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Module 1
Discounted cash flows
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Discounted cash flows overview
The time value of money Calculating present values Annuity and perpetuity
The basic idea
What would you be willing to pay today, to receive a cash flow in the future?
Present value (PV)

> Future value (FV)
Time
1. Opportunity
2. Risk
3. Inflation
The discount rate
The discount rate is also referred to as the rate of return.

This rate is expressed as a percentage.
Discount rate
Present value (PV)

= Future value (FV)
Present value (PV)

= Future value (FV)
Discount rate
-20%
The time value of money
Which is more valuable to you?
$100 today $100 in one year’s time
1. Opportunity
2. Risk
3. Inflation
The time value of money
At a 10% interest rate, $100 today is financially equivalent to $133.10 in three years
Today Year 1 Year 2 Year 3

$100 $110 $121 $133.10
Indifferent
Interest rate of 10%
The formula for time value of money
PV x (1+r)n = FV

$100 $110 $121 $133.10
x (1 + r)
Interest rate r Numbers of years n
PV x (1.10)n = FV

$100 $110 $121 $133.10
x (1.10) x (1.10) x (1.10)
PVPV x (1+r)1 nto=3 FV

x (1.10) = FV

$100 $110 $121 $133.10
x (1.10)3
Compounding and discounting
Compounding
PV x (1+r)n = FV
Discounting
1
PV = FV x 𝑛
1+𝑟
Discount factor
Rate of return r Numbers of years n
Net present value
Year 0 1 2 3
Cash flows -1000 400 600 200
Discount
0.9091 0.8264 0.7513
factors @10%
-1000.00
1
Discount factor = 𝑛
1+𝑟
Net present value
Year 0 1 2 3
Cash flows -1000 400 600 200
Discount
0.9091 0.8264 0.7513
factors @10%
-1000.00
363.64
495.87
150.26
9.77
1 1
Discount factor
Positive NPV = 𝑛 = = 0.8264
1+𝑟 1+.10 2
Annuities introduction
Equal payments, over equal time periods,

guaranteed for a fixed number of years
Year 1 Year 2
Understanding annuities

Today $100 $100 $100
Year 1 Year 2 Year 3
Interest rate of 10%
Understanding annuities

Discount Cash Present

factor flow value
Year 1 0.9091 100 90.91
Year 2 0.8264 100 82.64
Year 3 0.7513 100 75.13
248.69
1
Interest rate of 10% Discount
Discountfactor
factor= =1+.10
1+𝑟 1𝑛𝑡𝑜 3
The annuity factor

Discount
factor
Year 1 0.9091
Year 2 0.8264 2.4869
Year 3 0.7513 x 100
2.4869 248.69
Annuity factor
Interest rate per year
No. of years 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 .990 .980 .971 .962 .952 .943 .953 .926 .917 .909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367
15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606
Perpetuities
Perpetuities
Examples:
1. War loans: UK bonds with no redemption date
2. Real estate: income received from rent
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 …

∞
Perpetuity types:
Constant perpetuity and growing perpetuity Present value = 0
Perpetuity example
r = 10%
Year 1 Year 2
$100 $110 $100 $110 $100 …
$10 $10
$𝟏𝟎
PV = $100 = 𝟎.𝟏
Constant perpetuity
It is possible to calculate the PV

of the a cash flow which in perpetuity
𝒄 𝟏𝟎
PV = = = 100
𝒓 𝟎.𝟏
Cash flow c
Rate of return r
Growing perpetuity
A growing perpetuity is an infinite stream

of cash flows, that grows at a constant rate
𝒄
PV =
(𝒓−𝒈)
Cash flow c
Rate of return r
Constant growth rate g
Discounted cash flows conclusion
Money received today is Single cash flows, annuities

Use the discount factor to
worth more than an and perpetuities can all be
find the present value of a
equivalent amount received calculated using DCF
future cash flow
in the future framework
Module 2
Bond pricing and yields
Bond pricing and yield overview
Use discounted cash Calculate yields used to Examine the

flows to find the price assess the return from relationship between
of a bond a bond bond price and yield
Bonds
“ A bond is a debt instrument

requiring the issuer (also called the
debtor or borrower) to repay to the
lender/investor the amount borrowed
plus interest over some specified
period of time.
“
Source: Frank Fabozzi
Bond Markets Analysis & Strategies
Bonds
• Vanilla bonds pay a fixed amount of interest to the bond investor at regular time intervals
• Convertible
• Callable MATURITY DATE

30 SEPTEMBER, 2022. 10% COUPON
PAID SEMIANNUALY
• Inflation-linked
• Zero coupon
• Floating rate
• Fixed rate
Par value
A bond's par value is the amount returned

To price a bond, we always assume par of $100
to the bond investor by the issuer
$5000 bond $1000 bond
$100 par value Value at $100

x50 x10
Price of 1 bond Price of 1 bond
Forecasting cash flows
$100
$10 $10 $10 + $100

$110
Coupon rate of 10%
Yield to maturity of 9%
Coupon rate and yield to maturity
$100
$10 $10 $10
Coupon rate of 10%
Coupon rate and yield to maturity
The yield to maturity is the overall return

the bond investor makes if they purchased
the bond today and held it to maturity
$100
$5 $5 $5 $5 $5 $5
Coupon rate of 10%
Valuing a bond
To find the price of a bond, we follow these steps:

1. Determine the future cash flows from the bond
2. Find the present value of each future cash flow
3. Sum all of the present values to find the current price
Par value Number of years
Coupon rate Yield to maturity
Setting up the cash flow
Year 0 1 2 3
Cash flows 10 10 110
Discount
0.9174 0.8417 0.7722
factors @9%
9.17
8.42
84.94
102.53
1 11
Yield to maturity of 9% Discount factor = 𝑛 = = 0.8417
1+𝑟 1+.09 21 to 3
Semi annual bond cash flows
For semi annual coupons, we adjust the interest recieved,

discount factor, and number of periods
$100
$10 $10 $10
Coupon rate of 10% /2 = 5%
Semi annual bond cash flows
For semi annual coupons, we adjust the interest recieved,

discount factor, and number of periods
$100
$5 $5 $5 $5 $5 $5
Coupon rate of 10% /2 = 5%
Semi annual bond yield to maturity
With semi annual bonds, we need to adjust the YTM

in the discount factor equation, for semi annual payments
Divide the yield to maturity by 2
Earnings per time period of 5%
Coupon rate of 10%
Semi annual diagram of cash flow
Year 1 2 3 4 5 6
Cash flows 5 5 5 5 5 5
105
Discount
0.9569 0.9157 0.8763 0.8386 0.8025 0.7679
factor @4.5%
4.78
4.58
4.38
4.19
4.12
80.63
102.57
𝟏 𝟏
Discount factor = 𝒏 = 𝟑 = 0.8763
𝟏+𝒓 𝟏+.𝟎𝟒𝟓
Yield to maturity
The yield to maturity is the overall return the bond investor

earns upon buying the bond today at it's current price
It is made up of two components:

1. Income in the form of coupons
2. Capital gains or losses depending on whether
the bond is trading at a premium or discount
Break down of YTM
Yield to maturity = coupon + capital gain/loss
Today
$100 $5 $5 $5 + $100
< Par $105
Yield to maturity of 8%
Coupon rate of 5%
Bond prices and yield
There is an inverse relationship between the price of a bond and its yield to maturity.
Three year bond with a 10% coupon
Yield Price
9% 102.53
10% 100.00
11% 97.56
Yield Price
Yield Price
9% 102.53
10% 100.00
11% 97.56
Yield Price
9% 102.53
10% 100.00
11% 97.56
YTM and current yield
Current yield is the return we get from

the income component of a bond
as a percentage of it's current price
𝐂𝐨𝐮𝐩𝐨𝐧 𝐫𝐚𝐭𝐞 𝟏𝟎
= = 9.75%
𝐏𝐫𝐢𝐜𝐞 𝟏𝟎𝟐.𝟓𝟑
Relationship between yields
Premium
Coupon Rate
> Current Yield
> YTM
Par
Coupon Rate
= Current Yield
= YTM
Discount
Coupon Rate
< Current Yield
< YTM
Bond pricing and yield conclusion
A bond is a debt instrument The price of a bond is the

that the issuer pays back at par sum of the present values of
value with interest/coupons all future cash flows
The yield to maturity of a The current yield is the

bond is the overall return annual income from a bond
earned by the bond investor as a percent of its price
Module 3
Key statistical skills
Key Statistical skills overview
Calculate different Calculate variance and

Smooth data using
measures of central standard deviation to
moving averages
tendency measure dispersion
Measures of central tendency
Measures of central tendency are used to find the middle/center of a distribution
Centre
x xx x xx xx x x x x
1 2 3 4 5
The mean is the most common

1. Arithmetic mean
2. Weighted mean
3. Expected values
Arithmetic mean
This is the most common type of number averages
The mean of: {1, 5, 4, 8, 2}
∑𝒙 𝟏+𝟓+𝟒+𝟖+𝟐 𝟐𝟎
= = = 4
𝒏 𝟓 𝟓
ത
Mean or average 𝐱
Number of data n
Sum of the data ∑
Weighted mean
When some numbers in a data set should have larger influence,

we assign higher weights
Weight 12 11 10 … 1
Dec Nov Oct … Jan
WACC
The capital structure at Buyout Inc.
$6m of equity with a cost of equity of 12%

$2m of mezzanine finance with a cost of debt of 8%
$2m of senior debt with a cost of debt of 6%
What would the WACC for Buyout be?
WACC equation
The capital structure at Buyout Inc.
Weight
$6m equity 0.6 = 6m / 10m = 0.6 x 0.12 = 7.2%
$2m mezzanine 0.2 = 2m / 10m = 0.2 x 0.08 = 1.6%
$2m senior debt 0.2 = 2m / 10m = 0.2 x 0.06 = 1.2%
$10m 10.0%
Expected values
Expected values are applied to many business situations
and are similar to weighted averages
Future outcomes Probability

x 23%
x 11%
x 16%
x 37%
x 13%
100%
Moving averages
Time series data is simply data collected over time
The two types of moving average we cover are:

• Simple moving average
• Weighted moving average
Simple moving average
Simple moving average is the average price of a security

over a specific number of periods
3 days
1 2 3 4 5 6 7 8 9 10
5 days
1 2 3 4 5 6 7 8 9 10
Simple moving average
Simple moving average is the average price of a security

over a specific number of periods
3 days
1 2 3 4 5 6 7 8 9 10
5 days
1 2 3 4 5 6 7 8 9 10
Simple moving example
Last 10 days 3 day MA 5 day MA

5
6
7 6.0
8 7.0
8 7.7 6.8
9 8.3 7.6
7 8.0 7.8
6 7.3 7.6
5 6.0 7.0
4 5.0 6.2
Weighted moving average
A weighted moving average is a moving average

where more important values are weighted more heavily
Closing Price Weight

Day 5 5
Day 4 4
Day 3 3
Day 2 2
Day 1 1
Weighted moving example
Last 10 days 3 day WMA

5 x1
6 x2
7 x3 6.3
8 7.3
𝟕×𝟑 + 𝟔×𝟐 + 𝟓×𝟏 𝟑𝟖
8 7.8 = = 6.3
𝟑+𝟐+𝟏 𝟔
9 8.5
7 7.8
6 6.7
5 5.7
4 4.7
Measures of dispersion
Measures of dispersion tell us how spread out a set of data is
X
The three common measures are:
• Range
• Variance
• Standard deviation
Range
Range is very simple to calculate. However it is

not an accurate measure of dispersion because
it doesn’t take into account extreme values.
Range = Highest value – Lowest value
Variance
Variance is a measure of dispersion of set of

data points around their mean value.
We use this as a measure of an asset's risk.
ഥ
∑ 𝒙𝒊 − 𝒙 𝟐
Variance example
ഥ
∑ 𝒙𝒊 − 𝒙 𝟐
Frequency
X
X X
X X X X X X
X X X X X X X X X X X
Negative Positive Salaries
Mean (x)
Population versus sample variance
When a population is too large to measure we take

a sample instead. This means we may not have the very
smallest or the very largest values in our sample.
ഥ
∑ 𝒙𝒊 − 𝒙 𝟐
𝒏−𝟏
Standard deviation
The standard deviation is more accurate than the

variance because it is in the same units as the mean
ഥ
∑ 𝒙𝒊 − 𝒙 𝟐
𝒏−𝟏
Variance (units) = $2
Standard deviation (units) = $
Variance v.s. standard deviation
Variance = $ 500
2
Standard deviation = $22.36
Key statistical skills conclusion
Measures of central tendency The moving average is the

tell us where the middle/average mean of data over time, used
of the data is to smooth data
Measures of dispersion are The most important measures

used to find out how spread of dispersion are the variance
out the data is and standard deviation
Module 4
Covariance, correlation and regression
Covariance, correlation and regression overview
Use regression analysis to

Use correlation and covariance How to measure the
describe the relationship
to describe the relationship strength of our
between dependent and
between two variables regression analysis
independent variables
Relationship between variables
x x x x x x
x x x x x
x x x
x x x x x x x
x x
x x x x x
x x x xx x
x x x x
x x x x x
Perfect Perfect
Positive None Negative
positive negative
How do the variables move in relation to each other?

How much do the variables co-vary?
How strong is the relationship between them?
Covariance and correlation
The
We use
variance
the
units ofstandard
is measured
correlation
the deviation
inare
units
because
notthat
coefficient
covariance are
thenot
because
easily itunits
is 2 are
intuitively
squaredand
precise rooted
understood obvious
andbecause
unitless
similar therefore
measure
to they
more
areaccurate
between
the variance in -1.0
unitsandsqared
1.0
2
∑ 𝑥𝑖 −𝑥ҧ
Variance =
𝑛−1
2
∑ 𝑥𝑖 −𝑥ҧ
Standard deviation =
𝑛−1
Covariance = Imprecise units
Correlation coefficient = Unitless
Covariance
Oil (x) Oil stock (y) (x – μx) (y – μy) (x – μx) (y – μy)

45 26 9 6 54
39 27 3 7 21
33 20 -3 0 0
31 16 -5 -4 20
32 11 -4 -9 36
36 avg. 20 avg. avg. 26.2
Calculating the covariance

45 26 9 6 54
39 27 3 7 21
33 20 -3 0 0
31 16 -5 -4 20
32 11 -4 -9 36
36 avg.
= μx 20 avg.
= μy Covariance
avg.
= 26.2
Drivers of covariance
When two variables move together

we call it positive correlation
When two variables move in opposite

directions we call it negative correlation
The drivers of covariances are:
1. Do the variables move together in positive correlation, or in

opposite directions showing negative correlation?
2. How dispersed are the y and x variables from their means?
Covariance = Correlation x S.D.(x) x S.D.(y)
Correlation
Covariance = Correlation x S.D.(x) x S.D.(y)
Correlation
The correlation coefficient is a dimensionless number

that is always between -1.0 and +1.0
Covariance
Correlation coefficient =
S.D.(x) x S.D.(y)
Correlation

45 26 9 6 54
39 27 3 7 21
33 20 -3 0 0
31 16 -5 -4 20
32 11 -4 -9 36
36 = μx 20 = μy Covariance = 26.2
5.29 = S.D. 6.03 = S.D.
Correlation

45 26 9 6 54
36 = μx 20 = μy Covariance = 26.2
39 27 3 7 21
5.29
33 = S.D. 6.03
20 = S.D. -3 0 0
31 16 -5 -4 20
32 11 -4 -9 36
Covariance
26.2
Correlation coefficient
0.82 =
S.D.(x)
5.29 x S.D.(y)
6.03
Correlation coefficient = r or ρ
Correlation
The coefficient of 0.82 is very close to a perfect positive correlation (+1.0)

Therefore, we call this a strong positive correlation
Strong positive Covariance

26.2
Correlation coefficient
0.82 =
correlation S.D.(x)
5.29 x S.D.(y)
6.03
Correlation coefficient = r or ρ
Regression analysis
Regression analysis is used to predict the behaviour of

the dependent variable based on the fluctuations of
the independent variable
Income
The 3 basic steps:

1. Plot the data
2. Perform regression analysis
3. Interpret the results
Years of experience
Simple linear regression
Wal-mart
y=α + βx + ε
S&P500
Distance2 Summing each of these together is known as

ordinary least squared regression, or OLS regression
The regression equation
The regression analysis gives us a line where the dependent

variable (y) is predicted by the independent variable (x)
y = a + b(x) + ε y = α + βx + ε Yi = b0 + b1xi + εi
Dependent Independent
Sum of squares
Wal-mart
y = 0.358x – 0.0006
Avg. return = 0.1%

S&P500
Distance2
Sum of Square
Sum ofSum
Regression
Square
of Square
Errors Total
SSR + SSE = SST
R squared and the correlation coefficient
R2 is the fraction of the dependent

variable that is explained by the independent variable
R2 = explained variation / total variation

R2 = SSR / SST
R2 = (correlation coefficient)2
If the R2 equals 1 then, same as the correlation, it means

that the variables are in perfect positive correlation
Covariance, correlation and regression conclusion
The covariance measures the Simple linear regression

Correlation makes
variance of two random analyzes the relationship
interpreting the covariance
variables measured in the between independent and
easier
same time period dependent variables

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Present value (PV)

The discount rate is also referred to as the rate of return.

Present value (PV)

Present value (PV)

Which is more valuable to you?

$100 today $100 in one year’s time

Today Year 1 Year 2 Year 3

Interest rate of 10%

Today Year 1 Year 2 Year 3

Interest rate r Numbers of years n

Today Year 1 Year 2 Year 3

x (1.10) x (1.10) x (1.10)

Interest rate r Numbers of years n

PVPV x (1+r)1 nto=3 FV

Today Year 1 Year 2 Year 3

Interest rate r Numbers of years n

Rate of return r Numbers of years n

Equal payments, over equal time periods,

Equal payments, over equal time periods,

Today $100 $100 $100

Year 1 Year 2 Year 3

Interest rate of 10%

Equal payments, over equal time periods,

Discount Cash Present

Year 2 0.8264 100 82.64

Year 3 0.7513 100 75.13

Equal payments, over equal time periods,

Year 2 0.8264 2.4869

Year 3 0.7513 x 100

Year 1 Year 2 Year 3

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 …

$100 $110 $100 $110 $100 …

It is possible to calculate the PV

A growing perpetuity is an infinite stream

Constant growth rate g

Money received today is Single cash flows, annuities

Use discounted cash Calculate yields used to Examine the

“ A bond is a debt instrument

• Callable MATURITY DATE

A bond's par value is the amount returned

$5000 bond $1000 bond

$100 par value Value at $100

Price of 1 bond Price of 1 bond

Year 1 Year 2 Year 3

$10 $10 $10 + $100

Coupon rate of 10%

Year 1 Year 2 Year 3

$10 $10 $10

Coupon rate of 10%

The yield to maturity is the overall return

Year 1 Year 2 Year 3

Coupon rate of 10%

To find the price of a bond, we follow these steps:

Par value Number of years

Coupon rate Yield to maturity

For semi annual coupons, we adjust the interest recieved,

Year 1 Year 2 Year 3

$10 $10 $10

Coupon rate of 10% /2 = 5%

For semi annual coupons, we adjust the interest recieved,

Year 1 Year 2 Year 3

Coupon rate of 10% /2 = 5%