Merged Seminar SOLNS

Problem Set 1
Course: Foundations of Finance

Term: Term 2, 2022
Welch, Chapter 1 and 2

To solve this problem set, you must study textbook chapters 1 and 2, in addition to the slides
from lectures 1 and 2. All material from the required textbook reading and in the lecture slides is
examinable. The problem set emphasizes the following topics:
• Lecture 1: investments as projects; cash in- and out-flows; project valuation; law of one price;
opportunity cost of capital; finance projects with debt / equity
• Lecture 2: time value of money; rates of return; present value; future value; net present value;
capital budgeting in perfect markets
1.∗ Shell and Royal Dutch merged in 1907 on 60-40 basis. Suppose that the value of one share of
Royal Dutch is £10. How much should a share of Shell cost, according to the law of one price?
Solution: To answer this question we apply the law of one price, which states that identical
assets should cost the same. In this case Shell and RD are in fact the same company:
revenues from both arms are pulled together and then distributed back to shareholders on
60-40 basis. So the price of Shell should be worth 1.5 times the share price of RD. Applying
the law of one price means that: P riceShell = 1.5 × P riceRD = 15
2.∗ What is the difference between owning a bond issued by a company, or owning shares in a
company?
Solution: When you lend money to a company your are a creditor or bond holder. You
make a loan to the company for a promised repayment at a later date. There is no upside in
this case; you cannot get more than the promised payment. Ownership amounts to owning
stock in the company. In this case, there is no promised rate of return. If the company
does well, you get paid a large amount, if not you get a small amount or even nothing.
Importantly, the bondholders are paid first, and then whatever is left accrues to stock
holders.
3.∗ The central bank has decided to cut interest rates, in an attempt to boost the economy. What
effect does this have on the time value of money? Would this announcement affect stock prices?
Solution: The time value of money has decreased, because with lower interest rates we
earn less on our savings. This announcement
P∞ would tend to increase stock prices. To see
i=1 CFi
this consider the formula P V = (1+r)i . The PV is the present value of the future cash
flows, so its the stock price. If everything stays the same and r decreases, the PV would go
up.
4.∗ In lecture 2 we explained the foundation of the NPV rule. Discuss whether positive NPV stocks
can be found in the stock market. [hint: think competition]
Solution: This depends to what assumptions we make about the stock market. If the
market is perfect, i.e., everyone has the same knowledge, no frictions etc, then everyone
will want to buy the positive NPV stocks because they are undervalued. However, in this
process the price of these stocks will rise, and this procedure will end when the NPV of the
stock is 0. In economic terms this is called an equilibrium, i.e., no one has the incentive to
trade any more. Such a market is also called efficient, because the prices reflect all available
information.
5.∗ Answer the following questions:

(a) What is the six-year discount factor at an annual interest rate of 12%
(b) The PV of £139 is £125. What is the discount factor?
(c) Suppose you invest £100,000 at 6%. How much will you have after 8 years?
(d) What is the PV of £37,400 to be received in 9 years if the interest rate is 9%?
(e) If the interest rate is 5% per annum how long will it take to double your money?
(f) An initial investment of £1,000 will return £1,150 in 18 months time. The interest rate
is 15% per annum. Calculate its net present value and the annualized rate of return it
provides.
1 1 139
Solution: a. DF = (1+r)T
= 1.126
≈ 0.51 b. 125 = x ⇒ x = 139/125 = 1.112
so DF = 1/1.112 ≈ 0.9 c. F V = 100, 000(1 + 0.06)8
= 100, 000 × 1.59 = 159384.81 d.
37,400 T ln2
P V = (1.09)9 = 17220. e. (1+0.05) = (1+100%)) ⇒ T = ln1.05 = 14.2 years approximately.
1150
f. a): N P V = −1000 + (1+0.15)1.5
= −67.50 b) 1000(1 + r)1.5 = 1150
3
(1 + r) 2 = 1.150
2
(1 + r) = 1.150 3
r = 0.09765 or 9.765%.
Here the exponent is 1.5, since we have 1.5 years.
6.∗ A firm with yearly net income of £50M has only two customers, each of whom makes identical
purchases once per year. Timely Tom makes his purchase today and at the start of next year,
while Late Louie makes his purchase half a year from today and halfway into next year (18
months from today). Late Louie, however, always pays 6 months late, i.e. at year end. What is
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the NPV of all cash flows to this firm in the next two years? Assume a yearly discount rate
of 5%. How much do you think the lateness of Louie is costing this company in present value
terms?[hint: think of this problem as one with 4 periods, each of which is 1/2 year in length].
Solution: To obtain the NPV of these semi-annual cash flows, however, we need to convert
the annual interest rate to a semi-annual one r = (1.05)0.5 − 1 ≈ 2.47%.
Each year, the firm earns 50M, equally divided between Louie and Tom. Thus, the cash
flows are:
Period 0 0.5 1 1.5 2

Cash Flow 25M 0 50M 0 25M
N P V = 25M + 50M/(1.0247)2 + 25M/(1.0247)4 = 95.294.

If Louie was not late the company would receive the following cash flows:
Period 0 0.5 1 1.5 2
Cash Flow 25M 25M 25M 25M 0
N P V = 25M + 25M/(1.0247) + 25M/(1.0247)2 + 25M/(1.0247)3 = 96.44 So lateness costs

roughly 1.146M.
7.∗ You purchase a house for £100,000 as an investment and pay an additional transaction fee
of 1% at the time of purchase. Your best alternative investment, i.e,, the opportunity cost of
capital (OCC) for this project, would have paid a return of 5% per year. Assuming that in one
year you plan to sell this house, which will then be worth price p. At that time you must also
pay a 6% of p as a brokers fee. What must p be in order for this investment to be at least as
good as its OCC?
Solution: The original investment is the sum of the house cost and the transaction fee, or
101,000. Your return on the home will be the sale price, p, minus 6%, or a net of .94*p. Then
solve the following, after discounting the future sale price by the original cost of capi-tal:
101000 = .94p/1.05. Thus, break-even p = 112,819. Confirming: 0.94×112,819
101000 −1 ≈ 0.05.
8.∗ On April 12 2006 Microsoft stock traded for $27.11 and claimed to pay an annual dividend of
$0.36 per share. Assuming that the first dividend will be paid in one year, and that it then
grows by 5% each year for the next 4 years. Further assume that the appropriate cost of capital
for Microsoft is 6% per year. At what price would you have to sell Microsoft in 5 years to break
even?
Solution: Recall that we are still doing the calculation being at t = 0. In effect we are asking
what should be the price in 5 years so that we break even (NPV=0), if we buy the stock today.
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Answer: The cash flows are:
Time
0 1 2 3 4 5
Cash Flow –$27.11 $0.36 $0.378 $0.3969 $0.4167 $0.4376
Discount Factor 1.0000 0.9434 0.8900 0.8396 0.7921 0.7473
Present Value –$27.11 $0.340 $0.336 $0.333 $0.330 $0.327
The
PV of the dividend stream is 1.67, so the NPV is -27.11 + 1.67 =-25.44.
Out total NPV if we were to sell this stock at a price x in .5 years would be: N P V =
−27.11 + 1.67 + x/1.065
We need to solve for x that sets the NPV=0.
This is equal to 25.44 × 1.06^5 ≈ 34.04.
References
Welch, I. (2017). Corporate finance (4th ed.).
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Foundations of Finance: Seminar 2.
1. A movie producer is in desperate need of funds for a new movie. The only source of
income available to him is his brothers house, which could be rented out for a period
of 5 years until his brother returns from working aborad. A potential tenant offers
to pay £12,000 per year at the end of each of the 5 years for the right to live in the
house. The six-month interest rate (OCC for this project) is 4%. How much money
can this producer collect right now from the house to finance the movie?
Answer
The amount than can be collected is the price (PV) of this annuity, which pays 12K
per year, with a six-month interest rate of 4%.
The first thing to do is to calculate the annual interest rate: (1+0.04)2 = (1+0.0816).
So annual r =8.16%.
P V = 12,000
0.0816
1
.[1 − 1.08165 ] = 47, 711.15
Of course this assumes that markets are fully perfect, and therefore every project can
be traded at its present value.
2. In 2000, the P/E ratio of the stock market reached about 45. If you assume that
these corporations will grow roughly at the overall economy’s (GDP) growth rate of
5% per year, what rate of return should investors expect to earn from investing in
stocks?[hint: the OCC is the expected rate of return]
Answer
E E E
Using the GGM: P = r−g ⇒r−g = P
⇒r= P
+g
r = 5% + 1/45 ≈ 7.2%
3. A tall Starbucks coffee costs 1.65 a day. If the banks quoted interest rate is 6% per
annum and if the price of the coffee never changed what would an endless inheritable
free subscription to one Starbucks coffee per day be worth today [hint: you will need
to calculate the daily interest rate that when compounded results to an annual r of
6%.
Answer
First we need to get the daily interest rate that implies an annual 6%.
(1 + r)365 = (1.06) ⇒ 1 + r = 1.061/365 ⇒ r = 0.016%.
The perpetuity is then worth 1.65/0.00016 ≈ 10334.9.
This is a perpetuity because it is inheritable.
4. How would your answer change if the subscription was not inheritable, assuming that
you expect to live N more years? Write out the relevant formula.
Answer
This is now an annuity, which pays £1.65 per day for N more years.
1.65
P V = 0.00016 [1 − 1.000161N×365 ]
1
5. Suppose that the price of the coffee increases by 3% per year. What is the perpetuity
worth now?
Answer
Growing perpetuity is CF 1/(r − g).
We need to find the daily growth rate that implies annual increase by 3%. Following
the procedure above we get 0.000081.
However, the coffee would increase in price next day by this much so, the price of the
coffee tomorrow would be 1.65 × (1 + 0.000081) = 1.650134
1.650134
⇒ (0.00016−0.000081) = 20887.77
6. After a successful career as a hedge fund manager you want to fund a new Arts center
in Warwick University, financing its operations forever. Every five years will donate
£5M, and the first payment will occur 5 years from today. If the interest rate is 8%
per year, what is the value of this gift today? [hint: you need to calculate the five
year interest rate].
Answer
First we need the five year rate (easier to think of this problem in periods of five years).
This is equal to (1.08)5 = 1.4693 so r=46.93%. The cash flows are a perpetuity so
P V = 5000000
0.4693
≈ 10, 654, 165.8
7. Company ABC has two different kinds of bonds outstanding. Bond M has a face
value (FV) of £20,000 and matures (T) in 20 years. M makes no payments for the
first 6 years, then pays £1,200 every six months over the subsequent 8 years, and
finally pays £1,500 every six months for the final 6 years. N is a zero-coupon bond
with FV=£20,000 and T=20. The appropriate opportunity cost of capital for these
bonds is 5% per six-months. Find out the price of M and the price of N today. Before
you do any calculations, which bond do you think will have the highest price? Why?
Answer
M will have the highest price because it makes interim payments. The last payment
is the same for both bonds, therefore M will cost more than N by an amount equal
to the present value of the interim payments.
Bond M is basically the sum of the following:
One annuity that starts in 6 years and pays £1,200 every six months for 8 years so
1200
0.05
(1 − 1.051 16 ) = £13005.32.
Now this is however the value of the annuity at the of year 6 (12 6-month periods).
To get the PV we discount it to the present: 13005.32
1.0512
= 7241.85
A second annuity then starts for 6 years, paying £1,500 every six months:
1500
0.05
(1 − 1.051 12 ) = £13294.88.This is the value at the end of year 14, so we need to
discount it to get the PV 13294.88
1.0528
= 3391.439
20000
Finally the PV of the face value of the bond payable in 20 years is 1.05 40 = 2840.914
The price (PV) of the bond M is therefore = 7241.85 + 3391.439 + 2840.914 = 13474.2
20000
The price of N is 1.05 40 = 2840.914. Therefore PM > PN .
2
8. The prevailing cost of capital is 9% per annum. Determine the relevant valuation
metric for each project under the 4 different valuation rules [use Excell’s IRR func-
tion, =IRR(cells with cash flows), for the IRR rule]. What are the advantages and
disadvantages of IRR, PI and payback rules?
Project Y0 Y1 Y2 Y3 Y4
A -1000 300 400 500 600
B -1000 150 200 1000 1200
C -2000 1900 200
D -200 300
E -200 300 0 -100
Answer
Project NPV IRR PI Payback
A 423.05 24.89% 1.423 3
B 928.24 34.49% 1.928 3
C -88.54 4.56% 0.956 2
D 75.23 50% 1.376 1
E -1.99 0% 0.99 1
3
Problem Set 3: Bonds, Uncertainty, Default and Risk Attitude

Term: Term 2, 2020
Due: Week 4
Welch, Chapters 5 and 6

To solve this problem set, you must study textbook chapters 5 and 6 and previously assigned
chapters, in addition to the slides from lectures 5 and 6, and previous lectures. All material from
the assigned textbook reading and in the lecture slides is examinable. The problem set emphasizes
the following topics:
• Lecture 5: bonds; zero coupon vs coupon bonds; bond pricing and ytm calculations; how
interest rate changes and time affect the price of bonds; yield curve
• Lecture 6: mean and variance of a random variable; risk attitude and utility functions; npv in
the presence of uncertainty and risk neutrality; distinguished between promised and expected
returns; time and default premiums
1.∗ A 25-year zero coupon bond costs £25, 000 today and will repay £50, 000. What is its YTM?
Solution: For help with this problem, refer to chapter 5.1.

50,000
The YTM is the solution to: −25, 000 + (1+r)25
=0
1
(1 + r)25 =2⇔r=2 25 − 1 ≈ 2.81%
2.∗ Suppose a firm issued a bond with 10 years until maturity, a face value of 1000, and a coupon
rate of 7% (annual payments). The YTM is a constant 6%.
(a) What was the price of the bond when it was issued?
(b) What is the price of the bond immediately before the first coupon payment?

(a) The coupon payment is 1000 × 0.07 = 70
The price of the bond is an annuity of 70 for 10 years plus the payment of the face
value in 10 years.
70 1 1000
Price= 0.06 (1 − 1.06 10 ) + 1.0610 = 1073.6.
(b) Immediately before its first coupon payment its price was:
70 1 1000
70 + 0.06 (1 − 1.069 ) + 1.069 = 1138.017
Notice that immediately before the first coupon payment there is no time value of
money issue, so it is not discounted. The rest is an annuity of £70 for 9 years, plus the
PV of the payment of the face value in 9 years.
3.∗ Consider the following £100 face-value bonds:

Bond Coupon rate Maturity
(annual pay- (years)
ment)
A 0% 15
B 0% 10
C 4% 15
D 8% 10
(a) What is the percentage change in price of each bond if its YTM falls from 6% to 5%?
(b) Which of the bonds is most and least sensitive to a 1% drop in interest rates from 6% to
5%? Provide some intuition for your answer.
recall that the equation for coupon bond
prices is P = CP N × Y T M 1 − (1+Y T M )N + (1+YFTVM )N
1 1

(a) We need to compute the price of each bond at each YTM using the equation above.
For the coupon bonds, CPN is calculated as F V × coupon rate.
Bond P(YTM 6%) P(YTM 5%) % change
A 41.73 48.10 15.3%
B 55.84 61.39 9.94%
C 80.58 89.62 11.2%
D 114.72 123.17 7.4%
(b) Bond A is more sensitive because it has the longest maturity and no coupons. Bond D
is the least sensitive. Intuitively, higher coupon rates and shorter maturity typically
make a bond less sensitive to interest rate changes.
4.∗ An L.A. Lakers’ bond promises to pay a return of 9%. A government bond with the same time
to maturity promises to pay 5%. Is the Lakers bond a good investment?

Not, necessarily. Most probably the Lakers have a higher probability of default so the
expected returns from the Lakers’ bond maybe lower.
5.∗ A bond will pay off £100 with probability 99% and nothing with probability of 1%. The interest
rate is 5%. What is the price of this bond under risk neutrality? What is its promised rate of
return? Decompose its promised rate of return into a time and default premium.
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Solution: For help with this problem, refer to chapters 6.1 and 6.2.
The bonds expected payoff is 0.99 × 100 = 99. Given that we are risk neutral the expected
return must be 5%. So 99/P − 1 = 0.05 ⇒ P = 94.28.
100-94.28 = 6.06%.
At this price the promised rate of return is
94.28
6.06% = 5% + 1.06%, time premium+default premium
√
6.∗ Suppose that B. Griffin with initial wealth W0 = 20.5 has the utility function U (W ) = W,
and is faced with an investment that yields £4.5 with pG =50% probability, and −£4.5 with
pB = 50% probability. If there is no cost to play this gamble, would BG accept it?
Solution: For help with this problem, refer to chapters 6.1.

BG in this case would compare his utility without the gamble, with his expected utility if
he plays the gamble, and choose the
√ alternative with the highest utility.
Utility without gamble: U (W ) = 20.5 ≈ 4.53
Expected Value (EV ): 0.5 × (20.5 + 4.5) + 0.5 × (20.5 − 4.5) = 20.5
Expected utility √
with the gamble: EU √(W ) = pG × U (W0 + 4.5) + pB × U (W0 − 4.5)
EU (W ) = 0.5 × 20.5 + 4.5 + 0.5 × 20.5 − 4.5 = 4.5
Since 4.53 > 4.5 BG would not play the gamble. This is of course the case since he is risk
averse and would therefore reject a fair gamble.
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References
Page 4
Problem Set 4: Risk, Return, and Beta

Term: Term 2, 2020
Due: Week 5
Welch, Chapters 7 and 8

To solve this problem set, you must study textbook chapters 6, 7, and 8 and previously assigned
chapters, in addition to the slides from lectures 7 and 8 and slides from previous lectures. All
material in required readings and in lecture slides is examinable. This problem set emphasizes the
following topics:
• Lecture 7: computing project prices under uncertainty; deriving promised and expected returns
for risk-neutral investors; project risk, equity risk, and debt risk; risk and return relationships
in real-world data.
• Lecture 8: project valuation under uncertainty and risk aversion; benefits of diversification;
efficient frontier; justification for holding the tangency portfolio; beta as a measure of risk.
1.∗ A factory can be worth £500,000 or £1,000,000 in two years depending on product demand,
and each outcome has equal probability. The appropriate cost of capital is 6% per year. The
cost of building the can be funded using either retained earnings, or using a £500,000 loan and
some equity.
(a) Assuming risk neutrality, what is the expected rate of return for the factory when retained
earnings are used to fund the factory?

In the unlevered equity case, the expected factory value in two years is 0.5 × 500, 000 +
0.5 × 1, 000, 000 = 750, 000. Its present value (price) is therefore 750, 000/1.062 =
667, 497. The expected rate of return is 750, 000/667, 497 − 1 = 12.36%.
(b) Assuming the loan it taken, what are the promised and expected rates of return for the
lender? What is the expected rate of return for the levered equity holder? [Hint: you need
to calculate the two-year cost of capital].

Bond holder: This is a risk neutral world so the bond must pay 1.062 × 500, 000 = 561,
800 in two years time, in expectation. The bond in the bad state pays 500,000. It must pay
x in the good state to equal 561,800 in expectation. So 0.5×500, 000+0.5×x = 561, 800 ⇔
x = 623, 600. The promised rate of return is therefore 623, 600/500, 000−1 = 24.72%.
The expected rate of return is 561, 800/500, 000 − 1 = 12.36%.
Levered Equity holder: Equity investors must pay the difference between the price of
the project and the money received from the loan 667, 497 − 500, 000 = 167, 497. The
expected equity payoff in the good state is 1,000,0000-623,600=376,400 and in the bad
state is 0, for an expected payoff of 0.5 × 376, 400 = 188, 200. The expected rate of
return is thus 188, 200/167, 497 − 1 = 12.36% (6% p.a., compounded).
2.∗ In the above question, what is the risk of the bond and the risk of the stock, as measured by
the standard deviation of returns across states of nature? Explain the implications of this risk
under the assumption that investors are risk neutral.
To calculate risk we need to find how much these assets pay in the good and the bad state,
and calculate the standard deviation in percentage terms.
Bond: E[r] = 12.36%. In the good state it pays the promised return of 24.72% so the mean
deviation is 24.72 − 12.36 = 12.36%. In the bad state the project pays £500,000, so return
is 0, making the mean deviation −12.36%.
To find the standard deviation, square the mean deviations, weight them by the probabilities
of the good and bad states, and sum over states to get the variance, Var(r) = 152.76. The
standard deviation is sd(r) = 12.36%.
Equity: E[r] = 12.36%. In the good state it pays 376, 400/167, 497 − 1 = 124.72%. In the
bad state it pays -100%. With an E[r] = 12.36%, the standard deviation is sd(r) = 112.36%
Remark: Equity is clearly riskier than the bond yet both have the same expected return.
This is a consequence of risk neutrality. Investors do not care about risk, only about E[r].
However, if the risk neutrality assumption were relaxed and we recognized that investors
are generally risk averse, then stocks would offer a higher expected return than bonds.
3.∗ Consider the following assets, where the probabilities for the three states are equal.
State 1 2 3
M -5% 5% 15%
X -3% -2% 25%
Y -6% -4% 30%
Asset M is the market portfolio, while assets X and Y are individual securities.
(a) Compute the correlations between X and M , and between Y and M .
(b) Compute market betas for the assets X and Y .
(c) You are choosing between a portfolio with 90% wealth in M and 10% in X, and a second
portfolio with 90% wealth in M and 10% in Y . Which portfolio is riskier?

Compute these values using a spreadsheet, or by hand using the formulas in the lecture
slides. The portfolio with M and Y is riskier because the correlation between M and
Y is higher.
4. Identify whether the following risks can be diversified away:
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(a) your production plant shuts down due to a tornado.
(b) the central bank raises interest rates.
(c) energy prices spike.
(d) an R&D investment does not yield a patent.
(a) Yes.
(b) No.
(c) No.
(d) Yes.
5. Explain what we mean when we say that portfolio X is efficient.

An efficient portfolio is one that maximizes return for a given level of risk (or minimizes
risk for a given level of return). Assume X yields expected return E[rx ] = z%. Then X is
efficient if among all the portfolios that also yield z%, portfolio X has the lowest risk. You
may find it useful to draw a diagram to illustrate the frontier of efficient portfolios.
6.∗ An employee working for Apple Inc. wants to invests in stocks, and the employee decides to
buy shares of Apple Inc.’s stock. From the perspective of risk and diversification, is this a good
investment decision? Explain.

If the investor is risk averse, then the investor has made a bad decision. The investor is paid
a salary or wage by Apple Inc, and if Apple Inc. does poorly then the investor’s wage may
rise at a slower rate, may fall, or in extreme cases the investor may become unemployed.
At the same time, the income the investor earns from their stock investment will also fall.
The investor will enjoy no benefits from diversification. The investor would be better off
investing in assets uncorrelated (or even negatively correlated) with the performance of
Apple Inc.
7.∗ Consider an economy with two types of firms, S and I. For any two firms i and j of type S,
returns ri and rs are perfectly correlated: ρSi,j = 1. For any two firms i and j of type I, returns
ri and rs are perfectly uncorrelated: ρIi,j = 0. Each individual firm, regardless of type, has a
60% probability of earning a 15% return, and a 40% probability of earning a -10% return.
(a) Find the standard deviation of returns on a portfolio that equally weights type S firms.
(b) Find the standard deviation of returns on a portfolio that equally weights type I firms.
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First calculate the expected returns and variance of returns:
E[rS ] = E[rI ] = 0.6 · 0.15 + 0.4 · (−0.1) = 0.05

Var(rS ) = Var(rI ) = 1.5%.
For portfolios, recall that:
Var(rp ) = σp2 = wx2 σx2 + wy2 σy2 + 2wx wy ρxy σx σy .
Denote the two portfolio returns rpS and rpI . Using the above formula, compute the variance
of the portfolio returns as:
Var(rpS ) = σp2S = 0.52 · 1.5% + 0.52 · 1.5% + 2 · 0.52 · 1 · 1.5% = 1.5%

Var(rpI ) = σp2I = 0.52 · 1.5% + 0.52 · 1.5% + 2 · 0.52 · 0 · 1.5% = 0.75%
Portfolio S enjoys no benefits from diversification since ρ = 1. In portfolio I risk is halved

due to diversification since ρ = 0.
8. PepsiCo has a mean return of 16.1%, a return standard deviation of 27.4% and a market beta
of 0.84. Sony has a mean return of 20.3%, a return standard deviation of 63% and a market
beta of 1.49. Explain the factors that influence the average returns on these stocks.

PepsiCo has a lower beta than Sony, therefore it has lower expected returns. It offers some
diversification benefits, so risk averse investors accept a lower return to hold it.
Conversely, Sony has a higher beta, therefore it offers fewer diversification benefits. Risk
averse people are less willing to hold it, therefore its price is lower and its expected return
is higher. If an asset has a high beta, risk averse investors are reluctant to buy the asset,
and the asset’s market price is relatively lower. All else equal this implies that the asset’s
expected return is relatively higher.
9.∗ Should higher or lower variance projects offer higher rates of returns?

Returning back to the example, notice that the mean return of Sony is roughly 4% higher
than the mean return of PepsiCo, whereas the σ of Sony is more than double that of
PepsiCo. This reminds us that not volatility, but rather covariance with the market matters
to investors. [Beta measures covariance with the market, relative to market variance.
Rational investors will hold the market portfolios, so the beta of the project with
respect to the market portfolio matters for risk.]
Page 4
References
Page 5
Foundations of Finance (IB1320): Seminar 5
Based on lectures 9 and 10.
Below is a list of useful formulae for this seminar just as a friendly reminder. You should already know
these by now (and you will not be given these in tests/exams):
1. CAPM: 𝐸(𝑟𝑖 ) = 𝑟𝑓 + 𝛽𝑖 (𝐸(𝑟𝑚 ) − 𝑟𝑓 )

𝑐𝑜𝑣(𝑟𝑀 ,𝑟𝑖 ) 𝜎𝑚 𝜎𝑖 𝜌𝑚,𝑖 𝜎𝑖 𝜌𝑚,𝑖
2. Beta: 𝛽𝑖 = 2 = 2 = , with standard deviation of a random variable
𝜎𝑚 𝜎𝑚 𝜎𝑚
x as the square root of its variance, i.e., 𝜎(𝑥) = √𝑣𝑎𝑟(𝑥).
3. A portfolio’s expected return: 𝐸(𝑟𝑝 ) = 𝑟𝑓 + 𝛽𝑝 (𝑟𝑚 − 𝑟𝑖 ), Where 𝛽𝑝 = Σi∈{portfolio} 𝑤𝑖 𝛽𝑖
and 𝑤𝑖 is the weight of the value of asset 𝑖 in the portfolio.
𝐸(𝐶𝐹 )
4. PV of a risky cash flow at time t: 𝑃𝑉 = (1+𝑟)𝑡 𝑡
5. Suppose 𝑃𝑎 is the ask price and 𝑃𝑏 is the bid price, then 𝑃𝑎 > 𝑃𝑏 . [“Brokers buy at the
bid”, so the investors buy at the ask price].
1+ 𝑅
6. 1 + 𝑟 = 1+𝜋 , or 𝑟 ≈ 𝑅 − 𝜋 , where 𝑟 here represents the real return, 𝜋 is the inflation
rate, and 𝑅 represents the nominal return.
7. Capital budgeting with inflation, 1 period:
𝐸(𝐶𝐹𝑟𝑒𝑎𝑙 ) 𝐸(𝐶𝐹𝑛𝑜𝑚𝑖𝑛𝑎𝑙 ) 𝐸(𝐶𝐹𝑟𝑒𝑎𝑙 )⋅(1+𝜋)
𝑃𝑉 = 1+𝑟 = (= ), the first “=” shows how to calculate PV
1+𝑅 1+𝑅
in real terms, the second “=” shows how to calculate PV in nominal terms, and third
“=” shows that the PV remains the same regardless of whether to use real terms or
nominal terms.
8. 𝐶𝐹𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 = 𝐶𝐹𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥 (1 − 𝜏𝑐 )= 𝐸[𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑡 − 𝑐𝑜𝑠𝑡𝑡 − 𝑝𝑟𝑜𝑓𝑖𝑡𝑡 × 𝜏𝑐 ]
9. Tax adjusted cost of capital = (𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙) × (1 − 𝜏𝑐 )

𝐸[𝐶𝐹1,𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 ] 𝐸[𝐶𝐹2,𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 ]
10. With 3-period cash flow, 𝑃𝑉 = 𝐶𝐹0,𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 + + , where 𝑟𝑡,𝑡+1 is
1+𝑟0,1 (1+𝑟0,1 )×(1+𝑟1,2 )
the tax-adjusted cost of capital.
𝑎1 (1−𝑞𝑛 )
11. The formula for the summation of geometric sequence is Σ(a1 + 𝑎2 … . +𝑎𝑛 ) = 1−𝑞
,
where 𝑎1 is the first term, and 𝑞 is the common ratio.
Question 1. The risk-free rate is 4%, the market portfolio has an expected return of 𝐸[𝑟𝑀 ] = 10%, and a
standard deviation of 𝜎𝑀 = 16%. The return 𝑟𝐽 on JNJ Co. stock has a variance of Var(𝑟𝐽 ) = 4% and a
correlation with the market return of 𝜌𝑀,𝐽 = 0.06. What is JNJ’s beta with respect to the market? What is its
expected return according to the CAPM?
Cov(𝑟𝑀 ,𝑟𝐽 )
Recall the definition of beta: 𝛽𝐽 = .
Var(𝑟𝑀 )
The covariance is given by
Page 1 of 5
Cov(𝑟𝑀 , 𝑟𝐽 ) = 𝜎𝑀 ⋅ 𝜎𝐽 ⋅ 𝜌𝑀,𝐽
= 0.06 ⋅ 0.2 ⋅ 0.16 = 0.00192.
0.00192
Now beta can be computed as 𝛽𝐽 = = 0.075. Using the capital asset pricing equation, JNJ Co.’s return
0.162
is given by 𝐸[𝑟𝐽 ] = rf + 𝛽𝑗 ⋅ (𝐸(𝑟𝑀 ) − 𝑟𝑓 ) = 0.04 + 0.075 × (0.1 − 0.04) = 4.45%.
Question 2. Suppose Intel stock has a beta of 2.16, whereas Boeing stock has a beta of 0.69. If the risk free
interest rate is 4% and the expected return on the market portfolio is 10%, what is the expected return on a
portfolio of 60% Intel stock and 40% Boeing stock, according to the CAPM?
We’re given betas for two stocks, and we want to find the return that CAPM implies for a portfolio with 60-40
weights. For that we need the portfolio’s beta:
𝛽𝑝 = 0.6 × 2.16 + 0.4 × 0.69 = 1.572.
Now we can use the capital asset pricing equation to compute the portfolio return that the model predicts:
𝐸(𝑅𝑝 ) = 4% + 1.572 × (10% − 4%) ≈ 13.4%.
Question 3. A lottery ticket costs £1 and gives you 1 in 14 million chances of winning £20 million. The lottery
winner receives 20 installments of 1 million over 20 years with the first installment occurring immediately.
Winnings are taxed at the marginal rate of 40%. The appropriate after-tax discount rate is 10%. What is the
NPV of the lottery?
The after-tax installment in the event that you win is (1 − 0.4) ⋅ 1𝑀 = £600,000. You win with 1/14M
1
probability, so expected cash installment is = 𝐶𝐹 ⋅ (1 − 𝜏) ⋅ Pr(winning) = £600,000 ⋅ 14,000,000 ≈ £0.04.
Using the annuity formula, the present value of the stream of expected installment payments is given by
1 20
CF0 ⋅ (1 − (1.1) )
0.04 × 1.1 1 20
𝑃𝑉 = = ⋅ [1 − ( ) ] ≈ £0.4
1 0.1 1.1
1−
1.1
It would make sense to purchase a lottery ticket if the present value of expected installment payments were
greater than or equal to the cost of the ticket—i.e., if the net present value were positive. The net present
value is
𝑁𝑃𝑉 = −£1 + £0.4 = −£0.6 < 0,
Page 2 of 5
Question 4. A project of Firm A will generate taxable profits of 500M next year. The after-tax cost of capital for
the firm is 15%, and the firm is all equity financed. The firm’s marginal tax rate on profit is 25%. What is the
project’s present value?
Solution:
Tax paid is 500 × 0.25 = 125. So the value next period will be 500-125=375.
Discounted at 15%: 375/1.15= £326.087M.
𝐶𝐹 (1−𝜏𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 )⋅𝐶𝐹𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥 (1−25%)⋅500𝑀
Or simply 𝑃𝑉 = 1+𝑟𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 = =
𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 1+𝑟𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 1+15%
Question 5. A firm is undertaking a two-stage project. The first stage is a yearlong R&D project with an upfront
cost of £1 million. This stage is risky and capital costs 15%. After one year, if the R&D project succeeds (with
80% probability), the second stage is a factory that costs £10 million upfront and generates £20 million after
one year. The second stage is safe and capital costs 6%. If the R&D project is not successful, then no further
cash flows at the second stage.
a) Assume there are no taxes. What is the value of this project?
Solution:
With no taxes: 𝑟0,1 = 15%, 𝑟1,2 = 6%. Therefore,
E(C1 ) E(C2 ) −10m 20m
PV = C0 + + = −1m + 0.8 × [ + ] = £5.168m
1 + 𝑟0,1 (1 + 𝑟0,1 ) ⋅ (1 + 𝑟1,2 ) 1.15 1.15 × 1.06
b) Assume the firm pays a marginal tax rate of 33%. If the firm equity-financed, what is the PV of the
project?
Solution:
With taxes, the firm’s capital costs must be adjusted: The tax-adjusted first- and second-stage costs of
capital are 𝑟0,1 = (1 − 0.33) × 0.15 ≈ 10% and 𝑟1,2 = (1 − 0.33) × 0.06 ≈ 4%, respectively. Taxes
are paid on the profits that the project generates. In this case we incur a cost in year 0, which is the
R&D project. Then, if the project is successful, we incur another cost to build the factory in year 1. After
that we have inflows in year 2, and we need to calculate profit therefore by comparing inflows in year
2 with costs in year 0 and year 1.
Using #10 in the formula sheet, with all-equity:
−10m 20m − (20m − 10m − 1m) × 0.33
PV = −1m + 0.8 × [ + ] = £3.636m
1 + 10% 1.1 × 1.04
Question 6. A project yields a nominal cash flow of 100,000 in one year (𝐶1 ) and a real cash flow of 170,000 in
two years time (𝐶2 ). The project costs 95,000 today. The real interest rate 𝑟0,1 is 2%, and the nominal interest
rate for the following year 𝑅1,2 is 4%. Inflation for the next year is 1.5%, and then grows by 20% the year after.
Calculate the project’s 𝑁𝑃𝑉.
Page 3 of 5
Recall that for the answer to be correct both numerators and denominators must be expressed on the same
basis. This means we need to use either all real quantities, or all nominal quantities. The formula that links real
and nominal returns is:
(1 + 𝑅)
(1 + 𝑟) = , or
(1 + 𝜋)
𝑟 ≈ 𝑅 − 𝜋.
In nominal terms first:
• The nominal interest rate: 𝑅0,1 = (1 + r0,1 ) ⋅ (1 + π0,1 ) − 1 = 1.02 ⋅ 1.015 − 1 = 3.53%
• The inflation in the second year: 𝜋1,2 = π0,1 ⋅ (𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 + 1) = 0.015 ⋅ 1.2 = 1.8%
• The nominal cash flow in second year: 𝑛𝑜𝑚𝑖𝑛𝑎𝑙(𝐶2 ) = real(C2 ) ⋅ (1 + π0,1 ) ⋅ (1 + π1,2 ) = 170,000 ⋅
1.015 ⋅ 1.018 ≈ 175,656
100000 175,656
• The net present value: 𝑁𝑃𝑉 = −95,000 + + (1.0353⋅1.04) ≈ 164,731
1.0353
Now in real terms:

• The real interest rate: 𝑟1,2 = 1.04/1.018 − 1 = 0.0216
nominal(C1 )
• The real cash flow in year one: 𝑟𝑒𝑎𝑙(𝐶1 ) = = 100,000/1.015 = 98,522.17
1+𝜋0,1
98,522.17 170,000
• The net present value: 𝑁𝑃𝑉 = −95,000 + + 1.02×1.0216 ≈ 164,731
1.02
Note that accounting for inflation does not affect PV because both expected cash flows and 𝑂𝐶𝐶’s are
adjusted in the same way. However, this does not mean that inflation is unimportant, because inflation still
affects real returns, which is what investors care about.
Question 7. The bid price of an IBM share is currently £212 and the ask price is £215. If you invest in IBM, and
IBM’s value rises by 1.17% in one year, what is the annual return on your investment?
At the end of the year, the bid and ask prices have increased by 1.17% to 𝑃𝑏′ = £214.48 and 𝑃𝑎′ = £217.51,
respectively. Recall that the market maker sells at the ask price, so you buy at the ask price. Likewise, the
market maker buys at the bid price, so you sell at the bid price.
Since one-year elapses between when you buy and when you sell, your return will be:
𝑃𝑏′ − 𝑃𝑎
𝑟 =
𝑃𝑎
214.48 − 215
= ≈ −0.24%.
215
Page 4 of 5
Alternatively, you can use the bid-ask spread to compute the return. Using the bid-ask defined as follows,
𝑃𝑎 − 𝑃𝑏
Spread =
𝑃𝑎
𝑃𝑎′ − 𝑃𝑏′
= ≈ 0.014,
𝑃𝑎′
We can write the return alternatively as
𝑃𝑎′
𝑟 = (1 − Spread) − 1
𝑃𝑎
217.51
= (1 − 0.014) − 1 ≈ −0.24%.
215
Question 8. Sam is the manager of a company and wants to calculate the present value from expanding the
operations of his company abroad. He calculates that the expected cash flow of the company will be £1 million
at the end of Year 1 and grow at 3% from Year 2 to the end of Year 5. Sam estimates that the appropriate cost
of capital for this project is 7% per year. However, Sam is overconfident and has overestimated the expected
cash flows, the growth rate and the OCC all by 20%. By how much does Sam overestimate the present value
of this project due to his overconfidence?
Solution:
To calculate how much Sam’s overconfidence costs in PV terms we must calculate the PV of the project using
his numbers, and the PV of the project using the correct numbers and take their difference.
First Sam’s estimation is:
𝐶𝐹 1+𝑔 𝑇 1𝑀 1.03 5
𝑃𝑉𝑆𝑎𝑚 = [1 − ( ) ]= [1 − ( ) ] = £4,336,340.17
𝑟−𝑔 1+𝑟 0.07 − 0.03 1.07
Now use correct numbers in the present value calculation:

The cash flow is 1𝑀/1.2 = 833,333.3. The OCC is 7%/1.2 = 5.8%. The growth rate is 3%/1.2 = 2.5%.
𝐶𝐹 1+𝑔 𝑇 833,333.3 1.025 5

𝑃𝑉𝐶𝑜𝑟𝑟𝑒𝑐𝑡 = [1 − ( ) ]= [1 − ( ) ] = 3,700,116.97
𝑟−𝑔 1+𝑟 0.058 − 0.025 1.058
So, Sam overestimates the PV of the project by

£4,336,340.17 − £3,700,116.97
= £636,223.2
Page 5 of 5
This seminar is based on Lectures 11 and 12.
Below is a list of useful formulae for this seminar just as a friendly reminder. You should already know these by
now (and you will not be given these in tests/exams):
1. CAPM: 𝐸(𝑟𝑖 ) = 𝑟𝑓 + 𝛽𝑖 (𝐸(𝑟𝑚 − 𝑟𝑖 )

𝐸 𝐷
2. Unlevered beta: 𝛽𝑈 = 𝐷+𝐸 𝛽𝐸 + 𝐷+𝐸 𝛽𝐷 , 𝐸 is the value of equity, 𝐷 is the value of
debt, and 𝛽𝐸 is the equity beta, 𝛽𝐷 is the beta on debt/corporate bond. If the debt
is riskless, then 𝛽𝐷 = 0.
3. Payoff to equity holder = max{0, 𝐶𝐹 − 𝐷}, CF- disposable cash flow, D-debt
payment; payoff to the creditor = min{D,CF}.
𝐸(𝐶𝐹)
4. Single period PV with uncertainty and risk aversion: 𝑃𝑉 = 1+𝑟 , where r is the
relevant cost of capital.
𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑝𝑎𝑦𝑜𝑓𝑓 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 Σ (𝑝𝑠 × 𝐶𝐹𝑠 )
o 𝑃𝑟𝑖𝑐𝑒𝑝𝑟𝑜𝑗𝑒𝑐𝑡 = 1+𝑟 = s 1+𝑟
𝑝𝑟𝑜𝑗𝑒𝑐𝑡′ 𝑠 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
𝑝𝑟𝑜𝑚𝑖𝑠𝑒𝑑 𝑝𝑎𝑦𝑜𝑓𝑓 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑

o 𝑃𝑟𝑖𝑐𝑒𝑏𝑜𝑛𝑑 = 1+𝑝𝑟𝑜𝑚𝑖𝑠𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛
o If there are two possible states (Good vs Bad) for cash flows at a future time
(𝐶𝐹𝑔 , 𝐶𝐹𝑏 ), with probability 𝑝𝑔 and 𝑝𝑏 respectively, and 𝑝𝑔 + 𝑝𝑑 = 1, the
expected cash flow is 𝐸(𝐶𝐹) = 𝑝𝑔 𝐶𝐹𝑔 + 𝑝𝑏 𝐶𝐹𝑏
2
5. 𝐸(𝑟) = Σs 𝑟𝑠 𝑝𝑠 , 𝑉𝑎𝑟(𝑟) = 𝐸[(𝑟𝑠 − 𝐸(𝑟)) ], 𝑠𝑑(𝑟) = √𝑉𝑎𝑟(𝑟), s denotes state.
Question 1 [cost of capital for a levered firm] A project promises to pay £1000. However, with probability
15% this project will run into bad times and will only yield 70% of its promised payment. The beta of this
project is 0.3, the risk-free rate is 1% and the expected return on the market portfolio is 4%. Price this project,
assuming investors are risk averse.
Cost of capital: 𝐸(𝑟) = 1% + 0.3 ⋅ (4% − 1%) = 1.9%
0.85 × 1000 + 0.15 × (1000 × 0.7) 955
𝑃𝑉 = = = £937.2
1.019 1.019
Page 1 of 7
Question 2 [Use comparables to estimate beta] You want to re-estimate the beta of the project in Question 1
using the method of comparables. You identify a firm with projects similar to yours. This firm has equity 𝐸 =
£200 million, 𝛽 = 0.8, and riskless debt 𝐷 = £50 million. Value the project using the method of comparables.
We need to determine the unlevered beta from this company, which we will use in our calculations for the
cost of capital. To do this, first find the unlevered beta:
200 50
𝛽𝑈 = × 0.8 + × 0 = 0.64.
200 + 50 200 + 50
Now use the CAPM to find the expected cost of capital:
𝐸[𝑟] = 1% + 0.64 × (4% − 1%) = 2.92%.
The price of the project using this method is
955
𝑃𝑉 = = £927.9
1.0292
Since the cost of capital is higher using the comparable, the price of the project is less, and equivalently its
expected return is higher.
Question 3. [unlevered beta and cost of capital] AirJ Co. specializes in sports equipment. The firm has equity
beta 𝛽 = 1, stock price 𝑆 = £20, 15 million shares outstanding, and riskless debt 𝐷 = £100 million. The risk-
free rate is 𝑟𝑓 = 4% and the market risk premium is (𝐸[𝑟𝑀 ] − 𝑟𝑓 ) = 5%. What are AirJ Co.’s unlevered beta
and unlevered cost of capital?
To find unlevered cost of capital we need unlevered beta, to find unlevered beta we need to find AirJ’s total
value, and to find AirJ’s total value we need the value of its equity: 𝐸 = £20 ⋅ 15𝑀 = £300𝑀. Now, AirJ’s total
value is given by
𝑉 = 𝐸 + 𝐷 = £300 + £100 = £400𝑀
Now we can find the levered beta:

300 100
𝛽𝑈 = ×1+ × 0 = 0.75.
400 400
Finally, using the unlevered beta in the capital asset pricing equation, we can find the unlevered cost of
capital:
𝑟𝑈 = 4% + 0.75 × (5%) = 7.75%.
Question 4 [Expected payoff/cash flow/return on equity/debt/firm]. With probability 0.25 your firm will be
worth €60M next year, and with probability 0.75 it will be worth €100M. Your firm’s cost of capital is 20%.
Page 2 of 7
(1) Assuming perfect markets, calculate the cash flows to debt holders and equity holders in each state,
expected payoff and price of 100% unlevered equity in your firm.
The cash flows to unlevered equity are the cash flows of the firm: €60M in the bad state with
probability 0.25, and €100M in the good state with probability 0.75.
The expected payoff is therefore
E(CFfirm ) = 0.25 × 60 + 0.75 × 100 = €90𝑀.
The cost of capital (i.e., expected return on capital) is 20%, so the price of unlevered equity is
𝐸(𝐶𝐹𝑓𝑖𝑟𝑚 ) 90
𝑃𝑈𝐸 = 𝑃𝑓𝑖𝑟𝑚 = = = €75𝑀
1+𝑟 1.2
(2) Now assume that you can raise €65M in debt for a promised return of 16.92%. Under this alternative
capital structure, assume firm value remains the same, what are the cash flows to equity holders and
debt holders in each state, what are their expected returns.
Bond: From the question, Pbond = €65𝑀. In the good state the bond receives 65(1 + 0.1692) ≈
€76𝑀. In the bad state, the cash flow generated is less than debt payment, so debt holders get
everything, which is €60M, for a return of 60/65 − 1 = −7.69%. The expected return for debt
holders is thus
𝑟𝑑 = 𝑝𝑏 𝑟𝑑,𝑏 + 𝑝𝑔 𝑟𝑑,𝑔 = 0.25 × (−7.69%) + 0.75 × (16.92%) ≈ 10.77%.
(Levered) equity: In the good state, equity holders get 100-76=24M, in the bad state they get
max{0,60 − 76} = 0.
Therefore, the expected payoff for equity holders
E(CFequity ) = 0.25 × 0 + 0.75 × 24 = €18𝑀.
Since the levered equity is worth Pequity = 𝑃𝑓𝑖𝑟𝑚 − 𝑃𝑏𝑜𝑛𝑑 = 75 − 65 = €10M, the expected return of
equity is
𝐸(𝐶𝐹𝐸 ) 18
rE = − 1 = 10 − 1 = 80%.
𝑃𝐸
Alternatively, you can use

24 − 10 8
𝑟𝐸 = 𝑝𝑏 𝑟𝐸,𝑏 + 𝑝𝑔 𝑟𝐸,𝑔 = 0.25 × (−1) + 0.75 × = = 80%
10 10
(3) Present your answers in (1) and (2) in a table, that shows the cash flows of different state of the world,
cost of capital, price of equity and debt, under different capital structure.
Page 3 of 7
Solution:
100% equity bond Levered equity

𝑝𝑏 = 0.25 CF in b 60 60 0
𝑃𝑔 = 0.75 CF in g 100 76 24
E(CF) 90 72 18
𝑃0 75 65 10
E(r) 20% 10.77% 80%
Question 5. A project can generate in one year ¥100M (with 20% probability), ¥200M (with 60% probability),
or ¥300M (with 20% probability). The appropriate cost of capital for this project is 10% per year. The firm has
one senior bond outstanding, promising to pay ¥80 million. It also has one junior bond outstanding, promising
to pay ¥70M. The senior bond promises an interest rate of 5%. The junior bond promises an interest rate of
26%. If the firm’s projects require an appropriate cost of capital of 10%, then
(1) what is the expected return on the firm’s levered equity (i.e., its cost of capital)?
(2) Draw the payoff diagram for shareholders, senior creditors, and junior creditors, given any future cash
flows in the range of 𝐶𝐹 ∈ [0, ¥300𝑀]
[¥ here represents Renminbi or Chinese yuan. Assume perfect markets. Note that the senior bond is always
paid first, then the junior bond, then finally levered equity.]
Solution:
(1) To the expected return on the firm’s levered equity, we need the expected payoff to the equity holder, and
the price of equity. To determine the price of equity we must figure out the price of the bonds.
The cash flows to the senior bond are:
state 1: ¥ 80M;
state 2: ¥ 80M;
state 3: ¥80M.
This means that the promised return of this bond is the expected rate of return, which equals the risk free rate
of return in this economy (because the bond is riskless). The price of the bond is therefore
80𝑀
𝑃𝑏𝑜𝑛𝑑 = ≈ ¥76.2M.
1.05
The cash flows to the junior bond are:
state 1: ¥20M;
state 2: ¥70M;
Page 4 of 7
state 3: ¥70M.
[Note: The expected payoff for the junior bond is then
𝐸[𝐶𝐹𝑗𝑢𝑛𝑖𝑜𝑟 𝑑𝑒𝑏𝑡 ] = 20 ⋅ 0.2 + 70 ⋅ 0.6 + 70 ⋅ 0.2 = ¥60𝑀.]
To calculate the price of the junior bond we can use the information that the promised return is 26%. This
means that 𝑃𝑗𝑢𝑛𝑖𝑜𝑟 ⋅ 1.26 = 70𝑀 ⇔ 𝑃𝑗𝑢𝑛𝑖𝑜𝑟 = ¥55.56𝑀.
The price of the project is

0.2 ⋅ 100 + 0.6 ⋅ 200 + 0.2 ⋅ 300
𝑃𝑝𝑟𝑜𝑗𝑒𝑐𝑡 = = ¥181.8𝑀.
1.1
This means that equity is worth 181.8 − 76.2 − 55.56 ≈ ¥50𝑀.
Cash flows to Equity are:
state 1: 0;
state 2: 200 − 80 − 70 = ¥50𝑀;
state 3: 300 − 80 − 70 = ¥150𝑀.
The expected cash flow for equity is therefore
𝐸[𝐶𝐹𝑒𝑞𝑢𝑖𝑡𝑦 ] = 0 ⋅ 0.2 + 50 ⋅ 0.6 + 0.2 ⋅ 150 = ¥60𝑀.
60
The expected return is then 𝐸[𝑟] = 50 − 1 = 20%.
(2)
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Payoff for Three Types of Investors
160
140
120
100
Payoff
80
60
40
20
0
0 80 100 150 200 300
Firm Cash Flow
Senior Creditor Payoff Junior Creditor Payoff Shareholders Payoff
Part II: Market (in)efficiency

Question 1. What do we mean when we say the stock market is efficient? If the stock market is efficient what
factors determine stock returns in such markets? Exhibit 10.3 on page 230 of the Welch textbook shows the
cumulative return from investing £1 in a portfolio of low and high beta stocks, from 1960-2014. Is this picture
in line with efficient markets?
An efficient market is one whereby investor correctly forecast future cash flows, and discount them using a
discount factor that is proportional to their systematic risk, e.g. using the CAPM beta. In this case prices will be
set correctly.
In efficient markets returns only depend on systematic risks and abnormal returns are 0.
The picture overleaf strongly rejects this view, as the returns of high beta stocks are lower than the returns of
lower beta stocks. The opposite from what the CAPM predicts!
Question 2. What factors could be behind the fact that the returns of low beta stocks are higher than the
returns of high beta stocks?
We cannot know for sure what is driving this effect, but we can speculate:
a) Maybe investors are risk seeking? That could be an explanation, but there is no evidence from
microeconomics (which studies individual decision making) that people are risk seeking. Rather people are risk
averse. So this is not a convincing explanation.
Page 6 of 7
b) Perhaps the CAPM beta is not a good measure of risk. The CAPM is based on a number of assumptions, and
perhaps it is too simplistic to capture reality. According to this explanation riskier stocks do have higher
returns than less risky stocks, but it is just that we don’t have the knowledge to identify which are the riskier
stocks.
c) Maybe investors suffer from behavioural biases, and somehow mis-estimate risks and/or cash flows of low
and high beta stocks. The picture suggests that high beta stocks are overvalued, and low beta stocks are
undervalued. So their actual returns are not those that are implied by the CAPM. This is my preferred
explanation, but this is a matter of taste!
Question 3. Is there any other evidence that violate efficient markets? Can investor irrationality create an
inefficient market?
Yes, there are evidence that violate efficiency. Various factors seem to predict abnormal returns, i.e., past
returns, earnings announcements, B/M ratios, etc.
Question 4. Ok, so the market may be inefficient. Should we (financial managers) care?
Yes! We use the CAPM to get the appropriate cost of capital that we use to determine the present value of
investment projects.
By using CAPM, we effectively assume that only systematic risk matters, and that other projects with similar
amounts of systematic risk must provide the same return as our project of interest. Therefore cash flows from
our project of interest can be discounted at the CAPM rate as an application of the law one price.
If the market is inefficient, then the relationship between 𝛽 and returns breaks down, so valuation on the
basis of the law of one price also breaks down. In this case we cannot obtain trust CAPM to provide the
appropriate 𝑂𝐶𝐶 for our project.
Page 7 of 7
Below is a list of useful formulae for this seminar just as a friendly reminder. You should already know these by
now (and you will not be given these in tests/exams):
Suppose 𝜏𝑐 : tax rate on the corporate income; 𝜏𝑑 : dividend tax rate or individual income tax rate;
𝜏𝑐𝑔 : capital gains tax rate.
1. 𝐶𝐹𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 = 𝐶𝐹𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥 (1 − 𝜏𝑐 ) = 𝐸[𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑐𝑜𝑠𝑡 − 𝑝𝑟𝑜𝑓𝑖𝑡 × 𝜏𝑐 ] where 𝜏𝑐 is the

marginal tax rate. This relationship holds if all the revenues and costs occur at the same period of
time. Otherwise, see Q5 in Seminar 5 as the correct approach.
2. 𝑡𝑎𝑥 𝑠𝑎𝑣𝑖𝑛𝑔 𝑓𝑟𝑜𝑚 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = (𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡) × 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 = (𝐷 × 𝑟𝑑 ) × 𝜏𝑐
3. Tax adjusted cost of capital = (𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙) × (1 − 𝜏)
4. 𝑊𝐴𝐶𝐶 = 𝑤𝑑𝑒𝑏𝑡 × 𝑟𝑑𝑒𝑏𝑡 + 𝑤𝑒𝑞𝑢𝑖𝑡𝑦 × 𝑟𝑒𝑞𝑢𝑖𝑡𝑦
5. With leverage and 1 period cash inflow,

𝐸[𝐶𝐹𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 ]+𝑡𝑎𝑥 𝑠𝑎𝑣𝑖𝑛𝑔
a. 𝐴𝑃𝑉 = (if all-equity instead, then 𝑡𝑎𝑥 𝑠𝑎𝑣𝑖𝑛𝑔 = 0)
1+𝑟𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝐸[𝐶𝐹𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 ]
b. 𝐴𝑊𝐴𝐶𝐶 = 𝑤𝐷 × 𝑟𝑑 × (1 − 𝜏𝑐 ) + 𝑤𝐸 × 𝑟𝑒 = 𝐸(𝑟𝑓𝑖𝑟𝑚 ) − 𝑟𝑑 × 𝜏𝑐 × 𝑤𝐷 , 𝑃𝑉 = 1+𝐴𝑊𝐴𝐶𝐶
2
6. 𝐸(𝑟) = Σs 𝑟𝑠 𝑝𝑠 , 𝑣𝑎𝑟(𝑟) = 𝐸[(𝑟𝑠 − 𝐸(𝑟)) ], 𝑠𝑑(𝑟) = √𝑉𝑎𝑟(𝑟), s denotes state. 𝑠𝑑 denotes the
standard deviation of a random variable, 𝑣𝑎𝑟 is the variance.
7. CAPM: 𝐸(𝑟𝑖 ) = 𝑟𝑓 + 𝛽𝑖 (𝐸(𝑟𝑚 − 𝑟𝑓 )
Question 1: This is a follow-up question of Q4 in Seminar 6 [Remind: you’ve solved (1),(2),(3) in Seminar 6,
please proceed with (4) and (5)]
With probability 0.25 your firm will be worth €60M next year, and with probability 0.75 it will be worth
€100M. Your firm’s cost of capital is 20%.
(1) Assuming perfect markets, calculate the cash flows to debt holders and equity holders in each state,
expected payoff and price of 100% unlevered equity in your firm.
(2) Now assume that you can raise €65M in debt for a promised return of 16.92%. Under this alternative
capital structure, assume firm value remains the same, what are the cash flows to equity holders and
debt holders in each state, what are their expected returns.
Page 1 of 6
(3) Present your answers in (1) and (2) in a table, that shows the cash flows of different state of the world,
cost of capital, price of equity and debt, under different capital structure. The answers are listed below:
100% equity bond Levered equity

𝑝𝑏 = 0.25 CF in b 60 60 0
𝑃𝑔 = 0.75 CF in g 100 76 24
E(CF) 90 72 18
𝑃0 75 65 10
E(r) 20% 10.77% 80%
(4) What is the WACC of the firm under the new capital structure that included both debt and equity?
How does the new cost of capital compare to the one in (1)?
Vd 65
Leverage is 𝑤𝑑 = 𝑉 = 75 = 86.7%. Equity is 1 − 𝑤𝑑 = 13.33%. Therefore:
𝑓𝑖𝑟𝑚
𝑊𝐴𝐶𝐶 = 𝑤𝑑 × 𝑟𝑑 + 𝑤𝑒 × 𝑟𝑒 = 0.8667 × 10.77% + 0.1333 × 80% = 20%.

The firm’s cost of capital remains the same as the unlevered case in (1), that is, before raising debt. In
other words, this is MM at work because regardless of how we finance the project, firm’s cost of
capital is the same.
(5) Calculate the expected return, the variance of the return, and the standard deviation of the overall
firm, levered equity and debt.
Basicaly by levering up we split one medium risky project into a high risk claim (equity) and a low risk
claim (bond). Using the answers we obtained from previous sub-questions,
Firm Return: 𝑟𝑏 = −20% and 𝑟𝑔 = 33%. The expected return, variance, and standard deviation are
therefore 𝐸[𝑟𝑓𝑖𝑟𝑚 ] = 𝑝𝑏 𝑟𝑏 + 𝑝𝑔 𝑟𝑔 = 20%, Var(𝑟𝑓𝑖𝑟𝑚 ) = 5.3%, and sd(𝑟𝑓𝑖𝑟𝑚 ) = 23.1%.
Return on debt 𝑟𝑏 = −7.7% or 𝑟𝑔 = 16.9%. The expected return, variance, and standard deviation are
therefore 𝐸[𝑟𝑑 ] = 10.77%, Var(𝑟𝑑 ) = 1.1%, and sd(𝑟𝑑 ) = 10.7%.
Return on levered equity, we have possible outcomes 𝑟𝑏 = −100% or 𝑟𝑔 = 140%. The expected return,
variance, and standard deviation are therefore 𝐸[𝑟𝑒 ] = 80%, Var(𝑟𝑒 ) = 108%, and sd(𝑟𝑒 ) = 104%.
Page 2 of 6
Question 2. This is a follow-up question of Q4 in Seminar 5. [Recall that you’ve solved (1) in Seminar 5, please
proceed with (2) and (3)] A project of Firm A will generate taxable profits of 500M next year. The after-tax cost
of capital for the firm is 15%, and the cost of debt is 7.5%. The firm’s marginal tax rate on profit is 25%.
(1) If the firm is all equity financed what is the project’s present value?
Solution: Tax paid is 500 × 0.25 = 125. So the value next period will be 500-125=375.
Discounted at 15%: 375/1.15=326.087.
(2) If the project is now partially financed with £164.37M in debt, what is the project’s value? Use the APV
approach.
The interest expense is 0.075 × 164.37 = 12.33.
This results in tax savings of 0.25 × 12.33 = 3.08
Using APV the value of the firm is:375/1.15 + 3.08/1.15 = 326.087 + 2.68 ≈ 328.8
(3) If the project is still partially financed with £164.37M in debt, what is the project’s value using the
adjusted WACC method?
First we need to find the debt/firm value ratio, 𝑤𝐷 .
This is 164.37/328.8 ≈ 0.5
The adjusted WACC is 0.15 − 0.25 × 0.075 × 0.5 = 0.1406. Firm value is therefore 375/(1 + 0.1406) ≈
328.8
Question 3. This is a follow-up question of Q5 in Seminar 5. [Recall that you’ve solved (a) and (b), please
proceed with (c)]. A firm is undertaking a two-stage project. The first stage is a yearlong R&D project with an
upfront cost of $1 million. This stage is risky and capital costs 15%. After one year, if the R&D project succeeds
(with 80% probability), the second stage is a factory that costs $10 million upfront and generates $20 million
after one year. The second stage is safe and capital costs 6%.
a) Assume there are no taxes. What is the value of this project?
−10M 20
Solution: PV = −1M + 0.8 × [ + 1.15×1.06] = $5.168M
1.15
b) Assume the firm pays a marginal tax rate of 33%. If the firm equity-financed, what is the PV of the
project?
−10M 20−(20−10−1)×0.33
Solution: PV = −1M + 0.8 × [1+10% + ] = $3.636M
1.1×1.04
c) Still assuming 33% marginal tax rate, what is the project’s APV if the factory is fully financed with risk-free
debt? Notice that the risk free rate should be 6%.
Solution:
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In this case, the present value of the tax shield will be added to the value of the project. The interest on
the debt is 6%, which is the risk free rate in this case. Note that this is the before tax rate, because this is
the nominal interest that we have to pay to the person who has lent us the money. With 10 million of
debt at 6%, the interest payment is 0.6 million. So the tax saving are 0.6 × 0.33 ≈ 0.2 million. The PV of
0.2×0.8
expected tax saving is 1.10×1.04 ≈ 0.14M.
APV = 3.636 + 0.14 = $3.77M

Note again that for us the after tax risk free rate is 4%.
Question 4. Using the example in lecture 13 (the project with expected cash flow of 182), answer the
following questions, assuming that the expected rate of return on the market portfolio is 31.4% per year, and
the risk-free rate is 2.86% per year.
(1) Calculate the beta of the project, beta of the debt and beta of the equity in all the scenarios.
(2) Highlight the MM proposition in your workings. That is, comment on the level of the weighted average
cost of capital of different scenarios shown in the lecture.
To solve this problem, we need to find the project, debt, and equity betas in different scenarios. We can do
this using the CAPM pricing equation to back out the relevant values of beta in each of the scenarios:
E[𝑟] = 𝑟𝑓 + 𝛽[E[𝑟𝑀 ] − 𝑟𝑓 ],
where the example gives us information on expected return, risk-free, and expected market return, leaving
beta as the only unknown variable.
No debt scenario:
In this case, there is no debt beta, and the project and equity betas coincide. The expected return on the
project is 20%. To find beta, we have
0.2 = 0.0286 + 𝛽𝑃𝑟𝑜𝑗𝑒𝑐𝑡 × (0.314 − 0.0286)
0.2 − 0.0286
⇔ 𝛽𝑃𝑟𝑜𝑗𝑒𝑐𝑡 = = 0.6.
0.314 − 0.0286
Medium debt scenario (131):
With debt now present, we need to find the debt beta and equity beta, where the equity beta now differs
from the project beta. To find the relevant betas, we again use the capital asset pricing model,
E[𝑟𝑒 ] = 𝑟𝑓 + 𝛽𝑒 [E[𝑟𝑚 ] − 𝑟𝑓 ],
E[𝑟𝑑 ] = 𝑟𝑓 + 𝛽𝑑 [E[𝑟𝑚 ] − 𝑟𝑓 ],
where after plugging in numbers and rearranging as above, we find that 𝛽𝑑 = 0.26 and 𝛽𝑒 = 2.74. Notice that
debt has made equity riskier, so its E[𝑟𝑒 ] is higher.
High debt scenario (142):
Again using the capital asset pricing model, we find that 𝛽𝑑 = 0.41 and 𝛽𝑒 = 3.33. Notice that both debt and
Page 4 of 6
equity are now riskier, but remember that debt represents a larger share of the firm’s external financing, and
debt is less expensive that equity, so the weighted average cost of capital for the firm will be unchanged,
despite the increased riskiness of both debt and equity.
Low debt scenario (71):
Again using the capital asset pricing model, we find that 𝛽𝐷𝑒𝑏𝑡 = 0 and 𝛽𝐸𝑞𝑢𝑖𝑡𝑦 = 1.13. Now debt and equity
are less risky, relative to the medium and high debt case, and the betas are correspondingly lower.
The expected returns on debt and equity reflect risk (as measured by 𝛽𝑒 and 𝛽𝑑 ). By changing the debt level
the betas of the individual assets change accordingly, which in turn determines their expected return.
However, the WACC in all cases is the same, and reflects the riskiness of the underlying project, so capital
structure decision does not matter (in this frictionless setting). We can confirm this intuition by computing
unlevered betas, which we would expect to be equal across all funding scenarios:
Low debt scenario: 𝛽𝑈 = 0.468 × 0 + 0.532 × 1.13 = 0.6,
Medium debt scenario: 𝛽𝑈 = 0.864 × 0.26 + 0.136 × 2.74 = 0.6,
High debt scenario: 𝛽𝑈 = 0.936 × 0.41 + 0.064 × 3.33 = 0.6.
Using the unlevered beta to compute expected returns, we find that E[𝑟] = 0.0286 + 0.6 ⋅ (0.314 −
0.0286) ≈ 0.2, i.e. the project return.
Question 5. (This question is added after some feedback from the convertible bonds in Lecture 12). Suppose a
firm has two types of financial claims. Equity and convertible bonds. The number of outstanding shares of
equity is 200. The firm has 100 outstanding convertible bonds that promise £20k each on a future date. Each
of these bonds can be converted at the bondholders’ discretion, into 2 new shares of stock on that future
date. Use a table to represent the value of convertible bonds and the value of equity if the firm value is 0, £0.5
million, £1 million, £1.5 million, £ 2 million, … £3.5 million, £4 million, …. £6 million on that future date.
Solution: If we convert bonds into equity, we will have 200 shares, and own 50% of the firm.
We need to find the firm value to make our 50% worth the same as the bond payment of 100 × 20k = £2m
0.5 × Firm Value = 2m → Firm Value = £4m
The convertible debt holders are indifferent between converting and not converting if the firm value is £4m
The convertible’s payoff slope beyond a firm value of £4m is 0.5, and the equity holders payoff slope beyond
that is 0.5. The payoff graphs should have been covered during seminars.
Firm Convertible Equity

0 0 0
0.5m 0.5m 0
1m 1m 0
1.5m 1.5m 0
2m 2m 0
2.5m 2m 0.5m
Page 5 of 6
3m 2m 1m
3.5m 2m 1.5m
4m 2m 2m
4.5m 2.25m 2.25m
5m 2.5m 2.5m
5.5m 2.75m 2.75m
6m 3m 3m
Question 6. Discuss the advantages and disadvantages of debt and equity financing.
Solution: For help with this problem, refer to chapters 18 and 19.
Base your answer on the textbook reading and lecture slides.
Page 6 of 6
Below is a list of useful formulae for this seminar just as a friendly reminder. You should already know these by now (and
you will not be given these in tests/exams):
1 𝑑
1. 𝑃𝑐𝑢𝑚 = 𝑑0 + 𝑟−𝑔 = 𝑑0 + 𝑃𝑒𝑥 , If shares are repurchased at the current market price and if the market
is perfect, then 𝑃𝑎𝑓𝑡𝑒𝑟 𝑟𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 = 𝑃𝑏𝑒𝑓𝑜𝑟𝑒 𝑟𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 .
2. Payoff for long call at the maturity = max{0, 𝑆𝑇 − 𝑋}, the buyer of the option paid price 𝐶 to buy the
option.
3. Payoff for short call at the maturity = − max{0, 𝑆𝑇 − 𝑋} = min{0, 𝑋 − 𝑆𝑇 }, the seller of the option
got payment of 𝐶 when selling the option.
4. Payoff for long put at the maturity = max{0, 𝑋 − 𝑆𝑇 }, paid 𝑃
5. Payoff for short put at the maturity = − max{0, 𝑋 − 𝑆𝑇 } = min{0, 𝑆𝑇 − 𝑋}, charged 𝑃
6. After-tax dividend income = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 × (1 − 𝜏𝑑 )
7. After-tax share repurchase income = 𝐶𝐹𝑠ℎ𝑎𝑟𝑒 𝑟𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 − 𝜏𝑐𝑔 × 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠, where capital
gains=payments received in repurchase-initial price paid for the shares.
8. Put-call parity: price of underlying equity + price of put = price of call + present value of exercise
price, i.e., 𝑆 + 𝑃 = 𝐶 + 𝑃𝑉(𝐾)
𝑆
ln( )
𝑃𝑉(𝐾)
9. Black-Scholes formula: call option value 𝐶 = 𝑆 × 𝑁(𝑑1 ) − 𝑃𝑉(𝐾) × 𝑁(𝑑2 ), where 𝑑1 = +
𝜎√𝑇
𝜎√𝑇
, and 𝑑2 = 𝑑1 − 𝜎√𝑇, 𝑆 =spot price of an asset, 𝐾 = exercise price of call, 𝑟𝑓 =annual
2
risk-free rate of return, continuously compounded, 𝜎 2 = variance (per year) of the
continuous share price return, 𝑇 =Time (in years) to expiration date. 𝑁(𝑑) = probability that
a standardized, normally distributed, random variable will be less than or equal to 𝑑.
If d is negative, 𝑁(d) = 1 − N(−d)
10. In general, r = t 1 + rt − 1 , r is annual interest rate, t is the number of compounding periods in

a year.
Question 1. On March 2nd, 2021 you decide to purchase 10 August call option contracts on Amazon’s stock
with an exercise price of $2800 that matures in a month. Each contract is for 100 shares. You find out that the
bid price is $343.50 and the ask price $350.05 and last trade price was $327. The prices here are for per share
of the Amazon’s stock.
a) How much money will this cost you?
b) Is this option in-the-money or out-of-money on March 8th?
Page 1 of 9
Solution: For help with this problem, refer to chapter 27.A.
Since you are buying you must do so at the ask price, which is $350.05. Since you are purchasing 10 contracts
this will cost you 350.05 × 10 × 100 = $350.05𝑘.
Because these are call options and the stock price of Amazon on March 8th is higher than the strike price
(~$2951>$2800) these options were in the money on March 8th. (The ~$2951 is the price of Amazon’s stock
on March 8th, 2021. This question requires the students to get this price on their own from sources such as
yahoo finance or Google finance, etc).
Question 2. You sold one put option of Warwick Corp. to another party, with a strike price of $20 (i.e., you
have a short position in the put option).
a) Write the formula that describes your payoff at expiration as a function of the stock price on that date.
b) Draw the figure that describes your payoff (y-axis payoff, x-axis stock price)
c) What is the maximum loss you can incur at the expiration date?
d) Draw the graph that describes the payoff of the holder of the put option (i.e., the person who is long in the
contract). What do you notice?
Solution: For help with this problem, refer to chapter 27.A.
Let 𝑆 be the stock price at expiration. Then your payoff from holding this option is −𝑚𝑎𝑥(20 − 𝑆, 0). This
means that if the price is higher than 20 at expiration, the option will be out of the money, so will not be
exercised (in this case the option is worthless, and your payoff is 0. However, your profit is positive and equal
to the option price that you received when you sold your put to the other party. If however the price is less
than 20, the option will be exercised, in which case you have to pay the holder of the contract the difference
between 20 − 𝑆.
Page 2 of 9
The maximum (negative) payoff is 20, which will occur if the stock price at expiration is worth 0, i.e., the
company has gone bankrupt.
The graph for the holder’s payoff mirrors the graph for the seller. The similarity between payoff graphs shows
that options are zero-sum games: what the seller pays, the buyer receives, if the option is exercised. If it is not
exercised then nothing happens at expiration, the seller only receives the upfront price for the contract.
Notice also that no stocks need be traded to close out the contract. For example, say that the stock is worth
15. Hypothetically, the put holder can buy the stock at 15 from the market, and sell to the put seller for 20,
thus earning 5. The seller must pay 20 for the stock, and sell on the market for 15, thus losing 5. In practice,
however, it’s easier for the put seller to give the put owner 5 at expiration.
Question 3. Suppose you buy one European call option with an exercise price of £1.80 and a premium of
£0.05. You also hold one European put option with an exercise price of £1.20 and premium of £0.10 of the
same security. What would be the net profit for you if the market price of security at maturity are the
followings:
Market Price of Security £1.00 £1.50 £2.00
Call @ £1.80 0 – 0.05 -0.05 0.15
Put @ £1.20 1.20 - 1.00 – 0.10 -0.10 -0.10
Net +0.05 -0.15 +0.05
When the market price is £1.50, you optimally do not exercise the option, that is, do not buy the stock at the
strike price of £1.80 while the stock is traded at £1.50. Meanwhile, you paid the call option price of £0.05. So
the net payoff on your long position of the call is -£0.05. You would not exercise your put option either, why?
Because the put option gives you the right to sell only at £1.2 while you could sell at the market price of £1.5.
You paid for the put option premium, so the net payoff for your long position in the put option is -£0.1. In
total, the net payoff is -£0.15.
When the market price is £2.00, and you can buy at the strike price of £1.8, so it is optimal for you to exercise
the option and buy the stock. By doing so, the payoff is 2.0-1.8, and you paid the premium, so the long
position of the call option gives you the payoff of 2.0-1.8-0.05=0.15. You still would not exercise your put
option b/c by exercising the put option, you sell the stock at £1.2 while it is trading in the market for a higher
price of £2.0. You paid the put premium, so the payoff for your long position in the put option is -0.1. In total,
the net payoff is £0.05.
Alternatively, you should know the payoff for the long call is max{𝑆𝑇 − 𝐾𝐶 , 0} − 𝐶, where 𝑆𝑇 is the spot price
at maturity and 𝐾𝐶 is the strike price of the call, 𝐶 is the option price. The payoff for the long put is
max{0, 𝐾𝑃 − 𝑆𝑇 } − 𝑃. The 𝑆𝑇 is either £1.5 or £2.0 in the 3rd and 4th column, while the strike price is 𝐾𝐶 =
£1.8, and 𝐾𝑃 = £1.2. With 𝐶 = 0.05 and 𝑃 = 0.1, you can get the results as shown in the table as well.
Page 3 of 9
You are encouraged to draw your payoff diagram for the two options, and combine them together to see the
payoff of this option combination with regard to the spot price at maturity.
Also note, when figuring out the optimal strategy (of exercise the options or not), you need to think of the
option premiums as sunk (you cannot recover such costs even if you choose not to exercise).
Question 4. Suppose shares of Gibbet Corp are currently selling for £4.29 per share. A put option with an
exercise price of £4.40 sells for £0.25 and expires in 3 months. If the risk-free rate is 2.6% per year, what is the
price of a call option with the same exercise price and expiration date?
Solution: For help with this problem, refer to chapter 27.B.
Using the put-call parity, we have 𝑆 + 𝑃 = 𝑃𝑉(𝐾) + 𝐶, therefore:
4.40
4.29 + 0.25 = +𝐶
1.0263/12
⇔𝐶 = 0.169.
Note that, 3 months is shorter than 1 year, we use discrete compounding here.
Question 5. A newly hired CEO is offered a 3-year package of an annual salary of £400,000 which is paid at the
end of each year. He is also given 10,000 at the money European call stock options on the company’s shares
which expire in 3 years. The current share price is £40 per share, and the annual standard deviation of returns
is 68%. Risk-free, zero-coupon bonds that mature in three years pay an interest rate of 5%. The appropriate
cost of capital for the CEO’s salary payments is 9%. What is the CEO’s total remuneration package worth
today? Use the Black-Scholes formula to determine the present value of the options.
Solution: For help with this problem, refer to chapter 27.C and 27.E.
The options are at the money when issued, so the strike price is equal to the stock price at £40. For the Black-
Scholes option pricing formula, we need to know a few values:
40
𝑃𝑉(𝐾) = ≈ 34.55
1.053
𝑆
𝑙𝑛 ( ) = 0.15
𝑃𝑉(𝐾)
𝜎 × √𝑇 = 0.68 × √3 = 1.18
𝑆
ln ( ) 𝜎√𝑇
𝑃𝑉(𝐾)
𝑑1 = + = 0.12 + 0.59 = 0.71
𝜎√𝑇 2
𝑑2 = 𝑑1 − 𝜎√𝑇 = 0.71 − 1.18 = −0.47.
Now use the probability table from the lecture notes to look up the cumulative normal probabilities: 𝑁(𝑑1 ) =
0.7611, 𝑁(𝑑2 ) = 1 − N(0.47) = 0.3192.
Now, plugging into the Black-Scholes formula,
𝐶 = 40 × 0.7611 − 34.55 × 0.3192 ≈ £19.42.
Page 4 of 9
Since the CEO was given 10,000 contracts, total current value of options 19.42 × 10,000 ≈ 194,156. Now
find the 𝑃𝑉 of his salary payments:
400,000
𝑃𝑉(Salaries) = × [1 − 1/1.093 ] ≈ £1,012,518.
0.09
Total value of remuneration package is therefore: 𝑉 = 1,012,518 + 194,156 = 1,206,674.
Question 6. Firm Rzor has an excess cash flow of 100,000 to be distributed to shareholders. Rzor has no debt.
Tom is a shareholder who owns 10% of Rzor. Tom pays 40% marginal tax on dividends, and 18% marginal tax
on capital gains. Consider the following scenarios:
(1) Scenario A: Rzor pays all the excess cash flow in the form of a dividend immediately. Calculate
Tom’s present value of the dividend payment. Is this the same as the PV of Tom’s investment in
Rzor?
Solution: For help with this problem, refer to chapter 20.3–20.5.
The after-tax dividend payment to Tom is (100k × 10%) × (1 − 0.4) = 6k. Because the dividend is paid
immediately, we do not need to discount this cash flow in the calculation of PV. Therefore, PV(dividend
payment)=6k. However, this may not be the same as the PV of Tom’s investment in Rzor because after the
dividend payment, Tom still holds 10% of the firm’s equity which may give him future cash flow. For example,
if the company’s current asset generates new excess cash flow next period and the firm decides to pay
dividend, then Tom is entitled to receive the new dividend. Thus, 6k is the lower bound of PV of Tom’s
investment in Rzor.
(2) Scenario B: A new project arises, which costs 100,000 and generates an expected cash flow of
120,000 in one year. The appropriate after-tax cost of capital for the project is 5%. Rzor invests in
this project, and returns the money to shareholders next year as a dividend. The corporate tax rate
of Rzor is 12%. Calculate Tom’s present value of the dividend payment. Is this the same as the PV of
Tom’s investment in Rzor?
Solution: The firm uses the current excess of 100k to pay for the cost of the project. Next year, the firm needs
to pay corporate tax (with the rate of 12%) on the profit of the project (i.e., 120k-100k=20k), and then use the
residual cash flow (i.e., 120k-20k*12%)) to pay out as dividend to all shareholders, and Tom gets 10%. Tom
pays tax rate of 40% on the dividend because dividend is regarded as ordinary income. The after-tax dividend
needs to be discounted from next year to this year in order to calculate the PV(dividend).
If we do it step by step:
Project value next year net of cost: 120,000 − 100,000 = 20,000
Corporate tax next year: 20,000 × 0.12 = 2,400
Cash from project next year: 120,000 − 2,400 = 117,600
Dividend paid to Tom next year: 117,600 × 0.1 = 11,760
Tax paid by Tom on dividend next year: 11,760 × 0.4 = 4,704
After tax cash flow to Tom next year: 11,760 − 4,704 = 7,056
PV of cash flow 7,056/1.05 = 6,720.
Page 5 of 9
Alternatively, the totally payout to equity holders is 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑛𝑒𝑥𝑡 𝑦𝑒𝑎𝑟 − (𝑝𝑟𝑜𝑓𝑖𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡) × 𝜏𝑐 =
117600. And
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 × (1 − 𝜏𝑑 )
𝑃𝑉(𝑇𝑜𝑚′ 𝑠𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑) =
1+𝑟
(𝑇𝑜𝑡𝑎𝑙 𝑃𝑎𝑦𝑜𝑢𝑡 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 ℎ𝑜𝑙𝑑𝑒𝑟𝑠) × 𝑇𝑜𝑚′ 𝑠 𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑡𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦 × (1 − 𝜏𝑑 )
=
1+𝑟
117600 × 10% × 0.6
= = 6.7𝑘.
1.05
(3) Scenario C: Rzor carries out the project described in B, and returns the money to shareholders next
year (after the project has been taken on) using a share repurchase. Rzor raised 20,000 in equity
when it first became public. Calculate Tom’s present value of the share repurchase. Is this the same
as the PV of Tom’s investment in Rzor?
Solution: Tom’s capital gain equals what he gets from selling his shares in the share repurchase program
minus his original investment in the firm. Assume that Tom is one of the buyers when Rzor raised equity in
IPO, thus Tom paid 20k*10%=2k for his shares (If we don’t make this assumption, then it is possible that Tom
have bought his shares at a much higher/lower price, so his capital gains from the share repurchase would be
different). Note from Scenario B that the company has 117.6k as excess cash flow after the project finishes
next year. We assume the company uses this cash flow to buy back all the shares, so Tom gets
117.6k*10%=11.76k in exchange for the 10% of the company’s shares that he owns. The capital gains for Tom
is thus 11.76k-2k=9.76k, on which he needs to pay the capital gains tax at 18%. Given that Tom’s initial
investment is already sunk, we can say the PV of the share repurchase is (11760-capital gains tax)/1.05.
Step by step:
Rzor raised 20K so Tom’s share is 20k × 0.1 = 2k
Toms capital gain next year 11,760 − 2000 = 9,760
Note that 11,760 is the amount to be received by Tom in the repurchase program.
Capital gains tax next year 9,760 × 0.18 = 1,759
Cash flow next year 11,760 − 1,759 = 10,001
PV 10,001/1.05 = 9,524.
Alternatively:
𝐶𝐹 𝑓𝑟𝑜𝑚 𝑟𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑜𝑔𝑟𝑎𝑚 − 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠 𝑡𝑎𝑥 11.76𝑘 − (11.76𝑘 − 2𝑘) × 18%
𝑃𝑉 = = = 9.52𝑘
1+𝑟 1.05
We can say this is the same as Tom’s PV of investment in Rzor, b/c Tom no longer owns any shares after the
repurchase program, and thus has no claim on the firm’s future cash flow.
Interestingly, the increase from scenario B is 2.8k, which is the PV of the difference in the tax bill in the two
scenarios (4,704 − 1,759)/1.05. Is this a coincidence? No. In a perfect market, PV of dividend payment and
PV of share repurchase should be the same. However, in this question, the market is not perfect, and it has
taxes. The difference between these two PVs comes from the difference in tax rates of capital gain and
income.
Page 6 of 9
Question 7. Gibbet Foods plc pays a semi-annual dividend of £1. Suppose the stock price is expected to fall on
the ex-dividend date by £0.90.
(a) Would you prefer to buy on the cum-dividend date (i.e. just before the ex-dividend date) or just after the ex-
dividend date if you were
i) a tax-exempt investor?
ii) an investor with a marginal tax rate of 40% on income and 16% on capital gains?
Answer: Just before the ex-dividend date, the share price 𝑃𝐵 will include the dividend. Just after, the
price 𝑃𝐴 will not. If the share is later sold for 𝑃𝐶 at an effective tax rate of 𝜏, then the after-tax value
received on sale will be 𝑃𝐶 − 𝜏 × (𝑃𝐶 − 𝑃𝐵 ) if bought just before the ex-dividend date, or 𝑃𝐶 − 𝜏 × (𝑃𝐶 −
𝑃𝐴 ) if bought just after.
Thus, ignoring discounting, the net difference in after-tax value between buying before the ex-dividend
date and buying after is the following (with 𝑇𝑐𝑔 the capital gains tax rate, 𝑇𝑖 the income tax rate, 𝐷 the
dividend):
(𝑃𝐶 − 𝑃𝐵 ) ⋅ (1 − 𝜏𝑐𝑔 ) + 𝐷 × (1 − 𝜏𝑖 ) − [𝑃𝐶 − 𝜏𝑐𝑔 × (𝑃𝐶 − 𝑃𝐴 ) − 𝑃𝐴 ]
= 𝐷 × (1 − 𝜏𝑖 ) − (1 − 𝜏𝑐𝑔 ) × (𝑃𝐵 − 𝑃𝐴 )
= 1 × (1 − 𝜏𝑖 ) − 0.9 × (1 − 𝜏𝑐𝑔 )
i) If 𝜏𝑐𝑔 = 𝜏𝑖 = 0, then the net benefit of buying before is
1 × (1 − 𝜏𝑖 ) − 0.9 × (1 − 𝜏𝑐𝑔 ) = 1 − 0.9 = 0.1
So there is a tax advantage to buying before the ex-dividend date.
ii) If 𝜏𝑐𝑔 = 0.16, 𝜏𝑖 = 0.40, then the net benefit of buying before is
1 × (1 − 0.4) − 0.9 × (1 − 0.16) = 0.6 − 0.756 = −0.156
so there is a tax advantage to buying just after the ex-dividend date.
b) In a study of ex-dividend behaviour, Elton and Gruber estimate that the stock price fell on average by
85% of the dividend. Assuming that the tax-rate on capital gains was 40% of the tax-rate on income,
what did Elton and Gruber’s results imply about investors’ marginal rate of income tax?
Answer: For the marginal investor, the after-tax drop in the share price should equal the after-tax
dividend payment.
(𝑃𝐵 − 𝑃𝐴 )(1 − 𝜏𝑐𝑔 ) = 𝐷 × (1 − 𝜏𝑖 )
𝑃𝐵 −𝑃𝐴 𝜏𝑐𝑔
If = 0.85 and = 0.4 then this implies a rate of income tax for the marginal investor of
𝐷 𝜏𝑖
(𝑃𝐵 − 𝑃𝐴 ) ⋅ (1 − 𝜏𝑐𝑔 ) 1 − 0.85
(1 − 𝜏𝑖 ) = = 0.85 ⋅ (1 − 0.4 × 𝜏𝑖 ) ⇒ 𝜏𝑖 = = 0.227
𝐷 1 − 0.85 × 0.4
c) Elton and Gruber also observed that the ex-dividend price fall was different for high-payout stocks and
for low-payout stocks. Which group would you expect to show the larger price fall as a proportion of
the dividend? Why?
Answer: High dividend-yield stocks should fall by a larger proportion of the dividend if they are held by
investors with lower marginal rates of tax than low dividend-yield stocks (held by investors with higher
marginal tax rates). Holding the price drop relative to the dividend payment and the relative ratios of
capital gains and income tax constant, comparing the answers to (a) (i) and (ii) show higher rates of
income tax decrease the relative benefit of buying shares before the ex-dividend date, because they
decrease the after-tax value of the dividend (by more than the decrease in the after-tax value due to the
change in the stock price). Hence taxpayers with high marginal rates of tax should prefer low dividend-
yield stocks and vice-versa. Similarly firms with investors with high marginal tax rates (low dividend-
yield stocks) will experience a smaller relative price drop, since
Page 7 of 9
𝑃𝐵 − 𝑃𝐴 1 − 𝜏𝑖
=
𝐷 1 − 0.4𝜏𝑖
decreases as 𝜏𝑖 increases.
d) Do the results of Elton and Gruber’s study imply that firms will maximize shareholder value by not paying
dividends?
Answer: No, Elton and Gruber’s paper is not a prescription for dividend policy. In a world with taxes, a
firm should never issue stock to pay a dividend, but the presence of taxes does not imply that firms
should not pay dividends from excess cash. The prudent firm, when faced with other financial
considerations and legal constraints, may choose to pay a dividend.
e) In Hong Kong, neither dividends nor capital gains are taxable. By how much would you expect the
price of a stock in Hong Kong to change due to a dividend payment of HK$ 1, and when?
𝑃 −𝑃 1−𝜏
Answer: In this case we have 𝜏𝑐𝑔 = 𝜏𝑖 = 0 and so 𝐵𝐷 𝐴 = 1−𝜏 𝑖 = 1 for all investors. Hence the stock
𝑐𝑔
price should drop by HK$ 1 on the ex-dividend date.
Question 8. In perfect capital markets, would investors care if the firm redistributes cash using dividends or
repurchases? Explain.
In perfect capital markets, investors should be indifferent between dividends and share repurchases.
In dividend case, investors hold both cash and stock, whereas in the repurchase case (assuming the investor
does not sell), they hold only stock. So investors can choose their own optimal stock/cash mix.
In the dividend case, if investors want more stock, they can use cash from the dividend payment to buy more.
In the repurchase case, if investors want more cash, they can sell some of shares of the stock. This practice is
known as creating "home-grown dividends."
Question 9. In imperfect markets, would rational investors prefer dividends or repurchases? Explain.
Repurchases because the tax on dividends is higher than then tax on capital gains.
Question 10. If repurchases offer tax advantages, why do we still observe significant redistributions via
dividends? Explain.
Solution: For help with this problem, refer the lecture notes.
Irrational investors may avoid create "home dividends", due to mental accounting (for example), and
therefore would like the sense of stability given by dividends. Firms, may exploit this and pay dividends.
Moreover, demand for dividends may be time-varying. In some periods, investors may prefer dividends to
capital gains, because these feel safer. Therefore, managers may recognize this and pay more dividends when
investors want them (in order to attract more investors and boost their stock price).
Page 8 of 9
Question 11. Since dividends are inefficient, they should be completely abolished and all the payouts should
be made via repurchases. Do you agree with this statement?
It depends on whether dividends can improve valuations. For example, irrational investors may prefer them.
Moreover, managers may be overconfident so dividends can help discipline them.
Question 12. If markets are inefficient and price ≠ value, what should we observe for firms that engage in
share buy-backs, i.e. firms that repurchase shares from existing shareholders?
Firms would only buy back their shares if they believe shares are underpriced. This means we should observe
the opposite from what we observe from SEO’s, i.e., on average the share prices of firms which engage in buy-
backs rise over time to reach their correct fundamental values. This is exactly what we observe from empirical
studies which analyze how prices of companies who engage in buy-backs behave over time after the event.
SEO: seasoned equity offering.
Page 9 of 9

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Problem Set 1

Course: Foundations of Finance

Welch, Chapter 1 and 2

5.∗ Answer the following questions:

Period 0 0.5 1 1.5 2

N P V = 25M + 50M/(1.0247)2 + 25M/(1.0247)4 = 95.294.

N P V = 25M + 25M/(1.0247) + 25M/(1.0247)2 + 25M/(1.0247)3 = 96.44 So lateness costs

Course: Foundations of Finance

Welch, Chapters 5 and 6

Solution: For help with this problem, refer to chapter 5.1.

Solution: For help with this problem, refer to chapter 5.3.

3.∗ Consider the following £100 face-value bonds:

Solution: For help with this problem, refer to chapter 5.3.

Solution: For help with this problem, refer to chapter 6.2.

Solution: For help with this problem, refer to chapters 6.1.

Course: Foundations of Finance

Welch, Chapters 7 and 8

Solution: For help with this problem, refer to chapter 6.1.

Solution: For help with this problem, refer to chapter 6.2.

Solution: For help with this problem, refer to chapter 8.2.

4. Identify whether the following risks can be diversified away:

Solution: For help with this problem, refer to chapter 8.3.

5. Explain what we mean when we say that portfolio X is efficient.

Solution: For help with this problem, refer to chapter 8.2.

Solution: For help with this problem, refer to chapter 8.3.

E[rS ] = E[rI ] = 0.6 · 0.15 + 0.4 · (−0.1) = 0.05

For portfolios, recall that:

Var(rp ) = σp2 = wx2 σx2 + wy2 σy2 + 2wx wy ρxy σx σy .

Var(rpS ) = σp2S = 0.52 · 1.5% + 0.52 · 1.5% + 2 · 0.52 · 1 · 1.5% = 1.5%

Portfolio S enjoys no benefits from diversification since ρ = 1. In portfolio I risk is halved

Solution: For help with this problem, refer to chapter 8.3.

Solution: For help with this problem, refer to chapter 8.3.

1. CAPM: 𝐸(𝑟𝑖 ) = 𝑟𝑓 + 𝛽𝑖 (𝐸(𝑟𝑚 ) − 𝑟𝑓 )

9. Tax adjusted cost of capital = (𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙) × (1 − 𝜏𝑐 )

The covariance is given by

Now in real terms:

Now use correct numbers in the present value calculation:

𝐶𝐹 1+𝑔 𝑇 833,333.3 1.025 5

So, Sam overestimates the PV of the project by

1. CAPM: 𝐸(𝑟𝑖 ) = 𝑟𝑓 + 𝛽𝑖 (𝐸(𝑟𝑚 − 𝑟𝑖 )

𝑝𝑟𝑜𝑚𝑖𝑠𝑒𝑑 𝑝𝑎𝑦𝑜𝑓𝑓 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑

Now we can find the levered beta:

Alternatively, you can use

100% equity bond Levered equity

𝐸[𝐶𝐹𝑗𝑢𝑛𝑖𝑜𝑟 𝑑𝑒𝑏𝑡 ] = 20 ⋅ 0.2 + 70 ⋅ 0.6 + 70 ⋅ 0.2 = ¥60𝑀.]

The price of the project is

Senior Creditor Payoff Junior Creditor Payoff Shareholders Payoff

Part II: Market (in)efficiency

1. 𝐶𝐹𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 = 𝐶𝐹𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥 (1 − 𝜏𝑐 ) = 𝐸[𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑐𝑜𝑠𝑡 − 𝑝𝑟𝑜𝑓𝑖𝑡 × 𝜏𝑐 ] where 𝜏𝑐 is the

5. With leverage and 1 period cash inflow,

100% equity bond Levered equity

𝑊𝐴𝐶𝐶 = 𝑤𝑑 × 𝑟𝑑 + 𝑤𝑒 × 𝑟𝑒 = 0.8667 × 10.77% + 0.1333 × 80% = 20%.

APV = 3.636 + 0.14 = $3.77M

Firm Convertible Equity

10. In general, r = t 1 + rt − 1 , r is annual interest rate, t is the number of compounding periods in

Market Price of Security £1.00 £1.50 £2.00

Call @ £1.80 0 – 0.05 -0.05 0.15

Put @ £1.20 1.20 - 1.00 – 0.10 -0.10 -0.10

Net +0.05 -0.15 +0.05

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