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298 Final Equations

Stock Value Po = D1 + D2 + (D3+D4/(r-g)) (1+r) (1+r)2 (1+r)3
Po  price today D1  future dividend D4+  constant growth dividend r  period interest rate g  growth rate

Price Earnings Ratio P/E = Price EPS
EPS = earnings per share Low P/E = low future growth High P/E = high future growth

Systematic Risk β = σam σm2

If >1, sensitive to market fluctuations. β = systematic risk σam = covariance σm2 = variance

Rate of Return r = D1 + [E(P1) - P0] P0

Expected Return E(X) = Σ[x*Pr(x)]
Σ = sum of x = possible return Pr(x) = chance of that return

Security Market Line E(rp) = rf + β [E(rm) - rf]

r  rate of return Po  price today D1  any dividends received E(P1) – P0  change in price

Realized Rate of Return(ROR) FV = PV(1+ROR)n
FV  future value PV  present value ROR  realized rate n number of periods

Functions of Variables f = a*X E(f) = a*E(x) σf2 = a2*σx2 σf = a*σx Variance σx2 = E(X2)-E(X)2 = E(X-Xexp)2 = Σ(x-xexp)Pr(x)
σx2 = variance Xexp = expected value of X Pr(X) = probability of X

Expected return according to market activity. Use CML to find best weight of portfolio mixed with market for higher return & lower σ.

r α 1 “higher = buyer” P
If r < E(r) compared with β, overpriced, sell. If r > E(r), underpriced, buy.

Net Present Value
NPV = initial cost + PV of future cash flows If >0, accept. If <0 reject. If near 0, justify.

Capital Market Line Equation CML = σp(rm-rf) + rf σm E(rp) = wmE(rm) + (1-wm)rf
σp = wmσm (because σf = 0) σp2 = wm2σm2 If σp>m, borrow at rf. If σp<m, lend at rf.

Internal Rate of Return
0 = C0 + C1 + C2 +… (1+IRR) (1+IRR)2 C = future cash flow IRR = internal rate of return r = cost of capital Rate that creates an NPV = 0. If IRR>r, accept. Easy to understand. Beware non-conventional cash flows.

Covariance σxy = E(X*Y) – E(X)E(Y) = E[(X-Xexp)(Y-Yexp)] = Σ(x-xexp)(y-yexp)Pr(x|y)
σxy = covariance Xexp = expected value of X Σ = sum of Pr(x|y) = probability of x and y

WACC =

(D/V)rd + (Ep/V)rp + (Ec/V)rc

Profitability Index
PV of future revenues PV of future costs If >1.00, accept. Good for capital rationing with limited cash.

Correlation ρxy = σxy σxσy

ρxy = correlation σxy = covariance σx = standard deviation

V = total value of firm D = total debt rd = cost of debt = yield to maturity Ep = total preferred shares rp = required preferred return Ec = total common shares rc = required share return (find with stock price & dividends) Apply WACC to new projects

Payback Method
# years until initial costs are covered *if recovered part-way through year, use fraction of that year’s total revenue If > cutoff (set internally), than accept. Easy to understand. Ignores time value of money. Ignores future cash flows.

Portfolio Variance σp2 = wx2σx2 + wy2σy2 + 2wxwyσxy
wx = weight of X σx2 = variance of X σxy = covariance