FM All Slides

Introduction and Overview
RWJ Chapter 1
Course Outline
2
• Learning Outcomes:
1. Have a broad overview of what will be covered in this
module.
2. Know the 3 main questions that Corporate Finance
addresses.
3. The Corporation and Principal-Agent Problem
4. Appreciate that debt and equity are contingent claims.
5. Have a good grasp of what should be the goal of the
corporate firm.
3
Course Schedule
4
Course Materials
• S.A. Ross, R.W. Westerfield and B.D. Jordan

(2019), Fundamentals of Corporate
Finance, 12th Edition, McGraw-Hill
Education, ISBN-13: 9781259918957
• A financial calculator is
recommended but not compulsory
5
module.
addresses.
corporate firm.
6
Corporate Finance – what is it about?
• Corporate Finance addresses the following three main

questions:
– What long-term assets should the firm (choose to) invest in?
Capital Budgeting
– How can the firm raise (and distribute) cash for the required
capital expenditures? Capital Structure (and payout policy)
– How should short-term operating cash flows be managed?
Cash management, Receivables management, Inventory
management, Payables management.
Working Capital Management
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Role of Financial Manager
Capital Capital Working Capital

Budgeting Structure Management
What long-term How should the firm How should the firm
investments should pay for its assets? manage the day-to-day
the firm take on?- Should it use debt or operations of the firm?
Investment Decision equity? –
Financing Decision
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Example: Investment Decision
BioNTech to set up regional HQ and manufacturing site in
Singapore – Straits Times, May 10 2021
• BioNTech, the vaccine maker that has partnered with Pfizer on its Covid-19 shot, will
be designating Singapore as its regional headquarters for South-east Asia, and will set
up an mRNA manufacturing facility here.
• It plans to open its Singapore office and start the construction of the manufacturing
facility in 2021. The site is expected to be operational in 2023 and will create at least
80 jobs.
Example: Financing Decision
GRAB to list in the US through world’s biggest SPAC merger,
valued at nearly US$40 billion -- CNA, 13 April 2021
• Grab confirmed its US$40 billion merger with Altimeter Capital.

• Shares will be traded on NASDAQ under the symbol “GRAB”.
10
module.
addresses.
corporate firm.
11
MULTIMEDIA
Week 1: The Corporation and the Principal- Agent

Problem
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Forms of Business Organizations
• Sole proprietorship
– It is a business owned and run by one person. There is no separation
between the business and the owner. The owner is personally liable
for all the debts. He has unlimited liability.
• Partnership
– It is like a sole proprietorship but has more than one owner.
– In a general partnership, all partners are liable for the firm’s debt.
– In a limited partnership, there are general partners and limited
partners. A limited partner does not participate in the management of
the business. His liability is limited to the capital provided.
• Corporation
– It is a legally defined, artificial being, separate from its owners. The
owners are not liable for any obligation of the corporation. Their
liability is limited to the capital invested.
– Often ownership and control are separate. The firm is managed by the
board of directors (BOD) and the chief executive officer (CEO).
Distinguishing Features
Corporation Partnership
Capital Standard method of raising Restricted to a few individuals
large sums
Liquidity Shares can be easily Subject to substantial restrictions
exchanged
Taxation Depends on tax code Partners taxed on distributions
Liability Limited liability General partners may have
unlimited liability; limited partners
enjoy limited liability
Continuity Perpetual life Limited life
Voting Rights Usually each share gets one General partner is in charge; limited
vote partners may have some voting
rights
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Corporate Structure - Separation of Ownership and Control
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Ownership and Control of Corporations
• With separation of ownership and control, managers are expected to

maximize shareholder wealth. But, do they?
• Managers have their own interests. They might work just hard enough to
give shareholders “reasonable” returns,.
• Instead of maximizing returns for shareholders, they may seek to protect

their own jobs, build their own empire, and consume perks.
Principal-Agent Problem
• In most large corporations, agency conflicts can be significant, because

these managers generally own only a small percentage of the shares.
• Instead of maximizing shareholder wealth, managers may seek to

maximize firm size and growth in order to:
– (1) increase their job security because a hostile takeover is less likely in
a large rapidly growing firm;
– (2) increase their power, status, and salaries;
– (3) create opportunities for their lower and middle level managers.
These are examples of agency problems that can arise from separation of
ownership from control.
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Agency Problem Example:
Madoff’s Ponzi scheme
• Bernie Madoff's name is also almost synonymous with the principal-agent

problem.
• Madoff created an elaborate sham business that ultimately cost investors nearly
$16.5 billion in 2009.
• Many small investors lost all of their savings in this scandal.
• Ultimately, Madoff was criminally charged and convicted for his actions. He is
now serving a 150-year prison sentence.
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Died April 14, 2021
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Suggest some solutions for the principal
(shareholders) agent (managers) problem
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Solution 1: Interest Alignment
• At 100% ownership, the

manager is frugal;
• As the outside ownership

becomes bigger, the manager is
less frugal since some of the
costs are borne by the outside
shareholders.
• What can be a solution for this

principal-agent problem?
21
Discovery CEO made $156million in 2014
David Zaslav became CEO in Jan 2007 when stock price was $8.30.
As of Aug 2016, stock price was 26.40.
The $156 million includes:

1. $3 million base salary
2. $6 million bonus
3. $50.5 million of stock appreciation rights vests over 4 years
4. $94.6 million of performance based restricted stock vest over
time
5. $1.9 million in other compensation
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Solution 2: Internal Monitoring
• Shareholders elect BOD;

• BOD have the ultimate decision-
making authority in the corporation.
They have legal power to
– select and monitor CEO
– make large investment outlays
– declare dividends
– issue securities
• If the CEO does not run the
corporation in the interest of
shareholders, he will be replaced by
the BOD.
23
Solution 3: External Monitoring
• In many corporations, the board is

“captured” by an entrenched CEO,
maybe because the board comprises
people who are close friends of the
CEO and lack objectivity.
• If the CEO is entrenched and

performs poorly, the share price will
drop. Low share prices may lead to a
hostile takeover, where an
individual or organization purchase a
large fraction of the shares and get
enough votes to replace the BOD
and the CEO.
Agency Costs
• Agency costs are costs of the conflict of interest between shareholders
and management. These costs may be direct or indirect.
– Direct agency costs include perks consumed, and expenses to monitor

management.
– Indirect agency costs include lost opportunities, e.g. a manager may

overemphasize organizational survival to ensure job security. He may
choose to forego a positive NPV project because of the possibility that
things may turn out badly causing him to lose his job.
25
module.
addresses.
corporate firm.
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Sources Of Funds
The Firm
Equity Debt
Share Retained Bank Bond

Issuance Earnings Borrowing Issuance
Residual Claims Contractual Obligations 27

Components of Capital Structure and Total Firm Value
• Two main components of capital structure:

– Debt is a promise by the borrowing firm to repay a fixed dollar amount
by a certain date.
– Equity holders (shareholders) can claim the residual value of a firm

that remains after the debtholders are paid.
• Priority of claim: debtholders > shareholders.

– If the value of the firm is less than the amount promised to the
debtholders, the shareholders get nothing.
– So shareholders have the incentive to maximize the firm value.
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Debt and Equity as Contingent Claims
Payoff to Payoff to
debt holders shareholders
If the value of the firm is less

than $D, share holders get
If the value of the firm is more nothing.
than $D, debt holders get a
maximum of $D.
$D
$D $D
Value of the firm ($X) Value of the firm ($X)
Debt holders are promised $D. If the value of the firm is more than
If the value of the firm is less than $D, they get $D, shareholders get everything
whatever the firm is worth. above $D.
Algebraically, the bondholder’s claim is: Algebraically, the shareholder’s
Min[$D,$X] claim is: Max[0,$X – $D]
Combined Payoffs to Debt and Equity
Combined Payoffs to debt holders

and shareholders If the value of the firm X is less than $D, the
shareholder’s claim is: Max[0,$X – $D] = $0
and the debt holder’s claim is Min[$D,$X] = $X.
The sum of these is = $X (value of the firm)
Payoff to shareholders
$D
Payoff to debt holders
If the value of the firm X is more than $D, the
shareholder’s claim is: Max[0,$X – $D] = $X – $D
$D
Value of the firm (X) and the debt holder’s claim is: Min[$D,$X] = $D.
The sum of these is = $X (value of the firm)
Debt holders are promised $D.
Does Capital Structure matter for the firm value?
• The value of the firm can be thought of as a pie.
• The goal of the manager is to increase the size of the pie.
• The Capital Structure decision can be viewed as how best to cut the pie.
• If how you cut the pie (Capital Structure) affects its size (firm or project
value), then the capital structure decision matters.
S B
module.
addresses.
corporate firm.
32
What should be the Goal of a Corporation?
Commonly cited:
– Maximise sales/market share
– Minimise costs
– Maximise profits
Each of the above can be achieved at the expense of

something else.
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Commonly Cited Goals
• lower price or relax credit policy
– Minimise costs
• lower quality or cut down on certain expenses eg. R&D
• shift future revenue to current period -- channel stuffing
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Channel Stuffing
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Bristol-Myers Squibb guilty of Channel Stuffing
• From 2000 to 2001, BMS perpetrated a fraudulent earnings management
scheme.
• It sold excessive amounts of pharmaceutical products to its wholesalers
ahead of demand, improperly recognizing revenue of $1.5 billion.
• Discounts were offered to encourage wholesalers to load up
• In 2002, BMS suddenly said earnings per share would be down 25% - 30%.
• Security Exchange Council: "For 2 years, BMS deceived the market into
believing that it was meeting its financial projections and market
expectations, when in fact the company was making its numbers primarily
through channel stuffing and manipulative accounting devices.”
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Bristol Myers Squibb’s share
price
80
70
60
50
Steep fall on announcement
40
30
20
10
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• lower price or relax credit policy
– Minimise costs
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Was General Motors guilty of Channel Stuffing?
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General Motors (filed for bankruptcy in 2009, IPO in Nov 2010 at $33)
• On 5 July 2011, Bloomberg published an article that GM was falling into old,
bad habits of "channel stuffing" whereby excessive inventory were "sold" to
dealerships so that GM could record those sales on its books, creating the
false appearance of revenue even while those cars remained unsold on dealer
lots.
• From July 2011, GM's share price trended downwards.
• On 26 June 2012 (price at $19.85, 40% loss), IPO investors filed class action
suit
– Accused GM of falsely stating in the Prospectus that increased inventories
were attributable to and indicative of higher demand.
• On 4 Sep 2014, class action dismissed on grounds that pre-IPO disclosures
included enough information for investors to assess the vehicle distribution
and sales practices.
40
General Motors’ share price
Filed for bankruptcy in June 2009. Reorganized GM had IPO in Nov 2010 at $33 a
45 share
40
35 5 July 2011: $30.86

Bloomberg published article
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25 4 Sep 2014: $34.63

Suit dismissed
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15
10
5
26 June 2012: $19.85
0 Filed suit
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• lower price or relax credit terms
– Minimise costs
• shift current expenses to future period
42
America Online Shifted Current Expenses to Future Period
• AOL had spent heavily on direct mail advertising, including distribution of

disks containing AOL software.
• 1994 capitalized and spread marketing costs over 12 months
• 1995 over 18 months
• 1996 over 24 months
• AOL reported profits for 6 of 8 quarters in 1995 and 1996, rather than the
losses it would have reported had the costs been expensed as incurred.
• Security Exchange Council : complained that AOL had improperly
capitalized costs of advertising, and reporting them as an asset on its
balance sheet. 43
WorldCom Shifted Current Expenses to Future Period
• On 25 June 2002, WorldCom admitted that it had misclassified over $3.8
billion in payments for line costs as capital expenditures rather than
current expenses.
– Line costs are what WorldCom pays other companies for using their
communications networks.
• By doing so, WorldCom showed a higher net income.
• Prior to the announcement, WorldCom’s share price had fallen from a
high of $64.50 in mid-1999 to less than $2 a share. After the
announcement of the accounting irregularity, it fell below $1.
• WorldCom filed for Chapter 11 bankruptcy on 21 July 2002.
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– Minimise costs
• shift future expenses to current period
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Sunbeam Shifted Future Expenses to Current Period
• July 1996 – Sunbeam hired Al Dunlap who had a reputation of turning
companies around.
• Dec 1996 – took $337.6m in restructuring charges, wrote down inventory
and plant assets.
• 1996 – operating loss of $285.2m
1997 – operating income of $199.4m
• Made to restate 1997 operating income to $104.1m
• Security Exchange Council: Al Dunlap and Sunbeam's CFO used improper

tactics to inflate earnings. Millions in expenses in 1997 were wrongly
charged to 1996, … created fake profits in 1997. Sunbeam unreasonably
reduced the value of its inventory so that it could record large profits when
the goods were sold.
• Other tricks … 46
• SEC: In addition, Sunbeam recorded some sales that were not real, through a
variety of methods, and recorded other sales that came from ''channel
stuffing'' putting inventory onto the books of distributors and retailers.
– In one case, … electric blankets that had been packaged for a certain
retailer were sent to a distributor who agreed, in return for a guaranteed
profit, to hold the blankets until the retailer was ready to accept them.
– In another case, sales were made by offering deep discounts to persuade
customers to buy merchandise that they would not need for many
months.
• SEC: Sunbeam should have recorded the sales of the “electric blankets” in
later quarters and disclosed the discounts.
• When the “turnaround” was exposed as a sham to make Sunbeam appear
healthy (when, in fact, it remained financially troubled), stock price
plummeted.
• Al Dunlap banned permanently from serving in a public company. 47
Big Bath
• A strategy of manipulating a company’s income statement to make

poor results look even worse so that future results will look better
– Companies, that experienced low earnings in a given year, take
discretionary write downs to reduce even further the current
period’s earnings.
– The notion is that the company will not be punished proportionately
more for the big hit it takes to its already depressed earnings.
– By wiping the slate clean, companies will find it easier to generate
higher profits in future.
• Evidence:
– This is a practised method of managing earnings.
– Acceptable as long as there is no intention to deceive investors
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Cisco System’s Big Bath not considered fraudulent
• In 2001, at tail end of tech bubble crash, Cisco (worldwide leader in IT and
networking) wrote off $2.5 billion in excess or obsolete inventory and
about $1 billion in restructuring charges.
• After the announcement -- Cisco's stock price was up 12%.
• Instead of scrapping or selling the inventory, Cisco cordoned them off in
"secure" areas of its facilities. If things picked up, Cisco could use them at
little or no cost, which might fatten its future gross profit margins.
• The SEC said that it was "closely following“ tech write-offs to see that they
do not deceive investors.
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– Minimise costs
• shift future expenses to current period
• defer expenses to the future eg. maintenance expenses 50
SMRT was delisted from SGX in Oct 2016.
Bought out by Temasek (an investment company owned by the govt).
The govt decided that SMRT should focus on serving the public without
the distractions of being a listed company and having to answer to
investors.
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Commonly cited goals:
• lower price and relax credit terms
– Minimise costs
• lower quality and cut down on certain expenses eg. R&D
• defer maintenance expenses
• defer writing off bad debts
• stuffing the channels
• defer expenses to the future
• this measure does not address risk
These goals may sometimes be achieved in ways that are detrimental to

the company.
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So, what should be the Goal of the manager?
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An all-encompassing Goal
• shareholder wealth maximization

– maximize share price or share value
– to attain shareholder wealth maximization, companies drill
down to the drivers of maximizing sales, minimizing costs and
maximizing profits
• Does this mean we should do anything and everything to maximize

shareholder wealth?
– do companies have social responsibilities?
– should companies behave ethically?
– is share price maximization good for society?
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Shareholder Wealth Maximization
Pre-reading: “Why Share-Owner Value?” written in 1997 by the late

Robert Goizueta ,CEO, Coca Cola for 16 years. He introduced Diet Coke
and slogans "Coke is it!", "You Can't Beat the Feeling" and "Always
Coca-Cola”.
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Mission of managers: Max shareholder wealth because it
– is what is expected of us
• primary calling is creating value for their owners.
– allows us to contribute meaningfully to society

• If the company is worth more, people have more to give, and so on… a beneficial
ripple effect throughout society.
– keeps us from acting shortsightedly

• To be of unique value to our owners over the long haul, we must also be of unique
value to our consumers, our customers, our bottling partners, our fellow employees
and all other stakeholders – over the long haul.
• Only in a healthy stable society can a company’s profitable growth be sustained. Thus,
the exercise of what is commonly referred to as “corporate responsibility” is a
supremely rational, logical corollary
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Corporate social
responsibility refers to
the ethical and moral
way of doing business.
CSR covers issues

ranging from whether
companies procure
goods in a responsible
way, such as not using
child labour, to how it
treats its employees and
also covers its activities
in the community 57
Straits Times
May 27,
2020
Avoids pollutive businesses.
Focuses on renewable and
clean fuels.
Invests in social causes to

combat climate change.
Creates new business

opportunities such as high
rise green data centres and
floating data centre parks.
An all-encompassing Goal
• shareholder wealth maximization

– maximize stock value or stock price
– to attain shareholder wealth maximization, companies drill
down to the drivers of maximizing sales, minimizing costs and
maximizing profits
• Does this mean we should do anything and everything to maximize

shareholder wealth?
– do firms have social responsibilities?
– should firms behave ethically?
– is stock price maximization good for society?
59
Quote from Milton Friedman
“So the question is, do corporate executives, provided they stay within
the law, have responsibilities in their business activities other than to
make as much money for their stockholders as possible?
And my answer to that is, no they do not.”
Milton Friedman
Nobel Laureate
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Capitalism's convulsive chaos
Straits Times 28 October 2008
At his appearance before the House Oversight and Government Reform Committee
Mr Alan Greenspan (chairman of Fed Reserve from 1987 to 2006) had this to say about the
subprime crisis and financial meltdown:
“Those of us who have looked to the self-interest of lending institutions to
protect shareholders' equity, myself included, are in a state of shocked
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disbelief.”
How to maximize stock value?
• Should concentrate on “long-term”
• What determines stock value in the long-term? -- the ability to generate
cash flows
• Three aspects of cash flows that affect stock value
– Amount of cash flows expected by shareholders

– Timing of the cash flows Div

P  t
(1  r)
0 t
t 1
– Riskiness of the cash flows
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• Reputation is important too.

Quote from Warren Buffet
"If you lose money for the firm, I will be understanding. If you lose
reputation for the firm, I will be ruthless."
Warren Buffett
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What is Reputation?
o A compilation of impressions held by all of the entity’s stakeholders.
o Managing an entity’s reputation involves managing the perceptions and

expectations of these stakeholders
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Stakeholders of Your Organization
Media
Society Customers
Entity
Shareholders Employees
Suppliers Banks
Government
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Perceptions and Expectations involve:
1. Products & Services:
– the quality, innovation, value, and reliability of its products and services
2. Innovation:
– whether the company has been successful in translating ideas or inventions into a good or service that creates
value
3. Workplace:
– whether it is well managed, and the quality of its employees
4. Governance:
– management structure, employee relations and compensation
5. Citizenship:
– whether it contributes to society
6. Leadership:
– whether management and Board demonstrate clear vision and strong leadership
7. Financial Performance:
– its profitability, prospects, and risk
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Note: developed by Charles Fombrun of Reputation Institute to measure reputation value

Reputation Institute, a global private consulting firm based in New York, surveys more
than 68,000 respondents across the world’s 15 largest economies annually to gauge
perception regarding a brand’s product and services, innovation, citizenship,
performance, governance, leadership and workplace.
To be considered, the corporation must generate at least $2 billion a year in annual

sales.
In 2021, what are the top 10 most reputable companies in the world?
67
Time Value of Money
Part 1
1
Learning Outcomes
1. Appreciate the time value of money concept.
2. Apply FV and compounding to a single cash flow.
• Simple interest versus Compound interest
• Frequency of compounding
3. Apply PV and discounting to a single cash flow.
4. Extend to multiple cash flows.
5. Explore annuities.
6. Appreciate difference between annual percentage rates and effective
rates
2
What is Time Value of Money?
• $1 received today is preferred to $1 received some time later
• Three reasons:
• lost earnings - invest to earn interest
• loss of purchasing power - inflation
• uncertainty of payment
3
There is a convention that is built into every formula—related
to the fact that all decisions can be placed on a Time Line
Beginning
Today End of the of the
third year fourth year
0 1 2 3 4
• Time 0 represents today (the decision point). 1st year. 2nd year. 3rd year. 4th year.
• Assume cash flows occur at the end of a time interval.
– Mary received $100 in year 1. It means end of year 1
• Cash outflows are negative amounts. Cash inflows are positive amounts.
4
More Timelines
General Timeline
0 1 2 3
i%
CF0 CF1 CF2 CF3
Time line for a $100 lump sum due at the end of Year 2
0 1 2
i%
100 5
More Timelines
Time line for $100 a year for 3 years
0 1 2 3
i%
100 100 100
Time line for uneven CFs: -$50 at t = 0 and $100, $75, and $50 at the end of
Years 1 through 3.
0 i% 1 2 3
-50 100 75 50
A negative sign means it is a cash outflow 6
Basic Definitions: PV and FV
• Present Value (PV) – the value of something today. On a timeline t = 0.
– Translating a value that comes at some point in the future to its value in the
present is referred to as discounting.
7
• Future Value (FV) – the value of a cash flow sometime in the future. On a
timeline t > 0.
− Translating a value to the future is referred to as compounding.
8
• Future Value (FV) – the value of a cash flow sometime in the future. On a
timeline t > 0.
− Translating a value to the future is referred to as compounding.
• Keep in mind that what PV and FV do is to put cash flows which come in at
different times on a comparable basis!
• Once they are expressed in the same units, we can add and subtract them.
9
Learning Outcomes
2. Apply FV and compounding to a SINGLE cash flow.
rates
10
Future Value and Compounding
How much will you get in the future if you invest a sum of money
now at a given interest rate?
Answer depends on:

-- whether Simple Interest or Compound Interest applies
-- whether you are paid interest on an annual, semiannual, monthly or daily basis
11
Simple versus Compound Interest
• Simple Interest: Interest is earned only on the original
investment.
• Compound Interest: Interest is earned on the original

investment & on ACCUMULATED INTEREST.
12
Example: Simple Interest
Today you deposit $500 into a fixed deposit account paying
10% simple interest. How much will you have in 3 years?
Solution: $500 + 3 yrs X 500(10%) = $650
Principal
Interest earned per year: $50
13
Simple Interest
Year 1: 10% of $500 = $50 + $500 = $550
Year 2: 10% of $500 = $50 + $550 = $600
Year 3: 10% of $500 = $50 + $600 = $650
Interest earned per year is the same
14
Simple Interest
15
Example: Compound Interest
Suppose you deposit your $500 into a Savings Deposit where
interest is earned at 10% on the previous year’s balance (which
includes accumulated interest):
Interest earned per year

=Prior Year Balance x 10%
16
Simple Interest
Year 1: 10% of $500 = $50 + $500 = $550
Compound Interest Year 2: 10% of $500 = $50
Year 3: 10% of $500 = $50
+ $550 = $600
+ $600 = $650
Year 1: 10% of $500 = $50 +500= $550

Year 2: 10% of $550 = $55 +550= $605
Year 3: 10% of $605 = $60.5 +605= $665.5
Interest earned per year increases
FVt = PV(1 + r)t
= 500(1 + 0.1)3
17
= 500(1 + 0.1)(1+0.1)(1+0.1)
= 665.50
Future Values: General Formula
FV = PV(1 + r)t = PV (1+i)n
 FV = future value
 PV = present value
 r = i = period interest rate, expressed as a decimal (e.g. 10% =0.1)
 t = n = number of periods
0 10% 1 2 3
CF FV = ?
Finding FVs (moving to the right on a time line) is called compounding.
18
Compound Interest
19
Effects of Compounding
• Consider the previous example at the end of 3 years:
FV with simple interest = 500 + 50 + 50 +50 = 650
FV with compound interest = 500 +50 + 55 + 60.5=665.50
The extra 15.50 comes from the interest earned on the interest payments
• The effect of compounding is small for a small number of periods but

grows
• as the number of periods increases and
• as the interest rate increases.
20
How much for that island?
In 1626, Peter Minuit bought Manhattan Island for about $24 in goods
and trinkets from the American Indians.
If the Indians had invested the $24 at 5% interest rate from 1626 to 2018
(392 years), it would have grown to
FVt= PV(1 + r)t =$24 (1+0.05)392 = $4,857,541,024
Compared to Simple Interest:

FVt= PV+ rxPVx392 = $24 + 0.05($24)(392) = $494.4 21
Interest rate at 10%
In 1626, Peter Minuit bought Manhattan Island for about $24 in goods
and trinkets from the American Indians.
If the Indians had invested the $24 at 10% interest rate from 1626 to
2018 (392 years), it would have grown to
FVt= PV(1 + r)t =$24 (1+0.10)392 = $403,779,088,891,871,000
Compared to simple interest:

FVt= PV+ rxPVx392 = $24 + 0.10($24)(392) = $964.8 22
Practice 1a
You just turned 35 and have been saving for an around the world
vacation. You want to take a trip to celebrate your 40th birthday. You have
set aside, as of today, $15,000 for such a trip. You expect the trip will cost
$25,000. The financial instruments you have invested the $15,000 in
have been earning 8%. Ignore taxes.
a. Will you have enough on your 40th birthday to take the trip?
1yr 2yr 3yr 4yr 5yr
8%
$15,000
FV5 = $15,000(1.08)5 = $22,039.92

Learning Outcomes
rates
24
Future Value and Compounding
How much will you get in the future if you invest a sum of money
now at a given interest rate?
Answer depends on:

-- whether Simple Interest or Compound Interest applies
-- whether you are paid interest on an annual, semiannual, monthly or daily basis
25
What is the FV of $500 in 3 years if r=10% is compounded annually?
Semi-annually?
0 1 2 3
10%
500 665.50
Future Value  Present Value (1  interest rate)
time
 PV(1 r) t
Annual compounding: FV3 = $500(1.10)3 = $665.50
0 1 2 3
0 1 2 3 4 5 6
5%
500 670.05
Semiannual compounding: FV6 = $500(1.05)6 = $670.05
26
What will happen to the FV if the frequency of compounding
is higher?
FV will be LARGER!
If compounding is more frequent, eg. semiannually, quarterly, or
daily -- interest is earned on interest more often.
The higher the frequency of compounding, the higher the FV.
27
28
29
A general formula for FV :
mt
 r 
FVmt  PV1  
 m 
m is the number of compounding periods per year
t is the number of years
12t
 r 
For monthly compounding, m = 12: FV12t  PV1  
 12 
365t
 r 
For daily compounding, m = 365: FV365t  PV1  
 365 
For continuous compounding: FV  PV x e rt  PV x 2.718 rt

30
Annual compounding: FV3 = $500(1.10)3 = $665.50
Semiannual compounding: FV6 = $500(1.05)6 = $670.05
What is the FV of $500 in 3 years if r=10% is compounded monthly? Daily?
Continuously?
12t
 r 
FV12t  PV1  
 12 
Monthly compounding: FV36 = $500(1+ 0.008333)36 = $674.08

365t
 r 
FV365t  PV1  
 365 
Daily compounding: FV1,095 = $500(1+0.000274)1,095 = $674.92
FV  PV x e rt  PV x 2.71828 rt
Continuous compounding: FV = $500(2.71828)0.3 = $674.93 31
32
If you are earning interest, you want the compounding
to be more frequent.
What if you are paying interest?

‒ You will NOT want compounding to be so frequent.
‒ For example, your credit card makes you pay monthly interest instead
of yearly interest. You are effectively paying more.
33
Learning Outcomes
rates
34
PV is the reverse of FV
Present Value : Value today of an amount in the future.
FVt  PV1  r 
t
Rearranging
FVt
PV 
1  r t
35
Example:
How much must you put in the bank now, so that you will have $665.50
at the end of 3 years? if interest is 10% compounded annually?
0 1yr 2yr 3yr

10%
PV ? 665.50
FVt 665 .50
PV = 
(1  r) t (1  0.10 ) 3
665 .50

(1  0.10 )(1  0.10 )(1  0.10 )
 $500 36
Example:
How much must you put in the bank now, so that you will have $665.50
at the end of 3 years? if interest is 10% compounded annually?
0 1yr 2yr 3yr

10%
PV ? 665.50
FVt 665 .50 if you invest in a risky venture today, you
PV = 
(1  r) t (1  0.10 ) 3 project that you will have a cash flow of
665 .50 $665.50 at the end of 3 years.

(1  0.10 )(1  0.10 )(1  0.10 ) Given that your required return is 10%,
how much will you pay for the venture
 $500 today? 37
Practice 2a
Your company has been offered a contract for the development and
delivery of a solar-powered military troop transport vehicle. It stipulates
that 2 working, economically feasible prototypes must be delivered in 4
years, at which time, you will receive a single and final payment of
$50,000. Assume an interest rate of 18%. Ignore taxes.
a. What lump sum dollar amount would you be willing to accept today
instead of $50,000 in 4 years?
Today 1yr 2yr 3yr 4yr
18%
$50,000
FVt 50,000
PV    $25,789.44 (Table 3)
1  r t (1.18) 4
Learning Outcomes
rates
39
Multiple Cash Flow Example
Consider the following cash flows:
Time Cash Flow
yr 0 CF0 - $ 2,000
yr 1 CF1 + $ 1,000
yr 2 CF2 + $ 1,500
yr 3 CF3 + $ 2,000
The interest rate (r) is 10% compounded annually.

40
PV of Multiple Cash Flows
= sum of the PV of the individual cash flows
0 1yr 2yr 3yr
10%
-2000 +1000 +1500 +2000

CF1 CF2 CF3
PV  CF0   
(1  r) (1  r) 2 (1  r)3
1000 1500 2000

 2000   
(1  0.1) (1  0.1) 2 (1  0.1) 3
 2000  909.09  1239.67  1502.63  1651.39 41

FV (at t=3) of Multiple Cash Flows
FV of multiple cash flows at a common point in the future
= sum of the FV of the individual cash flows at that point in time
0 1yr 2yr 3yr
10%
-2000 +1000 +1500 +2000

FVt  CF0 1  r   CF1 1  r   CF2 1  r   CF3
3 2 1
FV3  2000(1  0.1) 3  1000(1  0.1) 2  1500(1  0.1)  2000
Alternatively… 42
 2662  1210  1650  2000  2198
FV (at t=3) of Multiple Cash Flows
CF1 CF2 CF3
PV  CF0   
(1  r) (1  r) 2 (1  r)3
Compute the PV at time 0.  2000 

1000

1500

2000
(1  0.1) (1  0.1) 2 (1  0.1) 3
Then bring forward 3 years.  2000  909.09  1239.67  1502.63  1651.39

0 1yr 2yr 3yr
10%
1651.39
FVt  CF0 1  r   CF1 1  r   CF2 1  r   CF3
3 2 1
FVt  PV 1  r 
3
FV3  2000(1  0.1) 3  1000(1  0.1) 2  1500(1  0.1)  2000
 1651 .39 (1  0.1) 3  2198
 2662  1210  1650  2000  2198
43
If cash flows in each period are the same,
short cut methods for computing PV or FV are
available
44
Learning Outcomes
rates
45
Definition of an Annuity
An annuity is a series of cash flows in which the same cash flow
takes place each period for a set number of periods.
−An ordinary annuity is one in which the first cash flow occurs
one period from now (at end of the period 1), eg. salary.
−An annuity due is an annuity in which the first cash flow occurs
immediately (at beginning of period 1), eg. house rental.
46
Difference Between Ordinary Annuity & Annuity Due:
Ordinary Annuity
0 1 2 3
i%
CF CF CF
Annuity Due
0 1 2 3
i%
CF CF CF
47
Learning Outcomes
• FV and PV of yearly annuities
rates
48
FV: Ordinary Annuity
A series of equal cash flows spaced evenly
0 1yr 2yr 3yr
$80 $80 $80

Example:
If I invest $80 at the end of each year for the next 3 years in a 6% savings
account, how much will I have at the end of 3 years?
 (1  r) t  1 
FVt  801  r   801  r   80 FV  A 
2 1
 r 
FV3  80(1  0.06) 2  80(1  0.06) 1  80  (1  0.06 ) 3  1 
 80 
 80(1.1236  1.06  1)  80 (3.1836 )  254.69  0.06 
 80 (3.1836 )  254.69 49
FV Example: Annual Savings for Retirement
0 Y1yr 2yr 3yr 24yr 25yr
You wish to retire 25 years from today with $2 million in the bank. If the bank pays 2.5%
interest per year, how much do you have to save at the end of each year to reach your
goal? Assume annual compounding.
 (1  r)  1 
t
FV of an annuity  A 
 r 
Rearrangin g :
 r 
A  FV 
 (1  r) t
 1 
 0.025 
A  2,000,000    58,551.84 (Table 6i) 50
 (1  0.025) 25
 1 
FV: Annuity Due
0 1yr 2yr 3yr
$80 $80 $80
Example:
If I invest $80 today and at the beginning of each of the next 2 years in a
6% savings account, how much will I have at the end of 3 years?
 (1  r) t  1 
FV  A 1  r 
FVt  80 1  r   80 1  r   80 1  r 
3 2 1
 r 
FV3  80 (1  0.06) 3  80 (1  0.06) 2  80 (1  0.06)  (1  0.06) 3  1 
 80 1.06 
 80 (1.191  1.1236  1.06 )  80 (3.3746 )  269.97  0.06 
 80 (3.3746 )  269.97
51
Ordinary Annuity versus Annuity Due
$254.69 *1.06= $269.97
52
53
FV Example: Term Insurance to Protect Dependents
• Min coverage=$1m, Max coverage=$10m
• Up to 100 years old
• Ratio of income to annual premium must be 15 times or more
• For a 54 year old male, no loading and $1m coverage
Assume individual chooses a 25 year term. Pays $11,190
No of years Annual per year starting immediately. Annual income >= $167,850.
premium
If insured dies after paying 20 premiums, his beneficiaries
15 years 7020 receive $1m. What is the return?
20 years 9170
25 years 11,190
30 years 13,980
35 years 17,130
40 years 20,090
r = 12.81%
45 years 20,640 54
If the individual chooses a 45 year term but dies after
paying 20 premiums, what is the return?
FV Example : Term Insurance to Protect Dependents
• Min coverage=$1m, Max coverage=$10m
• Up to 100 years old
• Ratio of income to annual premium can be 15 times or more
• For a 54 year old male, no loading and $1m coverage
No of years Annual
premium If the individual chose a 45 year term but dies after
15 years 7020 paying 20 premiums, what is the return?
20 years 9170
25 years 11,190
30 years 13,980
35 years 17,130
40 years 20,090
45 years 20,640 55
r = 7.83%
Practice 1b
You just turned 35 and have been saving for an around the world vacation. You
want to take a trip to celebrate your 40th birthday. You have set aside, as of
today, $15,000 for such a trip. You expect the trip will cost $25,000. The
financial instruments you have invested the $15,000 in have been earning 8%.
b. You decide to make, starting immediately, 5 annual $500 contributions into
the account. How much will you have on your 40th birthday?
Today 1yr 2yr 3yr 4yr 5yr

8%
$15,000
$500 $500 $500 $500 $500
 (1  r) t  1   (1  0.08)5  1 
FV of annuity  A 1  r   500  1.08   500 (6.3359 )  3,167.96 (Table 6ii)
 r   0.08 
Total  22,039.92  3,167.96  $25,207.88
Learning Outcomes
• FV and PV of yearly annuities
rates
57
PV: Ordinary Annuity
0 1yr 2yr 3yr
$70 $70 $70
Example:
Suppose you are to receive $70 at the end of the next 3 years, what is the
present value monetary amount as of today? Assume a 12% interest.
 1 
 1- 
CF1 CF2 CF3  (1  r) t 
PV    PV  A
 
(1  r) (1  r) 2
(1  r)3 
r

 
70 70 70
   
 1-
1 
3 
(1  0.12) (1  0.12) 2 (1  0.12) 3  70
(1  0.12 ) 
 
 70(0.8929  0.7972  0.7118 )  70 (2.402 )  $168 .14 
0.12

  58
 70 ( 2.402 )  168 .14
PV: Annuity Due
0 1yr 2yr 3yr
$70 $70 $70
Example:
Suppose you are to receive $70 today and at the beginning of the next 2 years, what is
the present value monetary amount as of today? Assume a 12% interest.
 1 
CF2 CF3  1- t 
PV  CF1   (1  r) 
PV  A  (1  r)
(1  r) (1  r) 2  r 
 
70 70  
 70    
(1  0.12) (1  0.12) 2  1-
1
3 
(1  0.12 ) 
 70(1  0.8929  0.7972 )  70 (2.6901)  $188 .31  70  (1.12 )
 0.12  59
 
 
 70 ( 2.6901 )  188 .31
Ordinary Annuity versus Annuity Due
CF1 CF2 CF3

PV   
(1  r) (1  r) (1  r)3
2
70 70 70
  
(1  0.12) (1  0.12) 2
(1  0.12) 3
 70(0.8929  0.7972  0.7118 )  70(2.402 )  $168 .14
CF2 CF3 $168.14 *1.12= $188.31

PV  CF1  
(1  r) (1  r) 2
70 70
 70  
(1  0.12) (1  0.12) 2
 70(1  0.8929  0.7972 )  70 (2.6901)  $188 .31
60
Practice 2b
Your company has been offered a contract for the development and
delivery of a solar-powered military troop transport vehicle. It stipulates
that 2 working, economically feasible prototypes must be delivered in 4
years, at which time, you will receive a single and final payment of
$50,000. Assume an interest rate of 18%. Ignore taxes.
b. Alternatively, what 4 yearly receipts starting a year from now would
you be willing to accept instead of a PV of $25,789.44?
Today 1yr 2yr 3yr 4yr

18%
$25,789.44
 1   1 
 1-   1- 
 (1  r) t   A (1  0.18)
4
  A  $9,586.93 (Table 8i)
PV  A
 r   0.18 
   
   
Practice 3a
The aged but centrally located golf course you manage does not have an
in-ground automated water sprinkling system. Instead, it is done manually
which is a tedious and laborious task. You project that an automated
system will result in annual savings of about $4,000 over the next 12 years.
Ignore taxes.
a. What is the max price you would pay for the system? Assume an
interest rate of 6%.
Today Y1 2 3 11 12 years
$4,000 $4,000 $4,000 $4,000 $4,000
 1   1 
 1-   1- 
 (1  r) t   (1  0.06 )12   33,535 .38 (Table 8)
PV  A  4,000
 r   0.06 
   
   
Practice 3b
The aged but centrally located golf course you manage does not have an in-
ground automated water sprinkling system. Instead, it is done manually which is
a tedious and laborious task. You project that an automated system will result in
annual savings of about $4,000 over the next 12 years. Ignore taxes.
b. Redo using 10 years and $4,800 in annual savings. Assume an interest rate of
6%.
Today Y1 2 3 9 10 years
$4,800 $4,800 $4,800 $4,800 $4,800

 1   1 
 1-   1- 
 (1  r) t   (1  0.06 )10   35,328 .42 (Table 8)
PV  A  4,800
 r   0.06 
   
   
Practice 3c
c. Redo using $5,000 in annual savings for the first 6 years and $3,000 in annual
savings for the next 6 years. Assume an interest rate of 6%.
Today Y1 2 3 7 11 12 years
$5,000 $5,000 $5,000 $3,000 $3,000 $3,000
PV 
Break it into 2 annuities
 1   1 
 1-   1- 
 (1  0.06 )12   2,000  (1  0.06 )
6

PV  3,000
 0.06   0.06 
   
   
 25,151 .53  9,834 .65
 $34,986 .18
$5,000 $5,000 $5,000 $3,000 $3,000 $3,000

Practice 3c (alternative method)
b. Redo using $5,000 in annual savings for the first 6 years and $3,000 in annual
savings for the next 6 years.
$5,000 $5,000 $5,000 $3,000 $3,000 $3,000
 1   1 
 1-   1- 
(1  0.06) 6   3,000  (1  0.06)  
6
 1 14,751 .97
PV  5,000    24,586 .62 
6 
 $24,586 .62  $10,399 .56  $34,986 .18
 0.06   0.06  (1  0.06)  (1.06) 6
   
   
FV of Growing Annuity
67
PV of Growing Annuity
68
Perpetuity
69
Growing Perpetuity
• A growing perpetuity is a set of payments which grows at a constant rate, g, forever.
• If the first payment is $C1, C = C ´(1+ g) and C3 = C2 ´(1+g) = C1 ´(1+g)2

2 1
70
Time Value of Money
Part 2
1
Learning Outcomes
• FV and PV of monthly annuities
rates
2
Monthly Annuities
Jan Feb Mar Dec
$1000 $1000 $1000 $1000 $1000

1. If I put aside a sum of money every month (starting end of this month) for a year, how much
will there be in the account at year end? Solve for FV.
 (1  r/m) mt  1  Compare
FV of annuity  A
 

 r/m 
3
FV Example: Monthly Savings for Retirement
You will be retiring 10 years from today. You have decided to put aside $2,500
each month in a bank. If the bank pays 2% p.a. compounded monthly, how
much will you have when you retire? What if the interest is 5% p.a.
compounded monthly?
If interest is 2% pa compounded monthly :
 (1  r/12) 12t  1   (1  0.02 /12) 120  1 
FV of an annuity  A   2,500    $331,799.1 5
 r/12   0.02/12 
If interest is 5% pa compounded monthly :

 (1  0.05 /12) 120  1 
FV of an annuity  2,500    $388 ,205 .70
 0.05/12  4
Learning Outcomes
• FV and PV of monthly annuities
rates
5
Monthly Annuities
Jan Feb Mar Dec
$1000 $1000 $1000 $1000 $1000

1. If I put aside a sum of money every month (starting end of this month) for a year, how much
will there be in the account at year end? Solve for FV.
Compare
 (1  r/m) mt  1 
FV of annuity  A  

 r/m 
2. If I borrow a sum of money now to buy a house, how much do I have to pay per month
(starting immediately) over the next 15 years? Solve for A.
 1 
 1- 
 (1  r/m) mt 
PV of annuity  A
 r/m  6
 
 
PV Example: Monthly Payments for Housing Loan
If you can afford a $5,000 monthly mortgage payment, what is the maximum
housing loan you can take if the interest rate is 2% p.a. on a 180-month loan
(15 years)? Assume that mortgage payments start immediately.
$5,000 $5,000 $5,000 $5,000 $5,000
0 1 2 3 179
7
(24 years)? Assume that payments start immediately.
$5,000 $5,000 $5,000 $5,000 $5,000
0 1 2 3 287
8
(24 years)? Assume that payments start immediately.
$5,000 $5,000 $5,000 $5,000 $5,000
0 1 2 3 287
9
What if interest rate rises from 2% to 4%?
What will be the monthly mortgage payment if the interest
rate rises to 4% p.a. (assuming 24-year loan tenure)?
$6,169.33 $6,169.33 $6,169.33 $6,169.33 $6,169.33
0 1 2 3 287
10
Consolidated Example
You have just celebrated your 30th birthday. You plan to retire on your 60th
birthday, and you would like to be able to have a cash flow stream of $100,000 a
year for 20 years starting from your 61st birthday until you are 80.
To achieve this, you have committed to set aside 20 equal annual savings from
your 31st birthday until your 50th birthday. If the annual interest rate is 8%, how
much should your annual savings be?
30 50 60  1  80
 1- 
(1  0.08) 20
PV60  100 ,000  ?
 0.08 
 
 
PV60
PV50 = ?
Solve for A (1  0.08)10
 (1  0.08) 20  1 
FV of annuity  PV50  A 
 0.08  11
30 50 60 80
 1 
 1- 
(1  0.08) 20
PV60  100 ,000    981,814 .74
 0.08 
 
 
981,814.74
 (1  0.08) 20  1  PV50 =  454 ,770 .19
454,770.19  A  (1  0.08)10
 0.08 
A  9937 .73
12
Consolidated Example 2
30 50 60 80
 1 
 1- 
 .04) 20
PV60  100 ,000    ?(Table8)
(1 0
 0.04 
 
PV60  
Solve for A (Table 6) PV50 =  ?(Table3)
(1  0.04 )10
 (1  0.04 ) 20  1 
 0.04 
A?
13
30 50 60 80
 1 
 1- 
(1  0.04 ) 20
PV60  100 ,000    $1,359 ,032 .63 (Table 8)
 0.04 
 
PV60  
Solve for A (Table 6) PV50 =  $918 ,113 .75 (Table3)
(1  0.04 )10
 (1  0.04 ) 20  1 
 0.04 
A  $30,831 .87 14
Learning Outcomes
rates
15
Annual Percentage Rate (APR)
• This is the annual rate that is quoted by law.
• By definition, APR = period rate * the number of periods per year
Examples:
– What is the APR if the monthly rate is 0.5%? APR= 0.5% * 12 = 6%
– What is the APR if the semi-annual rate is 4%? APR= 4% * 2 = 8%
• To get the period rate, rearrange the APR equation:
Period rate = APR / number of periods per year
Example:
– What is the monthly rate if the APR is 12%? Monthly rate = 12% / 12 = 1%
16
The r in the Annuity formulas
 (1  r/m) mt  1 
FV of annuity  A
 

 r/m 
 1 
 1- 
 (1  r/m) mt 
PV of annuity  A
 r/m 
 
 
17
Effective Annual Rate (EAR)
• The effective annual rate of interest refers to the actual rate
paid (or received).
• If you want to compare two alternative investments, you need
to compute the EAR and use that for comparison.
18
Effective Annual Rate (EAR)
 EAR is the actual rate received or paid. Useful for comparing alternatives with different
compounding frequency.
 EAR may differ from the Annual Percentage Rate (APR) because of compounding
periods m
 APR 
EAR  1   1
 m 
where m is the number of compounding periods a year
Real example: Suppose you can borrow using either

• a credit card which charges 2% per month
• a bank loan which charges 24% compounded quarterly
Which would you choose?  APR 
m

12
0.24 
EAR of credit card loan  1    1  1    1  26.82%
 m   12 
m 4
 APR   0.24 
EAR of bank loan   1   1   1   1  26.25%
 m   4 
20
You are considering two loans. The terms are the same except for the
interest rates. Loan A offers a rate of 7.45% compounded daily. Loan B
offers a rate of 7.5% compounded semi-annually.
Loan A: effective rate = (1+7.45%/365)**365 – 1 = 7.73%
Loan B: effective rate = (1+7.5%/2)**2 – 1 = 7.64%
Loan B has the lower effective rate.

Example of DBS Cashline-- Interest payable monthly
Here are the criteria to qualify for DBS Cashline:
Applications Requirements for DBS Cashline
Nationality Age Minimum Gross Annual Income
Singaporean or Permanent
21 years & above S$20,000 & above
Resident
Foreigner 21 years & above S$45,000 & above
Note: Existing DBS Cashline, POSB Loan Assist or POSB Loan Assist Plus customers are not eligible.
Nationality Singaporean OR Permanent Resident Foreigner
S$20,000 - below
Gross Annual Income S$30,000 & above S$45,000 & above
S$30,000
Up to 2 times monthly Up to 4 times monthly Up to 2 times or

Credit Limit
salary salary max. S$15,000
Effective interest rate 19% per annum 17.8% per annum
Minimum monthly
2.5% of outstanding balance or S$50, whichever is higher
repayment
Minimum interest charge S$5
Late payment charge S$60

Extracted in May 2012
DBS Cashline. Sign up online now and receive 40% rebate for 2 months!
Be rewarded with the most exclusive deal in town, by signing up for DBS Cashline online now!
Enjoy 40% rebate on your monthly interest^ for not 1, but 2 months! To enjoy this promotion, simply access your
extra cash through internet bank transfer or at any of the DBS/POSB ATMs islandwide, 24/7. Or issue a cheque with
your free chequebook (mailed to you upon account approval).
Interest charged at
Month of Usage 40% Interest charged after
17.8%
Usage Amount Rebates rebates
(based on 30 days)
September $5,000 $73.15 $29.26 $43.89
October $8,000 $117.04 $46.82 $70.22
You Save $76.08
30
$5,000x17.8%x  73.15
365
30
$8,000x17.8%x  117.04
365
m 12
 APR   0.178 
EAR of APR 17.8% compoundedmonthly  1    1   1   1  19.33%
 m   12 
Another reason why APR may differ from EAR
Different basis of interest calculation

 reducing balance
 flat basis
 annual rest
24
Different Basis
A borrower approached a bank for a loan of $100,000 repayable over 36 equal
monthly installments. The bank quoted a rate of 12% but did not state the
basis of interest calculation. What is the EAR if reducing balance applies? flat
basis applies? annual rest applies?
+$100,000 A A A A
……
0 1mth 2mth 3mth 36mth
Reducing Balance
A borrower approached a bank for a loan of $100,000 repayable over 36
equal monthly installments, starting end of the month. The bank quoted a
rate of 12% but did not state the basis of interest calculation. What is the EAR
if reducing balance applies? flat basis applies? annual rest applies?
+$100,000 A A A A

 1   1 
 1 - 1
1 - (1  r/m) mt   1 - 1
1 - (1  0.12 / 12 ) 36 
PV of an annuity  A  (1  r/m) mt   A  (1  0.12 / 12 ) 36   $100 ,000
PV of an annuity  A    A    $100 ,000
 r/m
r/m 0.12/12
0.12/12
   
   
A
A $$3321.43
3321.43
m 12
 APR  m  0.12 12
EAR  1  m   1  1  12  
     1
EAR 1 APR 1 1 0.12
1  12
12 ..68
68 %
% (Table
(Table 7)
7)
 m   12 
Beg Balance PMT Interest= Paymt to principal= End Balance=
Beg*0.12/12 PMT-Interest Beg-Paymt to principal
1 $100,000 $3,321.43 $1,000 $2,321 $97,679
2 $97,679 $3,321.43 $977 $2,345 $95,334
3 $95,334 $3,321.43 $953 $2,368 $92,966
4 $92,966 $3,321.43 $930 $2,392 $90,574
5 $90,574 $3,321.43 $906 $2,416 $88,158
6 $88,158 $3,321.43 $882 $2,440 $85,719
7 $85,719 $3,321.43 $857 $2,464 $83,254
8 $83,254 $3,321.43 $833 $2,489 $80,765
9 $80,765 $3,321.43 $808 $2,514 $78,252
10 $78,252 $3,321.43 $783 $2,539 $75,713
11 $75,713 $3,321.43 $757 $2,564 $73,148
12 $73,148 $3,321.43 $731 $2,590 $70,558
13 $70,558 $3,321.43 $706 $2,616 $67,943
14 $67,943 $3,321.43 $679 $2,642 $65,301
15 $65,301 $3,321.43 $653 $2,668 $62,632
16 $62,632 $3,321.43 $626 $2,695 $59,937
17 $59,937 $3,321.43 $599 $2,722 $57,215
18 $57,215 $3,321.43 $572 $2,749 $54,466
19 $54,466 $3,321.43 $545 $2,777 $51,689
20 $51,689 $3,321.43 $517 $2,805 $48,884
21 $48,884 $3,321.43 $489 $2,833 $46,052
22 $46,052 $3,321.43 $461 $2,861 $43,191
23 $43,191 $3,321.43 $432 $2,890 $40,301
24 $40,301 $3,321.43 $403 $2,918 $37,383
25 $37,383 $3,321.43 $374 $2,948 $34,435
26 $34,435 $3,321.43 $344 $2,977 $31,458
27 $31,458 $3,321.43 $315 $3,007 $28,451
28 $28,451 $3,321.43 $285 $3,037 $25,415
29 $25,415 $3,321.43 $254 $3,067 $22,347
30 $22,347 $3,321.43 $223 $3,098 $19,249
31 $19,249 $3,321.43 $192 $3,129 $16,120
32 $16,120 $3,321.43 $161 $3,160 $12,960
33 $12,960 $3,321.43 $130 $3,192 $9,768 27
34 $9,768 $3,321.43 $98 $3,224 $6,545
35 $6,545 $3,321.43 $65 $3,256 $3,289
36 $3,289 $3,321.43 $33 $3,289 $0
Different Basis
A borrower approached a bank for a loan of $100,000 repayable over 36 equal
monthly installments. The bank quoted a rate of 12% but did not state the
basis of interest calculation. What is the EAR if reducing balance applies? flat
basis applies? annual rest applies?
+$100,000 A A A A
……
Flat Basis at quoted rate of 12%
 Interest is charged on the full sum of the principal over 3 years.
Interest  100,000 x 0.12 x 3  36,000
100,000  36,000
Monthly payments   $3,777.78
36
 1   1 
 1- mt   1- 
 (1  r/m)   (1  r/12) 36   $100,000
PV of an annuity  A  $3,777.78
 r/m   r/12 
   
   
Solve for r  21.2%
m 12
 APR   0.212 
EAR  1    1  1    1  23.39% (Table 2)
 m   12 
Annual Rest at quoted rate of 12%
 For interest calculation, the principal is reduced by the installment amount at the end of every year.
 Interest charged on balance at beginning of the year.
Interest computatio n assumes that only 3 annual payments are made :
 1   1 
 1-   1- 
(1  r) t   A  (1  0.12 )
3
PV of an annuity  A    $100,000
 r   0.12 
   
   
Solve for A  $41,634 .90
41,634.90
On a monthly basis, the payment   $3,469.57
12
 1   1 
 1- 12t   1- 
(1  r/12)  (1  r/12) 36
PV of an annuity  A  $3,469.57    $100,000
 r   r 
   
   
Solve for r  15.06%
m 12
 APR   0.1506 
EAR  1    1  1    1  16 .15 %
 m   12 
Car Loan: Flat Basis at quoted rate of 3.25%
31
 Assume that you take a $70,000 car loan and will make monthly installment
payments over 5 years. Assume that the payments start at end of the month.
Interest 
Interest 770,000
0,000 x
x 0.0325
0.0325 x
x55
 11,375
11,375
70,000 
70,000  11,375
payments 
Monthly 11,375  1,356.25
Monthly payments  60  1,356.25
60
 1   1 
 1 1
1 -- (1  r/12) 5t   1 1
1 -- (1  r/12) 60 
5t 
 (1  r/12)   1,356.25  (1  r/12) 60   70,000
PV
PV of
of an annuity 
an annuity AA    1,356.25    70,000
 r/12
r/12 r/12
r/12
   
   
solve for rr 
solve for 66..09
09%%
m 12
 APR   1  1  0.609
APR m
0.609   1  6.26 % (Table 2)
12
EAR   1 
EAR  1  m   1  1  12   1  6.26 % (Table 2)
 m   12 
 Assume that first installment payment made immediately.
Interest  70,000 x 0.0325 x 5  11,375
70,000  11,375
Monthly payments   1,356.25
60
 1   1 
 1- 5t   1- 
(1  r/12)  r   (1  r/12)
60
1  r   70,00 0
PV of an annuity  A  1    1,356.25
 r/12  12   r/12  12 
   
   
Solve for r  6.31 %
m 12
 APR   0.631 
EAR  1    1  1    1  6.49 % (Table 2)
 m   12 
Personal Loan: Flat Basis at quoted rate of 8.55% (extracted
Oct 18, 2016)
34
Personal Loan: Flat Basis at quoted rate of 8.55%
 Assume that you take a $15,000 personal loan and will make monthly installment
payments over 5 years. Assume payments start at end of month.
Interest  15,000 x 0.0855 x 5  6,412 .5
15,000  6,412 .5
Monthly payments   356 .875
60
 1   1 
 1- 5t   1- 
 (1  r/12)   (1  r/12) 60   15,000
PV of an annuity  A  356.875
 r/12   r/12 
   
   
solve for r  15 .00 %
m 12
 APR   0.15 
EAR  1    1  1    1  16 .08 %
 m   12 
Personal Loan: Flat Basis at quoted rate of 8.55%
 Assume that you take a $15,000 personal loan and will make monthly installment
payments over 5 years. Assume payments start at end of month.
 Deduct processing fee of 2% = $300
Interest  15,000 x 0.0855 x 5  6,412 .5
15,000  6,412 .5
Monthly payments   356 .875
60
 1   1 
 1- 5t   1- 
 (1  r/12)   (1  r/12) 60   14,700
PV of an annuity  A  356.875
 r/12   r/12 
   
   
solve for r  15 .923 %
m 12
 APR   0.15923 
EAR  1    1  1    1  17 .138 %
 m   12 
Things to Remember
• You ALWAYS need to make sure that payment frequency and

compounding frequency match.
– If you have monthly compounding and payments are not on
monthly basis, adjust the interest rate.
– If you have annual compounding and payments are not on an
annual basis, adjust the interest rate.
40
What if payment frequency and compounding
frequency do not match?
You plan to invest $6,000 at the end of each of the next 3 years. The
APR is 10% and compounding is monthly. How much will you have at
the end of 3 years?
0 yr1 yr2 yr3

10.4713%
6,000 6,000 6,000
12 1
 0.10   APR 
1  EAR  1    1  
 12   1 
1  EAR  1  10.4713 %  APR  10 .4713 %
So 10% compounded monthly is the same as 10.4713%

41
compounded annually. Apply 10.4713% to the cash flows.
APR is 10% and compounding is monthly. How much will you have at
the end of 3 years?
0 yr1 yr2 yr3

10.4713%
6,000 6,000 6,000
42
APR is 10% and compounding is semi-annually. How much will you
have at the end of 3 years?
0 yr1 yr2 yr3

10.25%
6,000 6,000 6,000
2 1
 0.10   APR 
1  EAR  1    1  
 2   1 
1  EAR  1  10.25%  APR  10.25%
So 10% compounded semi-annually is the same as 10.25%

43
compounded annually. Apply 10.25% to the cash flows.
have at the end of 3 years?
0 yr1 yr2 yr3

10.25%
6,000 6,000 6,000
44
You plan to invest $500 at the end of each of the next 36 months. The
have at the end of 36 months?
0 mth1 mth2 mth36

9.798%
….
500 500 500

2 12
 0.10   APR 
1  EAR  1    1  
 2   12 
1  EAR  1  10.25%  APR  9.798%
So 10% compounded semi-annually is the same as 9.798%

45
compounded monthly. Apply 9.798% to the cash flows.
You plan to invest $500 at the end of each of the next 36 months. The
have at the end of 36 months?
0 mth1 mth2 mth36

9.798%
….
500 500 500
46
Risk & Return Introduction
RWJ Chapter 12
Learning Outcomes
1. Appreciate the concept of risk and return by

examining how various investments have performed
in the past
2. Appreciate how inflation can affect return
3. Estimate return
4. Appreciate the concept of stand alone risk
2
A First Look at Risk and Return
Let’s begin by looking at historical return and risk (volatility) experienced by
various investments.
3
What Are Investment Returns?
• Investment returns measure the financial results of an
investment.
• Returns may be historical or prospective (anticipated).
• Returns can be expressed in:
 Dollar terms: Amount received – Amount invested
 Percentage terms: Am ount received – Am ount invested

Am ount invested
4
Dollar Returns
• When an investor buys a stock or a bond, his return comes in 2 forms:

1. Any dividend income or interest income received, and
2. A capital gain or a capital loss (due to change in price)
Total dollar return = income+ capital gain (loss) due to change in price
Examples:
 You bought PepsiCo stock at $43 a share. By the end of the year, the value of
each share has appreciated to $49. In addition, PepsiCo paid a dividend of
$0.56 a share.
Total dollar return = dividend income + capital gain = $0.56 + $6 = $6.56
 You bought a bond for $950 one year ago. You have received two coupons of
$30 each. You can sell the bond for $975 today. What is your total dollar return?
Total dollar return = interest income + capital gain = $60+25 = $85
5
12-5
Percentage Returns
• It is generally more intuitive to think in terms of percentage, rather than
dollar, returns
– Dividend yield = dividend / beginning price
– Capital gains yield = (ending price – beginning price) / beginning price
– Total percentage return = dividend yield + capital gains yield
Div 0.56
Dividend Yield =   0.013 or 1.3%
Initial Share Price 43
Capital Gain 6
Capital Gain Yield =   .140 or 14.0%
Dividend  Capital Gain 0.56  6
Total Percentage Return =   .153 or 15.3%
Initial Share Price 43 6
12-6
Learning Outcomes

in the past
3. Estimate return
7
What is the Impact of Inflation?
• What we have calculated earlier is a nominal return.
• With inflation, the ending dollars may not be able to buy the same basket of goods.
• To find out the return in terms of the increase in purchasing power relative to initial
investment purchasing power, we need the real rate of return
– To find out how much more can be bought with the money at end of year.
• Fisher equation describes the relationship between interest rates and inflation:
1  rnominal  (1  rreal rate)(1  inflation rate)

1+rnominal = 1 + rreal rate + inflation rate + (rreal rate )(inflation rate)
• An approximation for the relationship:
rnominal  rreal rate  inflation rate 8

Example: Inflation
• Let’s go back to the PepsiCo example. If the inflation for the year was
2.8%, what was the real rate of return?
Dividend  Capital Gain 0.56  6
Total Percentage Return =   .153 or 15.3%
1  rnominal  (1  rreal rat e)(1  inflation rate)

1  0.153  (1  rreal rat e)(1  0.028)
(1  rnominal)
rreal rat e   1  12.2%
(1  inflation rate)
Approximation:
rreal rat e  rnominal  inflation rate  12.5%
9
Learning Outcomes

in the past
3. Estimate return
10
How to estimate return?
• There are 2 ways of doing so
1. If given possible returns and the probabilities, calculate expected return:
n
rˆ   ri Pi
i 1
where
ri = ith possible return
Pi = probability of ith possible return
n= number of possible returns
Expected return takes into account uncertainties that are present in

different scenarios.
11
Example: Expected Return
Probability of Possible
Return Return
An asset has a
• 30% probability of a 10% return 0.3 10%
• 10% probability of a -10% return 0.1 -10%

• 60% probability of a 25% return 0.6 25%
What is the expected return?
Expected Return = (0.30)(10%) + (0.10)(-10%) + (0.60)(25%) = 17%

2. If using historical data on an asset, calculate the average return which can
either be the arithmetic average return or the geometric average return
Arithmetic average return also called Arithmetic mean

T
r t
r t 1
Geometric average return also called Geometric mean
r  T ( 1  r1 )( 1  r2 )( 1  r3 )( 1  r4 )......(1  rT )  1
where rt are the actual nominal returns in year 1, year 2, ...

Geometric vs. Arithmetic
• If an investor buys an asset at time 0 and holds it till time T:
‒ the geometric mean is what he actually earned per year on average

compounded annually. It is also known as the mean holding period
return or average compound return earned per year over a multi-
year period.
‒ the arithmetic mean is what he earned in a typical year.
14
Geometric Mean
𝑃1 𝑃2 𝑃3 𝑃4 𝑃4
× × × =
𝑃0 𝑃1 𝑃2 𝑃3 𝑃0
1 + 𝑟1 1 + 𝑟2 1 + 𝑟3 1 + 𝑟4 = 1 + ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑟𝑒𝑡𝑢𝑟𝑛
1 + 𝑟1 1 + 𝑟2 1 + 𝑟3 1 + 𝑟4 = 1 + 𝑟 4
where r is the geometric mean
4
r= 1 + 𝑟1 1 + 𝑟2 1 + 𝑟3 1 + 𝑟4 - 1
15
Example: Geometric Mean
Suppose you bought an investment and held it for 4 years. It provided the
following returns over the 4-year period:
Year Return Holding period return 

1 10%  (1  r1 )(1  r2 )(1  r3 )(1  r4 )  1
2 -5%  (1.10)(. 95)(1.20)(1.15)  1
3 20%  .4421  44.21%
4 15%
Geometric mean return
4
r= 1 + 𝑟1 1 + 𝑟2 1 + 𝑟3 1 + 𝑟4 - 1
4
= 1.10 0.95 1.20 1.15 - 1
= 0.0958 = 9.58%
So, you realized 9.58% annual return on your money for 4 years or
equivalently a holding period return of 44.21% 16
Example: Arithmetic Mean
Year Return r1  r2  r3  r4
Arithmetic average return 
1 10% 4
2 -5% 10%  5%  20%  15%
  10%
3 20% 4
4 15%
Benchmark
So, let’s say we have estimated a return:

• How does one determine whether the return is adequate?
– By comparing to a benchmark
• What should be the benchmark?

– The required rate of return
• What determines the required return?

– The risk of the investment
– What type of risk?
– Systematic risk – the risk that you cannot diversify away
18
Learning Outcomes

in the past
3. Estimate return
19
Stand-Alone Risk
• Stand-alone risk is the risk an investor faces if he holds only this one
asset.
• Measured by the standard deviation.
• The larger the standard deviation, the higher the probability that actual
returns will be far away from the expected or average return.
20
Standalone Risk
Stock X
Stock Y
Rate of
-20 0 15 50 return (%)
Stocks X and Y both give the same expected return.

Stock Y has higher standalone risk. 21
But Stock Y may not have higher systematic risk.
Risk & Return Part 1
RWJ Chapter 13
Risk and Return: Portfolio Theory & CAPM
Learning Outcomes:
1. Know how to compute the expected return and variance of
individual securities, as well as the covariance and
correlation between 2 securities.
2. Know how to compute portfolio risk and return of 2
securities
3. Appreciate how portfolios can reduce risk and be able to
identify the efficient set of a 2 security portfolio.
4. Apply the same reasoning to a portfolio of many securities
5. Understand the rationale behind the CAPM
23
Individual Securities
• Characteristics of individual securities that are of interest:
– Expected Return
– Variance and Standard Deviation
– Covariance and Correlation
• Consider the following 2 risky security world with 3 possible
states of the economy. The 2 securities are a stock fund and a
bond fund. The 3 states each has 1/3 chance of occurring.
Scenario Probability Return of Return of
Stock fund Bond fund
Recession 1/3 -7% 17%
Normal 1/3 12% 7%
Boom 1/3 28% -3%
The table contains the future possible returns of the stock fund and the bond fund in
the 3 states. Note that these are future possible returns, not historical returns. 24
Expected Returns, Variance, and Covariance
Scenario Probability Stock fund Bond fund
Return Squared Return Squared
Deviation Deviation
Normal 1/3 12% 7%
Boom 1/3 28% -3%
Expected return 𝐸 𝑟
Variance 𝜎 2
Standard Deviation 𝜎
𝑁
• Expected return: 𝐸 𝑟 = 𝑖=1 𝑝𝑖 𝑟𝑖 (where i means the i-th economy state)
𝑁 2
• Variance: 𝜎 2 = 𝑝
𝑖=1 𝑖 𝑖 𝑟 − 𝐸 𝑟
• Covariance: 𝜎𝑆𝐵 = 𝑁 𝑖=1 𝑝𝑖 𝑟𝑖𝑆 − 𝐸 𝑟𝑆 𝑟𝑖𝐵 − 𝐸 𝑟𝐵
𝜎
• Correlation coefficient: 𝜌𝑆𝐵 = 𝑆𝐵
𝜎𝑆 𝜎𝐵
Expected Returns
Deviation Deviation
Normal 1/3 12% 7%
Boom 1/3 28% -3%
Expected return 𝐸 𝑟 11.00% 7.00%
Variance 𝜎 2
3 1 1 1
• Expected return: 𝐸 𝑟𝑆 = 𝑖=1 𝑝𝑖 𝑟𝑖 = −7% + 12% + 28% = 𝟏𝟏%
3 3 3
26
Variance
Deviation Deviation
Recession 1/3 -7% 324%𝟐 17% 100%2
Normal 1/3 12% 1%2 7% 0%2
Boom 1/3 28% 289%2 -3% 100%2
Variance 𝜎 2
• Squared deviation of each state:

𝑟𝑖 − 𝐸 𝑟 2 = −7% − 11% 2 = 𝟑𝟐𝟒%𝟐
27
Variance
Deviation Deviation
Recession 1/3 -7% 324%2 17% 100%2
Normal 1/3 12% 1%2 7% 0%2
Boom 1/3 28% 289%2 -3% 100%2
Variance 𝜎 2 205%𝟐 66.67%2
• Variance:
3
2 1 1 1
𝜎2 = 𝑝𝑖 𝑟𝑖 − 𝐸 𝑟 = 324% + 1% + 289%2 = 205%2
2 2
3 3 3
𝑖=1
28
Standard Deviation
Deviation Deviation
Recession 1/3 -7% 324%2 17% 100%2
Normal 1/3 12% 1%2 7% 0%2
Boom 1/3 28% 289%2 -3% 100%2
Variance 𝜎 2 205%2 66.67%2
Standard Deviation 𝜎 14.31% 8.16%
2 2
• Standard deviation: 𝜎 = 𝜎2 = 205%2 = 14.31%
29
In summary
Deviation Deviation
Recession 1/3 -7% 324%2 17% 100%2
Normal 1/3 12% 1%2 7% 0%2
Boom 1/3 28% 289%2 -3% 100%2
Expected return 𝐸 𝑟 11.00% > 7.00%
Variance 𝜎 2 205%2 > 66.67%2
Standard Deviation 𝜎 14.31% > 8.16%
• Expected return: Stock > Bond;

• Standard deviation (risk): Stock > Bond.
30
Covariance
Deviation Deviation
Recession 1/3 -7% 324%2 17% 100%2
Normal 1/3 12% 1%2 7% 0%2
Boom 1/3 28% 289%2 -3% 100%2
Variance 𝜎 2 205%2 66.67%2
Covariance: 𝜎𝑆𝐵 = 3𝑖=1 𝑝𝑖 𝑟𝑖𝑆 − 𝐸 𝑟𝑆 𝑟𝑖𝐵 − 𝐸 𝑟𝐵

1 1
= −7% − 11% 17% − 7% + 12% − 11% 7% − 7%
3 3
1
+ 28% − 11% −3% − 7% = −116.67%2
3 31
Correlation
Deviation Deviation
Recession 1/3 -7% 324%2 17% 100%2
Normal 1/3 12% 1%2 7% 0%2
Boom 1/3 28% 289%2 -3% 100%2
Variance 𝜎 2 205%2 66.67%2
𝜎𝑆𝐵 −116.67%2
Correlation coefficient: 𝜌𝑆𝐵 = = = −0.9991 ≈ −1
𝜎𝑆 𝜎𝐵 14.31%∗8.16%
32
Given Historical Data
If given historical data (rather than information on future possible
outcomes and probabilities), the formulas for average return, std
deviation and covariance are the following:
 r  r 
T 2
r t

t
t 1
r t 1
T T 1
arithmetic mean
 (r At  rA )(rBt  rB )
 AB  t 1
T 1
where rt are the actual returns
Example
• Below are DEF Inc’s historical returns over the last 4 years. What is its
average return in a typical year?
Year Return
1 10%
2 -7%
3 28%
4 -11%
• The appropriate average return is the arithmetic mean, also known as

ex-post average return, observed average return and historical average
return.
r1  r2  r3  r4
Average return in a typical year 
4
10%  7%  28%  11% 20%
   5%
4 4
Example (cont’d)
What is its standard deviation?
Year Return
1 10%
2 -7%
3 28%
4 -11%
4 2
𝑡=1𝑟𝑡 − 𝑟
𝜎=
4−1
10%−5% 2 + −7%−5% 2 + 28%−5% 2 + −11%−5% 2
=
3
5% 2 + −12 2 + 23% 2 + −16% 2
=
3
954%2
= =17.83%
3
Learning Outcomes:
securities
36
Portfolio Return and Risk
Deviation Deviation
Recession 1/3 -7% 324%2 17% 100%2
Normal 1/3 12% 1%2 7% 0%2
Boom 1/3 28% 289%2 -3% 100%2
Expected return 𝐸 𝑟 11.00% > 7.00%
Variance 𝜎 2 205%2 > 66.67%2
Standard Deviation 𝜎 14.31% > 8.16%
• Let’s explore a portfolio that is 50% invested in the stock fund and 50%
invested in the bond fund.
37
Portfolio Return
Scenario Probability Rate of Return
Stock Bond fund Portfolio Squared
fund 50% 50% Deviation
Recession 1/3 -7% 17% 5.0%
Normal 1/3 12% 7% 9.5%
Boom 1/3 28% -3% 12.5%
Variance 𝜎 2 205%2 66.67%2
• In each state, the rate of return on the portfolio is a weighted average of

the return on the stock fund and the bond fund.
• In the Recession state, the portfolio return is 5%:
𝑟𝑃 = 𝑤𝐵 𝑟𝐵 + 𝑤𝑆 𝑟𝑆 = 50% −7% + 50% 17% = 5%
38
Portfolio Return
Recession 1/3 -7% 17% 5.0%
Normal 1/3 12% 7% 9.5%
Boom 1/3 28% -3% 12.5%
Expected return 𝐸 𝑟 11.00% 7.00% 9.0%
Variance 𝜎 2 205%2 66.67%2
• The expected rate of return on the portfolio is:

1 1 1
𝐸 𝑟𝑃 = 3 5% + 3 9.5% + 3 12.5% = 9%
• Alternatively, expected rate of return on the portfolio can be computed as the
weighted average of the stock fund and the bond fund. The expected returns on
the stock fund and the bond fund are 11% and 7%:
𝐸 𝑟𝑃 = 𝑤𝑆 𝐸 𝑟𝑆 + 𝑤𝐵 𝐸 𝑟𝐵 = 50% 11% + 50% 7% = 9%
39
Portfolio Risk
Recession 1/3 -7% 17% 5.0% 16%𝟐
Normal 1/3 12% 7% 9.5% 0.25%2
Boom 1/3 28% -3% 12.5% 12.25%2
Variance 𝜎 2 205%2 66.67%2
• Squared deviation of each state:

𝑟𝑖𝑃 − 𝐸 𝑟𝑃 2 = 5% − 9% 2
= 16%2
40
Portfolio Risk
Recession 1/3 -7% 17% 5.0% 16%2
Normal 1/3 12% 7% 9.5% 0.25%2
Boom 1/3 28% -3% 12.5% 12.25%2
Variance 𝜎 2 205%2 66.67%2 9.50%𝟐
Standard Deviation 𝜎 14.31% 8.16% 3.08%
• The variance of the portfolio is:
3 1 1 1
2
𝜎𝑃 = 𝑝𝑖𝑃 𝑟𝑖𝑃 − 𝐸 𝑟𝑃 2 = 16%2 + 0.25%2 + 12.25%2 = 9.5%2
𝑖=1 3 3 3
𝜎𝑃 = 3.08%
• Alternatively, the variance of the portfolio can be computed using:
𝜎𝑃2 = (𝑤𝑆 𝜎𝑆 )2 + (𝑤𝐵 𝜎𝐵 )2 + 2 𝑤𝑆 𝜎𝑆 𝑤𝐵 𝜎𝐵 𝜌𝑆𝐵 = 𝑤𝑆2 𝜎𝑆2 + 𝑤𝐵2 𝜎𝐵2 + 2𝑤𝑆 𝑤𝐵 𝜎𝑆 𝜎𝐵 𝜌𝑆𝐵 41
Portfolio Standard Deviation: Alternative Way
= w12 12 + w22 22 + 2 w1 w212

Variance terms Co-variance term
w1 w2
w1 w12 12 w1 w212
 2 2
W2 1 2 12 w2 2
w w
w2
Portfolio Risk: 3-Asset Portfolio Formula
Variance terms
• Var( rp ) = w12 12 + w22 22 + w32 32
+ 2 w1 w212 + 2 w2 w3 23 + 2 w1 w3 13 Co-variance terms
w1 w2 w3
2
w1 w1  12 w1 w212 w1 w313
W2 w1 w212 2 2
w2 2 w2 w323
w2W3 w w  w w  2 2
1 3 13 2 3 23 w3  3
w3 are 3 variance terms and 3 -3 = 6 covariance terms
Note that there 2
For n asset portfolio, there will be n variance terms and n2-n covariance terms
Portfolio Risk
Recession 1/3 -7% 17% 5.0% 16%2
Normal 1/3 12% 7% 9.5% 0.25%2
Boom 1/3 28% -3% 12.5% 12.25%2
Variance 𝜎 2 205%2 66.67%2 9.50%𝟐
Standard Deviation 𝜎 14.31% 8.16% 3.08%
Alternatively, the variance of the portfolio can be computed using:

𝜎𝑃2 = (𝑤𝑆 𝜎𝑆 )2 + (𝑤𝐵 𝜎𝐵 )2 + 2 𝑤𝑆 𝜎𝑆 𝑤𝐵 𝜎𝐵 𝜌𝑆𝐵 = 𝑤𝑆2 𝜎𝑆2 + 𝑤𝐵2 𝜎𝐵2 + 2𝑤𝑆 𝑤𝐵 𝜎𝑆 𝜎𝐵 𝜌𝑆𝐵
𝜎𝑃2 = 0.52 (205) +0.52 (66.67) + 2 0.5 0.5 (14.31)(8.16)(−1) = 9.5%2
𝜎𝑃 = 3.08%
44
In summary
Recession 1/3 -7% 17% 5.0% 16%2
Normal 1/3 12% 7% 9.5% 0.25%2
Boom 1/3 28% -3% 12.5% 12.25%2
Variance 𝜎 2 205%2 66.67%2 > 9.50%2
Standard Deviation 𝜎 14.31% 8.16% > 3.08%
• bond return < portfolio return < stock return

• Portfolio risk < bond risk < stock risk
45
In summary
Recession 1/3 -7% 17% 5.0% 16%2
Normal 1/3 12% 7% 9.5% 0.25%2
Boom 1/3 28% -3% 12.5% 12.25%2
Variance 𝜎 2 205%2 66.67%2 > 9.50%2
Standard Deviation 𝜎 14.31% 8.16% > 3.08%
• bond return < portfolio return < stock return

• Portfolio risk < bond risk < stock risk
– Does this contradict the famous quote “high risk high return”?
• Diversification reduces the risk. But the return is a weighted average. 46

Risk & Return Part 2
Learning Outcomes:
securities
48
The Efficient Set for Two Securities
% in stocks Risk (σ) Return
• We can combine the stock fund and the bond fund 0% 8.16% 7.00%
5% 7.04% 7.20%
using different weights, e.g., (0%, 100%), (5%, 95%), 10% 5.92% 7.40%
…… 15% 4.80% 7.60%
20% 3.68% 7.80%
25% 2.56% 8.00%
30% 1.44% 8.20%
35% 0.39% 8.40%
40% 0.86% 8.60%
45% 1.97% 8.80%
50% 3.08% 9.00%
55% 4.20% 9.20%
60% 5.32% 9.40%
65% 6.45% 9.60%
70% 7.57% 9.80%
75% 8.69% 10.00%
80% 9.81% 10.20%
85% 10.94% 10.40%
90% 12.06% 10.60%
95% 13.18% 10.80%
100% 14.31% 11.00%
105% 15.43% 11.20%
110% 16.55% 11.40%
115% 17.68% 11.60%
120% 18.80% 11.80%
49
125% 19.92% 12.00%
• We can combine the stock fund and the bond fund 0% 8.16% 7.00%
5% 7.04% 7.20%
using different weights, e.g., (20%, 80%), (0%, 10% 5.92% 7.40%
100%), …… 15% 4.80% 7.60%
20% 3.68% 7.80%
• What weights give the minimum variance or 25% 2.56% 8.00%
30% 1.44% 8.20%
minimum
14.00%
standard dev portfolio? 35% 0.39% 8.40%
40% 0.86% 8.60%
45% 1.97% 8.80%
12.00%
50% 3.08% 9.00%
55% 4.20% 9.20%
10.00%
60% 5.32% 9.40%
Portfolio Return
65% 6.45% 9.60%

8.00%
100% stock fund 70% 7.57% 9.80%
75% 8.69% 10.00%
6.00% 80% 9.81% 10.20%
85% 10.94% 10.40%
100% bond fund 90% 12.06% 10.60%
4.00%
95% 13.18% 10.80%
100% 14.31% 11.00%
2.00% 105% 15.43% 11.20%
110% 16.55% 11.40%
0.00% 115% 17.68% 11.60%
0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00% 20.00% 22.00% 120% 18.80% 11.80%
Portfolio Risk (standard deviation σ) 50
125% 19.92% 12.00%
Derivation of formula
Workings
 B 2   B S 66.67  (1)(14.31)(8.16) 66.67  116.77 183.44

xs  2     0.3631
 S   B 2  2  B S 205  66.67  2(1)(14.31)(8.16) 205  66.67  233.54 505.21
Portfolio Risk and Return 0% 8.16% 7.00%
14.00% 5% 7.04% 7.20%
10% 5.92% 7.40%
12.00% 15% 4.80% 7.60%
20% 3.68% 7.80%
10.00% 25% 2.56% 8.00%
100% stock fund
Portfolio Return
30% 1.44% 8.20%

8.00% 35% 0.39% 8.40%
40% 0.86% 8.60%
6.00%
100% bond fund 45% 1.97% 8.80%
50% 3.08% 9.00%
4.00% 55% 4.20% 9.20%
60% 5.32% 9.40%
2.00% 65% 6.45% 9.60%
70% 7.57% 9.80%
0.00% 75% 8.69% 10.00%
0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00% 20.00% 22.00%
80% 9.81% 10.20%
Portfolio Risk (standard deviation σ) 85% 10.94% 10.40%
90% 12.06% 10.60%
95% 13.18% 10.80%
• Some portfolios are “better” than others, as they 100% 14.31% 11.00%
have higher returns for the same level of risk. 105% 15.43% 11.20%
110% 16.55% 11.40%
• These portfolios comprise the efficient frontier. 115% 17.68% 11.60%
120% 18.80% 11.80%
53
125% 19.92% 12.00%
Two-Security Portfolios with Various Correlations (ρ)
• The risk-return relation of
a two-security portfolio
depends on the
return
100%
correlation coefficient:
 = -1.0 stocks -1.0 <  < +1.0
• If  = +1.0, no risk
 = 1.0 reduction is possible.
100%
bonds
54
Portfolios – Correlation Coefficient
 The correlation coefficient between two stocks (X and Y) , denoted by ρXY
measures the extent to which two securities X and Y move together
Rho – pronounced “roe”

ρXY = -1 ρXY = 0
In general
1  XY  -1
Perfectly Perfectly
positively negatively
ρXY = 0 correlated correlated
ρXY = +1
 The variance of a portfolio depends on the correlation between the assets

included in the portfolio.
55
Workings
σ P2  (wB σ B )2  (wS σ S )2  2(wB σ B )(wS σ S )ρBS

 wB σ B  wS σ S  2wB σ B wS σ S ρBS
2 2 2 2
 wB σ B  wS σ S  2wB wS σ B σ S ρBS
2 2 2 2
when   1,
σ P2  wB σ B  wS σ S  2wB wS σ B σ S  ( wB σ B  wS σ S ) 2
2 2 2 2
σ p  ( wB σ B  wS σ S )
𝑟𝑃 = 𝑤𝐵 𝑟𝐵 + 𝑤𝑆 𝑟𝑆
56
Workings
σ P2  (wB σ B )2  (wS σ S )2  2(wB σ B )(wS σ S )ρ BS

 wB 2 σ B 2  wS 2 σ S 2  2wB σ B wS σ S ρ BS
 wB 2 σ B 2  wS 2 σ S 2  2wB wS σ B σ S ρ BS
when   1,
σ P2  wB 2 σ B 2  wS 2 σ S 2  2wB wS σ B σ S  ( wB σ B  wS σ S ) 2
σ p  ( wB σ B  wS σ S )
when   1,
σ P2  wB 2 σ B 2  wS 2 σ S 2  2wB wS σ B σ S  ( wB σ B  wS σ S ) 2
σ p  ( wB σ B  wS σ S )
57
Two-Security Portfolios with Various Correlations (ρ)
• The risk-return relation of
a two-security portfolio
depends on the
return
100%
correlation coefficient:
 = -1.0 stocks -1.0 <  < +1.0
• If  = +1.0, no risk
 = 1.0 reduction is possible.
100%
 = 0.2
bonds
• The smaller the
correlation, the greater
 the risk reduction
potential.
58
Learning Outcomes:
securities
59
Portfolio Risk as a Function of the Number of Securities in the Portfolio
In a large portfolio, the nonsystematic risk are effectively diversified

away, but the systematic risk are not.
Portfolio risk
Nondiversifiable risk;
Systematic Risk; Market Risk
n
60
Portfolio Risk as a Function of the Number of Securities in the Portfolio
In a large portfolio, the nonsystematic risk are effectively diversified

away, but the systematic risk are not.
Diversifiable Risk;
Nonsystematic Risk; Firm
Specific Risk; Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk; Market Risk
n
Diversification can eliminate firm specific risk but not market wide risk.
Investors are only rewarded for bearing systematic risk.
61
Question
• Which one of the following is an example of a nondiversifiable risk?

– a well-respected president of a firm suddenly resigns
– a well-respected chairman of the Federal Reserve suddenly resigns
– a key employee suddenly resigns and accepts employment with a key
competitor
– a well-managed firm reduces its work force and automates several
jobs
– a poorly managed firm suddenly goes out of business due to lack of
sales
62
Question
• Which one of the following is an example of a nondiversifiable risk?

– a well-respected president of a firm suddenly resigns
– a well-respected chairman of the Federal Reserve suddenly resigns
– a key employee suddenly resigns and accepts employment with a key
competitor
– a well-managed firm reduces its work force and automates several
jobs
– a poorly managed firm suddenly goes out of business due to lack of
sales
63
The Efficient Set for Many Securities
return
Individual
Assets
P
Consider a world with many risky assets; we can still identify
the opportunity set of risk-return combinations of various
64
portfolios.
return
Individual
Assets
P
Consider a world with many risky assets; we can still identify
the opportunity set of risk-return combinations of various
65
portfolios.
return
minimum
variance
portfolio
Individual Assets
P
Given the opportunity set, we can identify the minimum
variance or minimum standard deviation portfolio.
return
minimum
variance
portfolio
Individual Securities
P
The section of the opportunity set from the minimum
variance portfolio and up is the efficient frontier.
Riskless Borrowing and Lending
return
rf

In addition to risky securities, consider a world that also has a
risk-free security.
In practice, we use the yield on the 10 year government bond as
the risk-free rate.
return
rf
P
Now an investor can allocate his money between the risk free
security and a portfolio of risky securities on the
opportunity set.
return
M
rf
P
With a risk free security and the efficient frontier identified,
the investor will choose the capital allocation line with the
steepest slope, i.e., combinations of 𝑟𝑓 and M.
Learning Outcomes:
securities
71
Key Assumptions
• If all investors have the same perception regarding the

probability distribution of risky securities (homogeneous
expectations)
and
• if they can borrow and lend at the same rate (same 𝑟𝑓 )
then
• they will agree on the same risky portfolio M, i.e., all investors
have the same capital allocation line (going through 𝑟𝑓 and M).
72
Market Equilibrium
All investors have the same capital
allocation line. This line is the Capital
return
Market Line (CML).

Where a specific investor chooses to
invest along the CML depends on his
Optimal risk tolerance.
Risky
Portfolio M
rf

Market Equilibrium
All investors have the same capital
allocation line. This line is the Capital
return
Market Line (CML).

Where a specific investor chooses to
invest along the CML depends on his
Optimal risk tolerance.
Risky
Portfolio M
The Separation Property states that the
rf
market portfolio, M, is the same for all
investors— that is, the choice of the
market portfolio is separate from the
 investors’ risk tolerance.
Equation of CML
CML is a straight line y = mx + c
return
• 2 points: risk free asset and M

M – Risk free asset (0, 𝑟𝑓 )
E(rm)
– M (𝜎𝑚 , E(𝑟𝑚 ))
E(ri) 𝐸 𝑟𝑚 −𝑟𝑓
rf • Slope =
𝜎𝑚 −0
• Intercept =𝑟𝑓
𝜎𝑖 𝜎𝑚  • Y = mx + c
𝐸 𝑟𝑚 −𝑟𝑓
• 𝐸 𝑟𝑖 = (σi ) + 𝑟𝑓
𝜎𝑚 −0
• 𝐸 𝑟𝑖 = 𝑟𝑓 + 𝜎𝑖
𝜎𝑚 75
Equation of CML
CML: 𝐸 𝑟𝑖 = 𝑟𝑓 + 𝜎𝑖
return
𝜎𝑚
M
E(rm) • CML applies only to 2
E(ri) benchmark securities: the
rf market portfolio (M) and the
risk free security.
𝜎𝑖 𝜎𝑚  • It does not apply to individual

securities or just any portfolio!!
76
Capital Asset Pricing Model (CAPM)
• The CML does not say anything about the expected returns on
individual securities or other portfolios.
• We will now turn to a relationship that does so --- CAPM.
• The CAPM is mathematically derived from the CML.
From our earlier discussion,

• The market rewards investors only for holding systematic risk.
• Beta measures the systematic risk.
77
Risk in a Diversified Portfolio
• The best measure of the risk of a security in a large portfolio is

the beta (b) of the security.
• Beta measures the responsiveness of a security to movement
in the market portfolio.
𝐶𝑜𝑣 𝑅𝑖 , 𝑅𝑀
𝛽𝑖 =
𝜎 2 R𝑀
– Clearly, the estimate of beta will depend on the choice of a

proxy for the market portfolio.
78
Beta of the market portfolio
cov(rm , rm )  2r
b m arket   2 1 m
 2r m  r m
Beta of the risk free asset
cov(rf , rm ) 0
b riskfree   0
 2
rm  2
rm
79
CAPM
• In equilibrium, all securities and portfolios must have the
same reward-to-risk ratio and that must equal the reward-to-
risk ratio for the market portfolio.
𝐸 𝑅𝑖 − 𝑅𝑓 𝐸 𝑅𝑀 − 𝑅𝑓
=
𝛽𝑖 𝛽𝑀
• As βM = 1 by definition, rearranging the above gives the CAPM

equation
𝐸 𝑅𝑖 −𝑅𝑓 𝐸 𝑅𝑀 −𝑅𝑓
𝛽𝑖
= 1
𝐸 𝑅𝑖 = 𝑅𝑓 + 𝛽𝑖 𝐸 𝑅𝑀 − 𝑅𝑓 80
Expected Return on any Security
• This equation is called the Capital Asset Pricing Model
or Security Market Line
𝐸 𝑅𝑖 = 𝑅𝑓 + 𝛽𝑖 𝐸 𝑅𝑀 − 𝑅𝑓
Expected
Riskfree Beta of Market risk
return on = + ×
rate security premium
any
security
• If bi = 0, then the expected return is Rf.

• If bi = 1, then the expected return is 𝐸 𝑅𝑀 .
CAPM or Security Market Line (SML)
SML: 𝐸 𝑅𝑖 = 𝑅𝑓 + 𝛽𝑖 𝐸 𝑅𝑀 − 𝑅𝑓
82
Estimating b with regression
Model: (Ri -Rf)= a i + bi (Rm -Rf )+ ei
Excess Security Returns

𝐸 𝑅𝑖 − 𝑅𝑓 Slope = bi
Excess Return on
market %
𝐸 𝑅𝑀 − 𝑅𝑓
Impact of Inflation Change on SML
84
Impact of a Risk Aversion Change
What happens when investors become more risk averse?
Slope steepens as risk

premium increases
85
More on β (Systematic Risk Measure)
• In summary, how do we measure systematic risk?
– We use the beta coefficient to measure systematic risk
• What does beta tell us?
 A beta = 1 implies the asset has the same systematic risk as
the overall market
 A beta < 1 implies the asset has less systematic risk than the
overall market
 A beta > 1 implies the asset has more systematic risk than
the overall market
86
Example: Total Risk versus Systematic Risk
• Consider the following information:
Standard Deviation Beta
Security C 20% 1.25
Security K 30% 0.95
• Which security has more total risk? K

• Which security has more systematic risk? C
• Which security should have the higher expected return? C
87
Calculate the expected returns and std deviation
based on possible returns and probabilities
Calculate the expected returns and standard deviations of the

above investment alternatives.
88
Expected Return of Alta
n
rˆAlta   ri Pi
i 1
=0.1 (-22%) +0.2 (-2%) +

0.4 (20%) +0.2 (35%) +
0.1 (50%)
= 17.4%
Standard Deviation of Alta
n 2
 Alta   P r  rˆ 
i 1
i i
σ 2 Alta  0.1 (-22% -17.4%)2 +

0.2 (-2% -17.4 %)2 +
0.4 (20% -17.4%)2 +
0.2 (35% -17.4%)2 +
0.1 (50% -17.4%)2
= 401.44%2
s Alta = 20%
Expected Returns & Standard Deviations
given possible returns and probabilities
Investment r̂ 
Alta 17.4% 20%
Market 15.0 15.3
Am. F. 13.8 18.8
T-bonds 8.0 0
Repo Men 1.7 13.4

Calculate the required return given beta
Investment r̂ beta
Alta 17.4% 1.29
Market 15.0 1.00
Am. F. 13.8 0.68
T-bonds 8.0 0.00
Repo Men 1.7 -0.86
Given a risk free rate of 8% and market risk premium of 7%, what are the
required returns of the various alternatives, given the betas?
Apply CAPM
• Given a risk free rate of 8% and market risk premium of

7% and a beta of 1.29 for Alta
𝐸 𝑅𝐴𝑙𝑡𝑎 = 𝑅𝑓 + 𝛽𝐴𝑙𝑡𝑎 𝐸 𝑅𝑀 − 𝑅𝑓
= 8% + 1.29 (7%)
= 8% + 9.03
= 17.03%
≈ 17.0%
Expected Returns & Required Returns
Required
Investment r̂ return Attractive?
Alta 17.4% 17.0% Underpriced

Market 15.0 15.0
Am. F. 13.8 12.8
T-bonds 8.0 8.0
Repo Men 1.7 2.0
►For a fairly priced asset, the expected return is on the SML.

►For an underpriced asset, the expected return is above the SML.
►For an overpriced asset, the expected return is below the SML.
Alta has an expected
. return of 17.4% which is higher than what is required based on its beta
of 1.29 (which gives a required return of 17%).
This is an underpriced asset. Its expected return is above the SML.
Everybody wants to hold Alta. That will bid up the price P0. That means P0 is larger
causing (P1-P0) to be smaller.
The return will therefore be lower: (P1-P0)/P0 = smaller/larger = a smaller number.

That is, Alta's expected return will move down towards the SML. In equilibrium, all investments
95
will be on SML.
Expected Returns & Required Returns
Required
Investment r̂ return Attractive?
Alta 17.4% 17.0% Underpriced

Market 15.0 15.0 Fairly Valued
Am. F. 13.8 12.8 Underpriced
T-bonds 8.0 8.0 Fairly Valued
Repo Men 1.7 2.0 Overpriced
►For a fairly priced asset, the expected return is on the SML.

►For an underpriced asset, it would be above the SML.
►For an overpriced asset, it would be below the SML.
Portfolio βs – Portfolio Systematic Risk Measure
• Given a large number (m) of assets in a portfolio, we would
multiply each asset’s beta by its portfolio weight and then
sum up the results to get the portfolio beta:
m
b p   wj b j
j 1
• Consider the following four securities in a portfolio:
Security Weight Beta

DCLK 0.133 3.69
KO 0.2 0.64
INTC 0.267 1.64
KEI 0.4 1.79
What is the portfolio beta (βP)?
98
Example: Portfolio Betas
• Consider the following four securities in a portfolio:

Security Weight Beta w i βi
DCLK 0.133 3.69 0.491
KO 0.2 0.64 0.128
INTC 0.267 1.64 0.438
KEI 0.4 1.79 0.716
portfolio beta (βP) = 1.77
99
Finding Betas
• One source of betas is Yahoo Finance

• Try it out: Visit http://finance.yahoo.com/
– Enter a ticker symbol and get a basic quote
– Click on Key Statistics
• Compare the betas of
• Pepsi (PEP), Coca-Cola (KO)
• General Motors (GM), Honda (HMC), Toyota Motor (TM)
• Apple (AAPL), Samsung Electronics (SSNLF)
• Alibaba (BABA), Amazon (AMZN)
100
PepsiCo, Inc (PEP)
101
Coca-Cola Company (KO)
102
General Motors Company (GM)
103
Honda (HMC)
104
Application to Capital Budgeting: Cost of Capital
1. Understand why the risk and return concept (so far applied only
to financial securities) can be applied to capital budgeting
2. Know how to compute the cost of capital if project is an
expansion of the firm (has same risk) and the firm uses only
equity
expansion of the firm (has same risk) and the firm uses both debt
and equity
4. Know how to compute the cost of capital if project has different
risk from the firm
105
Application to Capital Budgeting
Firm with Shareholder
Pay cash dividend
excess cash getting dividends
A firm with excess cash can either make a

capital investment or pay a dividend
Invest in project Shareholder’s Invest in

Terminal Value financial asset
Because stockholders can reinvest the dividend in risky financial

securities, the expected return on a capital-budgeting project
should be at least as great as the expected return on a financial
security of comparable risk.
106
Learning Outcomes:
equity
and equity
risk from the firm
107
Cost of Capital for an expansion project
of an all-equity firm
• Suppose the stock of Stansfield Enterprises, a publisher of

PowerPoint presentations, has a beta of 1.5. The firm is
100% equity financed.
• Assume a risk-free rate of 3% and a market risk premium

of 6%.
• What is the appropriate discount rate for an expansion of

this firm?
108
• Appropriate discount rate for the expansion is
the Cost of Equity Capital (CAPM):
R i  R F  β i (R M  R F )
R i  3 %  1 .5  6 %  12 %
Learning Outcomes:
equity
and equity
risk from the firm
110
Cost of Capital when the project is an expansion
and the firm has debt
• Firstly, estimate cost of equity and cost of debt.
– need equity beta to estimate cost of equity (CAPM)
– use yield to maturity (YTM) to estimate cost of debt
• Secondly, compute WACC by weighting these two
costs appropriately:
𝑆 𝐵
𝑟𝑊𝐴𝐶𝐶 = ∗ 𝑟𝑆 + ∗ 𝑟𝐵 ∗ (1 − 𝑇𝑐 )
𝑆+𝐵 𝑆+𝐵
– Where Tc is the corporate tax rate. We multiply the
last term by (1-Tc) because interest is tax deductible.
Example
• International Paper has equity beta of 1.2, risk free rate of 5%
and market risk premium of 5%.
• The cost of equity capital is ri  RF  βi ( R M  RF )
 5 %  1 .2  5 %
 11%
• Yield on debt = 6%, tax rate = 17%, debt to value ratio = 32%
𝑆 𝐵
𝑟𝑊𝐴𝐶𝐶 = ∗ 𝑟𝑆 + ∗ 𝑟𝐵 ∗ (1 − 𝑇𝑐 )
𝑆+𝐵 𝑆+𝐵
= 0.68 x 11% + 0.32 x 6% x (1-.17)

= 9.0736%
• If project’s risk and leverage are the same as the firm, then its 112
cost of capital=9.0736%.
Learning Outcomes:
equity
and equity
risk from the firm
113
Extension of the Basic Model:
project has different risk from the firm
• What discount rate to use?
– The cost of capital depends on the use to which the capital
is being put (project) —not the source (firm).
– It depends on the risk of the project .
• If a firm’s cost of capital is 15%, should it only accept projects

with return ≥ 15%?
– No
– Accepting projects with return ≥ cost of capital is known as
the cost of capital rule.
114
Project
return SML
Incorrectly accepted
negative NPV projects
Hurdle
rate
Incorrectly rejected
rf positive NPV projects
Risk of project
Thus, a firm that uses one discount rate for all projects will
have a lower value over time.
Note: In capital budgeting, hurdle rate is the minimum rate that a company expects from a
115
project. Under this COST OF CAPITAL RULE, a project will only be accepted if its return is higher
than the hurdle rate.
Example: Assume an all equity firm
• Conglomerate Company has risk-free rate of 5%, market
risk premium of 8% and equity beta of 1.3. According to
CAPM, the cost of equity capital is:
5% + 1.3 (8%) =15.4%
Breakdown of the company’s investment projects:

1/3 Automotive retailer b = 2.0
1/3 Computer Hard Drive Mfr. b = 1.3
1/3 Electric Utility b = 0.6
Average b of assets = 1.3
When evaluating a new electrical utility investment, which discount rate
should be used? Use b = 0.6 116
Project IRR SM L
21%
Investments in hard
drives and auto retailing
15.4%
should have higher
9.8% discount rates, according
to CAPM.
Risk (beta)
0.6 1.3 2.0
E.U. H.D. Auto.
9.8% reflects the opportunity cost of capital on an investment in
electrical utility.
5% + 0.6 (8%) =9.8% 117

Additional notes on Risk and Return
Systematic and Unsystematic risk
When someone talks about a security's beta, he usually refers to the security's beta
with respect to the market portfolio. This is denoted by i,m or simply i. The beta of
the security measures how closely the security's return varies with that of the market
or how sensitive the security's performance is relative to market movements. Beta is
thus a measure of the volatility of the individual security's return relative to the market
return.
It is equal to the covariance of the security’s return with the market portfolio’s return
divided by the variance of the market portfolio’s return.
cov (ri , rm )
i = ----------------------
m2
i m i m
= -----------------
m2
i m i
= --------
m
The return of a security ri can be written as ri = i + i rm + ei and its variance

i2 = E( ri - E(ri ))2 . Given that E(ei) = 0 and E(ei (rm - E(rm )) = 0 (market return is
unrelated to unique return), we can rewrite i2 as follows:
i2 = E(i + i rm + ei - E(i + i rm + ei ))2

= E(i rm + ei - E(i rm ))2
= E(i [rm - E(rm )] + ei )2
= i2 E [rm - E(rm )]2 + 2i E ei [rm - E(rm )] + E(ei)2
= i2 m2 + E(ei)2
This gives us the following result: the total risk of a security can be decomposed into
the systematic and unsystematic parts as follows:
Total risk = i2

Systematic risk = i2 m2
Unsystematic risk = i2 - i2 m2
A/P Ruth Tan Page 1

Capital Budgeting I
Appraisal Techniques
1
Consider…
• Our job is to find valuable investment opportunities.
• Examples of potential projects:

– Deepening existing markets
– Selling new products/features in existing markets
– Selling existing products in new markets
– Selling new products in new markets
• How do we go about picking the right projects?

– We could look at $ terms. How much money will the project save us/make us?
• Finance term: Net Present Value
– We could look at % terms. What is the project’s return on investment?
• Finance term: Internal Rate of Return
– We could look at time. How long will it take for the project to recover the initial investment?
• Finance term: Payback, Discounted Payback
2
Learning Outcomes
1. Consider the steps in valuation
2. Evaluate investments using various appraisal techniques:
• Payback period
• Discounted payback period
• Net present value
• Internal rate of return
• Profitability index
3. Evaluate projects with unequal lives
4. Appreciate what is used in practice
5. Practices
3
Steps in Valuation
1. Estimate future CF from project. Qty to sell, price, production cost.

2. Assess risk and determine a required return
3. Compute present value of expected CF
4. If present value of the expected CF is greater than the cost, project creates
value
Accept if: Benefit > Cost
4
Valuation is only as good as the assumptions used
Cash flows based on

projections from
Sales Department and
Production Department
CF1 CF2 CF3 CFn

Value  CF0     ... 
(1  r) (1  r) 2 (1  r)3 (1  r) n
Interest rate /
Number of periods
discount rate / ahead
required rate of return/
cost of capital/
Opportunity cost of capital
5
Definition of mutually exclusive projects and
independent projects
• 2 projects are mutually exclusive if “can only accept 1”

– build bridge versus buy boat to go across river
– commercial versus residential on a piece of land
• 2 projects are independent if “can accept both”

– Invest in India & Invest in China
6
Learning Outcomes
• Payback period
5. Practices
7
You are looking at 2 potential projects and
you have estimated the following cash flows
Growth Enterprises Inc
Type of Cash Flow Year 0 Year 1 Year 2 Year 3
Project C Revenue 10,000 11,000 30,000

Operating expenses -5,555 -4,889 -15,555
Investment -10,000
Project D Revenue 30,000 10,000 5,000

Investment -10,000
8
9
You are looking at 2 potential projects and
you have estimated the following cash flows

Investment -10,000

Investment -10,000
Assumptions
1. Investment depreciated to zero on straight line basis over 3 years. What is the
depreciation per year?
2. Tax rate = 40%
3. The cost of capital for projects of this risk is 10% . How to estimate this? 10
How to estimate the interest rate?
Use $50,000 of
own money
Bank Borrow $50,000 @7% p.a. Shareholders
Invest
$100,000 in the
project
Project
The interest rate that the bank charges will depend on the risk.
The interest rate that shareholders “charge” will depend on the risk.
Use interest rate = Weighted Average Cost of Capital to evaluate the projects.
Debt Equity
WACC  rdebt (1  tax rate)  requit y
Debt  Equity Debt  Equity 11

Investment -10,000

Depreciation -3,333 -3,333 -3,333
Profit before taxes 1,111 2,778 11,112
Taxes @ 40% -444 -1,111 -4,445
Profit after taxes 667 1,667 6,667
Depreciation 3,333 3,333 3,333
Investment -10,000
Cash Flow -10,000 4,000 5,000 10,000
12

Investment -10,000
Project D
Revenue 30,000 10,000 5,000
Depreciation -3,333 -3,333 -3,333
Profit before taxes 11,112 1,112 -555
Taxes @ 40% -4,445 -445 222
Profit after taxes 6,667 667 -333
Investment -10,000
Cash Flow -10,000 10,000 4,000 3,000
13
Depreciation -3,333 -3,333 -3,333
Taxes @ 40% -444 -1,111 -4,445
Investment -10,000
Cash Flow -10,000 4,000 5,000 10,000
Project D
Revenue 30,000 10,000 5,000
Depreciation -3,333 -3,333 -3,333
Profit before taxes 11,112 1,112 -555
Taxes @ 40% -4,445 -445 222
Profit after taxes 6,667 667 -333
Investment -10,000
Cash Flow -10,000 10,000 4,000 3,000
14
What is a Good Appraisal Technique?
1. A technique that adjusts for the time value of money

2. A technique that computes the value created
15
Learning Outcomes
• Payback period or Regular payback
5. Practices
16
Payback Period Rule
How long does it take to get your money back?
Number of years to recover cost.
Accept if the payback period is less than some preset

limit (cutoff period)
determined by company
17
Payback
Project Cash Flows
Type of Cash Flow Year 0 Year 1 Year 2 Year 3 Payback
Project C
Cash Flow -10,000 4,000 5,000 10,000 2.1 yrs
Project D
Cash Flow -10,000 10,000 4,000 3,000 1 yr
Project C: 2 + 1000/10000 = 2.1 years

Project D: 1 year
If cutoff period is 2 years….

18
Payback
Advantages Disadvantages
 Quick and easy to calculate  Requires cutoff from company
 Easy to understand Cutoff can differ, for example
 Favours liquidity − High tech project in country with high
 Common political uncertainty
− Utility project
 Ignores the time value of money (required return
of 10%)
19
Address the disadvantages of Payback
Project Cash Flows
Type of Cash Flow Year 0 Year 1 Year 2 Year 3 Sum CF
Project C
Cash Flow -10,000 4,000 5,000 10,000 9,000
Project D
Cash Flow -10,000 10,000 4,000 3,000 7,000
• What if the cash flows are forthcoming only many years later? Would it matter?
• How do we adjust for the timing of the cash flows?
• A more accurate method involves incorporating the cost of capital of 10% by
− Finding the present value of the cash flows
20
Learning Outcomes
• Payback period
5. Practices
21
Discounted Payback Period Rule
Accept if the discounted payback period is less than some

preset limit (cutoff period)
22
Project C
0 1 2 3
10%
-10000 4000 5000 10000

4000 5000 10000
(1.1) (1.1)2 (1.1)3
PV(CFt) -10000 3636 4132 7513
Cumulative -10000 -6364 - 2232 5281
Discounted payback = 2 + (2232 / 7513) = 2.30 years

23
Project D
0 1 2 3
10%
-10000 10000 4000 3000

100 00 400 0 300 0
(1.1 ) (1.1 )2 (1.1 )3
PV(CFt) -10000 9091 3306 2254

Cumulative -10000 -909 2397

24
Discounted Payback
Project Cash Flows Regular Discounted
Type of Cash Flow Year 0 Year 1 Year 2 Year 3 Payback Payback
Project C
Cash Flow -10,000 4,000 5,000 10,000 2.10 yrs 2.30yrs
Project D
Cash Flow -10,000 10,000 4,000 3,000 1 yr 1.275yrs
25
Discounted Payback
− Utility project
 Ignores cash flows beyond the payback year
− Add $1,000,000 in year 4 does not change
the payback period.
26
Project C
0 1 2 3 4
10%
-10000 4000 5000 10000 1,000,000

4000 5000 10000 1,000,000
(1.1) (1.1)2 (1.1)3 (1.1) 4
PV(CFt) -10000 3636 4132 7513

Cumulative -10000 -6364 -2232 5281

27
Project D
0 1 2 3 4
10%
-10000 10000 4000 3000 1,000,000

100 00 400 0 300 0 1,000,000
(1.1 ) (1.1 )2 (1.1 )3 (1.1) 4
PV(CFt) -10000 9091 3306 2254

Cumulative -10000 -909 2397

28
Discounted Payback
Project Cash Flows
Discounted
Type of Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Payback
Project C
Cash Flow -10,000 4,000 5,000 10,000 1,000,000 2.3 yrs
Project D
Cash Flow -10,000 10,000 4,000 3,000 1,000,000 1.275 yrs
Discounted Payback period remains the same. In addition ….
29
Discounted Payback
− Utility project
 Ignores cash flows beyond the payback year
− Add $1,000,000 in year 4 does not change
the payback
 Does not say how much value is created
Let’s look at a method that addresses all these disadvantages.

30
Learning Outcomes
• Payback period
5. Practices
31
Net Present Value Rule Consider all
cash flows
CF1 CF2 CFn

NPV  CF0    ... 
1  r  1  r 
1 2
1  r n
Accept the project if NPV > 0 Incorporate cost

of capital
Have a natural benchmark of 0.

If NPV is positive, project creates value.
32
Rationale for the NPV method
NPV = PV (cash inflows) – cost
= Net gain in value
Accept project if NPV > 0

• A positive NPV adds value to the firm
• For mutually exclusive projects, choose higher NPV
• Higher NPV adds more value
33
CF1 CF2 CF3
NPV  CF0   
1  r 1 1  r 2 1  r 3
Project C:
0 1 2 3
10%
-10000 4000 5000 10000

4000
(1.1)
$3637 5000
$4132
2
(1.1) 10000
3
(1.1)
$7513
NPVC= $5282 Refer to excel spreadsheet
34
Interpretation: given the project’s risk level, the value that the project is expected to create, in today’s dollars, is
$5,282. This project compensates for the cost of capital of 10% and creates value of $5,282.
NPV shows a return and value created
Project C compensates for the cost of capital of 10%

and creates value of $5,282.
r = 10%
NPVC= $5282
35
CF1 CF2 CF3
NPV  CF0   
1  r 1 1  r 2 1  r 3
Project D:
0 1 2 3
10%
-10000 100 00 10000 4000 3000

(1.1 )
$9091 400 0
(1.1 )2
$3306 300 0
(1.1 )3
$2254
NPVD= $4651 Refer to alternative excel spreadsheet 36
Net Present Value
Project Cash Flows NPV
Type of Cash Flow Year 0 Year 1 Year 2 Year 3 10%
Project C
Cash Flow -10,000 4,000 5,000 10,000 5,282
Project D
Cash Flow -10,000 10,000 4,000 3,000 4,651
Which project/projects to accept?

If C and D are independent, accept both
NPVc > 0 NPVD > 0
If C and D are mutually exclusive (can at most accept 1), accept C
NPVc > NPVD > 0
37
Learning Outcomes
• Payback period
5. Practices
38
IRR is the interest rate that equates the PV of the benefits to the initial investment (NPV=0).
For example, if you invest $100,000 now and get $120,000 in one year. What is your return?
0 1 120,000
100,000 
1  IRR 
CF0 CF1 120,000
- 100,000  0 Or NPV=0
Cost 1  IRR 
IRR  20%
IRR=20%
If you have more than 1 year of cash flows, how do you solve for IRR?
39
IRR is the interest rate where the PV of the benefits equal initial investment.
IRR is the interest rate at which NPV=0.
0 1 2 3
CF0 CF1 CF2 CF3

Cost Inflows
CF1 CF2 CFn

NPV  CF0    ... 
1  r 1 1  r 2 1  r n
CF1 CF2 CFn
NPV  CF0    ...  0
1  IRR 1 1  IRR 2 1  IRR n 40
NPV: input r, solve for NPV
CF1 CF2 CFn

NPV  CF0    ... 
1  r 1 1  r 2 1  r n
IRR: input NPV = 0, solve for IRR

CF1 CF2 CFn
CF0    ...  0
1  IRR 1 1  IRR 2 1  IRR n
IRR converts the NPV to a percentage
41
NPV shows a return IRR shows only 1
and value created number
Project C compensates for the

cost of capital of 10% and
creates value of $5,282.
r = 10% NPVC= 0
NPVC= $5282 IRR = ?
42
If NPV > 0, IRR > r

IRR Rule
CF1 CF2 CFn

CF0    ...  0
1  IRR 1 1  IRR 2 1  IRR n
Accept the project if IRR > r
If the IRR > r, the project creates value.
If NPV concludes that the project is good (NPV> 0),

IRR will also conclude that the project is good (IRR > r) 43
If the IRR is high enough, we may not need to
estimate the required return (WACC), which is
often a difficult task
44
CF1 CF2 CF3
CF0    0
1  IRR 1 1  IRR 2 1  IRR 3
Project C
0 1 2 3
IRR=?
-10000 4000 5000 10000

4000
(1  IRR)
PV1 5000
(1  IRR) 2
PV2 10000
(1  IRR) 3
PV3
NPVC= 0
45
Project Cash Flows IRR
NPV ($)
Project C
Cash Flow -10,000 4,000 5,000 10,000 33.53%
Project D
Cash Flow -10,000 10,000 4,000 3,000
9000
7000
C
Refer to excel spreadsheet
33.53%
0 r
IRRC
46
Project C
Cash Flow -10,000 4,000 5,000 10,000 33.53%
NPV ($) Project D

Cash Flow -10,000 10,000 4,000 3,000 42.75%
9000
7000
D
42.75%
0 r
IRRD
47
Internal Rate of Return
Project C
Cash Flow -10,000 4,000 5,000 10,000 33.53%
Project D
Cash Flow -10,000 10,000 4,000 3,000 42.75%
Which project/projects should be accepted? r=10%

•If C and D are independent, accept both because
IRRC > r IRRD > r
•If C and D are mutually exclusive, do we accept D since
IRRD > IRRC > r
48
Note that the NPVC (5282) > NPVD (4651) at r=10%
IRR
- knowing a return is intuitively - Has problem choosing between

appealing mutually exclusive projects (this
limitation is explained next)
- It is a simple way to
communicate the value of a
project to someone else
- If the IRR is high enough, we

may not need to estimate the
required return, which is often
a difficult task 49
In our
example
NPV ($) r=10%
9000
C
7000 Crossover
When r < 16.67
D Point = 16.67% NPVC > NPVD
IRRC < IRRD
Conflict
D IRRD
C When r > 16.67
33.53% NPVC < NPVD
0 IRRC < IRRD
42.75%
No conflict
IRRC 50
NPV ($)
Project C
Cash Flow -10,000 4,000 5,000 10,000 33.53%
Project D
Cash Flow -10,000 10,000 4,000 3,000 42.75%
9000
C
7000 Crossover Difference in the pattern of the CF
D Point = 16.67% causes the NPV profiles to cross
D IRRD
C
33.53%
0
42.75%
IRRC 51
How to find the Crossover Point?
-- IRR of the Difference in the Cash Flows
Project Cash Flows NPV
Project C
Cash Flow -10,000 4,000 5,000 10,000 5,282
Project D
Cash Flow -10,000 10,000 4,000 3,000 4,651
C-D 0 -6,000 1,000 7,000 631
4000 5000 10000 10000 4000 3000

- 10000     - 10000   
1  r  1  r  1  r 
1 2 3
1  r  1  r  1  r 3
1 2
4000 - 10000 5000 - 4000 10000 - 3000

0   0
1  rcrossover1 1  rcrossover2 1  rcrossover3
- 6000 1000 7000
0    0  rcrossover  16.67%
1  rcrossover 1  rcrossover 1  rcrossover3
1 2
52
Whenever there is a conflict…
• Whenever there is a conflict between NPV and another

decision rule, use NPV.
• NPV directly measures the increase in value to the firm.
• Maximizing NPV is equivalent to maximizing shareholder
wealth.
53
Learning Outcomes
• Payback period
5. Practices
54
Profitability Index
• Measures the benefit per unit of cost.
“benefit”
PV of inflows
PI 
Initial cost
“cost”
• If NPV > 0  PI > 1
55
Profitability Index
Decision Rule:
Accept if PI > 1
Consistent with NPV rule
56
CF1 CF2 CF3
 
PI 
1 r
1
1 r
2
1 r
3

15,282
 1.5282
CF0 10,000
Project C: 0 1 2 3
10%
4000 5000 10000

4000
(1.1)
$3636 5000
$4132
2
(1.1) 10000
3
(1.1)
$7513
PV= $15282
57
CF1 CF2 CF3
 
PI 
1 r
1
1 r
2
1 r
3

14,651
 1.4651
CF0 10,000
Project D: 0 1 2 3
10%
100 00 10000 4000 3000

(1.1 )
$9091 400 0
(1.1 )2
$3306 300 0
(1.1 )3
$2254
PV= $14651
58
Profitability Index
Project Cash Flows PI NPV

Project C
Cash Flow -10,000 4,000 5,000 10,000 1.5282 5,282
Project D
Cash Flow -10,000 10,000 4,000 3,000 1.4651 4,651
If C and D are independent: accept both as PI>1
59
Capital Rationing
• PI can help to rank projects when there is limited capital/funds.
• Keep in mind that the aim is to maximize total NPV.
Project Initial Outlay PV of inflows NPV PI

R 15,000 19,500 4,500 1.30
S 10,000 14,000 4,000 1.40
T 5,000 7,500 2,500 1.50
Given that the firm has only $15,000, which projects will max NPV?
60
Project Initial Outlay PV NPV PI
R 15,000 19,500 4,500 1.30
S 10,000 14,000 4,000 1.40
T 5,000 7,500 2,500 1.50
If firm has only $15,000, use PI to rank the projects

Choose projects T and S
The firm will be better off by $6,500 instead of $4,500
61
Capital Rationing
Project Cost in Year 0 PV of Cash NPV Profitability Index
inflows
A $30m $77,026,534.64 $ 47,026,534.64
B $90m $167,448,988.30 $77,448, 988.34
C $150m $304,757,158.80 $15,757, 158.80
D $30m $58,262,578.94 $28,262, 578.94
E $60m $197,586,137.30 $137,586,137.30
F $90m $263,448,183.00 $173,448,183.00
a. The company has $180 million to invest. Which projects should it choose?
b. The company has $120 million to invest. Which projects should it choose? 62
ACCOUNTING & FINANCE FOR NON-FINANCIAL
MANAGERS
26 – 30 JULY 2021
GROUPING LIST
GROUP 1 GROUP 2 GROUP 3 GROUP 4
Ger Veen Sam Li Cheow (JC) Anthony
David Khoon Aik Guangda Po Ben
Rachel Amanda Siew Peng Lai Yin
Ramani Hoy Meng Anne Nurhidayah

Learning Outcomes
• Payback period
5. Practices
64
Projects with Unequal Lives
You have to choose between Projects S and L (mutually exclusive).
Which is better?
0 1 2 3 4
r = 10%
S L
Project S NPV 4.132 6.190
60 60 Refer to excel
(100)
NPVL > NPVS
But is L better?
Project L
33.5 33.5 33.5 33.5
(100)
65
S L
NPV 7.547 6.190
Assume that Project S can be repeated NPVS > NPVL
S is better
0 1 2 3 4
Project S
(100) 60 60 60 60
(100)
(100) 60 (40) 60 60
NPVs = 7.547 66
If the projects cannot be repeated, then decide based on the NPV
given here.
0 1 2 3 4
r = 10%
S L
60 60
(100) NPVL > NPVS
L is better
Project L
33.5 33.5 33.5 33.5
(100)
67
Learning Outcomes
• Payback period
5. Applications
68
Which technique to use?
NPV always give unique solution regardless of whether

projects are mutually exclusive.
Without question, NPV is a superior technique.
However, sophisticated managers should consider all

techniques because each provides a useful piece of
information.
69
Survey Published in 2001
• Survey of 392 CFOs from a large cross section of firms
• Large firms are more likely to use NPV
• Small firms are more likely to use payback
• If interested, please see

“The theory and practice of corporate finance: evidence from the field” John R.
Graham & Campbell R. Harvey; Journal of Financial Economics, Volume 60, 2001
70
Survey Published in 2002
• Survey of the Fortune 1000 CFOs finds NPV to be the most preferred tool over
IRR and all other capital budgeting tools.
• Most financial managers utilize multiple tools in the capital budgeting process.
• If interested, please see

“Capital Budgeting Practices of the Fortune 1000: How Have Things Changed?”
Patricia A. Ryan & Glenn P. Ryan; Journal of Business and Management,
Volume 8, Number 4, Fall 2002
71
72
73
Capital Budgeting II
What Cash Flows to include in the analysis?
New Balance
2012 London Olympics
VP of product development Monte

Holliday
CEO Jim Davies
2
3
Kirani James won gold in the 400m dash, 2012 London Olympics:
first non-US athlete to win the event in 3 decades
4
5
(6 year life)
(3 year life)
6
Learning Outcomes
1. Cash Flows, not accounting numbers
2. Identify incremental cash flows
• Costs to get the project up and running (outflows)
• Additional revenue (inflows)
• Additional costs (outflows)
• Reduction in costs (inflows)
• Changes in Net Working Capital
• Sunk costs
• Opportunity costs
• Side effects like erosion
• Taxes
3. Ignore financing charges
4. Apply appraisal techniques to Sneaker case
7
Cash Flows not accounting numbers
Costs of fixed assets
 When an asset is purchased, the amount paid is considered as cash outflow at the
time of payment.
 In accounting, this amount is not deducted immediately. It sits on the balance sheet
as an ASSET and is gradually expensed as depreciation.
Depreciation -3,333 -3,333 -3,333
Taxes @ 40% -444 -1,111 -4,445
Cost of fixed assets – paid at time 0, Investment -10,000
Cash Flow -10,000 4,000 5,000 10,000
consider at time 0!
Sneaker case
How to handle purchase of factory and purchase/installation of equipment?
9
Depreciation
 This is deducted from revenue to arrive at profit before tax which is then taxed. It
reduces tax payable. It is a tax shield.
 However, depreciation itself is not a cash outflow.
If depreciation has been deducted to

compute tax payable, add it back!
Sneaker case: How to handle depreciation charges? Modified
accelerated cost
recovery system
is the tax
depreciation
system in the
US
25.1%
100%
11
Credit Sales
 Recognized as revenue in financial statements at time of sale but, for investment decisions, the
sale will not be considered as cash inflows until cash is received.
Expenses
 Matched to the revenue in financial statements but, for investment decisions, the expense will
not be considered as cash outflows until cash is paid.

Investment -10,000

Investment -10,000
In our example, revenues and expenses were in cash otherwise adjustments have to be made
through changes in net working capital.
Learning Outcomes
• Sunk costs
• Taxes
4. Apply appraisal techniques to Sneaker case 13
Only Incremental Cash Flows
• Only incremental Cash Flows are relevant. How do you test whether cash flows are
incremental?
– firm’s Cash Flows with the project minus firm’s Cash Flows without the project
• Will this Cash Flow (both inflows and outflows) occur ONLY if we accept the project?
– If “yes”, it is incremental and should be included in the analysis
• Need additional staff in production and HR
– If “no”, it is not incremental because it will occur anyway
– If “part of it”, then only that part of it is incremental
• Additional utilities, overtime pay
Incremental Cash Flows
With Project Without Project Incremental CF

Revenue $1200 $1000 $200
Expenses $800 $700 $100
Staff costs $500 $450 $50

Rental $100 $100 0
Utilities $80 $70 $10
15
Learning Outcomes
• Sunk costs
• Taxes
16
Sneaker case
How to handle additional revenue?
17
Sneaker case
How to handle additional revenue?
18
Learning Outcomes
• Sunk costs
• Taxes
19
Sneaker case
How to handle additional costs?
20
Sneaker case
How to handle additional costs?
21
Learning Outcomes
• Changes in Net Working Capital – involves current assets and current liabilities
• Sunk costs
• Taxes
22
Net Working Capital
Current Assets
 Additional accounts receivable may result because of additional sales affect cash inflow
 Additional inventories may be needed in the form of raw materials, or may sit in the
warehouse as finished goods  affect cash outflow
 These additional Current Assets means more working capital is needed. Why? Less cash
inflow because of receivables. More cash outflow because of inventory.
Additional current assets  more working capital is needed

 Note that at the end of the project’s life, the inventories and receivables will go back to
their original levels
Current Liabilities
 Additional payables may result when firm orders more raw materials. Suppliers
provide additional credit affect cash outflow
 Additional accruals (wages, rentals, utilities) may also result  affect cash outflow
 These additional Current Liabilities means less working capital is needed. Why?
The firm has not paid suppliers, employees, landlord, water and electricity yet
Additional current liabilities less working capital is needed
 At the end of the project’s life, the payables and accruals will go back to their
original levels
Note that CA and CL have offsetting effect. Additional CA means more working capital is needed
while Additional CL means less working capital is needed.
Sneaker case
How to handle changes in current asset and current liabilities?
25
Sneaker case
How to handle changes in current asset/current liabilities?
26
Sneaker case
How to handle changes in current asset/current liabilities?
27
28
Learning Outcomes
• Sunk costs
• Taxes
3. Ignore financing charges 29
Sunk Cost
• A cost (an expense, not an asset) that has already been incurred. You cannot
alter this fact even if you decide not to go ahead with the project.
• With or without the project, the expense is there.
• It is not incremental in nature.

R&D cost $1,000,000 $1,000,000 0
Test Marketing done $20,000 $20,000 0
Test Marketing $20,000 0 $20,000

to be conducted
Sunk Cost
• A cost (an expense, not an asset) that has already been incurred. You cannot
alter this fact even if you decide not to go ahead with the project.
• With or without the project, the expense is there.
• It is not incremental in nature.
Example
Extensive R&D done last year (-$1,000,000 in time 0 dollars) have resulted in a new product. This year, it
will cost $500,000 to bring the product to market. The project is expected to bring in $800,000 in time 0
dollars. Question: Should we spend $500,000 to bring in $800,000?
− Regardless of the decision, the $1,000,000 in R&D has been spent. Not incremental. It is sunk.
− If we consider the $1,000,000 in answering the question,
NPV= -$1,000,000 -$500,000 + $800,000= -$700,000
Reject project  cannot recover the $1,000,000 at all
− If we recognise that the $1,000,000 is a sunk cost,
NPV= -$500,000 + $800,000= $300,000
Accept project  can offset some of the R&D spent
Sunk Cost Example
• General Dairy Company hired a financial consultant to help evaluate whether
to launch a new line of chocolate milk.
• When the consultant turned in the report, General Dairy observed that the
consultant had left out its hefty consulting fee in the calculation of payback,
NPV and IRR.
• Is this correct?
• Yes, it should be left out. It is a sunk cost
Sneaker case
How to handle research and development costs?
33
34
Learning Outcomes
• Sunk costs
• Taxes
3. Ignore financing charges 35
Opportunity Costs
• Cash Flows that can be generated from an asset (that the firm already owns)
if it is not used for the project in question
Example
You have an existing factory which is currently vacant. You can rent it out or
you can use it for the new project.
If you decide to use it for the new project, you can’t rent it out. The lost
rental is an opportunity cost.
The value that the project really adds is therefore smaller .
How to account for this?
Deduct the rental from the project’s cash flows.
What if the company has a policy -- “cannot rent out the premises because of sensitive information”?
Incremental Cash Flows

Rental 0 0 0
37
Persistence case
How to handle idle portion of the factory?
Overhead allocation such as utilities and staff costs are for internal accounting purposes
to measure departmental performance.
For investment decisions, the goal is shareholder wealth maximization.
We want to know how the company will fare as a whole. We are interested in incremental CF.
The $1.8 million is not an incremental CF. It will not be included.

38
Learning Outcomes
• Sunk costs
• Taxes
Side Effects or Externalities
• If a new product is likely to affect the sales of the firm’s other products, there is an
“externality”.
• Externalities can be positive (in the case of complements) or negative (substitutes).

o Complement
o Substitute / Cannibalization / Erosion

“externality”.

o Complement
If a new product is likely to increase sales of an existing product, the Cash Flow
gain must be added to the new product at the evaluation stage.
Complement Example
• If a firm launches a printer, the sales of its computers may increase.

• This additional sales of its computers must be added to the printer project in
evaluating its attractiveness.

Sales of Printer $400 0 $400
Sales of Computers $1000 $800 $200
Complement Example
• If a firm launches a printer, the sales of its computers may increase.

• This additional sales of its computers must be added to the printer project in
evaluating its attractiveness.
• Another example – Introduce Ipod, improve sales of ITune

“externality”.

o Complement
If a new product is likely to increase sales of an existing product, the Cash Flow
gain must be added to the new product at the evaluation stage.
If a new product is likely to take away sales from an existing product, the Cash
Flow loss must be charged to the new product at the evaluation stage.
Substitute (or Erosion) Example
• McDonald is considering opening a new branch. Some of the customers at

nearby branches may switch over to the new branch.
• The reduction of sales revenue at these nearby branches must be deducted
from the Cash Flow of the new branch at the evaluation stage.

New Branch $100,000 0 $100,000
Existing Branch $80,000 $100,000 -$20,000
Sneaker case
How to handle cannibalization of other sneaker sales?
46
Will the erosion occur anyway?
-- not clearcut
• If a new IPhone is launched, the sales of older IPhones may be eroded. Should the
drop in sales of these older models be deducted from the new IPhone project?
• Answer will depend on whether the drop in sales or erosion of older models will occur
regardless
– If yes (because competitors will introduce new models), then the drop is not due to
the new IPhone should not be deducted from the new IPhone project.
New Model X $200 0 $200
Existing Models $900 $1,000 -$100
Existing Models $900 $900 0

(drop will occur regardless)
Corporate Disruption
• Not new.
• Take the example of New York-based Steinway versus Yamaha of Japan.
• Yamaha entered the race in the 1950s. It codified the knowledge and
automated production. Its grand pianos got better and better.
• Why didn’t Steinway automate? Maybe it was afraid that automation would
cannibalise its handmade masterpieces. It failed to innovate.
• In addition, rather than reinvent, some companies find it “cheaper” to leverage
on what they already have. For example, upgrade an existing process, add
another production shift. Open up opportunities for others to disrupt your
business. 48
In order to defy competition, companies have to innovate
• Besides automating soap making (which competitors could also do), P&G
– pioneered new ways to reach consumers eg. radio, drama programmes to

reach housewives.
– shifted its knowledge base and invented synthetic detergents which

cannibalised its own soap-based detergents
“This synthetic detergent may ruin the soap business. But if anybody is going
to ruin the soap business, it had better be Proctor and Gamble”
– Chairman William Proctor (1930-1934)
Combination of automation, savvy marketing and cannibalising innovation enable

P&G to remain a household name. Future proof your business. 49
Learning Outcomes
• Sunk costs
• Taxes
Taxes
• When a firm makes profits, it has to pay taxes
• Always consider cash flows after tax.

Depreciation -3,333 -3,333 -3,333
Taxes @ 40% -444 -1,111 -4,445
Investment -10,000
Cash Flow -10,000 4,000 5,000 10,000
Sneaker case
How to handle taxes?
14. New Balance’s effective tax rate is 40%.
52
Sneaker case
How to handle taxes?
14. New Balance’s effective tax rate is 40%.
53
Learning Outcomes
• Sunk costs
• Taxes
Ignore Financing Charges
- Do not minus interest expense or dividends
• Financing costs (cost of debt and cost of equity) have already been taken into
account because Cash Flows are discounted using the Weighted Average Cost
of Capital.
Equity Debt
rwacc  re  rd (1  T)
Debt  Equity Debt  Equity
CF1 CF2 CFn
NPV  CF0    ... 
1  rwacc  1  rwacc 
1 2
1  rwacc n
• Deducting interest expense and dividends from the Cash Flows will result in
“double counting” financing costs.

Investment -10,000

Depreciation -3,333 -3,333 -3,333
Taxes @ 40% -444 -1,111 -4,445
Investment -10,000
Cash Flow -10,000 4,000 5,000 10,000
Interest expense not deducted

Sneaker case
How to handle interest costs?
Financing charges are not included in a project’s cash flow projection.

They are embedded in the discount rate (WACC).
Deducting financing charges will result in double counting.
57
In summary, what are the relevant Cash Flows?
• Consider
• Changes in net working capital
• Side effects or Externalities
• Taxes
• Ignore
• Sunk costs
• Side effects that are not incremental in nature
• Financing costs 58
Learning Outcomes
• Sunk costs
• Taxes
59
Broad Classification of Project Cash Flows
 Initial
• up-front cost of fixed assets + increases in Net Working Capital
 Operating Cash Flows over project’s life
• after-tax operating income + depreciation
 Terminal
• salvage value of fixed assets,
• tax on salvage value
• recovery of Net Working Capital (sometimes, NWC is recovered gradually
over the project’s life)
60
Set up a time line for the project’s cash flows
0 1 2 3 4 5 6
Initial OperatingCF1 OperatingCF2 OperatingCF3 OperatingCF4 OperatingCF5 OperatingCF6
CF +
Terminal CF
CF0 CF1 CF2 CF3 CF4 CF5 CF6

61
Sneaker’s Initial Cash Flow
62
Initial CFs
63
Classification of Project Cash Flows
 Initial
 Terminal
64
Sneaker’s Operating Cash Flows
65
Classification of Project Cash Flows
 Initial
 Terminal
66
Terminal CFs
From where?
67
Sneaker’s Terminal Cash Flows
68
Sneaker’s Terminal Cash Flows
69
Terminal CFs
70
Total depreciated = 25.1%
Undepreciated = 74.9%
74.9% x $150m = 112.35
71
Terminal CFs
72
73
Terminal CFs
74
Here are all Sneaker’s CFs
75
Here are all Sneaker’s CFs on a time line
Payback = 5.10 years

Discounted Payback = 5.83 years
With no established benchmark, it is not a good idea to only employ payback and discounted payback
to make a decision.
NPV = $13.36
This represents value that can be created above and beyond what investors require, given the project’s
risk level.
IRR = 12.82%
This exceeds the 11% cost of capital, providing additional evidence that the project should be accepted.
76
PI = 1.07 > 1
From a quantitative standpoint, Sneakers creates value for New Balance.

Sneakers 2013
Scenario Analysis
If price drops by 20% and quantity sold increase by 30%?
77
Scenario Analysis
If price drops by 20% and quantity sold increase by 30%

Discounted Payback = 5.73 years 78
NPV = $21.18
IRR = 13.87%
PI = 1.12
Sneaker 2013
Scenario Analysis
If advertising & promotions increase by 20% and quantity sold increase by 20%?
79
Persistence Cash Flows

Discounted Payback = 2.73 years
NPV = $8.59
IRR = 21.75%
PI = 1.16 80
Persistence creates value for New Balance.
The NPV is positive.
The IRR is greater than the cost of capital of 14%
From New Balance Perspective, which is more
risky -- Sneaker or Persistence?
81
Which projects are acceptable if they
are independent?
Which projects are acceptable if they

are mutually exclusive?
(1) Projects cannot be repeated
(2) Projects can be repeated
Payback Disct Payback NPV IRR PI

Sneakers 2013 5.10 years 5.83 years $13.36m 12.82% 1.07
Persistence 2.34 years 3.73 years $8.59m 21.75% 1.16
82
Additional Slides on Projects with Unequal Lives
1
You have to choose between Projects S and L (mutually exclusive).
Which is better?
0 1 2 3 4
r = 10%
S L
60 60
(100)
NPVL > NPVS
But is L better?
Project L
33.5 33.5 33.5 33.5
(100)
2
S L
NPV 7.547 6.190
Assume that Project S can be repeated NPVS > NPVL
S is better
0 1 2 3 4
Project S
(100) 60 60 60 60
(100)
(100) 60 (40) 60 60
3
NPVs = 7.547
Alternative Method to Common Life:
Equivalent Annual Annuity (EAA) Approach
• How do we compare one project that has a 6-year life with another
that has a 10-year life?
Need common life of 30 years
• Find the EAA whose PV is equal to the project’s NPV
4
S L
Project S (EAA): NPV 4.132 6.190
0 1 2
10%
2.381 2.381
PV1
PV2
4.132 = NPVS
5
Project L (EAA): S L
NPV 4.132 6.190
0 1 2 3 4
10%
1.953 1.953 1.953 1.953

PV1
PV2
PV3
PV4
6.190 = NPVL
6
S L
NPV 4.132 6.190
NPV (common life) 7.547 6.190
EAV 2.381 1.953
EAVS > EAVL
S is better
• Project S has higher NPV using common life, and higher EAV/EAA.
• Common life approach and EAA approach always lead to the same decision.
7
Example: Analyze a Proposed
Project
Proposed Project
• Depreciable cost $240,000
‒ Machinery $200,000, Shipping $10,000, Installation $30,000
‒ Depreciation schedule given (33%, 45%, 15%, 7%)
• At time 0, inventories rise by $25,000 and payables rise by
$5,000. Net working capital will be recovered at end of project.
• Economic life 4 years
• Salvage value $25,000
• Sales 100,000 units/year @ $2 each
• Variable cost 60% of sales
• Tax rate 40%
• WACC 10%
Timeline of CF
0 1 2 3 4
Initial OCF1 OCF2 OCF3 OCF4

Costs CF0 +
Terminal CF
CF0 CF1 CF2 CF3 CF4

Machinery $200,000
Shipping $10,000
Installation $30,000
Inventories rise by $25,000
Investment at t = 0 Payables rise by $5,000
Equipment -$240
*Increase in inventories -25

*Increase in A/P 5
Net CF0 -260
*NWC = $25 – $5 = 20
Depreciable cost $240,000
Economic life 4 years
What is the annual depreciation?
Year Rate x Basis Depreciation

1 0.33 $240 $ 79.2
2 0.45 240 108.0
3 0.15 240 36.0
4 0.07 240 16.8
1.00
Sales 100,000 units/yr @ $2 each
Variable cost 60% of sales
Tax rate 40%
Operating CF
1 2 3 4
Revenues $200 $200 $200 $200
Var. cost 60% -120 -120 -120 -120
Depreciation -79.2 -108 -36 -16.8
Operating inc (BT) 0.8 -28 44 63.2
Tax 40% -0.3 11.2 -17.6 -25.3
Operating inc (AT) 0.5 -16.8 26.4 37.9
Add back dep. 79.2 108 36 16.8
Operating CF 79.7 91.2 62.4 54.7
Depreciation Tax Shield
(Rev – COGS – Depreciation) (1-Tax) + Depreciation
Focus on the Depreciation:

-Depreciation (1-Tax) + Depreciation
= -Depreciation + Depreciation*Tax + Depreciation
= Depreciation*Tax
= Depreciation Tax Shield
Salvage value $25,000
Tax rate 40%
Terminal CF at t = 4 At t=4,
Machine fully depreciated
Recovery of NWC $20

Salvage Value 25
Tax on salvage value (40%) -10
Net terminal CF $35
Here are the project’s CF on a timeline
0 1 2 3 4
r = 10%
-260 79.7 91.2 62.4 54.7

Terminal CF 35
89.7
What is the regular payback period?
0 1 2 3 4
-260 79.7 91.2 62.4 89.7
-260 -180.3 -89.1 -26.7 63
Regular Payback = 3 + 26.7/89.7 = 3.3 years

What is the discounted payback period?
0 1 2 3 4
-260 79.7 91.2 62.4 89.7

72.45 75.37 46.88 61.27
-260 -187.55 -112.18 -65.3 -4.03
Discounted Payback > 4 years

What are the NPV, IRR and PI?
0 1 2 3 4
-260 79.7 91.2 62.4 89.7

72.45 75.37 46.88 61.27
-260 -187.55 -112.18 -65.3 -4.03
NPV = -4.03 IRR = 9.28% PI = 255.97/260 =0.98

Example: Analyze a Proposed
Project
Example
• Capital expenditure of $500,000. Fully depreciated in 5 years.
Equipment can be sold for $5,000 at the end of 5 years.
• Net working capital: 27% of change in sales. Incurred at
beginning of year.
• Sales: $10m, $13m, $13m, $8.667m, $4.333m
• Cost of Goods Sold: 60% of sales
• Selling, general & admin expenses: 23.5% of sales
• Introductory expense at time 1= $200,000
• Already spent $1m on research and development
• Tax=40%
• weighted average cost of capital = 20%
21
Capital expenditure of $500,000.
Change in Net working capital: 27% of change in sales. Incurred at beginning of year
Initial Cash Flows (in ‘000)
Equipment -$500
Change in net working capital=

-$2,700
27% of change in sales (0 in Year 0
and $10m in year 1)
CF0 -$3,200
22
Sales: $10m, $13m, $13m, $8.667m, $4.333m.
COGS: 60% of sales.
Selling, general & admin expenses: 23.5% of sales
Introductory expense at time 1= $200,000.
Change in Net working capital: 27% of change in sales. Incurred at beginning of year
Operating cash flows over project’s life (in ‘000s)

1 2 3 4 5
Sales 10,000 13,000 13,000 8,667 4,333
Cost of Good Sold (60% of sales) -6,000 -7,800 -7,800 -5,200 -2,600
Selling, general & admin expenses (23.5% of sales) -2,350 -3,055 -3,055 -2,037 -1,018
Introductory expenses -200
Depreciation -100 -100 -100 -100 -100
Profit before taxes 1,350 2,045 2,045 1,330 615
Taxes (40%) -540 -818 -818 -532 -246
Profit after taxes 810 1,227 1,227 798 369
Add depreciation 100 100 100 100 100
Change in net working capital (27% of change in sales) -810 0 1,170 1,170 1,170
Operating Cash Flow 100 1,327 2,497 2,068 1,639
Note that Net Working Capital is recovered eventually: -2700 – 810 + 0

+ 1170 + 1170 + 1170= 0
23
Equipment can be sold for $5,000 at the end of 5 years.
Terminal Cash Flows (‘000)
Salvage Value of Equipment $5
Tax on salvage value -$2

40% of (salvage value – book value)
CF5 $3
24
Here are all the project’s net Cash Flows
(in ‘000) on a time line
0 r = 20% 1 2 3 4 5
-3200 100 1327 2497 2068 1642
Payback = 2+ (1773/2497)=2.71 yrs

Discounted payback = 3+ (750/997)=3.75 yrs
Cash Flows cumulate PV at t=0 cumulate
CF0 -3200 -3200 -3200
NPV = $907,066 CF1 100 -3100 83.33 -3116.67
CF2 1327 -1773 921.53 -2195.14
IRR = 29.55% CF3 2497 724 1445.02 -750.12
CF4 2068 2792 997.30 247.18
PI = 1.28 CF5 1642 4434 659.88 907.07 25
If the initial R&D of $1,000,000 is deducted…
0 r = 20% 1 2 3 4 5
-4200 100 1327 2497 2068 1642
NPV = -$92,933
IRR = 19.19%
PI = 0.98
Reject project. Cannot recover the initial research & development cost at all. 26
Financial Statement Analysis
How to conduct a complete FSA when given a copy of a company’s annual report
1
2
3
Background of Food Empire
• Founded in 1992. Headquarters in Singapore.
• In April 2000, IPO on SGX at an offer price of S$0.13 each.
• Food and beverage brand owner and manufacturer of instant beverage
products, frozen convenience foods, confectionery and snacks.
• Its best-selling product was MacCoffee 3-in-1. Does the name ring a bell?
– a leader in instant mixed coffee in Russia, Kazakhstan and Ukraine
– In 2003, ranked one of “The Strongest Singapore Brands”
4
Revenue by Geographical Regions
• Food Empire’s main market was Russia, followed by Ukraine in distant second,
then Kazakhstan and the Commonwealth of Independent State (CIS) countries
(Armenia, Azerbaijan, Belarus, Kazakhstan, Moldova, Russia, Tajikistan, Uzbekistan)
– In 2014, Russia contributed 54.77% of Food Empire’s total revenue of US$249.5 million
– In 2014, Ukraine contributed 10.71%.
300
250 27
26 38
200 25 48
45 48
Revenue
43 35
150 29 29 27
100
129 137 153 137
50
0
2011 2012 2013 2014
Others 25 26 27 38
Kazakhstan & CIS countries 43 45 48 48 5
Ukraine 29 29 35 27
Russia 129 137 153 137
Revenue by Product Groups
• In terms of product group, beverages ranked top. In 2014, beverages
accounted for 91.96% of total revenue.
300
250 16 1
14 19
13
200
Revenue
11
150
247 229
100 212 224
165
50
0
2010 2011 2012 2013 2014
Ingredients 1
Non-Beverages 11 13 14 16 19 6
Beverages 165 212 224 247 229
Background of Food Empire
• Founded in 1992. Headquarters in Singapore.
• In April 2000, IPO on SGX at an offer price of S$0.13 each.
• Food and beverage brand owner and manufacturer of instant beverage
products, frozen convenience foods, confectionery and snacks.
• Its best-selling product was MacCoffee 3-in-1.
– a leader in instant mixed coffee in Russia, Kazakhstan and Ukraine
– In 2003, ranked one of “The Strongest Singapore Brands”
• In 2005, Food Empire named one of the top 15 most valuable Singapore brands
• In 2007, made it into Forbes Magazine’s prestigious list of top 200 firms in Asia
with turnover under $1 billion
7
Background of Food Empire (cont’d)
• Food Empire grew from strength to strength. Its share price hit a
high of S$1.19 in April 2007 from an IPO price of $0.13.
• During the financial crisis, share price touched a low of S$0.20 in
March 2009.
8
• From 2010, Food Empire started to pay more attention to Asia.
• In 2011, it took loans for two freehold properties in Singapore and a
freehold property in Klang (a town in Selangor).
• In 2013, it took loans to finance the land, construction and building of
factories and machineries in Klang, Johor and Chennai (a city in India).
9
• From a low during the financial crisis, Food Empire managed to
recover ground and trade at S$0.73 in Feb 2013.
10
• The geopolitical problems in Ukraine started in 2013 and share price trended down again.
• Ukraine’s dismal economic performance and political unrest had led to the depreciation of its currency, the
hryvnia, and then devaluation in January 2014.
• In March 2014, Russia completed the annexation of Crimea – a move that upset Ukraine and escalated the
uncertainty between the two nations. This led to further depreciation of both the Russian rouble and
Ukrainian hryvnia against the U.S. dollar which was Food Empire’s reporting currency.
• July 17, 2014– Malaysia Airlines Flight 17 (MH17) was shot down by a Russian missile. All 283 passengers and
15 crew died.
11
1 US$ = ___ rubles
At the end of 2013, the exchange rate was 1US$ = 32.86 RUB.
At the end of 2014, it was 60 RUB.
At the end of 2015, it was 73.03 RUB 12
1 US$ = ___ hryvnia
At the end of 2013, the exchange rate was 1US$ = 8.24 UAH.
At the end of 2014, it was 15.82 UAH.
On January 1, 2016, it was 24.13 UAH. 13
At time of case …
• As political tensions between the Ukrainian government and the Russian-backed
separatists grew, the likelihood that the conflict would be resolved soon seemed doubtful.
• In addition, the drop in oil prices also hurt Russia’s economy which was highly dependent
on oil and gas.
14
West Texas Intermediate (WTI) Crude Oil prices
below
$27
15
At time of case …
• As political tensions between the Ukrainian government and the Russian-backed
separatists grew, the likelihood that the conflict would be resolved soon seemed doubtful.
• In addition, the drop in oil prices also hurt Russia’s economy which was highly dependent
on oil and gas.
• On Jan 1, 2016, Food Empire’s share price was at $0.21.
Jan 1, 2016: $0.21

Dropped 71% from $0.73 in Feb’13
16
How Food Empire fared compared to STI Index
17
Question
• Should investors sell their shares in Food Empire?
18
19
Learning Outcomes
1. Read Management Discussion – summarize performance in preceding year and projected
performance in coming year
2. Identify the 2 basic approaches of comparing financial statements
– Time series
– Cross sectional
3. Identify the ways of getting rid of the size problem
– Standardized financial statements
– Ratio analysis
4. Evaluate a firm using financial ratios
– Liquidity ratios
– Solvency ratios
– Asset management ratios
– Profitability ratios
– Market value ratios
5. Summary 20
21
Dividends?
22
Did not pay dividends in 2014
23
Food Empire’s Past Dividends Per Share
Dividends in S$
2000 0.00500
2001 0.00750
2002 0.01250
2003 0.01250
2004 0.01500
2005 0.01875
2006 0.01600
2007 0.01900
2008 0.00350
2009 0.01000
2010 0.01052
2011 0.01052
2012 0.01231
2013 0.00563
2014 0.00000 24
Commonwealth Independent States 25
Armenia, Azerbaijan, Belarus, Kazakhstan,
Moldova, Russia, Tajikistan, Uzbekistan
Coffee
Tea
Chocolate drink
Cereal drink
Macfito health drinks
Frozen finger food
Potato crisps
Apple chips
Rice crackers
MacFood eg. seafood snacks
MacCandy eg. coffee candy
26
27
28
Learning Outcomes
1. Read Management Discussion
– Time series
– Cross sectional
– Ratio analysis
– Solvency ratios
5. Summary
29
Basic Approaches
Across Time
Time-series analysis helps identify financial trends over

time for a single company or business unit
 Performance of the same company over time
 Problem: same company may have grown over time
Basic Approaches
Across Companies
Cross-sectional analysis helps identify similarities and differences

across companies or business units at a single moment in time.
 Performance relative to other companies in the same industry
 Problem: different companies have different sizes
Solutions to problem of comparing over time and across firms
o Standardize
 common size statements
o Ratio Analysis
Learning Outcomes
– Time series
– Cross sectional
– Ratio analysis
– Solvency ratios
5. Summary
33
Standardized Financial Statements
• Common-Size Income Statements
– Compute all line items as a percent of sales
• Common-Size Balance Sheets
– Compute all accounts as a percent of total assets
• Standardized statements make it easier to compare financial

information of a company over time, particularly if the
company has grown
34
COMMON SIZE INCOME STATEMENT
Fiscal Year Ended December Lower Cost of Revenue
Units: Millions of USD
Note 5-YEAR TREND INCOME STATEMENT COMMON SIZE INCOME STATEMENT
2010 2011 2012 2013 2014 2010 2011 2012 2013 2014
Revenue 176 226 238 263 250 100.00% 100.00% 100.00% 100.00% 100.00%
Cost of revenue (101) (125) (131) (155) (137) -57.39% -55.31% -55.04% -58.94% -54.80%
Gross profit 1 74 100 106 108 113 42.05% 44.25% 44.54% 41.06% 45.20%
Total operating expenses (69) (85) (87) (94) (99) -39.20% -37.61% -36.55% -35.74% -39.60%
Operating income 2 6 15 19 14 13 3.41% 6.64% 7.98% 5.32% 5.20%
Interest Expense 0 0 0 0 0 0.00% 0.00% 0.00% 0.00% 0.00%
Foreign exchange gains 0 (1) 1 (2) (29) 0.00% 0.44% 0.42% 0.76% -11.60%
(losses)
Other income (expense) 8 2 2 1 0 4.55% 0.88% 0.84% 0.38% 0.00%
Income before taxes 2 14 16 22 13 (16) 7.95% 7.08% 9.24% 4.94% -6.40%
Provision for income taxes 0 (1) (1) (1) 3 0.00% 0.44% 0.42% 0.38% 1.20%
Net income 2 14 15 20 12 (13) 7.95% 6.64% 8.40% 4.56% -5.20%
Higher Gross Margin
Common size trend analysis shows improvement in gross margin.
Lower Cost of Revenue indicates efficient management of direct selling expenses.
35
Fiscal Year Ended December
2010 2011 2012 2013 2014 2010 2011 2012 2013 2014
Revenue 176 226 238 263 250 100.00% 100.00% 100.00% 100.00% 100.00%
Cost of revenue (101) (125) (131) (155) (137) -57.39% -55.31% -55.04% -58.94% -54.80%
Gross profit 1 74 100 106 108 113 42.05% 44.25% 44.54% 41.06% 45.20%
(losses)
Net income 2 14 15 20 12 (13) 7.95% 6.64% 8.40% 4.56% -5.20%
Gross Margin improved but Profit Margin turned negative in 2014.

I. Total Operating Expenses has increased
II. Other Income has declined (from 4.55% of total sales in 2010 to 0% in 2014)
III. Non-operating Expenses has increased (0% of total sales in 2010 to 11.6% in 2014).
36
2010 2011 2012 2013 2014 2010 2011 2012 2013 2014
Revenue 176 226 238 263 250 100.00% 100.00% 100.00% 100.00% 100.00%
Cost of revenue (101) (125) (131) (155) (137) -57.39% -55.31% -55.04% -58.94% -54.80%
Gross profit 1 74 100 106 108 113 42.05% 44.25% 44.54% 41.06% 45.20%
(losses)
Net income 2 14 15 20 12 (13) 7.95% 6.64% 8.40% 4.56% -5.20%
OVERALL REMARKS
Food Empire’s common size income statements indicate that Total Operating
Expenses and Foreign Exchange Risks need to be monitored.
37
COMMON SIZE BALANCE SHEET
Note 5 YEAR TR END STATEMENT OF FINANCIAL POSITION COMMON SIZED
2010 2011 2012 2013 2014 2010 2011 2012 2013 2014
Cash and cash equivalents 42 35 47 28 20 24.85% 18.72% 22.27% 11.81% 9.01%
Receivables 50 55 55 53 40 29.59% 29.41% 26.07% 22.36% 18.02%
Inventories 24 22 27 43 46 14.20% 11.76% 12.80% 18.14% 20.72%
Prepaid expenses 2 7 7 7 4 1.18% 3.74% 3.32% 2.95% 1.80%
Other current assets 2 4 2 3 6 1.18% 2.14% 0.95% 1.27% 2.70%
Total current assets 1 120 123 138 134 116 71.01% 65.78% 65.40% 56.54% 52.25%
Net property, plant and 18 24 34 62 67 10.65% 12.83% 16.11% 26.16% 30.18%

equipmentassets
Intangible 13 13 13 13 10 7.69% 6.95% 6.16% 5.49% 4.50%
Other long-term assets 18 23 27 29 30 10.65% 12.30% 12.80% 12.24% 13.51%
Total non-current assets 2
49 61 74 104 106 28.99% 32.62% 35.07% 43.88% 47.75%
Total assets 169 187 211 237 222 100.00% 100.00% 100.00% 100.00% 100.00%
Short-term debt 1 1 1 4 9 0.59% 0.53% 0.47% 1.69% 4.05%

Accounts payable 26 26 27 31 36 15.38% 13.90% 12.80% 13.08% 16.22%
Other current liabilities 2 2 11 11 14 1.18% 1.07% 5.21% 4.64% 6.31%
Total current liabilities 3 29 29 38 42 50 17.16% 15.51% 18.01% 17.72% 22.52%
Long-term debt 5 12 12 28 33 2.96% 6.42% 5.69% 11.81% 14.86%

Deferred taxes liabilities 1 0 0 1 1 0.59% 0.00% 0.00% 0.42% 0.45%
Total non-current liabilities
4 6 13 12 29 34 3.55% 6.95% 5.69% 12.24% 15.32%
Common stock 40 40 40 41 41 23.67% 21.39% 18.96% 17.30% 18.47%
Retained earnings 93 103 119 125 110 55.03% 55.08% 56.40% 52.74% 49.55%
Accumulated other
comprehensive income 1 2 2 0 -13 0.59% 1.07% 0.95% 0.00% -5.86%
Total stockholders' equity
134 145 161 166 138 79.29% 77.54% 76.30% 70.04% 62.16%
Total liabilities and
stockholders' equity 169 187 211 237 222 100.00% 100.00% 100.00% 100.00% 100.00%
38
NOTES
[1] CURRENT ASSETS / TOTAL ASSETS
Down trend in Receivables/TA. Could be due to lower Sales or better collection efforts.
Up trend in Inventories/TA. Could be due to lower Sales or inefficient inventory management.
Drop in Cash holdings/TA. Could be due to lower profits or higher investments. Could also be intentional in view of forex 39
risk.
[2] NON-CURRENT ASSETS / TOTAL ASSETS
Net Property Plant and Equipment increased dramatically. Suggest heavy investment for future growth
40
[3] CURRENT LIABILITIES / TOTAL ASSETS
Increase in Payables may be due to re-negotiations with suppliers for longer credit periods, given slow-
down in Sales.
Increase in Short-term Debt mirrors increase in Long-term Debt (in next slide).
41
[4] NON-CURRENT LIABILITIES / TOTAL ASSETS
Obvious uptrend in Long-term Debt in tandem with increase in Property, Plant and Equipment.
Loans are in S$ and US$. 42
43
Learning Outcomes
– Time series
– Cross sectional
– Ratio analysis
– Solvency ratios
5. Summary
44
Ratio Analysis
• When we compute a ratio, size divides out and becomes a non-issue.
• Ratios standardize numbers and facilitate comparison over time and
across firms.
• Time-Trend Analysis (over time)
– Compare how the firm performs over time
• Peer Group Analysis (with others)
– Compare against similar companies within industry
45
Benchmarks
Benchmark comparison
against either:
- past performance or
- peer averages
Food Empire’s 10 Potential Peers
CCL Pioneer
Super Tenfu Petra Premier Dongw Kraft
Food Product Ottogi Food Nestle
Group Holding Foods Foods on F&B Heinz
Empire s India Corp Group SA
Ltd s Co Ltd Ltd Plc Co Co.
Ltd Ltd
Current ratio 2.32 3.21 2.30 1.60 2.32 1.40 1.38 0.94 1.89 1.03 1.00
Quick ratio 1.40 2.14 1.72 0.83 1.83 1.10 0.76 0.81 0.95 0.75 0.63
Total debt to asset
0.19 0.03 0.21 0.24 0.16 0.11 0.14 0.48 0.20 0.16 0.44
ratio
Inventory period 122.55 113 242 94 74 29 71 61 66 67 46
Accounts receivable
58.40 63 49 39 57 24 36 104 33 51 21
period
Accounts payable
95.91 38 26 20 39 50 62 192 28 129 42
period
Total asset turnover 1.13 0.88 0.65 1.35 1.08 1.60 1.44 0.38 1.98 0.72 0.79
Gross margin 0.45 0.35 0.62 0.37 0.32 0.22 0.30 0.35 0.28 0.48 0.27
Profit margin1 -0.052 0.13 0.16 0.11 0.10 0.05 0.05 -0.29 0.03 0.16 0.06
Return on Assets1 -0.059 0.11 0.10 0.14 0.10 0.08 0.08 -0.11 0.07 0.11 0.05
Return on Equity1 -0.094 0.14 0.14 0.24 0.17 0.13 0.15 -1.16 0.13 0.22 0.22
Total assets to total
1.609 1.27 1.35 1.68 1.59 1.63 1.94 10.51 2.00 1.91 4.83
equity
1Food Empire had negative net income in 2014, making it meaningless to analyse these ratios.
47
Infront Analytics
Pay-per-use version for occasional use
Daily access
• 3 days valid for 2 months £899

• 10 days valid for 12 months £1899
International, regional and domestic peers

Ratios and comparative charts
48
COMPANY CHARACTERISTICS
North American Industry
Classification System Revenue Book value Same 3-digit NAICS code,
NAICS No of FY2014 FY 2014
(2012) Employees (US mil) (US mil)
removed Tenfu and Nestle
Food Empire 311920 626 250 222
Super Group 311920 1233 425.8 477.7 Similar scale of operations,
Tenfu (Cayman)
Holdings Co Ltd 551112 5286 275.1 463.4 removed Kraft and Nestle
CCL Products India Ltd 311920 350 119.5 121.1
Petra Foods Ltd 311351 5970 504 470.5 Left with 7 peers
Ottogi Corp 311999 3231 1,692.00 1,231.80
Pioneer Food Group Ltd 311211 8099 1,673.70 1,145.30
Premier Food Plc 311999 3848 1,551.30 2,841.80
Dongwon F&B Co 311710 2350 1,704.50 817.6
Nestle SA 312111 335000 100,134.50 135,071.30
Kraft Heinz Co. 311941 42000 29,118.00 36,571.00
49
5 Categories of Ratios
Types of Analysis Categories of Ratios
Short Term Liquidity: ability to pay bills in the short term
Cross Sectional Analysis

(Benchmark: peers in the industry)
Solvency: how heavily in debt
Asset Use Efficiency: how long to sell inventory, how long to

Time Series Analysis collect receivables, how much sales generated per $ of assets
(Benchmark: past performance)
Profitability: ability to control costs
Market Value: how investors feel about the growth potential and
value creation potential
Learning Outcomes
– Time series
– Cross sectional
– Ratio analysis
– Solvency ratios
5. Summary
51
Short Term Liquidity
• Liquidity is the “ability to convert assets to cash quickly without a
significant loss in value”
• Indicates the ability to meet short term obligations.
• Is high liquidity always good?
− Kirk Kerkorian’s takeover bid for Chrysler in April, 1995, is an example of investor
dissatisfaction with excess liquidity. At the time, Chrysler’s management had accumulated $7.3
billion in cash and marketable securities as a cushion against an economic downturn. KK was
Chrysler’s largest shareholder with 10%.
− KK instigated a takeover bid because Chrysler’s management refused to pay this cash to
stockholders. He made a $22.8 billion hostile offer which dragged on for 10 months. KK agreed
to halt his bid and not try again for 5 years. In return Chrysler repurchased some stocks. That
raised share price and KK made $2.7 billion from his investment.
52
Lots of Cash
• As of Q4 2020, Apple has $195.57 billion in cash (Q3 2020 -- $191.83;

Q4 2019 -- $207.06 billion). Much of these cash were earned overseas.
If repatriated, they will be subject to significant taxes.
• As of April 2021, Google has $135 billion (Q2 2020, $121.08 billion) in
cash
• As of March 2021, Facebook has $64.21 billion in cash
• US government exploring a one-time repatriation tax of 10% to

incentivize US companies to bring the profits back.
53
DEFINITION OF FINANCIAL RATIOS
Short-term liquidity
A Current Ratio > 1 shows that current assets can service current liabilities. A higher
number indicates greater liquidity. However, there is a trade-off between liquidity
and profitability.
Current Assets
Current Ratio 
Current Liabilitie s
Quick Ratio removes inventory from the equation.

Current Assets - Inventory
Quick Ratio 
Current Liabilitie s
54
Short Term Liquidity
Peer
2010 2011 2012 2013 2014 Average
Current ratio=
current assets/current liab 4.14 4.24 3.63 3.19 2.32 1.71
Quick ratio=
(Current Assets-inventory)/CL 3.31 3.48 2.92 2.17 1.40 1.15
Food Empire is not as liquid as before but it is more liquid than its peers.
Learning Outcomes
– Time series
– Cross sectional
– Ratio analysis
– Solvency ratios
5. Summary
56
Solvency
The Total Debt to Asset ratio reflects the fraction of the firm that is funded by debt.
Higher number  greater risk of not being able to meet compulsory interest or principal
repayment.
Total Debt
Total Debt to Asset Ratio 
Total Asset
The equity multiplier is another measure of leverage. Higher number  higher liabilities.
Total Asset
Equity Multiplier 
Total Equity
57
Total Asset
Equity Multiplier 
Total Equity
Total Assets = Total Liabilities + Total Equity

If Total Liabilities ↑ then Total Equity ↓ Equity Multiplier ↑
A higher EM reflects more liabilities i.e. more risk
58
Solvency
Peer
2010 2011 2012 2013 2014 Average
Total Debt to Asset ratio 0.04 0.07 0.06 0.14 0.19 0.15
Equity Multiplier 1.26 1.29 1.31 1.43 1.61 1.69
• Food Empire increased debt usage to 19% of Total Assets.

• In 2014, its Debt Ratio surpassed the peer average.
• Its Equity Multiplier is comparable to peers.
Food Empire increased debt usage to 19% of Total Assets.
The notes to the financial statements provided some clues to the reason
behind the increase in long term interest bearing loans.
− In 2011, it took loans for two freehold properties in Singapore and a freehold
property in Klang.
− In 2013, it took loans to finance the land, construction and building of factories
and machineries in Klang, Johor and Chennai.
61
62
Learning Outcomes
– Time series
– Cross sectional
– Ratio analysis
– Solvency ratios
5. Summary
63
Asset use efficiency
Asset use efficiency can be indicated by the number of days it takes to sell
inventory, and collect receivables. A related item on the liability side is payables.
Inventory Receivable s Payables
Inventory Period  Receivable Period  Payable Period 
Daily COGS Daily Sales Daily COGS
Total asset turnover can also be used to analyse efficiency. It indicates the amount
of sales that the company can generate per dollar of assets.
Sales
Total Asset Turnover 
Total Asset
64
What is Working Capital?
• Net Working capital is defined as the difference between current assets (CA) and current
liabilities (CL).
• Net Working capital = CA- CL = $160,000 - $65,000 = $95,000
• Positive net working capital indicates that the CA can cover CL.
• The amount of net working capital is commonly used to measure a firm's liquidity and efficiency.
• Working capital management involves managing inventories, accounts receivable, cash and
accounts payable.
65
Shorten Operating Cycle
• When it comes to managing working capital - TIME IS MONEY.
• We do not need so much working capital if
– we can collect receivables more quickly
– we can reduce the amount of money tied up in inventory
– We can negotiate improved terms with suppliers
If you ....... Then ......

•Collect receivables (debtors) faster You release cash from the cycle
•Collect receivables (debtors) slower Your receivables soak up cash
•Get better credit (in terms of duration or amount) from suppliers You increase your cash resources
•Shift inventory (stocks) faster You free up cash
•Move inventory (stocks) slower You consume more cash
66
Operating Cycle
• It is the number of days between acquiring inventory, selling inventory, and collecting cash.
• It describes how a product moves through the current asset accounts from inventory to
receivable and finally to cash
67
Operating cycle = inventory period + accounts receivable period
Operating cycle = accounts payable period + cash cycle period
Raw material
purchased
Finished goods sold Cash received
Order Stock
Placed Arrives
Inventory period Receivable period

(Days it take to sell inventory) (Days it take to collect receivables)
(Days to pay suppliers)

Time
Payable period
Firm receives invoice Cash paid for materials
Cash cycle
Operating cycle
68
Cash Cycle
• How to calculate the cash cycle?
Operating cycle = inventory period + receivable period
Operating cycle = payable period + cash cycle period
Cash cycle = inventory period + receivable period - payable period
• The cash cycle is the number of days from when we pay suppliers to when we collect
from customers. This is the time period during which the firm needs financing.
• A lengthening cash cycle can indicate that the firm is having trouble selling its inventory
or collecting on its receivables.
• For most firms, the cash cycle is +ve -- require financing for inventories and receivables.
69
Inventory Receivable s
COGS / 365 Sales / 365
Finished goods sold

Cash received
Order Stock
Placed Arrives

(Days it take to sell inventory) (Days it take to collect receivables
(Days to pay suppliers) Time

Payable period
Cash cycle
Operating cycle
70
Receivable Period = Total receivables / Sales per day
Assume sales per day of $10. Customers are given 5 days to pay.
0 1 2 3 4 5 6
$10 $10 $10 $10 $10 $10 $10

Total receivables = $50
Receivable Period = Total receivables / Sales per day = $50/$10 = 5 days
71
Payables
Purchases / 365
Finished goods sold

Cash received
Order Stock
Placed Arrives

(Days it take to sell inventory) (Days it take to collect receivables
(Days to pay suppliers) Time

Payable period
Cash cycle
Operating cycle
72
120
Apple’s negative cash cycle
100 Payable period
80
60
40
Receivable period
20
0 Inventory period
-20
-40
-60
Cash cycle
-80
2011 2012 2013 2014 2015 2016
Inventory period 4 3 6 7 6 6
Receivable period 18 25 28 35 26 27
Payable period 83 88 77 98 92 104
Cash cycle -61 -60 -43 -56 -60 -71
Inventory period = 6 days (efficient demand planning)

Receivable period = 27 days
Payable period = 104 days (able to negotiate good credit terms with vendors)
Cash cycle = -71 days
74
Amazon’s negative cash cycle
Payables period
Inventory period
Receivables period
Cash cycle
Cash cycle = inventory period + receivables period – payables period

= 28.9 days + 10.6 days – 54 days = -14.5 days
75
Range between -10 to -30 days
76
77
78
Sales = $250 million
Cost of Goods sold = $137 million
79
Inventory period or Cash days of inventory
Inventory
daily COGS
Too much inventory ties up cash.

Compute cash days of inventory.
Cost of Goods sold = $137m

Food Empire Inventory=$46m
$137 million
Daily COGS 
365 days
$46 million
Inventory Period   122.55 days
$137 million 365 days
80
Receivable period or
Cash days of receivables
Receivable s
daily sales
Call up accounts that are due or overdue.

Reduce cash days of receivables.
Food Empire Sales = $250m

Receivables =$40m
$250 million
Daily Sales 
365 days
$40 million
Receivable Period   58.4 days
See Note 24 pg111, trade receivables are non-interest bearing and are generally on 30-90 days’ term.
81
82
Payable period or
Cash days of payables
Payable Payable
or
daily purchases daily COGS
Suppliers may offer discount to encourage early payment.

If Food Empire delays payment, it may lose the discount.
Food Empire Cost of Goods sold = $137m

$137 million Payables =$36m
Daily COGS 
365 days
$36 million
Payable Period   95.91 days
83
Food Empire Cash Cycle
Cash cycle = Inventory + Receivable – Payable

period period period
= 122.55 + 58.40 – 95.91 days

= 85.04 days.
Food Empire needs financing for 85.04 days.
84
Operating cycle = inventory period + receivable period
Cash cycle = inventory period + receivable period – payable period
Raw material
purchased Finished goods sold
Cash received
Order Stock
Placed Arrives
122 days 58 days

Payable period Time

95 days 85 days
company receives Cash paid
invoice Cash cycle
Operating cycle
Food Empire Cash Cycle
from 2010 to 2014 (in days)
4-year
Units are in number of days 2010 2011 2012 2013 2014 average
Inventory period= Inventory / daily COGS 87 64 75 101 122
Receivable period = Receivable / daily sale 104 89 84 73 58
Payable period= Payable / daily COGS 94 76 75 73 95
Cash cycle 97 77 84 101 85 90
Inventory is taking longer to sell.

Collecting faster.
Taking longer to pay.
Its cash cycle has improved (lower than the 4 year average).
Is it doing better or worse than its peers?
86
Inventory period, Receivable period and Payable period
Units are in number of days 2010 2011 2012 2013 2014 Peer Average
Inventory period= Inventory / daily COGS 87 64 75 101 122 73
Receivable period = Receivable / daily sale 104 89 84 73 58 51
Payable period= Payable / daily COGS 94 76 75 73 95 61
Cash cycle 97 77 84 101 85 62
• Compared to peers, it takes longer to sell, collect and pay. Its cash cycle is longer.
Summarized Data for Food Empire (in ‘000s)
Inventory $ 45,662 CL $ 49,775

Other CA 70,288 Non-CL 34,184
Non-CA 106,442 Equity 138,433
Total assets $222,392 Total L&E $222,392
Q. How would reducing inventory period from 122 days to 72 days affect the firm?
First, find daily COGS = $137m / 365 =$375k

88
Effect of reducing inventory period from 122 days to 72 days:
$137 million
Daily COGS 
365 days
$46 million
Inventory Period   122.55 days
Old Inventory = = $45,662,000

New Inventory= $375k x 72 = 27,000,000
Cash freed up = $18,662,000
Shows up as additional cash.

89
Inventory reduced by $18,662,000 free up cash
Added cash $ 18,662k CL $ 49,775k
Inventory 27,000k Non-CL 34,184k
Other CA 70,288k Equity 138,433k
Non-CA 106,442k
Total assets $222,392k Total L&E $222,392k
90
Asset use efficiency
Asset use efficiency can be indicated by the number of days it takes to sell inventory, and collect
receivables. A related item on the liability side is payables.
Inventory Receivable s Payables
Inventory Period  Receivable Period  Payable Period 
Daily COGS Daily Sales Daily COGS
This is working capital management. Managing current assets and current liabilities.
Total asset turnover can also be used to analyse efficiency. It indicates the amount
of sales that the company can generate per dollar of assets.
Sales
Total Asset Turnover 
Total Asset
91
Total Asset Turnover
Peer
2010 2011 2012 2013 2014 Average
Total asset turnover=
revenue/total assets 1.04 1.21 1.13 1.11 1.13 1.24
Food Empire’s Total Asset use efficiency has declined from 2011.
Improved slightly in 2014.
92
Compared to peers, it uses assets less efficiently.
Learning Outcomes
– Time series
– Cross sectional
– Ratio analysis
– Solvency ratios
5. Summary
93
Profitability
The ability of the company to control the raw material costs and labour costs is reflected
by the gross margin ratio. The ability to control all costs including operating, financing
and restructuring is reflected by the net profit margin ratio.
Gross Profit
Gross Margin 
Sale
Net Income
Profit Margin 
Sale
Two other commonly used measures are return on assets (ROA) and return on equity
(ROE). ROA measures profitability relative to assets, while ROE measures profitability
relative to ownership.
Net Income
ROA 
Total Asset
Net Income
ROE 
Total Equity 94
Profitability
• Gross margin reflects the ability to control raw material costs and labour costs.
• Profit margin reflects the ability to control all costs.
Peer
2010 2011 2012 2013 2014 Average
Gross profit / Revenue 42.05% 44.25% 44.54% 41.06% 45.20% 31.29%
Net profit / Revenue 7.95% 6.64% 8.40% 4.56% -5.20% 3.00%
Food Empire did well in keeping raw material and labour costs down as evidenced by its
Gross Margin, not just when compared to the past but also when compared to peers. 95
However, on a net profit basis, it lost out.
Profitability
• ROA measures profitability relative to assets
• ROE measures profitability relative to equity
Peer
2010 2011 2012 2013 2014 Average
ROA 8.28% 8.02% 9.48% 5.06% -5.86% 7%
ROE 10.45% 10.34% 12.42% 7.23% -9.42% 16%
• ROA and ROE are on downtrend since 2012.

• Both are negative in 2014. 96
Du Pont Identity
Two other commonly used measures are return on assets (ROA) and return on equity
(ROE). ROA measures profitability relative to assets, while ROE measures profitability
relative to ownership.
Net Income
ROA 
Total Asset
Net Income
ROE 
Total Equity
The Du Pont identity further breaks down the ROE into three ratios linking profitability,
efficiency and solvency, namely profit margin, total asset turnover and equity
multiplier: Net Income
ROE 
Total Equity
NetIncome Sales Total Assets
 x x
Sales Total Assets Total Equity 97
Breaking down the ROE into 3 component parts
NI
• ROE =
TE
• Multiply by TA/TA (= 1) and then rearrange

NI TA
• ROE = TE X TA
= ROA x EM
• Multiply by Sales/Sales (=1) and then rearrange

NI TA Sales
• ROE = TA X TE X Sales
= PM x TA TO x EM
98
Three Component Ratios of ROE
Net Income
ROE 
Total Equity
NetIncome Sales Total Assets
 x x
Sales Total Assets Total Equity
 PM x TA TO x EM
1. Profit Margin (PM) is a measure of the firm’s operating efficiency – how

well it controls costs. Higher  more profitable
2. Total Asset Turnover (TA TO) is a measure of the firm’s asset use efficiency
– how well it manages its assets. Higher  more efficient
3. Equity Multiplier (EM) is a measure of the firm’s financial leverage – how
much debt it has. Higher  riskier 99
Three Component Ratios of ROE
2010 2011 2012 2013 2014
Profit Margin = Net Income / Sales 7.95% 6.64% 8.40% 4.56% -5.20%
Total Asset Turnover = Sales / Total Assets 1.041 1.209 1.128 1.110 1.126
Equity Multiplier = Total Assets / Total Equity 1.261 1.290 1.311 1.428 1.609
ROE 10.45% 10.34% 12.42% 7.23% -9.42%
In 2013,
ROE = (Profit Margin) x (TA Turnover) x (Equity Multiplier)
= 0.0456 x 1.110 x 1.428
= 0.0723
In 2014,
ROE = (Profit Margin) x (TA Turnover) x (Equity Multiplier)
= -0.052 x 1.126 x 1.609
= -0.0942
• Efficiency improved
• Leverage increased.
100
• Profitability suffered.
Learning Outcomes
– Time series
– Cross sectional
– Ratio analysis
– Solvency ratios
5. Summary
101
Market value ratios
Relate the market price to earnings, book value of equity, and sales
The price earnings (P/E) ratio indicates how much investors are willing to pay per dollar of earnings.
High P/E are associated with high growth.
Price per share
P/E ratio 
Earnings per share
The price to book ratio indicates how much investors are willing to pay per dollar of net assets (assets less liabilities).
Price per share
Price to Book ratio 
Book Equity per share
The price to sales ratio indicates the value placed on each dollar of sales. When comparing firms under different
accounting regime, this ratio is especially useful.
Price per share

Price to Sales ratio 
Sales per share
102
Why buy High P/E shares?
• Assume that P=$10, EPS=$1

– P/E = 10
– 10 years to get your money back
• Assume that P=$40, EPS=$1

– P/E = 40
– 40 years to get your money back
103
Price Earning Multiple
104
Price to Book Multiple
Price to Sales Revenue Multiple
105
Relative Valuation
• This is also known as market multiple method, peer comparison
method, or comparable valuation.
• The market multiple method involves standardizing prices by

earnings, book value, or sales.
– Price/Earnings, Price/Book, Price/Sales
• The share price of a company can be estimated by multiplying the

peers’ mean (or median) multiple by its earnings, book value, or
sales:
– share price of A = peers’ mean P/E * company A’s earnings per share
– share price of A = peers’ mean P/B * company A’s book equity per share
– share price of A = peers’ mean P/S * company A’s sales per share 106
Barron (Dow Jones publication)’s cover story, Sep 12, 2015
Alibaba: Why It Could Fall 50% Further
• It’s time to get real. A decline of up to 50% looks far more likely. Alibaba shares trade at about 25
times the consensus earnings estimate, and that should be closer to eBay’ s (EBAY) multiple of
15. Both outfits match sellers and buyers on the Web, and eBay has ample emerging-market
exposure. We’d also give the earnings estimates a haircut—Wall Street’s optimism looks
overdone in the face of the challenges.
$63.83 / $2.59 = 24.6
P/E * EPS of Alibaba = estimated price

15 * $2.59 = $38.85
Sep 19, 2014: IPO at $68
Aug 31, 2015: close at $66.12, < IPO price
Sep 10, 2015: $63.83
Sep 12, 2015: cover story
Sep 28, 2015: $57.39 lowest 107
From IPO to Sep 24, 2021
Sep 19, 2014 -- Alibaba IPO at $68

First day close -- $93.89 (Up 38%)
Nov 10, 2014 – reached $119.15 108
Aug 31, 2015 – closed at $66.12, below IPO price

Sep 28, 2015 -- $57.39 lowest
Singapore GIC buys S$1.4 billion of Alibaba stock in SoftBank sale
Reuters Thursday June 2, 2016
May 31, 2016 closing price = $82

Transacted at $74
109
Market value ratios
Relate the market price to earnings, book value of equity, and sales
The price earnings (P/E) ratio indicates how much investors are willing to pay per dollar of earnings.
High P/E are associated with high growth.
Price per share
P/E ratio 
Earnings per share
The price to book ratio indicates how much investors are willing to pay per dollar of net assets (assets less
liabilities).
Price per share
Price to Book ratio 
Book Equity per share
The price to sales ratio indicates the value placed on each dollar of sales. When comparing firms under
different accounting regime, this ratio is especially useful.
Price per share
Price to Sales ratio 
Sales per share
110
Market Value
2010 2011 2012 2013 2014

Peer Average
Price/Earnings 15.4 9.1 12 14.7 — 21.25*
Price/Book 1.6 0.9 1.5 1.4 0.8 4.09**
Price/Sales 1.2 0.6 1 0.9 0.5 1.85***
*Removed Petra Foods which is an outlier and Premier Foods which has negative P/E
**and *** Removed Premier Foods which is an outlier
• The ratios show that investors were pessimistic about the growth potential and
value creation potential of Food Empire, relative to its peers.
• Applying the peer multiples to Food Empire would result in an inflated price.
111
Valuation using Food Empire’s own average
2014 Key
Food 2014 Key statistic in
Empire statistic in S$ (US$1 = Intrinsic
2010 2011 2012 2013 2014 Average US$ S$1.42876 Value
Price/Earnings 15.4 9.1 12 14.7 — 12.8 — — —

BV per BV per
Price/Book 1.6 0.9 1.5 1.4 0.8 1.24 share=0.24 share=0.34 $0.42
Sales per Sales per
Price/Sales 1.2 0.6 1 0.9 0.5 0.84 share =0.47 share =0.67 $0.56
• Applying the peer multiples to Food Empire would result in an inflated price.
• A more reasonable approach would be to apply Food Empire’s own average multiple.
– Intrinsic value using P/B = Food Empire’s average P/B x Book Equity per share
= 1.24 x 0.34 = $0.42
– Intrinsic value using P/S = Food Empire average P/S x Sales per share
= 0.84 x 0.67 = $0.56
112
Learning Outcomes
– Time series
– Cross sectional
– Ratio analysis
– Solvency ratios
5. Summary
113
Summary
• Food Empire’s ratios did not inspire confidence. It did not compare well
with its peers in four categories.
– less solvent
– less efficient in selling and collecting, and in using assets
– less profitable
– not valued highly by investors.
• There was some explanation for the higher debt level which helped to allay
some fears.
• Main concern -- concentration of business in Russia and Ukraine.

In 2014, 66 per cent of its revenue were from there. 114
• To a certain extent, Food Empire had been able to cope with the
depreciating currencies
– its manpower costs and some operating expenses were in local currencies BUT it
imported its coffee and dairy creamer.
• It had invested in a non-dairy creamer factory in Johor and a coffee

plant in India which should help to stabilise the price of raw materials in
the long term.
• It had been trying to grow its business in Asia, and had plans to go into
ingredient sales in Asia. These should improve its future outlook.
115
2015 results
116
117
118
119
120
2016 Results
121
122
2017 Results
123
2018 Results
124
2019 Results
125
2020
Results
126
From IPO to September 24, 2021
127
Valuation of Bonds
Learning Outcomes
• Recognize bond features

• Evaluate why bond values fluctuate
• Appreciate impact on bond ratings
• Distinguish bond types
2
What is a Bond?
• Security issued in connection with a borrowing arrangement

• Borrower issues (sells) a bond to lender
– Bond is an IOU of the borrower
• Borrower obliged to make specified payments on specified dates
• Default risk
– Risk that issuer will not make interest or principal payments
$100m 8.45% notes due May 2017. Rickmers unable to pay $4.2 m
of coupons due in Nov 2016. Rickmers proposed a swap of the
$100m principal for $40m due Nov 2023
Straits Times Sep 29, 2016
4
In August 2017, Rickmers Marine Trust wound up…
5
Otto Marine extended maturity of $70m bonds by 6 months
to Feb 2017, price dropped to 80 cents on the dollar
Straits Times Sep 27, 2016.
6
Otto Marine redeemed bonds – part of plan to go private
7
Otto Marine taken over…
8
Key Features
• If you buy a bond, the issuer (i.e., the borrower) promises to pay
you back (i) the “par value” (typically $1,000) on a particular day
– the "maturity date" – and (ii) periodic “coupons”
• As a bondholder, your cash inflows will be the par value and the
periodic coupon payments.
• Par Value: The face value of a bond (i.e., its principal amount).
This amount will be repaid at maturity. Generally $1,000.
• Coupon rate: The stated annual coupon interest rate of the
bond. It is equal to the annual coupon payment divided by the
par value of the bond.
• Periodic Coupon Payment
Coupon Payment 
Stated Annual Coupon rate * Par Value
Number of Coupon Payments per year 9
Origin of Coupon Terminology
10
Example
You Buy a GE Bond With a $1,000 Face Value,
a 5% Coupon Paid Annually and a 10-year Maturity
• GE promises to pay back your principal ($1,000 value) plus

periodic annual interest of $50. If you hold it to maturity, you
know exactly how much cash inflow you will receive and when
you will receive it.
"fixed-income" investments
• The regular payments make bonds inherently less volatile than
stock.
11
Some Other Features
• Callability. A feature whereby the issuer may call/refund/redeem
the bond before it matures. A bond with this feature is a callable
bond.
• How does adding a call provision affect a bond?
– Issuer may call/refund/redeem if rates decline
– Helps issuer, hurts investors
– Issuer willing to pay more
– Investors require more on callable bonds
12
Some Other Features
• Putability. A feature whereby the buyer can redeem the bond
before it matures. A bond with this feature is a putable bond.
• Seniority. Preference in lender position over other lenders are
sometimes labelled as senior to indicate seniority, e.g., some
debts are subordinated.
• Basis points. A unit of measure, used to express yields or
interest rates. Most often used to express differences between
yields. The basis point unit is one-hundredth of one percent
(0.01% = 0.0001). For example, if a bond begins with a yield of
5.50% and the yield increases over time to 5.62% -- it has
increased by 12 basis points.
13
Some Other Features
• Convertibility. The option to exchange a bond for a specified
amount of stock. Bonds with this feature are called convertible
bonds. Conversion will occur at specified times, specified prices
and under specified conditions, all of which are indicated in
writing at the time of bond issue.
• Protective Covenants. indenture or loan agreement that limits
certain actions (e.g., limits additional debt the company can take
on, requires a minimum working capital ratio, etc.).
• Sinking Fund.
14
Sinking Fund
• Provision to pay off a loan gradually over its life rather than all at
once at maturity
• Reduces risk to investors, shortens average maturity but not good
for investors if market rates decline after issuance
• Sinking funds are generally handled in 2 ways
‒ Call x% per year at a specified sinking fund price (usually at par)
‒ Buy bonds on open market
• Company would
‒ call if bond sells at a premium
‒ Use open market purchase if bond sells at a discount
15
Bond Indenture
• Contract between the company and the bondholders
– basic terms of the bonds: the principal, coupon rate,
maturity date, and the rights and duties of the buyers
– total amount of bonds issued
– description of property used as collateral if applicable
– call provisions
– details of protective covenants
– sinking fund provisions
16
Financial Asset Valuation
Value CF1 CF2 CFn

r ...
0 1 2 n
CF1 CF2 CFn

PV    ... 
1 r  1
1 r 2 1 r n
The discount rate (ri) is the opportunity cost of capital, i.e., the rate that could
be earned on alternative investments of equal risk
Bond Pricing
The price of a bond is the PV of all cash flows
generated by the bond (i.e. coupons and face value)
discounted at the required rate of return.
C C CM
PV    ... 
(1  r)
1
(1  r) 2
(1  r)
n
Bond Valuation
For Annual Coupons
 1 
1 - (1  r ) N  Face Value
Bond Value  Coupon  
 r  (1  r) N
 
PV of an annuity PV of Par Value
19
Zero coupon bonds
• Bonds that do not make periodic coupon payments
• Investor ‘earns’ interest from the difference between
maturity value and purchase price
M
PV 
(1  r)n
Learning Outcomes

21
Price–Yield relationship
• Price changes in opposite direction to the change in required

yield
• Reason: Price of a bond is the PV of cash flows
– Required yield ↑, PV 
– Required yield , PV ↑
Shape of the Price-Yield relationship
Price
Convex-shaped
0 Yield
Let’s suppose the bond was issued 20 years
ago with a coupon rate of 10% and now has 10
years to maturity.
What would happen to its value over time if the

required rate of return remained at 10%, or at
13%, or at 7%?
Bond value ($)
1,372
1,211
rd = 10%
1,000 M
837
775
30 25 20 15 10 5 0
Years remaining to maturity

ago and now has 10 years to maturity.

13%, or at 7%?
Bond value ($)
1,372
1,211
rd = 10%
1,000 M
837
rd = 13%
775
30 25 20 15 10 5 0

ago and now has 10 years to maturity.

13%, or at 7%?
Bond value ($)
1,372
1,211 rd = 7%
rd = 10%
1,000 M
837
775
30 25 20 15 10 5 0

What would happen to its value over time if the required rate of return
remained at 10%, or at 13%, or at 7%?
• At maturity, the value of any bond must equal its par value
• The value of a premium bond would decrease to $1,000
• The value of a discount bond would increase to $1,000
• A par bond stays at $1,000 if rd remains constant
Yield to Maturity
31
What is “yield to maturity”?
• YTM is the rate of return earned on a bond held to maturity.
Also called “promised yield”
• The yield-to-maturity (YTM) equates the present value of all
cash flows from a bond to the price of the bond.
• Used for comparison with other investments of the same risk
level.
C C C+Par
r ...
0 1 2 n
Present
Value
C1 C2 Cn  Par
PV    ... 
1  r  1  r 
1 2
1  r n
YTM
Which bond will have higher YTM?
• The risk characteristics of the bond determines the yield.
• Which bond will have a higher yield, all else equal?
– Secured debt versus a debenture?
– Subordinated debenture versus senior debt?
– A bond with a sinking fund versus one without?
– A callable bond versus a non-callable bond?
34
What is “yield to maturity”?
• YTM is the rate of return earned on a bond held to maturity.
Also called “promised yield”
• The yield-to-maturity (YTM) equates the present value of all
cash flows from a bond to the price of the bond.
• Used for comparison with other investments of the same risk
level.
• Why not just look at the coupon rate to determine the bond’s
risk?
• Bonds of same risk (and maturity) will be priced to yield the
same return (YTM), regardless of the coupon rate.
Coupon Rate
36
Example: Bond Valuation
A bond has a $1,000 par value due at t = 10, annual $100 coupon
(coupon rate =10%) payments, and a required return of 10%.
• Solution with timeline:
0 1 2 10
100
100 100 ….
PV
PV 1000
PV
PV
PV = 1000
Using A Financial Calculator To Value A Bond
• This bond has a $1,000 par value due at t = 10, years and annual
$100 coupon payments beginning at t = 1. Assuming the required
return is 10%, the price (or PV) of the bond can be found as
follows:
INPUTS 10 10 100 1000

N I/YR PV PMT FV
OUTPUT -1000
38
3 variation of this example:
Required return =10%, 13%, 7%
Example: Bond Valuation
A bond has a $1,000 par value due at t = 10, annual $100 coupon
(coupon rate =10%) payments, and a required return of 10%.
• Solution with timeline:
0 1 2 10
100
100 100 ….
PV
PV 1000
PV
PV
PV = 1000
1. If the coupon rate equals to the required return, the price of bond equals its face value.
Example: Required Return ↑
• Suppose required return rises to 13%. When r rises above the
coupon rate (10%), bond value will fall below par.
INPUTS 10 13 100 1000

N I/YR PV PMT FV
OUTPUT -837.21
2. If the coupon rate is smaller than the required return, the price of bond is smaller
40
than its face value  discount bond.
Example: Required Return ↓
• Suppose required return falls to 7%. When r falls below the
coupon rate (10%), the bond value will rise above par.
INPUTS 10 7 100 1000

N I/YR PV PMT FV
OUTPUT -1210.71
3. If the coupon rate is larger than the required return, the price of bond is higher
than its face value  premium bond. 41
Relationship btw coupon rate and YTM
• If coupon rate < rd,
– bond sells at a discount
• If coupon rate = rd,
– bond sells at its par value
• If coupon rate > rd,
– bond sells at a premium
Current Yield
43
What is Current Yield?
Current yield = Annual coupon payment

Current price
‒ Takes only coupon interest into account
Find current yield for a 9%, 10-yr bond when the bond sells for $887.
$90
Current yield = $887
= 10.15%
Current Yield
• What is the current yield of a bond that sells for $1,000 and
pays a 10% annual coupon ( $100 per year)
Current Yield = $100 / $1,000

= 10%
45
Coupon Rate, Current Yield, YTM
46
Example: Bond selling at Par (Time = 0)
• You paid $1,000 for a $1,000 bond maturing in 10
years with a 10% annual coupon.
• In this case,
Coupon Rate = Current Yield = YTM
The condition holds for all bonds selling at par.
47
Example: Premium Bond (7 years later)
• 7 years later, new bonds of the same risk have a 5% YTM at issuance.
So what could you sell the bond for? 3 more years of $100 annual
coupon and the $1000 at maturity. Based on required yield of 5%:
0 1 2 3
Current Bond Price = $1136.16
Current Yield = 100/1136.16 = 8.8%
Note:
10% > 8.8% > 5%
100 100 1,100 Coupon Rate > Current Yield > YTM
PV
PV The condition holds for all bonds selling
PV at a premium.
PV = 1136.16
48
Example: Discount Bond (7 years later)
• If 7 years later, new bonds of the same risk have a 12% YTM at
issuance.
• So what could you sell the bond for? 3 more years of $100 annual
coupon and the $1000 at maturity. Based on required yield of 12%:
0 1 2 3
 Current Bond Price = $951.96
 Current Yield = 100/951.96 = 10.50%
 Note:
10% < 10.5% < 12%
100 100 1,100 Coupon Rate < Current Yield < YTM
PV
PV The condition holds for all bonds selling
PV
at a discount.
PV = 951.96
49
A Summary
Bond Selling at . . . Satisfies This Condition
Par Coupon Rate = Current Yield = YTM

Premium Coupon Rate > Current Yield > YTM
Discount Coupon Rate < Current Yield < YTM
50
Yield to Call
51
What is “yield to call”?
A 10-year, 10% semiannual coupon, $1,000 par value bond is

selling for $1,135.90 with an 8% yield to maturity. It can be
called after 5 years at $1,050.
What is the bond’s yield to call YTC?
INPUT 10 -1135.9 50 1050

N I/YR PV PMT FV
OUTPUT 7.53%
r = 7.53% is the rate brokers would quote
What is the EAR to call?

EAR = (1 + 7.53%/2)2 – 1
= 7.672%
Use this rate for comparing with other investment

opportunities
If you bought this callable bond, would you be
more likely to earn YTM or YTC?
• YTM = 8% vs YTC = 7.53%

– Firm could raise money by selling new bonds which pay
7.53%
• Investors should expect a call
• Likely to earn YTC = 7.53%, not YTM = 8%
Semi-annual Coupons
55
Semi-Annual Coupons
Suppose you are looking at a bond that has a coupon rate of 10%,
paid semi-annually, and a face value of $1000. There are 20 years to
maturity.
• How many coupon payments are there?
− Number of years = 20 years, so 20 * 2 = 40
• What is the semiannual coupon payment?
− Semi-annual coupon rate = 10%/2 = 5%
− Semi-annual coupon = 10% / 2 * $1000 = 5% * $1000 = $50
Or simply
Stated Annual Coupon rate * Par Value
Coupon Payment 
Number of Coupon Payments per year
56
YTM with Semiannual Coupons
Suppose a bond with a 10% coupon rate paid semiannually, has a face
value of $1000, 20 years to maturity and is selling for $1197.93
• Timeline:
0 1 2 40
6 months 1 year 20 years
50 50 50
….
PV
PV 1000
PV
PV
PV = 1197.93 Is the YTM more or less than 10%?
YTM with Semiannual Coupons
• Suppose a bond with a 10% coupon rate paid semiannually, has a

face value of $1000, 20 years to maturity and is selling for
$1197.93.
− Is the YTM more or less than 10%?
set P/YR=2, N = 40; PV = -1197.93; PMT = 50; FV = 1000

 I/Y = 8% (yield per year)
58
With $1,000, you could buy either a 10%, 10-year, annual
payment bond or an equally risky 10%, 10-year
semiannual bond. Which would you prefer?
m
 iNom 
The semiannual
EAR%   1  equivalent
bond’s   1 annual return (EAR) is
 m 
2
 0.10 
 1   1
 2 
 10.25%
Buy the semiannual coupon bond

If $1,000 is the fair price for the semiannual coupon
bond, what is the fair price for the annual coupon bond?
The semiannual coupon bond has EAR = 10.25%. The

annual coupon bond should earn the same EAR
INPUT 10 10.25 100 1000

N I/YR PV PMT FV
OUTPUT -984.80
The annual and semiannual coupon bonds would be in

equilibrium when both earn 10.25% for the same risk.
2 1
 0.10   APR 
1  EAR  1    1  
 2   1 
1  EAR  1  10.25%  APR  10.25%
61
Interest Rate (Price) Risk
62
What is interest rate (price) risk?
Interest rate risk: Rising rd causes bond’s price to fall
Does a 1-year or 10-year 10% coupon bond have more

price risk (compared with its face value)?
rd 1-year Change 10-year Change
5% $1,048.6 $1,386.1
+4.86% +38.61%
10% 1,000.0 1,000.0
-4.34% -25.09%
15% 956.5 749.1
Value
1,500
10-year
1-year
1,000
1-year
10-year
500
0
0% 5% 10% 15%
rd
Reinvestment Rate Risk
65
What is reinvestment rate risk?
The risk that CFs may have to be reinvested in the
future at lower rates, reducing income
Illustration:
1. Let’s suppose you just won $500,000 playing the
lottery
2. You’ll invest the money and live off the interest
3. You buy a 1-year bond with a YTM of 10%
Year 1 income = $50,000
At year-end get back $500,000 to reinvest
If rates fall to 3%, income will drop from $50,000 to

$15,000
Had you bought 30-year bonds at 10% YTM,

income would have remained constant at $50,000
Maturity and reinvestment rate risk
• Long-term bonds: High interest rate (price) risk, low reinvestment

rate risk
• Short-term bonds: Low interest rate (price) risk, high reinvestment
rate risk
True or False: All 10-year bonds have the
same price risk and reinvestment rate risk
False!
Low coupon bonds have less
reinvestment rate risk but more price
risk than high coupon bonds
Learning Outcomes

70
Default risk
• Reflects the ability of the issuing firm to service its bonds
• Firms that want to sell their bonds to the public are usually
required to first obtain a credit rating from a bond rating
agency, such as Moody’s or Standard and Poor’s
• Rating provides overall assessment of issuer’s credit risk
• For Standard and Poor’s Ratings
– AAA for firms with highest financial strength
– Followed by AA, A, and BBB ratings
– Junk bonds (BB, B, CCC)
Bond ratings provide one measure of default risk.
Provides an overall assessment.
Investment Grade Junk Bonds
Moody’s Aaa Aa A Baa Ba B Caa C
S&P AAA AA A BBB BB B CCC D

Speculative Investment Grade
Bond Ratings
73
Factors Affecting Default Risk & Bond Ratings
• Financial performance (for example):
– Solvency ratios
• Bond contract provisions (for example):

– Secured vs. Unsecured debt
– Senior vs. Subordinated debt
– Sinking fund provisions
74
NOL bond holders hit by change in control
PUBLISHED BY STRAITS TIMES
JAN 9, 2016
• After Singapore state investor, Temasek Holdings, said

that it would sell its majority stake (67%) in NOL to
France's CMA CGM, NOL bonds have lost as much as
13%.
• CMA CGM is the world’s 3rd largest container shipper. Its
bonds are rated “non-investment grade”.
• Temasek, on the other hand, has AAA rating.
75
76
77
• Certain reports noted that some of NOL’s bonds had clauses that would be “triggered by
the planned sale, allowing for potential early repayment or compensation.”
• Such clauses were often inserted in bonds that received implicit parental support of
triple A-rated majority stakeholders like Temasek.
• Of the 4 outstanding NOL bonds, two contained trigger clauses (the 2017 and 2019
bonds), while the other two (the 2020 and 2021 bonds) did not. The prices of all four
bonds had suffered.
• The head of fixed income at Coutts Royal Bank of Scotland commented that, “The
confidence placed in government-owned companies was somewhat over-extended.
Investors who are looking to invest in these companies should look closer at the
covenants of each issue, ensuring they are well protected on the downside should
government support be removed.”
78
Learning Outcomes

79
Government Bonds
• Highest quality
– used as benchmark for other bonds
• Market is well regulated and very liquid
• Treasury Securities
1. T-bills – pure discount bonds (zero coupon bonds) with
original maturity of one year or less
2. T-notes – coupon debt with original maturity between
one and 10 years
3. T-bonds - coupon debt with original maturity greater
than 10 years 80
Size of Singapore Debt Market
www.sgs.gov.sg 81
Singapore Corporate Debt Market
82
Corporate Bonds
• Issued by corporations using a syndicate of banks
• Different types available
– Callable bonds
– Convertible: option to exchange bonds for a specified
amount of stock. Ability to share in price appreciation
of firm’s stock
– Floating rate bonds: coupon payments pegged to
some measure of current market rates, e.g. SIBOR
plus 2%. Have have less price risk. The coupon floats,
so it is less likely to differ substantially from the YTM.
• Generally listed and traded on exchanges
Other Bond Types
• Disaster bonds
– Issued by property and casualty companies. Pay interest and principal as
usual unless claims reach a certain threshold for a single disaster. At that
point, bondholders may lose all remaining payments. Bondholders require
higher return.
• Income bonds
– coupon payments depend on level of corporate income. If earnings are not
enough to cover the interest payment, it is not owed. Bondholders require
higher return.
• Convertible bonds
– bonds can be converted into shares of common stock at the bondholders
discretion. Bondholders require lower return.
• Putable bond
– bondholder can force the company to buy the bond back prior to maturity.
Bondholders require lower return.
• There are many other additional provisions that can be added to a bond and 84
many bonds have several provisions – it is important to recognize how these

provisions affect required returns
85
86
87
88
Valuation of Stocks
Learning Outcomes
• Features of common stock

• Common stock valuation
• Issuing equity
• Rights issue
Features of Common Stock
• Residual ownership in a company

• Common stockholders are owners of the company
• Elect company directors
• Preemptive right – common stockholders have the right to
purchase additional shares sold by the company
Stock and Bond valuation compared
Stock
• Infinite cash flows
• Horizon or life of the investment can be infinite
• Future cash flows not explicitly promised
– estimated on basis of expectations about the company’s
future earnings and dividend policy
Common Stock Valuation
• Assets in place: book value
• Future performance
– discounted dividends
– discounted cash flows (DCF)
• Relative performance: market multiples

– Earnings multiples: P/E, EV/EBITDA
– Book value multiples: P/B, EV/BV
– Revenue multiples: P/S, EV/Sales
5
Book Value
Net tangible assets (NTA)
= Total assets – Total liabilities – Intangible assets - Par value of preferred shares
= Shareholder equity – Intangible assets – Par value of preferred shares
Balance Sheet (in thousands)
Assets Liabilities & Equity

Cash 13,191 Long term debt 744
Working capital 11,735 Other liabilities 9,278
Other assets 4,592 Shareholder equity 19,496
Total assets 29,518 Total liab. & equity 29,518
Given that there are 3.316m shares
19,496,000−0−0
 NTA per share = = $5.88
3,316,000 6
Assessment of the Book Value Method
• Book value is based on historical costs and does not reflect
current market value.
• Book value does not incorporate the earnings potential of the

assets.
7
Valuation of Common Shares

8
Dividend Valuation Model
The value of a share of common stock depends entirely

on future dividends and the required return
Let P0 be value of a share of common stock today

Recent dividend paid D0
Expected future dividends are D1, D2,...
• For an investor with a 1-year horizon, the value of

the stock is
D1 P1
P0  
(1  rs )
1
(1  rs )1
where
D2 P2
P1  
(1  rs ) (1  rs )
1 1
Note that 𝑟𝑠 is the required return of shareholders

• For an investor with a 2-year horizon, the value of

the stock is
D1 D2 P2
P0   
(1  rs )
1
(1  rs ) 2
(1  rs )2
where
D3 P3
P2  
(1  rs ) 1
(1  rs )1
• For an investor with a n-year horizon, the value of

the stock is
D1 D2 Dn
P0    ...  
(1  rs )
1
(1  rs ) 2
(1  rs )
n
Pn
(1  rs )
n
What determines the stock price
at time n?
• Value at time n (Pn) is the PV of

– expected future (after n) dividends
– eventual selling price
• Therefore, P0 depends
– on dividends the investor receives for n periods
– indirectly on dividends after time n
• As a result, the value of a common share is the PV of all

future expected dividends.
D1 D2
P0    ...
(1  rs ) (1  rs ) 2
 Dt

t 1 (1  rs )
t
In practice
• It is difficult to project all the future dividends.

• Hence, we need some simplifying assumptions.
– Zero growth model
– Constant growth model
15
DDM: Zero Growth Model
• Assume that dividends remain the same forever:
D1 = D2 = D3 = ⋯
• Since it is a perpetuity, the PV of a zero growth share is given by:
D1
𝑃0 =
𝑟𝑆
Note that first dividend is at time 1

16
DDM: Constant Growth Model
• If the dividends are expected to grow forever at a constant
rate, g:
D1 = 𝐷0 1+𝑔
2
D2 = 𝐷0 1+𝑔
3
D3 = 𝐷0 1+𝑔
𝑡
D𝑡 = 𝐷0 1+𝑔
• Then, the share will be worth:
D1 𝐷0 (1 + 𝑔)
𝑃0 = =
𝑟𝑆 − 𝑔 𝑟𝑆 − 𝑔 17
Why do share prices change?
𝐸(𝐷1 )
𝑃0 =
𝑟𝑆 − 𝑔
1. rs = rf + s(rM – rf ) is affected by
• risk aversion (rM – rf )
• risk of investment s
• changes in inflation
2. g and D are affected by

• economic situation
• firm situation
18
Relationship between g and r
D1
P0  requires rs  g
rs  g
(1) If rs < g, negative stock price

(2) If rs = g, infinite stock price
• Neither (1) nor (2) makes economic sense

• Model not useful unless
(a) rs > g and
(b) g is expected to be constant forever
Assume beta = 1.2, rRF = 7%, and rM = 12%. What is the
required return rs of stock?
Use the SML to calculate rs:

rs = rRF + β(rM – rRF)
= 7% + (1.2)(12% – 7%)
= 13%
What is the stock price?
D0 = $2, rs = 13%, g = 6%
Constant growth model:

D1 = D0 1 + g = $2 (1.06) = $2.12
D1 $2.12
P0  
rs  g 0.13  0.06
 $30.29
What would P0 be if g = 0?
D0 = $2, rs = 13%, g = 0%
The dividend stream would be a perpetuity.
$2 $2 $2
13%
0 1 2 3 ...
PMT PMT
$2.00 $2.00
P0  P0   $15.38
 $15.38
rs rs
0.13 0.13
If we have supernormal growth of 30% for 3 years,
then a long-run constant g = 6%, what is P0?
Assume rs is still 13%
• Can no longer use constant growth model

• However, growth becomes constant after 3 years
Supernormal growth followed by constant
growth:
D0 = 2.00 2.60 3.38 4.394 4.658

rs = 13%
g = 30% g = 30% g = 30% g = 6%
0 1 2 3 4 ...
P0  4.658 
54.109 P3   
 (0.13  0.06) 
 2.6 
2.301  (1.13)   66.54
   3.38 
2.647  2
 (1.13)   4.394 
3.045  3
 (1.13) 
66.54
46.116
(1.13)3
Suppose g = 0 for t = 1 to 3, and then g is a
constant 6%. What is P0?
2.00 2.00 2.00 2.00 2.12

rs=13%
g = 0% g = 0% g = 0% g = 6%
0 1 2 3 4 ...
1.77
2.12
1.57 P3   30.29
1.39 0.13  0.06
20.99
30.29
25.72
1.133
If g = -6%, would anyone buy the stock? If so,
at what price?
Firm still has earnings and still pays

dividends, so P0 > 0:
D1 D0 (1  g)
P0  
rs  g rs  g
$2.00(0.94) $1.88
   $9.89
0.13  (0.06) 0.19

27
Free cash flows
1 2 3 4 5
Sales
less variable cost
less Depreciation
Earnings before interest and tax (EBIT)
less Tax
Earnings before interest but after tax
Add Depreciation
Operating Cash Flow
less Change in NWC
less Net Capital Spending
Free Cash Flow
FCF is cash that the firm is free to distribute to creditors and stockholders
because it is not needed for working capital or fixed asset investment.
𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒 = 𝑃𝑉 𝑜𝑓 𝑓𝑢𝑡𝑢𝑟𝑒 𝑓𝑟𝑒𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 28
DCF (cont’d)
• By definition,
𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 = 𝐸𝑉 + 𝑒𝑥𝑐𝑒𝑠𝑠 𝑐𝑎𝑠ℎ
Value of Equity + Value of Debt = EV + excess cash
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝐸𝑉 + 𝐸𝑥𝑐𝑒𝑠𝑠 𝐶𝑎𝑠ℎ0 − 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡
where Excess Cash0 is today’s cash above and beyond the firm’s liquidity needs.
• Assuming constant growth of FCF,
𝐹𝐶𝐹0 ∗ (1 + 𝑔)
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = + 𝐸𝑥𝑐𝑒𝑠𝑠 𝐶𝑎𝑠ℎ0 − 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡
𝑟𝑊𝐴𝐶𝐶 − 𝑔
• FCF method is often preferred to the dividend growth model because

– a large number of firms do not pay dividends; 29
– dividends are hard to forecast.

DCF: an example
• Given that long-run g = 6% from 4th year onwards and the

required return r= 10%, use the FCF model to find the intrinsic
value of the firm. Assume there is no excess cash today.
0 1 2 3 4
r = 10%
...
g = 6%
-5 10 20
-4.545
8.264
15.026
398.197 20(1  0.06)
PV3   530
416.942 0.10  0.06
30
• If the firm has $100 million in debt and 10 million shares
outstanding, what is the firm’s intrinsic value (IV) per share?
• IV of equity = IV of firm – debt

= $416.94 - $100
= $316.94 million
• IV per share = IV of equity / # of shares
= $316.94m / 10m
= $31.69
31
SIA takeover offer for Tigerair a 'tactically well-
timed move’
PUBLISHED BY STRAITS TIMES, NOV 6, 2015
The offer of $0.41 (32% above the closing price of $0.31) is well below
the cost of $0.67 for long term shareholders.
"This a tactically well-timed move for Singapore Air," Mr Alan Richardson,

a Hong Kong-based money manager at Samsung Asset Management
Ltd, said. "Tigerair has been restructuring operations by cancelling loss-
making routes. By doing so, earnings are at an inflection point.“
32
33
Tigerair had an IPO in Jan 2010 at an offer price of $1.50 per share.
When Tigerair was first listed, SIA had a minority share in the company,
and limited influence. In late 2014, SIA increased its stake to 55.8%.
Tigerair had suffered losses of

 $104 million in 2012,
 $45 million in 2013,
 $223 million in 2014, and
 $264 million in 2015
Tigerair traded at $0.31 on Nov 5, 2015.

On Nov 6, SIA offered $0.41 per share.
34
35
Tiger Airways
36
SIA set to take over and delist Tiger Airways
PUBLISHED BY STRAITS TIMES, MAR 4, 2016
SIA raised its offer from $0.41 to $0.45 and was able to acquire
95.6% of Tigerair by Feb 26, 2016.
This allows for compulsory acquisition of all Tigerair shares.
Note that for long term shareholders, the average price of Tigerair after
3 rights issue was $0.67
37
SIA audited results for the financial
year ended March 31, 2016
Tiger Airways’ operating profit for the financial year was $14 million,
contrasting with a full year loss of $40 million incurred in the prior
year (up $54 million). The better operating performance was mainly
due to
– higher passenger revenue, and
– reduced net fuel costs
38
39
• Relative performance
– Book value multiples: P/B
– Revenue multiples: P/S
40
Relative Valuation
• This is also known as market multiple method, peer comparison
method, or comparable valuation.
• Price multiples involve standardizing prices by earnings, book

value, or sales.
– Price/Earnings, Price/Book, Price/Sales
• The share price of a company can be estimated by multiplying

the peers’ mean (or median) multiple by its earnings, book
value, or sales:
– share price of A = peers’ mean P/E * company A’s earnings per share
– share price of A = peers’ mean P/B * company A’s book equity per share
– share price of A = peers’ mean P/S * company A’s sales per share 41
Price Earning Multiple
𝑃 𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒
=
𝐸 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
– High P/E means that the market expects the firm to do well
in the future. You will only buy a high P/E share if you believe
that it will be much more profitable in the future.
Limitations of P/E Multiple

Difficult to compare P/E across different countries with different accounting
rules.
P/E can be extremely large for firms with very small earnings per share.
P/E multiple cannot be used when earnings are negative.

42
Enterprise Value to EBITDA Multiple
𝐸𝑉
𝐸𝐵𝐼𝑇𝐷𝐴
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡 − 𝑒𝑥𝑐𝑒𝑠𝑠 𝑐𝑎𝑠ℎ

=
𝐸𝐵𝐼𝑇𝐷𝐴
 From EV/EBITDA to share price:

– Company A’s EV = peers’ mean EV/EBITDA * company A’s EBITDA
– A’s share price = (A’s EV + Excess Cash – Debt)/ No. of shares outstanding
43
Price to Book Multiple
𝑃 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
=
𝐵 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
– High P/B means that the market values the share highly.
44
Price to Sales Revenue Multiple
𝑃 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
=
𝑆 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
Advantages of P/S Approach
– Since the denominator revenue is less affected by

accounting choices (vs. earnings or book value), it is easier to
compare firms that are under different accounting regimes.
– Since revenue is non-negative, it is also useful in sectors
comprising young companies, where most or all are losing
money.
45
Issuing Equity
• Cost of new issues
• Consider the reaction to a Seasoned Offering
• Understand the theory behind underpricing
• Appreciate the mechanics behind rights issues
46
Cost of New Issues (IPO and seasoned offering)
a. Direct expenses – Spread or underwriting discount which is
the difference between underwriter’s buying price and the
subsequent offer price
b. Other direct expenses such as filing fees, legal fees, taxes:
reported in prospectus
c. Indirect expenses (not reported in prospectus) such as
management time
d. Underpricing (offer price < first day price)
e. Green Shoe Option where underwriter has option to buy
additional shares from the issuer at the offer price to cover
oversubscription.
f. Price drop upon announcement of seasoned offering
47
Cost of Large versus Small Issues
Proceeds Direct Costs (a+b) Underpricing (d)
(in millions) SEOs IPOs IPOs
2 - 9.99 35.11% 25.22% 20.42%
10 - 19.99 13.86% 14.69% 10.33%
20 - 39.99 9.54% 14.03% 17.03%
40 - 59.99 13.96% 9.77% 28.26%
60 - 79.99 6.85% 8.94% 28.36%
80 - 99.99 6.72% 8.55% 32.92%
100 - 199.99 5.23% 7.96% 21.55%
200 - 499.99 4.94% 6.84% 6.19%
500 and up 3.37% 5.50% 6.64%
Average 7.69% 10.37% 19.34%
Study by Lee, Lockheed, Ritter and Zhao (JFR 1996)
• Large issues incur proportionately lower costs than small issues.

• On average, IPOs incur higher expenses than SEOs.
• Direct costs of IPOs = approx 10% of proceeds raised.
• Underpricing of IPOs = approx 19% of proceeds raised.
48
Underpricing
Some reasons:
• Positive publicity for firm (if price goes up)
• Ease of raising funds in future
• Underwriter's self-interest
• Kevin Rock's theory: informed vs. uninformed subscribers (~ lemon
theory)
– Assume: informed investors bid only on the offerings they think will gain
superior returns (good IPOs); uninformed investors bid without
information with regard to the quality of the IPO (good or bad IPOs);
and uninformed cannot tell who are informed.
– If informed investors know that it’s a bad IPO, they won’t bid.
Uninformed investors bid with the expectation of 50% good and 50%
bad, and they will lose money. Eventually they will leave the IPO market.
– Underpricing brings in uninformed investors and ensures that they bid
as there are not sufficient informed investors (undersubscribed IPO). 49
IPO Underpricing - A persistent anomaly in all
countries
50
Greenshoe Option
• Assume company decides to IPO by selling 100m shares.
• Assume underwriter buys the shares at $9 each from the
company and sells to investors at an OFFER price of $10.
Spread or underwriting discount = $10-$9 = $1
• Assume underwriter is allowed to sell an additional allocation
of the offering size above the 100m shares and is given a
green shoe option.
• If over allocation is set at 15% of the offering, this would
amount to 15m extra shares. The option allows the
underwriter to buy the 15m shares from the company at the
OFFER price of $10.
• The underwriter does not have the extra shares yet so it
effectively shorts the shares (sells shares it does not have). 51
Greenshoe Option
• WHAT HAPPENS IF THE SHARE PRICE FALLS TO $8 WHEN MARKET OPENS?
Underwriter will buy the 15m shares from the market at $8 to
close its short position. The underwriter makes a profit. Why?
Sold the extra 15m shares at the offer price of $10 and bought
from market at $8. Made ($10-$8) x 15m = $30m.
• WHAT HAPPENS IF THE SHARE PRICE RISES TO $11.90 WHEN MARKET

OPENS?
There is underpricing = $11.90-$10 = $1.90 per share.
Underwriter will exercise the Greenshoe option – this allows the
underwriter to buy the 15m shares from the company at the
offer price of $10. The underwriter does not gain or lose.
52
Reaction to Seasoned Offering
• On announcement of seasoned offering, market value of existing
equity drops.
• Reasons:
– Managerial Information
Since the managers are the insiders, perhaps they are selling
additional shares because they think the share is overpriced.
– Debt Capacity
The market may infer that the managers are issuing new
equity to reduce the D/E ratio in the face of financial distress.
53
Rights Issue
• If a preemptive right is contained in the firm’s articles of

incorporation, the firm must offer any new issue of common
stock to existing shareholders first.
• This allows shareholders to maintain their percentage

ownership if they so desire.
54
Mechanics of Rights Offerings
• The management of the firm must decide on:

– The exercise price (price that existing shareholders must pay
for new shares).
– The number of rights (the number of existing shares) required
to buy 1 new share
• Rights have value:

– Shareholders can either exercise their rights or sell their rights.
55
Example on Rights Offering
A firm has 200,000 outstanding shares trading at

$25 each. It is proposing a rights offering of 10,000
new shares at a $20 subscription price. One existing
share is one right.
1. What is the new market value of the firm?

2. What is the ex-rights price?
3. What is the value of a right?
1 new share for every 20 existing shares.

1 new share for every 20 rights. 56
1. What is the new market value of the firm?
There are 200,000 outstanding shares at $25 each. There
will be 10,000 new shares issued at a $20 subscription
price.
(200,000 shares  $25)  (10,000 shares  $20)

 $5,200,000
57
2. What is the ex-rights price?
There are 210,000 outstanding shares with a mkt value of
$5,200,000. The ex-rights price is:
$ 5 , 200 , 000
 $ 24 . 7619
210 , 000 shares
3. What is the value of a right?
new price - subscripti on price $ 24 . 7619  $ 20

  $ 0 . 2381
no. of rights 20
Alternatively, old price – new price = $25 - $24.7619 = 0.2381

Why? 58
Old firm value + New capital raised through rights = New firm value
$25 * 200k shares + $20 * 10k shares = $24.7619 * 210k shares
$25 * 200k shares + $20 * 10k shares = $24.7619 * (200k + 10k) shares
Collect terms:
($25 - $24.7619) * 200k = ($24.7619- $20) * 10k
($25 - $24.7619) * 20k = ($24.7619- $20) * 1k
($25 - $24.7619) / 1k = ($24.7619- $20) / 20k
new price - subscripti on price $ 24 . 7619  $ 20

  $ 0 . 2381
no. of rights 20
Alternatively, old price – new price = $25 - $24.7619 = 0.2381

59
Value of existing shares with & without rights issue:
Value of 20 existing shares without rights issue  20 x $25  $500
With rights issue, sell the rights at $0.2381 each

no. of existing shares x new price  20 x $24.7619  $495.2380
no. of existing shares x value of right  20 x $0.2381  $4.7620
With rights issue, exercise the rights at $20 for 1 new share, that is,
pay an additional $20.
Total no. of shares x new price  21 x $24.7619  $520
In Practice: More listed Companies turn to
shareholders (19 April 2008, Straits Times)
• Rights issues are proving very popular amidst the current credit
squeeze. This is where existing shareholders may buy new shares
in proportion to their holdings, usually at a discount to the
current market price.
• ‘…estimates that debt is 6 to 7 times more expensive on average
for companies than raising the same sum via a rights issue.’
• 'If credit is more scarce, banks have more choices. It may not be
that they are tightening lending, but they can afford to be more
selective and pick the better ones.'
61
Parkway rights issue 1.5 times subscribed
despite weak markets (13 June 2008, Straits Times)
• PARKWAY Holdings … successfully raised $785.7 million in one of
the largest rights issues staged here
• Investors will get 7 new shares for every 15 existing shares at
$2.18 apiece
• At $2.18 apiece, the rights share is priced at a 30.6 per cent
discount to the theoretical ex-rights price of $3.14.
(15*$3.59 + 7*$2.18)/22 = $3.14
• (when).. rights issue was announced on March 31st, Parkway

shares plunged 39 cents, or 10.9 per cent, to close at $3.20.
• The response … was so strong that it was 1.5 times subscribed.
62
Rights issues falter in weak market
(23 August 2008, Straits Times)
Evergro Properties announced on May 30, 2008
• When the rights issue of Evergro Properties closed … share
price was 17.5 cents which was lower than the rights price (3
new shares for every 2 existing shares at 18 cents. At the time
of announcement, share price was 23 cents).
• Its majority shareholder Keppel Land (which held a 71.37%
interest in Evergro) had agreed to subscribe to any rights
shares not taken up. It took up its full entitlement as well as …
the balance of the shares not taken up (1.01% of the shares).
63
Rights issue undersubscribed
Mapletree Logistics Trust announced on June 24, 2008
• Unit holders were offered the right to buy 3 units for every 4
held at 73 cents each. At the time of announcement, the price
was 91.7 cents
• …(at) closing… units .. at 72.5 cents.

• … only 59.9% of the total number of rights were taken.
• Mapletree Investments took up the balance of the units.
64
The Rights Puzzle:
Rights issue vs. SEO
• Over 90% of new issues in the US are underwritten, even though
rights offerings are much cheaper.
• Some explanations:
– Underwriters increase the stock price. There is not much
evidence of this.
– Underwriters provide a form of insurance to the issuing firm
in a firm-commitment underwriting.
– Proceeds from underwriting may be available sooner than
the proceeds from a rights offering.
• None of the above is entirely convincing.
65
Mergers and Acquisitions
References: RWJ Chapter 26
“Organic” growth versus Acquisitions
• Over time, businesses grow "organically”:

– they become better (more efficient) at what they do
– they add new customers or associated businesses to their
traditional activity base.
– they expand sales revenue and profits
• But, "organic growth" may be too slow to fulfil corporate
objectives.
• Taking over other companies can help in growing strategically.
2
Takeovers (transfer of control of a firm from
one group of shareholders to another)
Merger or
Consolidation
Acquisition Acquisition of Stock
control transferred to
BOD of acquiring firm
Acquisition of Assets
Takeovers Proxy Contest
Some shareholders solicit proxies from
other shareholders to gain control
of BOD by voting in new directors LBO
Going Private
purchased by small group such
as management and then
delisted MBO
3
Learning Outcomes
1. Consider the basic legal forms of acquisitions
2. Consider why firms are acquired
3. Examine sources of synergy from acquisitions
4. Look out for dubious reasons for acquisitions
5. Consider case where shareholders bear cost of reduction in
risk
6. Merger Arbitrage
7. Analyse NPV of an acquisition
8. Know various defensive tactics
9. Examine empirical evidence on whether acquisitions add value
4
Basic Legal Forms of Acquisitions
– Merger or Consolidation (must be approved by
shareholders of both firms)
• Merger: acquiring firm retains its name and identity and acquires all
the assets and liabilities of the target
• Consolidation: an entirely new firm is created
– Acquisition of Stock (no need for a general meeting to get
the approval of target shareholders)
• Once the bidding firm has > 30% (HK: 35%, Malaysia: 33%, NYSE:
30%), a tender offer to all remaining shareholders is mandatory. The
bidding firm can deal directly with the target shareholders
bypassing the target firm’s management and BOD.
– Acquisition of Assets (must be approved by target
shareholders)
• involves transferring title of individual assets which can be costly
5
Examples
• In Sep 2013, Citigroup sold Citi Venture Capital International

(a $4.3 billion private equity fund) to The Rohatyn Group.
• In Dec 2014, Citigroup sold its Japan brokerage business to
Sumitomo Mitsui for $5.6 billion.
6
Classifications of Acquisitions
Horizontal
– firms are in the same industry eg. Exxon with Mobil; Glaxo with
Wellcome; SIA take over Tiger; CMA CGA take over NOL; Lazada take
over Redmart; Jacobs Douwe Egberts (JDE) take over Super
7
8
In December 2013
9
In Nov 2020, Korean Air announced plans to buy a 64%
stake in Asiana for US$1.3 billion
10
As of October 2021 -- still a maybe
11
12
Horizontal
Wellcome; SIA take over Tiger; CMA CGA take over NOL; Lazada
takeover Redmart; JDE takeover Super
Vertical
– firms are at different stages of the production process.
Forward integration -- controls stages downstream
13
Alibaba buys stake in SingPost’s
Quantium Solutions International in 2016
To enhance e-commerce logistics

capabilities in Southeast Asia and
Oceania.
Horizontal
Vertical
Forward integration -- controls stages downstream
Backward integration -- controls stages upstream
15
Tata Steel’s Acquisition of Labrador Iron Mines
Horizontal
Vertical
Forward integration -- controls stages downstream eg. iron mining
companies that own steel factories.
Backward integration -- controls stages upstream eg. movie distributor
Netflix manufactures content.
Conglomerate
– firms are in unrelated business areas eg. Walt Disney Company and
American Broadcasting Corporation
17
Amazon (online retailer) crossed over to brick and
mortar grocery business in 2017
Learning Outcomes
risk
6. Merger Arbitrage
19
Why Are Firms Acquired?
– Synergy
Δ𝐶𝐹𝑡
• VAB – (VA + VB) = 1+𝑟 𝑡
– Where are synergies from?

ΔCF =ΔRev – ΔCost – ΔTax – ΔCapital Requirement
A. Revenue Enhancement
B. Cost Reduction
C. Tax Gains
D. Capital Requirement
20
Example: SBC Communications bought AT&T
for US$16b in 2005
• Combines AT&T's national and global IP-based networks and expertise
with SBC's strong local telephone services, broadband and wireless assets
• Expected to yield NPV of more than $15 billion in synergies. The synergies
are expected to come from:
– About 50% from consolidating facilities and operations such as
network and IT. Sell duplicate facilities. (synergies from capital
requirement)
– Approximately 25% from consolidating services such as sales and
support functions. (synergies from cost reduction)
– About 10% to 15% from consolidating corporate functions. (synergies
from cost reduction)
– Approximately 10% to 15% from service offerings to new customer
segments. (synergies from revenue enhancement)
Source: http://www.att.com/gen/pressroom?pid=4800&cdvn=news&newsarticleid=21566 21
Example: Mergers in the US airline industry
• Revenue synergies from expanding routes and destinations and efficient
scheduling of round trips (synergies from revenue enhancement)
• Cost synergies from increased operational efficiencies, savings in integrating
information systems, better utilization of gate space, and other facilities.
(synergies from cost reduction)
22
Learning Outcomes
risk
6. Merger Arbitrage
23
Sources of Synergy from Acquisitions
– Marketing gains
due to more efficient use of promotional campaigns and
distribution networks, and better product mix
– Create beachhead
– Reduce competition / Increase market power
24
8 February 1988 The Dallas Morning News
SEAGRAM: MARTELL DEAL TO GET BETTER WITH AGE
• ….Seagram Co…. $850 million winning bid for Martell

• ….over time…. Seagram's worldwide liquor and wine business
will definitely be enhanced by the Martell acquisition.
• Seagram plans to use its international marketing resources to
boost Martell's image,
• Seagram also hopes to help its other brands by making use of
Martell's strong distribution network in the Far East, the
fastest growing liquor market in the world.
25
– Marketing gains
to enter a new market through the intangible relationships
established
26
14 February 2004 Straits Times
ComfortDelGro inks China deals totalling $12m.
• Tied up with Chengdu Yiyou, an existing taxi operator. Has

51% stake.
• Has 51% stake in Sichuan Yinxing Motors Trade, an authorized

distributor for Mitsubishi vehicles -- offer automotive repair
and maintenance services and sales of parts.
• Has 51% stake in Chengdu Jitong Integrated Vehicle Inspection

Co.
• Has stake in Chengdu Wantong, an enterprise set up by the

Chengdu Transport Bureau.
27
23 August 2005 Straits Times
ComfortDelGro expands into Australia
• Joined forces with an Australian company to purchase Westbus,

one of Australia's largest private bus firms
• Holds a 51% stake.
• ‘.. marks.. entry into the Australian transport sector, widening ..
global footprint …’
28
10 July 2008 Business Times
ComfortDelGro unit to acquire Custom Coaches
• Comfortdelgro’s Australian subsidiary, ComfortDelgro

Cabcharge (CDC) will acquire bus builder Custom Coaches to
get a 35% share of the Australian bus building market.
• The acquisition will act as a base when CDC’s new
manufacturing plant … opens in early 2009.
• ‘…. help .. get a foothold until the building plant goes into
operation’
• … Comfortdelgro, the world’s 2nd largest land transport
company, …has operations in 7 countries (Singapore, China,
UK, Ireland, Australia, Vietnam, Malaysia)
29
First foray into New Zealand in a 50:50 joint venture
from Jan 2022
30
– Marketing gains
to enter a new market through the intangible relationships
established
Antitrust laws may limit such monopoly gains
31
32
B. Cost Reduction / Operational Synergy
– Economies of scale
Ave cost of production falls. Spread fixed production costs over
larger volume.
Share central HQ services (R&D, marketing)
Reduce overlapping jobs (layoffs)
– Economies of vertical integration
Better access to customers.
More efficient in co-ordinating closely related operating activities.
eg. timber firms also own sawmills and hauling equipment.
Better control over supplies “may” reduce costs.

eg. GM produced its own parts (but Ford found that outsourcing
was cheaper. GM later spun off the parts division). 33
– Combining complementary resources
Great product and established distribution network. Merging
may result in a firm filling in the “missing pieces” with pieces
from other firms.
Firm A
Firm B
– Technology Transfer
e.g., Automobile manufacturer acquire an aircraft firm. Use
aerospace technology to improve automotive quality
– Elimination of inefficient management
Replace management who overspend on perks and pet
projects. Cut down staff strength
34
C. Tax Gains
– Valuable tax loss credits from accumulated losses

in one firm can be used to offset against profits of another
thereby lowering overall tax burden
– Unused Debt Capacity
– Use of Surplus Funds
35
Tax Motive: An Example
• Assume equal probabilities for State 1 and State 2.
• Assume no carryback or offset against other profits.
36
C. Tax Gains
– Valuable tax loss credits from accumulated losses

in one firm can be used to offset against profits of another
thereby lowering overall tax burden
– Unused Debt Capacity

Take advantage of interest tax shields
– Use of Surplus Funds

Under FCF hypothesis, one of the ways to remove free cash is
to pay dividends – may result in shareholders having to pay
more tax.
Use the surplus funds to make acquisitions will avoid the
additional tax.
37
D. Reduce Capital Requirement
Sell duplicate facilities (eg. SBC acquires AT&T)
Reduce working capital
38
Learning Outcomes
risk
6. Merger Arbitrage
39
Dubious Reasons for Acquisitions
A. Diversification or risk reduction
– This is a dubious reason because shareholders can diversify
their portfolios at a much lower cost by buying shares of
different companies. Thus they will not pay more for a
diversified firm.
B. Growth in EPS
– If there are no synergies or other benefits from the merger,
then the growth in EPS is just an accounting illusion and not
due to true growth.
40
The Bootstrap Game
Acquiring Firm has high P/E ratio
Target firm has low P/E ratio
After merger, acquiring firm has short

term EPS rise
41
Buy companies with lower P/E ratios. Merged firm has higher EPS.
This is an accounting illusion that the firm is experiencing spectacular growth
Example
Acquiring firm: EPS=$5, P/E=20, 10000 shares
Market value = EPS x P/E x shares = $1m
Target firm: EPS=$2, P/E=10, 5000 shares

Market value = EPS x P/E x shares = $100,000
Assume no synergy, merged firm value = $1.1m. Assume target gets new shares
Target firm receives 1/11 of merged firm or 1000 new shares
Total number of shares = 11000
Earnings of merged firm = EPS of acquirer x shares + EPS of target x shares
= $5 x 10000 + $2 x 5000 = $60,000
EPS of merged firm = total earnings / total shares = $60000/ 11000 =$5.45
42
Learning Outcomes
risk
6. Merger Arbitrage
43
A Cost to Stockholders from Reduction in Risk
If two all-equity firms merge, there is no gain to bondholders, but…
If the firms have Debt

The bondholders can now draw on the funds of both firms.
This mutual guarantee is called the coinsurance effect. It makes
existing debt less risky and therefore more valuable to existing
bondholders.
The gain to bondholders are at the expense of shareholders.
How can Shareholders reduce the costs of the Coinsurance Effect?
Retire existing debt before the merger and/or increase post-
merger debt usage.
44
Example State 1 State 2 Market Value
Probability 0.5 0.5
1. Base Case (No debt)
Values before Merger:
Firm A $80 $20 $50
Firm B 10 40 25
Values after Merger
Firm AB $90 $60 $75
II. Debt with face value of $30 in Firm A and $15 in Firm B
Firm A $80 $20 $50
Debt 30 20 25
Equity 50 0 25
Firm B $10 $40 $25
Debt 10 15 12.5
Equity 0 25 12.5
Values after Merger
Firm AB $90 $60 $75
Debt 45 45 45
Equity 45 15 30
Loss to stockholders in firm A $20 - $25 = -$5
Loss to stockholders in firm B $10 - $12.5 = -$2.5 45
Combined gains to bondholders to both firms $45 - $37.5 = $7.5
Probability 0.5 0.5
Firm A $80 $20 $50
Firm B 10 40 25
Values after Merger
Firm AB $90 $60 $75
Firm A $80 $20 $50
Debt 30 20 25
Equity 50 0 25
Firm B $10 $40 $25
Debt 10 15 12.5
Equity 0 25 12.5
Values after Merger
Firm AB $90 $60 $75
Debt 45 45 45
Equity 45 15 30
Probability 0.5 0.5
Firm A $80 $20 $50
Firm B 10 40 25
Values after Merger
Firm AB $90 $60 $75
Firm A $80 $20 $50
Debt 30 20 25
Equity 50 0 25
Firm B $10 $40 $25
Debt 10 15 12.5
Equity 0 25 12.5
Values after Merger
Firm AB $90 $60 $75
Debt 45 45 45
Equity 45 15 30
Probability 0.5 0.5
Firm A $80 $20 $50
Firm B 10 40 25
Values after Merger
Firm AB $90 $60 $75
Firm A $80 $20 $50
Debt 30 20 25
Equity 50 0 25
Firm B $10 $40 $25
Debt 10 15 12.5
Equity 0 25 12.5
Values after Merger
Firm AB $90 $60 $75
Debt 45 45 45
Equity 45 15 30
State 1 State 2 Market Value
Example
Probability State
0.5 1 State
0.5 2 Market Value
Probability
1. Base Case (No debt) 0.5 0.5
1. Basebefore
Values Case (No debt)
Merger:
Values
Firm A before Merger: $80 $20 $50
Firm BA $80
10 $20
40 $50
25
Firm B after Merger
Values 10 40 25
Values
Firm ABafter Merger $90 $60 $75
Firm AB $90 $60 $75
II. Debtbefore
Values with face value of $30 in Firm A and $15 in Firm B
Merger:
Values
Firm A before Merger: $80 $20 $50
Firm A Debt $80
30 $20
20 $50
25
Debt
Equity 30
50 20
0 25
Firm B Equity 50
$10 0
$40 25
$25
Firm B Debt $10
10 $40
15 $25
12.5
Debt
Equity 10
0 15
25 12.5
Equity
Values after Merger 0S/H of A receive $20
25 of AB = 25/(25+12.5)*30
12.5
Values
Firm ABafter Merger $90 $60 $75
Firm ABDebt $90
45 $60
45 $75
45
Debt
Equity 45 45
15 45
30
Equity
Loss to stockholders in firm A 45 15 = -$5
$20 - $25 30
Loss to stockholders in firm B A $10$20 - $25 = -$2.5
- $12.5 -$5
Loss to stockholders
Combined in firm B to both firms
gains to bondholders $10
$45 -- $12.5
$37.5 == -$2.5
$7.5 49
Learning Outcomes
risk
6. Merger Arbitrage
50
Merger Arbitrage
• Once a tender offer is announced, the uncertainty about

whether the takeover will succeed adds volatility to the stock
price.
– This uncertainty creates an opportunity for investors to
speculate on the outcome of the deal.
– Traders who speculate on the outcome of the deal, when
the takeover offer is announced, are risk arbitrageurs.
51
Merger Arbitrage
• In September 2001, HP’s CEO Carly Fiorina announced that HP

would purchase Compaq by swapping 0.6325 share of HP for
each share of Compaq.
– After the announcement, HP traded at $18.87 per share,

while Compaq traded at $11.08 per share.
– Compaq’s share price implied by HP’s offer:
$18.87 × 0.6325 = $11.9353
– Difference in value= $11.9353 -$11.08 =$0.8553.
– Why?
52
Merger Arbitrage
• Just after the announcement, a risk arbitrageur would short
sell 6325 HP shares at $18.87 and simultaneously buy 10,000
Compaq shares at $11.08.
• If the takeover was successfully completed, he would be able

to exchange the 10,000 Compaq shares for 6325 HP shares to
close his short position.
6325 × $18.87 – 10,000 × $11.08 = $8553
• That way, he would have made $8553 profit (also known as

the merger-arbitrage spread).
• Is this a true arbitrage profit?
53
Merger Arbitrage Spread
for the Merger of HP and Compaq
54
Learning Outcomes
risk
6. Merger Arbitrage
55
NPV of an acquisition
‒ An acquisition can be accomplished through either a cash
offer or a stock offer.
‒ The NPV to the acquirer (A) is the difference between the
synergy obtained and the premium paid to the target (B):
NPV to acquirer = Synergy – Premium
𝑆𝑦𝑛𝑒𝑟𝑔𝑦 = 𝑉𝐴𝐵 − 𝑉𝐴 + 𝑉𝐵
Premium = Price paid for B – VB
‒ NPV to acquirer
= Synergy – Premium
= 𝑉𝐴𝐵 − 𝑉𝐴 + 𝑉𝐵 − 𝑃𝑟𝑖𝑐𝑒 𝑝𝑎𝑖𝑑 𝑓𝑜𝑟 𝐵 − 𝑉𝐵
= 𝑉𝐴𝐵 − 𝑉𝐴 − 𝑉𝐵 − 𝑃𝑟𝑖𝑐𝑒 𝑝𝑎𝑖𝑑 𝑓𝑜𝑟 𝐵 + 𝑉𝐵
= 𝑉𝐴𝐵 − 𝑉𝐴 − 𝑃𝑟𝑖𝑐𝑒 𝑝𝑎𝑖𝑑 𝑓𝑜𝑟 𝐵
56
In a Cash offer
NPV to acquirer
= Synergy – Premium
= 𝑉𝐴𝐵 − 𝑉𝐴 + 𝑉𝐵 − 𝑃𝑟𝑖𝑐𝑒 𝑝𝑎𝑖𝑑 𝑓𝑜𝑟 𝐵 − 𝑉𝐵
= 𝑉𝐴𝐵 − 𝑉𝐴 − 𝑉𝐵 − 𝑃𝑟𝑖𝑐𝑒 𝑝𝑎𝑖𝑑 𝑓𝑜𝑟 𝐵 + 𝑉𝐵
= 𝑉𝐴𝐵 − 𝑉𝐴 − 𝑃𝑟𝑖𝑐𝑒 𝑝𝑎𝑖𝑑 𝑓𝑜𝑟 𝐵
NPV to acquirer
= 𝑉𝐴𝐵 − 𝑉𝐴 − 𝐶𝑎𝑠ℎ 𝑝𝑎𝑖𝑑 𝑓𝑜𝑟 𝐵
57
In a Stock offer
The cost of acquisition depends on the
– number of shares given to the target stockholders
exchange ratio: number of new shares buyer offers in exchange for each seller’s share
– price of the combined firm’s stock after the merger
Target firm gets  α x New firm value  α VAB

New shares issued
 VAB
Old shares  New shares issued
n
 VAB
mn
n
Premium  VAB - VB
mn
NPV = 𝑉𝐴𝐵 − 𝑉𝐴 − 𝑃𝑟𝑖𝑐𝑒 𝑝𝑎𝑖𝑑 VAB𝑓𝑜𝑟 𝐵
Post merger price per share 
mn
n
= VAB - VA - VAB
mn 58
Cash offer versus Stock offer
– Sharing Gains
• In a cash transaction, shareholders of the target firm receive a fixed
price. They do not participate in the success/failure of the merger.
– Control
• In a cash transaction, there is no dilution of control.
• Acquirer signals confidence.
– Taxes
• In a cash transaction, target shareholders are deemed to have sold
their shares so they will have to pay taxes.
• In a stock transaction, target shareholders are deemed to have
exchange their shares so they will pay taxes when they eventually sell
the shares.
– Overvaluation
• If the target deems that its shares are overvalued, it will ask for cash. 59
Avoid Mistakes in Calculating the Value of the Firm
– Do not Ignore Market Values
In an efficient market, prices should reflect value. Use
market value to estimate existing value.
– Estimate only Incremental Cash Flows

Only incremental cash flows will add value.
– Use the Correct Discount Rate

Should reflect the risk associated with the use of the funds.
– Do not Forget Transactions Costs

Fees to investment bankers, legal fees and disclosure
requirements. 60
Method of Payment
• Cash offering
– Cash offering may be cash from existing
acquirer balances or from a debt issue.
• Securities offering
– Target shareholders receive shares of
common stock, preferred stock, or debt of
the acquirer.
• Factors influencing method of payment:

– Sharing of risk among the acquirer and
target shareholders.
– Signaling by the acquiring firm.
– Capital structure of the acquiring firm.
Based on data from Mergerstat Review, 2006.
FactSet Mergerstat, LLC (www.mergerstat.com). 61
Friendly versus Hostile Merger
• A friendly merger is one where the target’s board negotiates and accepts an offer.
• A hostile merger is one where the target’s board attempts to prevent the merger.
Friendly merger: Offer made through the Hostile merger: Offer made directly to
target’s board of directors the target shareholders
Approach target management. Types
• Bear hug
• Tender offer
Enter into merger discussions. • Proxy fight
Perform due diligence.
Enter into a definitive merger agreement.
Shareholders and regulators approve.

62
62
Learning Outcomes
risk
6. Merger Arbitrage
63
Defensive Tactics before firm is ‘in play’
Target makes shark repellent charter amendments to forestall takeover attempts.

For example:
– Stagger the terms of the BOD which increases the difficulty of electing
a new BOD quickly.
• Only a fraction of the board is elected each year, increase the time needed
to control the firm
– Require a supermajority (> 50%) shareholder approval for acquisition
• For example 2/3 majority for approving mergers
– Adopt poison pills which are measures taken by a target to make it
unattractive to bidders.
• existing shareholders have rights to buy additional shares at an attractive
price if a bidder acquires a large holding.
64
Defensive Tactics when firm is ‘in play’
– Adopt poison pills

• This may also be used when firm is “in play" -- PeopleSoft offer customers up
to 5 times their money back in the event of an Oracle takeover
65
66
Oracle's hostile bid hits PeopleSoft's earnings
9 July 2004, BT Singapore
• PeopleSoft …warned that the threat from Oracle had severely

dented its earnings and revenues in the past quarter.
• Uncertainty ... led customers to put off purchases of PeopleSoft's
software.
• .. .companies that buy,.. software made by PeopleSoft… expect such
investments to last many years, making them less willing to buy
new software if the future of the company behind it is in doubt.
• PeopleSoft used a controversial guarantee to maintain its sales,
offering customers up to 5 times their money back in the event of
an Oracle takeover.
67
Oracle / PeopleSoft
68
Managerial Resistance
– Management of the target activates press releases and mailings to shareholders.
– The resistance may be in pursuit of management’s own interest.
• Only 34% of target CEOs are retained as officers of the merged firm (Hartzell,
Ofek and Yermack, 2000)
69
Managerial Resistance
–Management of the target activates press releases and
mailings to shareholders.
–The resistance may be in pursuit of target management’s
own interest.
• Only 34% of target CEOs are retained as officers of
the merged firm (Hartzell, Ofek and Yermack, 2000)
• Use golden parachutes (compensation to target
management) to align interests.
–However, resistance may benefit shareholders if it results in
a higher offer from the bidding firm or another bidder. An
example is the Oracle-PeopleSoft takeover
70
Example where managerial resistance hurt shareholders
• The rise and fall of Yahoo

https://www.youtube.com/watch?v=Ec_IHQWyTXY
71
Yahoo Microsoft Saga
• Feb 1 2008, Microsoft (CEO Steve Ballmer) made an unsolicited
acquisition offer for Yahoo at $44.6 billion or $31 per share
– 62% premium over Yahoo’s stock price of $19.18
• Feb 11, Yahoo rejected Microsoft’s offer as being too low.
Asked for $35-$37
‒ Yahoo began looking for a white knight.
• Feb 22, two pension companies sued Yahoo and its BOD for
breaching their duty to shareholders by opposing Microsoft’s
takeover bid.
• Early March, Google CEO Eric Schmidt said he was concerned
that a Microsoft-Yahoo merger might hurt the internet by
compromising its openness.
• May 2, Yahoo’s stock closed at $28.67. 72
• May 3, Microsoft withdrew its bid. Yahoo stock price plunged to
$23.02
• May 15, Carl Icahn ( a well known corporate raider) started a proxy
contest to attempt a boardroom coup to oust Yahoo's management
at its August annual meeting.
• June 12, Yang issued statement that talks with Microsoft had ended
‒ Announced a search advertising alliance with Google. Many executives and
senior management announced plans to leave Yahoo. Lost confidence in
Yahoo’s strategies.
• July 7, Microsoft declared that it might consider another bid if
Yahoo’s 9 directors were ousted at the August annual meeting
– Able to better negotiate with a new board
• July 21, Yahoo appointed Carl Icahn and 2 of his allies onto an
expanded board. 73
• Aug 1, all directors were re-elected.
• Nov 20, Yahoo’s stock dropped to a 52 week low of $8.94.
• Nov 30, Microsoft offered to buy Yahoo for $20 billion
(1st offer at $44.6 billion).
• Jan 13 2009, Carol Bartz replaced Jerry Yang as CEO.

Stock price at $12.10
74
Feb Nov
So managerial resistance don’t always work in shareholders’ favor.
Scorched earth policies to make target less attractive. Target

undertakes Divestitures
– Increases corporate focus by getting rid of inefficiencies.
Before the firm is in play, target management puts off divesting. Why?
Because it is an admission that a bad choice was made initially. Bad
managers are less willing to correct mistakes.
– May also get rid of crown jewels to a friendly 3rd party
Target buys Assets that bidder does not want

– Makes target less appealing
– Purchase may pose antitrust problems for the bidder
76
Leveraged Recapitalizations
– Target issues debt to pay dividends
Stock price may rise because of interest tax shield. Makes
the acquisition offer less attractive.
Repurchases
– Target with a lot of cash uses the cash to buy back stocks.
This reduces the appeal of the firm to the acquirer.
Stock price may rise. Makes the acquisition offer less
attractive.
77
White Knight Defense: friendly bidder to outbid the Black
Knight
– Target facing a hostile takeover may arrange to be taken over by a
friendly suitor. The white knight may be favored because it is willing
to pay a higher price or because it promises not to lay off
employees, fire managers or sell off divisions. eg. Chevron acquired
Gulf Oil to avoid hostile takeover by T Boone Pickens (corporate
raider); Nissin’s friendly bid for Myojo Foods to fend off Steel
Partners.
White Squire Defense to prevent acquirer from gaining a

controlling interest
– In cases where target wishes to avoid the acquisition, a third party
may be invited to make a significant investment (to buy shares at
favorable prices) under the condition that it votes with management
eg Warren Buffett has acted as a white squire to many firms
including Gillette
78
Standstill Agreements
– Contracts whereby the bidding firm, for a fee, agrees to limit
its holdings in the target. Often the bidder also gives the
target the right of first refusal in the event that it sells the
shares.
Targeted Repurchase / Greenmail

– Target buys back its own stock from a potential acquirer,
often at a premium with the provision that the potential
acquirer promises not to acquire the firm for a specified
period of time.
79
Mickey Mouse vs Corporate Raider
Ron Miller Saul Steinberg
Disney Corp Chairman Well Known Corporate

Raider
Apr 83 - Disney trading at $84.38
Nov 83 - Disney trading at $62.38, announced 17% drop in earnings. Stock

price dropped further to $47.50
April 84 - Disney trading at $50. Steinberg announced that he had

purchased 6.1%
June 84 - Steinberg owned 12.1% and announced intention to purchase

25% of Disney. Disney bought Arvida Corp (a community and resort
developer, for $200m in stock) and attempted to buy Gibson greetings for
$300 million (principally in stock).
Steinberg announced OFFER to buy 49% of Disney at $67.50

Disney borrowed $325.5m to buy back Steinberg’s shares at $71.72 each 80
Empirical evidence on the reaction of stock prices to
takeover defenses are mixed.
Not always to the advantage of shareholders.
81
Learning Outcomes
risk
6. Merger Arbitrage
82
Do acquisitions add value?
– Empirical evidence show that between the period 1980 to
2001, small mergers created value (acquirer and target
combined) but mergers involving the largest firms have lost
value.
Agency Theory can explain why the biggest failures

involve large firms
– Managers of large firms are likely to have a smaller
percentage interest in their firm’s stock.
– Managers who own a smaller fraction of their firm’s stock
have less incentive to behave responsibly (agency cost of
equity).
83
Empirical Evidence
– Acquisitions benefit target’s shareholders. The median
merger premium is 37.9% over the period 1973 to 1998.
This is the difference btw the acquisition price and the pre-
acquisition price.
• Implies that we should be skeptical of target managers who resist
takeovers.
• Implies a hurdle for the acquiring shareholders who will lose if the
premium exceeds the synergies.
– A study (Harford Jarrad, 1999) found that cash rich bidders

are more likely to attempt acquisitions. They destroy 7 cents
for every dollar of reserves held.
• This is consistent with Free Cash Flow Hypothesis. The idea is that
managers can only spend what they have. Managers with CF above
what is needed for good projects have an incentive to spend them
on negative NPV projects because they are rewarded for growth.
84
Why Acquisitions fail to create value
– Most acquisitions fail to create value for the acquirer.

– Main reason is the failure to integrate the two companies
• Failure to convert client loyalty
• Failure to engage employee
• Difference in corporate culture
• Failure to share knowledge
• ……
– Traditionally, acquisitions deliver value when they result in
scale economies (horizontal mergers that lead to efficiencies in warehousing, volume
buying and corporate overhead), market power (makes it more difficult for competitors to
enter), better products (integration that allows superior production), better
services, or technology transfer. 85

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Introduction and Overview

• S.A. Ross, R.W. Westerfield and B.D. Jordan

• Corporate Finance addresses the following three main

Capital Capital Working Capital

• Grab confirmed its US$40 billion merger with Altimeter Capital.

Week 1: The Corporation and the Principal- Agent

• With separation of ownership and control, managers are expected to

• Instead of maximizing returns for shareholders, they may seek to protect

• In most large corporations, agency conflicts can be significant, because

• Instead of maximizing shareholder wealth, managers may seek to

• Bernie Madoff's name is also almost synonymous with the principal-agent

• At 100% ownership, the

• As the outside ownership

• What can be a solution for this

The $156 million includes:

• Shareholders elect BOD;

• In many corporations, the board is

• If the CEO is entrenched and

– Direct agency costs include perks consumed, and expenses to monitor

– Indirect agency costs include lost opportunities, e.g. a manager may

Share Retained Bank Bond

Residual Claims Contractual Obligations 27

• Two main components of capital structure:

– Equity holders (shareholders) can claim the residual value of a firm

• Priority of claim: debtholders > shareholders.

If the value of the firm is less

Combined Payoffs to debt holders

Each of the above can be achieved at the expense of

35 5 July 2011: $30.86

25 4 Sep 2014: $34.63

• AOL had spent heavily on direct mail advertising, including distribution of

• Security Exchange Council: Al Dunlap and Sunbeam's CFO used improper

• A strategy of manipulating a company’s income statement to make

– Maximise sales/market share

These goals may sometimes be achieved in ways that are detrimental to

• shareholder wealth maximization

• Does this mean we should do anything and everything to maximize

Pre-reading: “Why Share-Owner Value?” written in 1997 by the late

– allows us to contribute meaningfully to society

– keeps us from acting shortsightedly

CSR covers issues

Invests in social causes to

Creates new business

• shareholder wealth maximization

• Does this mean we should do anything and everything to maximize

And my answer to that is, no they do not.”

– Amount of cash flows expected by shareholders

• Reputation is important too.

o A compilation of impressions held by all of the entity’s stakeholders.

o Managing an entity’s reputation involves managing the perceptions and

Note: developed by Charles Fombrun of Reputation Institute to measure reputation value

To be considered, the corporation must generate at least $2 billion a year in annual

CF0 CF1 CF2 CF3

Answer depends on:

• Compound Interest: Interest is earned on the original

Solution: $500 + 3 yrs X 500(10%) = $650

Interest earned per year is the same

Interest earned per year

Year 1: 10% of $500 = $50 +500= $550

• The effect of compounding is small for a small number of periods but

FVt= PV(1 + r)t =$24 (1+0.05)392 = $4,857,541,024

Compared to Simple Interest:

FVt= PV(1 + r)t =$24 (1+0.10)392 = $403,779,088,891,871,000