FOUNDATIONS OF

FINANCE
SESSION 1 – THE TIME VALUE OF MONEY

The time value of money (TVM) is a basic financial concept which fundamentally states that money cannot be
compared in value when they are received or – more generally- referred to at different points in time. The basic
idea underlying the concept is the fact that if we receive 1$ today, we can invest it, earn interests and end up with
more than $1 in the future time. Therefore, the rate of interest determines the value of receiving money today or
in the future.
The concept of time value of money was specifically introduced in the financial sector taking into account the fact
that financial decisions often require combining cashflows or comparing values referred to different points in
time. There are three specific rules, known as the rules of time travel which define how we should compare and
combine cashflows at different points in time:
1. Only compare or combine values at the same point in time
2. If move cash forward in time: compound it (adjust it for the amount of interest rate you would get if you
decided to invest that amount of money)
3. If move cashflow backward in time: discount it

RULE 1: only compare cashflows at the same point of time → this rule derives from the previously stated
principle that a euro today and a euro in one year are not equivalent. It is, therefore, only possible to compare or
combine values at the same point in time. If you were asked if you prefer a gift of €1,000 today or €1,210 in two
years’ time, you would need to know: either the value of those €1,000 in two years ( compounding) or what the
value of those €1,210 would be today (discounting ).

RULE 2: compound to move CF forward → what is the future value of those €1,000 in two years? Compounding
allows you to move cashflows forward in time, in the sense that it would help you calculate the value those
money could have in a given number of years if you decided to invest them today and gain interest on them. For
this purpose, you would need, of course, to know the interest you would get if you decided to invest that amount
of money today (assume you can earn 10% annually for the investment). The investment gives you interest on
the initial capital in the first year of investing (€1,000*(1+r)) but also interest on the interest earned over the
first year. The effect of earning interest on interest is known as compound interest.

Future Value (FV) of a Cashflow:

𝐹𝑉𝑛 = 𝐶(1 + 𝑟) ∗ (1 + 𝑟) ∗ … ∗ (1 + 𝑟) = 𝑪 ∗ (𝟏 + 𝒓)𝒏

Example How would your answer change if the annual interest rate is 10% but compounded daily?

→ this basically means that you do not get 10% daily, but rather 10%/365 daily (in such a case, the simple
interest rate that you are supposed to receive does not, in fact, change, but you will “gain more money” since you
will be benefiting more from the “interest-on-interest” compounding effect.

0.10 1 0.10 2 0.10 3 0.10 365∗2

𝐹𝑉𝑛 = €1,000 ∗ (1 + ) ∗ (1 + ) ∗ (1 + ) ∗ … = €1,000(1 + ) = €1,221
365 365 365 365
𝒓
Generalizing the formula for more frequent compounding brings to the following formula: 𝑭𝑽𝒏 = 𝑪 ∗ (𝟏 + )𝒎𝒏
𝒎
At an extreme point, compounding could happen so often that the number of compounding periods becomes
infinitely large (m will basically end up approaching infinity). Standard results show that the right formula for
continuous compounding is: 𝑭𝑽𝒏 = 𝑪𝒆𝒓𝒏

RULE 3: discount CF to move them backward → to move a cashflow back in time, we must discount it. The
discounting process of converting future cashflows to their present value is concretely the inverse of
compounding them. Today’s value of a future amount of money is known as the present value (PV) and the
discounting interest rate we use is known as the discount rate.

Example Assume you are promised a payment of €1,210 in two-years time. What is the value of that amount of
money today?

𝟏
𝑃𝑉𝑛 = €1,210 DISCOUNT FACTOR
(𝟏 + 𝒓)𝒏
 Generalizing the formula of more frequent discounting we get:
𝑭𝑽
𝑃𝑉𝑛 = 𝒓 𝒏𝒎 .
(𝟏+ )
𝒎
Also in this case, we can assume at an extreme compounding
situation where m approaches infinity and discounting becomes
basically continuous: 𝑷𝑽𝟎 = 𝑭𝑽𝒆−𝒓𝒏

Valuing a stream of cashflows Most investment opportunities have multiple cashflows that occur at different
points in time. To find the present value of a stream of cashflows, the basic process involves simply adding up the
present value of each.

Example Assume that you are lending €10,000 today and that the loan will be repaid in two annual €6,000
payments. The way to calculate the present value of the stream of cashflows is to discount the two payments to
the present days and basically add them up together:

𝑵
𝐶0 𝐶0 𝑪.
𝑃𝑉 = 𝐶0 + + +⋯= ∑
(1 + 𝑟) (1 + 𝑟)𝑛 (𝟏 + 𝒓)𝒏
𝒏=𝟎

To compute the future value of a stream of cashflows, we employ the same approach but with compounding,
meaning we add up the future value of each payment we get during the interested period. The best example to
visualize the computation of FV of a stream of cashflows is to take a savings plan as an example.

Example Suppose we plan to save €1,000 today and €1,000 at the end of each next two years. If we can earn a
fixed 10% interest rate on our own savings, how much will we have three years from today?

𝐹𝑉𝑛 = $1,000 + $1,000 ∗ (1 + 𝑟)2 + $1,000 ∗ (1 + 𝑟)1

Perpetuities and Annuities Many business situations require computing the present value of a series of
expected future cash flows (retirement plans, savings plans, mortgages and loans). There are some shortcuts
that make it easy to calculate the present value of an asset that pays off in different periods. Instead of calculating
the present value of every cashflow for every period, we can apply some simplification formulae (provided that
certain conditions need to be fulfilled)
Perpetuities are defined when a constant cashflow will be earned at regular intervals forever, with the first
cashflow occurring one period from today.

𝐶
𝑃𝑉 ( 𝐶 𝑖𝑛 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦) =
𝑟

Example 1. In the 1800s, the British government decided to consolidate the huge debt accumulated during the
Napoleonic wars and to replace it with a single issue of bonds with no termination date and a coupon rate of
2,5%.
Suppose that the current interest rate in the UK is 9%, what is the present value of a consol with face value of
£25
£1,000? → PV ( C in perpetuity) = = £277,78 today
0.09

2. Suppose you decide to endow a chair in finance and the goal of the endowment is to provide €100,000 of
financial support per year forever. If the endowment earns a rate of 4%, how much money will you need to
donate to provide the desired level of support?
€100,000
PV ( C in perpetuity) = = €2,500,000
0.04

Today, you would need to donate €2.5m to endow the

chair.

Annuities differ from perpetuity in the sense that the constant cashflow will be received at regular intervals, but
only for a finite number of N periods and not perpetually as in the case of perpetuities. Also in this case, however,
the first cashflow comes one period from today. The present value of an annuity can, nonetheless, be derived by
the PV of a perpetuity (from which we would need to subtract the values referred to the “additional years)

𝐶 𝐶 𝐶 𝐶
𝑃𝑉𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 = + 2
+⋯+ 𝑁
+ +⋯
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑁+1
PV annuity

𝐶 1 𝐶 𝐶 𝑪 𝟏
→ 𝑃𝑉𝑎𝑛𝑛𝑢𝑖𝑡𝑦 = − (1+𝑟)𝑁 ((1+𝑟) + (1+𝑟)2 + ⋯ ) = (𝟏 − (𝟏+𝒓)𝑵)
𝑟 𝒓

PV perpetuity = C/r

Example US Powerball Lottery wins can be paid out as lump sum or instalments. The current advertised jackpot
is $222 million, which is the total amount paid should the winner accept the option of 25 instalments of $8.88
million per year. If the interest rate are 5,9% and payments occur at the end of each year, what is the value of the
lump sum payment (→ the lump sum payment should be the present value of the instalments)?

8.88 1
𝑙𝑜𝑡𝑡𝑒𝑟𝑦 𝑣𝑎𝑙𝑢𝑒 = (1 − ) = $114,602,894
0.059 (1 + 0.059)25

The future value of an annuity can be expressed as just the future value of the present value of the annuity.

𝑪 𝟏 (𝟏+𝒓)𝑵 −𝟏
𝐹𝑉𝑎𝑛𝑛𝑢𝑖𝑡𝑦 = 𝑃𝑉𝑎𝑛𝑛𝑢𝑖𝑡𝑦 ∗ (1 + 𝑟)𝑁 = (𝟏 − (𝟏+𝒓)𝑵) ∗ (1 + 𝑟)𝑁 = 𝑪 ∗
𝒓 𝒓

Growing perpetuities and annuities, instead, assume that the cashflow you suppose to receive annually or
perpetually is growing at a constant rate denoted as g.

𝐶
𝑃𝑉𝑔𝑟𝑜𝑤𝑖𝑛𝑔 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 =
𝑟−𝑔
1 1+𝑔 𝑁
𝑃𝑉𝑔𝑟𝑜𝑤𝑖𝑛𝑔 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 = 𝐶 ∗ (1− ( ) )
𝑟−𝑔 1+𝑟
Calculating the NPV The Net Present Value (NPV) of a project investment is the present value of the benefits
coming from that investment minus the cost of undertaking such an investment. The value basically compares
the value of cash inflows to the present value of cash outflows and calculating it allows us to evaluate an
investment decision. According to the NPV decision rule, one should accept those projects with positive NPV
because accepting them is equivalent to receiving their NPV in cash today, and reject those projects with
negative NPV because accepting them would reduce the wealth of investors. To choose among several projects,
compute NVP of each alternative and select the one with the higher NPV → alternative with highest NPV lead to
largest increase in value.

Example You have been offered to invest in a project that costs €5,000 and which will generate the following
cashflows at the end of each of the next three years respectively: €3,000 in year 1, €2,000 in year 2 and €1,000 in
year 3. Assume you can borrow/save at 7% per year in your bank, should you invest?

3,000 3,000 3,000

𝑃𝑉 = + 2
+ = €5366.91
(1 + 0.07) (1 + 0.07) (1 + 0.07)3

→ to the value, you should, then, subtract the costs currently faced to undertake the project:€ 5366.91 −
€5,000 = 𝟑𝟔𝟔. 𝟗𝟏. Because the benefits of undertaking the project, exceed the cost, then you should invest.

SESSION 2 – BOND PRICING

Bonds are securities sold by governments and corporations to raise money from investors in exchange for
promised future payments. The interest income paid to investors is fixed and therefore are bonds also called
fixed-income securities. We can distinguish among different kind of bonds, namely sovereign bonds issued by the
national government, municipal bonds issued by municipalities and corporate bonds issued by corporations.

Usually, corporate bonds differentiate themselves from the other kinds of bonds thanks to some specific
characteristics: they are usually employed as long-term debt financing (> 12 months) and have a face value of
$1,000 or multiples of that. Largest investors in those bonds are life insurances and pension funds, which usually
seek to minimize their risk whilst still pursuing their budget-enlarging goals. Less than 1% of corporate bonds
trade on exchanges, since most of the actually is exchanged on OTC markets.
The main type of corporate bonds are coupon bonds, zero-coupon bonds, convertible bonds and callable/putable
bonds. Convertible bonds specifically can be converted into ordinary shares at a pre-determined ratio and at
discretion of the bondholder; callable/putable bonds, instead, give the issuer the right to prepay (get the
company to repay) a bond at a fixed price (principal) prior to the stated maturity date.
Coupon bonds, instead, grant their holders the right to get coupon
payments fixed for the whole life of the bond. Usually coupons are
delivered annually or semiannually, where the amount is coupon rate x face value. The coupon rate is set by the
issuer and is stated on the bond certificate. At maturity principal is repaid and the bond is retired.
Zero-coupon bonds do not make coupon payments and only
offer one payment (amounting to the face value of the bond) at
maturity. They are usually sold below their face value (at a
discount) because they offer no coupons. They are also known
as pure discount bonds.
Interest rates are important ingredients of coupon rates, coupon payments and discount rates. It is therefore
extremely important to determine for which period the interest rate is quoted and how often you are receiving
coupon payments.

Nominal vs. real interest rate Nominal interest rates fundamentally measure the rate at which money grows.
Interest rates quoted by banks are nominal. With inflation, nominal interest rates do not measure the increase in
purchasing power that result from investing. Real interest rates more interestingly measure the rate at which
your purchasing power grows after adjusting for inflation.
The growth in purchasing power is usually measured as:

1+r growth of money

1 + rr = = also approximated as rr = 𝐫 − 𝟏 ( FISCHER EQUATION)
1+i growth of inflation

Normally, we use the nominal interest rate in order to discount cashflows, even though we must be precise in
defining that only cahsflows in constant prices (after being adjusted for inflation) can be discounted making use
of real interest rates. Real interest rates can be negative, whereas nominal interest rates are usually not (except
for extreme circumstances such as the past three years in the Euro zone). There also are some special bonds,
whose face value is adjusted for inflation, which are commonly known as TIPS (Treasury Inflation Protected
Securities). For such bonds, indeed, the principal increases with inflation and decreases with deflation as the
latter is measured by the Consumer Price Index. When a TIPS matures, you are basically paid the greater of the
adjusted principal or the original principal.
Annual Percentage Rates (APR) are simple yearly interests, which are quoted without taking compounding into
account. They basically indicate the amount of simple interest earned in one year. The APR is derived, then, from
the following formula, APR = periodic rate * m , where m stands for the number of periods where interest is
compounded. Nonetheless, since APR does not reflect or take into account the effect of compounding, the latter
cannot be defined as a precise measure of return in borrowing and investing.

Example Anna is charges 1% interest when she borrows $2,000 for one week. What is the annual percentage
interest rate (APR) on the loan.

𝐴𝑃𝑅 = (0.01) ∗ 𝟓𝟐 = 0.52 = 52%

The effective annual rate (EAR) indicates total (actual) amount of interest that will be earned in the end of one
year. This measure actually considers the joint effect of compounding and accounts for numbers of compounding
periods, adjusting the APR for the time value of money.
Following the fact that is does not take compounding into account, the APR itself can actually not be used as a
discount rate: APR with m compounding periods, indeed, is just a simple way of quoting interest earned in each
compounding period but without any account for actual compounding. The only case in which APR and EAR can
be used alternatively is when the compounding period is annual and therefore the interest rate does basically
not need to take into account compounding interests when determining the amount earned in the year.
Nonetheless, as soon as m >1, APR must be converted into EAR!
In order to do so, we can use the following formula:

𝐴𝑃𝑅 𝑚 1
1 + EAR = (1 + ) → 𝐴𝑃𝑅 = 𝑚[1 + 𝐸𝐴𝑅)𝑚 − 1]
𝑚

EAR increases, then, with the frequency of compounding APR. If we take continuous compounding into account,
we just assume that compounding happens at every instant. Consequently, with continuous compounding we
apply the formula in the following way: EAR = 𝑒 𝐴𝑃𝑅 − 1 .
In general, given a one-period discount rate r, we can compute an equivalent interest rate for a period differend
than one period as follows:

Equivalent n − period discount rate = (𝟏 + 𝐫)𝐧 − 𝟏

In this formula, n can be larger than 1 (to compute a rate over more than one period) or smaller than 1 (to
compute a rate over the fraction of a period). For instance, if we set n = 1/12, we can compute the equivalent
monthly discount from a yearly discount rate.

Bond Valuation The value, or price, of any asset is the present value of its future cashflows. To calculate a bond’s
price, then, we follow the same process as to value any other kind of financial asset. Estimated expected future
cashflows for a bond are basically represented by the coupons that the bond will pay, plus the principal to be
paid at maturity.

Steps in bond valuation → 1) determine the expected future cashflows – meaning the coupon payments and the
par value of the bond which will be received by the holder at maturity;
2) determine the required rate-of-return: the market interest rate or the bond’s yield to maturity
3) compute the current market value, or price (PB) by calculating the present value of the expected cashflows:

𝑃𝐵 = 𝑃𝑉 (𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑜𝑓 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠) + 𝑃𝑉(𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠)

Zero-coupon bonds are an easy introduction to bond pricing because they only have two payments: there is a
cash outflow the moment you buy them and a cash inflow at maturity when you will receive back the principle.
The best way to start talking about these kind of bonds is to consider the risk-free zero coupon bonds, like T-
bills.

Example Suppose that a one-year, risk-free, zero-coupon bond with a $100,000 face value is sold at a price of
$96,618.36. Then the cashflow would be:

→ and although the bond basically pays no interest, your compensation is

given by the actual difference between the initial price and the face value.
Therefrom it follows, that zero-coupon bonds are always issued at a discount.
The return you get on the bond, in this specific situation, is called the yield to
maturity.

The yield-to-maturity (YTM) is the single discount rate which equates the PV of the bond’s cashflows to the
bond’s market price, and for a n – year zero-coupon bond, the yield-to-maturity is the per-period return from
holding the bond to maturity and receiving the promised face value payment.

The price of a zer-coupon bond is therefore given by:

NOTE: there is an inverse relationship
1
𝐹 𝑭 𝑛 between the YTM and the price of the
𝑃𝐵 = 𝑛
→ 𝒀𝑻𝑴𝒏 = ( ) − 1 bond, meaning that when yield
(1 + 𝑌𝑇𝑀) 𝑷𝑩
increases, then bond prices are just
going down

Bond valuation, nonetheless, is also based on a specific economic condition , known as the law of one price. The
latter states that if equivalent investment opportunities trade simultaneously in different competitive markets,
then they must trade for the same price in both markets. Because we are talking of risk-free zero-coupon bonds,
their YTM is a risk-free returns which must equal the risk-free rate for the corresponding maturity of the bond.
In other words, imagine there is a bank from which you can borrow cash or to which you can lend at a specific
rate, and there is also a bond market. In order for the LOP to hold, the price at which you can buy the bond must
be exactly equal to the price at which you can borrow or lend from the bank. If this was not the case and the LOP
were violated, then arbitrage profit possibilities will be caught by market participants, thereby restoring the
equality anyway.
The term structure of interest rates simply represents the
relationship between yield-to-maturity and term-to-
maturity (borrowing period) on a bond. This can be used
in order to compute PV and FV of risk-free cashflows over
different investment horizons. The yield curve just
represents a graph of the term structure and defines the
shape and position of how interest rates comove with the
maturity time of a bond are not constant. As a matter of
fact, as the overall level of interest rate changes, yield curve shifts up and down and changes its shape and slope.
Generally speaking, ascending or normal yield curves slope upward from left to right and imply higher interest
rates are likely (the long-term interest rates are higher than he short-term ones); descending or inverted yield
curves slope downward from left to right and imply lower interest rates are likely; flat yield curves imply
interest rates are unlikely to change. Slopes of yield curve are actually very important to observe, since they can
tell us a lot about the current status of the economy: indeed, long-term rates are usually determined by future
expected short-term rates (→ “Expectation Hypothesis”).
There are three main factors which might influence the slope of the yield curve:

1. expected interest rates (+): the central banks usually determine the short-term interest rates (which are
therefore precisely indicated on the yield curve) whereas the other longer-term interest rates are largely
determined by the market and – more specifically- by market expectations;

2. expected rate of inflation (+): higher expected inflation means that the holder kind of receives an inflation
premium in the long end. As a matter of fact, inflation tends to make long-term interest rates higher;
3. interest rate risk and liquidity (+): the greater the interest rate right now, the higher the risk of uncertain
economic conditions in the future.

Coupon bonds are, instead, those kind of bonds which pay regular coupon interest payments until maturity and,
eventually, face value at maturity. In such a case, then, the price of the bond is not simply resulting from the
present value of its face value as paid at maturity, but it also needs to take coupons into account. The price of a
coupon bond is, thus, given by:

𝐶 𝐶 𝐶+𝐹 𝟏 𝟏 𝑭
𝑃𝐵 = + +⋯+ or simplifed 𝑷𝑩 = 𝑪 ∗ (𝟏 + )+
(1 + 𝑦) (1 + 𝑦)2 (1+𝑦)𝑛 𝒚 (𝟏 + 𝒚)𝒏 (𝟏 + 𝒚)𝒏

In practice, there are three ways to calculate the price of a risk-free coupon bond:

1. use the prices of risk-free zero-coupon bonds to find the equivalent price of a risk-free coupon bond → take a
three-year, $1,000 bond with 10% annual coupons. We can actually replicate the cashflow if this bond by taking
up three zero-coupon bonds. We basically exploit to our favour the law of one price in order to determine the
price of the security: the zero-coupon bonds need to mature at the same time as the coupon rate of the coupon
bond and, according to the law of one price, equivalent investment opportunities must trade at the same price .

Assume the equivalent zero-coupon prices are the

following:

By the law of one price, the three-year coupon bond must trade for the same price as the three zero-coupon
bonds whose face value is paid at similar times when the coupon payments are paid. In order to determine the
price of the three-year bond, we basically proceed in adding up all the prices of the zero-coupon bonds we are
equalling it to.
2. use the zero-coupon bond yields as discount rates for the coupon bonds: an alternative method is also the one
of using the zero-coupon bond’s yields-to-maturity as discount rates for both coupons and the final payment (is
basically the same thing as before):

100 100 100

𝑃𝐵 = + 2
+ ∗ 11 = $1,153
(1.035) (1.04) (1.045)3

3. use the YTM of your own coupon bond (provided that it is given to you) and discount annual coupons to the
appropriate discount rate.

100 100 100

𝑃𝐵 = + + ∗ 11 = $1,153
(1.0444) (1.0444)2 (1.0444)3

It is, nonetheless, important to consider that YTM is usually quoted as APR, so we must basically use the per-
period discount rate when considering bonds paying coupons with a higher frequency and in order to determine
their price. Therefore, the price of bonds that pay semi-annual (m=2) coupons is:

𝟏 𝟏 𝑭
𝑷𝑩 = 𝑪 ∗ 𝒚 (𝟏 + )+ 𝒚
𝒚 𝒏𝒎 (𝟏 + )𝒏𝒎
𝒎 (𝟏 + ) 𝒎
𝒎

𝒂𝒏𝒏𝒖𝒂𝒍 𝒄𝒐𝒖𝒑𝒐𝒏
𝑪=
𝒎

Example What is the price of a 3 year, 10% coupon bond with a YTM of 4.44% and semi-annual coupon
payments?

100
𝑠𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛 = = $50
2
1 1 1000
𝑃𝐵 = 𝟓𝟎 ∗ (1 + )+ = $𝟏𝟏𝟓𝟓. 𝟕𝟗
𝟎. 𝟎𝟒𝟒 0.044 3∗2 0.044 3∗2
(1 + ) (1 + )
𝟐 2 2

What to (and not to) use the YTM for:

• the good: you can use YTM to quote prices of bonds

• the bad: YTM is not a good measure of bond returns, since it assumes bonds are held until maturity and
interest is reinvested at the YTM rate (but bonds can be disposed of also before maturity comes, as well
as, spot rate can change and with them the yield to maturity)
• the ugly: you can use YTM only to compare bonds if they have the same coupon and the same maturity
Bond Price Dynamics In relation to its face value, a bond can trade at:

• par, meaning with a price equal to the one of its

face value. In such a case, coupon rate = YTM;
• at a premium, meaning at a price greater than the
face value of the bond, in such a case the coupon
rate > YTM
• at a discount, meaning at a price lower than the
face value of the bond (typical situation of zero-
coupon bonds), where the coupon rate < yield to
maturity

Until maturity, then, bond prices fluctuate for three fundamental reasons:
1) credit quality of the issuer: if the credit risk increases with respect to a bond issuer, then the price of the
bond almost automatically falls in response to the increased required bond yield which investors would
hope for in order to be compensated for the additional risk taken on. Investors, indeed, usually pay less
for bonds with credit risk than they would for an otherwise identical default-free bond. In response to
the lower price, they would basically receive a higher yield, known as credit risk premium. Yields for
bonds with credit risk will be higher than of otherwise identical default-free bonds. Usually, individuals
and small businesses rely on outside agencies for information on default potential of bonds, the so called
credit rating agencies. CRAs rank bonds in order of probability of default and loss-given-default and
publish ratings as letter grades.
2) time: bond price converges towards face value at maturity, without any change in yield required. As a
matter of fact, if interest rates remain the same a bond selling at par will continue selling at par, a bond
selling at discount will appreciate in price (and converge towards the face value of the bond), whereas
the bond selling at a premium will depreciate in price and come to match the original face value of the
bond;
3) interest rates: an important characteristic of a bond is the sensitivity of its price to interest rate changes.
An increase in the bond’s yield will decrease its price. The duration tells us approximately how much the
bond’s price will change for a given change in the bond’s yield: mathematically, the duration is
expressed as the derivative of the bond price with respect to its yield.

SESSION 3- CAPITAL ASSET PRICING MODEL

Risk and Return of a portfolio Basic definitions:

• return on portfolio, 𝑹𝑷 , is given by the weighted average of returns on the investments in the portfolio,
where the single weight 𝒙𝒊 correspond to the portfolio weights
𝑹 𝑷 = 𝒙𝟏 𝑹 𝟏 + 𝒙𝟐 𝑹 𝟐 + ⋯ + 𝒙𝒏 𝑹 𝒏 = ∑ 𝒊 𝒙𝒊 𝑹 𝒊 .
→ the single weights are calculated as a fraction describing how much of the total wealth you invested in
𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝒊
that specific asset: 𝒙𝒊 =
𝒕𝒐𝒕𝒂𝒍 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒕𝒉𝒆 𝒑𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐
→ ∑𝑖 𝑥𝑖 = 1 (the sum of the weights must always equal one)
• expected return on a portfolio is represented by the weighted average of expected returns of the
investment within it → 𝐸[𝑹𝑷 ] = ∑𝒊 𝒙𝒊 𝑬[𝑹𝒊 ] (these returns are computed conditional on the single
expectation each investor has with respect to the asset they invested in → when deciding where to
invest your money in, indeed, you are always unsure of the returns the single asset will yield).

Example You hold $25,000 of Intel Stock and $35,000 of ATP Oil and Gas in your own portfolio. Your expected
return is 18% for Intel and 25% for ATP Oil and Gas. What is the expected return for your portfolio?

$25,000 $35,000
𝐸[𝑹𝑷 ] = (18%) + (25%) = 22,1%
$60,000 $60,000

In order, instead, to know the risk of your own portfolio, you do not compute the weighted average of the
individual stock’s risk. You need, indeed, to find the risk of a portfolio, one must know the degree to which the
stocks’ returns move together.
 From the selected three stocks, we put two in a
portfolio with equal weights and perform some
observations:
• 3 stocks have the same volatility and
average returns
• two airline stocks behave similarly →
they belong to the same industry
• oil and airline stocks seem to behave
in opposite ways

When putting the two selected stocks together in a portfolio, the portfolio volatility yields a lower value than the
volatility of the individual stocks and the volatility also appears to be lower if the stock returns are less similar.
Therefore, the portfolio where we combine the two airline stock will yield a higher volatility with respect to the
portfolio where we will combine one of the two stocks with the TexOil stock. Why this? Because in the first
portfolio, we are combining two firms which are active in the same industry and are consequently highly likely to
behave similarly and react analogously to shocks hitting the sector (→ their stock returns are very likely to co-
move and to fall and rise together). In the second portfolio, instead, where one airline company is combined with
the oil company, the portfolio yields a lower volatility: this can be explained by underlining the fact that the two
stocks are referred to companies active in very different industries, whose value will not be affected by the same
shocks and – if they did – then they are highly likely to react differently to them (their stock returns are unlikely
to move together). This is a manifestation of the principle of diversification.

Therefrom we can conclude that:

• combining stocks in a portfolio reduces risk;
• diversification depends on the degree of stock co-movement

When determining which asset to combine in your portfolio, then, you should take into account some measures
of co-movement, among which the most common are:

• covariance: is the expected product of deviations of two returns 𝑹𝒊 and 𝑹𝒋 from their means:
𝒄𝒐𝒗 (𝑹𝒊 , 𝑹𝒋 ) = 𝑬[( 𝑹𝒊 − E(𝑹𝒊 )) (𝑹𝒋 − 𝑬(𝑹𝒋 ))]. Nonetheless, covariance gives you only the “sign” of the
co-movement, but it actually is not a good indicator of the strength of the co-movement between the two
stock returns. The measure is also pretty much influenced by outliers and therefore determined by
volatility.
• correlation, instead, is a much more efficient measure since it captures the common risk shared by
stocks that does not depend on their volatility. It basically gives you an indication of how strongly two
𝒄𝒐𝒗 (𝑹𝒊 ,𝑹𝒋 )
stocks move together: 𝒄𝒐𝒓𝒓 (𝑹𝒊 , 𝑹𝒋 ) = → correlation is bounded between -1 and 1 (the sign
𝑺𝑫(𝑹𝒊 )𝑺𝑫(𝑹𝒋 )
of the correlation will be the same as the one of the covariance in the sense that it describes whether the
two stocks move together in the same direction or move completely in the opposite one. It also gives you
an idea of how strong the movements are correlated→ if stock A increases by 1%, by how much
increases/decreases stock B?)

Digression
The covariance of a stock with itself always gives as a result the variance of the examined stock.
Conversely, the correlation of a stock with itself is equal to one.

The variance of a two stock portfolio is often taken as a measure of its combined risk and is given by the
following formula:
𝒗𝒂𝒓(𝑹𝑷 ) = 𝒙𝟐𝟏 𝒗𝒂𝒓( 𝑹𝟏 ) + 𝒙𝟐𝟐 𝒗𝒂𝒓(𝑹𝟐 ) + 𝟐𝒙𝟏 𝒙𝟐 𝒄𝒐𝒗(𝑹𝟏 , 𝑹𝟐 )
𝑺𝑫(𝑹𝑷 ) = √𝒗𝒂𝒓(𝑹𝑷 )

Example Assume your portfolio consist of $25,000 of Intel stock and $35,000 of ATP Oil and Gas and that the
annual standard deviation of returns is 43% for Intel and 68% for ATP. If you knew that the correlation between
Intel and ATP is 0.49, what is the standard deviation of your portfolio?
𝑆𝐷(𝑅𝑃 ) = √𝑥12 𝑣𝑎𝑟( 𝑅1 ) + 𝑥22 𝑣𝑎𝑟(𝑅2 ) + 2𝑥1 𝑥2 𝑐𝑜𝑣(𝑅1 , 𝑅2 ) =
2 2
√($25000) (0.43) + ($35000) (0.68) + 2 ($25000) ($35000) 0.49 = 50.89%
$60000 $60000 $60000 $60000

→ with N assets, the formula of the portfolio variance changes and gets to become: ∑𝑁 𝑁
𝑖=1 ∑𝑖=1 𝒙𝟏 𝒙𝟐 𝒄𝒐𝒗(𝑹𝟏 , 𝑹𝟐 )

Risks of the portfolio always results in being lower than weighted average volatility of individual stocks (unless
all stocks in portfolio have correlation of +1 with one another). This is because the correlation between two
stocks is inevitably related to the correlation of the stocks which are part of the portfolio and, as the correlation
between the stocks decreases, then also the standard deviation of the portfolio gets closer to zero with respect to
the weighted average of all correlations which does not take into account the correlation between the stocks
included.

As we can see, the higher the

number of stocks we include in
our portfolio, the smaller its
volatility. We can notice,
nonetheless, that the volatility
goes down steeply at the
beginning (when our portfolio is
made up of 10 stocks), whereas
once we have enough stocks, the
volatility continues to go down
at a much slower pace until the
curve flattens out → there is
always a portion of risk which
cannot be diversified away from
your portfolio (you can never
achieve zero risk).

This depends fundamentally on the fact that we are investing in assets whose covariance is likely to be positive:
this implies the fact that risk cannot completely be diversified away, since no matter how many stocks we insert
in the portfolio, there will always be a portion of risk related to the market itself which can never be eliminated
through diversification.
Risk specifically comes in two flavours:
• firm-specific news: good or bad news about the firm which can cause the investor’s expectation drop or
rise with respect to the stock’s future cashflow and can, therefore, cause huge fluctuations in the price.
Firm-specific news are the first source of idiosyncratic or firm-specific risk;
• market-wide news: good or bad news about the whole economy are, instead, the source of the
systematic and undiversifiable market risk → even when holding a large portfolio, one can never get rid
of the market risk.

Mean – Variance Analysis Since there is a portion of risk which can never be eliminated through diversification,
the goal of each investor is the one of creating an efficient portfolio, meaning a portfolio for which there is no
way of reducing the volatility of the asset combination without lowering its expected return. In contrast,
inefficient portfolios are those for which it is actually possible to find another portfolio that is better in terms of
both expected return and volatility (“being better” meaning finding a portfolio with lower volatility). Of course,
for the investor it would make no sense to invest in an inefficient portfolio, since it simply does not make sense
to accept an excessive amount of risk for a combination of stocks yielding a lower return than another portfolio
(always remember that returns are seen as a reward for risk → the higher the risk, the higher the returns).

Example We first illustrate the case in which we build up an efficient portfolio starting from two risky assets.
Consider a portfolio of Intel and Coca-Cola with statistics as follows:

• Intel: E(𝑹𝟏 ) = 𝟐𝟔% and 𝑺𝑫(𝑹𝟏 ) = 𝟓𝟎%

• Coca – Cola: E(𝑹𝟐 ) = 𝟔% and 𝑺𝑫(𝑹𝟐 ) = 𝟐𝟓%
As we can see from confronting the different-weights portfolios plotted on the graph, correlation does not affect
the expected portfolio returns, but it does affect portfolio volatility. As a matter of fact, the lower the correlation,
the lower the volatility we can obtain. As correlation decreases, the same does volatility (the less correlated are
the stocks included, the safer will the portfolio be, since the loss of a stock will be mitigated by the gain of
another stock,…).
The graph specifically represents the portfolio frontier, depicting both the expected returns and the standard
deviations of all possible portfolios made up of Intel and Coca-Cola, given different values of correlation between
the two stocks. We see that if the correlation beween the two stocks were exactly -1, one would be able to build
up a portfolio where they will be able to achieve zero volatility of returns (whereas the returns will always be
given by the weighted average of the expected returns of the chosen stocks).

Portfolio frontier with n >2 risky assets The mean- standard deviation frontier describes the set of portfolio
where no other portfolio with the same expected return has a lower standard deviation. It basically represents
all the portfolios for which the combination between the chosen stocks is optimal in the sense that it minimizes
standard deviation as much as possible given a target return.
In practice, starting with a set of n risky assets, you need to find the portfolio weights which minmize the
portfolio variance subject to the following two restrictions:
1. portfolio expected return equals a target return
2. portfolio weights sum to one
You repreat the above minimization for different target returns and thereby trace out a mean-standard deviation
frontier. Graphically, this is a hyperbola in the expected return- standard deviation space.
→ find the portfolio weights that minimize 𝑣𝑎𝑟(𝑹𝑷 ) = ∑𝑁 𝑁
𝑖=1 ∑𝑖=1 𝒙𝟏 𝒙𝟐 𝒄𝒐𝒗(𝑹𝟏 , 𝑹𝟐 ) subject to:
1. 𝐸(𝑹𝑷 ) = ∑𝒊 𝒙𝒊 𝑬[𝑹𝒊 ] = 𝒕𝒂𝒓𝒈𝒆𝒕
2. ∑𝑖 𝑥𝑖 = 1

out of this portfolio efficient frontier, we can identify:

• minimum variance portfolio: the portfolio with

the lowest variance of all feasible portfolios
• efficient frontier: part of the mean-standard
deviation that is above the global minimum
variance portfolio (investors will only choose
portfolios on this frontier)
• inefficient frontier: part of the mean-standard
deviation frontier that is below the global-
minimum variance portfolio (investors will
never choose portfolios on this frontier)

Risk- free saving and borrowing Investing in risk-free assets is also a great way to reduce risk. It is, then,
important to understand combined effects of investing in a risk-free investment and an efficient portfolio. So far,
have only discussed ways to reduce risks which implied diversification and, consequently, investing in a
multitude of different risky assets minimally correlated with each other. An additional method to reduce your
portfolio’s risk is, nonetheless, to invest a portion of your portfolio in risk-free investment (T-bills or generally
government bonds); this behaviour, as much as being effective for reducing risk, also lowers expected returns.
Alternatively, an aggressive investor might borrow money at a risk-free rate to invest even more in the stock
market to achieve higher expected returns (with higher risk).

Example You invest fraction x in an arbitrary risky portfolio and a fraction (1-x ) in risk-free Treasury Bills.
Expected return and standard deviation are as follows:

𝐸(𝑹𝑷 ) = (𝟏 − 𝒙)𝒓𝒇 + 𝒙𝐸(𝑹𝑷 ) = 𝒓𝒇 + 𝒙(𝐸(𝑹𝑷 ) − 𝒓𝒇 )

𝑺𝑫(𝑹𝑷 ) = √(𝟏 − 𝒙)𝟐 𝒗𝒂𝒓( 𝒓𝒇 ) + 𝒙𝟐 𝒗𝒂𝒓(𝑹𝑷 ) + 𝟐(𝟏 − 𝒙)𝒙 𝒄𝒐𝒗(𝒓𝒇 , 𝑹𝑷 ) = √𝒙𝟐 𝒗𝒂𝒓(𝑹𝑷 ) = 𝒙𝑺𝑫(𝑹𝑷 )
0 0

In the case where the investor also chooses to invest part

of their funds in a risk-free investment, any arbitrary
portfolio on the efficient frontier not always is the best
choice. In such a case, for instance, portfolio P is not the
best choice for the investor: it does not yield the highest
returns given the risk taken on. In order to find the best
portfolio of risky investments to combine with the risk-
free rate, we need to find the steepest possible line that
connects the risk-free rate and the risky portfolio, which
will yield the portfolio providing us with the highest
expected returns for any level of risk. The slope of the line
through P is referred to as the SHARPE RATIO. The latter
basically measures the ratio of the portfolio reward-to-
volatility:

𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑒𝑥𝑐𝑒𝑠𝑠 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 𝐸(𝑹𝑷 ) − 𝒓𝒇

𝑆ℎ𝑎𝑟𝑝𝑒 𝑅𝑎𝑡𝑖𝑜 = =
𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑣𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 𝑆𝐷(𝑹𝑷 )

The risky asset portfolio with the largest Sharpe Ration is, then:
• on the tangent line between risk-free investment and efficient frontier
• known as the tangent portfolio → the tangent portfolio is the set of portfolio weights {𝒙𝟏 , 𝒙𝟐 , … } that
maximizes the Sharpe Ratio subject to a series of standard conditions (not universally applicable):
1. the returns of the portfolio must equal the weighted average of returns of all assets included in
the portfolio → 𝐸(𝑹𝑷 ) = ∑𝒊 𝒙𝒊 𝑹𝒊
2. the portfolio standard deviation in equal to the square root of the variance of the portfolio →
𝑆𝐷(𝑹𝑷 ) = √𝒗𝒂𝒓(𝑹𝑷 )
3. the sum of all the weights placed on each single asset must equal one → ∑𝑖 𝑥𝑖 = 1

Efficient Portfolio and Required Returns Can we improve the Sharpe Ratio of an arbitrary portfolio?

Introductory Example Assume you own a portfolio of 25 different “large cap” stocks. You expect your own
portfolio will have a return of 12% and a standard deviation of 15%. Given the current market environment,
several investment professionals recommend investors to add gold to their portfolios. Assume gold has an
expected return of 8%, a standard deviation of 15% and a correlation with your portfolio of -0.05. Will adding
gold to your portfolio improve its Sharpe Ratio?

Adding securities to one’s own portfolio implies the happening of two different effects: the risk and return effect.
As a matter of fact, improving the Sharpe Ratio of your own portfolio P by adding another security i , surely
implies selling part of the risk-free rate in order to gain additional funds to invest in the asset (you shouldn’t
change the total amount invested, as well as, you do not forego any other security in order to add an additional
one). Adding a security will, consequently, have two effects:
1. by replacing risk-free returns with i’s returns, the expected return of the total portfolio will increase, by
excess return 𝐸(𝑹𝒊 ) − 𝒓𝒇 (meaning the excess return of i with respect to the foregone risk-free return);
2. add risk that i has in common with portfolio (non-diversifiable risk) → incremental risk =
𝑆𝐷(𝑹𝒊 ) 𝒄𝒐𝒓𝒓(𝑹𝑷 , 𝑹𝒊 )
Is a gain in return from investing in portfolio i adequate to make up for increase in risk? The measure for the
return-risk-trade-off is the Sharpe Ratio (SR): we basically want the SR of investment i with respect to the
portfolio to be higher than the SR of the portfolio scaled by their correlation (which represents the additional
portion of risk taken on):
 𝐸(𝑹𝑷 ) − 𝒓𝒇
𝐸(𝑹𝒊 ) − 𝒓𝒇 > 𝑆𝐷(𝑹𝒊 ) 𝒄𝒐𝒓𝒓(𝑹𝑷 , 𝑹𝒊 ) ∗
𝑆𝐷(𝑹𝑷 ) RETURN PER UNIT VOLATILITY
ADDITIONAL RETURN FROM OF PORTFOLIO P
ADDITIONAL VOLATILITY FROM
INVESTMENT i INVESTMENT i

One can simplify the previous equation by defining a new term:

𝑆𝐷(𝑹𝑷 )𝒙 𝒄𝒐𝒓𝒓(𝑹𝑷 , 𝑹𝒊 ) 𝑐𝑜𝑣(𝑹𝑷 , 𝑹𝒊 )

𝛽1𝑃 = = → 𝑬(𝑹𝒊 ) > 𝒓𝒇 + 𝜷𝑷𝟏 ( 𝑬(𝑹𝑷 ) − 𝒓𝒇 )
𝑆𝐷(𝑹𝑷 ) 𝑣𝑎𝑟(𝑹𝑷 )

In words: in order to increase the Sharpe Ratio of portfolio P, i' s expected returns must exceed the required
return for the portfolio previously composed (where 𝜷𝑷𝟏 depicts the asset’s returns sensitivity with respect to the
portfolio P)

Introductory Example Going back to the introductory example, in order to understand whether it is convenient
for the investor to add gold to their portfolio, we must compute 𝜷𝑮𝑶𝑳𝑫 :

𝑆𝐷(𝑹𝑮𝑶𝑳𝑫 )𝒙 𝒄𝒐𝒓𝒓(𝑹𝑮𝑶𝑳𝑫 , 𝑹𝑷 ) 25% − 0.05

𝜷𝑮𝑶𝑳𝑫 = = = −0.08333
𝑆𝐷(𝑹𝑷 ) 15%

Then, given gold’s sensitivity of returns with respect to the previously composed portfolio, we now compute the
required return to make gold attractive as a portfolio addition:

𝒓𝑮𝑶𝑳𝑫 > 𝒓𝒇 + 𝜷𝑮𝑶𝑳𝑫 ( 𝑬(𝑹𝑷 ) − 𝒓𝒇 ) → 𝟖% > 𝟐% − 𝟎. 𝟎𝟖𝟑𝟑𝟑 ∗ (𝟏𝟐% − 𝟐%) = 𝟏, 𝟓%

We know that gold has an expected return of 8%, which exceeds the required return of 1.5% → adding gold to
your portfolio will increase the Sharpe Ratio.

Previous results, then imply that:

• add security i to your portfolio if 𝑬(𝑹𝒊 ) > 𝑹𝑷 → HOLDING SECURITY I TO YOUR PORTFOLIO
IS OPTIMAL IF 𝑬(𝑹𝒊 ) = 𝑹𝑷
• reduce weight of security i in portfolio if 𝑬(𝑹𝒊 ) < 𝑹𝑷

If your portfolio P is the efficient portfolio, the equation becomes the following:

𝒆𝒇𝒇
𝑬(𝑹𝒊 ) = 𝒓𝒊 = 𝒓𝒇 + 𝜷𝟏 ( 𝑬(𝑹𝒆𝒇𝒇 ) − 𝒓𝒇 ) YOUR PORTFOLIO IS EFFICIENT IF AND ONLY IF, THE EXPECTED
RETURN ON EVERY AVAILABLE SECURITY EQUALS THE REQUIRED
RETURN

The Capital Asset Pricing Model (CAPM) The CAPM is a

theoretical model based on a series of assumptions. When those
assumptions hold, efficient portfolio can be implemented
without knowledge of correlations since we will know, for sure,
that the efficient (tangent) portfolio is the market portfolio
(portfolio of all securities on the market) and that the optimal
portfolio is a combination of the risk-free investment and the
market portfolio.
In the model, the tangent line that connects the risk-free rate
with the market portfolio is known as the Capital Market Line
(CML).
Previously, we showed that the 𝑬(𝑹𝒊 ) is determined by the β of
the chosen security to add to the portfolio; the CAPM model
allows us to use the market portfolio in order to estimate the
expected return of the securities. The expected return of an individual security is, thus, given by:

𝑬(𝑹𝒊 ) = 𝒓𝒊 = 𝒓𝒇 + 𝜷 (𝑬(𝑹𝑴 ) − 𝒓𝒇 ) RISK PREMIUM FOR SECURITY i → SECURITY MARKET LINE

MARKET RISK PREMIUM
The Security Market Line equation shows the relationship between the security’s expected return 𝑬(𝑹𝒊 ) and the
risk of this additional security (β). The equation signals a linear relationship between the two variables. The SML
is, thus, a line which goes through the risk-free rate and the market expected return as a function of β. Because
the market portfolio is efficient, all stocks and portfolios should lie on the SML.
The β of a portfolio is given by the weighted average βs of all other securities in the portfolio:

𝑐𝑜𝑣(𝑹𝑷 , 𝑹𝑴 ) 𝑐𝑜𝑣(∑𝒊 𝒙𝒊 𝑹𝒊 , 𝑹𝑴 ) 𝑐𝑜𝑣(𝑹𝒊 , 𝑹𝑴 )

𝜷𝑷 = = = ∑ 𝒙𝒊 = ∑ 𝒙𝒊 𝜷𝒊
𝑣𝑎𝑟(𝑹𝑴 ) 𝑣𝑎𝑟(𝑹𝑴 ) 𝑣𝑎𝑟(𝑹𝑴 )
𝒊 𝒊

SUMMARIZING: all investors need to pick point on the CML and which point you pick is governed only by your
own aversion to risk and nothing else. Consequently, all investors have the same fund or risky assets in their
portfolio (the tangency portfolio or the efficient portfolio) and to achieve the right combination of risk and
return, investors simply need to choose the right mix of the risk-free rate and the tangency portfolio.

SESSION 4 – MARKET EFFICENCY

The efficiency market hypothesis (EMH) states that securities with equivalent risk should have the same
expected returns. Competition among investors to learn about risk and expected returns eliminates all positive
NVP trading opportunities and this implies that securities will be fairly priced based on the available information
regarding their future cashflows and their risk, given all what is known to investors at the moment of valuation.
When it comes to information available to the public of investors, we distinguish among two types:
• public information: the firm’s earnings announcements or data in annual reports, public statistics on
macroeconomic variables,…. Stock prices usually instantaneously react to such news;
• private information: information held by a relatively small number of market participants (corporate
managers,…). Prices usually adjust to these kinds of information over time.
On the basis of these two types of information, we can distinguish among three levels/forms of market
efficiencies. The weakest form of market efficiency implies that it is not possible to profit by trading on
information in past prices. This implies that information on past prices should actually non reveal information
regarding future prices and make it profitable to trade information about that prices. A semi-strong form of
efficiency implies, instead, that it is not possible to consistently profit by trading public information; whereas a
strong form efficiency underlines the fact that it is not possible to profit by trading on private information.
The implication of the market efficiency hypothesis underline that current stock prices should provide accurate
information aggregated from a multitude of investors with respect to the true value of the shares traded on the
market.
Since EMH relies on the definition of “equivalent risk”, CAPM
allows us to test the validity of the hypothesis by allowing us
to define risk → in the CAPM world, how do investors react
to information?
In CAPM, required return is based on SML: 𝒓𝒊 = 𝒓𝒇 +
𝜷 (𝑬(𝑹𝑴 ) − 𝒓𝒇 ) and to improve the performance of their
portfolios, investors will compare the expected return of a
security with its required return from the security market
line. When market portfolio is efficient, all stocks are on the
security market line and have a zero alpha.
The stock’s alpha is given by the stock expected return and
the required return according to the SML:. 𝜶𝒔 = 𝑬(𝑹𝑺 ) − 𝒓𝒔 .
Investors can improve the performance on their portfolio by
buying stocks with positive alphas and selling stocks with
negative alphas.

Suppose some bad news hits the market about IBM: then expected returns on IBM stocks will for sure fall, since
investors and market participants now change their ideas about the company’s potential future cashflows (i.e.
they think they will be negative or consistently fall). Now we probably are in a phase where we observe a
negative alpha because the expected return on the stock is unavoidably less than the one predicted by the SML.
As a consequence, due to the negative expectations, investors will sell IBM stocks, causing the price of the stock
to go down and the expected returns to go up again. This mechanism will restore the “equilibrium condition”
until the α goes back to zero.
Efficiency of the Market Portfolio Most fund managers cannot consistently outperform the market: this means
that it is not possible even for skilled managers to realise returns which on average will yield a positive alpha. As
a matter of fact, the median mutual fund usually destroys value, since most fund managers appear to trade too
much and, consequently, cause their trading costs to exceed profits from any trading opportunity. Studies,
moreover, report that net of fees, returns to investors of the average mutual fund have a negative alpha (-1.11%
per year). Gross alpha might still be positive, but not enough to cover the fees which investors are charged by
managers which destroy any abnormal profit. Superior past performance is not even a good predictors of a
fund’s future ability to outperform the market since the observation of positive alpha can be due to two different
factors: either the manager’s effective superior skills or luck (in order to distinguish between the two cases, it is
nonetheless very important to actually look at the persistency of the performance).

Style – based anomalies Puzzling anomalies regarding the performance of specific stocks’ portfolios usually
regard the size, value and momentum effects which are created by investing in stocks satisfying specific
characteristics:
• size effect: small cap stocks have historically earned higher market-risk adjusted returns than large
market cap stocks;
• value effect: value stocks (high book-to-market stocks) have typically earned higher market-risk
adjusted returns than growth stocks (low book-to-market stocks)
• momentum effect: past winners (stocks with high returns over the last years) have historically earned
higher market-adjusted returns than past losers (stocks with low returns over the last years).
All of these types of stocks (small stocks, value stocks and past winners) tend to have all positive alphas.
Nonetheless, trading positive alpha stocks can have some implications:
1) positive alpha strategies can only persist if some barriers to entry restrict competition. This is,
nonetheless, very unlikely because of these trading strategies have now been implemented and have
been known for a whole long time;
2) or they can be sustained because of an inefficiency of the portfolio. The stock’s beta with the market is
not the only measure of systematic risk and positive alphas can be interpreted as returns for bearing
risk that CAPM does not capture. Possible explanation for a choice of an inefficient market portfolio can
be given by: proxy errors (the true market portfolio might be efficient, but the proxy we have used for it
may be inaccurate), behavioural biases (by falling prey to behavioural biases, investors might hold
inefficient portfolios) and alternative risk preferences (investors may care about risk characteristics
other than the volatility of their traded portfolio).

Multifactor models of risk To adjust for these anomalies, instead of the market portfolio, one could use other
portfolios. We know that the expected return of any marketable security is given by: 𝑬(𝑹𝒊 ) = 𝒓𝒊 = 𝒓𝒇 +
𝒆𝒇𝒇
𝜷𝟏 ( 𝑬(𝑹𝒆𝒇𝒇 ) − 𝒓𝒇 ). When the market portfolio is not efficient, though, we need to find a method in order to
identify the efficient portfolio before we can use the above equation. As a matter of fact, whenever the portfolio is
efficient, you can compute the returns of all securities in the portfolio by being dependent on the efficient
portfolio. However, it is not strictly necessary to identify the efficient portfolio itself; all that is required is to
identify a collection of factors portfolios from which the efficient portfolio can actually be constructed.
We call portfolios that measure risk “factors portfolios”: finance theory tells us that if the efficient portfolio can
be constructed from N factor-portfolios with returns 𝑹𝑭𝟏 , 𝑹𝑭𝟐 , … . , 𝑹𝑭𝑵 then, the expected return of any asset s, is
defined as:
𝑵

𝑬(𝑹𝒔 ) = 𝒓𝒇 + 𝜷𝑭𝟏
𝒔 ( 𝑬(𝑹𝑭𝟏 ) − 𝒓𝒇 ) + 𝜷𝑭𝟐
𝒔 ( 𝑬(𝑹𝑭𝟐 ) − 𝒓𝒇 ) + ⋯ 𝜷𝑭𝑵
𝒔 ( 𝑬(𝑹𝑭𝑵 ) − 𝒓𝒇 ) = 𝒓𝒇 + ∑ 𝜷𝑭𝑵
𝒔 ( 𝑬(𝑹𝑭𝑵 ) − 𝒓𝒇 )
𝒏=𝟏
When selecting among market portfolios, a single investor must of course decide which strategy to undertake
and which factors to add to the standard CAPM model in order to capture risk:
• market capitalization strategy: self-financing portfolios known as small-minus big (SMB) portfolio
• book-to-market strategy: this is a self-financing portfolio knowns as high-minus-low (HML) portfolio
• past return strategy: self-financing portfolio known as prior one-year- momentum portfolio (PR1YR)

FAMA – FRENCH-CARHART THREE-FACTOR MODEL expresses a collection of these three portfolios

plus the market portfolio estimated thanks to the CAPM. The specification is known as the following:
𝑬(𝑹𝒔 ) = 𝒓𝒇 + 𝜷𝑴 𝑺𝑴𝑩
𝒔 ( 𝑬(𝑹𝑴 ) − 𝒓𝒇 ) + 𝜷𝒔 ( 𝑬(𝑹𝑺𝑴𝑩 )) + 𝜷𝑯𝑴𝑳
𝒔 ( 𝑬(𝑹𝑯𝑴𝑳 )) + 𝜷𝑷𝑹𝟏𝒀𝑹
𝒔 ( 𝑬(𝑹𝑷𝑹𝟏𝒀𝑹 ))
The portfolio is implemented using historical average returns on the portfolios, even with long data
series it still reveals to be largely imprecise
Example You are considering making an investment in the semi-conductor industry. The project has the same
level of non-diversifiable risk as investing in Intel stocks.

The factors betas for Intel and the monthly risk premia you have calculated are:

𝜷𝑴
𝑰𝑵𝑻𝑪 = 𝟎. 𝟏𝟕𝟏 𝑬(𝑹𝑴 ) − 𝒓𝒇 = 0.61%
𝜷𝑺𝑴𝑩
𝑰𝑵𝑻𝑪 = 𝟎. 𝟒𝟑𝟐 𝑬(𝑹𝑺𝑴𝑩 )= 0,25%
𝜷𝑯𝑴𝑳
𝑰𝑵𝑻𝑪 = 𝟎. 𝟒𝟏𝟗 𝑬(𝑹𝑯𝑴𝑳 ) = 0,38%
𝜷𝑷𝑹𝟏𝒀𝑹
𝑰𝑵𝑻𝑪 = 𝟎. 𝟏𝟐𝟏 𝑬(𝑹𝑷𝑹𝟏𝒀𝑹 )= 0.70%

Determine the Cost of Capital by using the FFC factor-specification if the monthly risk-free rate is 0.5%

𝑬(𝑹𝒔 ) = 𝒓𝒇 + 𝜷𝑴 𝑺𝑴𝑩
𝒔 ( 𝑬(𝑹𝑴 ) − 𝒓𝒇 ) + 𝜷𝒔 ( 𝑬(𝑹𝑺𝑴𝑩 )) + 𝜷𝑯𝑴𝑳
𝒔 ( 𝑬(𝑹𝑯𝑴𝑳 )) + 𝜷𝑷𝑹𝟏𝒀𝑹
𝒔 ( 𝑬(𝑹𝑷𝑹𝟏𝒀𝑹 )) = 𝟎. 𝟓% +
(𝟎. 𝟏𝟕𝟏)(𝟎. 𝟔𝟏%) + (𝟎. 𝟒𝟑𝟐)(𝟎. 𝟐𝟓%) + (𝟎. 𝟒𝟏𝟗)(𝟎. 𝟑𝟖%) + (𝟎. 𝟏𝟐𝟏)(𝟎. 𝟕𝟎%) = 𝟎. 𝟎𝟎𝟗𝟓𝟔𝟐

The computed expected return is, nonetheless, expressed in monthly terms, which implies that in order to find
the annual cost of capital one should multiply the resulting number by 12 → 𝟎. 𝟎𝟎𝟗𝟓𝟔𝟐 𝒙 𝟏𝟐 = 𝟏𝟏. 𝟒𝟕%

APPLICATION OF THE FFC SPECIFICATION: the Fama-French three-factor model is widely used in research to
measure risk, but debate actually exists about whether factor specification is significant improvement over
CAPM. The model surely reveals to be better than CAPM when measuring risk of actively managed mutual funds:
funds with high returns in the past usually have positive alphas under the CAPM but no such evidence when
using FFC factor specification to compute alphas.

SESSION 5 – STOCK VALUATION

Determining the value of a company reveals to be of outmost importance especially for: control transactions
(IPOs, M&As,..), asset and financial restructuring (asset sales, divestitures,…), strategic analysis, raising capital
and for the fundamental analysis of portfolio selection (is the selected stock over- or undervalued?).
Assets are commonly assigned a specific value because the investor usually believes that the asset will generate
cashflows in the future. The value of an asset specifically depends on the magnitude of the cashflow (the larger,
the better), the timing of the cashflow (the quicker, the better) and the risk of the cashflow (less risky is better).
To perform intrinsic valuation, consider an asset that is a claim on future expected cashflows 𝑪𝑭𝟏 , 𝑪𝑭𝟐 , … . , 𝑪𝑭𝑻 ,
at which value will the investor be willing to trade this asset?
You need to compute the present discounted value of the asset’s expected cashflows:

𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝑻

𝑉= + 2
+ ⋯+
(1 + 𝑟) (1 + 𝑟) (1+𝑟)𝑇

The discount rate r reflects the opportunity cost of capital: r basically is the expected return on investment
available on the market with the same risk as the asset’s cashflows (what is the cost of investing in that specific
cost rather than in another one which has the same risk?). Any Discounted Cash Flow (DCF) is a tool to compute
an asset’s intrinsic value. There exist different DCF choices and these depend on the cashflows being discounted:
dividends per share (in order to determine the value of a stock), total payout to equity holders (value of equity),
free cashflow (to determine the value of equity and debt). The discount rate must match the riskiness of the
flows being discounted. There also exist
different ways of accounting for the tax
interest shield in valuation (WACC or AVP).
The tax code, indeed, might allow the firm to
deduct interest expenses regarding debt (for
any euro that you are paying on your debt
will not be taxed → advantages in terms of
taxes if you gave more debt). Alternatively,
we could value the asset relative to other
comparable firms (relative valuation → here,
instead of making forecast about the
company’s cashflows, you look at the
cashflows of similar companies)
Estimating the Cost of Capital The starting point for estimating the cost of capital is the SML equation: 𝑬(𝑹𝒊 ) =
𝒓𝒊 = 𝒓𝒇 + 𝜷 (𝑬(𝑹𝑴 ) − 𝒓𝒇 ) → RISK PREMIUM FOR SECURITY i . The equation provides us, indeed, with the
necessary ingredients to estimate the required return of our portfolio: the market portfolio (expected market
return), risk-free rate and the stock’s β. We proceed as follows:
(1) construct the market portfolio by using a broad index. Indeed, the market portfolio is theoretically the
total supply of securities and is value-weighted, meaning that the portfolio weight are proportional to
the market value of each security. Good proxies for the market portfolio are usually S&P 500 (500
largest stocks representing roughly 70% of US stock market caps) or CDAX (all companies listed at the
Frankfurt Stock Exchange);
(2) estimate the risk-free rate by using long-term government bonds: usually in order to acquire a good
estimate of the risk-free rate, practitioners use 10 to 30 year government bonds taken from the euro
area yield curve for AAA countries published yearly by ECB. Next step is to estimate the market risk
premium using historical average excess return of the market over the risk-free interest rate. generally,
the more historical data points, the better but estimation error is always a concern. Another approach is
to use forward looking measures like surveys and option prices,…
(3) estimate β: we know that β basically expresses the %
change in excess return of the security for a 1% change in
excess return of the market portfolio. Hence, in the scatter
plot, excess return of a security would be plotted on the y-
axis and excess return of market portfolio on the x-axis.
The presented graph, specifically shows Cisco’s monthly
stock returns and S&P500 excess retunrs as market
portfolio. As the scatterplot shows, Cisco tends to be up
when the market is up and this corresponds to basically a
15% increase in Cisco’s return, given a 10% change in the
market’s return. Thus, Cisco’s returns move about 1.5 for
one with the overall market, so Cisco’s β is about 1.5 for
the period. The linear regression results in being the most efficient statistical technique that identifies
the best-fitting line through a set of options: (𝑹𝒊 − 𝒓𝒇 ) = 𝜶 + 𝜷 (𝑬(𝑹𝑴 ) − 𝒓𝒇 )+⋲ , where α describes
the intercept term of the regression and 𝜷 (𝑬(𝑹𝑴 ) − 𝒓𝒇 ) represents the sensitivity of the stock to the
market risk. When the market’s return increases by 1%, then the security’s return increases by β%. ⋲ is
the error term and represents the deviation from the best-fitting line and is zero on average. Since E(⋲)
=0, then 𝐸(𝑹𝒊 ) = 𝒓𝒇 + 𝜷 (𝑬(𝑹𝑴 ) − 𝒓𝒇 ) + 𝜶, where the latter represents the distance above/below the
SML and consequently a risk-adjusted performance measure for the historical returns. If α is positive,
then the stock has historically performed better than predicted, otherwise, when α is negative, the
stock’s historical returns lie below the SML.
Another way to correctly estimate the cost of capital is to rely of the cost of debt: if a firm has a bond, then take
the YTM on long term bonds. The YTM, nonetheless, usually overstates the cost of debt when the bond is
assumed to be risky. If the firm is rated, then you should add the rating default spread to the risk-free rate or an
interest rate from a recent long-term bonk loans of the firm → 𝒓𝑫 = 𝒀𝑻𝑴 − 𝒑𝒓𝒐𝒃(𝒅𝒆𝒇𝒂𝒖𝒍𝒕) ∗
𝒆𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒍𝒐𝒔𝒔 𝒓𝒂𝒕𝒆
The required rate of return for an asset firm finance through both equity and debt is cost of capital. In such a
case, the expected return on the company must be more than the cost of debt (𝒓𝑫 ) but not as much as the
expected return on equity (𝒓𝑬 ). We therefore compute the WEIGHTED AVERAGE COST OF CAPITAL (WACC):

𝑬 𝑫
𝒓𝑾𝑨𝑪𝑪 = 𝒓𝑬 + 𝒓 ( 1 − 𝝉𝒄 ) → AFTER TAX COST OF DEBT
𝑬+𝑫 𝑬+𝑫 𝑫

SESSION 5.1 – INTRINSIC VALUATION

Cashflows from stocks are usually generated by both dividends and capital gain. So, how to value a stock
propertly?

Dividend Discount Model To start with, assume we have a one year

investor, whose expected cashflows from buying one share include a
specific sum as dividends and proceeds from selling the stock. In order to
find the present value of the stock, one must discount the forecasted sums
at the equity cost of capital 𝒓𝑬 .
The price of the stock, then, must equal the present value of future cahsflows.

𝑫𝒊𝒗 + 𝑷𝟏 𝑫𝒊𝒗 + 𝑷𝟏
𝑷𝟎 = → 𝒓𝑬 = −𝟏
(𝟏 + 𝒓𝑬 ) (𝑷𝟎 )

Why do we use 𝒓𝑬 as a discount factor? 𝒓𝑬 is the expected return investors expect on investments of comparable
risk and the price of a single stock must exactly be in line with the price of similar securities yielding similar
cashflows and carrying similar risk:
𝑫𝒊𝒗+𝑷𝟏 𝑫𝒊𝒗+𝑷𝟏
• 𝑷𝟎 > , then 𝒓𝑬 > − 𝟏 and investors would sell the stock → 𝑷𝟎 will fall
(𝟏+𝒓𝑬 ) (𝑷𝟎 )
𝑫𝒊𝒗+𝑷𝟏 𝑫𝒊𝒗+𝑷𝟏
• 𝑷𝟎 < , then 𝒓𝑬 < − 𝟏 and investors would sell the stock → 𝑷𝟎 will rise
(𝟏+𝒓𝑬 ) (𝑷𝟎 )
As we suggested before and as we can derive from the equation, the stock return can be decomposed into two
different components. Specifically, we have that:

𝑫𝒊𝒗 + 𝑷𝟏 𝑫𝒊𝒗 𝑷𝟏 − 𝑷
𝒓𝑬 = − 𝟏 → 𝒓𝑬 = +
(𝑷𝟎 ) 𝑷𝟎 𝑷𝟎
CAPITAL GAIN
DIVIDEND RATE
YIELD

Example 3M is expected to pay dividends of $1.92 per share in the coming year. You expect the stock price to be
at $85 at the end of next year. Investments with equivalent risk have an expected return of 11%.
What is the most that you would pay today for 3M stock? What dividend yield and capital gain rate would you
expect at this price, and what is the total return?

𝑫𝒊𝒗 + 𝑷𝟏 $𝟏. 𝟗𝟐 + $𝟖𝟓

𝑷𝟎 = = = $𝟕𝟖. 𝟑𝟏
(𝟏 + 𝒓𝑬 ) (𝟏. 𝟏𝟏)

𝑫𝒊𝒗 𝟏.𝟗𝟐
• Dividend yield: = = 𝟐, 𝟒𝟓%
𝑷𝟎 𝟕𝟖.𝟑𝟏
𝑷𝟏 −𝑷 𝟖𝟓−𝟕𝟖.𝟑𝟏
• Capital gain rate: = = 𝟖. 𝟓𝟒%
𝑷𝟎 𝟕𝟖.𝟑𝟏

Total return: 2.45% + 8.54% = 10.99% (very close to 11%, meaning the price of the stock is substantially in line
with the return the investor should expect on a security carrying such a risk).

For a multiyear investor, the formula can be adapted to investments held for more than one period. Suppose an
investor holds the stock for two years, then:

𝑫𝒊𝒗𝟏 𝑫𝒊𝒗𝟐 + 𝑷𝟐
𝑷𝟎 = +
(𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 )𝟐

This formula isn’t, in fact, different from the generalized formula for an investor holding the stock for one period.
𝑫𝒊𝒗 +𝑷
The one-year horizon formula implies, indeed, that 𝑷𝟏 = 𝟐 𝟐 and consequently:
(𝟏+𝒓𝑬 )

𝑫𝒊𝒗𝟐 + 𝑷𝟐
𝑫𝒊𝒗𝟐 +
𝑫𝒊𝒗𝟏 + 𝑷𝟏 (𝟏 + 𝒓𝑬 ) 𝑫𝒊𝒗𝟏 𝑫𝒊𝒗𝟐 + 𝑷𝟐
𝑷𝟎 = = = +
(𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 )𝟐

In general, the price of a single stock if holding he stock for N years is given by:

𝑫𝒊𝒗𝟏 𝑫𝒊𝒗𝟏 𝑫𝒊𝒗𝑵 + 𝑷𝑵

𝑷𝟎 = + 𝟐
+ ⋯+
(𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 )𝑵

This is known as the DIVIDEND DISCOUNT MODEL and is characterized by the fact that single- and multiple-
horizon valuation formulas are consistent. Consequently, the value of a stock is independent of the investment
horizon.
If the stock is held forever, and the investor decides never to sell it:
 ∞
𝑫𝒊𝒗𝟏 𝑫𝒊𝒗𝟏 𝑫𝒊𝒗𝑵
𝑷𝟎 = + 𝟐
+⋯ = ∑
(𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 )𝑵
𝒏=𝟏
Constant Dividend Growth Model As we might know, though, dividends are not known in the amount they are
paid every year, since the amount of earnings distributed to investors usually changes year to year according to
the company’s needs, necessities and investment chances. So how to forecast dividends paid every year in order
to determine the correct price for a security?

The simplest forecast is to assume that dividends grow at a constant rate g from today to forever. This
assumption stays at the basis of the DIVIDEND GROWTH MODEL, which determines the current price of a
security through the following formula:

𝑫𝒊𝒗𝟏
𝑷𝟎 =
𝒓𝑬 − 𝒈

→ in such a case, the growth rate of dividends should not exceed the expected return on equity, as well as, it
shouldn’t exceed the annual growth rate estimated for the whole economy (otherwise the company will basically
outgrow the whole world economy, a scenario which should not appear possible)

Example AT&T plans to pay $1.44 per share in dividends in the coming year. Its equity cost of capital is 8% and
dividends are expected to grow by 4% per year in the future.
Estimate the value of AT&T’s stocks:

𝑫𝒊𝒗𝟏 $𝟏. 𝟒𝟒
𝑷𝟎 = = = $𝟑𝟔. 𝟎𝟎
𝒓𝑬 − 𝒈 𝟎. 𝟎𝟖 − 𝟎. 𝟎𝟒

Of course, we cannot use the constant dividend growth model to value a stock if the growth rate is not constant.
For instance, young firms often have very high initial earnings growth rates and during this period, these firms
often retain 100% of their earnings to exploit profitable investment opportunities. As they mature, their growth
slows, their earnings exceed their investment needs and they begin to pay dividends → we can use the general
form of the model by applying the constant growth to compute the future value of the stock once the expected
growth rate stabilizes.
In such case when we are not sure of the constancy of dividends, we basically try to forecast the amount on
dividend concretely paid by the company for an horizon up to maximum 10 years from now. Then, from a certain
point in time on, we just assume the dividends to grow at a constant rate and we basically compute the terminal
value of the security through the constant dividend discount model.

𝑫𝒊𝒗𝟏 𝑫𝒊𝒗𝟏 𝑫𝒊𝒗𝑵 + 𝑷𝑵 𝟏 𝑫𝒊𝒗𝑵+𝟏

𝑷𝟎 = + 𝟐
+ ⋯+ 𝑵
+ 𝑵
( )
(𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 ) 𝒓𝑬 − 𝒈
growth phase with individual dividend PV terminal value with
forecasts (could be zero) stable growth

Example Valuing a firm with two different growth rates Small Fry Inc. has just invented a potato chip that looks
and tastes like a French fry. Given the phenomenal market response to this product, Small Fry is reinvesting all of
its earnings to expand its operations. Earnings were $2 per share this past year and are expected to grow at a
rate of 20% per year until the end of year 4. At that point, other companies are likely to bring out competing
products. Analysts project that at the end of year 4, Small Fry will cut investment and begin paying 60% of its
earnings as dividends and its growth will slow to a long-run rate of 4%. If Small Fry’s equity cost of capital is 8%,
what is the value of the share today?

From the text we can summarize the following information:

• EPS = 2$
• g = 20% (until year 4)
• payout ratio from year 4 = 60%
 • g= 4% (from year 4 on)
• 𝑟𝐸 = 8%

We use the given data in order to make forecasts about the company’s future earnings and dividends

1. we compute the Terminal Value of the company at year 5 in

order to determine the current value of the shares:

𝑫𝒊𝒗𝟔 𝟐. 𝟔𝟗
𝑷𝟓 = = = $𝟔𝟐. 𝟐𝟓
𝒓𝑬 − 𝒈 𝟖% − 𝟒%

2. when applying the dividend-discount model with the terminal value, we find the current price of the
stock:

𝑫𝒊𝒗𝟏 𝑫𝒊𝒗𝟏 𝑫𝒊𝒗𝑵 + 𝑷𝑵 𝟏 𝑫𝒊𝒗𝑵+𝟏 $𝟔𝟐. 𝟐𝟓

𝑷𝟎 = + + ⋯+ + ( )= = $𝟒𝟗. 𝟒𝟐
(𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 )𝟐 (𝟏 + 𝒓𝑬 )𝑵 (𝟏 + 𝒓𝑬 )𝑵 𝒓𝑬 − 𝒈 (𝟏. 𝟎𝟖)𝟓

PROBLEMS WITH THE DIVIDEND DISCOUNT MODEL: DD model neglects share repurchases as cashflows and
there is high uncertainty associated with any forecast of a firm’s future dividends. Small changes in assumed
dividend growth rate can lead to large changes in the estimated stock price and forecasts might not be able to
keep up with those changes properly. Moreover, dividend forecasts depend on forecast of earnings, dividend
payout ratio and share count.

Total Payout Model Many firms actually use excess cash in order to buy back shares instead of paying dividends.
This has two specific implications for the Dividend Discount Model:
• less cash available to pay dividends;
• decreases in the number of shares outstanding which increases earnings and dividends per share.
Given this behaviour on behalf of the firm, a valid alternative in order to understand which value to attribute to
the company is to discount the total amount spent on dividends and buybacks.
The total payout model, then, suggests:

𝑷𝑽 (𝒇𝒖𝒕𝒖𝒓𝒆 𝒕𝒐𝒕𝒂𝒍 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔 𝒂𝒏𝒅 𝒓𝒆𝒑𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒔)

𝑷𝑽𝟎 =
𝒔𝒉𝒂𝒓𝒆𝒔 𝒐𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈

The difference with respect to the Dividend Discount Model is that, in the latter, we valued a single share,
whereas through the dividend discount model we use the growth rate of earnings in order to forecast the growth
on the firm’s total payout.

Example 1) Suppose Amazon.com Inc. pays no dividends but spent $2 billion per share repurchases this year. If
Amazon’s equity cost of capital is 8%, and if the amount spent on repurchases is expected to grow by 6% per
year, estimate the Amazon’s market capitalization. If Amazon has 450 million shares outstanding, what stock
price does this correspond to?

From the text we can derive that:

• share repurchases = $2 billion
• growth total market cap = 6%
• shares outstanding= 450 million

Total Payout Next Year = $2 billion * 1.06 = $2.12 billion

Equity value = 2.12 billion/ (8%-6%) = $106 billion
Share price = $106 billion/ 450 million = $235.56
2) Titan Industries has 217 million shares outstanding and expects earnings at the end of this year of $860
million. Titan plans to pay out 50% of its earnings in total, paying 30% as a dividend and using 20% to
repurchase shares. If Titan’s earnings are expected to grow by 7.5% per year and these payout rates remain
constant, determine Titan’s share price assuming an equity cost of capital of 10%.

From the text we can derive that:

• number of shares outstanding = 217 million
• earnings in period 1 = $860 million
• growth rate (earnings) = 7.5%
• payout rate =50%
• 𝒓𝑬 = 10%

1 STEP: you estimate the company’s payout for the current year

The company will payout this year → 50% * $860 million = $430 million

2 STEP: based on the prospective earnings rate, we assume that also the total amount paid out will be growing at
the same rate. Hence, we compute the company’s total value of equity at the present moment.

$𝟒𝟑𝟎 𝒎𝒊𝒍𝒍𝒊𝒐𝒏
𝑷𝑽𝟎 = = $𝟏𝟕. 𝟐 𝒃𝒊𝒍𝒍𝒊𝒐𝒏 → this represents the company’s total equity
(𝟏𝟎% − 𝟕. 𝟓%) value
STEP 3: based on the company’s total value of equity, we compute the value per share by dividing PV for the total
amount of shares outstanding

Value per share = $17.2 billion/ 217 million = $79.26 per share

NOTE: using the total payout method, we did not need to know the firm’s split between dividends and share
repurchases. To compare this method with the dividend discount model, note that Titan will pay a dividend of
(30%*$860 million)/ 217 million shares outstanding = $1.19 per share, resulting in a total dividend yield of
$1.19/$79.26 = 1.50%.
Also note that Titan’ expected EPS, dividend and share price growth rate is 8.50% (𝒓𝑬 − 𝑫𝒊𝒗/𝑷) → this per share
growth rate, of course, exceeds the growth of total earnings since Titan’s shares outstanding will progressively
diminish due to the repurchase operations.

Discounted Free Cash Flow Model The discounted Cash Flow Model determines the value of the firm to all
investors, including both debt and equity holders.

𝑬𝒏𝒕𝒆𝒓𝒑𝒓𝒊𝒔𝒆 𝑽𝒂𝒍𝒖𝒆 = 𝒎𝒂𝒓𝒌𝒆𝒕 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 + 𝒅𝒆𝒃𝒕 − 𝒄𝒂𝒔𝒉

The enterprise value can be interpreted as the net cost of acquiring the firm’s equity, taking its cash (the amount
in excess of capital working needs), paying off all debt and owning the unlevered business.
The value of the enterprise can be given by:
𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 = 𝐸𝐵𝐼𝑇 (1 − 𝑇) + 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 − 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠 𝑖𝑛 𝑁𝑒𝑡 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

Unlevered Net Income

where, the Free Cash Flow can be interpreted as the cash flow available to the company to pay both debt holders
and equity holders net of investment and working capital needs. The discounted cash flow model is structured as
follows:

𝑽𝟎 = 𝑷𝑽( 𝒇𝒖𝒕𝒖𝒓𝒆 𝒄𝒂𝒉𝒔 𝒇𝒍𝒐𝒘𝒔 𝒐𝒇 𝒕𝒉𝒆 𝒇𝒊𝒓𝒎) → 𝐞𝐧𝐭𝐞𝐫𝐩𝐫𝐢𝐬𝐞 𝐯𝐚𝐥𝐮𝐞

𝑽𝟎 + 𝑪𝒂𝒔𝒉𝟎 − 𝑫𝒆𝒃𝒕𝟎
𝑷𝟎 = → 𝐬𝐭𝐨𝐜𝐤 𝐯𝐚𝐥𝐮𝐞
𝑺𝒉𝒂𝒓𝒆𝒔 𝒐𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈 𝟎

Implementing the model STEP 1: compute the enterprise value of the firm
 𝑭𝑪𝑭𝟏 𝑭𝑪𝑭𝟐 𝑭𝑪𝑭𝟑 𝑭𝑪𝑭𝑵 𝑽𝑵
𝑽𝟎 = + 𝟐
+ 𝟑
+ ⋯+ 𝑵
+
(𝟏 + 𝒓𝑾𝑨𝑪𝑪 ) (𝟏 + 𝒓𝑾𝑨𝑪𝑪 ) (𝟏 + 𝒓𝑾𝑨𝑪𝑪 ) (𝟏 + 𝒓𝑾𝑨𝑪𝑪 ) (𝟏 + 𝒓𝑾𝑨𝑪𝑪 )𝑵
STEP 2: in order to estimate the terminal value 𝑽𝑵 , one usually assumes a constant long-run growth rate g for
PV (Free Cash Flows)
free cash flows beyond year N , such that: PV (terminal value)

𝑭𝑪𝑭𝑵+𝟏 𝟏 + 𝒈𝑭𝑪𝑭
𝑽𝑵 = =( ) ∗ 𝑭𝑪𝑭𝑵
(𝒓𝑾𝑨𝑪𝑪 − 𝒈𝑭𝑪𝑭 ) (𝒓𝑾𝑨𝑪𝑪 − 𝒈𝑭𝑪𝑭 )

Definition of Free Cash Flow

𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 = 𝐸𝐵𝐼𝑇 (1 − 𝑇) + 𝑑𝑒𝑝. −𝐶𝑎𝑝𝐸𝑥 − 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠 𝑖𝑛 𝑁𝑒𝑡 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 = 𝐸𝐵𝐼𝑇 (1 − 𝑇) + 𝒏𝒆𝒕 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 − 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠 𝑖𝑛 𝑁𝑒𝑡 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

EBIT = revenues – COGS – SGA – Depreciation

NWC (Net Working Capital) = current assets – current liabilities = cash + inventory+ accounts receivables-
accounts payables

IN ORDER TO COMPUTE THEM, WE NEED TO FORECAST ACCOUNTING ITEMS!

Note: the operating income we need to compute the Free Cash Flow eliminates any financial effect from
the net income of the company → one must not take interest expenses into account
Moreover, sales price, units sold and cost per unit of each single item must be based on forecasts.

For some items, we basically simplify their figure to:

• Net working capital = CA (current assets) – CL (current liabilities)
• CapEx = New PPE (Property, Plant & Equipment) – Old PPE + Dep

To make forecasting even simples, we often put the forecast variables in relation to the revenue (% of
revenue)

Example Kenneth Cole (KCP) had sales of $518 million in 2005. Suppose you can expect its sales to grow at 9%
rate in 2006, but that this growth rate will slow by 1% per year to a long-run growth rate for the apparel
industry of 4% by 2011. Based on KCP’s past profitability and investment needs, you expect EBIT to be 9% of
sales, increases in net working capital requirement to be 10% of any increase in sales and net investment
(capital expenditures in excess of depreciation) to be 8% of any increase in sales. If KCP has $100 million in cash,
$3 million in debt, 21 million in shares outstanding, a tax rate of 37% and a weighted average cost of capital of
11%, what is your estimated value of KCP’s stock in early 2006?

From the text, we can derive the following information:

• Total sales (2005) = $18 million
 • Sales growth (2006) =9% → diminishing each year by 1% until touching a constant growth rate of 4%
• EBIT = 9% of sales
• Increase in NWC = 10% of any increase in sales
• Net investment = 8% of any increase in sales
• Number of shares outstanding = 21 million
• Tax rate = 37%
• WACC = 11%

𝐅𝐫𝐞𝐞 𝐂𝐚𝐬𝐡 𝐅𝐥𝐨𝐰 = 𝐄𝐁𝐈𝐓 (𝟏 − 𝐓) + 𝐧𝐞𝐭 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 − 𝐈𝐧𝐜𝐫𝐞𝐚𝐬𝐞𝐬 𝐢𝐧 𝐍𝐞𝐭 𝐰𝐨𝐫𝐤𝐢𝐧𝐠 𝐜𝐚𝐩𝐢𝐭𝐚𝐥

Using the information in the text, we can estimate KPC’s future cash flows based on the estimates given:

STEP 1: because we expect KPC’s free cash flows to grow at a constant rate after 2011, we can compute the
company’s terminal value as follows:

1 + 𝑔𝐹𝐶𝐹 1 + 4%
𝑉𝑁 = ( ) ∗ 𝐹𝐶𝐹2011 = ( ) ∗ 37.6 = $558.6 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
(𝑟𝑊𝐴𝐶𝐶 − 𝑔𝐹𝐶𝐹 ) 11% − 4%

STEP 2: therefrom, we can compute the current enterprise value of the company, by discounting all cashflows
available until 2011

23.6 24.4 29.3 32.2 35.0 37.6 + 558.6

𝑉0 = + 2
+ 3
+ 4
+ 5
+ = $424.8 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
1.11 1. 11 1. 11 1. 11 1. 11 1. 116

STEP 3: we now compute the value per share of the company

$424.8 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 + 100 − 3

𝑃0 = = $24.85
21 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

Valuation with leverage: WACC In the discounted free cash flow model we discount cash flows to both equity
holders and debt holders. Therefore, those cashflows should be discounted at the firm’s weighted average cost of
capital (WACC), 𝒓𝑾𝑨𝑪𝑪 .
If the firm has no debt then 𝑟𝑊𝐴𝐶𝐶 = 𝑟𝐸 , whereas if the firm has debt, 𝑟𝑊𝐴𝐶𝐶 adjusts the cost of capital for the
interest tax shield (TS) that is the change in income taxes resulting from interest deductions: 𝑇𝑆 = 𝜏𝐶 ∗ 𝐷 ∗ 𝑟𝐷
(it basically represents the amount of taxes the single firm does not need to pay because of the fact that it is
leveraged and can, consequently, not pay taxes on the amount of money it pays as interest on debt.

𝐸 𝐷 - 𝑟𝐸 : cost of equity capital

𝑟𝑊𝐴𝐶𝐶 = 𝑟 + 𝑟 (1 − 𝜏𝐶 ) - 𝑟𝐷 : cost of debt capital
𝐸+𝐷 𝐸 𝐸+𝐷 𝐷
- 𝜏𝐶 : corporate tax rate
- 𝐸 : market value of equity
- 𝐷: market value of debt

WACC incorporates the interest tax shield using the after-tax cost of debt → consider, indeed, a firm which is
financed both through debt and equity, where equity holders require and expected return of 𝑟𝐸 on their
investment and debt holders require a return of 𝑟𝐷 . Hence, the expected value of the investment in the firm is:
𝑬(𝟏 + 𝒓𝑬 ) + 𝑫(𝟏 + 𝒓𝑫 ). Of course, the firm will generate a free cashflow of 𝑭𝑪𝑭𝟏 at the end of the year and, in
addition, the interest tax shield provides tax savings amounting to 𝜏𝐶 𝑟𝐷 𝐷. In the next period, the firm’s
continuation value is described as 𝑉1𝐿 . If you are the exclusive firm holder (you hold all the equity and debt), the
expected payoff from the investment is of 𝑭𝑪𝑭𝟏 + 𝜏𝐶 𝑟𝐷 𝐷 + 𝑉1𝐿 .
Therefore, the following equality is: 𝑬(𝟏 + 𝒓𝑬 ) + 𝑫(𝟏 + 𝒓𝑫 ) = 𝑭𝑪𝑭𝟏 + 𝜏𝐶 𝑟𝐷 𝐷 + 𝑉1𝐿
Rearranging: if we move the interest tax shield to the left side of the last equation, we get: : 𝑬(𝟏 + 𝒓𝑬 ) +
𝑫(𝟏 + 𝒓𝑫 ) − 𝜏𝐶 𝑟𝐷 𝐷 = 𝑭𝑪𝑭𝟏 + 𝐷 + 𝑉1𝐿 → (𝟏 + 𝒓𝑬 ) + 𝑫(𝟏 + 𝒓𝑫 (𝟏 − 𝜏𝐶 )) = 𝑭𝑪𝑭𝟏 + 𝑉1𝐿
𝑬 𝑫
Because 𝑉1𝐿 = 𝐸 + 𝐷 and 𝒓𝑾𝑨𝑪𝑪 = 𝒓𝑬 + 𝒓𝒅 (𝟏 − 𝜏𝐶 )- The left side of the equation can be re-written as
𝑉1𝐿 𝑉1𝐿
𝑉1𝐿 (1 + 𝒓𝑾𝑨𝑪𝑪 ) and dividing by 1 + 𝒓𝑾𝑨𝑪𝑪 , we can express the value of the investment today as the present value
of the next period’s free cashflows and continuation value:

𝑭𝑪𝑭𝟏 + 𝑉1𝐿
𝑉1𝐿 =
1 + 𝒓𝑾𝑨𝑪𝑪

In the same way, we can write the value in one year as the discounted value of the free cashflows and the
continuation value in year 2. If the WACC is the same next year, then:

𝑭𝑪𝑭𝟐 + 𝑉2𝐿
𝑭𝑪𝑭𝟏 + 𝑭𝑪𝑭𝟏 𝑭𝑪𝑭𝟐 + 𝑉2𝐿
1 + 𝒓𝑾𝑨𝑪𝑪
𝑉1𝐿 = = +
1 + 𝒓𝑾𝑨𝑪𝑪 1 + 𝒓𝑾𝑨𝑪𝑪 (1 + 𝒓𝑾𝑨𝑪𝑪 )2

By repeatedly replacing each continuation value and assuming the WACC remains constant, then we can derive
the general formula for the DCF method:

𝑭𝑪𝑭𝟏 𝑭𝑪𝑭𝟐 𝑭𝑪𝑭𝟑

𝑉1𝐿 = + 2
+ +⋯
1 + 𝒓𝑾𝑨𝑪𝑪 (1 + 𝒓𝑾𝑨𝑪𝑪 ) (1 + 𝒓𝑾𝑨𝑪𝑪 )3

The Weighted Average Cost of Capital (WACC) can nonetheless be further decomposed in:

𝐸 𝐷 𝐷
𝑟𝑊𝐴𝐶𝐶 = 𝑟𝐸 + 𝑟𝐷 − 𝑟 𝜏
𝐸+𝐷 𝐸+𝐷 𝐸+𝐷 𝐷 𝐶
PRE – TAX WACC
• the pre – tax WACC is basically the WACC of the firm if the tax rate was zero and when a firm keeps a
target leverage ratio, the pre-tax WACC is independent of the capital structure and equal to the
unlevered cost of capital 𝒓𝑼 (the importance of debt and equity in the firm’s structure is decided
exclusively by the firm’s policy, since the company itself can decide to adjust the capital structure in
order to keep a constant debt-to-value ratio. Nonetheless, as much as the single ratios depend on the
firm’s policy and capital structure, their sum is totally independent);
• 𝒓𝑼 is the cost of capital of the firm if it were unlevered (meaning it has no debt) and is determined by the
riskiness of the firm’s cashflow. Tendentially, the unlevered cost of capital basically indicates the reward
investors expect given the specific business risk of the firm

Suppose an investor holds a portfolio of all the equity and debt of the firm. Then the investor will receive the free
cashflows of the firm plus the tax savings from the interest tax shield. These are the same cashflows an investor
would receive from a portfolio providing the investor with the same cashflow as the one potentially generated by
the unlevered firm and a separate security that paid the investor the amount of the tax shield each period.
Because the two portfolios generate the same cashflows, by the Law of One Price they have the same market
values: 𝑽𝑳𝟏 = 𝑬 + 𝑫 = 𝑽𝑼 𝟏 + 𝑻 ( 𝑻 is the present value of the tax shield). Because these portfolios have equal
cashflows and market values, they also have identical expected returns which implies: 𝑬𝑟𝐸 + 𝑫𝑟𝐷 = 𝑽𝑼 𝟏 𝑟𝐷 + 𝑻𝑟𝑇
(𝑻𝑟𝑇 is the price of the tax-shield asset + expected return on the tax-shield which depends on the riskiness of the
firm → if the firm wants to keep a constant leverage ratio, then the market value of debt is equal to the ratio
times value of the firm; the return of the tax-shield portfolio will then be equal to tax rate times the cost of debt
times the leverage ratio. Nonetheless, since D is given by debt ratio * enterprise value, this tax-shield return will
adjust to the firm’s size).
Suppose the firm adjusts its debt continuously to maintain a target debt-to-equity ratio: because the firm’s debt
and interest payments will vary with the firm’s value and cashflows, the risk of the interest tax shield will equal
that of the firm’s free cashflows, so 𝑟𝑇 = 𝑟𝑈 , where the latter describes the so-called unlevered cost of capital of
the firm (the discount rate that the firm will have if it was unlevered and relied only on equity for financing). As a
𝑬 𝑫
consequence, 𝑬𝒓𝑬 + 𝑫𝒓𝑫 = 𝑽𝑼 𝑼
𝟏 𝒓𝑫 + 𝑻𝒓𝑻 = ( 𝑽𝟏 + 𝑻)𝒓𝑼 = (𝑬 + 𝑫)𝒓𝑼 → 𝒓𝑼 = 𝒓𝑬 + 𝒓𝑫 (the unlevered
𝑬+𝑫 𝑬+𝑫
cost of capital is equal to the pre-tax cost of debt; in case the firm has a constant leverage ratio then the WACC
can be written as the pre-tax WACC adjusted for the tax shield.

Example Suppose Avco is considering the acquisition of another firm in its industry that specializes in custom
packaging. The acquisition is expected to increase Avco’s free cash flow by $3.8 million the first year, and this
contribution is expected to grow at rate of 3% per year from then on. Avco has negotiated a purchase price $80

million. After the transaction, Avco will adjust its capital structure to maintain its current debt-equity ratio. Is the
acquisition has similar risk to the resto of Avco, what is the value of this deal?
• Avco pays a corporate tax rate 40%

𝐸 𝐷 300 300
𝑟𝑊𝐴𝐶𝐶 = 𝑟 + 𝑟 (1 − 𝜏𝐶 ) = 10% + 6%(1 − 0.40) = 6.8%
𝐸+𝐷 𝐸 𝐸+𝐷 𝐷 600 600

The free cash flows of the acquisition can be valued as a growing perpetuity. Because its risk matches the risk for
the rest of Avco, and because Avco will maintain the same debt-equity ratio going forward, we can discount these
cashflows using the WACC of 6.8% → as a consequence the value of the acquisition will be:

3.8
𝑽𝑳𝟏 = = $𝟏𝟎𝟎 𝒎𝒊𝒍𝒍𝒊𝒐𝒏
6.8% + 3%

Given the purchase price of $80 million, the acquisition has an NVP of $20 million.

For valuation and capital budgeting purposes, we may want to estimate the unlevered cost of capital 𝑟𝑈 from
comparable firms. Especially useful is to estimate it in cases of valuation of a private firm with no data on equity
cost of capital and in case of undertaking a project with different market risk and leverage than the average
project for the firm. The approach requires comparable firms to maintain a target leverage ratio, so pre-tax
WACC is independent of the capital structure and equal to 𝑟𝑈 .

Example Suppose Avco launches a new plastic manufacturing division that faces different market risks that its
main packaging business. The unlevered cost of capital for the plastics division can be estimated by looking at
other single-division plastics firms that have a similar business risk. Assume two are comparable to the plastics
division and have the following characteristics:

Assuming that both firms maintain a target leverage ratio, the unlevered cost of capital for each competitor can
be estimated by calculating their pre-tax WACC.

Competitor 1: 𝑟𝑈 = 0.6 ∗ 12% + 0.4 ∗ 6% = 9.6%

Competitor 2: 𝑟𝑈 = 0.75 ∗ 10.7% + 0.25 ∗ 5.5% = 𝟗. 𝟒% → why is it different than the one we computed before?
The difference lies in the unlevered cost of capital (which previously was 8%; the new business is riskier
meaning that the total cost of capital will be adjusted and go up at 8.3%)

Based on these comparable firms, we estimate 𝑟𝑈 for the plastics division to be approximately 9.5%. if the firm
maintains a target leverage ratio d, we can use: 𝒓𝑾𝑨𝑪𝑪 = 𝒓𝑼 − 𝒅𝒓𝑫 𝝉𝑪
SESSION 5.2 – RELATIVE VALUATION

Relative valuation implies estimating the firm value based on the value of other comparable firms that we expect
will generate very similar cash flows in the future. In this sense, the relative valuation technique looks at how
similar assets are priced in the market. The method is widespread use in equity research reports and acquisition
valuations, and DCF valuation in consulting and corporate finance always have a relative valuation component
since the terminal value is estimated using a multiple (this mean that we multiply some specific income variable
for a ratio specific to the firm). Two standard market multiple valuation models are:
• using multiples form publicly traded companies
• using multiples from comparable transactions.
How does the process work? You first measure a market multiple – the relation between the value and usually
an earnings-based or cash flow-based denominator (EBIDTA) for comparable companies with known values of
the numerator and denominator. Secondly, you measure the value of the company you would like to value and
multiply the company’s measure of the chosen denominator by the market multiple of the comparable
companies.
The real challenges when valuating through such a procedure include identifying comparable companies which
are priced similarly to the company being valued. Usually, a company’s direct competitors are a good starting
point, since choosing among them specifically controls for business risk (close competitors usually have similar
business risks). Choosing the wrong company can bring to detrimental errors in the valuation of a company. Key
drivers of the differences in the market multiples across companies are business risk, capital structure
(especially through its impact on the cost of capital), as well as, growth in the industry. Some multiples are also
affected by expenditures and investments of the companies in specific fields or growth projects.

P/E ratio Among the most common multiples we have the price – earnings (P/E) ratio, which is computed by
dividing share price by earnings per share. If we use as a denominator trailing earnings (earnings over the last
12 months), then the computed multiple is known as trailing P/E; conversely, if we compute the ratio on the
basis of expected earnings over the next 12 months, we denote the ratio as forwards P/E.
The fundamental drivers for the multiple are the following → if we apply the simple DCF model with constant
growth, we have that:

𝑃 𝑃0 𝐷𝑖𝑣1 /𝐸𝑃𝑆1 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑒

𝐹𝑜𝑟𝑤𝑎𝑟𝑑 = = =
𝐸 𝐸𝑃𝑆1 𝑟𝑒 − 𝑔 𝑟𝑒 − 𝑔

• firms with low cost of equity capital, high growth and high payout rates, should have high P/E ratios
• firms with similar growth rates, cost of equity capital, payout rates should have similar P/E multiples.
This implies that if A and B are comparable in the sense that they have similar values for the three
parameters of the formula, we will have similar values for the ratio and will therefore also have an
approximately correct value for the firm’s value by multiplying known figures for the derived multiple
for the comparable firm.
We can use P/E multiple to illustrate the logic of relative valuation. Assume you want to value the stock of a
company A. You know also company B, which is comparable to A in terms of cost of equity, growth rate and
payout rate. You can observe both 𝑃𝐵 and 𝐸𝑃𝑆𝐵 and can therefore compute the P/E ratio for company B and use
𝑃
it to compute the enterprise value of company A. → 𝑃𝐴 = 𝐸𝑃𝑆𝐴 𝑥 𝐵
𝐸𝑃𝑆𝐵
The same logic applies when – preferring other multiples for valuation- two firms seem comparable in terms of
other key drivers for that specific multiple.

Example 1. Suppose the furniture manufacturer Herman Miller, Inc. has earnings per share of $1.38. If the
average P/E of comparable furniture stocks is 31.3, estimate a value for Herman Miller using the P/E as
valuation multiple. What are the assumptions underlying the estimate?

We estimate a price for Herman Miller based on the P/E ratio of those signalled as comparable companies.
Consequently, 𝑷𝑨 = $𝟏. 𝟑𝟖 𝒙 𝟐𝟏. 𝟑 = $𝟐𝟗. 𝟐𝟗. This estimate assumes that Herman Miller will have similar future
risk, payout rates and growth rates to comparable firms in the industry.

2. Assume that BestBuy Co. Inc. (BBY) has earnings per share of $2.22 and that the average P/E of comparable
companies’ stocks is 19.7. The estimated value for Best Buy using the P/E as a valuation multiple is: 𝑷𝑩𝑩𝒀 =
$𝟐. 𝟐𝟐 𝒙 𝟏𝟗. 𝟕 = $𝟒𝟑. 𝟕𝟑.

Other Multiples Another commonly used ratio is the price-book multiple, whose fundamental drivers can be
derived by implementing and defining the ROE as 𝐸𝑃𝑆1 /𝐵𝑉0 :

𝐸𝑃𝑆1 𝐷𝑖𝑣1 /𝐵𝑉0 𝐸𝑃𝑆1 ∗ 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜/𝐵𝑉0 𝑅𝑂𝐸 ∗ 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜

= = =
𝐵𝑉0 𝑟𝑒 − 𝑔 𝑟𝑒 − 𝑔 𝑟𝑒 − 𝑔

As we can derive from the formula: the ratio is specifically higher for firms with a low cost of capital, high ROE
and high payout rates.
The enterprise value multiple is conversely calculated as follows:

𝑒𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 − 𝑐𝑎𝑠ℎ 𝑉0 𝐹𝐶𝐹1 /𝐸𝐵𝐼𝑇𝐷𝐴1
= = =
𝐸𝐵𝐼𝐷𝑇𝐴 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡, 𝑇𝑎𝑥𝑒𝑠 𝑎𝑛𝑑 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐸𝐵𝐼𝑇𝐷𝐴1 𝑟𝑊𝐴𝐶𝐶 − 𝑔

This valuation multiple is higher for firms with low cost of capital, high FCF growth rates and low capital
requirements (so that FCF is high in proportion to EBITDA)

Example 1. Suppose Rocky Shoes and Boots (RCKY) has earnings per share of $2.30 and EBIDTA of $30.7
million. RCKY also has 5.4 million shares outstanding and debt of $125 million (net of cash). You believe Dockers
Outdoor Corporation is comparable to RCKY in terms of underlying business, but Dockers has no debt. If Dockers
has a P/E if 13.3 and enterprise value to EBITDA multiple of 7.4, estimate the value of RCKY’s shares using both
multiples. Which estimate is likely to be more accurate?

Using Decker’s P/E → 𝑷𝟎 = $𝟐. 𝟑𝟎 𝒙 𝟏𝟑. 𝟑 = $𝟑𝟎. 𝟓𝟗

Using EV/EBITDA → 𝑽𝟎 = $𝟑𝟎. 𝟕 𝒎𝒊𝒍𝒍𝒊𝒐𝒏 𝒙 𝟕. 𝟒 = $𝟐𝟐𝟕. 𝟐 𝒎𝒊𝒍𝒍𝒊𝒐𝒏 (enterprise value for RCKY). In order to
compute the value of the company:

$𝟐𝟐𝟕. 𝟐 𝒎𝒊𝒍𝒍𝒊𝒐𝒏 − 𝟏𝟐𝟓

= $𝟏𝟖. 𝟗𝟑
5.4 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

→ we notice that we have very different values of RCKY shares according to whether the used ratio is P/E or
EV/EBIDTA ratio, why?

The difference probably lies in difference in cost of equity which the two firms are likely to have. Being them in
the same industry, indeed, their unlevered cost of capital is likely to be very similar, since the latter depends on
systematic risk and is closely industry-related. Nonetheless, the two considered firms are very different in terms
𝑫
of capital structure which causes the cost of equity to be very different among them: 𝒓𝒆 = 𝒓𝑼 − (𝒓𝑼 − 𝒓𝑫 ),
𝑬
impliying that the cost of equity expresses a reward for the business risk the firm is facing, as well as, for the risk
caused by the capital structure of the firm (debt makes equity riskier, since when a firm is highly leveraged,
investors will be exceedingly worried about default risks and will consequently require an higher return on
equity). Being Decker’s unlevered (the firm has no debt), then the cost of equality will be simply given by the
unlevered cost of capital and will simply represent the firm’s compensation for business risk.

The example then witnesses that companies can actually have very similar business risk (faced by being in the
same industry and consequently reacting to shocks in a similar way) but very different capital structure and, as a
consequence, also very different cost of equity due to the additional risk related to debt which is added to the
company’s business risk in case of a leveraged capital structured.

2. Best Buy Co. Inc (BBY) has EBITDA of $2,766,000,000 and 410 million shares outstanding. Best Buy also has
$1,963,000,000 in debt and $509,000,000 in cash. If Best Buy has an enterprise value to EBITDA multiple of 7.7,
estimate the value for a share of Best Buy stock:

• compute the EV of BBY by using the multiple valuation : $2,766,000,000 * 7.7 = $ 212,982,000,000
• compute the FCF for the company : $ 21,298,200,000 + $509,000,000 - $1,963,000,000
• compute the share price : ($ 21,298,200,000 + $509,000,000 - $1,963,000,000)/ 410 million = $48.40

Final Example As an analyst, you are requested to value the automobile manufacturer Volkswagen AG using
multiples approach. To find comparable companies, you screen for industry and geography and find BMW,
Daimles and Renault to be its best-match comparables. You collect the following data from the firm’s financial
statements:

With respect to DCF method, relative valuation is much more

likely to reflect market perception and moods than DCF
valuation. This can be an advantage when it is important that
the price reflect these perceptions as in the case of an IPO. The
DCF method have the advantage that the can incorporate
specific information about the firm’s cost of capital or future
growth. The DCF also has the potential of being more accurate
than the use of valuation multiples.
SESSION 6 – CAPITAL BUDGETING

Capital budgeting describes the process used to analyse alternate investments and decide which ones to accept.
The role of the financial manager, indeed, is to basically make investment decisions (identify good projects which
the firm should take up) and financing decisions (how should those projects be implemented, with whose
money?)
The process of project valuation specifically consists of three steps:
• determine the free cashflow of the investment
• compute the weighted average cost of capital (including tax benefits over leverage)
• compute the value of the investment by discounting the free cashflow of the investment using the WACC
For now, the process is conducted by considering two underlying assumptions: the firm maintains constant debt-
to-equity ratio and project risks are the same as firm-risks.
When evaluating firm-specific projects, we use: 𝑭𝑪𝑭 = 𝑬𝑩𝑰𝑻 (𝟏 − 𝝉𝑪 ) + 𝑫𝒆𝒑 − 𝑪𝒂𝒑𝑬𝒙 − ∆𝑵𝑾𝑪 and discount
𝑭𝑪𝑭
the resulting cashflow using the WACC: 𝑃𝑉 = ∑𝑇𝑡=1 . Then, of course, we compare the PV to the project’s
(𝟏+𝒓𝑾𝑨𝑪𝑪 )
initial investment cost and implement the WACC decision rule: accept project if and only if PV > initial
investment cost. The firm’s free cashflow is equal to the sum of the free cashflows from the firm’s current and
future investments, so we can interpret the firm’s enterprise value as the total NVP that the firm will earn from
continuing its existing projects and initiating new ones. The NVP of any individual project represents its
contribution to the firm’s enterprise value and to maximize the firm’s share price, the firm should accept only
those projects which have a positive NVP.

In order to determine FCF:

• only compare cashflows of the same risk at the same time (you can’t compare cash today with cash
tomorrow)
• no financing effects: decide where to invest firms, than worry about how to pay for it
• incremental analysis: only include a cashflow if it directly depends on whether you take the project or
not (do not consider sunk costs which do not directly relate to the project itself and its generated
cashflows)
• remember side-effects (project externalities): some projects already in place within the company might
be affected by the decision to take up a new project (internal cannibalization). This must be taken into
account;
• taxes matter: if you avoid paying $1 in tax, then this represents and additional $ for your own investors.

The expected return of each project is the weighted average of the expected return on debt 𝒓𝑫 and equity 𝒓𝑬
(weighted average cost of capital – WACC). Of course, tax deductibility should also be considered in WACC:

𝐸 𝐷 𝐷 𝐸 𝐷
𝑟𝑊𝐴𝐶𝐶 = 𝑟𝐸 + 𝑟𝐷 − 𝑟𝐷 𝜏𝐶 = 𝑟𝐸 + 𝑟 (1 − 𝜏𝐶 )
𝐸+𝐷 𝐸+𝐷 𝐸+𝐷 𝐸+𝐷 𝐸+𝐷 𝐷
reduction due to
the tax-shield
𝑟𝑈 is the expected return required by the firm’s investors to hold the firm’s underlying assets (it basically is the
reward investors require to face and be compensated for the business risk of the company). WACC is, instead,
𝐷
the actual cost of capital of the firm and might be written as: 𝑟𝑊𝐴𝐶𝐶 = 𝑟𝑈 − 𝑟 𝜏 . As one can derive from the
𝐸+𝐷 𝐷 𝐶
formula, because interest expenses are tax deductible, : 𝑟𝑊𝐴𝐶𝐶 < 𝑟𝑈 .
WACC can, nonetheless, only be used to evaluate a project with the same risk and same financing as the firm
itself.
To calculate and estimate the WACC, three steps are necessary:
• determine the sources of capital the company utilizes from the balance sheet:
 • determine the cost of each component of capital based on current conditions. The historical cost of
raising fund is, nonetheless, irrelevant. Therefrom it follows that, the cost of debt 𝒓𝑫 is given by a pool of
sources:
- if the firm has bonds, then we can take the YTM on long-term bonds. A drawback is, nonetheless,
represented by the fact that, if the company and the bond is risky, then YTM overstates the cost
of debt;
- if the firm is rated, then adding the default-spread to the risk-free rate is necessary:
𝑟𝐷 = 𝑌𝑇𝑀 − 𝑃𝑟𝑜𝑏(𝑑𝑒𝑓𝑎𝑢𝑙𝑡) ∗ 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑠 𝑟𝑎𝑡𝑒;
- if those information are not available, assume as cost of debt the interest rate from recent long-
term bank loans of the firm
The cost of equity, instead, is given by 𝒓𝑬 and is usually computed by implementing the CAPM formula
• weight each component to determine the weighted average cost of capital and, to do this, we need the
value of each source of funds and total value of the project. Weights, indeed, are proportion that each
source of funds represents of total sources used to finance the projects. The current capital structure can
be used, but if expected to change, it is better to use the company’s target capital structure. Weights
should be calculated using the current market values rather than the book values and they should reflect
the amount investors can realize from selling their own investment.

Example Consider the example of FFM Industries Limited (FIL).

• debt capital of FIL comprises commercial bills, bonds and a bank overdraft with the following
characteristics:

• equity capital of FIL comprises preference and ordinary shares:

The company’s payable tax rate is given by: 𝜏𝐶 = 0.12

Using the equation for the WACC and letting V = E+ D, we have:

𝐷 𝐸 37.411 54.000
𝑟𝑊𝐴𝐶𝐶 = 𝑟𝐷 ( 1 − 𝜏𝐶 ) + 𝑟𝐸 = 0.0775 (1 − 0.12) ( ) + 0.1158 ( ) = 0.096319(9.63%)
𝑉 𝑉 37.411+54.000 37.411+54.000

Project WACC vs. firm WACC Using the company’s WACC for new projects assumes that: 1) the risk of the new
project is equivalent to the risk of existing projects; 2) new projects will not cause the company’s optimal or
target capital structure to change. If the company operates in more than one industry, and industries differ in
risk, a single company’s WACC will not be appropriate for project evaluation and might lead to incorrect
investment decisions.

Example Specific project (or division) may have different market risk than the average project of the firm. In
addition, different projects may vary in the amount of leverage they will support. Let’s suppose AVCO launches a
new plastic manufacturing division that faces different market risks than its main packaging business.
Assume two other firms are comparable to the new plastic division and have the following characteristics:
The unlevered cost of capital for each competitor can be estimated by calculating their pre-tax WACC, where:

Competitor 1: 𝑟𝑈 = 0.4 ∗ 0.6 + 0.6 ∗ 0.12 = 9.6%

Competitor 2: 𝑟𝑈 = 0.25 ∗ 0.55 + 0.75 ∗ 0.107 = 9.4%

In order to estimate a correct cost of capital for the new plastic division we take the average of the cost of capital
of these competitors: 𝑟𝑈 = 9.5% → based in these comparable firms, estimated unlevered cost of capital for
plastics division is 9.5%.

Avco expects the plastic division to be able to maintain an equal mix of debt and equity financing to optimize its
tax savings (hence, D=E). It also expects its borrowing cost to be 6% and corporate tax to be 40%.
Given the unlevered cost of capital of 9.5%, the plastics division’s WACC can now be estimated to be:

𝑟𝑊𝐴𝐶𝐶 = 9.5% − 0.50 ∗ 0.40 ∗ 0.6 = 8.3%

NVP of project depends on FCF and WACC estimates, both of which are base-case estimates. Your job as a
manager is to understand what makes a project tick and you should therefore check for the sensitivity of
project’s NVP to errors in both FCF and WACC estimates.
1) FCF check: sensitivity analysis: your financial advisor recommends to you a unique investment
opportunity. It is a three-year project with initial cash outlay of $40,000 and WACC of 10% per annum.
The following project estimates have been provided to you:

(70 − 60) ∗ 2,000 20,000 20,000

𝑁𝑉𝑃 = + + − 40,000 = $9,737
1.10 1.102 1.103

How sensitive is the NVP to changes in estimates? You need to compute the NVP for pessimistic and
optimistic scenario of each single variable (you compute it by changing each single variable at a time and
inserting it for the values of both the optimistic and pessimistic case scenario):

we see that with respect to the variable

cost and sales volume, the decision to
undertake the project is robust. Even in
the worst case scenario, indeed, the NVP
results in being positive and not so
sensitive to changes in the variables.
Conversely, the decision-making
process is far more critical with respect
to the selling price variable, since the
NVP appears to be very sensitive and
even to turn negative in the worst-case
BENEFITS: the sensitivity analysis indicates where additional scenario → you need to gather more
information is useful and what areas to focus on when the project reliable information with respect to this
begins given variable
DISADVANTAGES: it is difficult to determine what does optimistic
and pessimistic mean and underlying variables are highly likely to
be correlated with each other

2) FCF check: break-even analysis: the sensitivity analysis focuses on how serious it would be for the
company if sales or costs turn out to be worse than forecasted. Conversely, break-even analysis analyses
how bad things can become before the projects decreases the company’s wealth. Break -even analysis
 involves the analysis of the conditions under which the NVP of a project is reduced to zero (you basically
set the NVP to zero and try to find the value that for each critical variable will reduce the NVP to zero)

(𝑆𝑃 − 60) ∗ 2,000 (𝑆𝑃 − 60)20,000 (𝑆𝑃 − 60)20,000

𝑁𝑉𝑃 = + + − 40,000 = 0 → 𝑆𝑃 = $68.04
1.10 1.102 1.103

By conducting this analysis, we discovered that the price of a unit can go down to $68.04 before the
project reaches a zero NVP: this implies that when the selling price is reduced by 2.8% with respect to
the projected value of $70, the project is no longer worth taking.

ADVANTAGE: instead of having pessimistic and optimistic values and assuming probabilities, the break-
even analysis simply looks at the causes for zero NVP’s
DISADVANTAGE: similar to the sensitivity analysis, break-even analysis assumes that only one variable
changes at a time.

3) WACC check: NVP profile and IRR: consider a take-it-or-leave-it investment decision involving a single,
stand-alone project for FFF. The project costs $250 million and is expected to generate cashflows of
$5million per year, starting at the end of the first year and lasting forever. The NVP of the project is
𝟑𝟓
calculated as: 𝑁𝑉𝑃 = −250 + where the NVP of the project clearly depends on the chosen and
𝒓
estimated discount rate. If the company’s WACC was 10%, then the NVP is $100 million and they should
undertake the investment, but what if the discount rate was set to be lower?

INTERNAL RATE OF RETURN (IRR) is the

discount rate that makes the present value of the
future cashflows of a project equal to its initial
cost.
For a stream of cash flows (positive or negative),
the IRR it that discount rate for which the sum of
all the cashflows brough to be expressed in
present-value terms is equal to zero.
IRR rule: take any investment for which the IRR
exceeds the cost of capital and turn down those
projects for which the cost of capital is larger than
the IRR. This rule, nonetheless, works only for
stand – alone projects whose negative cashflows
precede its positive cashflows → indeed, if the
cashflows happened to switch sing more than
once, then we will have more than one solution for
Sometimes, alternative investment rules may give the same IRRanswer as NVP rule, but at other times they
might also disagree. When the rules conflict, NVP decision rule should be followed.
IRR might also have other problems, since there might exist multiple IRR for a single project or it might
even not exist → the IRR rule should, therefore, be safely used only if all the project’s negative cashflows
precede its positive cashflows.

Choosing between projects Two projects are independent if acceptance or rejection of one has no effect on
acceptability of the other. In the presence of multiple independent projects, the firm should accept all projects
with positive NVP and reject all projects with negative NVP.
Conversely, two projects are defined as mutually exclusive if acceptance of one project precludes acceptance of
the other. When projects are mutually exclusive, pick the project with the higher NVP and invest in the project if
NVP is positive. The IRR rule can be used to rank profitability of two mutually exclusive projects only if all these
conditions are met:
• Projects have the same scale of investment
• Projects have the same timing of their cashflows
• Projects have the same risk
If any of these conditions is violated, using IRR to rank projects can lead to mistakes and it is safer to use the NVP
rule.
Sometimes it is also the case that companies should choose among projects underlying a specific budget or
resource constraint.
Example 1. Consider three possible projects with a $100 million budget constraint.

In such a case, it is optimal for the company to compute each project’s profitability index, which reveals the more
profitable combination of projects to undertake. The index can be computed as follows:

𝑣𝑎𝑙𝑢𝑒 𝑐𝑟𝑒𝑎𝑡𝑒𝑑 𝑁𝑉𝑃

𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝐼𝑛𝑑𝑒𝑥 = =
𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒 𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑑 𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒 𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑑

From the table, we are told that we should select project II and III.
2. Your division at NetIt, a large networking company, has put together a project proposal to develop a new
home networking router. The expected NVP of the project is $17.7 million and the project will require 50
software engineers. NetIt has a total of 190 engineers available and the router project must compete with a
series of other proposals for these engineers.

The goal is to maximize the total NVP we can create with 190 engineers at most; therefore, we compute the
profitability index for each project, using Engineering Headcount in the denominator (in this case, engineers
represent the needed resources), and then sort projects based on the index:

We now assign the resource to the project in descending order according to the profitability index (we prioritize
the assignment of resources to the more profitable projects). The final column shows the cumulative use of the
resource as each project is taken on until the resource is used up.
To maximize NVP within the constraint of 190 engineers, NetIt should choose the first four projects on the list.
There is no other combination of projects that will create more value without using more engineers than we
have. Note, however, that the resource constraint forces NetIt to forego three otherwise valuable projects with a
total NVP pf $33.6 million.
In some situations the profitability index does not give an accurate answer: indeed, suppose that NetIt has an
additional small project with an NVP of $120,000 that requires three engineers. The profitability index in this
case is 0.12/3 = 0,04, so this project would appear at the bottom of the ranking. Nonetheless, in such a situation
as the one we depicted above, 3 out of the 190 employees are not being used after the first four projects are
selected. As a result, it would make sense to take on this project even through it would be ranked last.

With multiple resource constraints the profitability index can break down completely.