Sebenta - Finance - Vasco Tamen

NOTEBOOK
FINANCE
2020/2021
AUTHOR | Vasco Ribeiro Tamen
Vasco Ribeiro Tamen | Nº 43238 1

TABLE OF CONTENTS
I. Introduction to Corporate Finance ....................................................................... 4

1. What is Corporate Finance? .................................................................................. 4
2. Financial Ratios ..................................................................................................... 4
II. Time Value of Money .......................................................................................... 7
1. Future & Present Value ......................................................................................... 7
2. Interest Rates ......................................................................................................... 8
3. Special Cases ......................................................................................................... 9
3.1. Perpetuity .................................................................................................................. 9
3.2. Growing Perpetuity ................................................................................................. 10
3.3. Annuity .................................................................................................................... 10
3.4. Growing Annuity.................................................................................................... 12
III. Valuation of Stocks and Bonds ......................................................................... 13
1. Bond Valuation .................................................................................................... 13
1.1. Types of Bonds........................................................................................................ 13
1.1.1. Coupon Bonds ............................................................................................................. 13
1.1.2. Zero-coupon Bonds...................................................................................................... 14
1.1.3. Consols ........................................................................................................................ 14
1.2. Bond Premiums and Discounts ............................................................................... 15
1.3. Computing YTM ..................................................................................................... 15
1.3.1. Yield Curve (or Term structure of interest rates) ......................................................... 16
1.3.2. Default Risk (or Credit Risk) ....................................................................................... 18
2. Stocks Valuation .................................................................................................. 19
2.1. Dividends Growth Model ........................................................................................ 19
2.1.1. Zero Growth................................................................................................................. 19
2.1.2. Constant Growth (Gordon Model) ............................................................................... 19
2.1.3. Differential Growth...................................................................................................... 20
2.1.4. Estimation of Parameter ............................................................................................... 21
2.2. NPVGO Model ........................................................................................................ 21
IV. Capital Budgeting .............................................................................................. 23
1. Project Cash Flows .............................................................................................. 23
1.1. Operating Cash Flow ............................................................................................... 23
1.2. Investment Cash Flow ............................................................................................. 24
2. Investment Rules ................................................................................................. 26
2.1. Net Present Value (NPV) ........................................................................................ 26
2.2. Payback Period ........................................................................................................ 26
2.3. Internal Rate of Return (IRR) .................................................................................. 27
2.4. Profitability Index ................................................................................................... 29
2.5. Additional Items on Investment Rules .................................................................... 29
3. Risk Analysis ....................................................................................................... 31
V. Risk and Return ................................................................................................. 32
1. Returns ................................................................................................................. 32
2. Risk - Return Trade-off ....................................................................................... 33

VI. Portfolio Theory ................................................................................................. 35
1. Individual Securities ............................................................................................ 35
2. Portfolios ............................................................................................................. 36
3. Mean-Variance Analysis ..................................................................................... 37
3.1. Two Stocks .............................................................................................................. 37
3.2. Many Stocks ............................................................................................................ 39
3.3. Conclusions ............................................................................................................. 39
4. Diversification & Portfolio Risk.......................................................................... 39
5. Risk-free Assets ................................................................................................... 40
5.1. Capital Allocation Line (CAL)................................................................................ 40
6. Optimal Risky Portfolio: Tangency Portfolio ..................................................... 41
6.1. Two Stocks .............................................................................................................. 41
6.2. Many stocks............................................................................................................. 43
VII. Capital Asset Pricing Model (CAPM) ............................................................. 44
1. Capital Market Line (CML) ................................................................................ 44
2. Security Market Line (or CAPM) ........................................................................ 45
2.1. Beta of a Portfolio, 𝛽 ............................................................................................... 46
3. CML vs. SML ...................................................................................................... 46
4. Estimations .......................................................................................................... 46
VIII. Capital Structure ........................................................................................... 48
1. Modigliani-Miller Theory.................................................................................... 48
1.1. Pie Theory ............................................................................................................... 48
1.2. Assumptions ............................................................................................................ 48
1.3. MM with No Taxes ................................................................................................. 48
1.4. MM with Corporate Taxes ...................................................................................... 49
2. Limits to the Use of Debt .................................................................................... 50
2.1. Policy Rules............................................................................................................. 50
2.2. Tradeoff Theory ...................................................................................................... 52
2.3. Pecking Order Theory ............................................................................................. 53
2.4. Conclusion: How Firms establish Capital Structure ............................................... 53
3. Valuation and Capital Budgeting with Debt........................................................ 54
3.1. Weighted Average Cost of Capital (𝑊𝐴𝐶𝐶) ........................................................... 54
3.2. Adjusted Present Value (APV)................................................................................ 57
3.3. Flow to Equity (𝐹𝑇𝐸) .............................................................................................. 58
3.4. Summary: Valuation ............................................................................................... 59
IX. Payout Policy ...................................................................................................... 60
1. Payout Decision ................................................................................................... 60
1.1. Dividends ................................................................................................................ 60
1.2. Repurchases............................................................................................................. 61
1.3. In Practise ................................................................................................................ 61
X. Market Efficiency: Efficient Markets Hypothesis .......................................... 62
1. Assumptions ........................................................................................................ 62
2. Types of Efficiency ............................................................................................. 62

I. Introduction to Corporate Finance
1. What is Corporate Finance?
Corporate finance is the division of finance that deals with how corporations work with funding
sources, capital structuring, and investment decisions. Corporate finance is primarily concerned
with:
Investment decision: What long-term investments in fixed assets should the firm do?
• Cash flows
• Cost of capital
Financing decision: How should the firm raise funds for the selected investments?
• The mix of debt and equity (capital structure)
• Financing alternatives (loans, bonds, stocks)
The Role of Financial Markets and Banking System
Primary Market Secondary Markets Banking System

Firm issues securities Buying and selling of In the alternative, firms
(stocks and bonds) for the previously issued can raise funds in the
first time securities banking system through
loans
⇓ Securities are traded in
stock exchanges between
The firm raises funds
investors
2. Financial Ratios
Financial ratios are a convenient way to analyze 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

There are many types of ratios, we will study the following:
➢ Liquidity (ST Solvency) Ratio
Liquidity is the capacity of turning an asset into cash, that is, an asset can be easily sold without
affecting its price.
Liquidity Ratios will measure a firm’s liquidity, or in other words, the ability the firm has to pay
its bills over the short run
Current Assets Measures a company's ability to cover its

Current Ratio =
Current Liabilities ST debt with its current assets
Current Assets − Inventory Measures a company’s ability to meet its

Quick Ratio =
Current Liabilities ST obligations with its most liquid assets.
Cash Shows a company's ability to cover its

Cash Ratio = ST obligations using only cash and cash
Current Liabilities equivalents.
➢ Financial Leverage
Leverage Ratios measure how much a firm relies on financial debt (i.e., interest-bearing) rather
than equity.
Total Debt Examines the percent of the company that is

D/A Ratio =
Total Assets financed by debt.
Total Debt Reflects the ability of shareholder equity to

D/E Ratio = cover all outstanding debt in the event of a
Total Equity business downturn.
EBIT Measures the ability a firm has to pay for the

Coverage Ratio =
Interest Expenses interest in its debt
Total Debt Measures a company's ability to pay off its

D/EBITDA Ratio =
EBITDA incurred debt
➢ Turnover (Asset Management) Ratios
Cost of Sales Measures how many times in a given period a

Inventory
= company can replace the inventories that it has
Turnover Inventory sold.
Receivables Sales Quantifies a company's effectiveness in

=
Turnover Account Receivable collecting its receivables owed by clients.
Payables Purchases Quantify the rate at which a company pays off

=
Turnover Account Payable its suppliers.
Asset Sales Measures the efficiency with which a company

=
Turnover Total Assets is using its assets to generate revenue.

➢ Period of Collection Ratios
Inventory Indicates the average number of days

Inventory = × 365 that a company takes to turn its
Cost of Sales inventory, including WIP, into sales.
Account Receivable Indicates the average number of days it

Receivables = × 365 took to collect the company's accounts
Sales receivable
Account Payable Indicates the average number of days a

Payables = × 365 company needs to pay its bills and
Purchases obligations.
➢ Profitability Ratios
Profitability Ratios measure the ability to sell the product for more than cost and return on
investment
Net Income Measures how much net income is generated

Net Profit Margin =
Sales as a percentage of revenues received.
EBIT Indicator of how well a company utilizes its

ROA =
Total Assets assets in terms of profitability.
Net Income Measures how the profitability of a corporation

ROE =
Total Equity in relation to stockholders’ equity.
EBIT Measure the amount of return on a particular

ROI =
Invested Capital investment, relative to the investment’s cost
Invested Capital Net Working Capital

Total Equity + Total Debt Current Assets - Current Liabilities
Fixed Assets + Net Working Capital Debt−Debt
Net Income Sales Total Assets

Du Pont Identity: ROE = Sales
× Total Assets × Total Equity
⟺ ROE = Net Profit Margin × Asset Turnover × Equity Multiplier

Sales
⟺ ROE = ROA × Equity Multiplier =
Total Assets
➢ Market value Ratios

Market value Ratios provide an idea of the firm’s performance and future prospects.
Net Income
Earnings per share = Shares Outstanding
Market Price Market Price

P/E Ratio = P/B Ratio =
Earnings per share Book value per share

II. Time Value of Money
Investment projects and financial assets yield streams of future cash flows for a given cost today.
Therefore, we need to value these streams of cash flows (and decide how to choose among them),
recognizing that: a dollar today is preferred to a dollar in the future since a dollar today is less
risky.
1. Future & Present Value
𝐶𝑇 = 𝐶0 × (1 + 𝑟)𝑇 ⟺ 𝐹𝑉 = 𝑃𝑉 × (1 + 𝑟)𝑇
where:
- 𝐶𝑇 is the cash flow after 𝑇 periods
- 𝐶0 is the cash flow today (time zero)
- 𝑟 is the interest rate per period 𝑇 in %
Example:
A. Suppose one deposit 100€ at a 10% interest rate per year for the next 5 years. How much
will one have in five years?
𝐹𝑉 = 100€ × (1 + 10%)5 = 161,051€
Notice that the deposit in 𝑇 = 5 is higher than

the sum of the initial value plus the interest:
161.051 > 100 + 5 × [100 × 0.10] = 150
This is due to the power of compounding since

we compute the interest of each year on the value
obtained in the last year.
B. How much an investor have to set aside today to have 5.000€ in 5 years at 10% per year?
𝐹𝑉 5000€
𝑃𝑉 = 𝑇
= = 3104,61€
(1 + 𝑟) (1 + 10%)5
C. If we deposit 5.000€ today in an account paying 10%, how long does it take to grow to
10,000€?
𝐹𝑉 = 𝑃𝑉 × (1 + 𝑟)𝑇 ⇔ 10,000€ = 5,000€ × (1 + 10%)𝑇 ⇔ T = log1,1 2 = 7,27 years
D. Assume the total cost of a college education will be 50.000€ in 12 years. You have 5.000€
to invest today. What rate of interest must you earn to cover the cost?
12
𝐹𝑉 = 𝑃𝑉 × (1 + 𝑟)𝑇 ⇔ 50,000€ = 5,000€ × (1 + 𝑟)12 ⇔ 𝑟 = √10 − 1 = 21.15%

2. Interest Rates
Annual Percentage Rate (APR) or Stated Annual Interest Rate (SAR)
The truth-in-lending laws require that when quoting interest rates, companies should use an
annual percentage rate or APR. APRs are helpful because they allow us to think in terms of
compounding periods, but they are not effective interest rates (more about this below).
Example: if an interest rate of 1% per month is charged on your car loan, the company will quote
an APR of 12%.
Compounding an investment 𝑚 times a year (monthly, quarterly, or semi-annually) for 𝑇 years

provides the future value:
𝐴𝑃𝑅 𝑚×𝑇
𝐹𝑉 = 𝑃𝑉 × (1 + )
𝑚
where:
- APR = Annual Percentage Rate
- 𝑚 = Number of Compounding periods
Example:
If our initial balance is 100€, what is the end-of-year balance (no payments during the year)?
The APR for our credit card is 12% compounded:
• Monthly
𝐴𝑃𝑅 𝑚×𝑇 12% 12×1
𝐹𝑉 = 𝑃𝑉 × (1 + ) = 100€ × (1 + ) = 112,68€
𝑚 12
• Quarterly
𝐴𝑃𝑅 𝑚×𝑇 12% 4×1
𝐹𝑉 = 𝑃𝑉 × (1 + ) = 100€ × (1 + ) = 112,55€
𝑚 4
Effective Annual Rate (EAR)

Effective Annual Rate (EAR) of interest is the annual rate that would give us the same end-of-
investment value after 𝑇 years compounded 𝑚 times, that is:
𝐴𝑃𝑅 𝑚×𝑇 𝑇
𝑨𝑷𝑹 𝒎
𝑃𝑉 × (1 + ) = 𝑃𝑉 × (1 + 𝐸𝐴𝑅) ⟺ 𝑬𝑨𝑹 = (𝟏 + ) −𝟏
𝑚 𝒎
Example: Cont. of the previous example

12% 12
𝐸𝐴𝑅 = (1 + ) − 1 = 12,68%
12
EAR of 12.68% compounded annually is the same as an APR of 12% compounded monthly.

Equivalent Interest Rate (EIR)
Two interest rates are equivalent (or indifferent) if they produce equal EAR´s (or the same future
value).
Example: Cont. of the previous example:
A. What is the equivalent APR with semi-annual compounding in our Credit Card?
12% 12 𝐸𝐼𝑅 2
(1 + ) = (1 + ) ⇔ 𝐸𝐼𝑅 = 12,30%
12 2
B. Consider an economy with only one 𝐸𝐴𝑅 = 10%.

Now, let’s explore the effective rates for different periods (𝐸𝐼𝑅𝑇 ).
What is the implied effective monthly rate (𝐸𝐼𝑅month )?
(1 + 𝐸𝐼𝑅month )12 = 1 + 𝐸𝐴𝑅 = 1,1 ⇔ 𝐸𝐼𝑅month = 0.797%
What is the implied effective semi-annual rate (𝑟semester)?
(1 + 𝐸𝐼𝑅semester )2 = 1 + 𝐸𝐴𝑅 = 1,1 ⇔ 𝐸𝐼𝑅semester = 4.881%
C. Now, consider another lender that offers loans that require monthly payments. This lender
would have to advertise an APR compounded monthly. What is the implied APR
compounded monthly (𝐴𝑃𝑅month )?
𝐴𝑃𝑅month = 12 × 𝐸𝐼𝑅month = 12 × 0.797% = 9.564%
Imagine that a lender offers a loan in which you need to make semi-annual payments. The
lender would have to advertise an APR compounded semi-annually. What would that be?
𝐴𝑃𝑅semester = 2 × 𝐸𝐼𝑅semester = 2 × 4.881% = 9.762%
3. Special Cases
Let´s recall the concept of Geometric Series which is the infinite sum of a geometric sequence.
𝑁 𝑁
𝑛
1 − 𝑓𝑁
𝑁
∑ 𝑎𝑛 = ∑ 𝑎 ∙ 𝑓 = 𝑎 + 𝑎 ∙ 𝑓 + ⋯ + 𝑎 ∙ 𝑓 = 𝑎 ×
1−𝑓
𝑛=0 𝑛=0
1−𝑓𝑁 1−0 𝒂
The sum of all terms (infinite geometric series) if |𝑓| < 1: lim (𝑎 × 1−𝑓
) = 𝑎 × 1−𝑓 = 𝟏−𝒇
𝑁∈ℕ
3.1. Perpetuity
Constant stream of cash flows that lasts forever
𝐶 𝐶
𝐶 𝐶 (1 + 𝑟) (1 + 𝑟) 𝐶
𝑃𝑉 = + +⋯= = 𝑟 =
(1 + 𝑟) (1 + 𝑟)2 1 𝑟
1− (1 + 𝑟)
(1 + 𝑟)

Example:
What is the present value of a perpetuity of 15€ if the interest rate is 10% per year? The first
payment is made at the end of the first year.
15
𝑃𝑉 = = 150€
10%
3.2. Growing Perpetuity
Stream of cash flows that grow at a
constant rate forever.
𝐶 𝐶
𝐶 𝐶(1 + 𝑔) 𝐶(1 + 𝑔)2 (1 + 𝑟) (1 + 𝑟) 𝐶
𝑃𝑉 = + + +⋯= = 𝑟−𝑔 =
(1 + 𝑟) (1 + 𝑟) 2 (1 + 𝑟)3 1 + 𝑔 𝑟−𝑔
1− (1 + 𝑟)
(1 + 𝑟)
Example:
What is the present value of a perpetuity of 15€ if it grows forever at 5% and the interest rate is
10% per year? The first payment is made at the end of the first year.
15
𝑃𝑉 = = 150€
10% − 5%
3.3. Annuity
Stream of constant cash flows that lasts for
a fixed number of periods (maturity).
Pretty much any (government or corporate) bond is an annuity.

1
𝐶 𝐶 𝐶 𝐶 1−
(1 + 𝑟)𝑇
𝑃𝑉 = + + ⋯+ = ×
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)𝑇 (1 + 𝑟) 1
1−1+𝑟
1
1−
(1 + 𝑟)𝑇
=𝐶× = 𝐶 × 𝐴𝑇𝑟
𝑟
Annuity Factor
Present value of 1€ a year for 𝑇 years at interest rate of 𝑟.
Notes:
• The annuity formula provides the value of the annuity one period before the first cash
flow.
• You can use the function “PV” in excel.

Examples:
A. If you can afford a 5.000€ annual car payment, how much a car can you afford if interest
rates are 7% per year on 3-year loans?
𝑃𝑉 = 𝐶 × 𝐴𝑇𝑟 ⟺ 𝑃𝑉 = 5,000€ × 𝐴37% = 13.122€
B. If you could afford a 400€ monthly car payment, how much a car can you afford on a 36-
month loan if the APR compounded monthly is 7% per year?
𝑃𝑉 = 𝐶 × 𝐴𝑇𝑟 ⟺ 𝑃𝑉 = 5,000€ × 𝐴36
7%/12 = 12.955€
C. What is the constant payment (installment) of a 10-semester mortgage of 250.000€ if the

APR is 6%? (Note that since the mortgage payments are semi-annual the APR is already
compounded semi-annually)
𝑃𝑉 = 𝐶 × 𝐴𝑇𝑟 ⟺ 250.000€ = C × 𝐴10
6%/2 ⟺ 𝐶 = 29.307,6€
D. What is the constant payment (installment) of a 10-semester mortgage of 250.000€ if APR

is 6% and the first installment is paid at the end of year 1?
𝑃𝑉𝑡=1 = 𝐶 × 𝐴10
6%/2
1 1
𝑃𝑉𝑡=0 = 𝑃𝑉𝑡=1 × = 𝐶 × 𝐴10
3% × ⇔ 𝐶 = 30.187€
1 + 6%/2 1 + 3%
To convert value at end of 1st

semester to today’s euros
What if installments are paid at beginning of each period:
𝑃𝑉𝑡=−1 = 𝐶 × 𝐴10
6%/2
𝑃𝑉𝑡=0 = 𝑃𝑉𝑡=−1 × (1 + 6%/2) = 𝐶 × 𝐴10

3% × (1 + 3%) ⇔ 𝐶 = 28.454€
To convert to today’s euros
What if the first installment paid at end of year 1 but at the end of semester 1 we pay interest?
250.000€ × 3% 1
250.000€ = + C × 𝐴10
3% × ⟺ 𝐶 = 29.308€
1 + 3% 1 + 3%

3.4. Growing Annuity
Stream of cash flows that grow at a constant
rate for a fixed number of periods.
1+𝑔 𝑇
𝐶 𝐶(1 + 𝑔) 𝐶(1 + 𝑔) 2
𝐶(1 + 𝑔) 𝑇−1
𝐶 1 − (1 + 𝑟 )
𝑃𝑉 = + + + ⋯+ = ×
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)𝑇 (1 + 𝑟) 1+𝑔
1− 1+𝑟
𝐶 1+𝑔 𝑇
= × [1 − ( ) ]
𝑟−𝑔 1+𝑟
Example:
A defined-benefit retirement plan offers to pay 20.000€ per year for 20 years and increase the
annual payment by 3% each year. What is the present value at retirement if the interest rate is
10% per year?
𝐶 1+𝑔 𝑇 20.000€ 1 + 3% 20
𝑃𝑉 = × [1 − ( ) ]= [1 − ( ) ] = 209.010€
𝑟−𝑔 1+𝑟 10% − 3% 1 + 10%

III. Valuation of Stocks and Bonds
1. Bond Valuation
A bond is an agreement between a borrower (issuer) and a lender (investor) by which the issuer
is required to pay the investor the amount borrowed and interest over several periods.
• Issuer (or borrower): sovereign or corporate
• Face value or par value (F): Reimbursement, usually paid at maturity
• Coupon rate (C%): APR to compute the coupon payments paid throughout the bond’s life
• Coupon Payments frequency (𝑚): annual or semi-annual
• Maturity date (T): number of periods to maturity
How to value a bond?

Value of financial security = 𝑃𝑉 of expected future cash flows
⇓
Value of a Bond = 𝑃𝑉 of Coupon payments + Face Value
⇓
Bond Price = Discounted Future Cash Flows
The Bond´s discount rate is the Yield to Maturity (𝑦) which represents the yield of alternative
investments with comparable risk in the market.
• Sets the 𝑃𝑉 of Future Cash Flows equal to the current market price
• Required interest rate on the bond if all payments are met
• It is usually presented as an effective annual rate (EAR)
There are three different types of bonds that we are going to study:
1.1. Types of Bonds
1.1.1. Coupon Bonds
Bonds that pay periodic Coupons
Payments (C) until maturity and the
Face Value (F) at maturity.
Coupon Payments (C) = 𝐹 × 𝐶%
Therefore, these types of bonds are just a combination of an annuity of C and the 𝑃𝑉 of F.
𝑪 𝟏 𝑭
Bond Value = [𝟏 − (𝟏+𝒚)𝑻 ] + (𝟏+𝒚)𝑻
𝒚
Note: 𝐶, 𝑇, and 𝑦 need to be consistent with the frequency of payments. For semi-annual
payments, y as effective semi-annual rate, T in semesters, and C as the payment per semester

Example:
Consider a bond with a 6.375% coupon rate that expires in 10 years. The face value is 100, and
coupons are paid annually. What is the bond value if the required annual yield = 𝑦 is 5%?
𝐶 = 100 × 0.06375 = 6.375
6.375 1 100
Bond Value = 5%
[1 − (1+5%)10 ] + (1+5%)10 = 110,617 €
1.1.2. Zero-coupon Bonds

Bonds that only pay Face Value (F)
at maturity. Do not pay any Coupons
throughout the contract
Therefore, these types of bonds have:

• No periodic interest payments (coupon rate = 0%)
• Cannot sell for more than par value unless the yield to maturity is negative
• Value = 𝑃𝑉 of F
𝑭
𝐁𝐨𝐧𝐝 𝐕𝐚𝐥𝐮𝐞 =
(𝟏 + 𝒚)𝑻
Example:
Find the value of a 30-year zero-coupon bond with a 100 € par value and a YTM = 𝑦 of 6%.
100
Bond Value =
(1 + 6%)30
1.1.3. Consols
C Bonds that pay a fixed infinite
stream of coupons.
∞
Therefore, these types of bonds do not have final maturity, they are just a Perpetuity.
𝒄
𝐁𝐨𝐧𝐝 𝐕𝐚𝐥𝐮𝐞 =
𝒚

1.2. Bond Premiums and Discounts
There are situations where the 𝑦 ≠ 𝐶%. What happens to bond values?
Bond price ≠ Par value!
𝐶% < 𝑦 ⟹ Bond Price < Face Value ⟹ Traded at Discount, Losing Money
𝐶% = 𝑦 ⟹ Bond Price = Face Value ⟹ Traded at Par Value, Market Value
𝐶% > 𝑦 ⟹ Bond Price > Face Value ⟹ Traded at Premium, Raising Money
Example:
Consider a bond with a 6.375% coupon rate and face value is 100, coupons are paid annually.
𝐶% > 𝑦 ⇒ Premium 𝐶% < 𝑦 ⇒ Discount
𝐶% = 𝑦 ⇒ Par Value
Clean Price ⟹ Quoted Price Dirty Price ⟹ Discounted Cash Flows, actually paid
Dirty Price = Clean Price + Accrued Interest

Accrued Interests (𝐴𝐼) arise from a situation where the owner wants to sell its bonds before
maturity. Therefore, 𝐴𝐼 acknowledges that coupons start earning interest from the last period of
coupon payment. [Class #3 - 1:05:46]
𝑇𝑖𝑚𝑒 𝑠𝑖𝑛𝑐𝑒 𝑙𝑎𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
𝐴𝐼 = 𝐶𝑜𝑢𝑝𝑜𝑛 ×
𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠
1.3. Computing YTM

Rate of return on the investment that sets the 𝑃𝑉 of Future Cash Flows equal to the current market
price, if:
• Investor holds the bond until maturity • Reinvests the coupons at a rate equal to 𝑦.
Now, let´s do the exercises above the other way around. Having the value of the Bond and all
future cash flows, try to compute the yield:
𝐶 1 𝐹
Bond Value = [1 − (1+𝑦)𝑇 ] + (1+𝑦)𝑇
𝑦
Since, in this case, solving the above equation for y is hard, we should use Excel - Yield Function,
What-If Analysis, or Goal Seek. [Class 25/02] [Excel File]

Example: Suppose a bond with a 10% coupon rate and quarterly coupons has a face value of 100,
10 years to maturity, and is trading at 115. What is the bond’s yield to maturity?
2,5 1 100 𝐸𝑥𝑐𝑒𝑙
115 = 𝑦
[1 − (1+𝑦)40 ] + (1+𝑦)40 ⇒ 𝑦 = 2,31% ⇒ 𝐴𝑃𝑅 = 2,31% × 4 = 9,23%
So, 𝐸𝐴𝑅1 = (1 + 2,31%)4 − 1 = 9,55%
1.3.1. Yield Curve (or Term structure of interest rates)

The yield curve is how bond yields change with bond maturity.
So far, we have assumed a flat yield curve, i.e. yields are equal regardless of maturity, which is
not realistic. For instance, if we think of cash flow in 10 years or 2 years, the risk involved is way
lower in the last. Moreover, discount rates are usually increasing over time (but not always)!
Determinants of yields (𝑦)

𝑦 = 𝑟 ∗ + 𝐼𝑃 + 𝑀𝑅𝑃
Where,
- 𝑦 = Required Return on risk-free bond (Discount Rate)
- 𝑟 ∗ = Real risk-free rate (Usually Gov. Bonds)
- 𝐼𝑃 = Expected Inflation Premium
- 𝑀𝑅𝑃 = Maturity Risk Premium
When 𝐼𝑃 is expected to ↑ When 𝐼𝑃 is expected to ↓

The inflation premium and the maturity risk The inflation is expected to decrease
premium typically increase with the time (recession expected), the inflation premium
horizon, which gives an upward-sloping decreases with the time horizon, which can
yield curve. give a downward-sloping yield curve.
1
Annual yields in Europe are often reported as EAR´s but in the US, they report them as APRs. The Excel
yield function gives APR.

Spot Rates
Spot rates are the current yields at different maturities which are determined from yield to maturity
of zero-coupon bonds. We use zero-coupon bonds because it allows us to avoid the condition of
reinvesting the coupon payments.
Rates are known today, and investment starts today. Spot Rates are EAR.
Example:
Let us assume that we have 4 zero-coupon bonds, each with a par value of 1000 €, as follows:
• 1-year bond with a market price of 925,93 €
1000
925,93 = ⟺ 𝑟1 = 8%
1 + 𝑟1
1000
841,75 = ⟺ 𝑟2 = 9%
(1 + 𝑟2 )2
1000
925,93 = ⟺ 𝑟3 = 9,66%
(1 + 𝑟3 )3
1000
925,93 = ⟺ 𝑟4 = 9,99%
(1 + 𝑟4 )4
What are the implications of the yield curve for bond pricing?
If the term structure is not flat, then to compute the price of the coupon bond you need to use:
𝐶 𝐶 𝐶 𝐶+𝐹
𝑃= + 2
+ ⋯+ 𝑇−1
+
(1 + 𝑟1 ) (1 + 𝑟2 ) (1 + 𝑟𝑇−1 ) (1 + 𝑟𝑇 )𝑇
Example: Continuation of the last example

Consider a 4-year government bond with a 10% coupon rate and a par (or maturity) value of
1000€, paying the coupon rate on an annual basis. Compute the price of the bond considering that
the yield curve is the above.
100 100 100 1100
𝑃= + 2
+ 3
+ = 1004,2 €
(1 + 8%) (1 + 8,995%) (1 + 9,66%) (1 + 9,993%)4
What is the yield to maturity of the bond?
100 100 100 1100 𝐸𝑥𝑐𝑒𝑙
1004,2 € = + + + ⇒ 𝑦 = 9,87%
(1 + 𝑦) (1 + 𝑦)2 (1 + 𝑦)3 (1 + 𝑦)4
Investors & Yield Curves

Yield Curves are extremely important because with them we can estimate the future of the
economy.
One common belief is that a downward sloping yield curve predicts a recession.

1.3.2. Default Risk (or Credit Risk)
Default risk refers to the possibility of the issuer defaulting on the payments of the bond. In other
words, is the probability of the issuer failing in the promised cash flows, that is to make timely
principal and interest payments to the bondholders.
Government Bonds are usually considered free default risk. However, some countries have
defaulted in the past. Rating agencies evaluate the risk of default.
Bond value is 𝑃𝑉 of promised bond payments but interest rate (i.e., discount rate) needs to be
adjusted by default risk:
𝑦 = 𝑟 ∗ + 𝐼𝑃 + 𝑀𝑅𝑃 + 𝑫𝑹𝑷
Where,
- 𝐷𝑅𝑃 = Default Risk Premium
- 𝑟 ∗ = Real risk-free rate (Usually Gov. Bonds)
- 𝐼𝑃 = Expected Inflation Premium
- 𝑀𝑅𝑃 = Maturity Risk Premium
There is a different term structure of interest rates for different levels of default risk/rating.
The higher probability of default, the higher will be the yields. Because of this risk, bonds with
default risk trade in the market at a lower price/higher yield than the comparable government
bond.

2. Stocks Valuation
Common stock is a security that provides ownership of a corporation. Allow the stockholder to:
• Elect the board of directors
• Vote on corporate policies
• Receive dividend payments after preferred stockholders are paid.
Common stock is at the bottom of the priority ladder in the ownership structure: if the firm goes
bankrupt, common shareholders only have rights to the assets after bondholders, preferred
shareholders, and other debtholders are paid out.
Intrinsic vs. Market value

Intrinsic Value = 𝑃𝑉 of cash flows Market Value = Stock price
Typically, they are similar, but sometimes the expectation of the future dividends may be different
between investments.
Intrinsic Value < Market Value ⟹ Overvalued ⟹ Should not buy

Intrinsic Value > Market Value ⟹ Undervalued ⟹ Should buy
2.1. Dividends Growth Model

The value of a stock is the present value of its expected future cash flows which could be:
• Dividends
• Capital Gains
We can think of a stock value today (𝑃0 ) as the present value of future dividends and capital gains.
Therefore, we have three different types of stocks´ valuation:
2.1.1. Zero Growth

This type of stocks assume that dividends will remain the same forever: 𝐷 = 𝐷1 = 𝐷2 = ⋯ = 𝐷𝑇
Therefore, the value of a zero-growth stock is the present value of perpetuity:
𝑫
𝑷𝟎 =
𝑹
Where 𝑅 = Appropriate Discount Rate.
2.1.2. Constant Growth (Gordon Model)

This type of stocks assume that dividends will grow at the rate of 𝑔: 𝐷𝑛 = 𝐷1 (1 + 𝑔)𝑛−1
Therefore, the value of a constant growth stock is the present value of growing perpetuity:
𝑫𝟏
𝑷𝟎 =
𝑹−𝒈
Note: we assume that the first dividend is paid at the end of year 1.

Example:
A. “One” will pay a dividend of 0.50 € per share a year from today. It is expected to increase
its dividend by 2% per year. If investors require a return of 15%, what is the stock value?
0,50
𝑃0 = = 3,846 €
15% − 2%
B. “One” just paid a dividend of $0.50 per share today. It is expected to increase its dividend
by 2% per year. If investors require a return of 15%, what is the stock value today right
after the dividend payment?
0,50
𝑃0 = × (1 + 2%) = 3,923 €
15% − 2%
C. “One” is a growing firm and does not plan to pay dividends in the next two years. They
plan to pay their first dividend of $0.50 per share at the end of year 3. After that, their
dividend is expected to increase by 4% per year. If investors require a return of 12%,
what is the stock value today?
0,50 1
𝑃0 = × = 4,982 €
15% − 2% (1 + 2%)2
2.1.3. Differential Growth

This type of stocks assume that dividends will grow at the rate of 𝑔1 until 𝑇 and grow at the rate
of 𝑔2 thereafter.
Therefore, the value of a differential growth stock is the sum of:

𝐷1 1 + 𝑔1 𝑇
T-years growing annuity at rate 𝑔1 × [1 − ( ) ]
𝑅 − 𝑔1 1+𝑅
+ +
Present value of growing perpetuity 𝐷𝑇+1 1
×
at rate 𝑔2 which starts in year 𝑇 + 1 𝑅 − 𝑔2 (1 + 𝑅)𝑇
𝐷1 1 + 𝑔1 𝑇 𝐷𝑇+1 1
Stock Price 𝑃0 = × [1 − ( ) ]+ ×
𝑅 − 𝑔1 1+𝑅 𝑅 − 𝑔2 (1 + 𝑅)𝑇
Example:
The dividend is expected to grow at 8% for two years (after year 1). Afterward, dividends are
expected to grow at 4% in perpetuity. The firm will pay a dividend of 2 € a year from today. What
is the price of the stock today if the discount rate is 12%?
Cash flows considering that after
year 4 dividends grow at a constant
rate (4%).
2 1 + 8% 3 2(1 + 8%)2 (1 + 4%) 1

𝑃0 = × [1 − ( ) ]+ × = 26,8 €
12% − 8% 1 + 12% 12% − 4% (1 + 12%)3

2.1.4. Estimation of Parameter
The value of a stock depends upon its growth rate (𝑔) and its discount rate (𝑅).
➢ Where does 𝑔 come from?
Assuming that there´s no new debt or capital, that is, the only way to finance the business is by
retaining profits.
𝑔 = 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜 × 𝑅𝑂𝐸 ⟺ 𝒈 = (𝟏 − 𝑷𝒂𝒚𝒐𝒖𝒕) × 𝑹𝑶𝑬
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
⟺ 𝑔 = (1 − )×
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝐸𝑞𝑢𝑖𝑡𝑦
𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜 = share of profits are retained by the company and available to invest
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑃𝑎𝑦𝑜𝑢𝑡 = Fraction of earnings that is paid out to stockholders = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
➢ Where does 𝑅 come from?
Discount rate can be broken into two parts:

𝐷 𝐷1 𝐷1
1. Dividend yield ( 𝑃1 ) 𝑃0 = ⇔𝑅= +𝑔
0 𝑅−𝑔 𝑃0
2. Growth rate (𝑔)
2.2. NPVGO Model

Until now, we have learned the dividend growth model but there are other alternative models.
One such model is the NPVGO model that assesses the firm as the sum of two parts:
i. Value as a “cash cow” as if there are no growth opportunities
ii. The present value (per share) of the growth opportunities (NPVGO)
The value of a firm is then the sum of the value of a firm that pays out 100% of its earnings
(𝐸𝑃𝑆) as dividends and the net present value of the growth opportunities (𝑁𝑃𝑉𝐺𝑂).
𝑬𝑷𝑺𝟏
𝑷𝟎 = + 𝑵𝑷𝑽𝑮𝑶
𝑹
The key part is to assess the growth opportunities. This is not easy since it involves a lot of
uncertainty but under some assumptions, we can estimate the value. Growth opportunities are
opportunities to invest in positive NPV projects.

Example:
Firm has 𝐸𝑃𝑆1 = 5€, a payout ratio of 30%, a discount rate of 16%, and ROE of 20%.
𝐷1 = 5 × 0,3 = 1,5€
𝑔 = (1 − 0,3) × 20% = 14%
𝐸𝑃𝑆1 5
Value of the firm as a “Cash Cow”: 𝑃0 = 𝑅
= 0,16 = 31,25
𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑃𝑆1 ×𝑅𝑂𝐸
Value of Growth Opportunities: 𝑁𝑃𝑉1 = −𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑃𝑆1 + 𝑅
5×0,75×0,2
= −5 × 0,7 + 0,16
= 0,875
Bearing in mind that 𝑁𝑃𝑉1 will grow every year at a constant rate of 𝑔 = 14% we can then
consider NPV as a growing annuity:
𝑁𝑃𝑉1 0,875
𝑁𝑃𝑉𝐺𝑂0 = = = 43,75
𝑅 − 𝑔 16% − 14%
And so, finally, we get:
𝑃0 = 31,25 + 43,75 = 75
Conclusions:
If the 𝑅𝑂𝐸 < 𝑅 ⟹ NPVGO < 0
The firm’s investment opportunities are worse than the ones available to investors. In this case,
firms are better off paying out dividends to investors instead of retaining earnings to invest
internally.
The NPVGO is very useful in situations in which it is not a linear function of the 𝑅𝑂𝐸, that is,
the firm has new growth projects that are different from its current business. In this case, the DGM
will not work.
Price-Earnings Ratio
Analysts frequently relate earnings per share to price. The Price-earnings ratio is calculated as the
current stock price divided by next year (annual) EPS (i.e., number of years to recover investment)
𝑷 𝑷𝟎
=
𝑬 𝑬𝑷𝑺𝟏
Using Dividend Growth Model:
𝐷1 𝐸𝑃𝑆1 × 𝑃𝑎𝑦𝑜𝑢𝑡 𝑷 𝑷𝟎 𝑷𝒂𝒚𝒐𝒖𝒕
𝑃0 = = ⟹ = =
𝑅−𝑔 𝑅−𝑔 𝑬 𝑬𝑷𝑺𝟏 𝑹−𝒈
𝑃
If firms are comparable in terms of payout, growth, and risk we may compare 𝐸 across firms to
access:
𝑃
Low 𝐸 ⟹ Stock is cheap 𝑃
↑ 𝑃𝑎𝑦𝑜𝑢𝑡 𝑜𝑟 𝑔 ⟹ ↑
𝐸
𝑃
High 𝐸 ⟹ Stock is expensive 𝑃
↑𝑅 ⟹↓
𝐸

IV. Capital Budgeting
Capital Budgeting goal is to maximize the value of the assets. Corporate investment projects:
Fixed assets: Types of projects:

• Tangibles • Start-up
e.g., new plant and equipment • Established companies:
• Intangibles - Replacement
- Scale-enhancing
e.g., R&D and advertising
- Innovation
1. Project Cash Flows
When considering each project´s cash flows we should always consider an Incremental Cash
Flows basis, that is, we should capture all the differences in the cashflows which arise from
investment.
Relevant cost (we should consider) Not Relevant (we shouldn´t consider)
• Opportunity Costs • Sunk Costs

• Side Effects (Externalities)
• Taxes
• Inflation
• Sunk Costs
They are irreversible. A decision should not evaluate what was spent but what will be spent.
• Opportunity Costs
If an existing asset is used in a new project, potential revenues from alternative uses of the asset
are lost. The lost revenues should be considered as a cost (opportunity cost) of the new project.
• Side Effects (Positive or Negative Externalities)
For example, Erosion and cannibalism. If our new product causes existing customers to demand
less (or more) of current products, we need to recognize that.
Bear in mind: Cash Flows ≠ Accounting Earnings/Profits

𝑭𝒓𝒆𝒆 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘 (𝑭𝑪𝑭) = 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝑭(𝑶𝑪𝑭) + 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝑪𝑭 (𝑰𝑪𝑭)
1.1. Operating Cash Flow

Assume an all-equity financed project, that is, the firm´s level of Debt (and, hence, interest
expense) is independent of the project at hand. Since you never write a check to pay out
“depreciation”, and it is a tax-deductible expense. So, we should account it when computing OCF:
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 (𝑂𝐶𝐹) = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
= 𝐸𝐵𝐼𝑇 ∙ (1 − 𝑡) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
= 𝐸𝐵𝐼𝑇𝐷𝐴 ∙ (1 − 𝑡) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 ∙ 𝑡
where 𝑡 is the marginal corporate tax rate.

1.2. Investment Cash Flow
To calculate the second part of the cash flows equation we need to understand the following
concepts:
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐶𝐹 (𝐼𝐶𝐹) = 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 − 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 (𝐶𝐴𝑃𝐸𝑋) − ∆ 𝑁𝑊𝐶
Changes in Net Working Capital (∆ 𝑁𝑊𝐶)

Operating cash flow must be adjusted by changes in net working capital.
𝑁𝑒𝑡 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 + 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 − 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠

∆ 𝑁𝑊𝐶𝑇 = 𝑁𝑊𝐶𝑇 − 𝑁𝑊𝐶𝑇−1
Capital Expenditures (𝐶𝐴𝑃𝐸𝑋)

CAPEX is the amount we will invest in fixed assets. It stands for the investment in fixed assets
for the following period with these characteristics:
• Usually, take place at the beginning
• Include opportunity cost (such as unused land)
• Replacement during project
• Considers the residual value of fixed assets in the final year (Terminal Value)
Terminal Value
It is the residual value of a fixed asset at the end of a project. We may compute it through one of
the following ways:
a) Salvage Value after taxes
At end of the project is to be liquidated or sold by the market value.
𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 = 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒 − 𝑇𝑎𝑥 = 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑎𝑖𝑛 × 𝑡
= 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒 − (𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒 − 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒) × 𝑡
Where,
- 𝑡 = marginal corporate tax rate
- 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 = Purchase Value − Acc. Depr.= Net of Depreciation
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑎𝑖𝑛 < 0 ⟹ Loss in the sale of Fixed Asset ⟹ No tax, but it may be Tax-Deductible
⇓
Tax Saving
b) Continuation Value
The firm will last forever (end of life Year 𝑇), and therefore we will use the Growing Perpetuity.
𝐹𝐶𝐹𝑇+1 𝐹𝐶𝐹𝑇 × (1 + 𝑔)
𝐶𝑉 = =
𝑅−𝑔 𝑅−𝑔

Example:
Costs of test marketing (already spent): 250.000€; Market value of the building (which we own):
200.000€, Book value is 60.000€ (fully depreciated in 1 year) and Salvage value is 50.000€; Cost
of equipment: 100.000€ (depreciated in 5 years) and Salvage Value is 30,000€; Working capital
is 10% of sales of the following year; Sales (in units) by year during the 5-year life of the
equipment: 5k, 8k, 12k, 10k, 6k; Price for the first year is 20€ and increases 2% per year thereafter;
Cost of sales for the first year is 5€/unit; Selling, General and Administrative costs are expected
to be 25,000€ per year; Corporate tax rate is 30%.
So let´s organize the information and compute the Operating Cash Flows (OCF):
So, let´s organize the information and compute the Investment Cash Flows (ICF):
So, we can now compute the Free Cash Flows (FCF):
How to make the investment decision? Use one of the following rules!

2. Investment Rules
Investment rules help managers deciding whether they should invest in a given project or not.
2.1. Net Present Value (NPV)
The NPV is the present value of all future cash flows considering the initial investment made in
each project. Consider 𝑟 as the discount rate.
𝑵
𝑪𝒋
𝑵𝑷𝑽 = 𝑷𝑽 𝒐𝒇 𝑭𝒖𝒕𝒖𝒓𝒆 𝑪𝑭 − 𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 = ∑ − 𝑪𝟎
(𝟏 + 𝒓)𝑵
𝒋=𝟏
Acceptance Criteria Ranking Criteria

𝑁𝑃𝑉 > 0 Choose the one with the highest 𝑁𝑃𝑉
Therefore, to compute the 𝑁𝑃𝑉 value we have to estimate the following:

• Future Cash Flows
• Discount Rate (time value of money and risk)
• Initial Investment (includes Opportunity Cost and Externalities)
Assumption: 𝑁𝑃𝑉 rule assumes that all cash flows can be reinvested at the discount rate
Perks:
• Accepting positive NPV projects benefits shareholders while maximizing shareholder
value (stock price)
• NPV uses cash flows
• NPV discounts the cash flows properly (need to find appropriate discount rate based on
the risk of cash flows)
2.2. Payback Period

Number of years to recover the initial investment.

Set by the management board Set by the management board
Problems:
• Ignores the time value of money
• Ignores cash flows after the payback period (biased against long-term projects)
• Requires arbitrary acceptance criteria
To face these problems, we could evaluate the Discounted Payback Period, that is, considering
the time value of money.
Decision Rule: Accept the project if it pays back on a discounted basis within the specified time.

2.3. Internal Rate of Return (IRR)
The Internal Rate of Return is the discount rate that makes the 𝑁𝑃𝑉 = 0.
𝑵
𝑪𝒋
𝑵𝑷𝑽 = 𝟎 ⇔ ∑ − 𝑪𝟎 = 𝟎
(𝟏 + 𝑰𝑹𝑹)𝑵
𝒋=𝟏

𝐼𝑅𝑅 > 𝑟 Choose the one with the highest 𝐼𝑅𝑅
Assumption: 𝐼𝑅𝑅 rule assumes that all cash flows can be reinvested at the 𝐼𝑅𝑅
To find the 𝐼𝑅𝑅, in most cases, we need to solve a non-linear equation which is not easy!
Therefore, we will use Excel tools as IRR, solver, goal seek functions… Alternatively, we use a
graphical approach by plotting NPV versus the discount rate where the 𝐼𝑅𝑅 will be the 𝑥-axis
intercept.
Problems:
• Problem 1: Investing or financing?
The difference between them is when considering an investing project, the initial investment is
negative and future cash flows are positive, whereas in a financing project today we receive a
positive cash flow, and then future cash flows will be negative.
Let´s consider the following one-year examples:
Financing Project Investing Project

(100, −130) (−100, 130)
130 130
100 − =0 −100 + =0
1 + 𝐼𝑅𝑅 1 + 𝐼𝑅𝑅
Solving both equations, we get 𝐼𝑅𝑅 = 30%
Accept if 𝑰𝑹𝑹 < 𝒓 Accept if 𝑰𝑹𝑹 > 𝒓
Example:
Consider two mutually exclusive projects (𝑟 = 8%): Project A (−1800, 3200); Project B
(−1200, 2300). Build the incremental cash flows and identify which project we should invest in.
900
Incremental Cash Flow: Project A – B: (−600,900) ⟹ −600 + 1+𝐼𝑅𝑅 ⇔ 𝐼𝑅𝑅 = 50% > 8%
So, we should invest in Project A since it is valuable to invest 600€ today with a discount of 8%
because the 𝑃𝑉 𝑜𝑓 𝐹𝑢𝑡𝑢𝑟𝑒 𝐶𝐹 > 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡!

• Problem 2: Multiple or none IRRs
We may have multiple IRR (or none) when cash flows change signs two or more times.
Descartes’ rule of sign: The number of positive real zeros in a polynomial function 𝑓 (𝑥) is the
same or less than by an even number as the number of changes in the sign of the coefficients.
If there is just one change in signs, there is only one IRR.
Solution for multiple IRRs: use the MIRR method (Modified IRR). Cash flows are reinvested at
the cost of capital instead of IRR. This method is beyond the context of our course.
So, we should evaluate the project using the 𝑁𝑃𝑉 Rule: 𝑁𝑃𝑉 > 0!
• Problem 3: Problems with mutually exclusive investments (alternative)

Scale Problem
Let´s consider two mutually exclusive projects (𝑟 = 10%):
Small Project Large Project

(−1000, 2000) (−2000, 3500)
𝐼𝑅𝑅 = 100% 𝐼𝑅𝑅 = 75%
𝑁𝑃𝑉 = 818 𝑁𝑃𝑉 = 1182
𝐼𝑅𝑅 and 𝑁𝑃𝑉 give different answers: IRR favors small scale project, which has lower NPV; but
we should pick large scale project!
Solution: Look at incremental cash flows!
In this example create a project where Large − Small: (−1000, 1500).
Since, 𝐼𝑅𝑅 = 50% > 10%, we should accept the Large Project!
Timing Problem
Let´s consider two mutually exclusive projects (𝑟 = 10%):
Slow Project Fast Project

(−100, 10, 35, 100) (−100, 60, 60, 10)
𝐼𝑅𝑅 = 15.4% 𝐼𝑅𝑅 = 18%
𝑁𝑃𝑉 = 13 𝑁𝑃𝑉 = 12
IRR and NPV give different answers: IRR

favors a small fast project, which has a lower
NPV; but we should pick a slow project!
Solution: Look at incremental cash flows!
In this example create a project where Slow-
Fast: (0, −50, −25, 90).
Since, 𝐼𝑅𝑅 = 11.5% > 10%, we should
accept the Slow Project!
Note: Bear in mind, you should create an investment project and not a financing project!

Summary of 𝑁𝑃𝑉 vs. 𝐼𝑅𝑅 Rule
𝑁𝑃𝑉 and 𝐼𝑅𝑅 will generally give the same decision! But there are exceptions:
• Non-conventional cash flows: cash flow signs change more than once.
• Mutually exclusive projects (reinvestment rate = 𝐼𝑅𝑅)
- Initial investments are substantially different
- Timing of cash flows is substantially different
2.4. Profitability Index

The Profitability Index compares the present value of all future expected cash flows with the
initial investment.
𝑷𝑽 𝒐𝒇 𝑭𝒖𝒕𝒖𝒓𝒆 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘𝒔 𝑁𝑃𝑉
𝑷𝑰 = = +1
𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝑃𝐼 > 1 Choose the one with the highest 𝑃𝐼
Problem: Problem with mutually exclusive investments (scale problem)

Example:
A. Consider the project (𝑟 = 10%):
50 100 150
+ +
(1 + 10%) (1 + 10%)2 (1 + 10%)3 240,8
𝑃𝐼 = = = 1,204 ⟹ Accept!
200 200
B. We have 20 to invest. Consider three independent projects (𝑟 = 12%):
Project A Project B Project C

(−20, 70, 10) (−10, 15, 40) (−10, −5, 60)
𝑁𝑃𝑉 = 50,5 𝑁𝑃𝑉 = 35,3 𝑁𝑃𝑉 = 33,4
𝑃𝐼 = 3,53 𝑃𝐼 = 4,53 𝑃𝐼 = 4,34
To evaluate which one is the best we should first rank by 𝑃𝐼, that is (𝐵, 𝐶, 𝐴).
Then we should pick 𝐵 first but our capital constraint is not fulfilled, whereas we also could invest
in 𝐶: 𝑁𝑃𝑉 = 35,3 + 33,4 = 68,7 > 50,5.
Therefore, we could opt between 𝐴 and combining 𝐵 and 𝐶. Since the 𝑁𝑃𝑉 of combining 𝐵 and
𝐶 is higher than the 𝑁𝑃𝑉 of 𝐴, we should choose the combination of 𝐵 and 𝐶.
2.5. Additional Items on Investment Rules

Mutually Exclusive Independent Projects
Only one of several potential projects can be Accepting or rejecting one project does not
chosen. affect the decision of the other projects.
Rank all alternatives and select the best one. Must exceed minimum acceptance criteria.

Investments of Unequal Lives
𝑁𝑃𝑉 rule can lead to incorrect decisions when we have to decide between alternative (mutually
exclusives) projects with unequal lives.
Example:
Consider the following mutually exclusive projects and assume 𝑟 = 10% and 𝑡 = 0.
• Machine A costs 4.000€, has annual operating costs of 100€ and lasts 10 years.
• Machine B costs 1.000€, has annual operating costs of 500€ and lasts 5 years.
Since we do not have revenues and assuming they are the same for the two machines we could
compute the present value of costs:
𝑃𝑉𝐴 = 4000 + 100 × 𝐴10
10% = 4614,5€ Using the 𝑁𝑃𝑉 rule the machine B will have
5 lower costs and so it would be the best.
𝑃𝑉𝐵 = 1000 + 500 × 𝐴10% = 2895,4€
But in this case, we are ignoring the fact that machine A has twice the lifetime expectance than
B. Therefore, we should use one of the following methods to evaluate which one is the best:
I. Replacement Chain Approach

Repeat projects until both projects end at the same time (minimum multiple numbers between
project´s lifetime, for instance, if A has 3y and B has 2y, we should repeat 2 × 𝐴 and 3 × 𝐵).
Then compute NPV for the “repeated projects”.
Machine A: 𝑁𝑃𝑉𝐴 = 4614,5€
Machine B: 𝑁𝑃𝑉𝐵 = 4639,2€

nd
In Year 5, the firm buys 2 machine B
Now, using the 𝑁𝑃𝑉 rule the machine A will have lower costs and so it would be the best pick.
II. Equivalent Annual Cost

Puts costs on a per-year basis. 𝐸𝐴𝐶 is the value of the (constant) annuity that has the same NPV
as the original set of cash flows (with no initial investment).
Assumption: machines can be replaced by similar machines at end of its life.
𝐸𝐴𝐶𝐴 1
𝑃𝑉𝐴 = 4614,5€ = × (1 − ) ⟺ 𝐸𝐴𝐶𝐴 = 751€
10% (1 + 10%)10
𝐸𝐴𝐶𝐵 1
𝑃𝑉𝐵 = 2895,4€ = × (1 − ) ⟺ 𝐸𝐴𝐶𝐵 = 763,8€
10% (1 + 10%)5
Now, pick machine A because it has a lower EAC.

Example: Decision to Replace
Assume discount rate = 15%
• New machine: costs 9.000€, the annual maintenance cost of 1.000€, lasts for 8 years, and
a Salvage value of 2.000€ after taxes.
• Old machine: can last one more year with the maintenance cost of 1.000€; Salvage value
after taxes is now 4.000€ and 2.500€ in one year.
New Machine: Old Machine:

8 2000 1000 − 2500
𝑃𝑉𝑁 = 9000 + 1000 × 𝐴15% − 𝑃𝑉𝑂 = 4000 + = 2.696€
(1 + 15%)8 (1 + 15%)1
= 12.833€ 2.696€ = 𝐸𝐴𝐶 × 𝐴115% ⟺ 𝐸𝐴𝐶𝑂 = 3100€
8
12.833€ = 𝐸𝐴𝐶 × 𝐴15% ⟺ 𝐸𝐴𝐶𝑁 = 2860€
Replace the machine immediately because 𝐸𝐴𝐶𝑁 < 𝐸𝐴𝐶𝑂 .
3. Risk Analysis
Allows us to look behind the 𝑁𝑃𝑉 number to see how stable our estimates are. We will only study
the following three types of risk analysis:
I. Sensitivity Analysis
Calculate 𝑁𝑃𝑉 (or 𝐼𝑅𝑅) with one input varied while keeping all other inputs constant.
II. Scenario Analysis

A variation on sensitivity analysis is scenario analysis. Calculate 𝑁𝑃𝑉 (or 𝐼𝑅𝑅) with more than
one input varied while keeping all other inputs constant.
III. Break-Even Analysis

Evaluate what is the minimum (or maximum) input value such that NPV is at least zero, that is
𝐼𝑅𝑅 = 𝑟.
Example: Stell Mill firm [Class 24/03/2021, 10:00-36:30]

Note: Revenues are a function of the Market share, Size of the steel market, and Price of steel.
Costs are a function of Market share/market size, Variable cost, and Fixed cost.
Real Options [Not Important]

Because corporations make decisions in a dynamic environment, they have options that should
be considered in project valuation. Traditional 𝑁𝑃𝑉 does not include options value, such as:
Option to Expand Option to Abandon Option to Delay
Has value if demand turns out Has value if demand turns out Has value if the underlying
to be higher than expected to be lower than expected variables are changing with a
favorable trend

V. Risk and Return
In this chapter, we will study again financial markets and how to calculate the opportunity cost of
a project. Also, we will study the trade-off between risk and return.
1. Returns
Dollar Returns = 𝑃𝑡+1 + 𝐷𝑡+1 − 𝑃𝑡
𝑃𝑡+1 +𝐷𝑡+1 −𝑃𝑡 𝑃𝑡+1 −𝑃𝑡 𝐷𝑡+1

Percentage Return: 𝑟𝑡+1 = 𝑃𝑡
= 𝑃𝑡
+ 𝑃𝑡
= Capital Gain + Dividend Yield
Where,
- 𝑃𝑡 : Market Price at the beginning period
- 𝑃𝑡+1 : Market Price at the end period
- 𝐷𝑡+1 : Dividends (cash flow) paid during the period
Example:
Suppose you bought 100 shares of the firm one year ago at 25€. You received 20€ in dividends
(0,20 €/share × 100 shares). At the end of the year, stock sells for 30€. What was the total
percentage return?
Investment: 25€ × 100 = 2500€
At the end of the year, the stocks are worth 3000€ and dividends of 20€.
𝑃𝑡+1 +𝐷𝑡+1 −𝑃𝑡 𝑃𝑡+1 −𝑃𝑡 𝐷𝑡+1 3000−2500 20
Percentage Return: 𝑟𝑡+1 = = + = + = 20,08%
𝑃𝑡 𝑃𝑡 𝑃𝑡 2500 2500
Holding Period Return

Holding period return is the return that an investor would get when holding an investment over
𝑛 years.
Assumption: immediate reinvestment of dividends
Holding Period Return = (1 + 𝑟1 ) × (1 + 𝑟2 ) × … × (1 + 𝑟𝑛 ) − 1
Where 𝑟𝑖 is the return during year 𝑖.
Example:
Suppose your investment provides the following returns over a four-year period: Year 1 = 10%;
Year 2 = −5%; Year 3 = 20%; Year 4 = 15%.
Holding Period Return = (1 + 10%) × (1 − 5%) × (1 + 20%) × (1 + 15%) − 1 = 44,21%

Average Return
Arithmetic average return: return earned in an average year over a particular period.
∑𝑛𝑖=1 𝑟𝑖
𝑟̅ =
𝑛
Geometric average return: average compound return per year over a particular period.
1
𝑛 𝑛
𝑟̅𝑔 = (∏(1 + 𝑟𝑖 )) − 1
𝑖=1
Note: 𝑟̅𝑔 < 𝑟̅ , unless all the returns are equal.
Which is better?
Geometric average is an excellent measure Arithmetic average is the best estimate of
of past realized performance and a good the expected return in a single period in the
estimate of annual return to be obtained over future.
extended periods in the future.
Cont. of the previous example:

What is the geometric average return (per year)?
(1 + 𝑟)4 = (1 + 10%) × (1 − 5%) × (1 + 20%) × (1 + 15%) ⟺ 𝑟 = 9,58%
So, our investor made an average of 9.58% per year, realizing a holding period return of 44.21%.
What is the arithmetic average return (per year)?

10% + (−5%) + 20% + 15%
𝑟= = 10%
4
2. Risk - Return Trade-off

The history of capital market returns can be summarized by describing the:
• Arithmetic Average Return
• Standard Deviation of Returns: a measure of risk
∑𝑇 (𝑟𝑖 − 𝑟̅ )2
𝜎 = √ 𝑖=1
𝑇−1
• Frequency Distribution of Returns

Example: Historical Return US 1926-2015

Risk Premium
Risk Premium is a measure to quantify the Risk-Return trade-off. It is the added return (over and
above the risk-free rate2) resulting from bearing risk.
Stock markets offer long-run excess of stock return over the risk-free return, for instance, let´s
consider the US example:
• Average excess return from stocks: 11.8% − 3.5% = 8,3%
• Average excess return from long-term corporate bonds: 6.3% − 3.5% = 2,8%
• Average excess return from long-term government bonds: 6.0% − 3.5% = 2,5%
Given the superior performance of stocks over such a long period, why does anyone hold bonds?
Because Stocks have higher risk involved (higher 𝜎)!
2
Given by the return on Treasury Bills.

VI. Portfolio Theory
Now, we will study how to take the best advantage of the risk-return trade-off. We will use the
Markowitz approach of mean-variance portfolio analysis.
The optimal portfolio of risky assets (stocks) should contain:
• Large number of assets – it should be well-diversified – and is the same for all investors.
• Investors should control the risk of their portfolio not by re-allocating among risky assets,
but through the split between risky assets and the risk-free asset.
1. Individual Securities
To make this type of analysis we will need the following concepts.
Consider that there are 𝑆 states of the world (Recession, normal, and Boom). If you know the
probability of each state (𝑃𝑠 ) and the return in each state (𝑟𝑠 ), then you can compute all of the
following:
𝑆
Expected Return
𝐸(𝑟) = 𝜇 = ∑ 𝑃𝑠 ∙ 𝑟𝑠
(Average)
𝑠=1
𝑆 𝑆
Variance (Var) 𝑉𝑎𝑟(𝑟) = 𝜎 = ∑ 𝑃𝑠 ∙ (𝑟𝑠 − 𝜇) = ∑ 𝑃𝑠 ∙ (𝑟𝑠 )2 − 𝜇2
2 2
𝑠=1 𝑠=1
Standard Deviation
(Stdev) 𝜎 = +√𝜎 2
Covariance (Covar)
𝑆 𝑆
Measure the direction of 𝐶𝑜𝑣𝐴,𝐵 = 𝜎𝐴,𝐵 = ∑ 𝑃𝑠 ∙ (𝐴𝑠 − 𝐴̅)(𝐵𝑠 − 𝐵̅) = ∑ 𝑃𝑠 ∙ 𝐴𝑠 𝐵𝑠 − 𝐴̅𝐵̅
a linear relationship
𝑠=1 𝑠=1
between two variables.
Correlation Coefficient
𝐶𝑜𝑣𝐴,𝐵
(Correl) 𝜌𝐴,𝐵 = , 𝑟𝑥,𝑦 𝜖[−1,1]
𝜎𝐴 ∙𝜎𝐵
Measures co-movement 2
between two random Closer to 0 ⟹ Weak Relationship; |𝜌𝐴,𝐵 | ≥ ⟹ Significant
√𝑛
variables.
Example:
Consider the following two risky assets.
There is a 1/3 chance of each state of the
economy, and the only assets are stock 𝐴
and stock 𝐵.
1
𝐸(𝑟𝐴 ) = 𝜇 = × [−7% + 12% + 28%] = 11%
3
1
𝜎𝐴 2 = 3 × [(−7%)2 + (12%)2 + (28%)2 ] − (11%)2 = 0,0205 ⟹ 𝜎 = √0,0205 = 14,3%

Doing the same process to stock 𝐵, we get the following information:
1
𝐶𝑜𝑣𝐴,𝐵 = × [(−7%)(5%) + (12%)(25%) + (28%)(−5%)] − 11% × 8,33% = −0,005
3
−0,005
𝜌𝐴,𝐵 = = −0,28
14,3% ∙ 12,5%
Estimations
In real life, we do not know the probability of each state of the world and the corresponding return.
We need to use historical data to estimate average returns, variance, and covariance of returns.
Expected Return Variance Covariance
∑𝑇𝑡=1 𝑟𝑡 2
∑𝑇𝑡=1(𝑟𝑡 − 𝑟̅ )2 ∑𝑆𝑠=1(𝐴𝑠 − 𝐴̅)(𝐵𝑠 − 𝐵̅)
𝑟̅ = 𝜎̂ = 𝜎̂
𝐴,𝐵 =
𝑇 𝑇−1 𝑇−1
We are implicitly assuming that the returns came from the same probability distribution in each
year of the sample.
The estimated mean and variance are themselves random variables since there is an estimation
error that depends on the particular sample of data used (sampling error).
We can calculate the standard error of our estimates and figure out a confidence interval for them.
This contrasts with the true (but unknown) mean and variance which are fixed numbers, not
random variables.
Annualizing Parameters
Annual return is approximately equal to the sum of the 12 monthly returns, assuming monthly
returns are independently distributed (a consequence of market efficiency) and have the same
variance. So, to annualize:
• Mean, Variance; Covariance: × 12
• Standard Deviation: × √12
2. Portfolios
Combination of many securities.
It is described by the weights (𝑤) of each security: fraction of wealth invested in different assets.
𝑤1 + 𝑤2 + ⋯ + 𝑤𝑘 = 1
Can we have negative portfolio weights? Yes, if we short sell a stock.

That is, we borrow a stock, sell it, and then buy it back to return the stock to the lender. Short
sellers are betting that the stock they sell will drop in price, therefore they would get a:
Profit (or Loss) = Selling P – Buying P
Example:
Consider the following portfolio: $500 MSFT (buy), $200 in GE (short sell).
Total Investment = 500 − 200 = 300
500 5 −200 2
Portfolio weights: MSFT ⟹ 300 = 3 ; GE ⟹ 300
= −3
Portfolio Expected Return and Variance

The portfolio return is computed as the average of returns on individual securities weighted by
their portfolio weights.
𝑟𝑃 = 𝑤1 × 𝑟1 + 𝑤2 × 𝑟2
𝑬(𝒓𝑷 ) = 𝑬(𝒘𝟏 𝒓𝟏 + 𝒘𝟐 𝒓𝟐 ) = 𝒘𝟏 × 𝑬(𝒓𝟏 ) + 𝒘𝟐 × 𝑬(𝒓𝟐 )

𝝈𝟐 (𝒓𝑷 ) = 𝑽𝒂𝒓(𝒘𝟏 𝒓𝟏 + 𝒘𝟐 𝒓𝟐 ) = [𝒘𝟏 ∙ 𝝈𝒓𝟏 ]𝟐 + [𝒘𝟐 ∙ 𝝈𝒓𝟐 ]𝟐 + 𝟐𝒘𝟏 ∙ 𝒘𝟐 ∙ 𝑪𝒐𝒗𝒓𝟏,𝒓𝟐
Continuation of the Previous example: Consider 𝑤𝐴 = 60% and 𝑤𝐵 = 40%.

𝐸(𝑟) = 𝐸(60% ∙ 𝑟𝐴 + 40% ∙ 𝑟𝐵 ) = 60% × 11% + 40% × 8,3% = 9,92%
𝜎𝐴,𝐵 2 = 𝑉𝑎𝑟(60% ∙ 𝑟𝐴 + 40% ∙ 𝑟𝐵 )
= [60% ∙ 14,31%]2 + [40% ∙ 12,47%]2 + 2 ∙ 60% ∙ 40% ∙ (−0,005) = 0,0075
Observe the decrease in risk that diversification offers. A portfolio with 60% in stock 𝐴 and
40% in stock 𝐵 has less risk than either stock in isolation.
3. Mean-Variance Analysis
3.1. Two Stocks
The mean-variance space is a representation of all different
portfolios in terms of:
• 𝑦-axis: Expected return, 𝐸(𝑅)
• 𝑥-axis: Standard deviation, 𝜎(𝑅)
It is possible to consider other weights besides 𝑤𝐴 = 60% and

𝑤𝐵 = 40%. If you plot all possible portfolios of the two assets,
you obtain the mean-variance frontier!
Once we know the frontier it is easy to compute the minimum
variance portfolio, the portfolio that has the minimum risk!

Algebraically,
𝐦𝐢𝐧 𝝈𝑨,𝑩 𝟐 = [𝑤𝐴 ∙ 𝜎𝐴 ]2 + [𝑤𝐵 ∙ 𝜎𝐵 ]2 + 2𝑤𝐴 ∙ 𝑤𝐵 ∙ 𝜎𝐴,𝐵 ; 𝑠. 𝑡. 𝑤𝐴 + 𝑤𝐵 = 1
𝒘𝑨 ,𝒘𝑩
Solving the F.O.C. we get that:

𝜎𝐵 2 − 𝜎𝐴,𝐵
𝑤𝐴 =
{ 𝜎𝐴 2 + 𝜎𝐵 2 − 2 × 𝜎𝐴,𝐵
𝑤𝐵 = 1 − 𝑤𝐴
From this rule we can infer the following:
• 𝜌𝐴,𝐵 = 1 ⟹ No diversification Effect

𝜎(𝑟𝑃 ) = 𝑤𝐴 ∙ 𝜎𝐴 + (1 − 𝑤𝐴 ) ∙ 𝜎𝐵
• 𝜌𝐴,𝐵 < 1 ⟹ Some diversification Effect
𝜎(𝑟𝑃 ) < 𝑤𝐴 ∙ 𝜎𝐴 + (1 − 𝑤𝐴 ) ∙ 𝜎𝐵
• 𝜌𝐴,𝐵 = −1 ⟹ High Diversification Effect which eliminates the risk
𝜎(𝑟𝑃 ) = ∓ 𝑤𝐴 ∙ 𝜎𝐴 ± (1 − 𝑤𝐴 ) ∙ 𝜎𝐵
Efficient Portfolio
Efficient Portfolios are the points of the frontier above the global minimum variance portfolio
(green line). Therefore, the best portfolios are the ones that maximize 𝐸(𝑅) [or minimum 𝜎(𝑅)]
given a level 𝜎(𝑅) [or 𝐸(𝑅)].
Given this, which portfolio is the best, 𝑃4 or 𝑃5 ?

Among the portfolios in the mean-variance frontier,
investors choose the one that suits their risk
preferences.
In other words, it will depend on if the investor is
looking for more risk or less risk.

3.2. Many Stocks
For a portfolio with 𝑁 stocks, we need:
- 𝑁 Expected returns (one for each asset)
- 𝑁 Variances (one for each asset)
𝑁 𝑁(𝑁−1)
- 𝐶2 = Covariances (for each pair of assets)
2
𝑵
𝑬(𝒓𝑷 ) = ∑ 𝑤𝑖 ∙ 𝐸(𝑟𝑖 )
𝒊=𝟏
𝑵 𝑵 𝑵 𝑵 𝑵
𝟐 ]2
𝝈 (𝒓𝑷 ) = ∑ ∑ 𝑤𝑖 ∙ 𝑤𝑘 ∙ 𝜎𝑖,𝑘 = ∑[𝑤𝑖 𝜎𝑖 + 𝟐∑ ∑ 𝑤𝑖 ∙ 𝑤𝑘 ∙ 𝜎𝑖,𝑘
𝒊=𝟏 𝒌=𝟏 𝒊=𝟏 𝒊=𝟏 𝒌=𝟏 ; 𝒊<𝒌
Given a set of 𝑁 individual securities, we can build

the Mean-Variance (MV) Frontier.
It has the same shape as the one for two securities!
The segment of the MV frontier above the minimum
variance portfolio is the efficient MV frontier.
3.3. Conclusions
• The Efficient Frontier is the set of mean-variance combinations from the minimum-variance
frontier where for a given risk no other portfolio offers a higher expected return.
• Investors should only pick portfolios from the Efficient Mean-Variance Frontier.
• Investors will never want to hold a portfolio below the minimum variance point. They will
always get higher returns along the positively sloped part of the minimum-variance frontier.
4. Diversification & Portfolio Risk

Diversification reduces the variability of returns
without an equivalent reduction in expected returns
since lower returns of one asset are offset by another.
However, there is a minimum level of risk that cannot
be diversified away, and that is the systematic risk
(or market risk):
• Affects a large number of assets.
• Includes changes in GDP, inflation, interest
rates, etc.
[Slide 45: Derivation of the limits to Diversification]
The unsystematic risk (or idiosyncratic risk):

• Affects a small number of assets, so it can be eliminated by combining assets in a portfolio
(≈ 60 stocks)
• Includes: labor strikes, part shortages, earnings announcements

The Total risk = Systematic risk + Unsystematic risk:
• Standard deviation of returns is a measure of total risk.
• For well-diversified portfolios, idiosyncratic risk is very small, consequently, the total
risk is equivalent to the systematic risk.
In a large portfolio, the variance terms are effectively diversified away, but the covariance terms
are not.
5. Risk-free Assets
Let´s consider expanding the Markowitz approach by considering investing not just in risky
assets but also in a risk-free asset.
The risk-free asset has a certain payoff. There is no uncertainty about the terminal value of this
type of asset.
- Risk of the risk-free asset is zero ⟹ 𝜎𝑓 = 0
- Covariance between the risk-free asset and any risky asset is zero ⟹ 𝜎𝑀,𝑓 = 0
Let assume a portfolio, 𝑃, which is well-diversified and combines Risky Assets, 𝑀, and Risk-free
Asset, 𝐹. Then the investor determines the weights of each type of assets in the portfolio:
• 𝑤𝑀 is the weight of Risky Assets
• 𝑤𝑓 = 1 − 𝑤𝑀 is the weight of a Risk-free asset
Expected Return (or Complete Portfolio)

𝐸(𝑟𝑃 ) = 𝑤𝑀 ∙ 𝐸(𝑟𝑀 ) + (1 − 𝑤𝑀 ) ∙ 𝐸(𝑟𝑓 ) ⟺ 𝑬(𝒓𝑷 ) = 𝒘𝑴 ∙ 𝑬(𝒓𝑴 ) + (𝟏 − 𝒘𝑴 ) ∙ 𝒓𝒇
Variance (or Risk)

2
𝜎 2 (𝑟𝑃 ) = [𝑤𝑀 ∙ 𝜎𝑀 ]2 + [𝑤𝑓 ∙ 𝜎𝑓 ] + 2𝑤𝑀 ∙ 𝑤𝑓 ∙ 𝐶𝑜𝑣𝑀,𝑓 = [𝑤𝑀 ∙ 𝜎𝑀 ]2 ⟺ 𝝈(𝒓𝑷 ) = 𝒘𝑴 ∙ 𝝈𝑴
5.1. Capital Allocation Line (CAL)

Let´s combine the two equations from above:
𝐸(𝑟𝑃 ) = 𝑤𝑀 ∙ 𝐸(𝑟𝑀 ) + (1 − 𝑤𝑀 ) ∙ 𝑟𝑓 𝐸(𝑟𝑃 ) = 𝑤𝑀 ∙ [𝐸(𝑟𝑀 ) − 𝑟𝑓 ] + 𝑟𝑓

{ ⇔{ 𝜎(𝑟 )
𝜎(𝑟𝑃 ) = 𝑤𝑀 ∙ 𝜎𝑀 𝑤𝑀 = 𝑃 𝜎𝑀
[𝑬(𝒓𝑴 ) − 𝒓𝒇 ]
𝑬(𝒓𝑷 ) = ∙ 𝝈(𝒓𝑷 ) + 𝒓𝒇
𝝈𝑴
This relationship between 𝐸(𝑟𝑃 ) and 𝜎(𝑟𝑃 ) is
called Capital Allocation Line!
Bear in mind that we are assuming 𝑟𝑀 as the best
portfolio risky asset.
𝐸(𝑟𝑀 )−𝑟𝑓
Slope: Sharpe ratio 𝜎𝑀
CAL shows the higher the risk of the portfolio the

higher is the expected return.

6. Optimal Risky Portfolio: Tangency Portfolio
1) Find out the Mean-Variance frontier for the risky assets.
2) Try to find the combination of risk-free with risky assets that has the highest reward-to-
risk ratio.
The optimal risky portfolio is the Tangency
CAL portfolio which offers the highest reward-to-risk
ratio.
When the mean-variance frontier is constructed
using all the risky assets in the market, the tangency
portfolio is also known as the market portfolio.
The optimal portfolio combining the risky and risk-
free assets depends on the degree of risk aversion,
so they are represented by our new efficient frontier
which is the CAL that maximizes the Sharpe
ratio.
All investor has the same optimal risky portfolio. But the investor’s risk aversion will determine
how much of their wealth is invested in the optimal risky portfolio and how much is invested in
the risk-free asset (i.e., determine the actual position on the CAL).
6.1. Two Stocks

Algebraically, the Tangency Portfolio for two stocks is the maximization of the Sharpe Ratio:
𝐸(𝑟𝑃 ) − 𝑟𝑓 𝑤𝐴 ∙ 𝐸(𝑟𝐴 ) + (1 − 𝑤𝐴 ) ∙ 𝐸(𝑟𝐵 ) − 𝑟𝑓
max = max
𝑤𝐴 𝜎𝑃 𝑤𝐴 √[𝑤 ∙ 𝜎 ]2 + [(1 − 𝑤 ) ∙ 𝜎 ]2 + 2𝑤 ∙ (1 − 𝑤 ) ∙ 𝜎
𝐴 𝐴 𝐴 𝐵 𝐴 𝐴 𝐴,𝐵
Solving the F.O.C., we get the following:

(𝐸(𝑟𝐴 ) − 𝑟𝑓 ) ∙ 𝜎𝐵 2 − (𝐸(𝑟𝐵 ) − 𝑟𝑓 ) ∙ 𝜎𝐴,𝐵
𝑤𝐴 =
{ (𝐸(𝑟𝐴 ) − 𝑟𝑓 ) ∙ 𝜎𝐵 2 + (𝐸(𝑟𝐵 ) − 𝑟𝑓 ) ∙ 𝜎𝐴 2 − (𝐸(𝑟𝐴 ) + 𝐸(𝑟𝐵 ) − 2𝑟𝑓 ) × 𝜎𝐴,𝐵
𝑤𝐵 = 1 − 𝑤𝐴
To decide which of the efficient portfolio is the best we should use quadratic utility function since
the investor only cares about the mean and variance (risk) of returns:
𝝈𝟐𝑷
𝑼(𝒓𝑷 ) = 𝑬(𝒓𝑷 ) − 𝜸 ∙
𝟐
Where 𝛾 stands for Risk Aversion Coefficient. Usually determined using surveys and on average,
𝛾 ∈ [2,4]. A Higher 𝛾 ⟹ High-risk aversion, that is, the investor does not like risk.
To find optimal portfolio choice for a combination of a risky asset and a risk-free asset, we
have to maximize the utility function above subject to the CML we get that:
𝐸(𝑟𝑀 ) − 𝑟𝑓
𝑤𝑀 =
𝛾 × 𝜎𝑀 2

To find optimal portfolio choice with only risky assets, we have to maximize the utility function
above subject to the efficient frontier to we get that:
𝐸(𝑟𝐴 ) − 𝐸(𝑟𝐵 ) + 𝛾 ∙ (𝜎𝐵 2 − 𝜎𝐴,𝐵 )
𝑤𝐴 =
{ 𝛾 ∙ (𝜎𝐴 2 + 𝜎𝐵 2 − 2 × 𝜎𝐴,𝐵 )
𝑤𝐵 = 1 − 𝑤𝐴
Examples:
A. You are advising two investors (Investor A and B) about portfolio allocation. For simplicity,
suppose the only three asset categories you focus on are the risk-free asset, the US stock
market, and venture capital (not part of the US stock market). You have estimated the
following based on annual data:
The riskless rate is 5% and the correlation
between US stocks and venture capital is
0,5.
Based on this the Tangency Portfolio is to invest 73,3% of risky asset holdings in US stocks
and 26,7% in venture capital.
1) What are the expected return and standard deviation of the Tangency Portfolio?
The Tangency Portfolio and Market portfolio are the same!
𝐸(𝑟𝑃 ) = 𝑤𝑈𝑆 × 𝐸(𝑟𝑈𝑆 ) + 𝑤𝑉𝐶 × 𝐸(𝑟𝑉𝐶 ) = 0,733 × 0,10 + 0,267 × 0,14 = 0,1107
𝜎 2 (𝑟𝑃 ) = [𝑤𝑈𝑆 ∙ 𝜎𝑈𝑆 ]2 + [𝑤𝑉𝐶 ∙ 𝜎𝑉𝐶 ]2 + 2𝑤𝑈𝑆 ∙ 𝑤𝑉𝐶 ∙ 𝐶𝑜𝑣𝑈𝑆,𝑉𝐶 =
= 0,7332 × 0,152 + 0,2672 × 0,302 + 2 × 0,733 × 0,267 × 0,5 = 0,0273
𝜎(𝑟𝑃 ) = √0,0273 = 0,1653
2) Investor A has $50 million and she is fairly risk-averse, she will only accept a standard
deviation of 12% in her portfolio returns. What dollar amounts should Investor A invest
(or short, if you get a negative amount for an asset category) in each of the three asset
categories (riskless asset, US stocks, venture capital)? What expected return (in %) can
Investor A expect on this portfolio?
How much to invest in a Risk-free asset and Tangency Portfolio?
𝜎(𝑟𝑃 ) = 𝑤𝑀 ∙ 𝜎𝑀 ⟺ 12% = 𝑤𝑀 ∙ 0,1653 ⟺ 𝑤𝑀 = 0,7261 = 72,61%
Invest 72,61% in tangency portfolio and 27,39% in risk-free asset!
The expected return of the portfolio is:

𝐸(𝑟𝑃 ) = 𝑤𝑀 ∙ 𝐸(𝑟𝑀 ) + (1 − 𝑤𝑀 ) ∙ 𝑟𝑓 = 0,7261 ∙ 0,1107 + 0,2739 ∙ 0,05 = 0,094 = 9,4%
Investment breakdown for Investor A:

Riskless: 27,39% × $50𝑀 = $13, 694, 331
US Stocks: 72,61% × 73,3% × $50𝑀 = $26, 612, 055
Venture Capital: 72,61% × 26,7% × $50𝑀 = $9, 693, 614

3) Investor B has $800 million and would like you to design a portfolio with an expected
return of 13% and the smallest possible standard deviation. What standard deviation (in
%) can Investor B expect on this portfolio?
𝐸(𝑟𝑃 ) = 𝑤𝑀 ∙ 𝐸(𝑟𝑀 ) + (1 − 𝑤𝑀 )𝑟𝑓 ⟺ 0,13 = 0,1107𝑤𝑀 + 0,05(1 − 𝑤𝑀 ) ⟺ 𝑤𝑀 = 1,3184
Invest 1,3184 in tangency portfolio and −0,3184 in risk-free asset, which means that you need
to borrow 0,3184 of Investor B´s wealth.
𝜎(𝑟𝑃 ) = 𝑤𝑀 ∙ 𝜎𝑀 = 1,3184 × 0,1653 = 0,2179 = 21,79%
B. Consider the Tangency Portfolio from the two-stock example: the expected return is 10,17%
and the standard deviation is 9,54%. Now assume that the investor wants to invest in an
optimal portfolio. The risk-free rate is 8%.
1) If the investor has a risk aversion coefficient of 𝛾 = 2, what is the fraction of wealth that
she should invest in the tangency portfolio?
The fraction of wealth invested in the tangency portfolio should be:
10,17% − 9,54%
𝑤𝑀 = = 1,19
2 × 9,54%2
2) And what is the expected return of the portfolio?
𝐸(𝑟𝑃 ) = 𝑤𝑀 ∙ 𝐸(𝑟𝑀 ) + (1 − 𝑤𝑀 ) ∙ 𝑟𝑓 = 1,19 ∙ 0,1017 + (1 − 1,19) ∙ 0,08 = 10,59%
3) And what is the standard deviation of the portfolio?

𝜎(𝑟𝑃 ) = 𝑤𝑀 ∙ 𝜎𝑀 = 1,19 × 0,0954 = 0,1138 = 11,38%
6.2. Many stocks

Portfolio weights of tangency portfolio given by solving the maximization problem of the Sharpe
Ratio. Analytically is very difficult to solve, only possible using the excel functions.
𝐸(𝑟𝑃 ) − 𝑟𝑓 ∑𝑖 𝑤𝑖 ∙ (𝐸(𝑟𝑖 ) − 𝑟𝑓 )
max = max 1/2
𝑤𝐴 𝜎𝑃 𝑤𝐴
(∑ ∑ 𝑤 ∙ 𝑤 ∙ 𝜎 )
𝑖 𝑗 𝑖 𝑗 𝑖,𝑗

VII. Capital Asset Pricing Model (CAPM)
This model will enable us to determine the opportunity cost of the capital/discount rate of an
economy.
Assumptions
• No Frictions in the markets: No trading costs; No taxes.
• Unlimited borrowing and lending, in particular, no restrictions on short sales.
• Lending and borrowing rates are the same.
• Investors care only about means and variances.
• All investors are fully rational and have the same information (homogeneous
expectations).
Given this assumption, everyone has the same efficient frontier and holds the same tangency
portfolio (of stocks). Then, the tangency portfolio is the market portfolio.
Market Equilibrium
Every investor solves the mean-variance problem and holds a combination of risk-free assets and
a portfolio of risky assets (tangency). The sum of all investors’ risky portfolios will have the same
weights as tangency one.
In equilibrium, the sum of all investors’ desired portfolios must equal the aggregate supply and
demand of assets is the market portfolio.
1. Capital Market Line (CML)

In the CAPM world, we call the capital allocation line the capital market line (CML).
[𝑬(𝒓𝑴 ) − 𝒓𝒇 ]
𝑬(𝒓𝑷 ) = ∙ 𝝈(𝒓𝑷 ) + 𝒓𝒇
𝝈𝑴
Investors choose a point along the line – Capital Market Line (CML). Efficient portfolios are a
combination of the risk-free asset and the market portfolio 𝑀.
Although investors have the same CML, depending on the risk aversion the investor
chooses along the line!

2. Security Market Line (or CAPM)
CML gives a risk-return trade-off for efficient portfolios. Individual stocks are inefficient because
they are always below CML. How can we compute the risk-return trade-off?
Let´s do the following exercise: how does a well-diversified portfolio´s variance is affected by
adding a small weight of an individual stock?
In a well-diversified portfolio, the unsystematic risk does not matter, therefore the only systematic
risk is affected. As a consequence, the individual stock risk is measured by its covariance with
the market portfolio because it is the marginal variance.
Algebraically, we can suppose you hold portfolio M and are considering adding a little more of
asset 𝑖 (weight 𝑤𝑖 ):
𝐸(𝑟𝑃 ) = 𝑤𝑖 ∙ 𝐸(𝑟𝑖 ) + (1 − 𝑤𝑖 ) ∙ 𝐸(𝑟𝑀 )

𝜎 2 (𝑟𝑃 ) = [𝑤𝑖 ∙ 𝜎𝑖 ]2 + [(1 − 𝑤𝑖 ) ∙ 𝜎𝑀 ]2 + 2𝑤𝑖 ∙ (1 − 𝑤𝑖 ) ∙ 𝜎𝑖,𝑀
Now evaluate change in risk and return:
𝜕𝐸(𝑟𝑃 ) 𝜕𝜎 2 (𝑟𝑃 )
= 𝐸(𝑟𝑖 ) − 𝐸(𝑟𝑀 ) = 2 ∙ [𝑤𝑖 ∙ 𝜎𝑖2 − (1 − 𝑤𝑖 ) ∙ 𝜎𝑀
2
+ (1 − 2𝑤𝑖 ) ∙ 𝜎𝑖,𝑀 ]
𝜕𝑤𝑖 𝜕𝑤𝑖
In equilibrium (𝑀) excess demand for stock 𝑖 is zero; now evaluate change in risk and return for
𝑤 = 0. The risk-return trade-off (Sharpe ratio) in equilibrium (𝑀) needs to be equal to the CML
Sharpe ratio. So, we get the following:
𝜕 𝐸(𝑟𝑃 )
𝜕 𝑤𝑖 𝐸(𝑟𝑖 ) − 𝐸(𝑟𝑀 ) 𝐸(𝑟𝑖 ) − 𝐸(𝑟𝑀 ) 𝐸(𝑟𝑀 ) − 𝑟𝑓
= 2 ⟹ 2 =
𝜕 𝜎(𝑟𝑃 ) 𝜎𝑖,𝑀 − 𝜎𝑀 𝜎𝑖,𝑀 − 𝜎𝑀 𝜎𝑀
𝜕 𝑤𝑖 𝜎𝑀 𝜎𝑀
𝝈𝒊,𝑴
⟺ 𝑬(𝒓𝒊 ) = 𝒓𝒇 + 𝟐 [𝑬(𝒓𝑴 ) − 𝒓𝒇 ]
𝝈𝑴
𝜎𝑖,𝑀
Usually, the above equation is written with a 𝛽 = 2 which is a measure of the responsiveness
𝜎𝑀
of stock to movements in the market portfolio (i.e., systematic risk).
𝑬(𝒓𝒊 ) = 𝒓𝒇 + 𝜷 ∙ [𝑬(𝒓𝑴 ) − 𝒓𝒇 ]
Expected Return on Stock = Risk-free rate + Beta of Stock × Master Risk Premium
This curve is called Security Market Line (SML) or CAPM!
𝛽 = 0 ⟹ 𝐸(𝑟𝑖 ) = 𝑟𝑓 𝛽 < 1 ⟹ 𝐸(𝑟𝑖 ) < 𝐸(𝑟𝑀 )

𝛽 = 1 ⟹ 𝐸(𝑟𝑖 ) = 𝐸(𝑟𝑀 ) 𝛽 > 1 ⟹ 𝐸(𝑟𝑖 ) > 𝐸(𝑟𝑀 )

2.1. Beta of a Portfolio, 𝛽
The beta of a portfolio is a portfolio-weighted average of individual assets:
𝑁
𝛽𝑃 = ∑ 𝑤𝑖 ∙ 𝛽𝑖
𝑖=1
Thus, we can use SML for any portfolio: 𝑬(𝒓𝑷 ) = 𝒓𝒇 + 𝜷𝑷 ∙ [𝑬(𝒓𝑴 ) − 𝒓𝒇 ]
High 𝜷 ⟹ Stocks are risky

Therefore, they must offer a higher return on average to compensate for the risk.
High 𝛽, stocks are risky because they pay up just when you need the money least (i.e., when the
overall market is doing well) and they lose money when you really need it (i.e., when the overall
market is doing poorly).
3. CML vs. SML

Capital Market Line Security Market Line
CML plots the relationship between expected SML is the relationship between expected
returns and standard deviation for efficient returns and 𝛽.
portfolios.
All portfolios, whether efficient or not, must lie on the SML but only efficient portfolios are on
the CML.
𝐸(𝑟𝐴 ) = 𝐸(𝑟𝐵 ) ⇎ 𝜎𝐴 = 𝜎𝐵 In other words, the only relevant measure of risk for pricing
securities is 𝛽 (a measure of covariance or marginal variance).
⟺ 𝛽𝐴 = 𝛽𝐵
4. Estimations
To apply to real life, we have to discover reliable proxy/estimations for the following inputs.
➢ Market Portfolio
In CAPM, the market portfolio should include all assets in the world. However, that´s not possible
to do in real life so we will use a broad and value-weighted stock market index as a proxy (for
example, MSCI World, S&P 500).
➢ Risk-free Rate: 𝑟𝑓
CAPM says that should be riskless and match the horizon of the investment. People use 3 months
of Treasury Bills.

➢ Market Risk Premium: [𝐸(𝑟𝑀 ) − 𝑟𝑓 ]
To estimate we will use a long historical average on risk premium. The standard error of the
estimate is 2%.
From 1926 to 2015, the market risk premium has been 8,3%. Depending on the sample and on
whether we use the arithmetic or geometric mean, we can come up with numbers between 5%
and 8%
➢ Beta: 𝛽
Note that the CAPM formula is a relationship based on expectations. So, we usually use a time-
series regression based on realized returns:
𝑟𝑖,𝑡 − 𝑟𝑓,𝑡 = 𝛼𝑖 + 𝛽𝑖 (𝑟𝑀,𝑡 − 𝑟𝑓,𝑡 ) + 𝜖𝑖,𝑡 ⟺ 𝑌 = 𝛼𝑖 + 𝛽𝑖 ∙ 𝑋 + 𝜖𝑖,𝑡
Characteristics:
• It may change over time, 𝑡.
• Do not use data from too long ago.
• Five years of weekly or monthly data is reasonable.
➢ Risk: 𝜎
The standard deviation of stock returns can be broken down into systematic risk and idiosyncratic
risk.
𝑟𝑖 − 𝑟𝑓 = 𝛼𝑖 + 𝛽𝑖 (𝑟𝑀 − 𝑟𝑓 ) + 𝜖𝑖
Applying the variance function we get:

𝑉𝑎𝑟(𝑟𝑖 − 𝑟𝑓 ) = 𝛽𝑖2 ∙ 𝑉𝑎𝑟(𝑟𝑀 − 𝑟𝑓 ) + 𝑉𝑎𝑟(𝜖𝑖 ) ⟺ 𝝈𝟐𝒊 = 𝜷𝟐𝒊 ∙ 𝝈𝟐𝑴 + 𝝈𝟐𝝐𝒊
⟺ Total Risk = Systematic + Idiosyncratic
➢ Jensen´s Alpha: 𝛼𝑖
Excess return over that predicted by CAPM, therefore, is the intercept in the above formula. It is
used as a measure of portfolio performance.
𝛼𝑖 = (𝑟̅𝑖 − 𝑟𝑓 ) − 𝛽𝑖 (𝑟̅̅̅
𝑀 − 𝑟𝑓 )
𝛼𝑖 > 0 ⟹ Security has earned a higher return on average than is required for its risk level.

VIII. Capital Structure
We will study what is the optimal capital structure (i.e., mix of Debt and Equity) in a firm.
1. Modigliani-Miller Theory
1.1. Pie Theory
The market value of a firm is the sum of the market value (net book value) of the firm’s debt and
equity:
𝑉𝑎𝑙𝑢𝑒 (𝑉) = 𝐷𝑒𝑏𝑡(𝐷) + 𝐸𝑞𝑢𝑖𝑡𝑦(𝐸)
So, our goal will be to choose the debt-to-equity ratio that maximizes the size of the pie. However,
not all firms have the same capital structure and shareholders are more interested in maximizing
the shareholders’ value than the firm´s value.
So, what is the ratio of debt-to-equity that maximizes the shareholder´s value?
1.2. Assumptions
Although not all assumption is reasonable, they are essential to start studying this subject.
• Perfect capital markets:
- no transaction costs and no taxes
- no bankruptcy costs.
- no agency costs.
- no asymmetric information
- no arbitrage
• Firms and individuals can borrow at the same rate.
1.3. MM with No Taxes

Based on these assumptions, the market value of the firm is constant regardless of the capital
structure and is determined by its real assets and growth opportunities, not by the types of
securities it issues. We may conclude two propositions:
i. Cost of capital is constant and independent of capital structure also.
- Levered Firms: Debt > 0
- Unlevered Firms: Debt = 0 (only have equity)
Intuition: Investors can create a levered or unlevered position by adjusting the trading in
their own account (i.e., raising debt). This homemade leverage suggests that capital
structure is irrelevant in determining the market value of the firm:
𝑉𝐿𝑒𝑣𝑒𝑟𝑒𝑑 = 𝑉𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑
Example:
Consider an investor with 2000€ and the following trading strategies for a company with
a stock price of 20€:
• A - Investor buys 100 shares of the levered firm: Cost = 100 × 20 = 2000€
• B - Investor loans 2000€, and use proceeds plus initial wealth to buy 200 shares
of unlevered firm: Cost = 200 × 20 − 2000 = 2000€

The future cash flows of these two strategies will be exactly equal based on the
information given, so we may conclude:
Investors can leverage (or unleverage) a firm’s capital structure to any given level through
a personal loan (or deposit), as long as the cost of debt is the same for individual
investors and the firm.
𝐷 𝐸
ii. Weighted average cost of capital: 𝑊𝐴𝐶𝐶 = ∙𝑟 + ∙ 𝑟 . It represents how much
𝐷+𝐸 𝐷 𝐷+𝐸 𝐸
costs the capital structure of the firms. Where,
- 𝑟𝐷 : Required return on debt (cost/interest of debt)
- 𝑟𝐸 : Required return on equity (cost/interest of equity)
Since we have that cost of capital of unlevered firm, 𝑟𝑈 , is constant and independent of capital
structure we can say that:
𝐷 𝐸 𝑫
𝑟𝑈 = ∙ 𝑟𝐷 + ∙ 𝑟𝐸 ⟺ 𝒓𝑬 = 𝒓𝑼 + (𝒓𝑼 − 𝒓𝑫 ) ∙
𝐷+𝐸 𝐷+𝐸 𝑬
Proposition II says that the required return on equity holders increases with leverage.
Increasing the debt load does not affect the riskiness

of the assets, but it does increase the riskiness of the
equity.
𝒓𝑬 > 𝒓𝑫 , because the debt has a higher priority and
thus less risk.
But the weighted sum (WACC) of the costs of debt
and equity is always a constant.
1.4. MM with Corporate Taxes

Maintaining constant all other assumptions and only changing corporate taxes on profits introduce
a new claim holder on the firm’s cash flows (government). Minimizing the government’s share
of the pie leaves more for debt and equity holders. Let´s evaluate the same propositions:
i. 𝑉𝐿𝑒𝑣𝑒𝑟𝑒𝑑 ≠ 𝑉𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 , and the financial policy now matters when trying to increase a
firm´s value.
Pre-tax Cash Flow: 𝐹𝐶𝐹 = 𝐸𝐵𝐼𝑇 Interest Payments: 𝐷 × 𝑟𝐷
After-tax cash flow to shareholders and debtholders: 𝐹𝐶𝐹 = 𝐸𝐵𝐼𝑇(1 − 𝑡) + 𝑡 ∙ 𝐷 ∙ 𝑟𝐷
Levered firm value is the present value of FCFs:
𝐸𝐵𝐼𝑇(1 − 𝑡) 𝑡 ∙ 𝐷 ∙ 𝑟𝐷 Tax Shield from Debt
𝑉𝐿 = + ⟺ 𝑽𝑳 = 𝑽𝑼 + 𝒕 ∙ 𝑫
𝑟𝑈 𝑟𝐷
ii. Cash Flows from Assets part of the Balance sheet: 𝑉𝑈 ∙ 𝑟𝑈 + 𝑡 ∙ 𝐷 ∙ 𝑟𝐷

Cash Flows from Equity and Liabilities part of the Balance sheet: 𝐸 ∙ 𝑟𝐸 + 𝐷 ∙ 𝑟𝐷
𝑉𝑈 ∙ 𝑟𝑈 + 𝑡 ∙ 𝐷 ∙ 𝑟𝐷 = 𝐸 ∙ 𝑟𝐸 + 𝐷 ∙ 𝑟𝐷 .
By rearranging the formula, we get:
𝑫
𝒓𝑬 = 𝒓𝑼 + (𝒓𝑼 − 𝒓𝑫 )(𝟏 − 𝒕) ∙
𝑬
Some of the increase in equity risk and return is offset by the interest tax shield.

Regarding the weighted average cost of capital (WACC) with corporate taxes:
𝐷 𝐸
𝑊𝐴𝐶𝐶 = ∙ (1 − 𝑡) ∙ 𝑟𝐷 + ∙𝑟
𝐷+𝐸 𝐷+𝐸 𝐸
Rearranging it and plugging in the expression for 𝑟𝐸 , we get:
𝑫∙𝒕
𝑾𝑨𝑪𝑪 = 𝒓𝑼 ∙ (𝟏 − )
𝑫+𝑬
Optimal capital structure: 100% debt!

The levered firm pays less in taxes than
an all-equity firm. Thus,
𝐷𝐿 + 𝐸𝐿 > 𝐸𝑈
This is how cutting the pie differently can

make pie “larger” - the government takes
a smaller slice of the pie!
Warning: Correct tax rate to value interest tax shield is the expected marginal tax rate (or
expected increase in firm’s tax liability when its taxable income increases by $1). This may not
be the statutory rate3!
The firm may not always be taxable. Earnings may not be large enough to fully utilize the shield
Losses can be carried forward (and also carried back in some countries). Non-debt tax shields
may already suffice to offset earnings: Depreciation; Investment tax credit.
2. Limits to the Use of Debt

2.1. Policy Rules
So far, we have seen that capital structure either does not matter (Modigliani and Miller) or that
there is a huge advantage of debt (Corporate Tax Advantage of Debt). So, why firms do not have
a capital structure with 100% Debt?
↑ 𝑫 ⟹ ↑ Risk of Bankruptcy
Financial Distress Costs
Financial distress (firm’s financial claims cannot be serviced) does not imply economic distress
(firm’s assets are generating a net economic loss).
Costs of financial distress are not that firm defaults, but that expected cash flows may decrease
because the firm is near or in bankruptcy. There are three types of costs:
➢ Direct Costs
Legal and administrative costs of bankruptcy, for example, legal expenses, court costs, advisory
fees, etc. These costs represent new claims on firm cash flows (decreasing the pie for debt and
equity holders).
3
rate imposed by law on taxable income.

➢ Indirect Costs
Impaired ability to conduct business, for example, reputation costs. Financial distress may affect:
• Demand in product markets, since the firm cannot commit to remaining in business
• Suppliers may stop sending goods: Firms lose flexibility when so closely monitored by
creditors
• Assets may be liquidated at fire-sale prices
• Intangible assets may be destroyed if a firm is broken up or sold to someone else
➢ Agency Costs
Conflicts of interest between shareholders and debt holders - 3 Selfish Strategies:
1) Incentive to take large risks (risk shifting) and overinvestment
Shareholders may take high-risk, negative NPV projects in the hope of realizing the
upside potential, leaving bondholders to bear the downside risk.
Example:
What happens if the firm is liquidated today? Bondholders get 200 (= Bond Market Value) and
shareholders get nothing.
Without gamble: PV of Bonds = 200; PV of Stocks = 0. Let´s consider the option of gambling
which has an initial investment of 200€ (all the firm’s cash). Required return is 50% (discount
rate). What is the 𝑁𝑃𝑉 of “The Gamble” project?
Expected cash flow gamble = 1000 × 0.10 + 0 = 100€
100
𝑁𝑃𝑉 = −200 + = −133
1 + 50%
Will the project be accepted by shareholders?
Expected cash flow from gamble
• To Bondholders = 300 × 0,10 + 0 = 30€
• To Shareholders = (1000 − 300) × 0,10 + 0 = 70€
30 70
𝑁𝑃𝑉Bond = = 20 𝑁𝑃𝑉Stock = = 47
1 + 50% 1 + 50%
So, this is a perfect example of Risk Shifting, shareholders gain with gamble at expenses of
bondholders and decide to do a project with negative NPV!
2) Incentive toward underinvestment (debt overhang)

Shareholders may be unwilling to finance positive NPV projects when the firm is in
financial distress since debt-holders have priority over the cash flows.

Example: Cont. of the previous example
Now, consider that the government sponsored the project and guarantees 350€ in one period. But
now they have to invest 300€ (the firm only has 200€ now), so the stockholders will have to
supply an additional 100€ to finance the project. Required return is 10% (discount rate).
350
𝑁𝑃𝑉 = −300 + = 18,18€
1 + 10%
Expected cash flow from gamble
• To Bondholders = 300€
• To Shareholders = 350 − 300 = 50€
30 50
𝑁𝑃𝑉Bond = = 273 𝑁𝑃𝑉Stock = −100 + = −55
1 + 10% 1 + 10%
So, this is a perfect example of Debt Overhang, shareholders lose with the project and decide to
reject project with positive NPV!
3) Cashing out (milking the property)

Shareholders may try to get money out of the firm ahead of higher priority claims (e.g.
by paying cash dividends).
Solutions for these type of conflicts:
• Bond covenants (terms, restrictions, …)
• Different type of debt: Collateral; Seniority; Maturity
• Monitoring: banks vs bonds
• Convertibles
2.2. Tradeoff Theory

Now the optimal capital structure is no longer 100% Debt since there is a trade-off between tax
advantage of debt and costs of financial distress. Therefore, the value of levered firms:
𝑽𝑳 = 𝑽𝑼 + 𝑷𝑽(𝑻𝒂𝒙 𝑺𝒉𝒊𝒆𝒍𝒅) − 𝑷𝑽(𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝑫𝒊𝒔𝒕𝒓𝒆𝒔𝒔 𝑪𝒐𝒔𝒕𝒔)
In terms of the Pie Theory talked earlier if we consider Taxes and bankruptcy costs can be viewed
as just another claim on the cash flows of the firm and that:
𝐺 ⟹ Payments to Government 𝐿 ⟹ Bankruptcy Cost
So, now the value of a firm is:
𝑽=𝑬+𝑫+𝑮+𝑳

2.3. Pecking Order Theory
One of the major conclusions of the trade-off theory is that the most successful (profitable) firms
have more Debt since if they are more profitable, they will have less probability of financial
distress, so the expected costs are lower and the value of the firm higher.
However, in practice, this is not true! Within the same industry, although there are a wide variety
of capital structures, the most successful firms have less debt. This model tries to explain this
behavior.
According to this theory, there is a pecking order to source and use of funds:
1) Internal Financing: Cash
2) External Financing: Debt
3) External Financing: Equity
𝐷
It is apart from the Trade-off Theory because there is no target 𝐸
ratio; profitable firms use less
debt, they prefer to use cash; companies like financial slack.
Assumption: Asymmetric Information

Investors (unlike management) cannot infer the quality of a firm, so the “average” quality of
shares issued by firms will be low. The firm would prefer to sell shares only when it knows it is
of bad quality. High-quality firms are reluctant to sell shares because they will get a low price
Since only a bad firm will sell shares, the act of issuing equity signals to investors that the firm is
of poor quality. Investors infer that shares are overvalued and as a consequence share price drops!
2.4. Conclusion: How Firms establish Capital Structure

𝐷
Most corporations have low 𝐴 ratios. Changes in financial leverage affect firm value:
• Stock price increases with leverage and vice-versa (consistent with M&M with taxes)
• Firms signal good news when they lever up (signaling)
There are differences in capital structure across industries. But evidence shows that firms behave
as if they had a target debt-to-equity ratio.
Factors in target 𝐷⁄𝐸 ratio

➢ Profitability
Since interest is tax-deductible, highly profitable firms should use more debt (i.e., greater tax
benefit).
But pecking order theory predicts the reverse!
➢ Growth Opportunities
Firms with more growth opportunities have higher costs of financial distress, thus high-growth
firms will have lower debt ratios than low-growth firms.
But pecking order theory predicts the reverse
➢ Uncertainty of Operating Income
Even without debt, firms with uncertain operating income have a high probability of experiencing
financial distress. Firms with more uncertainty about operating income use less debt.

➢ Taxes
Higher corporate taxes mean a higher interest tax shield and consequently more debt.
➢ Type of Assets
Costs of financial distress depend on the types of assets the firm has, firms with more tangibles
use more debt.
3. Valuation and Capital Budgeting with Debt

So far, we have valued investment projects (or firms) as if they were purely equity-financed which
is a valid approach, under the Modigliani and Miller assumptions. But, we have shown that
deviations from these assumptions cause the value to depend on financing choices:
• Interest payments are tax-deductible
• Financial distress is costly
• Optimal tradeoff between tax benefits and distress costs may also be affected by costs
and benefits of debt versus equity (information sensitivity, incentive effects, etc)
Therefore, now we will study ways to adjust our valuation techniques to account for the effects
of financial leverage. We will look at three methods: WACC; APV; and FTE.
3.1. Weighted Average Cost of Capital (𝑊𝐴𝐶𝐶)

𝑊𝐴𝐶𝐶 approach considers the value of the cash flows as there is no debt and then to account for
the effect of debt/interest tax shields we adjust the discount rate downwards relative to the
discount rate for an unlevered firm (𝑟𝑈 ). Intuitively, WACC measures the average return that the
firm must pay to its investors on an after-tax basis.
To be profitable, an investment project should generate an expected return at least equal to 𝑊𝐴𝐶𝐶.
Step 1
Estimate free cash flows from the investment (or firm), ignoring interest payments to debt holders
and tax deductions from debt financing.
𝐹𝐶𝐹 = 𝐸𝐵𝐼𝑇(1 − 𝑡) + 𝐷𝑒𝑝𝑟. −(∆𝑁𝑊𝐶 + 𝐶𝐴𝑃𝐸𝑋)
Step 2
Value project (or a firm) by discounting stream of 𝐹𝐶𝐹 using 𝑊𝐴𝐶𝐶 as discount rate:
𝐷 𝐸
𝑊𝐴𝐴𝐶 = ∙ (1 − 𝑡) ∙ 𝑟𝐷 + ∙𝑟
𝐷+𝐸 𝐷+𝐸 𝐸
Where,
- 𝐸: market value of equity (Market capitalization = #𝑆ℎ𝑎𝑟𝑒𝑠 × 𝑃𝑆ℎ𝑎𝑟𝑒 )
- 𝐷: market value of debt (book value of debt is a common assumption)
- 𝑡: effective marginal corporate tax rate
- 𝑟𝐷 : Required return on debt (cost/interest of debt)
There are two ways to compute it:
1) 𝑌𝑇𝑀 of corporate (firm) bonds
2) 𝐶𝐴𝑃𝑀: 𝑟𝐷 = 𝑟𝑓 + 𝛽𝐷 ∙ [𝐸(𝑟𝑀 ) − 𝑟𝑓 ]
Notice that: 𝛽𝐷 < 𝛽𝐸 ; a common assumption is 𝛽𝐷 = 0 ⟹ 𝑟𝐷 = 𝑟𝑓 .

- 𝑟𝐸 : Required return on equity (cost/interest of equity)
To compute the cost of equity we use the SML
𝑟𝐸 = 𝑟𝑓 + 𝛽𝐸 ∙ [𝐸(𝑟𝑀 ) − 𝑟𝑓 ]
𝜎𝑖,𝑀
𝛽𝐸 = 2
𝜎𝑀
Determinant of 𝛽𝐸
We could divide it into two main risks: Business Risk (BR) and Financial Risk (FR).
• BR: Cyclicality of Revenues
High Cyclical Stocks ⟹ High 𝛽 Cyclicality ≠ Variability: High 𝜎 ⇏ High 𝛽
Revenues depend on the business cycle, for example, retailers.
• BR: Degree Operating Leverage (DOL)

Measures the degree to which a firm or project can increase operating income by increasing
revenue.
∆𝐸𝐵𝐼𝑇 𝑆𝑎𝑙𝑒𝑠
𝐷𝑂𝐿 = ×
𝐸𝐵𝐼𝑇 ∆𝑆𝑎𝑙𝑒𝑠
Alternatively, it measures how sensitive a firm (or project) is to its fixed costs of production!
↑ 𝐷𝑂𝐿 ⟹ ↑ 𝐹𝐶 ; ↓ 𝑉𝐶
• FR: Financial Leverage

Financial leverage is the sensitivity to a firm’s fixed costs of financing. Financial leverage always
increases 𝛽𝐸 relative to 𝛽𝑈 (business risk).
Unlevered Beta, 𝛽𝑈 , and Levered Beta, 𝛽𝐸

Unlevered beta is a weighted average of the levered beta and debt beta:
𝐸 𝐷 𝑫
𝛽𝑈 = 𝛽𝐸 ∙ + 𝛽𝐷 ∙ ∙ (1 − 𝑡) ⟺ ⋯ ⟺ 𝜷𝑬 = 𝜷𝑼 + (𝜷𝑼 − 𝜷𝑫 )(𝟏 − 𝒕) ∙
𝑉𝑈 𝑉𝑈 𝑬
Therefore, the levered beta is a function of business and financial risk!

Example:
A company is considering expanding production (scale-enhancing project):
• 𝑃𝑆ℎ𝑎𝑟𝑒 = 30€ • 𝑟𝑓 = 6%
• # Shares Outstanding = 100𝑀 • 𝑀𝑅𝑃 = 8%
• 𝛽𝐸 = 1 • Expansion costs = 50𝑀 €
• 𝐷 = 1,5 𝐵 € and is currently at its long-term target leverage ratio.
• 𝐹𝐶𝐹 = 10𝑀 € per year starting next year and continuing in perpetuity
• Yield to maturity of company bonds is 6%
• Company expects to be consistently profitable and, therefore, 𝑡 = 30%
What is the NPV of the expansion project?
Step 1: Find WACC

- Cost of debt (𝑟𝐷 ): we can use the YTM of 6%
- Cost of equity (𝑟𝐸 ): we can use CAPM to find the cost of equity capital
𝑟𝐸 = 𝑟𝑓 + 𝛽𝐸 ∙ 𝑀𝑅𝑃 = 6% + 1 ∙ 8% = 14%
Thus, the weighted average cost of capital is given as:
1500 30 × 100
𝑊𝐴𝐴𝐶 = ∙ (1 − 30%) ∙ 6% + ∙ 14% = 10,73%
1500 + (30 × 100) 1500 + (30 × 100)
Step 2: Value Project

We can now use 𝑊𝐴𝐶𝐶 to discount free cash flows to find the project’s 𝑁𝑃𝑉:
10
𝑁𝑃𝑉 = −50 + = 43€
10,73%
𝐷
Target Leverage: 𝐷+𝐸 = 33%.
Project Debt Capacity: 33% × (50 + 43) = 31, that is, the firm requires 31 in additional debt to
maintain its target leverage ratio if it undertakes the project.
Changing Business Risk and/or Target Leverage

If the capital structure or business risk changes as a consequence of the project we should use the
following framing:
i. Step 1: If the project changes firm’s target debt-to-equity (business risk), calculate the
project’s unlevered beta 𝛽𝑈 based on firm (industry) information.
𝐷
𝛽𝐸 = 𝛽𝑈 + (𝛽𝑈 − 𝛽𝐷 )(1 − 𝑡) ∙
𝐸
ii. Step 2: Calculate the new project’s levered beta 𝛽𝐸 using the project’s target debt-to-
equity.
iii. Step 3: Calculate the project’s 𝑟𝐸 using CAPM.
𝑟𝐸 = 𝑟𝑓 + 𝛽𝐸 ∙ [𝐸(𝑟𝑀 ) − 𝑟𝑓 ]
iv. Step 4: Calculate the project’s 𝑊𝐴𝐶𝐶
𝐷 𝐸
𝑊𝐴𝐴𝐶 = 𝐷+𝐸 ∙ (1 − 𝑡) ∙ 𝑟𝐷 + 𝐷+𝐸 ∙ 𝑟𝐸

Example:
Suppose that instead of expanding operations, the company is investing in a new division:
𝐷
Comparable firms in the industry (average) 𝛽𝐸 = 1,5, 𝑟𝐷 = 6% and 𝐸 = 0,25. The project will
𝐷
be financed with = 0,4 and 𝑟𝐷 = 6%.
𝐸
We may assume industry and project 𝛽𝐷 = 0 ⟹ 𝑟𝐷 = 𝑟𝑓 .

Step 1: calculate project unlevered beta:
1,5 = 𝛽𝑈 + (𝛽𝑈 − 0)(1 − 30%) ∙ 0,25 ⟺ 𝛽𝑈 = 1,276
Step 2: calculate project levered beta:
𝛽𝐸 = 1,275 + (1,275 − 0)(1 − 30%) ∙ 0,4 = 1,633
Step 3: calculate project cost of equity using CAPM:
𝑟𝐸 = 6% + 1,633 ∙ 8% = 19,06%
Step 4: calculate the project WACC:
0,4 1
𝑊𝐴𝐴𝐶 = 1,4 ∙ (1 − 30%) ∙ 6% + 1,4 ∙ 19,06%
We can now use 𝑊𝐴𝐶𝐶 to discount free cash flows to find the project’s 𝑁𝑃𝑉:
10
𝑁𝑃𝑉 = −50 + = 17,6
14,8%
3.2. Adjusted Present Value (APV)
Value of a project can be thought of as the value of the project to an unlevered firm (𝑁𝑃𝑉) plus
the present value of financing side effects (𝑁𝑃𝑉𝐹):
𝐴𝑃𝑉 = 𝑁𝑃𝑉 + 𝑁𝑃𝑉𝐹
There are four side effects of financing:
• Interest tax shield
• Costs of issuing new securities (flotation costs)
• Costs of financial distress
• Subsidies to debt financing
Example:
Consider a project with the following incremental
after-tax cash flows for an all-equity firm:
Unlevered cost of equity is 𝑟𝑈 = 9%.
A. Suppose firm finances the project with 600€ of debt at 𝑟𝐷 = 8% and the tax rate is 30%.
125 250 375 500
𝑁𝑃𝑉 = −1000 + (1+9%) + 1,092 + 1,093 + 1,094 = −31,1 ⟹ Unleverd firm do not Accept
Interest Tax Shield = 𝐷 × 𝑟𝐷 × 𝑡 = 600 × 8% × 30% = 14,4

14,4 14,4 14,4 14,4 14,4 1
𝑁𝑃𝑉𝐹 = 1+8% + 1,082 + 1,083 + 1,084 = 8%
[1 − (1+8%)4 ] = 47,69
𝐴𝑃𝑉 = 𝑁𝑃𝑉 + 𝑁𝑃𝑉𝐹 = −31,1 + 47,69 = 16,6 ⟹ Firm should Accept the project with Debt!

B. With the previous exercise values, now suppose the firm has to pay flotation costs of
1% on gross proceeds, so gross proceeds should be such that net proceeds are 600€
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑐𝑒𝑒𝑑𝑠 × (1 − 1%) = 600€ ⟺ 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑐𝑒𝑒𝑑𝑠 = 606,06€
Interest Tax Shield = 𝐷 × 𝑟𝐷 × 𝑡 = 606,06 × 8% × 30% = 14,55

14,55 14,55 14,55 14,55 14,55 1
𝑁𝑃𝑉𝐹 = 1+8% + 1,082 + 1,083 + 1,084 = 8%
[1 − (1+8%)4 ] = 47,69
30%×6,06
Flotations Costs = 606.06 × 1% = 6.06 ⇒ Generates a Tax Shield = 4
= 0,45 each year
0,45 0,45 0,45 0,45 0,45 1
𝑁𝑃𝑉𝐹 = −6,06 + 1+8% + 1,082 + 1,083 + 1,084 = −6,06 + 8%
[1 − 1,084 ] = −4,57
𝐴𝑃𝑉 = 𝑁𝑃𝑉 + 𝑁𝑃𝑉𝐹 = −31,1 + 48,19 − 4,57 = 12,52 ⟹ Firm should Accept!
C. Suppose now firm finances the project with 600€ of debt at a below-market rate of 2%
(special line of credit, government subsidy)
After-tax Interest Tax Shield = 𝐷 × 𝑟𝐷 × (1 − 𝑡) = 600 × 2% × 70% = 8,4
8,4 1 600
𝑁𝑃𝑉𝐹 = 600 − [1 − 4 ]− = 131,2
8% (1 + 8%) (1 + 8%)4
𝑁𝑃𝑉𝐹 captures both the interest tax shield and the non-market rate effect; notice that we discount
at 8% (market rate).
𝐴𝑃𝑉 = 𝑁𝑃𝑉 + 𝑁𝑃𝑉𝐹 = −31,1 + 131,2 = 100,1 ⟹ Firm accept the project with Debt!
3.3. Flow to Equity (𝐹𝑇𝐸)

Discount cash flow from project to equity holders of the levered firm at cost of levered equity
capital 𝑟𝐸 .
There are three steps in 𝐹𝑇𝐸 Approach:
• Step 1: Calculate the levered cash flows (𝐿𝐶𝐹)
• Step 2: Calculate 𝑟𝐸
• Step 3: Value levered cash flows at 𝑟𝐸
• 𝐿𝐶𝐹 = 𝐹𝐶𝐹 − Interest expenses after taxes − Debt repayments
Example: Returning to the previous example, suppose the firm finances the project with 600€ of
debt at 𝑟𝐷 = 8% and the tax rate is 30%.
Thus, equity holders only have to provide 400€ of the initial 1.000€ investment: 𝐶𝐹0 = −400
After-tax Interest Tax Shield = 𝐷 × 𝑟𝐷 × (1 − 𝑡) = 600 × 0.08 × (1 − 0.3) = 33.6
Step 1: Levered cash flows are:
Year 1: 125 − 33,6 = 91,4€ Year 3: 375 − 33,6 = 341,4€
Year 2: 250 − 33,6 = 216,4€ Year 4: 500 − 33,6 − 600 = −133,6€

Step 2: Calculate 𝑟𝐸 :
𝐷 = 600€
𝐸 = 400 + 𝐴𝑃𝑉 = 400 + 16,6 = 416,6€
600
𝑟𝐸 = 9% + (9% − 8%) ∙ (1 − 30%) ∙ = 10%
416,6
Step 3: Value levered cash flows at 𝑟𝐸 = 10%
91,4 216,4 341,4 133,6
𝑁𝑃𝑉 = −400 + + + − = 27,2€
(1 + 10%) 1,12 1,13 1,14
3.4. Summary: Valuation
𝐷
➢ WACC and FTE: is constant over time.
𝐸
WACC is by far the most common method. FTE is a reasonable choice for highly levered
firms.
➢ APV: level of debt is known over time.
APV method is frequently used for special situations like interest rate subsidies, flotation costs,
LBOs.

IX. Payout Policy
Shareholders may receive in many different forms:
➢ Cash: Paid regularly, quarterly, or yearly. In a case of bankruptcy, the firm may pay
liquidating dividend
➢ Stock Dividends/Splits: no cash is paid, instead the firm increases the number of shares
outstanding, giving shares for free.
If you own 100 shares and the company declared a 10% stock dividend, you would
receive an additional 10 shares
➢ In-kind: dividends are paid in things
1. Payout Decision
1.1. Dividends
The process for a cash dividend has 4 important dates:
• Declaration Date: Board of Directors declares payment of dividends.
• Ex-Dividend Date: If you purchase the stock on and after the ex-dividend date you are
not entitled to receive a dividend
• Record Date: Corporation prepares a list of all individuals believed to be stockholders
• Payment Date: Stockholders receive the dividend.
In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date.
Taxes complicate things a bit. Empirically, the price drop is less than the dividend and occurs
within the first few minutes of the ex-date.
Irrelevance of Dividend Policy

Since investors do not need dividends to convert shares to cash; they will not pay higher prices
for firms with higher dividends. In other words, dividend policy will have no impact on the value
of the firm because investors can create whatever income stream they prefer by using “homemade
dividends”.
Example:
CashKing Inc. is a 42€ stock about to pay a 2€ cash dividend. Investor Bob owns 80 shares and
prefers a 3€ dividend. Bob’s homemade dividend strategy: Sell 2 shares on the ex-dividend date.
Recall that one of the assumptions underlying the dividend-irrelevance argument is: “The
investment policy of the firm is set ahead of time and is not altered by changes in dividend policy”.

1.2. Repurchases
Instead of declaring cash dividends, firms can rid themselves of excess cash by buying shares of
their own stock. Recently, share repurchase has become an important way of distributing earnings
to shareholders.
• Keeps stock price higher. Good for insiders who hold stock options
• As an investment of the firm (undervaluation)
• Tax benefits: Taxes on capital gains are usually lower than taxes on dividends
• Flexibility for shareholders
1.3. In Practise
Corporations “smooth” dividends. Fewer companies are paying dividends.
Dividends provide information to the market: Positive reactions in Dividends Increases!
Firms should follow a sensible policy:
• Do not forgo positive NPV projects just to pay a dividend
• Avoid issuing stock to pay dividends
• Consider share repurchase when there are few better uses for the cash

X. Market Efficiency: Efficient Markets Hypothesis
An efficient capital market is one in which stock prices fully reflect available information.
1. Assumptions
• Since information is reflected in security prices quickly, knowing information when it is
released does an investor little good
• Firms should expect to receive the fair value for securities that they sell - the price they
receive for the securities they issue is the present value of future cash flows
• Firms cannot profit from fooling investors in an efficient market
This means that the only way you can get higher returns is by taking on more risk; and there is
no information out there that can be used to construct strategies that earn returns higher than
required for their risk, so money management is a waste of effort.
2. Types of Efficiency
➢ Weak (Past Information)

Current prices fully reflect all information in past prices. Using past prices, returns, volumes will
produce no predictable patterns that can be exploited to yield better returns in the future
Technical analysis will not produce profits:
- Search for recurring and predictable patterns in prices
- Called “chartists” because they study charts of past stock prices and volumes
(candlesticks, heads, and shoulders, moving averages)
➢ Semi-strong (Public)
Current prices fully reflect all past prices and all publicly available information.
Fundamental analysis - using economic and accounting information
- Sorting through income statements, talking to the company
- Studying industries and the macroeconomy
Some evidence for semi-strong efficiency
- No abnormal returns after public announcements
- Professional money managers do not outperform the market consistently
➢ Strong (Private)
Current prices fully reflect all information, public and private.
Insider trading will not produce profits. Knowing a merger is going to take place before it is
announced publicly will not produce profits. Although illegal, evidence that prices move before
public announcements, suggesting insider information
Mixed evidence: On the one hand, insider trading appears profitable, indicating markets are not
strong form efficient. But on the other hand, these profits are short-lived, suggesting the market
may be close to efficient.

Why Should Markets be Efficient?
There are a large number of competing profit-seeking investors. It is not necessary that the
average investor is smart, only that there are a few smart investors (with deep pockets)
Forces of arbitrage: Smart investors exploit the mispricing in securities until it disappears

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NOTEBOOK

AUTHOR | Vasco Ribeiro Tamen

Vasco Ribeiro Tamen | Nº 43238 1

I. Introduction to Corporate Finance ....................................................................... 4

Vasco Ribeiro Tamen | Nº 43238 2

Vasco Ribeiro Tamen | Nº 43238 3

The Role of Financial Markets and Banking System

Primary Market Secondary Markets Banking System

Vasco Ribeiro Tamen | Nº 43238 4

Current Assets Measures a company's ability to cover its

Current Assets − Inventory Measures a company’s ability to meet its

Cash Shows a company's ability to cover its

Total Debt Examines the percent of the company that is

Total Debt Reflects the ability of shareholder equity to

EBIT Measures the ability a firm has to pay for the

Total Debt Measures a company's ability to pay off its

➢ Turnover (Asset Management) Ratios

Cost of Sales Measures how many times in a given period a

Receivables Sales Quantifies a company's effectiveness in

Payables Purchases Quantify the rate at which a company pays off

Asset Sales Measures the efficiency with which a company

Vasco Ribeiro Tamen | Nº 43238 5

Inventory Indicates the average number of days

Account Receivable Indicates the average number of days it

Account Payable Indicates the average number of days a

Net Income Measures how much net income is generated

EBIT Indicator of how well a company utilizes its

Net Income Measures how the profitability of a corporation

EBIT Measure the amount of return on a particular

Invested Capital Net Working Capital

Net Income Sales Total Assets

⟺ ROE = Net Profit Margin × Asset Turnover × Equity Multiplier

➢ Market value Ratios

Market Price Market Price

Vasco Ribeiro Tamen | Nº 43238 6

Notice that the deposit in 𝑇 = 5 is higher than

161.051 > 100 + 5 × [100 × 0.10] = 150

This is due to the power of compounding since

Vasco Ribeiro Tamen | Nº 43238 7

Compounding an investment 𝑚 times a year (monthly, quarterly, or semi-annually) for 𝑇 years

Effective Annual Rate (EAR)

Example: Cont. of the previous example

Vasco Ribeiro Tamen | Nº 43238 8

B. Consider an economy with only one 𝐸𝐴𝑅 = 10%.

Constant stream of cash flows that lasts forever

Vasco Ribeiro Tamen | Nº 43238 9

Pretty much any (government or corporate) bond is an annuity.

Vasco Ribeiro Tamen | Nº 43238 10

C. What is the constant payment (installment) of a 10-semester mortgage of 250.000€ if the

D. What is the constant payment (installment) of a 10-semester mortgage of 250.000€ if APR

To convert value at end of 1st

What if installments are paid at beginning of each period:

𝑃𝑉𝑡=0 = 𝑃𝑉𝑡=−1 × (1 + 6%/2) = 𝐶 × 𝐴10

To convert to today’s euros

Vasco Ribeiro Tamen | Nº 43238 11

Vasco Ribeiro Tamen | Nº 43238 12

How to value a bond?

Vasco Ribeiro Tamen | Nº 43238 13

1.1.2. Zero-coupon Bonds

Therefore, these types of bonds have:

Vasco Ribeiro Tamen | Nº 43238 14

𝐶% = 𝑦 ⟹ Bond Price = Face Value ⟹ Traded at Par Value, Market Value

𝐶% > 𝑦 ⇒ Premium 𝐶% < 𝑦 ⇒ Discount