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Finance Is One of The Most Difficult Subjects You Will Ever Love!
CORPORATE FINANCE Presented by Dr. Duong Thi Thuy An

GRADE COMPONENTS
Diligence,
awarenes
s,attitude
10% Small quizes:
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exam
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Dr. Duong Thị Thuy An Faculty of Finance Ho Chi Minh University of Banking
RECOMMENDED READING
• [1] Ross, S. A., Westerfield, R. W. and Jordan, B. D. (2019) Fundamentals of Corporate Finance. 12th ed.
New York: McGraw-Hill Education.
• [2] Brealey, R. A., Myers, S. C. and Allen, F. (2020) Principles of Corporate Finance. 13th ed. New York:
McGraw-Hill Education.
• [3] Trần Nguyễn Minh Hải, Nguyễn Đức Trung và ctg. (2021) Tài chính doanh nghiệp. Trường ĐH Ngân hàng
TP Hồ Chí Minh.
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COURSE OUTLINE
Chapter 1: An Introduction to Corporate finance
Chapter 2: Time value of money
Chapter 3: Risk and return
Chapter 4: Cost of capital
Chapter 5: Financial leverage and capital structure

CHAPTER 1
INTRODUCTION TO CORPORATE
FINANCE
KEY CONCEPTS AND SKILLS
1-7 Know Know the basic types of financial management decisions and the
role of the financial manager
Know Know the financial implications of the different forms of business
organization
Know Know the goal of financial management
Understand Understand the conflicts of interest that can arise between owners
and managers
Understand Understand the various types of financial markets
Understand Understand the various financial statements.
Compute Compute and, more importantly, interpret some financial ratios

Faculty of Finance
CHAPTER OUTLINE
1. Corporate Finance and the Financial Manager
2. Forms of Business Organization
3. The Goal of Financial Management
4. The Agency Problem and Control of the Corporation
5. Financial Markets and the Corporation
6. Financial statements and some key financial indicators
1-8
CORPORATE FINANCE
• Some important questions that are answered using finance:
• What long-term investments should the firm take on?
• Where will we get the long-term financing to pay for the investment?
• How will we manage the everyday financial activities of the firm?
1-9
FINANCIAL MANAGER
• Financial managers try to answer some or all of these questions
• The top financial manager within a firm is usually the Chief Financial Officer
(CFO)
• Treasurer – oversees cash management, credit management, capital expenditures,
and financial planning
• Controller – oversees taxes, cost accounting, financial accounting and data processing
Video: Understanding Corporate Structure
1-10
FINANCIAL MANAGEMENT DECISIONS
• Capital budgeting
• What long-term investments or projects should the business take on?
• Capital structure
• How should we pay for our assets?
• Should we use debt or equity?
• Working capital management

• How do we manage the day-to-day finances of the firm?
1-11
CAPITAL BUDGETING DECISION
• Capital budgeting decision (investment decision, capital expenditure-capex) is the
process of planning and managing a firm’s long-term investments.
• The financial manager tries to identify investment opportunities that the value of the
cash flow generated by that investment exceeds the cost of that investment.
• The types of investment opportunities that would typically be considered depend in
part on the nature of the firm’s business
• Evaluating the size, timing, and risk of future cash flows is the essence of capital
budgeting.
CAPITAL STRUCTURE DECISION
• Capital structure (or Financing decision) concerns ways in which the firm obtains and
manages the long-term financing it needs to support its long term investments. A firm’s
capital structure (or financial structure) is the specific mixture of long-term debt and
equity the firm uses to finance its operations.
• First, how much should the firm borrow? Second, what are the least expensive sources
of funds for the firm?
• Firms have a great deal of flexibility in choosing a financial structure. The question of
whether one structure is better than any other for a particular firm is the heart of the
capital structure issue.
• The financial manager has to decide exactly how and where to raise the money.
WORKING CAPITAL MANAGEMENT
• Working capital include firm’s short-term assets and liabilities, such as inventory,
money owed to suppliers.
• Managing the firm’s working capital is a day-to-day activity that ensures that the firm
has sufficient resources to continue its operations and avoid costly interruptions
• Some questions of working capital management: How much cash and inventory should
we keep on hand? (2) Should we sell on credit? If so, what terms will we offer, and to
whom will we extend them? (3) How will we obtain any needed short-term financing?
Will we purchase on credit or will we borrow in the short term and pay cash? If we
borrow in the short term, how and where should we do it?
CONCEPT QUESTIONS
• What is the capital budgeting decision?
• What do you call the specific mixture of long-term debt and equity that a firm chooses
to use?
• Into what category of financial management does cash management fall?
EXAMPLES OF RECENT INVESTMENT AND FINANCING DECISIONS BY
MAJOR PUBLIC CORPORATIONS.
Capital budgeting decision Capital structure decision
Intel (U.S.) Invests $7 billion in expanding semiconductor plant in Borrows $600 million from Chandler Industrial
Chandler, Arizona Development Authority.
Amazon (U.S.) Acquires self-driving start-up, Zoox, for over $1.2 Reinvests $33 billion that it generates from
billion operations
Amazon (U.S.) Announces construction of new plant to build the Announces plans to sell $2 billion of shares
electric Cybertruck
Shell (U.K./Holland Starts production at a deep-water development in the Cuts dividend to preserve cash
Gulf of Mexico
GlaxoSmithKline Spends $6 billion on research and development for Raises $1 billion by an issue 8-year bonds
(U.K.) new drugs.
Ørsted (Denmark) Completes a 230-MW wind farm in Nebraska Arranges a borrowing facility with 14 international
banks
Unilever Spends $8 billion on advertising and marketing Pays a dividend and completes $200 million
(U.K./Holland) program to buy back shares
Carnival Launches four new cruise ships Raises $770 million by sale of bonds; each bond can
Corporation be converted into about 19 shares
(U.S./U.K.)
FORMS OF BUSINESS ORGANIZATION-1
• Three major forms of business
• Sole Proprietorship
• Partnership
• General
• Limited
• Corporation
• Joint stock company
• Limited Liability Company
1-17
SOLE PROPRIETORSHIP
• Advantages • Disadvantages
• Easiest to start • Limited to life of owner
• Least regulated • Equity capital limited to owner’s
• Single owner keeps all the profits personal wealth
• Taxed once as personal income • Unlimited liability
• Difficult to sell ownership interest
1-18
PARTNERSHIP
• Two or more owners • Unlimited liability
• More capital available • General partnership
• Relatively easy to start • Limited partnership
• Income taxed once as • Partnership dissolves

personal income when one partner dies
or wishes to sell
• Difficult to transfer
ownership
1-19
CORPORATION
• Limited liability • Separation of ownership
• Unlimited life and management
• Separation of ownership • Double taxation (income
and management taxed at the corporate
• Transfer of ownership is rate and then dividends
easy taxed at the personal
rate)
• Easier to raise capital
1-20
GOAL OF FINANCIAL MANAGEMENT
• What should be the goal of a corporation?
• Maximize profit?
• Minimize costs?
• Maximize market share?
• Maximize the current value of the company’s stock?
• Does this mean we should do anything and everything to maximize owner
wealth?
1-21
THE AGENCY PROBLEM
• Agency relationship
• Principal hires an agent to represent his/her interests
• Stockholders (principals) hire managers (agents) to run the company
• Agency problem
• Conflict of interest between principal and agent
• Management goals and agency costs

• the term agency costs refers to the costs of the conflict of interest between stockholders and
management. These costs can be indirect or direct.
• Direct agency costs come in two forms. The first type is a corporate expenditure that benefits
management but costs the stockholders. The second type of direct agency cost is an expense that arises
from the need to monitor management actions
1-22
MANAGING MANAGERS
• Managerial compensation
• Incentives can be used to align management and stockholder interests
• The incentives need to be structured carefully to make sure that they achieve their
goal
• Corporate control
• The threat of a takeover may result in better management
• Other stakeholders
1-23
WORK THE WEB EXAMPLE
• The Internet provides a wealth of information about individual companies
• Some information providers: cafef.vn, vietstock.vn, cophieu68.vn
• Click on the web surfer to go to the site, choose a company and see what
information you can find!
1-24
QUICK QUIZ
• What are the three types of financial management decisions and what
questions are they designed to answer?
• What are the three major forms of business organization?
• What is the goal of financial management?
• What are agency problems and why do they exist within a corporation?
• What is the difference between a primary market and a secondary market?
1-25
ETHICS ISSUES
• Is it ethical for tobacco companies to sell a product that is known to be addictive and a
danger to the health of the user? Is it relevant that the product is legal?
• Should boards of directors consider only price when faced with a buyout offer?
• Is it ethical to concentrate only on shareholder wealth, or should stakeholders as a whole be
considered?
• Should firms be penalized for attempting to improve returns by stifling competition (e.g.,
Microsoft)?
1-26
FINANCIAL STATEMENTS AND KEY
FINANCIAL INDICATORS
FINANCIAL STATEMENTS
• Balance sheet
• Income statement
• Cash flow statement
• Explanatory note
BALANCE SHEET
• The balance sheet is a snapshot of the firm’s assets and liabilities at a given
point in time
• Assets are listed in order of decreasing liquidity
• Ease of conversion to cash
• Without significant loss of value
• Balance Sheet Identity
• Assets = Liabilities + Stockholders’ Equity
• Video : Financial statements
2-29
THE BALANCE SHEET - FIGURE 2.1
2-30
NET WORKING CAPITAL AND LIQUIDITY
• Net Working Capital= Current Assets – Current Liabilities
• Positive when the cash that will be received over the next 12 months exceeds the cash
that will be paid out
• Usually positive in a healthy firm
• Liquidity
• Ability to convert to cash quickly without a significant loss in value
• Liquid firms are less likely to experience financial distress
• But liquid assets typically earn a lower return
• Trade-off to find balance between liquid and illiquid assets
2-31
AN EXAMPLE OF A BALANCE SHEET -TABLE 2.1 TEXTBOOK
2-32
MARKET VALUE VS. BOOK VALUE
• The balance sheet provides the book value of the assets, liabilities, and equity.
• Market value is the price at which the assets, liabilities ,or equity can actually be bought
or sold.
• A company's book value is the amount of money shareholders would receive if assets
were liquidated and liabilities paid off.
• Market value and book value are often very different. Why?
• Which is more important to the decision-making process?
2-33
EXAMPLE 2.2 KLINGON CORPORATION
KLINGON CORPORATION
Balance Sheets
Market Value versus Book Value
Book Market Book Market
Assets Liabilities and Shareholders’ Equity
Market
NWC $ 400 $ 600 LTD $ 500 $ 500 capitalization=
NFA 700 1,000 SE 600 1,100 No.of shares*
Stock price
1,100 1,600 1,100 1,600
2-34
INCOME STATEMENT
• The income statement is more like a video of the firm’s operations for a
specified period of time.
• You generally report revenues first and then deduct any expenses for the
period
• Matching principle – GAAP says to show revenue when it accrues and match
the expenses required to generate the revenue
2-35
AN EXAMPLE OF AN INCOME STATEMENT – TABLE 2.2 TEXTBOOK
2-36
THE CONCEPT OF CASH FLOW
• Cash flow is one of the most important pieces of information that a financial
manager can derive from financial statements
• The statement of cash flows does not provide us with the same information
that we are looking at here
• We will look at how cash is generated from utilizing assets and how it is
paid to those that finance the purchase of the assets
2-37
STATEMENT OF CASH FLOWS
• Statement that summarizes the sources and uses of cash
• Changes divided into three major categories
▪ Operating Activity – includes net income and changes in most current accounts
▪ Investment Activity – includes changes in fixed assets
▪ Financing Activity – includes changes in notes payable, long-term debt, and equity
accounts, as well as dividends
3-38
Dr. Duong Thị Thuy An Copyright © 2016 by McGraw-Hill Global Education LLC. All
Faculty of Finance Horights reserved.
Chi Minh University of Banking
CASH FLOW FROM ASSETS
• Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders
• Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in
NWC
2-39
AN EXAMPLE OF A CASH FLOW STATEMENT
KEY FINANICAL INDICATORS
FINANCIAL STATEMENTS ANALYSIS
• Common-Size Balance Sheets
• Compute all accounts as a percent of total assets
• Common-Size Income Statements
• Compute all line items as a percent of sales
• Standardized statements make it easier to compare financial information,
particularly as the company grows.
• They are also useful for comparing companies of different sizes,
particularly within the same industry.
3.2 RATIO ANALYSIS
• Ratios also allow for better comparison through time or between companies.
• As we look at each ratio, ask yourself:
• How is the ratio computed?
• What is the ratio trying to measure and why?
• What is the unit of measurement?
• What does the value indicate?
• How can we improve the company’s ratio?
CATEGORIES OF FINANCIAL RATIOS
• Short-term solvency or liquidity ratios
• Long-term solvency or financial leverage ratios
• Asset management or turnover ratios
• Profitability ratios
• Market value ratios
SHORT-TERM SOLVENCY OR LIQUIDITY RATIOS
• Short-term solvency ratios: provides information about a firm’s liquidity (liquidity
measures).
• Measure the firm’s ability to pay its bills over the short run without undue stress.
• These ratios focus on current assets and current liabilities
• Short-term creditors of interest.
• Book values and market values are likely to be similar
• Current assets and liabilities can change fairly rapidly
SOME TERMINOLOGIES
Net income− preferred stock dividend
• EPS = Earnings per Share=
Average of outstanding shares
• DPS=Dividend per share
Shareholder′ s equity−preferred stock
• BVPS= Book value per share=
Average of outstanding shares
• EBIT = Earnings Before Interest and Taxes
• EBITDA = Earnings Before Interest, Taxes, Depreciation and Amortization
• EBT: Earning before tax
• EAT: Earning after tax= EBT (1-t)=(EBIT-I)(1-t)
t: corporate income tax rate
I: interest payment
Example: Prufrock corporation has 33 millions outstanding stocks, calculate EPS, BVPS.
COMPUTING LIQUIDITY RATIOS
Prufrock corporation example:
• Current Ratio = CA / CL
• 708 / 540 = 1.31 times
• Quick Ratio = (CA – Inventory) / CL
• (708 - 422) / 540 = .53 times
• Cash Ratio = Cash / CL
• 98 / 540 = .18 times
COMPUTING LONG-TERM LIQUIDITY RATIO (LEVERAGE RATIOS)
• Total Debt Ratio = (TA – TE) / TA
• (3588 - 2591) / 3588 = 28%
• Debt/Equity = TD / TE
• (3588 – 2591) / 2591 = 38.5%
• Equity Multiplier = TA / TE = 1 + D/E
• 1 + .385 = 1.385
ASSET MANAGEMENT (TURNOVER) RATIOS
• Inventory Turnover = Cost of Goods
Sold / Inventory
• 1344 / 422 = 3.2 times
• Receivables Turnover = Sales /
Accounts Receivable
• 2311 / 188 = 12.3 times
• Total Asset Turnover = Sales / Total
Assets
• 2311 / 3588 = .64 times
• It is not unusual for TAT < 1, especially
if a firm has a large amount of fixed
assets.
COMPUTING PROFITABILITY MEASURES
• Profit Margin = Net Income / Sales
• 363 / 2311 = 15.7%
• Return on Assets (ROA) = Net Income /
Total Assets
• 363 / 3588 = 10.1%
• Return on Equity (ROE) = Net Income /
Total Equity
• 363 / 2591 = 14.0%
• EBITDA Margin = EBITDA / Sales
• 967 / 2311 = 41.8%
COMPUTING MARKET VALUE MEASURES
Prufrock corporation example: 33 million
share outstanding
• Market Capitalization = $88 per share x 33
million shares = 2904 million
• PE Ratio = Price per share / Earnings per share
• 88 / 11 = 8 times
• Market-to-book ratio = market value per share /
book value per share
• 88 / (2591 / 33) = 1.12 times
USING FINANCIAL STATEMENTS
• Ratios are not very helpful by themselves: they need to be compared to something
• Time-Trend Analysis
• Used to see how the firm’s performance is changing through time
• Peer Group Analysis

• Compare to similar companies or within industries
• SIC and NAICS codes
POTENTIAL PROBLEMS
• There is no underlying theory, so there is no way to know which ratios are
most relevant.
• Benchmarking is difficult for diversified firms.
• Globalization and international competition makes comparison more
difficult because of differences in accounting regulations.
• Firms use varying accounting procedures.
• Firms have different fiscal years.
• Extraordinary, or one-time, events
End of Chapter
1-56
CHAPTER 2
TIME VALUE OF MONEY
CHAPTER ORGANISATION
2.1 Future Value and Compounding
2.2 Present Value and Discounting
2.3 More on Present and Future Values
2.4 Present and Future Values of Multiple Cash Flows
2.5 Valuing Equal Cash Flows: Annuities and Perpetuities
2.6 Comparing Rates: The Effect of Compounding Periods
2.7 Loan Types and Loan Amortization
2.8 Applications of time value of money: Bond valuation
2.9 Applications of time value of money: Stock valuation
2.10 Applications of time value of money: Project evaluation: NPV, IRR, MIRR, DPP.
58
CHAPTER OBJECTIVES
Distinguish Distinguish between simple and compound interest.
Calculate Calculate the present value and future value of a single amount for both
one period and multiple periods.
Calculate Calculate the present value and future value of multiple cash flows.
Calculate Calculate the present value and future value of annuities.
Compare Compare nominal interest rates (NIR) and effective annual interest rates
(EAR).
Distinguish Distinguish between the different types of loans and calculate the present
value of each type of loan.
Calculate NPV, IRR, MIRR, DPP, stock and bond value
59
TIME VALUE TERMINOLOGY
• Future value (FV) is the amount an investment is worth after one or more periods.
• Present value (PV) is the amount that corresponds to today’s value of a promised
future sum.
• The number of time periods between the present value and the future value is
represented by ‘t’.
• The rate of interest for discounting or compounding is
called ‘r’.
• All time value questions involve four values: PV, FV, r and t. Given three of them, it is
always possible to calculate the fourth.
60 Faculty of Finance
TIME VALUE TERMINOLOGY
• Compounding is the process of accumulating interest in an investment over time to
earn more interest.
• Interest on interest is earned on the reinvestment of previous interest payments.
• Discount rate is the interest rate that reduces a given future value to an equivalent
present value.
• Compound interest is calculated each period on the principal amount and on any
interest earned on the investment up to that point.
• Simple interest is the method of calculating interest in which, during the entire term of
the loan, interest is computed on the original sum borrowed.
2.1 FUTURE VALUE OF A SINGLE CASH FLOW
• Suppose you invest $1,000 for one year at 5% per year. What is the future value in
one year?
• Interest = 1,000(.05) = 50
• Value in one year = principal + interest = 1,000 + 50 = 1,050
• Future Value (FV) = 1,000(1 + .05) = 1,050
• Suppose you leave the money in for another year. How much will you have two years
from now?
• FV = 1,000(1.05)(1.05) = 1,000(1.05)2 = 1,102.50
FUTURE VALUES: GENERAL FORMULA
• FV = PV(1 + r)t
• FV = future value
• PV = present value
• r = period interest rate, expressed as a decimal
• t = number of periods
• Future value interest factor = (1 + r)t
63 5C-63
EFFECTS OF COMPOUNDING
• Simple interest
• Compound interest
• Consider the previous example
• FV with simple interest = 1,000 + 50 + 50 = 1,100
• FV with compound interest = 1,102.50
• The extra 2.50 comes from the interest of .05(50) = 2.50 earned on the
first interest payment
64 5C-64
FUTURE VALUES – EXAMPLE 2
• Suppose you invest the $1,000 from the previous example for 5 years. How much
would you have?
• 5 N; 5 I/Y; 1,000 PV
• CPT FV = -1,276.28
• The effect of compounding is small for a small number of periods, but increases as the
number of periods increases. (Simple interest would have a future value of $1,250,
for a difference of $26.28.)
65 5C-65
FUTURE VALUES – EXAMPLE 3
• Suppose you had a relative deposit $10 at 5.5% interest 200 years ago. How much
would the investment be worth today?
• 200 N; 5.5 I/Y; -10 PV
• CPT FV = -447,189.84
• What is the effect of compounding?
• Simple interest = 10 + 200(10)(.055) = 120.00
• Compounding added $447,069.84 to the value of the investment
66 5C-66
FUTURE VALUE AS A GENERAL GROWTH FORMULA
• Suppose your company expects to increase unit sales of widgets by 15%
per year for the next 5 years. If you sell 3 million widgets in the current
year, how many widgets do you expect to sell in the fifth year?
• 5 N;15 I/Y; 3,000,000 PV
• CPT FV = -6,034,072 units (remember the sign convention)
67 5C-67
QUICK QUIZ – PART I
• What is the difference between simple interest and compound interest?
• Suppose you have $500 to invest and you believe that you can earn 8%
per year over the next 15 years.
• How much would you have at the end of 15 years using compound interest?
• How much would you have using simple interest?
68 5C-68
FUTURE VALUES OF $100 AT 10%
FUTURE VALUE OF $1 FOR DIFFERENT PERIODS AND RATES
PRESENT VALUES
• How much do I have to invest today to have some amount in the future?
• FV = PV(1 + r)t
• Rearrange to solve for PV = FV / (1 + r)t
• When we talk about discounting, we mean finding the present value of some future
amount.
• When we talk about the “value” of something, we are talking about the present value
unless we specifically indicate that we want the future value.
74 5C-74
PRESENT VALUE – ONE PERIOD EXAMPLE
• Suppose you need $10,000 in one year for the down payment on a new car.
If you can earn 7% annually, how much do you need to invest today?
• PV = 10,000 / (1.07)1 = 9,345.79
75 5C-75
PRESENT VALUES – EXAMPLE 2
• You want to begin saving for your daughter’s college education and you
estimate that she will need $150,000 in 17 years. If you feel confident
that you can earn 8% per year, how much do you need to invest today?
• N = 17; I/Y = 8; FV = 150,000
• CPT PV = -40,540.34 (remember the sign convention)
76 5C-76
PRESENT VALUES – EXAMPLE 3
• Your parents set up a trust fund for you 10 years ago that is now
worth $19,671.51. If the fund earned 7% per year, how much did
your parents invest?
• N = 10; I/Y = 7; FV = 19,671.51
• CPT PV = -10,000
77 5C-77
PRESENT VALUE OF $1 FOR DIFFERENT PERIODS AND RATES
PRESENT VALUE – IMPORTANT RELATIONSHIP I
• For a given interest rate – the longer the time period, the lower
the present value
• What is the present value of $500 to be received in 5 years? 10 years?
The discount rate is 10%
• 5 years: N = 5; I/Y = 10; FV = 500
CPT PV = -310.46
• 10 years: N = 10; I/Y = 10; FV = 500
CPT PV = -192.77
82 5C-82
PRESENT VALUE – IMPORTANT RELATIONSHIP II
• For a given time period – the higher the interest rate, the smaller
the present value
• What is the present value of $500 received in 5 years if the interest rate
is 10%? 15%?
• Rate = 10%: N = 5; I/Y = 10; FV = 500
CPT PV = -310.46
• Rate = 15%; N = 5; I/Y = 15; FV = 500
CPT PV = -248.59
83 5C-83
QUICK QUIZ – PART II
• What is the relationship between present value and future value?
• Suppose you need $15,000 in 3 years. If you can earn 6% annually, how
much do you need to invest today?
If you could invest the money at 8%, would you have to invest more or
less than at 6%? How much?
84 5C-84
DISCOUNT RATE
• Often we will want to know what the implied interest rate is on an
investment
• Rearrange the basic PV equation and solve for r
• FV = PV(1 + r)t
• r = (FV / PV)1/t – 1
• If you are using formulas, you will want to make use of both the yx and the
1/x keys
85 5C-85
2.3 DETERMINING THE DISCOUNT RATE
• You currently have $100 available for investment for a 21-year period. At what
interest rate must you invest this amount in order for it to be worth $500 at maturity?
• r can be solved in one of three ways:
• Use a financial calculator
• Take the nth root of both sides of the equation
• Use the future value tables to find a corresponding value. In this example, you
need to find the r for which the FVIF after 21 years is 5 (500/100).
DETERMINING THE DISCOUNT RATE
• To determine the discount rate (r) in this example, a financial calculator is used.
Enter:
21 100 - 500
N I/Y PV FV
Solve for → 7.97
r = 7.97%
DISCOUNT RATE – EXAMPLE 3
• Suppose you have a 1-year old son and you want to provide $75,000
in 17 years towards his college education. You currently have $5,000
to invest. What interest rate must you earn to have the $75,000 when
you need it?
• N = 17; PV = -5,000; FV = 75,000
• CPT I/Y = 17.27%
89 5C-89
QUICK QUIZ – PART III
• What are some situations in which you might want to know the implied
interest rate?
• You are offered the following investments:
• You can invest $500 today and receive $600 in 5 years. The investment is low
risk.
• You can invest the $500 in a bank account paying 4%.
• What is the implied interest rate for the first choice, and which investment should
you choose?
90 5C-90
QUICK QUIZ – PART III
• What are some situations in which you might want to know the
implied interest rate?
• You are offered the following investments:
• You can invest $500 today and receive $600 in 5 years. The investment is
low risk.
• You can invest the $500 in a bank account paying 4%.
• What is the implied interest rate for the first choice, and which investment
should you choose?
91 5C-91
FINDING THE NUMBER OF PERIODS
• Start with the basic equation and solve for t (remember your logs)
• FV = PV(1 + r)t
• t = ln(FV / PV) / ln(1 + r)
• You can use the financial keys on the calculator as well; just remember the sign
convention.
92 5C-92
FINDING THE NUMBER OF PERIODS
• You have been saving up to buy a new car. The total cost will be $10,000. You
currently have $8000. If you can earn 6% on your money, how long will you have to
wait?
• To determine the number of periods (t) in this example, a financial calculator is used.
Enter:
6 8000 - 10 000
N I/Y PV FV
Solve for → 3.83
t = 3.83 years
NUMBER OF PERIODS – EXAMPLE 1
• You want to purchase a new car, and you are willing to pay
$20,000. If you can invest at 10% per year and you currently
have $15,000, how long will it be before you have enough
money to pay cash for the car?
• I/Y = 10; PV = -15,000; FV = 20,000
• CPT N = 3.02 years
94 5C-94
NUMBER OF PERIODS – EXAMPLE 2
• Suppose you want to buy a new house. You currently have $15,000, and
you figure you need to have a 10% down payment plus an additional 5%
of the loan amount for closing costs. Assume the type of house you want will
cost about $150,000 and you can earn 7.5% per year. How long will it be
before you have enough money for the down payment and closing costs?
95 5C-95
NUMBER OF PERIODS – EXAMPLE 2 CONTINUED
• How much do you need to have in the future?
• Down payment = .1(150,000) = 15,000
• Closing costs = .05(150,000 – 15,000) = 6,750
• Total needed = 15,000 + 6,750 = 21,750
• Compute the number of periods

• PV = -15,000; FV = 21,750; I/Y = 7.5
• CPT N = 5.14 years
• Using the formula

• t = ln(21,750 / 15,000) / ln(1.075) = 5.14 years
96 5C-96
QUICK QUIZ – PART IV
• When might you want to compute the number of periods?
• Suppose you want to buy some new furniture for your family room. You currently have
$500, and the furniture you want costs $600. If you can earn 6%, how long will you
have to wait if you don’t add any additional money?
97 5C-97
SUMMARY OF TIME VALUE CALCULATIONS
COMPREHENSIVE PROBLEM
• You have $10,000 to invest for five years.
• How much additional interest will you earn if the investment provides a 5%
annual return, when compared to a 4.5% annual return?
• How long will it take your $10,000 to double in value if it earns 5%
annually?
• What annual rate has been earned if $1,000 grows into $4,000 in 20
years?
99 5C-99
2.4 FUTURE VALUE OF MULTIPLE CASH FLOWS
• You deposit $1000 now, $1500 in one year, $2000 in two years and $2500 in three
years in an account paying 10 per cent interest per annum. How much do you have
in the account at the end of the third year?
• You can solve by either:
• compounding the accumulated balance forward one year at a time
• calculating the future value of each cash flow first and then totaling them.

SOLUTIONS
• Solution 1
• End of year 1: ($1 000  1.10) + $1 500 = $2 600
• End of year 2: ($2 600  1.10) + $2 000 = $4 860
• End of year 3: ($4 860  1.10) + $2 500 = $7 846
• Solution 2
$1 000  (1.10)3 = $1 331
$1 500  (1.10)2 = $1 815
$2 000  (1.10)1 = $2 200
$2 500  1.00 = $2 500
Total = $7 846

SOLUTIONS ON TIME LINES
Future value calculated by compounding forward one period at a time
0 1 2 3
Time
(years)
$0 $1100 $2860 $5346
1000 1500 2000 2500
x 1.1 x 1.1 x 1.1
$1000 $2600 $4860 $7846
Future value calculated by compounding each cash flow separately
0 1 2 3
Time
(years)
$1000 $1500 $2000 $2500

x 1.1
2200
x 1.12
1815
x 1.13
1331
Total future value $7846

PRESENT VALUE OF MULTIPLE CASH FLOWS
• You will deposit $1500 in one year’s time, $2000 in two years time and $2500 in
three years time in an account paying 10 per cent interest per annum. What is the
present value of these cash flows?
• You can solve by either:

• discounting back one year at a time
• calculating the present value of each cash flow first and then totaling them.

SOLUTIONS
• Solution 1
• End of year 2: ($2500  1.10–1) + $2000= $4273
• End of year 1: ($4273  1.10–1) + $1500= $5385
• Present value: ($5385  1.10–1) = $4895
• Solution 2
$2500  (1.10) –3 = $1878
$2000  (1.10) –2 = $1653
$1500  (1.10) –1 = $1364
Total = $4895

2.5 ANNUITIES
• Annuities: A sequence of payments required to be made or received at equal
intervals of time (payments are usually equal in value)
• Some examples of annuities include insurance premiums, rental payments, dividends
on government bonds and instalments for loans or mortgages
• It is assumed that payments and interest periods coincide (Simple Ordinary Annuity)
• A perpetuity is an annuity in which the cash flows continue forever.

PRESENT VALUE OF AN ANNUITY
C = equal cash flow

1 − 1/ (1 + r )t 
PV = C   

 r 
• The discounting term is called the present value interest factor for annuities (PVIFA).

• Example 1
You will receive $1000 at the end of each of the next ten years. The current
interest rate is 6 per cent per annum. What is the present value of this series of
cash flows?
PV = $1 000  

1 − 1/(1.06) 

10

 0.06 
= $1 000  7.3601
= $7 360.10
• Example 2
You borrow $10 000 to buy a car and agree to repay the loan by way of equal
monthly repayments over four years. The current interest rate is 12 per cent per
annum, compounded monthly. What is the amount of each monthly repayment?

1 − 1/ (1.01)48
$10 000 = C  

 0.01 
C = $263.33

FINDING THE RATE FOR AN ANNUITY
• You have a loan of $5000 repayable by instalments of $745.15 at the end of each
year for 10 years. What rate is implicit in this 10 year annuity?
• To determine the discount rate (r) in this example, a financial calculator is used.
Enter:
10 5000 0 -745.15
N I/Y PV FV PMT
Solve for → 8.00
r = 8%

FINDING THE NUMBER OF PAYMENTS FOR AN ANNUITY
• You have $2000 owing on your credit card. You can only afford to make the minimum payment of $40
per month. The interest rate on the credit card is 1 per cent per month. How long will it take you to pay
off the $2000.
• To determine the number of payments (t) in this example, a financial calculator is used.
Enter:
1 2 000 0 -40
N I/Y PV FV PMT
Solve for → 69.66
t = 69.66 months ÷ 12 = 5.81 years

FUTURE VALUE OF AN ANNUITY
• The compounding term is called the future value interest factor for annuities (FVIFA).
Refer to Table A 4.
FV = C 
(1 + r ) − 1
t

EXAMPLE—FUTURE VALUE OF AN ANNUITY
What is the future value of $1000 deposited at the
end of every year for 20 years if the interest rate is 6
per cent per annum?
FV = $1 000 
(1.06) 20

−1
0.06
= $1 000  36.7856
= $36 785.60

ANNUITIES DUE
• An annuity for which the cash flows occur at the beginning of the period. Example: a
lease.
• Suppose an annuity due has five payments of $400 each, and the relevant discount
rate is 10 percent. The time line looks like this:
• Notice how the cash flows here are the same as those for a four-year ordinary
annuity, except that there is an extra $400 at Time 0. For practice, check to see that
the value of a four-year ordinary annuity at 10 percent is $1,267.95. If we add on
the extra $400, we get $1,667.95, which is the present value of this annuity due.
Annuity due value = Ordinary annuity value × (1 + r)
PERPETUITIES
• The future value of a perpetuity cannot be calculated as the cash flows are infinite.
• The present value of a perpetuity is calculated as follows:
C
PV =
r

GROWING ANNUITIES AND PERPETUITIES
• Annuities commonly have payments that grow over time. Suppose, for example, that
we are looking at a lottery payout over a 20-year period. The first payment, made
one year from now, will be $200,000. Every year thereafter, the payment will grow
by 5 percent, so the payment in the second year will be $200,000 × 1.05 =
$210,000. The payment in the third year will be $210,000 × 1.05 = $220,500, and
so on. What’s the present value if the appropriate discount rate is 11 percent?
• g is the growth rate

2.6 COMPARING RATES
• The nominal interest rate (NIR) (stated interest rate, quoted interest rate) is the interest
rate expressed in terms of the interest payment made each period.
• The effective annual interest rate (EAR) is the interest rate expressed as if it was
compounded once per year.
• When interest is compounded more frequently than annually, the EAR will be greater
than the NIR.
• Annual percentage rate (APR) : The interest rate charged per period multiplied by
the number of periods per year.

CALCULATION OF EAR
m
 NIR 
EAR = 1 +  − 1
 m 
m = number of times the interest is compounded

COMPARING EARS
• Consider the following interest rates quoted by three banks:
• Bank A: 8.3%, compounded daily
• Bank B: 8.4%, compounded quarterly
• Bank C: 8.5%, compounded annually

COMPARING EARS
365
 0.083 
EAR Bank A = 1 +  − 1 = 8.65%
 365 
4
 0.084 
EAR Bank B = 1 +  − 1 = 8.67%
 4 
1
 0.085 
EAR Bank C = 1 + − 1 = 8.50%
 1 

COMPARING EARS
• Which is the best rate? For a saver, Bank B offers the best (highest) interest rate. For
a borrower, Banks A and C offer the best (lowest) interest rates.
• The highest NIR is not necessarily the best.
• Compounding during the year can lead to a significant difference between the NIR
and the EAR, especially for higher rates.

COMPLETE THE TABLE BELOW:
Nominal annual Compounding Effective rate
rate periods
11.5% Daily
15% Monthly
Fortnightly 14.5%
Quarterly 14.8%
5% Semi annually
7% Quarterly
20% Daily
Semi annually 6%
Quarterly 8%
Daily 12%

COMPLETE THE TABLE BELOW:
Nominal annual Compounding Effective rate
rate periods
11.5% Daily 12.19%
15% Monthly 16.08%
13.58% Fortnightly 14.5%
14.04% Quarterly 14.8%
5% Semi annually 5.06%
7% Quarterly 7.19%
20% Daily 22.13%
5.91% Semi annually 6%
7.77% Quarterly 8%
11.33% Daily 12%

2.7 APPLICATION OF TIME VALUE OF MONEY:
AMOTIZATION OF A LOAN
123
2.7 TYPES OF LOANS
• A pure discount loan is a loan where the borrower receives money today and repays
a single lump sum in the future.
• An interest-only loan requires the borrower to only pay interest each period and to
repay the entire principal at some point in the future.
• An amortised loan requires the borrower to repay parts of both the principal and
interest over time.

AMORTIZATION OF A LOAN
A loan of $5,000 is negotiated for 5 years at 9% p.a.
• (a) Calculate the annually repayments.
• (b) How much principal and interest are paid with the 4th repayment? How much is
still owed after the 4th repayment?
• (c) How much principal and interest have been paid over the three years of the loan?
• (d) After the first year it is possible to increase the yearly repayment to $1,500. If
this is done how long will it now take to repay the loan and how much interest will be
saved?

AMORTIZATION OF A LOAN
Year Beginning Total Interest Principal Ending

Balance Payment Paid Paid Balance
1 $5000.00 $1285.46 $450.00 $835.46 $4164.54
2 $4164.54 $1285.46 $374.81 $910.65 $3253.89
3 $3253.89 $1285.46 $292.85 $992.61 $2261.28
4 $2261.28 $1285.46 $203.52 $1081.94 $1179.33
5 $1179.33 $1285.46 $106.13 $1179.33 $0.00
Totals $6427.30 $1427.30 $5000.00

SUMMARY 2.1-2.7
• For a given rate of return, the value at some point in the future of an investment
made today can be determined by calculating the future value of that investment.
• The current worth of a future cash flow or series of cash flows can be determined for
a given rate of return by calculating the present value of the cash flow(s) involved.
• It is possible to find any one of the four components
(PV, FV, r, t) given the other three.
• A series of constant cash flows that arrive or are paid at the end of each period is
called an ordinary annuity.
• For financial decisions, it is important that any rates are converted to effective rates
before being compared.

BOND VALUATION
BOND TERMINOLOGY
• Coupon: The stated interest payment made on a bond.
• Face value: The principal amount of a bond that is repaid at the end of the term.
Also called par value.
• Coupon rate: The annual coupon divided by the face value of a bond.
• Maturity: The specified date on which the principal amount of a bond is paid.
• Yield to maturity (YTM): The rate required in the market on a bond.

BOND CHARACTERISTICS
• A bond is a type of fixed income security. Its promise is to deliver known future cash
flows.
• Investor (bondholder) lends money (principal amount) to issuer for a defined period of
time, at a variable or fixed interest rate
• In return, bondholder is promised
• Periodic coupon payments (most of the times paid semiannually); and/or
• The bond’s principal (maturity value/par value/face value) at maturity.
130 Dr. Duong Thị Thuy An Faculty of Finance Ho Chi Minh University of Banking
THE BOND PRICING FORMULA – 1
• Consider a bond paying coupons with frequency n.
• Cash flows: coupon C paid with frequency n up to year T, plus the principal M, paid at
T.
0 1 2 3 4 n
Purchase Coupon Coupon Coupon Coupon Coupon +

Price Face Value
Cash Outflows Cash Inflows

to the Investor to the Investor
• How much is the stream of cash flows worth today? To answer this question we need to
calculate the present value of the cash flows.
• The present value (purchase price) is the price we are willing to pay today in order to
receive the stream of cash flows.
THE BOND PRICING FORMULA-2
• Bond price is equal to present value of all the cash flows you receive if you hold to
maturity.
nT
𝑀𝐶
𝑃=෍ y s+ y nT
s=1 (1 + 𝑛) (1 + )
𝑛
• P: bond price;
• C: coupon payment (assumed constant);
• n: number of coupon payments per year;
• T: number of years to maturity;
• y: interest rate used to discount the cash flows; yield-to-maturity (YTM) or market
required yield;
• M: par value (or face value, or maturity value) of the bond.
THE BOND PRICING FOMULA-3
• Bond Price is equal to Present Value of all the cash flows you receive if you hold to
maturity
(2.2)
ZERO COUPON BONDS
• Make no periodic interest payments (coupon rate = 0%)
• The entire yield-to-maturity comes from the difference between the purchase price
and the par value
• Cannot sell for more than par value
• Sometimes called zeroes, deep discount bonds, or original issue discount bonds (OIDs)
• Treasury Bills and principal-only Treasury strips are good examples of zeroes

THE BOND PRICING FOMULA-4
Three special cases of the bond pricing formula:
• A zero-coupon bond:
• An annuity (coupons only):
• A perpetuity bond (coupons only, infinite maturity):
EXAMPLE
• Suppose the Xanth (pronounced “zanth”) Co. were to issue a bond with 10 years to
maturity. The Xanth bond has an annual coupon of $80. Similar bonds have a yield to
maturity of 8 percent. Based on our preceding discussion, the Xanth bond will pay $80
per year for the next 10 years in coupon interest. In 10 years, Xanth will pay $1,000 to
the owner of the bond. What would this bond sell for?
136
BOND PRICES: RELATIONSHIP BETWEEN COUPON AND YIELD
• If YTM = coupon rate, then par value = bond price

• If YTM > coupon rate, then par value > bond price
• Why? The discount provides yield above coupon rate
• Price below par value, called a discount bond
• If YTM < coupon rate, then par value < bond price
• Why? Higher coupon rate causes value above par
• Price above par value, called a premium bond
137 7-137
COMPUTING YIELD TO MATURITY
• Yield to Maturity (YTM) is the rate implied by the current bond price
• Finding the YTM requires trial and error if you do not have a financial
calculator and is similar to the process for finding r with an annuity
• If you have a financial calculator, enter N, PV, PMT, and FV, remembering
the sign convention (PMT and FV need to have the same sign, PV the
opposite sign)
140 7-140
YTM WITH ANNUAL COUPONS
• Consider a bond with a 10% annual coupon rate, 15 years to maturity and
a par value of $1,000. The current price is $928.09.
• Will the yield be more or less than 10%?
• N = 15; PV = -928.09; FV = 1,000; PMT = 100
• CPT I/Y = 11%
141 7-141
YTM WITH SEMIANNUAL COUPONS
• Suppose a bond with a 10% coupon rate and semiannual coupons, has a
face value of $1,000, 20 years to maturity and is selling for $1,197.93.
• Is the YTM more or less than 10%?
• What is the semiannual coupon payment?
• How many periods are there?
• N = 40; PV = -1,197.93; PMT = 50; FV = 1,000; CPT I/Y = 4% (Is this the YTM?)
• YTM = 4%*2 = 8%
142 7-142
TABLE 7.1
143 7-143
CURRENT YIELD VS. YIELD TO MATURITY
• Current Yield = annual coupon / price
• Yield to maturity = current yield + capital gains yield
• Example: 10% coupon bond, with semiannual coupons, face value of 1,000, 20 years to
maturity, $1,197.93 price
• Current yield = 100 / 1,197.93 = .0835 = 8.35%
• Price in one year, assuming no change in YTM = 1,193.68
• Capital gain yield = (1,193.68 – 1,197.93) / 1,197.93 = -.0035 = -.35%
• YTM = 8.35 - .35 = 8%, which is the same YTM computed earlier
144 7-144
GRAPHICAL RELATIONSHIP BETWEEN PRICE AND YIELD-TO-MATURITY (YTM)
1500
1400
1300
1200
Bond Price
1100
1000
900
800
700
600
0% 2% 4% 6% 8% 10% 12% 14%
YTM
Yield-to-maturity (YTM)
7-145 Dr. Duong Thị Thuy An Faculty of Finance Ho Chi Minh University of Banking
BOND CHARACTERISTICS AND REQUIRED RETURNS
• The coupon rate depends on the risk characteristics of the bond
when issued
• Which bonds will have the higher coupon, all else equal?
• Secured debt versus a debenture
• Subordinated debenture versus senior debt
• A bond with a sinking fund versus one without
• A callable bond versus a non-callable bond
146 7-146
INFLATION AND INTEREST RATES
• Real rate of interest – change in purchasing power
• Nominal rate of interest – quoted rate of interest, change in
actual number of dollars
• The ex ante nominal rate of interest includes our desired real rate
of return plus an adjustment for expected inflation
147 7-147
THE FISHER EFFECT
• The Fisher Effect defines the relationship between real rates, nominal rates,
and inflation
• (1 + R) = (1 + r)(1 + h), where
• R = nominal rate
• r = real rate
• h = expected inflation rate
• Approximation
• R=r+h
148 7-148
EXAMPLE 7.5
• If we require a 10% real return and we expect inflation to be
8%, what is the nominal rate?
• R = (1.1)(1.08) – 1 = .188 = 18.8%
• Approximation: R = 10% + 8% = 18%
• Because the real return and expected inflation are relatively
high, there is significant difference between the actual Fisher
Effect and the approximation.
149 7-149
• What is the price of a $1,000 par value bond with a 6% coupon rate paid
semiannually, if the bond is priced to yield 5% and it has 9 years to
maturity?
• What would be the price of the bond if the yield rose to 7%.
• What is the current yield on the bond if the YTM is 7%?
150 7-150
STOCK VALUATION
COMMON STOCK-VALUE
• Face value (par value)
• Book value: The net asset value of a company, calculated by total assets minus
intangible assets (patents, goodwill) and liabilities. It is the total value of the company's
assets that shareholders would theoretically receive if a company were liquidated
• Market value: The current quoted price at which investors buy or sell a share of common
stock at a given time
• Intrinsic value: The actual value of a company or an asset based on an underlying
perception of its true value including all aspects of the business, in terms of both tangible
and intangible factors. This value may or may not be the same as the current market
value
5
STOCK CHARACTERISTICS
• Cash Flows for Stockholders
• If you buy a share of stock, you can receive cash in two ways
• The company pays dividends
• You sell your shares, either to another investor in the market or back to the
company
• As with bonds, the price of the stock is the present value of these expected cash
flows
• Preferred stock: receive a fix dividend over time.

DDM -SINGLE HOLDING PERIOD
• Buy a stock and hold for one year
D1 P1 D1 + P1
V0 = 1
+ 1
= 1
(1 + r) (1 + r) (1 + r)
• P1 :the expected price per share at t=1

• D1:the expected dividend per share for year 1, assumed to be paid at the end of the year at t=1
• Example: suppose that you expect Carrefour SA (NYSE Euronext Paris: CA) to pay a €1.10
dividend next year. You expect the price of CA stock to be €53.55 in one year. The required
rate of return for CA stock is 9 percent. What is your estimate of the value of CA stock?
Discounting the expected dividend of €1.10 and the expected sales price of €53.55 at the
required return on equity of 9 percent, we obtain
D + P1 1.1 + 53.55
V0 = 1 1
= 1
= 50.14
1 (1 + r ) (1 + 0.09)
DDM-MULTIPLE HOLDING PERIODS
• Buy a stock and hold for n periods:
n Dt Pn
V0 =  t + (1 + r) n
t =1 (1 + r)
Example: For the next five years, the annual dividends of a stock are expected to be $2.00, $2.10,
$2.20, $3.50, and $3.75. In addition, the stock price is expected to be $40.00 in five years. If the
required return on equity is 10 percent, what is the value of this stock?
• The present values of the expected future cash flows can be written out as:
V0=
• Calculating and summing these present values gives a stock value of Po 1.818 +1.736 +1.653 +2.391
+2.328 +24.837 = $34.76.
• The five dividends have a total present value of $9.926 and the terminal stock value has a present
value of $24.837, for a total stock value of $34.76.
1
The Dividend discount model (DDM)
Infinite holding period:

 Dt
V0 = 
(2) t =1 (1 + r) t
Dt :dividend of period t
Vo: Present value of a stock
r: required rate of return on the stock
156
DIVIDEND CONSTANT GROWTH MODEL (GORDON MODEL)
• Dividends are expected to grow at a constant percent per period.
• P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 + …
• P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 + D0(1+g)3/(1+R)3 + …
• With a little algebra and some series work, this reduces to:
D 0 (1 + g) D1
P0 = =
R -g R -g

DGM – EXAMPLE 1
• Suppose Big D, Inc., just paid a dividend of $0.50 per share. It is
expected to increase its dividend by 2% per year. If the market requires
a return of 15% on assets of this risk, how much should the stock be
selling for?
• P0 = .50(1+.02) / (.15 - .02) = $3.92

DGM – EXAMPLE 2
• Suppose TB Pirates, Inc., is expected to pay a $2 dividend in one year. If the
dividend is expected to grow at 5% per year and the required return is 20%, what is
the price?
• P0 = 2 / (.2 - .05) = $13.33
• Why isn’t the $2 in the numerator multiplied by (1.05) in this example?

CONSTANT GROWTH MODEL (GORDON MODEL)
Example:
1. Suppose that an annual dividend of € 5 has just been paid (Do= € 5). The expected long - term
growth rate is 5% and the required return on equity is 8 percent.
Answer: The Gordon growth model value per share is Vo =Do(1 +g )/( r – g ) =(€ 5 *1.05)/(0.08 –
0.05) =€ 5.25/0.03= € 1752
2. A manufacturer of paper and plastic packaging has a sustainable increases in the level of earnings
with increases in dividends, payout ratio is 40 - 60 %. Most recent quarterly dividend was $0.26
.The forecasted dividend growth rate is 6.0 %per year, r= 10.1 %.
a) Calculate the Gordon growth model value for the above stock.
b) The current market price of stock is $30.18. Using your answer to question 1, judge whether the
stock is fairly valued, undervalued, or overvalued.
1
FEATURES OF PREFERRED STOCK
• Dividends
• Stated dividend that must be paid before dividends can be paid to common
stockholders
• Dividends are not a liability of the firm, and preferred dividends can be
deferred indefinitely
• Most preferred dividends are cumulative – any missed preferred dividends
have to be paid before common dividends can be paid
• Preferred stock generally does not carry voting rights
161 8-161
GORDON GROWTH MODEL- NO GROWTH (PREFERRED STOCK)
• If dividends are expected at regular intervals forever, then this is a
perpetuity and the present value of expected future dividends can be
found using the perpetuity formula
Po=D/r
• Stocks that have earnings and dividends that are expected to remain
constant → Preferred Stock
• Example: Suppose stock is expected to pay a $0.50 dividend every
quarter and the required return is 10% with quarterly compounding.
What is the price?
• P0 = .50 / (.1 / 4) = $20
QUICK QUIZ – PART I
• What is the value of a stock that is expected to pay a constant dividend of $2 per
year if the required return is 15%?
• What if the company starts increasing dividends by 3% per year, beginning with the
next dividend? The required return stays at 15%.

USING THE GORDON GROWTH MODEL TO FIND R
• Start with the DGM:
D 0 (1 + g) D1
P0 = =
R -g R -g
D 0 (1 + g) D1
R= +g= +g
P0 P0
164 8-164
FINDING THE REQUIRED RETURN - EXAMPLE
• Suppose a firm’s stock is selling for $10.50. It just paid a $1
dividend, and dividends are expected to grow at 5% per year.
What is the required return?
• R = [1(1.05)/10.50] + .05 = 15%
• What is the dividend yield?
• 1(1.05) / 10.50 = 10%
• What is the capital gains yield?
• g =5%
165 8-165
TABLE 8.1 - STOCK VALUATION SUMMARY
166 8-166
DIVIDEND AND CAPITAL GAIN
• Dividend:
• Common stockholders have the right to receive dividends if the board
of directors declares them.
• Dividends are usually paid in cash (cash dividends), but sometimes may
be paid in additional shares (stock dividends).
• Capital gains:
• Investors buy stock is to receive dividends; they may sell their stock for
more than they paid→ capital gain.
• When a stock is sold after having been held for 12 months or less, the
profit or loss is known as a short-term gain or loss. For stocks held
longer than 12 months, any gain or loss is long-term. Long-term gains
provide the greatest tax advantage
6
DIVIDEND CHARACTERISTICS
• 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
• Dividends and Taxes
• Dividend payments are not considered a business expense; therefore, they are not
tax deductible
• The taxation of dividends received by individuals depends on the holding period
• Dividends received by corporations have a minimum 70% exclusion from taxable
income
168 8-168
DIVIDEND
• Dividend payout ratio: The
percentage of earnings paid to
shareholders in dividends.Calculated
as:
• Dividend rate: The fixed or

adjustable rate paid on common Dividend per share
stock or preferred stock base on par =
value.Calculated as: Par value per share
6
• XYZ stock currently sells for $50 per share. The next
expected annual dividend is $2, and the growth rate is 6%.
What is the expected rate of return on this stock?
• If the required rate of return on this stock were 12%, what
would the stock price be, and what would the dividend yield
be?
170 8-170
2.10 PROJECT EVALUATION-NPV, IRR, MIRR,
DPP
171
NET PRESENT VALUE (NPV)
• Net present value is the difference between an investment’s market value (in today’s
dollars) and its cost (also in today’s dollars).
• Net present value is a measure of how much value is created by undertaking an

investment.
• Estimation of the future cash flows and the discount rate are important in the
calculation of the NPV.

NET PRESENT VALUE
Steps in calculating NPV:
• The first step is to estimate the expected future cash flows.

• The second step is to estimate the required return for projects of this risk level.
• The third step is to find the present value of the cash flows and subtract the initial
investment.

NPV ILLUSTRATED
0 1 2
Initial outlay Revenues $1000 Revenues $2000

($1100) Expenses 500 Expenses 1000
Cash flow $500 Cash flow $1000
– $1100.00
1
$500 x
1.10
+454.55
1
$1000 x
1.102
+826.45
+$181.00 NPV

NPV
• An investment should be accepted if the NPV is positive and rejected if it is negative.
• NPV is a direct measure of how well the investment meets the goal of financial
management—to increase owners’ wealth.
• A positive NPV means that the investment is expected to add value to the firm.

PAYBACK PERIOD
• The amount of time required for an investment to generate cash flows to recover its
initial cost.
• Steps of caculating payback period:
• Estimate the cash flows.
• Accumulate the future cash flows until they equal the initial investment.
• The length of time for this to happen is the payback period.
• An investment is acceptable if its calculated payback is less than some prescribed

number of years.

PAYBACK PERIOD ILLUSTRATED
Initial investment = –$1000
Year Cash flow
1 $200
2 400
3 600
Accumulated
Year Cash flow
1 $200
2 600
3 1200
Payback period = 2 2/3 years

ADVANTAGES OF PAYBACK PERIOD
• Easy to understand.
• Adjusts for uncertainty of later cash flows.
• Biased towards liquidity.

DISADVANTAGES OF PAYBACK PERIOD
• Time value of money and risk ignored.
• Arbitrary determination of acceptable payback period.
• Ignores cash flows beyond the cut-off date.
• Biased against long-term and new projects.

DISCOUNTED PAYBACK PERIOD
• The length of time required for an investment’s discounted cash flows to equal its
initial cost.
• Takes into account the time value of money.
• More difficult to calculate.
• An investment is acceptable if its discounted payback is less than some prescribed

number of years.
EXAMPLE—DISCOUNTED PAYBACK
Initial investment = —$1000
R = 10%
PV of
Year Cash flow Cash flow
1 $200 $182
2 400 331
3 700 526
4 300 205

EXAMPLE—DISCOUNTED PAYBACK (CONTINUED )
Accumulated
Year discounted cash flow
1 $182
2 513
3 1039
4 1244
Discounted payback period is just under three years

ORDINARY AND DISCOUNTED PAYBACK
R = 12.5%
Cash Flow Accumulated Cash Flow
Year Undiscounted Discounted Undiscounted Discounted
1 $ 100 $ 89 $ 100 $89

2 100 79 200 168
3 100 70 300 238
4 100 62 400 300
5 100 55 500 355
• Ordinary payback?
• Discounted payback?

ADVANTAGES AND DISADVANTAGES OF DISCOUNTED PAYBACK
- Includes time value of money - May reject positive NPV investments

- Easy to understand - Arbitrary determination of acceptable payback
period
- Does not accept negative estimated NPV investments
- Ignores cash flows beyond the cutoff date
- Biased towards liquidity
- Biased against long-term and new products

ACCOUNTING RATE OF RETURN (ARR)
• Measure of an investment’s profitability.
average net profit

ARR =
average book value
• A project is accepted if ARR > target average accounting return.

EXAMPLE—ARR
Year
1 2 3
Sales $440 $240 $160
Expenses 220 120 80
Gross profit 220 120 80
Depreciation 80 80 80
Taxable income 140 40 0
Taxes (25%) 35 10 0
Net profit $105 $30 $0
Assume initial investment = $240

EXAMPLE—ARR ( CONTINUED )
$105 + $30 + $0
Average net profit =
3
= $45
Initial investment + Salvage value

Average book value =
2
$240 + $0
=
2
= $120

EXAMPLE—ARR ( CONTINUED )
Average net profit

ARR =
Average book value
$45
=
$120
= 37.5%

DISADVANTAGES OF ARR
• The measure is not a ‘true’ reflection of return.
• Time value is ignored.
• Arbitrary determination of target average return.
• Uses profit and book value instead of cash flow and market value.

ADVANTAGES OF ARR
• Easy to calculate and understand.
• Accounting information almost always available.

INTERNAL RATE OF RETURN (IRR)
• The discount rate that equates the present value of the future cash flows with the
initial cost.
• Generally found by trial and error.
• A project is accepted if its IRR is > the required rate of return.
• The IRR on an investment is the required return that results in a zero NPV when it is
used as the discount rate.
EXAMPLE—IRR
Year Cash flow
1 $ 50
2 100
3 150
n Find the IRR such that NPV = 0
50 100 150
0 = –200 + + +
(1+IRR)1 (1+IRR)2 (1+IRR)3
50 100 150
200 = + +
(1+IRR)1 (1+IRR)2 (1+IRR)3

EXAMPLE—IRR (CONTINUED )
Trial and Error
Discount rates NPV
0% $100
5% 68
10% 41
15% 18
20% –2
IRR is just under 20%—about 19.44%

NPV PROFILE
Net present value
120 Year Cash flow

0 – $275
100 1 100
2 100
80 3 100
4 100
60
40
20
– 20
– 40 Discount rate
2% 6% 10% 14% 18% 22%
IRR

PROBLEMS WITH IRR
• More than one negative cash flow → multiple internal rates of return.
• Project is not independent → mutually exclusive investments. Highest IRR does not
indicate the best project.
Advantages of IRR
• Popular in practice
• Does not require a discount rate

MULTIPLE RATES OF RETURN
Assume you are considering a project for
which the cash flows are as follows:
Year Cash flows
0 –$252
1 1431
2 –3035
3 2850
4 –1000

n What’s the IRR? Find the rate at which
the computed NPV = 0:
at 25.00%: NPV = 0
at 33.33%: NPV = 0
at 42.86%: NPV = 0
at 66.67%: NPV = 0
n Two questions:
u 1. What’s going on here?
u 2. How many IRRs can there be?

IRR AND NON-CONVENTIONAL CASH FLOWS
• When the cash flows change sign more than once, there is more than one IRR.
• When you solve for IRR you are solving for the root of an equation and when you
cross the x axis more than once, there will be more than one return that solves the
equation.
• If you have more than one IRR, you cannot use any of them to make your decision.

NPV
$0.06
$0.04
IRR = 25%
$0.02
$0.00
($0.02) IRR = 33.33% IRR = 66.67%
IRR = 42.86%
($0.04)
($0.06)
($0.08)
0.2 0.28 0.36 0.44 0.52 0.6 0.68

Discount rate

THE MODIFIED INTERNAL RATE OF RETURN (MIRR)
• Controls for some problems with IRR
• Calculate the net present value of all cash outflows using the borrowing rate.
• Calculate the net future value of all cash inflows using the investing rate.
• Find the rate of return that equates these values.
• Benefits: single answer and specific rates for borrowing and reinvestment
• Three methods:
1.Discounting approach = Discount future outflows to present and add to CF0
2. Reinvestment approach = Compound all CFs except the first one forward to end
3. Combination approach = Discount outflows to present; compound inflows to end
• MIRR will be unique number for each method
• Discount (finance) /compound (reinvestment) rate externally supplied
MIRR- EXAMPLE
Project cash flows:
• Time 0: -$500 today; Time 1: + $1,000; Time 2: -$100
• Use combined method and RRR = 11%
• PV (outflows) = -$500 + -$100/(1.11)2 = -$581.16
• FV (inflow) = $1,000 x 1.11 = $1,110
• MIRR: N=2; PV=-581.16; FV=1,110; CPT I/Y = MIRR = 38.2

MIRR VS IRR
• Different opinions about MIRR and IRR.
• MIRR avoids the multiple IRR problem.
• Managers like rate of return comparisons, and MIRR is better for this than IRR.
• Problem with MIRR: different ways to calculate with no evidence of the best method.
• Interpreting a MIRR is not obvious.
8-202
IRR, NPV AND MUTUALLY-EXCLUSIVE PROJECTS
Net present value
Year
160 0 1 2 3 4
140 Project A: – $350 50 100 150 200
120
100 Project B: – $250 125 100 75 50
80
60
40
Crossover Point
20
0
– 20
– 40
– 60
– 80
– 100 Discount rate
0 2% 6% 10% 14% 18% 22% 26%
IRR A IRRB

PROFITABILITY INDEX (PI)
• Expresses a project’s benefits relative to its initial cost.
PV of inflows
PI =
Initial cost
• Accept a project with a PI > 1.0.

EXAMPLE—PI
Assume you have the following information on Project X:

Initial investment = –$1100 Required return = 10%
Annual cash revenues and expenses are as follows:

Year Revenues Expenses
1 $1000 $500
2 2000 1000

EXAMPLE—PI (CONTINUED )
500 1 000
NPV = + − 1100
1.10 (1.10)2
= $181
181 + 1100
PI =
1100
= 1.1645 Net Present Value Index
= 181
1100
= 0.1645

EXAMPLE—PI (CONTINUED )
Is this a good project? If so, why?
• This is a good project because the present value of the inflows exceeds the outlay.
• Each dollar invested generates $1.1645 in value or $0.1645 in NPV.

ADVANTAGES AND DISADVANTAGES OF PI
Advantages Disadvantages
• Closely related to NPV, generally • May lead to incorrect decisions in

leading to identical decisions. comparisons of mutually exclusive
investments.
• Easy to understand.
• May be useful when available

investment funds are limited.
208
CAPITAL BUDGETING IN PRACTICE
• We should consider several investment criteria when making decisions.
• NPV and IRR are the most commonly used primary investment criteria.
• Payback is a commonly used secondary investment criteria.

• An investment project costs $15,000 and has annual cash flows of $4,300 for six
years. What is the discounted payback period if the discount rate is zero percent?
What if the discount rate is 5 percent? If it is 19 percent?
• 13.A project that provides annual cash flows of $28,500 for nine years costs
$138,000 today. Is this a good project if the required return is 8 percent? What if
it’s 20 percent? At what discount rate would you be indifferent between accepting the
project and rejecting it

• 7.Grohl Co. issued 11-year bonds a year ago at a coupon rate of 6.9 percent. The
bonds make semiannual payments. If the YTM on these bonds is 7.4 percent, what is
the current bond price?
• 8.The McKeegan Corporation has two different bonds currently outstanding. Bond M
has a face value of $20,000 and matures in 20 years. The bond makes no payments
for the first six years, then pays $1,100 every six months over the subsequent eight
years, and finally pays $1,400 every six months over the last six years. Bond N also
has a face value of $20,000 and a maturity of 20 years; it makes no coupon
payments over the life of the bond. If the required return on both these bonds is 7
percent compounded semiannually, what is the current price of bond M? Of bond N?

CHAPTER 3
RISK AND RETURN
CHAPTER OUTLINE
1.Dollar returns vs. Percentage returns
2.Historical average return and variance
3.Arithmetic vs. Geometric average returns
4.Expected Returns and Variances of a single asset
5.Portfolios, expected returns and variances of a portfolio of 2 assets
6.Diversification and Portfolio Risk
7.Risk: Systematic, Unsystematic Risk and Beta
8.The Security Market Line
9.The SML and the Cost of Capital: A Preview
*****Reading: RWJ 12edition: Chapter 12,13
213
EXPECTED LEARNING OUTCOMES
Know how to calculate the return on an investment
Understand the historical returns on various types of investments
Understand the historical risks on various types of investments
Know how to calculate expected returns, variance, covariance,correlation of a
single asset and a portfolio
Understand the impact of diversification
Understand the systematic risk principle
Understand the security market line
Understand the risk-return trade-off
Be able to use the Capital Asset Pricing Model
214
SIX FUNDAMENTAL PRINCIPLES OF FINANCE
P1: There Is No Such Thing As A Free Lunch
P2: Other Things Equal, Individuals :
􀂃 Prefer more money to less (non-satiation)
􀂃 Prefer money now to later (impatience)
􀂃 Prefer to avoid risk (risk aversion)
P3: All Agents Act To Further Their Own Self-Interest
P4: Financial Market Prices Shift to Equalize Supply and Demand
P5: Financial Markets Are Highly Adaptive and Competitive
P6: Risk-Sharing and Frictions Are Central to Financial Innovation
215
DOLLAR RETURNS
• Total dollar return = income from investment + capital gain (loss) due to
change in price
• Example 1:
▪ You bought a bond for $1000 one year ago. You have received two coupons of $30
each. You can sell the bond for $1025 today. What is your total dollar return?
• Income = 30 + 30 = 60
• Capital gain = 1025 – 1000 = 25
• Total dollar return = 60 + 25 = $85
216
PERCENTAGE RETURNS
• It is generally more intuitive to think in terms of percentage, rather than dollar, returns
• Dividend yield (or income yield) = income / beginning price
• Capital gains yield = (ending price – beginning price) / beginning price
• Total percentage return = dividend yield + capital gains yield
Example 1 (Cont.):
Dividend yield (income yield)=60/1000=6%
Capital gains yield= (1025-1000)/1000=2.5%
Total percentage return= 6%+2.5%=8.5%
217
EXAMPLE 2: CALCULATING RETURNS
• You bought a stock for $35, and you received dividends of $1.25. The stock
is now selling for $40.
▪ What is your dollar return?

• Dollar return = 1.25 + (40 – 35) = $6.25
▪ What is your percentage return?

• Dividend yield = 1.25 / 35 = 3.57%
• Capital gains yield = (40 – 35) / 35 = 14.29%
• Total percentage return = 3.57 + 14.29 = 17.86%
218
FIGURE 12.4: A $1 INVESTMENT IN DIFFERENT TYPES OF PORTFOLIOS OVER 1925-2013
219
FIGURE A: YEAR-BY-YEAR TOTAL RETURNS ON FIGURE B: YEAR-BY-YEAR TOTAL RETURNS
SMALL-COMPANY STOCKS ON LONG-TERM GOVERNMENT BONDS
220
AVERAGE RETURN: ARITHMETIC VS. GEOMETRIC
• Arithmetic Mean Return (AM)
AM =  Ri / T
where  Ri = the sum of all the annual return, i=1,2….,T.
T = number of years
• Geometric Mean Return (GM)
Example: Year Beginning Value Ending Value Ri
1 100 115 ?
2 115 138 ?
3 138 110.4 ?
Arithmetic mean return=

Geometric mean return=
221
AVERAGE RETURN: ARITHMETIC VS. GEOMETRIC MEAN
• Arithmetic average – return earned in an average period over multiple periods
• Geometric average – average compound return per period over multiple periods
• The geometric average will be less than the arithmetic average unless all the returns are
equal
• Which is better?
▪ The arithmetic average is overly optimistic for long horizons
▪ The geometric average is overly pessimistic for short horizons
▪ So, the answer depends on the planning period under consideration
• 15 – 20 years or less: use the arithmetic
• 20 – 40 years or so: split the difference between them
• 40 + years: use the geometric
222
AVERAGE RETURNS
Investment Average Return
Large Stocks 12.1%
Small Stocks 16.9%
Long-term Corporate Bonds 6.3%
Long-term Government Bonds 5.9%
U.S. Treasury Bills 3.5%

Inflation 3.0%
223
RISK PREMIUMS
• The “extra” return earned for taking on risk
• Treasury bills are considered to be risk-free
• The risk premium is the return over and above the risk-free rate
224
TABLE 12.3: AVERAGE ANNUAL RETURNS AND RISK PREMIUMS
Investment Average Return Risk Premium
Large Stocks 12.1% 8.6%
Small Stocks 16.9% 13.4%
Long-term Corporate Bonds 6.3% 2.8%
Long-term Government Bonds 5.9% 2.4%
U.S. Treasury Bills 3.5% 0.0%
225
VARIANCE AND STANDARD DEVIATION OVER A PERIOD
• Variance and standard deviation measure the volatility of asset returns
• The greater the volatility, the greater the uncertainty
• Historical variance = sum of squared deviations from the mean / (number of observations
– 1)
where R1, R2,…RT is return at time 1, 2, …,T; 𝑅 is the average return over the whole period.
• Standard deviation = square root of the variance= 𝑉𝑎𝑟(𝑅)
226
EXAMPLE: VARIANCE AND STANDARD DEVIATION OVER A PERIOD
Year Actual Average Deviation from the Mean Squared Deviation
Return Return
1 .15 .105 .045 .002025
2 .09 .105 -.015 .000225
3 .06 .105 -.045 .002025
4 .12 .105 .015 .000225
Totals .42 .00 .0045
Variance = .0045 / (4-1) = .0015 Standard Deviation = .03873
227
EXPECTED RETURNS OF A SINGLE ASSET OVER SCENARIOS
• Expected returns are based on the probabilities of possible outcomes
• In this context, “expected” means average if the process is repeated
many times
• Expected return is equal to the sum of the potential returns 𝑅𝑖 multiplied
with the corresponding probability of the returns 𝑃𝑖
𝑛
Expected Return = ෍(Probability of Return) × (Possible Return)

𝑖=1
n
or E ( R ) =  pi Ri
i =1
EXAMPLE: EXPECTED RETURNS OF A SINGLE ASSET
• Suppose you have predicted the following returns for stocks C and T in
three possible states of the economy. What are the expected returns?
State Probability C T
Boom 0.3 15 25
Normal 0.5 10 20
Recession ??? 2 1
• RC = .3(15) + .5(10) + .2(2) = 9.9%

• RT = .3(25) + .5(20) + .2(1) = 17.7%

VARIANCE AND STANDARD DEVIATION OF A SINGLE ASSET
• Variance and standard deviation measure the volatility of returns
• Using unequal probabilities for the entire range of possibilities
• Weighted average of squared deviations
𝑛
Variance 𝜎 2 = ෍ Probability × Possible Return − Expected Return 2
𝑖=1
n
Or σ 2 =  pi ( Ri − E ( R )) 2
i =1
Standard deviation is the square root of the variance

EXAMPLE: EXPECTED RETURN AND VARIANCE OF A SINGLE ASSET
Price return [Ri-E(Ri)]^2 [Ri-E(Ri)]*[Rj-E(Rj]
time index GMD MBB Index GMD MBB index GMD MBB Index-GMD Index-MBB
1 710 16,450 13,786
2 783 18,000 13,743 10.3% 9.4% -0.3% 0.13% 0.08% 0.48% 0.01% -0.36%
3 854 19,400 14,906 9.2% 7.8% 8.5% 0.07% 0.01% 0.03% -0.03% -0.03%
4 791 17,800 13,484 -7.4% -8.2% -9.5% 1.98% 2.21% 2.61% 2.44% 2.70%
5 889 23,800 15,337 12.4% 33.7% 13.7% 0.33% 7.34% 0.51% 1.42% 0.24%
6 950 23,450 18,628 6.9% -1.5% 21.5% 0.00% 0.65% 2.20% -0.03% 0.03%
7 1,020 29,500 20,808 7.4% 25.8% 11.7% 0.01% 3.68% 0.26% 0.12% 0.02%
8 1,194 35,750 26,750 17.1% 21.2% 28.6% 1.10% 2.12% 4.81% 1.26% 1.98%
9 1,169 32,700 27,350 -2.1% -8.5% 2.2% 0.77% 2.30% 0.19% 1.55% 0.65%
10 1,239 33,500 30,200 6.0% 2.4% 10.4% 0.00% 0.17% 0.14% 0.04% 0.00%
Mean of return 6.6% 9.1% 9.6%
Variance of return 0.55% 2.25% 1.30%
Covariance 0.85% 0.65%
Correlation 0.76 0.77
PORTFOLIOS
▪ A portfolio is simply a specific combination of securities, usually defined
by portfolio weights that sum to 1:
• 𝜔𝑖 is the weight of security i; 𝑁𝑖 is the number of security i; 𝑃𝑖 is the price

of security i.

EXAMPLE: PORTFOLIO WEIGHTS
• Suppose you have $15,000 to invest and you have purchased securities
in the following amounts. What are your portfolio weights in each
security?
• $2000 of DCLK
• $3000 of KO
• $4000 of INTC
• $6000 of KEI
•DCLK: 2/15 = .133
•KO: 3/15 = .2
•INTC: 4/15 = .267
•KEI: 6/15 = .4
PORTFOLIO EXPECTED RETURNS AND VARIANCE
• The expected return of a portfolio is the weighted average of the expected returns of the
respective assets in the portfolio
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜: 𝐸 𝑅𝑝𝑜𝑟𝑡 = 𝑤𝑖 𝐸 𝑅𝑖 + 𝑤𝑗 𝐸 𝑅𝑗
𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜: 𝑉𝑎𝑟 𝑅𝑝𝑜𝑟𝑡 = 𝑤𝑖2 𝜎𝑖2 + 𝑤𝑗2 𝜎𝑗2 + 2𝑤𝑖 𝑤𝑗 𝐶𝑜𝑣𝑖𝑗
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 (stdev): 𝜎𝑝𝑜𝑟𝑡 = 𝑉𝑎𝑟 𝑅𝑃

Where:
• 𝜔𝑖 is the weight of security i
• 𝐸 𝑅𝑖 : expected return of security i
• 𝐶𝑜𝑣𝑖𝑗 : Covariance of security i and j

PORTFOLIO EXPECTED RETURNS AND VARIANCE-COVARIANCE OF RETURNS
• A measure of the direction of the relationship beween two variables. A positive
covariance means that both variables tend to be high or low at the same time. A
negative covariance means that when one variable is high, the other tends to be low.
• For two assets, i and j, the covariance of rates of return is𝑛defined as :
𝑛
1 1
𝐶𝑜𝑣𝑖𝑗 = ෍ 𝑅𝑖𝑡 − 𝐸 𝑅𝑖 𝑅𝑗𝑡 − 𝐸 𝑅𝑗 𝐶𝑜𝑣𝑖𝑗 = ෍ 𝑅𝑖𝑡 − 𝐸 𝑅𝑖 𝑅𝑗𝑡 − 𝐸 𝑅𝑗
𝑛 𝑛−1
𝑡=1 𝑡=1
• The covariance of a variable with itself:
𝑛 𝑛
1 1 2
𝐶𝑜𝑣𝑖𝑖 = ෍ 𝑅𝑖𝑡 − 𝐸 𝑅𝑖 𝑅𝑖𝑡 − 𝐸 𝑅𝑖 = ෍ 𝑅𝑖𝑡 − 𝐸 𝑅𝑖 = 𝜎2
𝑛−1 𝑛−1
𝑡=1 𝑡=1
• Note: when applying to sample data, we divide the values by (n – 1) rather than by n to
avoid statistical bias.
PORTFOLIO EXPECTED RETURNS AND VARIANCE-CORRELATION
• The correlation coefficient is obtained by standardizing (dividing) the covariance
by the product of the individual standard deviations
Where:
𝐶𝑜𝑣𝑖𝑗
𝜌𝑖𝑗 = ρij = correlation coefficient of returns
𝜎𝑖 𝜎𝑗 σi = standard deviation of Ri
σj = standard deviation of Rj
Note: when sample data is used, σ is divided by (n – 1) to avoid statistical bias.
• The coefficient can vary only in the range +1 to −1
• A value of +1 would indicate perfect positive correlation. This means that returns for
the two assets move together in a positively and completely linear manner
• A value of −1 would indicate perfect negative correlation. This means that the returns
for two assets move together in a completely linear manner, but in opposite directions
236
EXAMPLE: COVARIANCE, CORRELATION BETWEEN TWO RISKY ASSETS
time index GMD MBB index GMD MBB index GMD MBB Index-GMD Index-MBB
1 710 16,450 13,786
2 783 18,000 13,743 10.3% 9.4% -0.3% 0.13% 0.08% 0.48% 0.01% -0.36%
3 854 19,400 14,906 9.2% 7.8% 8.5% 0.07% 0.01% 0.03% -0.03% -0.03%
4 791 17,800 13,484 -7.4% -8.2% -9.5% 1.98% 2.21% 2.61% 2.44% 2.70%
5 889 23,800 15,337 12.4% 33.7% 13.7% 0.33% 7.34% 0.51% 1.42% 0.24%
6 950 23,450 18,628 6.9% -1.5% 21.5% 0.00% 0.65% 2.20% -0.03% 0.03%
7 1,020 29,500 20,808 7.4% 25.8% 11.7% 0.01% 3.68% 0.26% 0.12% 0.02%
8 1,194 35,750 26,750 17.1% 21.2% 28.6% 1.10% 2.12% 4.81% 1.26% 1.98%
9 1,169 32,700 27,350 -2.1% -8.5% 2.2% 0.77% 2.30% 0.19% 1.55% 0.65%
10 1,239 33,500 30,200 6.0% 2.4% 10.4% 0.00% 0.17% 0.14% 0.04% 0.00%
EXAMPLE: COVARIANCE, CORRELATION BETWEEN TWO RISKY ASSETS
time index GMD MBB index GMD MBB index GMD MBB Index-GMD Index-MBB
1 710 16,450 13,786
2 783 18,000 13,743 10.3% 9.4% -0.3% 0.13% 0.08% 0.48% 0.01% -0.36%
3 854 19,400 14,906 9.2% 7.8% 8.5% 0.07% 0.01% 0.03% -0.03% -0.03%
4 791 17,800 13,484 -7.4% -8.2% -9.5% 1.98% 2.21% 2.61% 2.44% 2.70%
5 889 23,800 15,337 12.4% 33.7% 13.7% 0.33% 7.34% 0.51% 1.42% 0.24%
6 950 23,450 18,628 6.9% -1.5% 21.5% 0.00% 0.65% 2.20% -0.03% 0.03%
7 1,020 29,500 20,808 7.4% 25.8% 11.7% 0.01% 3.68% 0.26% 0.12% 0.02%
8 1,194 35,750 26,750 17.1% 21.2% 28.6% 1.10% 2.12% 4.81% 1.26% 1.98%
9 1,169 32,700 27,350 -2.1% -8.5% 2.2% 0.77% 2.30% 0.19% 1.55% 0.65%
10 1,239 33,500 30,200 6.0% 2.4% 10.4% 0.00% 0.17% 0.14% 0.04% 0.00%
PORTFOLIO OF TWO RISKY ASSETS -EXAMPLE
• Example: From 2018-2021, Gemadept had an average monthly return of 9.1%
and a std dev of 15%. Military bank had an average return of 9.6% and a std
dev of 11.41%. Their correlation is 0.51.How would a portfolio of the two
stocks perform, given the weight in the following table?
w_GMD w_MBB E[RP] var(RP) stdev(RP)

0 1 1.08% 0.3881% 6.23%
0.25 0.75 1.25% 0.3616% 6.01%
0.5 0.5 1.42% 0.4459% 6.68%
0.75 0.25 1.58% 0.6409% 8.01%
1 0 1.75% 0.9467% 9.73%
PORTFOLIO OF TWO RISKY ASSETS -MEAN/STANDARD DEVIATION TRADE-OFF
MBB
Faculty of Finance
PORTFOLIO DIVERSIFICATION
• Portfolio diversification is the investment in several different asset classes or sectors
• Diversification is not just holding a lot of assets
• For example, if you own 50 Internet stocks, you are not diversified
• However, if you own 50 stocks that span 20 different industries, then you are
diversified
The Principle of 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
• However, there is a minimum level of risk that cannot be diversified away and that is
the systematic portion

TABLE 13.7

FIGURE 13.1- THE POWER OF DIVERSIFICATION

SYSTEMATIC RISK VS. UNSYSTEMATIC RISK
Systematic Risk Unsystematic risk
• Risk factors that affect a large number of • Risk factors that affect a limited number of
assets assets
• Also known as non-diversifiable risk or • Also known as unique risk and asset-specific
market risk risk, idiosyncratic risk, diversifiable risk
• Includes such things as changes in GDP, • Includes such things as labor strikes, part
inflation, interest rates, etc. shortages, etc.
• There is a reward for bearing risk • The risk that can be eliminated by
• There is not a reward for bearing risk combining assets into a portfolio
unnecessarily • If we hold only one asset, or assets
• The expected return on a risky asset in the same industry, then we are
depends only on that asset’s systematic risk exposing ourselves to risk that we
since unsystematic risk can be diversified could diversify away
away
244
TOTAL RISK
• Total risk = systematic risk + unsystematic risk
• The standard deviation of returns is a measure of total risk
• For well-diversified portfolios, unsystematic risk is very small
• Consequently, the total risk for a diversified portfolio is essentially
equivalent to the systematic risk

MEASURING SYSTEMATIC RISK
• How do we measure systematic risk?
• We use the beta coefficient
• What does beta tell us?
• A beta of 1 implies the asset has the same systematic risk as the overall market
• A beta < 1 implies the asset has less systematic risk than the overall market
• A beta > 1 implies the asset has more systematic risk than the overall market

TABLE 13.8
Insert Table 13.8 here

TOTAL VS. SYSTEMATIC RISK
• Consider the following information:
Standard Deviation Beta
Security C 20% 1.25
Security K 30% 0.95
• Which security has more total risk?

• Which security has more systematic risk?
• Which security should have the higher expected return?

WORK THE WEB EXAMPLE
• Many sites provide betas for companies
• International stock market: Yahoo Finance provides beta, plus a lot of
other information under its Key Statistics link
• Vietnam stock market: cophieu68.vn, cafef.vn

EXAMPLE: PORTFOLIO BETAS
• Consider the previous example with the following four securities
Security Weight Beta
DCLK .133 2.685
KO .2 0.195
INTC .267 2.161
KEI .4 2.434
• What is the portfolio beta?
• .133(2.685) + .2(.195) + .267(2.161) + .4(2.434) = 1.947

BETA AND THE RISK PREMIUM
• Remember that the risk premium = expected return – risk-free rate
• The higher the beta, the greater the risk premium should be
• Can we define the relationship between the risk premium and beta so
that we can estimate the expected return?
• YES!

EXAMPLE: PORTFOLIO EXPECTED RETURNS AND BETAS
30%
25%
Expected Return
20%
E(RA)
15%
10%
5%
0% Rf
0 0.5 1 1.5 2 2.5 3
Beta
A

REWARD-TO-RISK RATIO: DEFINITION AND EXAMPLE
• The reward-to-risk ratio is the slope of the line illustrated in the previous example
• Slope = (E(RA) – Rf) / (A – 0)

• Reward-to-risk ratio for previous example =
(20 – 8) / (1.6 – 0) = 7.5
• What if an asset has a reward-to-risk ratio of 8 (implying that the asset plots above
the line)?
• What if an asset has a reward-to-risk ratio of 7 (implying that the asset plots below
the line)?

MARKET EQUILIBRIUM
• In equilibrium, all assets and portfolios must have the same reward-to-risk
ratio, and they all must equal the reward-to-risk ratio for the market
E ( RA ) − R f E ( RM − R f )
=
A M

SECURITY MARKET LINE
• The security market line (SML) is the representation of market equilibrium
• The slope of the SML is the reward-to-risk ratio: (E(RM) – Rf) / M
• But since the beta for the market is ALWAYS equal to one, the slope can
be rewritten
• Slope = E(RM) – Rf = market risk premium

THE CAPITAL ASSET PRICING MODEL (CAPM)
• The capital asset pricing model defines the relationship between risk and
return
• E(RA) = Rf + A(E(RM) – Rf)
• If we know an asset’s systematic risk, we can use the CAPM to determine
its expected return
• This is true whether we are talking about financial assets or physical
assets

FACTORS AFFECTING EXPECTED RETURN
• Pure time value of money: measured by the risk-free rate
• Reward for bearing systematic risk: measured by the market risk premium
• Amount of systematic risk: measured by beta

EXAMPLE - CAPM
• Consider the betas for each of the assets given earlier. If the risk-free rate is 4.15%
and the market risk premium is 8.5%, what is the expected return for each?
Security Beta Expected Return

DCLK 2.685 4.15 + 2.685(8.5) = 26.97%
KO 0.195 4.15 + 0.195(8.5) = 5.81%
INTC 2.161 4.15 + 2.161(8.5) = 22.52%
KEI 2.434 4.15 + 2.434(8.5) = 24.84%

FIGURE 13.4

QUICK QUIZ
• How do you compute the expected return and standard deviation for an individual
asset? For a portfolio?
• What is the difference between systematic and unsystematic risk?
• What type of risk is relevant for determining the expected return?
• Consider an asset with a beta of 1.2, a risk-free rate of 5%, and a market return of
13%.
• What is the reward-to-risk ratio in equilibrium?
• What is the expected return on the asset?

• The risk free rate is 4%, and the required return on the market is 12%.
What is the required return on an asset with a beta of 1.5?
• What is the reward/risk ratio?
• What is the required return on a portfolio consisting of 40% of the asset
above and the rest in an asset with an average amount of systematic
risk?

• Consider the following information about Stocks I and II:
State of economy Probability of state Rate of return if state occurs

of economy Stock I Stock II
Recession 0.25 0.09 -0.3
Normal 0.5 0.42 0.12
Irrational exuberance 0.25 0.26 0.44
• The market risk premium is 8 percent, and the risk-free rate is 4 percent. Which stock has the most systematic
risk? Which one has the most unsystematic risk? Which stock is “riskier”? Explain.

END OF CHAPTER

CHAPTER 4
COST OF CAPITAL
KEY CONCEPTS AND SKILLS
• Know how to determine a firm’s cost of equity capital
• Know how to determine a firm’s cost of debt
• Know how to determine a firm’s overall cost of capital
• Understand pitfalls of overall cost of capital and how to manage them
267
LEARNING OBJECTIVES
Determine Determine a firm’s cost of equity capital.
Determine Determine a firm’s cost of debt.
Determine Determine a firm’s overall cost of capital and how to use it to

value a company.
Explain Explain how to correctly include flotation costs in capital

budgeting projects.
Describe Describe some of the pitfalls associated with a firm’s overall

cost of capital and what to do about them.
268
CHAPTER OUTLINE
1. The Cost of Capital: Some Preliminaries
2. The Cost of Equity
3. The Costs of Debt and Preferred Stock
4. The Cost of retained earnings.
5. The Weighted Average Cost of Capital
6. Divisional and Project Costs of Capital
7. Flotation Costs and the Weighted Average Cost of Capital
269
1. WHY COST OF CAPITAL IS IMPORTANT
• We know that the return earned on assets depends on the risk of those
assets
• The return to an investor is the same as the cost to the company
• Our cost of capital provides us with an indication of how the market
views the risk of our assets
• Knowing our cost of capital can also help us determine our required
return for capital budgeting projects

REQUIRED RETURN
• The required return is the same as the appropriate discount rate and is
based on the risk of the cash flows
• We need to know the required return for an investment before we can
compute the NPV and make a decision about whether or not to take the
investment
• We need to earn at least the required return to compensate our investors
for the financing they have provided
271
2. COST OF EQUITY
• The cost of equity is the return required by equity investors given the risk of the cash
flows from the firm
• Business risk: The equity risk that comes from the nature of the firm’s operating activities
• Financial risk: The equity risk that comes from the financial policy (the capital structure)
of the firm
• There are two major methods for determining the cost of equity
• Dividend growth model
• SML, or CAPM
272
THE DIVIDEND GROWTH MODEL APPROACH
• Start with the dividend growth model formula and rearrange to solve for RE
D1
P0 =
RE − g
D1
RE = +g
P0
273
DIVIDEND GROWTH MODEL EXAMPLE
• Suppose that your company is expected to pay a dividend of $1.50 per
share next year. There has been a steady growth in dividends of 5.1%
per year and the market expects that to continue. The current price is
$25. What is the cost of equity?
1.50
RE = + .051 = .111 = 11.1%
25

EXAMPLE: ESTIMATING THE DIVIDEND GROWTH RATE
• One method for estimating the growth rate is to use the historical
average
• Year Dividend Percent Change
• 2005 1.23 -
• 2006 1.30
• 2007 1.36 (1.30 – 1.23) / 1.23 = 5.7%
• 2008 1.43 (1.36 – 1.30) / 1.30 = 4.6%
• 2009 1.50 (1.43 – 1.36) / 1.36 = 5.1%
(1.50 – 1.43) / 1.43 = 4.9%
Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%
ADVANTAGES AND DISADVANTAGES OF DIVIDEND GROWTH MODEL
• Advantage – easy to understand and use
• Disadvantages
• Only applicable to companies currently paying dividends
• Not applicable if dividends aren’t growing at a reasonably constant rate
• Extremely sensitive to the estimated growth rate – an increase in g of 1% increases
the cost of equity by 1%
• Does not explicitly consider risk

THE SML APPROACH
• Use the following information to compute our cost of equity
• Risk-free rate, Rf
• Market risk premium, E(RM) – Rf
• Systematic risk of asset, 
RE = R f +  E ( E ( RM ) − R f )
277
EXAMPLE - SML
• Suppose your company has an equity beta of .58, and the current risk-
free rate is 6.1%. If the expected market risk premium is 8.6%, what is
your cost of equity capital?
• RE = 6.1 + .58(8.6) = 11.1%
• Since we came up with similar numbers using both the dividend growth
model and the SML approach, we should feel good about our estimate

ADVANTAGES AND DISADVANTAGES OF SML
• Advantages
• Explicitly adjusts for systematic risk
• Applicable to all companies, as long as we can estimate beta
• Disadvantages
• Have to estimate the expected market risk premium, which does vary over time
• Have to estimate beta, which also varies over time
• We are using the past to predict the future, which is not always reliable
279
EXAMPLE – COST OF EQUITY
• Suppose our company has a beta of 1.5. The market risk premium is expected to be
9%, and the current risk-free rate is 6%. We have used analysts’ estimates to
determine that the market believes our dividends will grow at 6% per year and our
last dividend was $2. Our stock is currently selling for $15.65. What is our cost of
equity?

3. COST OF DEBT
• The cost of debt is the required return on our company’s debt
• We usually focus on the cost of long-term debt or bonds
• The required return is best estimated by computing the yield-to-maturity on the
existing debt
• We may also use estimates of current rates based on the bond rating we expect
when we issue new debt
• The cost of debt is NOT the coupon rate

EXAMPLE: COST OF DEBT
• Suppose we have a bond issue currently outstanding that has 25 years
left to maturity. The coupon rate is 9%, and coupons are paid
semiannually. The bond is currently selling for $908.72 per $1,000 bond.
What is the cost of debt?
• N = 50; PMT = 45; FV = 1000; PV = -908.72; CPT I/Y = 5%; YTM = 5(2) = 10%
 1 
1 -
 (1 + r) t  FV
Bond Value = C  +
 r  (1 + r) t
 

COST OF PREFERRED STOCK
• Reminders
• Preferred stock generally pays a constant dividend each period
• Dividends are expected to be paid every period forever
• Preferred stock is a perpetuity, so we take the perpetuity formula,
rearrange and solve for RP
• RP = D / P 0
283
EXAMPLE: COST OF PREFERRED STOCK
• Your company has preferred stock that has an annual dividend of $3. If the current price
is $25, what is the cost of preferred stock?
• RP = 3 / 25 = 12%
284
COST OF RETAINED EARNINGS (1)
• New common equity is raised in two ways: (1) by retaining some of the current year’s
earnings and (2) by issuing new common stock.
• Retained earnings refers to that part of the current year’s earnings not paid as dividends
(hence, available for reinvestment in the business this year)
• Cost of Retained Earnings (rs) The rate of return required by stockholders on a firm’s
common stock.
• Cost of New Common Stock (re) The cost of external equity; based on the cost of retained
earnings, but increased for flotation costs necessary to issue new common stock
• The firm needs to earn at least as much on any earnings retained as the stockholders could
earn on alternative investments of comparable risk.
• If the firm cannot invest retained earnings to earn at least rs , it should pay those funds to
its stockholders and let them invest directly in stocks or other assets that will provide that
return
285
COST OF RETAINED EARNINGS (2)- MEASURES
• CAPM APPROACH
• BOND-YIELD-PLUS-RISK-PREMIUM APPROACH
• DIVIDEND-YIELD-PLUS-GROWTH-RATE, OR DISCOUNTED CASH FLOW (DCF),
APPROACH
286
COST OF RETAINED EARNINGS (2)- MEASURES-CAPM APPROACH
• Step 1: Estimate the risk-free rate, rRF. We generally use the 10-year Treasury bond rate
as the measure of the risk-free rate, but some analysts use the short-term Treasury bill
rate.
• Step 2: Estimate the stock’s beta coefficient, bi , and use it as an index of the stock’s risk.
• Step 3: Estimate the market risk premium. Recall that the market risk premium is the
difference between the return that investors require on an average stock and the risk-
free rate.
• Step 4: Substitute the preceding values in the CAPM equation to estimate the required
rate of return :
287
COST OF RETAINED EARNINGS (2)- MEASURES-CAPM APPROACH
• Example: Assume that in today’s market, rRF 5 5.6%, the market risk premium is RPM
55.0%, and Allied’s beta is 1.48. Using the CAPM approach, Allied’s cost of equity is
estimated to be 13.0%:
288
COST OF RETAINED EARNINGS (3)- MEASURES
BOND-YIELD-PLUS-RISK-PREMIUM APPROACH
• This measure is usually used when reliable inputs for the CAPM approach are not
available
• Empirical studies suggest that the risk premium on a firm’s stock over its own bonds
generally ranges from 3 to 5 percentage points (evidence from Roger G. Ibbotson for
US stock market)
rs=bond yield + risk premium
Example: Allied’s bonds yield 10%, its cost of equity might be estimated as follows
rs= Bond yield + Risk premium= 10.0% + 4.0% =14.0%
289
COST OF RETAINED EARNINGS (2)- MEASURES-DIVIDEND-YIELD-PLUS-GROWTH-RATE, OR DISCOUNTED CASH FLOW (DCF), APPROACH
• According to DCF model, assume P0 is the current stock price, Dt is the dividend expected to
be paid at the end of Year t,rs is the required rate of return. Current stock price is→
If dividends are expected to grow at a constant rate, the above equation reduces to:
solve for rs :
→investors expect to receive a dividend yield, D1/P0, plus a capital gain, g, for a total
expected return of rs
290
4. THE WEIGHTED AVERAGE COST OF CAPITAL
• We can use the individual costs of capital that we have computed to get
our “average” cost of capital for the firm.
• This “average” is the required return on the firm’s assets, based on the
market’s perception of the risk of those assets
• The weights are determined by how much of each type of financing is
used

CAPITAL STRUCTURE WEIGHTS
• Notation
• E = market value of equity = # of outstanding shares times price per share
• D = market value of debt = # of outstanding bonds times bond price
• V = market value of the firm = D + E
• Weights
• wE = E/V = percent financed with equity
• wD = D/V = percent financed with debt

EXAMPLE: CAPITAL STRUCTURE WEIGHTS
• Suppose you have a market value of equity equal to $500 million and a market
value of debt equal to $475 million.
• What are the capital structure weights?
• V = 500 million + 475 million = 975 million
• wE = E/V = 500 / 975 = .5128 = 51.28%
• wD = D/V = 475 / 975 = .4872 = 48.72%

TAXES AND THE WACC
• We are concerned with after-tax cash flows, so we also need to consider the effect of
taxes on the various costs of capital
• Interest expense reduces our tax liability
• This reduction in taxes reduces our cost of debt
• After-tax cost of debt = RD(1-TC)
• Dividends are not tax deductible, so there is no tax impact on the cost of equity
• WACC = wERE + wDRD(1-TC)
294
EXTENDED EXAMPLE – WACC - I
• Equity Information • Debt Information
• 50 million shares • $1 billion in outstanding debt
(face value)
• $80 per share
• Current quote = 110
• Beta = 1.15
• Coupon rate = 9%,
• Market risk premium = 9% semiannual coupons
• Risk-free rate = 5% • 15 years to maturity
• Tax rate = 40%

EXTENDED EXAMPLE – WACC - II
• What is the cost of equity?
• RE = 5 + 1.15(9) = 15.35%
• What is the cost of debt?
• N = 30; PV = -1,100; PMT = 45; FV = 1,000; CPT I/Y = 3.9268
• RD = 3.927(2) = 7.854%
• What is the after-tax cost of debt?
• RD(1-TC) = 7.854(1-.4) = 4.712%

EXTENDED EXAMPLE – WACC - III
• What are the capital structure weights?
• E = 50 million (80) = 4 billion
• D = 1 billion (1.10) = 1.1 billion
• V = 4 + 1.1 = 5.1 billion
• wE = E/V = 4 / 5.1 = .7843
• wD = D/V = 1.1 / 5.1 = .2157
• What is the WACC?
• WACC = .7843(15.35%) + .2157(4.712%) = 13.06%

EASTMAN CHEMICAL I
• Click on the web surfer to go to Yahoo Finance to get information on Eastman
Chemical (EMN)
• Under Profile and Key Statistics, you can find the following information:
• # of shares outstanding
• Book value per share
• Price per share
• Beta
• Under analysts estimates, you can find analysts estimates of earnings growth (use as
a proxy for dividend growth)
• The Bonds section at Yahoo Finance can provide the T-bill rate
• Use this information, along with the CAPM and DGM to estimate the cost of equity

EASTMAN CHEMICAL II
• Go to FINRA to get market information on Eastman Chemical’s bond issues
• Enter Eastman Ch to find the bond information
• Note that you may not be able to find information on all bond issues due to the
illiquidity of the bond market
• Go to the SEC site to get book valve information from the firm’s most recent 10Q

EASTMAN CHEMICAL III
• Find the weighted average cost of the debt
• Use market values if you were able to get the information
• Use the book values if market information was not available
• They are often very close
• Compute the WACC
• Use market value weights if available
300
EXAMPLE: WORK THE WEB
• Find estimates of WACC at www.valuepro.net
• Look at the assumptions
• How do the assumptions impact the estimate of WACC?

TABLE 14.1 COST OF EQUITY

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Finance Is One of The Most Difficult Subjects You Will Ever Love!

CORPORATE FINANCE Presented by Dr. Duong Thi Thuy An

Chapter 2: Time value of money

Chapter 3: Risk and return

Chapter 4: Cost of capital

Chapter 5: Financial leverage and capital structure

Understand Understand the various financial statements.

Compute Compute and, more importantly, interpret some financial ratios

Video: Understanding Corporate Structure

• Working capital management

• Income taxed once as • Partnership dissolves

• Management goals and agency costs

• Video : Financial statements

• Peer Group Analysis

Calculate Calculate the present value and future value of annuities.

Calculate NPV, IRR, MIRR, DPP, stock and bond value

• Compute the number of periods

• Using the formula

100 Faculty of Finance

101 Faculty of Finance

Future value calculated by compounding each cash flow separately

$1000 $1500 $2000 $2500

Total future value $7846

102 Faculty of Finance

• You can solve by either:

103 Faculty of Finance

104 Faculty of Finance

• A perpetuity is an annuity in which the cash flows continue forever.

105 Faculty of Finance

106 Faculty of Finance

108 Faculty of Finance

109 Faculty of Finance

t = 69.66 months ÷ 12 = 5.81 years

110 Faculty of Finance

111 Faculty of Finance

112 Faculty of Finance

• The present value of a perpetuity is calculated as follows:

114 Faculty of Finance

115 Faculty of Finance

116 Faculty of Finance

117 Faculty of Finance

• Bank A: 8.3%, compounded daily

• Bank B: 8.4%, compounded quarterly

• Bank C: 8.5%, compounded annually

118 Faculty of Finance

119 Faculty of Finance

• The highest NIR is not necessarily the best.

120 Faculty of Finance

121 Faculty of Finance

122 Faculty of Finance

124 Faculty of Finance

125 Faculty of Finance

Year Beginning Total Interest Principal Ending

1 $5000.00 $1285.46 $450.00 $835.46 $4164.54

2 $4164.54 $1285.46 $374.81 $910.65 $3253.89

3 $3253.89 $1285.46 $292.85 $992.61 $2261.28

4 $2261.28 $1285.46 $203.52 $1081.94 $1179.33

5 $1179.33 $1285.46 $106.13 $1179.33 $0.00

Totals $6427.30 $1427.30 $5000.00

126 Faculty of Finance

127 Faculty of Finance

129 Faculty of Finance

Purchase Coupon Coupon Coupon Coupon Coupon +