MODULE 1

Financial markets allow participants to reallocate resources across time, to decide correctly about – and
make – real asset investments, and shape the riskiness of their holdings.

Market interest rate

The market interest rate is the ​rate of exchange between present and future resources​. The reason
why there can simultaneously be many market interest rates is that interest rates can cover different
lengths​ of time in the future, and different ​riskiness​ of transactions.

Financial markets do not quote an interest rate for your purchase of ordinary shares, but they do quote a
price for the shares. And when you receive dividends or cash from selling the shares, you will earn a rate
of return that is similar to an interest rate.

Simple financial market

Suppose a participant will receive both £1000 ‘now’ and £1540 ‘later’. The participant could consume the
£1000 immediately, wait until ‘later’, and then also consume the £1540. Market interest rate of 10%.

The figure below shows how that set of cash flows, point E, appears on a graph with CF1 (t1), the cash
flow expected ‘later’ on the vertical axis and CF0 (t0), the ‘now’ cash flow on the horizontal. The line is the
financial exchange line.

Suppose he increase t0 consumption to £1200 by borrowing £200 (E -> A) now and promising to repay
that amount plus 10% interest at t1. He would owe £200 × (1 + 10%), or £220 at t1, so at t1 he could
consume £1540 minus £220, or £1320. Finding the ​present value​ of the £1540:
The participant could borrow £1400 at t0 with the promise to pay £1540 at t1.​ Finding the present value
of a future cash flow is often called discounting the cash flow​.

Present value is also used when setting a price on a financial asset e.g. suppose that our participant does
not wish to borrow money, but instead wishes to sell outright the expectation of receiving cash at t1. The
participant can do this by issuing a ​security​ that endows its owner with the legal right to claim the t1 cash
flow. In other words, present value is the ​market value​ of a security when market interest rates are used
as discount rates.

Present wealth​ tells us the total value of a participant’s entire time-specified resources with a single
number (e.g. present value of all of our participant’s present and future resources (cash flows) is £2400).
If one wishes to increase one’s wealth by buying and selling in those markets, one would be forced to find
another participant who, doubtless inadvertently, would allow his wealth to be reduced.

Investing
If we cannot expect to change our wealth by transacting in financial markets, how can we get richer? The
answer is by ​investing in real assets ​such as productive machinery​. ​It​ ​creates new future cash flows
(wealth) that did not previously exist.

Suppose that our participant discovers an opportunity to invest £550 at t0 in a real asset that is expected
to return £770 at t1. This appears as a move from point E to point I. That investment would result in t1
resources of £2310 and t0 resources of £450
We can calculate the amount of this parallel shift by taking the present value of any position on the new
line. Since we know point I already, we can use it:

The outward shift in the exchange line is to £2550 at t0. But this is also the horizontal intercept of the new
exchange line, which is our participant’s new present wealth.
Investments are desirable when they produce more present value than they cost.

Net Present Value

The ​NPV​ of an investment is the ​present value​ of ​all​ of its ​present​ and ​future​ ​cash flows​ (in and out),
discounted​ at the ​opportunity cost​ of those cash flows. These opportunity costs reflect the returns
available on investing in an alternative of equal timing and equal risk.

The difference between the present values of the cash inflows and outflows of the investment is +£150,
which is the ​net present value of the investment.

NPVs are equal to the changes in the present wealths of participants who undertake the investments.

If our participant had put that money in the financial market instead of the investment, he or she could
have earned £550 × (1.1) = £605 at t1. Since the investment returned £770 at t1 the earnings were £770
– £605 = £165 more at t1.

I.e. It is the present value of the future amount by which the returns from the investment exceed the
opportunity costs of the investor.

If NPV positive, better than comparable alternative.

Internal Rate of Return

IRR tells us how good or bad an investment is by calculating the ​average per-period rate of return on
the money invested​.
NPV​ describes an investment by the ​amount​ of the wealth increase that would be experienced by the
participant who accepts it, whereas ​IRR​ tells us how the average earning rate on the investment
compares​ with the opportunity rate.

The company can ignore its shareholders’ preferences for particular patterns of cash flow across time
because the financial market allows shareholders to reallocate those resources by borrowing and lending
as they see fit. This lets the company concentrate on maximising the present wealth of its shareholders,
the result of adhering to the investment evaluation techniques of NPV and IRR in this market.

More realistic financial markets

Multiple-Period Finance
Suppose that we wished to invest £100 in the financial market at t0, and leave it there until t2, so as to
then have an amount CF2. How much would CF2 be?

Naturally, the present-value calculation works in exactly the opposite way. If we expected to receive £121
at t2, and wished to know its present value (its market price right now) we would calculate:

Compound Interest
Compounding means that the exchange rate between two time points is such that you ​earn interest​ not
only on your ​original investment​ + (in subsequent periods) o
​ n interest you earned previously​.

The amount of money you end up with by investing CF0 at compound interest is:

CF0 x [1 + (i/m)]​mt
i = interest rate, m = number of times per period that compounding happens, t = number of periods of
investment. You can see that this formula becomes our familiar CF0(1 + i)​t​ when interest is compounded
only once per period.
Compounding of interest can be even more frequent than daily. ​Continuous compounding​ means that
interest is calculated and added to ​begin earning interest​ on itself ​without any passage of time
between compoundings. The formula reduces to:

CF0 x (e​it​)

where e = 2.718 …, the base of the natural logarithm system.

Multiple-Period Cash Flows

The same general procedure will allow us to find the present value of a cash flow occurring at any future
time point. Where t can be any time, the general method for finding the present value of any cash flow is:

For example, suppose that we are interested in the present value of a ​stream​ of cash flows that
comprises £100 at each of t1, t2 and t3, and our opportunity costs are all 10% per period.
The value of an asset that generates a stream of future cash flows is the ​sum of the present values of
each of the future cash flows associated with the asset:

Multiple-Period Investment Decisions

Suppose that the stream we valued in the section above is the set of future cash flows of an investment
with a t0 cash outlay of £200. The NPV would be £248.69 - £200 = £48.69.

Finding the IRR of a set of cash flows that extends across several future periods is more complicated than
calculating its NPV. Remember that IRR is the discount rate that causes the present value of all cash
flows (NPV) to equal zero.

The way we solve the IRR of a multiple-period cash flow stream is with a technique called ‘trial and error’.
This means we choose some arbitrary discount rate for IRR in the above equation, and calculate NPV.

Let us try 25%:

A 25% discount rate yields a small but negative NPV, and so 25% is too large. Try 20% and see then.
Calculators will do this search process for the correct IRR for you.

Calculating Techniques and Shortcuts in Multiple-Period Analysis

When we wish to discount a stream of future cash flows to find its present value, we simply find the sum
of the present values as calculated above. The following equation (1.2) calculates the present value of a
stream of future cash flows:

Where discount rates are taken to be the same for all cash flows the equation (1.3) becomes:

(notice the t in i​t​is removed)

There are two shortcuts:

1. You start with the cash flow ​furthest​ into the future, ​discount​ it one period closer to the present,
add​ the cash flow from that closer time point, and ​discount​ that ​sum​ one period nearer to the
present; you ​continue​ that process until ​all​ cash flows are ​included​, and discounted back to t0.
2. Present value tables​. Note that in the column for a 10% discount, the factors for the first three
time points are indicated as 0.9091, 0.8264, and 0.7513 respectively. To find the present value of
our £100 per period for three periods, we multiply each of these factors by the £100 cash flow
occurring at its time point, and add up the result. The answer is, of course, £248.69
a. Useful for calculating the present value of a single cash flow located far into the ​future
when your calculator cannot perform exponentiation.
b. Useful is in finding the present value of ​annuities​. A constant annuity is a set of cash
flows that are the same amounts across future time points. Such a present value is
calculated with our Equation 1.3, but with no subscript on the cash flows since they are
all the same. To illustrate its use, note that under the column for 10% discount, the
three-period annuity factor is listed as 2.4869. It takes little effort to see that with £100 per
period for three periods, we arrive at our familiar answer, £248.69. When annuities run for
many periods, the use of this table rather than a calculator is wise.

Perpetuity
A ​perpetuity​ is a ​cash flow stream​ that is assumed to continue f​ or ever​. Perpetuity present values are
used because they are so easy to calculate. The formula for the present value of a perpetuity is:
For example, a £100 per period for ever at a discount rate of 10% has a present value of £100/0.10 =
£1000. (Another way of saying the same thing is that if you put £1000 in the bank at 10% interest, you
can take out £100 per year for ever.)

With a discount rate of 10%, £100 in the fortieth year has a present value of only £2.21 = £100/(1.10) x
40. As a matter of fact, the total present value of all cash flows from the fortieth year until the end of time
is only (£100/0.10)/(1.10) 40 = £22.10. This means that by using a perpetuity valuation, even if the stream
actually ends in the fortieth year instead of continuing for ever, the value error is £22.10 out of £1000, or
2.21%.

Though perpetuity valuation can be convenient and may not err greatly in long-lived assets, Equation 1.4
also assumes that the cash flows will be constant for each future period. That is not very representative of
actual patterns of cash flows that we see.

If we assume that the cash flows will continue for ever, but will grow or decline at a constant percentage
rate during each period, the perpetuity formula becomes:

where g is the constant per-period growth rate of the cash flow.

For example, suppose that we must value a cash-flow stream that begins at the end of this period with
£100, but that will grow at a rate of 5% per period every period thereafter (such that there will be a cash
inflow of £105 at t2, of £110.25 at t3, and so forth, for ever). With a discount rate of 10%, the value of the
stream is:

Caution: the equation obviously does not work when the discount rate i is less than or equal to the growth
rate g. The implication that a cash flow, growing for ever at a rate nearly equal to its opportunity cost, has
an infinitely high present value, is numerically correct, but not economically useful, because it could not
reasonably be expected to happen.

Summary
1. There is a simple ​calculator-based technique​ that is very effective for valuing cash-flow streams
that run for only a ​few periods​.
2. When the stream continues for ​several periods​ and has the ​same cash flow​ for each period,
annuity present-value tables​ (giving the present value of £1 per period) can be used.
3. When cash flows are ​well into the future​, and the calculator being used c​ annot​ exponentiate,
single-cash-flow present-value tables​ (‘present value of £1’) are useful.
4. Perpetuities​, either constant or growing (or even declining) by a constant percentage per period,
can often be used as ​reasonable approximations for cash-flow streams from very long-lived
assets.

Interest Rates, Interest Rate Futures and Yields

Suppose that the securities’ cash flows are riskless, and that the per-period interest rates that would apply
are 5% for the first period (between t0 and t1), 6% for the two-period rate (between t0 and t2), and 7% for
the three-period rate (between t0 and t3). Incidentally, in financial markets, ​interest rates that begin at
the present and run to some future time point ​are called ​spot interest rates​.

So another way of saying what we have just said is that the one-period spot rate is 5%, the two-period
spot rate is 6%, and the three-period spot rate is 7%.

The ​set of all spot rates​ in a financial market is called the ​term structure of interest rates​.

The market price of a security is the sum of the present values of the cash flows expected from it,
discounted at the rates appropriate to those flows. To calculate C:

We have designed the cash-flow pattern of A, B, C, D and E to be similar to that of c ​ oupon bonds
(cash-flow promises from the bond issuer), which are the type seen most often in bond markets. A
coupon bond has a ​face value ​(also called principal) that is used, along with its ​coupon rate ​(no
necessary relationship to market interest rates), to figure the pattern of cash flows promised by the bond.

These cash flows comprise ​interest payments​ each period (which are given by the​ face value of the
bond multiplied by its coupon rate​). This continues until the final (​maturity​) period, when the face
value itself, as a ​‘principal payment’ plus a final interest payment​, is promised. All of the bonds in
Table 1.1 are £1000 face-value bonds; their coupon rates differ, however.

Bond E has a 12% coupon rate, which means that E promises to pay 12% of £1000, or £120, each period
(t1 and t2) until it matures, when it will pay 12% ​plus​ £1000, or £1120 (at t3). Bond A, of course, is an 8%
coupon bond maturing in one period. See if you can similarly describe the other bonds.
The Yield to Maturity (vra Ben)

The ​yield to maturity​ is the ​rate​ that ​discounts​ a bond’s ​promised cash flows to equal its market
price​, and (from our knowledge of IRR) is the ‘average per-period earning rate on the money invested in
the bond’ (which money, of course, is the market price).

Look at C,D and E. If the same interest or discount rates have operated upon the bonds, how can their
average per-period earning rates differ? The answer is that the pattern of a bond’s cash flow across time
influences its YTM, and these three bonds have different cash-flow patterns.

Bond D, with a 4% coupon, has interim interest (£40) payments that are smaller relative to its final
payment than does bond E with its 12% (£120) coupon. In effect, bond D has a greater proportion of its
present value being generated by its t3 cash flow than does bond E with its relatively larger interim
interest payments. Remember that the spot interest rate for t3 is 7%, whereas the rates for t2 and t1 are
lower at 6% and 5% respectively.

The phenomenon we have described above has a name in finance; it is called the ​coupon effect on the
yield to maturity​. It gets this name because the ​size of the coupon of a bond determines the pattern
of its cash flows, and thus how its YTM will reflect the set of spot rates that exists in the market​.
The YTM is mathematically a very complex average of the spot rates of interest, as weighted by the
pattern of cash flows of a bond.

Bond B, of the £1037 invested in the bond at t0, £76 of it produces £80 at t1 for a 5% return during the
first period, and £961 of the t0 investment produces £1080 at t2, a 6% return per period for two periods.

It would be most unwise to make comparisons among securities on the basis of their YTMs unless their
patterns of cash flows (coupons, for bonds) were identical.

The YTMs are expressing not only the earning rates but also the amounts invested in the bonds across
time. In our example, bond E had a lower YTM than bond D because E’s higher interim cash interest
payments meant that relatively less was invested at the later periods (which had the higher interest rates).
Forward Interest Rates (vra Ben)
If there is £1037 invested at t0 and if the earning rate for the first period is 5%, the amount invested at t1
(before the t1 interest payment) must be £1037 × 1.05 = £1089. After the £80 payment, the amount
invested at t1 is thus £1089 – £80 = £1009.

The £1009 invested in bond B at t1 produces a payment of £1080 at t2. The implied earning or interest
rate for bond B between t1 and t2 (noted as ) must therefore be:

Bond B is earning 7% between t1 and t2: . ​The implied forward rate for bond B in the second time
period is 7%.

Since an earning rate is just a discount rate in reverse, we can also think of the £1080 at t2 being
discounted to t0 with the appropriate forward rates:

The present value of the t2 cash flow is calculated either by discounting with the spot rate for two periods
or by discounting with the forward rates for one period. This in turn implies that the relationship between
the rates is:

​ :
As an exercise, let us calculate 2​f 3

(Note that the rate i3 = 7% is not the simple average of the 5%, 7% and 9% forward rates, but is the result
of subtracting 1 from the nth root of the product of 1 plus the intervening forward rates (geometric mean).

The following three methods of calculating the value of bond D are all correct, the first using the spot
rates, the second using the forward interest rates, and the last using the bond’s YTM.
Interest Rate Futures
We discovered that bond B, after paying its t1 interest, was worth £1009 at that time point. That amount
can be regarded as bond B’s forward price for t1, given the information available as at t0. Examples of
forward markets: in exchange rates, commodities, and even in other financial assets much like the bonds
we have been studying. In these markets, participants enter into contracts whose worths are determined
by exactly the kinds of forward value and rate systems that we have been discussing.

To illustrate their use requires that we introduce the final important characteristic of financial markets:
risk. ​Financial markets often make very bad mistakes in the sense that implied forward rates and prices
turn out not to have been correct expectations of the interest rates that actually appear in the future
periods.

Why? The reason is simple: between the time the expectation is formed (t0) and its realisation occurs (t1)
additional information will have appeared that causes the market to revise its cash-flow expectations, its
opportunity costs, or both.

There are today available ‘financial futures’ markets that allow participants to guard against this kind of
risk (and many other related types) by buying and selling commitments to transact in financial securities
at future time points, at ​prices fixed as at the present.

One tactic to insure against the detrimental effects of interest rate increases would be to sell an ​interest
rate futures contract​ in the approximate amounts and timings of the cash inflows of the project.

and so the investment is acceptable. You recall that we can find the implied by the current term
structure by using the relationship between spot and forward rates:
Now suppose there is risk that the rate would increase to 15%. If this happens at t0, there will be a
new i2 of:

And the present value of the investment becomes negative:

NPV declines from +£20.71 with the original term structure to −£0.40 with the new term structure, a
wealth loss to you of £21.11. To avoid this, ​hedge​.
Suppose you are allowed to ​hedge​ the risk of a change in by ​selling​ an i​nterest rate futures
contract.​ The interest rate applies between t1 and t2, so your transaction will commit to sell at a fixed
price a security at t1 that has a single (£1000) cash flow at t2. ​If increases, the price of such a
security will decline. But since you will have a contract to sell that (now cheaper) security at a
fixed higher price, the value of your contract will increase.​ ​The increase in the value of your
contract will offset the decrease in the NPV of your investment, and you will have avoided the risk
of interest rate changes.

The increase in causes a £1000 cash flow at t2 to decline in value. The new t1 value of the t2 £1000
is:

This decline in value is actually good news to you because you own a contract (the interest rate
future you sold) that allows you to sell at t1 for £892.79 a security that promises £1000 at t2.
Even though the ​t​2​ cash flow is worth only £869.57 at the new interest rate, you can sell it for
£892.79. Now the contract must obviously be worth £892.79 – £869.57 = £23.22 at t1. That,
however, is a t1 amount. If we discount that value to t0, with the unchanged i1 = 10% we get:
£21.11 is therefore the ​increase​ in value of your interest rate futures contract at t0, as well as the
decrease​ in value of your investment’s NPV. Hedging means you lose both the bad and the good
surprises.

Caution: We have not worried about margins, brokerage fees, the difficulties of finding an exact
contractual hedge, and other characteristics of real-life transactions.

Interest Rate Risk and Duration

The variability of ​values​ due to ​changes in interest rates​ is the effect of ​interest rate risk​.

Duration​ is a kind of index that tells us ​how much​ a particular ​bond value will go up and down as
interest rates change​. It measures the ‘exposure’ of the value of a bond to changes in interest rates.

Look at bonds C and D. Their prices are indicated as £1029 and £923 respectively. Suppose that interest
rates instantaneously increased, such that the spot rates were 6%, 7% and 8%, instead of the 5%, 6%
and 7% that gave us the original values. The bonds’ values must, of course, decline, and if you do your
arithmetic correctly, you will now see that bond C is worth £1003 and bond D is worth £898. But notice
that the decline in value of bond C is less in percentage terms than is the decline in the value of bond D –
about 2.6% for bond C and 2.8% for bond D, because D has a greater duration than bond C.

Duration​ is the number of periods into the future where a bond’s value, on average, is generated.

Finding their durations is more complicated than finding durations for zero coupon bonds (no interim
payments, just a final one after some time) because bond C’s and bond D’s values come from more than
a single future time. We can calculate their durations by ‘weighting’ the time points from which cash flows
are generated, by the proportion of total value generated at each time.

Bond D’s average present value is generated 2.88 periods into the future, whereas bond C’s
average present value comes sooner, 2.78 periods into the future. And with this longer duration,
bond D experiences a greater interest rate risk; its value will go up or down more than bond C’s
for a given change in interest rates.

The idea that duration is a measure of interest rate risk is particularly valuable for coupon bonds,
where comparative riskinesses might not be obvious simply by inspection.

Duration is the starting point for an important aspect of professional bond investing called ​immunisation
which allows certain portfolios of coupon bonds or other types of investments to be shielded against
unexpected changes in interest rates.

Important Questions: 1.10, 1.11, 1.14, 1.15 (NB), 1.16, 1.18 (NB)
MODULE 2: FUNDAMENTALS OF COMPANY INVESTMENT DECISIONS
The corporation (plc) is an organisation that raises money from capital suppliers by issuing contracts (we
call them securities), invests that money in productive assets, operates those assets (perhaps hiring other
resources such as management and labour), and distributes the money proceeds from operating those
assets to all that have claims on those proceeds.

Those having claims upon the company’s cash flows include everyone holding contracts, formal and
informal, with the company. They include workers and management (receiving cash flows as
compensation for services), government (receiving cash flows as taxes and fees), suppliers of raw
materials (being paid for materials used in the productive process), and finally, capital suppliers (being
paid their capital returns in the forms of interest, principal and dividends). This latter group, the capital
suppliers, are those who have purchased the securities that the company has issued; the company issues
these securities so as to raise money to acquire productive assets. We usually know this group of capital
suppliers as those who own the equity and debt claims on a company.

Investment Decisions and Shareholder Wealth

A corporate investment NPV translates directly into a wealth increase of that amount for the shareholders
of the company. Companies seek to make investments that are in the best interests of their existing
shareholders.

Corporate Equity
When a company issues shares to raise money from the capital market, it creates a security known
variously as ‘ordinary shares’, ‘common stock’, ‘equity’, ‘common shares’, ‘ownership capital’ etc.

1. It is a ​residual claim​. That is, equity has ​no​ specific ​contract​ with the company that requires any
particular amounts of ​money​ to be paid to the shareholders at any particular time. The
shareholders are entitled ​only​ to ​vote​ for the directors of the company and to expect that the
company’s directors and management make decisions in the best interests of the shareholders.
2. Equity has ​limited liability​. This means that the possible losses that a shareholder can incur are
limited to the value of the shares that the shareholder owns.
3. Shareholders have agreed to stand last in queue for the corporate generosity, in exchange for ​all
that is left over.

Shareholder wealth is the market value of the common shares that the shareholders own. Since the
company wishes to maximise its shareholders’ wealth, it should seek to maximise the market value of the
shareholders’ ordinary shares.

The Market Value of Common Shares

The return that shareholders ​expect​ to earn on their common shares often comprises both ​dividends
and ​price increases​ (capital gains). However it is still ​dividends​ ​alone​ that are the basis for the value of
a company’s common shares in the financial markets.

The person to whom you sell your shares must in turn sell them to someone who expects to get some
dividends, and themselves sell to someone expecting dividends, and so forth. When all is said and done,
and all of the reasonable expectations of returns from holding the shares are included, we are left with
only future dividends as the basis for the market value of a company’s equity.

Suppose that International Eugenics has expectations of paying £100 in dividends for ever, and the
appropriate discount rate for the dividends is 10% per period:

Your shares are thus worth £1000, based upon the set of future dividends expected.

You, however, having a finite life, cannot expect to receive all of those dividends. In fact, you expect to
sell your shares at the end of this period. At that time the shares will still be expected to pay dividends of
£100 per period for ever, and with the same discount rate will still be worth £1000. So your expectation of
cash flow from holding the shares of International Eugenics is £100 of dividends and a £1000 sale price,
both at the end of the period:

Most basically, this argument is saying that the value of the claims against a company’s future cash flows
must finally depend upon the amounts of cash that the company is expected to pay to the claimholders,
not upon what claimholders are expected to pay each other when they buy and sell shares.

Therefore the market value of the common shares of a company is the ​present value of the future
dividends expected to be paid to the currently existing shares​ of the company.

Investment Decisions in All-Equity Corporations

The amounts listed are the ​changes​ that will occur when the investment (100K -> 500K) is accepted:

Cheetah has evaluated its prospective return to selling a convertible model as having a positive NPV of
£3 500 000. The necessary cash outlays associated with assembly-line and other changes associated
with the new model will total £10 000 000. The company can either raise that money from new
equityholders outside the corporation or use the cash that it was going to pay as a dividend to its old
shareholders in this period. Cheetah currently has 1 000 000 shares outstanding, and their market price
immediately before the project is announced is £100 apiece. Thus Cheetah before (or ‘without’) the
investment is worth £100 000 000, and the investment will add £13 500 000 to the market value of the
company, but will cost £10 000 000, producing an NPV of £3 500 000. If Cheetah undertakes the project
and if the market agrees with the opinion of profitability that Cheetah managers hold, the share value of
Cheetah will immediately go up by an amount that will produce a total wealth increase of £3 500 000 for
the existing shareholders of Cheetah, and thus of £3.50 for you who own one of Cheetah’s 1 000 000
shares.

Suppose now that the company decides to raise the money for the project by cancelling this period’s
dividend. That means you will be losing the £10 per share that you would have received as your dividend
this period (the £10 000 000 cost of the project divided by the 1 000 000 shares outstanding). But the
market will value Cheetah as being worth £113 500 000, £13 500 000 more than the £100 000 000 it was
worth without the project. And each of the 1 000 000 shares will therefore increase in value from £100 to
£113.50. Thus if the project is accepted and financed this way, you lose £10 per share in dividends, but
gain £13.50 in market value, a net gain of £3.50 per share. With 1 000 000 shares, the £3 500 000 NPV of
the project is attained.

Should Cheetah decide to raise the money from new equityholders, the company would sell them
£10 000 000 of newly issued shares upon the announcement of the project. All of the shares of the
company will at that point have a total worth of £113 500 000, so the new shareholders’ £10 000 000
comprises that amount of total value. This means that the original shareholders will own the rest, which is
£113 500 000 − £10 000 000 = £103 500 000. With 1 000 000 old shares outstanding, the share price of
the old equity is £103.50, so the old equityholders again get a wealth increase of £3.50 per share, which
is NPV per share. (Since new equityholders provide the cash for the investment, the old equityholders
simply receive the dividend that they would get without the project. Thus though your share price is £10
lower than had you forgone the dividend, your cash in hand is £10 greater, so you are exactly as well off.)
Regardless of the way the company gets the money to do the project, existing shareholder wealth
increases by an amount equal to the project NPV.

Investment Decisions in Borrowing Corporations

Suppose that Lynx Autos plc is a corporation identical to Cheetah except that Lynx occasionally borrows
money instead of raising all necessary cash for investments from equityholders. Suppose, further, that
Lynx faces an investment identical to Cheetah’s in that the Lynx investment requires an outlay of
£10 000 000 and, if accepted, will increase the total value of the company by £13 500 000 for a corporate
NPV of £3 500 000. Lynx intends to borrow £5 400 000 of the £10 000 000 necessary for the investment,
and reduce its dividend by £4 600 000 to get the rest of the cash.

The shareholders will get the same wealth increase regardless. You remember that Cheetah’s new
shareholders would give the £10 000 000 to the company only if they got £10 000 000 in share value as
compensation. The same idea applies to the new bondholders of Lynx: they will provide the £5 400 000 in
cash to the company if they, in return, receive £5 400 000 in bond value from Lynx.

Consequently, when the market value of Lynx increases by £13 500 000 as it undertakes the investment,
£5 400 000 of that market value increase is the value of the ​new bonds​ that Lynx has issued to finance
the investment. If the total value increase of the company is £13 500 000, and the company’s debt value
has increased by £5 400 000, Lynx’s equity value must have increased by the difference, £8 100 000.
Thus the equityholders of Lynx are richer by the £8 100 000 share value increase, but they have lost
£4 600 000 in dividends that they would have had were the project to have been rejected. The net of
those two amounts is the change in the wealth of Lynx’s equityholders. Of course that wealth increase is
equal to £3 500 000, the corporate NPV

Why do the equityholders get to keep the difference? Because, as we saw above, they are the r​esidual
capital claimants​ of the company; they get to keep whatever is left after all other claimants’ contracts
have been honoured.

Share Values and Price/Earnings Ratios

The ​multiplier​ of a company’s shares is the ratio of its market value to its earnings, usually on a
per-share basis. In other words, if Cheetah Auto Ltd’s earnings for this year are expected to be £10 per
share, and its shares are selling for £100, it would be said to have a multiplier or ​price/earnings (P/E)
ratio​ of 10.

The P/E ratio is nothing more nor less than the ratio between the present value of all the company’s future
dividends (its market price) and its expected earnings during the first period.

As we saw in the previous section, Cheetah’s market value (before the investment) is £100 per share,
which we can take to be the discounted present value of a perpetual stream of future cash dividends of
£10. If we assume that Cheetah’s earnings are also £10 per share, its earnings and its dividends are the
same. This implies that Cheetah is expected to pay out all of its earnings as dividends. Using the Module
1 constant perpetuity formula for varying Cheetah on a per-share basis, and re once again as the equity
discount rate, we have:

If dividends are equal to earnings, we can manipulate these a bit to see that:

For Cheetah, the P/E ratio is the reciprocal of the equity discount rate.
Ocelot is expected also to earn £10 per share this year, and has, like Cheetah, a market price of £100 per
share. Ocelot, however, is going to pay out only £7 of its earnings in dividends. Ocelot thus has the same
P/E ratio as Cheetah (Ocelot’s earnings and market price are the same as Cheetah’s), but the market
must be valuing a different stream of future dividends for Ocelot, because it is paying out only £7 per
share in contrast to Cheetah’s £10 per share.

Suppose that the market expects Ocelot’s future dividends to grow at a constant rate of 3 per cent per
period for ever, and also considers Ocelot to have the same risk as Cheetah (so the same value of re
would apply). Remembering our lesson on growth perpetuities from Module 1, we can state that Ocelot’s
market valuation is being generated thus:

The ​payout ratio​ is simply the proportion of a company’s earnings that it pays as dividends. If Ocelot is
expected to pay a constant 70 per cent of its earnings as dividends, we can find the relationship between
the price/earnings ratio and the discount rate by remembering that dividends are the result of multiplying
the earnings by the payout ratio:

The P/E ratio here is influenced not only by Ocelot’s discount rate, but also by the rate of growth expected
for the company’s future dividends and the proportion of its earnings that it will pay as dividends. (Of
course Cheetah’s P/E ratio is subject to the same general relationship, and happens to be reflecting an
expectation of a 100 per cent payout ratio and a dividend growth rate of 0 per cent.)

Though Cheetah and Ocelot have the same initial earnings (£10), the same market price per share (£100)
and thus the same P/E ratio, they are quite different in terms of the stream of dividends, associated rates
of growth in dividends and earnings, and the extent to which they pay out earnings as dividends

Suppose that Win-or-Lose was expected to pay all of its earnings as dividends of £10, £107, and £30 per
share for the next three periods, and then disappear. The market’s valuation of Win-or-Lose is thus:

Win-or-Lose has a market price of £100 per share, the same as Cheetah and Ocelot, and Win-or-Lose
also has the same P/E ratio, 10, as the two car companies. But Win-or-Lose otherwise bears almost no
similarity to the others. It is more risky, it is expected to last only a few more periods, and it is a mining
company rather than a car manufacturer
A company’s P/E ratio is a very complex number in terms of the information that can influence it. It is
affected by the pattern of dividends that a company pays, its payout ratio, the riskiness of the company as
evidenced by the discount rate of its equity, and the stream of earnings that the company is expected to
be able to generate across the future.

For certain companies with very simple cash-flow patterns (such as constant or constant growth
perpetuities), we can derive a specific relationship between P/E ratios and equity discount rates. But for
most companies the relationship is much too complex to make numerical estimation worthwhile.

The lesson is one of caution in using or attaching much importance to the P/E ratio of a company.
If the company is a constant perpetuity, the interpretation of its P/E ratio is straightforward. But
how many companies do we encounter that are expected to pay the same dividend each year for
ever? Precious few. We do not see many constant growth perpetuity companies either.

Possible uses of P/E: Take the Lose-or-Win Mining Co., for instance. If it has the same dividend
expectations as Win-or-Lose but a P/E ratio of 5 instead of 10, that tells us that the market is assigning a
much higher discount rate to Lose-or-Win, and thus the company must be more risky than Win-or-Lose.
Or if Leopard Motors was seemingly identical to Cheetah in risk and length of dividend stream and paid
the same initial dividend as Cheetah, but had a lower P/E ratio, the implication is that Leopard’s dividends
are expected to decline in the future.

If we are careful to limit the comparisons that we make (for example, staying within the same industry so
that the risk differences are minimised), we may be able to examine P/E ratios so as to gain some
qualitative information as to the market’s opinion about the companies whose ratios we examine. For
example, we might infer that future growth rates expected for a company’s dividends and earnings are
above average if its P/E ratio is higher than companies in the same industry (which companies therefore
have the same risk and perhaps similar payout ratios).

Important Questions: 2.1,2.2

MODULE 3: EARNINGS, PROFIT AND CASH FLOW