Finance Midterm Revision

Week 1: Time Value of Money .......................................................................................... 1

Week 2: Valuing Bonds ..................................................................................................... 3
Week 3: Net Present Value (NPV) and other investment criteria ....................................... 4
Week 4: Valuing Stocks..................................................................................................... 6
Week 5: Risk, Return and Opportunity Cost of Capital ...................................................... 9
Week 6: Risk, Return and Capital Budgeting..................................................................... 9
Week 7: Weighted-Average Cost of Capital and Company Valuation ............................... 10
Week 8: Debt Policy ........................................................................................................ 13
Week 9: Dividends / Payout Policy .................................................................................. 15
Week 10: Options ............................................................................................................ 16
Week 11: Hedging / Risk Management ............................................................................ 17

Week 1: Time Value of Money

1.1.Future Values and Compound Interest

Future Value: Amount investment will grow to with interest earned

Formula: Principal amount * (1+r)t
Simple Interest Compound Interest
Definition Interest earned on original Interest earned on interest-included
investment investments
Interest earned I = (Original investment $) * r I = (New balance with previous year’s
each year interest) * r

Future value at Original investment + (I * 5) Original investment * (1+r)n

end of n years

1.2.Present Values

Present Values: Today’s value of a future cash flow

Formula: Future value / (1+r)t = FV * (Discount Factor)
Can add PVs / FVs together to evaluate multiple cash flows

Discount Factor: Present value of a $1 future payment (used to compute PV of cash flows)
Formula: 1 / (1+r)t
Discount Rate r: Interest rate used to compute present values of future cash flows

1.3.Level Cash Flows: Perpetuities and Annuities

Perpetuity: A stream of level cash payments that never ends
Formula for PV of perpetuity: PV = C / r, where C = cash payment

Annuity: Level stream of cash flows at regular intervals with a finite maturity
Formula for PV of annuity: PV = C * {1/r – 1/[ r*(1+r)t ] }, where C = cash payment per year
and t = number of years cash payment is received
Formula in { } is PV Annuity Factor (PVAF) – the present value of $1 a year for each of t
years
FV = [ C * PVAF ] * (1+r)t
FVAF = PVAF * (1+r)t

Annuity due: level stream of cash flows starting immediately

PVAnnuity due = PVAnnuity * (1+r)
FVAnnuity due = FVAnnuity * (1+r)

1.4. Effective Annual Interest Rates: Interest rate annualised using compound interest
Annual percentage rate (APR): Interest rate annualised using simple interest
APR = MR*12, where MR = monthly interest rate
EAR = (1+MR)12 - 1

1.5.Inflation and the Time Value of Money

Inflation: Rate at which prices as a whole are increasing
Nominal interest rate: Rate at which money invested grows
Real interest rate: Rate at which the purchasing power of an investment increases
1 + real i/r = (1 + nominal i/r) / (1 + inflation rate)
Approximation formula: Real i/r = nominal i/r – inflation rate
With inflation, investor’s real interest rate is always less than the nominal interest rate.
Current dollar cash flows must be discounted by the nominal interest rate
Real cash flows must be discounted by the real interest rate

Week 2: Valuing Bonds

2.1. The Bond Market

Bond: Security that obligates issuer to make specified payments to the bondholder
Face Value (Par Value / Principal Value): Payment at the maturity of the bond
Coupon: Interest payments made to bondholder

Coupon Rate: Annual Interest payment, as a percentage of face value (not the discount rate in
PV); tells us what cash flow the bond will produce

Price of bond = PV of all cash flows generated by the bond (i.e. Coupons + face value)
discounted at the required rate of return (r)

PV = bond price in $ = (par value) * (bond price in %)

If have semi-annual coupons vs annual coupon payments, there are twice as many payments
cut in half, over the same time period. The period t becomes half years, hence discount rate is
also changed from annual rate to half year rate.

2.2. Yield to Maturity

Current Yield: Annual coupon payments / bond price
Yield to Maturity (YTM): Discount rate r for which PV of bond’s payments = price
To calculate YTM = r, solve for r by inputting price of bond (PV) and coupon rate into price
of bond formula.
Volatility (%) = duration / (1+yield)

2.3. Bond Rates of Returns: Total income per period per dollar invested
Rate of return = total income / investment = (coupon income + price change) / investment
Rate of return is also called discount rate, hurdle rate and opportunity cost of capital

2.4. The Yield Curve

Term Structure of interest rates: A listing of bond maturity dates and the interest rates that
correspond with each date
Yield curve: Plot of relationship between bond yields to maturity and time to maturity
(lower/higher yield for longer term bonds?)

2.5. Corporate Bonds and the Risk of Default

Default / Credit Risk: Risk that a bond issuer may default on its bonds

Default premium: Additional yield on a bond that investors require for bearing credit risk
Investment grade: Bonds rated Baa or above by Moody’s or BBB or above by Standard &
Poor’s
Junk bonds: Bonds with ratings below Baa or BBB

Zero-coupon bonds
Floating-rate bonds
Convertible bonds

Week 3: Net Present Value (NPV) and other investment criteria

3.1. NPV: PV of cash flows minus initial/required investments, something like profit
Opportunity cost of capital (r) : Expected rate of return given up by investing in a project
Initial cash flow C0 is often negative (since it’s the money you initially invest)

NPV rule: Accept all projects with a positive NPV, as managers increase shareholders’
wealth by accepting projects worth more than what they cost

Valuing an investment:
Step 1: Forecast cash flows
- Eg. Cost of building C0 = 350,000
- Eg. Sale price in Year 1 = C1 = 400,000
Sep 2: Estimate opportunity cost of capital. If equally risky investments in
- Eg. The capital market offers a return of 7%, then cost of capital = r = 7%
Step 3: Discount future cash flows
 - Eg. PV = C1 / (1+r) = 400,000 / 1.07 = 373,832
Step 4: Proceed if PV of payoff exceeds investment
- Eg. NPV = – 350,000 + 373,832 = 23,832

Higher risk projects require a higher rate of return, which cause lower PVs

3.2. Internal rate of return (IRR) rule

IRR: Discount rate at which NPV = 0
Rate of return rule: Invest in any project offering a rate of return that is higher than the
opportunity cost of capital
Rate of return = (C1 – investment) / investment; where C1 is the cash flow at time 1

Problems
1. Negative cash flows
a. For some cash flows, NPV of project increases as discount rate increases,
which is contrary to normal relationship

b. Can lead to multiple rates of return

i. Certain cash flows can generate NPV = 0 at two different discount
rates

2. Mutually Exclusive Projects

a. IRR ignores magnitude of the projects – a problem if we have to choose one.

3.3. Profitability Index: Ratio of NPV to initial investment

Profitability index = NPV / initial investment
Capital Rationing: Limit set on amount of funds available for investment
Soft Rationing: Limit on available funds, imposed by management
Hard Rationing: Limits on available funds imposed by unavailability of funds in the capital
market

3.4. Payback
Payback period: Time until cash flows recover initial investment of project
Payback rule: Project to be accepted if its payback period is less than a specified cut-off
period

3.5. Equivalent Annual Annuity: Cash flow per period with the same PV as the cost of buying
and operating a machine
EAA = PV of cash flows / annuity factor

Summary

Week 4: Valuing Stocks

4.1. Stocks and the stock market

Primary market: Market for the sale of new securities by corporations
Initial public offering (IPO): First offering of stock to general public
Primary offering: Corporation sells shares in the firm
Common stock: Ownership shares in a publicly held corporation
Secondary market: Market in which previously issued securities are traded among investors
Dividend: Periodic cash distribution from the firm to the shareholders;
Dividend Yield = Forward dividend & yield / previous close
P/E Ratio: Ratio of stock price (bid price) to earnings per share (EPS)
Bid price: Prices at which investors are willing to buy shares
Ask price: Prices at which current shareholders are willing to sell their shares

4.2. Market, book and liquidation values

Going Concern value: Cause of differences between firm’s actual market value and its
liquidation / book value
Factors: Extra earning power, intangible assets, value of future investments

Book value: Net worth of firm according to balance sheet

Liquidation value: Net proceeds that could be realised by selling the firm’s assets and paying
off its creditors
Market value balance sheet: Financial statement that uses market value of all assets and
liabilities

4.3. Valuing common stocks

Stock valuation methods:
1. Valuation by things that can be compared
a. Ratios
b. Multiples
2. Intrinsic value: Present value of future cash payoffs from a stock or other security
3. Dividend discount model

Expected return: Percentage yield that an investor forecasts from a specific investment over a
set period of time, sometimes called holding period return (HPR)

Can be broken down into (i) dividend yield + (ii) capital appreciation
Dividend Discount Model (DDM): Discounted cash-flow model – today’s stock price = PV
of all expected future dividends

If no growth is forecasted, and we plan to hold out stock indefinitely, value the stock as
perpetuity:

Constant-growth DDM: Version of DDM where dividends grow at a constant rate

4.4. Simplifying the dividend discount model

If firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase
because future dividends may be higher
Payout ratio: Fraction of earnings paid out as dividends
Plowback ratio: Fraction of earnings retained by the firm
Sustainable growth rate: Firm’s growth rate if it plows back a constant fraction of earnings,
maintains a constant return on equity, and keeps its debt ratio constant
Growth g = sustainable growth rate = ROE (return on equity) * plowback ratio
PV of growth opportunities (PVGO): NPV of a firm’s future investments; is the difference
between stock price if the company does plowback

4.5. Valuing non-constant growth

4.6. Market anomalies and behavioural finance

1. Existing Anomalies: Momentum factor, book-to-market factor
2. Old anomalies: Small firm effect, January effect, PE effect, neglected firm effect, value
line effect
- Attitudes towards risk
- Beliefs about probabilities
- Sentiment

Week 5: Risk, Return and Opportunity Cost of Capital

5.1. Rates of Return

Percentage return = (capital gain + dividend) / initial share price
Dividend yield = dividend / initial share price
Capital gain yield = capital gain / initial share price

1 + real rate of return (ROR) = (1 + nominal ROR) / (1 + inflation rate)

Expected market return = i/r on treasury bills + normal risk premium

5.2. Market Index: Measure of the investment performance of the overall market
Dow Jones Industrial Average (The Dow): Index of the investment performance of a
portfolio of 30 “blue-chip” stocks
Standard & Poor’s Composite Index (S&P 500): Index of the investment performance of a
portfolio of 500 large stocks

5.3. Measuring Risk

Variance: Average value of squared deviations from mean; a measure of volatility
Formula: (Squared deviations*100) / number of terms (years)
Standard deviation: Square root of variance; another measure of volatility

5.4. Risk and Diversification

Portfolio rate of return = (fraction of portfolio in first asset * ROR on 1st asset) + (fraction of
portfolio in second asset * ROR on 2nd asset)
Diversification: Strategy designed to reduce risk by spreading portfolio across many
investments
Specific Risk: Risk factors affecting only that firm, aka “diversifiable risk”
Market Risk: Economy-wide sources of risk that affect overall stock market, aka “systematic
risk”

- Some risks look big and dangerous but are diversifiable

- Market risks are macro risks
- Risk can be measured

Week 6: Risk, Return and Capital Budgeting

6.1. Measuring Market Risk

Market portfolio: Portfolio of all assets in the economy; in practice a broad stock market
index is used to represent the market
Beta: Sensitivity of a stock’s return to the return on the market portfolio
From average % returns on stocks with respect to market return % changes (up and down),
calculate beta = total average change / total market return % change.

6.2. Portfolio betas

- Diversification decreases variability from unique risk, but not from market risk
- Beta of portfolio will be average of betas of securities in the portfolio
Formula: (fraction of portfolio in stock 1 * beta of stock 1) + (fraction of portfolio in stock 2
* beta of stock 2)

6.3. Risk and Return

Market risk premium: market return – return on risk-free Treasury bills
CAPM: Theory of relationship between risk and return – expected risk premium on any
security = beta * market risk premium

Security market line

6.4. Capital Budgeting and Project Risk

Project cost of capital depends on use to which capital is being put. Hence, depends on risk of
project and not the company.
Company cost of capital: opportunity cost of capital for investment in the firm as a whole;
appropriate discount rate for an average-risk investment project undertaken by the firm.

Week 7: Weighted-Average Cost of Capital and Company Valuation

7.1. Cost of Capital: Portfolio return that firm’s investors can expect to earn if they invested
in securities with comparable degree of risk
Capital structure: Mix of long-term debt and equity financing

7.2. Weighted-Average Cost of Capital (WACC): expected rate of return on a portfolio of all
the firm’s securities, adjusted for tax savings due to interest payments
Company cost of capital = WA of debt and equity returns
 Where V = D+E (total firm market value); D = MV of
debt; E = MV of equity; rdebt = YTM on bonds; requity = CAPM = rf + beta (rm – rf)
Interest is tax deductible. If there is a tax rate, adjust new ROR = initial ROR * (1 – tax %),
then calculate WACC = portfolio return with new ROR
Tax is important consideration in company cost of capital since interest payments are
deducted from income before tax

Calculating cost of capital:

1. Calculate value of each security as proportion of firm’s market value
2. Determine required ROR on each security
3. Calculated weighted average of after-tax return on debt and equity

Interpreting WACC: Appropriate discount rate only for a project exactly the same as the
firm’s existing business
Costs of debt financing: Rate of interest bondholders demand (explicit), and required increase
in return from equity (implicit) and hence increase cost in equity demanded due to increase in
risk
Issues: Betas may change with capital structure

Corporate taxes complicate analysis and may change our decision

In estimating WACC, don’t use book value but market value of securities. Book values often
don’t represent true market value of a firm’s securities.

7.3. Measuring Capital Structure:

Market Value of Bonds: PV of all coupons and par value discounted at the current YTM
Market Value of Equity: market price per share * number of outstanding shares

7.4. Required ROR, for bonds and common stock

DDM Cost of Equity

Expected return on preferred stock:

7.5. Free Cash Flows and PV

FCF should be theoretical basis for all PV calculations; it’s a more accurate measurement of
PV than Div or EPS
Market price doesn’t always reflect PV of FCF
Always use FCF when valuing business for purchase

7.6. Capital budgeting

Valuing a business: Value of business or project is usually computed as the discounted value
of FCF out to a valuation horizon (H)
Valuation horizon is sometimes called the terminal value and is calculated like a perpetuity

First 3 dividers: PV of free cash flows, last: PV of horizon value

Week 8: Debt Policy

8.1. Value and capital structure

Capital structure: mix of long-term debt and equity financing
Restructuring: Process of changing firm’s capital structure without changing real assets

Modigliani and Miller (MM – Debt Policy doesn’t matter)

Cannot increase value by changing mix securities used to finance company since market
value of company does not depend on capital structure.
Assume:
- By issuing 1 security (rather than 2), company diminishes investor choice. This does
not reduce value if investors don’t need choice or there are sufficient alternative
securities
- Capital does not affect cash flows (eg. taxes, bankruptcy costs, effect on management
incentives)

8.2. Borrowing (debt financing) can increase earnings per share (EPS) for company, as
compared to just all equity

Firm value = equity value + debt

Expected income = Equity (operating) income + debt interest

Operating (business) risk: risk in firm’s operating income

Financial risk: risk to shareholders from use of debt
Financial leverage: debt financing to amplify effects of changes in operating income on
returns to stockholders
Interest tax shield: Tax savings resulting from deductibility of interest payments
8.3. Debt and cost of equity

8.4. Debt, Taxes and WACC

Weighted Average Cost of Capital

Tax benefit = face value * percentage of bonds * corporate tax rate

PV of tax benefit perpetuity = tax benefit / percentage of bonds

8.5. Costs of financial distress: arise from bankruptcy or distorted business decisions before
bankruptcy
Market value = value of all equity financed + PV tax shield – PV costs of financial distress

8.6. Financing choices

Conflict between shareholders and debtholders: bet bank’s money vs not betting own money
Risk shifting: Firms threatened with default tempted to shift to riskier investments
Debt overhang: Firms threatened with default may pass up positive-NPV projects because
bondholders capture part of value added
Loan covenant: Agreement between firm and lender requiring firm to fulfil certain conditions
to safeguard loan
Trade-off theory: Debt levels chosen to balance interest tax, shields against costs of financial
distress
Pecking order theory: Firms prefer to issue debt rather than equity if internal finance is
insufficient
Financial slack: Ready access to cash or debt financing
Week 9: Dividends / Payout Policy

9.1. Cash payouts to shareholders

Cash dividend: Payment of cash by firm to shareholders

Ex-dividend date: Cut-off date to hold stocks; determines entitlement to dividend payment
Stock dividend (splits): Distribution (Issue) of additional shares to firm’s stockholders
Stock repurchase: Firm distributes cash to stockholders by repurchasing shares

9.2. Dividends and repurchases

Dividend increases: convey managers’ confidence about future cash flow and earnings
(converse is true for dividend cuts), since high dividend payout policy is costly – so it signals
company’s good fortune

Stock repurchase by: (i) Open-market repurchase, (ii) Tender offer, (iii) (Dutch) auction, (iv)
direct negotiation (Greenmail)

How dividends are determined by senior executives

- Managers reluctant to make dividend changes that might need reversal
- Managers ‘smooth’ dividends, hate cutting. Dividend changes follow shifts in long-
run, sustainable levels of earnings
- Managers focus more on dividend changes than on absolute levels

Factors in deciding dividends:

- Target payout ratios
- Repurchase decisions
- Information content of dividends and repurchases
Dividend policy has no impact on firm value; investors do not need dividends to convert
shares to cash.

9.3. Dividends and effect on value

Market imperfections
- Natural clientele for high payout stocks does not mean any one firm can benefit by
increasing dividends
- This clientele already has lots of high-dividend stocks to choose from
- They increase price of stock through demand for a dividend-paying stock

Tax Consequences
- Companies can convert dividends into capital gains by shifting dividend policies
- If dividends are taxed more heavily than capital gains, taxpaying investors welcome
the move and value firm more favourably
 - Then total cash flow retained by the first + held by shareholders will be higher than if
dividends were paid

Week 10: Options

Derivatives: Financial instrument that is derived from another (eg. options, warrants, futures,
swaps etc.)
Call Option: Right to buy an asset at a specified exercise on or before the exercise date
Put Option: Right to sell “
Option Premium: Price paid for option, above price of underlying security
Intrinsic value: Strick price – stock price
Time premium: Value of option above intrinsic value

Value of option at expiration is function of stock and exercise price

When stock is worthless, option is worthless

When stock price becomes very high, option price approaches stock price less than PV of
exercise price
Option price always exceeds its minimum value (except at maturity or when stock price is 0)

Components of Option price

- Underlying stock price
- Striking / exercise price
- Volatility of stock returns (standard deviation of annual returns)
- Time to option expiration
- Time value of money (discount rate)

Options on real assets (to invest in, modify or dispose of capital investment project):
- Option to expand
- Option to abandon

Options on financial assets:

- Executive stock options (Long term call options given to executives as part of their
compensation package)
- Warrants (Rights to buy shares from a company at a stipulated price before a set date)
- Convertible Bond (Bond that holder may exchange for a specific number of shares)
- Callable Bond (Bond that may be repurchased by issuer before maturity at a specified
call price
Week 11: Hedging / Risk Management

11.1. Reasons to hedge

11.2. Reducing risk with options
11.3. Futures contracts: Exchange-traded promise to buy or sell an asset in the future at a pre-
specified price

11.4. Forward contracts: Agreement to buy or sell an asset in the future at an agreed price,
‘custom designed’; there are specific amounts and expiration dates to meet buyers’ needs

11.5. Swaps: Arrangement by two counterparties to exchange one stream of cash flows for
another
11.6. Innovation in derivatives market