COMM 308 – Section BB – Fall 2022

• Instructor: Moein Karami

• FINAL REVIEW

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COMM 308 – Section BB – Fall 2022

CH. 5

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Remarks and Best way to approach problems!

§ Very Important: The formulas for the PV of (ordinary) Annuity, Growing

annuity, Perpetuity and Growing Perpetuity will give you the PV of the cash
flows at one period before the first payment. So, if your payments start at
t=1 then the PV formula will give you PV0. If your payments start at t=4,
then PV formula will give you PV3 (Now, let’s say you want PV at 0, you
have PV at 3; just discount it back three years ( /(1 + %)' ) and you have
PV0)

§ Ignore the FV formulas for both annuity and annuity dues. Always get the
PV (which is going to be at one period before the first payment for annuity
and at 0 for annuity dues) and then discount/compound it to any point in
time you want using the basic formula.

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Remarks and Best way to approach problems!

§ Remember: Financial calculator is only giving you a number (PV or FV). It is

your job to determine what point in time that number is at. When using it for
ordinary annuities, you look at your timeline. If you compute PV, that would
be PV at one period before the first payment (then manually you can
compound/discount it to any point in time you want); if you compute FV that
would be exactly with your last payment ((then manually you can
compound/discount it to any point in time you want).

§ Remember the sign rule. When you enter PV in financial calculator enter it
as a negative number (press the number and then +/- button).

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Example 1

You want to calculate the present value of some payments.

The situation is as follows: Nothing will be paid over the
next nine years. Then, you are going to receive $10 in 10
years and that amount will increase by 5 percent per year
thereafter. If the required return is 14 percent, what is the
Present value of this investment?

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Example 1 (continued)

As you see, we have a growing perpetuity, we use the PV of growing

Perpetuity formula and it will give us PV at one period before the first
payment (here my first payment is at t = 10; so I get PV9.
But, I don’t want it at t=9; I want it at t = 0; so I discount the amount nine
years.
g=0.05
$10

∞
×
0 9 10
K=0.14

!%&'( 10
!"# = = = 111.111
)−+ 0.14 − 0.05

111.111
!"( = = $34.16
(1 + ))#

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 5.6 QUOTED VERSUS EFFECTIVE RATES

• Rates are sometimes presented as quoted rates

(QR); and sometimes presented as effective
rates (k).

• The important thing to remember is: to solve a

problem, we always use effective rate (right? We
always use (k) in our formulas and also
calculator)

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 5.6 QUOTED VERSUS EFFECTIVE RATES

• What effective rate should I use when solving a question

(e.g., getting the present value of my timeline)?
Depends on your payments; if you have annual payments,
you use effective annual rate (!"##$"% , sometimes we do
not write the annual and by k we mean !"##$"% ). If your
payments are monthly then you should use effective
monthly rate (!&'#()%* ).

• When solving for k, in the calculator, it will always give

you an effective rate (but effective (what) rate? Depends
on how you have entered the numbers (if you had
monthly payments then you should enter the amount as
PMT, and enter (n) as the number of months and CPT
I/Y, that rate given to you is an effective monthly rate
!&'#()%* )
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 5.6 QUOTED VERSUS EFFECTIVE RATES

• If I always use effective rates (k) to solve a question, why

should I learn about Quoted Rates? Because sometimes
in the questions they give you quoted rate! You should
be able to convert it to the effective rate that you want
(e.g., effective annual rate if your PMTs are annual,
effective monthly rate if your payments are monthly, etc.)
and then use it as your k to solve the problem (e.g.,
getting PV0 of an annuity).
• Also, you should be able to compare rates when they are
presented differently (e.g., which rate is higher? 8%
quoted rate compounded monthly or 9% quoted rate
compounded semi-annually?)
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 How to approach problems

• Long Story Short (Comprehensive Example)

!"#$%&'())*(++, = 10% !"12)34+, = 9.79%

/2 × 12
C
;1<=(?@;A<) '?
DC
89" = 5% 8E" = 0.0816%

Always follow the above guideline – it can also be the other way! - (the
longest question will be from a quoted rate to another quoted rate with
a different compounding)

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 Example – past finals – Winter 2014

Your company is planning to borrow $500,000 on a 5-year, 7 percent

(EAR), annual payment, fully amortized term loan. What fraction of the
payment made at the end of the second year will represent repayment
of principal?
Annual payments and EAR! I am good!
First step (find the payment either using formula or calculator):
500,000
!"# = = 121,945.35
1
1−
1 + 0.07 .
[ ]
0.07

This is my payment which I will be making at the end of each year (t=1,
t=2, t=3, t=4 and t=5)
Now, I want to find what fraction of my PMT that is made at the end of
year 2 (i.e., PMT at t=2), represent principal repayment.

Page 11
 Example – past finals – Winter 2014 (continued)

Second step: Try to find the “Interest Payment” of the t that you are
interested in (here t=2)- have a look at slide 21!

!"#$%$&#'()*+(-.+) = 1×34#&#5"67"8 9%7":7;5<=>?.+

So, you need 34#&#5"67"8 9%7":7;5<=>?.+ !

Beg. 2

0 1 2 3 4 5

1
1− K
1+1
3. 9.A(B.'()*+ = 9CD = PMT = 413,054.65
1

Page 12
 Example – past finals – Winter 2014 (continued)

My total PMT made at the end of year 2 (i.e., t=2) is 121,945.35.

Now, I can find the interest and as a result principal repayment of it.

)*+,-,.+/0123(563) = 9×;<+.+=*>?*@ A-?*B?C=DEFG.3

)*+,-,.+/0123(563) = 0.07×413,054.65 = 28,913.83
The rest of the PMT is principal repayment:
Principal repayment of year 2 = 121,945.35 - 28,913.83 = 93,031.52

You can also easily find the proportions.

3L,MNO.LO
= 23.7% = Interest repayment proportion of PMT
N3N,MPQ.OQ
MO,SON.Q3
= 76.3% = Principal repayment proportion of PMT
N3N,MPQ.OQ

Page 13
COMM 308 – Section BB – Fall 2022

CH. 6

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 Finding PMTs (coupons) or Cr
Example
• Example: What is the coupon payments on a Eurobond
semi-annual coupons with 10 years to maturity, a face value
of $1,000, a yield-to-maturity of 6% if the bond is selling at
925.61?
• First step:
• this is a semi-annual bond (PMTs are semi-annual) so:
• N should be the number of semi-annual payments (periods
to maturity) à N=10*2=20
• !"#$% and K (i.e., Kb or YTM) should be ESR:
From question:
!"#$% =? (we don’t have it and we don’t need it here)
/(
YTM = 6% QR compounded semi-annually → k = 3% ESR
© John Wiley & Sons Canada, Ltd. 15
 Finding PMTs (coupons) or Cr
Example - Continued
• Second Step:
• Find the Payments!
Second step (Formula):

I é 1 ù F
B= ê1 - nú
+
ë (1 + kb ) û (1 + kb )
n
kb
I é 1 ù 1000
925.61 = ê1 - 20 ú
+
0.03 ë (1.03) û (1.03) 20

! = $25

© John Wiley & Sons Canada, Ltd. 16

 Finding PMTs (coupons) or Cr
Example - Continued
(remember: using calculator, we only input PV as a negative number; PMTs
and FV are cash inflows)
Second step (Calculator):
- 925.61àPV
1000àFV
20àN
3àI/Y (=YTM)
CPT à PMT = 25
What is the !" ?
25 = !" ×%& = !" ×1000 à!" = 2.5% (ESR)
• So, !" = 5% QR compounded semi-annually

© John Wiley & Sons Canada, Ltd. 17

 Remember

• The relationship between the coupon rate and

the bond’s yield to maturity (YTM) determines if
the bond will sell at a premium, a discount, or at
par

Coupon vs YTM Price vs Face Value Pricing

Coupon Rate (or
Price < Face Value Discount
current yield) < YTM
Coupon Rate (or
Price = Face Value At Par
current yield) = YTM
Coupon Rate(or
Price > Face Value Premium
current yield) > YTM
© John Wiley & Sons Canada, Ltd. 18
COMM 308 – Section BB – Fall 2022

CH. 7

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 PREFERRED SHARE (review)

• So, preferred share is the below timeline (You buy the share today (at
t=0) and receive equal amount of dividend each year). So, it is a
perpetuity! The price of it today is present value of all future PMTs
(PV0) )% )% )%
∞

0 1 2 3

%&'
• For a perpetuity: !"# =
(
• PMT = )* (Dividend amount of preferred share)
• K = +* (required return; here for preferred share we show it as +* (like for bonds we
used to show it with+, ))

./
• So, price of a preferred share = PV0 à !* = 0/
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 Total Return on a stock

• So, let’s assume I buy a stock for the price P0 (PV0), today!
After one year (when I receive the D1; i.e., the first dividend
payment), I sell my stock for the price P1 (PV1). So the
return for this holding period will be:

()*+,*).)/
• !"#$%& = Which we can reorganized as follows:
)/

)*.)/ +,* )*.)/ ,*

• !"#$%& = = +
)/ )0 )0
Dividend yield
Capital Gain
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 Total Return on a stock - continued

• Capital gain refers to that part of return that stems from

changes in price of the asset (here, stock).
• HINT: “g” defines your capital gain. So, if your “g” (growth
rate) is 3%, then your capital gain for a holding period will be
3% (see for yourself below:)
Capital Gain
Dividend yield

$% $% $%
• !" = &'(
→&−(= !"
→&=(+ !"

• Dividend yield refers to that part of return that stems from

Dividend payments.

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Question

Duffs Co. is growing quickly. Dividends are expected to

grow at a 30 percent rate for the next three years, with the
growth rate falling of to a constant 6 percent thereafter. If
the required return is 13 percent and the company just paid
a $1.80 dividend, what is the current share price?

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Solution

Dividend today (D0=$1.80), is just paid, so it not on our timeline anymore.

The only use for D0, is to calculate D1, etc. which we need for our calculations.
As always, Think of the question as a TVM problem (We want PV0 of all the
cash flows i.e., the price of stock)

g1=0.30 g2=0.06

D1 D4

∞
0 1 2 3 4

K=0.13

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Solution (continued)

n We have 1 growing annuity and one growing perpetuity. If we get PV0 of

each, separately and add them up, we will have our total PV0 (the current
price of stock).
n Lets first calculate the amounts D1, D4 as they are our first payments in
each separate annuity/perpetuity and we need them (Be careful!!! g is not
the same through our timeline, so below is how we do it):

!" = !$ ×(1 + )" )" = 1.80×(1 + 0.30)" = 2.34

!1 = !2 ×(1 + )3 )" = !$ ×(1 + )" )2 ×(1 + )3 )" = 4.19

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Solution (continued)

For the growing annuity (n=number of PMTs =3)

-
%& 1 + )&
!"# = × 1− = 7.19
' − )& 1+'

First, lets calculate the amount of D1:

%& = %#×(1 + )&)&= 1.80×(1 + 0.30)&= 2.34

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Solution (continued)

For the growing perpetuity:

%& 4.19
!"# = = = 59.85
' − )* 0.13 − 0.06
(This is at t=3, we should discount it back, 3 years, to
get PV0 of it)
59.85
!"4 = # = 41.48
(1 + ')

n So, PV0 = 7.19 + 41.48 = $48.67

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COMM 308 – Section BB – Fall 2022

CH. 8

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Quick review of formulas:
./& 01 +22 "'$/",3 ∑,#=1 "#
!"#$ℎ&'$#( *'+, = =
$0$+2 ,/&4'" 01 043'"5+$#0,3 ,

∑3.=1(-. − -̅ )2
!"#$%&' = *
3−1
,

!"#$%&$' )$&*+, = !) = .(+0 1+230 )

0=1

!
"#$%&' = *∑%1=1(-./0 1 ) (. 1 −"4 1 )2

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Quick review of formulas:

n
COVAB = å Prob(rA,i - ERA )(rB ,i - ERB )
i =1

!",$% = ()$2 !$2 + )%2 !%2 + 2)$ )% ,-.$%

!"#$% = ($,% *$ *%

s P = wA2s A2 + wB2s B2 + 2wA wB r ABs As B

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 A situation! (derived from main formulas)
• If we invest a portion w of our wealth in the risky stock A
and the remainder (i.e., (1 – w)) in the risk-free asset

• The expected return on our portfolio will be:

Weight placed in risky
stock A

ERP = RF + w( ERA - RF )
Risk-free return Expected return on risky stock A

• The standard deviation of our portfolio will be:

s P = w s A = ws A
2 2

Weight invested in the Std dev. of risky stock A

risky stock A
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 PERFECT Positive CORRELATION

• Special Case Below Equation gives the standard

deviation of a portfolio where the correlation
between securities A and B is perfectly positive:

s P = ws A + (1 - w)s B
s p -s B
w=
s A -s B

© John Wiley & Sons Canada, Ltd. 32

 PERFECT NEGATIVE CORRELATION

• Special Case Equation 8-16 gives the standard

deviation of a portfolio where the correlation
between securities A and B is perfectly negative:

s P = ws A - (1 - w)s B

s p +s B
w=
s A +s B

© John Wiley & Sons Canada, Ltd. 33

COMM 308 – Section BB – Fall 2022

CH. 9

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 Big Picture

• So far, when I wanted to value a stock, “k” (required rate

of return) was given!

• Now, considering some factors, I can calculate the

required rate of return myself using CAPM:
Expected return
on market

ki = RF + bi ( ERM - RF )
Required return on
asset/portfolio i Beta of asset or
portfolio i Market Risk Premium

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 SML: Overpriced Vs. Underpriced
n Any return you
compute using CAPM
will fall on the SML.

n For a given beta, Any

actual return above the
SML means the stock
is undervalued.
And below is
overvalued

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COMM 308 – Section BB – Fall 2022

CH. 10

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 BIG Picture
Market efficiency is a hypothesis.

If you believe that you can look at the past prices of a stock, and find a
magical pattern to predict future (like what people are trying to do while doing
technical analysis) you believe that markets are not efficient at all!

Abovementioned view (i.e., past prices of a stock are useful in predicting

future prices) is a violation of market efficiency even in its weak form.

All three form of market efficiency have one thing in common: Prices follow a
random walk (past prises are not useful for analyzing the future of a stock).

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 BIG Picture
Strong form hypothesis:

Prices follow random walk.

Public information (e.g., financial statements of the company) is not useful.
Private information (insider information) is not useful.

This is pretty strong! It says, even if you have insider information about future
of a company you cannot benefit from it since even that information is
already reflected in the price of a stock.

If you believe private info. Might be useful, this is a violation of strong form of
market efficiency.

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 BIG Picture
Semi-Strong form hypothesis:
Prices follow random walk.
Public information is not useful.
Private information (insider information) might be useful.

This is less strong! It says, if you have insider information about a company
you may be able to benefit from it since it takes a little bit of time for that
private information to be reflected in the price of a stock.

If you believe public info. Might be useful, this is a violation of semi-strong

form of market efficiency (and consequently, violation of strong form, also).

Fundamental analysis is the analysis of financial info. Available about

company (which is publicly available). If you do fundamental analysis it
means you don’t believe markets are semi-strong efficient)
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 BIG Picture
Weak form hypothesis:
Prices follow random walk (past prices not useful)
Public information might be useful.
(To clarify: not only Private information (insider information) is useful, but
also recent public info. Might be useful, too).

It says, if you analyze recent public information about a company you may
be able to benefit from it since it takes a little bit of time for that public
information to be reflected in the price of a stock.

If you believe past prices might be useful, this is a violation of weak form of
market efficiency (and consequently, violation of semi-strong and strong
form, also).

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COMM 308 – Section BB – Fall 2022

CH. 12

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Summer1-2015 / Q3

Extra(you don’t
need this one)
buy
sell

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Summer1-2015 / Q3

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COMM 308 – Section BB – Fall 2022

CH. 13

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 Decision: ACCEPT / REJECT
• ACCEPT / REJECT

Accept Indifferent (so take Reject

it)
NPV > 0 NPV=0 NPV<0
IRR > k IRR=k IRR<k
PI > 1 PI = 1 PI<1
DPP < n DPP = n DPP > n
Payback period < n Payback period < n Payback period ?

• Remember: Last row comes from the fact that Payback period < DPP

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COMM 308 – Section BB – Fall 2022

CH. 14

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Example - Question

We believe we can sell 90,000 home security devices per

year at $150 a piece. They cost $130 to manufacture
(variable cost). Fixed production costs run $215,000 per year.
The necessary equipment costs $ 785,000 to buy and would
be depreciated at a 25 percent CCA rate. The equipment
would have a zero salvage value after the five-year life of the
project. We need to invest $140,000 in net working capital
upfront; no additional net working capital investment is
necessary. The discount rate is 19 percent, and the tax rate is
35 percent. What do you think of the proposal?

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Example - Solution

Remember our approach:

NPV = CF0 (which is a negative number) + PV(OCFs) + PV(∆"#$%)+
PV(NWCrecovery)+56$$789 :ℎ< =>? @ABCDEF + 56 9FEGF?< 6FED<
Now, lets do it step by step:
CF0 = -initial investment - "#$H = -785,000 – 140,000 = -$925,000
For PV(OCFs) first we need to calculate OCF for each year (which are equal):
I$JKLM = (sales – costs)*(1-Tr)
Sales = 90000*150=13,500,000 Costs=Variable + Fixed= (90,000*130) + 215000 =
11,915,000
I$JKLM = (13,500,000 – 11,915,000)(1 – 0.35) = $1,030,250
1,030,250 1
56(NOPKLM) = × 1− = $3,150,128.34
0.19 1 + 0.19 M

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Example - Solution(continue)

PV(∆"#$%) = 0 as we have no NWC and as a result no ∆"#$ in our timeline

6789,999
PV(NWC recovery)= = 58,666.9 as the question does not mention it, we always assume
(7697;)<
that the net working capital in our project, is going to be recovered (a positive number) at the end of
project (t=5). We want the PV0 of that amount, so we discount it for 5 years.
BC DEFGEHI CEFJI = 0 (given in the question: at t=5 the equipment has a zero salvage value)

BC$$KLD
= [N%I OℎI FQRH SQTUJFE VWOℎ $0 = 785,000, d = 0.25, T = 0.35, k
= 0.19 and SV = 0)
BC$$KLD = $143,645.55 (or using straight-line method as we do it)
Done! We have everything we want. Add them up and get NPV:
NPV = -925,000 + 3,150,128.34 + 58,666.9 +143,645.55 = 2,427,440.79
The NPV > 0 so it is a good project and we should accept it.

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