Business Finance I

Lecture 6
Stock Valuation
Readings: Chapter 8

Course Professor: Dr. Shi Li

Overview

 Equity Securities: General Characteristics

 How to value common stocks

 Dividend Growth Model (DGM)
 Case 1: Zero Growth
 Case 2: Constant Growth
 Case 3: Differential Growth

 Relative Valuation Approaches: “Using multiples”

 Price-to-Earnings ratio (P/E)
 Market-to-Book ratio (M/B)
Equity Securities: General Characteristics
 Shares of capital stock: Claims against a firm’s equity
 Residual claims to after-tax earnings or to the firm’s assets if there is
dissolution.
 Two general types of shares:
 Preferred shares: priority in dividend payments and liquidation (over
common shareholders) but typically have no “voting rights”
 Common shares: dividends for an ongoing firm and control over the
firm’s decisions (via “voting rights”)

 Shares have no specified maturity date

 Corporations are separate entities, and
 Corporations are assumed to have infinite lives.
 Equities (may) pay dividends from after-tax earnings.

3
Characteristics of Dividends

 The payment of dividends is at the discretion of the

board of directors.

 Dividends are not a liability of the firm until a

dividend has been declared by the Board

 Consequently, a firm cannot go bankrupt for not

declaring dividends
Preferred Stocks Features

 Dividends
 Most preferred stocks have a stated dividend that must be
paid before common dividends can be paid
 Dividends are not a liability of the firm so preferred
dividends can be deferred indefinitely

 Preferred stock generally does not carry voting rights;

voting is typically reserved to common share holders
Common Stock Valuation

 Recall: the value of any asset is the present value of its

expected future cash flows!!!

 Stock ownership produces cash flows from:

 Dividends: A distribution of the company’s earnings
 Capital Gains: Share price appreciation (Pt+1 – Pt)

 Stock Valuation with Dividend and its Growth

 Case 1: Zero Growth
 Case 2: Constant Growth
 Case 3: Differential Growth

6
 DGM Case 1: Zero Growth
 Assume that dividends are paid regularly and will remain at the
same level forever
Div 1  Div 2  Div 3 
Div1 Div2 Div3 C

One period ahead

0 1 2 3 T

 Since future cash flows are constant, the value of a zero

growth stock is just the PV of a perpetuity:
𝐶 Div1
𝑃𝑉 = P0 
𝑟 r
7
A Zero Growth Example

Q: Kyoxeus Corp. is expected to pay a $0.75 dividend per

annum, starting a year from now, in perpetuity. If stocks of
similar risk earn 15% annual return, what is the share price of
Kyoxeus Corp.?

A:

8
 DGM Case 2: Constant Growth
Assume that dividends will grow at a constant rate, g, forever:
Div2 = Div3 =
Div1 Div1 x (1+g) Div1 x (1 + g)2 C

One period ahead

0 1 2 3 T

Since future cash flows grow at a constant rate forever, the value of a
constant growth stock is the PV of a growing perpetuity:
More generally, we have:
𝐶 Div 1 𝐷𝑖𝑣𝑡+1
𝑃𝑉 = P0  𝑃𝑡 =
𝑟−𝑔 rg 𝑟−𝑔

9
A Constant Growth Example
Q: South Park Corporation has common stock that paid its annual
dividend this morning. It is expected to pay a $3.60 dividend
one year from now and then dividends are expected to grow at a
rate of 4% per year forever. If the required return for similar
stocks is 16% annually, what is the predicted price of a share of
South Park stock?

A:

10
 DGM Case 3: Differential Growth

 Assume that dividends will grow at different rates in the near

future but then will grow at a constant rate thereafter.
 To value a Differential Growth Stock we need to:
 Estimate future dividends in the foreseeable future.
 Estimate the future stock price when the stock “becomes” a
Constant Growth Stock (Case 2)
 Compute the total PV of the estimated future dividends and
future stock price at the appropriate discount rate.

11
DGM Case 3: Differential Growth
We can value this as the sum of:
A. An N-year growing annuity at rate g1

C  (1
PA  1
r
B. Discounted value of a growing perpetuity at rate g2 that starts
in year N+1
 DivN1  1 
PB    
 r  g 2  (1 r) 
N

Draw a Time Line!

12
A Differential Growth Example
Q: A common stock just paid a dividend of $2. The dividend is expected to
grow at 8% for 3 years, then it will grow at 4% in perpetuity. If stocks of
similar risk earn a12% annual return what is the stock worth?

C  (1 g1)T  C=2.16, r=12%,

A: PV(first growing annuity)=$5.5815. PA  1 
r  g1  (1 r)T  g1=8%, T=3
PV(perpetuity) = $23.3108,  DivN1  1  r=12%, g2=4%, N=3
PB    
 r  g 2  (1 r) N
 so Div4 = 2.62
Price=$28.89 Note: while we have two growth rates, the discount rate
(r) remains the same forever
13
Discussion of growth and discount rates (g, r)

 The value of a firm’s equity depends upon its

dividend growth rate (g) and its discount rate (r)

 What determines the value of g?

 What determines the value of r?

14
Discount rate (r)
 Re-arranging the constant dividend growth formula:
Divt 1 Divt1
Pt  r g
rg Pt
 The discount rate can be decomposed into two parts
𝐃𝐢𝐯𝐭+𝟏
 Dividend Yield ( )
𝐏𝐭
 Expected Dividend Growth Rate (g)

 We saw that estimates of g depends on assumptions which may be

incorrect leading to estimation error
 Our estimate of the discount rate (r) is, in turn, a function of our
estimate of g.
 Therefore, any estimation error in g leads us to a misleading
discount rate (r). → ‘GIGO’

15
Discount rate (r)
Q: Manitoba Shipping Co. (MSC) is expected to pay a
dividend of $8.06 per share next year. Future dividends
are expected to grow 2% per year indefinitely. If an
investor is currently willing to pay $62.00 for one share,
what is her required return for this investment?

A:

16
Dividend Growth Model: Concerns

 ‘g’ is just an estimate!

 How reasonable are the implicit assumptions?
 Not realistic for firms with high growth rates
 The model is well-specified only if r > g
 If g = r infinite firm value Div 1
P0 
 If g > r negative firm value rg
 What do we know about the estimate of r?
 What if firms change their dividend policy?
 What if firms don’t pay dividends?

17
 Relative Valuation
 Dividend payers can be valued via DGM…How to deal with non-
dividend payers?
 We can rely on relative valuation method. Specifically, Price-to-
Earnings (P/E) ratio is used for firms with positive earnings.
Price per share
P/E ratio 
EPS
 Calculated as current stock price over annual EPS
 P/E (TTM): often EPS is the sum of last 4 quarters’ earnings (so
it is also called Trailing P/E ratio.
 Need to compare firms’ P/E ratio with their benchmark P/E
ratio: A high (low) P/E ratio may suggest a stock is overvalued
(undervalued).

18
Relative Valuation: Price-to-Earnings Ratio
 Forward P/E: P/E ratio based on estimated future earnings.
 “Target” price: benchmark P/E ratio x estimated EPS.
Pt = Benchmark P/E ratio x EPSt

 Firms whose shares are “in fashion” sell at high multiples

 Growth stocks (e.g., SHOP, TSLA)
 Firms whose shares are out of favour sell at low multiples
 Value stocks (e.g., BCE, TECK)

19
Limitations of P/E ratio
 One year’s earnings can fall, but a stock price (according to the DGM
approach) is a function of many years of forecast cash flows.
 Falling earnings can result in skyrocketing P/E ratios.
 Earnings volatility creates great volatility in P/E ratios throughout the
business cycle.
 P/E ratios are uninformative when companies have negative, or very
low, earnings.

 Given the foregoing problems, analysts normally use smoothed or

normalized estimates of earnings for the forecast year, as well as
using a variety of different approaches to develop a range of potential
values for the stock.

20
 Other Price Ratios
 Analysts often relate share price to variables other than earnings
 Price/Sales ratio (for non-dividend payers with negative earnings)
 Current stock price over annual sales per share
 Amazon went public in 1997 but became profitable only after 2001

 Price/Book (a.k.a. “Market to Book” ratio)

 Current price over book value of equity per share
 An overvalued stock will have a higher Price/Book ratio.
 Other industry specific price ratios
 Monthly active users (MAU) in the social media industry;
 Price/FFO (funds from operation) in Real Estate Invest Trust (REIT)
industry
 Similar issues to P/E ratios
21
Business Finance I
Lecture 6
Stock Valuation
Readings: Chapter 8

Course Professor: Dr. Shi Li

Overview

 Equity Securities: General Characteristics

 How to value common stocks

 Dividend Growth Model (DGM)
 Case 1: Zero Growth
 Case 2: Constant Growth
 Case 3: Differential Growth

 Relative Valuation Approaches: “Using multiples”

 Price-to-Earnings ratio (P/E)
 Market-to-Book ratio (M/B)
Equity Securities: General Characteristics
 Shares of capital stock: Claims against a firm’s equity
 Residual claims to after-tax earnings or to the firm’s assets if there is
dissolution.
 Two general types of shares:
 Preferred shares: priority in dividend payments and liquidation (over
common shareholders) but typically have no “voting rights”
 Common shares: dividends for an ongoing firm and control over the
firm’s decisions (via “voting rights”)

 Shares have no specified maturity date

 Corporations are separate entities, and
 Corporations are assumed to have infinite lives.
 Equities (may) pay dividends from after-tax earnings.

3
Characteristics of Dividends

 The payment of dividends is at the discretion of the

board of directors.

 Dividends are not a liability of the firm until a

dividend has been declared by the Board

 Consequently, a firm cannot go bankrupt for not

declaring dividends
Preferred Stocks Features

 Dividends
 Most preferred stocks have a stated dividend that must be
paid before common dividends can be paid
 Dividends are not a liability of the firm so preferred
dividends can be deferred indefinitely

 Preferred stock generally does not carry voting rights;

voting is typically reserved to common share holders
Common Stock Valuation

 Recall: the value of any asset is the present value of its

expected future cash flows!!!

 Stock ownership produces cash flows from:

 Dividends: A distribution of the company’s earnings
 Capital Gains: Share price appreciation (Pt+1 – Pt)

 Stock Valuation with Dividend and its Growth

 Case 1: Zero Growth
 Case 2: Constant Growth
 Case 3: Differential Growth

6
 DGM Case 1: Zero Growth
 Assume that dividends are paid regularly and will remain at the
same level forever
Div 1  Div 2  Div 3 
Div1 Div2 Div3 C

One period ahead

0 1 2 3 T

 Since future cash flows are constant, the value of a zero

growth stock is just the PV of a perpetuity:
𝐶 Div1
𝑃𝑉 = P0 
𝑟 r
7
A Zero Growth Example

Q: Kyoxeus Corp. is expected to pay a $0.75 dividend per

annum, starting a year from now, in perpetuity. If stocks of
similar risk earn 15% annual return, what is the share price of
Kyoxeus Corp.?

A: P0 = 0.75 / 0.15 = $5

8
 DGM Case 2: Constant Growth
Assume that dividends will grow at a constant rate, g, forever:
Div2 = Div3 =
Div1 Div1 x (1+g) Div1 x (1 + g)2 C

One period ahead

0 1 2 3 T

Since future cash flows grow at a constant rate forever, the value of a
constant growth stock is the PV of a growing perpetuity:
More generally, we have:
𝐶 Div 1 𝐷𝑖𝑣𝑡+1
𝑃𝑉 = P0  𝑃𝑡 =
𝑟−𝑔 rg 𝑟−𝑔

9
A Constant Growth Example
Q: South Park Corporation has common stock that paid its annual
dividend this morning. It is expected to pay a $3.60 dividend
one year from now and then dividends are expected to grow at a
rate of 4% per year forever. If the required return for similar
stocks is 16% annually, what is the predicted price of a share of
South Park stock?

A: P0 = Divt = 1 / r – g = 3.60 / 0.16 – 0.04 = $30

10
 DGM Case 3: Differential Growth

 Assume that dividends will grow at different rates in the near

future but then will grow at a constant rate thereafter.
 To value a Differential Growth Stock we need to:
 Estimate future dividends in the foreseeable future.
 Estimate the future stock price when the stock “becomes” a
Constant Growth Stock (Case 2)
 Compute the total PV of the estimated future dividends and
future stock price at the appropriate discount rate.

11
DGM Case 3: Differential Growth
We can value this as the sum of:
A. An N-year growing annuity at rate g1

C  (1
PA  1
r
B. Discounted value of a growing perpetuity at rate g2 that starts
in year N+1
 DivN1  1 
PB    
 r  g 2  (1 r) 
N

Draw a Time Line!

12
A Differential Growth Example
Q: A common stock just paid a dividend of $2. The dividend is expected to
grow at 8% for 3 years, then it will grow at 4% in perpetuity. If stocks of
similar risk earn a12% annual return what is the stock worth?

A:

SIMILAR QUESTION ON THE FINAL EXAM

A Differential Growth Example
Q: A common stock just paid a dividend of $2. The dividend is expected to
grow at 8% for 3 years, then it will grow at 4% in perpetuity. If stocks of
similar risk earn a12% annual return what is the stock worth?

C  (1 g1)T  C=2.16, r=12%,

A: PV(first growing annuity)=$5.5815. PA  1 
r  g1  (1 r)T  g1=8%, T=3
PV(perpetuity) = $23.3108,  DivN1  1  r=12%, g2=4%, N=3
PB    
 r  g 2  (1 r) N
 so Div4 = 2.62
Price=$28.89 Note: while we have two growth rates, the discount rate
(r) remains the same forever
SIMILAR QUESTION ON THE FINAL EXAM 13
Discussion of growth and discount rates (g, r)

 The value of a firm’s equity depends upon its

dividend growth rate (g) and its discount rate (r)

 What determines the value of g?

 What determines the value of r?

15
Discount rate (r)
 Re-arranging the constant dividend growth formula:
Divt 1 Divt1
Pt  r g
rg Pt
 The discount rate can be decomposed into two parts
𝐃𝐢𝐯𝐭+𝟏
 Dividend Yield ( )
𝐏𝐭
 Expected Dividend Growth Rate (g)

 We saw that estimates of g depends on assumptions which may be

incorrect leading to estimation error
 Our estimate of the discount rate (r) is, in turn, a function of our
estimate of g.
 Therefore, any estimation error in g leads us to a misleading
discount rate (r). → ‘GIGO’

16
Discount rate (r)
Q: Manitoba Shipping Co. (MSC) is expected to pay a
dividend of $8.06 per share next year. Future dividends
are expected to grow 2% per year indefinitely. If an
investor is currently willing to pay $62.00 for one share,
what is her required return for this investment?

A:
P0 = Divt = 1 / r – g
62.00 = 8.06 / r – 0.02
R – 0.02 = 0.13
R = 0.15 or 15%

17
Dividend Growth Model: Concerns

 ‘g’ is just an estimate!

 How reasonable are the implicit assumptions?
 Not realistic for firms with high growth rates
 The model is well-specified only if r > g
 If g = r infinite firm value Div 1
P0 
 If g > r negative firm value rg
 What do we know about the estimate of r?
 What if firms change their dividend policy?
 What if firms don’t pay dividends?

18
 Relative Valuation
 Dividend payers can be valued via DGM…How to deal with non-
dividend payers?
 We can rely on relative valuation method. Specifically, Price-to-
Earnings (P/E) ratio is used for firms with positive earnings.
Price per share
P/E ratio 
EPS
 Calculated as current stock price over annual EPS
 P/E (TTM): often EPS is the sum of last 4 quarters’ earnings (so
it is also called Trailing P/E ratio.
 Need to compare firms’ P/E ratio with their benchmark P/E
ratio: A high (low) P/E ratio may suggest a stock is overvalued
(undervalued).

19
Relative Valuation: Price-to-Earnings Ratio
 Forward P/E: P/E ratio based on estimated future earnings.
 “Target” price: benchmark P/E ratio x estimated EPS.
Pt = Benchmark P/E ratio x EPSt

 Firms whose shares are “in fashion” sell at high multiples

 Growth stocks (e.g., SHOP, TSLA)
 Firms whose shares are out of favour sell at low multiples
 Value stocks (e.g., BCE, TECK)

20
Limitations of P/E ratio
 One year’s earnings can fall, but a stock price (according to the DGM
approach) is a function of many years of forecast cash flows.
 Falling earnings can result in skyrocketing P/E ratios.
 Earnings volatility creates great volatility in P/E ratios throughout the
business cycle.
 P/E ratios are uninformative when companies have negative, or very
low, earnings.

 Given the foregoing problems, analysts normally use smoothed or

normalized estimates of earnings for the forecast year, as well as
using a variety of different approaches to develop a range of potential
values for the stock.

21
 Other Price Ratios
 Analysts often relate share price to variables other than earnings
 Price/Sales ratio (for non-dividend payers with negative earnings)
 Current stock price over annual sales per share
 Amazon went public in 1997 but became profitable only after 2001

 Price/Book (a.k.a. “Market to Book” ratio)

 Current price over book value of equity per share
 An overvalued stock will have a higher Price/Book ratio.
 Other industry specific price ratios
 Monthly active users (MAU) in the social media industry;
 Price/FFO (funds from operation) in Real Estate Invest Trust (REIT)
industry
 Similar issues to P/E ratios
22
 In-class Problems
 Question 1: What would you pay for a share of ABC Corporation
stock today if the next dividend will be $2 per share in a year, your
required return on equity investments is 12%, and the stock is
expected to be worth $100 one year from now?
 Answer:
CF at the end of year 1 = $2 + 110 = $112
So PV today = ($112 / 1+12%) = 100)

23
 In-class Problems
 Question 2: The Reading Co. has adopted a policy of increasing the
annual dividend on its common stock at a constant rate of 3%
annually. The last dividend it paid today was $0.09 a share. What
will its dividend by in six (6) years?
 Answer:
D0 = 0.9, so D6 = 0.9 * (1 + 3%)6 = 1.07
= $1.07

24
 In-class Problems
 Question 3: RTF Inc pays an annual divided that increases by 3.8%
annually. The company just paid a dividend and now its common
stock sells for $22 a share
 If the market rate of return on this stock is 8.2%, what is the amount
o f the latest dividend just paid?

 Answer:
P0 = D1 / (r – g), so D1 = P0 * (r – g) = 0.968
So the latest dividend just paid = (0.968 / 1 + 3.8%) = $0.93

25
Business Finance I
Lecture 7
Capital Budgeting
Readings: Chapter 9

Course Professor: Dr. Shi Li

Overview

 Capital Budgeting Evaluation

 Net Present Value (NPV)
 Other Criteria
 Payback Period (and discounted payback period)
 Average Accounting Return (AAR)
 Profitability Index (PI)
 Internal Rate of Return (IRR)
 Strengths and Weaknesses of these measures

2
Capital Budgeting: The Process

 1. Forecast project cash flows

 2. Use the appropriate discount rate (r)
 3. Evaluate projects using one or more methods
 NPV, Payback Period, Discounted Payback Period, Profitability
Index, IRR etc.
 4. Accept or reject project(s) based on one or more of the
evaluation criteria.

NPV = -C0 + C1/(1+r) + C2/(1+r)2 + …

C1 = first cash flow
C2 = second cash flow
3
John’s Expansion Project: An Example
 John is evaluating two
possible expansion projects.

 The projects are of very

similar risk and John will
use a 10% discount rate for
both projects.

 Cash flow estimates are

provided in the table.
Sum of
$1,300 $1,500
Cash Inflow:  John needs your help to
Recall: evaluate whether he should
Time Value of Money! expand his business in New
Higher risk, higher return! York, Chicago, both or
neither!!!
4
Net Present Value (NPV) rWACC  wE rE  wD rD (1 TC )
 E r   D 
 NPV: Net Present Value rWACC   E  rD (1 TC )
 D  E   D  E 
 Present value of all future cash inflows discounted at the WACC
(weighted average cost of capital ) minus the initial investment.

T
NPV ( project)  

C0: Initial investment for the project

CFt: Periodic cash flows of the project

 NPV: Basic Investment Rule

 NPV > 0 → Accept project
 NPV < 0 → Reject project
5
Net Present Value (NPV) rWACC  wE rE  wD rD (1 TC )
 E r   D 
 NPV: Net Present Value rWACC   E  rD (1 TC )
 D  E   D  E 
 Present value of all future cash inflows discounted at the WACC
(weighted average cost of capital ) minus the initial investment.

T
NPV ( project)  

C0: Initial investment for the project

CFt: Periodic cash flows of the project

 NPV: Basic Investment Rule

 NPV > 0 → Accept project
 NPV < 0 → Reject project
6
 Net Present Value (NPV)

Using Time Value of Money techniques we

simply discount each cash flow to its time
zero value.

All (t=0) discounted cash flows are summed

up to determine the NPV of each project.

For the two projects John is considering, we

have:

$1,300 $1,500

NPV (NY): -1,000 + 500/(1.10) + 400/(1.10)2 + 300/(1.10)3 + 100/(1.10)4 = $78.8198

NPV (Chicago): -1,000 + 100/(1.10) + 400/(1.10)2 + 400/(1.10)3 + 600/(1.10)4 = $131.8216

SELECT CHICAGO BECAUSE WE HAVE A HIGHER RETURN AND NPV 7

Net Present Value (NPV)
 John’s Expansion Project: The Decision
 If projects are independent and the firm has sufficient
capital to finance both projects, accept all positive NPV
projects!!!

Therefore John should expand in both Chicago & New York!!!

8
Net Present Value (NPV)

 John’s Expansion Project: The Decision

 If the projects are mutually exclusive, choose the
investment with the highest NPV.
Therefore John should expand to Chicago!
($131.82 > $78.82 > 0)

9
Why Use NPV?

 NPV represents the expected change in firm value from

undertaking the project
 NPV > 0 → Increase firm value
 NPV < 0 → Destroy firm value

 Strengths of NPV
 NPV uses cash flows
 NPV uses all relevant project cash flows
 NPV discounts cash flows correctly

10
Payback Period Rule
 Payback Period (PBP)
 Amount of time required for an investment to generate sufficient cash
flows to recover its initial cost
 Payback Period Rule
 A project is accepted if its payback period is less than a specified cutoff
period (Q: if the cutoff period = 3 years, which one to choose?)

Only needs $100, which is 1/3 of CF in year 3

PBP = 2 years + 1/3 of the 3rd year = 2.33 years

After year 3, still needs $100, which is 1/6 of CF in year

4. PBP = 3 years + 1/6 of the 4rd year = 3.167 years

11
Payback Period Rule
Weaknesses
 Cash flows after the PBP are ignored
 TVM: Timing of cash flows is ignored
 Risk differences are ignored
 Arbitrary benchmark: 2 years? 3 years? more/less?

Strengths
 Very simple to calculate and easy to understand
• Useful for small day-to-day decisions Discounting effect is limited…
 May be useful for firms with limited access to capital
• Focus on quick cash recovery
 May not be as limited in practice as in theory
• Significant cash flows beyond the cutoff date may not be ignored
in practice.
12
Discounted Payback Period Rule

 The payback period of an investment project using cash

flows that have been discounted
 Accounts for the timing (TVM) and riskiness of cash flows
which is an improvement over basic Payback Period

 The other Payback Period weaknesses remain

 Arbitrary benchmark – when is the cutoff period?
 Cash flows beyond the payback period ignored

13
Average Accounting Return (AAR)

Average Net Incom

AAR 
Ave

AAR: Basic Investment Rule

 AAR > firm’s target AAR → Accept project
 AAR < firm’s target AAR → Reject project

“Another attractive and fatally flawed approach to making financial decisions is

the average accounting return (AAR).

The average accounting return is the average project earnings after taxes and
depreciation, divided by the average book value of the investment during its
life” – RJWR

14
The Profitability Index (PI)

 Profitability Index: Basic Investment Rules

PV(Cash flows subsequent to initial investment)
PI 
Initial investment
 PI shows you the value created per $1 dollar invested. Hence, it is
a measure of investment efficiency.

 According to NPV criterion, all NPV > 0 projects should be

accepted. Therefore, Profitability Index decision rule is:
 If NPV > 0 then PI > 1 → Accept project
 If NPV < 0 then PI < 1 → Reject project

15
 The Profitability Index (PI)
 PI decisions are largely consistent with NPV decisions.
 However,…
 If two mutually exclusive projects have PI > 1, which one
to choose? The project with a higher PI?
 PI is a ratio. It does not account for $$$ scale of the project,
leading to “wrong” decision
A: C0 = 10,000, PV(CFs) = 15,000, PIA = 15,000 / 10,000 = 1.5 = $5,000
B: C0 = 500, PV(CFs) = 1,000, PIB = 1,000 / 500 = 2, NPVB = $500

 A higher PI only means the investment in that project is

more efficient. It does not mean that project will maximize
shareholder’s wealth.
16
Internal Rate of Return (IRR)
 IRR: Internal Rate of Return
 Definition: Rate of return that causes the project to have NPV = 0
 The most important alternative to the NPV approach
 A single number that summarizes the merits of a project

 IRR: Basic Investment Rule

 IRR > discount rate → Accept project ↔ NPV > 0
 IRR < discount rate → Reject project ↔ NPV < 0
 IRR rule will often, but not always, coincide with the NPV
rule
𝐶1 𝐶2 𝐶𝑇
𝑁𝑃𝑉 = −𝐶0 + + + ⋯+ 𝑇
1+𝑟 1+𝑟 2 1+𝑟

17
Internal Rate of Return (IRR)
New York r  IRR  1

500 400 300 100

−1000 + + + + =0
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)4

Chicago r  IRR  14.8181%

100 400 400 600
−1000 + + + + =0
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)4

IRR Investment Decision:

 Independent projects:
Accept both Chicago and New York
14.8181% > 14.4888% > 10% = WACC
 Mutually exclusive projects:
Accept Chicago only (higher IRR than New York)
Same as the decision based on the NPV rule.
18
Internal Rate of Return (IRR)

 Problems with the IRR Approach

 Implicitly assumes investment of periodic cash flows at
the IRR

 Independent & mutually exclusive projects

 Multiple IRR solutions

 Mutually exclusive projects

 The scale problem

19
Problem 1: Multiple IRR solutions
Net
Present
Value
($)

Discount
0% Rate (%)

First
Candidate
for IRR Second
Candidate
for IRR

If cash flows are non-conventional (i.e., more than two CFs are negative), may
obtain non-unique IRR values
NPV < 0 if discount rate “low” or “high”
NPV > 0 for “moderate” discount rates 19
Problem 2: The Scale Problem
Mutually Exclusive Projects
Year 0 1 IRR NPV
Project A -$1,000 $2,500 150% $1,272.73

Project B -$10,000 $15,000 50% $3,636.36

2,500
NPV = -1,000 + .
(1+𝑟)
2,500
Given r = 10%, NPV = -1,000 + = 1,272.73.
(1+10%)
To get IRR, we make NPV = 0 (recall the definition of IRR)
2,500
Hence, -1,000 + = 0, IRR = 150%
(1+IRR)

The IRR rule chooses Project A.

But project B creates much more shareholder value (due to higher NPV)

21
Capital Budgeting Techniques

What techniques do managers use?

22
Business Finance I
Lecture 8
Lessons from Capital Market History
Readings: Chapter 12

Course Professor: Dr. Shi Li

1
Overview
 Measure of a Security’s Return
 Historical Return
 Expected Return

 Measure of a Security’s Risk

 Standard Deviation

 The Efficient Markets Hypothesis (EMH)

 Definition
 Different types (levels) of efficiency
 The historical evidence

2
Asset Classes
Three main asset classes:

 Cash Equivalents (or Money Market Instruments):

 Highly liquid, low-risk, and short-term investment securities
(e.g., Cash, T-bills, Commercial Papers)
 Commercial paper maturity is usually 2-3 months (short-term)
 Fixed Income (or Bonds):
 Debt instruments that have a longer maturity than Cash
Equivalents (e.g. Long term bonds)
 Equities (or Stocks):
 Ownership shares in a publicly held corporation (e.g. S&P
500, MSFT, TSLA)
 Alternative assets: commodity (e.g. gold or copper)
 Real Estate – hedges against inflation and Crypto

3
Measuring Historical Return
 What are the two components of a stock’s return?
 Dividends Dividend Yield
 Price appreciation Capital Gains (or Loss)

 For a single period, how do we calculate return?

D1 P1  P0
r1  
P0 P0 r1 = return at the end of period 1
D1 = dividend at the end of period 1
Dividend Yield* P1 = stock price at the end of period 1
Capital Gain/Loss* P0 = stock price at the end of period 0
Note*: assumes no tax consequences or transaction costs.

4
The Future Value of an Investment of $1 in 1957

Cumulative Return

$1(1 r1957 ) (1 r1958) $113

$62
$25

Common Stocks
Long Bonds
T-Bills

In the long-term, common stock presents a greater yield (high risk, high reward)
T-Bills stable over the long-term with minimal fluctuations
5
Measures of Risk: Variance/Standard Deviation

 The spread of a return distribution is a measure of how much an

observed return may deviate from its mean value (𝜇)

 We usually use the standard deviation (σ) to represent the spread

of a normal distribution
 Standard deviation is the square root of the variance
Assume the distribution (𝜇, 𝜎)
of final exam is (70, 5)
For a normal distribution
 68% of students’ grade vary
68% of obs within ± 1σ between 65 and 75;
 95% of students’ grade vary
95% of obs within ± 2σ between 60 and 80;
 99.7% (almost all) of students’
-3σ -2σ -σ r +σ +2σ +3σ 99.7% of obs within ± 3σ grade vary between 55 and 85

6
Calculating Variance – Historical Case
 Variance & standard deviation are measures of total risk
T

 ( r - r ̄ ) 2
and   2
  (2)(0.5)

2  t 1
---------------
 2  variance
T–1   standard deviation
r  arithmetic average
T  the number of data points (i.e.sometimes referred to as"N")

 Typically we speak in terms of standard deviation

 Variance is denominated in “squared units” which is hard to interpret

 It is the appropriate risk measure for individual securities or

assets in an undiversified portfolio

7
 Historical Return Statistics
 The history of capital market returns can be
summarized by:
σ 𝑟𝑖
Arithmetic Average Return = 𝑟ҧ =
𝑁
Geometric Average Return = 𝑁
1 + 𝑟1 1 + 𝑟2 … (1 + 𝑟𝑁 ሻ-1

Cumulative Return
 The standard deviation of those returns:
(R1  R) 2  (R2  R) 2   (R  R) 2
   2   (2)(0.5)  T
T 1
 The frequency distribution of the returns
8
 Average Annual Returns, 1957-2009
Arithmetic Avg Standard
Investment Annual Return Deviation Distribution

Canadian common stocks 10.70% 17.05%

Long Bonds 8.52 9.80

Treasury Bills 6.35 3.67

Generally
considered to
be the “risk
free” rate Inflation 4.01 3.18

9
Rates of Return 1957-2009

10
Risk-Return Tradeoff (1957-2009)
12.00
Higher expected return corresponds with
higher risk exposure
11.00

10.00
Common Shares
Annual Return Average

9.00

8.00 Long Bonds

7.00

6.00
T-Bills

5.00

4.00

3.00

2.00
0.00 5.00 10.00 15.00 20.00 25.00

Annual Return Standard Deviation

11
 Know Risk Premium for Final Exam
Risk Premium
 The Risk Premium is the additional return (over and above the
risk-free rate) resulting from bearing risk
 One of the most significant observations of stock and bond
market data is this long-run excess of security return over the
risk-free return
 The average excess return from Canadian common stocks
(i.e. their “risk premium”) for the period 1957 through 2009
was
10.70% – 6.35% = 4.35%
 The average excess return from Canadian long-term bonds
(i.e. their “risk premium”) for the period 1957 through 2009
was
8.52% – 6.35% = 2.17%
12
Can We Trust Historical Data?
 Historical data is helpful but should be used carefully
 “Torture numbers, and they'll confess to anything” – Gregg
Easterbrook (Author and NYT columnist)

 Which data sample & frequency to use?

 1 year, 5 years, 30 years, 100 years?

 “Difficult” to estimate expected return accurately

 Variance is more persistent  “easier” to estimate

 “Easier” to forecast average annual rate of return over longer

time periods
 Say, 5 to 10 years compared to just 1 year

13
S&P 500 Index
Which subset of the data are you sampling?

14
Nikkei Index
Which subset of the data are you sampling?

15
S&P 500 Index
Which subset of the data are you sampling?

16
The Efficient Market Hypothesis (EMH)

 Efficient market
 Information is widely and cheaply available to all investors.
 Security prices reflect all relevant and attainable information.

https://ca.finance.yahoo.com/

https://www.bloomberg.com/canada

https://www.sec.gov/edgar/searchedgar/companysear
ch.html

https://www.sedar.com/homepage_en.htm

17
The Efficient Market Hypothesis (EMH)
 The efficient market hypothesis states that
“prices react quickly and unambiguously to new information”

 Important lesson from market efficiency

 You can trust the market prices because they impound
available information about the value of a security.
18
 The Efficient Market Hypothesis (EMH)
 The efficient market hypothesis has a number of very
important messages for investors and managers:
 Since information is reflected in security prices quickly, knowing
information when it is released does an investor no good.
 Difficult to beat the market (i.e., “There's no free lunch”).
 The best estimate of the value of the firm is the market value of its stock
and bonds.
 When making investment decisions, the only way to increase the firm
value is to find superior investments whose expected return is greater than
the required return (i.e., positive NPV).
 In an efficient market you should expect to pay an equilibrium rate (or
price) for the financing obtained, commensurate with the riskiness of the
firm as perceived by investors.

19
The Different Types of Efficiency
 Weak Form
 Security prices reflect all information found in past prices
and volume.
 Technical Analysis is useless (e.g., MA, MACD, etc.)
 Semi-Strong Form
 Security prices reflect all publicly available information.
 Knowing current public information is useless
 Strong Form
 Security prices reflect all information—public and private.
 Knowing even inside information is useless!

20
What the EMH Does and Does NOT Say
 Much of the criticism of the EMH has been based on a
misunderstanding of what the hypothesis says/does not say.
 Mistake 1: Investors can throw darts to select stocks.
 This is almost, but not fully, true.
 An investor must still decide how risky a portfolio
she wants based on her risk appetite and the level
of expected return.

 Mistake 2: Prices are random

 Prices reflect information.
 The price CHANGE is driven by new information, which by
definition arrives randomly.
 Prices are no more random than the events that cause them to move!

21
The Evidence
 The record on the EMH is extensive, and on average it rather
supports EMH (in the semi-strong form) although many
examples of deviations from EMH exist.

 Studies fall into three broad categories:

1. Are changes in stock prices random? Are there profitable
“trading rules”?
2. Event studies: Does the market quickly and accurately
respond to new information?
3. The record of professionally managed investment firms.

22
Issues in Examining the Tests

 Have you really beaten the market?

 Is the investment strategy replicable?
 Have you adjusted for transaction costs?
 Have you adjusted for risk?
 Have you beaten the market consistently or is it luck or data
mining?
 What information was used to formulate your investment
strategy?
 Only price and volume data: Weak form
 All publicly available information: Semi-strong form
 Private information: Strong form

23
The Record of Mutual Funds

 If the market is semi strong-form efficient, then no matter

what publicly available information mutual-fund managers
rely on to pick stocks, their average returns should be the
same as those of the average investor in the market as a
whole.

 We can test efficiency by comparing the performance of

professionally managed mutual funds with the performance
of a market index.

24
The Record of Mutual Funds
Annual Return Performance of Different Types of U.S. Mutual Funds
Relative to a Broad-Based Market Index (1963-1998)
Small- Other-
company aggressive Growth and Maximum
All funds growth growth Growth Income income capital gains Sector

-1.06%
-0.39% -0.51%
-2.13% -2.17% -2.29%

-5.41%

-8.45%
Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and Seemingly Unrelated Assets,” Journal
of Financial Economics, 63 (2002).

25
Business Finance I
Lecture 10
Risk & Return: Portfolios 2
Readings: Chapter 13

Course Professor: Dr. Shi Li

1
 Compare to the Weighted Average Standard Deviation
Portfolio Combinations

1.40%

Second Cup
1.20%

50-50
1.00%

Minimum variance 50-50 If ρ = +1

portfolio
Expected Return

0.80%

0.60%

0.40%
Sleeman

0.20%

0.00%
4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00%

Standard Deviation

2
Portfolio Variance: Diversification Effects

3
Diversification
 Diversification can substantially reduce the variability of returns
without an equivalent reduction in expected returns
 This reduction in risk arises because worse than expected returns
from one asset are offset by better than expected returns from
another (Example: a company that makes umbrellas vs. one that
makes sunglasses)

 There is a minimum level of risk that cannot be eliminated by

diversification (i.e. economy-related risk)
 Systematic risk is not diversifiable (a.k.a. market risk)

 Unsystematic risk is diversifiable (a.k.a. firm-specific risk)

4
Diversification (continued)
 Variance (i.e., risk) of an asset’s return can be decomposed
 Systematic Risk
 Also called the Market Risk.
 Economy-wide random events that affect almost all assets to some
degree (e.g., GDP, CPI, financial crisis…)
 Unsystematic Risk
 Also called the Diversifiable Risk.
 Random events that affect single security or small groups of securities
(i.e., idiosyncratic risk, strike, resign of CEO, rejection from FDA)

 Diversification Effects
 Unsystematic risk is significantly reduced in “large” portfolios
 Systematic risk is not affected by diversification because all
securities in the portfolio are affected by macro-events.

5
 Diversification and Risk

Different Names, Same Thing

Adding securities to a
portfolio reduces total
risk (measured by σ)
thanks to diversification
effect.

Systematic risk which cannot be diversified away is measured by β

6
Next  combining assets
 Combining a risky portfolio and a risk-free asset
 The Capital Market Line (CML)

 Capital Asset Pricing Model (CAPM)

 The Security Market Line (SML)
 Limitations of the CAPM

7
Combine a Risky Portfolio and a Risk-free Asset

E(r)
K is called the
Tangency Portfolio

N
L Efficient Frontier
K
E(rK)

MV Port.
Sharpe Ratio (SR)
rf The slope of the CML is known
as the Sharpe Ratio (SR).

K 

8
Market Equilibrium
 Above analysis concerns one investor

 Assumptions:
 People only hold efficient portfolios.
 Markets are competitive and there are no frictions (i.e.
transaction costs, taxes, etc.).
 Investors have homogeneous beliefs regarding expected
returns, variances, and covariances.

9
 The Tangency Portfolio (Portfolio K)

 Two implications:
 Every investor’s portfolio is thus a combination of the
tangency portfolio and the riskless asset
 The sum of all investors’ risky asset portfolios must be the
portfolio of all risky assets in the economy. Therefore, the
tangency portfolio is the “Market Portfolio”

 All investors must be holding the market portfolio

 All investors are holding the same portfolio of risky assets
 The sum of all investor’s portfolios is “the market”.

10
Beta: A New Risk Measure
 Beta measures:
 Security’s market risk or systematic risk
 Security’s contribution to the market portfolio’s total risk
 Security’s responsiveness to changes in the market portfolio

Cov j,M  j,M  j M

j  
 2

 Calculating Beta:
 “Manually” using the formula above.
 Running a return regression model and finding the slope coefficient:

r j ,t   j   j rm,t   j ,t

11
Beta: A New Risk Measure
 Beta measures:
 Security’s market risk or systematic risk
 Security’s contribution to the market portfolio’s total risk
 Security’s responsiveness to changes in the market portfolio

Cov j,M  j,M  j M

j  
 2

12
 Stock Betas: IBM
IBM return

15.00
IBM Market

y = 0.8088x + 0.8116
10.00

5.00

0.00
Market return
-20.00 -15.00 -10.00 -5.00 0.00 5.00 10.00 15.00

-5.00

-10.00

-15.00

-20.00

-25.00

Beta is the slope of the regression line of the individual stock returns relative to the
market portfolio returns

12
Computing Beta: An Example
Q: The market portfolio has a standard deviation of 20%
and the covariance between the returns on the market and
those of stock W is 0.08.
What is the market’s beta?

 What is the beta of stock W?

 How do we interpret this value?

13
Estimates of  for Selected Stocks
Stock Beta

IBM 0.94
Google 0.96
Bank of Nova Scotia 0.89
Microsoft 1.01
Rogers Communications 0.58
Twitter 1.12
Kinross Gold Corporation1 -0.32

1. Data from Google Finance, Nov 14, 2017

Portfolio Beta
Diversification reduces variability from unique risk, but not
from market risk.
We calculate the beta of a portfolio as the weighted average
of the securities’ individual betas.

 p  W j j
n

j 1

Q: What is the average beta of a portfolio that includes all

the securities in the market?
A: average beta = 1. We actually hold the market.

16
Portfolio Beta: An Example


17
Security Market Line
Using beta as the appropriate risk measure, we can
derive a relationship between a security’s required
return and its SYSTEMATIC risk.
E(R)

Security Market Line (SML)

E(RM)
M
rf

βM = 1 β

18
Capital Asset Pricing Model (CAPM)

 The Security Market Line equation is a key result of the

Capital Asset Pricing Model (CAPM)

 Implications
 The relationship between required return & beta is linear
 All securities, if fairly priced, should be on the SML
 You only get rewarded for holding systematic risk because you can
always get rid of unsystematic risk by diversification.

19
Examining SML
rj : Required return under CAPM

Risk-free rate, Market Risk Premium,

Time Value of the premium for bearing
Money one unit of market risk

βj : the amount of market risk

for asset j

20
 CAPM (SML): An Example

Cov j,M  j,M j M

j  
2

21
CML vs. SML
Tangency Market
Portfolio Portfolio

The unit of horizontal axis is different!

 Capital Market Line (CML)
 Used with efficient portfolios. It traces the efficient set of holdings
formed with both risky assets and the risk-free asset.
 Measures risk using standard deviation (total risk).
 Security Market Line (SML)
 Relates return to market risk (beta) ONLY, not to total risk (standard
deviation).
 Used with individual assets or portfolios. All efficiently priced
individual securities and portfolios should lie on the SML.
22
Using CAPM: Some Concerns
 Practical problems with estimating required returns
 Estimates of the risk-free rate & market risk premium

 Is the CAPM even testable?

 Proxies must be used for the “market portfolio” Human Capital,
Properties,
 Commonly used proxies (e.g. S&P500) omit many assets Bonds,
etc.

 Academic research shows that factors other than β

materially impact investors’ expected returns
 Fama-French 3-Factors Model (Size Effect and Value Effect)
 Carhart 4-Factors Model (Momentum Effects)

23
 Alpha, Beta and the SML
 "Alpha" is the name commonly used
for "excess" returns earned on an
investment (portfolio)
A
RA = 11%  In the diagram, portfolios A and B
have betas of 1.0; therefore each
RM = 10% M should earn 10% according to CAPM
RB = 8% B
 However, if A produced a return of
RF 11%, we would say it has an alpha of
+1%, since it earns 1% more than
what it should earn for its level of risk
as measured by beta = 1
0 0.5 1.0 1.5 (i.e. 11% - 10% = +1%)
BetaM
 Similarly, B produces an alpha of -2%

(i.e. 8% - 10% = -2%)

24
 Summary of CAPM

 Capital Market Line → Used with efficient portfolios

 Security Market Line → Used with individual assets or
portfolios
 Beta is the relevant risk measure for individual assets
 Capital Asset Pricing Model
 Security Market Line equation:

 Limitations of CAPM

25
Business Finance I
Lecture 10
Risk & Return: Portfolios 2
Readings: Chapter 13

Course Professor: Dr. Shi Li

1
 Compare to the Weighted Average Standard Deviation
Portfolio Combinations

1.40%

Second Cup
1.20%

50-50
1.00%

Minimum variance 50-50 If ρ = +1

portfolio
Expected Return

0.80%

0.60%

0.40%
Sleeman

0.20%

0.00%
4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00%

Standard Deviation

2
Portfolio Variance: Diversification Effects

3
Diversification
 Diversification can substantially reduce the variability of returns
without an equivalent reduction in expected returns
 This reduction in risk arises because worse than expected returns
from one asset are offset by better than expected returns from
another (Example: a company that makes umbrellas vs. one that
makes sunglasses)

 There is a minimum level of risk that cannot be eliminated by

diversification (i.e. economy-related risk)
 Systematic risk is not diversifiable (a.k.a. market risk)

 Unsystematic risk is diversifiable (a.k.a. firm-specific risk)

4
Diversification (continued)
 Variance (i.e., risk) of an asset’s return can be decomposed
 Systematic Risk
 Also called the Market Risk.
 Economy-wide random events that affect almost all assets to some
degree (e.g., GDP, CPI, financial crisis…)
 Unsystematic Risk
 Also called the Diversifiable Risk.
 Random events that affect single security or small groups of securities
(i.e., idiosyncratic risk, strike, resign of CEO, rejection from FDA)

 Diversification Effects
 Unsystematic risk is significantly reduced in “large” portfolios
 Systematic risk is not affected by diversification because all
securities in the portfolio are affected by macro-events.

5
 Diversification and Risk

Different Names, Same Thing

Adding securities to a
portfolio reduces total
risk (measured by σ)
thanks to diversification
effect.

Systematic risk which cannot be diversified away is measured by β

6
Next  combining assets
 Combining a risky portfolio and a risk-free asset
 The Capital Market Line (CML)

 Capital Asset Pricing Model (CAPM)

 The Security Market Line (SML)
 Limitations of the CAPM

7
Combine a Risky Portfolio and a Risk-free Asset

E(r)
K is called the
Tangency Portfolio

N
L Efficient Frontier
K
E(rK)

MV Port.
Sharpe Ratio (SR)
rf The slope of the CML is known
as the Sharpe Ratio (SR).

K 

8
Market Equilibrium
 Above analysis concerns one investor

 Assumptions:
 People only hold efficient portfolios.
 Markets are competitive and there are no frictions (i.e.
transaction costs, taxes, etc.).
 Investors have homogeneous beliefs regarding expected
returns, variances, and covariances.

9
 The Tangency Portfolio (Portfolio K)

 Two implications:
 Every investor’s portfolio is thus a combination of the
tangency portfolio and the riskless asset
 The sum of all investors’ risky asset portfolios must be the
portfolio of all risky assets in the economy. Therefore, the
tangency portfolio is the “Market Portfolio”

 All investors must be holding the market portfolio

 All investors are holding the same portfolio of risky assets
 The sum of all investor’s portfolios is “the market”.

10
Beta: A New Risk Measure
 Beta measures:
 Security’s market risk or systematic risk
 Security’s contribution to the market portfolio’s total risk
 Security’s responsiveness to changes in the market portfolio

Cov j,M  j,M  j M

j  
 2

 Calculating Beta:
 “Manually” using the formula above.
 Running a return regression model and finding the slope coefficient:

r j ,t   j   j rm,t   j ,t

11
Beta: A New Risk Measure
 Beta measures:
 Security’s market risk or systematic risk
 Security’s contribution to the market portfolio’s total risk
 Security’s responsiveness to changes in the market portfolio

Cov j,M  j,M  j M

j  
 2

12
 Stock Betas: IBM
IBM return

15.00
IBM Market

y = 0.8088x + 0.8116
10.00

5.00

0.00
Market return
-20.00 -15.00 -10.00 -5.00 0.00 5.00 10.00 15.00

-5.00

-10.00

-15.00

-20.00

-25.00

Beta is the slope of the regression line of the individual stock returns relative to the
market portfolio returns

12
Computing Beta: An Example
Q: The market portfolio has a standard deviation of
20% and the covariance between the returns on the
market and those of stock W is 0.08.
What is the market’s beta?
Beta of market portfolio = Covariance of market
portfolio with itself / Variance of market portfolio
Beta of market portfolio = 20%^2 / 20%^2
Beta of market portfolio = 1

 What is the beta of stock W?

Beta of stock W = 0.08 / (20%^2)
Beta of stock W = 0.08 / 0.04
Beta of stock W = 2
 How do we interpret this value?
Therefore, the beta of stock W is 2, indicating that its returns are
twice as sensitive to the returns of the market portfolio.

13
Estimates of  for Selected Stocks
Stock Beta

IBM 0.94
Google 0.96
Bank of Nova Scotia 0.89
Microsoft 1.01
Rogers Communications 0.58
Twitter 1.12
Kinross Gold Corporation1 -0.32

1. Data from Google Finance, Nov 14, 2017

Portfolio Beta
Diversification reduces variability from unique risk, but not
from market risk.
We calculate the beta of a portfolio as the weighted average
of the securities’ individual betas.

 p  W j j
n

j 1

Q: What is the average beta of a portfolio that includes all

the securities in the market?
A: average beta = 1. We actually hold the market.

16
Portfolio Beta: An Example


17
Security Market Line
Using beta as the appropriate risk measure, we can
derive a relationship between a security’s required
return and its SYSTEMATIC risk.
E(R)

Security Market Line (SML)

E(RM)
M
rf

βM = 1 β

18
Capital Asset Pricing Model (CAPM)

 The Security Market Line equation is a key result of the

Capital Asset Pricing Model (CAPM)

 Implications
 The relationship between required return & beta is linear
 All securities, if fairly priced, should be on the SML
 You only get rewarded for holding systematic risk because you can
always get rid of unsystematic risk by diversification.

19
Examining SML
rj : Required return under CAPM

Risk-free rate, Market Risk Premium,

Time Value of the premium for bearing
Money one unit of market risk

βj : the amount of market risk

for asset j

20
 CAPM (SML): An Example

Cov j,M  j,M j M

j  
2

21
CML vs. SML
Tangency Market
Portfolio Portfolio

The unit of horizontal axis is different!

 Capital Market Line (CML)
 Used with efficient portfolios. It traces the efficient set of holdings
formed with both risky assets and the risk-free asset.
 Measures risk using standard deviation (total risk).
 Security Market Line (SML)
 Relates return to market risk (beta) ONLY, not to total risk (standard
deviation).
 Used with individual assets or portfolios. All efficiently priced
individual securities and portfolios should lie on the SML.
22
Using CAPM: Some Concerns
 Practical problems with estimating required returns
 Estimates of the risk-free rate & market risk premium

 Is the CAPM even testable?

 Proxies must be used for the “market portfolio” Human Capital,
Properties,
 Commonly used proxies (e.g. S&P500) omit many assets Bonds,
etc.

 Academic research shows that factors other than β

materially impact investors’ expected returns
 Fama-French 3-Factors Model (Size Effect and Value Effect)
 Carhart 4-Factors Model (Momentum Effects)

23
 Alpha, Beta and the SML
 "Alpha" is the name commonly used
for "excess" returns earned on an
investment (portfolio)
A
RA = 11%  In the diagram, portfolios A and B
have betas of 1.0; therefore each
RM = 10% M should earn 10% according to CAPM
RB = 8% B
 However, if A produced a return of
RF 11%, we would say it has an alpha of
+1%, since it earns 1% more than
what it should earn for its level of risk
as measured by beta = 1
0 0.5 1.0 1.5 (i.e. 11% - 10% = +1%)
BetaM
 Similarly, B produces an alpha of -2%

(i.e. 8% - 10% = -2%)

24
 Summary of CAPM

 Capital Market Line → Used with efficient portfolios

 Security Market Line → Used with individual assets or
portfolios
 Beta is the relevant risk measure for individual assets
 Capital Asset Pricing Model
 Security Market Line equation:

 Limitations of CAPM

25
Business Finance I
Lecture 11
Cost of Capital
Readings: Chapter 14

Course Professor: Dr. Shi Li

1
Overview
 Cost of Capital
 100% equity financed firm

 Weighted Average Cost of Capital (WACC)

 Cost of equity capital
 Common stock

 Preferred stock

 Cost of debt

 Liquidity and Cost of Capital

2
What is Cost of Capital: Example
 If we were developing a piece of software and
required $75,000 today to fund our work. At the end
of three years we believe we could sell the software
for $200,000.
 Let’s say that a venture capitalist looked at our
business plan and concluded that she would require a
return of 35% per year compounded annually to fund
this deal.
 This is like renting us the money at a cost of 35% per
year.

3
Cost of Capital: Example
 Does our software project cover the 35% cost of capital?
Interests (B)
$ we owe (A) A x 35% A+B

< 200,000
 We plan to rake in $200,000 by selling the software. We
can repay our financier or, in other words, repay our cost of
capital.
4
Cost of Capital: Example
 What if the financier wants 40%?
Interests (B)
$ we owe (A) A x 35% A+B

> 200,000
 Uh oh!

5
Cost of Capital: All Equity Firm
 From the firm’s perspective, the cost of (equity) capital is
the investors’ required return (on equity):

Investor’s
Return
E(ri )  rF  βi (E(rM )  rF ) Firm’s
Cost

 To estimate a firm’s cost of equity capital using CAPM (1st

way), we need to know three things
 The risk-free rate: r Cov(Ri , RM ) σ i,M
βi   2
 The company’s beta: Var(R M ) σM
The market risk premium E(rM )  rF
 OR using DGM (2nd way): 𝐷1
𝑟𝑖 = +𝑔
𝑃𝑖
,0 6
Example
 Suppose the stock of Facebook has a beta of 2.5.
The firm is 100-percent equity financed.

 Assume a risk-free rate of 5-percent and a market

risk premium of 10-percent. Q: Is this Rm or (Rm - Rf)?

 Q: What is the appropriate discount rate for this

firm?
Capital Budgeting & Project Risk
 Higher risk, higher return…

 A project’s cost of capital depends on the risk of the project

not the risk of the firm.

 If a new project has the same risk as the company’s existing

operations, we can use the firm’s cost of capital as the project’s
discount rate.

 The project’s cost of capital also does not depend on the

source of the funds.

8
Using Industry Betas

 Industry beta is a weighted average of firms’ betas

from a given industry

 It is frequently argued that using industry beta gives

better estimates of a firm’s beta.

 Use the industry beta if a firm’s operations are similar to

those of other firms in the industry.
 Use the firm’s beta if that firm’s operations are
fundamentally different from other firms in the industry.

9
Example: Capital Budgeting & Project Risk
Toucho Inc. has a 19% cost of equity (using CAPM). It has a
number of ongoing projects:
Project Project Beta rF  4%
Touch screen TVs 1.9
E(rM )  14%
Tablet PCs 1.5
USB Memory Sticks 0.8
β  1.50

If Toucho Inc. is interested in expanding its memory stick

production facility, what will be the cost of capital for that
project?

10
WACC: Cost of Common Stock
 Two methods previously introduced in this course

 Dividend Growth Models (DGM)

D1 D
PE ,0  r
r 

 CAPM Market Return

E(ri )  rF  βi (E(rM )  rF )
Market Risk Premium

11
 Tax Advantage of Debt
Issue $1000 debt at 6% Issue $1000 equity with 6% div.
Income Statement Income Statement

Revenues 5500 Revenues 5500

Expenses Expenses
Cost of goods sold Cost of goods sold 4125
412 Pre-tax profits 137
5 Interest expense 60 Tax (@ 40%)
Total Expenses After-tax profit
Pre-tax profits Less divid
Tax (@ 4 Prof
Afte

Tax difference: 550 - 526 = 24

Profit difference: 789 - 765 = 24
12
WACC: Cost of Debt

 Observe or compute the interest rate a firm must pay on

new borrowing
 We can observe interest rates in the market and assume that
new debt would require the same rate of return.
 If the firm has outstanding bonds, then the YTM on those bonds
may be used as the market’s required rate of return on new debt

 Don’t forget to make the tax-adjustment to the observed or

computed rate.

r r (
*
D

13
Capital Structure Weights

 Notation
 E = market value of equity = # outstanding shares
times price per share
 D = market value of debt = # outstanding bonds times
bond price
 V = market value of the firm = D + E
 Weights
 wE = E/V = Proportion financed with equity
 wD = D/V = Proportion financed with debt
Cost of Capital with Common Stock and Debt

Weighted Average Cost of Capital (WACC)

Computed in a similar manner to other weighted averages

rWACC  wE rE  wD rD (1 TC )


E   D 
rWACC rE   rD (1 TC )
 DE  DE

We make a “taxation adjustment” (1-TC) because a firm’s interest

payments are tax deductible.
(Remember: Debt is considered as “cost of doing business”. Thus,
it provides Interest Tax Shield to firms)

15
Estimating Cost of Capital for a company
(very important!!)
 To estimate the cost of capital for a company…
 Step 1: estimate the costs of debt and equity
 Estimate cost of equity with equity beta
 Estimate cost of debt using the YTM of the firm’s debt
 Step 2: calculate the weight of debt and equity
 Step 3: determine the WACC
rWACC  wE rE  wD rD (1 TC )

 
E   D 
rWACC E 
r  rD (1 TC )
 DE  DE
16
Estimating Cost of Capital for a company I

 Company’s beta is 1.39

 Risk-free rate is 4.16%
 Market risk premium is 4.32%
 The yield on the company’s bonds is 6.547%
 The firm has a 36.1% marginal tax rate
Security Market
value ($M)
Debt $6,245

Common $19,682
shares

17
Estimating Cost of Capital for a company II

 Company’s beta is 1.39

 Risk-free rate is 4.16%
 Market risk premium is 4.32%

 Cost of equity is easily calculated:

E(rE )  rF  βi (E(rM )  rF ) Market risk
premium

18
Estimating Cost of Capital for a company III

 The yield on the company’s outstanding bonds is

6.547%
 The firm has a 36.1% marginal tax rate
 Cost of debt is easily calculated:

𝑟∗ = 𝑟𝐷 1 − 𝑇𝐶
𝐷

19
Estimating Cost of Capital for a company IV
 To calculate the cost of capital, we need to estimate the
market-valued weights of equity and debt:
Security Market value ($M) Weight (%)

Debt $6,245

Common $19,682
shares

20
Estimating Cost of Capital for a company V

With the preliminary steps complete, compute WACC:

𝑟𝑊𝐴𝐶𝐶 = 𝑤𝐸 𝑟𝐸 + 𝑤𝐷 𝑟𝐷 (1 − 𝑇𝐶 )

This rate can be used to discount projects of similar risk to the

firm as a whole

21
WACC: Cost of Preferred Stock
Cost of preferred equity can be estimated using the
DGM:
Case I Case II
𝐷𝑝 𝐷𝑝
𝑃𝑝 = → 𝑟𝑝 = 𝑃𝑝,0 = 𝐷𝑝,1 → 𝑟𝑝 = 𝐷𝑝,1 + 𝑔
𝑟𝑝 𝑃𝑝 𝑟𝑝 − 𝑔 𝑃𝑝,0

The New WACC becomes:

rWACC  wS rS  wB (1 TC )rB  wP rP

  r   (1 T )r   r
S B P
rWACC S    P
S BP S BP S BP
C B

Notation:
S: Common Stock - B: Bonds (Debt) - P: Preferred Stock

22
Bond Pricing Notation

 Sometimes bond prices are expressed as a number

relative to 100.

 Eg. If a bond has a face value of $1,000 and the bond

price is expressed as “105” This means that the bond is
trading at $1050. ($1,000 x 105%)

 Similarly, if the bond price is expressed as “97”, it

means that the bond is trading at $970.

23
Problems and Pitfalls of WACC: 1

 WACC is an appropriate discount rate only if the

risk of the project is similar to the risk of the firm.

 If project risk differs from firm risk, other

approaches to determining the discount rate must
be adopted

24
Problems and Pitfalls of WACC: 2
 Comparing project return to the cost of
incremental financing to undertake the project

 Example: if a project yields 12% and can be

100% financed by debt that yields 8%, is it an
economically viable project?

 The side effect of the debt financing on yields of

other firm financing(s) must be taken into
account.

25
Problems and Pitfalls of WACC: 3
 Temporary Capital Structure
 If a firm’s capital structure is temporary, it may
not produce a WACC that is consistent with the
long-term risk/return relationship in the financial
markets.
𝑟𝑊𝐴𝐶𝐶
= 𝑤𝐸 𝑟𝐸 + 𝑤𝐷 𝑟𝐷 (1 − 𝑇𝐶 )

26
Problems and Pitfalls of WACC: 4
 Lack of market values of outstanding issues
 Use of book values of financings to determine
weights

27
Cost of Capital with Flotation Costs
 The transaction costs will increase the cost of capital for
firms beyond the required return of investors…
 Example: if you need $1M, but your underwriters ask for
a flotation cost of 10%. To ensure you have $1M in the
end, how much do you need to raise?
$1M = X * (1-10%) X = $1.11M
 General case:
𝑟 ∗ (1 − 𝑡𝑐)
𝑟 ∗ (1 − 𝑡𝑐 )
1−𝐹

28
Cost of Capital and Liquidity
Liquidity
 Academics have argued that the expected return on a stock and the
firm’s cost of capital are negatively related to the liquidity of the
firm’s shares.

 The cost of trading an illiquid stock reduces the total return an

investor receives (Bid-Ask spreads, brokerage fees, market-impact costs)

For stocks with

Investors demand higher trading costs Firms pay a higher
higher returns cost of capital
29
Liquidity and the Cost of Capital

Cost of Capital

Liquidity

→ An increase in liquidity lowers a firm’s cost of capital

30
Bond Credit Ratings and Cost of Debt
Credit Ratings
 Major bond rating firms: Standard & Poor’s (S&P), Moody’s, and
Fitch.

Also called high-yield

bond…attractive now?

 Credit rating is assigned based on a company’s default risk:

1) how likely a firms is to default;
2) protection for creditors in default events.
 Lower credit rating, higher cost of debt (i.e., higher YTM).
31
Conclusion
 Cost of Capital is the yardstick against which new
projects are measured

 Projects must earn at least the cost of capital to be

financially viable

 One indicator of the cost of capital is the cost of the firm’s

existing financing mix
 WACC is a technique to determine existing cost of capital

 Be aware of the limitations of WACC

32