party in a transaction has better information than the
other party
2. Before transaction occurs
3. Potential borrowers most likely to produce adverse outcome are ones
most likely to seek loan and be selected
Asymmetric Information: Adverse Selection and Moral Hazard
• Moral Hazard
1. Occurs when one party has an incentive to behave differently once an
agreement is made between parties
2. After transaction occurs
3. Hazard that borrower has incentives to engage in undesirable (immoral)
activities making it more likely they won’t pay loan back
The Lemons Problem: How Adverse Selection Influences Financial
Structure
• Lemons Problem in Used Cars
1. If we can’t distinguish between “good” and “bad” (lemons) used cars, we
are only willing to pay the average price.
2. Result: Good cars won’t be sold, and the used car market will function
inefficiently.
• What helps us avoid this problem with used cars?
15-70
The Lemons Problem: How Adverse Selection Influences Financial
Structure
• Lemons Problem in Securities Markets
1. If we can’t distinguish between good and bad securities, we are only
willing to pay for the average of good and bad securities’ value.
2. Result: Good securities are undervalued and firms won’t issue them; bad
securities are overvalued so too many are issued
3. Investors won’t want to buy bad securities, so market won’t function well,
and as a result we observe that:
• Stocks are not the most important source of finance.
• Marketable securities are not the primary funding source.
15-71
Tools to Help Solve Adverse Selection (Lemons) Problems
1. Private Production and Sale of Information
– Free-rider problem interferes with this solution
2. Government Regulation to Increase Information
– For example, annual audits of public corporations (although Enron is a
shining example of why this does not eliminate the problem)
In economics, the free-rider problem occurs when those who benefit from
resources, public goods, or services do not pay for them, which results in
an under-provision of those goods or services. For example, a free-rider
may frequently ask for available parking lots (public goods) from those who
have already paid for them, in order to benefit from free parking.
15-72
Tools to Help Solve Adverse Selection (Lemons) Problems
3. Financial Intermediation
Analogy to solution to lemons problem provided by used car
dealers
4. Avoid free-rider problem by making private loans
Indirect finance is far more important than direct finance. Banks
are the most important source of external finance.
5. Collateral and Net Worth
Collateral is a prevalent feature of debt contracts.
15-73
How Moral Hazard Affects the Choice Between Debt and
Equity Contracts
• Moral Hazard in Equity Contracts:
the Principal-Agent Problem
1. Result of separation of ownership by stockholders (principals) from control
by managers (agents)
2. Managers act in their own rather than stockholders’ interest
How Moral Hazard Affects the Choice Between Debt and
Equity Contracts
Suppose you become a silent partner in an ice cream store,
providing 90% of the equity capital ($9,000).
The other owner, Steve, provides the remaining $1,000 and will act
as the manager.
If Steve works hard, the store will make $50,000 after expenses,
and you are entitled to $45,000 of the profits.
How Moral Hazard Affects the Choice Between Debt and
Equity Contracts
However, Steve doesn’t really value the $5,000 (his part), so he
goes to the beach, relaxes, and even spends some of the “profit”
on art for his office.
How do you, as a 90% owner, give Steve the proper incentives to
work hard?
How Moral Hazard Affects the Choice Between Debt and
Equity Contracts
• Tools to Help Solve the Principal-Agent Problem:
1.Production of Information: Monitoring
Costly State Verification makes equity less desirable than debt
2.Government Regulation to Increase Information
3.Financial Intermediation (e.g, venture capital)
4.Debt Contracts
• This explains why debt is used more than equity
How Moral Hazard Influences Financial Structure in Debt
Markets
• Even with the advantages just described, debt is still subject to moral
hazard. In fact, debt may create an incentive to take on very risky
projects. This is very important to understand and partially explains
the recent financial crisis.
How Moral Hazard Influences Financial Structure in Debt
Markets
• Most debt contracts require the borrower to pay a fixed amount
(interest) and keep any cash flow above this amount.
• What if General Growth owes $100m in interest and principle, but
only has $90m in assets? It is bankrupt. The firm “has nothing to
lose” by looking for “risky” projects to raise the needed cash.
How Moral Hazard Influences Financial Structure in Debt
Markets
• Tools to Help Solve Moral Hazard in Debt Contracts
1. Net Worth
2. Monitoring and Enforcement of Restrictive Covenants.
3. Financial Intermediation—banks and other intermediaries have special
advantages in monitoring
15-80
Asymmetric Information Problems and Tools to Solve Them
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Chapter 6: Bonds
LG1 Review the legal aspects of bond financing and bond cost.
LG2 Discuss the general features, yields, prices, popular types, and
international issues of corporate bonds.
LG3 Understand the key inputs and basic model used in the
valuation process, assess the impact of factors affecting the
Demand for and Supply of Bonds, and appreciate the impact of
inflation (Fisher Effect).
LG4 Apply the basic valuation model to bonds and describe the
impact of required return and time to maturity on bond values.
LG5 Explain yield to maturity (YTM), its calculation, and the
procedure used to value bonds that pay interest semiannually.
Chapter 6_BONDS
Learning Objectives
After reading this chapter, you will understand
 the price-yield relationship of a bond, and estimate the
price of a bond
 the factors that affect the price volatility of a bond
when yields change
 the price-volatility properties of a bond
how to calculate and interpret the Macaulay duration,
modified duration, and dollar duration of a bond
 why duration is a measure of a bond’s price sensitivity
to yield changes
Learning Objectives (continued)
After reading this chapter, you will understand
limitations of using duration as a measure of price
volatility
 how price change estimated by duration can be adjusted
for a bond’s convexity
 how to approximate the duration and convexity of a bond
 the duration of an inverse floater
And you will be able to perform all these calculations
with EXCEL’s functions with numerical problems.
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Interest Rates and Required Returns: Interest
Rate Fundamentals
•The interest rate is usually applied to debt
instruments such as bank loans or bonds; the
compensation paid by the borrower of funds to the
lender; from the borrower’s point of view, the cost of
borrowing funds.
•The required return is usually applied to equity
instruments such as common stock; the cost of funds
obtained by selling an ownership interest.
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Interest Rates and Required Returns: Interest
Rate Fundamentals
• Several factors can influence the equilibrium interest rate:
1. Inflation, which is a rising trend in the prices of most goods and
services.
2. Risk, which leads investors to expect a higher return on their
investment
3. Liquidity preference, which refers to the general tendency of
investors to prefer short-term securities
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Matter of Fact
• Fear Turns T-bill Rates Negative
• Near the height of the financial crisis in December 2008, interest rates
on Treasury bills briefly turned negative, meaning that investors paid
more to the Treasury than the Treasury promised to pay back.
• Why would anyone put their money into an investment that they know
will lose money?
• Remember that 2008 saw the demise of Lehman Brothers, and fears
that other commercial banks and investments banks might fail were
rampant.
• Evidently, some investors were willing to pay the U.S. Treasury to
keep their money safe for a short time.
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Interest Rates and Required Returns: The
Real Rate of Interest
•The real rate of interest is the rate that creates
equilibrium between the supply of savings and the
demand for investment funds in a perfect world,
without inflation, where suppliers and demanders of
funds have no liquidity preferences and there is no
risk.
•The real rate of interest changes with changing
economic conditions, tastes, and preferences.
•The supply-demand relationship that determines the
real rate is shown in Figure 6.1 on the following
slide.
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Interest Rates and Required Returns:
Nominal or Actual Rate of Interest (Return)
• The nominal rate of interest is the actual rate of interest
charged by the supplier of funds and paid by the demander.
• The nominal rate differs from the real rate of interest, r* as a
result of two factors:
• Inflationary expectations reflected in an inflation premium (IP), and
• Issuer and issue characteristics such as default risks and contractual
provisions as reflected in a risk premium (RP).
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Interest Rates and Required Returns:
Nominal or Actual Rate of Interest (cont.)
• The nominal rate of interest for security 1, r1
, is given by the
following equation:
• The nominal rate can be viewed as having two basic
components: a risk-free rate of return, RF
, and a risk
premium, RP1
:
r1 = RF + RP1
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Interest Rates and Required Returns:
Nominal or Actual Rate of Interest (cont.)
• For the moment, ignore the risk premium, RP1
, and focus
exclusively on the risk-free rate. The risk free rate can be
represented as:
RF = r* + IP
• The risk-free rate (as shown in the preceding equation)
embodies the real rate of interest plus the expected inflation
premium.
• The inflation premium is driven by investors’ expectations
about inflation—the more inflation they expect, the higher
will be the inflation premium and the higher will be the
nominal interest rate.
Interest Rates:
“Nominal” vs. “Real” rates
r = represents any nominal rate
r* = represents the “real” risk-free rate of interest. Like a T-bill rate, if
there was no inflation. Typically ranges from 1% to 4% per year.
rRF = represents the rate of interest on Treasury securities.
Determinants of interest rates
r = r* + IP + DRP + LP + MRP
r = required return on a debt security
r* = real risk-free rate of interest
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP = maturity risk premium
Premiums added to r* for different
types of debt
IP MR
P
DR
P
LP
S-T Treasury 
L-T Treasury  
S-T Corporate   
L-T Corporate    
1
5
Bond Features
 What is a bond –
 debt issued by a corporation or a governmental body.
 A bond represents a loan made by investors to the issuer.
 In return for his/her money, the investor receives a legal claim on future cash
flows of the borrower.
 The issuer promises to:
 make regular coupon payments every period until the bond matures, and
 pay the face (par) value of the bond when it matures.
 Default
 an issuer who fails to pay is subject to legal action on behalf of the lenders
(bondholders).
6-95
Why do investors buy bonds?
Investors buy bonds because:
•They provide a predictable income stream (coupon payment).
•If the bonds are held to maturity, bondholders get back the
entire principal (or face value), so bonds are a way to preserve
capital while investing.
•Bonds can help offset exposure to more volatile stock holdings.
Companies, governments and municipalities issue bonds to
get money for various things, which may include:
•Providing operating cash flow
•Financing debt
•Funding capital investments in schools, highways, hospitals,
and other projects
96
Examples
– Pure Discount Bonds
Q1. Consider a zero-coupon bond, with a face value of $1,000, maturing in 5 years. Suppose that the
appropriate discount rate is 8%. What is the current value of the bond?
A1. This is a simple TVM problem:
PV = F / (1 + r)T = 1,000 / (1.08)5 = $
Q2. Suppose 6 months have passed. What is the bond value now?
A1. PV = F / (1 + r)T = 1,000 / (1.08)4.5 = $
Note: As we get closer to maturity(T), the z.c. bond value increases (PV), since we have to wait less
time to receive $1,000
Bond Valuation
1). With bonds two “rates” that are involved:
(i) the coupon rate and
(ii) the Yield-To-Maturity (YTM) or discount rate.
The discount rate can take on many names — market rate of interest, interest rate, rate of return,
required return and yield-to-maturity, weighted average cost of capital — they all mean the same
thing. With bonds think of the coupon payment as a cash flow. The coupon rate tells us what our
yearly payment will be. It is not a rate of return and it doesn’t change over time.
The discount rate (or yield-to-maturity in bonds’ terminology) tells us what rate of return we
want to earn on our investment in this bond. It can (and will) change over time — sometimes
increasing and sometimes decreasing — depending on market conditions such as the inflation or
the default of the issuer.
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4

9
8
Review of the Price-Yield Relationship for
Bonds
 As illustrated in Exhibit 4-1:
 An increase in the required yield decreases the present value
of its expected cash flows and therefore decreases the
bond’s price, and vis versa.
YTM leads to PV(bond) and Price of the bond
 As shown in the diagram in the Exhibit 4-2:
 The price-yield relation is negative, and not linear.
 The shape of the price-yield relationship for any bond is
referred to as a convex relationship.
4

9
9
Exhibit 4-1 Price–Yield Relationship for Six Hypothetical Bonds
Required
Yield (%)
Price at Required Yield (coupon/maturity in years)
9% / 5 9% / 25 6% / 5 6% / 25 0% / 5 0% / 25
6.00 112.7953 138.5946 100.0000 100.0000 74.4094 22.8107
7.00 108.3166 123.4556 95.8417 88.2722 70.8919 17.9053
8.00 104.0554 110.7410 91.8891 78.5178 67.5564 14.0713
8.50 102.0027 105.1482 89.9864 74.2587 65.9537 12.4795
8.90 100.3966 100.9961 88.4983 71.1105 64.7017 11.3391
8.99 100.0395 100.0988 88.1676 70.4318 64.4236 11.0975
9.00 100.0000 100.0000 88.1309 70.3570 64.3928 11.0710
9.01 99.9604 99.9013 88.0943 70.2824 64.3620 11.0445
9.10 99.6053 99.0199 87.7654 69.6164 64.0855 10.8093
9.50 98.0459 95.2539 86.3214 66.7773 62.8723 9.8242
10.00 96.1391 90.8720 84.5565 63.4881 61.3913 8.7204
11.00 92.4624 83.0685 81.1559 57.6712 58.5431 6.8767
12.00 88.9599 76.3572 77.9197 52.7144 55.8395 5.4288
4

1
0
0
Exhibit 4-2
Shape of Price-Yield Relationship for an
Option-Free Bond Price
Maximum
Price
Yield
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Prentice Hall. All rights
reserved.
5-101
Risk Structure
of Long Bonds in the U.S.
Term Structure of Interest Rates
• Bonds with identical risk, liquidity, and tax characteristics may have
different interest rates because the time remaining to maturity is
different
Term Structure of Interest Rates_ Yield
curve
• Yield curve: a plot of the yield on bonds with differing terms to
maturity but the same risk, liquidity and tax considerations
• Upward-sloping: long-term rates are above
short-term rates (occurs frequently)
• Flat: short- and long-term rates are the same
• Inverted: long-term rates are below short-term rates (occurs infrequently)
Yield curve (YC) and firm’s financing decision
1. An inverted YC (also called downward-sloping) is often a sign
that the economy is weakening.
2. A financial manager who faces a downward-sloping curve may
be tempted to rely more heavily on cheaper, long-term
financing. A risk in that strategy is that interest rates may fall
in the future, so long-term rates that seem cheap today may
be more expensive tomorrow.
3. A financial manager who faces an upward-sloping curve may
feel that it is wise to use cheaper, short-term financing.
Facts Theory of the Term Structure of Interest Rates
Must Explain
1. Interest rates on bonds of different maturities move together over
time
2. When short-term interest rates are low, yield curves are more likely to
have an upward slope; when short-term rates are high, yield curves
are more likely to slope downward and be inverted
3. Yield curves almost always slope upward
Theories explaining yield curve
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a. According to the expectations theory, the yield curve reflects investor expectations about future
interest rates, with the differences based on inflation expectations. The curve can take any of the
three forms. An upward-sloping curve is the result of increasing inflationary expectations, and
vice versa.
b. The liquidity preference theory is an explanation for the upward-sloping yield curve. This theory
states that long-term rates are generally higher than short-term rates due to the desire of investors
for greater liquidity, and thus a premium must be offered to attract adequate long-term
investment.
c. The market segmentation theory is another theory that can explain any of the three curve shapes.
Since the market for loans can be segmented based on maturity, sources of supply and demand for
loans within each segment determine the prevailing interest rate. If supply is greater than demand
for short-term funds at a time when demand for long-term loans is higher than the supply of
funding, the yield curve would be upward sloping. Obviously, the reverse also holds true.
4

1
0
7
Price Volatility Characteristics of Bonds
(i)Although the prices of bonds move in the opposite direction from the
change in yield required, the percentage price change is not the same for
all bonds (it depends on the convexity of the bond).
(ii)For very small changes in the yield required, the percentage price change
for a given bond is roughly the same, whether the yield required increases
or decreases.
(iii)For large changes in the required yield, the percentage price change is
not the same for an increase in the required yield as it is for a decrease in
the required yield.
(iv)For a given large change in basis points, the percentage price increase is
greater than the percentage price decrease.
 An explanation for these four properties of bond price volatility
lies in the convex shape of the price-yield relationship.
4

1
0
8
Characteristics of a Bond that Affect its Price
Volatility: Coupon and YTM
There are two characteristics of an bond that determine its price
volatility: coupon and term to maturity.
1) First, for a given term to maturity and initial yield, the price
volatility of a bond is greater, the lower the coupon rate.
 This characteristic can be seen by comparing the 9%, 6%, and
zero-coupon bonds with the same maturity (see Exhibit 4-3).
2) Second, for a given coupon rate and initial yield, the longer the
term to maturity, the greater the price volatility. The price
sensitivity increases with bond’s maturity but at a decreasing
rate.
 This can be seen in Exhibit 4-3 by comparing the five-year bonds
with the 25-year bonds with the same coupon.
4

1
0
9
EXHIBIT 4-3 Instantaneous Percentage Price Change for Six Hypothetical Bonds
Six hypothetical bonds, priced initially to yield 9%:
9% coupon, 5 years to maturity, price = 100.0000
9% coupon, 25 years to maturity, price = 100.000
6% coupon, 5 years to maturity, price = 88.1309
6% coupon, 25 years to maturity, price = 70.3570
0% coupon, 5 years to maturity, price = 64.3928
0% coupon, 25 years to maturity, price = 11.0710
Yield (%)
Change to:
Change in
Basis Points
Percentage Price Change (coupon/maturity in years)
9% / 5 9% / 25 6% / 5 6% / 25 0% / 5 0% / 25
6.00 -300 12.80 38.59 13.47 42.13 15.56 106.04
7.00 -200 8.32 23.46 8.75 25.46 10.09 61.73
8.00 -100 4.06 10.74 4.26 11.60 4.91 27.10
8.50 -50 2.00 5.15 2.11 5.55 2.42 12.72
8.90 -10 0.40 1.00 0.42 1.07 0.48 2.42
8.99 -1 0.04 0.10 0.04 0.11 0.05 0.24
9.01 1 -0.04 -0.10 -0.04 -0.11 -0.05 -0.24
9.10 10 -0.39 -0.98 -0.41 -1.05 -0.48 -2.36
9.50 50 -1.95 -4.75 -2.05 -5.09 -2.36 -11.26
10.00 100 -3.86 -9.13 -4.06 -9.76 -4.66 -21.23
11.00 200 -7.54 -16.93 -7.91 -18.03 -9.08 -37.89
12.00 300 -11.04 -23.64 -11.59 -25.08 -13.28 -50.96
4

1
1
0
Price Volatility Characteristics:
Effects of Yield to Maturity
 Holding other factors constant, the higher the YTM at which a bond trades, the
lower the price volatility.
 To see this, compare the 9% 25-year bond trading at various yield levels in
Exhibit 4-4 .
 The 1st column of Exhibit 4-4 shows the yield level the bond is trading at, and the
2
nd column gives the initial price.
 The 3rd column of Exhibit 4-4 indicates the bond’s price if yields change by 100
basis points.
 The 4th and 5th columns of Exhibit 4-4 show the dollar price decline and the
percentage price decline.
 The 4th and 5th columns of Exhibit 4-4 also show: higher the initial yield, the
lower the price volatility.
 An implication of this is that for a given change in yields, price volatility is
greater (lower) when yield levels in the market are low (high).
4

1
1
1
EXHIBIT 4-4 Price Change for a 100-Basis-Point Change in Yield for a 9% 25-Year
Bond Trading at Different Yield Levels
Yield Level (%) Initial Price New Price a Price Decline Percent Decline
7 $123.46 $110.74 $12.72 10.30
8 110.74 100.00 10.74 9.70
9 100.00 90.87 9.13 9.13
10 90.87 83.07 7.80 8.58
11 83.07 76.36 6.71 8.08
12 76.36 70.55 5.81 7.61
13 70.55 65.50 5.05 7.16
14 65.50 61.08 4.42 6.75
8 110.74 100.00 10.74 9.70
Price volatility is greater (lower) when YTM levels in the market are low (high).
1
1
2
Some Tips on Bond Pricing
Bond prices and market interest rates move in
opposite directions.
 When coupon rate = market rate (r) => price = par value.
(par bond)
 When coupon rate > market rate (r) => price > par value
(premium bond)
 When coupon rate < market rate (r) => price < par value
(discount bond)
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Interest Rates and Required Returns:
• The interest rate is usually applied to debt instruments such
as bank loans or bonds; the compensation paid by the
borrower of funds to the lender; from the borrower’s point of
view, the cost of borrowing funds.
• The required return is usually applied to equity instruments
such as common stock; the cost of funds obtained by selling
an ownership interest.
• Several factors can influence the equilibrium interest rate:
1. Inflation, which is a rising trend in the prices of most goods and services.
2. Risk, which leads investors to expect a higher return on their investment
3. Liquidity preference, which refers to the general tendency of investors to
prefer short-term securities
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Risk Premiums: Issue and Issuer
Characteristics
Applying the general valuation formula to a
bond
• What component of a bond represents the future cash flows?
• Coupon Payment: The amount the holder of the bond receives in interest at the
end of each specified period.
• The Par Value: The amount that will be repaid to the purchaser at the end of the
debt agreement.
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Corporate Bonds
• A corporate bond is a long-term debt instrument indicating
that a corporation has borrowed a certain amount of money
and promises to repay it in the future under clearly defined
terms.
• The bond’s coupon interest rate is the percentage of a
bond’s par value that will be paid annually, typically in two
equal semiannual payments, as interest.
• The bond’s par / face value, is the amount borrowed by the
company and the amount owed to the bond holder on the
maturity date.
• The bond’s maturity date is the time at which a bond
becomes due and the principal must be repaid.
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Corporate Bonds: Legal Aspects of
Corporate Bonds
• The bond indenture is a legal document that specifies both
the rights of the bondholders and the duties of the issuing
corporation.
• Standard debt provisions are provisions in a bond indenture
specifying certain record-keeping and general business
practices that the bond issuer must follow; normally, they do
not place a burden on a financially sound business.
• Restrictive covenants are provisions in a bond indenture
that place operating and financial constraints on the
borrower.
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Corporate Bonds: Legal Aspects of
Corporate Bonds (cont.)
The most common restrictive covenants do the following:
1. Require a minimum level of liquidity, to ensure against loan
default.
2. Prohibit the sale of accounts receivable to generate cash. Selling
receivables could cause a long-run cash shortage if proceeds were
used to meet current obligations.
3. Impose fixed-asset restrictions. The borrower must maintain a
specified level of fixed assets to guarantee its ability to repay the
bonds.
4. Constrain subsequent borrowing. Additional long-term debt may
be prohibited, or additional borrowing may be subordinated to the
original loan. Subordination means that subsequent creditors
agree to wait until all claims of the senior debt are satisfied.
5. Limit the firm’s annual cash dividend payments to a specified
percentage or amount.
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Corporate Bonds: Legal Aspects of
Corporate Bonds (cont.)
• Subordination in a bond indenture is the stipulation that
subsequent creditors agree to wait until all claims of the
senior debt are satisfied.
• Sinking fund requirements are a restrictive provision often
included in a bond indenture, providing for the systematic
retirement of bonds prior to their maturity.
• A trustee is a paid individual, corporation, or commercial
bank trust department that acts as the third party to a bond
indenture and can take specified actions on behalf of the
bondholders if the terms of the indenture are violated.
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Corporate Bonds:
Cost of Bonds to the Issuer
•In general, the longer the bond’s maturity, the higher
the interest rate (or cost) to the firm.
•In addition, the larger the size of the offering, the
lower will be the cost (in % terms) of the bond.
•Also, the greater the default risk of the issuing firm,
the higher the cost of the issue.
•Finally, the cost of money in the capital market is
the basis form determining a bond’s coupon interest
rate.
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Corporate Bonds:
General Features of a Bond Issue
• The conversion feature of convertible bonds allows
bondholders to change each bond into a stated number of
shares of common stock.
• Bondholders will exercise this option only when the market price of
the stock is greater than the conversion price.
• A call feature, which is included in nearly all corporate bond
issues, gives the issuer the opportunity to repurchase bonds at
a stated call price prior to maturity.
• The call price is the stated price at which a bond may be repurchased,
by use of a call feature, prior to maturity.
• The call premium is the amount by which a bond’s call price exceeds
its par value.
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Corporate Bonds: General Features of a
Bond Issue (cont.)
•In general, the call premium is equal to one year of
coupon interest and compensates the holder for
having it called prior to maturity.
•Furthermore, issuers will exercise the call feature
when interest rates fall and the issuer can refund the
issue at a lower cost.
•Issuers typically must pay a higher rate to investors
for the call feature compared to issues without the
feature.
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Corporate Bonds: General Features of a
Bond Issue (cont.)
•Bonds also are occasionally issued with stock
purchase warrants, which are instruments that give
their holders the right to purchase a certain number
of shares of the issuer’s common stock at a specified
price over a certain period of time. Occasionally
attached to bonds as “sweeteners.”
•Including warrants typically allows the firm to raise
debt capital at a lower cost than would be possible in
their absence.
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Corporate Bonds: Bond Yields
The three most widely cited yields are:
• Current yield
• Yield to maturity (YTM)
• Yield to call (YTC)
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Corporate Bonds: Bond Prices
• Because most corporate bonds are purchased and held by
institutional investors, such as banks, insurance companies,
and mutual funds, rather than individual investors, bond
trading and price data are not readily available to individuals.
• Although most corporate bonds are issued with a par, or face,
value of $1,000, all bonds are quoted as a percentage of
par.
• A $1,000-par-value bond quoted at 94.007 is priced at $940.07
(94.007%  $1,000). Corporate bonds are quoted in dollars and cents.
Thus, Company C’s price of 103.143 for the day was $1,031.43—that
is, 103.143%  $1,000.
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Table 6.2
Data on Selected Bonds
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Table 6.3 Moody’s and Standard & Poor’s
Bond Ratings
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Focus on Ethics
Can We Trust the Bond Raters?
• Credit-rating agencies evaluate and attach ratings to credit instruments
(e.g, bonds). Historically, bonds that received higher ratings were
almost always repaid, while lower rated more speculative “junk”
bonds experienced much higher default rates.
• Recently, the credit-rating agencies have been criticized for their role
in the subprime crisis. The agencies attached ratings to complex
securities that did not reflect the true risk of the underlying
investments.
• What effect will the new legislation likely have on the market share of
the largest rating agencies? How will the new legislation affect the
process of finding ratings information for investors?
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Table 6.4a Characteristics and Priority of Lender’s Claim
of Traditional Types of Bonds
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Table 6.4b Characteristics and Priority of Lender’s Claim
of Traditional Types of Bonds
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Table 6.5 Characteristics of
Contemporary Types of Bonds
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Corporate Bonds:
International Bond Issues
• Companies and governments borrow internationally by
issuing bonds in two principal financial markets:
• A Eurobond is a bond issued by an international borrower and sold to
investors in countries with currencies other than the currency in which
the bond is denominated.
• In contrast, a foreign bond is a bond issued in a host country’s
financial market, in the host country’s currency, by a foreign borrower.
• Both markets give borrowers the opportunity to obtain large
amounts of long-term debt financing quickly, in the currency
of their choice and with flexible repayment terms.
© 2012 Pearson Prentice Hall.
All rights reserved. 6-133
Valuation Fundamentals
• Valuation is the process that links risk and return
to determine the worth of an asset.
• There are three key inputs to the valuation process:
1. Cash flows (returns)
2. Timing
3. A measure of risk, which determines the required
return
© 2012 Pearson Prentice Hall.
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Basic Valuation Model
• The value of any asset is the present value of all future cash flows it
is expected to provide over the relevant time period.
• The value of any asset at time zero, V0
, can be expressed as
where
v0
= Value of the asset at time zero
CFT
= cash flow expected at the end of year t
r = appropriate required return (discount rate)
n = relevant time period
© 2012 Pearson Prentice Hall.
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Bond Valuation: Basic Bond Valuation
The basic model for the value, B0
, of a bond is given
by the following equation:
Where
B0
= value of the bond at time zero
I = annual interest paid in dollars
n = number of years to maturity
M = par value in dollars
rd
= required return on a bond
© 2012 Pearson Prentice Hall.
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Bond Valuation: Basic Bond Valuation (cont.)
• Mills Company, a large defense contractor, on January 1,
2007, issued a 10% coupon interest rate, 10-year bond with a
$1,000 par value that pays interest semiannually.
• Investors who buy this bond receive the contractual right to
two cash flows: (1) $100 annual interest (10% coupon
interest rate  $1,000 par value) distributed as $50 (1/2 
$100) at the end of each 6 months, and (2) the $1,000 par
value at the end of the tenth year.
• Assuming that interest on the Mills Company bond issue is
paid annually and that the required return is equal to the
bond’s coupon interest rate, I = $100, rd = 10%, M = $1,000,
and n = 10 years.
© 2012 Pearson Prentice Hall.
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Bond Valuation: Basic Bond Valuation (cont.)
© 2012 Pearson Prentice Hall.
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Table 6.6 Bond Values for Various Required Returns (Mills Company’s
10% Coupon Interest Rate, 10-Year Maturity, $1,000 Par, January 1,
2010, Issue Paying Annual Interest)
Time to Maturity and Bond Values …
• The premium or discount will diminish over time as the bond approaches
maturity. This is because at maturity, the bond will be worth the $1000 par value.
Therefore, assuming required returns (market rates of interest) stay constant
until maturity, the bond price will follow the pattern in the graph of the next
slide.
6-139
© 2012 Pearson Prentice Hall.
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… Figure 6.5 Time to Maturity and Bond
Values
An Approximation
n years to maturity
P present price of the bond
M maturity value of the bond
C annual coupon payment
where,
0.4 0.6
( )

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M P
n
M P
C
YTM
Use the same formula
with annual coupon
and n as no. of years
even if the coupon
payment is semiannual.
(To find out approx
YTM)
YTM: Example
• Consider a AED 1,000 par value bond, carrying a coupon rate of 9%,
maturing after 8 years. The bond is currently selling for AED 800.
What is YTM on this bond ?
© 2012 Pearson Prentice Hall.
All rights reserved. 6-142
Using approximate formula
13.1%
0.4 1000 0.6 800
8
(1000 800)
90
YTM 
  



The YTM calculation considers the current
coupon income as well as the capital gain or loss
the investor will realize by holding the bond to
maturity. In addition, it takes into account the
timing of the cash flows.
Another Approximate Formula


























2
M P
n
M – P
C
Approx YTM
3
M 2P
n
M – P
C
Approx YTM
or
Use the same formula
with annual coupon
and n as no. of years
even if the coupon
payment is semiannual.
(To find out approx
YTM)
Bond Yields: Formulas
















 


CGY
Expected
CY
Expected Expected totalreturn YTM
Beginning price
Change in price Capital gains yield (CGY)
Current price
Annual coupon payment Current yield (CY)
An example:
Current and capital gains yield
Find the current yield and the capital gains yield for a 10-
year, 9% annual coupon bond that sells for $887, and has
a face value of $1,000.
Current yield = $90 / $887
= 0.1015
= 10.15%
Calculating capital gains yield
Find CGY if YTM = 10.91 %
YTM = Current yield + Capital gains yield
CGY = YTM – CY
= 10.91% – 10.15%
= 0.76%
Could also find the expected price one year from now and
divide the change in price by the beginning price, which
gives the same answer.
6-148
Factors That Shift Bond Demand
1. Wealth
• Increases in wealth shift the demand for bonds to the right.
2. Expected Inflation
• Declining inflation means promised payments have higher
value – bond demand shifts right.
3. Expected Returns and Expected Interest Rates
• If the return on bonds rises relative to the return on
alternative investments, bond demand will shift right.
• When interest rates are expected to fall, price prices are
expected to rise shifting bond demand to the right.
6-149
Factors That Shift Bond Demand
4. Risk Relative to Alternatives
• If bonds become less risky relative to alternative investments, demand
for bonds shifts right.
5. Liquidity Relative to Alternatives
• Investors like liquidity: the more liquid the bond, the higher the demand.
• If bonds become less risky relative to alternative investments, demand
for bonds shifts right.
Factors Affecting the Demand for Bonds
•Holding all other factors constant (including
• price), the quantity of bonds demanded is:
1. positively related to wealth
2. positively related to expected real return rate
3. negatively related to risk relative to other assets
4. positively related to liquidity
© 2012 Pearson Prentice Hall.
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6-151
When bonds
become more
attractive for
investors, the
demand curve
shifts to the right.
This raises bond
prices, lowering
interest rates.
Factors That Shift Bond Demand: General
Principle
Scenario 1:Business Cycle Expansion
© 2012 Pearson Prentice Hall.
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Scenario 2: Increase in Expected Inflation
© 2012 Pearson Prentice Hall.
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6-154
Factors That Shift Bond Demand
6-155
Factors That Shift Bond Demand
Factors affecting the Supply of
Bonds
• Expected profitability of physical capital
• investment (hence of borrowing)
• Expected inflation rate (which affects the real cost of borrowing)
• Government deficits (requiring government
to sell bonds to finance expenditures)
© 2012 Pearson Prentice Hall.
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… Factors affecting the Supply of Bonds
• Expected profitability of investment
opportunities— In an expansion, the supply curve
for bonds shifts to the right.
• Expected inflation rate— Given an increase in the
expected inflation rate, the supply curve for bonds
shifts to the right.
•Government deficit— Given an increase in the
government budget deficit, the supply curve for
bonds shifts to the right.
© 2012 Pearson Prentice Hall.
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6-158
Duration
To deal with the ambiguity of the maturity of a bond making many
payments, we need a measure of the average maturity of the bond’s
promised cash flows to serve as useful summary statistics of the
effective maturity of a bond.
We would like use the measure as a guide to sensitivity of a bond to
interest rate changes.
Since we have noted that price sensitivity tends to increase with
time to maturity.
Duration
• Term to maturity is an imperfect measure of bond risk
because it ignores the valuation effects of differences
in coupon rate and principal payment schedule
•Duration: an estimate of economic life of a bond
measured by the weighted average time to receipt of
cash flows
• The shorter the duration, the less sensitive is a bond’s price
to fluctuations.
Rules for Duration
Rule 1 The duration of a zero-coupon bond equals its
time to maturity
Rule 2 Holding maturity constant, a bond’s duration is
higher when the coupon rate is lower
Rule 3 Holding the coupon rate constant, a bond’s
duration generally increases with its time to maturity
Rule 4 Holding other factors constant, the duration of a
coupon bond is higher when the bond’s yield to
maturity is lower The shorter the duration, the less
volatility present and vice versa.
Rules 5 The duration of a level perpetuity is equal to:
(1+YTM) / YTM
… Rules for Duration
© 2012 Pearson Prentice Hall.
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There are two important components of Duration’s computation:
interest rate and time to maturity:
 The higher the bond’s yield, the shorter the duration will be
and vice versa.
 The shorter the maturity period, the shorter the duration will
be and vice versa.
 Thus investing in bonds with higher yield and shorter maturity
will provide shorter duration and less price volatility in an
interest rate changing environment.
Duration: The Formula
That is :Duration (Years * Present Value)/Bon d price
(1 r)
C F
(1 r)
t(CF )
N
t 1
t
t
N
t 1
t
t



 




DMAC
© 2012 Pearson Prentice Hall.
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Duration Example
• 10% 30-year coupon bond, YTM=12%, semi-annual payments
1 7.3895 periods
(1 .0 6)
$1000
(1 .0 6)
5 0
(1 .0 6)
6 0($1000)
(1 .0 6)
($5 0)
6 0
1
6 0
6 0
1
6 0












t
t
t
t
MAC
t
D
Example continued
• Since the bond makes semi annual coupon payments, the duration of
17.389455 periods must be divided by 2 to find the number of years.
• 17.389455 / 2 = 8.6947277 years
• Duration indicates the average time taken by the bond, on a
discounted basis, to pay back the original investment.
Example_Duration
• Calculate duration of a bond with 3 years to maturity, an 8 percent
coupon rate paid annually, and a yield to maturity of 10%.
© 2012 Pearson Prentice Hall.
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Duration Calculations (concluded)
• Calculate duration of a bond with 3 years to maturity, an 8 percent
coupon rate paid annually, and a yield to maturity of 10%.
D  years





$80( )
( . )
$80
( . )
$80( )
( . )
$80
( . )
$ 1, ( )
( . )
$ 1,
( . )
.
1
11 0
11 0
2
11 0
11 0
080 3
11 0
080
11 0
2 7 8
1
1
2
2
3
3
The Effect of Convexity
Price
Yield
P*
Y* Y Y**
P**
P
Y-Y**=Y*-Y, but
P-P**<P*-P
Convexity
• Convexity measures the sensitivity of modified duration to changes in interest rate (the rate of
“acceleration” in bond price changes)
• The degree of bend in the price–yield curve
Figure 15.3 The Price-yield Curve for a 30-year 6% Bond is More Convex to the Origin than the
Price-yield Curve for a 5-year 6% Bond
0
500
1,000
1,500
2,000
2,500
0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%
Yield to maturity Bond Price ($)
30-year 6% Bond
5-year 6% Bond
4

1
7
0
Approximating Percentage Price Change Using Duration
and Convexity Measures
 Using duration and convexity measures together gives a better
approximation of the actual price change for a large movement in the
required yield.
Some Notes on Convexity
i. Convexity refers to the general shape of the price-yield relationship,
while the convexity measure relates to the quantification of how the price
of the bond will change when interest rates change.
ii. The approximation percentage change in price due to convexity is the
product of three numbers:
½ , convexity measure, and square of the change in yield
i. In practice different vendors compute the convexity measure differently
by scaling the measure in dissimilar ways.
4

1
7
1
Value of Convexity
 The following exhibit shows two bonds, A and B. The two
bonds have the same duration and are offering the same yield;
they have different convexities, however, Bond B is more
convex (bowed) than bond A.
4

1
7
2
Exhibit 4-16
Comparison of Convexity of Two Bonds
Price
Yield
Bond A
Bond B
Bond A
Bond B
Bond B Has Greater
Convexity Than Bond A
4

1
7
3
Value of Convexity
i. As portrayed in Exhibit 4-17, the required yield increases (decreases), the
convexity of a bond decreases (increases). This property is referred to as
positive convexity.
ii. For a given yield and maturity, lower coupon rates will have greater
convexity.
iii. For a given yield and modified duration, lower coupon rates will have smaller
convexity.
iv. Convexity indicates that as YTM increases, the price of a bond declines at a
declining rate.
4

1
7
4
Change in Duration as the
Required Yield Changes
Price
Yield
As yield ↓
Slope (duration) ↑
As yield ↑
Slope (duration) ↓
1
2
3
Bond pricing using convexity and duration
• % bond price change = – 1 × % Yield change × modified
duration + ½ × convexity × (Yield change)2
• Using both duration and convexity allows for a more
accurate estimation
 
 
 
2
1
2
Bond Price 1
1
Cash Payment
Convexity
Yield
Yield
t t
T
t
t
t
j
 

 


Convexity: The Formula
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CHAPTER 9
NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA
Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.
Key Concepts and Skills
• Be able to compute payback and discounted payback and
understand their shortcomings
• Understand accounting rates of return and their shortcomings
• Be able to compute internal rates of return (standard and
modified) and understand their strengths and weaknesses
• Be able to compute the net present value and understand why it is
the best decision criterion
• Be able to compute the profitability index and understand its
relation to net present value
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Chapter Outline
•Net Present Value
• The Payback Rule
• The Discounted Payback
• The Average Accounting Return
• The Internal Rate of Return
• The Profitability Index
• The Practice of Capital Budgeting
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Good Decision Criteria
• We need to ask ourselves the following questions when
evaluating capital budgeting decision rules:
 Does the decision rule adjust for the time value of money?
 Does the decision rule adjust for risk?
 Does the decision rule provide information on whether we are
creating value for the firm?
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Net Present Value
• The difference between the market value of a project
and its cost
•How much value is created from undertaking an
investment?
The first step is to estimate the expected future cash flows.
The second step is to estimate the required return for
projects of this risk level.
The third step is to find the present value of the cash flows
and subtract the initial investment.
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Project Example Information
• You are reviewing a new project and have estimated
the following cash flows:
Year 0:CF = -165,000
Year 1:CF = 63,120; NI = 13,620
Year 2:CF = 70,800; NI = 3,300
Year 3:CF = 91,080; NI = 29,100
Average Book Value = 72,000
• Your required return for assets of this risk level is 12%.
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NPV – Decision Rule
•If the NPV is positive, accept the project
•A positive NPV means that the project is expected to
add value to the firm and will therefore increase the
wealth of the owners.
• Since our goal is to increase owner wealth, NPV is a
direct measure of how well this project will meet our
goal.
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Computing NPV for the Project
•Using the formulas:
NPV = -165,000 + 63,120/(1.12) + 70,800/(1.12)2 +
91,080/(1.12)3 = 12,627.41
•Using the calculator:
CF0 = -165,000; C01 = 63,120; F01 = 1; C02 = 70,800; F02 = 1;
C03 = 91,080; F03 = 1; NPV; I = 12; CPT NPV = 12,627.41
•Do we accept or reject the project?
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Decision Criteria Test – NPV
•Does the NPV rule account for the time value of
money?
•Does the NPV rule account for the risk of the cash
flows?
•Does the NPV rule provide an indication about the
increase in value?
• Should we consider the NPV rule for our primary
decision rule?
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Calculating NPVs with a Spreadsheet
• Spreadsheets are an excellent way to compute
NPVs, especially when you have to compute the
cash flows as well.
•Using the NPV function
The first component is the required return entered as a
decimal
The second component is the range of cash flows
beginning with year 1
Subtract the initial investment after computing the NPV
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Payback Period
•How long does it take to get the initial cost back in a
nominal sense?
• Computation
Estimate the cash flows
Subtract the future cash flows from the initial cost until the
initial investment has been recovered
•Decision Rule – Accept if the payback period is less
than some preset limit
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Computing Payback
•Assume we will accept the project if it pays back
within two years.
Year 1: 165,000 – 63,120 = 101,880 still to recover
Year 2: 101,880 – 70,800 = 31,080 still to recover
Year 3: 31,080 – 91,080 = -60,000 project pays back in year 3
•Do we accept or reject the project?
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Decision Criteria Test – Payback
•Does the payback rule account for the time value of
money?
•Does the payback rule account for the risk of the cash
flows?
•Does the payback rule provide an indication about the
increase in value?
• Should we consider the payback rule for our primary
decision rule?
9-189 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.
Advantages and Disadvantages of
Payback
• Advantages
 Easy to understand
 Adjusts for uncertainty of later
cash flows
 Biased toward liquidity
• Disadvantages
 Ignores the time value of
money
Requires an arbitrary cutoff
point
 Ignores cash flows beyond
the cutoff date
Biased against long-term
projects, such as research
and development, and new
projects
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Discounted Payback Period
• Compute the present value of each cash flow and
then determine how long it takes to pay back on a
discounted basis
• Compare to a specified required period
•Decision Rule: Accept the project if it pays back on a
discounted basis within the specified time
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Computing Discounted Payback
• Assume we will accept the project if it pays back on a discounted
basis in 2 years.
• Compute the PV for each cash flow and determine the payback
period using discounted cash flows
 Year 1: 165,000 – 63,120/1.121 = 108,643
 Year 2: 108,643 – 70,800/1.122 = 52,202
 Year 3: 52,202 – 91,080/1.123 = -12,627 project pays back in year 3
• Do we accept or reject the project?
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Decision Criteria Test – Discounted Payback
• Does the discounted payback rule account for the time value of
money?
• Does the discounted payback rule account for the risk of the cash
flows?
• Does the discounted payback rule provide an indication about
the increase in value?
• Should we consider the discounted payback rule for our primary
decision rule?
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Advantages and Disadvantages of Discounted
Payback
• Advantages
 Includes time value of money
 Easy to understand
 Does not accept negative
estimated NPV investments when
all future cash flows are positive
 Biased towards liquidity
• Disadvantages
 May reject positive NPV investments
 Requires an arbitrary cutoff point
 Ignores cash flows beyond the cutoff
point
 Biased against long-term projects,
such as R&D and new products
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Average Accounting Return
• There are many different definitions for average
accounting return
• The one used in the book is:
Average net income / average book value
Note that the average book value depends on how the asset
is depreciated.
•Need to have a target cutoff rate
•Decision Rule: Accept the project if the AAR is greater
than a preset rate
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Computing AAR
• Assume we require an average accounting return of 25%
• Average Net Income:
 (13,620 + 3,300 + 29,100) / 3 = 15,340
• AAR = 15,340 / 72,000 = .213 = 21.3%
• Do we accept or reject the project?
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Decision Criteria Test – AAR
•Does the AAR rule account for the time value of
money?
•Does the AAR rule account for the risk of the cash
flows?
•Does the AAR rule provide an indication about the
increase in value?
• Should we consider the AAR rule for our primary
decision rule?
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Advantages and Disadvantages of AAR
• Advantages
 Easy to calculate
 Needed information will
usually be available
• Disadvantages
 Not a true rate of return; time value
of money is ignored
 Uses an arbitrary benchmark cutoff
rate
 Based on accounting net income and
book values, not cash flows and
market values
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Internal Rate of Return
• This is the most important alternative to NPV
• It is often used in practice and is intuitively appealing
• It is based entirely on the estimated cash flows and is independent of
interest rates found elsewhere
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IRR – Definition and Decision Rule
•Definition: IRR is the return that makes the NPV
= 0
•Decision Rule: Accept the project if the IRR is
greater than the required return.
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Computing IRR
•If you do not have a financial calculator, then this
becomes a trial and error process
• Calculator
Enter the cash flows as you did with NPV
Press IRR and then CPT
IRR = 16.13% > 12% required return
•Do we accept or reject the project?
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NPV Profile for the Project
-20,000
-10,000
0
10,000
20,000
30,000
40,000
50,000
60,000
70,000
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22
Discount Rate NPV
IRR = 16.13%
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Decision Criteria Test – IRR
•Does the IRR rule account for the time value of
money?
•Does the IRR rule account for the risk of the cash
flows?
•Does the IRR rule provide an indication about the
increase in value?
• Should we consider the IRR rule for our primary
decision criteria?
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Advantages of IRR
• Knowing a return is intuitively appealing
•It is a simple way to communicate the value of a
project to someone who doesn’t know all the
estimation details
•If the IRR is high enough, you may not need to
estimate a required return, which is often a difficult
task
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Calculating IRRs With A Spreadsheet
• You start with the cash flows the same as you
did for the NPV
• You use the IRR function
You first enter your range of cash flows, beginning
with the initial cash flow
You can enter a guess, but it is not necessary
The default format is a whole percent – you will
normally want to increase the decimal places to at
least two
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Summary of Decisions for the Project
Summary
Net Present Value Accept
Payback Period Reject
Discounted Payback Period Reject
Average Accounting Return Reject
Internal Rate of Return Accept
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NPV vs. IRR
• NPV and IRR will generally give us the same decision
• Exceptions:
 Nonconventional cash flows – cash flow signs change more than once
 Mutually exclusive projects
• Initial investments are substantially different (issue of scale)
• Timing of cash flows is substantially different
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IRR and Nonconventional
Cash Flows
•When the cash flows change sign more than
once, there is more than one IRR
•When you solve for IRR you are solving for the
root of an equation, and when you cross the xaxis more than once, there will be more than
one return that solves the equation
•If you have more than one IRR, which one do
you use to make your decision?
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Another Example: Nonconventional Cash
Flows
• Suppose an investment will cost $90,000
initially and will generate the following cash
flows:
Year 1: 132,000
Year 2: 100,000
Year 3: -150,000
• The required return is 15%.
• Should we accept or reject the project?
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NPV Profile
($10,000.00)
($8,000.00)
($6,000.00)
($4,000.00)
($2,000.00)
$0.00
$2,000.00
$4,000.00
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
Discount Rate NPV
IRR = 10.11% and 42.66%
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Summary of Decision Rules
• The NPV is positive at a required return of 15%, so you should Accept
• If you use the financial calculator, you would get an IRR of 10.11% which
would tell you to Reject
• You need to recognize that there are non-conventional cash flows and
look at the NPV profile
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IRR and Mutually Exclusive Projects
• Mutually exclusive projects
If you choose one, you can’t choose the other
Example: You can choose to attend graduate school
at either Harvard or Stanford, but not both
•Intuitively, you would use the following decision
rules:
NPV – choose the project with the higher NPV
IRR – choose the project with the higher IRR
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Example With Mutually
Exclusive Projects
Period Project
A
Project
B
0 -500 -400
1 325 325
2 325 200
IRR 19.43% 22.17%
NPV 64.05 60.74
The required return
for both projects is
10%.
Which project
should you accept
and why?
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NPV Profiles
($40.00)
($20.00)
$0.00
$20.00
$40.00
$60.00
$80.00
$100.00
$120.00
$140.00
$160.00
0 0.05 0.1 0.15 0.2 0.25 0.3
Discount Rate NPV
A
B
IRR for A = 19.43%
IRR for B = 22.17%
Crossover Point = 11.8%
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Conflicts Between
NPV and IRR
•NPV directly measures the increase in value to the
firm
•Whenever there is a conflict between NPV and
another decision rule, you should always use NPV
•IRR is unreliable in the following situations
Nonconventional cash flows
Mutually exclusive projects
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Modified IRR
• Calculate the net present value of all cash outflows
using the borrowing rate.
• Calculate the net future value of all cash inflows
using the investing rate.
• Find the rate of return that equates these values.
• Benefits: single answer and specific rates for
borrowing and reinvestment
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Profitability Index
• Measures the benefit per unit cost, based on the time value of money
• A profitability index of 1.1 implies that for every $1 of investment, we
create an additional $0.10 in value
• This measure can be very useful in situations in which we have limited
capital
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Advantages and Disadvantages of Profitability Index
• Advantages
 Closely related to NPV, generally
leading to identical decisions
 Easy to understand and
communicate
 May be useful when available
investment funds are limited
• Disadvantages
 May lead to incorrect decisions
in comparisons of mutually
exclusive investments
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Capital Budgeting
In Practice
• We should consider several investment criteria when making
decisions
• NPV and IRR are the most commonly used primary investment
criteria
• Payback is a commonly used secondary investment criteria
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Summary – DCF Criteria
• Net present value
 Difference between market value and cost
 Take the project if the NPV is positive
 Has no serious problems
 Preferred decision criterion
• Internal rate of return
 Discount rate that makes NPV = 0
 Take the project if the IRR is greater than the required return
 Same decision as NPV with conventional cash flows
 IRR is unreliable with nonconventional cash flows or mutually exclusive projects
• Profitability Index
 Benefit-cost ratio
 Take investment if PI > 1
 Cannot be used to rank mutually exclusive projects
 May be used to rank projects in the presence of capital rationing
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Summary – Payback Criteria
• Payback period
 Length of time until initial investment is recovered
 Take the project if it pays back within some specified period
 Doesn’t account for time value of money, and there is an arbitrary
cutoff period
• Discounted payback period
 Length of time until initial investment is recovered on a discounted
basis
 Take the project if it pays back in some specified period
 There is an arbitrary cutoff period
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Summary – Accounting Criterion
• Average Accounting Return
 Measure of accounting profit relative to book value
 Similar to return on assets measure
 Take the investment if the AAR exceeds some specified return level
 Serious problems and should not be used
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Quick Quiz
• Consider an investment that costs $100,000 and has a cash
inflow of $25,000 every year for 5 years. The required return is
9%, and required payback is 4 years.
What is the payback period?
What is the discounted payback period?
What is the NPV?
What is the IRR?
Should we accept the project?
• What decision rule should be the primary decision method?
• When is the IRR rule unreliable?
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Ethics Issues
• An ABC poll in the spring of 2004 found that one-third of students
age 12 – 17 admitted to cheating and the percentage increased as
the students got older and felt more grade pressure. If a book
entitled “How to Cheat: A User’s Guide” would generate a positive
NPV, would it be proper for a publishing company to offer the new
book?
• Should a firm exceed the minimum legal limits of government
imposed environmental regulations and be responsible for the
environment, even if this responsibility leads to a wealth reduction
for the firm? Is environmental damage merely a cost of doing
business?
• Should municipalities offer monetary incentives to induce firms to
relocate to their areas?
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Comprehensive Problem
• An investment project has the following cash flows: CF0 = –
1,000,000; C01 – C08 = 200,000 each
• If the required rate of return is 12%, what decision should be
made using NPV?
• How would the IRR decision rule be used for this project, and
what decision would be reached?
• How are the above two decisions related?
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CHAPTER 9
End of Chapter
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CHAPTER 13
RETURN, RISK, AND THE SECURITY MARKET LINE
Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.
Key Concepts and Skills
• Know how to calculate expected returns
•Understand the impact of diversification
•Understand the systematic risk principle
•Understand the security market line
•Understand the risk-return trade-off
•Be able to use the Capital Asset Pricing Model
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Chapter Outline
• Expected Returns and Variances
• Portfolios
• Announcements, Surprises, and Expected Returns
• Risk: Systematic and Unsystematic
• Diversification and Portfolio Risk
• Systematic Risk and Beta
• The Security Market Line
• The SML and the Cost of Capital: A Preview
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Expected Returns
• Expected returns are based on the probabilities
of possible outcomes
•In this context, “expected” means average if the
process is repeated many times
• The “expected” return does not even have to be
a possible return


n
i
i
Ri
E R p
1
( )
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Example: Expected Returns
State Probability C T___
Boom 0.3 0.15 0.25
Normal 0.5 0.10 0.20
Recession ??? 0.02 0.01
• RC = .3(15) + .5(10) + .2(2) = 9.9%
• RT = .3(25) + .5(20) + .2(1) = 17.7%
13-231
• Suppose you have predicted the following
returns for stocks C and T in three possible
states of the economy. What are the
expected returns?
Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.
Variance and Standard Deviation
• Variance and standard deviation measure the volatility of returns
• Using unequal probabilities for the entire range of possibilities
• Weighted average of squared deviations

 
n
i
pi
Ri
E R
1
2 2
σ ( ( ))
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Example: Variance and Standard
Deviation
• Consider the previous example. What are the variance
and standard deviation for each stock?
• Stock C
2 = .3(0.15-0.099)
2 + .5(0.10-0.099)
2
+ .2(0.02-0.099)
2 = 0.002029
 = 4.50%
• Stock T
2 = .3(0.25-0.177)
2 + .5(0.20-0.177)
2
+ .2(0.01-0.177)
2 = 0.007441
 = 8.63%
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Another Example
• Consider the following information:
State Probability ABC, Inc. Return
Boom .25 0.15
Normal .50 0.08
Slowdown .15 0.04
Recession .10 -0.03
•What is the expected return?
•What is the variance?
•What is the standard deviation?
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Portfolios
•A portfolio is a collection of assets
•An asset’s risk and return are important in how they
affect the risk and return of the portfolio
• The risk-return trade-off for a portfolio is measured by
the portfolio expected return and standard deviation,
just as with individual assets
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Example: Portfolio Weights
• Suppose you have $15,000 to invest and you have
purchased securities in the following amounts. What
are your portfolio weights in each security?
$2000 of C
$3000 of KO
$4000 of INTC
$6000 of BP
 C: 2/15 = .133
 KO: 3/15 = .2
 INTC: 4/15 = .267
 BP: 6/15 = .4
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Portfolio Expected Returns
• The expected return of a portfolio is the weighted average of the
expected returns of the respective assets in the portfolio
• You can also find the expected return by finding the portfolio return
in each possible state and computing the expected value as we did
with individual securities


m
j
E RP
wj
E R j
1
( ) ( )
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Example: Expected Portfolio Returns
• Consider the portfolio weights computed previously. If the individual
stocks have the following expected returns, what is the expected return
for the portfolio?
 C: 19.69%
 KO: 5.25%
 INTC: 16.65%
 BP: 18.24%
• E(RP
) = .133(19.69%) + .2(5.25%) + .267(16.65%) +
.4(18.24%) = 15.41%
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Portfolio Variance
• Compute the portfolio return for each state:
RP = w1R1 + w2R2 + … + wmRm
• Compute the expected portfolio return using the same
formula as for an individual asset
• Compute the portfolio variance and standard
deviation using the same formulas as for an individual
asset
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Example: Portfolio Variance
• Consider the following information on returns and
probabilities:
Invest 50% of your money in Asset A
State Probability A B Portfolio
Boom .4 30% -5% 12.5%
Bust .6 -10% 25% 7.5%
•What are the expected return and standard deviation
for each asset?
•What are the expected return and standard deviation
for the portfolio?
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Another Example
• Consider the following information on returns and
probabilities:
State Probability X Z
Boom .25 15% 10%
Normal .60 10% 9%
Recession .15 5% 10%
•What are the expected return and standard deviation
for a portfolio with an investment of $6,000 in asset X
and $4,000 in asset Z?
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Expected vs. Unexpected Returns
•Realized returns are generally not equal to
expected returns
• There is the expected component and the
unexpected component
At any point in time, the unexpected return can be
either positive or negative
Over time, the average of the unexpected component
is zero
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Announcements and News
•Announcements and news contain both an expected
component and a surprise component
•It is the surprise component that affects a stock’s price
and therefore its return
• This is very obvious when we watch how stock prices
move when an unexpected announcement is made or
earnings are different than anticipated
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Efficient Markets
• Efficient markets are a result of investors trading on the unexpected
portion of announcements
• The easier it is to trade on surprises, the more efficient markets should
be
• Efficient markets involve random price changes because we cannot
predict surprises
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Systematic Risk
• Risk factors that affect a large number of assets
• Also known as non-diversifiable risk or market risk
• Includes such things as changes in GDP, inflation, interest rates, etc.
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Unsystematic Risk
• Risk factors that affect a limited number of assets
• Also known as unique risk and asset-specific risk
• Includes such things as labor strikes, part shortages, etc.
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Returns
• Total Return = expected return + unexpected
return
• Unexpected return = systematic
portion + unsystematic portion
• Therefore, total return can be expressed as follows:
Total Return =
expected return + systematic portion
+ unsystematic portion
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Diversification
• Portfolio diversification is the investment in several different
asset classes or sectors
• Diversification is not just holding a lot of assets
• For example, if you own 50 Internet stocks, you are not
diversified
• However, if you own 50 stocks that span 20 different industries,
then you are diversified
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Table 13.7
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The Principle of Diversification
•Diversification can substantially reduce the variability
of returns without an equivalent reduction in
expected returns
• This reduction in risk arises because worse than
expected returns from one asset are offset by better
than expected returns from another
•However, there is a minimum level of risk that cannot
be diversified away and that is the systematic portion
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Figure 13.1
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Diversifiable Risk
• The risk that can be eliminated by combining assets
into a portfolio
•Often considered the same as unsystematic, unique or
asset-specific risk
•If we hold only one asset, or assets in the same
industry, then we are exposing ourselves to risk that
we could diversify away
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Total Risk
• Total risk = systematic risk +
unsystematic risk
• The standard deviation of returns is a measure of total
risk
• For well-diversified portfolios, unsystematic risk is very
small
• Consequently, the total risk for a diversified portfolio
is essentially equivalent to the systematic risk
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Systematic Risk Principle
• There is a reward for bearing risk
• There is not a reward for bearing risk unnecessarily
• The expected return on a risky asset depends only on that asset’s
• systematic risk since unsystematic risk can be diversified away
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Measuring Systematic Risk
•How do we measure systematic risk?
We use the beta coefficient
•What does beta tell us?
A beta of 1 implies the asset has the same systematic
risk as the overall market
A beta < 1 implies the asset has less systematic risk
than the overall market
A beta > 1 implies the asset has more systematic risk
than the overall market
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Table 13.8 – Selected Betas
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Total vs. Systematic Risk
• Consider the following information:
Standard Deviation Beta
Security C 20% 1.25
Security K 30% 0.95
•Which security has more total risk?
•Which security has more systematic risk?
•Which security should have the higher expected
return?
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Work the Web Example
•Many sites provide betas for companies
• Yahoo Finance provides beta, plus a lot of other
information under its Key Statistics link
• Click on the web surfer to go to Yahoo Finance
Enter a ticker symbol and get a basic quote
Click on Key Statistics
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Example: Portfolio Betas
• Consider the previous example with the following four securities
Security Weight Beta
C .133 2.685
KO .2 0.195
INTC .267 2.161
BP .4 2.434
• What is the portfolio beta?
• .133(2.685) + .2(.195) + .267(2.161) + .4(2.434) = 1.947
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Beta and the Risk Premium
•Remember that the risk premium = expected return
– risk-free rate
• The higher the beta, the greater the risk premium
should be
• Can we define the relationship between the risk
premium and beta so that we can estimate the
expected return?
YES!
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Example: Portfolio Expected Returns and
Betas
0%
5%
10%
15%
20%
25%
30%
0 0.5 1 1.5 2 2.5 3
Beta Expected Return
Rf
E(RA
)
A
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Reward-to-Risk Ratio: Definition and
Example
• The reward-to-risk ratio is the slope of the line
illustrated in the previous example
 Slope = (E(RA
) – Rf
) / (A – 0)
 Reward-to-risk ratio for previous example =
(20 – 8) / (1.6 – 0) = 7.5
• What if an asset has a reward-to-risk ratio of 8
(implying that the asset plots above the line)?
• What if an asset has a reward-to-risk ratio of 7
(implying that the asset plots below the line)?
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Market Equilibrium
•In equilibrium, all assets and portfolios must have
the same reward-to-risk ratio, and they all must
equal the reward-to-risk ratio for the market
M
M f
A
E RA
R f
E R R
 
( ) (  )


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Security Market Line
• The security market line (SML) is the representation of
market equilibrium
• The slope of the SML is the reward-to-risk ratio: (E(RM)
– Rf
) / M
•But since the beta for the market is always equal to
one, the slope can be rewritten
• Slope = E(RM) – Rf = market risk premium
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The Capital Asset Pricing Model (CAPM)
• The capital asset pricing model defines the
relationship between risk and return
• E(RA
) = Rf + A
(E(RM) – Rf
)
•If we know an asset’s systematic risk, we can use
the CAPM to determine its expected return
• This is true whether we are talking about
financial assets or physical assets
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Factors Affecting
Expected Return
• Pure time value of money: measured by the risk-free rate
• Reward for bearing systematic risk: measured by the market risk
premium
• Amount of systematic risk: measured by beta
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Example – CAPM
• Consider the betas for each of the assets given earlier. If the riskfree rate is 4.15% and the market risk premium is 8.5%, what is
the expected return for each?
Security Beta Expected Return
C 2.685 4.15 + 2.685(8.5) = 26.97%
KO 0.195 4.15 + 0.195(8.5) = 5.81%
INTC 2.161 4.15 + 2.161(8.5) = 22.52%
BP 2.434 4.15 + 2.434(8.5) = 24.84%
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Figure 13.4
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Quick Quiz
• How do you compute the expected return and standard deviation for an
individual asset? For a portfolio?
• What is the difference between systematic and unsystematic risk?
• What type of risk is relevant for determining the expected return?
• Consider an asset with a beta of 1.2, a risk-free rate of 5%, and a market
return of 13%.
 What is the reward-to-risk ratio in equilibrium?
 What is the expected return on the asset?
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Comprehensive Problem
• The risk free rate is 4%, and the required return on the
market is 12%.
• What is the required return on an asset with a beta of 1.5?
• What is the reward/risk ratio?
• What is the required return on a portfolio consisting of 40%
of the asset above and the rest in an asset with an average
amount of systematic risk?
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Chapter 13
End of Chapter
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TIME VALUE OF MONEY
Prof. Costas Siriopoulos, Ph.D.
Konstantinos.Syriopoulos@zu.ac.ae
272
Topics covered
• Future Values, Present Values
• Multiple Cash Flows
• Arbitrage opportunities
• Discounting with Inflation
• Applications
273
•274
Money has time value because of the following reasons:
• 1. Risk and Uncertainty : Future is always uncertain and risky. Outflow of
cash is in our control as payments to parties are made by us. There is no
certainty for future cash inflows. Cash inflows is dependent out on our
Creditor, Bank etc. As an individual or firm is not certain about future cash
receipts, it prefers receiving cash now.
• 2. Inflation: In an inflationary economy, the money received today, has more
purchasing power than the money to be received in future. In other words, a
dirham today represents a greater real purchasing power than a dirham a
year hence.
• 3. Consumption: Individuals generally prefer current consumption to
future consumption.
• 4. Investment opportunities: An investor can profitably employ a dirham
received today, to give him a higher value to be received tomorrow or after a
certain period of time. This is because TIME allows the investor the
opportunity to postpone current consumption and earn INTEREST.
275
Compounding: Future Value
Example: Assume that you have 100AED in a deposit account in a bank
and that the interest rate is 10% p.a.
Year 1: What this means is that if you invest 1000AED for one year, you have
been promised 100*(1+10/100) = 100*(1+0.1) = 110AED next year.
Year 2: Investing this 100AE D for yet another year at the same interest rate
promises to produce 110 *(1+0.1) or 121AED in 2-years.
In other words: 110 *(1+0.1) =

100*(1+0.1) * (1+0.1) = 100*(1+0.1)2
= 100*1.21 = 121.
Year 3: Calculate the end value of the deposit account at the end of the third
year.
276
277
Generalizing the method
• Generalizing the method requires some definitions. Let
• i be the interest rate
• n be the life of the lump sum investment
• PV be the present value
• FV be the future value
278
Future Value of a Lump Sum
n FV  PV * (1  i)
FV w ith grow ths from -6% to +6%
0
500
1,000
1,500
2,000
2,500
3,000
3,500
0 2 4 6 8 1 0 1 2 1 4 1 6 1 8 2 0
Y ears
Future V alue of $1000
6 %
4 %
2 %
0 %
-2 %
-4 %
-6 %
279
Example: Future Value of a Lump Sum
• Your bank offers an
asset with an interest
rate of 3% for a 5 year
investment.
• You wish to invest
$1,500 for 5 years, how
much will your
investment be worth?
$1738 .1111145
$1500 * (1 0.03)
* (1 )
5

 
 
n FV PV i
n 5
i 3%
PV 1,500
FV ?
Result 1738.911111
280
Discounting: Present Value
n
n
n
n
FV i
i
FV PV
i
FV PV i

 



 
*(1 )
(1 )
Divide both sides by (1 ) to obtain :
*(1 )
281
Example: Assume that one year from now you are
expecting to receive 100AED from your investment. Your
required rate of return is 10% p.a. What is the value today
(present value) of the future amount of 100AED?
Year 1: What this means is that if your are expecting 100AED
one year from now and your required return is 10%, then the
value of that amount today is:
PV = 100/(1+0.1) = 90.91AED.
Year 2: PV = 100/(1+0.1)
2= 82.64AED.
Year 3: Calculate the present value when you are expecting
100AED three years from now. Same required return.
To calculate Present Values,
you need three things:
•Amount of Payments – How much will be
received in future?
•Time Periods – At what time in the future will
the payments be received?
•Interest Rate – What is the risk and
opportunity cost associated with the
future values?
283
Example: Present Value of a Lump Sum
• You have been offered
$40,000 for your printing
business, payable in 2
years. Given the risk, you
require a return of 8%.
What is the present value
of the offer?
$34,293.55 today
34293.55281
(1 0.08)
40,000
(1 )
2





 n
i
FV PV
When interest rate is different …
B. FUTURE VALUE WHEN RATES OF INTEREST CHANGE.
Example:
You invest $10,000. During the first year the investment earned 20% for the
year. During the second year, you earned only 4% for that year. How much
is your original deposit worth at the end of the two years?
FV = PV x (1+i1) x (1+i2)
= $10,000 x (1.20`) x (1.04) = $12,480.
FV = PV x (1+i1) x (1+i2) x (1+i3) x … x (1+it).
284
285
Solving Lump Sum Cash Flow for Interest Rate
• If you invest
$15,000 for ten
years, you receive
$30,000. What is
your annual
return?
7.18% (to the nearest basis point)
0.071773463
1 2 1 2 1
15000
30000
1
10
1
10 10


     
 n 
PV
FV i
286
Solving Lump Sum Cash Flow for Number of
Periods
Example. Mariam opened a deposit account with 10,000 AED in a bank that offered her 5% interest rate
per year, and when liquidated the balance of the account was 18,000 AED. How many months did
Mariam owned the account?
Answer. PV = 10,000 AED, FV = 18,000 AED, r = 0.03, n = ?
By applying the above formula, we get :
n = (LN(18000)-LN(10000))/(LN(1+0.05)) = 12.04724 years. That is, 144.57 months approximately.
FUTURE VALUE USING SIMPLE INEREST
Simple interest means that you earn interest only on the principal. Your total balance will go up
each period, because you earn interest each period, but the interest is paid only on the amount
you originally borrowed/deposited. Simple interest is expressed through the formula in.
Simple Interest Formula: Simple interest is when interest is only paid on the amount you
originally invested (the principal). You don’t earn interest on interest you previously earned.
Suppose you make a deposit of $100 in the bank and earn 5% interest per year. After one year,
you earn 5% interest, or $5, bringing your total balance to $105. One more year passes, and it’s
time to accrue more interest. Since simple interest is paid only on your principal ($100), you
earn 5% of $100, not 5% of $105. That means you earn another $5 in the second year and will
earn $5 for every year of the investment.
In simple interest, you earn interest based on the original deposit amount, not the account
balance.
Example
•What is the total amount accumulated after three
years if someone invests $1,000 today with a
simple annual interest rate of 5 percent? With a
compound annual interest rate of 5%?
•Simple interest rate:
$1,000 + ($1,000)(5%)(3) = =$1,150
•Compound interest rate:
$1,000(1.05)
3 = $1,1582.
289
The Frequency of Compounding
290
The Frequency of Compounding-continued
Find the future value of $8,000 at 4% compounded quarterly for 6 years. The
calc in excel is:
That is:
10157.88
=8000*(1+(0.04/4))^(6*4)
291
The Frequency of Compounding-continued
26.9735
=100*(10157.88-8000)/8000
Examples
1). If $10,000 is deposited in the bank today at 9% compounded annually, what will be the balance in 5
years?
Answer
Using the formula of excel FV:
15386.24
=10000*(1+0.09)^5
years 5
periodic rate 9%
future value $15,386.24 =FV(B2,B1,,B4)
present value -10000 292

2). Assume you want to have $1,000 in an account at the end of a three-year period. The account
pays interest at 5% per year. How much money do you need to initially invest in order to have
$1,000 at the end of three years?
Answer
In this case we know the Future Value, $1,000. What we are asked to find is the Present Value. Note that the
present value is negative because it is a cash outflow with respect to the investor.
Or you can reach the same result applying the formula:
𝑃𝑉 =
𝐹𝑉
1 + 𝑖
𝑛
=
$1,000
1 + 0.05
3
= $863.84
years 3
periodic rate 5%
future value $1,000.00
present value ($863.84)
=PV(B2,B1,,B3) 293

3). A company needs $100,000 to retire bonds. What amount must be deposited on November 1, 2015
at 10% interest compounded semiannually in order to accumulate the desired sum by November 2022?
Answer
PV = 100,000/(1+0.1/2)^(2*7) = $50,506.8
In this example the discount factor is 1
1+
𝑖
𝑚

𝑚𝑛 =
1
1+
0.1
2

2∗7
294

4). If $731,190 can be invested now, what annual interest rate must be earned in order to accumulate
$1,000,000 3 years from now?
Answer
𝑖 =
1,000,000
731,190
3
− 1= 1.110000699 – 1 =11%
295
Continuous compounding
296
Example: Generous Grandma
Your Grandma puts $1,000 in a bank for you, at 5% interest. Calculate the amount
after 20 years.
Simple interest:
A = 1000 (1 + 0.0520) = $2,000.00
Compounded annually:
A = 1000 (1 + .05)20 =$2,653.30
Compounded daily:
Compounded continuously:
A = 1000 e
(.05)(20) = $2,718.28 $2,718.10
365
.05 1000 1
(365)(20)
 





A  
Exercise
What amount (to the nearest cent) will
an account have after 5 years if $100 is
invested at an annual nominal rate of
8% compounded :
(i) Annually?
(ii) Semiannually?
(iii) Continuously?
298
Present Value: Example 1
Single Period
Suppose you need $10,000 in one year for the down
payment on a new car. If you can earn 7% annually, how
much do you need to invest today?
Present Values: Example 2
Multi-Periods
You want to begin saving for your daughter’s college
education and you estimate that she will need $150,000 in
17 years. If you feel confident that you can earn 8% per
year, how much do you need to invest today?
Present Values: Example 3
Multi-Periods
Your parents set up a trust fund for you 10 years ago
that is now worth $19,671.51. If the fund earned 7%
per year, how much did your parents invest?
Discount Rate – Example 1
You are looking at an investment that will pay $1200
in 5 years if you invest $1000 today. What is the
implied rate of interest?
Discount Rate – Example 2
Suppose you are offered an investment that will allow
you to double your money in 6 years. You have
$10,000 to invest. What is the implied rate of interest?
Discount Rate – Example 3
Suppose you have a 1-year old son and you want to
provide $75,000 in 17 years towards his college
education. You currently have $5,000 to invest. What
interest rate must you earn to have the $75,000 when
you need it?
Number of Periods – Example
You want to purchase a new car and you are willing to
pay $20,000. If you can invest at 10% per year and you
currently have $15,000, how long will it be before you
have enough money to pay cash for the car?
Number of Periods – Example
•Formula Solution:
• FV/PV = 20,000/15,000 = 1.333
•ln(1.333) = 0.2877
•ln(1.10) = 0.0953
•t = 0.2877/0.0953 = 3.0189
ln(1 r)
PV
FV ln
t








Annuity
• An annuity is a contract between you and an insurance
company under which you make a lump-sum payment or
series of payments. In return, the insurer agrees to make
periodic payments to you beginning immediately or at some
future date. Annuities typically offer tax-deferred growth of
earnings and may include a death benefit that will pay your
beneficiary a guaranteed minimum amount, such as your
total purchase payments.
307
Examples of Annuities
• Student Loan Payments
• Car Loan Payments
• Insurance Premiums
• Mortgage Payments
• Retirement Savings
There are two basic questions with
annuities:
•Determine how much money will
accumulate over time given that equal
payments are made.
•Determine what periodic payments will
be necessary to obtain a specific amount
in a given time period.
309
310
Annuities
• Financial analysts use several annuities with differing assumptions
about the first payment. We will examine just two:
• regular (or ordinary) annuity with its first coupon one period from now
• annuity due with its first coupon today
RA vs AD
The difference between a regular annuity and an
annuity due is that:
• Given the same i, n and periodic payment, the AD will
always yield a
• greater present value
(less interest removed)
• and a
• greaterfuture value
(more interest added).
311
Discounting with inflation
312
313
314
315
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Chapter 7: Stocks
Differentiate between debt and equity.
Discuss the features of common and preferred stock and differentiate between internal
and external equity.
Describe the process of issuing common stock, including venture capital, going public and
the investment banker.
Understand the voting rights
Discuss the problems of a segmented capital markets and a potential solution of crosslisting
Understand the concept of market efficiency and basic stock valuation using zero-growth,
constant-growth, and variable-growth models.
Discuss the free cash flow valuation model and the book value, liquidation value, and
price/earnings (P/E) multiple approaches.
Explain the relationships among financial decisions, return, risk, and the firm’s value
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Differences Between Debt and Equity
•Debt and Equity are two different sources of external
financing used by corporations:
• Debt includes all borrowing incurred by a firm, including
bonds, and is repaid according to a fixed schedule of
payments.
• Equity consists of funds provided by the firm’s owners
(investors or stockholders) that are repaid subject to the
firm’s performance.
• Debt financing is obtained from creditors (banks or
bondholders) and equity financing is obtained from investors
who then become part owners of the firm.
• Creditors (lenders or debtholders) have a legal right to be
repaid, whereas investors only have an expectation of being
repaid.
Internal vs External Equity
• Internally: by retaining earnings rather than paying them out as
dividends to its stockholders;
• Externally: by selling common or preferred stock.
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Internal Equity vs External Equity
Capital Budget = B Target Capital Structure
Net Earnings = E (weight of Debt % and weight of Equity %)
Dividend payout ratio = k
Internal Equity External Equity
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Internal Equity vs External Equity: The criterion
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• If retained earnings are greater than the size of the capital budget to be financed by equity,
then equity is raised internally:
If E*(1 − k) ≥ (weight of equity) * B ⇒ internal equity.
In this case, cost of equity can be computed as
re = [D0(1 + g)/P0] +g or by the CAPM formula
• If retained earnings are LOWER than the size of the capital budget to be financed by equity,
then equity is raised externally:
If E*(1 − k) < (weight of equity) * B ⇒ external equity.
In this case, the cost of equity can be computed as
re = [D0(1 + g)/(P0-F)] +g where F is the flotation cost on external equity.
Example
A company finances its operations with 60 percent debt and 40 percent equity. Its net income is
$100 million and it has a dividend payout ratio of 10 percent. Due to an increasing market
share, company’s capital budget is $120 million this year, the company’s common stock trades
at $40 per share and its last dividend of $4.00 per share. It is expected to grow at a constant
rate of 5% a year. Find the cost of equity of the firm.
First, let’s see if equity will be internal or external:
E(1 − k) = 100 million(0.90) = 90 million.
(weight of equity) * B = (0.40)*120 million = 48 million.
Therefore, we have
E*(1 − k) > (weight of equity) * B ⇒ internal equity.
Now let’s find the cost of equity:
re = [D0(1 + g)/ P0] + g = 4*(1 + 0.05)/40 + 0.05 = 15.5%
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Table 7.1 Key Differences between Debt
and Equity Capital
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Differences Between Debt and Equity:
Voice in Management
•Unlike creditors, holders of equity (stockholders) are
owners of the firm.
•Stockholders generally have voting rights that
permit them to select the firm’s directors and vote on
special issues.
•In contrast, debtholders do not receive voting
privileges but instead rely on the firm’s contractual
obligations to them to be their voice.
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Differences Between Debt and Equity:
Claims on Income and Assets
•Equityholders’ claims on income and assets are
secondary to the claims of creditors.
• Their claims on income cannot be paid until the claims of
all creditors, including both interest and scheduled
principal payments, have been satisfied.
•Because equity holders are the last to receive
distributions, they expect greater returns to
compensate them for the additional risk they bear.
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Differences Between Debt and Equity:
Maturity
•Unlike debt, equity capital is a permanent form of
financing.
•Equity has no maturity date and never has to be
repaid by the firm.
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Differences Between Debt and Equity:
Tax Treatment
•Interest payments to debtholders are treated as taxdeductible expenses by the issuing firm.
•Dividend payments to a firm’s stockholders are not
tax-deductible.
•The tax deductibility of interest lowers the
corporation’s cost of debt financing, further causing
it to be lower than the cost of equity financing.
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Common and Preferred Stock:
Common Stock
• Common stockholders, who are sometimes referred to as
residual owners or residual claimants, are the true owners of
the firm.
• As residual owners, common stockholders receive what is
left—the residual—after all other claims on the firms income
and assets have been satisfied.
• They are assured of only one thing: that they cannot lose any
more than they have invested in the firm.
• Because of this uncertain position, common stockholders
expect to be compensated with adequate dividends and
ultimately, capital gains.
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Common Stock: Ownership
• The common stock of a firm can be privately owned by an
private investors, closely owned by an individual investor or
a small group of investors, or publicly owned by a broad
group of investors.
• The shares of privately owned firms, which are typically
small corporations, are generally not traded; if the shares are
traded, the transactions are among private investors and often
require the firm’s consent.
• Large corporations are publicly owned, and their shares are
generally actively traded in the broker or dealer markets .
Par Value
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Common Stock: Preemptive Rights
• A preemptive right allows common stockholders to
maintain their proportionate ownership in the corporation
when new shares are issued, thus protecting them from
dilution of their ownership.
• Dilution of ownership is a reduction in each previous
shareholder’s fractional ownership resulting from the
issuance of additional shares of common stock.
• Dilution of earnings is a reduction in each previous
shareholder’s fractional claim on the firm’s earnings resulting
from the issuance of additional shares of common stock.
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Common Stock: Preemptive Rights (cont.)
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Common Stock: Authorized, Outstanding,
and Issued Shares
• 1). If there are no potential growth opportunities in sight,
holding on to all that unused equity funding means
sharing ownership for no good reason.
• Shareholders demand returns on their investments in the
form of dividends which is a cost of equity – so the
business is essentially paying for the privilege of accessing
funds it isn’t using. Buying back some or all of the
outstanding shares can be a simple way to pay off
investors and reduce the overall cost of capital.

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Why would a company buyback its own
shares?
• 2). To take advantage of undervaluation. Due to investors
inability to assess the performance of the firm, to the
business cycle, investors’ behavior etc.
• If a stock is dramatically undervalued, the issuing company can repurchase
some of its shares at this reduced price and then re-issue them once the
market has corrected, thereby increasing its equity capital without issuing any
additional shares.
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Why would a company buyback its own
shares?
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Why would a company buyback its own
shares?
• 4). Because a share repurchase reduces the number of shares
outstanding, and increases the market value of the remaining shares.
Thus, the potential return for shareholders is greater.
• After repurchase, the shares are canceled or held as treasury shares,
so they are no longer held publicly and are not outstanding.
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Buybacks examples
• 1). In 2013, McDonald’s bought back 18.7 million
shares for $1.8 billion dollars — an average price of
$96.96. Without the share buyback, McDonald’s
would have finished the year with 1,008.7 million
shares outstanding. Each shareholder thus ended
that year owning a 1.8% greater share of the
company than they would have otherwise.
• 2). Walt Disney reduced its number of outstanding
shares in the market by buying back 73.8 million
shares valued at $7.5 billion in 2016.
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Buyback in U.A.E.
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Buyback in U.A.E.
• However the second paragraph of Article 168 of the Companies Law
does provide that the company may purchase some shares subject to
the following significant restrictions (for public companies):
– The shares bought back should not exceed (10%) of the company’s
share capital; and
– The shares should be bought back with the intention of re-selling
them.
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Buyback in U.A.E.
• However, in 2012 because private joint stock companies have
recently pressed to access the flexibility offered by share buy-back,
the Ministry of Economy has modified its position and has been
applying the provisions of Article 168 CCL to private joint stock
companies without imposing the general assembly approval
requirement (under the approval of the Ministry of Finance).
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Common Stock: Authorized, Outstanding, and
Issued Shares (cont.)
•Golden Enterprises, a producer of medical pumps,
has the following stockholder’s equity account on
December 31st
.
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Common Stock: Voting Rights
• Voting Rights – because the shareholders are owners of the firm, they are
entitled to elect the board of directors.
• Generally, each share of common stock entitles its holder to one vote
in the election of directors and on special issues.
• Votes are generally assignable and may be cast at the annual
stockholders’ meeting.
Methods of voting
• A proxy statement is a statement transferring the votes of a
stockholder to another party.
• Because most small stockholders do not attend the annual meeting to
vote, they may sign a proxy statement transferring their votes to
another party.
• Existing management generally receives the stockholders’ proxies,
because it is able to solicit them at company expense.
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• Two methods of voting: (1) in person or (2) by proxy
Proxy – A legal document giving one person(s) authority to act
for another.
Voting
Procedures Example
• Under majority-rule voting: You may cast 100 votes (1 per
share) for each of the 9 director positions open for a
maximum of 100 votes per position.
• Under cumulative voting: You may cast 900 votes (100 votes
x 9 positions) for a single position or divide the votes
amongst the 9 open positions in any manner you desire.
You are a shareholder of FunFinMan, Inc. You
own 100 shares and there are 9 director
positions to be filled.
Minimum Votes to Elect a Director –
Cumulative
• For example, to elect 3 directors out of 9 director positions at
FunFinMan, Inc., (100,000 voting shares outstanding) would
require 30,001 voting shares.
• (100,000 shares) x (3 directors)
10
Total number of
voting shares
Specific number of
directors sought
Total number of directors to be elected + 1
X
+ 1
+ 1 = 30,001 shares
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Common Stock: Voting Rights (cont.)
• A proxy battle is an attempt by a nonmanagement group to
gain control of the management of a firm by soliciting a
sufficient number of proxy votes.
• Supervoting shares is stock that carries with it multiple
votes per share rather than the single vote per share typically
given on regular shares of common stock.
• Nonvoting common stock is common stock that carries no
voting rights; issued when the firm wishes to raise capital
through the sale of common stock but does not want to give
up its voting control.
Segmented capital markets
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Market Segmentation
• In a segmented market, since there is no foreign
participants, the securities would be priced on the basis
of domestic rather than international standards
• In a word, escaping from a segmented market, a firm
could have a better price for its securities and thus a
lower cost of capital based on international rather than
domestic standards
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11-349
Local versus Global capital markets
Segmented domestic securities
market that prices shares
according to domestic standards
Access to global securities market
that prices shares according to
international standards
Illiquid domestic securities market
and limited international liquidity
Firm’s securities appeal only
to domestic investors
Firm’s securities appeal to
international portfolio investors
Highly liquid domestic market and
broad international participation
Firm-Specific Characteristics
Market Liquidity for Firm’s Securities
Effect of Market Segmentation on Firm’s Securities and Cost of Capital
Local Market Access Global Market Access
SMARIZING SEGMENTATION..
Cross-listing
•(1). There is a vast academic literature on the
impact of cross-listings on the value of the crosslisted firms. Most studies find that cross-listing in
official U.S. stock exchanges, but there are also
many cross-listings on exchanges in Europe and
Asia. Even U.S. firms are cross-listed in other
countries. In the 1950s there was a wave of crosslistings of U.S. firms in Belgium, in the 1960s in
France, in the 1970s in the U.K., and in the 1980s in
Japan.
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Cross-listing: Evidence
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Cross-listing: Evidence
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Cross-listing: Evidence
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Common Stock: Dividends
• The payment of dividends to the firm’s shareholders is at the
discretion of the company’s board of directors.
• Dividends may be paid in cash, stock, or merchandise.
• Common stockholders are not promised a dividend, but they
come to expect certain payments on the basis of the historical
dividend pattern of the firm.
• Before dividends are paid to common stockholders any past
due dividends owed to preferred stockholders must be paid.
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Common Stock:
International Stock Issues
• The international market for common stock is not as large as
that for international debt.
• However, cross-border issuance and trading of common
stock have increased dramatically during the past 30 years.
• Stock Issued in Foreign Markets
• A growing number of firms are beginning to list their stocks on
foreign markets.
• Issuing stock internationally both broadens the company’s ownership
base and helps it to integrate itself in the local business environment.
• Locally traded stock can facilitate corporate acquisitions, because
shares can be used as an acceptable method of payment.
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Common Stock: International Stock
Issues (cont.)
•Foreign Stocks in U.S. Markets
• American depositary receipts (ADRs) are dollardenominated receipts for the stocks of foreign companies
that are held by a U.S. financial institution overseas.
• American depositary shares (ADSs) are securities,
backed by American depositary receipts (ADRs), that
permit U.S. investors to hold shares of non-U.S.
companies and trade them in U.S. markets.
• ADSs are issued in dollars to U.S. investors and are
subject to U.S. securities laws.
• ADSs give investors the opportunity to diversify their
portfolios internationally.
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Preferred Stock
•Preferred stock gives its holders certain privileges
that make them senior to common stockholders.
•Preferred stockholders are promised a fixed periodic
dividend, which is stated either as a percentage or as
a dollar amount.
•Par-value preferred stock is preferred stock with a
stated face value that is used with the specified
dividend percentage to determine the annual dollar
dividend.
•No-par preferred stock is preferred stock with no
stated face value but with a stated annual dollar
dividend.
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Preferred Stock: Basic Rights of Preferred
Stockholders
• Preferred stock is often considered quasi-debt because, much
like interest on debt, it specifies a fixed periodic payment
(dividend).
• Preferred stock is unlike debt in that it has no maturity date.
• Because they have a fixed claim on the firm’s income that
takes precedence over the claim of common stockholders,
preferred stockholders are exposed to less risk.
• Preferred stockholders are not normally given a voting
right, although preferred stockholders are sometimes allowed
to elect one member of the board of directors.
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Issuing Common Stock (IPO)
•Initial financing for most firms typically comes from
a firm’s original founders in the form of a common
stock investment.
•Early stage debt or equity investors are unlikely to
make an investment in a firm unless the founders
also have a personal stake in the business.
•Initial non-founder financing usually comes first
from private equity investors.
•After establishing itself, a firm will often “go
public” by issuing shares of stock to a much broader
group.
3
6
0 Why Issue Equity Publicly
Advantages Disadvantages
1. Access to capital markets 1. Expensive
2. Improved liquidity for shareholders 2. Costs of dealing with shareholders
3. Allowing original owners to diversify 3. Allowing competitiors gain information
4. Monitoring by external capital markets 4. Public pressure
5. Information provided by capital markets
6. Enhanced credibility with stakeholders
The IPO Process
• Time 0: The firm decides to go public.
• Time 1: The firm chooses an underwriter (an
investment bank). The underwriter will advice the
firm on the type of security to issue, help with the
pricing, the marketing, and the registration of the
shares on an organized exchange.
• Time 2: The firm starts trading on the exchange.
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Issuing Common Stock:
Venture Capital
•Venture capital is privately raised external equity
capital used to fund early-stage firms with attractive
growth prospects.
•Venture capitalists (VCs) are providers of venture
capital; typically, formal businesses that maintain
strong oversight over the firms they invest in and
that have clearly defined exit strategies.
•Angel capitalists (angels) are wealthy individual
investors who do not operate as a business but invest
in promising early-stage companies in exchange for
a portion of the firm’s equity.
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Table 7.2 Organization of Institutional Venture
Capital Investors
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Going Public
•When a firm wishes to sell its stock in the primary
market, it has three alternatives.
1. A public offering, in which it offers its shares for sale
to the general public.
2. A rights offering, in which new shares are sold to
existing shareholders.
3. A private placement, in which the firm sells new
securities directly to an investor or a group of
investors.
•Here we focus on the initial public offering (IPO),
which is the first public sale of a firm’s stock.
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Going Public (cont.)
•IPOs are typically made by small, fast-growing
companies that either:
• require additional capital to continue expanding, or
• have met a milestone for going public that was established
in a contract to obtain VC funding.
•The firm must obtain approval of current
shareholders, and hire an investment bank to
underwrite the offering.
•The investment banker is responsible for promoting
the stock and facilitating the sale of the company’s
IPO shares.
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Going Public (cont.)
•The company must file a registration statement with
the SEC.
•The prospectus is a portion of a security registration
statement that describes the key aspects of the issue,
the issuer, and its management and financial
position.
•A red herring is a preliminary prospectus made
available to prospective investors during the waiting
period between the registration statement’s filing
with the SEC and its approval.
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Figure 7.1 Cover of a Preliminary
Prospectus for a Stock Issue
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Going Public (cont.)
• Investment bankers and company officials promote the company
through a road show, a series of presentations to potential investors
around the country and sometimes overseas.
• This helps investment bankers gauge the demand for the offering
which helps them to set the initial offer price.
• After the underwriter sets the terms, the SEC must approve the
offering.
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Going Public:
The Investment Banker’s Role
• An investment banker is a financial intermediary that
specializes in selling new security issues and advising firms
with regard to major financial transactions.
• Underwriting is the role of the investment banker in bearing
the risk of reselling, at a profit, the securities purchased from
an issuing corporation at an agreed-on price.
• This process involves purchasing the security issue from the
issuing corporation at an agreed-on price and bearing the risk
of reselling it to the public at a profit.
• The investment banker also provides the issuer with advice
about pricing and other important aspects of the issue.
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Going Public: The Investment Banker’s
Role (cont.)
•An underwriting syndicate is a group of other
bankers formed by an investment banker to share the
financial risk associated with underwriting new
securities.
•The syndicate shares the financial risk associated
with buying the entire issue from the issuer and
reselling the new securities to the public.
•The selling group is a large number of brokerage
firms that join the originating investment banker(s);
each accepts responsibility for selling a certain
portion of a new security issue on a commission
basis.
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Common Stock Valuation
• Common stockholders expect to be rewarded through
periodic cash dividends and an increasing share value.
• Some of these investors decide which stocks to buy and sell
based on a plan to maintain a broadly diversified portfolio.
• Other investors have a more speculative motive for trading.
• They try to spot companies whose shares are undervalued—meaning
that the true value of the shares is greater than the current market
price.
• These investors buy shares that they believe to be undervalued and
sell shares that they think are overvalued (i.e., the market price is
greater than the true value).
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Common Stock Valuation:
Market Efficiency
•Economically rational buyers and sellers use their
assessment of an asset’s risk and return to determine
its value.
•In competitive markets with many active
participants, the interactions of many buyers and
sellers result in an equilibrium price—the market
value—for each security.
•Because the flow of new information is almost
constant, stock prices fluctuate, continuously
moving toward a new equilibrium that reflects the
most recent information available. This general
concept is known as market efficiency.
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Common Stock Valuation:
Market Efficiency
• The efficient-market hypothesis (EMH) is a theory describing the
behavior of an assumed “perfect” market in which:
• securities are in equilibrium,
• security prices fully reflect all available information and react swiftly to new
information, and
• because stocks are fully and fairly priced, investors need not waste time
looking for mispriced securities.
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Common Stock Valuation:
Market Efficiency
•Although considerable evidence supports the
concept of market efficiency, a growing body of
academic evidence has begun to cast doubt on the
validity of this notion.
•Behavioral finance is a growing body of research
that focuses on investor behavior and its impact on
investment decisions and stock prices. Advocates are
commonly referred to as “behaviorists.”
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Common Stock Valuation:
Basic Common Stock Valuation Equation
•The value of a share of common stock is equal to the
present value of all future cash flows (dividends) that
it is expected to provide.
•where
• P0
= value of common stock
Dt
= per-share dividend expected at the end of year t
Rs
= required return on common stock
P0
= value of common stock
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Common Stock Valuation:
The Zero Growth Model
•The zero dividend growth model assumes that the
stock will pay the same dividend each year, year after
year.
•The equation shows that with zero growth, the value
of a share of stock would equal the present value of a
perpetuity of D1 dollars discounted at a rate rs
.
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Personal Finance Example
•Chuck Swimmer estimates that the dividend of
Denham Company, an established textile producer,
is expected to remain constant at $3 per share
indefinitely.
•If his required return on its stock is 15%, the stock’s
value is:
• $20= ($3 ÷ 0.15) per share
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Common Stock Valuation:
Constant-Growth Model
•The constant-growth model is a widely cited dividend
valuation approach that assumes that dividends will grow at a
constant rate, but a rate that is less than the required return.
•The Gordon model is a common name for the constantgrowth model that is widely cited in dividend valuation.
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Common Stock Valuation:
Constant-Growth Model (cont.)
•Lamar Company, a small cosmetics company, paid
the following per share dividends:
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Common Stock Valuation:
Constant-Growth Model (cont.)
•Using a financial calculator or a spreadsheet, we find that
the historical annual growth rate of Lamar Company
dividends equals 7%.
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Common Stock Valuation:
Variable-Growth Model
•The zero- and constant-growth common stock
models do not allow for any shift in expected growth
rates.
•The variable-growth model is a dividend valuation
approach that allows for a change in the dividend
growth rate.
•To determine the value of a share of stock in the
case of variable growth, we use a four-step
procedure.
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Common Stock Valuation:
Variable-Growth Model (cont.)
•Step 1. Find the value of the cash dividends at the
end of each year, Dt
, during the initial growth period,
years 1 though N.
•Dt = D0 × (1 + g1
)
t
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Common Stock Valuation:
Variable-Growth Model (cont.)
•Step 2. Find the present value of the dividends
expected during the initial growth period.
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Common Stock Valuation:
Variable-Growth Model (cont.)
•Step 3. Find the value of the stock at the end of the
initial growth period, PN = (DN+1)/(rs – g2
), which is
the present value of all dividends expected from year
N + 1 to infinity, assuming a constant dividend
growth rate, g2
.
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Common Stock Valuation:
Variable-Growth Model (cont.)
•Step 4. Add the present value components found in
Steps 2 and 3 to find the value of the stock, P0
.
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Common Stock Valuation:
Variable-Growth Model (cont.)
•The most recent annual (2012) dividend payment of Warren
Industries, a rapidly growing boat manufacturer, was $1.50 per
share. The firm’s financial manager expects that these
dividends will increase at a 10% annual rate, g1
, over the next
three years. At the end of three years (the end of 2015), the
firm’s mature product line is expected to result in a slowing of
the dividend growth rate to 5% per year, g2
, for the foreseeable
future. The firm’s required return, rs
, is 15%.

Steps 1 and 2 are detailed in Table 7.3 on the following slide.
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Table 7.3 Calculation of Present Value of Warren
Industries Dividends (2013–2015)
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Common Stock Valuation:
Variable-Growth Model (cont.)
•Step 3. The value of the stock at the end of the initial growth
period
(N = 2015) can be found by first calculating DN+1 = D2016.
•D2016 = D2015  (1 + 0.05) = $2.00  (1.05) = $2.10
•By using D2016 = $2.10, a 15% required return, and a 5%
dividend growth rate, we can calculate the value of the stock at
the end of 2015 as follows:
•P2015 = D2016 / (rs – g2
) = $2.10 / (.15 – .05) = $21.00
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Common Stock Valuation:
Variable-Growth Model (cont.)
•Step 3 (cont.) Finally, the share value of $21 at the end of
2015 must be converted into a present (end of 2012) value.
•P2015 / (1 + rs
)
3 = $21 / (1 + 0.15)3 = $13.81
•Step 4. Adding the PV of the initial dividend stream (found in
Step 2) to the PV of the stock at the end of the initial growth
period (found in Step 3), we get:
•P2012 = $4.14 + $13.82 = $17.93 per share
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Common Stock Valuation:
Free Cash Flow Valuation Model
•A free cash flow valuation model determines the value of an
entire company as the present value of its expected free cash
flows discounted at the firm’s weighted average cost of capital,
which is its expected average future cost of funds over the
long run.
•where
VC
= value of the entire company
FCFt
= free cash flow expected at the end of year t end of year t
ra
= the firm’s weighted average cost of capital
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Common Stock Valuation:
Free Cash Flow Valuation Model (cont.)
•Because the value of the entire company, VC
, is the
market value of the entire enterprise (that is, of all
assets), to find common stock value, VS
, we must
subtract the market value of all of the firm’s debt, VD
,
and the market value of preferred stock, VP, from VC
.
•VS = VC – VD – VP
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Table 7.4 Dewhurst, Inc.’s Data for the Free
Cash Flow Valuation Model
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Common Stock Valuation:
Free Cash Flow Valuation Model (cont.)
•Step 1. Calculate the present value of the free cash
flow occurring from the end of 2018 to infinity,
measured at the beginning of 2018.
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Common Stock Valuation:
Free Cash Flow Valuation Model (cont.)
•Step 2. Add the present value of the FCF from 2018 to
infinity, which is measured at the end of 2017, to the 2017
FCF value to get the total FCF in 2017.
•Total FCF2017 = $600,000 + $10,300,000 = $10,900,000
•Step 3. Find the sum of the present values of the FCFs for
2013 through 2017 to determine the value of the entire
company, VC
. This step is detailed in Table 7.5 on the
following slide.
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Table 7.5 Calculation of the Value of the Entire
Company for Dewhurst, Inc.
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Common Stock Valuation:
Free Cash Flow Valuation Model (cont.)
•Step 4. Calculate the value of the common stock.
•VS = $8,626,426 – $3,100,000 – $800,000 =
$4,726,426
•The value of Dewhurst’s common stock is therefore
estimated to be $4,726,426. By dividing this total by
the 300,000 shares of common stock that the firm has
outstanding, we get a common stock value of $15.76
per share ($4,726,426 ÷ 300,000).
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Common Stock Valuation:
Other Approaches to Stock Valuation
• Book value per share is the amount per share of common
stock that would be received if all of the firm’s assets were
sold for their exact book (accounting) value and the proceeds
remaining after paying all liabilities (including preferred
stock) were divided among the common stockholders.
• This method lacks sophistication and can be criticized on the
basis of its reliance on historical balance sheet data.
• It ignores the firm’s expected earnings potential and generally
lacks any true relationship to the firm’s value in the
marketplace.
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Common Stock Valuation: Other Approaches to
Stock Valuation (cont.)
•At year-end 2012, Lamar Company’s balance sheet
shows total assets of $6 million, total liabilities
(including preferred stock) of $4.5 million, and
100,000 shares of common stock outstanding. Its
book value per share therefore would be
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Common Stock Valuation: Other Approaches to
Stock Valuation (cont.)
•Liquidation value per share is the actual amount
per share of common stock that would be received if
all of the firm’s assets were sold for their market
value, liabilities (including preferred stock) were
paid, and any remaining money were divided among
the common stockholders.
•This measure is more realistic than book value
because it is based on current market values of the
firm’s assets.
•However, it still fails to consider the earning power
of those assets.
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Common Stock Valuation: Other Approaches to
Stock Valuation (cont.)
•Lamar Company found upon investigation that it
could obtain only $5.25 million if it sold its assets
today. The firm’s liquidation value per share therefore
would be
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Common Stock Valuation: Other Approaches to
Stock Valuation (cont.)
•The price/earnings (P/E) ratio reflects the amount
investors are willing to pay for each dollar of
earnings.
•The price/earnings multiple approach is a popular
technique used to estimate the firm’s share value;
calculated by multiplying the firm’s expected
earnings per share (EPS) by the average
price/earnings (P/E) ratio for the industry.
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Common Stock Valuation: Other Approaches to
Stock Valuation (cont.)
•Lamar Company is expected to earn $2.60 per share
next year (2013). Assuming a industry average P/E
ratio of 7, the firms per share value would be
•$2.60  7 = $18.20 per share
Stocks… details
• Debt Vs. Equity (table 7.1)
• Private Vs. Public Ownership
• Rights issue (Preemptive rights) and Dilution of Ownership
• Authorized, Outstanding, Treasury, and Issued shares (Outstanding + Treasury)
• Common Stock, International Issue, Dividends
• Preferred Stock (no voting, can elect board, pays dividend, seniority)
• Issuing CS (original owners, early debt or equity investors, private equity / VC, public)
• Going Public (Prospectus, road show, investment banker role, underwriting)
• Valuation (Thursday 30th April)
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Book Value
• At year-end 2012, Lamar Company’s balance sheet shows total assets of $6
million, total liabilities (including preferred stock) of $4.5 million, and 100,000
shares of common stock outstanding. Its book value per share therefore would be
• P/E
• Lamar Company is expected to earn $2.60 per share next year (2013). Assuming a
industry average P/E ratio of 7, the firms per share value would be
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Dividend Discount Model
• Constant Dividend
• Chuck Swimmer estimates that the dividend of Denham Company, an established textile producer, is expected
to remain constant at $3 per share indefinitely. If his required return on its stock is 15%, the stock’s value is:
• Growth Dividend
• Given the table on the side, we can calculate that the growth is 7% for dividends, what is the
• price of the stock?
• 2Stage Dividend (Not part of assignment)
• The most recent annual (2012) dividend payment of Warren Industries, a rapidly growing boat manufacturer, was $1.50
per share. The firm’s financial manager expects that these dividends will increase at a 10% annual rate, g1
, over the next
three years. At the end of three years (the end of 2015), the firm’s mature product line is expected to result in a slowing of
the dividend growth rate to 5% per year, g2
, for the foreseeable future. The firm’s required return, rs
, is 15%.
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