Financial Management Notes Resumen

VALENTINE HOUSSARD
FINANCIAL MANAGEMENT
CHAPTER 1: THE CORPORATION
1. The four types of firms

There are different types of firms:
★ Sole proprietorship,
★ Partnership,
★ Limited liability company,
★ Corporation.
Most companies are sole proprietorships. However, corporations bring up most of the revenues. That’s why we
study corporations, instead of sole proprietorship.
A. SOLE PROPRIETORSHIP
That is the easiest way. The business is owned and run by one person. Typically, the business has, if any, few
employees. The advantage is that it is easy to create those businesses. On the other hand, we can find
disadvantages: the unlimited personal liability and the limited life. There is neither separation between the firm
and the owner.
B. PARTNERSHIP
It is similar to a sole proprietorship, but with more than one owner. All partners are personally liable for all of
the firm’s debts. Indeed, a lender can require any partner to repay all of the firm’s outstanding debts. If one
partner wants to leave the partnership, he needs to find another partner. The partnership ends with the death
or withdrawal of any single partner.
Limited Partnership has two types of owners:
★ The General Partners. They have the same rights and liability as partners in a “regular” partnership.
They typically run the firm on a day-to-day basis.
★ The Limited Partners. They have limited liability and cannot lose more than their initial investment.
They have no management authority and cannot legally be involved in the managerial decision making
for the business.
C. LIMITED LIABILITY COMPANIES (LLC)

All owners have limited liability but they can also run the business. Those are relatively new business form in the
United States.
D. CORPORATION
I. Legal aspect
A corporation is a legal entity separate from its owners. It has many of the legal powers individuals have such as
the ability to enter into contracts, own assets and borrow money. The corporation is solely responsible for its
own obligations. Its owners are not liable or responsible for any obligation the corporation enters into. That leads
to agency problems, because agents don’t have the same objectives as the owners of the company.
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II. Formation
Corporations are hard to set up. They must be legally formed. The corporation files a charter with the state it
wishes to incorporate in. The state then charters the corporation, formally giving its consent to the incorporation.
Due to its attractive legal environment for corporations, Delaware is a popular choice for incorporation.
Moreover, setting up a corporation is more costly than setting up a sole proprietorship.
III. Ownership
A question that arises could be, who has the ownership in a corporation? It is represented by shares of stock.
The owner of stock is called a shareholder, a stockholder or an equity holder. The sum of all ownership value is
called equity. There is no limit to the number of shareholders and, thus, the amount of funds a company can
raise by selling stock. Owner is entitled to dividend payments. Owners have rights: dividends payments and vote
during the General Assembly.
IV. Taxation
Taxation is a big disadvantage of corporations. There is a double taxation. The first taxation is on the shares, the
amount before the company distribute any dividend, in other words, the profit. Then, the second taxation is on
dividends.
★ EBIT = 4.000.000
𝐸𝐵𝐼𝑇
★ =4
𝑆ℎ𝑎𝑟𝑒𝑠
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
★ = 4 ∗ (1 − 0,34) = 2,64
𝑆ℎ𝑎𝑟𝑒𝑠
★ After personal tax = 2,64 * (1-0,2) = 2,112
2. Ownership versus control of corporations
A. CORPORATE MANAGEMENT TEAM

In a corporation, ownership and direct control are
typically separate. The general meeting is the way to
avoid agency problems. The board of directors are the
people whom shareholders delegates to run the
company efficiently. They say to the managers what to
do. The board of directors is elected by the
shareholders and have the ultimate decision-making
authority. The board typically delegates day-to-day
decision making to the chief executive officer. The CEO
works every days in the company, while the board of
directors only comes into the company once in a while.
The financial manager is responsible for the investment decisions, the financing decisions and the cash for
treasury management.
Shareholders will agree that they are better off if management makes decisions that maximizes the value of their
shares.
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B. THE FIRM AND SOCIETY

Often, a corporation’s decisions that increase the value of the firm’s equity benefit society as a whole. As long as
nobody else is made worse off by a corporation’s decisions, increasing the value of the firm’s equity is good for
society. It becomes a problem when increasing the value of the firm’s equity comes at the expense of others.
I. Ethics and incentives within corporations
Agency problems are the situations where the agent is the manager and the principal is the owner. Managers
may act in their own interest rather than in the best interest of the shareholders. One potential solution is to tie
management’s compensation to firm performance.
II. CEO performance
If a CEO is performing poorly, shareholders can express their dissatisfaction by selling their shares. This selling
pressure will drive the stock price down. That can lead to a hostile takeover. Low prices may entice a Corporate
Raider to buy enough stock, so they have enough control to replace current management. The stock price will
rise after the new management team fixes the company.
III. Corporate bankruptcy
At the extreme, the failure is the corporate bankruptcy. By bankruptcy, we have two choices: reorganization or
liquidation. In a reorganization, we clean it up, but the company still exist. In a liquidation, the company totally
disappears. In both cases, we distribute whatever is left in a defined order.
3. The stock market

The stock market provides liquidity to shareholders. The liquidity is the ability to easily sell an asset for close to
the price at which you can currently buy it. In public companies, stock is traded by the public on a stock exchange.
In private companies, stock may be traded privately.
When a corporation itself issues new shares of stock and sells them to investors, they do so on the primary
market (Corporation  Investors). After the initial transaction in the primary market, the shares continue to
trade in a secondary market between investors (Investors  Investors).
A. TRADITIONAL TRADING VENUES

★ New York Stock Exchange (NYSE): each stock has only one market maker.
★ NASDAQ: it doesn’t meet in a physical location. It may have many market makers for a single stock.
★ Bid Price versus Ask Price.
In 2005, the NYSE and NASDAQ exchanges accounted for over 75% of all trade in US stocks. Today, due to
increased competition from new fully electronic exchanges and alternative trading systems, it handles more than
50% of all trades.
★ Limit order: an order to buy or sell a set amount at a fixed price.

★ Limit order book: the collection of all limit orders.
★ Market orders: orders that trade immediately at the best outstanding limit order.
★ High Frequency Traders: a class of traders who, with the aid of computers, execute trades many times
per second in response to new information.
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CHAPTER 2: INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS
1. Firm’s disclosure of financial information

The financial statements are the firm-issued accounting reports with past performance information. They are
filed with the relevant listing authority. The firm must also send an annual report with financial statements to
shareholders, so that they can read it and go to the annual general meeting.
There are 4 types of financial statements:
★ Balance sheet,
★ Income statement,
★ Statement of Cash flows,
★ Statement of changes in Shareholder’s Equity.
2. The balance sheet

The balance sheet is a snapshot in time of the firm’s financial position. The balance sheet identity is:
𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦
The assets are what the company owns, while the liabilities are what the company owes. The stockholder’s equity
is the difference between the value of the firm’s assets and liabilities.
A. ASSETS
The current assets are cash or expected assets to be turned into cash in the next year. In terms of assets, the
most liquid is the cash, then marketable securities, accounts receivable, inventories and the less liquid are the
other current assets.
The long-term assets are the net property, plant and equipment (depreciation), the goodwill and intangible
assets (amortization) and the other long-term assets.
B. LIABILITIES
The current liabilities are due to be paid within one year. In terms of liabilities, the most liquid is the accounts
payable, the short-term debt and the notes payable, current maturities of Long-term debts and the less liquid
are the other current liabilities. The long-term liabilities are the long-term debt, the capital leases and the
deferred taxes.
The net working capital is the difference between current assets and current liabilities.
𝑁𝑊𝐶 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
C. SHAREHOLDER’S EQUITY
The shareholder’s equity is the difference between the value of the firm’s assets and liabilities. The book value
of equity could possibly be negative and many of the firm’s valuable assets may not be captured on the balance
sheet.
𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
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The market value of Equity (market capitalization) cannot be negative. It often differs substantially from the book
value.
𝑀𝑎𝑟𝑘𝑒𝑡 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 ∗ 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
The market-to-book ratio compares both value. When the ratio is low, it is for big companies, with value stocks.
A high market-to-book ratio is for start-up, with growth stocks.
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦

𝑀𝑎𝑟𝑘𝑒𝑡 𝑡𝑜 𝑏𝑜𝑜𝑘 𝑟𝑎𝑡𝑖𝑜 =
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
The enterprise value is the total enterprise value. It is used in many ratios.
𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝐷𝑒𝑏𝑡 − 𝐶𝑎𝑠ℎ
★ Market Capitalization = 108 * 5M = 540M
★ Book Value of Equity = 50M
540𝑀
★ 𝑀𝑎𝑟𝑘𝑒𝑡 𝑡𝑜 𝑏𝑜𝑜𝑘 𝑟𝑎𝑡𝑖𝑜 = = 10,8
50𝑀
3. The income statement

KELLOGGS 2015 2016
Total Sales / Revenues Total Sales 13,525 13,014
- Cost of Sales (COGS - Cost of Goods Sold) - COGS - 8,844 - 8,259
= Gross Profit = Gross profit = 4,681 = 4,755
- Operating Expenses (OPEX – Selling, general, - OPEX - 3,590 - 3,360
= Operating = 1,091 = 1,395
administrative expenses, R&D, depreciation, amortization)
income
= Operating Income +/- Other 0 0
± Other Income income
= EBIT = EBIT = 1,091 = 1,395
+ Interests income +/- Interest - 227 - 406
- Interests expenses income or
= Pre-tax income expense
= Pre-tax income = 773 = 927
- Taxes
- Taxes - 159 - 233
= Net income = Net income = 614 = 695
The Earnings per Share (EPS) represents the portion of a company’s profit allocated to each outstanding share of
common stock. That is the net income for a period divided by the total number of shares outstanding during that
period.
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
There are also share (stock) options, convertible bonds and diluted earnings per share. If all possible shares are
issued, we speak about diluted earnings per share. The diluted EPS is always smaller than the EPS.
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4. The statement of Cash-flows

The net income typically does not equal the amount of cash the firm has earned.
★ Non-cash expenses (Depreciation and Amortization): no money moves

when we depreciate a machine, therefore we have to correct that.
★ Uses of Cash not on the Income Statement (Investment in Property,
Plant and Equipment).
In every annual report, we have 3 sections:
★ Operating Activity,
★ Investment Activity,
★ Financing Activity.
For the earnings, the company has two possibilities: the income can be retained
earnings and reinvest them in the company, or be transformed in dividend.
A. OPERATING ACTIVITIES
Here, we need to adjust the net income by all non-cash items related to operating activities and changes in net
working capital.
★ Depreciation – Add the amount of depreciation

★ Accounts receivable – Deduct the increases
★ Accounts payable – Add the increases
★ Inventories – Deduct the increases
B. INVESTING ACTIVITIES
★ Capital expenditures (CAPEX) are expenses, therefore it is a minus.
★ Buying or selling marketable securities are also an investing activity.
C. FINANCING ACTIVITY
★ Payment of dividends  Retained Earnings = Net Income – Dividends
★ Changes in borrowings
The decrease in depreciation has an

Sales
- COGS impact on the net income. But these
= Gross profit depreciation has to be corrected,
- OPEX therefore, we need to make *(1-Corporate
= EBITDA taxes).
- Depreciation
= EBIT We also have to deduct the accounts
- Corporate taxes receivable and payable, because they have
= Net income
an impact on the end-of year cash balance.
+ 750.000 ∗ (1 − 40%) − (5.000.000 − 3.000.000) = −1.550.000
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5. Other financial statement information
A. STATEMENT OF STOCKHO LDERS’ EQUITY

We would like to increase the equity for the shareholders.
Change in Stockholders’ equity

= Retained Earnings
+ Net sales of stocks (Sales of stocks – repurchase of stocks)
= Net income
- Dividends
+ Sale of stocks
- Repurchase of stocks
We are going to make a comparison between both
years. Then, we look at each segment and say where
the best change is. A dollar change doesn’t give us a
magnitude. We prefer to talk into percentage, what
gives us a better view over the changes.
93.864−80.095
★ = 17,19%
80.095
6. Financial statement analysis

This is used to compare the firm with itself over time or to compare the firm to other similar firms.
A. PROFITABILITY RATIOS
𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑚𝑎𝑟𝑔𝑖𝑛 = KELLOGGS 2015 2016
𝑆𝑎𝑙𝑒𝑠
Gross margin 4,681 4.755
The gross margin is direct. It is opposed to the operating margin, 13.525 13.014
which gives us a look to the price covering the costs. = 34,61% = 36,53%
Operating margin 1.091 1.395
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 13.525 13.014
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑚𝑎𝑟𝑔𝑖𝑛 = = 8,07% = 10,72%
EBIT margin 1.091 1.395
𝐸𝐵𝐼𝑇 13.525 13.014
𝐸𝐵𝐼𝑇 𝑚𝑎𝑟𝑔𝑖𝑛 = = 8,07% = 10,72%
Net profit margin 614 695
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 13.525 13.014
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 = = 4,54% = 5,34%
𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠
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The industry is improving. However, the United

Continental isn’t improving as much as the other,
except from December 2013, where they may have
change their policies to catch up with other companies.
B. LIQUIDITY RATIOS
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐶𝑎𝑠ℎ + 𝑆ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 + 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

𝑄𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑎𝑠ℎ
𝐶𝑎𝑠ℎ 𝑟𝑎𝑡𝑖𝑜 =
Rylan 2015 2016

Current ratio 57 65
= 2,11 = 1,86
27 35
Quick ratio 4 + 6 + 15 2 + 7 + 20
27 35
= 0,9259 = 0,8285
Cash ratio 4 2
27 35
= 0,1481 = 0,0571
The quick ratio is decreasing. However, there are close to 1, therefore there are nothing to worry about.
C. WORKING CAPITAL RATIOS
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑑𝑎𝑦𝑠 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
= =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑠𝑎𝑙𝑒𝑠 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑑𝑎𝑦𝑠 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠
= =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
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𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑑𝑎𝑦𝑠 = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
We are comparing data from the income statement and from the balance sheet. If we divide the sales or the cost
of sales by 365, we compare two snapshots, the same point at a time. Otherwise, we have a problem to compare
them.
D. INTEREST COVERAGE RATIOS

𝐸𝐵𝐼𝑇
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
Those are the interests to be paid on the debt to the bank, to the bonds, … Under 1,5, there is a real danger.
𝐸𝐵𝐼𝑇𝐷𝐴 𝐸𝐵𝐼𝑇 + 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + 𝑎𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛

=
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
Rylan 2015 2016

𝑬𝑩𝑰𝑻 87,5 100
= 9,72 = 10
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 9 10
𝑬𝑩𝑰𝑻𝑫𝑨 110 125
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 9 10
= 12,22 = 12,5
E. LEVERAGE RATIOS
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
𝐷𝑒𝑏𝑡 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
There are no perfect ratio, but best is when there are at least one third of debt.
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
𝐷𝑒𝑏𝑡 𝑡𝑜 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑟𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑡𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
𝑁𝑒𝑡 𝑑𝑒𝑏𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡 − 𝑒𝑥𝑐𝑒𝑠𝑠 𝑐𝑎𝑠ℎ 𝑎𝑛𝑑 𝑠ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑁𝑒𝑡 𝑑𝑒𝑏𝑡
𝐷𝑒𝑏𝑡 𝑡𝑜 𝑒𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑛𝑒𝑡 𝑑𝑒𝑏𝑡
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
𝐸𝑞𝑢𝑖𝑡𝑦 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
The equity multiplier is how many times a shareholder is ready to pay for assets in a company.
F. VALUATION RATIOS
These ratios enable us to calculate the value of a company. Bondholders and shareholders don’t want the same
things. Therefore, they fight together.
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𝑀𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑆ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒

𝑃𝑟𝑖𝑐𝑒 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑟𝑎𝑡𝑖𝑜 = =
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
As a shareholder, I’m ready to pay x times the earnings. In the case of Kellogg’s, the company is over-valued.
That means that shareholders really believe in the company and in her success.
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑑𝑒𝑏𝑡 − 𝑐𝑎𝑠ℎ

𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 𝑡𝑜 𝐸𝐵𝐼𝑇 =
𝐸𝐵𝐼𝑇
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑑𝑒𝑏𝑡 − 𝑐𝑎𝑠ℎ

𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 𝑡𝑜 𝑆𝑎𝑙𝑒𝑠 =
This ratio tells us nothing about the cost of producing those sales.
G. OPERATING RETURNS
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 =
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝑛𝑒𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑎𝑠𝑠𝑒𝑡𝑠 =
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
𝐸𝐵𝐼𝑇 ∗ (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 =
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑛𝑒𝑡 𝑑𝑒𝑏𝑡
We take the average book value of equity, to compare the income statement and the balance sheet. None of
those ratios is better than others. The most useful is the return on invested capital (ROIC) because it depends
on the debt structure.
7. Financial reporting in practice

If a firm’s price earnings ratio is lower than the industry average, do you expect the share price to go up? Could
there be reasons other than undervaluation for a firm to have a low P/E ratio? Prices are too small, that means
that someone doesn’t need to pay a lot to buy the company. That means high earnings, compare to the price.
This ratio could be influenced by sales, cost of goods sold and leverage. Even with safeguards, reporting abuses
still happen: Enron, WorldCom, Sarbanes-Oxley Act, Dodd-Frank Act, … You can’t trust the financial market to
regulate itself, it needs regulations.
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CHAPTER 3: FINANCIAL DECISION MAKING AND THE LAW OF ONE PRICE
Imagine, you have just won a context and are disappointed to learn that you won tickets for the Dour festival in
July, when you will already be on vacation celebrating the end of the school year (2 tickets for 120€ = 240€).
However, there is a second prize, which is a free CICHEC ski week (1 week for 399€).
With competitive markets, it’s not your personal preference nor the face value that guides your choice, but the
market value. The tickets can be sold for 220€ each while the ski week, for 399€. 2*220-399 = 41€. You will even
have money left to buy drinks for the other students on the ski trip.
1. Valuing decisions
A. IDENTIFY THE COSTS AND BENEFITS

May need the help from other areas in identifying the relevant costs and benefits: marketing, economics,
organizational behaviour, strategy and operations.
B. ANALYZING COSTS AND BENEFITS

Suppose Kellogg’s has the opportunity to trade 2.000 bushels of wheat and receive 4.000 bushels of oat. To
compare the costs and benefits, we first need to convert them to a common unit.
★ Suppose wheat can be bought and sold for a current market price of $5 per bushel. Then, the 2.000
bushels of wheat they give up has a cash value of $10.000 today.
★ Similarly, if the current market price for oat is $2 per bushel, then the 4.000 bushels of oat they receive
has a cash value of $8.000 today.
Therefore, Kellogg’s opportunity has a benefit of $8.000 and a cost of $10.000 today. In this case, the net value
of the project is -$2.000. Because it is negative, the costs exceed the benefits and the company should reject the
trade, not because you have too much oat, but because the costs are bigger than the benefits. You only accept
trades that create value.
C. USING MARKET PRICES TO DETERMINE CASH VALUES

A competitive market is a market in which goods can be bought and sold at the same price. In evaluating the
company’s decision, we used the current market price to convert from bushels to dollars. We did not concern
ourselves with whether the company thought that the price was fair or whether they would use oat or not.
We choose the motorcycle, because the price is

bigger than the 10.000 cash. You transform the
motorcycle into cash through the market and
you receive finally 12.000 cash. What matter is
transforming thing into what has value for us
(here: cash).
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The costs and benefits must be converted to their cash

values. Assuming competitive market prices:
★ 2.500 shares * $14 = $35.000

★ 10.000€ * 1,12$/€ = $11.200
The net value of the opportunity is 35.000 + 11.200 –

50.000 = -3.800. Therefore we should not go for it.
It is too simple because we ignore two aspects: the time value of money and the risks (interest rates). There
is unknown on the future. Therefore, we have to add some information.
2. Interest rates and the time value of money
A. TIME VALUE OF MONEY

Consider an investment opportunity with the following certain cash flows.
★ Cost: $100.000 today.

★ Benefit: $105.000 in one year.
The difference in value between money today and money in the future is due to the time value of money.
B. THE INTEREST RATE: AN EXCHANGE RATE ACROSS TIME

The rate at which we can exchange money today for money in the future is determined by the current interest
rate. Suppose the current annual interest rate is 7%. By investing or borrowing at this rate, we can exchange
$1,07 in one year for each $1 today. Risk-free interest rate (discount rate) is the interest rate at which money
can be borrowed or lent without risks, at any time.
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑓𝑎𝑐𝑡𝑜𝑟 = 1 + 𝑟𝑓
1
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑓𝑎𝑐𝑡𝑜𝑟 =
1 + 𝑟𝑓
I. Value of investment in one year
If the interest rate is 7%, then we can express our costs as:
𝐶𝑜𝑠𝑡 = ($100.000 𝑡𝑜𝑑𝑎𝑦) ∗ (1,07 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟) = $107.000 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟
Both costs and benefits are now in terms of dollars in one year, so we can compare them and compute the
investment’s net value. $105.000 - $107.000 = -$2.000. In other words, we could earn $2.000 more in one year
by putting our $100.000 in the bank rather than making this investment. We should reject the investment.
II. Value of investment today
Consider the benefit of $105.000 in one year. What is the equivalent amount in terms of dollars today?
$105.000 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟

𝐵𝑒𝑛𝑒𝑓𝑖𝑡 = = $98.130,84 𝑡𝑜𝑑𝑎𝑦
1,07
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This is the amount the bank would lend us today if we promised to repay $105.000 in one year. Now, we are
ready to compute the net value of the investment: $98.130,84 - $ 100.000 = -$1.869,16 today. Once again, the
negative result indicates that we should reject the investment.
III. Present versus future value
This demonstrate that our decision is the same whether we express the value of the investment in terms of
dollars in one year or dollars today. If we convert from dollars today to dollars in one year,
−$1.869,16 𝑡𝑜𝑑𝑎𝑦 ∗ 1,07 = −$2.000 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟
The two results are equivalent but expressed as values at different points in time. When we express the value of
dollars today, we call it the present value (PV) of the investment. If we express it in terms of dollars in the future,
we call it the future value (FV) of the investment.
3. Present value and the NPV decision rule

The net present value (NPV) of a project or investment is the difference between the present value of its benefits
and the present value of its costs.
𝑁𝑃𝑉 = 𝑃𝑉 (𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠) − 𝑃𝑉 (𝐶𝑜𝑠𝑡𝑠) = 𝑃𝑉 (𝑎𝑙𝑙 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠)
A. THE NPV DECISION RULE

When making an investment decision, take the alternative with the highest NPV. Choosing this alternative is
equivalent to receiving its NPV in cash today. Accept the project with positive NPV because it is equivalent to
receiving their NPV in cash today. Reject the projects with negative NPV, because it would reduce the wealth of
investors.
25.000
𝑁𝑃𝑉 = −23.500 + = 538,46
1,04
The NPV is positive, therefore, we accept the deal.
B. CHOOSING AMONG ALTERNATIVES

We can also use the NPV decision rule to choose among projects. To do so, we must compute the NPV of each
alternative and then select the one with the highest NPV. This alternative is the one which will lead to the largest
increase in the value of the firm.
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C. NPV AND CASH NEEDS

Regardless of our preferences for cash today versus cash in the future, we should always maximize NPV first. We
can then borrow or lend to shift cash flows through time and find our most preferred pattern of cash flows.
4. Arbitrage and the law of one price

The arbitrage is the practice of buying and selling equivalent goods in different markets to take advantage of a
price difference. An arbitrage opportunity occurs when it is possible to make a profit without taking any risk or
making any investment.
The normal market is a competitive market in which there are no arbitrage opportunities.
The law of one price: if equivalent investment opportunities trade simultaneously in different competitive
markets, then they must trade for the same price in both markets. The government has a big impact on the
prices. The taxes make the market imperfect.
5. No-arbitrage and security prices
A. VALUING A SECURITY WITH THE LAW OF ONE PRICE

Assume a security promises a risk-free payment of $1.000 in one year. If the risk-free rate interest rate is 5%,
what can we conclude about the price of this bond in a normal market?
$1.000 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟

𝑃𝑉 ($1.000 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟) = = $952,38 𝑡𝑜𝑑𝑎𝑦
1,05
B. IDENTIFYING ARBITRAGE OPPORTUNITIES WITH SECURITIES

What if the price of the bond is not $952,38?
★ Assume the price is $940. Today ($) In one year ($)

Buy the bond - 940,00 +1.000
The opportunity for arbitrage will force the price of Borrow from the bank + 952,38 -1.000
the bond to rise until it is equal to $952,38. BUY Net cash flow +12,38 0,00
★ Assume the price is $960. Today ($) In one year ($)

Sell the bond +960,00 -1.000
The opportunity for arbitrage will force the price of Borrow from the bank - 952,38 +1.000
the bond to fall until it is equal to $952,38. SELL Net cash flow +7,62 0,00
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C. DETERMINING THE NO -ARBITRAGE PRICE

Unless the price of the security equals the present value of the security’s cash flows, an arbitrage opportunity
will appear.
𝑃𝑟𝑖𝑐𝑒 (𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦) = 𝑃𝑉 (𝐴𝑙𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑝𝑎𝑖𝑑 𝑏𝑦 𝑡ℎ𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦)
D. DETERMINING THE INTE REST RATE FROM BOND PRICES

If we know the price of a risk-free bond, we can use
𝑃𝑟𝑖𝑐𝑒 (𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦) = 𝑃𝑉 (𝐴𝑙𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑝𝑎𝑖𝑑 𝑏𝑦 𝑡ℎ𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦)
to determine what the risk-free interest rate must be if there are no arbitrage opportunities.
Suppose a risk-free bond that pays $1.000 in one year is currently trading with a competitive market price of
$929,80 today. The bond’s price must equal the present value of the $1.000 cash flow it will pay.
$1.000 (𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟) $1.000

$929,80 (𝑡𝑜𝑑𝑎𝑦) = ↔ 1 + 𝑟𝑓 = = 1,0755
1 + 𝑟𝑓 $929,80
The risk free rate must be 7,55%.
E. NPV OF TRADING SECURITIES AND FIRM DECISION MAKING

In a normal market, the NPV of buying or selling a security is zero.
𝑁𝑃𝑉 (𝑏𝑢𝑦 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦) = 𝑃𝑉 (𝑎𝑙𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑝𝑎𝑖𝑑 𝑏𝑦 𝑡ℎ𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦) − 𝑃𝑟𝑖𝑐𝑒 (𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑦) = 0
𝑁𝑃𝑉 ( 𝑠𝑒𝑙𝑙 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦) = 𝑃𝑟𝑖𝑐𝑒 (𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑦) − 𝑃𝑉 (𝑎𝑙𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑝𝑎𝑖𝑑 𝑏𝑦 𝑡ℎ𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦) = 0
The security is the property or goods that you agree to give to someone who has lent you money if you can’t pay
the money back.
I. Separation principle
We can evaluate the NPV of an investment decision separately from the decision the firm makes regarding how
to finance the investment or any other security transactions the firm is considering.
F. VALUING A PORTFOLIO
A portfolio is the sum of each projects, and therefore the value of the company.
The law of one price also has implication for packages of securities. Consider two securities, A and B. Suppose a
third security, C, has the same cash flows as A and B combined. In this case, security C is equivalent to a portfolio,
or a combination of the securities A and B.
𝑃𝑟𝑖𝑐𝑒 (𝐶) = 𝑃𝑟𝑖𝑐𝑒 (𝐴 + 𝐵) = 𝑃𝑟𝑖𝑐𝑒 (𝐴) + 𝑃𝑟𝑖𝑐𝑒 (𝐵)
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For example: Price (Kellogg’s) = Price (breakfast division) + Price (Snack food division)
★ Due Beverage: 50% * $75 million = $37,5 million

★ Mountain industries: 70% * $100 million = $70 mo.
Under the value added method, the sum of the value

of the stakes in all three investments must equal $200
million market value of Moon. The Oxford bears must
be worth:
★ $200 million - $37,5 - $70 = $92,5 million
I. Value additivity and firm value
To maximize the value of the entire firm, managers should make decisions that maximize NPV. The NPV of the
decision represents its contribution to the overall value of the firm.
G. IMPACT OF RISK ON VALUATION

When cash flows are risky, we must discount them at a rate equal to the risk-free interest rate plus an appropriate
risk premium. The appropriate risk premium will be higher the more the project’s returns tend to vary with
overall risk in the economy.
6. Critical perspective challenging “Market efficiency”

If markets are efficient, then all future returns are already valued in the share price. In practice, markets have a
weak form of efficiency (taking into account information from the past, but not forward looking). But effective
return is rarely the same as expected return. There may be under or over performance. Of course, with efficient
markets, under or over-performances cancel out in the long-term. This does not mean there is no opportunity
for return, rather than return must be linked to risk.
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CHAPTER 4: THE TIME VALUE OF MONEY
1. The timeline
A timeline is a linear representation of the timing of potential cash flows. Drawing a timeline of the cash flows
will help you visualize the financial problem.
Assume that you made a loan to a friend. You will be

repaid in two payments, one at the end of each year
over the next two years.
We must differentiate two types of cash flows:
★ Inflows are positive cash flows.

★ Outflows are negative cash flows, which are indicated with a minus sign.
Assume that you are lending $10.000 today and that the
loan will be repaid in two annual $6.000 payments. The
first cash flow at date 0 (today) is represented as a
negative sum because it is an outflow.
Timelines can represent cash flows that take place at the end of any time period, a month, a week, a day, …
2. The three rules of time travel

Financial decisions often require combining cash flows or comparing values. Three rules govern these processes.
A. RULE 1: COMPARING AN D COMBINING VALUES

A dollar today and a dollar in one year are not equivalent. It is only possible to compare or combine values at the
same point in time.
★ Which would you prefer? A gift of $1.000 today or $1.210 at a later date?
★ To answer this, you will have to compare the alternatives to decide which is worth more. One factor to
consider is “How long is later?”
B. RULE 2: MOVING CASH FLOWS FORWARD IN TIME

To move a cash flow forward in time, you must compound it. Suppose you have a choice between receiving
$1.000 today or $1.210 in two years. You believe you can earn 10% on the $1.000 today, but want to know what
the $1.000 will be worth in two years.
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The timeline looks like this:
The future value of a cash flow:
𝐹𝑉𝑛 = 𝐶 ∗ (1 + 𝑟)𝑛
The future value of $5.000 at 10% for five years is

$8.053. You would be better off forgoing the gift of $5.000 today and taking the $10.000 in five years.
C. RULE 3: MOVING CASH FLOWS BACK IN TIME

To move a cash flow backward in time, we must discount it. The present value of a cash flow:
𝐶
𝑃𝑉 =
(1 + 𝑟)𝑛
The $10.000 is worth:
$10.000
= $6.209
1,15
D. APPLYING THE RULES O F TIME TRAVEL

Recall the first rule: it is only possible to compare or combine values at the same point in time. So far, we’ve only
looked at comparing.
Suppose we plan to save $1.000 today, and $1.000 at the end of each of the next two years. If we can earn a
fixed 10% interest rate on our savings, how much will we have three years from today?
The timeline would look like this:
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You can calculate the present value of the combined

cash flows by adding their values today.
$10.000
= $6.209
1,105
The present value of both cash flows is $11.209.
You can calculate the future value of the combined cash

flows by adding their values in year 5.
$5.000 ∗ 1,105 = $8.053
The future value of both cash flows is $18.053.
3. Valuing a stream of cash flows

Based on the first rule of time travel, we can derive a general formula for valuing a stream of cash flows: if we
want to find the present value of a stream of cash flows, we simply add up the present values of each.
𝑛
𝐶𝐹𝑡
𝑃𝑉 = ∑
(1 + 𝑟)𝑡
𝑡=0
The future value of a cash flow stream with a present value:
𝐹𝑉 = 𝑃𝑉 ∗ (1 + 𝑟)𝑡
4. Calculating the net present value

Calculating the NPV of future cash flows allows us to evaluate an investment decision. Net present value
compares the present value of cash inflows (benefits) to the present value of cash outflows (costs).
𝑇
𝐶𝑡
𝑁𝑃𝑉 = ∑ − 𝐶0
(1 + 𝑟)𝑡
𝑡=0
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The present value of the benefits is:
3.000 2.000 1.000

𝑃𝑉 = + + = 5.366,91
1,05 1,05² 1,05³
The present value of the cost is $5.000, because it

occurs now.
𝑁𝑃𝑉 = 5.366,91 − 5.000 = 366,91
5. Perpetuities and annuities
A. PERPETUITIES
When a constant cash flow will occur at regular intervals
forever, it is called a perpetuity. The value of a perpetuity
is simply the cash flow divided by the interest rate.
𝐶
𝑃𝑉 (𝐶 𝑖𝑛 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦) =
𝑟
The timeline of the cash flows looks like this:
This is a perpetuity of $100.000 per year. The

funding you would give is the present value of
that perpetuity. From the formula:
$100.000
𝑃𝑉 = = $2.500.000
0,04
You would need to donate $2,5 million to endow the chair.
B. ANNUITIES
When a constant cash flow will occur at regular intervals for a finite
number of N periods, it is called an annuity.
𝑁
𝐶
𝑃𝑉 (𝐶 𝑖𝑛 𝑎𝑛𝑛𝑢𝑖𝑡𝑦) = ∑
(1 + 𝑟)𝑛
𝑛=1
To find a simpler formula, suppose you invest $100 in

a bank account paying 5% interest. As with the
perpetuity, suppose you withdraw the interest each
year. Instead of leaving the $100 in forever, you close
the account and withdraw the principal in 20 years.
You have created a 20-year annuity of $5 per year, plus you will receive your $100 back in 20 years. For the
general formula, substitute P for the principal value and:
𝑃 1
𝑃𝑉 (𝑎𝑛𝑛𝑢𝑖𝑡𝑦) = 𝑃 − = 𝑃 (1 − )
(1 + 𝑟)𝑁 (1 + 𝑟)𝑁
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𝐶 1 1
𝐹𝑉 (𝑎𝑛𝑛𝑢𝑖𝑡𝑦) = (1 − 𝑁
) ∗ (1 + 𝑟)𝑁 = 𝐶 ∗ ∗ [(1 + 𝑟)𝑛 − 1]
𝑟 (1 + 𝑟) 𝑟
C. GROWING CASH FLOWS

I. Growing perpetuity
Assume you expect the amount of your perpetual

payment to increase at a constant rate, g.
𝐶
𝑃𝑉 (𝑔𝑟𝑜𝑤𝑖𝑛𝑔 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦) =
𝑟−𝑔
The cost of the endowment will start at $100.000 and

increase by 2% each year. This is a growing perpetuity.
$100.000
𝑃𝑉 = = $5.000.000
0,04 − 0,02
You would need to donate $5 million to endow the chair.
II. Growing annuity
The present value of a growing annuity with the initial cash flow, the growth rate and interest rate, is defined as:
𝐶 1+𝑔 𝑁
𝑃𝑉 = ∗ (1 − ( ) )
𝑟−𝑔 1+𝑟
The present value of the series of deposits is:
$12.000 1 + 0,03 45
𝑃𝑉 = ∗ (1 − ( ) )
0,08 − 0,03 1 + 0,08
= $211.567
The future value of the series of deposits is:
𝐹𝑉 = $211.567 ∗ (1,08)45 = $6.753.314
6. Non-annual cash flows

The same time value of money concepts apply if the cash flows occur at intervals other than annually. The interest
and number of periods must be adjusted to reflect the new time period.
7. Solving for the cash payments

Sometimes we know the present value or the future value, but we do not know one of the variables we have
previously been given as an input. For example, when you take out a loan, you may know the amount you would
like to borrow but may not know the loan payments that will be required to repay it.
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𝑃
𝐶=
1 1
∗ (1 − )
𝑟 (1 + 𝑟)𝑁
8. The internal rate of return

In some situations, you know the present value and cash flows of an investment opportunity, but you do not
know the internal rate of return (IRR), the interest rate that sets the net present value of the cash flows equal to
zero.
9. Solving for the number of periods

In addition to solving for cash flows or interest rate, we can solve for the amount of time it will take a sum of
money to grow, to a known value.
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CHAPTER 5: INTEREST RATES
As many different interest rates as there are different loans.
Irvin Fisher (1867-1947): if interests vary, projects become more attractive.
★ Impatience to consume
★ Attractivity of other projects (the opportunity cost of capital)
William Sharpe (1934-…) worked on:
★ Offer and demand

★ Economic growth
★ Inflation
★ Risk of borrower
𝑟 = 𝑟𝑓 + 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
1. The determinants of interest rates

The nominal interest rate is the rate quoted by financial institutions and used for discounting or compounding
cash flows.
Real interest rate is the rate of growth of your purchasing power, after adjusting for inflation.
1 + 𝑟 𝑔𝑟𝑜𝑤𝑡ℎ 𝑜𝑓 𝑚𝑜𝑛𝑒𝑦
𝐺𝑟𝑜𝑤𝑡ℎ 𝑖𝑛 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑖𝑛𝑔 𝑝𝑜𝑤𝑒𝑟 = =
1+𝑖 𝑔𝑟𝑜𝑤𝑡ℎ 𝑜𝑓 𝑝𝑟𝑖𝑐𝑒𝑠
𝑟−𝑖
𝑟𝑟 = ≈𝑟−𝑖
1+𝑖
0,0065−0,0070
𝑟𝑟 = = −0,00049652
1+0,0070
There is a relationship between the nominal interest rate

and the inflation rate, during some periods. There is the
internet bubble in 2001, and therefore we can see that the
inflation rate increases. In 2008, we have an inverse
relationship between the nominal interest rate and
inflation rate.
Interest rate is going to influence our investments. The

present value goes down when interest rate increases.
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2. Investment and interest rate policy

An increase in interest rates will typically reduce the NPV of an investment.
Consider an investment that requires an initial investment of $10 million and generates a cash flow of $3 million
per year for four years. If the interest rate is 5%, the investment has an NPV of:
3 3 3 3
𝑁𝑃𝑉 = −10 + + 2
+ 3
+ = $0,638 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
1,05 1,05 1,05 1,054
If the interest rate rises to 9%, the NPV becomes negative and, the investment is no longer profitable:
3 3 3 3
𝑁𝑃𝑉 = −10 + + 2
+ 3
+ = − $0,281 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
1,09 1,09 1,09 1,094
3. The yield curve and discount rates

Term structure is the relationship between the investment term and the interest rate. The yield curve is a graph
of the term structure.
Investors think that interest rates are

going to increase in the future. Then,
they won’t be interested in long term
investments. Rates for long term are
lower. If we expect high future rates,
than we should wait. If we expect low
future rates, we have to invest now.
The term structure can be used to compute the present and future values of a risk-free cash flow over different
investment horizons.
𝐶𝑛
𝑃𝑉 =
(1 + 𝑟𝑛 )𝑛
The present value of a cash flow stream using a term structure of discount rates is defined as:
𝑁
𝐶𝑛
𝑃𝑉 = ∑
(1 + 𝑟𝑛 )𝑛
𝑛=1
$500 $500 $500

𝑃𝑉 = + + = $1.473,34
1,00261 1,00723² 1,01244³
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4. The yield curve and the economy

The Federal Reserve determines very short-term interest rates through its influence on the federal funds rate,
which is the rate at which banks can borrow cash reserves on an overnight basis.
All other interest rates on the yield curve are set in the market and are adjusted until the supply of lending
matches the demand for borrowing at each loan term.
The shape of the yield curve is influenced by interest rate expectations. An inverted yield curve indicates that
interest rates are expected to decline in the future. Because interest rates tend to fall in response to an economic
slowdown, an inverted yield curve is often interpreted as a negative forecast for economic growth.
Each of the last six recessions in the

United States was preceded by a
period in which the yield curve was
inverted. The yield curve tends to be
sharply increasing as the economy
comes out of a recession, and interest
rates are expected to rise.
We are told already that the one-year rate is 3%.

To find r2, we know that if we invest $1 for one year
at the current one-year rate and then reinvest next
year at the new one-year rate, after two years, we
will earn:
𝑟2 = √(1,03 ∗ 1,02) − 1 = √$1,0506 − 1 = 2,499%
3 3
𝑟3 = √1,03 ∗ 1,02 ∗ 1,01 − 1 = √1,0611 − 1 = 1,997%
Therefore, the current yield curve has r1=3%, r2=2,499 and r3=1,997%. The yield curve is decreasing as a result of
the anticipated lower interest rates in the future.
5. Risk and taxes
A. RISK AND INTEREST RA TES

U.S. Treasury securities are considered risk-free. All other borrowers have some risk of default, so investors
require a higher rate of return.
Taxes influence the interest rate. We can’t compare because it depends from the
country where the investment is done. The interest rates depend on the risk of
investing. Risk free has very different meanings.
Government-bound would influence the risk of the country. Brexit had an impact
on risk-free rate. US election was positive for the government-bound in US.
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There are also companies which borrow money. Some companies are little
risky, but others are taking more risks. It depends on the risk on the borrowers.
For different borrowings, we have

different interest rates. Kellogg’s
has different rates because times
changes and the majority
changes. The size of the circle
equals how much Kellogg’s
borrow in an issue.
B. AFTER-TAX INTEREST RATES

Taxes reduce the amount of interest an investor can keep, and we refer to this reduced amount as the after-tax
interest rate.
𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑟 ∗ (1 + 𝑡)
6. The opportunity cost of capital

Investor’s opportunity cost of capital is the best available expected return offered in the market on an investment
of comparable risk and term to the cash flow being discounted. It is also referred to as cost of capital.
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CHAPTER 7: INVESTMENT DECISION RULES
1. NPV and Stand-alone projects

Consider a take-it-or-leave-it investment decision involving a single, stand-alone project for Frederick’s Feed and
Farm (FFF). The project costs $250 million and is expected to generate cash flows of $35 million per year, starting
at the end of the first year and lasting forever.
-250 + 35 +35
+ 35 + 35 ...
A. APPLYING THE NPV RULE

𝑐 𝐷
𝑃0 = =
𝑟 𝑟
The NPV of the project is calculated as…
35
𝑁𝑃𝑉 = −250 +
𝑟
The NPV is dependent on the discount rate. And the

discount rate is uncertain.
If FFF’s cost of capital is 10%, the NPV is $100 million

and they should undertake the investment.
B. ALTERNATIVE RULES VE RSUS THE NPV RULE

Sometimes alternative investment rules may give the same answer as the NPV rule, but at other times they may
disagree. When the rules conflict, the NPV decision rule should be followed.
2. The internal rate of return rule

The IRR is the rate that makes our future cash flows at present value equal to 0. Take any investment where the
IRR exceeds the cost of capital. Turn down any investment whose IRR is less than the cost of capital.
The IRR investment rule will give the same answer as the NPV rule in many, but not all, situations. In general, the
IRR rule works for a stand-alone project if all of the project’s negative cash flows precede its positive cash flows.
In figure 7.1, whenever the cost of capital is below the IRR of 14%, the project has a positive NOV and you should
undertake the investment.
In other cases, the IRR may disagree with the NPV rule and thus be incorrect. Situations where the IRR rule and
NPV rule may be in conflict are:
★ Delayed Investments
★ Multiple IRRs
★ Non-existent IRR
A. DELAYED INVESTMENTS
We have a delayed investment when the negative cash flow is not at time 0.
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Assume you have just retired as a CEO of a successful company. A major publisher has offered you a book deal.
The publisher will pay you $1 million upfront if you agree to write a book about your experiences. You estimate
that it will take three years to write the book. The time you spend writing will cause you to give up speaking
engagements amounting to $500.000 per year. You estimate your opportunity cost to be 10%. Should you accept
the deal?
+ 1MM - 500 ...
- 500 - 500
Calculate the IRR:
The IRR is greater than the cost of capital. Thus

the IRR rule indicates you should accept the
deal.
Since the NPV is negative, the NPV rule

indicates that you should reject the deal. The
project destroys value. The IRR gives us a
wrong context. Here, the negative cash flow is
at the end, and not at the beginning. Therefore,
we need to take the discount rate which are
bigger than the IRR.
When the benefits of an investment occur before the costs,

the NPV is an increasing function of the discount rate.
B. MULTIPLE IRR’S
Suppose Star informs the publisher that it needs to sweeten the deal before he will accept it. The publisher offers
$550.000 in advance and $1.000.000 in four years when the book is published. Should he accept or reject the
new offer?
The NPV is calculated as:
500 500 500 1.000

𝑁𝑃𝑉 = 550 − − − +
1 + 𝑟 (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)4
By setting the NPV equal to zero and solving for r, we find the IRR. In this case, there are two IRR’s: 7,164% and
33,673%. Because there is more than one IRR, the IRR rule cannot be applied.
Between 7,164% and 33,673%, the book deal

has a negative NPV. Since your opportunity cost
of capital is 10%, you should reject the deal.
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C. NON-EXISTENT IRR
Finally, Star is able to get the publisher increase his advance to $750.000, in addition to the $1 million when the
book is published in four years. With these cash flows, no IRR exists. There is no discount rate that makes the
NPV equal to zero.
No IRR exists because the NPV is positive for

all values of the discount rate. Thus the IRR
rule cannot be used.
D. IRR VERSUS THE IRR R ULE

While the IRR has shortcomings for making investment decisions, the IRR itself remains useful. IRR measures the
average return of the investment and the sensitivity of the NPV to any estimation error in the cost of capital.
While the IRR rule works for project A, it fails

for each of the other projects.
3. The payback rule

The payback period is the amount of time it takes to recover or pay back the initial investment. If the payback
period is less than a pre-specified length of time, you accept the project. Otherwise, you reject the project. The
payback rule is used by many companies because of its simplicity.
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$80
★ 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝐴 = = 3,2 𝑦𝑒𝑎𝑟𝑠
$25
$120
★ 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝐵 = = 4 𝑦𝑒𝑎𝑟𝑠
$30
$150
★ 𝑃𝑟𝑜𝑗𝑒𝑐𝑡 𝐶 = = 4,29 𝑦𝑒𝑎𝑟𝑠
$35
A. PITFALLS
★ Ignores the project’s cost of capital and time value of money
★ Ignores cash flows after the payback period
★ Relies on an ad hoc decision criterion
4. Choosing between projects
A. MUTUALLY EXCLUSIVE PROJECTS

When you must choose only one project among several possible projects, the choice is mutually exclusive.
★ NPV rule: Select the project with the highest NPV

★ IRR rule: Selecting the project with the highest IRR may lead to mistakes.
Assuming each business lasts indefinitely, we can

compute the present value of the cash flows from
each as a constant growth perpetuity.
All the alternatives have a positive NPV. But because

we can only choose one, the clothing store is the
best alternative.
$55.000
𝑁𝑃𝑉 (𝐷𝑎𝑡𝑖𝑛𝑔 𝐴𝑝𝑝) = −$250.000 + = $1.583.333
0,07 − 0,04
$75.000
𝑁𝑃𝑉 (𝐺𝑟𝑒𝑒𝑛 𝐸𝑛𝑒𝑟𝑔𝑦) = −$350.000 + = $1.525.000
0,08 − 0,04
$120.000
𝑁𝑃𝑉 (𝑊𝑎𝑡𝑒𝑟 𝑃𝑢𝑟𝑖𝑓𝑖𝑐𝑎𝑡𝑖𝑜𝑛) = −$400.000 + = $2.600.000
0,08 − 0,05
$125.000
𝑁𝑃𝑉 (𝑆𝑚𝑎𝑟𝑡 𝐶𝑙𝑜𝑡ℎ𝑒𝑠) = −$500.000 + = $2.625.000
0,12 − 0,08
B. DIFFERENCES IN SCALE
If a project’s size is doubled, its NPV will double. This is not the case with IRR. Thus, the IRR rule cannot be used
to compare projects of different scales.
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C. TIMING OF CASH FLO WS

Another problem with the IRR is that it can be affected by changing the timing of the cash flows, even when the
scale is the same. IRR is a return, but the dollar value of earning a given return depends on how long the return
is earned.
5. Project selection with resource constraints

Evaluation of projects with different
resource constraints. Consider
three possible projects with a $100
million budget constraint.
A. PROFITABILITY INDEX
The profitability index can be used to identify the optimal combination of projects to undertake.
𝑉𝑎𝑙𝑢𝑒 𝑐𝑟𝑒𝑎𝑡𝑒𝑑 𝑁𝑃𝑉

𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑖𝑛𝑑𝑒𝑥 = =
𝑅𝑒𝑠𝑜𝑢𝑟𝑐𝑒 𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑑 𝑅𝑒𝑠𝑜𝑢𝑟𝑐𝑒 𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑑
From table 7.1, we can see it is better to take projects II & III together and forgo project I.
Compute the profitability index for each project. And

then, rank order them by profitability index and see how
many projects you can have before you run out of space.
Project NPV Square feet Profitability Index Cumulative total

needed space used
Project 5 12,000 1,000 12,0 1.000
Project 2 88,000 30,000 2,93 31.000
Project 1 100,000 40,000 2,5 71.000
Project 3 80,000 38,000 2,1
Project 4 50,000 24,000 2,08
Total 330,000 133,000
B. SHORTCOMINGS OF THE PROFITABILITY INDEX

In some situations, the profitability index does not give an accurate answer. With multiple resource constraints,
the profitability index can break down completely.
In the previous example, project 4 is not selected. Its profitability index is 2,08 so this project would appear at
the bottom of the ranking. However, 29.000 square meters are not being used after the first 3 projects are
selected. As a result, it would make sense to take on this project even though it would be ranked as last.
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CHAPTER 8: FUNDAMENTALS OF CAPITAL BUDGETING
1. Forecasting earnings
The capital budget lists the investments that a company plans to undertake. The capital budgeting is the process
used to analyse alternate investments and decide which ones to accept. The incremental earnings are the
amount by which the firm’s earnings are expected to change as a result of the investment decision.
A. REVENUES AND COST ESTIMATES

Linksys has completed a $300.000 feasibility study to assess the attractiveness of a new product, HomeNet. The
project has an estimated life of four years. The revenue estimates are (= p x q):
★ Sales = 100.000 units per year (=q)

★ Per unit price = $260 (=p)
The cost estimates are:
★ Up-front R&D = $15.000.000

★ Up-front new equipment = $7.500.000
→ Expected life of the new equipment is 5 years
→ Housed in existing lab
★ Annual overhead = $2.800.000 (costs that we have for the whole company, not linked with the fact they
have started a new project)
★ Per unit cost = $110 (cost of production)
Revenues – Cost of goods sold = Operating expenditures
B. INCREMENTAL EARNINGS FORECAST
price * quantity
cost * quantity
Sales – COGS
Fixed costs when sales
First important line for t=0
Depreciation
Taxes! Even for t=0
We speak about unlevered net income, because we don’t take into account the fact that the company has debts.
C. CAPITAL EXPENDITURES AND DEPRECIATION

The $7,5 million in new equipment is a cash expense, but it is not directly listed as an expense when calculating
earnings. Instead, the firm deducts a fraction of the cost of these items each year as a depreciation.
The straight line depreciation is the asset’s costs divided equally over its life.
$7,5 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = $1,5 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
5 𝑦𝑒𝑎𝑟𝑠
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D. INTEREST EXPENSE ( SHOULD COME AFTER THE EBIT)

In capital budgeting decisions, interest expense is typically not included. The rational is that the project should
be judged on its own, not on how it will be financed.
E. TAXES ( SHOULD COME AFTER THE EBIT)

The marginal corporate tax rate is the tax rate on the marginal or incremental dollar of pre-tax income. A negative
tax is equal to a tax credit.
𝐼𝑛𝑐𝑜𝑚𝑒 𝑡𝑎𝑥 = 𝐸𝐵𝐼𝑇 ∗ 𝑡
The unlevered net income is the last line of the income statement.
𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 = 𝐸𝐵𝐼𝑇 ∗ (1 − 𝑡𝑎𝑥) = (𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝐶𝑜𝑠𝑡𝑠 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) ∗ (1 − 𝑡𝑎𝑥)
We can use both calculations, depending on where we begin in our income statement.
F. INDIRECT EFFECTS ON INCREMENTAL EARNINGS

I. Opportunity cost
The opportunity cost is the value a resource could have provided in its best alternative use. In the HomeNet
project example, space will be required for the investment. Even though the equipment will be housed in an
existing lab, the opportunity cost of not using the space in an alternative way must be considered.
II. Project externalities
The project externalities are the indirect effect of the project that may affect the profits of other business
activities of the firm. The cannibalization is when sales of a new product displaces sales of an existing product.
In the HomeNet project example, 25% of sales come from customers who would have purchased an existing
Linksys wireless router if HomeNet were not available. Because this reduction in sales of the existing wireless
router is a consequence of the decision to develop HomeNet, we must include it when calculating HomeNet’s
incremental earnings. It is going to impact sales, but also the COGS in a negative way.
G. SUNK COSTS AND INCRE MENTAL EARNINGS

Sunk costs are costs that have been or will be paid regardless of the decision whether or not the investment is
undertaken. Sunk costs should not be included in incremental earnings analysis.
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I. Fixed overhead expenses
Typically, overhead costs are fixed and not incremental to the project and should not be included in the
calculation of incremental earnings.
II. Past research and development expenditures
Money that has already been spent on R&D is a sunk cost and therefore is irrelevant. The decision to continue
or abandon a project should be based only on the incremental costs and benefits of the product going forward.
It doesn’t affect future cash flow.
III. Unavoidable competitive effects
When developing a new product, firms may be concerned about the cannibalization of existing products.
However, if sales are likely to decline in any case as a result of new products introduced by competitors, then
these lost sales should be considered as a sunk cost.
H. REAL-WORLD COMPLEXITIES
Typically,
★ Sales will change from year to year.

★ The average selling price will vary over time.
★ The average cost per unit will change over time.
2. Determining free cash flow and NPV

The incremental effect of a project on a firm’s available cash is its free cash flow.
A. CALCULATING THE FREE CASH FLOW FROM EARNINGS

I. Capital expenditures and depreciation
Capital expenditures are the actual cash outflows when an asset is purchased. These cash outflows are included
in calculating free cash flow. Depreciation is a non-cash expense. The free cash flow estimate is adjusted for this
non-cash expense.
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II. Net working capital (NWC)
𝑁𝑒𝑡 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

= 𝑐𝑎𝑠ℎ + 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 − 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠
Most projects will require an investment in net working capital. Trade credit is the difference between
receivables and payables. The increase in net working capital is defined as:
∆𝑁𝑊𝐶𝑡 = 𝑁𝑊𝐶𝑡 − 𝑁𝑊𝐶𝑡−1
∆𝑁𝑊𝐶 = 𝑌𝑛 − 𝑌𝑛−1
Pay attention to the year after the calculations. Here,

year 5 is: 0-765.
B. CALCULATING FREE CAS H FLOW DIRECTLY

𝐹𝑟𝑒𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 = 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝐸𝑥 − ∆𝑁𝑊𝐶
𝐹𝑟𝑒𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 = ((𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝑐𝑜𝑠𝑡𝑠) ∗ (1 − 𝑡)) − 𝐶𝑎𝑝𝐸𝑥 − ∆𝑁𝑊𝐶 + (𝑡 ∗ 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛)
The unlevered net income is the last line of the income statement. The term t * depreciation is called the
depreciation tax shield.
C. CALCULATING THE NPV

𝐹𝐶𝐹𝑡 1
𝑃𝑉 (𝐹𝐶𝐹𝑡 ) = 𝑡
= 𝐹𝐶𝐹𝑡 ∗
(1 + 𝑟) (1 + 𝑟)𝑡
3. Choosing among alternatives

Launching the HomeNet project produces a positive NPV, while not launching the project produces a 0 NPV.
A. EVALUATING MANUFACTURING ALTERNATIVES

In the HomeNet example, assume the company could produce each unit in-house for $95 if it spends $5 million
upfront to change the assembly facility (versus $110 per unit if outsourced). The in-house manufacturing method
would also require an additional investment in inventory equal to one month’s worth of production.
I. Outsource
★ Cost per unit = $110

★ Investment in accounts payable = 15% of COGS
→ COGS = 100.000 units * $110 = $11 million
→ Investment in A/P = 15% * $11 million = 1,65 million
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→ ∆NWC = -$1,65 million in Year 1 and will increase by $1,65 million in year 5
→ NWC falls since this A/P is financed by suppliers.
II. In-house
★ Cost per unit = $95

★ Up-front cost of $5.000.000
★ Investment in A/P = 15% of COGS
→ COGS = 100.000 units * $95 = $9,5 million
→ Investment in A/P = 15% * $9,5 million = $1,425 million
→ Investment in inventory = $9,5 million / 12 = $0,792 million
→ ∆NWC in year 1 = $0,792 million - $1,425 million = -$0,633 million
→ NWC will fall by $0,633 million in year 1 and increase by $0,633 million in year 5.
III. Comparing free cash flows cisco’s alternatives
It changes the EBIT and the unlevered net income in the two options. So we have a different free cash flow and
then, a different NPV. We have two negative NPV, so that means that those are two bad projects, because the
only thing we calculate here is the cost. Of course, we have two negative NPV. They have to be added to the
whole NPV of the whole project. Outsourcing is the less expensive alternative.
4. Further adjustments to free cash flow
A. OTHER NON-CASH ITEMS

Amortization
B. TIMING OF CASH FLOWS

Cash flows are often spread throughout the year. In a company, we often pretend that everything is done at the
end of the year, however, it is normally spread throughout the year. But we live with that.
C. ACCELERATED DEPRECIA TION

Modified accelerated cost recovery system (MACRS) depreciation. This is an hypothesis, because we don’t know
the future.
D. LIQUIDATION OR SALVA GE VALUE

𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛 = 𝑆𝑎𝑙𝑒 𝑝𝑟𝑖𝑐𝑒 − 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 = 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒 − 𝑎𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑓𝑟𝑜𝑚 𝑎𝑠𝑠𝑒𝑡 𝑠𝑎𝑙𝑒 = 𝑠𝑎𝑙𝑒 𝑝𝑟𝑖𝑐𝑒 − (𝑡𝑎𝑥 ∗ 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛)
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Sales – COGS = Gross profit

- Expenses = EBITDA
- Depreciation = EBIT
- Taxes = Unlevered net income
+ Depreciation – CAPEX - ∆NWC = Free Cash Flow
If the equipment is kept, the firm will have

$200.000 of additional depreciation, which will
reduce the firm’s taxable income by $200.000.
With a 34% marginal tax rate, this will reduce the
firm’s taxes by $200.000 * 34% = $68.000. Because
the firm will pay $68.000 less in taxes, free cash
flow will increase by the same amount for the year.
If the equipment is sold, the firm receive $1 million

in cash but will have to pay taxes on the gain above
the book value, $1 million - $200.000 = $800.000. The taxes due on the sale will be $800.000 * 34% = $272.000.
Thus, the firm’s free cash flow will increase by $1.000.000 - $272.000 = $728.000 for the year.
E. TERMINAL OR CONTINUA TION VALUE

This amount represents the market value of the free cash flow from the project at all future dates.
A big part of the NPV is going to be dependent on the

continuation value, which represents a lot.
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5. Analysing the project

The break-even level of an input is the level that causes the NPV of the investment to equal zero.
The EBIT break-even of sales is the level of sales where the EBIT equals zero.
A. SENSITIVITY ANALYSIS
The sensitivity analysis shows how the NPV varies with a change in one of the assumptions, holding the other
assumptions constant.
B. SCENARIO ANALYSIS
The scenario analysis considers the effect on the NPV of simultaneously changing multiple assumptions.
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CHAPTER 9: VALUING STOCKS
The value of a stock is the expected value of future cash flows that the investors will receive.
1. The dividend discount model (DDM)
A. A ONE-YEAR INVESTOR
Potential cash flows:
★ Dividend
★ Sale of stock
Timeline for a one-year investor:
Since the cash flows are risky, we must discount them at the equity cost of capital.
𝐷𝑖𝑣1 + 𝑃1
𝑃0 =
1 + 𝑟𝐸
If the current stock price were less than this amount, expect investors to rush in and buy it, driving up the stock’s
price. If the stock price exceeded this amount, selling it would cause the stock price to quickly fall.
B. DIVIDEND YIELDS, CAPITAL GAINS AND TOTAL RETURNS

𝐷𝑖𝑣1 + 𝑃1 𝐷𝑖𝑣1 𝑃1 − 𝑃0
𝑟𝐸 = −1= + = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛 𝑟𝑎𝑡𝑒
𝑃0 𝑃0 𝑃0
The expected total return of the stock should equal the expected return of other investments available in the
market with equivalent risk.
$1,92 + $85
𝑃0 = = $78,31
1 + 0,11
$1,92
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 = = 2,45%
$78,31
$85 − $78,31
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠 𝑌𝑖𝑒𝑙𝑑 = = 8,54%
$78,31
𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛 = 2,45% + 8,54% = 10,99%
C. A MULTI-YEAR INVESTOR
What is the price if we plan on holding the stock for two years?
𝐷𝑖𝑣1 𝐷𝑖𝑣2 + 𝑃2
𝑃0 = +
1 + 𝑟𝐸 (1 + 𝑟𝐸 )2
D. THE DIVIDEND-DISCOUNT MODEL EQUATION

What is the price if we plan on holding the stock for N years?
𝐷𝑖𝑣1 𝐷𝑖𝑣2 𝐷𝑖𝑣𝑁 + 𝑃𝑁

𝑃0 = + 2
+⋯+
1 + 𝑟𝐸 (1 + 𝑟𝐸 ) (1 + 𝑟𝐸 )𝑁
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This is known as the Dividend Discount Model. Note that the above equation holds for any horizon N. Thus all
investors (with the same beliefs) will attach the same value to the stock, independent of their investment
horizons.
∞
𝐷𝑖𝑣𝑛
𝑃0 = ∑
(1 + 𝑟𝐸 )𝑛
𝑛=1
The price of any stock is equal to the present value of the expected future dividends it will pay.
2. Applying the Discount Dividend Model
A. CONSTANT DIVIDEND GR OWTH

The simplest forecast for the firm’s future
dividends states that they will grow at a constant
rate g, forever.
𝐷𝑖𝑣1
𝑃0 =
𝑟𝐸 − 𝑔
𝐷𝑖𝑣1
𝑟𝐸 = +𝑔
𝑃0
The value of the firm depends on the current dividend level, the cost of equity and the growth rate.
$1,44
𝑃0 = = $36
0,08 − 0,04
B. DIVIDENDS VERSUS INVESTMENT AND GROWTH

I. Simple model of growth
The dividend pay-out ratio is the fraction of earnings paid as dividends each year.
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠𝑡
𝐷𝑖𝑣𝑡 = ∗ 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑒𝑡
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔𝑡
Assuming the number of shares outstanding is constant, the firm can do two things to increase its dividend:
★ Increase its earnings (net income)

★ Increase its dividend pay-out rate
A firm can do one of two things with its earnings:
★ It can pay they out to investors,

★ It can retain and reinvest them.
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = 𝑁𝑒𝑤 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 ∗ 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑛𝑒𝑤 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
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𝑁𝑒𝑤 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 ∗ 𝑟𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒
The retention rate is the fraction of current earnings that the firm retains.
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 = = 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 ∗ 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑛𝑒𝑤 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠
If the firm keeps its retention rate constant, then the growth rate in dividends will equal the growth rate of
earnings.
C. PROFITABLE GROWTH
If a firm wants to increase its share price, should it cut its dividend and invest more, or should it cut investment
and increase its dividend? The answer will depend on the profitability of the firm’s investments.
Cutting the firm’s dividend to increase investment will raise the stock price if, and only if, the new investments
have a positive NPV.
First, calculate the current price for Dren if they do

not introduce the new product. To calculate the
price, D1 is needed.
𝐸𝑃𝑆1 = 𝐸𝑃𝑆0 ∗ (1 + 𝑔) = $5 ∗ 1,05 = $5,25
𝐷1 = 𝐸𝑃𝑆1 ∗ 𝑃𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 = $5,25 ∗ 0,8 = $4,2
𝐷1 $4,2
𝑃0 = = = $70
𝑟𝐸 − 𝑔 0,11 − 0,05
Thus, the current price without the new product should be $70 per share. Next, calculate the expected current
price for Dren if they introduce the new product.
𝐸𝑃𝑆1 = 𝐸𝑃𝑆0 ∗ (1 + 𝑔) = $5 ∗ 1,07 = $5,35
𝐷1 = 𝐸𝑃𝑆1 ∗ 𝑃𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 = $5,35 ∗ 0,5 = $2,675
𝐷1 $2,675
𝑃0 = = = $66,875
𝑟𝐸 − 𝑔 0,11 − 0,07
Thus, the current price is expected to fall from $70 to $66,875 if the new product line is introduced.
D. CHANGING GROWTH RATES

We cannot use the constant dividend growth model to value a stock if the growth rate is not constant. For
example, young firms often have a very high initial earnings growth rates. During this period of high growth,
these firms often retain 100% of their earnings to exploit profitable investment opportunities. As they mature,
their growth slows. At some point, their earnings exceed their investment needs and they begin to pay dividends.
Although we cannot use the constant dividend growth model directly when growth is not constant, we can use
the general form of the model to value a firm by applying the constant growth model to calculate the future
share price of the stock once the expected growth rate stabilizes.
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𝐷𝑖𝑣𝑁+1
𝑃𝑁 =
𝑟𝐸 − 𝑔
𝐷𝑖𝑣1 𝐷𝑖𝑣2 𝐷𝑖𝑣𝑁 1 𝐷𝑖𝑣𝑁+1

𝑃0 = + + ⋯+ 𝑁
+ 𝑁
∗
1 + 𝑟𝐸 (1 + 𝑟𝐸 )² (1 + 𝑟𝐸 ) (1 + 𝑟𝐸 ) 𝑟𝐸 − 𝑔
E. LIMITATIONS OF THE DIVIDEND-DISCOUNT MODEL

There is tremendous amount of uncertainty associated with forecasting a firm’s dividend growth rate and future
dividends. Small changes in the assumed dividend growth rate can lead to large changes in the estimated stock
price.
3. Total pay-out and free cash flow valuation models

The share repurchase is when the firm uses excess cash to buy back its own stock. The more cash the firm uses
to repurchase shares, the less it has available to pay dividends. By repurchasing, the firm decreases the number
of shares outstanding which increases its earnings and dividends per share.
𝑃𝑉0 = 𝑃𝑉 (𝑓𝑢𝑡𝑢𝑟𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒)
𝑃𝑉 (𝐹𝑢𝑡𝑢𝑟𝑒 𝑡𝑜𝑡𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑎𝑛𝑑 𝑟𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠)

𝑃𝑉0 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔0
It values all the firm’s equity, rather than a single share. You discount total dividends and share repurchases and
use the growth rate of earnings (rather than earnings per share) when forecasting the growth of the firm’s total
payments.
A. DISCOUNTED FREE CASH FLOW MODEL

It determines the value of the firm to all investors, including both equity and debt holders.
𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝐷𝑒𝑏𝑡 − 𝐶𝑎𝑠ℎ
The enterprise value can be interpreted as the net cost of acquiring the firm’s equity, taking its cash, paying off
all debt and owing the unlevered business.
I. Valuing the enterprise
𝐹𝑟𝑒𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 = 𝐸𝐵𝐼𝑇 ∗ (1 − 𝑡𝑎𝑥) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝐸𝑥 − ∆𝑁𝑊𝐶
The free cash flow is the cash flow available to pay both debt holders and equity holders.
𝑉0 = 𝑃𝑉 (𝐹𝑢𝑡𝑢𝑟𝑒 𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑜𝑓 𝐹𝑖𝑟𝑚)
𝑉0 + 𝐶𝑎𝑠ℎ0 − 𝐷𝑒𝑏𝑡0
𝑃0 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔0
II. Implementing the model
Since we are discounting cash flows to both equity holders and debt holders, the free cash flows should be
discounted at the firm’s weighted average cost of capital, rWACC. If the firm has no debt, rWACC = rE.
𝐹𝐶𝐹1 𝐹𝐶𝐹2 𝐹𝐶𝐹𝑁 𝑉𝑁

𝑉0 = + 2
+ ⋯+ 𝑁
+
1 + 𝑟𝑊𝐴𝐶𝐶 (1 + 𝑟𝑊𝐴𝐶𝐶 ) (1 + 𝑟𝑊𝐴𝐶𝐶 ) (1 + 𝑟𝑊𝐴𝐶𝐶 )𝑁
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Often, the terminal value is estimated by assuming a constant long-run growth rate gFCF for free cash flows
beyond year N, so that:
𝐹𝐶𝐹𝑁+1 1 + 𝑔𝐹𝐶𝐹
𝑉𝑁 = =( ) ∗ 𝐹𝐶𝐹𝑁
𝑟𝑊𝐴𝐶𝐶 − 𝑔𝐹𝐶𝐹 𝑟𝑊𝐴𝐶𝐶 − 𝑔𝐹𝐶𝐹
Growth in sales: 9%  4%
EBIT = 9% *
∆NWC = 10% * ∆sales
CAPEX – depreciation = 8% * ∆sales
Taxes = 37%
WACC = 11%
FCF = EBIT (1-t) – (CAPEX – Depreciation) - ∆NWC
FCF1=[9%*∆Sales]*(1-37%)–(8%*∆Sales)–(10%*∆Sales)
(1 + 4%) ∗ 𝐹𝐶𝐹2011
𝑉2011 =
11% − 4%
𝐹𝐶𝐹1 𝐹𝐶𝐹2 𝐹𝐶𝐹3 𝐹𝐶𝐹4

𝑉0 = + + +
1,11 1,112 1,113 1,114
III. Connection to capital budgeting
The firm’s free cash flow is equal to the sum of the free cash flows from the firm’s current and future investments,
so we can interpret the firm’s enterprise value as the total NPV that the firm will earn from continuing its existing
projects and initiating new ones. The NPV of any individual project represents its contribution to the firm’s
enterprise value. To maximize the firm’s share price, we should accept projects that have a positive NPV.
IV. Comparison of discounted cash flow models of stock valuation
RE
RE
RWACC
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4. Valuation based on comparable firms

The method of comparables estimates the value of the firm based on the value of other, comparable firms or
investments that we expect will generate very similar cash flows in the future. (Example: If we want to sell the
building of ICHEC, at what price do we need to sell it? We compare with other building of the same genre.)
A. VALUATION MULTIPLES
A valuation multiple is a ratio of firm’s value to some measure of the firm’s scale or cash flow.
★ The price earnings ratio (P/E ratio) is the share price divided by earnings per share.
★ The trailing earnings are the earnings over the last 12 months.
★ The forward earnings are the expected earnings over the next 12 months.
𝐷𝑖𝑣1
𝑃0 𝐸𝑃𝑆1 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜
𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑝𝑟𝑖𝑐𝑒 𝑒𝑎𝑟𝑛𝑖𝑔 = = =
𝐸𝑃𝑆𝑡 𝑟𝐸 − 𝑔 𝑟𝐸 − 𝑔
Firms which high growth rates and which generate cash well in excess of their investment needs so that they can
maintain high pay-out rates, should have high price earnings multiples.
The share price for Best Buy is estimated by multiplying

its earnings per share by the price earning of
comparable firms.
𝑃0 = $2,22 ∗ 19,7 = $43,73
I. Enterprise value multiples
𝐹𝐶𝐹1
𝑉0 𝐸𝐵𝐼𝑇𝐷𝐴1
=
𝐸𝐵𝐼𝑇𝐷𝐴𝑡 𝑟𝑊𝐴𝐶𝐶 − 𝑔𝐹𝐶𝐹
This valuation multiple is higher for firms with high growth rates and low capital requirements (so that free cash
flow is high in proportion with EBITDA).
𝑉0 = 𝐸𝑞𝑉 + (𝑑𝑒𝑏𝑡 − 𝑐𝑎𝑠ℎ)
𝑉0 − (𝑑𝑒𝑏𝑡 − 𝑐𝑎𝑠ℎ)
𝑃0 =
#𝑠ℎ𝑎𝑟𝑒𝑠
Using the enterprise value to EBITDA multiple, Best

Buy’s enterprise value is $2,766 million * 7,7 =
$21.298,20 million.
Subtract out the debt, add the cash and divide by the
number of shares to estimate the Best Buy’s share
price.
$21.298,2 − $1.963 + $509

𝑃0 = = $48,40
410
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II. Other multiples
★ Multiple of sales
★ Price to book value of equity per share
★ Enterprise value per subscriber (which is used in cable TV industry)
B. LIMITATIONS OF MULTIPLES
When valuing a firm using multiples, there is no clear guidance about how to adjust for differences in expected
future growth rates, risk or differences in accounting policies.
Comparables only provide information regarding the value of a firm relative to other firms in the comparison set.
Using multiples will not help us determine if an entire industry is overvalued.
C. COMPARISON WITH DISC OUNTED CASH FLOW MET HODS

Discounted cash flows methods have the advantage that they can incorporate specific information about the
firm’s cost of capital or future growth. The discounted cash flow methods have the potential to be more accurate
than the use of a valuation multiple.
D. STOCK VALUATION TECH NIQUES: THE FINAL WO RD

No single technique provides a final answer regarding a stock’s true value. All approaches require assumptions
or forecasts that are too uncertain to provide a definitive assessment of the firm’s value. Most real-world
practitioners use a combination of these approaches and gain confidence if the results are consistent across a
variety of methods.
5. Information, competition and stock prices
A. INFORMATION IN STOCK PRICES

Our valuation model links the firm’s future cash flows, its cost of
capital and its share price. Given accurate information about any
two of these variables, a valuation model allows us to make
inferences about the third variable.
For a publicly traded firm, its current stock price should already provide very accurate information, aggregated
from a multitude of investors, regarding the true value of its shares. Based on its current stock price, a valuation
model will tell us something about the firm’s future cash flows or cost of capital.
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If we apply the constant dividend growth model

based on a 3% growth rate, we would estimate
$3,50
a stock price of 𝑃0 = = $38,89 per
0,12−0,03
share.
The market price of $45, however, implies that

most investors expect dividends to grow at a
somewhat faster rate.
If we continue to assume a constant growth rate, we can solve for the growth rate consistent with the current
market price, using Eq.9.7:
𝐷𝑖𝑣1 $3,5
𝑔 = 𝑟𝐸 − = 12% − = 4,22%
𝑃0 $45
Thus, given this market price for the stock, we should increase our expectations for the dividend growth rate
unless we have very strong reasons to trust our own estimate.
B. EFFICIENT MARKETS HYPOTHESIS

Efficient market hypothesis implies that securities will be fairly priced, based on their future cash flows, given all
information that is available to investors.
I. Public, easily interpretable information
If the impact of information that is available to all investors (news reports, financials statements, etc.) on the
firm’s future cash flows can be readily ascertained, then all investors can determine the effect of this information
on the firm’s value. In this situation we expect the stock price to react nearly instantaneously to such news.
II. Private or difficult-to-interpret information
Private information will be held by a relatively small number of investors. These investors may be able to profit
by trading on their information. In this case, the efficient markets hypothesis will not hold in the strict sense.
However, as these informed traders begin to trade, they will tend to move prices, so over time prices will begin
to reflect their information as well.
If the profit opportunities from having private information are large, others will devote the resources needed to
acquire it. In the long run, we should expect that the degree of inefficiency in the market will be limited by the
costs of obtaining the private information.
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C. LESSONS FOR INVESTOR S AND CORPORATE MANA GERS

I. Consequences for investors
If stocks are fairly priced, then investors who buy stocks can expect to receive future cash flows that fairly
compensate them for the risk of their investment. In such cases, the average investor can invest with confidence,
even if he is not fully informed.
II. Implications for corporate managers
★ Focus on NPV and free cash flow

★ Avoid accounting illusions
★ Use financial transactions to support investment
D. THE EFFICIENT MARKETS HYPOTHESIS VERSU S NO ARBITRAGE

The efficient markets hypothesis states that securities with equivalent risk should have the same expected
return. An arbitrage opportunity is a situation in which two securities with identical cash flows have different
prices.
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CHAPTER 10: CAPITAL MARKETS AND THE PRICING OF RISK
The essence of risk…
The first symbol is the symbol for danger, while the second is the symbol for
opportunity, making risk a mix of danger and opportunity.
1. Risk and return: Insights from 89 years of investor history

How would $100 have grown if it were placed in one of the following investments?
★ Standard & Poor’s 500: 90 U.S. stocks up to 1957 and 500 after that. Leaders in their industries and
among the largest firms traded on U.S. markets.
★ Small stocks: Securities traded on the NYSE with market capitalization in the bottom 20%.
★ World Portfolio: International stocks from all the world’s major stock markets in North America, Europe
and Asia.
★ Corporate Bonds: Long-term, AAA-rated U.S. corporate bonds with maturities of approximately 20
years.
★ Treasury bills: an investment in three-month treasury bills.
Value of $100 invested at the end of 1925:
Small stocks had the highest long-term returns,

while T-bills had the lowest long-term returns.
Small stocks had the largest fluctuations in
price, while T-bills had the lowest. Higher risk
requires a higher return.
But… Few people ever make an investment for

89 years. More realistic investment horizons
and different initial investment dates can
greatly influence each investment’s risk and
return.
Kellogg’s share price over 32 years:
What if we don’t keep the shares from 1984 until 2014?

Then, we look at the monthly return.
The average monthly return = 1,14%.
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2. Common measures of risk and return
A. PROBABILITY DISTRIBU TIONS

When an investment is risky, it may earn different returns. Each possible return has some likelihood of occurring.
This information is summarized with a probability distribution, which assigns a probability, P R, that each possible
return, R, will occur.
Assume BFI stock currently trades for $100 per share. In one year, there is a 25% chance the share price will be
$140, a 50% chance it will be $110 and & 25% chance it will be $80.
B. EXPECTED (MEAN) RETURN

It is calculated as a weighted average of the possible returns, where the weights correspond to the probabilities.
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝐸[𝑅] = ∑ 𝑃𝑅 ∗ 𝑅

𝑅
𝐸[𝑅𝐵𝐹𝐼 ] = 25% ∗ (−0,2) + 50% ∗ (0,1) + 25% ∗ (0,4) = 10%
C. VARIANCE AND STANDAR D DEVIATION

The variance is the expected squared deviation from the mean.
𝑉𝑎𝑟 (𝑅) = 𝐸[(𝑅 − 𝐸[𝑅])2 ] = ∑ 𝑃𝑅 ∗ (𝑅 − 𝐸[𝑅])2

𝑅
𝑉𝑎𝑟(𝑅𝐵𝐹𝐼 ) = 25% ∗ (−0,2 − 0,1)2 + 50% ∗ (0,1 − 0,1)2 + 25% ∗ (0,4 − 0,1)2 = 0,045
The standard deviation is the square root of the variance.
𝑆𝐷(𝑅) = √𝑉𝑎𝑟(𝑅)
𝑆𝐷(𝑅𝐵𝐹𝐼 ) = √0,045 = 21,2%
Both are measures of the risk of a probability distribution. In finance, the standard deviation of a return is also
referred to as its volatility. The standard deviation is easier to interpret because it is in the same units as the
returns themselves.
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𝐸[𝑅] = 0,25 ∗ 8% + 0,55 ∗ 10% + 0,2 ∗ 12%

= 0,02 + 0,055 + 0,024 = 0,099 = 9,9%
𝑉𝑎𝑟(𝑅) = 0,25 ∗ (8% − 9,9%)2 + 0,55 ∗ (10% − 9,9%)2

+ 0,2 ∗ (12% − 9,9%)2 = 0,000179
𝑆𝐷(𝑅) = √0,000179 = 0,011338 = 1,1338%
3. Historical returns of stocks and bonds
A. COMPUTING HISTORICAL RETURNS

The realized return is the return that actually occurs over a particular time period.
𝐷𝑖𝑣𝑡+1 + 𝑃𝑡+1 𝐷𝑖𝑣𝑡+1 𝐷𝑖𝑣𝑡+1 − 𝑃𝑡

𝑅𝑡+1 = −1= + = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛 𝑟𝑎𝑡𝑒
𝑃𝑡 𝑃𝑡 𝑃𝑡
If you hold the stock beyond the date of the first dividend, then to compute your return you must specify how
you invest any dividends you receive in the interim. Let’s assume that all dividends are immediately reinvested
and used to purchase additional shares of the same stock or security.
If a stock pays dividends at the end of each quarter, with realized returns, RQ1, … RQ4,each quarter, then its annual
realized return, Rannual is computed as follows:
1 + 𝑅𝑎𝑛𝑛𝑢𝑎𝑙 = (1 + 𝑅𝑄1 ) ∗ (1 + 𝑅𝑄2 ) ∗ (1 + 𝑅𝑄3 ) ∗ (1 + 𝑅𝑄4 )
1 + 𝑟 = (1 + 𝑟𝑚 )𝑚
First, we look up stock price data for NRG at the start and end
of the year, as well as dividend dates. From these data, we
construct the following table.
Date Price ($) Dividend ($) Return Date Price ($) Dividend ($) Return
12/31/2011 58.69 12/31/2015 6.73 0
1/31/2012 61.44 0.26 5.13% 3/31/2016 5.72 0 -15.01%
4/30/2012 63.94 0.26 4.49% 6/30/2016 4.81 0 -15.91%
7/31/2012 48.5 0.26 -23.74% 9/30/2016 5.2 0 8.11%
10/31/2012 54.88 0.29 13.75% 12/31/2016 2.29 0 -55.96%
12/31/2012 53.31 -2.86%
We compute each period’s return. For example, the return from December 31, 2011 to January 31, 2012 is
61,44 + 0,26
− 1 = 5,13%
58,69
We then determine the annual returns:
𝑅2012 = [(1 + 5,13%) ∗ (1 + 4,49%) ∗ (1 − 23,74%) ∗ (1 + 13,75) ∗ (1 − 2,86)] − 1 = −7,47%
𝑅2016 = [(1 − 15,01%) ∗ (1 − 15,91%) ∗ (1 + 8,11%) ∗ (1 − 55,96%)] − 1 = −66%
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Note that since NRG didn’t pay dividends during 2016, the return can also be computed as:
2,29
− 1 = −66%
6,73
 Since no dividends were paid on the whole period, we can compare the price from the end to the price from
the beginning.
By counting the number of times a

realized return falls within a particular
range, we can estimate the underlying
probability distribution.
An empirical distribution is when the probability distribution is plotted using historical data.
Average annual returns for U.S. Small stocks, large

stocks (S&P 500), Corporate Bonds and Treasury Bills,
1926-2014:
The historical risk free rate is 3,5% because we have no

chance that the government won’t pay back any return.
B. AVERAGE ANNUAL RETUR N

𝑇
1 1
𝑅̅ = (𝑅1 + 𝑅2 + ⋯ + 𝑅𝑇 ) = ∗ ∑ 𝑅𝑡
𝑇 𝑇
𝑡=1
Where Rt is the realized return of a security in year t, for the years 1 through T. Using data from table 10.2, the
average annual return for the S&P 500 from 2002-2014 is as follows:
1
𝑅̅ = ∗ (−0,221 + 0,287 + 0,109 + 0,109 + 0,158 + 0,055 − 0,370 + 0,265 + 0,151 + 0,021 + 0,160
13
+ 0,324 + 0,137) = 8,7%
C. THE VARIANCE AND VOL ATILITY OF RETURNS

𝑇
1
𝑉𝑎𝑟 (𝑅) = ∗ ∑(𝑅𝑡 − 𝑅̅)2
𝑇−1
𝑡=1
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The estimate of the standard deviation is the square root of the variance.
First, we need to calculate the average return for

Microsoft’s over that time period. Next, we calculate
the variance.
1
𝑅̅ = ∗ (−22% + 6,8% + 8,9% − 0,9% + 15,8% + 20,8% − 44,4% + 60,5% − 6,5% − 4,5%) = 3,5%
10
1
𝑉𝑎𝑟 (𝑅) = [(−22% − 3,5%)2 + (6,8% − 3,5)2 + (8,9% − 3,5%)2 + (−0,9% − 3,5%)2
10 − 1
+ (15,8% − 3,5%)2 + (20,8% − 3,5%)2 + (−44,4% − 3,5%)2 + (60,5% − 3,5%)2
+ (−6,5 − 3,5)2 + (−4,5% − 3,5%)2 = 7,63%
The volatility or standard deviation is therefore:
𝑆𝐷(𝑅) = √7,63% = 27,62%
4. The historical trade-off between risk and return
A. THE RETURNS OF LARGE POR TFOLIOS

The excess returns is the difference between the average return for an investment and the average return for
treasury bills. It is therefore the amount I receive for taking risks. Sigma shows how much risks I take (the
volatility)
𝑟 = 𝑟𝑓 + 𝑒𝑥𝑐𝑒𝑠𝑠 𝑟𝑒𝑡𝑢𝑟𝑛
The historical trade-off between risk and return in large portfolios:
B. THE RETURNS OF INDIVIDUAL STOCKS

Is there a positive relationship between volatility and average returns for individual stocks? NO. There is no
precise relationship between volatility and average return for individual stocks:
★ Larger stocks tend to have lower volatility than smaller stocks.

★ All sticks tend to have higher risk and lower returns than large portfolios.
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In green, these are the biggest shares and

in red, the smallest ones. It’s best to
invest in funds, because we will have a
higher return than the historical volatility.
5. Common versus independent risk

The common risk is the risk that is perfectly correlated, the risk that affects all securities. We can compare it with
floods, everybody gets hurt.
The independent risk is the risk that is uncorrelated, the risk that affects a particular security. We can compare
it with theft, only one home is hurt.
The diversification is the averaging out of independent risks in a large portfolio.
6. Diversification in stock portfolios
Firm-Specific = Diversifiable risk Systematic risk

Firm specific news Market-wide news
★ Good or bad news about an individual company ★ News that affects all stocks, such as news about
the economy
Independent risks = risks that you can get rid of  Common risks = risks that you can’t escape  risk
no return for that risk that you are rewarded for
★ Firm-specific risk ★ Systematic risk
★ Idiosyncratic risk ★ Undiversifiable risk
★ Unique Risk ★ Market risk
★ Unsystematic risk
★ Diversifiable risk
When many stocks are combined in a large portfolio, the firm-specific risks for each stock will average out and
be diversified. The systematic risk, however, will affect all firms and will not be diversified.
Consider 2 firms:
Firm-Specific Systematic
Type I firms are affected only by firm-specific risks. Type S firms are affected only by systematic risk.
Their returns are equally likely to be 35% or -25%, There is a 50% chance the economy will be strong
based on factors specific to each firm’s local market. and type S stocks will earn a return of 40%. There is
Because these risks are firm specific, if we hold a a 50% chance the economy will be weak and their
portfolio of the stocks of many type I firms, the risk return will be -20%. Because all these forms face the
is diversified. same systematic risk, holding a large portfolio of
type S firms will not diversify the risk.
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Actual firms are affected by both market-wide risks and firm-specific risks. When firms carry both types of risk,
only the unsystematic risk will be diversified when many firm’s stocks are combined into a portfolio. The volatility
will therefore decline until only the systematic risk remains.
A. NO ARBITRAGE AND THE RISK PREMIUM

The risk premium for diversifiable risk is zero, so investors are not compensated for holding firm-specific risk. If
the diversifiable risk of stocks were compensated with an additional risk premium, then investors could buy the
stocks, earn the additional premium and simultaneously diversify and eliminate the risk.
By doing so, investors could earn an additional premium without taking on additional risk. This opportunity to
earn something for nothing would quickly be exploited and eliminated. Because investors can eliminate firm-
specific risk “for free” by diversifying their portfolios, they will not require or earn a reward or risk premium for
holding it.
The risk premium of a security is determined by its systematic risk and does not depend on its diversifiable risk.
This implies that a stock’s volatility, which is a measure of total risk (that is, systematic risk plus diversifiable risk)
is not especially useful in determining the risk premium that investors will earn.
Standard deviation is not an appropriate measure of risk for an individual security. There should be no clear
relationship between volatility and average returns for individual securities. Consequently, to estimate a
security’s expected return, we need to find a measure of a security’s systematic risk.
7. Measuring systematic risk

To measure the systematic risk of a stock determine how much of the variability of its return is due to systematic
risk versus unsystematic risk. To determine how sensitive a stock is to systematic risk, look at the average change
in the return for each 1% change in the return of a portfolio that fluctuates solely due to systematic.
An efficient portfolio is a portfolio that contains only systematic risk. There is no way to reduce the volatility of
the portfolio without lowering its expected return.
A market portfolio is an efficient portfolio that contains all shares and securities in the market. The S&P500 is
often used as a proxy for the market portfolio.
A. SENSITIVITY TO SYSTE MATIC RISK (BETA)

The sensitivity to systematic risk is the expected percent change in the excess return of a security for a 1% change
in the excess return of the market portfolio. Beta differs from volatility, volatility measures total risk, while beta
is a measure of only systematic risk.
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The systematic risk of the strength of the economy

produces a 52% − (−21%) = 73% change in the
return of the market portfolio. The type S firm’s
return changes by 55% − (−24%) = 79% on
average. Thus the firm’s beta is:
79%
𝛽𝑆 = = 1,082
73%
That is, each 1% change in the return of the market portfolio leads to a 1,082% change in the type S firm’s return
on average. The return of a type I firm has only firm-specific risk, however, and so is not affected by the strength
of the economy. Its return is affected only by factors specific to the firm. Because it will have the same expected
return, whether the economy is strong or weak,
0%
𝛽𝐼 = =0
72%
B. INTERPRETING BETA
A security’s beta is related to how sensitive its underlying revenues and cash flows are to general economic
conditions. Stocks in cyclical industries are likely to be more sensitive to systematic risk and have higher betas
than stocks in less sensitive industries.
8. Beta and the cost of capital
A. ESTIMATING THE RISK PREMIUM

The market risk premium is the reward investors expect to earn for holding a portfolio with a beta of 1. What do
I get to take the extra risks?
𝑀𝑎𝑟𝑘𝑒𝑡 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 = 𝐸[𝑅𝑀𝑘𝑡 ] − 𝑟𝑓
B. ADJUSTING FOR BETA

It is estimating a traded security’s cost of capital of an investment from its beta.
𝐸[𝑅] = 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 + 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 = 𝑟𝑓 + 𝛽 ∗ (𝐸[𝑅𝑀𝑘𝑡 ] − 𝑟𝑓 )
It is the capital asset pricing model (CAPM). It is the most important method for estimating the cost of capital
that is used in practice.
𝐸[𝑅𝑀𝑘𝑡 ] = (60% ∗ 15%) + (40% ∗ 5%) = 11%
𝐸[𝑅] = 6% + 1,18 (11% − 6%) = 11,9%
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CHAPTER 11: OPTIMAL PORTFOLIO CHOICE AND THE CAPITAL ASSET PRICING MODEL
1. The expected return of a portfolio

The portfolio weights is the fraction of the total investment in the portfolio held in each individual investment in
the portfolio. The portfolio weight must add up to 1,00 or 100%.
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖
𝑥𝑖 =
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
Then the return on the portfolio Rp, is the weighted average of the returns on the investments in the portfolio,
where the weights correspond to portfolio weights.
𝑅𝑝 = 𝑥1 𝑅1 + 𝑥2 𝑅2 + ⋯ + 𝑥𝑛 𝑅𝑛 = ∑ 𝑥𝑖 𝑅𝑖
𝑖
The initial value of the portfolio is (500*$11) +

(100*$28) = $8.300. The new value of the
portfolio is (500*$13) + (100*$40) = $10.500,
for a gain of $2.200 or a 26,5% return on your
$8.300 investment.
$13
Ford’s return was − 1 = 18,18% and
$11
$40
Citygroup’s was − 1 = 42,86%. Given the
$28
$5.500
initial portfolio weights of = 66,3% for
$8.300
$2.800
Ford and = 33,7% for Citygroup, we can also compute the portfolio’s return.
$8.300
𝑅𝑝 = (66,3% ∗ 18,2%) + (33,7% ∗ 42,9%) = 26,5%
The expected return of a portfolio is the weighted average of the expected returns of the investments within it.
𝐸[𝑅𝑝 ] = 𝐸[∑ 𝑥𝑖 𝑅𝑖 ] = ∑ 𝐸[𝑥𝑖 𝑅𝑖 ] = ∑ 𝑥𝑖 𝐸[𝑅𝑖 ]

𝑖 𝑖 𝑖
Total Portfolio = $25.000 + $35.000 = $60.000
r W
Intel 18% 25/60 = 0,4167
ATP 25% 35/60 = 0,5833
𝐸[𝑅] = (0,4167 ∗ 18%) + (0,5833 ∗ 25%) = 22,1%
 If we go short of one of the investment, we borrow them, instead of having them in the portfolio. We just
have to make sure we have a hundred percent. For the rest, we don’t care about the minus sign.
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2. The volatility of a two-stock portfolio

Returns for Three stocks and portfolios of Pairs of stocks:
While the three stocks in the previous table have the same volatility and average return, the pattern of their
results differs. For example, when the airline stocks performed well, the oil stock tended to do poorly, and when
the airlines did poorly, the oil stock tended to do well.
Consider the portfolio which consists of equal investments in West Air and Tex Oil. The average return of the
portfolio is equal to the average return of the two stocks. However, the volatility of 5,1% is much less than the
volatility of the two individual stocks.
By combining stocks into a portfolio, we reduce risk through diversification. The amount of risk that is eliminated
in a portfolio depends on the degree to which the stocks face common risks and their prices move together. You
should always buy a portfolio and not only one share. Therefore, you reduce the risks.
A. DETERMINING COVARIAN CE AND CORRELATION

To find the risk of a portfolio, one must know the degree to which the stocks’ returns move together.
I. Covariance
The covariance is the expected product of the deviations of two returns from their means. The covariance
between returns Ri and Rj is:
𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝑗 ) = 𝐸[(𝑅𝑖 − 𝐸[𝑅𝑖 ]) ∗ (𝑅𝑗 − 𝐸[𝑅𝑗 ])]
The estimate of the covariance from historical data is:
1
𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝑗 ) = ∑ (𝑅 − 𝑅̅𝑖 ) ∗ (𝑅𝑗,𝑡 − 𝑅̅𝑗 )
𝑇 − 1 𝑡 𝑖,𝑡
If the covariance is positive, the two returns tend to move together. If the covariance is negative, the two returns
tend to move in opposite directions.
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II. Correlation
The correlation is a measure of the common risk shared by stocks that does not depend on their volatility.
𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝑗 )
𝐶𝑜𝑟𝑟(𝑅𝑖 , 𝑅𝑗 ) =
𝑆𝐷(𝑅𝑖 ) ∗ 𝑆𝐷(𝑅𝑗 )
The correlation between two stocks will

always be between -1 and +1.
EXTRA: How to build the best portfolio? We need the best return we can have with the lowest risks. Here, we
talk about the covariance between two shares.
★ The covariance of a share with itself is the variance of the share.
𝑉𝑎𝑟𝐴 = 𝐶𝑜𝑣𝐴,𝐴 = (𝑅𝐴 − ̅𝑅̅̅̅ ̅̅̅̅ ̅̅̅̅

𝑝 ) ∗ (𝑅𝐴 − 𝑅𝑝 ) = (𝑅𝐴 − 𝑅𝑝 )²
★ The correlation of a share with itself is 1. A correlation of 1 gives us a perfect diversification.
𝐶𝑜𝑣𝐴,𝐴 𝑉𝑎𝑟𝐴 𝜎𝐴 ²
𝐶𝑜𝑟𝑟𝐴,𝐴 = = = =1
𝜎𝐴 ∗ 𝜎𝐴 𝜎𝐴 ∗ 𝜎𝐴 𝜎𝐴 ∗ 𝜎𝐴
Negative
Correlated Correlated
The two airlines are correlated

because they have a positive
covariance and correlation.
Moreover, it is close to 1.
Using the Data, what is the

covariance between General
Mills and Ford?
𝐶𝑜𝑣(𝑅𝐺𝑀,𝑅𝐹) = 𝐶𝑜𝑟𝑟𝐴,𝐵 ∗ 𝜎𝐴 ∗
𝜎𝐵 = 0,6 ∗ 0,17 ∗ 0,5 = 0,051
B. COMPUTING A PORTFOLI O’S VARIANCE AND VOL ATILITY

For a two security portfolio,
𝑉𝑎𝑟(𝑅𝑃 ) = 𝐶𝑜𝑣(𝑅𝑃 , 𝑅𝑃 ) = 𝐶𝑜𝑣(𝑥1 𝑅1 + 𝑥2 𝑅2 𝑥1 𝑅1 + 𝑥2 𝑅2 )

= 𝑥1 𝑥1 𝐶𝑜𝑣(𝑅1 , 𝑅1 ) + 𝑥1 𝑥2 𝐶𝑜𝑣(𝑅1 , 𝑅2 ) + 𝑥2 𝑥1 𝐶𝑜𝑣(𝑅2 , 𝑅1 ) + 𝑥2 𝑥2 𝐶𝑜𝑣(𝑅2 , 𝑅2 )
𝑉𝑎𝑟(𝑅𝑃 ) = 𝑥12 ∗ 𝑉𝑎𝑟(𝑅1 ) + 𝑥22 ∗ 𝑉𝑎𝑟(𝑅2 ) + 2𝑥1 𝑥2 ∗ 𝐶𝑜𝑣(𝑅1 , 𝑅2 )
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𝑉𝑎𝑟𝐴 = 𝜎𝐴2
𝐶𝑜𝑣𝐴,𝐵 = 𝐶𝑜𝑟𝑟𝐴,𝐵 ∗ 𝜎𝐴 ∗ 𝜎𝐵
𝑆𝐷(𝑅𝑃 ) = √(0,41672 ∗ 0,432 ) + (0,58332 ∗ 0,682 ) + (2 ∗ 0,4167 ∗ 0,5833 ∗ 0,49 ∗ 0,43 ∗ 0,68)
= √0,0321 + 0,1573 + 0,0696 = √0,259 = 50,89%
3. The volatility of a large portfolio

The variance of a portfolio is equal to the weighted average covariance of each stock with the portfolio.
A. DIVERSIFICATION WITH AN EQUALLY WEIGHTED PORTFOLIO

An equally weighted portfolio is a portfolio in which the same amount is invested in each stock.
1
𝑉𝑎𝑟(𝑅𝑃 ) = (𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑖𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙 𝑠𝑡𝑜𝑐𝑘𝑠
𝑛
1
+ (1 − ) (𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘𝑠)
𝑛
1
What happens when N is very big? Then
𝑛
tends to zero. Then the first part becomes
insignificant. The first part is the specific risks,
the other one is the systematic risk. With tiny
Specific/individual risk
portfolio, we have some specific risks. In big
ones, those risks are insignificant.
B. DIVERSIFICATION WITH GENERAL PORTFOLIOS

For a portfolio with arbitrary weights, the standard deviation is calculated as follows:
𝑆𝐷(𝑅𝑃 ) = ∑ 𝑥𝑖 ∗ 𝑆𝐷(𝑅𝑖 ) ∗ 𝐶𝑜𝑟𝑟(𝑅𝑖 , 𝑅𝑝 )

𝑖
Unless all of the stocks in a portfolio have a perfect positive correlation of +1 with one another, the risk of the
portfolio will be lower than the weighted average volatility of the individual stocks:
𝑆𝐷(𝑅𝑃 ) = ∑ 𝑥𝑖 ∗ 𝑆𝐷(𝑅𝑖 ) ∗ 𝐶𝑜𝑟𝑟(𝑅𝑖 , 𝑅𝑝 ) < ∑ 𝑥𝑖 ∗ 𝑆𝐷(𝑅𝑖 )

𝑖 𝑖
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4. Risk versus return: choosing an efficient portfolio

Harry Markovitz (b. 1927): Nobel laureate for portfolio theory. He is the father of the portfolio theory. His
question were:
★ Why have a portfolio?

★ What is the goal?
★ How do you group?
★ What criteria?
In an inefficient portfolio, it is possible to find another portfolio that is better in terms of both expected return
and volatility. In an efficient portfolio there is no way to reduce the volatility of the portfolio without lowering its
expected return.
Consider a portfolio of Intel and Coca-Cola.
Consider investing 100% in Coca-Cola stock. As shown on the graph, other portfolios, such as the portfolio with
20% in Intel stock and 80% in Coca-Cola stock, make the investor better off in two ways. It has higher expected
return and it has lower volatility. As a result, investing solely in Coca-Cola stock is inefficient, because for the
same volatility, I could have a better return. For all the others combinations, I can get a better return for any risk
I take. When I choose to have the lowest risk, I take 20% Intel and 80% Coca-Cola.
A. THE EFFECT OF CORREL ATION

Correlation has no effect on the expected return of a portfolio.
However, the volatility of the portfolio will differ depending on
the correlation. The lower the correlation, the lower the volatility
we can obtain. As the correlation decreases, the volatility of the
portfolio falls. The curve showing the portfolios will bend to the
left to a greater degree as shown on the next slide.
If Coca-Cola and Intel were perfectly correlated, we would use

the red line. If they were negative correlated, we would take the
blue line. However, we would never have one of those lines. We
will have more often the purple one.
B. SHORT SALES
The long position is a positive investment in a security. A short position is a negative investment in a security. In
short sale, you sell a stock that you do not own and then, buy that stock back in the future. Short selling is an
advantage strategy if you expect a stock price to decline in the future.
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C. EFFICIENT PORTFOLIOS WITH MANY STOCKS

Consider adding Bore Industries to the two-stock portfolio:
Although Bore has a lower return and the

same volatility as Coca-Cola, it still may be
beneficial to add Bore to the portfolio for
the diversification benefits.
We see that Coca-Cola has a bigger return for the same risk.
Therefore, we can think that Coca-Cola is better to invest in.
However, this is true for only one share. For a portfolio, we
have to calculate and to take Bore into account.
D. RISK VERSUS RETURN: MANY STOCKS

The efficient portfolios, those offering the highest possible
expected return for a given level of volatility, are those on
the northwest edge of the shaded region, which is called
the efficient frontier for these three stocks.
In this case none of the stocks, on its own, is on the efficient

frontier, so it would not be efficient to put all our money in
a single stock.
5. Risk-free saving and borrowing

James Tobin (1918-2002): Nobel laureate for portfolio selection theory. He adds the implication of allowing
investors to combine risk-free assets with risky assets.
Risk can also be reduced by investing a portion of a portfolio in a risk-free investment, like treasury bills. However,
doing so will likely reduce the expected return. On the other hand, an aggressive investor who is seeking high
expected returns might decide to borrow money to invest even more in the stock market.
A. INVESTING IN RISK-FREE SECURITIES

Consider an arbitrary risky portfolio and the effect on risk and return of putting a fraction of the money in the
portfolio, while leaving the remaining fraction in risk-free treasury bills. The expected return would be:
𝐸[𝑅𝑥𝑃 ] = (1 − 𝑥) ∗ 𝑟𝑓 + 𝑥 ∗ 𝐸[𝑅𝑃 ] = 𝑟𝑓 + 𝑥 ∗ (𝐸[𝑅𝑃 ] − 𝑟𝑓 )
B. BORROWING AND BUYING STOCKS ON MARGIN

Buying stocks on margin is borrowing money to invest in a stock. A portfolio that consists of a short position in
the risk-free investment is known as a levered portfolio. Margin investing is a risky investment strategy.
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C. IDENTIFYING THE TANGENT

To earn the highest possible expected return for any level of volatility, we must find the portfolio that generates
the steepest possible line when combined with the risk-free investment.
William Sharpe (b. 1934): Nobel laureate for CAPM. The Sharpe ratio measures the ratio of reward-to-volatility
provided by a portfolio.
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑒𝑥𝑐𝑒𝑠𝑠 𝑟𝑒𝑡𝑢𝑟𝑛 𝐸[𝑅𝑃 ] − 𝑟𝑓

𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 = =
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑣𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 𝑆𝐷(𝑅𝑃 )
The portfolio with the highest Sharpe ratio is the

portfolio where the line with the risk-free investment
is tangent to the efficient frontier of risky investments.
The portfolio that generates this tangent line is known
as the tangent portfolio.
6. The capital asset pricing model

The capital asset pricing model (CAPM) allows us to identify the efficient portfolio of risky assets without having
any knowledge of the expected return of each security. Instead, the CAPM uses the optimal choices investors
make to identify the efficient portfolio as the market portfolio, the portfolio of all stocks and securities in the
market.
𝐸(𝑟) = 𝑟𝑓 + 𝛽 ∗ (𝐸𝑟 − 𝑟𝑓 )
A. THE CAPM ASSUMPTIONS

★ Investors can buy and sell all securities at competitive market prices (without incurring taxes or
transactions costs) and can borrow and lend at the risk-free interest rate.
★ Investors hold only efficient portfolios of traded securities-portfolios that yield the maximum expected
return for a given level of volatility.
★ Investors have homogeneous expectations regarding the volatilities, correlations and expected returns
of securities. Homogeneous expectations is when all investors have the same estimates concerning
future investments and returns.
B. SUPPLY, DEMAND AND T HE EFFICIENCY OF THE MARKET PORTFOLIO

Given homogeneous expectations, all investors will demand the same efficient portfolio of risky securities. The
combined portfolio of risky securities of all investors must equal the efficient portfolio. Thus, if all investors
demand the efficient portfolio, and the supply of securities is the market portfolio, the demand for market
portfolio must equal the supply of the market portfolio (all existing shares of the market).
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C. OPTIMAL INVESTING: THE CAPITAL MARKET LINE

When the CAPM assumptions are hold, an optimal portfolio is a
combination of the risk-free investment and the market portfolio.
When the tangent line goes through the market portfolio, it is called
the capital market line (CML).
The expected return and volatility of a capital market line portfolio are:
Excess return
𝐸[𝑅𝑥𝐶𝑀𝐿 = − 𝑥) ∗ 𝑟𝑓 + 𝑥 ∗ 𝐸[𝑅𝑀𝑘𝑡 = 𝑟𝑓 + 𝑥 ∗ (𝐸[𝑅𝑀𝑘𝑡 ] − 𝑟𝑓 )
] (1 ]
𝑆𝐷(𝑅𝑥𝐶𝑀𝐿 ) = 𝑥 ∗ 𝑆𝐷(𝑅𝑀𝑘𝑡 )
7. Determining the risk premium
A. MARKET RISK AND BETA

Given an efficient market portfolio, the expected return of an investment is:
Risk premium of the market
𝑀𝑘𝑡
𝐸[𝑅𝑖 ] = 𝑟𝑖 = 𝑟𝑓 + 𝛽𝑖 ∗ (𝐸[𝑅𝑀𝑘𝑡 ] − 𝑟𝑓 )
The beta is defined as:

Volatility of i that is common with the market
𝑆𝐷(𝑅𝑖 ) ∗ 𝐶𝑜𝑟𝑟(𝑅𝑖 , 𝑅𝑀𝑘𝑡 ) 𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝑀𝑘𝑡 )
𝛽𝑖𝑀𝑘𝑡 = 𝛽𝑖 = =
𝑆𝐷(𝑅𝑀𝑘𝑡 ) 𝑉𝑎𝑟(𝑅𝑀𝑘𝑡 )
0,68 ∗ 0,91
𝛽= = 1,41
0,44
𝐸(𝑅) = 0,05 + 1,41 ∗ (0,12 − 0,05) = 0,1487 = 14,87%
B. THE SECURITY MARKET LINE

There is a linear relationship between a stock’s beta and its expected return. The security market line (SML) is
graphed as the line through the risk-free investment and the market. According to the CAPM, if the expected
return and beta for individual securities are plotted, they should all fall along the SML.
We have a simple relationship between beta and the return. Therefore, we have a linear function. The beta tells
us about the market risks only, while the volatility gives us the total risks.
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The CML depicts portfolios combining the risk free investment and the efficient portfolio and shows the highest
expected return that we can attain for each level of volatility. According to the CAPM, the market portfolio is on
the CML and all other stocks and portfolios contain diversifiable risk and lie to the right of the CML. Kellogg’s is
probably in the middle of the graph.
The SML shows the expected return for each security as a function of its beta with the market. According to the
CAPM, the market portfolio is efficient, so all stocks and portfolios should lie on the SML. Kellogg’s has to be on
the red line. The companies on the right of the market portfolio are luxurious companies that react more than
the market. On the left, these are companies of necessary goods. Therefore, Kellogg’s is on the left, because it
underreacts than the market.
The beta of a portfolio is the weighted average beta of the securities in the portfolio.
𝐶𝑜𝑣(𝑅𝑃 , 𝑅𝑀𝑘𝑡 ) 𝐶𝑜𝑣(∑𝑖 𝑥𝑖 𝑅𝑖 , 𝑅𝑀𝑘𝑡 ) 𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝑀𝑘𝑡 )

𝛽𝑃 = = = ∑ 𝑥𝑖 ∗ = ∑ 𝑥𝑖 ∗ 𝛽𝑖
𝑉𝑎𝑟(𝑅𝑀𝑘𝑡 ) 𝑉𝑎𝑟(𝑅𝑀𝑘𝑡 ) 𝑖 𝑉𝑎𝑟(𝑅𝑀𝑘𝑡 ) 𝑖
𝛽𝑃 = 0,4 ∗ 0,69 + 0,6 ∗ 1,77 = 1,338
𝐸[𝑅𝑖 ] = 5% + 1,338 ∗ (12% − 5%)

= 0,1437 = 14,37%
C. SUMMARY OF THE CAPIT AL ASSET PRICING MODEL

The market portfolio is the efficient portfolio. The risk premium for any security is proportional to its beta with
the market.
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CHAPTER 12: ESTIMATING THE COST OF CAPIT AL
1. The equity cost of capital

The capital asset pricing model (CAPM) is a practical way to estimate. The cost of capital of any investment
opportunity equals the expected return of available investments with the same beta. The estimate is provided
by the Security market Line equation:
𝑟𝑖 = 𝑟𝑓 + 𝛽𝑖 ∗ (𝐸[𝑅𝑀𝑘𝑡 ] − 𝑟𝑓 )
Total risk is measured by volatility. Therefore, Walmart stock

has more total risk than J&J. Systematic risk is measured by
beta. J&J has a higher beta, so it has more market risk than
Walmart. Given J&J’s estimated beta of 0,54, we expect the
price for J&J’s stock to move by 0,54% for every 1% move of
the market. Therefore, J&J’s risk premium will be 0,54 times
the risk premium of the market and J&J’s equity cost of
capital is:
𝐸(𝑅𝐽𝑁𝐽 ) = 4% + 0,54 ∗ (12% − 4%) = 8,32%
𝐸(𝑅𝑊𝑀𝑇 ) = 4% + 0,20 ∗ (12% − 4%) = 5,6%
Because market risk cannot be diversified, it is the market risk that determines the cost of capital. Thus J&J has
a higher cost of equity capital than Walmart, even though it is less volatile.
2. The market portfolio
A. CONSTRUCTING THE MAR KET PORTFOLIO

The market capitalization is the total market value of a firm’s outstanding shares.
𝑀𝑉𝑖 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑓 𝑖 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 ∗ 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑖 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = 𝑁𝑖 ∗ 𝑃𝑖
B. VALUE-WEIGHTED PORTFOLIO
A value-weighted portfolio is a portfolio in which each security is held in proportion to its market capitalization.
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖 𝑀𝑉𝑖

𝑥𝑖 = =
𝑇𝑜𝑡𝑎𝑙 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑙𝑙 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 ∑𝑗 𝑀𝑉𝑗
A value-weighted portfolio is an equal-ownership portfolio. It contains an equal fraction of the total number of
shares outstanding of each security in the portfolio.
A passive portfolio is a portfolio that is not rebalanced in response to price changes.
C. MARKET INDEXES
Market indexes report the value of a particular portfolio securities.
★ S&P500: A value-weighted portfolio of the 500 largest U.S. stocks

★ Dow Jones Industrial Average (DJIA): A price weighted portfolio of 30 large industrial stocks
★ FTSE4Good
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Index funds are the mutual funds that invest in the S&P500, the Wilshire 5000 or some other index. The exchange
traded funds (ETFs) are a trade directly on an exchange but represent ownership in a portfolio of stocks.
Most practitioners use the S&P 500 as the market proxy, even though it is not actually the market portfolio.
D. THE MARKET RISK PREMIUM

Determining the risk-free rate:
★ The yield on U.S. Treasury securities

★ Surveys suggest most practitioners use 10- to 30-year treasuries.
The historical risk premium estimate the risk

premium using the historical average excess
return of the market over the risk-free
interest rate.
Using historical data has two drawbacks:
★ Standard errors of the estimates are large.

★ Backward looking, so may not represent current expectations.
One alternative is to solve for the discount rate that is consistent with the current level of the index.
𝐷𝑖𝑣1
𝑟𝑀𝑘𝑡 = + 𝑔 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 + 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒
𝑃0
3. Beta estimation
A. ESTIMATING BETA FROM HISTORICAL RETURNS

Recall, beta is the expected percent change in the excess return of the security for a 1% change in the excess
return of the market portfolio.
Consider Cisco Systems stock and how it changes with the market portfolio.
As the scatterplot shows, Cisco tends to be up when the market is up and vice versa. We can see that a 10%
change in the market’s return corresponds to about a 20% change in Cisco’s returns. Thus Cisco’s return moves
about two for one with the overall market, so Cisco’s beta is about 2.
Beta corresponds to the slope of the best-fitting line in the plot of the security’s excess returns versus the market
return.
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4. The debt cost of capital

Yield to maturity is the IRR an investor will earn from holding the bond to maturity and receiving its promised
payments. If there is little risk, the firm will default, yield to maturity is a reasonable estimate of investor’s
expected rate of return. If there is significant risk of default, yield to maturity will overstate investors’ expected
return.
Consider a one-year bond with YTM of y. For each $1 invested in the bond today, the issuer promises to pay
$(1+y) in one year. Suppose the bond will default with probability p, in which case bond holders receive only
$(1+y-L), where L is the expected loss per $1 of debt in the event of default.
So the expected return of the bond is
𝑟𝑑 = (1 − 𝑝)𝑦 + 𝑝(𝑦 − 𝐿) = 𝑦 − 𝑝𝐿 = 𝑌𝑖𝑒𝑙𝑑 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 − 𝑃𝑟𝑜𝑏 (𝑑𝑒𝑓𝑎𝑢𝑙𝑡) ∗ 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑠 𝑟𝑎𝑡𝑒
The importance of the adjustment depends on the riskiness of the bond.
5. A project’s cost of capital
A. ALL-EQUITY COMPARABLES
Find an all-equity financed firm in a single line of business that is comparable to the project. Use the comparable
firm’s equity beta and cost of capital as estimates.
B. LEVERED FIRMS AS COMPARABLES

The project is a little part of the company.
C. ASSET (UNLEVERED) CO ST OF CAPITAL

It is the expected return required by investors to hold the firm’s underlying assets. It is also the weighted average
of the firm’s equity and debt costs of capital.
𝐸 𝐷
𝑟𝑈 = ∗ 𝑅𝐸 + ∗𝑟
𝐸+𝐷 𝐸+𝐷 𝐷
With the unlevered cost of capital, what disappears is the tax shield.
Small example: A company has 10 of assets and 3 of debts. How much do you need to pay for buying the
company? The answer is 7.
𝐸𝑞𝑉 = 𝐸𝑉 − 𝐷𝑒𝑏𝑡
Suppose the company has an amount of cash of 2. How much do you pay now? The answer is 9.
𝐸𝑞𝑉 = 𝐸𝑉 − (𝐷𝑒𝑏𝑡 − 𝐶𝑎𝑠ℎ)
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D. CASH AND NET DEBT

Some firms maintain high cash balances. Cash is a risk-free asset that reduces the average risk of the firm’s assets.
Because the risk of the firm’s enterprise value is what we are concerned with, leverage should be measured in
terms of net debt.
𝑁𝑒𝑡 𝑑𝑒𝑏𝑡 = 𝐷𝑒𝑏𝑡 − 𝐸𝑥𝑐𝑒𝑠𝑠 𝐶𝑎𝑠ℎ 𝑎𝑛𝑑 𝑠ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠
6. The weighted average cost of capital

𝐸 𝐷
𝑟𝑊𝐴𝐶𝐶 = ∗ 𝑟𝐸 + ∗ 𝑟 ∗ (1 − 𝜏𝐶 )
Given a target leverage ratio,
𝐷
𝑟𝑊𝐴𝐶𝐶 = 𝑟𝑈 − ∗𝜏 ∗𝑟
𝐸+𝐷 𝐶 𝐷
How does rWACC compares with rU?
★ Unlevered cost of capital (or pre-tax WACC): Expected return investors will earn by holding the firm’s
assets. In a world with taxes, it can be used to evaluate an all-equity project with the same risk as the
firm.
★ In a world with taxes, the WACC is less than the expected return of the firm’s assets. With taxes, WACC
can be used to evaluate a project with the same risk and the same financing as the firm.
7. Final thoughts on using the CAPM

There are a large number of assumptions made in the estimation of cost of capital using the CAPM. How reliable
are the results?
The types of approximation are no different from those made throughout the capital budgeting process. Errors
in cost of capital estimation are not likely to make a large difference in NPV estimates.
CAPM is practical, easy to implement and robust. It imposes a disciplined approach to cost of capital estimation
that is difficult to manipulate. CAPM requires managers to think about risk in the correct way.
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CHAPTER 13 (15): DEBT AND TAXES
How did Kellogg’s debt/equity ratio change over the last years? Based on the evolution of the D/E ratio over the
last year, would you recommend that Kellogg’s issue additional debt and repurchase stock?
2013 2014 2015 2016 2017

D/E Kellogg’s 2,08 2,64 3,64 4,07 3,90
In 2017, there is a little decrease. However, for the rest, the debt to equity ratio maters to Kellogg’s. There are
people to figure out the ratio and to keep to it.
2013 2014 2015 2016 2017

D/E Nestlé 0,35 0,30 0,34 0,36 0,43
Nestlé has been criticized because it is under-leveraged (not enough debt). It looks like Nestlé has extremely low
D/E ratio, and it is really stable. In 2017, that could be the consequences of the investors’ intervention.
2016 without 2015 without 2014 without
Jan 2, 2016 Jan 3, 2015 Dec 28, 2013
leverage leverage leverage In black, we have the reality. In blue,
EBIT 1.000.000,00 1.000.000,00 1.034.000,00 1.034.000,00 2.841.000,00 2.841.000,00
Interest we make hypothesis that we don’t
expense -227.000,00 0,00 -209.000,00 0,00 -235.000,00 0,00
Income
have debt. More money goes to the
773.000,00 1.000.000,00 825.000,00 1.034.000,00 2.606.000,00 2.841.000,00
before tax state, when we don’t have debt.
Taxes -159.000,00 205.692,11 -186.000,00 233.120,00 -792.000,00 863.419,80
(tax rate) 0,21 0,23 0,30 With leverage, we actually have a
Net income
interest paid
614.000,00 794.307,89 632.000,00 800.880,00 1.807.000,00
1.977.580,20 greater value of the company. The
227.000,00 0,00 1.034.000,00 0,00 2.841.000,00 0,00
to
income tax shield is a protection for the
available to
equity holders
614.000,00 794.307,89 632.000,00 800.880,00 1.807.000,00 1.977.580,20 company.
total available
to all
investors
841.000,00 794.307,89 1.666.000,00 800.880,00 4.648.000,00 1.977.580,20
Interest tax shield
(tax rate x interest expense)
46.692,11 47.120,00 71.419,80
source: https://finance.yahoo.com/q/is?s=K&annual
1. The interest tax deduction
Corporations pay taxes on their profits after interest payments are deducted. Thus, interest expense reduces the
amount of corporate taxes. This creates an incentive to use debt.
A. INTEREST TAX SHIELD

It is the reduction in taxes paid due to the tax deductibility of interest.
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑 = 𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 ∗ 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
In Macy’s case, the gain is equal to the reduction in taxes with leverage: $980 million - $840 million = $140 million.
The interest payments provided a tax savings of 35% * $400 million = $140 million.
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𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑 = 5,35 ∗ 40%
= 2,14 𝑚𝑖𝑙𝑖𝑜𝑛
2. Valuing the interest tax shield

When a firm uses debt, the interest tax shield provides a corporate tax benefit each year. This benefit is the
computed present value of the stream of future interest tax shields the firm will receive.
 Cash Flows to Investors   Cash Flows to Investors 

      (Interest Tax Shield)
 with Leverage   without Leverage 
The total value of the levered firm exceeds

the value of the firm without leverage due
to the present value of the tax savings from
debt.
𝑉 𝐿 = 𝑉 𝑈 + 𝑃𝑉 (𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑)
1 − (1 + 6%)−8
𝑃𝑉 = 60 ∗
6%
𝑇𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑 ∗ 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑟𝑎𝑡𝑒
= 60 ∗ 39% = 23,4
1 − (1,06)−8
𝑃𝑉 (𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑) = 23,4 ∗ = 145,31
0,06
A. THE WEIGHTED AVERAGE COST OF CAPITAL WITH TAXES

With tax-deductible interest, the effective after-tax borrowing rate is r(1-τc) and the weighted average cost of
capital becomes:
𝐸 𝐷
𝑟𝑊𝐴𝐶𝐶 = ∗ 𝑟𝐸 + ∗ 𝑟 ∗ (1 − 𝑡𝑎𝑥)
Pretax WACC Reduction due to interest tax shield
𝐸 𝐷 𝐷
𝑟𝑊𝐴𝐶𝐶 = ∗ 𝑟𝐸 + ∗ 𝑟𝐷 − ∗ 𝑟 ∗ 𝑡𝑎𝑥
𝐸+𝐷 𝐸+𝐷 𝐸+𝐷 𝐷
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B. THE INTEREST TAX SHIELD WITH A TARGET DEBT-EQUITY RATIO

When a firm adjusts its leverage to maintain a target debt-equity ratio, we can compute its value with leverage,
VL, by discounting its free cash flow using the weighted average cost of capital.
The value of the interest tax shield can be found by comparing the value of the levered firm, V L, to the unlevered
value, VU, of the free cash flow discounted at the firm’s unlevered cost of capital, the pre-tax WACC.
We can estimate the value of Harris Solution(s interest

tax shield by comparing its value with and without
leverage. We compute its unlevered value by discounting
its free cash flow at its pre-tax WACC.
𝑃𝑟𝑒𝑡𝑎𝑥 𝑊𝐴𝐶𝐶 = Because Harris Solution’s free cash flow is expected

1 2,5 to grow at a constant rate, we can value it as a
( ) ∗ 12% + ( ) ∗ 7% = 8,43% constant growth perpetuity:
1 + 2,5 1 + 2,5
As if it has no impact on the value of the company. $1,75 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
𝑉𝑈 = = $35,50 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
8,43% − 3,50%
To compute Harris Solution’s levered value, we Thus, Harris Solution’s value including the interest
calculate its WACC: tax shield is:
𝑊𝐴𝐶𝐶 = $1,75 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
𝑉𝐿 = = $59,73 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
1 2,5 6,43% − 3,5%
( ) ∗ 12% + ( ) ∗ 7% ∗ (1 − 0,4)
1 + 2,5 1 + 2,5
= 6,43%
The value of the interest tax shield is therefore:
𝑃𝑉 (𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑) = 𝑉 𝐿 − 𝑉 𝑈 = $59,73 − $35,50 = $24,23 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
3. Personal Taxes
The cash flows to investors are typically taxed twice. Once at the corporate level and then investors are taxed
again when they receive their interest or divided payment. For individuals:
★ Interest payments received from debt are taxed as income.

★ Equity investors also must pay taxes on dividends and capital gains.
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The amount of money an investor will pay for a security depends on the cash flows the investor will receive after
all taxes have been paid. Personal taxes reduce the cash flows to investors and can offset some of the corporate
tax benefits of leverage.
The actual interest tax shield depends on both corporate and personal taxes that are paid. To determine the true
tax benefit of leverage, the combined effect of both corporate and personal taxes needs to be evaluated.
4. Optimal capital structure with taxes
A. DO FIRMS PREFER DEBT ? Bubble

When firms raise new capital from investors, they
do so primarily by issuing debt. In most years,
aggregate equity issues are negative, meaning
that on average, firms are reducing the amount of
equity outstanding by buying shares.
Mostly, companies reinvest their own money into

the company (CapEx). Financing is mostly done by
CapEx.
While firms seem to prefer debt when raising

external funds, not all investments are externally
funded. Most investment and growth are supported internally generated funds.
Even though firms have not issued new equity, the market value of equity has risen over time as firms have
grown. For the average firm, the result is that debt as a fraction of firm value has varied in a range from 30 to
45%.
The use of debt varies greatly by industry. Firms in

growth industries, like biotechnology or high
technology carry very little debt, while airlines,
automakers, utilities and financial firms have high
leverage ratios.
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𝑁𝑒𝑡 𝑑𝑒𝑏𝑡 = 𝑑𝑒𝑏𝑡 − 𝑐𝑎𝑠ℎ
To have a negative net debt, the company has a lot

of cash, what makes the net debt negative.
Nestlé is under-leveraged.
B. LIMITS TO THE TAX BE NEFIT OF DEBT

To receive the full tax benefits of leverage, a firm need not use 100% debt financing, but the firm does need to
have taxable earnings. This constraint may limit the amount of debt needed as a tax shield.
★ With no leverage, the firm receives no tax

benefit.
★ With high leverage, the firm saves $350 in taxes.
★ With excess leverage, the firm has a net
operating loss, and there is no increase in the
tax savings. Because the firm is already not
paying taxes, there is no immediate tax shield
from the excess leverage.
No corporate tax benefit arises from incurring interest payments that exceed EBIT. Because interest payments
constitute a tax disadvantage at the investor level, investors will pay higher personal taxes with excess leverage,
making them worse off.
The optimal level of leverage from a tax saving perspective is the level such that interest equals EBIT. At the
optimal level of leverage, the firm shields all of its taxable income and it does not have any tax-disadvantaged
excess interest.
However, it is unlikely that a firm can predict its future EBIT (and the optimal level of debt) precisely. If there is
uncertainty regarding EBIT, then there is a risk that interest will exceed EBIT. As a result, the tax savings for high
levels of interest falls, possibly reducing the optimal level of the interest payment.
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In general, as a firm’s interest expense approaches its

expected taxable earnings, the marginal tax advantage of
debt declines, limiting the amount of debt the firm should
use.
C. THE LOW LEVERAGE PUZZLE

Firms have used debt to shield a greater percentage of their
earnings from taxes in more recent years (mirroring the
increase in the effective tax advantage of debt).
Firms have far less leverage than our analysis of the interest
tax shield would predict.
Firms worldwide have similar low proportions of debt

financing. Although the corporate tax codes are similar
across all countries in terms of the tax advantage of debt,
personal tax rates vary more significantly, leading to greater variation in τ*.
It would appear that firms, on average, are under-

leveraged. However, it is hard to accept that most firms are
acting sub-optimally. In reality, there is more to the capital
structure story than discussed so far. For example, debt
increases the probability of bankruptcy (a cost to be
considered).
A key item missing from the analysis thus far is that increasing the level of debt increases the probability of
bankruptcy. If bankruptcy is costly, these costs might offset the tax advantages of debt financing.
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CHAPTER 14: PAYOUT POLICY (DISCUSSION + SCHEMA)
1. Preference for continuing to pay dividends or not

Shareholders wants more dividends because they love it and it makes them happy to receive a bigger one.
Dividends is a good way to articulate or regulate the cash flow in the company. Therefore, shareholders may like
not to receive dividends so that the cash is reinvest in the company, but if the company pays dividends, it doesn’t
invest in the company and may influence in a bad way the company. Finance theory says that nobody would care
about dividends. It makes no difference at all to receive dividends. If the company doesn’t pay dividend, you sell
your share, to receive money. Dividends shouldn’t influence rational investors.
Pay attention that the dividends aren’t constant. However, those tend to decrease over time. Companies pay
mostly less dividends. Dividends payments change over time, but not especially decreasing. The articles are a
discussion between authors.
2. Trends over time

There is for sure a decline, but some companies pay really more dividends than other to compensate. Dividends
payments are in the culture of the company. Indeed, there is a path dependency, which means that if I paid
dividends yesterday, I have to pay dividends today. However, dividends should normally reflect the wealth of the
company: when it is doing well, dividends should be paid and when it is not, dividends shouldn’t. But if they are
paying dividends even if they are doing badly, it shows to the market that the company is doing well, called the
signalling effect, even if not, and therefore it attracts new shareholders to invest in the company. We could view
dividends as an item of marketing.
3. How could companies not pay any dividends?

Net income is used to pay dividends (you pay taxes on dividends) and to retain earnings. That means that, with
the retained earnings, they go back into the company. What increases the net income again, and therefore the
value for shareholders. The price of the share is the enterprise value divided by the numbers of shares. If the
enterprise value goes up, the shareholders’ value increases too. But to receive money, you have to sell your
shares. There is always a difference between the theory and how it really happens. Why would any company
bother to pay dividends? They choose it to pay less taxes and then to increase the value of the enterprise and
the shareholder’s value.
4. Centralization of the dividends

Big companies pay more dividends. The short-term investors want more dividends, to know that the company is
doing well. We could think that the board of directors takes the decision about what to do with the net income,
paying dividends or retaining earnings, but in fact, shareholders could make this decision. The 4 th theory is the
clientele theory: if shareholders reclaim dividends, they are clients so I pay them dividends.
★ Catering theory,
★ Signalling theory,
★ Life-cycle theory: with economic life-cycle, we will pay more dividends at some moment and less at
other, due to the life-cycle of the company.
★ Clientele theory: viewing the shareholder has a client, and if he wants a dividend, I have to give him one.
There are different theories because different authors have proposed different theory. They tested all the
theories. Normally, dividends payments shouldn’t matter and influence the investors.
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CHAPTER 15 (18): CAPITAL BUDGETING AND VALUATION WITH LEVERAGE
1. Overview
Assumptions in this chapter are:
★ The project has average risk.

★ The firm’s debt-equity ratio is constant.
★ Corporate taxes are the only imperfection.
2. The weighted average cost of capital method

For now, it is assumed that the firm maintains a constant debt-equity ratio and that the WACC remains constant
over time.
𝐸 𝐷
𝑟𝑊𝐴𝐶𝐶 = ∗ 𝑟𝐸 + ∗ 𝑟 ∗ (1 − 𝜏𝐶 )
Because the WASS incorporates the tax savings from debt, we can compute the levered value of an investment
by discounting its future free cash flow using the WACC.
𝐹𝐶𝐹1 𝐹𝐶𝐹2 𝐹𝐶𝐹3

𝑉0𝐿 = + + +⋯
1 + 𝑟𝑊𝐴𝐶𝐶 (1 + 𝑟𝑊𝐴𝐶𝐶 )² (1 + 𝑟𝑊𝐴𝐶𝐶 )³
A. USING THE WACC TO VA LUE A PROJECT

Assume Avco is considering introducing a new line of packaging, the RFX series.
★ Avco expects the technology used in these products to become obsolete after four years. However, the
marketing group expects annual sales of $60 million per year over the next four years for this product
line.
★ Manufacturing costs and operating expenses are expected to be $25 million and $9 million, respectively,
per year.
★ Developing the product will require upfront R&D and marketing expenses of $6,67 million, together
with a $24 million investment in equipment. The equipment will be obsolete in four years and will be
depreciated using the straight-line method over that period.
★ Avco expects no net working capital requirements for the project.
★ Avco pays a corporate tax rate of 40%.
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Avco intends to maintain a similar (net) debt-equity ratio for the foreseeable future, including any financing
related to the RFX project. Thus, Avco’s WACC is:
300 300
𝑟𝑊𝐴𝐶𝐶 = ∗ 10% + ∗ 6% ∗ (1 − 40%) = 6,8%
600 600
Note that the net debt (D) = 320 – 20 = $300 million.
The value of the project, including the tax shield from debt, is calculated as the present value of its future free
cash flows:
18 18 18 18
𝑉0𝐿 = + + + = $61,25 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
1,068 1,068² 1,068³ 1,0684
The NPV of the project is $33,25 million ($61,25 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 − $28 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 = $33,25 𝑚𝑖𝑙𝑙𝑖𝑜𝑛)
B. SUMMARY OF THE WACC METHOD

1. Determine the free cash flow of the investment
2. Compute the weighted average cost of capital (rWACC)
3. Compute the value of the investment including the tax benefit of leverage, by discounting the free cash
flow of the investment using the WACC (𝑉𝑂𝐿 )
The WACC can be used throughout the firm as the companywide cost of capital for new investments that are of
comparable risk to the rest of the firm and that will not alter the firm’s debt-equity ratio.
The acquisition can be viewed as a growing perpetuity:
$5 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
𝑃𝑉 𝐿 = = 142.857.143
7,5% − 4%
The present value is the value of the business. However, the

value of the deal is the NPV, because we first need to invest
in the business to have the deal done.
The NPV of the acquisition is:
−110.000.000 + 142.857.143 = $32.857.143
The NPV is bigger than 0, therefore we have to go for it.
C. IMPLEMENTING A CONST ANT DEBT-EQUITY RATIO

By undertaking the RFX project, Avco adds new assets to the firm with initial market value $61,25 million.
Therefore, to maintain its debt-to-value ratio, Avco must add $30,625 million in new debt (50% * 61,25 = 30,625).
We want a debt to equity ratio of 1, we want as much equity as debt.
𝐸𝑉 = 𝐸𝑞𝑢𝑖𝑡𝑦 𝑣𝑎𝑙𝑢𝑒 + 𝑁𝑒𝑡 𝑑𝑒𝑏𝑡
𝑁𝑒𝑡 𝑑𝑒𝑏𝑡 = 𝑑𝑒𝑏𝑡 − 𝑐𝑎𝑠ℎ
Avco can add this debt either by reducing cash or by borrowing and increasing debt. Assume Avco decides to
spend its $20 million in cash and borrow an additional $10,625 million. Because only $28 million is required to
fund the project, Avco will pay the remaining $2,625 million to shareholders through a dividend or share
repurchase (30,625 – 28 = $2,625 million).
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The market value of Avco’s equity increases by $30,625 million (330,625 – 300 = $30,625 million). Adding the
dividend of $2,625 million, the shareholders’ total gain is $33,25 million (30,625 + 2,625 = $33,25 million)., which
is exactly the NPV calculated for the RFX project.
The debt capacity is the amount of debt at a particular date that is required to maintain the firm’s target debt-
to-value ratio. The debt capacity at date t is calculated as:
𝐷𝑡 = 𝑑 ∗ 𝑉𝑡𝐿
Where d is the firm’s target debt-to-value ratio and 𝑉𝑡𝐿 is the levered continuation value on date t. 𝑉𝑡𝐿 is calculated
as:
𝐿
𝐹𝐶𝐹𝑡+1 + 𝑉𝑡+1
𝑉𝑡𝐿 =
1 + 𝑟𝑊𝐴𝐶𝐶
18
𝑉3𝐿 = 16,85 =
1 + 6,8%
18 + 16,85
𝑉2𝐿 = 32,63 =
1 + 6,8%
From the previous example, the market value of the assets
acquired in the acquisition is $142.857.143. To maintain its
debt to equity ratio of 2, Chittenden must increase its debt
by $95.242.857.
𝐷 2
𝑊𝐷 = = = 66,67%
𝐸+𝐷 1+2
$142.857.173 ∗ 66,67% = $95.242.857
The remaining $14.757.143 of the $110.000.000 acquisition cost will be financed with new equity. In addition to
the $14.757.143 in new equity. Chittenden’s existing shares will increase in value by $32.857.143 (the NPV of the
acquisition), for a total increase in equity of $47.614.286.
3. The adjusted present value method

The adjusted present value is a valuation method to determine the levered value of an investment by first
calculating its unlevered value and then adding the value of the interest tax shield.
𝑉 𝐿 = 𝐴𝑃𝑉 = 𝑉 𝑈 + 𝑃𝑉 (𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑)
The first step in the APV method is to calculate the value of the free cash flows using the project’s cost of capital
if it were financed without leverage.
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A. UNLEVERED COST OF CA PITAL

The unlevered cost of capital is the cost of capital for a firm if it were unlevered. For a firm that maintains a target
leverage ratio, it can be estimated as the weighted average cost of capital computed without taking into account
taxes (pre-tax WACC).
𝐸 𝐷
𝑟𝑈 = ∗𝑟 + ∗ 𝑟 = 𝑃𝑟𝑒𝑡𝑎𝑥 𝑊𝐴𝐶𝐶
𝐸+𝐷 𝐸 𝐸+𝐷 𝐷
We value the interest tax shield separately. The firm’s unlevered cost of capital equals its pre-tax WACC because
it represents investors’ required return for holding the entire firm (equity and debt). This argument relies on the
assumption that the overall risk of the firm is independent of the choice of leverage. The tax shield will have the
same risk as the firm if the firm maintains a target leverage ratio.
B. TARGET LEVERAGE RATI O

The target leverage ratio is when a firm adjusts its debt proportionally to a project’s value or its cash flows, where
the proportion need not remain constant. A constant market debt-equity ratio is a special case.
For Avco, its unlevered cost of capital is calculated as:
𝑟𝑈 = 0,50 ∗ 10% + 0,50 ∗ 6% = 8%
The project’s value without leverage is calculated as:
18 18 18 18
𝑉𝑈 = + 2
+ 3
+ = $59,62 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
1,08 1,08 1,08 1,084
C. VALUING THE INTEREST TAX SHIELD

The value of $59,62 million is the value of the unlevered project and does not include the value of the tax shield
provided by the interest payments on debt.
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑡 = 𝑟𝐷 ∗ 𝐷𝑡−1
The interest tax shield is equal to the interest paid multiplied by the corporate tax rate.
𝑖2 = 6% ∗ 23,71 = 1,42
𝑖3 = 6% ∗ 16,32 = 0,98
𝐶𝐹(𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑)

𝑃𝑉 (𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑) =
1 + 𝑊𝐴𝐶𝐶𝑈
The next step is to find the present value of the interest tax shield. When the firm maintains a target leverage
ratio, its future interest tax shields have similar risk to the project’s cash flows, so they should be discounted at
the project’s unlevered cost of capital.
0,73 0,57 0,39 0,20

𝑃𝑉 (𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑) = + + + = $1,63 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
1,08 1,08² 1,08³ 1,084
The total value of the project with leverage is the sum of the value of the interest tax shield and the value of the
unlevered project.
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𝑉 𝐿 = 𝑉 𝑈 + 𝑃𝑉(𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑) = 59,62 + 1,63 = $61,25 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
The NPV of the project is $33,25 million (61,25 – 28 = $33,25 million). This is exactly the same value found using
the WACC approach.
D. SUMMARY OF THE APV M ETHOD

1. Determine the investment’s value without leverage
2. Determine the present value of the interest tax shield
→ Determine the expected interest tax shield
→ Discount the interest tax shield
3. Add the unlevered value to the present value of the interest tax shield to determine the value of the
investment with leverage
The APV method has some advantages:
★ It can be easier to apply than the WACC method when the firm does not maintain a constant debt-equity
ratio.
★ The APV approach also explicitly values market imperfections and therefore allows managers to
measure their contribution to value.
4. The flow-to-equity method

The flow-to-equity is a valuation method that calculates the free cash flow available to equity holders taking into
account all payments to and from debt holders. The cash flows to equity holders are then discounted using the
equity cost of capital.
The free cash flow to equity (FCFE) is the free cash flow that remains after adjusting for interest payments, debt
issuance and debt repayments. The first step in the FTE method is to determine the project’s free cash flow to
equity.
Two corrections need to be made: the

interest expense and the net borrowing.
The interest expenses are deducted

before taxes.
The proceeds from the firm’s net

borrowing activity are added in. These
proceeds are positive when the firm issues
debt and are negative when the firm
reduces its debt by repaying principal.
𝑁𝑒𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑎𝑡 𝐷𝑎𝑡𝑒 𝑡 = 𝐷𝑡 − 𝐷𝑡−1
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The FCFE can also be calculated, using the free cash flow, as:
After-tax interest expense
𝐹𝐶𝐹𝐸 = 𝐹𝐶𝐹 − − 𝜏𝐶 ) ∗ 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 + 𝑁𝑒𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔
(1
If the net borrowing are negative, I reimbursed the debt.
A. VALUING EQUITY CASH FLOWS

Because the FCFE represent payments to equity holders, they should be discounted at the project’s equity cost
of capital.
Given that the risk and leverage of the RFX project are the same as for Avco overall, we can use Avco’s equity
cost of capital of 10% to discount the project’s FCFE.
9,98 9,76 9,52 9,27

𝑁𝑃𝑉 (𝐹𝐶𝐹𝐸) = 2,62 + + 2
+ 3
+ = $33,25 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
1,10 1,10 1,10 1,104
The value of the project’s FCFE represents the gain to shareholders from the project, and it is identical to the
NPV computed using the WACC and APV methods.
B. SUMMARY OF THE FLOW -TO-EQUITY METHOD

1. Determine the free cash flow to equity of the investment
2. Determine the equity cost of capital
3. Compute the equity value by discounting the free cash flow to equity using the equity cost of capital
The FTE method offers some advantages:
★ It may be simpler to use when calculating the value of equity for the entire firm if the firm’s capital
structure is complex and the market values of other securities in the firm’s capital structure are not
known.
★ It may be viewed as a more transparent method for discussing a project’s benefit to shareholders by
emphasizing a project’s implication for equity.
The FTE method has a disadvantage:
★ One must compute the project’s debt capacity to determine the interest and net borrowing before
capital budgeting decisions can be made.
FCF = 5.000.000 (every year from Y2)

Debt capacity = 95.242.857 (every year)
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 = 6% ∗ 95.242.857 ∗ (1 − 40%)
= 3.428.742,85
Net debt(Y1) = 95.242.857 – 0 = 95.242.857
Net debt(from Y2) = 0
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𝐹𝐶𝐹𝐸 = 𝐹𝐶𝐹 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 + 𝑁𝐸𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 = 5.000.000 − 3.248.742,85 + 0 = 1.571.257
𝐶𝐹𝐸(1) = 𝐷𝑒𝑏𝑡 𝑐𝑎𝑝𝑎𝑐𝑖𝑡𝑦 + 𝐸𝑉 = 95.242.857 + 1.571.257 = 96.814.114
96.814.114
𝑃𝑉 = = 88.012.830,91
1,10
5. Project based costs of capital

In the real world, a specific project may have different market risk than the average project for the firm. In
addition, different projects will may vary in the amount of leverage they will support.
A. ESTIMATING THE UNLEVERED COST OF CAPITAL

Suppose Avco launches a new plastics manufacturing division that faces different market risks than its main
packaging business. The unlevered cost of capital for the plastics division can be estimated by looking at other
single-division plastics firms that have similar business risks.
Assume two firms are comparable to the plastics division and have the following characteristics:
Assuming that both firms maintain a target leverage ratio, the unlevered cost of capital for each competitor can
be estimated by calculating their pre-tax WACC.
𝐶𝑜𝑚𝑝𝑒𝑡𝑖𝑡𝑜𝑟 1: 𝑟𝑈 = 0,6 ∗ 12% + 0,4 ∗ 6% = 9,6%
𝐶𝑜𝑚𝑝𝑒𝑡𝑖𝑡𝑜𝑟 2: 𝑟𝑈 = 0,75 ∗ 10,7% + 0,25 ∗ 5,5% = 9,4%
Based on these comparable firms, we estimate an unlevered cost of capital for the plastics division is
approximately 9,5%. With this rate in hand, we can use the APV approach. To use the WACC or FTE methods, we
need to estimate the project’s equity cost of capital, which depends on the incremental debt the company will
take on as a result of the project.
B. PROJECT LEVERAGE AND THE EQUITY COST OF C APITAL

A project’s equity cost of capital may differ from the firm’s equity cost of capital if the project uses a target
leverage ratio that is different than the firm’s. The project’s equity cost of capital can be calculated as follows:
𝐷
𝑟𝐸 = 𝑟𝑈 + ∗ (𝑟𝑈 − 𝑟𝐷 )
𝐸
Now, assume that Avco plans to maintain an equal mix of debt and equity financing as it expands into plastics
manufacturing, and it expects its borrowing cost to be 6%. Given the unlevered cost of capital estimate of 9,5%,
the plastics division’s equity cost of capital is estimated to be:
0,5
𝑟𝐸 = 9,5% + ∗ (9,5% − 6%) = 13%
0,5
The division’s WACC can now be estimated to be:
𝑟𝑊𝐴𝐶𝐶 = 0,5 ∗ 13% + 0,5 ∗ 6% ∗ (1 − 40%) = 8,3%
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An alternative method for calculating the division’s WACC is:
𝑟𝑊𝐴𝐶𝐶 = 9,5% − 0,5 ∗ 0,4 ∗ 6% = 8,3%
C. DETERMINING THE INCREMENTAL LEVERAGE OF A PROJECT

To determine the equity or weighted average cost of capital for a project, the incremental financing that results
if the firm takes on the project needs to be calculated.
D. A COMPARISON OF METHODS
Typically, the WACC method is the easiest to use when the firm will maintain a fixed debt-to-value ratio over the
life of the investment.
For alternative leverage policies, the APV method is usually the simplest approach.
The FTE method is typically used only in complicated settings where the values in the firm’s capital structure or
the interest tax shield are difficult to determine.
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CHAPTER 16 (19): VALUATION AND FINANCIAL MODELING – A CASE STUDY
1. Valuation using comparables

Consider Ideko Corporation, a privately held firm. The owner has decided to sell the business. Your job, as a
partner in KKP Investments, is to evaluate purchasing the company, implementing operational and financial
improvements and selling the business at the end of the five years.
We could calculate a net profit margin.
6.939
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 =
75.000
= 9,25%
11.250
𝑆𝑎𝑙𝑒𝑠 & 𝑀𝑎𝑟𝑘𝑒𝑡𝑖𝑛𝑔 =
75.000
= 15% 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠
13.500
𝐴𝑑𝑚𝑖𝑛𝑖𝑠𝑡𝑟𝑎𝑡𝑖𝑣𝑒 =
75.000
= 18% 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠
150.000
𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝑒𝑞𝑢𝑖𝑡𝑦 = = 1,93
77.668
In the cash and equivalents, 6.500 is cash and the other 6.164 is the rest.
What is the enterprise value of Ideko for a proposed acquisition price of 150.000 million if you estimate that
Ideko holds 6.500 million in excess of its working capital needs?
𝐸𝑉 = 𝐸𝑞𝑢𝑖𝑡𝑦 𝑣𝑎𝑙𝑢𝑒 + 𝑁𝑒𝑡 𝑑𝑒𝑏𝑡 = 150.000 + (4500 − 6500) = 148.000
A price of $150 million for Ideko’s

equity has been suggested. The
data in the table provides some
reassurance that the acquisition
price of $150 million is reasonable
as the ratios are about the same or
better than the industry averages.
However, to assess whether this investment is attractive, the operational aspects of the firm and of the ultimate
cash flows the deal is expected to generate need to be analysed.
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2. The business plan
A. OPERATIONAL IMPROVEMENTS
By cutting administrative costs immediately and redirecting resources to new product development, sales and
marketing, you believe Ideko can increase its market share from 10% to 15% over the next five years. The
increased sales demand can be met in the short run using the existing production lines. Once the growth in
volume exceeds 50%, however, Ideko will need to undertake a major expansion to increase its manufacturing
capacity.
Ideko’s average selling price is forecast to increase 2% each year. Raw materials are forecast to increase at a 1%
rate. Labour costs are forecast to increase at a 4% rate.
B. CAPITAL EXPENDITURES: A NEEDED EXPANSION

In 2008, a major expansion will be necessary for Ideko, leading to a large increase in capital expenditures in 2008
and 2009.
C. WORKING CAPITAL MANA GEMENT

Ideko’s accounts receivable days is:
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 (𝑆) 𝑑𝑎𝑦𝑠 18.493

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑑𝑎𝑦𝑠 = ∗ 365 = ∗ 365 𝑑𝑎𝑦𝑠 = 90 𝑑𝑎𝑦𝑠
𝑆 𝑦𝑟 75.000
𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠 ( )
𝑦𝑟
While the industry average is 60 days. You believe that Ideko can tighten its credit policy to achieve the industry
average without sacrificing sales.
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Ideko’s inventory figure on its balance sheet includes $2 million of raw materials. Given raw material
expenditures of $16 million for the year, Ideko currently holds 45,6 days worth of raw material inventory.
2
( ) ∗ 365 = 45,6 𝑑𝑎𝑦𝑠
16
You believe that, with tighter controls of the production process, 30 days worth of inventory will be adequate.
D. CAPITAL STRUCTURE CHANGES: LEVERING UP

You believe Ideko is significantly underleveraged so you plan to increase the firm’s debt. The debt will have an
interest rate of 6,8% and Ideko will only pay interest during the next five years. The firm will seek additional
financing in 2008 and 2009 associated with the expansion.
The forecasted interest expense each year is computed as follows:
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑡 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 ∗ 𝑒𝑛𝑑𝑖𝑛𝑔 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟 (𝑡 − 1)
In addition to the $150 million purchase price for Ideko’s equity, $4,5 million will be used to repay Ideko’s existing
debt. With $5 million in transaction fees, the acquisition will require $159,5 million in total funds. KKP’s sources
of funds include the new loan of $100 million as well as Ideko’s own excess cash (which KKP will have access to).
Thus KKP’s required equity contribution to the transaction is $53 million.
3. Building the financial model
A. FORECASTING EARNINGS
Pro forma describes a statement that is not based on actual data but rather depicts a firm’s financials under a
given set of hypothetical.
To build the pro forma income statement, begin with Ideko’s sales. Each year, sales can be calculated as:
𝑆𝑎𝑙𝑒𝑠 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑆𝑖𝑧𝑒 ∗ 𝑀𝑎𝑟𝑘𝑒𝑡 𝑠ℎ𝑎𝑟𝑒 ∗ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑎𝑙𝑒𝑠 𝑝𝑟𝑖𝑐𝑒
The raw materials cost can be calculated from sales as follows:
𝑅𝑎𝑤 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙𝑠 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑠𝑖𝑧𝑒 ∗ 𝑚𝑎𝑟𝑘𝑒𝑡 𝑠ℎ𝑎𝑟𝑒 ∗ 𝑟𝑎𝑤 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙𝑠 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
Sales, marketing and administrative costs can be computed directly as a percentage of sales:
𝑆𝑎𝑙𝑒𝑠 𝑎𝑛𝑑 𝑚𝑎𝑟𝑘𝑒𝑡𝑖𝑛𝑔 = 𝑆𝑎𝑙𝑒𝑠 ∗ 𝑆𝑎𝑙𝑒𝑠 𝑎𝑛𝑑 𝑚𝑎𝑟𝑘𝑒𝑡𝑖𝑛𝑔 % 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠
The corporate income tax is computed as follows:
𝐼𝑛𝑐𝑜𝑚𝑒 𝑡𝑎𝑥 = 𝑝𝑟𝑒𝑡𝑎𝑥 𝑖𝑛𝑐𝑜𝑚𝑒 ∗ 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒
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B. WORKING CAPITAL REQUIREMENTS

The working capital forecast should include the plans to tighten Ideko’s credit policy, speed up customer
payments and reduce Ideko’s inventory of raw materials. Accounts receivables in 2006 is calculated as follows:
𝐴𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 $88.358

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 = 𝐷𝑎𝑦𝑠 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 ∗ = 60 ∗ = $14.525 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
365 𝑑𝑎𝑦𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 365
The minimum cash balance is the minimum level of cash needed to keep the business running. Firms typically
earn little or no interest on these balances. As a consequence, the opportunity cost of holding cash is accounted
for by including the minimal cash balance as part of the firm’s working capital.
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C. FORECASTING FREE CASH FLOW

Using the data from the previous tables, Ideko’s free cash flows over the next five years can be forecasted. The
after-tax interest expense is calculated as follows:
𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 = (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒) ∗ (𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑑𝑒𝑏𝑡 − 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑒𝑥𝑐𝑒𝑠𝑠 𝑐𝑎𝑠ℎ)
Net borrowing is calculated as follows:
𝑁𝑒𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑡 = 𝑛𝑒𝑡 𝑑𝑒𝑏𝑡 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑡 − 𝑛𝑒𝑡 𝑑𝑒𝑏𝑡 𝑖𝑛 𝑦𝑒𝑎𝑟 (𝑡 − 1)
D. THE BALANCE SHEET AN D STATEMENT OF CASH FLOWS

The information calculated so far can be used to project Ideko’s balance sheet and statement of cash flows. On
the balance sheet, the current assets and liabilities come from the net working capital spreadsheet. Inventory
figures includes both raw materials and finished goods. Property, plant and equipment figures come from the
capital expenditure spreadsheet.
The statement of cash flows starts with the net income. The cash from operating activities includes depreciation
as well as changes to working capital items, other than cash. Cash from investing activities includes the capital
expenditures. Cash from financing activities includes changes in outstanding debt and dividends or stock
issuance.
Debt figures come from the planned debt and interest payments spreadsheets. The new goodwill is calculated
as follows:
𝑁𝑒𝑤 𝑔𝑜𝑜𝑑𝑤𝑖𝑙𝑙 = 𝑎𝑐𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒 − 𝑒𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
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4. Estimating the cost of capital
A. CAPM-BASED ESTIMATION
Because Ideko is not publicly traded, comparable firms must be used to estimate the firm’s beta. The beta for
comparable firms is calculated as follows:
Excess return of stock s Excess return of market portfolio
𝑅𝑠 − 𝑟𝑓 = 𝛼𝑆 + 𝛽𝑠 ∗ (𝑅𝑚𝑘𝑡 − 𝑟𝑓 ) + 𝜀𝑆
B. UNLEVERING BETA
Given an estimate of each firm’s equity
beta, the “unlevered” beta must be
calculated, based on the firm’s capital
structure.
𝐸𝑞𝑢𝑖𝑡𝑦 𝑣𝑎𝑙𝑢𝑒 𝑁𝑒𝑡 𝑑𝑒𝑏𝑡 𝑣𝑎𝑙𝑢𝑒

𝛽𝑈 = ( ) ∗ 𝛽𝐸 + ( ) ∗ 𝛽𝐷
𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒
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C. IDEKO’S UNLEVERED CO ST OF CAPITAL

The data from the comparable firms provides guidance for estimating Ideko’s unlevered cost of capital. Ideko’s
products are not as high end as Oakley’s eyewear, so Ideko’s sales are unlikely to vary as much with the business
cycle as Oakley’s sales do. Ideko does not have a prescription eyewear division, as Luxottica does. Ideko’s
products are fashion items rather than exercise items.
Given the above analysis, Ideko’s cost of capital is likely to be closer to Oakley’s than to Nike’s or Luxottica’s. You
decide to use 1,20 as your preliminary estimate for Ideko’s unlevered beta. Your estimate of Ideko’s unlevered
cost of capital is:
𝑆𝑀𝐿 = 𝑟𝑈 = 𝑟𝑓 + 𝛽𝑈 ∗ (𝐸[𝑅𝑚𝑘𝑡 ] − 𝑟𝑓 ) = 4% + 1,2 ∗ 5% = 10%
5. Valuing the investment
A. THE MULTIPLES APPROA CH TO CONTINUATION V ALUE

Practitioners generally estimate a firm’s continuation value (also called the terminal value) at the end of the
forecast horizon using a valuation multiple, with the EBITDA multiple being the multiple most often used in
practice.
𝐶𝑜𝑛𝑡𝑖𝑛𝑢𝑎𝑡𝑖𝑜𝑛 𝑒𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡 ℎ𝑜𝑟𝑖𝑧𝑜𝑛

= 𝐸𝐵𝐼𝑇𝐷𝐴 𝑎𝑡 𝐻𝑜𝑟𝑖𝑧𝑜𝑛 ∗ 𝐸𝐵𝐼𝑇𝐷𝐴 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑒 𝑎𝑡 ℎ𝑜𝑟𝑖𝑧𝑜𝑛
The EBITDA multiple is the one from 2005. We just have to work with it because that’s the best we have. The
continuation enterprise value is for the whole company, therefore we need to discount it with the WACC. The
continuation equity value must be discounted with the rE.
Afterwards, we check if our results make sense. Therefore, we calculate the common multiples and we compare
them with the one of the sector.
★ Does our enterprise value make sense?
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑒𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 2010 292.052

= = 1,8
𝑆𝑎𝑙𝑒𝑠 𝑜𝑓 2010 158.526
★ Does the equity value make sense?
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑒𝑞𝑢𝑖𝑡𝑦 𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑎𝑡𝑖𝑜𝑛 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 2010 172.052

= = 16,3
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑜𝑓 2010 10.545
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★ Does the unlevered equity value make sense (unlevered means there is no debt)?
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑒𝑞𝑢𝑖𝑡𝑦 𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑎𝑡𝑖𝑜𝑛 𝑣𝑎𝑙𝑢𝑒 (𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑)𝑜𝑓 2010 292.052

= = 18,4
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑜𝑓 2010 10.545
Those numbers are reasonable to conservatives, we are not overvaluing the company.
One difficulty with relying on comparables when forecasting a continuation value is that future multiples of the
firm are being compared with current multiples of its competitors.
B. THE DISCOUNTED CASH FLOW APPROACH TO CON TINUATION VALUE

The enterprise value in year T, using the WACC valuation method, is calculated as follows:
𝐹𝐶𝐹𝑇+1
𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑇 = 𝑉𝑇𝐿 =
𝑟𝑊𝐴𝐶𝐶 − 𝑔
The free cash flow in year T+1 is computed as follows:
𝐹𝐶𝐹𝑇+1 = 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒𝑇+1 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑇+1 − 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠 𝑖𝑛 𝑁𝑊𝐶𝑇+1

− 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠𝑇+1
If firm’s sales are expected to grow at a nominal rate and the firm’s operating expenses remain a fixed percentage
of sales, then its unlevered net income will also grow at rate g. Similarly, the firm’s receivables, payables and
other elements of net working capital will grow at rate g.
If capital expenditures (our investments) are defined as:
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠𝑇+1 = 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑇+1 + (𝑔 ∗ 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠𝑇 )
Then free cash flows, given g, can be estimated as:
𝐹𝐶𝐹𝑇+1 = (1 + 𝑔) ∗ 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒𝑇 − 𝑔 ∗ 𝑛𝑒𝑡 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑇 − 𝑔 ∗ 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠𝑇
𝐿
𝐹𝐶𝐹2011 (1 + 5%) ∗ 𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 2010 − 𝑔 ∗ 𝑁𝑊𝐶2010 − 𝑔 ∗ 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡2010
𝑉2010 = =
𝑊𝐴𝐶𝐶 − 𝑔 (𝑟𝑈 − 𝑑 ∗ 𝜏 ∗ 𝑟𝐷 ) − 5%
The last line is a little check to see if the multiple we too before is not too different from the reality.
𝐿
𝑉2010
𝐸𝐵𝐼𝑇𝐷𝐴 𝑜𝑓 2010
Now we have two multiples. Therefore we can take one or the other, or make an average of both.
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Both the multiples approach and the discounted cash flow approach are useful in deriving a realistic continuation
value estimate. It is recommended to combine both approaches.
1/2/3 are given

information from
previous slides.
The projected EBITDA multiple of 9,1 can be justified according the discounted cash flow method with a nominal
long-term growth rate of about 5,3%. Given an inflation rate of 2%, this nominal rate represents a real growth
rate of about 3,3%. If this implied growth rate is much higher than the expectations of long-run growth for the
industry as a whole, you should be more sceptical of the estimate being used.
The estimate of Ideko’s continuation value can be combined with the forecasts for free cash flow through 2010
to estimate Ideko’s value today using the APV valuation model.
The first step is to compute Ideko’s unlevered value:
𝑈
𝐹𝐶𝐹𝑡 + 𝑉𝑡𝑈
𝑉𝑡−1 =
1 + 𝑟𝑈
Next, the interest tax shield needs to be computed:
𝑆
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑𝑡 + 𝑇𝑡𝑆
𝑇𝑡−1 =
1 + 𝑟𝐷
Using the APV valuation model, the estimate for Ideko’s initial enterprise value is $213 million, with an equity
value of $113 million. Given that KKP’s initial cost to acquire Ideko’s equity is $53 million, the deal looks attractive
with an NPV of $60 million(113 − 53 = $60 𝑚𝑖𝑙𝑙𝑖𝑜𝑛).
𝑃𝑉(𝐶𝐹𝑡 ) − 𝐼𝑛𝑣0 = 𝑁𝑃𝑉 (𝑖𝑓 > 0, 𝑔𝑜𝑜𝑑 𝑡𝑜 𝑔𝑜 𝑓𝑜𝑟)
𝐸 𝐷
𝑟𝑢 = 𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = ∗ 𝑟𝐸 + ∗ 𝑟 = 10%
𝑈
𝑈
10.328 + 292.052 𝐹𝐶𝐹2010 + 𝑉2010
𝑉2009 = =
1 + 10% 1 + 𝑟𝑈
𝑈
1.458 + 274.891
𝑉2008 =
1 + 10%
35% ∗ 8160 (𝑡𝑎𝑏𝑙𝑒 19.5)

𝑇𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑: = 2.674
1 + 6,8%
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C. A REALITY CHECK
At this point, it is wise to step back and assess whether the valuation results make sense. Does an initial value of
$213 million for Ideko seem reasonable compared to the values of other firms in the industry? Compute the
initial valuation multiples that would be implied by our estimated enterprise value of $213 million and compare
them to Ideko’s closest competitors.
It seems that Luxottica can do it, so it seems that we are ambitious, but we are in the same magnitude of our
competitors. We might want to go ahead.
The multiples are now at the top end or somewhat above the range of the values of the other firms used for
comparison. Although these multiples are not unreasonable given the operational improvements that KKP plans
to implement, they indicate that the forecast may be somewhat optimistic and depend critically on KKP’s ability
to achieve the operational improvements it plans.
D. IRR AND CASH MULTIPLES

Practitioners often use IRR and the cash multiple as alternative valuation metrics. To compute the IRR, KKP’s cash
flows over the life of the transaction must be computed. Assuming KKP will sell its equity share in Ideko at the
end of five years, the IRR for the transaction is 33,3% (NPV=0), as shown on the following table.
The cash multiple is the ratio of the total cash received to the total cash invested. The cash multiple is computed
as follows:
𝑇𝑜𝑡𝑎𝑙 𝑐𝑎𝑠ℎ 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 9.055 + 2.989 + 4.735 + 1.375 + 177.077

𝐶𝑎𝑠ℎ 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑒 = = = 3,7
𝑇𝑜𝑡𝑎𝑙 𝑐𝑎𝑠ℎ 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 53.000
KKP expects to receive a return that is 3,7 times its investment in Ideko.
The cash multiple has an obvious weakness. It does not depend on the amount of time it takes to receive the
cash, nor does it account for the risk of the investment. It is therefore useful only for comparing deals with similar
time horizons and risk.
6. Sensitivity analysis
It is important to assess the uncertainty of the forecasts and to determine their potential impact on the value of
the deal. Sensitivity analysis can show the sensitivity of the estimates of the value of KKP’s investment to changes
in the assumptions regarding the exit EBITDA multiple that KKP obtains when Ideko is sold, as well as Ideko’s
unlevered cost of capital.
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This table shows that each 1.0 increase in the EBITDA multiple represents about $20 million in initial value. KKP
will break even on its $53 million investment in Ideko with an exit multiple of slightly more than 6.0. The table
also shows, however, that an exit multiple of 6.0 is consistent with a future growth rate for Ideko of less than
2%, which is even less than the expected rate of inflation and probably unrealistically low. Even with a rate as
high as 14%, the equity value exceeds KKP’s initial investment.
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CHAPTER 17 (29): CORPORATE GOVERNANCE
1. Corporate governance and agency costs

The corporate governance is the system of controls, regulations and incentives designed to minimize agency
costs between managers and investors and prevent corporate fraud. The role of the corporate governance
system is to mitigate the conflict of interest that results from the separation of ownership and control without
unduly burdening managers with the risk of the firm.
The role of the corporate governance system is to reduce or eliminate conflicts of interest (agency problem) and
the effective use of assets (accounting scandals).
The board may not have the same interest as the shareholders. Most companies today are hold by professional
institutional investors, and it was not the case before.
2. Monitoring by the board of directors and others

In the United States, the board of directors has a clear fiduciary duty to protect the interests of the shareholders.
Most other countries give some weight to the interests of other stakeholders in the firm, such as the employees.
In Belgium, 5% is two-tier and 95% is mixed.
Define board responsibilities

towards shareholders.
How managers and directors

will be accountable.
How to be transparent about

operations, risk, financial,
performance.
A. BOARD INDEPENDENCE
On a board composed of insider, gray and independent directors, the role of the independent director is really
that of a watchdog. However, because independent directors’ personal wealth is likely to be less sensitive to
performance than that of insider and gray directors, they have less incentive to closely monitor the firm.
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B. BOARD SIZE AND PERFORMANCE

Researchers have found the surprisingly robust result that smaller boards are associated with greater firm value
and performance. The likely explanation for this phenomenon comes from the psychology and sociology
research, which finds that smaller groups make better decisions than larger groups.
C. OTHER MONITORS
It includes security analysts, lenders, the SEC and employees.
★ Securities analysts produce independent valuations of the firms they cover so that they can make buy
and sell recommendations to clients.
★ Lenders carefully monitor firms to which they are exposed as creditors.
★ Employees of the firm are most likely to detect outright fraud because of their inside knowledge.
★ The SEC protects the investing public against fraud and stock price manipulation.
3. Compensation policies
A. STOCK AND OPTIONS

Managers’ pay can be linked to the performance of a firm in many ways. Many companies have adopted
compensation policies that include grants of stock or stock options to executives. These grants give managers a
direct incentive to increase the stock price, which ties managerial wealth to the wealth of shareholders.
B. PAY AND PERFORMANCE SENSITIVITY

The use of stock and option grants in the 1990s has led to a substantial increase in management compensation.
However, this has had some negative consequences.
For example, often options are granted at the

money, meaning that the exercise price is
equal to the current stock price. Managers
therefore have an incentive to manipulate the
release of financial forecasts so the bad news
comes out before options are granted (to drive
the exercise price down) and good news comes
out after options are granted.
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4. Managing agency conflict

Academic studies have supported the notion that greater managerial ownership is associated with fewer value-
reducing actions by managers. But while increasing managerial ownership may reduce perquisite consumption,
it also makes managers harder to fire.
A. DIRECT ACTION BY SHA REHOLDERS

★ Shareholder voice
Any shareholder can submit a resolution that is put to a vote at the annual meeting. Recently, unhappy
shareholders have started to refuse to vote to approve the state of nominees for the board
★ Shareholder approval
Shareholders must approve many major actions taken by the board. For example, target shareholders must
approve merger agreements.
★ Proxy contests
Disgruntled shareholders can hold a proxy contest and introduce a rival slate of directors for election to the
board. This gives shareholders an actual choice between the nominees put forth by management and the current
board and a completely different slate of nominees put forth by dissident shareholders.
More and more, they agree before to make the real

decision, so that they are not disappointed at the moment
of the decision and they already know what will happen.
B. MANAGEMENT ENTRENCHMENT
Large investors have become increasingly interested in measuring the balance of power between shareholders
and managers in a firm. The investor responsibility research centre (IRRC) has collected information on 24
different characteristics that can entrench managers.
C. THE THREAT OF A TAKE OVER

Many of the provisions listed in the IRRC index concern protection from takeovers. One motivation for a takeover
can be to replace poorly performing management. An active takeover market is part of the system through which
the threat of dismissal is maintained.
5. Regulation
A. THE SARBANES-OXLEY ACT (SOX)

The overall intent of SOX was to improve the accuracy of information given to both boards and to shareholders.
SOX attempted to achieve this goal in three ways:
★ By overhauling incentives and independence in the auditing process,

★ By stiffening penalties for providing false information,
★ By forcing companies to validate their internal financial control processes.
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B. THE CADBURY COMMISSI ON

Following the collapse of some large public companies, the UK government commissioned Sir Adrian Cadbury to
form a committee to develop a code of best practices in corporate governance.
C. DODD-FRANK ACT
Dodd-Frank added a number of new regulations designed to strengthen corporate governance, including:
★ Independent compensation committees,

★ Nominating directors,
★ Vote on executive pay and golden parachutes,
★ Clawback provisions,
★ Pay disclosure.
D. INSIDER TRADING
It occurs when a person makes a trade based on privileged information. Some examples of insider information
include knowledge of an upcoming merger announcement, earnings release or change in pay-out policy. The
penalties for violating insider trading laws include jail time, fines and civil penalties.
There are over 100 codes internationally related to issues of corporate governance. The actors behind each set
of codes are very different, from country to country. The best corporate governance code is the one of South
Africa.
In the wake of the financial crisis of 2009, things have gone terribly wrong despite the codes. Why? Maybe the
focus needs to move away from codes to look more closely at international governance mechanisms.
6. Corporate governance around the world
A. PROTECTION OF SHAREH OLDER RIGHTS

The degree to which investors are protected against expropriation of company funds by managers and even the
degree to which their rights are enforced vary widely across countries and legal regimes.
B. CONTROLLING OWNERS AND PYRAMIDS

Much of the focus in the United States is on the agency conflict between shareholders and managers. In many
other countries, the central conflict is between what are called the controlling shareholders and the minority
shareholders.
★ Dual class shares and the value of control
When one class of a firm’s shares has superior voting rights over the other class. One way for families to gain
control over firms even when they do not own more than half the shares is to issue dual class shares. For example,
a class B share might have 10 votes for every one vote of a class A share. Controlling shareholders will hold all or
most of the shares with superior voting rights and issue the inferior voting class to the public.
★ Pyramid structures
This is a way for an investor to control a corporation without owning 50% of the equity whereby the investor first
creates a company in which he has a controlling interest. This company then owns a controlling interest in
another company. The investor controls both companies but may own as little as 25% of the second company.
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This slide represents an actual pyramid controlled by the Pesenti

family, in Italy, in 1995.
The Pesenti family effectively controls five companies even

though it does not have more than 50% ownership in any of
them.
★ Tunnelling
It is a conflict of interest that arises when a shareholder who has a controlling interest in multiple firms moves
profits (and hence dividends) away from companies in which he has relatively less cash flow toward firms in
which he has relatively more cash flow rights (up the pyramid).
★ Stakeholder model
It is the explicit consideration most countries (other than the United States) give to other stakeholders besides
equity holders, in particular, rank-and-file employees.
★ Cross-holdings
While in the United States, it is rare for one company’s largest shareholder to be another company, it is the norm
in many countries.
7. The trade-off of corporate governance

Corporate governance is a system of checks and balances that trades off costs and benefits. This trade-off is very
complicated. No one structure works for all firms. Good governance is value enhancing and is something
investors in the firm should strive for.
100

Financial Management Notes Resumen

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Financial Management Notes Resumen

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VALENTINE HOUSSARD

1. The four types of firms

Limited Partnership has two types of owners:

C. LIMITED LIABILITY COMPANIES (LLC)

★ After personal tax = 2,64 * (1-0,2) = 2,112

2. Ownership versus control of corporations

A. CORPORATE MANAGEMENT TEAM

B. THE FIRM AND SOCIETY

I. Ethics and incentives within corporations

II. CEO performance

III. Corporate bankruptcy

3. The stock market

A. TRADITIONAL TRADING VENUES

★ Limit order: an order to buy or sell a set amount at a fixed price.

CHAPTER 2: INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS

1. Firm’s disclosure of financial information

There are 4 types of financial statements:

2. The balance sheet

𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦

𝑁𝑊𝐶 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝑀𝑎𝑟𝑘𝑒𝑡 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 ∗ 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦

𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝐷𝑒𝑏𝑡 − 𝐶𝑎𝑠ℎ

★ Market Capitalization = 108 * 5M = 540M

★ Book Value of Equity = 50M

3. The income statement

4. The statement of Cash-flows

★ Non-cash expenses (Depreciation and Amortization): no money moves

In every annual report, we have 3 sections:

★ Depreciation – Add the amount of depreciation

The decrease in depreciation has an

+ 750.000 ∗ (1 − 40%) − (5.000.000 − 3.000.000) = −1.550.000

5. Other financial statement information

A. STATEMENT OF STOCKHO LDERS’ EQUITY

Change in Stockholders’ equity

6. Financial statement analysis

The industry is improving. However, the United

𝐶𝑎𝑠ℎ + 𝑆ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 + 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

Rylan 2015 2016

C. WORKING CAPITAL RATIOS

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑑𝑎𝑦𝑠 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠

D. INTEREST COVERAGE RATIOS

𝐸𝐵𝐼𝑇𝐷𝐴 𝐸𝐵𝐼𝑇 + 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + 𝑎𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛

Rylan 2015 2016

𝑀𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑆ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒

𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑑𝑒𝑏𝑡 − 𝑐𝑎𝑠ℎ

𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑑𝑒𝑏𝑡 − 𝑐𝑎𝑠ℎ

𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝑛𝑒𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

𝐸𝐵𝐼𝑇 ∗ (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)

7. Financial reporting in practice

CHAPTER 3: FINANCIAL DECISION MAKING AND THE LAW OF ONE PRICE

A. IDENTIFY THE COSTS AND BENEFITS

B. ANALYZING COSTS AND BENEFITS

C. USING MARKET PRICES TO DETERMINE CASH VALUES

We choose the motorcycle, because the price is

The costs and benefits must be converted to their cash

★ 2.500 shares * $14 = $35.000

The net value of the opportunity is 35.000 + 11.200 –

2. Interest rates and the time value of money

A. TIME VALUE OF MONEY

★ Cost: $100.000 today.