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PRINCIPLES of
Finance with Excel®
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PRINCIPLES of
®
Finance with Excel
SECOND EDITION

Simon Benninga

New York Oxford

OXFORD UNIVERSITY PRESS
2011
Oxford University Press, Inc., publishes works that further Oxford University’s
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All references to Excel in this text are understood to be “Microsoft® Excel®,” a trademark of
the Microsoft Corporation. The Microsoft Corporation is in no way affiliated with or endorses
this publication. The publisher and author have made every effort to make this book as complete and
accurate as possible, but no warranty or fitness is implied. The information herein is provided on an
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Library of Congress Cataloging-in-Publication Data

Benninga, Simon.
Principles of Finance with Excel / Simon Benninga.—2nd ed.
p. cm.
ISBN 978-0-19-975547-9 (acid-free paper)
1. Finance—Data processing. 2. Microsoft Excel (Computer file)
3. Capital assets pricing model. I. Title.
HG173.B463 2011
332.0285′554—dc22 2010009514

Printing number: 9 8 7 6 5 4 3 2 1

Printed in the United States of America

on acid-free paper
I dedicate this book to the
memory of my parents
Helen Benninga
(1913–2008)
and
Noach Benninga
(1909–1993)
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CONTENTS

Preface ix

Part One
CAPITAL BUDGETING AND VALUATION

Chapter 1 Introduction to Finance 3

Chapter 2 The Time Value of Money 16
Chapter 3 What Does It Cost? IRR and the Time Value of Money 68
Chapter 4 Introduction to Capital Budgeting 104
Chapter 5 Issues in Capital Budgeting 140
Chapter 6 Choosing a Discount Rate 184
Chapter 7 Using Financial Planning Models for Valuation 214

Part Two
PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Chapter 8 What Is Risk? 257

Chapter 9 Statistics for Portfolios 279
Chapter 10 Portfolio Returns and the Efficient Frontier 313
Chapter 11 The Capital Asset Pricing Model and the
Security Market Line 344
Chapter 12 Using the Security Market Line to Measure Investment Performance 373
Chapter 13 The Security Market Line and the Cost of Capital 394

Part Three
VALUING SECURITIES

Chapter 14 Efficient Markets—Some General Principles of Security Valuation 423

Chapter 15 Bond Valuation 449
Chapter 16 Valuing Stocks 482

Part Four
CAPITAL STRUCTURE AND DIVIDEND POLICY

Chapter 17 Capital Structure and the Value of the Firm 511

Chapter 18 The Evidence on Capital Structure 556
Chapter 19 Dividend Policy 567

vii
viii CONTENTS

Part Five
OPTIONS AND OPTION VALUATION

Chapter 20 Introduction to Options 589

Chapter 21 Option Pricing Facts 623
Chapter 22 Option Pricing—The Black-Scholes Formula 640
Chapter 23 The Binomial Option-Pricing Model 662

Part Six
BACKGROUND TO EXCEL

Chapter 24 Introduction to Excel 683

Chapter 25 Graphs and Charts in Excel 708
Chapter 26 Excel Functions 725
Chapter 27 Data Tables 755
Chapter 28 Using Goal Seek and Solver 766
Chapter 29 Working with Dates in Excel 776
Index 789
Preface

Finance is the study of financial decision making. Individuals and companies make
financial decisions every day, and it’s important to make them wisely. Principles of Finance
with Excel (PFE) will teach you how to make these decisions—both the theory and the imple-
mentation of wise financial decision making—and how to express your decisions using Excel.
Learning to do finance with Excel serves two purposes: It teaches you an important academic
and practical subject (finance), and it teaches you how to implement financial analysis using the
most important tool (in most cases, the only tool) for financial analysis (Excel). Your knowl-
edge of both finance and Excel will be enhanced by carefully working through the examples
and exercises in each chapter.
Finance is a very practical discipline. Most readers of this book will study finance not only
to increase their understanding of the valuation process, but also to get answers to practical prob-
lems. You will find that the extensive computation required in this book will not only enable you
to get numerical answers to important problems (although that alone would justify the Excel-
centered focus of this book)—but also deepen your understanding of the concepts involved.

Changes from the First Edition

Thanks to feedback solicited from the first-edition adopters, colleagues, and students, the sec-
ond edition of Principles of Finance with Excel incorporates a number of important changes:
• The structure of the book has been streamlined so that the reader goes straight into the
heart of finance—time value of money and discounting. Based on reviewer comments,
Chapters 1, 2, and 3 from the first edition have been removed, with the most important
material integrated in other places in the text where necessary.
• Nearly every example in every chapter—a centerpiece of the text—has been updated.
Most now refer to the post-2008-crash financial world.
• Every chapter and spreadsheet has been thoroughly reviewed for accuracy. Every page of
text has been revisited and, where appropriate, refined for clarity and conciseness.
• The second edition now uses Excel 2007 throughout the book.1 The disk that comes with
PFE includes chapter and exercise files for the whole book, so that it can easily be used for
self-teaching. As in the first edition, we include an Excel “primer” at the end of the book.
Note that all the examples and spreadsheets can be used with previous versions of Excel.

Prerequisites—What Excel Background Is Required for

Principles of Finance with Excel?
This book will teach you—alongside finance—all of the Excel concepts needed for finance.
However, you should not expect the book to be a complete Excel text. I expect that, before you

1
If you are using an earlier version of Excel, download a free compatibility pack by typing “Office 2007
compatibility pack” into the search box at http://www.microsoft.com. The Excel files are fully compatible
with Excel 2010.

ix
x Preface
start your finance course, you will know how to do the following in Excel (just in case, many
of these topics are covered in Chapter 24):
• Open and save an Excel workbook.
• Use basic Excel functions, for example: Sum( ) . . . .
• Format numbers: Here’s an example of something that is usually not explained in the text.

C D E F G
6 ($6,144.57) <-- =PV(10%,10,1000)
7
8
9 -6,144.57 <-- In many cases I prefer this format

• Use absolute and relative values in copying and formulas.

• Graphing—building the basic Excel charts. The favorite chart format for PFE is Excel’s
XY graph. You should know how to do the basics of graphing in Excel: label axes, add
chart titles, and format axes.

Somewhat More Advanced Excel Concepts

Chapters 25–29 cover a grab bag of other Excel concepts used in PFE. You can refer to these
chapters as you need them:
• Charts in Excel: More advanced charting techniques are explained in Chapter 25.
• Excel functions: Most of the Excel functions required for this book are explained the
first time they occur. Chapter 26 is a compendium of these explanations and may be use-
ful for reference.
• Data tables: “Data table” is Excel jargon for “sensitivity table.” The data table technique
is a little tricky, but it is well worth learning (for some reason, data tables are often not
covered in introductory Excel courses). Although the early chapters of PFE avoid the use
of data tables, their use is required in later chapters of the book. Chapter 27 will teach
you how to use data tables.
• Goal Seek and Solver: Excel’s optimization tools are discussed in Chapter 28.
• Dates in Excel: Many finance computations require the use of dates. This topic is cov-
ered in Chapter 29.

PFE’s CD-ROM
Each chapter is accompanied by two spreadsheets, which are on the enclosed CD-ROM. One
spreadsheet, typically called PFE2, chapter01.xlsm or PFE2, chapter15.xlsm, presents all
the examples covered in Chapter 1 or Chapter 15. A second spreadsheet, called something like
PFE2, exercise15.xlsm, gives the answers to the end-of-chapter exercises.2
When you open a PFE spreadsheet, you will see the following message informing you
that there is a macro attached to the spreadsheet.

2
Instructors can contact the author for a separate set of exercises to use in classes or exams. PowerPoints
for most chapters are also available.
 Preface xi

This message refers to a little program (in Excel jargon, a “macro”) that dynamically updates
cell references, so output like the following will automatically retain the correct cell references
even if you move things around or add rows.
A B C D
1 CALCULATING PRESENT VALUES WITH EXCEL
2
3 X, future payment 100
4 n, time of future payment 3
5 r, interest rate 6%
n
6 Present value, X/(1+r) 83.96 <-- =B3/(1+B5)^B4
7
8 Proof
9 Payment today 83.96
10 Future value in n years 100 <-- =B9*(1+B5)^B4

Clicking the Options . . . button gives you another box, in which you can safely click Enable
this content.

You can safely enable this macro.3

3
There is a document (GetFormula.doc) on the CD-ROM showing you how to put this macro into any
spreadsheet you will want to create.
xii Preface
A Final Word
Writing Principles of Finance with Excel was a lot of fun! I hope you enjoy the book. If you
have comments or suggestions, feel free to contact me.

Simon Benninga
[email protected]

Acknowledgments
During the years of writing Principles of Finance with Excel, I’ve gotten many wonder-
ful comments from readers of the many versions of the Web draft of the book. University
instructors, financial professionals, and students have all chipped in to make PFE a better
book. Students at a number of colleges and universities have been unwitting guinea pigs for
the materials: The Wharton School of the University of Pennsylvania, Tel Aviv University,
Gonzaga University, Otago University, Rutgers University, Rider University, Tulane University,
University of Amsterdam, University of Groningen.
I’ve tried to carefully note all the readers who’ve been helpful in the editorial/writing pro-
cess (if I’ve forgotten someone, there’s always the next printing of the book . . . ):
Second edition: Meni Aboudy, Olaf Alex, Andrei Belogolov, Kenrick Chatman, Yaron
Chechick, Sushil Dudani, Michael Ezewoko, Eugene Floyd, Yilmaz Guney, Loo Choo
Hong, Patrick Johnson, Michael Kesner, Susan Kleinmann, Ken Kotansky, Mingsheng Li,
Juan Mendoza, Andrew Naporano, Michelle O’Neill, Joseph Pagliari Jr., Warren Palmer,
Art Prunier, Csoma Róbert, Gerald Strever, Ilya Talman, Bin Xi, Mike Zylstra. I owe spe-
cial thanks to Sergey Popov and Eran Vodevoz, who read and commented on the revised
manuscript.
First edition: Meni Aboudy, Ilan Adam, Gil Aharony, Mazin A. M. Al Janabi, Thomas
C. Altman, Clifford S. Ang, Tom Arnold, Chana Arnon, Naftali Arnon, Almaz Asylbek,
Dan Atzmon, Erik Austin, Daniel Bachner, Robert Balik, Keshav Baljee, Naomi Belfer,
Helen Benninga, Ricardo Botero, Reider Bratvold, Lucas Brown, Yoshua Carhuamaca,
P. J. Carroll, Lydia Cassorla, Elizabeth Caulk, David Centeno, Le Chang, Peter Chepets,
Nikolai Chuvakhin, Marcus Cole, Robin Desman, Daniel Diamant, Ian Dickson, Bjarne
Eggesbo, Patricia A. Ellenburg, Etune Emelieze, Jon Fantell, Yiktat Fung, Brian Fusco,
Denis Gaiovy, Terry Garden, Glenn Gaston, Fan Ge, Gary Glassie, Kobi Glazer, Randy
Gordon, Kenji Goto, Michael Grant, Jonathan Gray, Pallav Gupta, George Guzzi, Kim
Hale, Mark Helmantel, Raoul Hermens, Charlyn Ho, Reginald Holden, James W. B. Hole,
Cesar Hurtado, Mafaz Ishaq, Ryan Scott Jackson, Youngsoo Kim, Itzik Kleschelski, Pierre
Kohn, Timo Korkeamaki, Krushna Kumaar, Jeff S. Lee, Rowan Legg, Ross Leimberg,
Björn Leonardz, Shai Leshkowitz, Daniel Leung, Hui Li, Shulin Liu, Paul Malherbe,
Ariela Markel, Carlos Martinez, William Matthaei, Walter McGuire, Steve Medwin,
Michael Miles, Kirill Mokh, Tal Mofkadi, Igor Morais, Eran Mordechai, Sviatoslav
Moskalev, Joshua Nabatian, Bharat Pardasani, Dror Parnes, Jayesh Patel, Langston Payne,
David Piccardi, Yong-Xuan Qiu, Justin Rapp, Ravinder Rayu, Roberto Rivalta, Jamie
Adler Rodriguez, Bas Röling, Yashwant Sankpal, Roderik Schlösser, Jason Scott, Hanan
Shahaf, Yaffa Shalit, Benny Sharvit, Teslim K. Shitta-Bey, Dmitry Shklovsky, Wayne
Smith, José Arnaldo Ribeiro Soares, Nagaratnam Sreedharan, Yossi Steinblatt, Nathaniel
 Preface xiii
V. Stevens, Lisa Sun, Maurry Tamarkin, Zoltan Till, Masahiro Tokoro, Efrat Tolkowsky, Jake Vachal,
Rafael Paschoarelli Veiga, Shally Venugopal, Torben Voetmann, Simon Wang, Michael Wassermann,
James L. Williams, Jared Work, Mark Yoffe, Jumana Zahalka, Aziza Zakhidova, Fan Zhang.
Finally, my thanks go to Marianne Paul, Patrick Lynch, Adam Tyrrell, and Terry Vaughn, my wonder-
ful editors at the Oxford University Press.
This page intentionally left blank
 PA R T

1
CAPITAL BUDGETING
AND VALUATION

C hapter 1 of PRINCIPLES OF FINANCE WITH EXCEL is an introductory chapter that discusses the
aims of this book: What is finance all about? What is the relation of risk to financial decision
making? Why Excel as the computational engine of a finance book?
Chapters 2 – 7 of Principles of Finance with Excel contain the core of most introductory of
finance courses. These chapters are wholly self-contained. They teach:
• Time value of money—net present value (NPV), internal rate of return (IRR)
• Pricing using IRR—real-world examples
• Capital budgeting
• Determining the discount rate
• Using the weighted average cost of capital (WACC)
• Financial planning models and valuation

Details and Outline

Chapter 2 addresses the basics of time value of money. We introduce the concepts of present
and future value, net present value (NPV), and internal rate of return (IRR). Excel has functions
that make all of these calculations easier to do, and Chapter 5 both illustrates the concepts and
shows you how to use the relevant Excel functions.
Chapter 3 is entitled “What Does It Cost?” This chapter stresses the uses of discounting and
present value in making effective financial decisions. The examples are taken primarily from
consumer math, and cover credit cards, mortgages, and auto leasing. Along the way we also dis-
cuss multiple IRRs and continuous compounding—all motivated by simple examples.
“Capital budgeting” is finance jargon for whether to spend money on a specific project.
Chapter 4 covers basic capital budgeting calculations. This chapter deals with the classic ques-
tions: making decisions using IRR versus NPV, choosing between projects with different life
spans, mid-year versus end-year discounting, sunk costs, and reinvestment rates.
2 PART ONE CAPITAL BUDGETING AND VALUATION

Chapter 5 discusses more advanced issues in capital budgeting. This chapter discusses sev-
eral problems with using IRR as a decision criterion. It also shows you how to choose between
projects with different lifetimes and how to discount cash flows that don’t occur at year end (we
call this “mid-year discounting”). Chapter 5 shows you how to incorporate taxes and inflation
into the capital budgeting process.
A critical factor in time-value-of-money computations is the choice of the discount rate.
Chapter 6 discusses how to compute a discount rate appropriate to both risk and tax consider-
ations. This chapter will show you how to use the weighted average discount rate to calculate
the value of a project.
Chapter 7 shows how to construct a financial planning model and how to use this model to
value a firm. This is a topic that integrates much of the material in Chapters 2 – 6: A financial
planning model combines both accounting and finance concepts to arrive at the valuation of the
firm and its shares. This highly useful tool is the core of most business plans and valuations.
CHAP TER

1 Introduction to Finance

CHAPTER CONTENTS
1.1. What Is Finance? 3
1.2. Microsoft Excel: Why This Book and Not Another? 6
1.3. Eight Principles of Finance 9
1.4. An Excel Note—Building Good Financial Models 11
1.5. A Note about Excel Versions 14
1.6. Adding “Getformula” to Your Spreadsheet 14
Summary 15

1.1. What Is Finance?

Finance is the study of financial decision making. Individuals and companies make finan-
cial decisions every day, and it’s important to make them wisely. Principles of Finance
with Excel discusses how to make these decisions. The book covers the theory and the
implementation of wise financial decision making and how to express your decisions using
Excel.
Learning to do finance with Excel serves two purposes: It teaches you an important aca-
demic and practical subject (finance), and it teaches you how to implement financial analysis
using the most important tool (in most cases, the only tool) for financial analysis (Excel).

3
4 PART ONE CAPITAL BUDGETING AND VALUATION

Individual Financial Decision Making

People are constantly called on to make financial decisions in their personal lives. Here are
examples of decisions we will examine in this book:
• How much should you save to attain a specific goal in the future? For example, you’re
starting a savings plan today to save for your college education. How much should you
put away each month for you to have the money to pay for your education?
• You’re thinking about buying a house and renting it out for the income. How should you
evaluate this decision?
• You have some money saved from working, and you’d like to invest it. How should
you choose your financial portfolio? Investors big and small have to decide whether to
invest in stocks, bonds, or other assets such as real estate, art, and gold. They also have
to decide how to choose the investment proportions: What percentage of your financial
portfolio should you invest in stocks (and what percentage in which stocks), what per-
centage in bonds, real estate, and so on?
• How should you finance a purchase, a project, or some other undertaking? Here are some
examples: You’re about to buy a new car. Should you borrow the money from the bank
or should you accept the car dealer’s “zero interest loan” alternative? That piece of real
estate you’re buying—should you finance it with a mortgage? If so, how large should the
mortgage be?
• What is financial risk and how can it be measured? Financial risk can be measured using
statistical tools. This book will show you which tools you need and how to apply them.
When you’re comfortable applying these tools, you will be better able to compare the
riskiness of two assets or two investments. Comparing risks is critical to making optimal
financial decisions.
• What is the fair value for stocks and bonds and other financial assets? This book will
show you how to compute the value of stocks and bonds. It will also discuss the role of
financial markets in incorporating available financial information into prices. If financial
markets do this well, you may not need to determine these values yourself: You can let
the financial markets tell you what the value should be.
• How can you value options? Options are securities that give you the right to buy a stock
in the future. If you work in a corporate environment, your employers are likely, at some
point, to offer you some options on the company’s stock instead of a regular salary. If
you’re trying to regulate the risk of your financial portfolio, your investment advisor may
try to sell you some options. In this book you’ll learn what an option is, how to use it to
regulate financial risk, and how to value it.
As these examples show, the study of finance can benefit you in many areas of your per-
sonal life by enabling you to make better financial decisions.

Financial Decisions in a Business Environment

You only have to turn on the TV, log onto the Internet, or read a newspaper to hear about the
financial decisions made every day by businesses. Some of these financial decisions are huge
and dramatic, like Kraft’s $16.7 billion bid to buy Cadbury; some are smaller but nonetheless
very important for the company, like Courier Corporation’s purchase of a new press for $12
million (Figure 1.1).
 FIGURE 1.1 Two financial decisions. Finance provides the tools to value Kraft’s offer for Cadbury and to decide whether Courier’s purchase of a new press
is worthwhile.

5
6 PART ONE CAPITAL BUDGETING AND VALUATION

Dramatic business decisions like mergers and acquisitions make the news, but “run-of-
the-mill” business decisions that are critical to the financial health of the firm are made by all
businesses, big or small. Here are some typical decisions businesses make:
• A company wants to replace its current production line with a line of new, improved
machines. The new machines cost more but are more efficient. Should the company buy
the new machines or leave the old ones in place?
• A firm needs to acquire a particular kind of machine. Should it buy a cheap machine with
a relatively short life or an expensive machine with a longer lifespan?
• When a company wants to develop and produce a new product, how can it integrate the
marketing forecasts for the new product with the financial requirements of the develop-
ment and production processes? How can the company deal with the fact that the biggest
costs of development and production will be incurred before any revenues have been
realized from the sale of the product?
• How should the financial officers of a corporation plan for a new or existing business?
A financial planning model can provide a systematic approach to making many of the
financial decisions in a new or existing business. Perhaps you’re thinking of setting up a
laundromat on the corner of Main and Pine Streets. Perhaps you’re starting a real estate
business. Or perhaps you’re trying to finance a new high-tech idea. In each case your
ability to get financing from financial institutions—whether banks or venture capital
funds or your Uncle Joe—will depend on your ability to make a financial model for the
new business. This financial model will show your thoughts about how the business will
develop, how much equipment you’ll need to purchase, and how you will finance sales.
Most important, the financial model will project future earnings from the business.
• All companies must decide how to finance their activities. This is true for multinational
conglomerates, mom-and-pop convenience stores, and the new taxi company you’re
about to start with your cousin Sarah. In all cases someone has to decide whether to
borrow the money from others or use shareholder funds (equity, in the terminology of
finance) to finance the company.

Wealth Maximization and Risk

This book is primarily about making sensible financial decisions. Sometimes a sensible finan-
cial decision is also an optimal financial decision. Optimal financial decisions make you better
off than all the other relevant alternatives, including doing nothing at all. Economists call this
property of optimal financial decisions wealth maximization. Not every case of money manage-
ment boils down to making a wealth-maximizing decision; sometimes we will be able to only
point to a sensible set of financial alternatives from which you can choose a final decision.
Making sensible or wealth-maximizing financial decisions always involves two elements.
• Defining the parameters of the decision: Financial decisions can always be defined
in terms of numbers. The outcomes of a financial decision almost always depend on the
decision parameters, the inputs that define the results of the financial decision.
Here’s an example: You’ve been given $100 for your birthday, and you decide to save it
toward your summer vacation next year. You have two choices: You can leave the money in your
checking account or you can put the money in a savings account. The two parameters of this
decision are the amount you’re saving ($100) and the interest paid on the account—the checking
account pays 1% interest, whereas the savings account pays 4% interest. The financial outcomes
 CHAPTER 1 Introduction to Finance 7

are that one year from now, you will have $101 if you leave the money in your checking account
and $104 if you put the money in a savings account. This decision is, of course, a no-brainer:
You always prefer earning 4% to earning 1% on your money.1
This book will help you distinguish between the parameters of financial decisions and the
outcomes of financial decisions.
• Recognizing the risks of financial decisions: Financial decisions should be made within
a framework that takes into account the risks associated with them.
Let’s go back to the $100 you intend to save for your summer vacation. In addition to the
two alternatives (1% on your checking account and 4% on your savings account), your Uncle Joe
suggests that you might want to buy shares in his new hot dog stand. Investors in Joe’s previous
hot dog stands have earned as much as 40% on their investment.
If you put your money in Uncle Joe’s hot dog stand, you might have $140 at the end of the
year, instead of $104, but if the hot dog stand does poorly, you could lose your $100 investment
and end up with nothing. Uncle Joe’s hot dog stand is much more risky than a bank account—
although some investors have made as much as 40%, others have lost all their money with Joe.
Comparing an investment in the hot dog stand with a deposit in a savings account must take into
account the differences in their risks. This book will show you how to account for risks inherent
in making financial decisions.

1.2. Microsoft Excel: Why This Book and Not Another?

There are dozens of introductory finance texts out there. Many of them are very good. So why
this one? In a word: Excel. Finance is the study of financial decision making and is therefore
inherently a topic requiring lots of computation. In this book the computation is done in, and
illustrated with, Excel, the premier business computational tool. Excel gives you the flexibility
to change the elements of an example and to immediately get a new answer. We will use this
flexibility extensively throughout Principles of Finance with Excel.
Finance is a very practical discipline. Most of you are studying fi nance not only to
increase your understanding of the valuation process, but also to get answers to practical
problems. You will find that the extensive computation required in this book will not just
enable you to get numerical answers to important problems (although that alone would jus-
tify the Excel-centered focus of this book)—it will also deepen your understanding of the
concepts involved.
Using Excel enables us to discuss many more real-life examples than is possible using a
calculator. Your knowledge of both finance and Excel will be enhanced by carefully working
through the examples and exercises in each chapter.2
Most college students will be coming to a finance course after having taken an initial com-
puting course that covers the basics of Excel used in this book. If you want an Excel review, the
last six chapters of this book cover the essential Excel concepts that are used in this book. In

1
Of course there may be other things going on: Checking account balances are always available, whereas
the balance in your savings account might need to be there for a minimum period of time before you earn
interest. These liquidity considerations are discussed in Chapter 14.
2
If you’re a finance student at a college or university, this combination of Excel and finance will also
enhance your employment opportunities. Excel is practically the only financial tool used by business
today.
8 PART ONE CAPITAL BUDGETING AND VALUATION

addition, throughout the book you will find explanations of Excel functions and their application
to financial problems. When things get really rough, you’ll find little boxes called “Excel Notes,”
which explain difficult concepts. Here is an example of such a box.

EXCEL NOTE

The Excel function Sum can often be used to simplify calculations. Here’s an example based on
the computation of a profit-and-loss statement:

A B C
USING SUM TO COMPUTE
1 THE PROFIT AND LOSS
2 Profit and loss
3 Sales 1,000
4 Cost of goods sold -500
5 Depreciation -100
6 Interest -35
7 Profit before taxes 365 <-- =SUM(B3:B6)
8 Taxes (40%) -146 <-- =-40%*B7
9 Profit after taxes 219 <-- =SUM(B7:B8)

Cells B7 and B9 use the Sum function to add multiple cells. An alternative to using Sum in cell
B7 would be to use the formula =B3+B4+B5+B6. As you can see, Sum is more concise.

Excel Versions: Excel 2007 versus Excel 2003 and Excel 2010
Principles of Finance with Excel illustrates all its examples using Excel 2007, but the spread-
sheets are fully compatible with earlier versions of Excel and with the forthcoming Excel 2010.
A slightly fuller discussion of compatibility issues is in Section 5 of this chapter.

What Are the Excel Prerequisites for This Book?

You do not have to be an Excel expert to use this book. Almost all the Excel concepts needed to
do finance are explained in the text itself. Although this book will teach you the Excel concepts
needed for finance, it is not a complete Excel text. Before you start Chapter 2, you should know
how to do the following in Excel (all are covered in Chapter 24):
• Open and save an Excel notebook.
• Format numbers: You can make numbers appear in different forms. In the example
below, the number 2313.88 is shown in three different ways. You should know how
to do this formatting. In this case, we’ve chosen an appropriate format from the drop-
down list on the Format section of the Home tab of Excel and indicated the appropriate
formatting.
 CHAPTER 1 Introduction to Finance 9

• Use absolute and relative values in copying and formulas: When you copy in Excel,
you can use either relative or absolute copying. As explained in Chapter 24, relative
copying changes the cell reference addresses, whereas absolute copying leaves them
the same.3
• Build basic Excel charts to graph data. You should know how to label axes, put in chart
titles, format axes, and so on.

1.3. Eight Principles of Finance

In this section we look at eight unifying principles of finance. At this stage you may not under-
stand them all or even find them convincing, but we introduce them here to give you an over-
view of what finance is all about. They will be more fully explained in the rest of Principles of
Finance with Excel.

3
If you find this sentence mysterious, look at Section 24.3.
10 PART ONE CAPITAL BUDGETING AND VALUATION

Principle 1: Buy Assets That Add Value;

Avoid Buying Assets That Don’t
On the simplest level, making optimal financial decisions has to do with buying assets that add
value and avoiding those that don’t. For example, you need to decide whether to keep using your
old, inefficient photocopying machine or buy an expensive new one that works faster, doesn’t break
down as often, and uses less ink and energy. The finance question about these two alternatives is
which—keeping the old photocopier or buying a new one—adds more value to your business. To
make a determination about how valuable things (such as stocks, bonds, machines, and compa-
nies) are, you need to be sure that you are comparing apples with apples and oranges with oranges.
This sounds like a simple principle to follow, but it can be surprisingly tricky to implement!

Principle 2: Cash Is King

The value of an asset is determined by the cash flows it produces over its life. The cash flow of
an asset is the after-tax cash that the asset produces at a given point in time.
Although it is too early in the book to give you the full flavor of the difference between a
cash flow and a profit number, we can give a small example. Suppose your pizza parlor sells
$500 of pizzas on Tuesday night, and suppose the same day you bought $300 worth of ingre-
dients. Looking in the cash register at the end of the day, you expect to find $200, but instead
you’re surprised to find $300. The explanation: Of the $500 of pizzas sold, you only collected
$400—the other $100 were sold to a campus fraternity that maintains an account with you that
they settle at the end of each month. Of the $300 of ingredients you bought, you only paid for
$100—the other $200 will be billed to you for payment in 10 days.
Cash flows are different from accounting profits or sales receipts. The pizza parlor’s
accounting profit for the day is $200, but its cash flow for the day is $300 ($400 collected from
sales minus $100 paid for supplies). The difference between the two is caused by the timing dif-
ference between inflows and outflows. (Of course, 10 days from now the pizza parlor will have
a negative cash flow of $200 as a result of paying for the ingredients.)
In finance, cash flow is all-important. Most corporate financial data come from accoun-
tants, who—despite the bad press they’ve gotten in the past few years—do a very good job at
representing the economic realities of corporate activities. When making financial decisions,
we have to translate the accounting data to their cash equivalents. Much of finance involves first
translating accounting information into cash flows.4

Principle 3: The Time Dimension of Financial Decisions Is Important

Many financial decisions have to do with comparing cash flows at different points in time. As an
example, you pay for that new photocopy machine today (a cash outflow), but you save money
in the future (a cash inflow). Finance has to do with correctly dealing with this time dimension
of cash flows.

Principle 4: Know How to Compute the Cost of Financial Alternatives

Financial alternatives are often bewildering: Is it more expensive to buy or lease a photocopier?
When your credit card charges you “daily interest,” is it more or less expensive than the bank

4
Not familiar with basic accounting? See the book’s Web site, http://www.simonbenninga.com, for a
review of basic accounting principles.
 CHAPTER 1 Introduction to Finance 11

loan that charges you “monthly interest?” In making financial decisions you need to know how
to compute the cost of two or more competing alternatives. This book will teach you how.

Principle 5: Minimize the Cost of Financing

Many financial decisions have to do with choosing the right alternative. Should you finance that
photocopier with a loan from the dealer or with a loan from the bank? Should you buy a new
car or lease it?
Choosing the right financial alternative is, in many cases, a decision made separately from
the investment decision: You’ve decided to purchase the copier (the investment decision), and
now you have to choose whether to finance it through a bank loan or by accepting the dealer’s
“zero interest financing” (the financing decision).

Principle 6: Take Risk into Account

Many financial alternatives cannot be directly compared without taking into account their risk.
Should you take money out of the bank and invest it in the stock market? On the one hand, peo-
ple who invest in the stock market on average earn more than those who leave their money in
the bank. On the other hand, a bank deposit is safe, whereas a stock market investment is much
less safe (riskier).
“Risk” is the magic word in finance. This book will show you how to quantify risk so you
can compare financial alternatives.

Principle 7: Markets Are Efficient and Deal Well with Information

Financial markets are awash in information. In making a financial decision, how can we possi-
bly know or obtain all the information we need to make a sensible, well-informed decision? The
bad news is that we probably can’t incorporate all available information into our decision-making
process. The good news is that we may not have to: The confluence of many market participants
striving to make use of what information they have leads markets to work to eliminate riskless
profitable opportunities. In many cases financial markets work so well that we can’t add anything
to their information-gathering abilities. In short, it may well be that the stock market’s valuation
of XYZ stock is correct given all the information available about the stock. This market efficiency
can simplify the way you think about assets and their prices when making financial decisions.

Principle 8: Diversification Is Important

“Don’t put all your eggs in one basket.” The financial equivalent of this hackneyed expression
is diversify the assets you hold; don’t hold just a few stocks or bonds, buy a portfolio. Principles
of Finance with Excel will show you how to analyze portfolios of assets and how to choose the
individual assets in your portfolio wisely.

1.4. An Excel Note—Building Good Financial Models

We’ve chosen this place in the chapter to tell you a bit about financial modeling. A few simple
rules will help you create better and neater Excel models.
Modeling rule 1: Put all the variables that are important (the fashionable jargon is
“value drivers”) at the top of your spreadsheet. In the “Saving for College” spreadsheet
12 PART ONE CAPITAL BUDGETING AND VALUATION

below, the three value drivers—the interest rate, the annual deposit, and the annual cost of
college—are in the top left corner of the spreadsheet.

A B C D E F G H I
1 SAVING FOR COLLEGE
2 Interest rate 8% Critical parameters (some times called "value
3 Annual deposit 12,000.00 drivers") are in the upper left corner. The
4 Annual cost of college 35,000 actual cost of saving for a college education is
5 discussed in Chapter 2.
In bank on birthday, Deposit or End of year
End of year
Birthday before withdrawal at before
with interest
deposit/withdrawal beginning of year interest
6
7 10 0.00 12,000.00 12,000.00 12,960.00
8 11 12,960.00 12,000.00 24,960.00 26,956.80
9 12 26,956.80 12,000.00 38,956.80 42,073.34
10 13 42,073.34 12,000.00 54,073.34 58,399.21
11 14 58,399.21 12,000.00 70,399.21 76,031.15
12 15 76,031.15 12,000.00 88,031.15 95,073.64
13 16 95,073.64 12,000.00 107,073.64 115,639.53
14 17 115,639.53 12,000.00 127,639.53 137,850.69
15 18 137,850.69 -35,000.00 102,850.69 111,078.75
16 19 111,078.75 -35,000.00 76,078.75 82,165.05
17 20 82,165.05 -35,000.00 47,165.05 50,938.25
18 21 50,938.25 -35,000.00 15,938.25
19
20 NPV of all payments 6,835.64 <-- =C7+NPV(B2,C8:C18)

Modeling rule 2: Never use a number where a formula will also work. Using formulas
instead of “hard-wiring” numbers means that when you change a parameter value, the rest of the
spreadsheet changes appropriately. As an example, cell C20 in the above spreadsheet contains
the formula =C7+NPV(B2,C8:C18). We could have written this as =C7+NPV(8%,C8:C18).
But this means that changing the entry in cell B2 will not go through the whole model.
Modeling rule 3: Avoid the use of blank columns to accommodate cell “spillovers.”
Here’s an example of a potentially bad model.

A B C
1 Interest rate 6%

Because “Interest rate” has spilled over to column B, the author of this spreadsheet has decided
to put the “6%” in column C. This could be confusing. A better way is to make column A wider
and put the 6% in column B.

A B
1 Interest rate 6%

Widening the column is simple: Put the cursor on the break between columns A and B.

Double clicking the left mouse button will expand the column to accommodate the widest cell.
You can also “stretch” the column by holding the left mouse button down and moving the
column width to the right.
Modeling rule 4: Make your Excel default one sheet. Excel’s default is to open note-
books with three spreadsheets, but 99% of the time you’ll only need one sheet. So set your
 CHAPTER 1 Introduction to Finance 13

default to one sheet, and if you need more, you can always add. In Excel 2007, go to the Office
Button ➔ Excel Options ➔ Popular.

Modeling Rule 5: Turn off the “auto jump down” feature. The Excel default is that
when you click Enter, the cursor jumps down to the next cell. But in financial modeling we need
to look at the formulas we’ve written to make sure that they make sense! So turn off this feature!
Go to the Office Button ➔ Excel Options ➔ Advanced:
14 PART ONE CAPITAL BUDGETING AND VALUATION

1.5. A Note about Excel Versions

This book uses Excel 2007 but the spreadsheets are compatible with both Excel 2003 and the
newly-arrived Excel 2010. All spreadsheets are saved in Excel 2007’s “xlsm” format. If this for-
mat does not open on your computer, you are probably using an older version of Excel and need
to download the free converter. The box below shows how to do this.

Users who use an earlier version of Excel can also download the Microsoft
office Compatibility Pack for 2007 Office Word, Excel and PowerPoint File
Formats to install updates and converters for the earlier version of Excel. This
allows them to open, edit, and save an Excel 2007 workbook in the earlier
version of Excel, without having to save it to that version’s file format first or
without having to upgrade the earlier version of Excel to Excel 2007.

Compatibility with Excel 2003: The clip above is taken from

http://office.microsoft.com/en-au/excel/HA100141071033.aspx. Downloading the Compatibility Pack
allows you to open Excel 2007 files in Excel 2003.

1.6. Adding “Getformula” to Your Spreadsheet

The spreadsheets that accompany Principles of Finance with Excel all include a short macro
called Getformula that tracks the cell contents. I’ve found Getformula to be extraordi-
narily useful in my work—it allows me to explain (to myself and to my readers) what I’ve
done in my spreadsheets. The macro is dynamic: When you change a spreadsheet by moving
something (for example, by adding rows or columns), Getformula automatically updates the
formulas.

Setting the Excel Security Level

To use Getformula, you have to first set the security level of Excel to medium. This allows you
to choose to open (or not) macros in Excel. Doing this is a two-step procedure.

Step 1: In Excel 2007, go to the Office Button and then to Excel Options|Trust
Center. Click Trust Center Settings.
 CHAPTER 1 Introduction to Finance 15

Step 2: Go to the Macro Settings tab and click Disable All Macros with Notification.
This is a backhanded way of saying that Excel will ask whether you want to open macros.

These steps need be done only once. Now, when you open a spreadsheet from Principles of
Finance with Excel, you will be asked whether to open the macros.

Summary
The combination of finance concepts with an Excel implementation is a “killer app”! Principles
of Finance with Excel is the only finance principles book on the market that contains this
combination.
Enjoy!
Cchapter
HAP TER

2 The Time Value of Money

CHAPTER CONTENTS
Overview 17
2.1. Future Value 17
2.2. Present Value 28
2.3. Net Present Value 35
2.4. The Internal Rate of Return (IRR) 39
2.5. What Does IRR Mean? Loan Tables and Investment Amortization 42
2.6. Computing Annual “Flat” Payments on a Loan—Excel’s PMT
Function 44
2.7. The PMT Function Can Solve Future Value Problems 46
2.8. Saving for the Future—Buying a Car for Mario 47
2.9. Solving Mario’s Savings Problem—Three Solutions 48
2.10. Saving for the Future—More Complicated Problems 50
2.11. How Long Will It Take to Pay Off a Loan? 54
Summing Up 55
Exercises 56
Appendix: Algebraic Present Value Formulas 63

16
 CHAPTER 2 The Time Value of Money 17

Overview
This chapter deals with the most basic concepts in finance: future value, present value, net pre-
sent value, and internal rate of return. These concepts tell you how much your money will grow
if deposited in a bank (future value), how much promised future payments are worth today (pre-
sent value), what an investment is worth (net present value), and what percentage rate of return
you’re getting on your investments (internal rate of return).
Financial assets and financial planning always have a time dimension. Here are some sim-
ple examples:
• You put $100 in the bank today in a savings account. How much will you have in 3 years?
• You put $100 in the bank today in a savings account and plan to add $100 every year for
the next 10 years. How much will you have in the account in 20 years?
• XYZ Corporation just sold a bond to your mother for $860. The bond will pay her $20
per year for the next 5 years. In 6 years she gets a payment of $1020. Has she paid a fair
price for the bond?
• Your Aunt Sara is considering making an investment. The investment costs $1,000 and
will pay back $50 per month in each of the next 36 months. Should she do this or should
she leave her money in the bank, where it earns 5%?
This chapter discusses these and similar issues, all of which fall under the general topic
of time value of money. You will learn how compound interest causes invested income to grow
(future value) and how money to be received at future dates can be related to money in hand
today (present value and net present value). You will also learn how to calculate the compound
rate of return earned by an investment (internal rate of return). The concepts of future value,
present value, net present value, and internal rate of return underlie much of the financial analy-
sis that will appear in the following chapters.
As always, we use Excel, the best financial analysis tool!

Finance Concepts Discussed

• Future value
• Present value
• Net present value
• Internal rate of return
• Pension and savings plans and other accumulation problems

Excel Functions Used

• Excel functions: FV, PV, NPV, IRR, PMT, NPER
• Goal seek

2.1. Future Value

Future value is the value at some future date of a payment (or payments) made before this
future date. The future value includes the interest earned on the payments.
18 PART ONE CAPITAL BUDGETING AND VALUATION

Future value (FV) is a concept that relates the value in the future of money deposited in a
bank account today and over time and left in the account to draw interest. Suppose, for example,
that you put $100 in a savings account in your bank today and the bank pays you 6% interest at
the end of every year. If you leave the money in the bank for 1 year, you will have $106 after 1
year: $100 of the original savings balance + $6 in interest. The $106 is the future value after 1
year of the initial deposit of $100 at 6% annual interest.
Now suppose you leave the money in the account for a second year: At the end of this year,
you will have the following:

$106 The savings account balance at the end of the first year

6%*$106 = $6.36 The interest on this balance for the second year

= $112.36 Total in account after 2 years

The $112.36 is the future value after 2 years of the initial deposit of $100 at 6% annual interest.
Another way to express this is $112.36 = $100*(1+6%)2:
2
$100
!""#""$ * 1.06
!"
"#""$ * 1.06
!"
"#""$ = $100 * (1 + 6%) = $112.36
↑ ↑ ↑
Initial deposit Year 1's future Year 2's
value factor at 6% future value factor
!"""""""""#"""""""""$
↑
Future value of $100 after
one year = $100*1.06
!"""""""""""""""#"""""""""""""""$
↑
Future value of $100 after two years

Note that the future value uses the concept of compound interest: The interest earned in the
first year ($6) itself earns interest in the second year. To sum up,

The future value of $X deposited today in an account paying r% interest annually and left in
the account for n years is FV = X * (1 + r)n .

NOTATION

In this book we will often match our mathematical notation to that used by Excel. Because in
Excel multiplication is indicated by an asterisk, “*”, we will sometimes write 6%*$106 = $6.36,
3
even though this is not necessary. Similarly, we will sometimes write (1.10 ) as 1.10 ^ 3 .

Future value calculations are easily done in Excel.

 CHAPTER 2 The Time Value of Money 19

A B C
1 CALCULATING FUTURE VALUES WITH EXCEL
2 Initial deposit 100
3 Interest rate 6%
4 Number of years, n 2
5
6 Account balance after n years 112.36 <-- =B2*(1+B3)^B4

Note the use of the carat (^) to denote the exponent: In Excel (1 + 6%)2 is written as (1+B3)^B4,
where cell B3 contains the interest rate and cell B4 the number of years.
We can use Excel to make a table of how the future value grows with the years and then use
Excel’s graphing abilities to graph this growth.

A B C D E F G
1 THE FUTURE VALUE OF A SINGLE $100 DEPOSIT
2 Initial deposit 100
3 Interest rate 6%
4 Number of years, n 2
5
6 Account balance after n years 112.36 <-- =B2*(1+B3)^B4
7
8 Year Future value
9 0 100.00 <-- =$B$2*(1+$B$3)^A9
10 1 106.00 <-- =$B$2*(1+$B$3)^A10
11 2 112.36 <-- =$B$2*(1+$B$3)^A11
12 3 119.10 <-- =$B$2*(1+$B$3)^A12
13 4 126.25 <-- =$B$2*(1+$B$3)^A13
14 5 133.82
15 6 141.85 Future Value of $100 at 6% Annual Interest
16 7 150.36
17 8 159.38
18 9 168.95 350
19 10 179.08 300
Future value

20 11 189.83 250
21 12 201.22 200
22 13 213.29 150
23 14 226.09 100
24 15 239.66 50
25 16 254.04 0
26 17 269.28 0 5 10 15 20
27 18 285.43 Years
28 19 302.56
29 20 320.71

EXCEL NOTE

Note that the formula in cells B9:B29 in the table has $ signs on the cell references (for exam-
ple, =$B$2*(1+$B$3)^A9). This use of the absolute references feature of Excel is explained in
Chapter 24.
20 PART ONE CAPITAL BUDGETING AND VALUATION

In the spreadsheet below, we present a table and graph that show the future value of $100
for three different interest rates: 0, 6, and 12%. As the spreadsheet shows, future value is very
sensitive to the interest rate! Note that when the interest rate is 0%, the future value doesn’t
grow.

A B C D E
FUTURE VALUE OF A SINGLE DEPOSIT AT
DIFFERENT INTEREST RATES
1 How $100 at time 0 grows at 0%, 6%, 12%
2 Initial deposit 100
3 Interest rate 0% 6% 12%
4
5 Year FV at 0% FV at 6% FV at 12%
6 0 100.00 100.00 100.00 <-- =$B$2*(1+D$3)^$A6
7 1 100.00 106.00 112.00 <-- =$B$2*(1+D$3)^$A7
8 2 100.00 112.36 125.44
9 3 100.00 119.10 140.49
10 4 100.00 126.25 157.35
11 5 100.00 133.82 176.23
12 6 100.00 141.85 197.38
13 7 100.00 150.36 221.07
14 8 100.00 159.38 247.60
15 9 100.00 168.95 277.31
16 10 100.00 179.08 310.58
17 11 100.00 189.83 347.85
18 12 100.00 201.22 389.60
19 13 100.00 213.29 436.35
20 14 100.00 226.09 488.71
21 15 100.00 239.66 547.36
22 16 100.00 254.04 613.04
23 17 100.00 269.28 686.60
24 18 100.00 285.43 769.00
25 19 100.00 302.56 861.28
26 20 100.00 320.71 964.63
27
28
29 1000
30 900
31 800
32 FV at 0%
700
33 FV at 6%
34 600
FV at 12%
35 500
36 400
37
300
38
39 200
40 100
41 0
42 0 5 10 15 20
43
44

Terminology: What’s a Year? When Does It Begin?

Although these questions may seem obvious, this is not the case. There’s a lot of semantic con-
fusion on this subject in finance courses and texts.
 CHAPTER 2 The Time Value of Money 21

Throughout this book we will use the following as synonyms:

Year 0 Year 1 Year 2

End of End of
Today year 1 year 2

Beginning Beginning Beginning

of year 1 of year 2 of year 3

0 1 2 3

To reiterate, the words “Year 0,” “Today,” and “Beginning of year 1” are synonyms. For exam-
ple, “$100 at the beginning of year 2” is the same as “$100 at the end of year 1.” If you’re at a loss
to understand what someone means, ask for a drawing; better yet, ask for an Excel spreadsheet.

Accumulation—Savings Plans and Future Value

In the previous example you deposited $100 and left it in your bank. Suppose you intend to make
10 annual deposits of $100, with the first deposit made in year 0 (today) and each succeeding
deposit made at the end of years 1, 2, . . . , 9. The future value of all these deposits at the end of
year 10 tells you how much you will have accumulated in the account. If you are saving for the
future (whether to buy a car at the end of your college years or to finance a pension at the end of
your working life), this is obviously an important and interesting calculation.
So how much will you have accumulated at the end of year 10? There’s an Excel function
for calculating this answer, which we will discuss later; for the moment we will set this problem
up in Excel and do our calculation the long way, by showing how much we will have at the end
of each year.

A B C D E F
FUTURE VALUE WITH ANNUAL DEPOSITS
1 at beginning of year
2 Interest 6%
3 =E5 =(C6+B6)*$B$2
Account Deposit at Interest Total in
balance, beginning earned account at
4 Year beg. year of year during year end of year
5 1 0.00 100.00 6.00 106.00 <-- =B5+C5+D5
6 2 106.00 100.00 12.36 218.36 <-- =B6+C6+D6
7 3 218.36 100.00 19.10 337.46
8 4 337.46 100.00 26.25 463.71
9 5 463.71 100.00 33.82 597.53
10 6 597.53 100.00 41.85 739.38
11 7 739.38 100.00 50.36 889.75
12 8 889.75 100.00 59.38 1,049.13
13 9 1,049.13 100.00 68.95 1,218.08
14 10 1,218.08 100.00 79.08 1,397.16
15
Future value
using Excel's
16 FV function $1,397.16 <-- =FV(B2,A14,-100,,1)
22 PART ONE CAPITAL BUDGETING AND VALUATION

For clarity, let’s analyze a specific year: At the end of year 1 (cell E5) you’ve got $106 in the
account. This is also the amount in the account at the beginning of year 2 (cell B6). If you now
deposit another $100 and let the whole amount of $206 draw interest during the year, it will earn
$12.36 interest. You will have $218.36 = (106+100)*1.06 at the end of year 2.

A B C D E
6 2 106.00 100.00 12.36 218.36

Finally, look at rows 13 and 14: At the end of year 9 (cell E13) you have $1,218.08 in the
account; this is also the amount in the account at the beginning of year 10 (cell B14). You then
deposited $100 and the resulting $1,318.08 earns $79.08 interest during the year, accumulating
to $1,397.16 by the end of year 10.

A B C D E
13 9 1,049.13 100.00 68.95 1,218.08
14 10 1,218.08 100.00 79.08 1,397.16

The Excel FV Function

The spreadsheet of the previous subsection illustrates in a step-by-step manner how money
accumulates in a typical savings plan. To simplify this series of calculations, Excel has a FV
function that computes the future value of any series of constant payments. This function is
illustrated in cell C16.

B C D E
Future value
using Excel's
16 FV function $1,397.16 <-- =FV(B2,A14,-100,,1)

The FV function and the inputs required can be computed using a dialog box—an impor-
tant feature that comes with each Excel function. The Excel note that follows illustrates how to
generate the dialog box for the computation in cell C16. If you already know how to use a dialog
box, here it is for this example.

The FV function requires as inputs the Rate of interest, the number of periods, Nper, and
the annual payment, Pmt. You can also indicate the Type, which tells Excel whether payments
 CHAPTER 2 The Time Value of Money 23

are made at the beginning of the period (type 1 as in our example) or at the end of the period
(type 0).1

EXCEL NOTE

FUNCTIONS AND DIALOG BOXES

Cell C16 of the previous example contains the function FV(B2,A14,-100,,1). In this note we
illustrate the use of the dialog box for FV to generate this function.
The last part of this Excel note discusses why the payment of $100 is entered into this func-
tion as a negative number. This is a peculiarity of the FV function shared by many other Excel
financial functions.
Going Through the Function Wizard
Suppose you’re in cell C16 and you want to put the Excel function for future value in the cell.
With the cursor in C16, you move your mouse to the icon on the tool bar.

1
Exercises 2 and 3 at the end of the chapter illustrate both cases.
24 PART ONE CAPITAL BUDGETING AND VALUATION

Clicking the icon brings up the dialog box below. We’ve chosen the category to be the
Financial functions, and we’ve scrolled down in the next section of the dialog box to put the
cursor on the FV function.

Clicking OK brings up the dialog box for the FV function, which can now be filled in as
illustrated below.

Excel’s function dialog boxes have room for two types of variables.
• Boldface variables must be filled in—in the FV dialog box these are the interest, Rate,
the number of periods, Nper, and the payment, Pmt. (Read on to see why we wrote a
negative payment.)
 CHAPTER 2 The Time Value of Money 25

• Variables that are not boldface are optional. For example, Type refers to when the pay-
ments are made and so has only two options—1 when the payments are made at the
beginning of the period and 0 when they are made at the end of the period. In the exam-
ple above we’ve indicated a 1 for the Type; this indicates (as shown in the dialog box
itself) that the future value is calculated for payments made at the beginning of the
period. Had we omitted this variable or put in 0, Excel would compute the future value
for a series of payments made at the end of the period; see the subsection of Section 2.1
entitled “Beginning versus End of Period” for an illustration.
Note that the dialog box already tells us (even before we click OK) that the future value of
$100 per year for 10 years compounded at 6% is $1,397.16.

A Short Way to Get to the Dialog Box

If you know the name of the function you want, you can just write it in the cell and then click
the icon on the toolbar. As illustrated below, you have to write
=FV(
and then click the icon—note that we’ve written an equal sign, the name of the function,
and the opening parenthesis.
Here’s how the spreadsheet looks in this case.

Look in the text displayed by Excel below cell C16: As illustrated here, some versions of
Excel show the format of the function when you type it in a cell.
26 PART ONE CAPITAL BUDGETING AND VALUATION

One Further Option

You don’t have to use a dialog box! If you know the format of the function then just type in its vari-
ables and you’re all set. In the example of Section 2.1 you could just type = FV(B2,A14,-100,,1)
in the cell. Pressing [Enter] would give the answer.

Why Is the Pmt Variable a Negative Number?

In the FV dialog box we’ve entered in the payment, Pmt, as a negative number, -100. The FV
function has the peculiarity (shared by some other Excel financial functions) that a positive
deposit generates a negative answer. We won’t go into the (strange?) logic that produced this
thinking; whenever we encounter it we just put in a negative deposit.

Beginning versus End of Period

In the preceding example you make deposits of $100 at the beginning of each year. In terms of
timing, your deposits are made at dates 0, 1, 2, 3, . . . , 9. Here’s a schematic way of looking at
this, showing the future value of each deposit at the end of year 10.

Deposits at Beginning of Year

Beginning Beginning Beginning Beginning Beginning Beginning Beginning Beginning Beginning Beginning End of
of year 1 of year 2 of year 3 of year 4 of year 5 of year 6 of year 7 of year 8 of year 9 of year 10 year 10

0 1 2 3 4 5 6 7 8 9 10

$100 $100 $100 $100 $100 $100 $100 $100 $100 $100

179.08 <-- =100*(1.06)^10

168.95 <-- =100*(1.06)^9
159.38 <-- =100*(1.06)^8
150.36 <-- =100*(1.06)^7
141.85 <-- =100*(1.06)^6
133.82 <-- =100*(1.06)^5
126.25 <-- =100*(1.06)^4
119.10 <-- =100*(1.06)^3
112.36 <-- =100*(1.06)^2
106.00 <-- =100*(1.06)^1

Total 1397.16<-- Sum of the above

Suppose you made 10 deposits of $100 at the end of each year. How would this affect the
accumulation in the account at the end of 10 years? The schematic diagram below illustrates the
timing and accumulation of the payments.
Deposits at End of Year
Beginning Beginning Beginning Beginning Beginning Beginning Beginning Beginning Beginning Beginning End of
of year 1 of year 2 of year 3 of year 4 of year 5 of year 6 of year 7 of year 8 of year 9 of year 10 year 10

0 1 2 3 4 5 6 7 8 9 10

$100 $100 $100 $100 $100 $100 $100 $100 $100 $100

168.95 <-- =100*(1.06)^9

159.38 <-- =100*(1.06)^8
150.36 <-- =100*(1.06)^7
141.85 <-- =100*(1.06)^6
133.82 <-- =100*(1.06)^5
126.25 <-- =100*(1.06)^4
119.10 <-- =100*(1.06)^3
112.36 <-- =100*(1.06)^2
106.00 <-- =100*(1.06)^1
100.00 <-- =100*(1.06)^0

Total 1318.08<-- Sum of the above

 CHAPTER 2 The Time Value of Money 27

The account accumulation is less when you deposit at the end of each year than in the pre-
vious case, where you deposit at the beginning of the year. When you deposit at the end of each
year, each deposit is in the account 1 year less and consequently earns 1 year’s less interest. In
a spreadsheet, this looks like the following.

A B C D E F
FUTURE VALUE WITH ANNUAL DEPOSITS
1 at end of year
2 Interest 6%
3 =$B$2*B6
Account Deposit at Interest Total in
=E5 balance, end earned account at
4 Year beg. year of year during year end of year
5 1 0.00 100.00 0.00 100.00 <-- =B5+C5+D5
6 2 100.00 100.00 6.00 206.00 <-- =B6+C6+D6
7 3 206.00 100.00 12.36 318.36
8 4 318.36 100.00 19.10 437.46
9 5 437.46 100.00 26.25 563.71
10 6 563.71 100.00 33.82 697.53
11 7 697.53 100.00 41.85 839.38
12 8 839.38 100.00 50.36 989.75
13 9 989.75 100.00 59.38 1,149.13
14 10 1,149.13 100.00 68.95 1,318.08
15
16 Future value $1,318.08 <-- =FV(B2,A14,-100)

Cell C16 illustrates the use of the Excel FV formula to solve this problem. Here’s the dialog
box for the FV function in cell C16.

DIALOG BOX FOR FV WITH END-PERIOD PAYMENTS

28 PART ONE CAPITAL BUDGETING AND VALUATION

In this example we’ve omitted any entry in the Type box. We could have also put a 0 in the
Type box and gotten the same result.

Some Finance Jargon and the Excel FV Function

An annuity is a series of equal periodic payments made over a specified amount of time.
Examples of annuities are widespread:
• The allowance your parents give you ($1,000 per month for your next 4 years of college)
is a monthly annuity with 48 payments.
• Pension plans often give a retiree a fixed annual payment for as long as he lives. This is
a bit more complicated because the number of payments is uncertain.
• Certain kinds of loans are paid off in fixed, periodic (usually monthly, sometimes annual)
installments. Mortgages and student loans are two examples.
An annuity with payments at the end of each period is often called a regular annuity. As
you’ve seen in this section, the value of a regular annuity is calculated with =FV(B2,A14,-100).
An annuity with payments at the beginning of each period is often called an annuity due and its
value is calculated with the Excel function =FV(B2,A14,-100,,1).

2.2. Present Value

The present value is the value today of a payment (or payments) that will be made in the
future.
Here’s a simple example: Suppose that you anticipate getting $100 in 3 years from your
Uncle Simon, whose word is as good as a bank’s. Suppose that the bank pays 6% interest on
savings accounts. How much is the anticipated future payment worth today? The answer is
100
$83.96 = ; if you put $83.96 in the bank today at 6% annual interest, then in 3 years
(1.06 )3
you would have $100 (see the “proof” in rows 9 and 10). 2 The value of $83.96 is also called the
discounted or present value of $100 in 3 years at 6% interest.

2
Actually, 100/(1.06)3 = 83.96193, but we’ve used Home|Cells|Format|Format Cells|Number to show only two
decimals.
 CHAPTER 2 The Time Value of Money 29

To summarize,
The present value of $X to be received in n years when the appropriate interest rate is r% is
X .
(1 + r )n
The interest rate r is also called the discount rate. We can use Excel to make a table of how
the present value decreases with the discount rate. As you can see, higher discount rates make
for lower present values.

A B C D E F G H

THE PRESENT VALUE OF $100 IN 3 YEARS

1 in this example we vary the discount rate r
2 X, future payment 100
3 n, time of future payment 3
4 r, interest rate 6%
5 Present value, X/(1+r)n 83.96 <-- =B2/(1+B4)^B3
6
Present
7 Discount rate value
8 0% 100.00 <-- =100/(1+A8)^3
9 1% 97.06 <-- =100/(1+A9)^3
10 2% 94.23 <-- =100/(1+A10)^3
11 3% 91.51 <-- =100/(1+A11)^3
12 4% 88.90 <-- =100/(1+A12)^3
13 5% 86.38
14 6% 83.96 Present Value of $100 to be Paid in 3 Years When
15 7% 81.63 Discount Rate Varies
16 8% 79.38 120
17 9% 77.22 100
18 12% 71.18
Present value

19 15% 65.75 80
20 18% 60.86 60
21 20% 57.87
22 22% 55.07 40
23 25% 51.20 20
24 30% 45.52
25 35% 40.64 0
26 40% 36.44 0% 10% 20% 30% 40% 50%
27 45% 32.80 Discount rate
28 50% 29.63

Why Does Present Value Decrease as the Discount Rate Increases?

The Excel table above shows that the $100 Uncle Simon promises you in 3 years is worth $83.96
today if the discount rate is 6% but worth only $40.64 if the discount rate is 35%. The mechan-
ical reason for this is that taking the present value at 6% means dividing by a smaller denomi-
nator than taking the present value at 35%:

100 100
83.96 = > = 40.64
(1.06 ) (1.35 )3
3

The economic reason relates to future values: If the bank is paying you 6% interest on your
savings account, you would have to deposit $83.96 today to have $100 in 3 years. If the bank pays
3
35% interest, then $40.64 today will grow to $100 in 3 years because $40.64* (1.35 ) = $100.
30 PART ONE CAPITAL BUDGETING AND VALUATION

What this short discussion shows is that the present value is the inverse of the future
value.

Time 0 1 2 3
$100.00

PV =
-3
$100.00/(1+6%)
= $83.96

FV=
3
$83.96*(1+6%)
= $100.00

Present Value of an Annuity

Recall that an annuity is a series of equal periodic payments. The present value of an annuity
tells you the value today of all the future payments on the annuity.
The present value of an annuity of $X to be received at the end of years 1, 2, 3, . . . , N when

X X X X
the appropriate interest rate is r% is + + + ... + .
(1 + r ) (1 + r ) (1 + r )
2 3
(1 + r )N

Here’s an example: Suppose you’ve been promised $100 at the end of each of the next 5
years. Assuming that you can get 6% at the bank, this promise is worth $421.24 today.

A B C D
PRESENT VALUE OF AN ANNUITY:
1 FIVE ANNUAL PAYMENTS OF $100 EACH
2 Annual payment 100
3 r, interest rate 6%
4
Payment Present
at end of value of
5 Year year payment
6 1 100 94.34 <-- =B6/(1+$B$3)^A6
7 2 100 89.00 <-- =B7/(1+$B$3)^A7
8 3 100 83.96
9 4 100 79.21
10 5 100 74.73
11
12 Present value of all payments
13 Summing the present values 421.24 <-- =SUM(C6:C10)
14 Using Excel's PV function 421.24 <-- =PV(B3,5,-B2)
15 Using Excel's NPV function 421.24 <-- =NPV(B3,B6:B10)
 CHAPTER 2 The Time Value of Money 31

The preceding example shows three ways of getting the present value of $421.24:

• You can sum the individual discounted values. This is done in cell C13.
• You can use Excel’s PV function, which calculates the present value of an annuity (cell
C14).
• You can use Excel’s NPV function (cell C16). This function calculates the present value
of any series of periodic payments (whether they’re flat payments, as in an annuity, or
nonequal payments).

We devote separate subsections to the PV function and the NPV function.

The Present Value of a Perpetuity

A perpetuity is an annuity that goes on forever. In Appendix 2.1 at the end of this chapter we
show that
The present value of a perpetuity of $X to be received at the end of years 1, 2, 3, . . . , when
the appropriate interest rate is r% is

X X X X
+ + + ... = .
(1 + r ) (1 + r ) (1 + r )
2 3 r

Suppose, for example, that you were offered a payment of $100 per year at the end of years
1, 2, 3, . . . . Suppose that the appropriate interest rate is r = 5%. As the following spreadsheet
shows, the present value of this perpetuity is $2,000.

A B C

PRESENT VALUE OF AN ANNUITY

1
2 Payment at end of each year 100
3 Interest rate 5%
4 Perpetuity present value 2,000 <-- =B2/B3

The Excel PV Function

The PV function calculates the present value of an annuity (a series of equal payments). It
looks a lot like the FV discussed above, and like FV, it also has the peculiarity that posi-
tive payments give negative results (which is why we set Pmt equal to –100). As in the
case of the FV function, Type denotes whether the payments are made at the beginning
or the end of the year. Because end-year is the default, you can either enter 0 or leave the
Type entry blank (if the payment is at the beginning of the period you have to enter 1 in the
Type box).
32 PART ONE CAPITAL BUDGETING AND VALUATION

DIALOG BOX FOR THE PV FUNCTION

The “Formula result” in the dialogue box shows that the answer is $421.24.

The Excel NPV Function

The NPV function computes the present value of a series of payments. The payments need not
be equal, although in the current example they are. The ability of the NPV function to handle
nonequal payments makes it one of the most useful of all Excel’s financial functions. We will
make extensive use of this function throughout this book. In the current example, because the
annual payments are equal, the result is the same ($421.24) whether we use the PV function or
the NPV function.
 CHAPTER 2 The Time Value of Money 33

DIALOG BOX FOR THE NPV FUNCTION

Excel’s NPV function computes the present value of a series of payments. You can either
enter the payments separately (as Value1, Value2, . . . ), or—as illustrated above—you can enter
a range of payments into the Value1 box.

IMPORTANT NOTATION NOTE

Finance professionals use “NPV” to mean “net present value,” a concept we explain in the next
section. Excel’s NPV function actually calculates the present value of a series of payments.
Almost all finance professionals and textbooks would call the number computed by the Excel
NPV function PV. Thus, the Excel use of NPV differs from the standard usage in finance, which
is explained in Section 2.3.
34 PART ONE CAPITAL BUDGETING AND VALUATION

Choosing a Discount Rate

X
We’ve defined the present value of $X to be received in n years as . The interest rate r
(1 + r )n
in the denominator of this expression is also known as the discount rate. Why is 6% an appro-
priate discount rate for the money promised you by Uncle Simon? The basic principle is to
choose a discount rate that is appropriate to the riskiness and the duration of the cash flows
being discounted. Uncle Simon’s promise of $100 per year for 5 years is assumed to be as good
as the promise of your local bank, which pays 6% on its savings accounts. Therefore, 6% is an
appropriate discount rate.3

The present value of Nonannuity (Meaning Nonconstant) Cash Flows

The present value concept can also be applied to nonannuity cash flow streams, meaning cash
flows that are not the same every period. Suppose, for example, that your Aunt Terry has prom-
ised to pay you $100 at the end of year 1, $200 at the end of year 2, $300 at the end of year 3,
$400 at the end of year 4, and $500 at the end of year 5. This is not an annuity, and so it cannot
be accommodated by the PV function. But we can find the present value of this promise using
the NPV function.

A B C D
1 CALCULATING PRESENT VALUES WITH EXCEL
2 r, interest rate 6%
3
Payment
at end of Present
4 Year year value
5 1 100 94.34 <-- =B5/(1+$B$2)^A5
6 2 200 178.00 <-- =B6/(1+$B$2)^A6
7 3 300 251.89
8 4 400 316.84
9 5 500 373.63
10
11 Present value of all payments
12 Summing the present values 1,214.69 <-- =SUM(C5:C9)
13 Using Excel's NPV function 1,214.69 <-- =NPV($B$2,B5:B9)

The example shows that the present value of Aunt Terry’s promised series of payments over
the next 5 years is $1,214.69:

$100 $200 $300 $400 $500

+ + + + = $1,214.69
1.06 (1.06 ) (1.06 ) (1.06 ) (1.06 )5
2 3 4

3
There’s more to be said on the choice of a discount rate, but we postpone the discussion until Chapters
5 and 6.
 CHAPTER 2 The Time Value of Money 35

EXCEL NOTE

Excel’s NPV function allows you to input up to 29 payments directly in the function dialogue
box. Here’s an illustration for the example above.

2.3. Net Present Value

The net present value (NPV) of a series of future cash flows is their present value minus the
initial investment required to obtain the future cash flows. The NPV = PV of future cash
flows − initial investment. The NPV of an investment represents the increase in wealth that
you get if you make the investment.
Here’s an example based on the spreadsheet on page 34. Would you pay $1,500 today
to get the series of future cash flows in cells B5:B9? Certainly not—they’re worth only
$1,214.69, so why pay $1,500? If asked to pay $1,500, the NPV of the investment would be
100 200 300 400 500
NPV = −!""
$1,500
"#"""$ + 1.06 + 2
+ + +
↑ (1.06 ) (1.06
!""""""""""""""""""" ) (1.06 ) (1.06 )5$
3 4
"#""""""""""""""""""""
Cost of the
investment ↑
Present value of
investment's future
cash flows at discount
rate of 6%
= −$1,500 + $1,214.69 = −!"""#"""
$285.31$
↑
Net present value
36 PART ONE CAPITAL BUDGETING AND VALUATION

If you paid $1,500 for this investment, you would be overpaying $285.31 for the investment, and
you would be poorer by the same amount. That’s a bad deal!
On the other hand, if you were offered the same future cash flows for $1,000, you’d snap up
the offer because you would be paying $214.69 less for the investment than it’s worth:

NPV = − $1,000
!"""#"""$ + $1,214.69
!"""#"""$ = $214.69
!"""#"""$
↑ ↑ ↑
Cost of the Present value of Net present value
investment investment's future
cash flows at discount
rate of 6%

In this case the investment would make you $214.69 richer. As we said before, the NPV of an
investment represents the increase in your wealth if you make the investment.
To summarize,
The net present value (NPV) of a series of cash flows is used to make investment decisions:
An investment with a positive NPV is a good investment and an investment with a negative
NPV is a bad investment. An investment with a zero NPV is a “fair game”—the future cash
flows of the investment exactly compensate you for the investment’s initial cost.
Net present value is a basic tool of financial analysis. It is used to determine whether a
particular investment ought to be undertaken; in cases where we can make only one of several
investments, it is the tool of choice to determine which investment to undertake.
Here’s another NPV example: You’ve found an interesting investment—If you pay $800
today to your local pawnshop, the owner promises to pay you $100 at the end of year 1, $150 at
the end of year 2, $200 at the end of year 3, . . . , and $300 at the end of year 5. You feel that the
pawnshop owner is as reliable as your local bank, which is currently paying 5% interest. The
following spreadsheet shows the NPV of this $800 investment.

A B C D
1 CALCULATING NET PRESENT VALUE (NPV) WITH EXCEL
2 r, interest rate 5%
3
Present
4 Year Payment value
5 0 -800 -800.00
6 1 100 95.24 <-- =B6/(1+$B$2)^A6
7 2 150 136.05 <-- =B7/(1+$B$2)^A7
8 3 200 172.77
9 4 250 205.68
10 5 300 235.06
11
12 NPV
13 Summing the present values 44.79 <-- =SUM(C5:C10)
14 Using Excel's NPV function 44.79 <-- =B5+NPV($B$2,B6:B10)

The spreadsheet shows that the value of the investment—the NPV of its pay-
ments, including the initial payment of -$800—is $44.79:

100 150 200 250 300

NPV = −800 + + + + + = 44.97
(1.05 ) (1.05 ) (1.05 ) (1.05 ) (1.05 )5
2 3 4
!"""""""""""""""""""""#"""""""""""""""""""""$
The present value of the future payments:
Calculated with Excel NPV function = 844.79

At a 5% discount rate, you should make the investment because its NPV is
$44.79, which is positive.
 CHAPTER 2 The Time Value of Money 37

EXCEL NOTE

As mentioned on page 3, the Excel NPV function’s name does not correspond to the standard
finance use of the term NPV.4 In finance, present value usually refers to the value today of future
payments (in the previous example, the present value is
100 150 200 250 300
+ + + + = 844.79). Finance professionals use NPV to mean
( ) (1.05 ) (1.05 ) (1.05 ) (1.05 )5
1.05 2 3 4

the present value of future payments minus the cost of the initial payment; in the previous example
this is $844.79 − $800 = $44.79. In this book we use the term NPV to mean its true finance sense.
The Excel function NPV will always appear in boldface. We trust that you will rarely be confused.

NPV Depends on the Discount Rate

A B C D E
1 CALCULATING NET PRESENT VALUE (NPV) WITH EXCEL
2 r, interest rate 5%
3
Present
4 Year Payment value
5 0 -800 -800.00
6 1 100 95.24 <-- =B6/(1+$B$2)^A6
7 2 150 136.05 <-- =B7/(1+$B$2)^A7
8 3 200 172.77
9 4 250 205.68
10 5 300 235.06
11
12 NPV
13 Summing the present values 44.79 <-- =SUM(C5:C10)
14 Using Excel's NPV function 44.79 <-- =NPV($B$2,B6:B10)+C5
15
Discount
16 rate NPV
17 0% 200.00 <-- =NPV(A17,$B$6:$B$10)+$B$5
18 1% 165.86 <-- =NPV(A18,$B$6:$B$10)+$B$5
19 2% 133.36 <-- =NPV(A19,$B$6:$B$10)+$B$5
20 3% 102.41
21 4% 72.92 NPV and the Discount Rate
250
22 5% 44.79
23 6% 17.96 200
24 6.6965% 0.00
25 8% -32.11 150
26 9% -55.48 100
27 10% -77.83
28 11% -99.21 50
29
NPV

12% -119.67
0
30 13% -139.26 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10 11 12 13 14 15 16
31 14% -158.04 -50 % % % % % % %
32 15% -176.03
-100 Discount rate
33 16% -193.28
34 -150
35
-200
36
37 -250
38
39

4
There’s a long history to this confusion, and it doesn’t start with Microsoft. The original spreadsheet—
Visicalc—(mistakenly) used NPV in the sense that Excel still uses today; this misnomer has been copied
ever since by all other spreadsheets: Lotus, Quattro, and Excel.
38 PART ONE CAPITAL BUDGETING AND VALUATION

Let’s revisit the pawnshop example on page 36 and use Excel to create a table that shows the
relation between the discount rate and the NPV. As the graph on page 37 shows, the higher the
discount rate, the lower the NPV of the investment.
Note that we’ve highlighted a special discount rate: When the discount rate is 6.6965%, the
net present value of the investment is zero. The 6.6965% rate is referred to as the internal rate
of return (IRR). For discount rates less than the IRR, the NPV is positive, and for discount rates
greater than the IRR the NPV is negative. We discuss the IRR in more detail in Section 2.4.

Using NPV to Choose between Investments

In the examples discussed thus far, we’ve used NPV only to choose whether to undertake
a particular investment. But NPV can also be used to choose between investments. Look
at the following spreadsheet: You have $800 to invest, and you’ve been offered the choice
between Investment A and Investment B. The spreadsheet shows that at an interest rate of
15%, Investment A has an NPV = $219.06 and Investment B has an NPV = $373.75. If the
investments are not mutually exclusive, you would want to invest in both A and B because
they each have a positive NPV. But if you are forced to choose only one investment, you
should choose Investment B because it has a higher NPV. Investment A will increase your
wealth by $219.06, whereas Investment B increases your wealth by $373.75.

A B C D
1 USING NPV TO CHOOSE BETWEEN INVESTMENTS
2 Discount rate 15%
3
4 Year Investment A Investment B
5 0 -800 -800
6 1 250 600
7 2 500 200
8 3 200 100
9 4 250 500
10 5 300 300
11
12 NPV 219.06 373.75 <-- =NPV(B2,C6:C10)+C5

TERMINOLOGY—IS IT A DISCOUNT RATE OR AN INTEREST RATE?

In some of the preceding examples we’ve used discount rate instead of interest rate to describe
the rate used in the NPV calculation. As you will see in further chapters of this book, the rate
used in the NPV has several synonyms: discount rate, interest rate, cost of capital, opportunity
cost—these are but a few of the names for the rate that appears in the denominator of the NPV:

Cash flow in year t

(1 + r )t
↑
Discount rate
Interest rate
Cost of capital
Opportunity cost
 CHAPTER 2 The Time Value of Money 39

To summarize,
In using the NPV to choose between two mutually exclusive positive NPV investments, we
choose the investment with the higher NPV.

2.4. The Internal Rate of Return (IRR)

The internal rate of return (IRR) of a series of cash flows is the discount rate that sets the net
present value of the cash flows equal to zero.
Before we explain in depth (in the next section) why you want to know the IRR, we explain
how to compute it. Let’s go back to the example on page 36: If you pay $800 today to your local
pawnshop, the owner promises to pay you $100 at the end of year 1, $150 at the end of year 2,
$200 at the end of year 3, $250 at the end of year 4 , and $300 at the end of year 5. Discounting
these cash flows at rate r, the NPV can be written as follows:

100 150 200 250 300

NPV = −800 + + + + +
(1 + r ) (1 + r )2 (1 + r )3 (1 + r )4 (1 + r )5

In cells B16:B32 of the spreadsheet below, we calculate the NPV for various discount rates. As
you can see, somewhere between r = 6% and r = 7%, the NPV becomes negative.

A B C D
1 CALCULATING THE IRR WITH EXCEL
2 r, interest rate 6.6965%
3
4 Year Payment
5 0 -800
6 1 100
7 2 150
8 3 200
9 4 250
10 5 300
11
12 NPV 0.00 <-- =NPV(B2,B6:B10)+B5
13 IRR 6.6965% <-- =IRR(B5:B10)
14
Discount
15 rate NPV
16 0% 200.00 <-- =NPV(A16,$B$6:$B$10)+$B$5
17 1% 165.86 <-- =NPV(A17,$B$6:$B$10)+$B$5
18 2% 133.36 <-- =NPV(A18,$B$6:$B$10)+$B$5
19 3% 102.41
20 4% 72.92 NPV and the Discount Rate
21 5% 44.79 250
22 6% 17.96 200
23 7% -7.65 150
24 8% -32.11 100
25 9% -55.48
50
26 10% -77.83
NPV

27 11% -99.21 0
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10 11 12 13 14 15 16
28 12% -119.67 -50
% % % % % % %
29 13% -139.26 -100 Discount rate
30 14% -158.04 -150
31 15% -176.03
-200
32 16% -193.28
33 -250
34
35
40 PART ONE CAPITAL BUDGETING AND VALUATION

In cell B13, we use Excel’s IRR function to calculate the exact discount rate at which the
NPV becomes 0. The answer is 6.6965%; at this interest rate, the NPV of the cash flows equals
zero (look at cell B12). We can use the dialog box for the Excel IRR function.

DIALOG BOX FOR IRR FUNCTION

Note that we haven’t used the second option (Guess) to calculate our IRR. We discuss this option
in Chapter 5.

What Does the IRR Mean?

Suppose you could get 6.6965% interest at the bank and suppose you wanted to save today to
provide yourself with the future cash flows of the example on page 39:
100
• To get $100 at the end of year 1, you would have to put the present value = 93.72
in the bank today. 1.06965
150
• To get $150 at the end of year 2, you would have to put its present value = 131.76
in the bank today. (1.06965 )2
• And so on . . . (see the picture on page 41)
The total amount you would have to save is $800, exactly the cost of this investment oppor-
tunity. This is what we mean when we say that
The IRR is the compound interest rate you earn on an investment.
 CHAPTER 2 The Time Value of Money 41

Time 0 1 2 3 4 5

Save for time 1's $100 FV=93.72*(1+6.6965%)

$100/(1+6.6965%) 93.72 =$100.00
Save for time 2's $150 2
FV=131.76*(1+6.6965%)
2
$150/(1+6.6965%) 131.76 = $150.00
Save for time 3's $200 3
FV=164.66*(1+6.6965%)
3
$200/(1+6.6965%) 164.66 = $200.00
Save for time 4's $250 4
FV=192.90*(1+6.6965%)
4
$250/(1+6.6965%) 192.90 =$250.00
Save for time 5's $300 5
FV=216.95*(1+6.6965%)
5
$300/(1+6.6965%) 216.95 = $300.00

Total saving at time 0 800.00

Using IRR to Make Investment Decisions

The IRR is often used to make investment decisions. Suppose your Aunt Sara has been offered
the following investment by her broker: For a payment of $1,000, a reputable finance company
will pay her $300 at the end of each of the next 4 years. Aunt Sara is currently getting 5% on her
bank savings account. Should she withdraw her money from the bank to make the investment?
To answer the question, we compute the IRR of the investment and compare it with the bank
interest rate:
A B C
USING IRR TO MAKE
1 INVESTMENT DECISIONS
2 Year Cash flow
3 0 -1,000
4 1 300
5 2 300
6 3 300
7 4 300
8
9 IRR 7.71% <-- =IRR(B3:B7)

The IRR of the investment, 7.71%, is greater than the 5% Sara can earn on her alternative
investment (the bank account). Thus, she should make the investment.
To summarize,

In using the IRR to make investment decisions, an investment with an IRR greater than the
alternative rate of return is a good investment and an investment with an IRR less than the
alternative rate of return is a bad investment.

Using IRR to Choose between Two Investments

We can also use the internal rate of return to choose between two investments. Suppose you’ve
been offered two investments. Both Investment A and Investment B cost $1,000, but they have
different cash flows. If you’re using the IRR to make the investment decision, then you would
choose the investment with the higher IRR. Here’s an example.
42 PART ONE CAPITAL BUDGETING AND VALUATION

A B C D
USING IRR TO CHOOSE BETWEEN
1 INVESTMENTS
Investment A Investment B
2 Year cash flows cash flows
3 0 -1,000.00 -1,000.00
4 1 450.00 550.00
5 2 425.00 300.00
6 3 350.00 475.00
7 4 450.00 200.00
8
9 IRR 24.74% 22.26% <-- =IRR(C3:C7)

We would choose Investment A, which has the higher IRR.

To summarize,

In using the IRR to choose between two comparable investments, we choose the investment
that has the higher IRR. This assumes that: (1) both investments have an IRR greater than
the alternative rate and (2) the investments are of comparable risk.

USING NPV AND IRR TO MAKE INVESTMENT DECISIONS

In this chapter we have now developed two tools, NPV and IRR, for making investment deci-
sions. We’ve also discussed two kinds of investment decisions. Here’s a summary.

“Yes or No”: Choosing “Investment ranking”: Comparing

whether to undertake a two investments that are mutually
single investment exclusive
NPV criterion The investment should be Investment A is preferred to invest-
undertaken if its NPV > 0: ment B if NPV(A) > NPV(B)
IRR criterion The investment should be Investment A is preferred to invest-
undertaken if its IRR > r, ment B if IRR(A) > IRR(B).
where r is the appropriate
discount rate.

In Chapter 4 we discuss further implementation of these two rules and two decision
problems.

2.5. What Does IRR Mean? Loan Tables and Investment Amortization
In the previous section we gave a simple illustration of what we meant when we said that the IRR
is the compound interest rate that you earn on an asset. This short sentence underlies a slew of
 CHAPTER 2 The Time Value of Money 43

finance applications: When finance professionals discuss the “rate of return” on an investment
or the “effective interest rate” on a loan, they are almost always referring to the IRR. In this
section we explore some meanings of the IRR. Almost the whole of Chapter 3 is devoted to this
topic.

A Simple Example
Suppose you buy an asset for $200 today, and suppose that the asset will pay you $300 in 1 year.
Then the asset’s IRR is 50%. To see this, recall that the IRR is the interest rate that makes the
NPV zero. Because the investment NPV = −200 + 300 , this means that the NPV is zero when
1+ r
300
1+ r = = 1.5. Solving this equation gives r = 50%.
200
Here’s another way to think about this investment and its 50% IRR:

• At time 0 you pay $200 for the investment.

• At time 1, the $300 investment cash flow repays the initial $200. The remaining $100
represents a 50% return on the initial $200 investment. This is the IRR.
The IRR is the rate of return on an investment; it is the rate that repays, over the life of the
asset, the initial investment in the asset and that pays interest on the outstanding investment
balances.

A More Complicated Example

We now give a more complicated example, which illustrates the same point. This time, you buy
an asset costing $200. The asset’s cash flow is $130.91 at the end of year 1 and $130.91 at the
end of year 2. Here’s our IRR analysis of this investment.

A B C D E F
1 THE IRR AS A RATE OF RETURN ON AN INVESTMENT
2 IRR 20.00% <-- =IRR({-200,130.91,130.91})
Investment Part of payment
at beginning Payment at Part of payment which is repayment
3 Year of year end of year which is interest of principal
4 1 200.00 130.91 40.00 90.91
5 2 109.09 130.91 21.82 109.09
6 3 0.00
7
8 =B4-E4 =$B$2*B4 =C4-D4
9
10 =B5-E5 =$B$2*B5 =C5-D5
11

• The IRR for the investment is 20.00%. Note how we calculated this—we simply typed
into cell B2 the formula =IRR({-200,130.91,130.91}) (if you’re going to use this method
of calculating the IRR in Excel, you have to put the cash flows in the curly brackets).
• Using the 20% IRR, $40.00 (=20%*$200) of the first year’s payment is interest, and the
remainder—$90.91—is repayment of principal. Another way to think of the $40.00 is
44 PART ONE CAPITAL BUDGETING AND VALUATION

to consider that to buy the asset, you gave the seller the $200 cost of the asset. When he
pays you $130.91 at the end of the year, $40 (=20%*$200) is interest—your payment for
allowing someone else to use your money. The remainder, $90.91, is a partial repayment
of the money lent out.
• This leaves the outstanding principal at the beginning of year 2 as $109.09. Of the $130.91
paid out by the investment at the end of year 2, $21.82 (=20%*109.09) is interest, and the
rest (exactly $109.09) is repayment of principal.
• The outstanding principal at the beginning of year 3 (the year after the investment fin-
ishes paying out) is zero.
As in the first example of this section, the IRR is the rate of return on the investment,
defined as the rate that repays, over the life of the asset, the initial investment in the asset and
that pays interest on the outstanding investment balances.

USING FUTURE VALUE, NET PRESENT VALUE, AND INTERNAL RATE

OF RETURN—THE REST OF THE CHAPTER

In the remaining sections we apply the concepts learned in the chapter to solve several common
problems:
Sections 2.6–2.8. Saving for the future
Section 2.9. Paying off a loan with “flat” payments of interest and principal
Section 2.10. How long does it take to pay off a loan?

2.6. Computing Annual “Flat” Payments on a Loan—Excel’s

PMT Function
You’ve just graduated and you have 10 years to pay off your student loan of $100,000. The loan
has an annual interest rate of 10% and payment is in “even payments,” meaning that you pay the
same amount each year. How much will you have to pay off?
Suppose we denote the annual payment by X. The correct X has the property that the pres-
ent value of all the payments equals the loan principal:

X X X X
100,000 = + + + ... +
1.10 (1.10 )2 (1.10 )3 (1.10 )10

Rewriting the right side slightly, you can see that

100,000
X=
1 1 1 1
+ 2
+ 3
+ ... +
1.10 (1.10 ) (1.10 ) (1.10 )10$
!"""""""""""""""""#"""""""""""""""""
↑
This expression can
be calculated using
Excel's PV function
 CHAPTER 2 The Time Value of Money 45

Here’s all this in an Excel spreadsheet.

A B C
1 LOAN PAYMENT
2 Loan principal 100,000
3 Loan interest 10%
4 Years to pay off loan 10
5 Annual payment 16,274.54 <-- =B2/PV(B3,B4,-1)
6 16,274.54 <-- =PMT(B3,B4,-B2)

In cell B6 we use Excel’s PMT function, which does the calculation of the loan payment
directly (see box below).

DIALOG BOX FOR PMT FUNCTION

Like some other Excel financial functions, PMT generates positive answers for negative entries
. . . in the Pv box. This explains our entry of -B2 in this box.

Loan Amortization Tables

“Amortize” means to pay off something over time. A loan amortization table shows how the
payments on a loan are split between interest and repayment of the loan principle. Here’s the
previous example, with the amortization table attached (rows 9–18).
When we put all the payments in a loan table (rows 9–18 of the following spreadsheet) you
can see the split of each end-year payment between interest on the outstanding principal at the
beginning of the year and repayment of principal. If you were reporting to the Internal Revenue
Service, the interest column (column D) is deductible for tax purposes; the repayment of prin-
cipal column (column E) is not.
46 PART ONE CAPITAL BUDGETING AND VALUATION

A B C D E F
1 LOAN PAYMENT
2 Loan principal 100,000
3 Loan interest 10%
4 Years to pay off loan 10
5 Annual payment 16,274.54 <-- =B2/PV(B3,B4,-1)
6 16,274.54 <-- =PMT(B3,B4,-B2)
7 =$B$3*B9
Part of Part of
Principal at payment payment
beginning of Payment at that is that is
8 Year year end of year interest principal
9 1 100,000.00 16,274.54 10,000.00 6,274.54 <-- =C9-D9
10 2 93,725.46 16,274.54 9,372.55 6,901.99
11 3 86,823.47 16,274.54 8,682.35 7,592.19
12 4 79,231.27 16,274.54 7,923.13 8,351.41
13 5 70,879.86 16,274.54 7,087.99 9,186.55
14 6 61,693.31 16,274.54 6,169.33 10,105.21
15 7 51,588.10 16,274.54 5,158.81 11,115.73
16 8 40,472.37 16,274.54 4,047.24 12,227.30
17 9 28,245.07 16,274.54 2,824.51 13,450.03
18 10 14,795.04 16,274.54 1,479.50 14,795.04
19
20 =B9-E9 The principal due at the beginning of year
21 10 equals the principal paid off at the end
22 of the year. Meaning: The loan is paid
23 off over 10 years.

2.7. The PMT Function Can Solve Future Value Problems

The PMT function can also be used to compute the annual payment required to achieve a given
accretion of funds in the future. As the following spreadsheet shows, if you deposit $5,087.87
annually at the beginning of each of 10 years, this will accumulate to $100,000 at 12% interest.
In cell B20, we do this computation in one step, using the PMT function.

A B C D E
USING THE PMT FUNCTION TO ACHIEVE A GIVEN
1 FUTURE VALUE
2 Interest rate 12%
3 Years 10
4 Annual deposit 5,087.872
5 Desired future value 100,000
6
In account at Deposit at Total in
beginning of beginning account at
7 Year year of year end of year
8 1 0.00 5,087.87 5,698.42 <-- =(B8+C8)*(1+$B$2)
9 2 5,698.42 5,087.87 12,080.64 <-- =(B9+C9)*(1+$B$2)
10 3 12,080.64 5,087.87 19,228.74
11 4 19,228.74 5,087.87 27,234.60
12 5 27,234.60 5,087.87 36,201.17
13 6 36,201.17 5,087.87 46,243.73
14 7 46,243.73 5,087.87 57,491.39
15 8 57,491.39 5,087.87 70,088.78
16 9 70,088.78 5,087.87 84,197.85
17 10 84,197.85 5,087.87 100,000.00
18
19 Solve this in one step using PMT
20 Annual payment 5,087.872 <-- =PMT(B2,B3,,-B5,1)
 CHAPTER 2 The Time Value of Money 47

The dialog box for cell B20 is given below.

2.8. Saving for the Future—Buying a Car for Mario

Mario has his eye on a car that costs $20,000. He wants to buy a car in 2 years. He plans to open
a bank account and to deposit $X today and $X in 1 year. Balances in the account will earn 8%.
How much does Mario need to deposit so that he has $20,000 in 2 years? In this section we’ll
show you that
To finance future consumption with a savings plan, the net present value of all the cash flows
has to be zero. In the jargon of finance, the future consumption plan is fully funded if the net
present value of all the cash flows is zero.
To see this, start with a graphical representation of what happens.

0 1 2
X X -20,000

X *(1.08)

X *(1.08)2

In year 2 Mario will have accumulated X * (1.08) + X * (1.08)2. This should finance the
$20,000 car, so that
2
X * (1.08 )+ X * (1.08 ) = 20,000
!""#""$
!""""""""" "#""""""""""$
↑ ↑
Future value of Desired accumulation
deposits in 2 years
48 PART ONE CAPITAL BUDGETING AND VALUATION

2
Now subtract the $20,000 from both sides of the equation and divide through by (1.08 ) :

X 20,000
X+ − =0
(1.08 ) (1.08 )2
!""""""""#""""""""$
↑
Net present value
of all cash flows

If you were to actually solve this equation, you would find that X = $8,903.13. To fully fund
the future purchase of the car, Mario has to deposit $8,903.13 today and another $8,903.13 a
total of 1 year from now. If he does this, the NPV of all the payments is zero:

$8,903.13 20,000
$8,903.13
!""""#""""$ + − =0
↑ (1.08
!"""
"#""") "$ (1.08 )2
!""#""$
The PV of the
deposit made ↑ ↑
today The PV of the The PV of the cost
deposit made 1 of the car in 2 years
year from now
!""""""""""""""""#""""""""""""""""$
↑
The NPV of the 2 deposits
and the cost of the car in
year 2

Excel Solution
Of course, this same solution is easily reached using Excel.

A B C D E
1 HELPING MARIO SAVE FOR A CAR
2 Deposit, X 8,903.13
3 Interest rate 8.00%
Total at
In bank, before Deposit or beginning of End of year
4 Year deposit withdrawal year with interest
5 0 0.00 8,903.13 8,903.13 9,615.38
6 1 9,615.38 8,903.13 18,518.52 20,000.00
7 2 20,000.00 (20,000.00) 0.00 0.00
8
NPV of all
deposits
9 and payments $0.00 <-- =C5+NPV(B3,C6:C7)

If Mario deposits $8,903.13 in years 0 and 1, then the accumulation in the account at the
beginning of year 2 will be exactly $20,000 (cell B7). The NPV of all the payments (cell C9)
is zero.
In the next section we discuss three methods for solving Mario’s savings problem.

2.9. Solving Mario’s Savings Problem—Three Solutions

We can solve Mario’s savings problem using one of three methods: trial and error, using Excel’s
Goal Seek, and using Excel’s PMT function. Each of these three methods is illustrated in this
section.
 CHAPTER 2 The Time Value of Money 49

Method 1: Trial and Error

You can “play” with the spreadsheet, adjusting cell B2 until cell C9 equals zero. For example, if
you put $5,000 into cell B2, you see that the NPV in cell C9 is negative, indicating that Mario
is saving too little.

A B C D E
1 HELPING MARIO SAVE FOR A CAR
2 Deposit, X 5,000.00
3 Interest rate 8.00%
Total at
In bank, before Deposit or beginning of End of year
4 Year deposit withdrawal year with interest
5 0 0.00 5,000.00 5,000.00 5,400.00
6 1 5,400.00 5,000.00 10,400.00 11,232.00
7 2 11,232.00 (20,000.00) (8,768.00) (9,469.44)
8
NPV of all
deposits
9 and payments ($7,517.15) <-- =C5+NPV(B3,C6:C7)

If you put 10,000 into cell B2, cell C9 will be positive; this indicates that the answer is
somewhere between 5,000 and 10,000. By trial and error you can reach the correct solution.

Method 2: Using Excel’s Goal Seek

Goal Seek is an Excel function that looks for a specific number in one cell by adjusting the
value of a different cell (for a discussion of how to use Goal Seek, see Chapter 29). To solve
Mario’s problem, we can use Goal Seek to set cell C9 equal to 0. The Excel 2007 menu selec-
tion is Data|Data Tools|What-If Analysis|Goal Seek.

Having chosen Goal Seek, we fill in the dialog box as shown below.
50 PART ONE CAPITAL BUDGETING AND VALUATION

When we click OK, Goal Seek will find the solution of 8,903.13.

Method 3: Using the Excel PMT Function

Excel’s PMT function can solve Mario’s problem directly, as illustrated by the following
spreadsheet.
A B C
HELPING MARIO SAVE FOR A CAR
1 using Excel PMT function
2 Goal 20,000.00 <-- The cost of the car
3 When to reach the goal? 2 <-- The year in which Mario wants to buy the car
4 Interest rate 8.00%
5 Deposit, X 8,903.13 <-- =PMT(B4,B3,,-B2,1)

The dialog box for this function is given below.

2.10. Saving for the Future—More Complicated Problems

In this section we present two more complicated versions of Mario’s problem from Section 2.8.
We start by trying to determine whether a young girl’s parents are putting enough money aside
to save for her college education. Here’s the problem:
• On her 10th birthday Linda Jones’s parents decide to deposit $4,000 in a savings account
for their daughter. They intend to put an additional $4,000 in the account each year on
her 11th, 12th, . . . , 17th birthdays.
 CHAPTER 2 The Time Value of Money 51

• All account balances will earn 8% per year.

• On Linda’s 18th, 19th, 20th, and 21st birthdays, her parents will withdraw $20,000 to pay
for her college education.
Is the $4,000 per year sufficient to cover the anticipated college expenses? We can easily
solve this problem in a spreadsheet.

A B C D E
1 SAVING FOR COLLEGE
2 Interest rate 8%
3 Annual deposit 4,000.00
4 Annual cost of college 20,000
5
In bank on birthday, Deposit or
before withdrawal at End of year
6 Birthday deposit/withdrawal beginning of year Total with interest
7 10 0.00 4,000.00 4,000.00 4,320.00
8 11 4,320.00 4,000.00 8,320.00 8,985.60
9 12 8,985.60 4,000.00 12,985.60 14,024.45
10 13 14,024.45 4,000.00 18,024.45 19,466.40
11 14 19,466.40 4,000.00 23,466.40 25,343.72
12 15 25,343.72 4,000.00 29,343.72 31,691.21
13 16 31,691.21 4,000.00 35,691.21 38,546.51
14 17 38,546.51 4,000.00 42,546.51 45,950.23
15 18 45,950.23 -20,000.00 25,950.23 28,026.25
16 19 28,026.25 -20,000.00 8,026.25 8,668.35
17 20 8,668.35 -20,000.00 -11,331.65 -12,238.18
18 21 -12,238.18 -20,000.00 -32,238.18 -34,817.24
19
20 NPV of all payments -13,826.4037 <-- =NPV(B2,C8:C18)+C7

By looking at the end-year balances in column E, the $4,000 is not enough—Linda and
her parents will run out of money somewhere between her 19th and 20th birthdays.5 By the
end of her college career, they will be $34,817 “in the hole” (cell E18). Another way to see
this is to look at the NPV calculation in cell C20: As we saw in the previous section, a combi-
nation savings/withdrawal plan is fully funded when the NPV of all the payments/withdraw-
als is zero. In cell C20 we see that the NPV is negative—Linda’s plan is underfunded.
How much should Linda’s parents put aside each year? There are several ways to answer
this question, which we explore below. These methods are basically the same as the three meth-
ods for solving Mario’s problem presented in the previous section, but for completeness we
present them again.

Method 1: Trial and Error

Assuming that you have put the correct formulas in the spreadsheet, you can “play” with cell B3
until cell E18 or cell C20 equals zero. Doing this shows that Linda’s parents should have planned
to deposit $6,227.78 annually.

5
At the end of Linda’s 19th year (row 16), there is $8,668.35 remaining in the account. At the end of the
following year, there is a negative amount in the account.
52 PART ONE CAPITAL BUDGETING AND VALUATION

A B C D E
1 SAVING FOR COLLEGE
2 Interest rate 8%
3 Annual deposit 6,227.78
4 Annual cost of college 20,000
5
In bank on birthday, Deposit or
before withdrawal at End of year
6 Birthday deposit/withdrawal beginning of year Total with interest
7 10 0.00 6,227.78 6,227.78 6,726.00
8 11 6,726.00 6,227.78 12,953.77 13,990.08
9 12 13,990.08 6,227.78 20,217.85 21,835.28
10 13 21,835.28 6,227.78 28,063.06 30,308.10
11 14 30,308.10 6,227.78 36,535.88 39,458.75
12 15 39,458.75 6,227.78 45,686.52 49,341.45
13 16 49,341.45 6,227.78 55,569.22 60,014.76
14 17 60,014.76 6,227.78 66,242.54 71,541.94
15 18 71,541.94 -20,000.00 51,541.94 55,665.29
16 19 55,665.29 -20,000.00 35,665.29 38,518.52
17 20 38,518.52 -20,000.00 18,518.52 20,000.00
18 21 20,000.00 -20,000.00 0.00 0.00
19
20 NPV of all payments 0.0000 <-- =NPV(B2,C8:C18)+C7

Note that the net present value of all the payments (cell C20) is zero when the solution is
reached. The future payouts are fully funded when the NPV of all the cash flows is zero.

Method 2: Using Excel’s Goal Seek

We can use Goal Seek to set E18 equal to zero. After hitting Data|What-If Analysis|Goal
Seek, we fill in the dialog box.
 CHAPTER 2 The Time Value of Money 53

When we click OK, Goal Seek looks for the solution. The result is the same as before:
$6,227.78.

Method 3: Using the Excel PV and PMT Formula

We can use the Excel PV and PMT functions to solve this problem directly, as illustrated in the
following spreadsheet screen.

A B C
SAVING FOR COLLEGE
1 Using PV and PMT functions
2 Interest rate 8%
3 Linda's age today 10
4 Age at starting college 18
5 Years of college 4
6
7 Annual cost of college 20,000
8
9 PV of college at 18 71,541.94 <-- =PV(B2,B5,-B7,,1)
10 Annual payment 6,227.78 <-- =PMT(B2,B4-B3,,-B9,1)

Explanation: Cell B9 is the present value of the college tuitions at the start of the 18th year.
The PMT function computes the annual payment required so that the future value of the pay-
ments (compounded at 8% for 8 years) will be equal to $71,541.94.
We can, of course, integrate the PV function into the PMT function, so that the result is
even simpler.

A B C
SAVING FOR COLLEGE
1 PV function is inside the PMT function
2 Interest rate 8%
3 Linda's age today 10
4 Age at starting college 18
5 Years of college 4
6
7 Annual cost of college 20,000
8
9 Annual payment 6,227.78 <-- =PMT(B2,B4-B3,,PV(B2,B5,B7,,1),1)

Pension Plans
The savings problem of Linda’s parents is exactly the same as that faced by an individual who
wishes to save for his retirement. Suppose that Joe is 20 today and wishes to start saving so
that when he’s 65 he can have 20 years of $100,000 annual withdrawals. Adapting the previous
spreadsheet, we get the following.
In the table in rows 12–27 you see the power of compound interest: If Joe starts saving
at age 20 for his retirement, an annual deposit of $2,540.23 will grow to provide him with his
54 PART ONE CAPITAL BUDGETING AND VALUATION

retirement needs of $100,000 per year for 20 years at age 65. On the other hand, if he starts sav-
ing at age 35, it will require $8,666.90 per year.

A B C
1 SAVING FOR RETIREMENT
2 Joe's age today 20
3 Joe's age at last deposit 64
4 Number of deposits 45 <-- =B3-B2+1
5 Number of withdrawals 20
6 Annual withdrawal from age 65 100,000
7 Interest rate 8%
8
9 Annual deposit 2,540.23 <-- =(B6/(1+B7)^(B4-1))*PV(B7,B5,-1)/PV(B7,B4,-1,,1)
10
11 Joe's age today Annual amount deposited
12 20 2,540.23 <-- =($B$6/(1+$B$7)^($B$3-A12))*PV($B$7,$B$5,-1)/PV($B$7,$B$3-A12+1,-1,,1)
13 22 2,978.96 <-- =($B$6/(1+$B$7)^($B$3-A13))*PV($B$7,$B$5,-1)/PV($B$7,$B$3-A13+1,-1,,1)
14 24 3,496.73 <-- =($B$6/(1+$B$7)^($B$3-A14))*PV($B$7,$B$5,-1)/PV($B$7,$B$3-A14+1,-1,,1)
15 26 4,109.02
16 28 4,834.85 40,000 Annual Deposit Required to Fund 20 Years of $100,000
17 30 5,697.73 When Joe is 65
35,000
18 32 6,727.03
30,000
19 34 7,959.85
25,000
20 35 8,666.90
21 38 11,239.91 20,000
22 40 13,430.03 15,000
23 42 16,123.53 10,000
24 44 19,471.60
5,000
25 46 23,688.86
0
26 48 29,090.61
27 50 36,159.79 20 25 30 35 40 45 50
28 Joe's age at start of plan
29

2.11. How Long Will It Take to Pay Off a Loan?

You’re getting a $1,000 loan from the bank at 10% interest. The maximum payment you can make is
$250 per year. How long will it take you to pay off the loan? There’s an Excel function that answers
this question, which we’ll show you in a bit. But first let’s do this the long way so we can understand
the question. In the spreadsheet below we look at a loan table like the one considered in Section 2.5.

A B C D E
1 HOW LONG TO PAY OFF THIS LOAN?
2 Loan amount 1,000
3 Interest rate 10%
4 Annual payment 250
5

Principal at Payment
beginning at end of Return of
6 Year of year year Interest principal
7 1 1,000.00 250.00 100.00 150.00
8 2 850.00 250.00 85.00 165.00
9 3 685.00 250.00 68.50 181.50
10 4 503.50 250.00 50.35 199.65
11 5 303.85 250.00 30.39 219.62
12 6 84.24 250.00 8.42 241.58
13
14
15 Year 6 is the first year in which the return of principal
16 at the end of the year > principal at the beginning of
17 the year--meaning that sometime during year 6 you
18 will have paid off the loan.
19
 CHAPTER 2 The Time Value of Money 55

As you can see from row 12, year 6 is the first year in which the return of principal at the
end of the year is bigger than the principal at the beginning of the year. Thus, sometime between
5 and 6 years you pay off the loan.
Excel’s NPER function, illustrated in cell B22, provides an exact answer to this question.

DIALOG BOX FOR NPER FUNCTION

Like the functions PMT, PV, and FV discussed elsewhere in this chapter, the NPER func-
tion requires you to make the amount owed negative to get a positive answer.

Summing Up
In this chapter we have covered the basic concepts of the time value of money:
• Future value (FV): The amount you will accumulate at some future date from deposits
made in the present.
• Present value (PV): The value today of future anticipated cash flows.
• Net present value (NPV): The value today of a series of future cash flows, including the
cost of acquiring these cash flows.
• We’ve gone to great pains to point out the difference between the finance concept of
NPV and the Excel NPV function. The Excel NPV function calculates the present value
of the future cash flows, whereas the finance concept of NPV computes the present value
of the future cash flows minus the initial cash flow.
56 PART ONE CAPITAL BUDGETING AND VALUATION

• Internal rate of return (IRR): The compound interest rate paid by a series of cash flows,
including the cost of their acquisition.
• NPER: The number of periods to pay off the investment.
We have also showed you the Excel functions (FV, PV, NPV, IRR, and NPER) that per-
form these calculations and discussed some of their peculiarities. Finally, we have showed you
how to do these calculations using formulas.

EXERCISES
1. You just put $600 in the bank and you intend to leave it there for 10 years. If the bank pays you 15%
interest per year, how much will you have at the end of 10 years?
2. Your generous grandmother has just announced that she’s opened a savings account for you with a
deposit of $10,000. Moreover, she intends to make nine more similar gifts, at the end of this year,
next year, etc. If the savings account pays 8% interest, how much will you have accumulated at the
end of 10 years (1 year after the last gift)?
Suggestion: Do this problem two ways, as shown below: (a) take each amount and calculate its
future value in year 10 (as illustrated in cells C4:C13) and then sum them; (b) use Excel’s FV func-
tion, noting that here the amounts come at the beginning of the year (you’ll need to enter “1” in the
Type option as described in Section 2.1).

A B C D
1 Interest rate 8.00%
2
Future value
3 Year Gift in year 10
4 0 10,000 21,589.25 <--=B4*(1+$B$1)^(10-A4)
5 1 10,000
6 2 10,000
7 3 10,000
8 4 10,000
9 5 10,000
10 6 10,000
11 7 10,000
12 8 10,000
13 9 10,000
14
15 Total (summing C4:C13)
16 Using FV function

3. Your uncle has just announced that he’s going to give you $10,000 per year at the end of each of
the next 4 years (he’s less generous than your grandmother . . . ). If the relevant interest rate is 7%,
what’s the value today of this promise? (If you’re going to use PV to do this problem, note that the
Type option is 0 or omitted.)
4. What is the present value of a series of four payments, each $1,000, to be made at the end of years
1, 2, 3, and 4? Assume that the interest rate is 14%.
 CHAPTER 2 The Time Value of Money 57

Suggestion: Do this problem two ways, as shown in rows 9 and 10 below.

A B C D
1 Interest rate 14%
2
3 Year Payment PV
4 1 1,000 877.19 <-- =B4/(1+$B$1)^A4
5 2 1,000
6 3 1,000
7 4 1,000
8
9 Total of C4:C7
10 Using NPV function

5. Screw-‘Em-Good Corp. (SEG) has just announced a revolutionary security: If you pay SEG $1,000
now, you will get back $150 at the end of each of the next 15 years. What is the IRR of this
investment?
Suggestion: Do this problem two ways—once using Excel’s IRR function and once using
Excel’s RATE function (illustrated below).

6. Make-‘Em-Happy Corp. (MEH) has a different security for sale: You pay MEH $1,000 today and
the company will give you back $100 at the end of the first year, $200 at the end of year 2, . . . ,
$1,000 at the end of year 10.
a. Calculate the IRR of this investment.
b. Show an amortization table for the investment.
7. You are thinking about buying a $1,000 bond issued by the Appalachian Development Authority.
The bond will pay $120 interest at the end of each of the next 5 years. At the end of year 6, the bond
will pay $1,120 (this is its face value of $1,000 plus the interest). If the relevant discount rate is 7%,
how much is the present value of the bond’s future payments?
8. Anuradha Dixit just turned 55. Anuradha is planning to retire in 10 years, and she currently has
$500,000 in her pension fund. Based on the longevity pattern of her family, she assumes that she
will live 20 years past her retirement rate; during each of these years she desires to withdraw
58 PART ONE CAPITAL BUDGETING AND VALUATION

$100,000 from her pension fund. If the interest rate is 5% annually, how much will Anuradha have
to save annually for the next 10 years? Assume that the first deposit to her pension fund will be
today, followed by nine more annual deposits, and that the annual withdrawals from age 65 will
occur at the beginning of each year.
Use the following spreadsheet (the numbers are not correct) and Goal Seek to find an answer.

A B C D E F
1 SAVING FOR THE FUTURE
2 Annual desired pension payout 100,000
3 Annual payment 10,000
4 Interest rate 5%
5
Account Deposit or
Interest Total in
balance, withdrawal
Your age earned account
beginning of beginning of
during year end of year
6 year year
7 55 500,000 10,000 25,500 535,500 <-- =D7+C7+B7
8 56 535,500 10,000 27,275 572,775 <-- =D8+C8+B8
9 57 572,775 10,000 29,139 611,914
10 58 611,914 10,000 31,096 653,009
11 59 653,009 10,000 33,150 696,160
12 60 696,160 10,000 35,308 741,468
13 61 741,468 10,000 37,573 789,041
14 62 789,041 10,000 39,952 838,993
15 63 838,993 10,000 42,450 891,443
16 64 891,443 10,000 45,072 946,515
17 65 946,515 (100,000) 42,326 888,841
18 66 888,841 (100,000) 39,442 828,283
19 67 828,283 (100,000) 36,414 764,697
20 68 764,697 (100,000) 33,235 697,932
21 69 697,932 (100,000) 29,897 627,829
22 70 627,829 (100,000) 26,391 554,220
23 71 554,220 (100,000) 22,711 476,931
24 72 476,931 (100,000) 18,847 395,778
25 73 395,778 (100,000) 14,789 310,566
26 74 310,566 (100,000) 10,528 221,095
27 75 221,095 (100,000) 6,055 127,150
28 76 127,150 (100,000) 1,357 28,507
29 77 28,507 (100,000) (3,575) (75,068)
30 78 (75,068) (100,000) (8,753) (183,821)
31 79 (183,821) (100,000) (14,191) (298,012)
32 80 (298,012) (100,000) (19,901) (417,913)
33 81 (417,913) (100,000) (25,896) (543,808)
34 82 (543,808) (100,000) (32,190) (675,999)
35 83 (675,999) (100,000) (38,800) (814,799)
36 84 (814,799) (100,000) (45,740) (960,539)

9. Solve the previous problem using functions PV and Pmt and the template below.

A B C
1 SAVING FOR THE FUTURE
2 Pension savings today 500,000
3 Annual desired pension payout 100,000
4 Number of years until retirement 10
5 Number of payout years after retirement 20
6 Interest rate 5%
7
8 Present value today of all future retirement payments
9 Annual payment until retirement
 CHAPTER 2 The Time Value of Money 59

10. If you deposit $25,000 today, Union Bank offers to pay you $50,000 at the end of 10 years. What
is the interest rate?
11. Assuming that the interest rate is 5%, which of the following is more valuable?
a. $5,000 today
b. $10,000 at the end of 5 years
c. $9,000 at the end of 4 years
d. $300 a year in perpetuity (meaning forever), with the first payment at the end of this year
12. You receive a $15,000 signing bonus from your new employer and decide to invest it for 2 years.
Your banker suggests two alternatives, which both require a commitment for the full 2 years. The
first alternative will earn 8% per year for both years. The second alternative earns 6% for the first
year and 10% for the second year. Interest compounds annually.
Which should you choose?
13. Your annual salary is $100,000. You are offered two options for a severance package. Option
1 pays you 6 months’ salary now. Option 2 pays you and your heirs $6,000 per year forever
(first payment at the end of this year). If your required return is 11%, which option should you
choose?
14. Today is your 40th birthday. You expect to retire at age 65 and actuarial tables suggest that you
will live to be 100. You want to move to Hawaii when you retire. You estimate that it will cost you
$200,000 to make the move (on your 65th birthday) and that your annual living expenses will be
$25,000 a year after that. You expect to earn an annual return of 7% on your savings.
a. How much will you need to have saved by your retirement date?
b. You already have $50,000 in savings. How much would you need to save at the end of each of
the next 25 years to be able to afford this retirement plan?
c. If you did not have any current savings and did not expect to be able to start saving money for
the next 5 years (that is, your first savings payment will be made on your 45th birthday), how
much would you have to set aside each year after that to be able to afford this retirement plan?
15. You have just invested $10,000 in a new fund that pays $1,500 at the end of each of the next 10
years. What is the compound rate of interest being offered in the fund? (Suggestion: Do this
problem two ways: Using Excel’s IRR function and using Excel’s Rate function.)
16. John is turning 13 today. His birthday resolution is to start saving toward the purchase of a car
that he wants to buy on his 18th birthday. The car costs $15,000 today, and he expects the price
to grow at 2% per year.
John has heard that a local bank offers a savings account that pays an interest rate of 5% per
year. He plans to make six contributions of $1,000 each to the savings account (the first contri-
bution to be made today); he will use the funds in the account on his 18th birthday as a down
payment for the car, financing the balance through the car dealer.
He expects the dealer to offer the following terms for financing: seven equal yearly payments
(with the fi rst payment due 1 year after he takes possession of the car); an annual interest rate
of 7%.
a. How much will John need to finance through the dealer?
b. What will be the amount of his yearly payment to the dealer?
(Hint: This is like the college savings problem discussed in Section 2.8.)
17. Mary has just completed her undergraduate degree from Northwestern University and is already
planning to enter an MBA program 4 years from today. The MBA tuition will be $20,000 per
year for 2 years, paid at the beginning of each year. In addition, Mary would like to retire 15
years from today and receive a pension of $60,000 every year for 20 years, with the first pension
payment paid out 15 years from today. Mary can borrow and lend as much as she likes at a rate of
60 PART ONE CAPITAL BUDGETING AND VALUATION

7%, compounded annually. To fund her expenditures, Mary will save money at the end of years
0–3 and at the end of years 6–14.
• Calculate the constant annual dollar amount that Mary must save at the end of each of these
years to cover all of her expenditures (tuition and retirement). (Hint: It might be helpful to use
Goal Seek.)
Note: Just to remove all doubts, here are the cash flows:

A B C D E F
1 MARY
Balance at
beginning Net
of year Withdrawal balance
before beginning beginning Savings at Account
2 Year withdrawal of year of year end of year end of year
3 0 0 $X
4 1 $X
5 2 $X
6 3 $X
7 4 $ (20,000.00)
8 5 $ (20,000.00)
9 6 $X
10 7 $X
11 8 $X
12 9 $X
13 10 $X
14 11 $X
15 12 $X
16 13 $X
17 14 $X
18 15 $ (60,000.00)
19 16 $ (60,000.00)
20 17 $ (60,000.00)
21 18 $ (60,000.00)
22 19 $ (60,000.00)
23 20 $ (60,000.00)
24 21 $ (60,000.00)
25 22 $ (60,000.00)
26 23 $ (60,000.00)
27 24 $ (60,000.00)
28 25 $ (60,000.00)
29 26 $ (60,000.00)
30 27 $ (60,000.00)
31 28 $ (60,000.00)
32 29 $ (60,000.00)
33 30 $ (60,000.00)
34 31 $ (60,000.00)
35 32 $ (60,000.00)
36 33 $ (60,000.00)
37 34 $ (60,000.00) 0

18. You are the CFO of Termination, Inc. Your company has 40 employees, each earning $40,000
per year. Employee salaries grow at 4% per year. Starting from next year, and every second year
thereafter, 8 employees retire and no new employees are recruited. Your company has in place a
retirement plan that entitles retired workers to an annual pension, which is equal to their annual
salary at the moment of retirement. Life expectancy is 20 years after retirement, and the annual
pension is paid at year end. The return on investment is 10% per year. What is the total value of
your pension liabilities?
 CHAPTER 2 The Time Value of Money 61

19. You are 30 today and are considering studying for an MBA. You just received your annual salary
of $50,000 and expect it to grow by 3% per year. MBAs typically earn $60,000 upon graduation,
with salaries growing by 4% per year.
The MBA program you’re considering is a full-time, 2-year program that costs $20,000 per
year, payable at the end of each study year. You want to retire on your 65th birthday. The relevant
discount rate is 8%.6 Is it worthwhile for you to quit your job to do an MBA (ignore income taxes)?
What is the internal rate of return of the MBA?
20. You’re 55 years old today, and you wish to start saving for your pension. Here are the
parameters:
• You intend to make a deposit today and at the beginning of each of the next 9 years (that is, on
your 55th, 56th, . . . , 64th birthdays).
• Starting from your 65th birthday until your 84th, you would like to withdraw $50,000 per year
(no plans after that).
• The interest rate is 12%.
a. How much should you deposit in each of the initial years to fully fund the withdrawals?
b. If you start saving at age 45, what is the answer?
c. (More difficult) Set up the formula for the savings amount so that you can solve for various
starting ages. Do a sensitivity analysis that shows the amount you need to save as a function
of the age at which you start saving.
21. Section 2.8 of this chapter discusses the problem of Linda Jones’s parents, who wish to save for
Linda’s college education. The setup of the problem implicitly assumes that the bank will let the
Jones’s borrow from their savings account and will charge them the same 8% it was paying on
positive balances. This is unlikely!
In this problem you are asked to program the following spreadsheet: In it you will assume that
the bank pays Linda’s parents 8% on positive account balances but charges them 10% on negative
balances.
If Linda’s parents can only deposit $4,000 per year in the years preceding college, how much
will they owe the bank at the beginning of year 22 (the year after Linda finishes college)?
A B C D E
1 SAVING FOR COLLEGE
2 Interest rates
3 On positive balances 8%
4 On negative balances 10%
5 Annual deposit 4,000.00
6 Annual cost of college 20,000
7
In bank on birthday, Deposit
before or withdrawal End of year
8 Birthday deposit/withdrawal at beginning of year Total with interest
9 10 4,000.00
10 11 4,000.00
11 12 4,000.00
12 13 4,000.00
13 14 4,000.00
14 15 4,000.00
15 16 4,000.00
16 17 4,000.00
17 18 -20,000.00
18 19 -20,000.00
19 20 -20,000.00
20 21 -20,000.00
21 22

6
Meaning: Your MBA is an investment, like any other investment. On other investments you can earn 8%
per year; the MBA has to be judged against this standard.
62 PART ONE CAPITAL BUDGETING AND VALUATION

Excel note: To set up this spreadsheet you will need to use the Excel If function (if you are not
familiar with this function, see Chapter 26).
22. A fund of $10,000 is set up to pay $250 at the end of each year indefinitely. What is the fund’s
IRR? (There’s no Excel function that answers this question—use some logic!)
23. In the spreadsheet below we calculate the FV of 5 deposits of $100, with the first deposit made
at time 0. As shown in Section 2.1, this calculation can also be made using the Excel func-
tion =FV(interest,periods,-amount,,1) .
a. Show that you can also compute this by =FV(interest,periods,-amount)*(1+interest).
b. Can you explain why FV(r,5,-100,,1)=FV(r,5,-100)*(1+r)?

A B C D E F
1 FUTURE VALUE
2 Interest 6%
3
Deposit at Interest Total in
Account balance, beginning earned account at
4 Year beginning of year of year during year end of year
5 1 0.00 100.00 6.00 106.00 <-- =B5+C5+D5
6 2 106.00 100.00 12.36 218.36 <-- =B6+C6+D6
7 3 218.36 100.00 19.10 337.46
8 4 337.46 100.00 26.25 463.71
9 5 463.71 100.00 33.82 597.53

24. Abner and Maude are both in their eighties. They’re thinking of selling their house for $500,000
and moving into an apartment complex for seniors. The apartment will cost $50,000 per year,
payable in full at the beginning of each year.
a. If they can earn 6% annually on the proceeds from their house and if they live for 10 more
years, how much will they be able to leave to their children as inheritance?
b. What is the longest they can live from the apartment proceeds before the money runs out?
25. What are your answers to the question above assuming that the interest rate is 7%? 5%?
26. Michael is considering his consumption habits, trying to figure out how to save money. He real-
izes that he could save $2 every day by ordering regular coffee instead of a latte at the local coffee
shop. Because he buys a cup of coffee every work day, this works out to $10 per week, which
amounts to a saving of $520 per year.
a. If Michael is 25 today and retires at age 65, how much money will he have accumulated from
savings on coffee versus latte? Assume that the annual interest rate is 4% and that the $520
savings occur at the end of each year.
b. Michael was astounded at the answer to part (a) of this problem. He realized he had more
wasteful habits, and he made a list of possible savings to see how much richer he could be at
age 65. What are the rewards to Michael’s frugality?
 CHAPTER 2 The Time Value of Money 63

A B C D
MICHAEL SAVES MONEY
1 By changing his consumption habits
2 Annual interest rate 4%
Weekly Yearly Future value at
3 Item savings savings age 65
4
5 Latte versus regular coffee $ 10.00 $ 520.00
6 Deli versus brown bag lunch $ 25.00 $ 1,300.00
7 Excess alcohol $ 10.00 $ 520.00
8 Cigarettes $ 11.00 $ 572.00
9 Candy $ 5.00 $ 260.00
10 Excess junk food $ 10.00 $ 520.00
11 Cell phone (chat vs. needed calls) $ 6.00 $ 312.00
12 Wasted groceries $ 7.00 $ 364.00
13 Restaurants.fast food vs. eat at home $ 30.00 $ 1,560.00
14 Wasted energy: heat, AC, lights $ 12.00 $ 624.00
15 Movies versus books $ 10.00 $ 520.00
16 Expensive cable TV $ 13.00 $ 676.00
17 Wasted gasoline on excessive trips, etc. $ 8.00 $ 416.00
18 Wasteful spending at mall $ 10.00 $ 520.00
19 Money saved by time Michael is 65

APPENDIX: ALGEBRAIC PRESENT VALUE FORMULAS

M ost of the computations in the chapter can also be done with one basic bit of high-
school algebra relating to the sum of a geometric series. Suppose you want to find the sum of a
geometric series of n numbers a + aq + aq 2 + aq 3 + ... + aq n−1 . In the jargon of geometric series,
a is the first term
q is the ratio between terms (the number by which the previous term is multiplied to get
the next term)
n is the number of terms

Denote the sum of the series by S: S = a + aq + aq 2 + aq 3 + ... + aq n−1 . In high school you
learned a trick to find the value of S:
1. Multiply S by q:
qS = aq + aq 2 + aq 3 + … + aq n−1 + aq n

2. Subtract qS from S:

S = a + aq + aq 2 + aq 3 + ⋯ + aq n − 1
−qS = − ( aq + aq 2 + aq 3 + … + aq n − 1 + aq n )

a (1 − q n )
(1 − q )S = a − aq n ⇒ S = 1− q

In the remainder of this appendix we apply this formula to a variety of situations covered
in the chapter.
64 PART ONE CAPITAL BUDGETING AND VALUATION

Future Value a Constant Payment

This topic is covered in Section 2.1. The problem there is to find the value of $100 deposited
annually over 10 years, with the first payment today:
S = 100 * (1.06)10 + 100 * (1.06)9 + ... + 100 * (1.06) = ???

For this geometric series,

a = first term = 100 * 1.06 10

1
q = ratio =
1.06
n = number of terms = 10
⎛ ⎛ 1 ⎞ 10 ⎞
100 * 1.06 ⎜ 1 − ⎜
10
⎟ ⎟
a (1 − q n ) ⎝ ⎝ 1.06 ⎠ ⎠
The formula gives S = = = 1397.16 , where we have done
1− q 1
1−
1.06
the calculation in Excel.

A B C
1 FUTURE VALUE FORMULA
2 First term, a 179.0848 <-- =100*1.06^10
3 Ratio, q 0.943396 <-- =1/1.06
4 Number of terms, n 10
5
6 Sum 1,397.16 <-- =B2*(1-B3^B4)/(1-B3)
7 Excel PV function 1,397.16 <-- =FV(6%,B4,-100,,1)

Substituting symbols for the numerical values we get

n⎛ ⎛ 1 ⎞ ⎞
n

Future value of n payments Payment * 1 + r 1 −

( ) ⎜ ⎝⎜ 1 + r ⎠⎟ ⎟
⎝ ⎠
at end of year n, at interest r = = FV(r,n,-1,,1)
1 !"""""#"""""$
first payment today 1 − ↑
1+ r The Excel function

PV of an Annuity
We can also apply the formula to find the present value of an annuity. Suppose, for example, that
we want to calculate the PV of an annuity of $150 per year for 5 years:
150 150 150 150 150 .
+ + + +
(1.06 ) (1.06 ) (1.06 ) (1.06 ) (1.06 )5
2 3 4
 CHAPTER 2 The Time Value of Money 65

For this annuity,

7
150 .
a = first term =
1.06
1
q = ratio =
1.06

n= number of terms = 5.
Thus, the present value of the annuity becomes

150 ⎛ ⎛ 1 ⎞ ⎞
5

1
⎜ ⎜− ⎟ ⎟
a (1 − q n ) 1.06 ⎝ ⎝ 1.06 ⎠ ⎠
S= = = 631.85 = PV(6%,5,-150)
!""""""#""""""$ .
1− q 1
1− ↑
1.06 The Excel function

We can work this out in a spreadsheet.

A B C
1 ANNUITY FORMULAS
2 First term, a 141.5094 <-- =150/1.06
3 Ratio, q 0.9434 <-- =1/1.06
4 Number of terms, n 5
5
6 Sum 631.85 <-- =B2*(1-B3^B4)/(1-B3)
7 Excel PV function 631.85 <-- =PV(6%,5,-150)

Cleaning Up the Formula (a Bit)

Textbooks often manipulate the annuity formula to make it look “better.” Here’s an example of
something you might see in a textbook.

annual payment ⎛ ⎛ 1 ⎞ ⎞
n

1 −
⎜ ⎜⎝ 1 + r ⎟⎠ ⎟
a (1 − q n ) (1 + r ) ⎝ ⎠
S= =
1− q 1
1−
1+ r
annual payment ⎛ ⎛ 1 ⎞ ⎞
n

= 1 −
⎜ ⎜⎝ 1 + r ⎟⎠ ⎟
r ⎝ ⎠

This is not a different annuity formula—it’s just an algebraic simplification of the formula
we’ve been using. If you put it in Excel you’ll get the same answer (and in our opinion, there’s
no point in the simplification).

7
If you’re like most of the rest of humanity, you (mistakenly) thought that the first term was
a = 150. But look at the series—the first term actually is 150 . So there you are.
1.06
66 PART ONE CAPITAL BUDGETING AND VALUATION

The Present Value of Series of Growing Payments

Suppose we’re trying to apply the formula to the following series:

2 3 4
150 150 * (1.10 ) 150 * (1.10 ) 150 * (1.10 ) 150 * (1.10 )
+ + + +
(1.06 ) (1.06 )2 (1.06 )3 (1.06 )4 (1.06 )5
Here there are five payments, the first of which is $150; this payment grows at an annual rate of
10%. We can apply the formula
150 .
a = first term =
1.06

1.10
q = ratio =
1.06
n = number of terms = 5.
In the following spreadsheet, you can see that the formula and the Excel NPV function give
the same answer for the present value:

A B C
1 A CONSTANT-GROWTH CASH FLOW
2 First term, a 141.5094 <-- =150/1.06
3 Ratio, q 1.0377 <-- =1.1/1.06
4 Number of terms, n 5
5
6 Sum 763.00 <-- =B2*(1-B3^B4)/(1-B3)
7
8 Year Payment
9 1 150.00
10 2 165.00 <-- =B9*1.1
11 3 181.50 <-- =B10*1.1
12 4 199.65
13 5 219.62
14
15 Present value 763.00 <-- =NPV(6%,B9:B13)

Note that the formula in cell B6 is more compact than Excel’s NPV function. NPV requires
you to list all the payments, whereas the formula in cell B6 requires only several lines (think
about finding the present value of a very long series of growing payments—clearly the formula
is more efficient).

The Present Value of a Constant Growth Annuity

An annuity is a series of annual payments; a constant growth annuity is an annuity whose pay-
ments grow at a constant rate. Here’s an example of such a series.

2 3 4
20 20 * (1.05 ) 20 * (1.05 ) 20 * (1.05 ) 20 * (1.05 )
+ + + + + ...
(1.10 ) (1.10 )2 (1.10 )3 (1.10 )4 (1.10 )5
 CHAPTER 2 The Time Value of Money 67

We can fit this into our formula:

20
a = first term =
1.10

1.05
q = ratio =
1.10

n=number of terms=∞.
The formula gives

20 ⎛ ⎛ 1.05 ⎞ ⎞
n

⎜1 − ⎜ ⎟ ⎟
a (1 − q n ) 1.10 ⎝ ⎝ 1.10 ⎠ ⎠
S= = .
1− q 1.05
1−
1.10
n
⎛ 1.05 ⎞
When n→∞, ⎜ → 0, so that
⎝ 1.10 ⎟⎠

20 ⎛ ⎛ 1.05 ⎞ ⎞
n

⎜1 − ⎜ ⎟ ⎟ 20
a (1 − q n ) 1.10 ⎝ ⎝ 1.10 ⎠ ⎠ 1.10 20
S= = = = = 400
1− q 1.05 1.05 0.10 − 0.05
1− 1−
1.10 1.10

Warning: You have to be careful! This version of the formula only works because the
growth rate of 5% is smaller than the discount rate of 10%. The discounted sum of an infinite
series of constantly growing payments only exists when the growth rate g is less than the dis-
count rate r.
Here’s a general formula:

∞
CF ⎛ ⎛ 1 + g ⎞ ⎞
1−
sumof
CF CF * (1 + g ) CF * (1 + g )
2
(1 + r )⎜⎝ ⎜⎝ 1 + r ⎟⎠ ⎟⎠
constant-growth = + + + ... =
(1 + r ) (1 + r )2 (1 + r)
3
1−
1+ g
annuity 1+ r
⎧ CF
⎪ when g < r
=⎨ r−g
⎪undefined otherwise
⎩

To summarize,
The present value of a constant-growth annuity—a series of cash flows with first term CF
that grows at rate g—that is discounted at rate r is CF , provided g < r.
r−g
We use this formula in Chapter 6 when we discuss the valuation of stocks using discounted
dividends (the “Gordon dividend model”).
CHAP TER

What Does It Cost? IRR and the

3 Time Value of Money

CHAPTER CONTENTS
Overview 68
3.1. Don’t Trust the Quoted Interest Rate—Three Examples 70
3.2. Calculating the Cost of a Mortgage 73
3.3. Mortgages with Monthly Payments 77
3.4. Lease or Purchase? 81
3.5. Auto Lease Example 84
3.6. More-Than-Once-a-Year Compounding and the EAIR 90
3.7. Continuous Compounding and Discounting (Advanced Topic) 93
Summing Up 97
Exercises 97

Overview
In Chapter 2 we introduced the basic tools of financial analysis—present value (PV), net present
value (NPV), and internal rate of return (IRR). In Chapters 3–7 we use these tools to answer
two basic types of questions:
• What is it worth? Presented with an asset—this could be a stock, a bond, a real estate
investment, a computer, or a used car—we would like to know how to value the asset.
The finance tools used to answer this question are mostly related to the concept of present

68
 CHAPTER 3 What Does It Cost? IRR and the Time Value of Money 69

value (PV) and net present value (NPV). The basic principle is that the value of an asset
is the present value of its future cash flows. Comparing this present value to the asset’s
price tells us whether we should buy it. We introduced PV and NPV in Chapter 2 and we
return to them and their applications in Chapter 4.
• What does it cost? This sounds like an innocuous question—after all, you usually know
the price of the stock, bond, real estate investment, or used car you’re trying to value.
But many interesting questions of fi nancing alternatives depend on the relative interest
costs of each alternative. For example, should you pay cash for a car or borrow money
to pay for it (and hence make a series of payments over time)? Should you lease that
new computer you want or buy it outright? Or perhaps borrow money from the bank
to buy it? It’s all clearly a question of cost—you’d like to pick the alternative that costs
the least.
The tools used for the second question—What does it cost?—are mostly derived from
the concept of internal rate of return (IRR). This concept—introduced in Chapter 2—mea-
sures the compound rate of return of a series of cash flows. In this chapter we’ll show
you that rate of return, when properly used, can be used to measure the cost of financing
alternatives. The main concept presented in this chapter is the effective annual interest
rate (EAIR), a concept based on the annualized IRR that you can use to compare financing
alternatives.
Much of the discussion in this chapter relates to calculating the EAIR and showing its
relation to the IRR. We show that the EAIR is a much better gauge of the financing costs than
the annualized percentage rate (APR), the financing cost often quoted by many lenders such as
banks and credit card companies. We show you how to apply this concept to credit-card bor-
rowing, mortgages, and auto leasing. A case that comes with this book applies the concept to
student loans.

Finance Concepts Discussed

• Effective annual interest rate (EAIR)
• Internal rate of return (IRR)
• Annual percentage rate (APR)
• Loan tables
• Mortgage points
• Lease versus purchase

Excel Functions Used

• IRR
• PMT, IPMT, and PPMT
• Rate
• NPV
• PV
• Exp
• Ln
• Sum
• Goal Seek
70 PART ONE CAPITAL BUDGETING AND VALUATION

3.1. Don’t Trust the Quoted Interest Rate—Three Examples

To set the stage for the somewhat more complicated examples in the rest of the chapter, we start
with three simple examples. Each example shows why quoted interest rates are not necessarily
representative of costs.
We use the three examples in this section to introduce the concept of EAIR.
The effective annual interest rate (EAIR) is the annualized internal rate of return (IRR) of
the cash flows of a particular credit arrangement or security.

Example 1: Borrowing from a Bank

In finance “cost” often refers to an interest rate: “I’m taking a loan from the West Hampton
Bank because it’s cheaper—West Hampton charges 8% instead of the 9% charged by the East
Hampton Bank.” This is a sentence we all understand—8% interest results in lower payments
than 9% interest.
But now consider the following alternatives. You want to borrow $100 for 1 year, and
you’ve investigated both the West Hampton Bank and the East Hampton Bank:
• West Hampton Bank is lending at 8% interest. If you borrow $100 from them today,
you’ll have to repay them $108 in 1 year.
• The East Hampton Bank is willing to lend you any amount you want at a 6% rate. BUT:
East Hampton Bank has a “loan initiation charge” of 4%. What this means is that for each
$100 you borrow, you’ll get only $96, even though you’ll pay interest on the full $100.1
Obviously the cost of West Hampton’s loan is 8%. But is this cheaper or more expensive
than the East Hampton loan? You reason as follows: To actually get $100 in your hands from
East Hampton, you’ll have to borrow $104.17; after they deduct their 4% charge, you’ll be left
with $100 in hand, which is exactly what you need (96% * 104.17 = 100). At the end of a year,
you’ll owe East Hampton Bank $104.17 + 6% interest = $110.42. So the actual interest rate
110.42
they’re charging you (the effective annual interest rate) is EAIR = − 1 = 10.42% .
100

A B C D
CHEAPER LOAN: WEST HAMPTON
1 OR EAST HAMPTON?
West East
2 Hampton Hampton
3 Quoted interest rate 8% 6%
4 Initial charges 0% 4%
Amount borrowed to
5 get $100 today 100.00 104.17 <-- =100/(1-C4)
6
7 Date Cash flow Cash flow
8 Date 1, get loan 100.00 100.00
9 Date 2, pay it back -108.00 -110.42 <-- =-C5*(1+C3)
Effective annual interest
10 rate, EAIR 8.00% 10.42% <-- =IRR(C8:C9)

1
Such charges are common in many kinds of bank loans, especially mortgages. They’re obviously a way
to increase the cost of the loan and befuddle the customer.
 CHAPTER 3 What Does It Cost? IRR and the Time Value of Money 71

This makes everything easier—West Hampton’s 8% loan (EAIR = 8%) is actually cheaper
than East Hampton’s “6%” loan (EAIR = 10.42%).
Note in this example that the EAIR is just an IRR, adjusted for the cost of taking the loan
from East Hampton. EAIR is always an interest rate, but usually with some kind of adjustment.
The lesson of Example 1: When calculating the cost of financial alternatives, you must
include the fees, even if the lender (in our case East Hampton Bank) fudges this issue.

Example 2: Monthly versus Annual Interest

You want to buy a computer for $1,000. You don’t have any money, so you’ll have to finance the
computer by taking out a loan for $1,000. You’ve got two financing alternatives:
• Your bank will lend you the money for 15% annual interest. When you ask the bank what
this means they assure you that they will give you $1,000 today and ask you to repay
$1,150 at the end of 1 year.
• Loan Shark Financing Company will also lend you the $1,000. Their ads say “14.4%
annual percentage rate (APR) on a monthly basis.” When you ask them what this
means, it turns out that Loan Shark charges 1.2% per month (they explain to you that
14.4%
= 1.2%). This means that each month Loan Shark adds 1.2% to the loan balance
12
outstanding at the end of the previous month:

A B C D E F G H
HOW LOAN SHARK CHARGES:
1 14.4% PER YEAR ON A MONTHLY BASIS = 1.2% PER MONTH
2
3 Loan balance outstanding at the end of each month
4 Month 0 Month 1 Month 2 Month 3 Month 4 Month 5 Month 6
5 $ 1,000.00
6 $ 1,012.00 <-- =A5*(1+1.2%)
7 $ 1,024.14 <-- =B6*(1+1.2%)
8 $ 1,036.43 <-- =C7*(1+1.2%)
9 $ 1,048.87 <-- =D8*(1+1.2%)
10 $ 1,061.46 <-- =E9*(1+1.2%)
11 $ 1,074.19 <-- =F10*(1+1.2%)
12
13 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12
14 $ 1,087.09 <-- =G11*(1+1.2%)
15 $ 1,100.13 <-- =A14*(1+1.2%)
16 $ 1,113.33 <-- =B15*(1+1.2%)
17 $ 1,126.69 <-- =C16*(1+1.2%)
18 $ 1,140.21 <-- =D17*(1+1.2%)
19 $ 1,153.89 <-- =E18*(1+1.2%)

By the end of the year, you will owe Loan Shark $1,153.89.

14.4% 12
$1,153.89 = $1,500 * 1 + ( 12 $
!""#""
)
↑
Loan Shark’s loan
is “compounded
monthly.” This means
that the 14.4% annual
interest translates
to 1.2% per month.

Because this is more than the $1,150 you will owe the bank, you should prefer the bank loan.
72 PART ONE CAPITAL BUDGETING AND VALUATION

The effective annual interest rate (EAIR) of each loan is the annualized interest rate
charged by the loan. The bank charges you 15% annually and the loan shark charges you 15.39%
annually:

A B C D
1 THE BANK OR LOAN SHARK?
2 Bank Loan Shark
3 Quoted interest rate 15.0% 14.4%
4 Borrow today 1,000.00 1,000.00
5 Repay in one year -1,150.00 -1,153.89 <-- =-C4*(1+C3/12)^12
Effective annual interest
6 rate, EAIR 15.00% 15.39% <-- =-C5/C4-1
7
A second way to
8 compute the EAIR
9 Monthly interest rate 1.20% <-- =C3/12
EAIR
10 Annualized monthly rate 15.39% <-- =(1+C9)^12-1

Cells C9 and C10 show another way to compute the 15.39% EAIR charged by the loan
shark. Cell C9 computes the monthly rate charged by the loan shark as 1.20%, and cell C10
12
annualizes this rate ⎛⎜ 1 +
14.4% ⎞
− 1 = 15.39%. Thus, there are two ways to compute the
EAIR: ⎝ 12 ⎟⎠

⎧ Payment at end of year $1,153.89

⎪ Loan taken out beginning of year − 1 = $1,000.00 − 1 ← Cell C6
⎪
EAIR = 15.39% = ⎨ 12
⎪⎛ 1 + 14.4% ⎞ − 1 ← Cell C10
⎪⎩⎜⎝ 12 ⎟⎠

The lesson of Example 2: The annual percentage rate (APR) does not always correctly
reflect the costs of borrowing. To compute the true cost, calculate the effective annual interest rate
(EAIR).

Example 3: An “Interest Free” Loan

You’re buying a used car. The Junkmobile your heart desires has a price tag of $2,000. You have
two financing options:
• The dealer explains that if you pay cash you’ll get a 15% discount. In this case you’ll pay
$1,700 for the car today. Because you don’t have any money now, you intend to borrow
the $1,700 from your Uncle Frank, who charges 10% interest.
• On the other hand, the dealer will give you “0% financing”: You don’t pay anything now,
and you can pay the dealer the full cost of the Junkmobile at the end of the year.
Thus, you have two choices: The dealer’s 0% financing and Uncle Frank’s 10% rate. Which
is cheaper?
 CHAPTER 3 What Does It Cost? IRR and the Time Value of Money 73

A little thought will show that the dealer is actually charging you an effective annual inter-
est rate (EAIR) of 17.65%: His “0% financing” essentially involves a loan to you of $1,700 with
an end-year repayment of $2,000:

A B C D E
1 FINANCING THE JUNKMOBILE
Dealer's
"0% Differential
2 Year Pay cash financing" cash flow
3 0 -1,700 0 1,700 <-- =C3-B3
4 1 -2,000 -2,000 <-- =C4-B4
5
Effective annual interest
rate (EAIR) charged by
6 dealer 17.65% <-- =IRR(D3:D4)

Uncle Frank’s EAIR is 10%: He will loan you $1,700 and have you repay only $1,870. So you’re
better off borrowing from him.
The lesson of Example 3: Free loans are usually not free! To compute the cost of a “free”
loan, calculate the EAIR of the differential cash flows.

3.2. Calculating the Cost of a Mortgage

Now that we’ve set the stage, we’ll proceed to a series of somewhat more complicated examples.
We start with a mortgage. Housing is most often the largest personal asset an individual owns.
Financing housing with a mortgage is something almost every reader of this book will do in
his or her lifetime. Calculating the cost of a mortgage is thus a useful exercise. In this chapter
mortgages will be one of the examples we use to illustrate the problems encountered in comput-
ing the cost of financial assets.

A Simple Mortgage
We start with a simple example. Your bank has agreed to give you a $100,000 mortgage, to
be repaid over 10 years at 8% interest. For simplicity, we assume that the payments on the
mortgage are annual.2 The bank calculates the annual payment as $14,902.95, using Excel’s PMT
function.
The PMT function calculates an annuity payment (a constant periodic payment) that pays
off a loan:

10
14,902.95 14,902.95 14,902.95 14,902.95 ... 14,902.95
100,000 = ∑ = + + + +
t =1 (1.08) t (1.08) (1.08)2 (1.08)3 (1.08)10

2
In the real world payments are probably monthly; see the example in Section 3.3.
74 PART ONE CAPITAL BUDGETING AND VALUATION

DIALOG BOX FOR PMT FUNCTION

The dialog box for Excel’s PMT function: Rate is the interest rate on the loan, Nper is the num-
ber of repayment periods, and Pv is the loan principal. As discussed in Chapter 2, if the loan
principal is written as a positive number, Excel presents the payment as a negative number; to
avoid this, we write Pv as a negative number.

We can summarize all of this in an Excel spreadsheet:

A B C
1 A SIMPLE MORTGAGE
2 Mortgage principal 100,000
3 Interest rate 8%
4 Mortgage term (years) 10
5 Annual payment $14,902.95 <-- =PMT(B3,B4,-B2)
6
Mortgage
7 Year cash flow
8 0 100,000.00
9 1 -14,902.95 <-- =-$B$5
10 2 -14,902.95
11 3 -14,902.95
12 4 -14,902.95
13 5 -14,902.95
14 6 -14,902.95
15 7 -14,902.95
16 8 -14,902.95
17 9 -14,902.95
18 10 -14,902.95
19
Effective annual
20 interest rate (EAIR) 8.00% <-- =IRR(B8:B18)
 CHAPTER 3 What Does It Cost? IRR and the Time Value of Money 75

The EAIR of this particular mortgage is simply the internal rate of return of its payments.
Because the payments on the mortgage are annual, the IRR in cell B20 is already in annual
terms.

The Bank Charges “Mortgage Points”

As in the previous example, you’ve asked the bank for a $100,000 mortgage. They’ve agreed to
give you this mortgage, and they’ve explained that you’ll be asked to repay $14,902.95 per year
for the next 10 years. However, when you get to the bank, you learn that the bank has deducted
“1.5 points” from your mortgage. What this means is that you only get $98,500 ($100,000 minus
1.5%). Your payments, however, continue to be based on a principal of $100,000.3 You realize
immediately that this mortgage is more expensive than the mortgage discussed in the previous
subsection. The question is: by how much is it more expensive? By calculating the EAIR on the
mortgage we can answer this question. The calculation below shows that you’re actually paying
8.34% interest annually.

A B C
1 A MORTGAGE WITH POINTS
2 Mortgage principal 100,000
3 "Points" 1.50%
4 Quoted interest 8.00%
5 Mortgage term (years) 10
6 Annual payment $14,902.95 <-- =PMT(B4,B5,-B2)
7
Mortgage
8 Year cash flow
9 0 98,500.00 <-- =B2*(1-B3)
10 1 -14,902.95 <-- =-$B$6
11 2 -14,902.95
12 3 -14,902.95
13 4 -14,902.95
14 5 -14,902.95
15 6 -14,902.95
16 7 -14,902.95
17 8 -14,902.95
18 9 -14,902.95
19 10 -14,902.95
20
Effective annual
21 interest rate (EAIR) 8.34% <-- =IRR(B9:B19)

Note that the EAIR of 8.34% is the IRR of the stream of payments consisting of the actual loan
amount ($98,500) versus the actual payments you’re making ($14,902.95 annually). Here’s the
calculation:

10
14,902.95 14,902.95 14,902.95 14,902.95 ... 14,902.95
98,500 = ∑ = + + + +
t =1
t
(1.0834 ) (1.0834 ) (1.0834 )2 (1.0834 )3 (1.0834 )10

3
Some banks and mortgage brokers also charge an “origination fee,” defined as a payment to cover the
initial cost of processing the mortgage. The net effect of “points” and the “origination fee” is the same—
you are charged interest on more money than you actually get in hand.
76 PART ONE CAPITAL BUDGETING AND VALUATION

At the end of each year, you will report to the Internal Revenue Service the amount of inter-
est paid on the mortgage. Because this interest is an expense for tax purposes, it’s important to
get it right. To calculate this interest, we need a loan table, which allocates the each year’s pay-
ment made between interest and repayment of principal (see Section 2.5, page 42). This table is
sometimes called an “amortization table” (“amortize” means to repay with a series of periodic
payments):

A B C D E F
Effective annual
21 interest rate 8.34% <-- =IRR(B9:B19)
22
23 MORTGAGE AMORTIZATION TABLE
$B$21*B25 Part of payment
Mortgage B25-E25 Part of payment that is repayment
principal at Payment that is interest of principal
beginning of at end of (expense for (not an expense
24 Year year year taxes!) for tax purposes)
25 1 98,500.00 $14,902.95 $8,211.41 6,691.54 <-- =C25-D25
26 2 91,808.46 $14,902.95 $7,653.58 7,249.37
27 3 84,559.09 $14,902.95 $7,049.23 7,853.71
28 4 76,705.38 $14,902.95 $6,394.51 8,508.44
29 5 68,196.94 $14,902.95 $5,685.21 9,217.74
30 6 58,979.20 $14,902.95 $4,916.78 9,986.17
31 7 48,993.03 $14,902.95 $4,084.28 10,818.66
32 8 38,174.37 $14,902.95 $3,182.39 11,720.56
33 9 26,453.81 $14,902.95 $2,205.31 12,697.64
34 10 13,756.17 $14,902.95 $1,146.78 13,756.17

Column D of the table gives the interest expense for tax purposes. If you report inter-
est payments on your tax return, this is the payment you’d be allowed to report. Note
that the interest portion of the annual $14,902.95 payments gets smaller over the years,
whereas the repayment of the principal portion (which is not deductible for tax purposes)
gets larger.

Calculating the Individual Payments with IPMT and PPMT

The above spreadsheet gives the intuition behind the loan table and the split between
interest and principal of each payment. The interest and repayment-of-principal payments
can be computed directly using the Excel functions IPMT and PPMT. This is illustrated
below.4

4
Note that IPMT and PPMT work only when the loan payments are equal.
 CHAPTER 3 What Does It Cost? IRR and the Time Value of Money 77

A B C D E F G

COMPUTING THE MORTGAGE PAYMENTS

1
USING IPMT AND PPMT
2 Loan principal 100,000
3 Points 1.50%
4 Quoted interest 8.00% The interest rate from the previous spreadsheet
5 Term (years) 10 has been formatted to show only two decimal
6 Effective interest rate 8.34% <-- ='Mortgage with points'!B21 places. The actual interest rate is
7 Annual payment $14,902.95 <-- =PMT(B6,B5,-B2*(1-B3)) 8.336459884%
8
9 MORTGAGE AMORTIZATION TABLE
Mortgage
Payment Part of payment
principal at Part of payment
Year at end of that is repayment
beginning of that is interest
year of principal
10 year
11 1 100,000.00 $14,902.95 $8,336.46 6,793.44
12 2 93,206.56 $14,902.95 $7,770.13 7,359.77
13 3 85,846.79 $14,902.95 $7,156.58 7,973.31
14 4 77,873.48 $14,902.95 $6,491.89 8,638.01
15 5 69,235.47 $14,902.95 $5,771.79 9,358.11
16 6 59,877.36 $14,902.95 $4,991.65 10,138.24
17 7 49,739.12 $14,902.95 $4,146.48 10,983.42
18 8 38,755.70 $14,902.95 $3,230.85 11,899.04
19 9 26,856.66 $14,902.95 $2,238.89 12,891.00
20 10 13,965.66 $14,902.95 $1,164.24 13,965.66
21
22 =IPMT($B$6,A11,$B$5,-$B$2)
23
24 =PPMT($B$6,A11,$B$5,-$B$2)

Here is the dialog box for IPMT in cell D9 (the syntax of PPMT is similar). Note that Per
specifies the specific period for which the interest is calculated:

3.3. Mortgages with Monthly Payments

We continue with the mortgage examples from Section 3.2. This time we introduce the concept
of monthly payments. Suppose you get a $100,000 mortgage with an 8% interest rate, payable
78 PART ONE CAPITAL BUDGETING AND VALUATION

monthly, and suppose you have to pay the mortgage back over 1 year (12 months).5 Many
banks interpret the combination of 8% annual interest and “payable monthly” to mean that the
8%
monthly interest on the mortgage is = 0.667% . This is often referred to as “monthly
12
compounding,” although the usage of this term is not uniform. To compute the monthly repay-
ment on the mortgage, we use Excel’s PMT function:

A B C
1 MORTGAGE WITH MONTHLY PAYMENTS
2 Loan principal 100,000
3 Loan term (years) 1
4 Quoted interest rate 8%
5
6 Month Cash flow
7 0 100,000.00
8 1 -8,698.84 <-- =PMT($B$4/12,$B$3*12,$B$2)
9 2 -8,698.84
10 3 -8,698.84
11 4 -8,698.84
12 5 -8,698.84
13 6 -8,698.84
14 7 -8,698.84
15 8 -8,698.84
16 9 -8,698.84
17 10 -8,698.84
18 11 -8,698.84
19 12 -8,698.84
20
21 Monthly IRR 0.667% <-- =IRR(B7:B19)
Effective annual
22 interest rate, EAIR 8.30% <-- =(1+B21)^12-1

The EAIR on the mortgage in the example is computed by using Excel’s IRR function (cell
B21). In our case the IRR function will give a monthly interest rate of 0.667% (we already knew
12
8% ⎛ 8% ⎞
this because = 0.667% ). Annualizing this gives 8.30% = ⎜ 1 + − 1 (cell B22).
12 ⎝ 12 ⎟⎠
Mortgages: A More Complicated Example
As we saw in Section 3.1, many mortgages in the United States have “origination fees” or
“discount points” (the latter are often just called “points”). All of these fees reduce the initial
amount given to you by the bank, without reducing the principal on which the bank computes
its payments (sounds misleading, doesn’t it?).
As an example, consider the above 12-month mortgage with an 8% annual rate, payable
monthly, but with an origination fee of 0.5% and 1 point. This means that you actually get

5
Most mortgages are, of course, for a much longer term. But 12 months enables us to fit the example com-
fortably within a page. Later we’ll consider longer terms, but the principles will be the same.
 CHAPTER 3 What Does It Cost? IRR and the Time Value of Money 79

$98,500 ($100,000 minus $500 for the origination fee and $1,000 for the point), but that
your monthly repayment remains $8,698.84:

A B C
MORTGAGE EXAMPLE WITH POINTS AND
1 ORIGINATION FEE
2 Loan principal 100,000.00
3 Loan term (years) 1
4 Quoted interest rate 8%
5 Discount points 1
6 Origination fee 0.5%
7
8 Month Cash flow
9 0 98,500.00 <-- =B2*(1-B5/100-B6)
10 1 -8,698.84 <-- =PMT($B$4/12,$B$3*12,$B$2)
11 2 -8,698.84
12 3 -8,698.84
13 4 -8,698.84
14 5 -8,698.84
15 6 -8,698.84
16 7 -8,698.84
17 8 -8,698.84
18 9 -8,698.84
19 10 -8,698.84
20 11 -8,698.84
21 12 -8,698.84
22
23 Monthly IRR 0.9044% <-- =IRR(B9:B21)
24 EAIR 11.41% <-- =(1+B23)^12-1
25
Monthly IRR using
26 Excel’s Rate function 0.9044% <-- =RATE(12,8698.84,-98500)

The monthly IRR (cell B23) is the interest rate that sets the present value of the monthly
payments equal to the initial $98,500 received:

$8,698.94 $8,698.94 $8,698.94 $8,698.94

$98,500 = + + + ... + .
(1 + 0.9044%) (1 + 0.9044%) (1 + 0.9044%)
2 3
(1 + 0.9044%)12

12
EAIR = 11.41% = (1 + 0.9044%) − 1 is the annualized cost of the mortgage payments.
As you can see in cell B26, Excel’s Rate function will also calculate the monthly IRR that
we’ve calculated in cell B23.
80 PART ONE CAPITAL BUDGETING AND VALUATION

EXCEL NOTE: CALCULATING THE MONTHLY IRR WITH RATE

The Rate function computes the IRR of a series of constant (the financial jargon is “flat”
or “even”) payments so that the discounted value equals the PV indicated. Note that in the Rate
function the signs of the payments (indicated by Pmt) and the Pv of these payments must be
different. This is a feature Rate shares with Excel functions like PMT and PV, discussed in
Chapter 2.

Longer-Term Mortgages
Suppose the mortgage in the previous example has a 30-year term (meaning: 360 = 30 * 12
repayments). Each repayment would be $733.76 and the EAIR would be 8.4721%:

A B C
30-YEAR MORTGAGE
1 with points and origination fee
2 Loan principal 100,000.00
3 Loan term (years) 30
4 Quoted interest rate 8%
5 Discount points 1
6 Origination fee 0.5%
7
8 Initial amount of loan, net of fees 98,500.00 <-- =B2*(1-B5/100-B6)
9 Monthly repayment 733.76 <-- =PMT(B4/12,B3*12,-B2)
10
11 Calculating the EAIR
12 Monthly interest rate 0.6800% <-- =RATE(B3*12,B9,-B8)
13 Effective annual interest rate (EAIR) 8.4721% <-- =(1+B12)^12-1

We’ve used PMT to calculate the payment and Rate to compute the monthly interest
rate. The EAIR is computed in the usual manner—by compounding the monthly payments
(cell B13).
 CHAPTER 3 What Does It Cost? IRR and the Time Value of Money 81

Note that the effect of the initial mortgage fees on mortgage EAIR declines when the mort-
gage is longer term:
• For the 1-year mortgage discussed previously, the 1.5% initial fee increased the EAIR of
the mortgage from 8 to 11.41%.
• For the 30-year mortgage, the same initial fees increase the EAIR from 8 to 8.4721%.
• The reason that the fees have a smaller effect for the second mortgage is that they are
spread out over a much longer term.

3.4. Lease or Purchase?

This section uses the concepts of present value and internal rate of return to explore the relative
advantages of leasing versus buying an asset. As you will see, the choice between leasing and
buying basically comes down to choosing the cheaper of two methods of financing.
Here’s our terminology: A lease is a rental agreement; in our examples leases will usually
be for equipment (we discuss a computer lease and a car lease), but the analysis for real estate is
virtually the same. The party that rents the asset and uses it is called the lessee and the owner
of the asset is called the lessor.

A Simple Lease Example

You need a new computer, but you can’t decide whether you should buy it or lease it. The com-
puter costs $4,000. The lessor is your neighborhood computer leasing company, which offers
to lease you the computer for $1,500 per year. The lessor’s conditions are that you make four
payments of $1,500: the first payment at the start of the lease (time 0) and subsequent payments
at the end of years 1, 2, and 3. Based on past experience, you know that you will keep your new
computer for about 3 years. One additional fact: you can borrow from your bank at 15%.
Here is a spreadsheet with the cash flows for the lease and for the purchase:

A B C D
1 BASIC LEASE VERSUS PURCHASE
2 Asset cost 4,000.00
3 Annual lease payment 1,500.00
4 Bank rate 15%
5
Purchase Lease
6 Year cash flow cash flow
7 0 4,000.00 1,500.00
8 1 1,500.00
9 2 1,500.00
10 3 1,500.00
11
12 PV of costs 4,000.00 4,924.84 <-- =C7+NPV($B$4,C8:C10)
13 Lease or purchase? purchase <-- =IF(B12<C12,"purchase","lease")

To decide whether the lease is preferable, we discount the cash flows from both the lease
and the purchase at the 15% bank lending rate. We write the outflows as positive numbers, so
that the PV in row 12 is the present value of the costs. As you can see in cell B12, the PV of the
82 PART ONE CAPITAL BUDGETING AND VALUATION

lease costs is $4,924.84, which is more than the $4,000 cost of purchasing the computer. Thus,
you prefer the purchase, which is less costly.
There’s another way of doing this same calculation. We compute the IRR of the differential
cash flows—subtracting the lease cash flow from the purchase cash flow in each of the years:
A B C D E
BASIC LEASE VERSUS PURCHASE
1 THE DIFFERENTIAL CASH FLOWS
2 Asset cost 4,000
3 Annual lease payment 1,500
4 Bank rate 15%
5
Purchase Lease Differential
6 Year cash flow cash flow cash flow
7 0 4,000 1,500 2,500 <-- =B7-C7
8 1 1,500 -1,500 <-- =B8-C8
9 2 1,500 -1,500 <-- =B9-C9
10 3 1,500 -1,500 <-- =B10-C10
11
12 IRR of differential cash flows 36.31% <-- =IRR(D7:D10)
13 Lease or purchase? purchase <-- =IF(D12>B4,"purchase","lease")
14
Explanation: The lease is like a loan--you save 2,500 in year 0 and pay back 1,500 in each of years 1-3. The IRR
15 of this "loan" is 36.31%.

The computer lease is equivalent to paying $1,500 for the computer in year 0 and taking a loan
of $2,500 from the computer leasing company. The computer leasing “loan” has three equal
repayments of $1,500 and an IRR of 36.31%. Because you can borrow money from the bank at
15%, you would prefer to purchase the computer with borrowed money from the bank (at 15%)
rather than “borrowing” $2,500 from the leasing company, which charges 36.31%.
In the spreadsheet below you can see another way to make this same point. If you borrowed
$2,500 from the bank at 15%, you’d have to pay back $1,094.94 per year for each of the next
3 years (assuming the bank asked for a flat repayment schedule). This is substantially less than
the $1,500 that the computer lessor asks for on the same loan.

1,094.94 1,094.94 1,094.94

2,500 = + + .
1.15 (1.15 )2 (1.15 )3
The conclusion is that if you decide to borrow $2,500 to purchase the computer, you should do
so from the bank rather than from the computer leasing company. In the spreadsheet, we’ve used
the Excel PMT function to compute the repayment:

A B C D E
17 What if you borrowed $2,500 from the bank?
Money Same
saved by amount from
18 Year leasing bank
19 0 2,500 2,500.00
20 1 -1,500 -1,094.94 <-- =PMT($B$4,3,$D$19)
21 2 -1,500 -1,094.94
22 3 -1,500 -1,094.94

What Have We Assumed about Leasing versus Purchasing?

The leasing example we’ve considered above illustrates the spirit of lease/purchase analysis.
The example makes some simplifying assumptions that are worth noting:
 CHAPTER 3 What Does It Cost? IRR and the Time Value of Money 83

• No taxes: When corporations lease equipment, the lease payments are expenses for tax
purposes; when these corporations buy assets, the depreciation on the asset is an expense
for tax payments. Taxes complicate the analysis somewhat; the case of leasing with taxes
is considered in Chapter 5.
• Operational equivalence of lease and purchase: In our analysis we don’t ask whether
you need a computer—we assume that you’ve already answered this question positively,
so that only the method of acquisition is in question. Our analysis also assumes that
any maintenance or repairs that need to be done on the computer will be done by you,
whether you lease or buy the computer.
• No residual value: We’ve assumed that the asset (in this case, the computer) is worthless
at the end of the lease term.
We explore the last point briefly. Suppose you think that the computer will be worth $800 at
the end of year 3. Then—as shown below—the purchase cash flows change, so that owning the
computer gives you an inflow of $800 in year 3.6 The cost of purchasing the computer is reduced
(the present value of the purchase is now $3,304) and the lease alternative becomes even less
attractive than the purchase. Another way of seeing this is to look at the IRR of the differential
cash flows, which is now 45.07% (cell B23).7
A B C D
1 LEASE VERSUS PURCHASE WITH RESIDUAL VALUE
2 Asset cost 4,000.00
3 Annual lease payment 1,500.00
4 Residual value, yr. 3 800 <-- Value of computer at end year 3
5 Bank rate 15%
6
Purchase Lease
7 Year cash flow cash flow
8 0 4,000.00 1,500.00
9 1 1,500.00
10 2 1,500.00
11 3 -800.00 1,500.00
12
13 PV of costs 3,304.35 4,924.84 <-- =C8+NPV($B$5,C9:C11)
14 Lease or purchase? purchase <-- =IF(B13<C13,"purchase","lease")
15
16 Calculating the IRR of the differential cash flow
Money
saved
17 Year by leasing
18 0 2,500.00 <-- =B8-C8
19 1 -1,500.00 <-- =B9-C9
20 2 -1,500.00
21 3 -2,300.00
22
23 IRR of differential 45.07% <-- =IRR(C18:C21)
24 Lease or purchase? purchase <-- =IF(C23>B5,"purchase","lease")

6
Note that because we’re writing outflows (like the cost of the computer) as positive numbers, we have to
write the inflows as negative numbers.
7
A caveat is in order here: We’re treating the computer’s residual value as if it has the same certainty as
the rest of the cash flows, whereas clearly it is less certain. The finance literature has a technical solution
to this: We find the certainty equivalent of the residual value. For example, it may be that we expect the
residual value to be $1,200, but that—recognizing the uncertainty of getting this value—we treat this as
equivalent to getting an $800 residual with certainty.
84 PART ONE CAPITAL BUDGETING AND VALUATION

3.5. Auto Lease Example

Here’s a slightly more realistic (and more complicated) example of leasing: You’ve decided to get a new
car. You can either lease the car or buy it; if you decide to buy the car, you can finance with a 3% bank
loan. The relevant facts are given in the spreadsheet that follows, but we’ll summarize them here:
• The manufacturer’s suggested retail price (MSRP) for the car is $24,550, but you’ve been
able to negotiate a price of $22,490 with the dealer.8 In the jargon of the car leasing busi-
ness, the $22,490 is referred to as the “capitalized cost.” To this price must be added a desti-
nation charge of $415, so that you end up paying $22,905 if you purchase the car. This price
represents your alternative purchase cost if you decide to buy instead of lease the car.
• The dealer has offered you the following lease terms:
• You pay $1,315 at the signing of the lease. The dealer explains that this is the total
of $415 “destination charge,” $450 “acquisition fee,” and a $450 security deposit.
The security deposit will be refunded at the end of the lease.
• You will pay $373.43 per month for the next 24 months. In month 24 you get your
security deposit of $450 back.
• You guarantee that the car will have a residual value of $13,994 at the end of the
lease. The dealer has based this value on 57% of the MSRP. What this means is
that if the car is worth less than $13,994 at the end of the 24th month, the lessee
(you) will make up the difference.9 The end-lease payment associated with this
residual can be written as:
⎧13,994 - market value if market value < 13,994
End-lease residual payment= ⎨
⎩ 0 otherwise

Another way of writing this payment is Max (13,994 − market value,0 ) . The max(A,B)
notation means that you pay the larger of A or B. Conveniently, Max is also a function in Excel.
The residual value turns out to be an important factor in the way you view leasing versus
purchase. We’ll devote more time to it later. For the moment, let’s assume that you think the car
will actually be worth $15,000 at the end of 2 years so your last payment on the lease is zero:

End-lease residual payment = Max (13,994 − market value,0 )

= Max (13,994 − 15,000,0 ) = Max (−1,006,0 ) = 0

All of the lease costs are listed in column C of the following spreadsheet. To evaluate these
costs, look at column D, which shows the costs associated with buying the car; there are only

8
The “manufacturer’s suggested retail price” (MSRP—also referred to as the car’s “sticker price”—is the
price the auto manufacturer suggests as an appropriate price for the car. In reality it’s a kind of official
fiction and forms the basis for negotiation between the dealer and the car purchaser. In our example the
MSRP is used in the residual value computation, but the actual price paid for the car is less.
9
According to www.edmunds.com: “The lease-end fees are generally reasonable, unless the car has
100,000 miles on it, a busted-up grille and melted chocolate smeared into the upholstery. Dealers and
financial institutions want you to buy or lease another car from them, and can be rather lenient regarding
excess mileage and abnormal wear. After all, if they hit you with a bunch of trumped-up charges you’re not
going to remain a loyal customer, are you? . . . But keep in mind that if you take your business elsewhere,
you’re going to be facing a bill for items like worn tires, paint chips, door dings, and the like.”
 CHAPTER 3 What Does It Cost? IRR and the Time Value of Money 85

two: the initial purchase price of the car ($22,490 + the destination cost of $415 = $22,905) and
what you anticipate will be the market value of the car at the end of the lease term (in the exam-
ple below, you think the car will actually be worth $15,000). Because we’ve used the convention
of making costs positive numbers, the inflow from selling the car is a negative number.
This last number bears some examination: If you lease, your last payment is

last lease payment= last month' s rental − return of security deposit

+ end-of -lease residual payment
= 373.43 − 450+ Max (13,994 − market value,0 )

If you’re right, and the actual market value of the car is $15,000, then your last “payment” is
−$76.57 (meaning that you’ll get $76.57 back from the lease company).

A B C D E F
1 AUTO LEASE VERSUS PURCHASE
2 MSRP 24,550 <-- Manufacturer’s suggested retail price
3 Capitalized cost 22,490 <-- Negotiated price
4 Destination charge 415 <-- Paid both by the lessee and the buyer
5 Acquisition fee 450 <-- Paid only by the lessee
6 Security deposit 450 <-- refunded at end of lease
7
8 Payment due at signing 1,315 <-- =SUM(B4:B6)
9 Monthly payment 373.43 <-- Dealer’s lease offer
10
11
12 Residual value after 2 years as % of MSRP 57%
13 Lease residual value after 2 years 13,994 <-- =B12*B2--lessee guarantees this value
14 Your estimated residual value 15,000 <-- Your guess
15
=B3+B4
16
17 Month Payment Purchase Difference
18 0 1,315.00 22,905.00 21,590.00 <-- =D18-C18
19 =B8 1 373.43 -373.43 <-- =D19-C19
20 2 373.43 -373.43 <-- =D20-C20
21 3 373.43 -373.43
22 4 373.43 -373.43
23 5 373.43 -373.43
24 6 373.43 -373.43
25 7 373.43 -373.43
26 8 373.43 -373.43
27 9 373.43 -373.43
28 10 373.43 -373.43
29 11 373.43 -373.43
30 12 373.43 -373.43
31 13 373.43 -373.43
32 14 373.43 -373.43
33 15 373.43 -373.43
34 16 373.43 -373.43
35 17 373.43 -373.43
36 18 373.43 -373.43
37 19 373.43 -373.43
38 20 373.43 -373.43
39 21 373.43 -373.43
40 22 373.43 -373.43
41 23 373.43 -373.43
42 24 -76.57 -15,000.00 -14,923.43 <-- =D42-C42
43
44 =$B$9-B6+MAX(B13-B14,0) Monthly IRR 0.44% <-- =IRR(E18:E42)
45 EAIR 5.39% <-- =(1+E44)^12-1
46
47 Buy or lease?
48 Alternative financing 7%
49 Buy or lease? lease <-- =IF(E48>E45,"lease","buy")
86 PART ONE CAPITAL BUDGETING AND VALUATION

Column E in the spreadsheet subtracts the lease from the purchase cash flows. Initially, the
lease saves you $21,590; in months 1–23, the lease costs you $373.43 more than the purchase,
and at the end of month 24 the lease costs you $14,923.43 more than the purchase.
The monthly IRR of the differential cash flows is 0.44%, which gives an EAIR of 14.36%
(cells E44 and E45).
Should you buy or should you lease? It depends on your alternative cost of financing. If you
can finance at a bank for less than 5.39%, then you should buy the car; otherwise, the lease looks
like a good deal. In our case you can finance at the bank for 3% (cell B48), so you should buy
the car with a bank loan instead of leasing it.

The Role of the Residual

The residual value of the car is very important in determining the cost of the lease. To illustrate
this we use the Data|Data Tools|What-if Analysis|Data Table feature of Excel (see Chapter 27)
to run a sensitivity table that shows the EAIR and the lease/buy decision as a function of your
estimated end-lease market value of the car:

A B C D E F G
Data table: The EAIR of the lease
as a function of the market value of car at
52 end of lease
Estimated
market value of car Lease or
53 at end-lease EAIR buy?
54 <-- Data table header has been hidden
55 10,000 2.6% lease
56 10,500 2.6% lease Lease EAIR As a Function of the Car's Market
57 11,000 2.6% lease Value at Lease-End
58 11,500 2.6% lease
59 12,000 2.6% lease 14%
60 12,500 2.6% lease
12%
61 13,000 2.6% lease
62 13,500 2.6% lease 10%
63 14,000 2.6% lease 8%
EAIR

64 14,500 4.0% lease 6%

65 15,000 5.4% lease 4%
66 15,500 6.7% lease 2%
67 16,000 8.1% buy
0%
68 16,500 9.4% buy
10,000 12,000 14,000 16,000 18,000
69 17,000 10.7% buy
70 17,500 11.9% buy Market value at lease-end
71 18,000 13.2% buy
72

As the data table shows, leasing is preferable if you think that the actual market value at the
end of the lease term will be low relative to the lease residual of $13,994. The lease is based on
your “reselling” the car to the dealer for $13,994; if you think that the actual market value of the
car will be much higher, then you would be selling it to the dealer at a loss, and you’re better off
buying the car and reselling it yourself.10 The break-even market value—the estimated market
value for which you are indifferent between leasing the car or financing it at the bank at 3%—is

10
Some leases actually give you the option of buying the car for the residual value at the end of the lease
term. This effectively locks in the lease EAIR, because if the car is worth more than the lease residual
value, you can always buy it for the residual and resell the car on the open market.
 CHAPTER 3 What Does It Cost? IRR and the Time Value of Money 87

somewhere between $14,000 and $14,500; in this range the EAIR of the lease is 3%, which is
equal to the cost of the alternative financing.11

Financing the Purchase of a Car with a Bank Loan:

Cheaper or More Expensive?
In our preceding analysis we concluded that the annual cost of the 2-year lease (cell E45) is an
EAIR of 5.39%. So it stands to reason that if you can get a cheaper loan from a bank, you should
take the bank loan and use the proceeds to buy the car. And yet . . . suppose the bank offers you
a 3% loan (with monthly compounding, so that the monthly interest rate is 3%/12 = 0.25%), and
suppose that we have the same amount to finance (namely, the car cost of $22,905 minus the
money down of $1,315). The spreadsheet below shows that the monthly payments on this bank
loan are much larger than those of the car lease:

H I J
2 Financing with a bank loan
3 Cost of car 22,905 <-- =B3+B4
4 Money down 1,315
5 Amount to finance 21,590 <-- =I3-I4
6
7 Bank rate 3%
8 Monthly loan payment 927.96 <-- =-PMT(I7/12,24,I5)
9 Monthly lease payment 373.43
10
11 Note: The PMT function in cell H8 calculates the
12 monthly payment on a $21,590 loan (cell H5) given for 24
13 months at monthly interest 0.25% (cell H7/12).

Now this is confusing: Borrowing from the bank at 3% to buy the car involves a much higher
monthly payment ($926.96) than the monthly lease payment ($373.43). Yet in our first analysis
of the lease on page 86, we concluded that a loan rate of 3% is preferable to the lease EAIR of
5.39%. To resolve this apparent contradiction, recall that the difference between the two—the
lease and the loan—is the residual value built into the lease: This residual value— essentially a
guarantee that you, the lessee, extend to the auto lessor—both reduces your monthly lease pay-
ments and increases your stake in the residual value of the car. Compared with the bank loan,
the lease gives you lower payments in return for bearing the higher risk of guaranteeing the
residual value of the car. There is no free lunch.
To see that the loan is actually cheaper, assume that you take a separate bank loan to
finance the car’s residual value of $15,000 in 2 years:

$15,000
PV of residual value = 24
= $14,127.53.
⎛ 3% ⎞
⎜⎝ 1 + 12 ⎟⎠

11
The exact residual value for which you are indifferent is $14,134.
88 PART ONE CAPITAL BUDGETING AND VALUATION

We can now divide the purchase price of $22,905 into two parts:

$22,905 = $14,127.53
!""""#""""$ + $8,777.47
↑
$15,000
24
⎛ 3% ⎞
⎜⎝ 1+ 12 ⎟⎠

The total cost of $8,777.47 is the cost of using the car for the next 2 years. Of this amount,
you have to pay an immediate down payment of $1,315, which leaves $7,462.47 to finance.
Financing this amount with a lease will cost $373.43 per month, whereas financing with a bank
loan will cost $320.75 per month:

A B C
AUTO LEASE VERSUS PURCHASE
1 COMPARING BANK LOAN TO LEASE PAYMENT
2 MSRP 24,550.00 <-- Manufacturer's suggested retail price
3 Capitalized cost 22,490.00 <-- Negotiated price
4 Destination charge 415.00 <-- Paid both by the lessee and the buyer
5 Acquisition fee 450.00 <-- Paid only by the lessee
6 Security deposit 450.00 <-- refunded at end of lease
7
8 Payment due at signing 1,315.00 <-- =SUM(B4:B6)
9 Monthly payment 373.43 <-- Dealer's lease offer
10
11 Residual value after 2 years as % of MSRP 57%
12 Lease residual value after 3 years 13,993.50 <-- =B11*B2--lessee guarantees this value
13 Your estimated residual value 15,000.00 <-- Your guess
14
15 Financing with a bank loan
16 Bank rate 3%
17 Monthly rate 0.25% <-- =B16/12
18
19 Cost of car 22,905.00 <-- =B3+B4
20 Money down 1,315.00
21 Amount to finance 21,590.00 <-- =B19-B20
22
23 Loan principal to finance residual in 2 years 14,127.53 <-- =B13/(1+B17)^24
24 Loan principal to finance car lease for 2 years 7,462.47 <-- =B19-B20-B23
25
Monthly loan payment to finance
26 car lease for 2 years 320.75 <-- =PMT(B17,24,-B24)
27 Monthly lease payment 373.43

The bank loan is cheaper. We’ve summarized our logic in Figure 3.1.
 THINKING ABOUT A CAR LEASE VERSUS A CAR LOAN FROM A BANK

Month 0 Months 1-24

Buy car
Car cost 22,905.00
PV of estimated residual 14,127.53
Cost of owning car for 2 years 8,777.47 <-- 22,905.00-14,127.53
Money down if you lease 1,315.00 Monthly lease payment 373.43

Amount to be financed Monthly bank

for owning the car for 2 years 7,462.47 <-- 8,777.47-1,315.00 loan payment 320.75<-- =PMT(3%/12,24,-7462.47)

Month 24--Residual value

Sell car 15,000
Pay off loan to cover residual 15,000<-- =14127.53*(1+3%/12)^24

Explanation: The cost of the car is $22,905. You estimate the residual value of the car in 2 years at $15,000, which
has a present value of $14,127.53. The cost of owning the car for 2 years is therefore $8,777.47. If you lease the car you
are required to put down $1,315.
Assume that you finance the remaining cost of $7,462.47 with a bank loan. This loan will cost you $320.75 per
month, compared with the $373.43 per month for the car lease. It’s thus cheaper to finance with a car loan from the
bank.

FIGURE 3.1 Car lease versus car loan.

CHAPTER 3 What Does It Cost? IRR and the Time Value of Money 89
90 PART ONE CAPITAL BUDGETING AND VALUATION

3.6. More-Than-Once-a-Year Compounding and the EAIR

Suppose you are charged interest on a monthly basis, but you want to compute the annual inter-
est cost. Here’s an example: XYZ Bank says that it charges an annual percentage rate (APR)
of 18% on your credit card balances, with “interest computed monthly.” Suppose that what the
bank means is that it charges 1.5% per month on the outstanding balance at the beginning of
the month. To determine what this means in practice, you should ask yourself “If I have a credit
balance of $100 outstanding for 12 months, how much will I owe at the end of the 12-month
period?” If we set this up in Excel, we get the following:
A B C D
MONTHLY COMPOUNDING OF CREDIT CARD
1 BALANCES
2 "Annual" rate 18%
3 Monthly rate 1.5% <-- =B2/12
4
Balance Balance at
at beginning of Interest for end of
5 Month month month month
6 1 100.00 1.50 101.50
7 2 101.50 1.52 103.02
8 3 103.02 1.55 104.57
9 4 104.57 1.57 106.14
10 5 106.14 1.59 107.73
11 6 107.73 1.62 109.34
12 7 109.34 1.64 110.98
13 8 110.98 1.66 112.65
14 9 112.65 1.69 114.34
15 10 114.34 1.72 116.05
16 11 116.05 1.74 117.79
17 12 117.79 1.77 119.56
18
19 Effective annual interest rate (EAIR) 19.56% <-- =D17/B6-1
20 19.56% <-- =(1+B3)^12-1

At the end of 12 months you would owe $119.56—the initial $100 balance plus $19.56 in
interest. Cells B19 and B20 show two ways of calculating the effective annual interest rate:
• In cell B19, we take the end-year balance that results from the initial $100 credit card
balance and divide it by the initial balance to calculate the interest rate:

End-year balance
EAIR = −1
Initial balance
119.56
= − 1 = 19.56%
100

• In cell B20 we take the monthly interest rate and compound it:

12
EAIR = (1 + monthly rate ) − 1
12
= (1.015 ) − 1 = 19.56%
 CHAPTER 3 What Does It Cost? IRR and the Time Value of Money 91

n
⎛ r⎞
When the annual interest rate r is compounded n times per year, the EAIR = ⎜ 1 + ⎟ − 1 .
⎝ n⎠

APR and EAIR

By an act of Congress (“The Federal Truth in Lending Act”) lenders are required to specify the
annual percentage rate (APR) charged on loans. Unfortunately, the Truth in Lending Act does
not specify how the APR is to be computed, and the use of the term by lenders is not uniform.
Although “APR” is legal terminology designed to help the consumer understand the true cost
of borrowing, in practice the APR is not well-defined and may not represent the actual cost of
borrowing. Sometimes the APR is the effective annual interest rate (EAIR), but in other cases—
like the credit card example in this section—the APR is something else. The result is much
convoluted wording and a lot of confusion.12

The EAIR and the Number of Compounding Periods per Year n

In the preceding example, the credit card company takes its 18% “annual” interest rate charge
and turns it into a 1.5% monthly interest rate. As we saw, the resulting EAIR is 19.56%.
In Figure 3.2 we compute the effect of the number of compounding periods on the EAIR
The EAIR grows with the number of compounding periods. The EAIR is

number of compounding periods per year

⎛ stated annual interest rate ⎞
EAIR = ⎜ 1 + ⎟ −1
⎝ number of annual compounding periods ⎠

When we do this in Excel, we see that the EAIR grows as the number of compounding
periods increases. For a very large number of compounding periods, the EAIR approaches a
limit of 19.722% (cell C20 below in the following spreadsheet).
There are two important things to note about the EAIR computation:
n
⎛ r⎞
• As the number of compounding periods per year n increases, the EAIR = ⎜ 1 + ⎟ − 1
⎝ n⎠
gets higher.
• The rate at which the EAIR increases gets smaller as the number of annual compound-
ing periods gets larger. There is very little difference between the EAIR when interest
is compounded 36 times per year (EAIR = 19.668%) and the EAIR when we compound
365 times per year (EAIR = 19.716%).

12
A case that accompanies this book gives three actual APR examples and the resulting EAIR. In each
case the definition of APR used by the lender is different. In only one of the three cases does the APR
correspond to the EAIR.
92 PART ONE CAPITAL BUDGETING AND VALUATION

THE EFFECTIVE ANNUAL INTEREST RATE (EAIR) AND THE NUMBER

OF COMPOUNDING PERIODS

The stated annual interest rate is 18%

Number of compounding EAIR formula EAIR (%)

periods per year

1 (1 + 18%) − 1 18.00

2 2 18.81
⎛ 18% ⎞
(Semiannual compounding) ⎜⎝ 1 + 2 ⎟⎠ − 1

4 4 19.252
⎛ 18% ⎞
(Quarterly compounding) ⎜⎝ 1 + 4 ⎟⎠ − 1

12 12 19.562
⎛ 18% ⎞
(Monthly compounding) ⎜⎝ 1 + 12 ⎟⎠ −1

24 24 19.641
⎛ 18% ⎞
(Semimonthly compounding) ⎜⎝ 1 + 24 ⎟⎠ −1

52 52 19.685
⎛ 18% ⎞
(Weekly compounding ⎜⎝ 1 + 52 ⎟⎠ −1

365 365 19.716

⎛ 18% ⎞
(Daily compounding) ⎜⎝ 1 + 365 ⎟⎠ −1

FIGURE 3.2: The EAIR when an annual interest rate of 18% is compounded for various times per
year.
 CHAPTER 3 What Does It Cost? IRR and the Time Value of Money 93

A B C D E
1 EAIR AND NUMBER OF COMPOUNDING PERIODS
2 "Annual" rate 18%
3
Number of compounding Rate per
4 periods per year period EAIR
5 1 18.00% 18.000% <-- =(1+B5)^A5-1
6 2 9.00% 18.810% <-- =(1+B6)^A6-1
7 3 6.00% 19.102% <-- =(1+B7)^A7-1
8 4 4.50% 19.252%
9 6 3.00% 19.405%
10 12 1.50% 19.562%
11 24 0.75% 19.641%
12 36 0.50% 19.668%
13 52 0.35% 19.685%
14 100 0.18% 19.702%
15 150 0.12% 19.709%
16 200 0.09% 19.712%
17 250 0.07% 19.714%
18 300 0.06% 19.715%
19 365 0.05% 19.716%
20 infinite 19.722% <-- =EXP(B2)-1
21
22 EAIR as a Function of the Number of
23 20.0% Compounding Periods Per Year
24 19.8%
25 19.6%
26 19.4%
27
19.2%
28
EAIR

19.0%
29
18.8%
30
18.6%
31
18.4%
32
18.2%
33
18.0%
34
17.8%
35
36 1 10 100 1000
37 Number of annual compounding periods
38

3.7. Continuous Compounding and Discounting

(Advanced Topic)
In cell C20 we compute the limit of the EAIR when the number of compounding periods gets
very large. This limit is called continuous compounding. For n annual compounding periods
n
⎛ r⎞
per year, the EAIR = ⎜ 1 + ⎟ − 1. When the number of annual compounding periods n gets
⎝ n⎠
very large, the EAIR becomes close to er-1. The number e = 2.71828182845904 is the base
of natural logarithms and is included in Excel as the function Exp( ). In the jargon of finance,
erT is called the continuously compounded future value after T years at annual interest rate r.
In the spreadsheet below you can see the difference between the discretely compounded future
value and the continuously compounded future value.
94 PART ONE CAPITAL BUDGETING AND VALUATION

A B C
1 CONTINUOUS COMPOUNDING
2 "Annual" rate 18%
Number of compounding periods
3 per year 250
4 Number of years, T 3
5 Effective annual interest rate, EAIR
6 19.71%
Discretely compounded future value
T
7 after t years =(1+EAIR) 1.7157 <-- =(1+B2/B3)^(B3*B4)
Continuously compounded future value
rT
8 =e 1.7160 <-- =EXP(B2*B4)

When the number of compounding periods gets very large, the difference between the
discrete and continuous interest rate becomes very small.

The Continuously Compounded Discount Factor

In Chapter 2 we saw that future value and present value are closely related:

DISCRETE COMPOUNDING
Period 0 T

Future value
T
X X*(1+r)

Present value
T -T
Y/(1+r) = Y*(1+r) Y

A similar relation holds for continuous compounding:

CONTINUOUS COMPOUNDING
Period 0 T

Future value
rT
X X*e

Present value
rT -rT
Y/e = Y*e Y

The following spreadsheet summarizes these relations:

A B C
1 DISCRETE AND CONTINUOUS COMPOUNDING
2 Interest rate 10%
3 Initial amount, X 100
4 Terminal date, T 3
5 Discretely compounded future value, X*(1+r)T 133.100 <-- =B3*(1+B2)^B4
6 Continuously compounded future value, X*erT 134.986 <-- =B3*EXP(B2*B4)
7
8 Interest rate 10%
9 Terminal amount, Y 100
10 Terminal date, T 3
11 Discretely compounded present value, Y/(1+r)T 75.131 <-- =B9/(1+B8)^B10
12 Continuously compounded present value, Y*e-rT 74.082 <-- =B9*EXP(-B10*B8)
 CHAPTER 3 What Does It Cost? IRR and the Time Value of Money 95

An Actual Credit Card Example

Continuously compounded interest may seem like an ethereal concept—highly theoreti-
cal but not very useful. The example in this subsection shows how useful continuously com-
pounded interest can actually be. The Columbus State University credit card in the ad below
charges a penalty annual percentage rate (APR) of 27.99%.13 The parentheses in the ad
make it clear that the company is actually charging 0.07669% per day on outstanding bal-
ances. This rate is calculated by taking 27.99% and dividing it by the number of days per year:
27.99% .
0.07669% =
365

If you carried a $100 balance throughout the year, you would owe 100*(1.007668)365 at the
end of the year.14 As the spreadsheet shows, this translates into a 32.286% EAIR (cell B5):

13
What is the penalty rate? As the card Web site explains: “If you are late making a payment, any rates not
exceeding the Penalty Rate may change to the same rate and type as the Penalty Rate.” In other words, if
you are overdue on any payment, the penalty rate applies to all existing balances.
14
Note the small discrepancy between our Excel and the Visa advertisement: 27.99%/365 = 0.0766849%.
By the normal rules of rounding off, this should be rounded down to 0.07668%, but Columbus State’s Visa
takes the extra 0.0001%! As they say: “Every little bit helps.”
96 PART ONE CAPITAL BUDGETING AND VALUATION

A B C
1 COLUMBUS STATE VISA CARD
2 APR 27.99%
3 Daily 0.07668% <-- =B2/365
4
5 Effective annual interest rate (EAIR) 32.286% <-- =(1+B3)^365-1
6 Continuously compounded interest 32.300% <-- =EXP(B2)-1

As you can see in cell B6, essentially the same interest rate can be computed using con-
tinuous compounding. From a computational point of view, using continuous compounding is
simpler than discretely compounding a daily interest rate.

CONTINUOUS COMPOUNDING IN THIS BOOK

We rarely use continuous compounding in this book, except in the options chapters (Chapters
20–23). In other cases we use only discrete compounding, although we may occasionally
point out in a footnote the continuously compounded counterpart of a discretely compounded
calculation.

Computing the Continuous Return

In past subsections we have measured discrete versus continuous compounding. In this section
we show how to measure discrete versus continuous rates of return. Suppose that an investment
grows from X at time zero to Y at time T. Then the discretely compounded annual return on
1/ T
⎛Y⎞
the investment is r = ⎜ ⎟ − 1. The continuously compounded annual return is given by
⎝ X⎠
1 ⎛Y⎞
r = Ln ⎜ ⎟ . In the example below, an investment of $100 grows to $200 over a period of 4
T ⎝ X⎠
years.15 The spreadsheet computes both the discretely compounded and the continuously com-
pounded annual returns:
A B C
COMPUTING DISCRETE AND CONTINUOUS
1 RETURNS
2 Investment at time 0 100
3 Value at time T 200
4 T (years) 4
5
6 Discretely compounded annual return 18.92% <-- =(B3/B2)^(1/B4)-1
7 Continously compounded annual return 17.33% <-- =(1/B4)*LN(B3/B2)
8
Why is this true: Compounding the initial investment
9 to get the future value
10 Discrete compounding 200 <-- =B2*(1+B6)^B4
11 Continuous compounding 200 <-- =B2*EXP(B7*B4)

15
The Excel function Ln computes the natural logarithm of a number. If Ln(a)=b, then eb = a.
 CHAPTER 3 What Does It Cost? IRR and the Time Value of Money 97

The discretely compounded annual return (cell B6) is 18.92%; this is proved in cell B10,
4
where we show that 200 = 100 * (1 + 18.92%) . In other words, over 4 years the discretely
compounded future value of $100 at 18.92% annually is $200.
The continuously compounded annual return is 17.32% (cell B7); this is proved in cell B11,
where we show that 200 = 100 * exp (17.32%* 4 ). Over 4 years the continuously compounded
future value of $100 at 17.32% annually is $200.
Note that you would be indifferent in choosing between an annual discretely compounded
return of 18.92% and an annual continuously compounded return of 17.32%. Over any given
time frame, both rates make an initial investment grow to the same final result!

Summing Up
In this chapter we’ve applied the time value of money (PV, NPV, and IRR) to a number of rel-
evant problems:
• Finding the effective annual interest rate (EAIR): This is the compound annual interest
rate implicit in a specific financial asset; another way to think about this is that it’s the
annualized IRR. We’ve given a number of examples—leases, mortgages, credit cards—
all of which illustrate that the only way to evaluate the financing cost is by calculating
the EAIR.
• The effect of nonannual compounding periods: Many interest rates are calculated on
a monthly or even a daily basis. The EAIR demands that we annualize these interest
rates so that we can compare them. When the number of compounding periods gets
very large (like our Columbus State University example), the EAIR = er, where e =
2.71828182845905 (computed by =Exp( ) in Excel) and r is the stated interest rate.

Exercises

1. You are considering buying the latest stereo system model. The dealer in “The Stereo World” store
has offered you two payment options. You can either pay $10,000 now, or you can take advantage
of their special deal and “buy now and pay a year from today,” in which case you will pay $11,100
in 1 year. Calculate the effective annual interest rate (EAIR) of the store’s special deal.
2. You have two options of paying for your new dishwasher: You can either make a single payment of
$400 today, or you can pay $70 for the next 6 months, with the first payment made today. What is
the effective annual interest rate (EAIR) of the second option?
3. Your lovely wife has decided to buy you a vacuum cleaner for your birthday (she always supports
you in your hobbies . . . ). She called your best friend, a manager of a vacuum cleaner store, and he
has suggested one of two payment plans: She can either pay $100 now or make 12 monthly pay-
ments of $10 each, starting from today. What are the monthly IRR and the EAIR of the payment-
over-time plan?
4. Your local bank has offered you a mortgage of $100,000. There are no points, no origination fees,
and no extra initial costs (meaning you get the full $100,000). The mortgage is to be paid back over
10 years in annual payments, and the bank charges 12% annual interest.
a. Calculate the monthly mortgage payments
b. What is the mortgage EAIR?
98 PART ONE CAPITAL BUDGETING AND VALUATION

5. Your local bank has offered you a 20-year, $100,000 mortgage. The bank is charging 1.5 points
and “processing” costs of $750; both points and processing costs are deducted from the mortgage
when it is given. Payments on the mortgage are annual and are based on a 10% interest rate on the
full amount of the mortgage (that is, $100,000).
a. Calculate the annual mortgage payment
b. Calculate the EAIR
c. Compute an amortization table that shows the amount of interest you can report for taxes each
year.
6. Your local bank has offered you a 10-year, $100,000 mortgage with monthly payments. The
bank is charging 1.5 points and “processing” costs of $750; both points and processing costs are
deducted from the mortgage when it is given. Monthly payments on the mortgage are based on the
12% annual interest rate on the full amount of the mortgage (that is, $100,000).
a. Calculate the monthly payment on the mortgage, show the amortization table, and compute
the EAIR.
b. Will the EAIR of the mortgage change if the loan period is 6 years?
c. Compute the total interest paid in each of the years of the mortgage. You can base your answer
on the amortization table or investigate the Excel function Cumipmt.
7. You just bought the first floor of the famous “Egg-Plant” Building for $250,000. You plan to
rent the space to convenience stores. Your banker has offered you a mortgage with the following
terms:
• The mortgage is for the full amount of $250,000.
• The mortgage will be repaid in equal monthly payments over 36 months, starting 1 month
from now.
• The annual interest rate on the mortgage is 8%, compounded monthly (meaning:
8%
= 2 / 3% per month).
12
• You have to pay the bank an initiation charge of $1,500 and 1 point.
a. What is the monthly payment you will pay the bank?
b. What is the EAIR of the mortgage?
c. Compute an amortization table that shows the amount of interest you can report for taxes
each month.
8. Your local bank has offered you a 5-year, $100,000 mortgage. The bank is charging 1.5 points
and “processing” costs of $750. If the interest rate is 12% compounded monthly (meaning: 1%
per month):
a. Calculate the monthly mortgage payment.
b. Calculate the EAIR.
c. Compute an amortization table that shows the amount of interest you can report for taxes each
month and use it to compute the annual mortgage interest you can report for tax purposes.
9. You’re considering buying an asset that has a 3-year life and costs $15,000. As an alternative to
buying the asset, you can lease it for $4,000 per year (four annual payments, the first due on the
day you sign the lease). If you can borrow from your bank at 10%, should you lease or buy?
10. You’re considering buying an asset that has a 3-year life and costs $2,000. As an alternative to
buying the asset, you can lease it for $600 per year (four annual payments, the first due today).
Your bank is willing to lend you money for 15%.
a. Should you lease or purchase the asset?
b. What is the largest lease payment you would be willing to make?
 CHAPTER 3 What Does It Cost? IRR and the Time Value of Money 99

11. You’re considering leasing or purchasing an asset with the following cash flows.
a. Calculate the present value of the lease versus the purchase. Which is preferable?
b. What is the largest annual lease payment you would be willing to pay?

A B C D
1 LEASE VERSUS PURCHASE WITH RESIDUAL VALUE
2 Asset cost 20,000
3 Annual lease payment 5,500
4 Residual value, year 3 3,000 <-- Value of asset at end year 3
5 Bank rate 15%
6
Purchase Lease
7 Year cash flow cash flow
8 0 20,000 5,500
9 1 5,500
10 2 5,500
11 3 -3,000 5,500

12. You intend to buy a new laptop computer. Its price at electronic shops is $2,000, but your
next-door neighbor offered to lease you the same computer for monthly payments of $70 for
a 24-month period, with the fi rst payment made today. Assuming you can sell the computer
at the end of 2 years at $500 and the interest rate in the market is 20%, should you buy or
lease?
13. You’re considering leasing or purchasing a car. The details of each method of financing are given
below. The lease is for 24 months. What should you do?

A B C D E F
1 AUTO LEASE VERSUS PURCHASE
2 MSRP 50,000.00 <-- Manufacturer's suggested retail price
3 Capitalized cost 45,000.00 <-- Negotiated price
4 Destination charge 415.00 <-- Paid both by the lessee and the buyer
5 Acquisition fee 450.00 <-- Paid only by the lessee
6 Security deposit 450.00 <-- refunded at end of lease
7
8 Payment due at signing 1,315.00
9 Monthly payment 600.00 <-- Dealer's lease offer
10
11 Residual value after 2 years as % of MSRP 60%
12 Lease residual value after 3 years 30,000.00 <-- =B11*B2
13 Your estimated residual value 35,000.00 <-- Your guess
14
15 Bank loan cost (annual) 7.00%

14. You are considering buying a new, very expensive, FancyCar. The details of your negotiation for
a 48-month lease are given below.
a. If your alternative cost of financing is 6%, should you buy or lease?
b. If you financed the purchase through the bank at 6%, what would be your monthly loan
payment?
c. As your estimated residual value (cell B15) gets larger, does leasing or buying become more
advantageous? Explain.
100 PART ONE CAPITAL BUDGETING AND VALUATION

d. What is the estimated residual value for which you are indifferent between buying and
leasing?

A B C
1 AUTO LEASE VERSUS PURCHASE: 48-MONTH LEASE
2 MSRP 50,000 <-- Manufacturer’s suggested retail price
3 Capitalized cost 45,000 <-- Negotiated price
4 Destination charge 415 <-- Paid both by the lessee and the buyer
5 Acquisition fee 450 <-- Paid only by the lessee
6 Security deposit 450 <-- refunded at end of lease
7
8 Payment due at signing 1,315
9 Monthly payment 400 <-- Dealer’s lease offer
10
11
12 Residual value after 4 years as % of MSRP 60%
13 Lease residual value after 4 years 30,000
14 Your estimated residual value 35,000 <-- Your guess

15. You’re considering buying a new top-of-the-line luxury car. The car’s list price is $99,000. The
dealer has offered you two alternatives for purchasing the car:
• You can buy the car for $90,000 in cash and get a $9,000 discount in the bargain.
• You can buy the car for the list price of $99,000. In this case the dealer is willing to take
$39,000 as an initial payment. The remainder of $60,000 is a “zero-interest loan” to be paid back
in equal installments over 36 months.
Alternatively, your local bank is willing to give you a car loan at an annual interest rate of 10%,
compounded monthly (that is, 10%/12 per month).
Decide how to finance the car: bank loan, zero-interest loan with the dealer, or cash payment.
16. You’ve been offered two credit cards:
• Credit card 1 charges 19% annually, on a monthly basis.
• Credit card 2 charges 19% annually, on a weekly basis.
• Credit card 3 charges 18.90% annually, on a daily basis.
Rank the cards on the basis of EAIR.
17. You plan to put $1,000 in a savings plan and leave it there for 5 years. You can choose between
various alternatives. How much will you have in 5 years under each alternative?
a. Bellon Bank is offering 12% stated annual interest rate, compounded once a year.
b. WNC Bank is offering 11% stated annual interest rate, compounded twice a year.
c. Plebian Bank is offering 10% stated annual interest rate, compounded monthly.
d. Byfus Bank is offering 11.5% stated annual interest rate, compounded continuously.
18. Assuming that the interest rate is 5%, compounded semiannually, which of the following is more
valuable?
a. $5,000 today.
b. $10,000 at the end of 5 years.
c. $9,000 at the end of 4 years.
d. $450 at the end of each year (in perpetuity) commencing in 1 year.
19. You plan to put $10,000 in a savings plan for 2 years. How much will you have at the end of 2
years with each of the following options?
 CHAPTER 3 What Does It Cost? IRR and the Time Value of Money 101

a. Receive 12% stated annual interest rate, compounded monthly.

b. Receive 12.5% stated annual interest rate, compounded annually.
c. Receive 11.5% stated annual interest rate, compounded daily.
d. Receive 10% stated annual interest rate in the first year and 15% stated annual interest rate in
the second year, compounded annually.
How much will you have at the end of 2 years in each option?
20. Michael Smith was in trouble: He was unemployed and living on his monthly disability pay of
$1,200. His credit card debts of $19,000 were threatening to overwhelm this puny income. Every
month in which he delayed paying the credit card debt cost him 1.5% on the remaining balance.
His only asset was his house, on which he had a $67,000 mortgage.
Then Michael got a phone call from Uranus Financial Corporation: The company offered to
refinance Michael’s mortgage. The Uranus representative explained to Michael that, with the rise
in real-estate values, Michael’s house could now be remortgaged for $90,000. This amount would
allow Michael to repay his credit card debts and even leave him with some money.
Here are some additional facts:
• The new mortgage would be for 25 years and would have an annual interest rate of 9.23%. The
mortgage would be repayable in equal monthly payments over this term, at a monthly interest
rate of 9.23% / 12 = 0.76917%. The fees on the mortgage are $8,000.
• There are no penalties involved in repaying the $67,000 existing mortgage.
Answer the following questions:
a. What will Michael’s monthly payments be on the new mortgage?
b. After repaying his credit card debts, how much money will Michael have left?
c. What is the effective annual interest rate (EAIR) on the Uranus mortgage?
21. A note from the author’s credit card company included the following statement.
Annual Percentage Rate for Cash Advances:
Your annual percentage rate for cash advances is the U.S. Prime Rate plus 14.99%, but
such cash advance rate will never be lower than 19.99%. As of August 1, 2004, this cash
advance ANNUAL PERCENTAGE RATE is 19.99%, which corresponds to a daily peri-
odic rate of 0.0548%. A daily periodic rate is the applicable annual percentage rate divided
by 365.
As of August 1, 2004, what is the effective annual interest rate (EAIR) charged by the
credit card on cash advances?
22. WindyRoad is an investment company that has two mutual funds. The WindyRoad Dull
Fund invests in boring corporate bonds and its Lively Fund invests in “high-risk, high-
return” companies. The returns for the two funds in the 5-year period 2001–2005 are given
below.
a. Suppose you had invested $100 in each of the two funds at the beginning of 2001. How much
would you have at the end of 2005?
b. What was the EAIR paid by each of the funds over the 5-year period 2001–2005?
c. Is there a conclusion you can draw from this example?
102 PART ONE CAPITAL BUDGETING AND VALUATION

A B C D

1 DULL FUND OR LIVELY FUND?

Dull Fund Lively Fund
2 Year return return
3 2001 9.20% 11.50%
4 2002 5.20% -14.50%
5 2003 4.30% -23.40%
6 2004 3.30% 42.40%
7 2005 7.00% 13.60%
8
9 Average return 5.80% 5.92% <-- =AVERAGE(C3:C7)

23. (Advanced).
a. Compute the annual continuous returns for Dull Fund and Lively Fund (exercise 22) for each of
the years 2001–2005. What is the average continuous return r continuous
average for each fund?
b. Suppose you had invested $100 in each of the two funds at the beginning of 2001. Show
that the total amount you would have in each fund (see Exercise 22.a) can be written as
continuous
$100 * e5*r average . Note that this makes computations much simpler.
24. Capital Star Motors of Canberra, Australia, has the following lease offer for a Smart car:
• Lease term: 48 months.
• No initial deposit, $8,995 balloon payment at end of lease.
• Daily payment: $9.95 per day, payable monthly.
• Smart car cash cost: $18,800.
a. Assuming 30 days per month, compute the effective annual interest rate (EAIR) in the
lease.
b. Compute the balloon payment that gives a 7% EAIR.
25. Ten years ago Reem and Forsan took out a $150,000 mortgage to buy their new house. The
mortgage was a 20-year, 10% mortgage with annual payments. Today their bank offers similar
mortgages at 8% interest; however, when the young couple went to the bank to inquire about the
possibility of refinancing the remainder of their mortgage with a 10-year, 8% mortgage, they were
informed that the bank has a $15,000 “exit fee” for the refinancing.16 Should they still refinance
the mortgage?
We offer some hints:
• The remaining mortgage principal at any point is the present value of the future payments on
the mortgage. Further hint: Use Excel’s PV function.
• Excel’s Rate function can compute the IRRs of fixed payment loans.

16
This question was inspired by an article in the Melbourne Age on 12 August 2009. High exit fees are
common in Australia; they are also called “early termination fees,” “deferred establishment fees,” or
“early repayment fees.”
 CHAPTER 3 What Does It Cost? IRR and the Time Value of Money 103

• A convenient template to solve this problem might be the following:

A B C
1 MORTGAGE EXIT FEE
2 Initial mortgage
3 Principal 150,000.00
4 Term (years) 20
5 Interest rate 10.00%
6 Annual payment <--
7 Term remaining 10
8 Remaining mortgage principal <--
9 Exit fee 15,000.00
10
11 New mortgage
12 Principal <--
13 Term (years) 10
14 Interest rate 8.00%
15 Annual payment <--
16 Effective annual cost (EAIR) <--
CHAP TER

4 Introduction to Capital Budgeting

CHAPTER CONTENTS
Overview 105
4.1. The NPV Rule for Judging Investments and Projects 105
4.2. The IRR Rule for Judging Investments 107
4.3. NPV or IRR—Which to Use? 108
4.4. The “Yes–No” Criterion: When Do IRR and NPV Give the
Same Answer? 109
4.5. Do NPV and IRR Produce the Same Project Rankings? 110
4.6. Capital Budgeting Principle: Ignore Sunk Costs and Consider Only
Marginal Cash Flows 114
4.7. Capital Budgeting Principle: Don’t Forget the Effects of Taxes—Sally
and Dave’s Condo Investment 115
4.8. Capital Budgeting and Salvage Values 122
4.9. Capital Budgeting Principle: Don’t Forget the Cost of
Foregone Opportunities 126
4.10. In-House Copying or Outsourcing? A Mini Case Illustrating
Foregone Opportunity Costs 127
4.11. Accelerated Depreciation 130
4.12. Conclusion 131
Exercises 132

104
 CHAPTER 4 Introduction to Capital Budgeting 105

Overview
Capital budgeting is finance jargon for the process of deciding whether to undertake an invest-
ment project. Two standard concepts are used in capital budgeting: net present value (NPV) and
internal rate of return (IRR). Both concepts were introduced in Chapter 2; in this chapter we
discuss their application to capital budgeting. Here are some of the topics covered:
• Should you undertake a specific project? We call this the “yes–no” decision, and we
show how both NPV and IRR answer this question.
• Ranking projects: If you have several alternative investments, only one of which you can
choose, which should you undertake?
• Should you use IRR or NPV? Sometimes the IRR and NPV decision criteria give differ-
ent answers to the yes–no and the ranking decisions. We discuss why this happens and
which criterion should be used for capital budgeting (if there’s disagreement).
• Sunk costs. How should we account for costs incurred in the past?
• The cost of foregone opportunities.
• Salvage values and terminal values.
• Incorporating taxes into the valuation decision. This issue is dealt with briefly in
Section 6.7. We return to it at greater length in Chapters 7–9.

Finance Concepts Discussed

• IRR
• NPV
• Project ranking using NPV and IRR
• Terminal value
• Taxation and calculation of cash flows
• Cost of foregone opportunities
• Sunk costs

Excel Functions Used

• NPV
• IRR
• Data table

4.1. The NPV Rule for Judging Investments and Projects

In the preceding chapters we introduced the basic NPV and IRR concepts and their application
to capital budgeting. We start off this chapter by summarizing each of these rules—the NPV
rule in this section and the IRR rule in the following section.
Here’s a summary of the decision criteria for investments implied by the net present value
(NPV):
106 PART ONE CAPITAL BUDGETING AND VALUATION

The NPV rule for deciding whether a specific project is worthwhile: Suppose
we are considering a project that has cash flows CF0, CF1, CF2, . . . , CFN. Suppose
that the appropriate discount rate for this project is r. Then the NPV of the project is
N
CF1 CF2 CFN CFt .
NPV = CF0 + +
(1 + r ) (1 + r )
+ …+ = CF0 + ∑
2
(1 + r )N t= 1 (1 + r )t

Rule: A project is worthwhile by the NPV rule if its NPV > 0.

The NPV rule for deciding between two mutually exclusive projects: Suppose you are
trying to decide between two projects A and B, each of which can achieve the same objective.
For example, your company needs a new widget machine, and the choice is between machine A
or machine B. You will buy either A or B (or perhaps neither machine, but you will certainly not
buy both machines). In finance jargon these projects are “mutually exclusive.”
Suppose Project A has cash flows CF0A ,CF1A ,CF2A ,...,CFNA and Project B has cash

flows CF0B ,CF1B ,CF2B ,...,CFNB .

Rule: Project A is preferred to Project B if
N N
CFtA CFtB
NPV (A) = CF0A + ∑ t
> CF0B + ∑ t
= NPV (B )
t =1 (1 + r ) t =1 (1 + r )

The logic of both NPV rules presented above is that the present value of a project’s cash
N
CFt
flows, PV = ∑ t
, is the economic value today of the project. Thus—if we have
t = 1 (1 + r )

correctly chosen the discount rate r for the project—the PV is what we ought to be
able to sell the project for in the market.1 The net present value is the wealth incre-
ment produced by the project, so NPV > 0 means that a project adds to our wealth:

N
CFt
NPV = !"CF
"#"0"$ + ∑ .
↑ t=1 (1 + r )$t
!""""#""""
Initial cash
flow required ↑
to implement Market value
the project. of future cash
This is usually flows.
a negative number.

An Initial Example
To set the stage let’s assume that you’re trying to decide whether to undertake one of two proj-
ects. Project A involves buying expensive machinery that produces a better product at a lower
cost. The machines for Project A cost $1,000 and, if purchased, you anticipate that the project
will produce cash flows of $500 per year for the next 5 years. Project B’s machines are cheaper,
costing $800, but they produce smaller annual cash flows of $420 per year for the next 5 years.
We’ll assume that the correct discount rate is 12%.

1
This assumes that the discount rate is “correctly chosen,” by which we mean that it is appropriate to the
riskiness of the project’s cash flows. For the moment we fudge the question of how to choose discount
rates; this topic is discussed in Chapter 6.
 CHAPTER 4 Introduction to Capital Budgeting 107

Suppose we apply the NPV criterion to Projects A and B.

A B C D
1 TWO PROJECTS
2 Discount rate 12%
3
4 Year Project A Project B
5 0 -1000 -800
6 1 500 420
7 2 500 420
8 3 500 420
9 4 500 420
10 5 500 420
11
12 NPV 802.39 714.01 <-- =C5+NPV($B$2,C6:C10)

Both projects are worthwhile because each has a positive NPV. If we have to choose between
the projects, then Project A is preferred to Project B because it has the higher NPV.

EXCEL’S NPV FUNCTION VERSUS THE FINANCE

DEFINITION OF NPV
We reiterate our Excel note from Chapter 2 (page 37): Excel’s NPV function computes the PV
of future cash flows; this does not correspond to the finance notion of NPV, which includes the
initial cash flow. To calculate the finance NPV concept in the spreadsheet, we have to include
the initial cash flow. Hence, in cell B12, the NPV is calculated as =NPV($B$2,B6:B10)+B5 and
in cell C12 the calculation is =NPV($B$2,C6:C10)+C5.

4.2. The IRR Rule for Judging Investments

An alternative to using the NPV criterion for capital budgeting is to use the internal rate of
return (IRR). Recall from Chapter 2 that the IRR is defined as the discount rate for which the
NPV equals zero. It is the compound rate of return you get from a series of cash flows.
Here are the two decision rules for using the IRR in capital budgeting:
The IRR rule for deciding whether a specific investment is worthwhile: Suppose we are
considering a project that has cash flows CF0, CF1, CF2, . . . , CFN.
IRR is an interest rate such that:
N
CF1 CF2 … + CFN CFt
CF0 + +
(1 + IRR ) (1 + IRR )2
+ N
= CF0 + ∑ t
=0.
(1 + IRR ) t =1 (1 + k )

Rule: If the appropriate discount rate for a project is r, you should accept the project if its
IRR > r and reject it if its IRR < r.
The logic behind the IRR rule is that the IRR is the compound return you get from the
project. Because r is the project’s required rate of return, it follows that if IRR > r, you get more
than you require.
108 PART ONE CAPITAL BUDGETING AND VALUATION

The IRR rule for deciding between two competing projects: Suppose you are try-
ing to decide between two mutually exclusive projects, A and B (meaning both projects
are ways of achieving the same objective, and you will choose at most one of the projects).
Suppose Project A has cash flows CF0A ,CF1A ,CF2A ,...,CFNA and Project B has cash flows
CF0B ,CF1B ,CF2B ,...,CFNB .

Rule: Project A is preferred to Project B if IRR(A) > IRR(B).

Again the logic is clear: Because the IRR gives a project’s compound rate of return, if we
choose between two projects using the IRR rule, we prefer the higher compound rate of return.
Applying the IRR rule to our Projects A and B, we get

A B C D
1 TWO PROJECTS
2 Discount rate 12%
3
4 Year Project A Project B
5 0 -1000 -800
6 1 500 420
7 2 500 420
8 3 500 420
9 4 500 420
10 5 500 420
11
12 IRR 41.04% 44.03% <-- =IRR(C5:C10)

Both Project A and Project B are worthwhile because each has an IRR > 12%, which is our
relevant discount rate. If we have to choose between the two projects using the IRR rule, Project
B is preferred to Project A because it has a higher IRR.

4.3. NPV or IRR—Which to Use?

We can sum up the NPV and the IRR rules as follows:

“Yes or no”: “Project ranking”:

Choosing whether to undertake Comparing two mutually exclusive
a single project projects
NPV criterion The project should be undertaken if its Project A is preferred to Project B if
NPV > 0. NPV(A) > NPV(B).

IRR criterion The project should be undertaken if its IRR Project A is preferred to Project B if
> r, where r is the appropriate discount rate. IRR(A) > IRR(B).

Both the NPV rules and the IRR rules look logical. In many cases your investment
decision—to undertake a project or not, or which of two competing projects to choose—will be
the same whether you use NPV or IRR. There are some cases, however (such as that of Projects
A and B illustrated above), where NPV and IRR give different answers. In our net present value
analysis Project A won out because its NPV was greater than that of Project B. In our IRR
analysis of the same projects, Project B was chosen because it had the higher IRR. In such cases
 CHAPTER 4 Introduction to Capital Budgeting 109

we should always use the NPV to decide between projects. The logic is that if individuals are
interested in maximizing their wealth, they should use NPV, which measures the incremental
wealth from undertaking a project.

4.4. The “Yes–No” Criterion: When Do IRR and NPV

Give the Same Answer?
Consider the following project: The initial cash flow of –$1,000 represents the cost of the project
today, and the remaining cash flows for years 1–6 are projected future cash flows. The discount
rate is 15%.
A B C
1 SIMPLE CAPITAL BUDGETING EXAMPLE
2 Discount rate 15%
3
4 Year Cash flow
5 0 -1,000
6 1 100
7 2 200
8 3 300
9 4 400
10 5 500
11 6 600
12
13 PV of future cash flows 1,172.13 <-- =NPV(B2,B6:B11)
14 NPV 172.13 <-- =B5+NPV(B2,B6:B11)
15 IRR 19.71% <-- =IRR(B5:B11)

The NPV of the project is $172.13, meaning that the present value of the project’s future
cash flows ($1,172.13) is greater than the project’s cost of $1,000.00. Thus, the project is
worthwhile.

A B C D E F G
Discount
18 rate NPV
19 0% 1,100.00 <-- =$B$5+NPV(A19,$B$6:$B$11)
20 3% 849.34 <-- =$B$5+NPV(A20,$B$6:$B$11)
21 6% 637.67
22 9% 457.83 NPV of Cash Flows
23 12% 304.16
24 15% 172.13 1,200
25 18% 58.10
1,000
26 21% -40.86
27 24% -127.14 800
28 27% -202.71 600
29 30% -269.16
NPV

400
30
31 200
32 0
33 0% 3% 5% 8% 10% 13% 15% 18% 20% 23% 25% 28% 30%
-200
34
35 -400
36 Discount rate
37
38
110 PART ONE CAPITAL BUDGETING AND VALUATION

If we graph the project’s NPV we can see that the IRR—the point where the NPV
curve crosses the x-axis—is very close to 20%. As you can see in cell B15, the actual IRR is
19.71%.

Accept or Reject? Should We Undertake the Project?

It is clear that the above project is worthwhile:
• Its NPV > 0, so that by the NPV criterion the project should be accepted.
• Its IRR of 19.71% > the project discount rate of 15%, so that by the IRR criterion the
project should be accepted.

A General Principle
We can derive a general principle from this example:
For conventional projects, projects with an initial negative cash flow and subsequent non-
negative cash flows ( CF0 < 0,CF1 ≥ 0,CF2 ≥ 0,...,CFN ≥ 0 ), the NPV and IRR criteria lead
to the same “yes–no” decision: If the NPV criterion indicates a “yes” decision, then so will
the IRR criterion (and vice versa).

4.5. Do NPV and IRR Produce the Same Project Rankings?

In the previous section we saw that for conventional projects, NPV and IRR give the
same “yes–no” answer about whether to invest in a project. In this section we’ll see that
NPV and IRR do not necessarily rank projects the same, even if the projects are both
conventional.
Suppose we have two projects and can choose to invest in only one. The projects are mutu-
ally exclusive: They are both ways to achieve the same end, and thus we would choose only one.
In this section we discuss the use of NPV and IRR to rank the projects. To sum up our results
before we start:
• Ranking projects by NPV and IRR can lead to possibly contradictory results. Using the
NPV criterion may lead us to prefer one project, whereas using the IRR criterion may
lead us to prefer the other project.
• Where a conflict exists between NPV and IRR, the project with the larger NPV is
preferred. That is, the NPV criterion is the correct criterion to use for capital bud-
geting. This is not to impugn the IRR criterion, which is often very useful. However,
NPV is preferred over IRR because it indicates the increase in wealth that the project
produces.

An Example
Next we show the cash flows for Project A and Project B. Both projects have the same initial cost
of $500, but have different cash flow patterns. The relevant discount rate is 15%.
 CHAPTER 4 Introduction to Capital Budgeting 111

A B C D
1 RANKING PROJECTS WITH NPV AND IRR
2 Discount rate 15%
3
4 Year Project A Project B
5 0 -500 -500
6 1 100 250
7 2 100 250
8 3 150 200
9 4 200 100
10 5 400 50
11
12 NPV 74.42 119.96 <-- =C5+NPV(B2,C6:C10)
13 IRR 19.77% 27.38% <-- =IRR(C5:C10)

Comparing the projects using IRR: If we use the IRR rule to choose between the proj-
ects, then B is preferred to A because the IRR of Project B is higher than that of Project A.
Comparing the projects using NPV: Here the choice is more complicated. When the
discount rate is 15% (as illustrated above), the NPV of Project B is higher than that of Project
A. In this case the IRR and the NPV agree: Both indicate that Project B should be chosen. Now
suppose that the discount rate is 8%; in this case the NPV and IRR rankings conflict.

A B C D
1 RANKING PROJECTS WITH NPV AND IRR
2 Discount rate 8%
3
4 Year Project A Project B
5 0 -500 -500
6 1 100 250
7 2 100 250
8 3 150 200
9 4 200 100
10 5 400 50
11
12 NPV 216.64 212.11 <-- =C5+NPV(B2,C6:C10)
13 IRR 19.77% 27.38% <-- =IRR(C5:C10)

In this case we have to resolve the conflict between the ranking on the basis of NPV (A
is preferred) and ranking on the basis of IRR (B is preferred). As we stated in the introduction
to this section, the solution to this question is that you should choose on the basis of NPV. We
explore the reasons for this later on, but first we discuss a technical question.

Why Do NPV and IRR Give Different Rankings?

Next we construct a table and graph that show the NPV for each project as a function of the
discount rate.
112 PART ONE CAPITAL BUDGETING AND VALUATION

A B C D E F G
1 RANKING PROJECTS WITH NPV AND IRR
2 Discount rate 15%
3
4 Year Project A Project B
5 0 -500 -500
6 1 100 250
7 2 100 250
8 3 150 200
9 4 200 100
10 5 400 50
11
12 NPV 74.42 119.96 <-- =C5+NPV(B2,C6:C10)
13 IRR 19.77% 27.38% <-- =IRR(C5:C10)
14
15 TABLE OF NPVs AND DISCOUNT RATES
Project A Project B
16 NPV NPV
17 0% 450.00 350.00 <-- =$C$5+NPV(A17,$C$6:$C$10)
18 2% 382.57 311.53 <-- =$C$5+NPV(A18,$C$6:$C$10)
19 4% 321.69 275.90 500
20 6% 266.60 242.84
21 8% 216.64 212.11 400
22 10% 171.22 183.49
23 12% 129.85 156.79 300
24 14% 92.08 131.84
25 16% 57.53 108.47 200
26 18% 25.86 86.57
27 20% -3.22 66.00
100
28 22% -29.96 46.66
29 24% -54.61 28.45
0
30 26% -77.36 11.28
31 28% -98.39 -4.93 0% 10% 20% 30%
-100
32 30% -117.87 -20.25 ProjectA ProjectB
33 NPV NPV
-200
34
35

From the graph you can see why contradictory rankings occur:

• Project B has a higher IRR (27.38%) than Project A (19.77%). (Remember that the IRR
is the point at which the NPV curve cuts the x-axis.)
• When the discount rate is low, Project A has a higher NPV than Project B, but when
the discount rate is high, Project B has a higher NPV. There is a crossover point (in
the next subsection you will see that this point is 8.51%) that marks the disagreement/
agreement range.
• Project A’s NPV is more sensitive to changes in the discount rate than Project B. The
reason for this is that Project A’s cash flows are more spread out over time than those
of Project B; another way of saying this is that Project A has substantially more of its
cash flows at later dates than Project B.
 CHAPTER 4 Introduction to Capital Budgeting 113

Summing up,

Discount rate < 8.51% Discount rate = 8.51% Discount rate > 8.51%

NPV criterion A preferred: Indifferent between A and B: B preferred:

NPV(A) > NPV(B) NPV(A) = NPV(B) NPV(B) > NPV(A)

IRR criterion B always preferred to A because

IRR(B) > IRR(A)

Calculating the Crossover Point

The crossover point—which we claimed earlier was 8.51%—is the discount rate at which the NPV
of the two projects is equal. A bit of formula manipulation will show you that the crossover point is
the IRR of the differential cash flows. To see what this means, consider the following example.

A B C D E
36 Calculating the crossover point
Differential cash flows:
37 Year Project A Project B cash flow(A) - cash flow(B)
38 0 -500 -500 0 <-- =B38-C38
39 1 100 250 -150 <-- =B39-C39
40 2 100 250 -150
41 3 150 200 -50
42 4 200 100 100
43 5 400 50 350
44
45 IRR 8.51% <-- =IRR(D38:D43)

Column D in this example contains the differential cash flows—the difference between the
cash flows of Project A and Project B. In cell D43 we use the Excel IRR function to compute
the crossover point.
A bit of theory (can be skipped): To see why the crossover point is the IRR of the differen-
tial cash flows, suppose that for some rate r, NPV(A) = NPV(B):

CF1A CF2A CFNA

NPV (A) = CF0A + + +
(1 + r ) (1 + r )2 (1 + r )N
…

CF1B CF2B CFNB

= CF0B + + + = NPV (B )
(1 + r ) (1 + r )2 (1 + r )N
…

Subtracting and rearranging shows that r must be the IRR of the differential cash flows:

CF1A − CF1B CF2A − CF2B CF A − CFNB

CF0A − CF0B + + …+ N =0
(1 + r ) (1 + r )2
(1 + r )N
114 PART ONE CAPITAL BUDGETING AND VALUATION

What to Use? NPV or IRR?

Let’s go back to the initial example and suppose that the discount rate is 8%.

A B C D
1 RANKING PROJECTS WITH NPV AND IRR
2 Discount rate 8%
3
4 Year Project A Project B
5 0 -500 -500
6 1 100 250
7 2 100 250
8 3 150 200
9 4 200 100
10 5 400 50
11
12 NPV 216.64 212.11 <-- =C5+NPV(B2,C6:C10)
13 IRR 19.77% 27.38% <-- =IRR(C5:C10)

In this case we know there is disagreement between the NPV (which would lead us to
choose Project A) and the IRR (by which we choose Project B). Which is correct?
The answer to this question is that we should—for the case where the discount rate is
8%—choose using the NPV (that is, choose Project A). This is just one example of the general
principal discussed in Section 3 that using the NPV is always preferred because the NPV is
the additional wealth that you get, whereas IRR is the compound rate of return. The economic
assumption is that consumers maximize their wealth, not their rate of return.

WHERE IS THIS CHAPTER GOING?

Until this point in the chapter, we’ve discussed general principles of project choice using the
NPV and IRR criteria. The following sections discuss some specifics:
• Ignoring sunk costs and using marginal cash flows (Section 4.6)
• Incorporating taxes and tax shields into capital budgeting calculations (Section 4.7)
• Incorporating the cost of foregone opportunities (Section 4.9)
• Incorporating salvage values and terminal values (Section 4.11)

4.6. Capital Budgeting Principle: Ignore Sunk Costs and Consider

Only Marginal Cash Flows
This is an important principle of capital budgeting and project evaluation: Ignore the cash flows
you can’t control and look only at the marginal cash flows—the outcomes of financial decisions
you can still make. In the jargon of finance, ignore sunk costs, costs that have already been
incurred and are thus not affected by future capital budgeting decisions.
Here’s an example: You recently bought a plot of land and built a house on it. Your intention
was to sell the house immediately, but it turns out that the house is really badly built and cannot
 CHAPTER 4 Introduction to Capital Budgeting 115

be sold in its current state. The house and land cost you $100,000, and a friendly local contrac-
tor has offered to make the necessary repairs, which will cost $20,000. Your real estate broker
estimates that even with these repairs you’ll never sell the house for more than $90,000. What
should you do? There are two approaches to answering this question:
• “My father always said ‘Don’t throw good money after bad.’ ” If this is your approach,
you won’t do anything. This attitude is typified in column B below, which shows that if
you make the repairs you will have lost 25% on your money.
• “My mother was a finance prof, and she said ‘Don’t cry over spilt milk. Look only at the
marginal cash flows.’ ” These turn out to be pretty good. In column C below you see that
making the repairs will give you a 350% return on your $20,000.

A B C D
1 IGNORE SUNK COSTS
2 House cost 100,000
3 Fix up cost 20,000
4
Cash flow Cash flow
5 Year wrong! right!
6 0 -120,000 -20,000
7 1 90,000 90,000
8 IRR -25% 350% <-- =IRR(C6:C7)

Of course your father was wrong and your mother right (this often happens): Even though
you made some disastrous mistakes (you never should have built the house in the first place),
you should—at this point—ignore the sunk cost of $100,000 and make the necessary repairs.

4.7. Capital Budgeting Principle: Don’t Forget the Effects of Taxes—

Sally and Dave’s Condo Investment
In this section we discuss the capital budgeting problem faced by Sally and Dave, two busi-
ness-school grads who are considering buying a condominium and renting it out for the
income.
We use Sally and Dave and their condo to emphasize the place of taxes in the capital bud-
geting process. No one needs to be told that taxes are very important.2 In the capital budgeting
process, the cash flows that are to be discounted are after-tax cash flows. We postpone a fuller
discussion of this topic to Chapters 6 and 7, where we define the concept of free cash flow. For
the moment we concentrate on a few obvious principles, which we illustrate with the example
of Sally and Dave’s condo investment.
Sally and Dave—fresh out of business school with a little cash to spare—are considering
buying a nifty condo as a rental property. The condo will cost $100,000, and (in this example at
least) they’re planning to buy it with all cash. Here are some additional facts:
• Sally and Dave figure they can rent out the condo for $24,000 per year. They’ll have to
pay property taxes of $1,500 annually and they’re figuring on additional miscellaneous
expenses of $1,000 per year.

2
Will Rogers: “The difference between death and taxes is death doesn’t get worse every time Congress
meets.”
116 PART ONE CAPITAL BUDGETING AND VALUATION

• All the income from the condo has to be reported on their annual tax return. Currently
Sally and Dave have a tax rate of 30%, and they think this rate will continue for the fore-
seeable future.
• Their accountant has explained to them that they can depreciate the full cost
of the condo over 10 years—each year they can charge $10,000 depreciation
condo cost
(= ) against the income from the condo.3 This means that
10-year depreciable life
they can expect to pay $3,450 in income taxes per year if they buy the condo and rent it
out and have net income from the condo of $8,050.
A B C
1 SALLY & DAVE'S CONDO
2 Cost of condo 100,000
3 Sally & Dave's tax rate 30%
4
5 Annual reportable income calculation
6 Rent 24,000
7 Expenses
8 Property taxes -1,500
9 Miscellaneous expenses -1,000
10 Depreciation -10,000
11 Reportable income 11,500 <-- =SUM(B6:B10)
12 Taxes (rate = 30%) -3,450 <-- =-B3*B11
13 Net income 8,050 <-- =B11+B12

SIDEBAR: WHAT IS DEPRECIATION?

In computing the taxes they owe, Sally and Dave get to subtract expenses from their income.
Taxes are computed on the basis of the income before taxes (=income−expenses−depreciation
−interest). When Sally and Dave get the rent from their condo, this is income—money earned
from their asset. When Sally and Dave pay to fix the faucet in their condo, this is an expense—a
cost of doing business.
The cost of the condo is neither income nor an expense. It’s a capital investment—money
paid for an asset that will be used over many years. Tax rules specify that each year part of the
capital investments can be taken off the income (“expensed,” in the accounting jargon). This
reduces the taxes paid by the owners of the asset and accounts for the fact that the asset has a
limited life.
There are many depreciation methods in use. The simplest method is straight-line depre-
ciation. In this method the asset’s annual depreciation is a percentage of its initial cost. In the
case of Sally and Dave, for example, we’ve specified that the asset is depreciated over 10 years.
This results in annual depreciation charges of
initial asset cost $100,000
straight-line depreciation = = = $10,000 annually
depreciable life span 10

3
You may want to read the sidebar on depreciation before going on.
 CHAPTER 4 Introduction to Capital Budgeting 117

In some cases depreciation is taken on the asset cost minus its salvage value: If you think that
the asset will be worth $20,000 at the end of its life (this is the salvage value), then the annual
straight-line depreciation might be $8,000:

straight-line depreciation initial asset cost − salvage value

=
with salvage value depreciable life span
$100,000 − $20,000
= = $8,000 annually
10

Accelerated Depreciation
Although historically depreciation charges are related to the life span of the asset, in many cases
this connection has been lost. Under U.S. tax rules, for example, an asset classified as having a
5-year depreciable life (trucks, cars, and some computer equipment are in this category) will be
depreciated over 6 years (yes 6) at 20, 32, 19.2, 11.52, 11.52, and 5.76% in each of the years 1,
2, . . . , 6. Note that this method accelerates the depreciation charges—more than one sixth of the
depreciation is taken annually in years 1–3 and less in later years. Because—as we show in the
text—depreciation ultimately saves taxes, this benefits the asset’s owner, who now gets to take
more of the depreciation in the early years of the asset’s life.

Two Ways to Calculate the Cash Flow

In the previous spreadsheet you saw that Sally and Dave’s net income was $8,050. In this section
you’ll see that the cash flow produced by the condo is much more that this amount. It all has
to do with depreciation: Because the depreciation is an expense for tax purposes but not a cash
expense, the cash flow from the condo rental is different. So even though the net income from
the condo is $8,050, the annual cash flow is $18,050—you have to add back the depreciation to
the net income to get the cash flow generated by the property.
A B C
Cash flow, method 1:
16 Add back depreciation
17 Net income 8,050 <-- =B13
18 Add back depreciation 10,000 <-- =-B10
19 Cash flow 18,050 <-- =B18+B17

In the above calculation, we’ve added the depreciation back to the net income to get the
cash flow.
An asset’s cash flow (the amount of cash produced by an asset during a particular period) is
computed by taking the asset’s net income (also called profit after taxes or sometimes just
“income”) and adding back noncash expenses like depreciation.4

Tax Shields
There’s another way of calculating the cash flow that involves a discussion of tax shields. A
tax shield is a tax saving that results from being able to report an expense for tax purposes.

4
In Chapter 6 we introduce the concept of free cash flow, which is an extension of the cash flow concept
discussed here.
118 PART ONE CAPITAL BUDGETING AND VALUATION

In general, a tax shield just reduces the cash cost of an expense—in the preceding example,
because Sally and Dave’s property taxes of $1,500 are an expense for tax purposes, the after-tax
cost of the property taxes is

(1 − 30%)* $1,500 = $1,500 − 30%* 1,500 = $1,050 .

!""""#""""$
↑
This $450 is the
tax shield

The tax shield of $450 ( = 30%* $1,500 ) has reduced the cost of the property taxes.
Depreciation is a special case of a noncash expense that generates a tax shield. A little
thought will show you that the $10,000 depreciation on the condo generates $3,000 of cash.
Because depreciation reduces Sally and Dave’s reported income, each dollar of depreciation
saves them $0.30 (30 cents) of taxes, without actually costing them anything in out-of-pocket
expenses (the $0.30 comes from the fact that Sally and Dave’s tax rate is 30%). Thus, $10,000
of depreciation is worth $3,000 of cash. This $3,000 depreciation tax shield is a cash flow for
Sally and Dave.
In the spreadsheet below we calculate the cash flow in two stages:

• We first calculate Sally and Dave’s net income ignoring depreciation (cell B29). If depre-
ciation were not an expense for tax purposes, Sally and Dave’s net income would be
$15,050.
• We then add to this figure the depreciation tax shield of $3,000. The result (cell B32)
gives the cash flow for the condo.

A B C D
Cash flow, method 2:
Compute after-tax income without
depreciation, then add depreciation
21 tax shield
22 Rent 24,000
23 Expenses This is what the net
24 Property taxes -1,500 income would have
been if depreciation
25 Miscellaneous expenses -1,000
were not an expense
26 Depreciation 0
for tax purposes.
27 Reportable income 21,500 <-- =SUM(B22:B26)
28 Taxes (rate = 30%) -6,450 <-- =-B3*B27
29 Net income without depreciation 15,050 <-- =B27+B28
30
The effect of
31 Depreciation tax shield 3,000 <-- =B3*10000
depreciation is to add
32 Cash flow 18,050 <-- =B31+B29
a $3,000 tax shield.
33

Is Sally and Dave’s Condo Investment Profitable?—

A Preliminary Calculation
At this point Sally and Dave can make a preliminary calculation of the NPV and IRR on their
condo investment. Assuming a discount rate of 12% and assuming that they only hold the condo
for 10 years, the NPV of the condo investment is $1,987 and its IRR is 12.48%.
 CHAPTER 4 Introduction to Capital Budgeting 119

A B C
1 SALLY & DAVE’S CONDO--PRELIMINARY VALUATION
2 Discount rate 12%
3
4 Year Cash flow
5 0 -100,000
6 1 18,050
7 2 18,050
8 3 18,050
9 4 18,050
10 5 18,050
11 6 18,050
12 7 18,050
13 8 18,050
14 9 18,050
15 10 18,050
16
17 Net present value, NPV 1,987 <-- =B5+NPV(B2,B6:B15)
18 Internal rate of return, IRR 12.48% <-- =IRR(B5:B15)

Is Sally and Dave’s Condo Investment Profitable?—Incorporating

Terminal Value into the Calculations
A little thought about the previous spreadsheet reveals that we’ve left out an important factor: the
value of the condo at the end of the 10-year horizon. In finance an asset’s value at the end of the
investment horizon is called the asset’s salvage value or terminal value. In the above spreadsheet
we’ve assumed that the terminal value of the condo is zero, but this assumption is implausible.
To make a better calculation about their investment, Sally and Dave will have to make an
assumption about the condo’s terminal value. Suppose they assume that at the end of the 10
years they’ll be able to sell the condo for $80,000. The taxable gain relating to the sale of the
condo is the difference between the condo’s sale price and its book value at the time of sale—the
initial price minus the sum of all the depreciation since Sally and Dave bought it. Because Sally
and Dave have been depreciating the condo by $10,000 per year over a 10-year period, its book
value at the end of 10 years will be zero.
In cell E10 below you can see that the sale of the condo for $80,000 will generate a cash
flow of $56,000.

A B C D E F
SALLY & DAVE'S CONDO: PROFITABILITY
1 AND TERMINAL VALUE
2 Cost of condo 100,000
3 Sally & Dave's tax rate 30%
4
5 Annual reportable income calculation Terminal value
Estimated resale value,
6 Rent 24,000 year 10 80,000
7 Expenses Book value 0
8 Property taxes -1,500 Taxable gain 80,000 <-- =E6-E7
9 Miscellaneous expenses -1,000 Taxes 24,000 <-- =B3*E8
Net after-tax cash flow
10 Depreciation -10,000 from terminal value 56,000 <-- =E8-E9
11 Reportable income 11,500 <-- =SUM(B6:B10)
12 Taxes (rate = 30%) -3,450 <-- =-B3*B11
13 Net income 8,050 <-- =B11+B12
14
Cash flow, method 1
15 Add back depreciation
16 Net income 8,050 <-- =B13
17 Add back depreciation 10,000 <-- =-B10
18 Cash flow 18,050 <-- =B17+B16
120 PART ONE CAPITAL BUDGETING AND VALUATION

To compute the rate of return of Sally and Dave’s condo investment, we put all the numbers
together.

A B C D
20 Discount rate 12%
21
22 Year Cash flow
23 0 -100,000
24 1 18,050 <-- =B18, Annual cash flow from rental
25 2 18,050
26 3 18,050
27 4 18,050
28 5 18,050
29 6 18,050
30 7 18,050
31 8 18,050
32 9 18,050
33 10 74,050 <-- =B32+E10
34
35 NPV of condo investment 20,017 <-- =B23+NPV(B20,B24:B33)
36 IRR of investment 15.98% <-- =IRR(B23:B33)

Assuming that the 12% discount rate is the correct rate, the condo investment is worth-
while: Its NPV is positive and its IRR exceeds the discount rate.5

BOOK VALUE VERSUS TERMINAL VALUE

The book value of an asset is its initial purchase price minus the accumulated depreciation.
The terminal value of an asset is its assumed market value at the time you “stop writing down
the asset’s cash flows.” This sounds like a weird definition of terminal value, but often when
we do present value calculations for a long-lived asset (like Sally and Dave’s condo or the com-
pany valuations we discuss in Chapters 6 and 7), we write down only a limited number of cash
flows.
Sally and Dave are reluctant to make predictions about condo rents and expenses beyond
a 10-year horizon. Past this point, they’re worried about the accuracy of their guesses. So they
write down 10 years of cash flows; the terminal value is their best guess of the condo’s value at
the end of year 10. Their thinking is, “Let’s examine the profitability of the condo if we hold on
to it for 10 years and sell it.”
This is what we mean when we say that “the terminal value is what the asset is worth when
we stop writing down the cash flows.”
Taxes: If Sally and Dave are right in their terminal value assumption, they will have to
account for taxes. The tax rules for selling an asset specify that the tax bill is computed on the
gain over the book value. So, in the example of Sally and Dave,
Terminal value − taxes on gain over book =
Terminal value − tax rate * (Terminal value − book value
= 80,000 − 30% * (80,000 − 0 ) = 56,000

5
When we say that a discount rate is “correct,” we usually mean that it is appropriate to the riskiness of the
cash flows being discounted. In Chapter 6 we have our first discussion in this book on how to determine
a correct discount rate. For the moment, let’s assume that the discount rate is appropriate to the riskiness
of the condo’s cash flows.
 CHAPTER 4 Introduction to Capital Budgeting 121

Doing Some Sensitivity Analysis (Advanced Topic)

A sensitivity analysis can show how the IRR of the condo investment varies as a function of
the annual rent and the terminal value. Using Excel’s Data Table (see Chapter 27) we build a
sensitivity table.

A B C D E F G H
38 Data table--Condo IRR as function of annual rent and terminal value
39 Rent
40 15.98% 18,000 20,000 22,000 24,000 26,000 28,000
41 Terminal value --> 50,000 9.72% 11.45% 13.15% 14.82% 16.47% 18.10%
42 60,000 10.26% 11.93% 13.59% 15.22% 16.84% 18.44%
43 70,000 10.77% 12.40% 14.01% 15.61% 17.19% 18.76%
44 =B36 80,000 11.25% 12.84% 14.42% 15.98% 17.54% 19.08%
45 90,000 11.71% 13.27% 14.81% 16.34% 17.87% 19.38%
46 100,000 12.15% 13.67% 15.19% 16.69% 18.19% 19.68%
47 110,000 12.58% 14.06% 15.55% 17.02% 18.50% 19.96%
48 120,000 12.98% 14.44% 15.90% 17.35% 18.80% 20.24%
49 130,000 13.37% 14.80% 16.23% 17.66% 19.09% 20.51%
50 140,000 13.75% 15.15% 16.56% 17.96% 19.37% 20.78%
51 150,000 14.11% 15.49% 16.87% 18.26% 19.65% 21.03%
52 160,000 14.46% 15.82% 17.18% 18.55% 19.91% 21.28%
53
54 Note: The data table above computes the IRR of the condo investment for combinations of rent (from $18,000 to
55 $26,000 per year) and terminal value (from $50,000 to $160,000).
56 Data tables are very useful though not trivial to compute. See Chapter 27 for more information.

The calculations in the data table aren’t that surprising: For a given rent, the IRR is higher
when the terminal value is higher, and for a given terminal value, the IRR is higher given a
higher rent.

Building the Data Table6

Here’s how the data table was set up:
• We build a table with terminal values in the left-hand column and rent in the top row.
• In the top left-hand corner of the table (cell B40), we refer to the IRR calculation in the
spreadsheet example (this calculation occurs in cell B36).
At this point the table looks like this:

A B C D E F G H
38 Data table--Condo IRR as function of annual rent and terminal value
39 Rent
40 15.98% 18,000 20,000 22,000 24,000 26,000 28,000
41 Terminal value --> 50,000
42 60,000
43 70,000
44 =B36 80,000
45 90,000
46 100,000
47 110,000
48 120,000
49 130,000
50 140,000
51 150,000
52 160,000

Using the mouse, we now mark the whole table. We use the Data|What-If Analysis|Data
Table command.

6
This subsection doesn’t replace Chapter 27, but it may help you recall what we said there.
122 PART ONE CAPITAL BUDGETING AND VALUATION

We can now fill in the cell references from the original example.

The dialog box tells Excel to repeat the calculation in cell B36, varying the rent number in
cell B6 and varying the terminal value number in cell E6. Pressing OK does the rest.

MINI CASE
A mini case for this chapter looks at Sally and Dave’s condo once more—this time under
the assumption that they take out a mortgage to buy the condo. Highly recommended!

4.8. Capital Budgeting and Salvage Values

In the Sally–Dave condo example we’ve focused on the effect of noncash expenses on cash
flows: Accountants and the tax authorities compute earnings by subtracting certain kinds of
expenses from sales, even though these expenses are noncash expenses. To compute the cash
 CHAPTER 4 Introduction to Capital Budgeting 123

flow, we add back these noncash expenses to accounting earnings. We showed that these non-
cash expenses create tax shields—they create cash by saving taxes.
In this section’s example we consider a capital budgeting example in which a firm sells its
asset before it is fully depreciated. We show that the asset’s book value at the date of the termi-
nal value creates a tax shield and we look at the effect of this tax shield on the capital budgeting
decision.
Here’s the example. Your firm is considering buying a new machine. Here are the facts:
• The machine costs $800.
• Over the next 8 years (the life of the machine) the machine will generate annual sales
of $1,000.
• The annual cost of the goods sold (COGS) is $400 per year and other costs; selling, gen-
eral, and administrative expenses (SG&A) are $300 per year.
• Depreciation on the machine is straight-line over 8 years (that is, $100 per year).
• At the end of 8 years, the machine’s salvage value (or terminal value) is zero.
• The firm’s tax rate is 40%.
• The firm’s discount rate for projects of this kind is 15%.
Should the firm buy the machine? Here’s the analysis in Excel.

A B C D E F G
1 BUYING A MACHINE--NPV ANALYSIS
2 Cost of the machine 800
3 Annual anticipated sales 1,000
4 Annual COGS 400
5 Annual SG&A 300 NPV Analysis
6 Annual depreciation 100 Year Cash flow
7 0 -800 <-- =-B2
8 Tax rate 40% 1 220 <-- =$B$23
9 Discount rate 15% 2 220
10 3 220
11 Annual profit and loss (P&L) 4 220
12 Sales 1,000 5 220
13 Minus COGS -400 6 220
14 Minus SG&A -300 7 220
15 Minus depreciation -100 8 220
16 Profit before taxes 200 <-- =SUM(B12:B15)
17 Subtract taxes -80 <-- =-B8*B16 NPV 187 <-- =F7+NPV(B9,F8:F15)
18 Profit after taxes 120 <-- =B16+B17
19
20 Calculating the annual cash flow
21 Profit after taxes 120
22 Add back depreciation 100
23 Cash flow 220

Note that we first calculate the profit and loss (P&L) statement for the machine (cells
B12:B18) and then turn this P&L into a cash flow calculation (cells B21:B23). The annual cash
flow is $220. Cells F7:F15 show the table of cash flows, and cell F17 gives the NPV of the proj-
ect. The NPV is positive, and we would therefore buy the machine.

Salvage Value—A Variation on the Theme

Suppose the firm can sell the machine for $300 at the end of year 8. To compute the cash flow
produced by this salvage value, we must make the distinction between book value and market
value.
124 PART ONE CAPITAL BUDGETING AND VALUATION

Book value An accounting concept: The book value of the machine is its initial cost minus the
accumulated depreciation (the sum of the depreciation taken on the machine since its
purchase). In our example, the book value of the machine in year 0 is $800, in year 1 it is
$700, . . . , and at the end of year 8 it is zero.

Market value The market value is the price at which the machine can be sold. In our example the mar-
ket value of the machine at the end of year 8 is $300.

Taxable gain The taxable gain on the machine at the time of sale is the difference between the market
value and the book value. In our case the taxable gain is positive ($300), but it can also be
negative (see an example at the end of this chapter).

Here’s the NPV calculation including the salvage value.

A B C D E F G
BUYING A MACHINE--NPV ANALYSIS
1 with salvage value
2 Cost of the machine 800
3 Annual anticipated sales 1,000
4 Annual COGS 400
5 Annual SG&A 300 NPV Analysis
6 Annual depreciation 100 Year Cash flow
7 0 -800 <-- =-B2
8 Tax rate 40% 1 220 <-- =$B$23
9 Discount rate 15% 2 220
10 3 220
11 Annual profit and loss (P&L) 4 220
12 Sales 1,000 5 220
13 Minus COGS -400 6 220
14 Minus SG&A -300 7 220
15 Minus depreciation -100 8 400 <-- =$B$23+B30
16 Profit before taxes 200 <-- =SUM(B12:B15)
17 Subtract taxes -80 <-- =-B8*B16 NPV 246 <-- =F7+NPV(B9,F8:F15)
18 Profit after taxes 120 <-- =B16+B17
19
20 Calculating the annual cash flow
21 Profit after taxes 120
22 Add back depreciation 100
23 Cash flow 220
24
25 Calculating the cash flow from salvage value
26 Machine market value, year 8 300
27 Book value, year 8 0
28 Taxable gain 300 <-- =B26-B27
29 Taxes paid on gain 120 <-- =B8*B28
30 Cash flow from salvage value 180 <-- =B26-B29

Note the calculation of the cash flow from the salvage value (cell B30) and the change in
the year 8 cash flow (cell F15).

One More Example

Suppose we change the example slightly:
• The annual sales, SG&A, COGS, and depreciation are still as specified in the original
example. The machine will still be depreciated on a straight-line basis over 8 years.
 CHAPTER 4 Introduction to Capital Budgeting 125

• However, we think we will sell the machine at the end of year 7 for an estimated salvage
value of $450. At the end of year 7 the book value of the machine is $100.
Here’s how our calculations look now.

A B C D E F G
BUYING A MACHINE--NPV ANALYSIS
with salvage value
1 Machine sold at end of year 7
2 Cost of the machine 800
3 Annual anticipated sales 1,000
4 Annual COGS 400
5 Annual SG&A 300 NPV Analysis
6 Annual depreciation 100 Year Cash flow
7 0 -800 <-- =-B2
8 Tax rate 40% 1 220 <-- =$B$23
9 Discount rate 15% 2 220
10 3 220
11 Annual profit and loss (P&L) 4 220
12 Sales 1,000 5 220
13 Minus COGS -400 6 220
14 Minus SG&A -300 7 530 <-- =$B$23+B30
15 Minus depreciation -100
16 Profit before taxes 200 <-- =SUM(B12:B15) NPV 232 <-- =F7+NPV(B9,F8:F15)
17 Subtract taxes -80 <-- =-B8*B16
18 Profit after taxes 120 <-- =B16+B17
19
20 Calculating the annual cash flow
21 Profit after taxes 120
22 Add back depreciation 100
23 Cash flow 220
24
25 Calculating the cash flow from salvage value
26 Machine market value, year 7 450
27 Book value, year 7 100
28 Taxable gain 350 <-- =B26-B27
29 Taxes paid on gain 140 <-- =B8*B28
30 Cash flow from salvage value 310 <-- =B26-B29

Note the subtle changes from the previous example:

• The cash flow from salvage value is
Salvage value − tax * (Salvage value − Book value )
!""""""""""""#""""""""""""$
↑
Taxable gain at time
of machine sale

In our example this is $310 (cell B30).

• Another way to write the cash flow from the salvage value is

Salvage value * (1 − tax ) + tax * book value

!""""""""""#""""""""""$ !""""""#""""""$
↑ ↑
After-tax proceeds from machine Tax shield on book
sale if the whole salvage value is value at time of machine
taxed sale
126 PART ONE CAPITAL BUDGETING AND VALUATION

Using this example, you can see the role taxes play even if we sell the machine at a loss.
Suppose, for example, that the machine is sold in year 7 for $50, which is less than the book
value:

A B C D E F G
BUYING A MACHINE--NPV ANALYSIS
with salvage value
1 Machine sold at end of year 7
2 Cost of the machine 800
3 Annual anticipated sales 1,000
4 Annual COGS 400
5 Annual SG&A 300 NPV Analysis
6 Annual depreciation 100 Year Cash flow
7 0 -800 <-- =-B2
8 Tax rate 40% 1 220 <-- =$B$23
9 Discount rate 15% 2 220
10 3 220
11 Annual profit and loss (P&L) 4 220
12 Sales 1,000 5 220
13 Minus COGS -400 6 220
14 Minus SG&A -300 7 290 <-- =$B$23+B30
15 Minus depreciation -100
16 Profit before taxes 200 <-- =SUM(B12:B15) NPV 142 <-- =F7+NPV(B9,F8:F15)
17 Subtract taxes -80 <-- =-B8*B16
18 Profit after taxes 120 <-- =B16+B17
19
20 Calculating the annual cash flow
21 Profit after taxes 120
22 Add back depreciation 100
23 Cash flow 220
24
25 Calculating the cash flow from salvage value
26 Machine market value, year 7 50
27 Book value, year 7 100
28 Taxable gain -50 <-- =B26-B27
29 Taxes paid on gain -20 <-- =B8*B28
30 Cash flow from salvage value 70 <-- =B26-B29

In this case, the negative taxable gain (cell B28, the jargon often heard is “loss over book”)
produces a “tax shield”—the negative taxes of -$20 in cell B29. This tax shield is really a reduc-
tion in your total taxes attributable to the $50 loss in cell B28. It is added to the market value
to produce a salvage value cash flow of $70 (cell B30). Thus, even selling an asset at a loss can
produce a positive cash flow.

4.9. Capital Budgeting Principle: Don’t Forget the Cost of

Foregone Opportunities
This is another important principle of capital budgeting. An example: You’ve been offered the
following project, which involves buying a widget-making machine for $300 to make a new
product. The cash flows in years 1–5 have been calculated by your financial analysts.
 CHAPTER 4 Introduction to Capital Budgeting 127

A B C
DON'T FORGET THE COST OF
1 FOREGONE OPPORTUNITIES
2 Discount rate 12%
3
4 Year Cash flow
5 0 -300
6 1 185
7 2 249
8 3 155
9 4 135
10 5 420
11
12 NPV 498.12 <-- =NPV(B2,B6:B10)+B5
13 IRR 62.67% <-- =IRR(B5:B10)

Looks like a fine project! But now someone remembers that the widget process makes use
of some already existing but underused equipment. Should the value of this equipment be some-
how taken into account?
The answer to this question has to do with whether the equipment has an alternative use.
For example, suppose that, if you don’t buy the widget machine, you can sell the equipment for
$200. Then the true year 0 cost for the project is $500, and the project has a lower NPV.

A B C
16 Discount rate 12%
17
18 Year Cash flow
The $300 direct cost + $200
19 0 -500 <-- value of the existing machines
20 1 185
21 2 249
22 3 155
23 4 135
24 5 420
25
26 NPV 298.12
27 IRR 31.97%

Although the logic here is clear, the implementation can be murky: What if the machine
is to occupy space in a building that is currently unused? Should the cost of this space be taken
into account? It all depends on whether there are alternative uses, now or in the future.7

4.10. In-House Copying or Outsourcing? A Mini Case Illustrating

Foregone Opportunity Costs
Your company is trying to decide whether to outsource its photocopying or continue to do it
in-house. The current photocopier won’t do anymore—it has to be either sold or thoroughly

7
There’s a fine Harvard case on this topic: “The Super Project,” Harvard Business School case
9-112-034.
128 PART ONE CAPITAL BUDGETING AND VALUATION

fixed up. Here are some details about the two alternatives:

• The company’s tax rate is 40%.

• Doing the copying in-house requires an investment of $17,000 to fix up the existing photo-
copy machine. Your accountant estimates that this $17,000 can be immediately booked
as an expense, so that its after-tax cost is (1 − 40%)* 17,000 = 10,200. Given this invest-
ment, the copier will be good for another 5 years. Annual copying costs are estimated to be
$25,000 on a before-tax basis; after-tax this is (1 − 40%)* 25.000 = 15,000.
• The photocopy machine is on your books for $15,000, but its market value is in fact much
less—it could only be sold today for $5,000. This means that the sale of the copier will
generate a loss for tax purposes of $10,000; at your tax rate of 40%, this loss gives a tax
shield of $4,000. Thus, the sale of the copier will generate a cash flow of $9,000.
• If you decide to keep doing the photocopying in-house, the remaining book value of the
copier will be depreciated over 5 years at $3,000 per year. Because your tax rate is 40%,
this will produce a tax shield of 40% * $3,000 = $1,200 per year.
• Outsourcing the copying will be $33,000 per year—$8,000 more expensive than doing
it in-house on the rehabilitated copier. Of course this $33,000 is an expense for tax pur-
poses, so that the net savings from doing the copying in-house is
(1 − tax rate)* outsourcing cos ts = (1 − 40%)* $33,000 = $19,800 .
• The relevant discount rate is 12%.

We will show you two ways to analyze this decision. The first method values each of the
alternatives separately. The second method looks only at the differential cash flows; while this
produces a somewhat “cleaner” set of cash flows that take explicit account of foregone opportunity
costs, we recommend the first method—it’s simpler and leads to fewer mistakes.

Method 1: Write Down the Cash Flows of Each Alternative

This is often the simplest way to do things; if you do it correctly, this method takes care of all
the foregone opportunity costs without your thinking about them. Below we write down the
cash flows for each alternative.

IN HOUSE OUTSOURCING

Sale price of machine

Year 0 − (1 − tax rate )* machine rehab cost
+ tax rate * loss over book value
= − (1 − 40% )* 17,000 = −$10,200
= $5,000 + 40% * ($15,000 − 5,000 )
= $9,000

Years 1–5 annual − (1 − tax rate )* in-house costs − (1 − tax rate )* outsourcing costs
cash flow + tax rate* depreciation = − (1 − 40% )* $33,000
= − (1 − 40% )* $25,000 = −$19,800
+ 40% * $3,000 = −$13,800
 CHAPTER 4 Introduction to Capital Budgeting 129

Putting these data in a spreadsheet and discounting at the discount rate of 12% shows that it
is cheaper to do the in-house copying. The NPV of the in-house cash flows is -$59,946, whereas
the NPV of the outsourcing cash flows is -$62,375. Note that both NPVs are negative; but the
in-house alternative is less negative (meaning more positive) than the outsourcing alternative;
therefore, the in-house method is preferred.

A B C
1 SELL THE PHOTOCOPIER OR FIX IT UP?
2 Annual cost savings (before tax) after fixing up the machine 8,000
3 Book value of machine 15,000
4 Market value of machine 5,000
5 Rehab cost of machine 17,000
6 Tax rate 40%
7 Annual depreciation if machine is retained 3,000
8 Annual copying costs
9 In-house 25,000
10 Outsourcing 33,000
11 Discount rate 12%
12
13 Alternative 1: Fix up machine and do copying in-house
14 Year Cash flow
15 0 -10,200 <-- =-B5*(1-B6)
16 1 -13,800 <-- =-$B$9*(1-$B$6)+$B$6*$B$7
17 2 -13,800
18 3 -13,800
19 4 -13,800
20 5 -13,800
21 NPV of fixing up machine and in-house copying -59,946 <-- =B15+NPV(B11,B16:B20)
22
23 Alternative 2: Sell machine and outsource copying
24 Year Cash flow
25 0 9,000 <-- =B4+B6*(B3-B4)
26 1 -19,800 <-- =-(1-$B$6)*$B$10
27 2 -19,800
28 3 -19,800
29 4 -19,800
30 5 -19,800
31 NPV of selling machine and outsourcing -62,375 <-- =B25+NPV(B11,B26:B30)

Method 2: Discounting the Differential Cash Flows

In this method we subtract the cash flows of Alternative 2 from those of Alternative 1.

A B C
34 Subtract Alternative 2 CFs from Alternative 1 CFs
35 Year Cash flow
36 0 -19,200 <-- =B15-B25
37 1 6,000 <-- =B16-B26
38 2 6,000
39 3 6,000
40 4 6,000
41 5 6,000
42 NPV(Alternative 1 - Alternative 2) 2,429 <-- =B36+NPV(B11,B37:B41)
130 PART ONE CAPITAL BUDGETING AND VALUATION

The NPV of the differential cash flows is positive. This means that Alternative 1 (in-house)
is better than Alternative 2 (outsourcing):

NPV (In-house − Outsourcing ) = NPV (In-house ) − NPV (Outsourcing) > 0

This means that
NPV (In-house )> NPV (Outsourcing)

If you look carefully at the differential cash flows, you’ll see that they take into account the
cost of the foregone opportunities.

Differential cash flow Explanation

Year 0 -$19,200 This is the after-tax cost of rehabilitating the old copier
(-$10,200) and the foregone opportunity cost of selling the copier
(-$9,000). In other words: This is the cost in year 0 of deciding to
do the copying in house.

Years 1–5 $6,000 This is the after-tax saving of doing the copying in house: If you
do it in house, you save $8,000 pretax (= $4,800 after tax) and
you get to take depreciation on the existing copier (= tax shield
of $1,200). Relative to in house copying, the outsourcing alter-
native has a foregone opportunity cost of the loss of the depreci-
ation tax shield.

If you examine the convoluted prose in the table above (“the outsourcing alternative has a
foregone opportunity cost of the loss of the depreciation tax shield”) you’ll agree that it might
just be simpler to list each alternative’s cash flows separately.

4.11. Accelerated Depreciation

As you know by now, the salvage value for an asset is its value at the end of its life; another
term sometimes used is terminal value. Here’s a capital budgeting example that illustrates the
importance of accelerated depreciation in computing the cash:

• Your company is considering buying a machine for $10,000.

• If bought, the machine will produce annual cost savings of $3,000 for the next 5 years;
these cash flows will be taxed at the company’s tax rate of 40%.
• The machine will be depreciated over the 5-year period using the accelerated deprecia-
tion percentages allowable in the United States. At the end of the 6th year, the machine
will be old; your estimate of its salvage value at this point is $4,000, even though for
accounting purposes its book value is $576 (cell B19 below).

You have to decide what the NPV of the project is, using a discount rate of 12%. Here are
the relevant calculations.
 CHAPTER 4 Introduction to Capital Budgeting 131

A B C D E F G
1 CAPITAL BUDGETING WITH ACCELERATED DEPRECIATION
2 Machine cost 10,000
3 Annual materials savings, before tax 3,000
4 Salvage value, end of year 5 4,000
5 Tax rate 40%
6 Discount rate 12%
7
8 Accelerated depreciation schedule (ACRS)
ACRS
depreciation Actual Depreciation
9 Year percentage depreciation tax shield
10 1 20.00% 2,000 800 <-- =$B$5*C10
11 2 32.00% 3,200 1,280 <-- =$B$5*C11
12 3 19.20% 1,920 768 <-- =$B$5*C12
13 4 11.52% 1,152 461 <-- =$B$5*C13
14 5 11.52% 1,152 461
15 6 5.76% 576 230 The book value at the end of year
16 6 is the initial cost of the machine
17 Terminal value ($10,000) minus the sum of all
18 Year 6 sale price, estimated 4,000 <-- =B4 the depreciation taken on the
19 Year 6 book value 576 <-- =B2-SUM(C10:C14) machine through year 6 ($9,424).
20 Taxable gain 3,424 <-- =B18-B19
21 Taxes 1,370 <-- =B5*B20
The net cash flow from the
22 Net cash flow from terminal value 2,630 <-- =B18-B21
terminal value equals the year 6
23
sale price minus applicable taxes.
24
25 Net present value calculation
After-tax cost Depreciation
26 Year Cost savings tax shield Terminal value Total cash flow
27 0 -10,000 -10,000
28 1 1,800 800 2,600 <-- =SUM(B28:E28)
29 2 1,800 1,280 3,080
30 3 1,800 768 2,568
31 4 1,800 461 2,261
32 5 1,800 461 2,261
33 6 2,630 2,630
34
35 Net present value 657 <-- =F27+NPV(B6,F28:F33)
36 IRR 14.36% <-- =IRR(F27:F33)

The annual after-tax cost saving is $1,800 = (1−40%) * $3,000. The depreciation tax shields
are determined by the accelerated depreciation schedule (rows 10–15). When the asset is sold at
the end of year 6, its book value is $576. This leads to a taxable gain of $3,424 (cell B20) and to
taxes of $1,370 (cell B21). The net cash flow (cell B22) from selling the asset at the end of year 6
is its sale price of $4,000 minus the taxes (cell B21). The NPV of the asset is $657 and the IRR
is 14.36% (cells B35 and B36).

4.12. Conclusion
In this chapter we’ve discussed the basics of capital budgeting using NPV and IRR. Capital
budgeting decisions can be crudely separated into “yes–no” decisions (“Should we undertake
a given project?”) and into “ranking” decisions (“Which of the following list of projects do we
prefer?”). We’ve concentrated on two important areas of capital budgeting:
• The difference between NPV and IRR in making the capital budgeting decision. In many
cases these two criteria give the same answer to the capital budgeting question. However,
there are cases—especially when we rank projects—where NPV and IRR give different
answers. Where they differ, NPV is the preferable criterion to use because the NPV is the
additional wealth derived from a project.
132 PART ONE CAPITAL BUDGETING AND VALUATION

• Every capital budgeting decision ultimately involves a set of anticipated cash flows, so
when you do capital budgeting, it’s important to get these cash flows right. We’ve illus-
trated the importance of sunk costs, taxes, foregone opportunities, and salvage values in
determining the cash flows.

EXERCISES
1. You are considering a project with the cash flows given below.

A B
3 Discount rate 25%
4
5 Year Cash flow
6 0 -1,000
7 1 100
8 2 200
9 3 300
10 4 400
11 5 500
12 6 600

a. Calculate the present value of the future cash flows of the project.
b. Calculate the project’s net present value.
c. Calculate the project’s internal rate of return.
d. Should you undertake the project?
2. Your firm is considering two projects with the following cash flows:

A B C
1 Discount rate 12%
2
3 Year Project A Project B
4 0 -500 -500
5 1 167 200
6 2 180 250
7 3 160 170
8 4 100 25
9 5 100 30

a. If the appropriate discount rate is 12%, rank the two projects.

b. Which project is preferred if you rank by IRR?
c. Calculate the crossover rate—the discount rate r in which the NPVs of both projects are
equal.
d. Should you use NPV or IRR to choose between the two projects? Give a brief discussion.
3. Your uncle is a proud owner of an up-market clothing store. Because business is down, he is con-
sidering replacing the languishing tie department with a new sportswear department. To examine
the profitability of such a move he has hired a financial advisor to estimate the cash flows of the
new department. After 6 months of hard work, the financial advisor came up with the following
calculation:
 CHAPTER 4 Introduction to Capital Budgeting 133

Investment (at t = 0)

Rearranging the shop 40,000

Loss of business during renovation 15,000

Payment for financial advisor 12,000

Total 67,000

Annual profits (from t = 1 to infinity)

Annual earnings from the sport department 75,000
Loss of earnings from the tie department -20,000
Loss of earnings from other departments* -15,000
Additional worker for the sport department -18,000
Municipal taxes -15,000
Total 7,000
*Some of your uncle’s stuck-up clients will not buy in a shop that sells
sportswear.

The discount rate is 12%, and there are no additional taxes. Thus, the financial advisor calcu-
lated the NPV as follows.
7,000
−67,000 + = −8,667
0.12
Your surprised uncle asked you (a promising finance student) to go over the calculations. What
are the correct NPV and IRR of the project?
4. You are the owner of a factory that supplies chairs and tables to schools in Denver. You sell each
chair for $1.76 and each table for $4.40 based on the following calculation:

Chair department Table department

No. of units 100,000 20,000

Cost of material 80,000 35,000

Cost of labor 40,000 20,000

Fixed cost 40,000 25,000

Total cost 160,000 80,000

Cost per unit 1.60 4.00

Plus 10% profit 1.76 4.40

134 PART ONE CAPITAL BUDGETING AND VALUATION

You have received an offer from a school in Colorado Springs to supply an additional 10,000
chairs and 2,000 tables for the price of $1.05 and $3.50, respectively. Your financial advisor advises
you not to take the offer because the price does not even cover the cost of production. Is the finan-
cial advisor correct?
5. A factory is considering the purchase of a new machine for one of its units. The machine costs
$100,000. The machine will be depreciated on a straight-line basis over its 10-year life to a salvage
value of zero. The machine is expected to save the company $50,000 annually, but to operate it the
factory will have to transfer an employee (with a salary of $40,000 a year) from one of its other
units. A new employee (with a salary of $20,000 a year) will be required to replace the transferred
employee. What is the NPV of the purchase of the new machine if the relevant discount rate is 8%
and corporate tax rate is 35%?

EBDT (Earnings before

Year depreciation and taxes)
0 -10,500
1 3,000
2 3,000
3 3,000
4 2,500
5 2,500
6 2,500
7 2,500

6. You are considering the following investment:

The discount rate is 11% and the corporate tax rate is 34%.
a. Calculate the project NPV using straight-line depreciation.
b. What will be the company’s gain if it uses a 7-year modified accelerated depreciation (MACRS)
schedule, given below?
MACRS
depreciation
Year Percentage
1 14.29%
2 24.49%
3 17.49%
4 12.49%
5 8.93%
6 8.93%
7 8.93%
8 4.45%
7. A company is considering buying a new machine for one of its factories. The cost of the machine
is $60,000 and its expected life span is 5 years. The machine will save the cost of a worker esti-
mated at $22,500 annually. The book value of the machine at the end of year 5 is $10,000 but the
company estimates that the market value will be only $5,000. Calculate the NPV of the machine if
the discount rate is 12% and the tax rate is 30%. Assume straight-line depreciation over the 5-year
life of the machine.
8. The ABD Company is considering buying a new machine for one of its factories. The machine cost
is $100,000 and its expected life span is 8 years. The machine is expected to reduce the production
cost by $15,000 annually. The terminal value of the machine is $20,000 but the company believes
 CHAPTER 4 Introduction to Capital Budgeting 135

that it would only manage to sell it for $10,000. If the appropriate discount rate is 15% and the
corporate tax is 40%,
a. Calculate the project NPV.
b. Calculate the project IRR.
9. You are the owner of a factory located in a hot tropical climate. The monthly production of the
factory is $100,000 except during June–September, when it falls to $80,000 because of the heat
in the factory. In January 2010 you get an offer to install an air-conditioning system in your fac-
tory. The cost of the air-conditioning system is $150,000 and its expected life span is 10 years.
If you install the air-conditioning system, the production in the summer months will equal the
production in the winter months. However, the cost of operating the system is $9,000 per month
(only in the 4 months that you operate the system). You will also need to pay a maintenance fee
of $5,000 annually in October. What is the NPV of the air-conditioning system if the interest
rate is 12% and the corporate tax rate is 35% (the depreciation costs are recognized in December
of each year)?
10. The “Cold and Sweet” (C&S) company manufactures ice-cream bars. The company is considering
the purchase of a new machine that will top the bar with high-quality chocolate. The cost of the
machine is $900,000.
Depreciation and terminal value: The machine will be depreciated over 10 years to zero salvage
value. However, the company intends to use the machine for only 5 years. Management thinks that
the sale price of the machine at the end of 5 years will be $100,000.
The machine can produce up to 1 million ice cream bars annually. The marketing director
of C&S believes that if the company will spend $30,000 on advertising in the first year and
another $10,000 in each of the following years, the company will be able to sell 400,000
bars for $1.30 each. The cost of producing of each bar is $0.50; and other costs related to the
new products are $40,000 annually. C&S’s cost of capital is 14% and the corporate tax rate
is 30%.
a. What is the NPV of the project if the marketing director’s projections are correct?
b. What is the minimum price that the company should charge for each bar if the project is to be
profitable? Assume that the price of the bar does not affect sales.
c. The C&S marketing vice president suggested canceling the advertising campaign. In his opin-
ion, the company sales will not be reduced significantly because of the cancellation. What is
the minimum quantity that the company needs to sell to be profitable if the vice president’s
suggestion is accepted?
d. The marketing vice president would like some sensitivity analysis done. He asks what the NPV
of the project would be if annual unit sales vary from 300,000, 350,000, . . . , 700,000 and if the
unit price per bar varies from $1.20, $1.30, . . . , $1.70. Show the Data Table that answers his
question.
11. The “Less Is More” company manufactures swimsuits. The company is considering expanding to
the bathrobe market. The proposed investment plan includes the following:
• Purchase of a new machine: The cost of the machine is $150,000 and its expected life span is 5
years. The terminal value of the machine is 0, but the chief economist of the company estimates
that it can be sold for $10,000.
• Advertising campaign: The head of the marketing department estimates that the campaign will
cost $80,000 annually.
• The fixed cost of the new department will be $40,000 annually.
• Variable costs are estimated at $30 per bathrobe but because of the expected rise in labor costs
they are expected to rise at 5% per year.
136 PART ONE CAPITAL BUDGETING AND VALUATION

• Each of the bathrobes will be sold at a price of $45 the first year. The company estimates that it
can raise the price of the bathrobes by 10% in each of the following years.
The “Less Is More” discount rate is 10% and the corporate tax rate is 36%.
a. What is the break-even point of the bathrobe department?
b. Plot a graph in which the NPV is the dependent variable of the annual production.
12. The Car Clean company operates a car wash business. The company bought a machine 2 years
ago at the price of $60,000. The life span of the machine is 6 years and the machine has no dis-
posal value; the current market value of the machine is $20,000. The company is considering
buying a new machine. The cost of the new machine is $100,000 and its life span is 4 years.
The new machine has a disposal value of $20,000. The new machine is faster than the old one;
thus, the company believes the revenue will increase from $1 million annually to $1.03 million.
In addition, the new machine is expected to save the company $10,000 in water and electricity
costs.
The discount rate of Car Clean is 15% and the corporate tax rate is 40%. What is the NPV of
replacing the old machine?
13. A company is considering whether to buy a regular or color photocopier for the office. The cost
of the regular machine is $10,000, its life span is 5 years, and the company has to pay another
$1,500 annually in maintenance costs. The color photocopier’s price is $30,000, its life span is
also 5 years, and the annual maintenance costs are $4,500. The color photocopier is expected
to increase the revenue of the office by $8,500 annually. Assume that the company is profitable
and pays 40% corporate tax; the relevant interest rate is 11%. Which photocopy machine should
the firm buy?
14. The Coka company is a soft drink company. Until today the company bought empty cans from an
outside supplier that charges Coka $0.20 per can. In addition the transportation cost is $1,000 per
truck that transports 10,000 cans. The Coka company is considering whether to start manufactur-
ing cans in its plant. The cost of a can machine is $1 million and its life span is 12 years. The
terminal value of the machine is $160,000. Maintenance and repair costs will be $150,000 for
every 3-year period. The additional space for the new operation will cost the company $100,000
annually. The cost of producing a can in the factory is $0.17.
The cost of capital of Coka is 11% and the corporate tax rate is 40%.
a. What is the minimum number of cans that the company has to sell annually to justify self-
production of cans?
b. Advanced: Use data tables to show the NPV and IRR of the project as a function of the num-
ber of cans.
15. The ZZZ Company is considering investing in a new machine for one of its factories. The com-
pany has two alternatives to choose from:
The life span of each machine is 5 years. ZZZ sells each unit for a price of $6. The company has
a cost of capital of 12% and its tax rate is 35%.
a. If the company manufactures 1 million units per year, which machine should it buy?

Machine A Machine B
Cost $4,000,000 $10,000,000
Annual fixed cost per machine $300,000 $210,000
Variable cost per unit $1.20 $0.80
Annual production 400,000 550,000
 CHAPTER 4 Introduction to Capital Budgeting 137

b. Plot a graph showing the profitability of investment in each machine type depending on the
annual production.
16. The Easy Sight company manufactures sunglasses. The company has two machines, each
of which produces 1,000 sunglasses per month. The book value of each of the old machines
is $10,000 and their expected life span is 5 years. The machines are being depreciated on a
straight-line basis to zero salvage value. The company assumes it will be able to sell a machine
today (January 2011) for the price of $6,000. The price of a new machine is $20,000 and its
expected life span is 5 years. The new machine will save the company $0.85 for every pair of
sunglasses produced.
Demand for sunglasses is seasonal. During the 5 summer months (May–September) demand is
2,000 sunglasses per month, whereas during the winter months it falls to 1,000 per month.
Assume that because of insurance and storage costs it is uneconomical to store sunglasses at
the factory. Should Easy Sight replace its two old machines with new ones if its discount rate is
10% and its corporate tax rate is 40%?
17. Poseidon is considering opening a shipping line from Athens to Rhodes. To open the ship-
ping line Poseidon will have to purchase two ships that cost 1,000 gold coins each. The life
span of each ship is 10 years, and Poseidon estimates that he will earn 300 gold coins in the
first year and the earnings will increase by 5% per year. The annual costs of the shipping
line are estimated at 60 gold coins annually, Poseidon’s interest rate is 8%, and Zeus’s tax
rate is 50%.
a. Will the shipping line be profitable?
b. Because of Poseidon’s good connections on Olympus, he can get a tax reduction. What is the
maximum tax rate at which the project will be profitable?
18. At the board meeting on Olympus, Hera tried to convince Zeus to keep the 50% tax rate intact
because of the budget deficit. According to Hera’s calculations, the shipping line will be more
profitable if Poseidon will buy only one ship and sell tickets only to first-class passengers. Hera
estimated that Poseidon’s annual costs will be 40 gold coins.
a. What are the minimum annual average earnings required for the shipping line to be profitable
assuming that earnings are constant throughout the 10 years?
b. Zeus, who is an old-fashioned god, believes that “blood is thicker than money.” He agreed to
give Poseidon a tax reduction if he will only buy one ship. Use data tables to show the profit-
ability of the project as dependent on the annual earnings and the tax rate.
19. Kane Running Shoes is considering the manufacturing of a special shoe for race walking that will
indicate whether an athlete is running (this happens if neither of the walker’s legs is touching the
ground). The chief economist of the company presented the following calculation for the Smart
Walking Shoes (SWS):
• Research and development (R&D) $200,000 annually in each of the next 4 years.
The manufacturing project:
• Expected life span: 10 years
• Investment in machinery: $250,000 (at t = 4); expected life span of the machine 10 years
• Expected annual sales: 5,000 pairs of shoes at the expected price of $150 per pair
• Fixed cost $300,000 annually
• Variable cost: $50 per pair of shoes
Kane’s discount rate is 12%, the corporate rate is 40%, and R&D expenses are tax deductible
against other profits of the company. Assume that at the end of project (that is, after 14 years) the
new technology will have been superseded by other technologies and therefore have no value.
138 PART ONE CAPITAL BUDGETING AND VALUATION

a. What is the NPV of the project?

b. The International Olympic Committee (IOC) decided to give Kane a loan without interest for
6 years to encourage the company to take on the project. The loan will have to be paid back in
six equal annual payments. What is the minimum loan that the IOC should give for the project
to be profitable?
20. The Aphrodite company is a manufacturer of perfume. The company is about to launch a new
line of products. The marketing department has to decide whether to use an aggressive or a reg-
ular campaign.

Aggressive Campaign
Initial cost (production of commercial advertisement using a top model): $400,000
First month profit: $20,000
Monthly growth in profit (months 2–12): 10%
After 12 months the company is going to launch a new line of products and it is expected that the
monthly profits from the current line would be $20,000 forever.

Regular Campaign
Initial cost (using a less famous model): $150,000
First month profit: $10,000
Monthly growth in profits (months 2–12): 6%
Monthly profit (month 13– ∞ ): $20,000
a. The annual cost of capital is 7%. Calculate the NPV of each campaign and decide which cam-
paign the company should undertake.
b. The manager of the company believes that because of the recession expected next year, the
profit figures for the aggressive campaign (both first-month profit and 2- to 12-month profit
growth) are too optimistic. Use a data table to show the differential NPV as a function of the
first-month payment and the growth rate of the aggressive campaign.
21. The Long-Life Company has a new vaccine. The company estimates that it has a 10-year monop-
oly for the production of the vaccine, and it is trying to estimate how many vaccines it should try
to sell annually.
Machines to produce the new vaccine cost $70 million and have a 5-year life, straight-line
depreciation, and a zero salvage value. Each machine is capable of producing 75,000 vaccines
annually. Annual fixed costs for producing the vaccine are $120 million, and the variable cost per
vaccine is $1,000. The company’s discount rate for this type of vaccine is 15%, and its corporate
tax rate is 30%. The total market for the vaccine is 250,000 annually.
Use the template below (on the disk with Principles of Finance with Excel) to answer the fol-
lowing questions:
 CHAPTER 4 Introduction to Capital Budgeting 139

a. If the annual sales are 200,000, what will be the NPV of the product over its 10-year life?
b. Fill in the data table at the bottom of the template. At a 16% discount rate, how many vaccines
should the company aim to sell?

A B C D E F G H I J K L
1 LONG-LIFE COMPANY
2 Discount rate 15%
3 Tax rate 30%
4 Machine cost 70,000,000
5 Annual depreciation 14,000,000
6 Annual vaccines per machine 75,000
7 Variable cost per vaccine 1,000
8 Annual fixed costs 120,000,000
9
10 Annual vaccines sold 200,000
11 Price per vaccine 1,500
12 Annual revenue 300,000,000
13 Annual production costs 200,000,000
14 Number of machines needed 3 <-- =ROUNDUP(B10/B6,0)
15
16 Year 0 1 2 3 4 5 6 7 8 9 10
17 Machines purchase
18 Revenue
19 Cost of vaccines
20 Depreciation
21 Profits before taxes
22 Taxes
23 Profits after taxes
24 Add back depreciation
25 Cash flow
26
27 Net present value
28 Internal rate of return
29
30
31 DATA TABLE: sensitivity of NPV to number of vaccines sold and to discount rate
32 Number of vaccines sold annually
33 100,000 150,000 160,000 180,000 200,000 220,000 250,000
34 WACC --> 10%
35 12%
36 14%
37 16%
38 18%
39 20%
40 22%
41 24%
42 26%
43 28%
44 30%
CHAP TER

5 Issues in Capital Budgeting

CHAPTER CONTENTS
Overview 141
5.1. A Problem with IRR: You Can’t Always Tell Good Projects
from Bad Ones 141
5.2. Multiple Internal Rates of Return 143
5.3. Choosing between Projects with Different Life Spans 146
5.4. Lease versus Purchase When Taxes Are Important 151
5.5. Capital Budgeting Principle: Think about Mid-year Discounting 154
5.6. Inflation: Real and Nominal Interest Rates and Cash Flows 162
5.7. Understanding TIPS 169
5.8. Using TIPS to Predict Inflation 172
5.9. Inflation-Adjusted Capital Budgeting 173
Conclusion 176
Exercises 177

140
 CHAPTER 5 Issues in Capital Budgeting 141

Overview
The capital budgeting decisions we examined in Chapter 4 were all pretty cut and dried: The
NPV and IRR criteria always indicated which investment was worthwhile for the individual or
the company. As you might expect, in real life the decisions of where and how to spend your
investment dollars are not always so clear cut.
In this chapter we expand on the discussion of capital budgeting started in Chapter 4 and
examine a number of issues that often cause confusion.

Finance Concepts Discussed

• Problems with IRR as a decision criterion
• IRR can’t distinguish between borrowing and lending
• Multiple IRRs
• Choosing between projects with different lifetimes
• Discounting cash flows that don’t occur at year end (“mid-year discounting”)
• Incorporating tax considerations into the lease vs. purchase problem
• Incorporating inflation into capital budgeting—discounting nominal versus real cash
flows

Excel Functions Used

• IRR, NPV
• Sum
• PMT
• If
• XNPV, XIRR

5.1. A Problem with IRR: You Can’t Always Tell Good

Projects from Bad Ones
Sometimes it’s hard to tell from the IRR whether a project is good or bad. Here’s a simple
example: You’ve decided to buy a car; the list price is $11,000, and the dealer has offered you
two purchase options:
• You can pay the dealer cash and get a $1,000 discount, thus paying only $10,000.
• You can pay $5,000 now and pay $2,000 in each of the next 3 years. The dealer calls this
his “zero-interest car loan” plan. The bank is giving car loans at 9% interest, so the dealer
claims that his plan is much cheaper.
Which offer is better? Having learned a bit of finance, you set up the following Excel
spreadsheet.
142 PART ONE CAPITAL BUDGETING AND VALUATION

A B C D E
1 BUYING A CAR
2 List price of car 11,000.00
3 Downpayment 5,000.00
4 Cash cost of car 10,000.00
5
Cash spent or
Payment Payment saved with
6 Year in cash with credit credit plan
7 0 -10,000.00 -5,000.00 5,000.00 <-- =C7-B7
8 1 -2,000.00 -2,000.00 <-- =C8-B8
9 2 -2,000.00 -2,000.00
10 3 -2,000.00 -2,000.00
11
12 Internal rate of return 9.70% <-- =IRR(D7:D10)
13
14 Bank rate of interest 9%
15 NPV of cash saved -62.59 <-- =D7+NPV(B14,D8:D10)

The critical element in the spreadsheet is column D, which compares the annual cash outlays
of the credit plan with those of the cash payment plan. Column D shows that if you pay with the
credit plan instead of paying cash, you’ll spend $5,000 less in year 0. On the other hand, you’ll
spend $2,000 more in years 1, 2, and 3. The IRR of this column is 9.70%. Because the bank is
lending money at 9%, you should take a bank loan instead of using the dealer’s credit plan.
To understand this further, note that the pattern of the cash flows in column D is like the
pattern of cash flows from taking a loan. When you take a loan, there is an initial positive cash
flow (this is when you get the loan) and subsequent negative cash flows (the loan repayments).
When you buy the car using the dealer’s credit plan, the cash flow pattern is the same: There is
an initial positive cash flow (the savings from paying only $5,000 instead of $10,000) and sub-
sequent negative cash flows (the additional $2,000 annual cost of the credit plan). Thus, the IRR
of 9.70% represents the cost of the dealer’s credit plan. Because the bank lends at a cost of 9%,
it is cheaper to borrow through the bank.
What if you don’t have the $10,000 cash for the cash payment plan? Then you should take
a bank loan (read on for details).
Cell B15 discounts the differential payment flow of column D at the bank interest rate. This
shows that this flow has a negative NPV, another indication that you shouldn’t undertake this
project: You should opt for the cash payment plan.

How Will You Pay for the Car?

So you’re better off paying the dealer cash. If you don’t have the $10,000 cash, you could borrow
$5,000 from the bank. This plan would have the following cash flows (assuming equal annual
payments of principal and interest, calculated using Excel’s PMT function).

A B C D E
18 Borrowing the money from the bank
Payment Bank loan Total cash flow
19 Year in cash cash flows to car owner
20 0 -10,000.00 5,000.00 -5,000.00
21 1 -1,975.27 -1,975.27 <-- =PMT(9%,3,C20)
22 2 -1,975.27 -1,975.27
23 3 -1,975.27 -1,975.27
 CHAPTER 5 Issues in Capital Budgeting 143

The cash flows in cells D20:D23 are an improvement over those in cells C7:C10, which
shows (again) that it’s better to buy the car in cash and borrow the money from the bank than to
take the dealer’s financing offer.

The Dealer’s Cash Flows

To see how confusing the IRR can be, consider the dealer’s cash flows. He’s offered you the
choice of paying $10,000 in cash or $5,000 down with three equal payments of $2,000.

A B C D E
1 IRR VERSUS NPV--THE DEALER'S PROBLEM
2 List price of car 11,000.00
3 Downpayment 5,000.00
4 Cash cost of car 10,000.00
5
Payment Payment Differential
6 Year in cash with credit dealer cash flow
7 0 10,000.00 5,000.00 -5,000.00 <-- =C7-B7
8 1 2,000.00 2,000.00 <-- =C8-B8
9 2 2,000.00 2,000.00
10 3 2,000.00 2,000.00
11
12 Internal rate of return 9.70% <-- =IRR(D7:D10)
13
14 Bank rate of interest 9%
15 NPV of cash saved 62.59 <-- =D7+NPV(B14,D8:D10)

Column D shows that between the two plans, the dealer has a negative cash flow of $5,000 in
year 0, but then has a positive cash flow of $2,000 in each of the 3 subsequent years. Effectively,
the dealer is acting like a bank giving a loan, and the 9.70% represents the interest earned by
the dealer on the loan; if he can borrow the $5,000 in cell D8 from the bank at 9%, he’s better
off—his NPV on the loan is $62.59.

What’s the Point?

The dealer’s IRR and your IRR are the same. But this turns out to mean that the payment plan
is bad for you and good for the dealer: The IRR of the dealer’s cash flows represents the interest
he earns on the loan he’s giving you; the IRR of your cash flows is the cost of the loan you’re
taking. To tell whether you’re getting a good deal or a bad deal, use the NPV of the differential
payments discounted at the bank’s loan rate; this NPV clearly shows that the payment plan is
bad for you (negative NPV of $62.59) and good for the dealer (positive NPV of $62.59).

5.2. Multiple Internal Rates of Return

A project has a “conventional cash flow pattern” when all the positive and negative cash flows
are bunched together. If this condition is not met, then we’ll call the cash flow pattern of the
project “nonconventional.” Here are some examples of conventional and nonconventional cash
flows.
144 PART ONE CAPITAL BUDGETING AND VALUATION

A B C D E F G
1 CONVENTIONAL AND NON CONVENTIONAL CASH FLOW PATTERNS
Cash flow Cash flow Cash flow Cash flow Cash flow Cash flow
2 Year Project A Project B Project C Project D Project E Project F
3 0 -100 -100 100 25 -25 -250
4 1 200 -50 55 35 80 35
5 2 500 60 35 -200 -100 145
6 3 50 80 50 33 200 330
7 4 60 99 -100 55 55 55
8 5 35 100 -35 155 -250 -250

Conventional Conventional Conventional Nonconventional Nonconventional Nonconventional

cash flow cash flow cash flow cash flow cash flow cash flow
9 pattern pattern pattern pattern pattern pattern
Initial negative Two initial Initial positive Two positive Initial negative Negative cash
cash flow negative cash cash flows cash flows, then cash flow, then flows at
followed by flows followed followed by negative, then positive, then beginning and
positive cash by positive negative cash three positive negative, end, other cash
flows cash flows flows cash flows positive, flows positive
negative
10 cash flows

In Section 3.4 of Chapter 3 we showed that for projects with conventional cash flows, the
NPV and the IRR criteria give the same answers to the “yes–no” capital budgeting question (the
question of whether a particular project is worthwhile). In this section we discuss the IRR of
projects with nonconventional cash flows. Such projects often have multiple IRRs, which makes
our analysis of a nonconventional project using the IRR confusing. We will ultimately conclude
that NPV is a better decision tool.
Consider the case of a company that operates sanitary landfills. A “landfill” is basically a
big hole in the ground where lots of garbage is dumped until the hole is filled in.
Here are the cash flows anticipated by the company for a new landfill:

• The initial cost of the landfill is $800,000: This covers the expense of digging the hole,
fencing it, and providing appropriate truck access.
• The annual net cash inflows from the landfill are $450,000. These represent the fees the
company collects in return for giving trash collection companies the right to dump their
trash in the landfill. These cash inflows are the net of any costs incurred by the landfill
company.
• After 5 years the landfill will be full. The costs of closing the landfill, incurred at the
end of year 6, are $1,500,000. This includes the costs of abiding by various ecological
regulations, etc.

In the next spreadsheet, the cash flows for the landfill are given in cells B3:B9. In columns E
and F we have created a table that computes the net present value of these cash flows at various
discount rates. The graph shows that the cash flows have two internal rates of return: These are
the two points at which the graph cuts the x-axis.
In cells B14 and B15 we identify both of these IRRs using Excel’s IRR function. We
have used the Guess option for this function. This option allows you to identify the approx-
imate IRR (we used the graph to identify this number); Excel then computes an IRR close to
this approximation. In the following spreadsheet we use 25% as a Guess in cell B15. Excel’s
IRR function then shows that the actual IRR that is close to this Guess is 27.74%.
 CHAPTER 5 Issues in Capital Budgeting 145

A B C D E F G H I J K
1 SANITARY LANDFILL, INC.
Discount
2 Year Cash flow rate NPV
3 0 -800,000 0% -50,000 <-- =NPV(E3,$B$4:$B$9)+$B$3
4 1 450,000 2% -10,900 <-- =NPV(E4,$B$4:$B$9)+$B$3
5 2 450,000 4% 17,848 <-- =NPV(E5,$B$4:$B$9)+$B$3
6 3 450,000 6% 38,123
7 4 450,000 8% 51,465
8 5 450,000 10% 59,143 Sanitary Landfill, Inc.
9 6 -1,500,000 12% 62,203
10 14% 61,507 80,000

Net present value

11 Sum of cash flows -50,000 16% 57,769 60,000
12 18% 51,580 40,000
13 20% 43,428 20,000
14 First IRR 2.68% <-- =IRR(B3:B9,0) 22% 33,721 0
15 Second IRR 27.74% <-- =IRR(B3:B9,25%) 24% 22,793 -20,000 0% 10% 20% 30% 40%
16 26% 10,923 -40,000
17 28% -1,658
-60,000
18 30% -14,758
-80,000
19 32% -28,219
Discount rate
20 34% -41,912
21 36% -55,727

DIALOG BOX FOR IRR FUNCTION, SHOWING USE OF GUESS

Note: If you entered a lower Guess (say 0 or 3%), Excel would find the IRR of 2.68%. If you do
not enter a Guess, Excel looks for the IRR closest to zero.

Two IRRs. What Does This Mean?

This business of two IRRs is confusing! Suppose we’re trying to decide whether to undertake
the landfill project. As you saw in Chapter 4, there are two traditional rules for accepting or
rejecting a project:
• NPV rule: A project is acceptable if its NPV > 0. In the case of the sanitary landfill, the
NPV rule says that the project is acceptable if the discount rate is larger than 2.68% and
smaller than 27.74%.
146 PART ONE CAPITAL BUDGETING AND VALUATION

• IRR rule: A project is acceptable if its IRR > appropriate discount rate. Because there are
two IRRs in this case, the IRR rule is impossible to apply. In practical terms, this means
that when a project has more than one IRR, you should determine its attractiveness only
by the NPV rule.

How Many IRRs Are There?

For a given set of cash flows, there are potentially as many IRRs as there are changes in sign of
the cash flow. The cash flow pattern of a conventional project has an initial negative cash flow
and thereafter only positive cash flows; there is only one change of sign (from negative to posi-
tive) and hence only one possible IRR. The previous cash flow example has two changes in sign
(and hence two possible IRRs): from –800,000 in year 0 to 450,000 in year 1 and then again
from 450,000 in year 5 to –1,500,000 in year 6.1

5.3. Choosing between Projects with Different Life Spans

Sometimes our capital budgeting choices involve projects with different life spans. Suppose
your company is considering buying one of two tank trucks to haul high-tech liquid materials.
The company is trying to decide between two alternatives:
• Truck A is a relatively cheap truck. It costs $100,000 and has a 6-year life, during which
it will produce an annual cash flow of $150,000.
• Truck B is much more expensive. It costs $250,000 and has only a 3-year life, after which
it has to be replaced. However, Truck B is much more efficient than Truck A, and during
each of the 3 years of its life it produces a cash flow of $300,000.
If your company’s discount rate is 12%, which truck should it choose? Here’s a simple (and, as
it turns out, misleading) way of doing the analysis.

A B C D
1 DIFFERENT LIFE SPANS
2 Discount rate 12%
3
4 Year Truck A Truck B
5 0 -100 -250
6 1 150 300
7 2 150 300
8 3 150 300
9 4 150
10 5 150
11 6 150
12
13 NPV 516.71 470.55 <-- =C5+NPV($B$2,C6:C11)

Using this analysis you might conclude that Truck A is preferable to Truck B because its
NPV is higher. But because the two trucks have different life spans, there’s a problem concluding

1
Exercises 2 and 3 at the end of this chapter show examples with three IRRs.
 CHAPTER 5 Issues in Capital Budgeting 147

that A is preferred to B. To make them comparable, we assume that at the end of year 3 we will
replace Truck B with another, similar truck. This makes the year 3 cash flow

Year 3 cash flow : "#""$ − !"250

!"300 "#""$ = 50 .
year 3 cash flow purchase price
from truck of new truck

Once we’ve replaced Truck B in year 3, the cash flows in years 4, 5, and 6 will be $300. We
can put this into a spreadsheet.

A B C D
DIFFERENT LIFE SPANS
1 at end of year 3, Truck B is replaced
2 Discount rate 12%
3
4 Year Cash flow (A) Cash flow (B)
5 0 -100 -250
6 1 150 300
7 2 150 300
8 3 150 50 <-- =300-250
9 4 150 300
10 5 150 300
11 6 150 300
12
13 NPV 516.71 805.48 <-- =C5+NPV($B$2,C6:C11)

As you can see in cells B13 and C13, the NPV from the two (now comparable) projects
indicates that B is preferred to A.
There’s another way to reach this same conclusion: Look at the following calculations:

150 150 150 150 150 150

NPV (A) = −100 + + + + + + = 516.71
( ) (1.12) (1.12) (1.12) (1.12) (1.12)6
1.12 2 3 4 5

6
125.68
=∑
t =1 (1.12)t
300 300 300
NPV (B ) = −250 + + + = 470.55
(1.12) (1.12) (1.12)3
2

3
195.91
=∑
t =1 (1.12)t

What these calculations show is that Truck A is equivalent to getting a constant cash flow of
$125.68 per year for each of the 6 years of its life, whereas Truck B is equivalent to getting a con-
stant cash flow of $195.91 for each of its 3 years of life. We call these cash flow the equivalent
annuity cash flow (EAC). Because every time you buy Truck B you get $195.91 per year and
every time you buy Truck A you get $125.68 per year, it is clear that Truck B is preferred.
148 PART ONE CAPITAL BUDGETING AND VALUATION

The EAC is easy to compute. It is defined as a constant future cash flow whose present
value is equal to the net present value of the project.

N
CFt N equivalent annuity cash flow (EAC )
NPV = CF0 + ∑ t
=∑ t
, where N is the project life
t =1 (1 + r ) t =1 (1 + r )

We rearrange this equation a bit and use the Excel function PMT to compute the EAC.

N
CFt
NPV = CF0 + ∑ t

EAC =
t =1 (1 + r ) = −PMT (r, N periods, NPV )
N
1
∑ t
t =1 (1 + r )
↑
Excel function

We implement this formula in the following spreadsheet.

A B C D
DIFFERENT LIFE SPANS
1 Computing the equivalent annuity cash flow (EAC)
2 Discount rate 12%
3
4 Year Cash flow (A) Cash flow (B)
5 0 -100 -250
6 1 150 300
7 2 150 300
8 3 150 300
9 4 150
10 5 150
11 6 150
12
13 NPV 516.71 470.55 <-- =C5+NPV($B$2,C6:C11)
EAC--Equivalent
14 annuity cash flow 125.68 195.91 <-- =-PMT(B2,3,C13)
15
16 =-PMT(B2,6,B13)

A Nontrivial Example of Different Life Spans: Choosing a Light Bulb

This business of the EAC may seem somewhat academic and ethereal, but it’s not. In this sec-
tion we offer a real-life example that can only be solved using the EAC.
 CHAPTER 5 Issues in Capital Budgeting 149

You’re considering replacing the light bulbs in a hotel you own. Currently you’re using 100-
watt incandescent bulbs, which cost $1 each and have an average lifetime of 1,000 hours. You’re
thinking of replacing them with compact fluorescent bulbs. These are much more expensive,
costing $5 each. But they produce the same luminescence, use only 15 watts, and last for 10,000
hours. Here are some additional facts:

• A kilowatt of electricity costs $0.10.

• You tend to burn a light bulb 250 hours per month.
• The interest rate is 8%. In the computations below we translate this to a monthly interest
1 / 12
rate of 0.643% = (1 + 8% ) − 1.

Should you replace the bulbs?

Standard incandescent bulb— Energy-saving fluorescent bulb—

cheap to buy, expensive to operate, expensive to buy, cheap to oper-
short life. ate, long life.

FIGURE 5.1 Standard bulbs versus energy-saving fluorescents.

This problem can be readily solved using the EAC.

150 PART ONE CAPITAL BUDGETING AND VALUATION

A B C
LIGHT BULBS
Choosing between cheap incandescents and
1 expensive fluorescents
2 Annual discount rate 8%
3 Monthly discount rate 0.643% <-- =(1+B2)^(1/12)-1
Electric cost per kilowatt
4 (a kilowatt = 1,000 watts) 0.10
5
6 Incandescent bulb
7 Watts 100
8 Cost $1.00
9 Hours per month used 250
10 Lifetime of bulb (hours) 1,000
11 Lifetime in months 4
12 Monthly cost 2.50 <-- =B9*$B$4*B7/1000
13 NPV of lifetime use 10.84 <-- =B8+PV(B3,B11,-B12)
Monthly equivalent annuity cash flow
14 (EAC) for cheap incandescent 2.75 <-- =-PMT(B3,B11,B13)
15
16 Equivalent fluorescent bulb
17 Watts 15
18 Cost $5.00
19 Hours per month used 250
20 Lifetime of bulb (hours) 10,000
21 Lifetime in months 40
22 Monthly cost 0.38 <-- =B19*$B$4*B17/1000
23 NPV of lifetime use 18.19 <-- =B18+PV(B3,B21,-B22)
Monthly equivalent annuity cash flow
24 (EAC) for expensive fluorescent 0.52 <-- =-PMT(B3,B21,B23)

This spreadsheet requires some additional explanation:

• An incandescent bulb costs $1.00 to buy and $2.50 per month to operate. As shown in
cell B13, the NPV of buying and operating one incandescent bulb during its 4-month
life is
2.50 2.50 2.50 2.50
1.00 + + + + = 10.84
1 + 0.643% (1 + 0.643%) (1 + 0.643%) (1 + 0.643%)4
2 3

• A fluorescent bulb costs $5.00 to buy and $0.38 per month to operate. As shown in cell
B23, the NPV of buying and operating one fluorescent bulb during its 40-month life is
0.38 0.38 0.38
5.00 + + +…+ = 18.19
1 + 0.643% (1 + 0.643%)2 (1 + 0.643%)40
• To find the monthly equivalent annuity cash flow (EAC) of each bulb, we divide the NPV
of the bulb’s cost and operation by the appropriate PV factor:
 CHAPTER 5 Issues in Capital Budgeting 151

10.84
Incandescent EAC = 4
= − PMT(0.643%,4,10.84) = 2.75 / month
1
∑
t=1 (1.00684 )t
18.19
Fluorescent EAC = 40
= − PMT(0.643%,40,18.19) = 0.52 / month
1
∑
t=1 (1.00684 )t

• As you can see, the monthly equivalent annuity cash flow (EAC) of the incandescent
light bulb is $2.75, whereas the monthly EAC of the fluorescent bulb is $0.52. The EAC
tells you that it’s much cheaper to switch to the fluorescent!

5.4. Lease versus Purchase When Taxes Are Important

We dealt with leasing in Section 3.4, but there we assumed that taxes were not a factor. This is
often true for individuals—when you’re considering leasing a computer or buying one, the tax
considerations are secondary, because you cannot usually subtract either your computer lease
payment or any part of the purchase price of the computer from your taxes.
On the other hand, for a business tax considerations are very important. Firms can subtract
depreciation from their pretax profits as a cost (as we showed in Chapter 4, this means that
depreciation gives rise to a tax shield). Furthermore, firms that finance with debt can subtract
their interest costs from their pretax profits; thus, the after-tax cost of an interest rate r% paid
by a firm with a tax rate of T is (1 − T) * r%.
In the example below we introduce tax considerations into the lease-versus-purchase deci-
sion. We use the same example introduced in Chapter 3 (page 81), but provide additional infor-
mation about the firm’s tax rate and depreciation policy.

An Example
Your business has decided that it needs another computer. Here are the facts:

• The business has a tax rate of 40% and can borrow from the bank at 15%.
• You can buy the computer for $4,000 and depreciate it on a straight-line basis over 3
years. This means annual depreciation of $4,000 / 3 = $1,333. Because you’re taxed at a
40% rate, this depreciation will save you 40%* $1,333 = $533 per year in taxes. This tax
shield is the cash savings from the depreciation deduction and must be taken into account
in deciding between the lease and the purchase.
• You can lease the computer for $1,500 a year, payable in advance for 4 years. This means
that if you lease the computer, you’ll pay $1,500 today and $1,500 at the end of each of
years 1, 2, and 3. The lease payment is an expense for tax purposes, so that its net after-
tax cost to the firm is (1 − 40%)* 1,500 = $900 .

Here’s a spreadsheet describing these cash flows.

152 PART ONE CAPITAL BUDGETING AND VALUATION

A B C D E F
LEASE OR PURCHASE?
1 Costs are negative numbers and inflows positive numbers
2 Asset cost 4,000.00
3 Annual depreciation if asset is purchased 1,333.33 <-- =B2/3
4 Annual lease payment 1,500.00
5 Bank rate 15%
6 Tax rate 40%
7
8 Year 0 1 2 3
9 Purchase cash flows
10 Cost of machine -4,000
11 Depreciation tax shield 533 533 533 <-- =$B$3*$B$6
12 Total -4,000 533 533 533 <-- =E11+E10
13
14 After-tax lease payments -900 -900 -900 -900 <-- =-$B$4*(1-$B$6)
15
16 The lease saves 3,100 -1,433 -1,433 -1,433 <-- =-E12+E14
17
18 IRR of lease savings 18.33% <-- =IRR(B16:E16)
19 Alternative cost (after-tax bank interest) 9.00% <-- =B5*(1-$B$6)
20
21 Lease or purchase? buy <-- =IF(B18>B19,"buy","lease")

Row 12 describes the after-tax cash flows associated with the purchase and row 14 the
after-tax cash flows from the lease. The lessee loses the depreciation tax shield that he would
have had if he had purchased and additionally bears the cost of the lease payments, which after
tax amount to $900 per year. Row 16 shows that, taking account of these two items, leasing the
computer is like taking a loan of $3,100 with after-tax repayments of $1,433 in years 1–3. The
IRR of this “loan” is 18.33% (cell B18).
Should you lease or buy? If the bank is willing to lend you money at 15% and if inter-
est costs are deductible expenses for tax purposes, then the after-tax cost of a bank loan is
(1 − 40%) * 15% = 9%. This means that the bank is a cheaper source of financing than the leasing
company. The conclusion (cell B21): Buy the computer.
Another way to reach the conclusion that a purchase is better than a lease is to think of
financing the machine with a 3-year bank loan of $3,100.

A B C D E F
24 Alternative: Borrow $3,100 from the bank and buy the computer
25 Year 0 1 2 3
26 Loan at beginning of year 3,100.00 2,207.27 1,180.63 <-- =D26-D30
27 Payment at end of year 1,357.73 1,357.73 1,357.73 <-- =PMT(B5,3,-$C$26)
28 Of this payment
29 Interest 465.00 331.09 177.10 <-- =$B$5*E26
30 Repayment of principal 892.73 1,026.64 1,180.63 <-- =E27-E29
31 Remaining principal at end of year 2,207.27 1,180.63 0.00 <-- =E26-E30
32
33 After-tax interest 279.00 198.65 106.26 <-- =(1-$B$6)*E29
34 Net after-tax loan cash cost 1,171.73 1,225.29 1,286.89 <-- =E33+E30
35
36 Machine + loan
37 Cost of machine -4,000.00 <-- =B10
38 Depreciation tax shield 533.33 533.33 533.33 <-- =E12
39 After-tax loan cash flow 3,100.00 -1,171.73 -1,225.29 -1,286.89 <-- =-E34
40 Total: Buy machine + take loan -900.00 -638.40 -691.96 -753.56 <-- =SUM(E37:E39)
41
42 Compare this to the after-tax lease payments -900.00 -900.00 -900.00 -900.00 <-- =E14
 CHAPTER 5 Issues in Capital Budgeting 153

Rows 26–31 are a standard loan table discussed in Chapter 2 (page 46). Because interest
is an expense for tax purposes, the after-tax interest cost to the firm is (1 − 40%)* Interest ; in
row 33 we compute this cost. The net after-tax cost of the loan to the firm (row 34) is the sum of
the after-tax interest (row 33) and the annual repayment of principal (row 30).
In rows 37–40 we compute the total after-tax cash flows from buying the loan-
financed machine. Comparing these to the after-tax lease payments (row 42 is just a copy of
row 14)—you can see that in each year the cost of buying the machine with the loan is less
than or equal to the cost of the after-tax lease payments, which is why the loan is preferable
to the lease.

What’s the Maximum Lease Payment We’ll Pay?

The above analysis shows that $1,500 per year is too much to pay for the lease. How much would
we be willing to pay? To do this calculation, we use Goal Seek to find the lease payment for
which the IRR of the differential cash flows (cell B18) is 9%. To get to the correct screen on
Excel 2007, click Data|What-If Analysis|Goal Seek.

Clicking on Goal Seek brings up the following dialog box, which we have filled in with the
relevant entries.

The conclusion is that a lease payment of $1,250.72 is the largest lease payment the lessee
would be willing to pay.
154 PART ONE CAPITAL BUDGETING AND VALUATION

A B C D E F
CORPORATE LEASING
1 Costs are negative numbers and inflows positive numbers
2 Asset cost 4,000.00
3 Annual depreciation if asset is purchased 1,333.33 <-- =B2/3
4 Annual lease payment 1,250.72
5 Bank rate 15%
6 Tax rate 40%
7
8 Year 0 1 2 3
9 Purchase cash flows
10 Cost of machine 4,000
11 Depreciation tax shield -533 -533 -533 <-- =-$B$3*$B$6
12 Total 4,000 -533 -533 -533 <-- =E11+E10
13
14 After-tax lease payments -750 -750 -750 -750 <-- =-$B$4*(1-$B$6)
15
16 The lease saves 3,250 -1,284 -1,284 -1,284 <-- =E12+E14
17
18 IRR 9.00% <-- =IRR(B16:E16)
19 Alternative cost 9.00% <-- =B5*(1-$B$6)

5.5. Capital Budgeting Principle: Think about Mid-year Discounting

We could have called this section “Think about the timing of cash flows,” but “mid-year dis-
counting” is catchier. To show what we mean, we present two examples. In our first example, a
company is thinking about spending $10,000 to produce an annual cash flow of $3,000 per year
for the next 5 years. If the discount rate is 15% and the cash flows occur at year end, then the
NPV of the project is $56.47.
A B C
NPV, CASH FLOWS OCCUR
1 AT YEAR END
2 Initial cost 10,000.00
3 Annual cash flow 3,000.00
4 Discount rate 15%
5

6 Year Cash flow

7 0 -10,000.00
8 1 3,000.00
9 2 3,000.00
10 3 3,000.00
11 4 3,000.00
12 5 3,000.00
13
NPV of year-end
14 cash flows 56.47 <-- =B7+NPV(B4,B8:B12)

The NPV of $56.47 assumes that the cash flow for each year occurs at the end of the year:

3,000 3,000 3,000 3,000 3,000

NPV = −10,000 + + + + + = 56.47 .
(1.15 ) (1.15 ) (1.15 ) (1.15 ) (1.15 )5
2 3 4

For many capital budgeting situations, this end-year cash flow assumption is not realistic. Think
of a company buying a machine and getting cash flows by selling the machine’s products—in
 CHAPTER 5 Issues in Capital Budgeting 155

this case the cash flows are likely to occur as a stream throughout the year rather than a single,
end-year, cash flow. Because it’s always better to get cash earlier, the NPV of the project will be
higher than $56.47.
To get some feeling for whether this is important, suppose that the $3,000 annual cash flow
is actually received as $750 at the end of each quarter. Then, as the spreadsheet below shows,
the NPV would increase significantly.

A B C
NPV, CASH FLOWS OCCUR
1 EACH QUARTER
2 Initial cost 10,000.00
3 Annual cash flow 3,000.00
4 Discount rate 15%
5 Quarterly discount rate 3.56% <-- =(1+B4)^(1/4)-1
6
Quarterly
7 Quarter cash flow
8 0 -10,000.00
9 1 750.00
10 2 750.00
11 3 750.00
12 4 750.00
13 5 750.00
14 6 750.00
15 7 750.00
16 8 750.00
17 9 750.00
18 10 750.00
19 11 750.00
20 12 750.00
21 13 750.00
22 14 750.00
23 15 750.00
24 16 750.00
25 17 750.00
26 18 750.00
27 19 750.00
28 20 750.00
29
30 NPV, quarterly cash flows 605.68 <-- =B8+NPV(B5,B9:B28)

Note that in calculating the NPV of the quarterly cash flows (cell E29), we’ve used the quarterly
discount rate, which is equivalent to the annual discount rate of 15% (3.56%, cell E4). This
quarterly discount rate is calculated by

(1 + quarterly discount rate) = (1 + annual discount rate)1 / 4

So far, the message of this section is clear and uncontroversial: When you discount you
should take the timing of the cash flows into account. The problem is that for many capital bud-
geting problems we project annual cash flows, even though the actual flows occur throughout
the year.2 In many cases it is difficult to project the precise timing of the cash flows throughout
the year, even though our example shows that this timing is very important.

2
This has a lot to do with most firms’ accounting cycles, which are annual. (There we go again—blaming
the accountants!)
156 PART ONE CAPITAL BUDGETING AND VALUATION

Mid-year Discounting—An Elegant Compromise

On the one hand the timing of cash flows is important, but on the other hand it’s difficult to
deviate from end-year cash flow projections and project the precise timing of each cash flow.
An elegant compromise is to project annual cash flow numbers but to assume that they occur
mid-year. Here’s how this looks in Excel.

A B C D
1 MID-YEAR DISCOUNTING
2 Initial cost 10,000.00
3 Annual cash flow 3,000.00
4 Discount rate 15%
5
6 Year Cash flow Discounted value
7 0 -10,000.00 -10,000.00 <-- =B7
8 1 3,000.00 2,797.51 <-- =B8/(1+$B$4)^(A8-0.5)
9 2 3,000.00 2,432.62 <-- =B9/(1+$B$4)^(A9-0.5)
10 3 3,000.00 2,115.32
11 4 3,000.00 1,839.41
12 5 3,000.00 1,599.49
13
14 NPV, midyear 784.36 <-- =SUM(C7:C12)
15 784.36 <-- =B7+NPV(B4,B8:B12)*(1+B4)^0.5

The spreadsheet shows two ways to do the calculation:

• In cells B8:B12, each cash flow has been discounted by a factor (1 + r )year −0.5 . This is
equivalent to calculating the following NPV:
3,000 3,000 3,000 3,000 3,000
NPV = −10,000 + 0.5
+ 1.5
+ 2.5
+ 3.5
+ = 784.36
(1.15)4.5
!""#""$
(1.15) (1.15) (1.15) (1.15) ↑
Cell C43

• In cell B15, we show a simple Excel formula that produces the same result: Simply take
0.5
the Excel NPV formula and multiply by (1 + r ) .

Using the XNPV Function

We can also do the mid-year NPV calculation using Excel’s XNPV function.3 To use XNPV
you have to indicate the dates on which the cash flows will be received. The spreadsheet below
shows an implementation of the function to our problem.

A B C
CALCULATING THE MID-YEAR
1 NPV WITH EXCEL'S XNPV FUNCTION
2 Annual discount rate 15%
3
4 Date Cash flow
5 1-Jan-02 -10,000
6 1-Jul-02 3,000
7 1-Jul-03 3,000
8 1-Jul-04 3,000
9 1-Jul-05 3,000
10 1-Jul-06 3,000
11
12 NPV 788.43 <-- =XNPV(B2,B5:B10,A5:A10)

3
If this function does not appear in your list of Excel functions, go to Tools|Add-ins on the Excel menu
and check Analysis Toolpak.
 CHAPTER 5 Issues in Capital Budgeting 157

USING THE XNPV FUNCTION

As the dialog box shows, XNPV requires you to input the annual discount rate, the values to be
discounted, and the dates on which these values occur. The function then finds the net present
value on the first date of the series (in our example: 1-Jan-02). The XNPV function differs from
the NPV function in one very important aspect: In Chapter 2 (page 37) we stressed that Excel’s
NPV calculates the present value of future cash flows; to calculate the true net present value,
you have to add in the initial cash flow separately. The XNPV function has all the cash flows as
inputs (including the initial cash flow) and has as output the true net present value.
The XNPV function (and its cousin, the XIRR function discussed later) are part of the stan-
dard Excel package, but they have to be separately installed as an add-in. Here’s what you do:

Step 2: Go to Add-Ins, find the appropriate

Step 1: Click on the Office Button
entry under Manage, and click Go:
and go to Excel Options

Step 3: Click Analysis ToolPak

158 PART ONE CAPITAL BUDGETING AND VALUATION

Calculating the Mid-year IRR

What if you want to compute the IRR of the cash flows, taking into account the fact that
they occur mid-year? The easiest way to do this is to use the Excel function XIRR, as shown
below.
A B C
CALCULATING THE IRR OF
MIDYEAR CASH FLOWS WITH
1 EXCEL'S XIRR FUNCTION
2 Date Cash flow
3 1-Jan-02 -10,000
4 1-Jul-02 3,000
5 1-Jul-03 3,000
6 1-Jul-04 3,000
7 1-Jul-05 3,000
8 1-Jul-06 3,000
9
10 IRR 19.06% <-- =XIRR(B3:B8,A3:A8)

AN EXCEL NOTE: THE XIRR FUNCTION

The XIRR function requires you to put in a list of dates at which the cash flows occur. The
syntax of the function is given in the dialog box below.

For cash flows with multiple IRRs, the XIRR function allows you to use a Guess (like
Excel’s IRR function discussed on page 145).

Applying Mid-year Cash Flows to Sally and Dave’s Condo

In this section we have stressed the importance of cash flow timing in determining the NPV
of a project. We have also suggested that—rather than try to determine the precise timing
of each cash flow—it may be roughly equivalent to assume that the cash flows occur mid-
period.
The implementation of this simple idea can be complicated. Take Sally and Dave’s condo,
for example, which was discussed in Chapter 4 (page 115). Recall that Sally and Dave’s annual
cash flow of $18,050 from the condo rental was computed as follows:
 CHAPTER 5 Issues in Capital Budgeting 159

• The annual rent of $24,000 is taxable income, and the annual property taxes ($1,500)
and maintenance ($1,000) are expenses for tax purposes. Because Sally and Dave’s tax
rate is 30%, these three items produce (1 − 30%)*($24,000 − 1,000 − 1,500) = $15,050 of
after-tax income per year.
• The condo’s annual depreciation of $10,000 produces a tax shield of
30% * $10,000 = $3,000. Adding this tax shield to the $15,050 gives Sally and Dave’s
annual cash flow of $18,050 in years 1–10.
• Sally and Dave plan to sell the condo for $100,000 after 10 years. At this point the condo
will be fully depreciated, so that all the money they receive from the sale will be income.
Thus, the after-tax terminal value of the condo is (1 − 30%) * $100,000 = $70,000. Adding
this to the condo’s year-10 cash flow produces a total year-10 cash flow of $88,050.
Our initial calculation gave us an IRR of 16.69% on Sally and Dave’s investment (cell B37
below).

A B C
SALLY & DAVE’S CONDO
1 Example from Section 4.7
2 Cost of condo 100,000
3 Sally & Dave’s tax rate 30%
4
5 Annual reportable income calculation
6 Rent 24,000
7 Expenses
8 Property taxes -1,500
9 Miscellaneous expenses -1,000
10 Depreciation -10,000
11 Reportable income 11,500 <-- =SUM(B6:B10)
12 Taxes (rate = 30%) -3,450 <-- =-B3*B11
13 Net income 8,050 <-- =B11+B12
14
15 Annual cash flow 18,050 <-- =B13-B10
16
17 Terminal value
18 Estimated resale value, year 10 100,000
19 Book value 0
20 Taxable gain 100,000 <-- =B18-B19
21 Taxes 30,000 <-- =0.3*B20
22 Net after tax--cash flow from terminal value 70,000 <-- =B20-B21
23
24 Year Cash flow
25 0 -100,000
26 1 18,050 <-- =$B$15
27 2 18,050
28 3 18,050
29 4 18,050
30 5 18,050
31 6 18,050
32 7 18,050
33 8 18,050
34 9 18,050
35 10 88,050 <-- =$B$15+B22
36
37 IRR 16.69%
160 PART ONE CAPITAL BUDGETING AND VALUATION

Incorporating the Timing of Cash Flows

Now suppose we try to incorporate the timing of the cash flows into our analysis of the condo
IRR. We make the following assumptions:
• The annual rent of $24,000 occurs mid-year. This is an approximation to the fact that the
renters pay their rent monthly.
• Miscellaneous expenses of $1,000 also occur mid-year.
• Property taxes and income taxes occur at the end of each year.
• The resale of the property (which produces a cash flow of $70,000) occurs at the end of
year 10.
These assumptions lead to the cash flows given in cells E4:E44 below. The IRR of these
cash flows (9.59%, cell E46) is the semiannual IRR (remember that our cash flows are now
semiannual). The annualized IRR is (1 + 9.59%)2 − 1 = 20.10%, which is significantly higher than
the 16.69% we calculated earlier assuming that all cash flows occur at year end. Because the
IRR gets higher when positive cash flows occur earlier, this is not surprising.

A B C
SALLY & DAVE'S CONDO
1 Example from Section 4.7
2 Cost of condo 100,000
3 Sally & Dave's tax rate 30%
4
5 Annual reportable income calculation
6 Rent 24,000
7 Expenses
8 Property taxes -1,500
9 Miscellaneous expenses -1,000
10 Depreciation -10,000
11 Reportable income 11,500 <-- =SUM(B6:B10)
12 Taxes (rate = 30%) -3,450 <-- =-B3*B11
13 Net income 8,050 <-- =B11+B12
14
15 Annual cash flow 18,050 <-- =B13-B10
16
17 Terminal value
18 Estimated resale value, year 10 100,000
19 Book value 0
20 Taxable gain 100,000 <-- =B18-B19
21 Taxes 30,000 <-- =0.3*B20
22 Net after tax--cash flow from terminal value 70,000 <-- =B20-B21
23
24 Year Cash flow
25 0 -100,000
26 1 18,050 <-- =$B$15
27 2 18,050
28 3 18,050
29 4 18,050
30 5 18,050
31 6 18,050
32 7 18,050
33 8 18,050
34 9 18,050
35 10 88,050 <-- =$B$15+B22
36
37 IRR 16.69%
 CHAPTER 5 Issues in Capital Budgeting 161

Two “Reality” Notes

Note 1: Sally and Dave’s condo example shows that getting the dates of the cash flows
right is important, but it also shows that this can be cumbersome. As a compromise, perhaps
we should have gone back to the mid-year IRR. In the spreadsheet below we use the XIRR
function in cell B37 to compute the IRR on the assumption that all the condo cash flows occur
mid-year.

A B C
1 SALLY & DAVE'S CONDO--MIDYEAR CASH FLOWS
2 Cost of condo 100,000
3 Sally & Dave's tax rate 30%
4
5 Annual reportable income calculation
6 Rent 24,000
7 Expenses
8 Property taxes -1,500
9 Miscellaneous expenses -1,000
10 Depreciation -10,000
11 Reportable income 11,500 <-- =SUM(B6:B10)
12 Taxes (rate = 30%) -3,450 <-- =-B3*B11
13 Net income 8,050 <-- =B11+B12
14
15 Annual cash flow 18,050 <-- =B13-B10
16
17 Terminal value
18 Estimated resale value, year 10 100,000
19 Book value 0
20 Taxable gain 100,000 <-- =B18-B19
21 Taxes 30,000 <-- =0.3*B20
22 Net after tax--cash flow from terminal value 70,000 <-- =B20-B21
23
24 Date Cash flow
25 1-Jan-02 -100,000
26 1-Jul-02 18,050 <-- =$B$15
27 1-Jul-03 18,050
28 1-Jul-04 18,050
29 1-Jul-05 18,050
30 1-Jul-06 18,050
31 1-Jul-07 18,050
32 1-Jul-08 18,050
33 1-Jul-09 18,050
34 1-Jul-10 18,050
35 1-Jul-11 88,050 <-- =$B$15+B22
36
37 IRR 18.69% <-- =XIRR(B25:B35,A25:A35)

Note 2: In this book we often ignore mid-year discounting—not because we don’t

believe it’s important, but because it’s cumbersome to explain this, along with all the other
myriad capital budgeting problems. In this case our advice to you is “Do as we say, don’t do
as we do.”
162 PART ONE CAPITAL BUDGETING AND VALUATION

5.6. Inflation: Real and Nominal Interest Rates and Cash Flows
Prices tend to rise and because they do, money loses its value over time. What else is new? This
section discusses the terminology of inflation. When you finish the section, you should under-
stand the difference between real and nominal interest rates and real and nominal cash flows.
We’ll illustrate these concepts with several “real world” examples, so that hopefully you’ll have
a better idea of the impact of inflation. In Section 5.7 we apply the concepts of this section to a
number of capital budgeting problems.
First some facts. The following spreadsheet shows the purchasing power of $1 from 1980
through 2009. All the numbers in column B are in terms of 2009 dollars. As the spreadsheet
shows, the goods you could buy with $1 in 1980 would cost you $2.62 in 2009. Adjusting for
inflation, $1 in 1990 would be worth $1.65 in 2009.

A B C D E F G H I
1 WHAT'S A DOLLAR WORTH?
Purchasing
power
of $1 in 2009
terms 2.80
2 Year
3 1980 2.6156
4 1981 2.3710 2.60
How Much Would $1 Then Buy You Now?
5 1982 2.2334
6 1983 2.1639
7 1984 2.0743 2.40
8 1985 2.0030
9 1986 1.9664 2.20
10 1987 1.8972
11 1988 1.8218
12 1989 1.7381 2.00
13 1990 1.6490
14 1991 1.5824 1.80
15 1992 1.5362
16 1993 1.4915
17 1994 1.4543 1.60
18 1995 1.4142
19 1996 1.3736
1.40
20 1997 1.3428
21 1998 1.3222
22 1999 1.2936 1.20
23 2000 1.2516
24 2001 1.2170
25 2002 1.1980 1.00
1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008
26 2003 1.1713
27 2004 1.1409
28 2005 1.1035
29 2006 1.0691
30 2007 1.0395
31 2008 1.0010
32 2009 1.0000

Here’s another way to understand this phenomenon. The following table gives the con-
sumer price index (CPI) for the United States from 1980 to 2009.4 The index has been nor-
malized so that the average CPI for 1982–1984 is 100. A basket of goods that cost $100 in
1984 would have cost $79.31 in 1980, $87.49 in 1981, and so on. The same basket would cost
$207.43 in 2001.

4
The consumer price index measures the market prices of a standard basket of goods. For (much)
more information look at the Web site of the Bureau of Labor Statistics, http://www.bls.gov/cpi/, or the
Minneapolis Federal Reserve Bank, http://minneapolisfed.org/Research/data/us/calc/index.cfm.
 CHAPTER 5 Issues in Capital Budgeting 163

K L M
3 Computations
4 $100 in 1984 in 1980 prices 79.31 <-- =100*B3/B7
5 $100 in 1984 in 1981 prices 87.49 <-- =100*B4/B7
6 $100 in 1984 in 2009 prices 207.43 <-- =100*B32/B7

In column C we’ve used Excel to compute the annual inflation rates from these data:
CPI t
Inflation rate in year t = − 1.
CPI t − 1

As you can see from the graph, the inflation rate at the beginning of the 1980s was considerably
higher than in the 1990s. Nevertheless, even throughout the relatively low inflation decade of

A B C D E F G H I
COMPUTING THE INFLATION RATE FROM
1 THE CONSUMER PRICE INDEX (CPI)
U.S. consumer Annual
2 Year price index inflation rate
3 1980 82.400
4 1981 90.900 10.32% <-- =B4/B3-1
5 1982 96.500 6.16% <-- =B5/B4-1
6 1983 99.600 3.21%
7 1984 103.900 4.32%
8 1985 107.600 3.56% Annual U.S. Inflation Rate
9 1986 109.600 1.86%
10 1987 113.600 3.65% 1980-2009
12%
11 1988 118.300 4.14%
12 1989 124.000 4.82%
13 1990 130.700 5.40% 10%
14 1991 136.200 4.21%
15 1992 140.300 3.01% 8%
16 1993 144.500 2.99%
17 1994 148.200 2.56% 6%
18 1995 152.400 2.83%
19 1996 156.900 2.95%
20 1997 160.500 2.29% 4%
21 1998 163.000 1.56%
22 1999 166.600 2.21% 2%
23 2000 172.200 3.36%
24 2001 177.100 2.85%
0%
25 2002 179.900 1.58%
1981

1984

1987

1990

1993

1996

1999

2002

2005

2008

26 2003 184.000 2.28%

27 2004 188.900 2.66%
28 2005 195.300 3.39%
29 2006 201.600 3.23%
30 2007 207.342 2.85%
31 2008 215.303 3.84% <-- =B31/B30-1
32 2009 215.522 0.10% <-- =B32/B31-1
33 Average annual inflation 3.37% <-- =(B32/B3)^(1/29)-1

the 1990s, the inflation rate in the United States has generally been between 2 and 4% per year.
Through the period surveyed, the average inflation rate (cell C33) was 3.37%.
Inflation of 3.37% per year may not seem like much, but it adds up. Suppose, for example, that
we had 3% inflation per year for 10 years. As the Excel spreadsheet that follows shows, this means
that the cumulative inflation over the decade would have been (1 + 3%)10 − 1 = 34.39%. Another
164 PART ONE CAPITAL BUDGETING AND VALUATION

way to think about this is that in every 10 years, $1 loses 26% of its value—an end-of-the-decade
dollar is worth only 1/(1 + 3%)10 = 0.7441 in terms of a beginning-of-the-decade dollar.

A B C
ANNUAL INFLATION RATES
1 AND CUMULATIVE INFLATION
2 Annual inflation rate 3%
Cumulative inflation
3 over 10 years 34.39% <-- =(1+B2)^10-1
End-decade $ worth
in terms of beginning of
4 decade $ 0.7441 <-- =1/(1+B2)^10

We can put this into a table.

A B C D
1 WHAT'S A DOLLAR WORTH?
End-decade $
worth
in terms of
beginning of Cumulative inflation
2 Annual inflation rate decade $ over 10 years
3 0% 1.00 0.00%
4 1% 0.91 10.46%
5 2% 0.82 21.90%
6 3% 0.74 34.39%
7 4% 0.68 48.02%
8 5% 0.61 62.89% =1/(1+B14)^10
9 6% 0.56 79.08%
10 7% 0.51 96.72%
11 8% 0.46 115.89%
12 9% 0.42 136.74%
13 10% 0.39 159.37% <-- =(1+A13)^10-1
14
15
16 1.20 180%
17 160%
Cumulative inflation rate
18 1.00
140%
19
0.80 120%
Value of $1

20
21 100%
0.60
22 80%
23 0.40 60%
24
25 40%
0.20
26 20%
27 0.00 0%
28 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
29
30 Annual inflation
31
32 End-decade $ worth Cumulative inflation
33 in terms of beginning of decade $ over 10 years
34

Nominal and Real Interest Rates

Inflation not only affects the prices of goods—it also affects interest rates. Financial economists
distinguish between nominal interest rates and real interest rates. The nominal interest rate is
the rate quoted on a loan or a bank deposit and the real interest rate is the loan or bank deposit
rate in purchasing-power terms (that is, after adjusting for inflation). In this section we explore
and define these concepts.
 CHAPTER 5 Issues in Capital Budgeting 165

Suppose you lend your friend Martha $100 with the agreement that she’ll repay you next
year. How much interest should you ask for? Martha suggests a 4% interest rate, but thinking
about it, you realize that you anticipate 5% inflation over the year—meaning goods worth $100
today will cost $100 * (1.05) = $105 next year when the money is repaid. So if Martha repays you
$100 * (1.04) = $104, she’s not even repaying you the purchasing power of the loan. In this case,
next year ' s
Amount repaid 100 * (1+ interest ) 104
repayment in = = = = 99.048
1 + inflation 1 + inflation 1.05
terms of this
year ' s dollars
In the jargon of finance, the 4% interest rate is called the nominal interest rate; the word
“nominal” indicates that the interest paid has not been adjusted for the effects of inflation.
This is another way of saying that Martha will repay you $104 regardless of how much prices
increase over the year. Quoted interest rates (whether on mortgages, credit cards, or government
bonds) are almost always nominal interest rates (“lend me $100 today and I’ll pay you back next
year with 10% interest”).
The real interest rate is defined as the interest rate in terms of purchasing power of money.
In our example, you can see that you loan Martha $100 but get back (in purchasing power terms)
$99.048. Thus, the real interest paid by Martha is -0.952%:
real interest purchasing power repaid 99.048
= −1= − 1 = −0.952% .
on one-year loan purchasing power lent 100

From the above formula, you can see that

1+ nominal interest 1 + 4%
real interest = −1= − 1 = −0.952%
1 + inflation 1 + 5%

An equivalent and easier way to define the real interest rate is

TERMINOLOGY REVIEW

Inflation: We almost always associate “inflation” with a decrease in the purchasing power
of money (and an increase in the price level). Historically there have also been periods of defla-
tion—increases in the purchasing power of money caused by decreases in the price level.5
Nominal interest rate or nominal cash flow: An interest rate or cash flow that has not
been adjusted for the effects of inflation. Example: You borrow $100 today and agree to repay
$120 at the end of the year. The nominal interest rate is 20% and the $120 repayment (which
will be in next year’s dollars, irrespective of the inflation over the next year) is a payment in
nominal dollars.
Real interest rate or real cash flow: An interest rate or cash flow adjusted for inflation.
To calculate the real cash flow, decide on a base year and compute all the cash flows in units of
that base year. The cash flows so computed are real cash flows (cash flows in constant dollars)
and the interest rates resulting from them are real interest rates.
166 PART ONE CAPITAL BUDGETING AND VALUATION

1 + nominal interest = (1+ real interest )* (1+ inflation rate ) .

This equation is often called the Fisher equation, after the famous American economist Irving
Fisher (1867–1947).

Nominal and Real Cash Flows

In the previous subsection we showed the relation between the real and nominal interest rates.
The nominal interest rate is the quoted interest rate, unadjusted for inflation, and the real interest
rate is the interest rate adjusted for the change in the purchasing power of money.5
In this section we show the relation between real and nominal cash flows. We start with a
1-year example: You make an investment $100 in year 0 and get back $120 at the end of year 1;
over this period the consumer price index increases from 131 to 138.

A B C D
1 REAL AND NOMINAL CASH FLOWS
2 Year 0 Year 1
3 Nominal cash flow -100 120
4 Consumer price index (CPI) 131 138
5
6 Inflation 5.34% <-- =C4/B4-1
7
Real cash flow
8 in year 0 dollars -100 113.913 <-- =C3*B4/C4
9
10 Nominal return 20.00% <-- =C3/-B3-1
11 Real return 13.91% <-- =C8/-B8-1

The real year-1 cash flow (defined in this case as the year-1 cash flow in year-0 dollars) is
computed as
year-1 cash flow
year-1 real cash flow =
1+ inflation rate over period
year − 1 cash flow 120
= = = 113.913
CPI end-period (138 / 131)
CPI beginning-period

To compute the real return on the investment,

year-1 real cash flow
1 + real investment return = −1
year-0 real cash flow
113.913
= − 1 = 13.91%
100
Equivalently, we can calculate the real return using the nominal rate of return and deflating it
by the inflation rate:
End − period nominal cash flow
1+ nominal return Beginning − period nominal cash flow
1 + real return = −1 =
1+ inflation rate CPI end -period
CPI beginning-period
120
1 + 20%
= 100 − 1 = = 1 + 13.91%
138 1 + 5.34%
131

5
During the 1990s, Japan had prolonged periods of declining prices. See next page.
 CHAPTER 5 Issues in Capital Budgeting 167

Investment Analysis: How Much Did You Really Earn?

Suppose that the end of 1995 you invested $1,000 in a security that subsequently paid you
$150 at the end of each year from 1996, 1997, . . . , 2004. At the end of 2005, you sold the
security for $1,150. Looking back, you realize that the CPI went from 133 in 1995 to 195
in 2004. What was your real rate of return? To do this calculation, we translate each of
the investment’s nominal cash flows into real cash flows, using the cumulative inflation
rate.

A B C D E F G
1 HOW MUCH DID YOU REALLY EARN?
Cumulative < -- This is the
Nominal inflation Real cash flow in 1995
2 Year cash flow CPI rate cash flow dollars
3 1995 -1,000 133 -1,000.00
4 1996 150 138 3.76% <-- =C4/$C$3-1 144.57 <-- =B4/(1+D4)
5 1997 150 142 6.77% <-- =C5/$C$3-1 140.49 <-- =B5/(1+D5)
6 1998 150 145 9.02% <-- =C6/$C$3-1 137.59
7 1999 150 148 11.28% 134.80
8 2000 150 153 15.04% 130.39
9 2001 150 166 24.81% 120.18
10 2002 150 172 29.32% 115.99
11 2003 150 180 35.34% 110.83
12 2004 150 191 43.61% 104.45
13 2005 1,150 195 46.62% <-- =C13/$C$3-1 784.36
14
15 Nominal IRR 15.00% <-- =IRR(B3:B13) Real IRR 10.93% <-- =IRR(F3:F14)

As you can see, your 15% nominal rate of return was reduced by inflation to a 10.93% real
rate of return (the rate of return adjusted for changes in the purchasing power of money).

Do Prices Always Go Up?

It seems like it, but the example below (Japan from 1990 to 2007) shows that prices can also
go down.

A B C D E F G H I
1 INFLATION AND DEFLATION IN JAPAN, 1990-2007
2 Year CPI Inflation
3 1990 95.60
4 1991 98.80 3.3% <-- =B4/B3-1
5 1992 100.40 1.6%
6 1993 101.60 1.2%
7 1994 102.00 0.4% Annual Inflation Rates in Japan
8 1995 101.80 -0.2% 2.8%
9 1996 101.80 0.0% 1990-2007
Annual inflation

10 1997 103.40 1.6%

11 1998 104.10 0.7% 1.8%
12 1999 103.70 -0.4%
13 2000 102.80 -0.9%
14 2001 101.80 -1.0% 0.8%
15 2002 100.70 -1.1%
16 2003 100.40 -0.3%
17 2004 100.40 0.0% -0.2%
18 2005 100.00 -0.4% 1991 1993 1995 1997 1999 2001 2003 2005 2007
19 2006 100.30 0.3%
20 2007 100.40 0.1% -1.2%
21
Japan, annual
22 inflation, 1990 - 2007 0.31% <-- =(B20/B3)^(1/16)-1
168 PART ONE CAPITAL BUDGETING AND VALUATION

Is Oil Cheap or Expensive?

In the 56 years between 1947 and 2009, the nominal price of a barrel of oil in the United States
increased from $1.93 in 1947 to $73.19 per barrel in 2009. This is an annual increase of 6.10%
per year: (73.19/1.93)(1/61) −1 = 6.14%. The annual price increase in real dollars is much lower:
The purchasing power, in terms of 2009 dollars, of the $1.93 that a barrel of oil cost in 1947 is
equivalent to $15.36. The real price increase over the period was 2.59% per year. This is less
than the overall cost-of-living increase of 3.46% per year.
A B C D E
NOMINAL AND REAL INCREASE IN U.S. OIL PRICES
1 1947-2009
2 Nominal price increase
3 1947 price per barrel 1.93
4 2009 price per barrel 73.18
5 Annual increase 6.14% <-- =(B4/B3)^(1/61)-1
6
7 Real price increase
1947 price per barrel
8 in 2009 dollars 15.36 1947 price index 15.51
2009 price per barrel
9 in 2009 dollars 73.18 2009 price index 123.43
10 Annual increase
11 Oil prices 2.59% General cost of living 3.46% <-- =(D9/D8)^(1/61)-1

Of course comparing two points in time doesn’t tell the whole story. Here’s a chart of the
real and nominal cost of oil throughout the period.

Real and Nominal Oil Prices, 1947-2009

100

90

80

70

60

50

40

30
Oil price per barrel, 2009 dollars
20

10
Nominal oil price per barrel
0
1947
1949
1951
1953
1955
1957
1959
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009

Data provided by James L. Williams of WTRG Economics

http://www.wtrg.com
 CHAPTER 5 Issues in Capital Budgeting 169

5.7. Understanding TIPS

The U.S. Treasury department issues securities called Treasury Inflation Protected Security
(TIPS).6 These securities promise a real rate of interest on your initial investment adjusted for
increases in the consumer price index. Here’s an example to show how this works:
• You invest $1,000 today in a 1-year TIPS that has a real interest rate of 4%. The consumer
price index today is 120.
CPI 1 year from now
• In 1 year the Treasury will pay you $1,000 * * (1 + 4%).
CPI today
Your investment in TIPS is fully inflation protected. To see this, break up the TIPS repay-
ment into two factors:
CPI 1 year from now
$1,000 * * 1 + 4% )
(!""
CPI today "#"""$
!""""""""""#""""""""""$ ↑
↑ Return of initial investment
Maintains the purchasing adjusted for inflation
power of $1,000 today PLUS
Interest on the inflation-adjusted
investment

To analyze TIPS, suppose you think that the CPI will rise from 120 today to 126 in 1 year.
As the spreadsheet below shows, you’ll anticipate a repayment of $1,092.00.
A B C
ANALYZING A 1-YEAR TREASURY INFLATION-
1 PROTECTED SECURITY (TIPS)
2
3 Initial investment 1,000.00
4 TIPS real interest rate 4.00%
5 Current CPI 120
6 Anticipated CPI in one year 126
7
8 TIPS repayment in one year 1,092.00 <-- =B3*(B6/B5)*(1+B4)
9
10 Further analysis
11 Anticipated inflation rate 5.00% <-- =B6/B5-1
12 TIPS repayment of inflation-adjusted investment 1,050.00 <-- =B3*(1+B11)
13 TIPS interest on inflation-adjusted investment 42.00 <-- =B4*B12
14 Total TIPS repayment in one year 1,092.00 <-- =B13+B12
15
TIPS interest on inflation-adjusted investment
16 (this is the real interest rate paid by the TIPS) 4.00% <-- =B13/B12

In rows 11–16 we show an alternative analysis of the 1-year TIPS repayment of $1,092.00:
CPI1 year from now 126
• Your anticipated inflation rate is −1 = − 1 = 5.
CPI today 120
• The TIPS always repays you the initial investment, adjusted for the inflation. In this case,
this is $1,000 * (1 + anticipated inflation) = $1,000 * (1.05) = $1,050.
• In addition, the TIPS pays you the real interest rate (4% in this case) on the inflation-
adjusted initial investment. As you can see in cell B13, this is $42.

6
The U.S. Treasury Web site offers good explanations of these securities and current prices: http://www.
treasurydirect.gov/instit/annceresult/tipscpi/tipscpi.htm.
170 PART ONE CAPITAL BUDGETING AND VALUATION

The result is that the TIPS maintains the purchasing power of your investment ($1,000 * (1.05) =
$1,050) and pays you interest on the inflation-adjusted investment (4% * $1,050 = $42).

Understanding a 10-Year TIPS

Suppose you’ve got $1,000 to save, and you’re considering buying a 10-year TIPS with the same
conditions as above. What will be the nominal payment on the TIPS you can expect in 10 years?
In the spreadsheet below, we assume an annual inflation rate of 3%; this brings the total antici-
pated TIPS repayment to $1,989.32. A little analysis (rows 10–16) shows the breakdown of this
payment into return of inflation-adjusted investment ($1,343.92) and interest ($645.41).
A B C
ANALYZING A 10-YEAR TREASURY INFLATION-PROTECTED
1 SECURITY (TIPS)
2
3 Initial investment 1,000.00
4 TIPS real interest rate 4.00%
5 Anticipated annual inflation rate 3.00%
6
7 TIPS repayment in 10 years 1,989.32 <-- =B3*(1+B5)^10*(1+B4)^10
8
9 Further analysis
10 Anticipated cumulative inflation rate over 10 years 34.39% <-- =(1+B5)^10-1
11 TIPS repayment of inflation-adjusted investment 1,343.92 <-- =B3*(1+B10)
12 TIPS interest on inflation-adjusted investment 645.41 <-- =B11*((1+B4)^10-1)
13 Total TIPS repayment in one year 1,989.32 <-- =B12+B11
14
TIPS interest on inflation-adjusted investment
15 (this is the real interest rate paid by the TIPS) 48.02% <-- =B12/B11
Annualized TIPS interest on inflation-adjusted
16 investment 4.00% <-- =(1+B15)^(1/10)-1
17
18 Anticipated nominal return on TIPS 7.12% <-- =(B7/B3)^(1/10)-1
Another way of computing the nominal return:
19 (1+TIPS real rate)*(1+inflation rate)-1 7.12% <-- =(1+B4)*(1+B5)-1

In cells B18:B19 we calculate the TIPS anticipated nominal return. As suggested in the
previous section,
1 + nominal interest = (1 + real interest )* (1 + inflation rate )
= (1 + 4% )* (1 + 3% )= 1.0712

Comparing TIPS and a Bank Certificate of Deposit

You have $1,000 extra cash that you don’t think you’ll need for the next 5 years. You’re consider-
ing two alternatives:
• You can put the money in a bank certificate of deposit. This is a security you buy from
the bank (in this case for $1,000). The bank has agreed to pay you 8% per year, so that
you anticipate receiving $1,000 * (1 + 8%)5 = $1,469.33 in 5 years.
• On the other hand, you’re considering buying a 5-year U.S. TIPS. This security costs
$1,000 and promises you 3.5% annual interest on your initial $1,000 investment, adjusted
for the CPI.
 CHAPTER 5 Issues in Capital Budgeting 171

How should you make your decision? The spreadsheet below shows the nominal payment made
by the TIPS in 5 years. The graph compares these payments to the $1,469.33 you will get from
the CD. As you can see from the table in cells A11:C19, if the anticipated inflation rate is more
than 4.3478%, the TIPS will pay off more than the CD.

A B C D
COMPARING A 5-YEAR TIPS
1 VERSUS A 5-YEAR BANK CERTIFICATE OF DEPOSIT (CD)
2 Initial investment 1,000.00
3 TIPS real interest rate 3.50%
4 Anticipated annual inflation rate 3.00%
5 Bank CD nominal interest rate 8.00%
6
7 TIPS repayment in 5 years 1,376.85 <-- =B2*(1+B4)^5*(1+B3)^5
8 Bank CD repayment in 5 years 1,469.33 <-- =B2*(1+B5)^5
9
CD
Anticipated annual payment
10 inflation rate in 5 years TIPS payment in 5 years
11 0% 1,469.33 1,187.69 <-- =$B$2*(1+$B$3)^5*(1+A11)^5
12 1% 1,469.33 1,248.27
13 2% 1,469.33 1,311.30
14 3% 1,469.33 1,376.85
15 4.3478% 1,469.33 1,469.33 <-- Breakeven inflation rate
16 5% 1,469.33 1,515.82
17 6% 1,469.33 1,589.39
18 7% 1,469.33 1,665.79
19 8% 1,469.33 1,745.10
20
21 1,800 TIPS Versus Bank CD
22
23 1,700
Payment in 5 years

24 1,600
25
26 1,500
27
1,400 CD payment
28
29 1,300 in 5 years
30 TIPS payment in 5
31 1,200 years
32 1,100
33 0% 2% 4% 6% 8%
34
Anticipated inflation rate
35
36

Nominal Return Certainty versus Real Return Certainty

The comparison of the CD and TIPS in the above spreadsheet shows you that whereas the
TIPS nominal return depends on the inflation rate, the CD nominal return is fixed. In some
ways this might make it look as if the CD is preferred to the TIPS. But wait! In the following
spreadsheet we compute the CD and TIPS real rate of returns. This time the tables are turned:
The TIPS always returns 3.5% in real terms, whereas the CD’s real rate of return depends on
the inflation rate.
172 PART ONE CAPITAL BUDGETING AND VALUATION

A B C D
1 REAL RETURN ON TIPS VERSUS 5-YEAR CD
2 Initial investment 1,000.00
3 TIPS real interest rate 3.50%
4 Anticipated annual inflation rate 3.00%
5 Bank CD nominal interest rate 8.00%
6
7 TIPS repayment in 5 years 1,376.85 <-- =B2*(1+B4)^5*(1+B3)^5
8 Bank CD repayment in 5 years 1,469.33 <-- =B2*(1+B5)^5
9
TIPS year 5 repayment
10 in year 0 dollars 1,187.69 <-- =B7/(1+B4)^5
CD year 5 repayment
11 in year 0 dollars 1,267.46 <-- =B8/(1+B4)^5
12
13 TIPS annual real rate of return 3.50% <-- =(B10/B2)^(1/5)-1
14 CD annual real rate of return 4.85% <-- =(B11/B2)^(1/5)-1
15
Anticipated annual CD real
16 inflation rate return TIPS real return
17 0% 8.00% 3.50% <-- =(B10/B2)^(1/5)-1
18 1% 6.93% 3.50%
19 2% 5.88% 3.50%
20 3% 4.85% 3.50%
21 4.3478% 3.50% 3.50% <-- Breakeven inflation rate
22 5% 2.86% 3.50%
23 6% 1.89% 3.50%
24 7% 0.93% 3.50%
25 8% 0.00% 3.50%
26
27 8% TIPS Versus Bank CD,
28 Real Returns
7%
29
Real annual return

6% CD real return
30
31 TIPS real return
5%
32
4%
33
34 3%
35 2%
36
37 1%
38 0%
39 0% 2% 4% 6% 8%
40 Anticipated inflation rate
41
42

TIPS or CD? What’s the answer?

Like all good finance questions, the answer depends on your assumptions. If you believe that
the inflation rate will be higher than 4.3478% per year, then the TIPS is preferred; otherwise,
you should choose the CD.

5.8. Using TIPS to Predict Inflation

We can use the interest data from TIPS and from Treasury bills to derive the market’s predic-
tion of future inflation. Here’s an example: On 21 August 2009, a 5-year nominal Treasury
 CHAPTER 5 Issues in Capital Budgeting 173

security sold in the market to yield an annual interest rate of 2.58%. On the same date, a 5-year
TIPS was yielding 1.22% annually. Because the TIPS yield is in real interest, we can surmise
that the market is predicting an inflation rate of 1.36% annually (=2.58−1.22%) over the 5-year
horizon.
Using available data for all maturities, here are the market’s predicted inflation rates on the
same date.

A B C D E F G H I J K L
1 NOMINAL AND REAL INTEREST RATES ON 21 AUGUST 2009
2 Treasury interest 1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 10 yr 30 yr
3 Nominal interest 0.10% 0.10% 0.26% 0.45% 1.10% 1.65% 2.58% 3.21% 3.56% 4.32% 4.36%
4
5 TIPS data 5 yr 7 yr 10 yr 10 yr
6 Real interest 1.22% 1.41% 1.69% 2.10%
7
8 Implied inflation -1.12% -1.12% -0.96% -0.77% -0.12% 0.43% 1.36% 1.80% 1.87% 2.22% 2.26%
9
10
11
Implied inflation, 21 Aug 2009
12 2.50%
13
14 2.00%
15
16 1.50%
17
18 1.00%
19
20 0.50%
21
22 0.00%
23 1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 10 yr 30 yr
-0.50%
24
25
-1.00%
26
27 -1.50%
28

The data predict negative inflation over the 2-year horizon and positive inflation afterward.
On the date of these data, the world was in a financial crisis, and the negative inflation rates are
indicative of an expectation that this crisis will continue for the next few years.7

5.9. Inflation-Adjusted Capital Budgeting

You’re considering an investment in a new widget machine. The machine will cost $9,500 today;
cells B9:B14 give the widget sales forecasts for years 1–6. Widgets today sell for $15 each (cell
B3), and the widget price in the future is expected to rise at the inflation rate of 4% (cell B2).
Your nominal discount rate is 12% (cell B4).

7
We’ve had to make some compromises to derive the inflation curve. See the spreadsheet with this chap-
ter (on the CD-ROM for Principles of Finance with Excel) for details on the computations and the data
sources.
174 PART ONE CAPITAL BUDGETING AND VALUATION

A B C D E F G
CAPITAL BUDGETING FOR THE WIDGET MACHINE
1 Widget prices increase at a different rate than the inflation rate
2 Inflation rate 4.00%
3 Widget price today 15.00
4 Annual increase in widget prices 8.00%
5 Nominal discount rate 12.00%
6 Equivalent real discount rate 7.69% <-- =(1+B5)/(1+B2)-1
7
Anticipated
real cash
Anticipated Anticipated flow in
Widgets nominal nominal year 0
8 Year sold widget price cash flow dollars
9 0 -9,500.00 -9,500.00
10 1 100 16.20 1,620.00 <-- =C10*B10 1,557.69 <-- =D10/(1+$B$2)^A10
11 2 125 17.50 2,187.00 <-- =C11*B11 2,022.00 <-- =D11/(1+$B$2)^A11
12 3 150 18.90 2,834.35 2,519.73
13 4 160 20.41 3,265.17 2,791.08
14 5 170 22.04 3,746.79 3,079.59
15 6 200 23.80 4,760.62 3,762.39
16
17 NPV calculations =$B$3*(1+$B$4)^A10
Discounting nominal cash
flows at nominal discount
18 rates 2,320.31 <-- =NPV(B5,D10:D15)+D9
Discounting real cash
flows at real discount
19 rates 2,320.31 <-- =NPV(B6,F10:F15)+F9
20
21 IRR calculations
22 Nominal IRR 18.87% <-- =IRR(D9:D15)
23 Real IRR 14.30% <-- =IRR(F9:F15)
24 (1+nominal IRR)/(1+inflation)-1 14.30% <-- =(1+B22)/(1+B2)-1

• Assuming a nominal discount rate of 12%, an equivalent real discount rate is given in
cell B5. This rate is computed by the formula

1 + nominal rate 1 + 12%

real discount rate = −1 = − 1 = 7.69%
1 + inflation rate 1 + 4%

• Column C of the spreadsheet shows the anticipated widget price in each of years 1–6.
We’ve computed this price by computing the nominal widget price in each of years 1–6
using the formula
t
nominal time-t price = price today* (1 + inflation )

• Column D shows the nominal cash flow.8 Discounting these cash flows at 12% gives the
NPV of $778.93 in cell B17. Because the NPV is positive, you should invest in the new
machine.
• Assuming that the increase in widget prices and the increase in general prices are the
same, we can compute the real cash flows as in column F:

real cash flow, year t = (widgets sold )* widget price today

Column F actually shows a different formula, which gives the same result:

⎛ nominal value of widgets sold ⎞

real cash flow, year t = ⎜ ⎟
⎜⎝ (1 + inflation rate)t ⎟⎠

8
We’ve assumed that it won’t cost you anything to produce the widgets once you buy the machine.
(Alternatively, you can assume that the widget price is the net of production costs.)
 CHAPTER 5 Issues in Capital Budgeting 175

• The NPV of these real cash flows, computed in cell B18, is the same as the $778.93
computed in B17.
Discounting nominal cash flows at a nominal discount rate and discounting real cash
flows at a real discount rate gives the same net present value in year-0 dollars.

Computing the Real and Nominal IRR

We can compute the real and nominal IRR for the widget machine as follows:
• Taking the IRR of the nominal cash flows (cell B22) gives a nominal IRR of 14.47%.
Because the nominal IRR is greater than the nominal discount rate of 12%, the widget
machine is a good investment.
• Computing the IRR of the real cash flows (cell B23) gives a real IRR of 10.06%. The
investment decision given by the real IRR is the same as the investment decision given
by the nominal IRR: Because the real IRR is greater than the real discount rate of 7.69%,
the machine is a good investment. Note that we’ve computed the real discount rate in cell
B5 using the formula
1+ nominal discount rate 1 + 12%
real discount rate = = − 1 = 7.69%
1+ anticipated inflation rate 1 + 4%

TWO WAYS OF COMPUTING THE REAL IRR

The real IRR can be computed by either

• Taking the IRR of the projected real cash flows (direct calculation of the real IRR) or
• Taking the IRR of the nominal cash flows, dividing by (1 + inflation rate), and subtract-
ing 1.
To see that these two are the same, note that the nominal NPV is computed by
CF1 (real )* (1+ inflation rate)
Nominal NPV = CF0 +
(1+ real interest rate )* (1+ inflation rate )
CF2 (real )* (1+ inflation rate)2
+ 2
⎡⎣(1+ real interest rate )* (1+ inflation rate )⎤⎦
CF2 (real )* (1+ inflation rate)3
+ 3
⎡⎣(1+ real interest rate )* (1+ inflation rate )⎤⎦
+...

Throughout this formula the (1 + inflation rate) term cancels out, so that
CF1 (real )
Nominal NPV = CF0 + +
(1+ real interest rate)
CF2 (real ) CF3 (real )
+ + + ...
(1+ real interest rate) (1+ real interest rate)3
2

= Real NPV
176 PART ONE CAPITAL BUDGETING AND VALUATION

• The real IRR can also be computed by the formula

1 + nominal IRR 1 + 14.47%

real IRR = −1 = − 1 = 10.06%
1 + inflation rate 1 + 4%

Widget Prices Have a Different Inflation Rate Than

the General Inflation Rate
In the previous problem the anticipated increase in widget prices was the same as the inflation
rate. Suppose this isn’t true—in the spreadsheet below, we assume that inflation (understood as
the increase in the CPI) will be 4% per year, but that widget prices will increase at 8% per year.
(Widget demand is expected to rise sharply, causing a big increase in prices.)
The analysis for this case is shown below. Although in principle it is not different than
the analysis for Problem 5, the results are, of course, different—making widgets an even more
profitable business.
A B C D E F G
CAPITAL BUDGETING FOR THE WIDGET MACHINE
1 Widget prices increase at a different rate than the inflation rate
2 Inflation rate 4.00%
3 Widget price today 15.00
4 Annual increase in widget prices 8.00%
5 Nominal discount rate 12.00%
6 Equivalent real discount rate 7.69% <-- =(1+B5)/(1+B2)-1
7
Anticipated
real cash
Anticipated Anticipated flow in
Widgets nominal nominal year 0
8 Year sold widget price cash flow dollars
9 0 -9,500.00 -9,500.00
10 1 100 16.20 1,620.00 <-- =C10*B10 1,557.69 <-- =D10/(1+$B$2)^A10
11 2 125 17.50 2,187.00 <-- =C11*B11 2,022.00 <-- =D11/(1+$B$2)^A11
12 3 150 18.90 2,834.35 2,519.73
13 4 160 20.41 3,265.17 2,791.08
14 5 170 22.04 3,746.79 3,079.59
15 6 200 23.80 4,760.62 3,762.39
16
17 NPV calculations =$B$3*(1+$B$4)^A10
Discounting nominal cash
flows at nominal discount
18 rates 2,320.31 <-- =NPV(B5,D10:D15)+D9
Discounting real cash
flows at real discount
19 rates 2,320.31 <-- =NPV(B6,F10:F15)+F9
20
21 IRR calculations
22 Nominal IRR 18.87% <-- =IRR(D9:D15)
23 Real IRR 14.30% <-- =IRR(F9:F15)
24 (1+nominal IRR)/(1+inflation)-1 14.30% <-- =(1+B22)/(1+B2)-1

Compare this spreadsheet to the calculations we did in the previous example: Because wid-
get prices increase faster than the inflation rate, both the nominal and the real anticipated cash
flows are greater every year. Thus, the project is more profitable, whether measured by real or
nominal NPV or real or nominal IRR.

Conclusion
This chapter has dealt with a variety of issues in NPV and IRR analysis. Some of these issues
dealt with problems associated with using the IRR: IRR may not always give you explicit
answers (there can be multiple IRRs, and complicated cash flows can have IRRs that make
it difficult to understand if you’re borrowing or lending). We also examined the problem of
 CHAPTER 5 Issues in Capital Budgeting 177

choosing between short-lived and long-lived assets that are alternatives, and we looked again
at the lease/purchase problem fi rst introduced in Chapter 2; this time we introduced taxes into
the problem and discussed how corporations should choose between leasing and purchasing
an asset.
Finally, we discussed how inflation should be incorporated into our analysis of capital
budgeting.

EXERCISES
1. You are considering building a hotel in northern Alaska. Your plan is to build the hotel and then
sell it. You’ve been offered an immediate planning grant of $500,000 from the Alaskan Tourist
Authority, and you estimate that to complete the hotel you’ll need to make an investment next year
of $1,700,000. Once built, you think you can sell the hotel at the end of year 2 for $1,400,000, so
that your cash flow pattern looks like the following.

A B
ALASKAN HOTEL
1 PROJECT
2 Year Cash flow
3 0 500,000
4 1 -1,700,000
5 2 1,400,000

a. Identify the two IRRs of this project.

b. If the discount rate is 28%, should you undertake the project?
2. Here’s an example of a cash flow with three changes in sign.
a. Graph the NPV of the cash flows using discount rates between 0 and 100%. Use this graph to
approximately identify the three IRRs.
b. Use Excel’s IRR function with its Guess option to identify the three IRRs exactly.
c. Can you “spin” a story about why a project might have such a complicated cash flow pattern?
A B
CASH FLOW
1 WITH 3 IRRs
2 Year Cash flow
3 0 -350,000
4 1 2,500,000
5 2 -3,000,000
6 3 500,000
7 4 500,000
8 5 500,000
9 6 500,000
10 7 -14,000,000
11 8 3,500,000
12 9 3,500,000
13 10 3,500,000
14 11 3,500,000
15 12 3,500,000
16 13 3,500,000
17 14 3,500,000
18 15 -11,000,000
178 PART ONE CAPITAL BUDGETING AND VALUATION

3. You are considering a project with the following cash flows.

A B
2 Year Cash flow
3 0 -300
4 1 5,000
5 2 -20,000
6 3 8,000
7 4 6,000
8 5 3,500

a. What is the NPV of the project when the discount rate is 0%?
b. What is the NPV of the project when the discount rate grows to infinity?
c. Find all project IRRs.
4. Your firm is considering two projects with the following cash flows.

A B C

3 Year Project A Project B

4 0 -22,500 -50,000
5 1 8,000 15,000
6 2 8,000 15,000
7 3 8,000 15,000
8 4 8,000 15,000
9 5 8,000 15,000
10 6 8,000 15,000

In which discount rate range will the company prefer Project A, in which discount rate range will
the company prefer Project B, and in which discount rate range will the company not invest?
5. You bought a house in January 1996 for $100,000, and you sold the house at the end of 2002 for
$185,000. The CPI rose in the period from 118 to 155.
a. What was your annualized nominal rate of return?
b. Calculate your annualized real rate of return.
6. The bank is offering you a new savings account that will give you a 2% real annual interest rate. If
the inflation rate is 5% annually, how long will it take you to double your money both in nominal
and in real terms?
7. You are considering purchasing a machine to produce golf balls. The cost of the machine is
$100,000 and its expected life span is 8 years. The machine will have an annual production
of 550,000 balls. The price of a golf ball is today $0.20, and it’s expected to rise by 10% each
year. The material used to produce a golf ball costs $0.08 and it’s expected to rise by 2% a year.
To operate the machine you’ll need two workers, each earning an annual salary of $30,000.
According to their contracts their salaries will rise by 7% a year starting in the third year.
The real discount rate is 4%, the expected inflation is 5%, and the corporate tax rate is 40%.
a. Calculate the NPV of the project using nominal values.
b. Repeat the calculation using real values.
8. A soft drink company is considering whether to use television or radio in its campaign for a new
line of products. According to the company’s estimates, the TV campaign will cost $205,000
initially (at t = 0) and another $100,000 annually. The campaign will generate an annual income
of $300,000 for 3 years.
 CHAPTER 5 Issues in Capital Budgeting 179

The radio campaign will cost $48,000 and an additional cost of $20,000 annually. The radio cam-
paign will generate an annual income of $150,000 for 3 years. If the company’s discount rate is
18% and the tax rate is 30%:
a. Calculate the NPV of the television and the radio campaigns.
b. Repeat your calculation using mid-year discounting and explain the difference in results.
9. A factory is considering purchasing a new machine. It has two alternatives.

A B C
1 Discount rate 8%
2 Tax rate 30%
3
4 Machine A Machine B
5 Cost 15,000 50,000
6 Annual costs 3,000 1,000
7 Life span 3 7

If the company chooses one machine, it will have to continue to choose the same machine
forever. Which machine should the company choose if the interest rate is 8% and the corporate tax
is 30%? Assume straight-line depreciation to zero salvage value over the life of each machine.
10. Your firm has to replace one of its fender-bender machines. One of your financial wizards has
determined that the appropriate discount rate for the machine cash flows is 10%. Your firm has
two alternatives.
a. Fender-bender Machine A costs $400,000 and produces annual cash flows of $200,000 at the
end of each of its 6 years of life.
b. Fender-bender Machine B costs $200,000 but has only a 2-year life. However, it produces a
$300,000 annual cash flow at the end of each of these 2 years.

A B C
Cash flow Cash flow
3 Year (A) (B)
4 0 -400 -200
5 1 200 300
6 2 200 300
7 3 200
8 4 200
9 5 200
10 6 200

Calculate the equivalent annuity cash flow (EAC) and determine which machine is preferable.
11. You are the owner of a 5-year-old taxi. Your doctor has advised you to quit driving because of a
health problem. You are considering two alternatives:
a. Selling the taxi for $15,000. Because the taxi’s book value is 0, you will have to pay tax.
b. Renting your taxi to your cousin. Your cousin will pay you $4,000 today and at the beginning
of each of the next 4 years. You estimate that in 4 years the taxi can be sold for $300.
Which is the more profitable alternative if your tax bracket is 25% and your discount rate is 5%?
12. A firm is considering the purchase of a machine for one of its factories. The machine’s cost is
$300,000 and it is expected to save the factory $100,000 annually. The machine’s life span is 4
years, the company discount rate is 15%, and the corporate tax rate is 35%.
a. Under the above conditions is it worth buying the new machine?
180 PART ONE CAPITAL BUDGETING AND VALUATION

b. Another supplier of the same machine suggested that instead of buying the machine, the fi rm
should lease it. If the leasing fee for the machine is 80,000 annually and it is an expense for tax
purposes, what is the NPV of the leasing offer?
c. The original supplier suggested lending the firm $210,000 that will be returned in three equal
payments without interest. What is the NPV of this offer?
13. In Section 5.2 we considered a project called Sanitary Landfill. Now consider a project called
Stranger Sanitary Landfill, which has the following cash flows.

A B
4 Year Cash flow
5 0 800,000
6 1 -450,000
7 2 -450,000
8 3 -450,000
9 4 -450,000
10 5 -450,000
11 6 1,500,000

Show that you would accept this project for a suitably low or a suitably high discount rate, but not
for discount rates in the middle. Explain.
14. You have a factory that produces light bulbs. Your old machine is costing a lot of money lately in
repairs and you are considering replacing it. You have two offers.

A B C
1 Discount rate 12%
2 Corporate tax rate 40%
3
4 Annual production 1,000,000
5 Price of light bulbs 0.40
6
7 Machine A Machine B
8 Cost 500,000 200,000
9 Variable cost per light bulbs 0.12 0.25
10 Fixed costs 100,000 75,000
11 Life span 10 4

You sell each light bulb for $0.40, the discount rate is 12%, and the corporate tax rate 40%.
a. Which machine would you prefer to buy if your annual production is 1,000,000 light bulbs?
b. At what level of production will you change your answer?
15. ABC Corp. is trying to decide whether to buy or lease a new egg-scrambling machine. Here are
some relevant facts:
• The new machine costs $120,000 and will be depreciated over a 5-year horizon to zero
salvage value on a straight-line basis.
• ABC Corp. has a 30% corporate tax rate.
• The company can lease the machine from a reputable lessor for $29,941 per year; payments
will be made on dates 0, 1, 2, . . . , 5 (in other words, six payments).
• ABC Corp. has a line of credit at its local bank. The bank is currently offering loans up to
6 years at 12%.
a. Should ABC Corp. lease or buy the machine? Justify your answer.
b. Suppose that the leasing company offers to sell the machine to ABC for $1 at the end of the
lease term. The company feels that the machine can be profitably sold at this point for $25,000.
Will this make the lease more or less attractive? (Give a qualitative rather than a numerical
answer.)
 CHAPTER 5 Issues in Capital Budgeting 181

16. Wharton Waste Disposal (WWD) is trying to decide whether to replace its aged trash compactor
with a new, more efficient model. Here are the relevant facts:
• The new trash compactor costs $400,000. If introduced, the company estimates that it
will save $60,000 annually on a before-tax basis (assume that this cash flow occurs at year
end).
• The old trash compactor has a book value of $100,000. Its market value is $50,000. The
remaining book value of the old compactor is being depreciated on a straight-line basis to
zero salvage value at the rate of $20,000/year.
• WWD has a corporate tax rate of 40% and is wildly profitable. The company uses a 15%
discount rate for all cash flows.
• Trash compactors never die—they have an essentially infinite life. However, the new com-
pactor will be straight-line depreciated on a 10-year life to zero salvage value.
• To encourage the replacement of smelly old trash compactors with shiny new ones, the
state Environmental Protection Agency is offering a replacement subsidy. The subsidy is
paid 1 year after the new compactor is put in use.
What is the minimum subsidy that will make the replacement of the old compactor a break-even
proposition?
17. Hunter Brothers Inc. needs to buy printers for its offices. It can buy expensive laser printers or
much cheaper (but shorter-lived) inkjets. Here are some relevant facts:
• A laser printer costs $1,000 and an inkjet costs $250.
• A laser printer has an anticipated life of 6 years, but an inkjet has an anticipated life of only
2 years. Printers are assumed to have zero market value at the end of their lives.
• The cost per page for a laser printer is $0.03, whereas the cost per page for an inkjet is
$0.10.
• Each printer purchased is anticipated to print 10,000 pages per year.
If Hunter Brothers has a discount rate of 12% and a tax rate of zero, which printers should it
buy? Assume that the whole year’s cost of printing falls at year end.
18. Torreo Coffee Roaster is considering replacing one of its existing machines with a new, more
automated and efficient machine. Torreo bought the machine 4 years ago for $87,500. It is being
depreciated on a straight-line basis over a 14-year life. The machine could be sold today, 1 January
2000, for $20,000.
The new machine costs $95,000. The new machine’s depreciable life is 10 years with a salvage
value of $13,000 in real terms. However, in accordance with U.S. tax law, the asset will be depre-
ciated to zero over 10 years via the straight-line method.
In 1999 Torreo’s current coffee roasting machine accounted for annual revenues of $50,000
and has annual costs of $25,000. The new machine will increase this revenue to $65,000 per year
(in real terms, that is, in 1999 dollars). The machine will also increase operating costs by $3,000
per year in real terms.
The nominal discount rate is 14% per annum. The corporate tax rate for both operating income
and capital gains is 40%. The annual anticipated inflation rate is 5%. All cash flows are riskless
and they occur at the end of the year. Taxes are also paid at the end of the same year. Torreo has
profitable ongoing operations that can be used to offset losses.
Should Torreo Coffee Roaster replace the old machine with the new machine?
19. One Stop Golf Inc. is considering building a plant to manufacture a child’s putter. The initial
outlay (year 0) for the plant will be $5 million. At the end of year 1 a further outlay of $1 million
on the plant is required. The plant will be built on land that could otherwise be rented out in any
of the years for $500,000, before taxes.
182 PART ONE CAPITAL BUDGETING AND VALUATION

The company anticipates producing this specialty item for only 3 years, in years 2, 3, and 4.
At the end of year 4, the company will close and sell the plant. It expects to produce and sell
500,000 putters in year 2, 400,000 in year 3 and 100,000 in year 4. Each putter can be sold for
$30 in year 2, and this price is expected to increase at a rate of 6% per year in years 3 and 4.
The raw materials required for each putter are expected to cost $15 on average for those putters
produced in year 2 and to increase at a rate of 3% per year in years 3 and 4. The cost of labor for
each putter produced in year 2 is $5 and is expected to increase at the rate of 5% per year in the
subsequent 2 years. Advertising the new putters will cost $500,000 in year 1, $220,000 in year 2,
and $50,000 in year 3. No other inputs are required for the production of the child’s putter.
The firm uses straight-line depreciation and the plant has a depreciable life of 6 years. Starting
at the end of year 1, the company will depreciate the plant’s total cost of $6 million to a salvage
value of zero. The anticipated sale price of the plant at the end of year 4 is anticipated to be $4
million. The firm can offset any losses against other profitable ongoing projects.
The appropriate discount rate for the project is 12%. Assume all cash flows occur at the end of
the year. The corporate tax rate is 34%.
a. Calculate the project’s incremental cash flows.
b. Calculate the NPV of the project.
20. Grandma Helen was reminiscing with her grandson Noah. “When I married Grandpa in 1937,”
she recalled, “his monthly salary was $300. We had to scrimp and save. Now here it is 2008, and
you’re telling me that your first job out of college is going to pay you $4,500 per month. Why,
that’s fi fteen times as much as Grandpa made!”
To compare the two salaries, Noah went to the Minneapolis Federal Reserve Web site and dug
out the consumer price index (CPI) figures for 1913–2008. Whose salary was larger—in inflation-
adjusted terms—Noah’s or Grandpa’s? (See the table of CPIs on disk with this book.)
21. Using the CPI data on the disk with this book, answer the following questions:
a. In 1803 the administration of President Thomas Jefferson purchased 800,000 square miles
of North American territory from the French government for $15,000,000. The Louisiana
Purchase doubled the size of the United States. Use the CPI series to adjust this price to 2009
dollars.9
b. There are 640 acres per square mile. What was the price of the Louisiana Purchase per acre
in 2009 dollars?
Some perspective: A random search of the Internet in 2009 reveals the following land
prices in the area of the Louisiana Purchase:
• 755 acres in Avoyelles Parish, Louisiana: $1,661,000
• 106 acres in Independence County, Arkansas: $119,900
• 5 acres in Pike County, Mississippi: $50,000
• 51 acres in Itasca County, Minnesota: $1,000,000
22.
a. On 1 January 2004, the Fluffy Finance Company made a $1,000,000 loan to one of its clients.
The loan interest was 12%, to be paid monthly (meaning 1% per month), with full repayment
of the loan on 1 January 2005. Because the client anticipated significant cash flow problems
during July and August, Fluffy Loan agreed to forego interest payments during these months.
Use XIRR to compute the annualized rate of return earned by Fluffy Finance on the loan.

9
For historical details and a map, please visit http://gatewayno.com/history/LaPurchase.html.
 CHAPTER 5 Issues in Capital Budgeting 183

b. Another Fluffy Finance client has asked for a similar loan, but has asked to forego interest
payments in May and June. If Fluffy can make only one of the loans, which should it make?
23. For each of the projects below, compute all the IRRs.

A B C D E F G
1 CONVENTIONAL AND NONCONVENTIONAL CASH FLOW PATTERNS
Cash flows Cash flows Cash flows Cash flows Cash flows Cash flows
2 Year Project A Project B Project C Project D Project E Project F
3 0 -100 -100 100 25 -25 -250
4 1 200 -50 55 35 80 35
5 2 500 60 35 -200 -100 145
6 3 50 80 50 33 200 330
7 4 60 99 -100 55 55 55
8 5 35 100 -35 155 -250 -250

Conventional Conventional Conventional Nonconventional Nonconventional Nonconventional

cash flow cash flow cash flow cash flow pattern cash flow pattern cash flow pattern
pattern pattern pattern
9
Initial negative Two initial Four initial Two positive Negative cash
cash flow negative cash positive cash cash flows, then Signs of cash flows at
followed by flows followed flows followed negative, then flows change beginning and
positive cash by positive by negative three positive several times end, other cash
10 flows cash flows cash flows cash flows flows positive

24. The disk that comes with Principles of Finance with Excel gives the CPI and inflation in Japan
from 1990 to 2007. Compute the annual inflation over this period in Japan and compare it with
the annual inflation in the United States.
CHAP TER

Choosing a Discount Rate

6
CHAPTER CONTENTS
Overview 184
6.1. Funding Cost as the Discount Rate 187
6.2. The Weighted Average Cost of Capital as the Firm’s Funding Cost 190
6.3. The Gordon Dividend Model: Discounting Anticipated Dividends to
Derive the Firm’s Cost of Equity, rE 193
6.4. Applying the Gordon Cost of Equity Formula—Courier Corp. 196
6.5. Calculating the WACC for Courier 200
6.6. Two Uses for the WACC 202
Summing Up 209
Exercises 210

Overview
When you use either net present value (NPV) or internal rate of return (IRR) to make invest-
ment decisions, you have to choose a discount rate r. Just to remind you:
• In the case of the NPV, the discount rate r is used to discount the future cash flows of the
investment. If the NPV is positive when cash flows are discounted at r, then the invest-
ment is a good one. An investment with a negative NPV should be rejected.
• In the case of the IRR, the discount rate r is the standard of comparison for the invest-
ment choice. If the rate r is less than the IRR of the investment, the investment is a good
one; if r > IRR, we should reject the investment.1

1
Recall from Chapter 5 that the IRR is not always the appropriate rule to use (for example, when there are
multiple IRRs). In these cases we should use the NPV.
184
 CHAPTER 6 Choosing a Discount Rate 185

As you can see, the choice of a discount rate is very important! This chapter discusses how
to choose the discount rate. The main principles we stress are as follows:
• The rate you choose should be appropriate to the riskiness of the cash flows being dis-
counted. The riskier the cash flows being discounted, the higher should be the discount
rate used in the NPV or IRR computations.
• In many cases the “funding cost” is a good choice for the discount rate. The funding cost
is the rate of return demanded by the provider of the funds for the project.
• In a large number of cases involving investments by firms, the appropriate discount rate
is the weighted average cost of capital (WACC). The WACC is the average funding cost
for a firm. The bulk of this chapter is devoted to defining the WACC and showing you
how to use it to value a firm.
Figure 6.1 summarizes the uses of NPV and IRR to make investment decisions. Despite the
extensive discussion of Chapters 2–5, there are two NPV/IRR questions we haven’t answered:
• What is the meaning of the cash flows that are discounted in the NPV and IRR computa-
tions? Suppose we’re considering an investment that costs $100 today and promises $120
in 1 year. What does this promise of a future cash flow actually mean?
• One possibility is that the $120 is riskless: In this case there is no doubt that the $120
will be paid 1 year from now. The $120 future cash flow is certain. Government bonds
and bank accounts are two examples of investments that offer riskless cash flows.
• Another possibility is that the $120 is an anticipated or expected cash flow, but is not
riskless. In this case the $120 is risky or uncertain. For example, it could be that the
investment’s cash flow 1 year from now is determined by the flip of a coin: If the coin
comes up heads, the cash flow will be $140 and if it comes up tails, the cash flow will
be $100. The average future cash flow is $120, but the actual cash flow is uncertain.
• How do we pick the proper discount rate r for the investment? In the NPV and IRR
calculations of Chapters 2–5, r is the rate of return that we require from the investment.
Once you realize that the cash flow figures you’re quoted mask the uncertainty behind
the numbers, you’ll agree that r should be risk adjusted: Investors dislike risk; therefore,
the greater the uncertainty about the cash flows, the higher the rate of return r investors
demand. To go back to the investment considered in the previous bullet:
• If the $120 is a riskless cash flow, then the appropriate discount rate r is the risk-
less interest rate. Good examples of riskless interest rates are the interest rates on
government bonds or bank accounts.

USING NPV AND IRR TO MAKE INVESTMENT DECISIONS

“Yes or no”: “Project ranking”:
Choosing whether to undertake Comparing two mutually exclusive
a single project projects
NPV criterion The project should be undertaken if its Project A is preferred to Project B if
NPV > 0. NPV(A) > NPV(B).

IRR criterion The project should be undertaken if its IRR Project A is preferred to Project B if
> r, where r is the appropriate discount rate. IRR(A) > IRR(B).

FIGURE 6.1 Summarizing the use of NPV and IRR for investment decisions. The critical question discussed in this
chapter: How to determine the appropriate discount rate r?
186 PART ONE CAPITAL BUDGETING AND VALUATION

• If the $120 is a risky cash flow, then the return investors demand will be higher. This
means that the appropriate discount rate r is a risk-adjusted discount rate (RADR).
The numerator of the NPV
is the cash flows--these can
be either riskless or risky.

Cash flow1 Cash flow 2 Cash flow 3

NPV = Cost today + + 2
+ ...
(1 + discount rate ) (1 + discount rate ) (1 + discount rate )3

The denominator of the NPV

is the discount rate. The
more risky the numerator, the
higher the discount rate.

FIGURE 6.2 The “numerator” and the “denominator” of the NPV. The cash flow in the numerator is the anticipated
investment cash flow; the discount rate in the denominator is adjusted for the riskiness of the cash flow in the numer-
ator. This chapter discusses the determination of the discount rate.

Risk: At a later point in the book (Chapters 8–13), we’ll give more formal definitions of
risk and how to measure it. For the moment we’ll rely on your intuitive understanding of risk.
You understand that investing in a government bond is less risky than investing in stocks. You
also understand that a real-estate investment is more risky than putting your money in a savings
account (but perhaps less risky than buying a race horse).
The main characteristic of the riskiness of a cash flow is its future variability: Some cash flows
are known almost with certainty; if your bank promises you 6% interest, you can be certain that
$100 today will grow to $106 in 1 year. Other kinds of cash flows are much more uncertain; past
experience shows that a $1,000 investment in stocks gives an average annual return of 12%, but you
also know that in some years this return has been as low as –20% and in other years it has been as
high as 35%. In general, the higher the variability of an investment’s return, the higher its risk.

TERMINOLOGY
The finance literature is full of synonyms for discount rates. Here are some terms you’re likely
to encounter; all of them are sometimes used to denote the appropriate discount rate for a series
of cash flows:
• Discount rate
• Cost of capital
• Opportunity cost
• Interest rate
• Risk-adjusted discount rate (RADR)

Finance Concepts Discussed

• Funding cost
• Cost of capital
• Cost of equity, rE
• Cost of debt, rD
• Free cash flow (FCF)
 CHAPTER 6 Choosing a Discount Rate 187

• Gordon dividend model

• Mid-year discounting

Excel Functions Used

• NPV
• IRR
• PMT

6.1. Funding Cost as the Discount Rate

The funding cost is the cost of raising the money needed for an investment. The funding cost is
often the appropriate candidate to use as the discount rate. The idea behind using the funding
cost as a discount rate is that we identify the cost of the funds used and use this cost to discount
the future investment cash flows. We’ll start with an example that illustrates the proper use of
the funding cost as the discount rate.

Example 1: Taking Money Out of a Savings Account to Buy a Bank

Certificate of Deposit (CD)
You’ve got $10,000 in a savings account at the bank that earns 4% per year, and you have no
intention of using this money for the next couple of years. Your bank has offered you an alterna-
tive investment: a 2-year certificate of deposit (CD) that earns 5%. This CD is like a bond issued
by the bank: You pay the bank $10,000 today and the CD will pay you $500 in 1 year ($500 =
5% * $10,000) and $10,500 in 2 years.
The CD looks like a good investment—instead of earning 4%, you’ll now earn 5%. Another
way to think about this investment is that it will cost you 4% (the foregone interest rate on your
savings account) to earn the 5% interest on the CD. Using the 4% rate as the appropriate dis-
count rate, the NPV of the CD is $188.61.

A B C
1 BANK CD
2 Savings account interest rate 4.00%
3 CD rate 5.00%
4
CD
5 Year cash flow
6 0 -10,000.00
7 1 500.00
8 2 10,500.00
9
10 NPV 188.61 <-- =B6+NPV(B2,B7:B8)

The $188.61 is the additional wealth you will gain from taking your money out of the sav-
ings account and putting it into the CD.
Warning: Markets aren’t stupid, so you have to ask yourself why the bank is offering you
5% on the CD and only 4% on the savings account. What are the risks involved in taking your
money out of the savings account and putting it into the CD?
• Lock-in risk: The money in the CD is locked in and is not available for 2 years, whereas
the money in the savings account is available at any time.
188 PART ONE CAPITAL BUDGETING AND VALUATION

• Interest rate risk: If interest rates go up, the bank will probably raise the interest rate on
the savings account (other banks will raise their savings interest rate and competitive pres-
sure will probably force your bank to raise its interest rate). On the other hand, the CD is
a 2-year contract between you and the bank during which the interest rate will not change.
(Of course there’s another aspect to the interest rate risk: If interest rates go down, then the
savings account interest will decrease, but not the interest paid on the CD.)
• Default risk: It is possible that the bank will not be able to keep the promises it made
with the CD. Most American bank CDs are guaranteed by the U.S. government, so this
is not really a factor.
The bottom line on this example is that if you think that the riskiness of the bank savings
account and the CD is not substantially different, you should use the savings bank rate of 4% to
discount the investment in the CD. The funding cost is an appropriate discount rate.

Example 2: When Is the Funding Cost Not a Good Discount Rate?

In the previous example the riskiness of a bank savings account is not substantially different from
the riskiness of a CD. This makes the savings account interest rate a good discount rate for eval-
uating the purchase of the CD. When the risks of funding finance differ substantially from the
risks of the investment, the funding cost is not a good choice for a discount rate. Suppose you’re
thinking about buying a 1-year Evelyn Wyer lipstick franchise. This franchise allows you to sell
the prestigious Evelyn Wyer lipsticks on your campus for 1 year. Evelyn’s lipstick comes in all
colors, but this year’s favorite among college students is vomit yellow. The franchise costs $1,000
and is good for 1 year. At the end of this year, you expect to earn $1,500 from the franchise.
If you make the investment, you’ll have to take this $1,000 out of your savings account,
which pays 4% interest. The 4% is thus the funding cost for the Evelyn Wyer franchise.
If you use the 4% as a discount rate, then the lipstick franchise is a very good investment.
It has NPV = $442 and an IRR of 50%:

A B C
EVELYN WYER LIPSTICK
1 FRANCHISE
Franchise
2 Year cash flow
3 0 -1,000
4 1 1,500
5
6 Discount rate 4%
7 NPV 442 <-- =B3+B4/(1+B6)
8 IRR 50% <-- =IRR(B3:B4)

However, to decide whether the 4% funding cost is really the appropriate discount rate, you
have to consider the relative risks of the lipstick franchise and the bank savings account.
• If you are certain that you will earn $1,500 from the lipstick franchise, then 4% (the
funding cost) is the appropriate discount rate.
• If, on the other hand, the $1,500 is uncertain and hence risky, then the 4% rate is too low
a discount rate. In this case you have to decide whether the 50% IRR is large enough to
compensate you for the riskiness of the investment.2

2
At this point in the book we use only an intuitive concept of risk. In Chapters 8–13 we define risk more
formally and show how the discount rate and risk are related.
 CHAPTER 6 Choosing a Discount Rate 189

Example 3: If Taxes Are a Factor, Use the After-Tax Funding Cost

Your company needs a new computer. The alternatives are to buy the computer for $4,000
or to lease it. A leasing company has offered you a lease that involves a payment of $1,500
now and $1,500 at the end of each of years 1–3. An alternative financing method is to borrow
the money from the bank, which is charging 15%. Your company has a tax rate of 40%; if it
buys the computer it can depreciate it over 3 years, giving an annual depreciation tax shield of
$4,000
* 40% = $533.33. If the company leases the computer instead of buying it, the $1,500
3
annual cost of leasing can be deducted from its taxable income. The annual after-tax cost of the
lease payment is thus (1−40%) * $1,500 = $900.
Here’s the solution we offer to this problem in Chapter 5.

A B C D E F G
1 LEASE VERSUS PURCHASE WITH TAXES
2 Asset cost 4,000.00
3 Annual lease payment 1,500.00
4 Bank rate 15%
5 After-tax bank rate 9% <-- =B4*(1-B6) This is the depreciation tax shield
6 Tax rate 40% if you buy the computer.
7
Purchase Lease The differential cash flows:
8 Year cash flows cash flows Lease minus purchase
9 0 -4,000.00 -900.00 <-- =-$B$3*(1-$B$6) 3,100.00 <-- =D9-B9
10 1 533.33 <-- =$B$2/3*$B$6 -900.00 -1,433.33
11 2 533.33 -900.00 -1,433.33
12 3 533.33 -900.00 -1,433.33
13 NPV -2,649.98 -3,178.17 <-- =D9+NPV(B5,D10:D12) 18.33% <-- =IRR(F9:F12)
14
Explanation: The lease is like a loan--an inflow of $3,100.00 in year 0, and an after-tax outflow of $1,433.33 in year 1, $1,433.33 in year 2,
and $1,433.33 in year 3. The IRR of these cash flows is 18.33%. Thus the lease is more expensive than borrowing the money from the bank,
15 since the after-tax cost of a bank loan is 9.00%.

Leasing instead of purchasing the asset saves you $3,100 in year 0 but costs you an addi-
tional $1,433.33 in years 1–3. The IRR of the differential cash flows (column F) is 18.33%.
Choosing a discount rate: In this case we can still use the alternative funding cost as the
discount rate. However, we have to take into account the fact that the interest on the bank loan
is an expense for tax purposes. Assuming that the riskiness of the lease and purchase cash flows
is similar to the riskiness of a bank loan, the appropriate discount rate is the after-tax bank dis-
count rate: (1−40%) * 15% = 9%.
It now follows that we should purchase the asset instead of leasing it because the IRR of the
lease minus purchase cash flows is higher than the after-tax cost of a bank loan. Another way to
see this is to compare the cash flows of a $3,100 bank loan to the cash flows saved by purchasing.
As you can see below, the bank loan costs substantially less in each of years 1–3 than the lease
minus purchase cash flows.
A B C D
17 What if you borrowed $3,100 from the bank?
After-tax
money Same
saved by amount from
18 Year leasing bank
19 0 3,100.00 3,100.00
20 1 -1,433.33 -1,224.67 <-- =PMT(B5,3,C19)
21 2 -1,433.33 -1,224.67
22 3 -1,433.33 -1,224.67
23
24 IRR 18.33% 9.00% <-- =IRR(C19:C22)
190 PART ONE CAPITAL BUDGETING AND VALUATION

FUNDING COST AS A DISCOUNT RATE—SUMMING UP

The leasing example illustrates the use of the funding cost as a way to find the discount rate:
Because your alternative financing for the computer is a bank loan (rather than the lease), we’ve
used the cost of the bank loan as a discount rate.
You have to be careful in applying this method: The funding cost is only an appropri-
ate discount rate if the cash flows being funded have the same riskiness as the source of the
funding.
• If you use a bank loan to finance a set of almost certain cash flows, then the bank loan
rate can be the discount rate. You know that you’ll repay the loan, and you’re convinced
that the cash flows being financed will occur with certainty. This is the case for the lease
discussed in this section.
• For corporations, the cost of bank loans is an expense for tax purposes; in this case the
after-tax funding cost should be used as a discount rate.
• If you use a bank loan to finance the purchase of a race horse, then the riskiness of the
cash flows is much greater than the loan cash flows (you’re almost certain to repay the
loan, but you’re much less certain about the cash flows from the race horse).

6.2. The Weighted Average Cost of Capital as the Firm’s Funding Cost
In the previous section we’ve illustrated why the funding cost—the cost of raising the money for
a given project—is often a good choice for the discount rate. The funding cost is a good choice
for a project’s discount rate when it is commensurate with the project’s risk.
The funding cost for a company is often called the company’s weighted average cost of
capital (WACC). Companies raise funds in two primary ways, either by raising funds from their
shareholders or by borrowing. The WACC is determined by averaging the funding costs of these
two methods.
• A company can raise funds from its shareholders either by selling additional shares on the
stock market or by using earnings to finance new projects instead of paying shareholders
dividends. The funding cost of a company’s raising money from its shareholders is called
the cost of equity. Symbolized by rE , the cost of equity is the rate of return demanded by
a company’s shareholders. In Section 6.3 we show you how to compute rE.
• A company can raise funds either by borrowing from banks or by selling bonds. The
funding cost of borrowing, symbolized by rD, is called the cost of debt and is the interest
rate charged by lenders, be they banks or the purchasers of a company’s bonds. The inter-
est on a company’s borrowing is an expense for tax purposes; denoting the corporate tax
rate by TC, the after-tax cost of borrowing is (1−TC) * rD.
The WACC is the average funding cost of a company’s equity and debt. Another way of
putting this is that the WACC is the average after-corporate-tax return shareholders and debt-
holders expect to receive from the company.3 The definition of the WACC is

3
In finance the expected return, the required return, the cost of capital (be it cost of equity or cost of debt),
and the required rate of return are all synonyms. They all represent the market-adjusted rate that investors
get (or demand) on various investments or securities.
 CHAPTER 6 Choosing a Discount Rate 191

E D
WACC = rE * + rD (1 − TC )*
E"#""
!" + D$ E"#""
!" + D$
↑ ↑
the percentage the percentage
of equity used to of debt used to
finance the firm finance the firm
where
rE = the firm’s cost of equity − the return required by the firm’s shareholders
rD = the firm’s cost of debt − the return required by the firm’s debtholders
E = market value of the firm’s equity
D = market value of the firm’s debt
TC = the firm’s tax rate

Here’s a simple example to show what we mean: United Transport Inc. has 3 million shares
outstanding; the current market price per share is $10. The company thinks its shareholders
want an annual return on their investment of 20%; this 20% return is the company’s cost of
equity rE.4 The company has also borrowed $10 million from its banks at a rate of 8%; this is
the company’s cost of debt, rD. United Transport has a tax rate of TC = 40%.5 To compute United
Transport’s WACC we use the formula
E D
WACC = rE * + rD (1 − TC )*
E+D E+D
30 10
= 20% * + 8% * (1 − 40%)* = 16.20%
30 + 10 30 + 10
rE = 20%
rD = 8%
E = 3,000,000 shares each worth $10 = $30,000,000
D = $10,000,000
TC = 40%

Here are the computations in a spreadsheet.

A B C
1 UNITED TRANSPORT–WACC
2 Number of shares 3,000,000
3 Market price per share 10
4
5 E, market value of equity 30,000,000 <-- =B3*B2
6 D, market value of debt 10,000,000
7
8 rE, cost of equity 20%
9 rD, cost of debt 8%
10 TC, firm's tax rate 40%
11
WACC, weighted average cost of capital:
12 WACC=rE*E/(E+D)+rD*(1-TC)*D/(E+D) 16.20% <-- =B8*B5/(B5+B6)+B9*(1-B10)*B6/(B5+B6)

The United Transport WACC computation shows you that the WACC depends on five criti-
cal variables.

4
How did United Transport come to the conclusion that its shareholders want a 20% return? This is the
question in the computation of the WACC, and we will spend a lot of this chapter discussing the answer.
So be patient!
5
We use the symbol TC to indicate the corporate tax rate.
192 PART ONE CAPITAL BUDGETING AND VALUATION

• rE , the cost of equity. rE is the return required by the firm’s shareholders. Of the five
parameters in the WACC calculation, rE is the most difficult to calculate. A model for
calculating rE is given in Section 6.3.
• E, the market value of a firm’s equity. We will usually take E to equal the number of
shares of the firm times the market price per share.
• rD, the cost of debt. rD is the cost of borrowing for the firm. In most cases we will take rD
to be the firm’s marginal interest rate—the interest rate at which the firm could borrow
additional funds from its banks or sell bonds. Alternatively, we will sometimes take rD to
be the company’s average borrowing rate on its current debt. A detailed example of the
calculation of rD for an actual firm is given in Section 6.5.
• D, the market value of the firm’s debt. In most cases we will take D to be the total value
of the firm’s financial obligations. An actual example of a calculation for D is given
below in Section 6.5.
• TC, the firm’s tax rate. Most often we calculate TC by computing the average tax rate of
the firm; see Section 6.5 for an example.

The WACC
The weighted average cost of capital is the average rate of return the firm has to pay its sharehold-
ers and its lenders. The WACC is the funding cost for a company’s projects, and it is widely used as
the appropriate risk-adjusted discount rate for a company’s investment cash flows. Two of the three
examples that follow illustrate the use of the WACC in evaluating investments. The third example
indicates when the WACC is not an appropriate discount rate for a corporate investment.
• White Water Rafting Corp. is considering buying a new type of raft. The raft is more
expensive than the existing rafts operated by the company because it is self-sealing—
holes in the raft are automatically and permanently fixed by a new technology. During
the rafting season, White Water’s existing rafts spend a considerable amount of down
time having their punctures fixed, and the company anticipates that the new self-sealing
rafts will improve its profitability by increasing efficiency and decreasing costs. By being
the first rafting company on the river to have the self-sealing rafts, White Water hopes
to attract business away from other rafting companies—customers naturally hate to have
their trips interrupted by “flat rafts” (the rafting equivalent of a flat tire), and when they
hear of White Water’s new rafts, they will prefer White Water over its competitors.
The White Water financial analyst has derived the set of anticipated cash flows for the new
raft. To complete the NPV analysis, the company needs to decide on an appropriate discount
rate. Here’s where the WACC comes in: Because the riskiness of the cash flows from the new
rafts is similar to the riskiness of White Water Rafting’s existing cash flows, the WACC is an
appropriate discount rate.
• Gorgeous Fountain Water Company (GF) sells bottled water from the Gorgeous Fountain
natural spring. The company is considering buying Dazzling Cascade Water Company.
Dazzling Cascade (DC) operates in a neighboring area to that dominated by GF, and its
operations, sales, and anticipated cash flows have been thoroughly analyzed by the GF
financial analysis staff.
To value DC, GF has to decide on an appropriate discount rate for the anticipated DC cash
flows. Here’s where the weighted average cost of capital comes in. GF’s WACC is the average
return demanded by its investors, taking into account the fact that debt interest is an expense
 CHAPTER 6 Choosing a Discount Rate 193

for corporate taxes. Assuming that the riskiness of DC’s cash flows is similar to that of GF, the
WACC is an appropriate discount rate for the GF cash flows. Discounting the DC cash flows at
GF’s WACC allows Gorgeous Fountain to establish a bid price for DC.
• We conclude with an example where the WACC is not an appropriate discount rate.
Delicious Licorice (DL) is a candy company whose WACC is WACCDL = 22%. To diver-
sify, DL is considering the purchase of Cheap Talk, a regional cell phone operator. The
cash flows of the potential purchase have been carefully analyzed by the DL financial
staff. They realize that the WACC of DL is not the appropriate rate for analyzing the pur-
chase of Cheap Talk—the risks that are included in the DL weighted average cost of capi-
tal are entirely different from the risks of the Cheap Talk cash flows. To use the WACC as
a discount rate, it must be appropriate to the riskiness of the cash flows being evaluated.

Some Important Terminology before We Start

When we talk about “firms” in this book we generally mean corporations, companies that have
shareholders and debtholders.6 A typical firm is incorporated, which means that it is a legal
entity that is separate from its shareholders and debtholders. The income of a corporation is
taxed at the corporate income tax rate.
The shareholders own stock in the firm. When the firm is profitable, management may
decide to pay dividends to the shareholders, but these dividend payments are not guaranteed.
Shareholders can also sell their shares and in doing so may make a profit (called a “capital
gain”) or a loss. As you can see, the cash flows of a shareholder in a firm are uncertain. The
shareholders in the firm have limited liability; they are not responsible for repaying the debt-
holders if the firm cannot do so out of its cash flows.
The cost of equity, denoted rE , is the discount rate applied by shareholders to their expected
future cash flows from the firm. It goes without saying that this cost of equity depends on the
riskiness of the shareholder cash flows. The higher the riskiness of the shareholder’s expected
future cash flows, the higher the cost of equity rE.
The firm’s debtholders are its lenders. Debtholders are promised a predetermined return
(interest) on their lending to the firm. Although most lending is at a fixed interest rate, it is also
common to find debt with interest rates that periodically reset to market rates or that are tied to
the inflation rate.
The debtholders may be banks that have lent money to the fi rm or they may be individuals
or pension funds that have bought the firm’s bonds. The interest payments to the firm’s debthold-
ers are expenses for tax purposes. The interest payments on the firm’s debt and the firm’s tax
rate determine the after-tax cost of debt for the firm, which we denote rD(1−T).

6.3. The Gordon Dividend Model: Discounting Anticipated

Dividends to Derive the Firm’s Cost of Equity, rE
In this section we present a formula for computing the firm’s cost of equity rE. This formula is
called the Gordon dividend model, in honor of Myron Gordon, who first set out the model in
1959.7 This section has two subsections:

6
Equivalent terminology for shareholders: stockholders, equity owners; for debtholders: lenders,
bondholders.
7
The model is sometimes simply called the Gordon model; others call it the dividend discount model.
194 PART ONE CAPITAL BUDGETING AND VALUATION

• In the first subsection we derive a model for calculating the value of a firm’s shares based
on their future anticipated dividends.
• In the second subsection, we use the share valuation model of the first section to derive
the cost of equity rE.

Valuing the Firm’s Shares as the Present Value of the

Future Anticipated Dividends
We start by computing the fair market value of a stock that pays a growing dividend stream. Here
is an example that presents most of the logic of our model: It is 2 March 2000, and you are think-
ing of purchasing a share of XYZ Corp. Here are some facts about the company and its stock:
• XYZ is a steady payer of dividends; in the past it has paid dividends annually, and these
dividends have tended to grow at an annual rate of 7%.
• The company just paid a dividend of $10 per share. This dividend was paid on March 1,
the company’s traditional dividend payment date.
You want to value XYZ shares by discounting the stream of future anticipated dividends.
In predicting the future dividends of XYZ Corp., you assume that the dividends will grow at a
rate of 7% per year. Then the future anticipated dividends per share are
Dividend today = Div0 = $10.00
Dividend next year = Div1 = Div0 (1 + g ) = $10 * (1 + 7%) = $10.70
2 2
Div2 = Div1 (1 + g ) = Div0 (1 + g ) = $10 * (1 + 7%) = $11.45
3 3
Div3 = Div2 (1 + g ) = Div0 (1 + g ) = $10 * (1 + 7%) = $12.25
.. ..
. .
t
Divt = Div0 (1 + g )
The three dots ( . . . ) indicate that you think that the dividend stream is very long (when we write
the actual model, we will assume that the dividend stream goes on forever).
Suppose you think that the appropriate discount rate for the dividend stream is XYZ’s cost
of equity rE = 15%. Using rE to discount the future anticipated dividends, you get the fair value
of the XYZ Corp.’s stock today (we will denote this by P0):
Valuing XYZ Corp. stock :
Div1 Div2 Div3
Fair share value today, P0 = + + +…
(1 + rE ) (1 + rE ) (1 + rE )3
2

2 3
Div0 (1 + g ) Div0 (1 + g ) Div0 (1 + g )
= + + +…
(1 + rE ) (1 + rE )2 (1 + rE )3
Div0 (1 + g )
=
rE − g
The last line of the above formula uses a formula for the present value of a constant-growth
annuity developed in Chapter 2 (page 67): The present value of the cash flows Div0 (1 + g),
Div0(1 + g)2, Div0(1 + g)3, . . . at the discount rate rE is

∞ t
Div0 (1 + g ) Div0 (1 + g )
P0 = ∑
8
= , when g < rE .
t
(1 + rE ) rE − g
t =1
8
The condition g < rE means that the absolute value of g is less than the absolute value of rE. If a firm’s
dividends have positive growth, then this is the same as assuming that 0 < g < rE.
 CHAPTER 6 Choosing a Discount Rate 195

Applying the valuation model to XYZ stock gives

2 3
10 (1.07 ) 10 (1.07 ) 10 (1.07 )
Fair share value today, P0 = + + +…
(1.15 ) (1.15 )2 (1.15 )3
This is Div0 (1+ g )
↓
&"""'"""(
10 (1.07 )
= = 133.75
0.15 − 0.07$
!""""#""""
↑
This is rE − g

Here’s a spreadsheet implementation of the Gordon dividend model.

A B C
1 VALUING XYZ CORP. SHARES
2 Current dividend, D0 10
3 Dividend growth rate, g 7%
4 Cost of equity, rE 15%
5 Share value 133.75 <-- =B2*(1+B3)/(B4-B3)

Using the Gordon Dividend Model to Calculate the Cost of Equity, rE

In the previous subsection we derived the value of a share P0 based on the current dividend per
share Div0, the anticipated growth rate of dividends g, and the cost of equity rE. In this section
we turn this formula around: We derive the cost of equity rE , based on the current value of a
share P0, the current dividend per share Div0, and the anticipated growth rate of dividends g.
According to the Gordon dividend model of the previous subsection, the stock price is given
by P0 = Div0 (1 + g )/(rE − g ) . Turning this formula around to solve for the cost of equity rE gives
Div0 (1 + g )
rE = +g.
P0

This is the Gordon dividend model cost of equity formula. In the Gordon dividend model
the cost of equity rE —the discount rate to be applied to equity cash flows—is the sum of two
terms:
Div0 (1 + g )
This is the anticipated dividend yield of the stock. Suppose you buy the
P0
• .
stock today, paying P0. Then you anticipate getting a next-period dividend of Div0(1 + g),
where g is the anticipated future growth rate of dividends. The term Div0 (1 + g ) is the
anticipated next period dividend return. P0
• g. This the growth rate of all future dividends paid on the stock.

Applying the Gordon Dividend Model Cost of Equity

Formula—A Simple Example
Consider a firm for which the current share price is P0 = $25.00 and that has just paid a per-
share dividend of Div0 = $3.00. Shareholders of the firm believe that dividends will grow at a
rate g = 8% per year. In this case the Gordon model cost of equity is rE = 20.96%.
196 PART ONE CAPITAL BUDGETING AND VALUATION

A B C
USING THE GORDON MODEL TO
1 COMPUTE THE COST OF EQUITY rE
2 Current dividend, Div0 3.00
3 Current share price, P0 25.00
4 Anticipated dividend growth rate, g 8%
5 Gordon model cost of equity, rE 20.96% <-- =B2*(1+B4)/B3+B4

Note that the Gordon model’s cost of equity rE is very sensitive to the parameter values. If,
for example, the dividend growth rate in the above example is 5%, then rE = 17.60%.

A B C
USING THE GORDON MODEL TO
1 COMPUTE THE COST OF EQUITY rE
2 Current dividend, Div0 3.00
3 Current share price, P0 25.00
4 Anticipated dividend growth rate, g 5%
5 Gordon model cost of equity, rE 17.60% <-- =B2*(1+B4)/B3+B4

6.4. Applying the Gordon Cost of Equity Formula—Courier Corp.

Courier Corp. (stock symbol CRRC) is a book manufacturer that has experienced rapid growth
of sales and profits. Courier’s financial year ends September 30. We use the Gordon dividend
model to calculate Courier’s cost of equity at the end of September 2002.
Here’s a spreadsheet that gives the relevant data and the calculations.

A B C
COURIER CORPORATION (CRRC)
1 Calculation of cost of equity using Gordon model
Year ended Dividend
2 30 Sept per share
3 1998 0.2533
4 1999 0.2667
5 2000 0.3200
6 2001 0.3700
7 2002 0.4000
8
9 g, growth rate of dividends 12.10% <-- =(B7/B3)^(1/4)-1
10 Div0, current dividend 0.40 <-- =B7
11 Div0*(1+g), dividend anticipated in 2003 0.45 <-- =B10*(1+B9)
12 P0, stock price, 30 Sept. 2002 37.99
13
14 rE, Gordon dividend model cost of equity 13.28% <-- =B11/B12+B9

To use the Gordon model to calculate the cost of equity in cell B14, we need the following
assumptions:
• The price of the share P0 is known. In this case P0 is the stock price on the date of the
calculation (30 September 2002). On this date P0 = $37.99.
 CHAPTER 6 Choosing a Discount Rate 197

• The current dividend per share Div0 is known. By “current dividend” we mean the
last dividend paid by the firm, which in this case is the year 2002 Courier dividend Div0
= $0.40 per share.
• The average growth rate of the dividends, g, can be derived. We derive this below
from the dividend series in cells B3:B8. Our assumption is that the average dividend
growth rate g can be calculated from the following assumption:

Div1998 = 0.2533
Div1999 = Div1998 (1 + g )
2
Div2000 = Div1998 (1 + g )
3
Div2001 = Div1998 (1 + g )
4
Div2002 = Div1998 (1 + g ) = 0.4000

Div2002 0.4000
This means that g = 4 −1= 4 − 1 = 12.10%
Div1998 0.2533
.
Given these assumptions, the cost of equity rE for Courier is given by

Div0 (1 + g ) 0.40 * (1 + 12.10%)

rE = +g= + 12.10% = 13.28%
P0 37.99

This is the calculation performed in cell B14.

Alternative Calculations of the Growth Rate

The implementation of the Gordon model illustrated above uses the geometric growth rate
D
g = 4 2002 − 1 to calculate the g in the Gordon model. Here are two alternative ways to com-
D1998
pute the growth rate, g:

• Alternative 1: Use a different time period. In the preceding example, we’ve assumed that
the future expected growth rate of dividends is predicted by the dividends between 1998
and 2002. However, we could—after some thought—decide that we need an extra year
of data and that the dividends are better predicted by the period 1997–2002. In this case
the dividend growth rate is

Div2002 0.40
g= 5 −1= 5 − 1 = 13.75%
Div1997 0.21

This changes the cost of equity because anticipated dividend growth g is higher in this
Div0 (1 + g )
alternative than before, the cost of equity rE = + g will be higher, as shown
P0
below.
198 PART ONE CAPITAL BUDGETING AND VALUATION

A B C
COURIER CORPORATION (CRRC)
1 Alternative 1: Using a different base year
Year ended Dividend
2 30 Sept per share
3 1997 0.2100
4 1998 0.2533
5 1999 0.2667
6 2000 0.3200
7 2001 0.3700
8 2002 0.4000
9
10 g, growth rate of dividends 13.75% <-- =(B8/B3)^(1/5)-1
11 Div0, current dividend 0.40 <-- =B8
12 Div0*(1+g), dividend anticipated in 2001 0.46 <-- =B11*(1+B10)
13 P0, stock price, 30 Sept. 2000 37.99
14
15 rE, Gordon dividend model cost of equity 14.95% <-- =B12/B13+B10

• Alternative 2: Ignore historical dividends altogether. You might decide that the past
history of Courier dividends is not indicative of its future dividend payouts. In this case,
you might want to use a different number altogether for the anticipated dividend growth
rate g. In the example below you’ve decided that the growth rate for Courier’s future
dividends is 15%. This gives a cost of equity of 16.21%.

A B C
COURIER CORPORATION (CRRC)
1 Alternative 2: Making up a future growth rate of dividends
2 g, growth rate of dividends 15.00%
3 Div0, current dividend 0.40
4 Div0*(1+g), dividend anticipated in 2001 0.46 <-- =B3*(1+B2)
5 P0, stock price, 30 Sept. 2000 37.99
6
7 rE, Gordon dividend model cost of equity 16.21% <-- =B4/B5+B2

A Final Alternative to Computing the Cost of Equity rE: Using the Total
Equity Payout Instead of Per-Share Data
In some of the years 1998–2002, Courier purchased stock from its shareholders in open-market
repurchase transactions. In many ways a share repurchase is like a dividend—both dividends
and repurchases represent money paid by the firm to its shareholders. The following Excel
spreadsheet computes the total dividends plus share repurchases in each of the years 1998–2002
and uses this “total equity payout” to compute the Gordon dividend model cost of equity rE.
The data in column C are for the total dividend paid out by Courier (total dividend =
dividend per share * number of shares); in column D we see the amount of cash paid out to
shareholders for the repurchase of their shares. Column E gives the total equity payout: the sum
of the dividends + repurchases. In column F we compute the year-on-year growth rates of total
equity payouts. As you can see, these are quite variable, especially when compared to the rela-
tively smooth growth of the cash dividends (columns B and C). In cell B14, we’ve decided to use
 CHAPTER 6 Choosing a Discount Rate 199

A B C D E F G
COURIER CORPORATION (CRRC)
1 Computing the total equity payout
Total equity
payout: Annual
Dividends growth of
Year ended Dividend Total Share + total dividend
2 30 Sept per share dividends repurchases repurchases payout
3 1998 0.2533 1,205,000 0 1,205,000
4 1999 0.2667 1,354,000 455,000 1,809,000 50.12% <-- =E4/E3-1
5 2000 0.3200 1,572,000 114,000 1,686,000 -6.80% <-- =E5/E4-1
6 2001 0.3700 1,824,000 0 1,824,000 8.19% <-- =E6/E5-1
7 2002 0.4000 2,086,000 0 2,086,000 14.36% <-- =E7/E6-1
8
9 Stock price, 30 Sept. 2002 37.99
10 Number of shares, 30 Sept. 2002 5,215,000
11 Market value of equity, 30 Sept. 2002 198,117,850 <-- =B10*B9
12
13 2002 total dividend 2,086,000 <-- =E7
14 Anticipated dividend growth rate 11.27% <-- =AVERAGE(F6:F7)
15
16 Gordon model cost of equity, rE 12.45% <-- =B13*(1+B14)/B11+B14

the average of the last 2 years of total cash payout growth rates as our prediction of the future
growth rate g. This gives us a cost of equity rE of 12.45% (cell B16):
Gordon dividend model for cost of equity
using all payouts to equity holders :
⎛ ⎞
⎜ ⎟
⎡Total current ⎤⎜ ⎟
⎢equity payout = ⎥⎜ ⎟
⎢total dividends + ⎥⎜ 1 + g
) ⎟
⎢ ⎥⎜
anticipated ⎟
↑
⎣repurchases of stock ⎦ ⎜ Thegrowth rate ⎟
⎜⎝ of total equity ⎟
⎠
payouts
rE = +g
Total equity value today
2,086,000 * (1 + 11.27%)
= + 11.27% = 12.45%
198,117,850

Although there is some controversy attached to the use of total equity payouts to compute
the cost of equity rE , we think it is the correct method. In the examples for Courier Corp. that
follow, we will assume that the rE for Courier is 12.45%.

WHY DO FIRMS REPURCHASE STOCK?

In recent years share buybacks have exceeded dividends as a form of distribution to sharehold-
ers. Firms repurchase stock instead of paying extra dividends for several reasons:
• Repurchases are used to “soak up” extra cash and keep dividend growth predictable. Most
dividend-paying firms think their shareholders want to see a steady pattern of dividend
growth. So if they have extra cash, they’ll use it to buy back shares instead of increasing the
dividend paid to shareholders.
• Repurchases help reduce shareholder taxes on cash paid out to shareholders. When a div-
idend is paid, all the shareholders receiving the dividend pay taxes on it at their ordinary
income tax rate. Stock repurchases are voluntary (you don’t have to sell your stock back to
200 PART ONE CAPITAL BUDGETING AND VALUATION

the company). If you let your stock be repurchased, the gain in most cases is taxed at your
capital gains tax rate (lower than the ordinary income tax rate).
• Stock repurchases benefit both the shareholder who is bought out and the share-
holder who does not let his shares be repurchased. Why? When some of the shares
of the firm are repurchased, those shareholders who “stay in” the firm will get
a larger share of its income and dividend payments in the future. So all parties
gain.

6.5. Calculating the WACC for Courier

So far we’ve calculated Courier’s cost of equity as rE = 12.45%. This is the return demanded
by the company’s shareholders, taking into account their expectations of cash dividend growth
and stock repurchases. Now we want to calculate Courier’s weighted average cost of capital
E D Before we can do this, however, we need to compute the
WACC = rE + r (1 − TC )
E+D D E+D.
values of the following variables:
• E: the market value of Courier’s equity. As you can see from the previous spreadsheet,
on 30 September 2002, Courier had 5,215,000 shares worth $37.99 per share. This gives
E = 5,215,000 * $37.99 = $198,117,850.
• D: The value of Courier’s debt. On 30 September 2002, Courier had debt of $752,000.
This information comes from the company’s annual report (see Figure 6.3). Courier’s
debt includes both the current portion of long-term debt and the long-term debt itself.9
Note that Courier’s debt has declined significantly from the previous year: 2001 debt for
the company was $16,577,000.

September 28, 2002 September 29, 2001

Liabilities and Stockholders’ Equity

Current liabilities:
Current maturities of long-term debt $ 78,000 $ 76,000
Accounts payable (Note A) 6,708,000 11,933,000
Accrued payroll 7,642,000 6,652,000
Accrued taxes 6,965,000 6,092,000
Other current liabilities 6,362,000 6,789,000
Total current liabilities 27,755,000 31,542,000
Long-term debt (Notes A and D) 674,000 16,501,000
Deferred income taxes (Note C) 4,658,000 2,801,000
Other liabilities 2,652,000 2,446,000
Total liabilities 35,739,000 53,290,000

FIGURE 6.3 Courier’s liabilities from its balance sheet. The financial debt items are marked. The com-
pany repaid significant amounts of debt during the financial year.

9
The calculation of the WACC actually calls for the market value of the firm’s debt. However, this is a
number that is very difficult to calculate; instead it is standard practice to use the book value of the debt
as illustrated.
 CHAPTER 6 Choosing a Discount Rate 201

• rD, the cost of Courier’s borrowing. In theory rD ought to be the marginal cost of debt—
the borrowing rate of the company for additional debt. However, this rate is usually dif-
ficult to derive. A plausible alternative is to use information about the current borrowing
rate of the company. In Figure 6.3 you can see what the company reports about its debt
and from Courier’s profit and loss statement (Figure 6.4) you can learn about its interest
paid. We use the average borrowing rate of 5.54% (the rate applicable to most of the debt)
as the company’s cost of debt rD.

A B C D
COURIER CORPORATION (CRRC)
1 Analysis of interest paid
2 Year ending 30 September 2002 2001
3 Total debt 752,000 16,577,000
4 Interest paid 480,000
5
6 Average interest rate, rD 5.54% <-- =B4/AVERAGE(B3:C3)

For the Years Ended September 28, 2002 September 29, 2001 September 30, 2000

Net sales (Note A) $202,184,000 $211,943,000 $192,226,000

Cost of sales 137,991,000 150,572,000 144,132,000
Gross profit 64,193,000 61,371,000 48,094,000
Selling and administrative
expenses 39,602,000 39,258,000 31,406,000
Amortization of goodwill
(Note A) - 1,410,000 596,000
Interest expense 480,000 1,899,000 325,000
Other income (Note J) - (1,230,000) (119,000)
Income before taxes 24,111,000 20,034,000 15,886,000
Provision for income taxes
(Note C) 7,936,000 6,817,000 5,249,000
Net income $ 16,175,000 $ 13,217,000 $ 10,637,000

FIGURE 6.4 Courier’s income statements, showing interest of $480,000 paid in 2002.
Computing the interest paid on the average debt outstanding over the year (see Figure 6.3) gives
480,000
rD = = 5.54% . By dividing the company’s year 2002 taxes of
(752,000 + 16,577,000 )/ 2
7,936,000
$7,936,000 by its income before taxes, we arrive at a tax rate of TC = = 32.91% .
24,111,000

• TC, Courier’s tax rate. We can calculate Courier’s tax rate from its provision for income
7,936,000
taxes. Courier’s provision for income taxes in 2002 was TC = = 32.91% . We
24,111,000
use this as an estimate for the firm’s tax rate TC.

A B C D
COURIER CORPORATION (CRRC)
1 Analysis of taxes paid
2 Year ending 30 September 2002 2001 2000
3 Income before taxes 24,111,000 20,034,000 15,886,000
4 Provision for income taxes 7,936,000 6,817,000 5,249,000
5
6 Average tax rate 32.91% 34.03% 33.04%
202 PART ONE CAPITAL BUDGETING AND VALUATION

So What’s Courier’s WACC?

Here’s our calculation for Courier’s WACC.
A B C
COURIER CORPORATION (CRRC)
1 Calculating the WACC, Sept. 2002
2 Cost of equity, rE 12.45% <-- Computed from total equity payouts
3 Cost of debt, rD 5.54% <-- From Courier Corp. financial statements
4
5 Sept. 2002 equity value, E 198,117,850 <-- Number of shares times current share price
6 Sept. 2002 debt value, D 752,000 <-- From Courier Corp. financial statements
7 Total: Equity + Debt, E+D 198,869,850 <-- =SUM(B5:B6)
8
9 Percentage of equity, E/(E+D) 99.62% <-- =B5/B7
10 Percentage of debt, D/(E+D) 0.38% <-- =B6/B7
11
12 Tax rate, TC 32.91% <-- From Courier Corp. financial statements
13
14 WACC 12.41% <-- =B2*B9+B3*(1-B12)*B10

In the next section we’ll use the WACC of 12.41% for Courier to value the company.

6.6. Two Uses for the WACC

The weighted average cost of capital is the weighted average rate of return required by a com-
pany’s shareholders and debtholders. We presume that this rate of return reflects the average risk
of shareholder and debtholder future cash flows. This is plausible because we have derived the
cost of equity rE from anticipated future payouts to shareholders, and we have derived the cost
of debt rD from the rate demanded on the firm’s debts by its lenders. Thus, the WACC represents
a weighted average of the riskiness of shareholder and debtholder cash flows.
When the riskiness of a stream of cash flows is similar to the riskiness of the cash flows
received by shareholders and debtholders, the WACC is the appropriate risk-adjusted discount
rate. There are two important cases where this is often true:
• In capital budgeting situations. When a company is considering investing in a project
whose risk is comparable to the riskiness of the company as a whole, the WACC is an
appropriate discount rate for the project’s cash flows. We’ve previously illustrated this
use of the WACC in the White Water Rafting example of Section 6.2.
• To value the company as a whole. Later we define the concept of FCF. The value of the
Courier is the discounted value of its future anticipated FCFs, where the WACC is the
discount rate. The Gorgeous Fountain Water Company example of Section 6.2 gave a
preliminary discussion of this use of the WACC.
In this section we illustrate both these uses of the WACC for Courier.

Using the WACC as a Discount Rate for Projects

The WACC of Courier Corp. is 12.41%—this is the weighted average return demanded by
the firm’s shareholders and bondholders. Recall that Courier is in the book-printing business.
Suppose the company is thinking of investing in a project whose riskiness is like the riskiness of
its current business. This could be something as simple as another printing press to print more
 CHAPTER 6 Choosing a Discount Rate 203

books or a warehouse to house them, but it could also be something much more complicated—
like the acquisition of another printing company.
In all of these cases, the WACC is the natural starting point as a discount rate. What we
mean by “starting point” is that—in discounting the cash flows of the project—Courier should
assume that initial discount rate is 12.41% and then “tweak” the discount rate a bit to adjust for
perceived risks.
Let’s say that the company is considering buying a machine that will allow them to print
more books. The cash flows, NPV, and IRR of the machine are given below. If the riskiness
of the machine’s cash flows is similar to the riskiness of Courier’s overall cash flows, then the
WACC is a reasonable discount rate. The analysis below shows that the company should not
undertake the investment—the investment’s NPV is negative (-$11,777) and its IRR (7.80%) is
less than the WACC of 12.41%:

A B C
COURIER CORPORATION (CRRC)
1 Using the WACC as a discount rate
2 WACC 12.41%
3
4 Year Cash flows
5 0 -100,000
6 1 15,000
7 2 22,000
8 3 33,000
9 4 44,000
10 5 12,000
11
12 NPV -11,777 <-- =B5+NPV(B2,B6:B10)
13 IRR 7.80% <-- =IRR(B5:B10)
14
15 Extreme case: Cash flow riskiness same as Courier debt
16 Cost of debt 5.54%
17 Courier tax rate 32.91%
18 After-tax cost of debt 3.72% <-- =(1-B17)*B16

Of course there’s always room for adjustment because some of the assumptions we made
may not be as accurate as we thought. Suppose, for example, that the machine’s cash flows
are perceived to be much less risky than the overall cash flows of Courier. As an extreme case
we might consider the case where the machine cash flows are only as risky as Courier’s debt.
Because the company’s after-tax cost of debt is 5.54% * (1−32.91%) = 3.72%, this would then be
an appropriate discount rate for the project and the company should accept it (because the IRR
of 7.80% is higher than 3.72%).

Valuing Courier Corporation Using Its WACC and

Predicted Free Cash Flows (FCFs)
In the previous subsection we used the WACC to value a typical project of the firm. The second
major use of the WACC is to value companies. A complete explanation of this use of the WACC
will have to wait until Chapter 7, where we explain the use of the free cash flow (FCF) in detail.
For our purposes in this chapter, the FCF is the amount of cash generated by the company’s
business activities, by its operations as opposed to its financing activities. The FCF is “free” in
the sense that it can be used to provide cash to the firm’s shareholders and debtholders in the
204 PART ONE CAPITAL BUDGETING AND VALUATION

form of dividends and share repurchases (payments to shareholders) and interest payments (to
debtholders).
To accurately define the FCF, you need some familiarity with accounting. Here’s the definition
of the FCF.

Defining the Free Cash Flow (FCF)

Profit after taxes This is the basic measure of the profitability of the business,
but it is an accounting measure that includes financing flows
(such as interest), as well as noncash expenses such as depre-
ciation. Profit after taxes does not account for either changes
in the firm’s working capital or purchases of new fixed assets,
both of which can be important cash drains on the firm. The
FCF definition takes changes in working capital and purchases
of new fixed assets into account separately.
+ Depreciation This noncash expense is added back to the profit after tax.
The sum of the next two items is the change in net working capital, often denoted by ∆NWC
- Increase in current assets related to the fi rm’s When the firm’s sales increase, more investment is needed in
operations. inventories, accounts receivable, etc. This increase in cur-
rent assets is not an expense for tax purposes (and is therefore
ignored in the profit after taxes), but it is a cash drain on the
company. For purposes of calculating the FCF, the increase in
current assets does not include changes in cash and marketable
securities.
+ Increase in current liabilities related to the An increase in sales often causes an increase in fi nancing
firm’s operations related to sales (such as accounts payable or taxes payable).
This increase in current liabilities—when related to sales—
provides cash to the firm. The FCF includes all current lia-
bility items related to operations; it does not include financial
items such as short-term borrowing, the current portion of
long-term debt, and dividends payable.
- Capital expenditures (CAPEX) An increase in fixed assets (the long-term productive assets of
the company) is a use of cash, which reduces the firm’s FCF.
+ After-tax interest payments (net) FCF measures the cash produced by the business activity of
the firm. It is a flow to both debtholders and equity holders and
should therefore be cash before any distributions to the provid-
ers of financing. In particular we need to neutralize the effect
of interest payments that appear in the firm’s profit after taxes.
We do this by:
• Adding back the after-tax cost of interest on debt (after-
tax because interest payments are tax deductible),
• Subtracting out the after-tax interest payments on cash
and marketable securities.
FCF = sum of the above

In 2002 Courier Corp. had an FCF of $22,519,493. Cell B9 in the following spreadsheet
shows how this number is derived using the company’s consolidated statement of cash flows.
 CHAPTER 6 Choosing a Discount Rate 205

A B C
COURIER CORPORATION
1 Calculation of free cash flow for 2002
2 Profit after taxes 16,175,000 <-- =E11
3 Add back depreciation 10,687,000 <-- =B16
4 Changes in working capital
5 Subtract increases in current assets 4,515,000 <-- =SUM(B17:B19)
6 Add increases in current liabilities -2,411,000 <-- =B22+B21+B23
7 Subtract out capital expenditures -6,739,000 <-- =B27+B28
8 Add back after-tax interest 292,493 <-- =(1-B50)*B44
9 Free cash flow (FCF) 22,519,493 <-- =SUM(B2:B8)
10
11
12 CONSOLIDATED STATEMENT OF CASH FLOWS 2002
13 Operating activities
14 Net income 16,175,000
Adjustments to reconcile net income to cash
15 provided from operating activities
16 Depreciation and amortization 10,687,000
17 Change in accounts receivable 2,914,000
18 Change in inventory 728,000
19 Change in accrued taxes 873,000
20
21 Change in accounts payable -5,225,000
22 Deferred income taxes 1,531,000
23 Other changes in current liabilities 1,283,000
24 Cash provided from operating activities 28,966,000
25
26 Investment activities
27 Capital expenditures -4,918,000
28 Prepublication costs -1,821,000
29 Cash used for investment activities -6,739,000
30
31 Financing activities
32 Scheduled long-term debt repayments -76,000
33 Repayments of debt, net -15,750,000
34 Cash dividends -2,058,000
35 Stock repurchases 0
36 Proceeds from stock plans 1,114,000
37 Cash provided from financing activities -16,770,000
38
39 Increase (decrease) in cash and equivalents 5,457,000
40 Cash and equivalents at beginning of period 173,000
41 Cash and equivalents at end of period 5,630,000
42
43 Supplemental information
44 Interest paid 436,000
45
46 Income before taxes 24,111,000
47 Provision for income taxes 7,936,000
48 Net income 16,175,000
49
50 Tax rate =B47/B46 32.91%
206 PART ONE CAPITAL BUDGETING AND VALUATION

Using FCFs and WACC to Value Courier

In finance theory, the enterprise value of a company’s debt and equity is the value of its free
cash flows discounted at its weighted average cost of capital:
Enterprise value = Present Value value of future FCFs , discounted at WACC

The enterprise value represents the value today of the cash flows produced by the firm’s future
business activities. Suppose that you’ve performed a careful analysis of Courier Corp. and you
think the future growth of Courier’s FCF is 4% per year. Because Courier’s WACC is 12.41%,
its enterprise value is
Courier enterprise value = PV (FCFs, discounted at WACC )
∞ ∞ t
FCFt FCF2002 * (1 + FCF growth rate )
=∑ =∑
t =1 (1 + WACC )t (1 + WACC )t
t =1
∞ 22,519,493* 1 + 4% t
=∑
( ) = 22,519,493* (1 + 4% ) = 278,376,871
(1 + 12.41% )t 12.41% − 4%
t =1

Note that this valuation—like the Gordon dividend model of Section 6.3—makes use of the
constant-growth annuity formula developed in Chapter 2 (page 67):

∞ t
FCF2002 * (1 + FCF growth rate ) FCF2002 * (1 + FCF growth rate )
∑ t
=
WACC − FCF growth rate
t =1 (1 + WACC )
To get from this enterprise valuation to a valuation of the company’s shareholder equity, we
have to make two additional adjustments:
• We add in the cash and marketable securities balances of $5,630,000 that Courier has on
hand in 2002. The enterprise value measures the value today of Courier’s future FCFs.
The cash and marketable securities that the company has on hand today are not part of
these future FCFs, but they belong to the company, so they must be added. In cell B8
of the next spreadsheet, you can see that adding in the cash balances gives an estimated
asset value of $284,006,871.
• We subtract out the company’s debt of $752,000 in 2002. In cell B10, you can see that
subtracting out the debt value gives an estimated equity valuation of $283,254,871.
Here’s our valuation with these two adjustments.
A B C
1 VALUING COURIER
2 Year 2002 FCF 22,519,493
3 Anticipated FCF growth 4%
4 WACC 12.41%
5
6 Enterprise value 278,376,871 <-- =B2*(1+B3)/(B4-B3)

Initial cash and marketable From 2002 balance

7 securities 5,630,000 <-- sheet
8 Asset value 284,006,871 <-- =B6+B7
9 Debt value 752,000
10 Equity value 283,254,871 <-- =B8-B9
11
12 Number of shares 5,215,000
13 Per-share valuation 54.32 <-- =B10/B12
 CHAPTER 6 Choosing a Discount Rate 207

Our per-share valuation of Courier is $54.32: Because there are 5,215,000 shares, each
$283,254,871
share is worth = $54.32 . This compares favorably with the current share price
5,125,000
of Courier, $37.99, so this makes Courier (in the parlance of stock market analysts) a “buy”
recommendation.

Valuing Courier Using Mid-year Discounting

We introduced this topic in Chapter 5 (page 154). The idea was that because most cash flows
occur throughout the year, the appropriate discounting process should discount them as if they
occur mid-year. In terms of the computation just done for Courier, instead of calculating

2
FCF2002 (1 + FCF growth ) FCF2002 (1 + FCF growth )
Enterprise value = + +…
(1 + WACC ) (1 + WACC )2
FCF2002 (1 + FCF growth )
=
WACC − FCF growth
we should be calculating the

FCF2002 (1 + FCF growth ) FCF2002 (1 + FCF growth )

Enterprise valueMid -year discounting = +
(1 + WACC )0.5 (1 + WACC )1.5
⎡ FCF2002 (1 + FCF growth )⎤ 0.5
=⎢
WACC − FCF growth ⎥ * (1 + WACC )
⎣ ⎦
As explained in Chapter 5, mid-year discounting raises our valuation of cash flows because
the earlier a cash flow occurs, the more it is worth. If we use mid-year discounting for Courier,
then our valuation of Courier’s shares increases from $54.32 to $56.45.

A B C
VALUING COURIER
1 Using midyear discounting
2 Year 2000 FCF 22,519,493
3 Anticipated FCF growth 4%
4 WACC 12.41%
5
6 Enterprise value 295,149,271 <-- =(1+B4)^0.5*B2*(1+B3)/(B4-B3)

Initial cash and marketable From 2002 balance

7 securities 5,630,000 <-- sheet
8 Asset value 300,779,271 <-- =B6+B7
9 Debt value 752,000
10 Equity value 294,397,271 <-- =B6-B9
11
12 Number of shares 5,215,000
13 Per-share valuation 56.45 <-- =B10/B12

One Further Note: Doing Some Sensitivity Analysis

No valuation is complete without doing some sensitivity analysis on the main parameters. For
example, what happens to the per-share valuation if Courier’s WACC is 15% instead of the
12.41% we have used? What happens to the per-share valuation if Courier’s FCF growth rate is
5% instead of the 4% we used above? With Excel’s Data Table (Chapter 27) this is easy.
208 PART ONE CAPITAL BUDGETING AND VALUATION

A B C
VALUING COURIER
Sensitivity analysis
1 Still using mid-year discounting
2 Year 2000 FCF 22,519,493
3 Anticipated FCF growth 5% <-- 5% instead of 4%
4 WACC 15.00% <-- 15% instead of 12.41%
5
6 Enterprise value 253,569,392 <-- =(1+B4)^0.5*B2*(1+B3)/(B4-B3)

Initial cash and marketable From 2002 balance

7 securities 5,630,000 <-- sheet
8 Asset value 259,199,392 <-- =B6+B7
9 Debt value 752,000
10 Equity value 252,817,392 <-- =B6-B9
11
12 Number of shares 5,215,000
13 Per-share valuation 48.48 <-- =B10/B12

A B C D E F G H
1 Courier Valuation--Sensitivity Analysis
2 Year 2000 FCF 22,519,493
3 Anticipated FCF growth 5%
4 WACC 15.00%
5
6 Enterprise value 253,569,392 <-- =(1+B4)^0.5*B2*(1+B3)/(B4-B3)
Initial cash and marketable
7 securities 5,630,000
8 Asset value 259,199,392 <-- =B6+B7
9 Debt value 752,000
10 Equity value 252,817,392 <-- =B6-B9
11
12 Number of shares 5,215,000
13 Per-share valuation 48.48 <-- =B10/B12
14 Current share value 37.99
15
Data table: share value of Courier for various
=IF(B4>B3,B13,"nmf") assumptions on WACC and FCF growth rates
16
17 FCF growth rate
18 48.48 0% 2% 4% 6% 8% 10%
19 6% 73.95 113.23 231.04 nmf nmf nmf
20 WACC --> 8% 55.95 76.15 116.53 237.70 nmf nmf
21 10% 45.15 57.60 78.36 119.87 244.42 nmf
22 12% 37.94 46.47 59.27 80.59 123.24 251.20
23 14% 32.79 39.05 47.81 60.95 82.85 126.65
24 16% 28.92 33.74 40.16 49.15 62.64 85.12
25 18% 25.92 29.76 34.70 41.29 50.52 64.35
26 20% 23.51 26.66 30.60 35.67 42.43 51.89
27 22% 21.54 24.18 27.41 31.45 36.65 43.58
28 24% 19.89 22.15 24.86 28.17 32.31 37.64
29
Note: The valuation formula in cell B6 is correct only when
the WACC (cell B4) > growth rate (cell B3). Therefore we've put
a formula into cell B18 that indicates that when B3 exceeds B4,
the data table prints out "no meaningful figure" (nmf).
30
31
Note: The highlighted cells are combinations of WACC and FCF
growth for which the Courier valuation exceeds the current share
value of $37.99. We've used Excel's Conditional Formatting
32 to color these cells.
 CHAPTER 6 Choosing a Discount Rate 209

A more extensive sensitivity analysis can be performed by using the Data Table feature of
Excel explained in Chapter 27. In cells C19:H28 in the preceding spreadsheet you can see the
valuation of Courier for various combinations of WACC and FCF growth. The highlighted cells
are those combinations of WACC and FCF growth for which the per-share valuation exceeds
the current market value of $37.99.

Summing Up
In this chapter we have calculated the firm’s weighted average cost of capital (WACC). The
WACC is the risk-adjusted discount rate (RADR) for the firm’s free cash flows (FCFs). It is often
used to value projects with riskiness that is similar to the riskiness of the firm’s existing activ-
ities, and it is also used to derive the value of the firm. Both of these uses have been illustrated
in this chapter.
The WACC is defined as
E D
WACC = rE + rD (1 − TC )
E+D E+D
In the table below we summarize how we derived each of the elements of this formula.

Cost of equity rE We’ve used the Gordon model to determine the cost of equity:

Div0 (1 + g )
rE = +g,
P0

where Div0 = total dividends + stock repurchases of the current year

g = anticipated growth rate of dividends + repurchases
P0 = total equity value on current date
Cost of debt rD In principle, this should be the firm’s marginal borrowing rate, but this is often dif-
ficult to determine. For Courier, we used a number representative of the fi rm’s cost
of borrowing. An alternative is to use the firm’s average borrowing cost over the
previous year:

Interest paid in current year

rD =
Average debt , this year and last
Market value of equity E Current number of shares * current market price per share
Market value of debt D The market value of a firm’s debt is difficult to calculate. We almost always substi-
tute the book value of the firm’s debt for this number. In the Courier example we
showed how to determine this book value from the firm’s balance sheets.
Firm’s tax rate TC TC ought to be the firm’s marginal tax rate. In practice we usually use either of the
following:

a. The firm’s average tax rate, measured by:

Taxes from Profit and Loss Statement
average tax rate = = 33.04%
Profit before taxes

b. The firm’s statutory tax rates. Courier’s statutory Federal tax rate is 34%.
State taxes are another 2.98% of its income. Another estimate of its tax rates might
thus be 36.98% .
210 PART ONE CAPITAL BUDGETING AND VALUATION

A Final Warning
Cost of capital calculations are critical for valuations. Because cost of capital calculations
involve a mixture of theory and judgment, they are quite often controversial. Almost every
number in the preceding WACC calculation can be determined in several ways. In many cases
professionals do extensive sensitivity analysis on the WACC and the FCF growth to establish
a price range—the range of valuations that appears to be reasonable, given the variation in
plausible assumptions.
The most important modification you might want to make to the WACC calculation above
involves the cost of equity rE. An important competing model to the Gordon model is the capital
asset pricing model (CAPM). In Chapter 13 we will show you how to use this model to calculate
the cost of equity.

Exercises

1. Compute the weighted average cost of capital (WACC) for a company with the following:
Market value of debt $200,000
Market value of equity $300,000
Cost of debt, rD 7.5%
Cost of equity, rE 13%
Tax rate, TC 40%
2. Calculate the cost of equity rE for a company with the following:
Market value of debt $2,500,000
Market value of equity $1,000,000
Cost of debt, rD 5%
Tax rate, TC 25%
WACC 10%
3. Aboudy Corp.’s stock price is currently $22.00 per share. The company has just paid a dividend of
$0.55 per share, and shareholders anticipate that this dividend will grow in the future at a rate of
6% per year. Use the Gordon model to calculate the company’s cost of equity rE.
4. You wish to estimate the share price of Softy, your favorite underwear company. You know that tomor-
row the company will pay its annual dividend of $1.50 per share, and you anticipate that the company’s
futures dividends will grow at a rate of 4% per year. As an experienced investor, you demand a yield of
12% on your investment in the company. What should be the company’s share price?
5. XYZ Corp. has just paid a dividend of $5 per share. You think this dividend will grow at 8% per
year.
a. If you think the correct discount rate for the dividend stream of XYZ is 25%, how much should
you be willing to pay for the stock?
b. Show in an Excel graph the share’s price as a function of the XYZ dividend growth rate (let the
growth rate be 0, 2, 4, . . . , 20% ).
6. You just bought a share of ABC Corp. for $28. The company has just paid a dividend of $2 per
share, and you anticipate that this dividend will grow at a rate of 12% per year. What is your
implied cost of equity for ABC?
7. Gradcom’s anticipated next-year dividend is $1.20. Analysts anticipate that this dividend will grow
at a 4% annual rate.
 CHAPTER 6 Choosing a Discount Rate 211

a. If the stock’s current share price is $30, what is its cost of equity rE according to the Gordon
Model?
b. Show in an Excel graph the cost of equity as a function of the dividend growth rate (let the
growth rate be 0, 2, 4, . . . , 20%).
8. You are considering purchasing a stock of ABC Corp, which has just paid a $3 annual dividend
per share. The company does not repurchase any of its shares. You anticipate that the company’s
dividends will grow at a rate of 20% per year for the next 5 years. After this time, you think that
the growth of the annual dividends will slow to 5% per year. If your cost of equity for ABC is
10%, what price should you be prepared to pay for the stock?
9. Assume that Gradcom (from Exercise 7) has changed its dividend growth forecasts. The year-1
dividend is still anticipated to be $1.20, but the growth rate in the following 2 years is expected to
be 6 and 4%. After this, the annual dividend growth rate is expected to be 3%. If Gradcom’s cost
of equity is 10%, what will be its share price?
10. Consider the following data regarding Cinema Company.

A B C D E F
1 Cinema Company
Number of Payments
Year Dividend Total share from share
2 per share dividends repurchases repurchases Total
3 1995 0.25 ??? 0 0 ???
4 1996 0.25 ??? 115,000 140,000 ???
5 1997 0.3 ??? 0 0 ???
6 1998 0.31 ??? 200,000 260,000 ???
7 1999 0.35 ??? 120,000 180,000 ???
8 2000 0.37 ??? 0 0 ???
9 2001 0.39 ??? 0 0 ???
10 2002 0.42 ??? 120,000 220,000 ???
11
12 Stock price, end of 2002 1.83
13 Number of shares, January 1995 4,300,000

a. Complete the ??? in the spreadsheet above (assume that the dividend payment was before the
share repurchase).
b. Find the cost of equity rE of Cinema using the Gordon dividend model for the total equity
payout.
c. What would be Cinema’s cost of equity if we consider only the dividend payments without the
share repurchases?
11. It is 1 January 2005 and you are interested in finding the cost of equity rE of your company. After
a quick search you have found the following data:
• The company currently has 1,600,000 shares outstanding. The current share price is $3.
• The company’s earnings for 2004 were $2,000,000. The company policy has just paid
out $300,000 in dividends, and it intends to continue this 15% dividend payout from
earnings in the future.
• During 2004 the company spent $600,000 on share repurchases. It is the company’s
intention to increase the amount spent on share repurchases at the same growth rate as
the amount spent on dividends.
• Projected earnings growth is 2% per year.
Using the Gordon model for the total equity payout, what is the company’s cost of equity rE?
12. Suppose that a firm is financed with 70% equity and 30% debt. The interest rate on debt is 8%,
and the expected return on the common stocks is 17%. The firm’s tax rate is 40%. What is the
firm’s WACC?
212 PART ONE CAPITAL BUDGETING AND VALUATION

13. Your boss asked you to find the WACC of Welcome to Paradise company, based on the following
data:
• The company has 1,600,000 shares, currently sold for $2 per share.
• The company’s debt is $2,500,000. The interest paid last year by the company was
$300,000.
• The corporate tax rate is 40%.
• The cost of capital requested by the investors is 13%.
14. You are interested in calculating the cost of capital of Lion Company, based on the average WACC
of its industry, which is 11%. You know that the company stock price is $11, and it has 5,500,000
shares. The company cost of debt is 9%, its debt is $4,000,000, and the company’s tax rate is 40%.
What is the company’s cost of equity?
15. You want to compute the WACC of ABC Company. The company’s stock price is $8, and it has
a debt-to-equity ratio of 1. ABC’s cost of debt is 9%, its cost of equity is 12%, and the company’s
tax rate is 40%. What is the company’s WACC?
16. Assume the following data concerning ZZZ Company and use it to compute the company’s
WACC:
• The company has 2,000,000 shares, currently sold for $2.5 per share.
• The company’s debt is 3,000,000 from the company market value. The interest rate paid
last year by the company was $250,000.
• The company paid total dividend of $600,000 last year, and its expected dividend growth
is 3%. In addition, the company repurchases 150,000 of its shares.
• The corporate tax rate is 30%.
17. You have come up with the following data concerning Zion Company.
• The company has 2,500,000 shares.
• The company’s debt is 90% from the company market value. The interest rate paid last
year by the company was $500,000.
• The company paid total dividends of $800,000 last year, which is 25% of its pretax
profit, and its expected growth next year is $50,000 more.
• The company paid taxes of $950,000.
• The cost of capital requested by the investors is 13%.
What is the company’s WACC?
18. You have come up with the following data concerning your sister’s company.
• The company market value is $6,000,000.
• The company’s debt is 75% from the company market value. The interest rate paid last
year by the company was $450,000.
• The company paid total dividends of $600,000 last year, which is 20% of its pretax
profit, and its expected growth next year is $45,000 more.
• The company paid taxes in the amount of $1,200,000.
What is the company’s WACC?
19.
a. You are considering a new project for your firm. This project requires investment of $500,000
and generates cash flow of $70,000 for the next 10 years. You think that these cash flows are
completely riskless. You know that your company’s WACC is 14% and that the risk-free rate
is 6%. Should you take this project?
b. Should you take the project if its risk is comparable to the overall riskiness of the company’s
other activities?
 CHAPTER 6 Choosing a Discount Rate 213

20.
a. Sauce, a well-known pizza factory, has asked you to evaluate the factory FCF. You estimate
that the FCF of the factory is $4,500,000, its WACC is 12.5%, and its estimated growth is
5% each year. If you know that Sauce’s debt is $19,000,000 and it has 6,500,000 outstanding
shares, what should be its share price?
b. Repeat the question using mid-year discounting.
21. You are given the following information for Twin, Inc.

Long-term debt outstanding: $300,000

Current debt yield to maturity (rD): 8%
Number of shares of common stock: 10,000
Price per share: $50
Book value per share: $25
Expected rate of return on stock (rE): 15%

a. Calculate Twin, Inc.’s, WACC (assuming that the firm pays no taxes).
b. How would rE and the WACC change if Twin, Inc.’s, stock price falls to $25 because of declin-
ing profits? Assume that the business risk is unchanged.
CHAP TER

Using Financial Planning

7 Models for Valuation

CHAPTER CONTENTS
Overview 214
7.1. Initial Accounting Statements for a Financial Planning Model 215
7.2. Building a Financial Planning Model 218
7.3. Extending the Model to Years 2 and Beyond 225
7.4. FCF: Measuring the Cash Produced by the Firm’s Operations 226
7.5. Reconciling the Cash Balances—The Consolidated
Statement of Cash Flows 230
7.6. Valuing Whimsical Toenails Using a DCF Model 231
7.7. Using the DCF Valuation—A Summary 235
7.8. Sensitivity Analysis 238
7.9. Advanced Section: The Theory behind the DCF Model 241
Conclusion 243
Exercises 244

Overview
This chapter explains how to build spreadsheet models that allow you to predict the future
performance of a firm. These models are called financial planning models or pro forma mod-
els. Recall that accounting statements—the firm’s income statement, its balance sheet, and its

214
 CHAPTER 7 Using Financial Planning Models for Valuation 215

consolidated statement of cash flows—report what happened to the firm in the past. On the
other hand, a financial planning model predicts what the firm’s accounting statements will look
like in the future. In accounting jargon something that looks like an accounting statement but
that is forward looking is sometimes called a “pro forma” statement.
Financial planning models have a variety of uses:
• Projecting future financing needs of the firm: Building a financial planning model helps
you predict whether the firm will need financing in the future. It also helps you tie the
firm’s financing needs to its future performance. For example, does an increase in the
growth rate of sales create cash or use cash? The answer is not always clear: More sales
produce more profits (and hence produce more cash). However, an increase in the growth
rate of sales may also require more capital investment (machines, land, etc.) and may
require greater working capital (inventories, credit to clients, etc.). A financial planning
model can help us sort out these two opposing trends.
• Creating business plans: When you make a business plan (which you then take to inves-
tors to get financing or to a bank to explain why you need a loan and can pay it back),
you’ll often need to build a pro forma model of your firm. The model you build illustrates
your assumptions about the financial and business environment in which your firm will
operate in the future.
• Valuing a firm: Financial planning models can be used to predict the future free cash flows
(FCF), dividends, and profits of a firm. This chapter shows how to use the pro forma predic-
tion of FCF to value a firm. The valuation technique we employ—called discounted cash
flow (DCF) valuation—is the valuation technique universally favored by the finance profes-
sion. When a financial planning model is used to do a DCF valuation, it is also used to do
much of the sensitivity analysis that helps determine whether the valuation is reasonable.

Finance Concepts Used

• Present value and net present value
• Free cash flow (FCF)
• Gordon model
• Terminal value
• Mid-year valuation

Excel Functions Used

• NPV
• Sum
• If
• Relative versus absolute copying
• Circular references
• Data tables

7.1. Initial Accounting Statements for a Financial Planning Model

Financial planning models are predictions of what a firm’s future financial statements will look
like. To build such a model we start with the present—the firm’s current financial statements.
216 PART ONE CAPITAL BUDGETING AND VALUATION

To illustrate the process by which financial planning models are constructed, in the next sec-
tion we will project 5 years of financial statements for Whimsical Toenails, a company that
runs a chain of toenail-painting parlors. Whimsical’s management and bankers want to project
the firm’s future performance, and we will help them by constructing a financial planning
model.
Our starting point is Whimsical Toenail’s current income statement and balance sheet for
year-end 2004.

WHIMSICAL TOENAILS INCOME

STATEMENT 31 December 2004
Sales 10,000,000
Cost of goods sold -5,000,000
Depreciation -1,000,000
Interest payments on debt -320,000
Interest earned on cash 64,000
Profit before tax 3,744,000
Taxes (40% tax rate) -1,497,600
Profit after tax 2,246,400
Dividends -898,560
Retained earnings 1,347,840

WHIMSICAL TOENAILS BALANCE SHEET 31 December 2004

Assets Liabilities and equity

Cash 800,000 Current liabilities 800,000

Current assets 1,500,000 Debt 3,200,000
Fixed assets
Fixed assets at cost 10,700,000 Equity
Accumulated depreciation -3,000,000 Stock (paid-in capital) 4,500,000
Net fixed assets 7,700,000 Accumulated retained earnings 1,500,000
Total assets 10,000,000 Total liabilities and equity 10,000,000

Accounting versus Financial Planning Model Concepts

In the next section we build the Whimsical Toenails financial planning model. However, before
we do this, it is important to point out some differences between the use of certain concepts used
by accountants and their adaptation to financial modeling. Although most of the terminology
in this chapter follows the standard accounting classification, some changes are necessary to
accommodate the structure of financial planning models. For example, whereas accountants use
“current assets” to denote both operating current assets (like inventories and accounts receiv-
able—as yet unpaid customer bills) and financial short-term assets (like cash and marketable
securities), financial planning models use “current assets” to mean only operating short-term
assets. To emphasize this point, the terminology “operating current assets” is sometimes used.
Similarly, in the accounting framework “current liabilities” includes both operational items (like
accounts payable—bills that are as yet unpaid by the firm) and financial items (like short-term
 CHAPTER 7 Using Financial Planning Models for Valuation 217

debt and current portion of long-term debt). Financial planning models use “current liabilities”
to denote operational items only. To emphasize this point, we sometimes use the terminology
“operating current liabilities.”
The next two subsections discuss these differences between accounting and financial con-
cepts of current assets and current liabilities in more detail.

Current Assets—What’s Included in the Financial

Planning Model and What’s Not?
In financial planning models the “current assets” category contains only items that are related to
the operations of the firm. Here are several typical items that would be included in the financial
planning model definition of current assets.
• Accounts receivable: These are payments due from customers and are generated by
the operations of the firm. Because accounts receivable are generated by the firm’s
sales, they are included in the operating current assets of the financial planning
model.
• Inventories: Inventories include both raw materials to be used for production and unsold
finished products. Inventories are part of the operating current assets of the financial
planning model.
• Prepaid expenses: Prepaid expenses are costs that the fi rm pays before it actually receives
the associated services. An example might be rent paid by the firm for future periods:
If the firm pays this rent in advance (for example, not month by month, but 6 months in
advance), then this prepayment of the rent is recorded by the accountant as a prepaid
expense, which is part of current assets. For our financial planning model, we assume
that prepaid expenses are part of operating current assets.
Two important examples of accounting current assets that are not included in the financial
planning model definition of current assets are cash and marketable securities:
• Cash: The “cash” item on the balance sheet refers to money kept in the firm’s bank
accounts. Sometimes the accounting line item is called “cash and equivalents,” with the
second term denoting assets like certificates of deposit and money market accounts that
can be easily converted into cash. Cash is an operating current asset to the extent that it
is needed by the firm for its daily operations. In most cases, however, the cash accounts
on the balance sheets simply refer to nonoperating assets that are kept in liquid form by
the firm.
• Marketable securities: This item on the balance sheet refers to other financial assets—
such as stocks and bonds—bought by the firm. Marketable securities are not needed for
the firm’s operations and are thus not an operating current asset.
The distinction between cash as an operating asset and cash as a store of value is usually
obvious once you understand the business of the firm. A taxi driver needs to keep some cash
on hand to make change for his customers, and a supermarket needs to keep some cash in the
till for the same reason; in these cases at least some of the cash is an operating current asset
(although even for a taxi or supermarket, most of the cash is likely to be a financial, nonop-
erating current asset). On the other hand, in March 2003, Microsoft reported having $4.3 bil-
lion in cash and another $41.9 billion in marketable securities. It is unlikely that almost any
of this $46.2 billion is needed for daily operations. It is not an operating current asset, but
rather a financial current asset. In a fi nancial planning model financial current assets—cash
218 PART ONE CAPITAL BUDGETING AND VALUATION

and marketable securities not needed for the operations of the fi rm—are not included in the
current assets.

Current Liabilities
For purposes of the financial planning model, “current liabilities” contains only items that are
related to the operations of the firm. Here are two typical items that would be included in the
current liabilities of our financial planning model:
• Accounts payable: These are unpaid bills the firm owes to its suppliers. Because this
item is related to the operations of the firm, we include it in the financial planning model
definition of current liabilities.
• Taxes payable: When a firm’s payment of taxes does not coincide with the accounting
period, the taxes owed are entered into the balance sheet as a current liability. For exam-
ple, for the year ending 31 December 2005, XYZ Corp. owes $2,000 in taxes, but it won’t
pay this tax bill until 15 January 2006. The financial statements of XYZ Corp. for 2005
will report taxes of $2,000 in the income statement statement; the firm’s balance sheet
will report taxes payable of $2,000 in the current liabilities. Taxes payable relate to the
firm’s operations and are included in the financial planning model definition of current
liability.
Accounting current liability items that are not included in the financial planning model def-
inition of current liabilities are typically financial items. Here are two examples:
• Short-term debt: These are borrowings by the firm that are due within 1 year. A bank
overdraft (a credit line on a business’s checking account) is a good example of a short-
term debt. Accountants include this item in current liabilities, but financial planning
models include them as debt.
• Current portion of long-term debt: This is the portion of the firm’s debt that is due for
payment within the current financial year. Accountants include this item in current lia-
bilities; financial planning models include the current portion of long-term debt in the
debt category.

7.2. Building a Financial Planning Model

Now that we have our terminology straight, we can build our financial planning model for
Whimsical Toenails. A typical financial planning model has three major components:
• The model parameters. Also called the value drivers, a financial planning model’s param-
eters include the major assumptions of the model. For example, we might assume that
the sales growth parameter is 10% per year. Or we might assume that the current assets
to sales parameter is 15%—meaning that an increase of $1,000 in sales requires an
additional $150 of current assets. Typically, financial statement models are sales driven;
this term means that many of the most important financial statement value drivers are
assumed to be functions of the firm’s sales.
• The financial policy assumptions. We will make assumptions about how the firm
finances itself in the future. What is the mix between debt and new equity issued? Does
excess cash produced by the firm go toward repaying debt, is it distributed as payments
 CHAPTER 7 Using Financial Planning Models for Valuation 219

to shareholders, or does it end up in the firm’s cash balances? These assumptions are
important determinants of the firm’s future financial statements.
• The pro forma financial statements. Once we decide on the financial model’s param-
eters, we will build the pro forma financial statements for the firm we are modeling—the
income statement, balance sheets, and free cash flows (FCF).
When we’ve used the model’s parameters and the financing assumptions to project the
future financial statements of the firm, we can then use the model. By varying the model’s
assumptions, we can use the financial planning model to build different scenarios of how the
firm will perform in the future. In Sections 7.6–7.8 we use the financial planning model to pro-
ject the future FCFs of the firm to value the firm. We might also want to use the model to eval-
uate the ability of the firm to repay its debts (there’s an end-of-chapter exercise that illustrates
this use).

The Model’s Parameters—The Value Drivers

The sales growth parameter is usually the most important parameter of the financial planning
model. In our example Whimsical Toenails current (year 0) level of sales is $10,000,000. Over
the 5-year horizon of the financial planning model, the firm expects its sales to grow at a rate
of 10% per year.
Other model parameters are derived from the following financial statement relations.1
• Current assets: We assume that Whimsical’s end-year current assets on the balance sheet
will be 15% of the annual firm sales.
• Current liabilities: We assume that Whimsical’s end-year current liabilities on the bal-
ance sheet will be 8% of the annual firm sales.
• Net fixed assets: End-year net fixed assets are assumed to be 77% of annual sales.
• Depreciation: The annual depreciation charge is 10% of the average cost of the fixed
assets on the books during the year.
• Cost of goods sold: Assumed to be 50% of sales.
• Interest rate on debt: 10%.
• Interest earned on cash: Whimsical Toenails earns 8% on the average balances of cash.
• Tax rate: 40% of the firm’s profit before taxes.
• Dividends paid: We assume that Whimsical Toenails pays out 40% of its profits after
taxes as dividends to shareholders.

The Model’s Financial Policy Assumptions

The second component of a financial planning model is the model’s financial policy assump-
tions. In this initial financial planning model we make the following assumptions:
• Debt: Whimsical currently has debt of $3,200,000 on its balance sheet. The com-
pany’s agreement with the bank specifies that it will repay $800,000 of this debt in
each of the next 4 years. Once the debt is fully repaid, the company intends to stay
debt free.

1
In practice the model’s parameters are often derived from an analysis of the company’s historic financial
statements.
220 PART ONE CAPITAL BUDGETING AND VALUATION

• Stock: Company management does not intend to either issue new stock or repurchase
stock over the 5-year model horizon. The stock item in the firm’s balance sheets thus
remains at its 2004 level of $4,500,000.
• Cash. In our model this item is the plug: The cash item is defined so that the left-hand
side of the balance sheet always equals the right-hand side of the balance sheet:
Cash = Total liabilities and equity − Current assets − Net fixed assets

The plug is the balance sheet item that guarantees the equality of the future projected total
assets and the future projected total liabilities and equity. Every financial planning model has a
plug, and the plug is almost always cash (as in this case), debt, or stock.
To see how the plug fits into our model, consider the projected future balance sheets.

WHIMSICAL TOENAILS balance sheet model assumptions

Assets Liabilities and equity

Cash [PLUG] Current liabilities [8% of sales]

Current assets [15% of sales] Debt [repaid by $800,000/year until zero]
Fixed assets Fixed assets at cost-Accumulated Equity Stock (paid in capital) [constant]
depreciation [10% of average assets] Net fixed assets Accumulated retained earnings [previous year’s
[77% of sales] accumulated retained + this year’s retained from
income statement]
Total assets Total liabilities and equity

The plug assumption has two meanings:

1. The mechanical meaning of the plug: By defining cash to equal the total liabilities and
equity minus current assets and minus net fixed assets, we guarantee that future pro-
jected assets and liabilities will always be equal. This is important, because the two
sides of the balance sheet must always be equal. As mentioned previously, cash is not the
only candidate to plug the financial model; we could also use either stock or debt (there
are some examples of this in the end-of-chapter exercises). However, no matter what
your plug, its “mechanical” function is the same—to guarantee that the two sides of the
financial model’s balance sheet are equal.
2. The fi nancial meaning of the plug: Whimsical Toenails sells no additional stock and
is locked into a debt repayment schedule. By defining the plug to be cash, we are also
making a statement about how the firm finances itself. For the case of Whimsical
Toenails, this means that all incremental financing (if needed) for the firm will come
from the cash; it also means that if the firm has additional cash, it will go into this
account.

Projecting the 2005 Balance Sheet and Income Statement

Given Whimsical Toenails’ financial statements and our assumptions, we can now develop the
pro forma model and project the financial statements for 2005.
 CHAPTER 7 Using Financial Planning Models for Valuation 221

A B C D
WHIMSICAL TOENAILS
SETTING UP THE FINANCIAL STATEMENT MODEL
1 for 2005
2 Sales growth 10%
3 Current assets/Sales 15%
4 Current liabilities/Sales 8%
5 Net fixed assets/Sales 77%
6 Costs of goods sold/Sales 50%
7 Depreciation rate 10%
8 Interest rate on debt 10.00%
9 Interest earned on cash balances 8.00%
10 Tax rate 40%
11 Dividend payout ratio 40%
12
13 Year 2004 2005
14 Income statement
15 Sales 10,000,000 11,000,000 <-- =B15*(1+$B$2)
16 Costs of goods sold (5,000,000) (5,500,000) <-- =-C15*$B$6
17 Depreciation (1,000,000) (1,166,842) <-- =-$B$7*(C30+B30)/2
18 Interest payments on debt (320,000) (280,000) <-- =-$B$8*(B36+C36)/2
19 Interest earned on cash and marketable securities 64,000 57,595 <-- =$B$9*(B27+C27)/2
20 Profit before tax 3,744,000 4,110,753 <-- =SUM(C15:C19)
21 Taxes (1,497,600) (1,644,301) <-- =-C20*$B$10
22 Profit after tax 2,246,400 2,466,452 <-- =C21+C20
23 Dividends (898,560) (986,581) <-- =-$B$11*C22
24 Retained earnings 1,347,840 1,479,871 <-- =C23+C22
25
26 Balance sheet
27 Cash 800,000 639,871 <-- =C39-C28-C32
28 Current assets 1,500,000 1,650,000 <-- =C15*$B$3
29 Fixed assets
30 At cost 10,700,000 12,636,842 <-- =C32-C31
31 Depreciation (3,000,000) (4,166,842) <-- =B31-$B$7*(C30+B30)/2
32 Net fixed assets 7,700,000 8,470,000 <-- =C15*$B$5
33 Total assets 10,000,000 10,759,871 <-- =C32+C28+C27
34
35 Current liabilities 800,000 880,000 <-- =C15*$B$4
36 Debt 3,200,000 2,400,000 <-- =B36-800000
37 Stock 4,500,000 4,500,000 <-- =B37
38 Accumulated retained earnings 1,500,000 2,979,871 <-- =B38+C24
39 Total liabilities and equity 10,000,000 10,759,871 <-- =SUM(C35:C38)

EXCEL NOTE: RELATIVE VERSUS ABSOLUTE REFERENCING

The dollar signs within a formula indicate that when the formulas are copied the cell references
to the model parameters should not change. The technical jargon for this in Excel is absolute
referencing as opposed to the relative referencing when variables are indicated without dollar
signs. The distinction between absolute and relative copying is critical for financial planning
models—if you fail to put the dollar signs correctly in the model, it will not copy correctly when
you project years 2 and beyond.
222 PART ONE CAPITAL BUDGETING AND VALUATION

Two cells in the previous spreadsheet have been highlighted to stress this important
distinction:
• Cell B15: Sales in 2005 equal sales in the previous year times 1 + sales growth rate.
Because we want to copy this definition to subsequent cells, cell B15’s formula is
=B15*(1+$B$2). “$B$2” is the sales growth rate parameter, which stays the same as we
copy the cell contents.
• Cell B16: Cost of goods sold in 2005 equal 50% of 2005 sales. The 50% parameter is in
cell B6 and will stay the same as we copy the B16 formula to subsequent cells. Therefore,
we write the formula in cell B16 as =C15*$B$6.
The use of relative versus absolute referencing is explained in Chapter 24.

Income Statement Equations

Here are the relations for our financial planning model, with model parameters in boldface.
These relations will end up as the formulas in the cells of our Excel model.
• Sales(t) = Sales(t−1)*(1 + Sales growth)
• Costs of goods sold = Sales * Costs of goods sold/Sales
We assume that Whimsical’s only expenses related to sales are costs of goods sold. Most
companies also book an expense item called selling, general and administrative expenses
(SG&A). Exercise 2 at the end of this chapter illustrates how you would introduce SG&A into
the model.
• Interest payments on debt = Interest rate on debt * Average debt over the year. We
use this formula to estimate Whimsical’s interest payments on the debt. For example, if
the company’s debt at the end of 2004 is $3,200,000 and its debt at the end of 2005 is
$2,400,000, the financial planning model estimates its 2005 interest payments as

3,200,000 + 2,400,000
10% * = 10% * 2,800,000
!"""#"""$ = 280,000
2 ↑
Whimsical's
average debt
in year 1
.
• Interest earned on cash = Interest rate on cash * Average cash over the year. This is the
same logic used for the interest payments on debt. Whimsical earns 8% on its average
cash balances over the year. If end-2004 cash balances are $800,000 and end-2005 cash
balances are $639,871, then the firm earned $57,595 on its cash balances:
800,000 + 639,871
8% * = 8% * 719,935
!"""#"""$ = 57,595
2 ↑
Whimsical's
average cash
in year 1

• Depreciation = Depreciation rate * Average fixed assets at cost over the year. This
assumes that all new fixed assets are purchased more or less evenly throughout the
year. We also assume that there is no disposal of fixed assets. Looking at the financial
model may help you understand the calculation of the depreciation: Whimsical’s 2004
 CHAPTER 7 Using Financial Planning Models for Valuation 223

fixed assets at cost are $10,700,000 and its projected fixed assets at cost for 2005 are
$12,636,842. Because the company’s depreciation rate is 10%, its year-1 depreciation in
the income statement is
10,700,000 + 12,636,842
10% * = 10% *11,668,411
!""""#""""$ = 1,166,842
2 ↑
Average fixed
assets at cost
in year 1

• Profit before taxes = Sales − Costs of goods sold − Interest payments on debt + Interest
earned on cash & marketable securities − Depreciation.
• Taxes = Tax rate * Profit before taxes
• Profit after taxes = Profit before taxes − Taxes
• Dividends = Dividend payout ratio * Profit after taxes.
Whimsical Toenails has a policy of paying out a fixed percentage of its profits as dividends.
In the exercises for this chapter we explore some alternative dividend policies.
• Retained earnings = Profit after taxes − Dividends.

Balance Sheet Equations

• Cash = Total liabilities − Current assets − net fixed assets.
As explained earlier, this definition means that cash is the balance sheet plug.
• Current assets = Current assets/sales * Sales
• Net fixed assets = Net fixed assets/sales * Sales.
• Accumulated depreciation = Previous year’s accumulated depreciation + Depreciation
rate * average fixed assets at cost over the year.
• Fixed assets at cost = Net fixed assets + accumulated depreciation.
Note that this model does not distinguish among plant, property, and equipment (PP&E)
and other fixed assets, such as land.
• Current liabilities = Current liabilities/Sales * Sales.2
• Debt is assumed to decrease by $800,000 per year. This means that Whimsical Toenails
will repay all of its debt by the end of the fourth year of the financial model. An alterna-
tive model, which assumes that debt is the balance sheet plug, is the subject of one of the
end-of-chapter exercises.
• Stock is assumed to be unchanged. The company is assumed to issue no new stock or
repurchase any existing stock.
• Accumulated retained earnings = Previous year’s accumulated retained earnings +
current year’s additions to retained earnings.

2
Some modelers prefer to model current liabilities as a percentage of the firm’s cost of goods sold (COGS).
The thinking here is that—because current liabilities include the firm’s accounts payable (which in turn
include the firm’s unpaid bills for inventories and the like)—current liabilities are largely dependent on
the level of the firm’s costs of goods sold. Although it is easy to incorporate this assumption in our model,
it doesn’t make much difference: If COGS are a percentage of sales and current liabilities are a percentage
of sales, then the current liabilities are also a percentage of the COGS.
224 PART ONE CAPITAL BUDGETING AND VALUATION

EXCEL NOTE—SOLVING CIRCULAR REFERENCES

Financial statement models in Excel always involve cells that are mutually dependent. In our
model, for example, the interest earned on cash depends on the profits of the firm, but the
profits depend on the interest earned on cash. Another example of mutual dependence in our
model involves the fixed asset accounts: Fixed assets at cost are the sum of net fixed assets
plus accumulated depreciation, but accumulated depreciation is a function of the fixed assets
at cost.
As a result of these inevitable mutual dependencies, the solution of the model depends on
the ability of Excel to solve circular references. To make sure your spreadsheet recalculates, you
have to set your spreadsheet to allow for iterative calculations (for how to do this, read on in
this box). If you open a spreadsheet that involves iteration and the spreadsheet is not set up for
iterations, you will see the following Excel error message.

Get out of this message by clicking Cancel. Then click the Office button . From
here go to Excel Options|Formulas and click to enable iterative calculations.
 CHAPTER 7 Using Financial Planning Models for Valuation 225

Note that we have also clicked the Automatic button—this guarantees that the spreadsheet
will recalculate every time a new entry is made. If your spreadsheet is very large or your com-
puter somewhat aged, automatic recalculation can really slow you down. In this case it may be
wise to click the Manual button and recalculate the spreadsheet manually by pressing either the
F9 key or the [Shift]+F9 keys. (F9 recalculates the whole spreadsheet, and [Shift]+F9 recalcu-
lates only the current spreadsheet.)
FIGURE 7.1 Solving circular references in Excel.

7.3. Extending the Model to Years 2 and Beyond

Now that you have the model set up, you can extend it by copying the columns.

A B C D E F G
1 WHIMSICAL TOENAILS--FINANCIAL MODEL
2 Sales growth 10%
3 Current assets/Sales 15%
4 Current liabilities/Sales 8%
5 Net fixed assets/Sales 77%
6 Costs of goods sold/Sales 50%
7 Depreciation rate 10%
8 Interest rate on debt 10.00%
9 Interest earned on cash balances 8.00%
10 Tax rate 40%
11 Dividend payout ratio 40%
12
13 Year 2004 2005 2006 2007 2008 2009
14 Income statement
15 Sales 10,000,000 11,000,000 12,100,000 13,310,000 14,641,000 16,105,100
16 Costs of goods sold -5,000,000 -5,500,000 -6,050,000 -6,655,000 -7,320,500 -8,052,550
17 Depreciation -1,000,000 -1,166,842 -1,374,773 -1,613,102 -1,885,879 -2,197,668
18 Interest payments on debt -320,000 -280,000 -200,000 -120,000 -40,000 0
19 Interest earned on cash and marketable securities 64,000 57,595 47,355 42,349 42,755 80,609
20 Profit before tax 3,744,000 4,110,753 4,522,582 4,964,248 5,437,376 5,935,491
21 Taxes -1,497,600 -1,644,301 -1,809,033 -1,985,699 -2,174,950 -2,374,196
22 Profit after tax 2,246,400 2,466,452 2,713,549 2,978,549 3,262,426 3,561,295
23 Dividends -898,560 -986,581 -1,085,420 -1,191,419 -1,304,970 -1,424,518
24 Retained earnings 1,347,840 1,479,871 1,628,130 1,787,129 1,957,455 2,136,777
25
26 Balance sheet
27 Cash 800,000 639,871 544,001 514,730 554,145 1,461,078
28 Current assets 1,500,000 1,650,000 1,815,000 1,996,500 2,196,150 2,415,765
29 Fixed assets
30 At cost 10,700,000 12,636,842 14,858,615 17,403,417 20,314,166 23,639,190
31 Depreciation -3,000,000 -4,166,842 -5,541,615 -7,154,717 -9,040,596 -11,238,263
32 Net fixed assets 7,700,000 8,470,000 9,317,000 10,248,700 11,273,570 12,400,927
33 Total assets 10,000,000 10,759,871 11,676,001 12,759,930 14,023,865 16,277,770
34
35 Current liabilities 800,000 880,000 968,000 1,064,800 1,171,280 1,288,408
36 Debt 3,200,000 2,400,000 1,600,000 800,000 0 0
37 Stock 4,500,000 4,500,000 4,500,000 4,500,000 4,500,000 4,500,000
38 Accumulated retained earnings 1,500,000 2,979,871 4,608,001 6,395,130 8,352,585 10,489,362
39 Total liabilities and equity 10,000,000 10,759,871 11,676,001 12,759,930 14,023,865 16,277,770

The most common Excel mistake to make in the transition between the two-column finan-
cial model and this one is the failure to mark the model parameters with dollar signs. We discuss
this critical point in the Excel note on page 221. If you commit this error, you will get zeros in
places where there should be numbers.3

3
If this paragraph is mysterious to you, change the model by putting in the following mistake: In cell C28,
write the formula =C15*B3 (instead of the correct formula =C15*$B$3). Then copy cell C28 to D28:G28.
Now you will understand the importance of dollarizing the correct cell references!
226 PART ONE CAPITAL BUDGETING AND VALUATION

Understanding the Model by Changing Some of the Value Drivers

The financial model we’ve built shows that our firm’s profits after tax will grow from $2,246,400
in 2004 to $3,561,295 in 2009. The balances of cash grow from $800,000 to $1,461,078, the
firm’s total assets grow to $16,277,770, and so on . . . .
What would happen if we changed some of the value drivers in the model? For example,
what would happen to profits if the growth rate of sales were to be 8% instead of 10% and if the
cost of goods sold were to be 55% of sales instead of the 50% currently in the model? Given our
Excel model, we simply have to make the relevant changes in the parameters in cells B2 and B6.
Our intuition is that these performance changes will make the firm’s financial results worse, and
this is indeed confirmed in the model, as shown below.

A B C D E F G
1 WHIMSICAL TOENAILS MODEL WITH SOME CHANGES
2 Sales growth 8% <-- Changed from 10%
3 Current assets/Sales 15%
4 Current liabilities/Sales 8%
5 Net fixed assets/Sales 77%
6 Costs of goods sold/Sales 55% <-- Changed from 50%
7 Depreciation rate 10%
8 Interest rate on debt 10.00%
9 Interest earned on cash balances 8.00%
10 Tax rate 40%
11 Dividend payout ratio 40%
12
13 Year 2004 2005 2006 2007 2008 2009
14 Income statement
15 Sales 10,000,000 10,800,000 11,664,000 12,597,120 13,604,890 14,693,281
16 Costs of goods sold (5,500,000) (5,940,000) (6,415,200) (6,928,416) (7,482,689) (8,081,304)
17 Depreciation (1,000,000) (1,158,737) (1,348,145) (1,562,886) (1,806,057) (2,081,118)
18 Interest payments on debt (320,000) (280,000) (200,000) (120,000) (40,000) -
19 Interest earned on cash and marketable securities 64,000 55,181 39,185 26,432 16,813 42,050
20 Profit before tax 3,244,000 3,476,444 3,739,840 4,012,250 4,292,956 4,572,909
21 Taxes (1,297,600) (1,390,578) (1,495,936) (1,604,900) (1,717,182) (1,829,163)
22 Profit after tax 1,946,400 2,085,866 2,243,904 2,407,350 2,575,774 2,743,745
23 Dividends (778,560) (834,347) (897,562) (962,940) (1,030,309) (1,097,498)
24 Retained earnings 1,167,840 1,251,520 1,346,342 1,444,410 1,545,464 1,646,247
25
26 Balance sheet
27 Cash 800,000 579,520 400,102 260,691 159,629 891,628
28 Current assets 1,500,000 1,620,000 1,749,600 1,889,568 2,040,733 2,203,992
29 Fixed assets
30 At cost 10,700,000 12,474,737 14,488,162 16,769,550 19,351,589 22,270,768
31 Depreciation (3,000,000) (4,158,737) (5,506,882) (7,069,767) (8,875,824) (10,956,942)
32 Net fixed assets 7,700,000 8,316,000 8,981,280 9,699,782 10,475,765 11,313,826
33 Total assets 10,000,000 10,515,520 11,130,982 11,850,042 12,676,128 14,409,446
34
35 Current liabilities 800,000 864,000 933,120 1,007,770 1,088,391 1,175,462
36 Debt 3,200,000 2,400,000 1,600,000 800,000 0 0
37 Stock 4,500,000 4,500,000 4,500,000 4,500,000 4,500,000 4,500,000
38 Accumulated retained earnings 1,500,000 2,751,520 4,097,862 5,542,272 7,087,736 8,733,984
39 Total liabilities and equity 10,000,000 10,515,520 11,130,982 11,850,042 12,676,128 14,409,446

If you compare the model above to our previous version of the model, you’ll see that the
firm’s sales growth has slowed (from 10 to 8%) and that its sales have become more expensive
(cost of goods sold is 55% of sales instead of 50%). The result is that profits after taxes (row 22)
are lower than before. Cash balances (row 27) are also lower than in the previous version of the
model.

7.4. FCF: Measuring the Cash Produced by the Firm’s Operations

In this section we use our model to measure the firm’s projected free cash flow (FCF). We have
previously discussed the concept of FCF in Chapter 6. A good way to think of FCF is that it is
the amount of cash the firm would produce if it had no debt whatsoever. This is equivalent to
the amount of cash produced by the firm if the shareholders have to finance all of the operations
 CHAPTER 7 Using Financial Planning Models for Valuation 227

of the firm. For short, we’ll say that the FCF is a measure of the cash produced by the firm’s
operations.
The FCF is the measure on which we base our valuation of the firm. We gave an example of
this in Chapter 6 (page 206, where we used the future predicted FCFs of Courier Corp. to value
the company). In Section 7.6 we return to this topic and show how a financial planning model’s
predictions of FCFs can be used to value a company.
In this section we merely use the financial planning model to project the firm’s future FCFs.
Before we do so, however, let’s recap the definition and the terminology we use.
The definition of the free cash flow is as follows.

Defining the Free Cash Flow (FCF)

Profit after taxes This is the basic measure of the profitability of the business, but it is an
accounting measure that includes financing flows (such as interest), as well as
noncash expenses such as depreciation. Profit after taxes does not account for
changes in the firm’s working capital or purchases of new fixed assets, both of
which can be important cash drains on the firm.
+ Depreciation This noncash expense is added back to the profit after tax.
- Increase in current assets When the fi rm’s sales increase, more investment is needed in inventories,
accounts receivable, etc. This increase in current assets is not an expense for
tax purposes (and is therefore ignored in the profit after taxes), but it is a cash
drain on the company. Note that our use of the term “current assets” is slightly
different from the standard accounting usage—see the discussion in Section 7.1.
+ Increase in current liabilities An increase in the sales often causes an increase in fi nancing related to sales or
purchases (such as accounts payable or taxes payable). This increase in current
liabilities—when related to sales—provides cash to the fi rm. Because it is
directly related to sales, we include this cash in the FCF calculations. Note that
our use of the term “current liabilities” is slightly different from the standard
accounting usage—see the discussion in Section 7.1.
- Increase in fixed assets An increase in fixed assets (the long-term productive assets of the company) is a
at cost (also called “capital use of cash, which reduces the firm’s FCF.
expenditures”—CAPEX)
+ After-tax interest payments FCF is an attempt to measure the cash produced by the business activity of the
(net) firm. To neutralize the effect of interest payments on the firm’s profits, we
• Add back the after-tax cost of interest on debt (after-tax because
interest payments are tax-deductible) and
• Subtract out the after-tax interest payments on cash.
FCF = sum of the above The free cash flow measures the cash produced by the firm’s operations.

Here is the FCF calculation for Whimsical Toenails. Note that we have returned to the ini-
tial model (sales growth = 10%, cost of goods sold = 50% of sales).

A B C D E F G
42 Free cash flow calculation
43 Year 2004 2005 2006 2007 2008 2009
44 Profit after tax 2,466,452 2,713,549 2,978,549 3,262,426 3,561,295
45 Add back depreciation 1,166,842 1,374,773 1,613,102 1,885,879 2,197,668
46 Subtract increase in current assets -150,000 -165,000 -181,500 -199,650 -219,615
47 Add back increase in current liabilities 80,000 88,000 96,800 106,480 117,128
48 Subtract increase in fixed assets at cost -1,936,842 -2,221,773 -2,544,802 -2,910,749 -3,325,025
49 Add back after-tax interest on debt 168,000 120,000 72,000 24,000 0
50 Subtract after-tax interest on cash -34,557 -28,413 -25,410 -25,653 -48,365
51 Free cash flow 1,759,895 1,881,136 2,008,739 2,142,733 2,283,085
228 PART ONE CAPITAL BUDGETING AND VALUATION

The FCFs in row 51 are substantially lower than the firm’s profits after taxes in row 44. The
major reasons for this are the large capital expenditure (row 48), which outweighs the cash effect
of the depreciation (row 45).
The FCF calculations are sensitive to the model assumptions. Suppose that Whimsical
Toenail’s sales growth is 8% (instead of 10%) and that its cost of goods sold is 55% of sales
(instead of 50%). You might suspect that these negative changes in the model assump-
tions will make Whimsical’s future projected FCFs substantially lower, and you’re
right.

A B C D E F G
1 WHIMSICAL TOENAILS MODEL WITH SOME CHANGES
2 Sales growth 8% <-- Changed from 10%
3 Current assets/Sales 15%
4 Current liabilities/Sales 8%
5 Net fixed assets/Sales 77%
6 Costs of goods sold/Sales 55% <-- Changed from 50%
7 Depreciation rate 10%
8 Interest rate on debt 10.00%
9 Interest earned on cash balances 8.00%
10 Tax rate 40%
11 Dividend payout ratio 40%
41
42 Free cash flow calculation
43 Year 2004 2005 2006 2007 2008 2009
44 Profit after tax 2,085,866 2,243,904 2,407,350 2,575,774 2,743,745
45 Add back depreciation 1,158,737 1,348,145 1,562,886 1,806,057 2,081,118
46 Subtract increase in current assets (120,000) (129,600) (139,968) (151,165) (163,259)
47 Add back increase in current liabilities 64,000 69,120 74,650 80,622 87,071
48 Subtract increase in fixed assets at cost (1,774,737) (2,013,425) (2,281,388) (2,582,040) (2,919,179)
49 Add back after-tax interest on debt 168,000 120,000 72,000 24,000 0
50 Subtract after-tax interest on cash (33,108) (23,511) (15,859) (10,088) (25,230)
51 Free cash flow 1,548,758 1,614,633 1,679,670 1,743,160 1,804,266

EXCEL NOTE: HIDING AND GROUPING ROWS

In the above example we’ve hidden rows 12–40 to make more room on the screen. To hide rows
in Excel:
• Mark the rows you want to hide.
• Right-click on the mouse and click Hide.
 CHAPTER 7 Using Financial Planning Models for Valuation 229

Here’s what the screen looks like.

Marking the rows and clicking Unhide reverses the action.

Another slightly more sophisticated way to accomplish the same result is to Group the rows.
To do this, first mark the rows as before. Then go to Data|Outline|Group as shown below.

The result is a marker in the left-hand margin of the spreadsheet that allows you to hide or
unhide the rows: Clicking on the in the margin collapses the grouped rows. Clicking on the
in the margin expands the grouped rows. You can also use Ungroup and Group on the toolbar.
FIGURE 7.2 Hiding and grouping rows in Excel.
230 PART ONE CAPITAL BUDGETING AND VALUATION

7.5. Reconciling the Cash Balances—The Consolidated

Statement of Cash Flows
The free cash flow (FCF) calculation is different from the “consolidated statement of cash flows”
that is a part of every accounting statement. The FCF calculation shows you how much cash is
produced by the firm’s operations. On the other hand, the purpose of the accounting statement
of cash flows is to explain the increase in the cash accounts in the balance sheet as a function of
the cash flows from the firm’s operating, investing, and financing activities. Here’s the consoli-
dated statement of cash flows for our model.

A B C D E F G
WHIMSICAL TOENAILS–RECONCILING THE CASH BALANCES
1 Note that the profit and loss statement and FCF statement have been hidden
2 Sales growth 10%
3 Current assets/Sales 15%
4 Current liabilities/Sales 8%
5 Net fixed assets/Sales 77%
6 Costs of goods sold/Sales 50%
7 Depreciation rate 10%
8 Interest rate on debt 10.00%
9 Interest earned on cash balances 8.00%
10 Tax rate 40%
11 Dividend payout ratio 40%
12
25
26 Balance sheet
27 Cash 800,000 639,871 544,001 514,730 554,145 1,461,078
28 Current assets 1,500,000 1,650,000 1,815,000 1,996,500 2,196,150 2,415,765
29 Fixed assets
30 At cost 10,700,000 12,636,842 14,858,615 17,403,417 20,314,166 23,639,190
31 Depreciation (3,000,000) (4,166,842) (5,541,615) (7,154,717) (9,040,596) (11,238,263)
32 Net fixed assets 7,700,000 8,470,000 9,317,000 10,248,700 11,273,570 12,400,927
33 Total assets 10,000,000 10,759,871 11,676,001 12,759,930 14,023,865 16,277,770
34
35 Current liabilities 800,000 880,000 968,000 1,064,800 1,171,280 1,288,408
36 Debt 3,200,000 2,400,000 1,600,000 800,000 0 0
37 Stock 4,500,000 4,500,000 4,500,000 4,500,000 4,500,000 4,500,000
38 Accumulated retained earnings 1,500,000 2,979,871 4,608,001 6,395,130 8,352,585 10,489,362
39 Total liabilities and equity 10,000,000 10,759,871 11,676,001 12,759,930 14,023,865 16,277,770
40
41
54 CONSOLIDATED STATEMENT OF CASH FLOWS–RECONCILING THE CASH BALANCES
55 Cash flows from operating activities
56 Profit after tax 2,466,452 2,713,549 2,978,549 3,262,426 3,561,295
57 Add back depreciation 1,166,842 1,374,773 1,613,102 1,885,879 2,197,668
58 Adjust for changes in net working capital:
59 Subtract increase in current assets (150,000) (165,000) (181,500) (199,650) (219,615)
60 Add back increase in current liabilities 80,000 88,000 96,800 106,480 117,128
61 Net cash from operating activities 3,563,294 4,011,322 4,506,950 5,055,135 5,656,475
62
63 Cash flow from investing activities
64 Aquisitions of fixed assets–capital expenditures (1,936,842) (2,221,773) (2,544,802) (2,910,749) (3,325,025)
65 Purchases of investment securities 0 0 0 0 0
66 Proceeds from sales of investment securities 0 0 0 0 0
67 Net cash used in investing activities (1,936,842) (2,221,773) (2,544,802) (2,910,749) (3,325,025)
68
69 Cash flow from financing activities
70 Net proceeds from borrowing activities -800,000 -800,000 -800,000 -800,000 0
71 Net proceeds from stock issues, repurchases 0 0 0 0 0
72 Dividends paid (986,581) (1,085,420) (1,191,419) (1,304,970) (1,424,518)
73 Net cash from financing activities (1,786,581) (1,885,420) (1,991,419) (2,104,970) (1,424,518)
74 =C73+C67+C61
75 Net increase in cash and cash equivalents -160,129 -95,870 -29,271 39,415 906,933
76 Cash balances at end of previous year =B27 800,000 639,871 544,001 514,730 554,145
77 Cash balances at end of current year 639,871 544,001 514,730 554,145 1,461,078
78
79 =C75+C76 . This number should
80 be equal to cell C27 .
 CHAPTER 7 Using Financial Planning Models for Valuation 231

Row 77 checks that the ending balances in the cash accounts derived through the con-
solidated statement of cash flows match those derived in row 27 of the balance sheets (which
use cash as a plug). The fact that row 77 is the same as row 27 shows that our model correctly
accounts for all the accounting relations. To see this, look at cells C75, C76, and C77:
• C76 shows that at the end of year 0 the firm’s cash balances were $800,000.
• C75 shows that everything the firm did during the year—sales, costs of sales, interest
paid, new financing through debt and equity, . . . everything—produced a net decrease in
cash of $160,129.
• C77 is the sum of the previous two cells: If the firm started off the year with $800,000
in cash and if its total activities produced -$160,129 in cash, then the ending cash bal-
ances should be $639,871. And so they are—this is the cash listed in cell C27. Our model
accounts for all of the firm’s activities!

What’s more useful—The consolidated statement of

cash flows or the free cash flow?
What’s more useful—the cash increment in row 75 of the consolidated statement of cash flows
or the free cash flow we derived in Section 7.4? Although they both have their purposes, there’s
no doubt that for finance purposes the FCF is a more useful and more widely used number.
The FCF measures the cash produced by the firm’s business activities. It is the relevant finance
measure for the effectiveness of the firm at doing what it was founded to do—make something
and sell it. The cash increment in row 75 is also important, however: First, it allows us to check
that we’ve done our calculations correctly by giving a check and balance on the cash line in the
balance sheet. Second, it shows us why the cash line in the balance changed.

7.6. Valuing Whimsical Toenails Using a DCF Model

The terms “value of a company” or “value of a firm” are often used interchangeably by finance
professionals. Even finance professionals, however, can use a confusing variety of meanings for
these terms. In finance the definition most often used for “firm value” is the following:
The finance definition of firm value: The value of a firm is the market value of the firm’s
equity plus the market value of the firm’s financial debt.
The finance definition of firm value, which we use in this chapter, is not the only definition
of firm value that is in use. Often when individuals discuss the firm value, they really mean the
value of its shares. It is better to use the term equity value for the value of a company’s shares
and to use the term firm value (or company value) to denote the market value of the firm’s equity
plus its debt. In our calculations on page 233, we also show you how to compute the value of a
firm’s shares.
Sometimes the term firm value is used to denote the accounting value of the firm. Also
known as the book value, this value is based on the firm’s balance sheets. Because accounting
statements are based on historical values, people in finance generally prefer not to use this defi-
nition. At the end of this section we illustrate why we do not like this valuation method.
In this section we illustrate three methods of computing the finance definition of firm
value.
• The simplest valuation method is to value the firm’s equity (its shares) using the firm’s
share price in the market and to add to this the value of the firm’s debt.
232 PART ONE CAPITAL BUDGETING AND VALUATION

• A second valuation method, the DCF method, is based on discounted cash flows. This
is the method preferred by finance professionals; it is the main method illustrated in this
section. In a DCF valuation firm value equals the PV of the firm’s futures FCFs plus the
value of its currently available liquid assets. The discount rate is the firm’s WACC, which
we have previously discussed in Chapter 6.
• A third valuation method values the firm using the book value of a firm’s assets.

The Share Price Valuation Method: Valuing Whimsical

Toenails Using Current Share Price
The simplest way to value Whimsical Toenails is to look at the value of its share. Whimsical
Toenails has 1 million shares, which were trading on 31 December 2004 at $10 per share. Thus
the market value of the firm’s equity is $10 million. In addition, the company’s balance sheet
shows that it has debt of $3.2 million; we use these balance sheet values (also called book val-
ues) of the debt as an approximation of the debt’s market value.4
Using the current share price, the firm value of Whimsical Toenails is $13,200,000.

A B C
WHIMSICAL TOENAILS
1 Valuation using share price
2 Number of shares 1,000,000
3 Current share price 10.00
4 Market value of equity 10,000,000 <-- =B2*B3
5
6 Debt 3,200,000
7
8 Firm value: Market Value of Equity + Debt 13,200,000 <-- =B4+B6

The DCF Valuation Method: Valuing Whimsical

Toenails by Discounting Its Future Free Cash Flows
The advantage of the share-price valuation method illustrated above is that it is very simple: The
firm value equals the market value of the firm’s shares plus the book value of its debt. Valuing
the company at its current price of $10 per share is perfectly acceptable for someone considering
buying a few shares of the company, but it makes less sense if Whimsical Toenails is selling a
controlling block of shares. In this case the purchaser would probably have to take the following
considerations into account:
• If the purchaser tried to buy a big block of shares of Whimsical shares on the open mar-
ket, he might have to offer more than the current market price per share. As he bought
more and more shares, the price would go up; in addition, the announcement that some-
one was trying to take over Whimsical Toenails would—in many cases—force the share
price up.
• There are benefits to controlling a company that are not included in the market price
per share. The market price of a share reflects the value of a company’s future dividends
to a passive shareholder who has no control over the company. In general, the value of
a controlling block of shares is larger than the market value because the controlling

4
This is common practice. Most company debt is not traded on financial markets, and therefore there is
no easily available market value for the debt. As a first approximation, most finance professionals use the
book value of a firm’s debt as a proxy for the debt’s market value.
 CHAPTER 7 Using Financial Planning Models for Valuation 233

shareholder can actually decide what the company will do. He can also derive consider-
able private benefits from running the company.5
To deal with these problems, we use the discounted cash flow (DCF) valuation method to
value the shares. DCF valuations are a standard finance methodology, which defines the value
of the firm as the present value of the firm’s future free cash flows (FCF), discounted at the
weighted average cost of capital (WACC), plus the firm’s initial cash and marketable securities.
Section 7.9 discusses the theory behind this method of valuation, but for the moment we skip all
the theory and simply present the formula:

Market value Market value

DCF firm value = +
of firm ' s debt of firm ' s equity

⎛ all future FCFs ⎞ Today ' s cash and

= PV ⎜ ⎟+
⎝ discounted
!""""""""""" at WACC"$⎠ marketable securities
"#"""""""""""
↑
Often called the "enterprise value"
of the firm

As you can see in the equation, the present value of the firm’s future FCFs is often called
the firm’s enterprise value. Using the financial planning model for Whimsical Toenails, we con-
clude that when the WACC is 14%, the shares of Whimsical are worth $20.11.

A B C D E F G
1 WHIMSICAL TOENAILS–DCF VALUATION
2 Year 2005 2006 2007 2008 2009
3 Estimated free cash flow 1,759,895 1,881,136 2,008,739 2,142,733 2,283,085
4 Terminal value 30,250,880 <-- =F3*(1+B8)/(B7-B8)
5 Total 1,759,895 1,881,136 2,008,739 2,142,733 32,533,966
6
7 Weighted average cost of capital, WACC 14.00%
8 Long-term FCF growth 6.00%
9
10 Enterprise value, PV of future FCFs + terminal value 22,512,874 <-- =NPV(B7,B5:F5)
11 Add current cash & marketable securities 800,000
12 Firm value 23,312,874 <-- =B11+B10
13
14 Subtract out debt -3,200,000
15 Estimated value of equity 20,112,874 <-- =B12+B14
16
17 Number of shares 1,000,000
18 Estimated value per share 20.11 <-- =B15/B17

There are a few things to explain about this valuation:

• We have used the financial planning model of Section 7.4 to project 5 years of future
FCFs. At the end of the 5 years, we have projected a terminal value for the com-
pany. The DCF methodology requires us to estimate the PV of all the future FCFs:
⎛ all future FCFs ⎞
PV ⎜ ⎟ . However, instead of estimating all future FCFs, we
⎝ discounted at WACC ⎠

5
Economists use the term private benefits to denote all kinds of financial and nonfinancial benefits asso-
ciated with firm ownership. The big car with a driver that the company gives its president is a private
benefit of ownership and so is the feeling of ownership—a psychological benefit, perhaps, but nonetheless
valuable.
234 PART ONE CAPITAL BUDGETING AND VALUATION

estimate 5 years of FCFs and then estimate the terminal value, the value of Whimsical
at the end of year 5:

⎛ all future FCFs ⎞

Enterprise value = PV ⎜ ⎟
⎝ discounted at WACC ⎠
FCF2005 FCF2006 FCF2009 Terminal Value
= + + ... + +
(1 + WACC ) (1 + WACC ) 2 5
(1 + WACC ) (1 + WACC )
5

• The terminal value is estimated by assuming that the 2009 FCF of $2,283,085 will grow
in years 2010, 2011, . . . at a long-term FCF growth rate of 6% (cell B8). This means that
the terminal value is

Terminal value FCF2010 FCF2011 FCF2012

= + + + ...
at end of 2009 (1 + WACC ) (1 + WACC ) (1 + WACC )3
2

2
FCF2009 * (1 + LT growth ) FCF2009 * (1 + LT growth )
= +
(1 + WACC ) (1 + WACC )
2

3
FCF2009 * (1 + LT growth )
+ 3
+ ...
(1 + WACC )
FCF2009 * (1 + LT growth )
=
WACC − LT growth
$2,283,085* (1.06 )
= = $30,250,880
14% − 6%

The theory behind this is further explained in Section 7.9.

• If the weighted average cost of capital (WACC) is 14%, the enterprise value—the pre-
sent value of the free cash flows and the terminal value—is $22,512,874 (cell B10 in the
previous spreadsheet).6
• Adding current balances of cash and marketable securities to the present value of the
FCFs and subtracting out the value of the firm’s debts gives an equity valuation of
$20,112,874 (cell B15). Because there are 1 million shares outstanding, this values each
share at $20.11 (cell B18).
Thus, the conclusion from this DCF valuation is that the shares of Whimsical Toenails are
worth $20.11, more than double their current market value of $10.

Valuation Using the Firm’s Book Value—A Definition

We’d Rather Not Use
There’s another valuation method that is sometimes used to value a firm: The accounting def-
inition of firm value uses the balance sheet to arrive at the value of the firm. For the case of
Whimsical Toenails, the balance sheet at the end of 2004 looks like this:

6
See Chapters 6 and 13 for two techniques to compute the WACC.
 CHAPTER 7 Using Financial Planning Models for Valuation 235

A B C D E F
WHIMSICAL TOENAILS, BALANCE SHEET
1 31 December 2004
2 Assets Liabilities and equity
3 Cash and marketable securities 800,000 Current liabilities 800,000
4 Current assets 1,500,000 Debt 3,200,000
5 Fixed assets at cost 10,700,000
6 Accumulated depreciation -3,000,000 Common stock 4,500,000
7 Net fixed assets 7,700,000 Accumulated retained earnings 1,500,000
8 Total assets 10,000,000 <-- =B3+B4++B7 Total liabilities and equity 10,000,000 <-- =SUM(E3:E7)

By the accounting definition of firm value, the firm is worth

Firm value, accounting definition = Debt + Equity
= 3,200,000
!"""#"""$ + 4,500,000
!""""#""""$ + 1,500,000
!"""#"""$
↑ ↑ ↑
Debt Common Accumulated
stock retained earnings
!"""""""""#"""""""""$
↑
Book value of equity
= 9,200,000

The accounting definition of firm value relies on book values, the value of the firm’s debt
and equity as listed in the firm’s balance sheet. Recall from Chapter 3 that the accounting
definition, which is based on historical values, is a backward-looking definition. The finance
definition of firm value is a forward-looking definition (it discounts the future anticipated values
of the cash flows). In general, the accounting definition gives an inappropriate firm valuation.7 In
the case of Whimsical Toenails, the forward-looking DCF valuation of the firm is $23,312,874,
whereas the backward-looking accounting definition is $9,200,000.

7.7. Using the DCF Valuation—A Summary

The discounted cash flow (DCF) valuation of a firm is based on discounting the firm’s future
expected free cash flows (FCF), using the weighted average cost of capital (WACC) as the dis-
count rate. In this section we summarize the steps for implementing this valuation.

Step 1: Estimate the WACC

The WACC is the discount rate for the future FCFs. We discussed the WACC in Chapter 6 and
gave an example of how to estimate it.8 In this chapter we will not go into the details of esti-
mating the WACC; calculating the WACC entails many assumptions and in many cases the
calculation itself becomes a topic of controversy among the parties involved in the valuation.
For this example, we assume that the WACC is 14%. In Section 7.8 we perform some sensitivity
analysis (using an Excel Data Table, discussed in Chapters 4 and 27) to show how changes in
the WACC affect the valuation.

Step 2: Project a Reasonable Number of FCFs

A financial planning model’s predictions of future FCFs are based on the assumption that the
parameters of the model will not change by too much. Most financial analysts define “reasonable”

7
This is not meant to disparage accounting (very important) or accountants (most of whom would readily
agree that book values are an inappropriate approximation to market values).
8
Later in the book, Chapter 13 gives another approach to estimating the WACC.
236 PART ONE CAPITAL BUDGETING AND VALUATION

to mean number of periods over which this basic assumption is not too silly.9 Everyone recog-
nizes that a firm’s environment is dynamic and that the model parameters will change over time,
a fact that is usually addressed by doing sensitivity analysis (see Section 7.8). In our valuation
we assumed that we can reasonably project the next 5 years of cash flows.

Step 3: Project the Long-Term FCF Growth Rate and the Terminal Value
Valuation using the DCF method in principle requires us to project an infinite number of future
FCFs, but in a standard financial planning model we project only a limited number of FCFs.
A solution to this problem is to define the firm’s terminal value as the firm value at the end of
year 5. The definition we use is illustrated in Figure 7.3.

SCHEMATIC: DCF VALUATION OF THE FIRM

⎛ all future FCFs ⎞ Current cash and

DCF firm value = PV ⎜ +
⎝ discounted at WACC ⎠⎟ marketable securities

FCF1 FCF2 FCF3 Current cash and

= + + + ... +
(1 + WACC ) (1 + WACC )2 (1 + WACC )3 marketable securities

FCF1 FCF2 FCF3 FCF4 FCF5

= + + + + ← Line 1: We estimate these FCFs with
(1 + WACC ) (1 + WACC )2 (1 + WACC )3 (1 + WACC )4 (1 + WACC )5
a financial planning model

FCF6 FCF7
+ + + ... ← Line 2 : We use the terminal value
(1 + WACC )6 (1 + WACC )7
in place of these numbers:
1 FCF5 * (1 + long-term FCF growth )
WACC − long-"#"""""""""""""""
(1 + WACC )5 !"""""""""""""""term FCF growth "$
↑
This is the "terminal value"
Today ' s cash and
+ ← Line 3 : The last term in the valuation
marketable securities

FIGURE 7.3 A DCF valuation.

As you can see, there are three parts to this valuation equation:
• Line 1 is the present value of the first 5 years of free cash flows. We projected these cash
flows one by one, using our financial planning model.
• Instead of projecting the present value of each of the cash flows in years 6, 7, 8, . . . , infinity,
we summarized them in the present value of the terminal value. In Line 2 this is given as
1 FCF5 *(1+ long-term FCF growth )
.
(1+WACC ) 5
WACC −long-term
!"""""""""""""" FCF growth $
"#"""""""""""""""
↑
This is the “terminal value”

Terminal value is what we project the firm to be worth at the end of the projection hori-
zon. In Section 7.9 we explain how this expression for the terminal value is derived.

• Line 3 gives the value of the cash and marketable securities.

9
The author defines “not too silly” as something he can explain to his mother with a straight face.
 CHAPTER 7 Using Financial Planning Models for Valuation 237

The terminal value formula requires us to estimate the long-term FCF growth rate. In
the financial planning model for the Whimsical Toenails FCFs, this long-term growth rate is
different from the sales growth rate projected for the company’s next 5 years. As you saw in
Section 7.2, we project a growth rate of sales of 10% for Whimsical over the 5-year horizon of
the planning model. Our criterion for choosing the long-term FCF growth rate of the company
is that a company’s cash flows cannot grow forever at a rate greater than the economy in which
it operates. The long-term rate of 6% for Whimsical Toenails is meant to represent an estimate
of the company’s sustainable FCF growth rate.
Using this model, we estimate that Whimsical’s year-5 FCF is $2,283,085. Using the WACC
of 14% and the long-term FCF growth rate of 6%, the company’s terminal value is $30,250,880:
FCF * (1 + long-term FCF growth ) $2,283,085* (1 + 6% )
Terminal value = 5 = = $30,250,880
WACC − long-term FCF growth 14% − 6%

Step 4: Determine the Value of the Firm

At this point all the elements of the firm valuation formula are in place:
• WACC: the discount rate for the FCFs and the terminal value
• Five years of FCFs projected from the financial planning model
• The terminal value of the firm
• The firm’s initial (year 0) balances of cash and marketable securities
We can now value the firm.

A B C D E F G
1 WHIMSICAL TOENAILS–DCF VALUATION
2 Year 2005 2006 2007 2008 2009
3 Estimated free cash flow 1,759,895 1,881,136 2,008,739 2,142,733 2,283,085
4 Terminal value 30,250,880 <-- =F3*(1+B8)/(B7-B8)
5 Total 1,759,895 1,881,136 2,008,739 2,142,733 32,533,966
6
7 Weighted average cost of capital, WACC 14.00%
8 Long-term FCF growth 6.00%
9
10 Enterprise value, PV of future FCFs + terminal value 22,512,874 <-- =NPV(B7,B5:F5)
11 Add current cash & marketable securities 800,000
12 Firm value 23,312,874 <-- =B11+B10
13
14 Subtract out debt -3,200,000
15 Estimated value of equity 20,112,874 <-- =B12+B14
16
17 Number of shares 1,000,000
18 Estimated value per share 20.11 <-- =B15/B17

The value of the firm is $23,312,874 (cell B10). In cells B15 and B18 we’ve added two more
steps.

Step 5: Value the Firm’s Equity by Subtracting the Value of the

Firm’s Debt Today from the Firm Value
The firm value is the value of the firm’s debt + equity. We are often interested in valuing only
the firm’s equity—our estimate of the market value of the firm’s shares.
Firm value = Debt + Equity = $23,312,874
This means that
Equity = Firm value − Debt = $23,312,874 − $3,200,000 = $20,112,874
238 PART ONE CAPITAL BUDGETING AND VALUATION

Stock market analysts often use the estimate of a firm’s equity value to arrive at a per-share
valuation of the firm. They then compare this estimated per-share value to the current market
price to come up with a buy or sell recommendation for the stock. Because Whimsical Toenails
$20,112,874
has 1,000,000 shares outstanding, the estimated market value per share is = $20.11 .
1,000,000
This share valuation is much higher than the current market value per share of $10. If the
DCF valuation analysis were being used to make recommendations about the stock, we would
expect the analyst would make a “buy” recommendation for the shares of Whimsical Toenails.

Step 6: Adding Mid-year Valuation

In Chapter 5 (page 156) we discussed mid-year valuation of cash flows. The idea was that when
cash flows occur over the course of the year and not at the end of the year, we should take the
0.5
standard present value formula and multiply it by (1 + WACC ) . For Whimsical Toenails, mid-
year valuation makes sense, because the company’s sales occur throughout the year and not just
at year end. In the spreadsheet below you can see how mid-year valuation affects the value of the
firm and projected share valuation: Cell B10 shows that the present value of future cash flows
and terminal value firm value increases to $24 million. In cell B18 you can see that the projected
share value increases to $21.64 from the $20.11 computed without the mid-year valuation.

A B C D E F G
WHIMSICAL TOENAILS–DCF VALUATION
1 using mid-year discounting (see cell B10)
2 Year 2005 2006 2007 2008 2009
3 Estimated free cash flow 1,759,895 1,881,136 2,008,739 2,142,733 2,283,085
4 Terminal value 30,250,880 <-- =F3*(1+B8)/(B7-B8)
5 Total 1,759,895 1,881,136 2,008,739 2,142,733 32,533,966
6
7 Weighted average cost of capital, WACC 14.00%
8 Long-term FCF growth 6.00%
9
10 PV of future FCFs + terminal value 24,037,172 <-- =NPV(B7,B5:F5)*(1+B7)^0.5
11 Add current cash & marketable securities 800,000
12 Firm value 24,837,172 <-- =B11+B10
13
14 Subtract out debt -3,200,000
15 Estimated value of equity 21,637,172 <-- =B12+B14
16
17 Number of shares 1,000,000
18 Estimated value per share 21.64 <-- =B15/B17

Step 7: Don’t Trust Anything! Do a Sensitivity Analysis

Valuations are based on a formidable number of assumptions! Performing a sensitivity analy-
sis helps us evaluate the effect of changing values of the main variables on the value of the
firm. Our “weapon of choice” for sensitivity analysis is the Data Table feature of Excel (see
Chapter 27). In the next section we demonstrate the use of sensitivity analysis in the DCF valu-
ation of Whimsical Toenails.

7.8. Sensitivity Analysis

Given the full-blown financial planning model, there are obviously many sensitivity analyses
we can perform. Next we show two data tables. The first table analyzes the effect of the sales
 CHAPTER 7 Using Financial Planning Models for Valuation 239

A B C D E F G H I
1 WHIMSICAL TOENAILS–FINANCIAL MODEL
2 Sales growth 10%
3 Current assets/Sales 15%
4 Current liabilities/Sales 8%
5 Net fixed assets/Sales 77%
6 Costs of goods sold/Sales 50%
7 Depreciation rate 10%
8 Interest rate on debt 10.00%
9 Interest earned on cash balances 8.00%
10 Tax rate 40%
11 Dividend payout ratio 40%
12
13 Year 2004 2005 2006 2007 2008 2009
14 Income statement
15 Sales 10,000,000 11,000,000 12,100,000 13,310,000 14,641,000 16,105,100
16 Costs of goods sold -5,000,000 -5,500,000 -6,050,000 -6,655,000 -7,320,500 -8,052,550
17 Depreciation -1,000,000 -1,166,842 -1,374,773 -1,613,102 -1,885,879 -2,197,668
18 Interest payments on debt -320,000 -280,000 -200,000 -120,000 -40,000 0
19 Interest earned on cash and marketable securities 64,000 57,595 47,355 42,349 42,755 80,609
20 Profit before tax 3,744,000 4,110,753 4,522,582 4,964,248 5,437,376 5,935,491
21 Taxes -1,497,600 -1,644,301 -1,809,033 -1,985,699 -2,174,950 -2,374,196
22 Profit after tax 2,246,400 2,466,452 2,713,549 2,978,549 3,262,426 3,561,295
23 Dividends -898,560 -986,581 -1,085,420 -1,191,419 -1,304,970 -1,424,518
24 Retained earnings 1,347,840 1,479,871 1,628,130 1,787,129 1,957,455 2,136,777
25
26 Balance sheet
27 Cash 800,000 639,871 544,001 514,730 554,145 1,461,078
28 Current assets 1,500,000 1,650,000 1,815,000 1,996,500 2,196,150 2,415,765
29 Fixed assets
30 At cost 10,700,000 12,636,842 14,858,615 17,403,417 20,314,166 23,639,190
31 Depreciation -3,000,000 -4,166,842 -5,541,615 -7,154,717 -9,040,596 -11,238,263
32 Net fixed assets 7,700,000 8,470,000 9,317,000 10,248,700 11,273,570 12,400,927
33 Total assets 10,000,000 10,759,871 11,676,001 12,759,930 14,023,865 16,277,770
34
35 Current liabilities 800,000 880,000 968,000 1,064,800 1,171,280 1,288,408
36 Debt 3,200,000 2,400,000 1,600,000 800,000 0 0
37 Stock 4,500,000 4,500,000 4,500,000 4,500,000 4,500,000 4,500,000
38 Accumulated retained earnings 1,500,000 2,979,871 4,608,001 6,395,130 8,352,585 10,489,362
39 Total liabilities and equity 10,000,000 10,759,871 11,676,001 12,759,930 14,023,865 16,277,770
40
41
42 Free cash flow calculation
43 Year 2004 2005 2006 2007 2008 2009
44 Profit after tax 2,466,452 2,713,549 2,978,549 3,262,426 3,561,295
45 Add back depreciation 1,166,842 1,374,773 1,613,102 1,885,879 2,197,668
46 Subtract increase in current assets -150,000 -165,000 -181,500 -199,650 -219,615
47 Add back increase in current liabilities 80,000 88,000 96,800 106,480 117,128
48 Subtract increase in fixed assets at cost -1,936,842 -2,221,773 -2,544,802 -2,910,749 -3,325,025
49 Add back after-tax interest on debt 168,000 120,000 72,000 24,000 0
50 Subtract after-tax interest on cash -34,557 -28,413 -25,410 -25,653 -48,365
51 Free cash flow 1,759,895 1,881,136 2,008,739 2,142,733 2,283,085
52
53
54 Valuing the firm
55 Weighted average cost of capital, WACC 14%
56 Long-term growth rate of FCFs, g 6%
57
58 Year 5 FCF 2,283,085
59 Terminal value 30,250,880 <-- =B58*(1+B56)/(B55-B56)
60
61 Year 2004 2005 2006 2007 2008 2009
62 FCF 1,759,895 1,881,136 2,008,739 2,142,733 2,283,085
63 Terminal value 30,250,880 <-- =B59
64 Total 1,759,895 1,881,136 2,008,739 2,142,733 32,533,966
65
66 PV of row 64 22,512,874 <-- =NPV(B55,C64:G64)
67 Add in initial (year 0) cash and mkt. securities 800,000 <-- =B27
68 Firm value 23,312,874 <-- =B67+B66
69 Subtract out value of firm's debt today -3,200,000 <-- =-B36
70 Equity value 20,112,874 <-- =B68+B69
71 Per-share equity valuation 20.11 <-- =B70/1000000
72
73 Valuing the firm using midyear valuation
74 PV of row 64, with mid-year adjustment 24,037,172 <-- =NPV(B55,C64:G64)*(1+B55)^0.5
75 Add in initial (year 0) cash and mkt. securities 800,000 <-- =B27
76 Firm value 24,837,172 <-- =B75+B74 Sales Growth and Share Value
77 Subtract out value of firm's debt today -3,200,000 <-- =-B36
78 Equity value 21,637,172 <-- =B76+B77 22.00
79 Per-share equity valuation 21.64 <-- =B78/1000000
21.50
80
Data table: effect of sales growth on Sales
Share value

21.00
81 share value growth 21.64 <-- =B79
82 0% 20.25 20.50
83 2% 20.70
84 3% 20.89 20.00
85 6% 21.36
19.50
86 8% 21.55
87 10% 21.64 19.00
88 12% 21.60 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
89 15% 21.30
Sales growth
90 20% 19.98
91
240 PART ONE CAPITAL BUDGETING AND VALUATION

growth assumption (cell B2 of the model) on the share valuation. In our initial model we esti-
mated sales growth of 10% annually for the next 5 years. In rows 81–90, we use the Data Table
feature of Excel to explore the effect of different rates of sales growth on the share valuation of
Whimsical Toenails.
The sales growth assumption produces a surprising result: Up to a point, larger sales growth
rates produce large share valuations. But very large growth rates actually reduce the value of
the shares.10
A second sensitivity analysis examines the effect of the weighted average cost of capital
(WACC) and the long-term growth rate (cells B55 and B56) on the per-share valuation. Note
that these two parameters affect the valuation in two ways:
FCF * (1 + long-term FCF growth )
• The terminal value calculation in cell G63 is 5 . This
WACC − long-term FCF growth
computation is affected by both the long-term growth and the WACC parameters.
• The PV calculation in cell B66 is affected by the WACC.
To examine the effect of these two parameters, we build a two-dimensional data table.

A B C D E F G
95 =IF(B55>B56,B78,"nmf")
96 WACC
97 21,637,172 10% 14% 20% 22% 24%
98 0% 20,381,232 13,905,234 9,073,530 8,053,685 7,205,794
99 Long-term FCF growth 2% 24,469,956 15,623,442 9,743,593 8,571,101 7,613,120
100 4% 31,284,495 18,028,934 10,581,171 9,203,499 8,101,912
101 6% 44,913,574 21,637,172 11,658,057 9,993,996 8,699,323
102 8% 85,800,810 27,650,902 13,093,905 11,010,349 9,446,088
103 10% nmf 39,678,362 15,104,092 12,365,487 10,406,214
104 12% nmf 75,760,741 18,119,373 14,262,680 11,686,382
105 14% nmf nmf 23,144,842 17,108,469 13,478,617
106 16% nmf nmf 33,195,778 21,851,451 16,166,970
107
108 Note: Data tables are discussed in Chapter 27

The results produced by this sensitivity analysis are not surprising:

• Going across rows shows that as the WACC increases, the value per share decreases.
Because a larger WACC means that the present value of a future cash flow is less, this
is to be expected.
• Going down columns shows that the larger the long-term growth rate expected from
Whimsical Toenails, the more the shares are worth. Again, this is not a surprise, because
larger long-term growth rates mean higher FCFs after the year-5 model horizon. As
noted in the box on the next page, our terminal value model only works when the long-
term growth rate is less than the WACC. When this assumption is not true (meaning the
long-term growth > WACC), we’ve had Excel write “nmf” (“no meaningful figure”). The
technique for doing this is explained next.

10
The reason for this is probably that large sales growth rates require large amounts of new fixed assets.
This reduces the FCFs by enough to also reduce share value.
 CHAPTER 7 Using Financial Planning Models for Valuation 241

EXCEL/FINANCE NOTE

Note our use of the If function in cell B97 of the preceding data table. The terminal value formula is
FCF5* (1 + long-term FCF growth rate)
Terminal value =
WACC − long-term FCF growth rate
As noted in Chapter 2 (page 67), this formula is only valid when WACC > long-term FCF growth.
Because some of the combinations of growth and WACC in the data table violate this condition,
we’ve used the If function to isolate them. As used in cell B97, this function says

If(B55>B56, !"B78
"#""$ , "nmf"
!"
"#""$ )
↑ ↑
If WACC>long-term If WACC ≤ long-term
FCF growth, FCF growth,
put in the valuation write "no meaninful
as performed in cell figure"
B78

7.9. Advanced Section: The Theory behind the DCF Model

In this section we explain some theoretical points about the valuation model illustrated in
the previous section. Not all of this is easy, and you may (understandably) want to skip this
section.11

Why Is the Firm’s Value Related to the PV of the Future FCFs?

Our basic valuation formula is

Firm value = Debt + Equity

Initial cash
FCF1 FCF2 FCF3
= and marketable + 1
+ 2
+ 3
+…
securities (1 + WACC ) (1 + WACC ) (1 + WACC )
The enterprise value of the firm is defined to be the value of the firm’s operations. In finan-
cial theory, the enterprise value is the present value of the firm’s future anticipated cash flows.
In this section we explain these concepts.

The Valuation Process

One way of viewing valuation is through the use of the accounting paradigm, but using market
values. We rewrite the balance sheet by moving the current liabilities from the liabilities/equity
side to the asset side of the balance sheet.

11
Why would an author put a section like this in this book? Our experience is that ultimately almost all
finance professionals are called upon to do valuations. At some point in every valuation, someone is going
to question your techniques and theory. That’s the time to come back to this section.
242 PART ONE CAPITAL BUDGETING AND VALUATION

USING THE BALANCE SHEET AS AN

ENTERPRISE VALUATION MODEL
ORIGINAL BALANCE SHEET
Assets Liabilities
Cash and marketable securities Operating current liabilities
Operating current assets Debt
Net fixed assets Equity
Goodwill
Total assets Total liabilities and equity

THE ENTERPRISE VALUATION "BALANCE SHEET"

Assets Liabilities
Cash and marketable securities
Operating current assets Debt
- Operating current liabilities
=PV(FCFs discounted
= Net working capital
Net fixed assets Equity at WACC)
Goodwill
Firm value Firm value

To value a company, we set

FCFt
Firm value = Initial cash balances + ∑
t (1 + WACC )t
= Initial cash balances + Enterprise value

If we are valuing the equity of the firm, we subtract the value of the debt:

Equity value = Firm value − Debt

FCFt
= Initial cash balances + ∑ − Debt
(1 + WACC )t
t
FCFt
=∑ − Debt − Initial cash )
t (
t (1 + WACC )

Note that this means that we can write the enterprise balance sheet in a slightly different
form.

THE ENTERPRISE VALUATION "BALANCE SHEET"

A slight variation (cash netted out from debt)

Assets Liabilities
Operating current assets Debt - cash & Mkt. securities
- Operating current liabilities = Net debt
= Net working capital =PV(FCFs discounted
at WACC)
Net fixed assets Equity
Goodwill
Enterprise Value Enterprise Value

Note that both variations on the enterprise valuation "balance sheet"

give the same equity value.

We can use the FCF projections and a cost of capital to determine the enterprise value of
the firm. Suppose we have determined that the firm’s weighted average cost of capital (WACC)
 CHAPTER 7 Using Financial Planning Models for Valuation 243

is 20%.12 Then the enterprise value of the firm is the discounted value of the firm’s projected
FCFs plus its terminal value.
FCF1 FCF2 FCF5 Year -5 Terminal Value
Enterprise value = 1
+ 2
+ ... + 5
+
(1 + WACC ) (1 + WACC ) (1 + WACC ) (1 + WACC )5
In this formula, the Year-5 Terminal Value is a proxy for the present value of all FCFs from
year 6 onward.13

Terminal Value
In determining the terminal value we use a version of the Gordon model described in Chapter 6.
We have assumed that—after the year-5 projection horizon—the cash flows will grow at a long-
term FCF growth of 6%. This gives the terminal value as
∞ ∞ t
FCFt + 5 FCF5 * (1 + LT FCF growth )
Terminal Value at end of year 5 = ∑ =∑
(1 + WACC )t t =1
t =1 (1 + WACC )t
FCF5 * (1 + LT FCF growth )
=
WACC − growth

The last equality is derived in a manner similar to the dividend valuation of shares (the Gordon
model) discussed in Chapter 6.

Conclusion
In this chapter we’ve used Excel to construct financial planning models. These models, also
called pro forma models or financial planning models, have a variety of uses in finance. Financial
planning models are at the heart of most business plans, the financial projections that firms use
to persuade banks to loan them money and to persuade investors to buy their shares. Financial
planning models are used to value firms (see Chapter 8) and to build scenarios showing how the
firm will perform under various operating and financial assumptions.
Building a financial planning model is a powerful intellectual exercise: It forces you to
combine accounting statements, a firm’s operational parameters, and the firm’s financing into
one integrated model of the firm.
To do a DCF valuation you have to understand almost all facets of the business:
• How the business works—this affects the financial parameters used in the financial plan-
ning model. The composition of the firm’s current assets and current liabilities (meaning
its net working capital needed to do its business) and the amount of fixed assets (build-
ings and equipment and land) needed to do this business—all of these factors affect a
firm’s valuation.
• How to compute the cost of capital. The WACC is the discount rate used to value the
future FCFs of the firm. In this chapter we have not discussed its computation (Chapters
6 and 13 give different methods of computing the WACC).
• How to use Excel to do the relevant computations.

12
In Chapter 6 we introduced the topic of the WACC and showed you how to calculate this using the
Gordon dividend model. In Chapter 13 we show an alternative calculation of the WACC that uses the secu-
rity market line. In this chapter we simply assume a value for the WACC.
13
We don’t actually project these cash flows. We determine the terminal value based on year-5 FCF.
244 PART ONE CAPITAL BUDGETING AND VALUATION

Exercises
Note: The CD-ROM that comes with Principles of Finance with Excel contains an Excel notebook
entitled PFE2, chapter07template.xlsm. Except for Exercise 1, this template can be used as the basis
for almost all the problems (although you may have to make some changes in the template).
1. The following data describes the activity of your firm in the previous year:
• The company’s cash at the end of the year was $105,000.
• The company owes $20,000 to its suppliers.
• The company bought securities in the amount of $22,000.
• The company’s income during the year was $170,000. Of this amount only 70% was paid.
• The company was forced to pay damages to one of its clients of $40,000. This amount has still
not been paid.
• The company had materials inventory of $7,500 and product materials of $5,000 at the end of
the year.
• The company has to pay $12,000 to its bank in the following year.
• The company tax payment is $45,000. Half of the taxes remain unpaid and are due in the cur-
rent year.
• The company rented a store for 3 years at the beginning of the year, paying $14,000 for each
year in advance for the entire period.
Calculate the firm’s operating current assets and its operating current liabilities.
2. Build a financial model on the following template. Assuming that the WACC is 20%, value the
company’s equity.
A B C D E F G
1 FINANCIAL MODEL TEMPLATE
2 Sales growth 10%
3 Current assets/Sales 15%
4 Current liabilities/Sales 8%
5 Net fixed assets/Sales 77%
6 Costs of goods sold/Sales 50%
7 Depreciation rate 10%
8 Interest rate on debt 10.00%
9 Interest paid on cash and marketable securities 8.00%
10 Tax rate 40%
11 Dividend payout ratio 40%
12
13 Year 0 1 2 3 4 5
14 Income statement
15 Sales 1,000
16 Costs of goods sold (500)
17 Interest payments on debt (32)
18 Interest earned on cash and marketable securities 6
19 Depreciation (100)
20 Profit before tax 374
21 Taxes (150)
22 Profit after tax 225
23 Dividends (90)
24 Retained earnings 135
25
26 Balance sheet
27 Cash and marketable securities 80
28 Current assets 150
29 Fixed assets
30 At cost 1,070
31 Depreciation (300)
32 Net fixed assets 770
33 Total assets 1,000
34
35 Current liabilities 80
36 Debt 320
37 Stock 450
38 Accumulated retained earnings 150
39 Total liabilities and equity 1,000
 CHAPTER 7 Using Financial Planning Models for Valuation 245

3.
a. The model in Exercise 2 includes costs of goods sold but not selling, general, and administra-
tive (SG&A) expenses. Suppose that the firm has $200 of these expenses each year, irrespective
of the level of sales. Change the model to accommodate this new assumption. Show the result-
ing income statements, balance sheets, the free cash flows (FCF), and the valuation.
b. Build a data table in which you show the sensitivity of the equity value to the level of SG&A.
Let SG&A vary from $0 per year to $600 per year.
4. Suppose that in the model in Exercise 2 the fixed assets at cost for years 1–5 are 100% of sales (in
the current model, it is net fixed assets that are a function of sales). Change the model accordingly.
Show the resulting income statements, balance sheets, and free cash flows (FCF) for years 1–5.
(Assume that in year 0, the fixed assets accounts are as shown in Section 7.2. Note that because
year 0 is given—it is the current situation of the firm, whereas years 1-5 are the predictions for the
future—there is no need for the year 0 ratios to conform to the predicted ratios for years 1–5.)
5. Back to the model of Exercise 2. Suppose that the fixed assets at cost follow the following step
function:
⎧100% * Sales if Sales ≤ 1,200
⎪
Fixed Assets at Cost = ⎨1,200 + 90% * (Sales − 1,200 ) 1,200 < Sales ≤ 1,400
⎪1,380 + 80% * (Sales − 1,400 ) Sales > 1,400
⎩

Incorporate this function into the model.

6.
a. Consider the model in Exercise 2. Make two changes in the model: (i) Let debt be the plug
and keep cash constant at its year-0 level. (ii) Suppose that the firm has 1,000 shares and that
it decides to pay, in year 1, a dividend per share of $0.15. In addition, suppose that it wants this
dividend per share to grow in subsequent years by 12% per year. Incorporate these changes into
the pro forma model.
b. Do a sensitivity analysis in which you show the effect on the debt/equity ratio of the annual
growth rate of dividends. Vary this rate from 0 to 18%, in steps of 2%.
7. The Excel sheet below presents a firm’s balance sheet and income statement.
Assume the following:
• The firm expects its sales growth rate to be 10% per year.
• The current assets at the end of each year are 20% of the annual firm sales.
• The current liabilities at the end of each year are 15% of the annual firm sales.
• The net fixed assets at the end of each year are 320% of annual sales.
• The annual depreciation is 5% of the average of the fixed assets value during the year.
• The cost of goods sold is 50% of sales.
• Interest earned on cash is 5% on the average balances of cash.
• The tax rate is 40%.
Use the above data to project the financial statements for year 1.
246 PART ONE CAPITAL BUDGETING AND VALUATION

A B

BALANCE SHEET AND INCOME STATEMENT

1
2 Year 0
3 Income statement
4 Sales 50,000
5 Costs of goods sold (25,000)
6 Depreciation (20,000)
7 Interest earned on cash 7,000
8 Profit before tax 12,000
9 Taxes (40%) (4,800)
10 Profit after tax 7,200
11 Retained earnings 7,200
12
13 Balance sheet
14 Cash 140,000
15 Accounts receivable 10,000
16 Fixed assets
17 At cost 400,000
18 Depreciation (240,000)
19 Net fixed assets 160,000
20 Total assets 310,000
21
22 Current liabilities 20,000
23 Debt -
24 Stock 275,000
25 Accumulated retained earnings 15,000
26 Total liabilities and equity 310,000

8.
a. Extend the model of the previous exercise to 5 years.
b. The model in Exercise 8a contains the costs of goods sold (COGS) but doesn’t contain selling,
general, and administrative expenses (SG&A). Assume that this cost is $2,000 in year 0 and has
a growth rate of 7.5%. Make the appropriate adjustment to the model of Exercise 8a.
 CHAPTER 7 Using Financial Planning Models for Valuation 247

9. The following sheet presents a firm’s balance sheets and income statement.

A B C D E
1 BALANCE SHEET AND INCOME STATEMENT
2 Assets Liabilities and Equity
3 Current assets Current liabilities
4 Cash 10,000 Accounts payable 2,000
5 Prepaid expenses 1,500 Total current liabilities 2,000
6 Total current assets 11,500
7 Long-term liabilities
8 Debt 10,000
9 Fixed assets
10 At cost 30,000 Equity
11 Accumulate depreciation -14,000 Equity 10,500
12 Net Fixed assets 16,000 Accumulated retained earnings 5,000
13
14 Total assets 27,500 Total liabilities and equity 27,500
15
16 Income statement
17 Sales 20,000
18 Cost of Goods Sold (COGS) -12,000
19 Depreciation -2,000
20 Interest on cash 300
21 Interest payments on debt -400
22 Profit before tax 5,900
23 Tax (40%) -2,360
24 Profit after tax 3,540
25 Dividend -708
26 Retained Earnings 2,832

a. You believe that these financial statements are representative of the firm’s value drivers (For
example, if the sales are $20,000 and the COGS are $12,000, then the COGS to sales param-
eter is 60%). Find and calculate the value drivers that can be derived from the firm’s balance
sheet and P&L statement.
b. Use the following data to project the financial statements for year 1:
• The sales growth is 12%.
• The depreciation is 10% of the average of the fixed assets value during the year.
• The interest rate earned on cash is 5% on the average cash balances.
• The debt payments are $2,000 each year.
• The interest rate on debt is 8%.
c. Show in a graph the change in the firm’s profit relative to the change in the COGS.
10.
a. Extend the project of the previous exercise to 6 years.
b. The model we are dealing with doesn’t contain advertising and marketing costs (these are
usually a part of the SG&A). Assume that these costs are $800 in year 0 and 5% of sales in
years 1–6. Furthermore, assume that the firm has to pay each year for its license a fixed cost of
$1,500. Adjust the model in Exercise 10a to these new assumptions.
c. Show in a graph the change in the firm’s profit relative to the change in the license fee.
11. Compute the FCF for the firm model in Exercise 8a and Exercise 10a.
12. Compute the consolidated statements of cash flow for the firm’s model of Exercise 8a and
Exercise 10a.
13. The following sheet contains data concerning Donna Company’s balance sheet, income state-
ment, and its value drivers.
248 PART ONE CAPITAL BUDGETING AND VALUATION

A B C D E F G
1 DONNA'S BALANCE SHEET AND INCOME STATEMENT
2 Value Drivers
3 Sales growth 15%
4 Current assets/sales 20%
5 Current liabilities/sales 14%
6 Net fixed assets/sales 80%
7 Costs of goods sold/sales 45%
8 Depreciation rate 10%
9 Interest rate on debt 8%
10 Interest earned on average cash balances 5%
11 Tax rate 36%
12 Dividend payout ratio 30%
13 Annual debt repayments 6,000
14
15 Income statement
16 Year 0 1 2 3 4 5
17 Sales 45,000
18 Cost of goods sold (COGS) -33,000
19 Depreciation -4,000
20 Interest on cash 80
21 Interest payments on debt -150
22 Profit before tax 7,930
23 Tax (36%) -2,855
24 Profit after tax 5,075
25 Dividend -1,523
26 Retained earnings 3,553
27
28 Balance sheet
29 Assets
30 Cash 10,000
31 Current assets 4,700
32 Fixed assets
33 At cost 47,000
34 Accumulated depreciation -14,000
35 Net Fixed assets 33,000
36 Total assets 47,700
37
38 Liabilities and Equity
39 Current liabilities 4,000
40 Debt 30,000
41 Equity
42 Equity 10,000
43 Accumulated retained earnings 3,700
44 Total liabilities and equity 47,700

You know that Donna Company pays $6,000 of its debt every year and that the interest rate, paid
and earned, is on the average debt and cash balances, respectively, and the depreciation is on the
average fixed assets.
Make a model of Donna’s balance sheet, income statement, and its FCF evaluation for the follow-
ing 5 years based on these data.
14. Consider the following changes in the assumptions regarding Donna Company from Exercise 13:
• Assume the debt remains at its current level and the loan is paid back only at the end of year 5.
• The dividend has a constant growth of 15%, irrelevant of the increase in the company sales.
• The company pays a bonus of 5% from sales to its employees if the sales are more than
$70,000.
Combine these changes to the pro forma model and the FCF evaluation.
15. How will your answer to Exercise 13 change if you know that Donna Company intends to
increase its debt by 6% each year for the next 5 years and that the current liabilities are 25% of
COGS?
 CHAPTER 7 Using Financial Planning Models for Valuation 249

16. The following sheet presents the balance sheet of your fi rm.

A B C D E
1 BALANCE SHEET
2 Assets Liabilities and Equity
3 Current assets Current liabilities
4 Cash 72,000 Accounts payable 40,000
5 Marketable securities 80,000 Tax payable 35,000
6 Accounts receivable 42,000 Short-term debt 32,000
7 Prepaid expenses 15,000 Total current liabilities 107,000
8 Total current assets 209,000
9 Long-term liabilities
10 Debt 420,000
11 Fixed assets
12 At cost 500,000 Equity
13 Accumulated depreciation -25,000 Equity 120,000
14 Net fixed assets 475,000 Accumulated retained earnings 37,000
15
16 Total assets 684,000 Total liabilities and equity 684,000

What is the firm’s value according to the share price valuation model if the share price in the mar-
ket is $5.50 and there are 90,000 outstanding shares?
17. What is the share value of the firm of Exercise 16 using the book value? How do you explain the
difference between this valuation and the per-share market price?
18. The Yahoo! profile for PepsiCo Company (PEP) is given below. What is PEP’s firm value accord-
ing to the share price valuation model? What is the PEP book value?
250 PART ONE CAPITAL BUDGETING AND VALUATION
 CHAPTER 7 Using Financial Planning Models for Valuation 251

19. The Yahoo! profile for Boeing (BA) is given below. What is BA’s firm value according to the share
price valuation model? What is BA’s book value?
252 PART ONE CAPITAL BUDGETING AND VALUATION

20. Go back to the firm of Exercise 16. In the firm’s board meeting it was decided to evaluate the firm
using the DCF evaluation, and after performing evaluation you came up with the data described
in the following sheet.

A B C D E F
1 DCF VALUATION
2 Year 1 2 3 4 5
3 Estimated free cash flow 220,115 232,150 274,410 315,145 316,000
4 Terminal value 750,456
5 Total 220,115 232,150 274,410 315,145 1,066,456

What is the firm’s equity value, assuming the firm’s WACC is 18% and using the firm’s balance
sheet? What is the equity value per share?
21. Repeat Exercise 20, but instead of using the firm’s terminal value, assume that the FCF of the firm
from the 6th year will remain constant forever (perpetuity cash flow). Use mid-year discounting.
22. The following sheet presents the balance sheet and value drivers of Yummy Company, which
manufactures a very special tomato sauce.

A B C
1 Yummy Company, Financial model
2 Value drivers:
3 Sales growth 12%
4 Current assets/Sales 22%
5 Current liabilities/Sales 20%
6 Net fixed assets 5%
7 Costs of goods sold/Sales 45%
8 Depreciation rate 20%
9 Interest rate on debt 8.00%
10 Interest earned on cash balances 4.00%
11 Tax rate 36%
12 Dividend payout ratio 25%
13 Sales 2,000,000
14 Weighted average cost of capital 16%
15 Long-term FCF growth rate 4%
16
17 Balance sheet
18 Cash 460,000
19 Current assets 440,000
20 Fixed assets
21 At cost 4,000,000
22 Depreciation (500,000)
23 Net fixed assets 3,500,000
24 Total assets 4,400,000
25
26 Current liabilities 400,000
27 Debt 3,000,000
28 Stock (1,500,000 shares, issued at $0.5 each) 750,000
29 Accumulated retained earnings 250,000
30 Total liabilities and equity 4,400,000
31

Additional model assumptions are as follows:

• The FCF evaluation is for a 5-year period. In addition, a terminal value should be determined
using the long-term FCF growth rate.
 CHAPTER 7 Using Financial Planning Models for Valuation 253

• The debt principal repayments are $300,000 each year.

• Cash is a plug in the model.
Make a pro forma model for Yummy and compute the firm value using a DCF valuation model
with year-end discounting.
23. Compute the following while referring to Yummy Company from Exercise 22:
• Show how the company value and its share value change if you use mid-year discounting.
• Show in a graph the sensitivity of the enterprise value (of the end-year calculation) to the
growth in sales.
• Show in a graph the sensitivity of the enterprise value (of the end-year calculation) to the com-
pany’s WACC.
24. The following sheet presents the balance sheet and value drivers of Little India, a company that
operates Indian food restaurants.

A B C
1 Little India, Financial model
2 Value drivers:
3 Sales growth 25%
4 Current assets/Sales 10%
5 Current liabilities/Sales 30%
6 Net fixed assets 15%
7 Costs of goods sold/Sales 35%
8 Depreciation rate 5%
9 Interest rate on debt 8.00%
10 Interest earned on cash balances 3.00%
11 Tax rate 40%
12 Dividend payout ratio 20%
13 Sales 1,100,000
14 Weighted average cost of capital 12%
15 Long-term FCF growth rate 3%
16
17 Balance sheet
18 Cash 370,000
19 Current assets 110,000
20 Fixed assets
21 At cost 2,000,000
22 Depreciation (500,000)
23 Net fixed assets 1,500,000
24 Total assets 1,980,000
25
26 Current liabilities 330,000
27 Debt 1,000,000
28 Stock (500,000 shares, issued at $1 each) 500,000
29 Accumulated retained earnings 150,000
30 Total liabilities and equity 1,980,000
31

Additional model assumptions are as follows:

• The FCF evaluation is for a 5-year period. In addition, a terminal value should be determined
using the long-term FCF growth rate.
• The debt principal repayments are $200,000 each year.
• Cash is a plug in the model.
Make a pro forma model including a DCF valuation to determine the company value and its esti-
mated share value using a mid-year discounting.
This page intentionally left blank
 PA R T

2
PORTFOLIO ANALYSIS AND THE
CAPITAL ASSET PRICING MODEL

P art 2 of PRINCIPLES OF FINANCE WITH EXCEL discusses how portfolio composition affects the
risk of the combined assets. Most individuals hold investment portfolios composed of multiple
stocks and bonds. This means that the risk of the investment portfolio is related to the combined
riskiness of the securities in the portfolio, as opposed to the riskiness of the individual portfolio
assets.
Chapter 8 starts by introducing and illustrating the concept of financial risk. This chapter
examines the three components of an asset’s risk: horizon, safety, and liquidity. Using illustra-
tions from the stock and bond markets, we show how even safe assets can be risky. We also
show how risk can be measured.
To discuss portfolio risks, you will need some statistical background. Chapter 9 develops
the statistical concepts that you need to analyze portfolios. Although many readers of Principles
of Finance with Excel have had a statistics course, Chapter 9 assumes virtually no background.
Of course Excel—with its many mathematical and statistical functions—is extraordinarily
helpful in doing portfolio statistics.
Chapters 10 and 11 combine the statistical analysis of portfolios with some basic econom-
ics. The result is the capital asset pricing model (CAPM). This model relates portfolio returns
to portfolio risks (a concept summarized in the capital market line, the CML). The CAPM also
relates the risks of individual assets to their returns, a concept known as the security market
line (SML).
Chapters 12 and 13 show how the SML can be used. In Chapter 12 we examine the uses
of the SML to measure portfolio performance: How well do portfolio managers perform, given
the riskiness of their portfolios? Chapter 13 returns to the concept of the weighted average cost
of capital (WACC) first discussed in Chapter 6; this chapter shows how the SML can be used to
compute the cost of equity and the WACC.
This page intentionally left blank
CHAP TER

8 What Is Risk?

CHAPTER CONTENTS
Overview 257
8.1. The Risk Characteristics of Financial Assets 258
8.2. A Safe Security Can Be Risky Because It Has a Long Horizon 262
8.3. Risk in Stock Prices—McDonald’s Stock 266
8.4. Advanced Topic: Using Continuously Compounded
Returns to Compute Annualized Return Statistics 273
Conclusion 274
Exercises 274

Overview
Risk is the magic word in finance. Whenever finance people can’t explain something, we try to
look confident and say “it must be the risk.” If you want to appear intelligent when hearing a
financial presentation, look skeptical and say “Have you considered the risks?” Usually that’s
enough to score a point or two.1

1
I give my students the following hint about taking finance exams: Suppose you have to answer a question
to which you absolutely don’t know the answer (“What is the zeta function of the annual returns?” “How
do you explain the difference between XYZ Corp’s annual returns over time?”). If you know nothing about
the question, make up a meaningless sentence that includes the word “risk” (“The zeta function of the
annual returns relates to the riskiness of the returns.” “XYZ’s annual returns vary because of the changing
risk of the company.”) You’re bound to get a point or two.

257
258 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Our intuition usually relates financial risks to unpredictability. A financial asset like a sav-
ings account is thought to be not risky because its future value is known, whereas a financial
asset like a stock is risky because we do not know what it will be worth in the future. Financial
assets of different types have different gradations of risk: Our intuitions tell us that a savings
account is less risky than a share in a company, and a share in a high-tech start-up is more risky
than a share in a well-established blue-chip company.
The intuition that ties unpredictability and risk together is valid, but can have some surpris-
ing aspects. For example, in Section 8.2 we show that a Treasury bill (“T-bill”), a certain kind of
bond issued by the U.S. government, can sometime be risky, even though it is completely safe.
The T-bill becomes risky if you need to sell it before it matures. We illustrate this risk with an
example. We also look at the risk of holding a share and show that it can be quantified statisti-
cally. This is an important insight for Chapters 12–14, where we use a statistical description of
stock price risk to talk about choosing portfolios of stocks.
We have tried to make the chapter unstatistical and nonmathematical. However, inevitably
the measurement of risk involves some calculations.2

Finance Concepts Discussed

• Ex post and ex ante returns
• Holding-period returns
• Treasury bond returns
• Return statistics—mean, variance, and standard deviation

Excel Functions Used

• Sqrt
• Average
• Stdevp
• Varp
• Frequency
• Count
• Ln

8.1. The Risk Characteristics of Financial Assets

In the course of your life you’ll be exposed to many financial assets. You’ve already been exposed
to them, even if you didn’t know that they were “financial assets”: When you were small, your
parents might have opened a savings account for you at the local bank, or your grandparents
bought you a few shares of stock. Now that you’re a student, you’re stuck with student loans, and
each month you’re trying to decide whether to pay off your credit card balances or let them ride

2
Students reading this book will generally have had a statistics course. This chapter assumes some famil-
iarity with basic statistical concepts and Chapter 9 reviews these concepts in the context of financial assets.
In this sense Chapters 8 and 9 are twins.
 CHAPTER 8 What Is Risk? 259

for another month and pay interest on them. Once you finish school, you’ll be taking a car loan,
buying a house and taking a mortgage, buying stocks and bonds, . . . .
All financial assets have different characteristics of horizon, safety, and liquidity. As you
will see, all three of these terms are in some basic sense indicative of the asset’s riskiness. In
this section we briefly review these concepts.

Horizon
Some assets are short term and others long term. Money deposited in a checking account is a
good example of a very short-term financial asset; the money can be withdrawn at any time.
On the other hand, many savings accounts require you to deposit the money for a given period
of time. Look at Figure 8.1, which shows the rates offered on certificates of deposits (CD) by
Discover Bank of Delaware. A CD is a time-deposit at a bank—a deposit that cannot be with-
drawn for a certain period of time without the payment of a penalty. Not surprisingly, longer-
term CDs offer higher interest rates.
You’re not always “locked in” to a financial asset with a long horizon. Many long-horizon
assets can be sold in the open market. Suppose, for example, that you buy a 10-year government
bond. You can “cash out” of the bond at almost any time by selling the bond in the open mar-
ket, but selling the bond before its 10-year maturity exposes you to the riskiness of an unknown
market price. This subject is explored in detail in Section 8.2.
Some assets have a long and indeterminate horizon. A share of stock in a company is
a good example. Holding a share of McDonald’s stock, for example, entitles you to what-
ever dividends the company pays its shareholders for as long as you hold the stock and the
company exists. You can, of course, sell the stock in the stock market, but this exposes
you to the risks of the stock price fluctuations. In Section 8.3 we discuss how to analyze
the riskiness of stock holding; this is a topic to which we return in much greater detail in
Chapters 9–13.

Safety
Financial assets differ in the certainty with which you get back your money. The Discover
Bank CDs in Figure 8.1 are guaranteed by the Federal Deposit Insurance Corporation, an
agency of the U.S. government, up to a limit of $100,000. Up to this limit, the purchaser of a
Discover Bank CD will get his money back (including interest), even if the bank fails to meet
its obligations.
Figure 8.2 compares the rates offered by Discover Bank to those available to investors in
bonds issued by the General Motors Acceptance Corporation (GMAC). The market rates on
GMAC bonds are much higher than those of Discover. However, there is a distinct difference
in safety between these two types of securities: When this data was collected in May 2009,
General Motors, the parent company of GMAC, was close to bankruptcy, and the uncertainty
associated with actualizing the GMAC yields was great. Subsequently, the company went into
bankruptcy. Clearly an investment in GMAC bonds is much less safe than an investment in a
Discover Bank CD.
In general, the less safe an asset, the greater the return investors will demand and expect
from the asset. Thus, for example, if Discover Bank’s CDs pay interest of between 1 and 4%,
intelligent holders of McDonald’s stock (less safe and more uncertain than a CD) should expect
a return greater than 1 to 4%.
260 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

FIGURE 8.1 Discover Bank of Delaware offers certificates of deposit (CD) with varying maturities.
The difference between “interest rate” and “APY” (annual percentage yield) stems from the fact
that Discover’s quoted interest rate is compounded daily. For example, the 10-year interest rate of
365
⎛ 3.93% ⎞
3.93% gives an APY of ⎜ 1 + − 1 = 4% . This topic has been previously discussed in
⎝ 365 ⎟⎠
Chapter 3.

This business of “expected return” is complicated:

• If you buy a Discover Bank 5-year CD, you are promised an annual return of 3.60%.
You will get this annual return with absolute certainty (well, almost absolutely: There’s
always the remote possibility of a catastrophe that prevents both Discover Bank and
the U.S. government from honoring their obligations). For the Discover Bank 5-year
CD, the expected return and the realized return (by which we mean the actual return
received) are the same. In economists’ jargon, the expected return is often called the ex
 CHAPTER 8 What Is Risk? 261

20.0%
17.5%
Discover Bank CD
15.0%
GMAC bonds
12.5%
d
l 10.0%
i
e 7.5%
Y
5.0%
2.5%
0.0%
0 1 2 3 4 5 6 7 8 9 10
Term to maturity

FIGURE 8.2 GMAC bonds are much more risky than Discover Bank CDs! Not surprisingly the prom-
ised yield of the GMAC bonds is much higher than that of the (very safe) Discover Bank CDs.

ante return and the realized return is often called the ex post return (this terminology is
derived from Latin words for “before” and “after”).
• If you buy a share of McDonald’s stock, you will expect to get more than 3.60% annual
return. However, in this case this expectation is merely an anticipated average future
return. In other words, you would be disappointed but not too surprised if the actual
annual return on the stock after 5 years was less than 3.60%.

Liquidity
The ease with which an asset can be bought or sold is the asset’s liquidity. In general, the more
liquid an asset, the easier it is to “get rid of” and the lower its risk.
Listed stocks of major American companies have very high liquidity. For the 10 years
between 1999 and 2008, the average daily number of McDonald’s shares traded (meaning
shares bought and sold) on the New York Stock Exchange was 6.2 million shares. This is the
average; the highest number of shares traded daily was almost 87 million and the lowest num-
ber of shares was 1.3 million. If you want to buy or sell a single share of stock (or even several
thousand shares), you’ll have no trouble doing so: McDonald’s stock is very liquid.
Liquidity has another aspect, which financial economists call price impact. Suppose you
decided to sell the 1,000 shares of McDonald’s stock your grandmother gave you. You’ll have
no trouble selling the stock, but will your sale affect the market price? For McDonald’s stock the
answer is no.
Not all stocks are equally liquid. Audiovox, which trades on the NASDAQ exchange, is a
much smaller company than McDonald’s. On an average day, around 165,000 shares of Audiovox
are bought and sold, but in the 10 years between 1999 and 2008, this number has been as low
as 3,600 shares per day. You would have relatively little trouble buying or selling several thou-
sand shares of Audiovox stock, but your action might well affect the market price of the stock.
Audiovox is not nearly as liquid as McDonald’s and consequently has greater liquidity risk.

What Now?
Horizon, safety, and liquidity all determine the risk of a financial asset. In the succeeding sec-
tions we’ll give some concrete examples. We start by looking at the risks inherent in holding a
262 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

U.S. Treasury bill. A T-Bill is completely safe, in the sense that the U.S. Treasury will keep its
obligation to pay back the money borrowed. It’s also very liquid—billions of dollars of T-bills
are bought and sold every day in the financial market. However, we’ll show that the horizon of
a T-bill means that it is somewhat risky—if you try to sell it before it matures, the market price
is unpredictable.
From the T-bill we move on to an analysis of the risks inherent in McDonald’s stock.
McDonald’s stock is not safe in the sense that the company makes no promises about either
the dividends or the future market price of the stock. We’ll analyze the returns on McDonald’s
stock over the decade 1990–2000 and we’ll try to make some statistical sense out of these
returns.

IS IT RISK OR UNCERTAINTY?

Frank H. Knight (1885–1972) wrote a dissertation in 1921 called Risk, Uncertainty and Profit.
Knight used risk to mean randomness with knowable probabilities and uncertainty to mean
randomness that is unmeasurable. In finance the distinction between these two concepts is
often blurred and in this book the words “risk” and “uncertainty” are used interchangeably.

8.2. A Safe Security Can Be Risky Because It Has a Long Horizon

Finance people use the words “risk free” and “riskless” to describe an asset whose value in the
future is known with certainty. One classic textbook example of a risk-free asset is a bank sav-
ings account. If you deposit $100 in your federally insured bank savings account that currently
earns 10%, then you know that 1 year from now there will be $110 in the account. It’s risk free
and it’s safe.
A U.S. Treasury bill is an example of a safe asset that is not riskless. Treasury bills are
short-term bonds issued by the government of the United States.3 Unlike bank CDs, Treasury
bills do not have an explicit interest rate. Instead they are sold at a discount—a bill with a face
value of $1,000 that matures 1 year from now might be sold today for $953.04. In this case the
purchaser of the bill who holds the bill to maturity would be paid $1,000 by the U.S. Treasury
1,000
and would thus earn a rate of return of − 1 = 4.93% . Treasury bills are issued by the U.S.
953.04
government, and thus at least one kind of risk—default risk—is absent from these instruments:
Because the government owns the printing machines that produce dollar bills, they can always
run off a few dollars to make good on their promises.
Although Treasury bills are free of default risk, however, they may have elements of price
risk. The rest of this section illustrates this.
Suppose that on 1 June 2008 you buy a 1-year $1,000 U.S. Treasury bill, intending to hold
the bill until its maturity on 1 June 2009. As we said, a Treasury bill doesn’t pay any interest;
instead, it is bought at a discount—that is, for less than its face value. In the case at hand, sup-
pose you buy the bill for $977.04; because it matures in 1 year after the purchase, you antici-
pated getting interest of 2.35%:

3
There are many different kinds of bonds. For a more complete discussion, see Chapter 15.
 CHAPTER 8 What Is Risk? 263

A B C
1 INTEREST ON THE TREASURY BILL
2 Purchase price 977.04
3 Payoff on maturity 1,000.00 <-- This is the Treasury bill's face value
4 Interest 2.35% <-- =B3/B2-1

Now before we start doing fancier calculations, let’s make one thing perfectly clear: If you
hold the Treasury bill from 1 June 2008 until its maturity 1 year later, you will absolutely,
definitely earn 2.35% interest. T-bills are obligations of the U.S. government, which has never
defaulted on them.
In finance jargon the ex ante return (sometimes called the anticipated or expected return)
is the return you think you’re going to get. The ex post return (also called the realized return) is
the actual return that you get when you sell the asset. For the Treasury bill illustrated here, the
ex ante return equals the ex post return if you hold the bill until maturity. This is always true
for riskless bonds.

The Price Risk of Treasury Bills

Out of curiosity, you track the market price of the bill on the first of each month during the year.
Here’s what you find.

A B C D E F G
1 THE PRICE OF THE TREASURY BILL THROUGHOUT THE YEAR
2 Date Bill price
3 1-Jun-08 977.04 1-Year Treasury Bill Price Through the Year
1,000
4 1-Jul-08 980.25
5 1-Aug-08 982.75
6 1-Sep-08 986.27 995
7 1-Oct-08 990.90
8 1-Nov-08 993.98 990
9 1-Dec-08 997.66
10 1-Jan-09 998.26 985
11 1-Feb-09 998.01
12 1-Mar-09 998.46 980
13 1-Apr-09 999.14
14 1-May-09 999.88 975
15 1-Jun-09 1,000.00
1-Aug-08

1-Apr-09

1-May-09
1-Jun-08

1-Jul-08

1-Sep-08

1-Oct-08

1-Nov-08

1-Dec-08

1-Jan-09

1-Feb-09

1-Mar-09

1-Jun-09

16
17
18
19

We use these monthly price data to compute some returns.

What ex Post Rate of Return Would You Have Earned

If You’d Sold the Treasury Bill Early?
Suppose you had sold the T-bill after 3 months on 1 September 2008 for $986.27. What would
you have earned? A relatively simple calculation provides the answer. The monthly rate of
return—the ex post return—is defined by
264 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

1/ 3
⎛ Price on 1 September 2008 ⎞
1 + ex-post monthly rate of return = ⎜ ⎟
⎝ Initial price on 1 June 2008 ⎠
1/ 3
⎛ 986.27 ⎞
=⎜ ⎟ = 1.0031
⎝ 977.04 ⎠

The exponent of 1/3 is there because of the 3-month interval between June and September. If we
raise this to the 12th power, we will get an annual rate of return of 3.83%.

A B C
1 ANNUALIZED EX-POST RETURN, June-September
2 Bought 1 June 2009 977.04
3 Sold 1 September 2009 986.27
4 Monthly return 0.31% <-- =(B3/B2)^(1/3)-1
5 Annualized return 3.83% <-- =(1+B4)^12-1

If, instead, you had sold the Treasury bill on August 1, 1 month earlier, you would have
made 3.56% in annual terms.

A B C
1 ANNUALIZED EX-POST RETURN, June-August
2 Bought 1 June 2009 977.04
3 Sold 1 August 2009 982.75
4 Monthly return 0.29% <-- =(B3/B2)^(1/2)-1
5 Annualized return 3.56% <-- =(1+B4)^12-1

We can do this exercise for each of the months from July 2008 to May 2009. In the spread-
sheet below we calculate the ex post, annualized return from selling the Treasury bill at the
beginning of July, August, . . . May.

A B C D E F G H
1 EX-POST ANNUALIZED RETURN, MONTH BY MONTH
Annualized return if
Date Bill price sold at beginning
2 of month
3 Jun-08 977.04
4 Jul-08 980.25 4.01% <-- =(B4/$B$3)^(12/COUNT($A$4:A4))-1
5 Aug-08 982.75 3.56% <-- =(B5/$B$3)^(12/COUNT($A$4:A5))-1
6 Sep-08 986.27 3.83% <-- =(B6/$B$3)^(12/COUNT($A$4:A6))-1
7 Oct-08 990.90 4.32%
8 Nov-08 993.98 4.21%
9 Dec-08 997.66 4.27% Annualized Ex-Post Return
10 Jan-09 998.26 3.75%
11 Feb-09 998.01 3.24% 4.50%
12 Mar-09 998.46 2.93%
4.00%
13 Apr-09 999.14 2.72%
14 May-09 999.88 2.55% 3.50%
15 Jun-09 1,000.00 2.35%
16 3.00%
17
18 2.50%
19
20 2.00%
21 Jun-08 Jul-08 Sep-08 Oct-08 Dec-08 Feb-09 Mar-09 May-09 Jul-09
22
23 Month sold
24
 CHAPTER 8 What Is Risk? 265

As you can see, if the T-bill is sold before its maturity, there is a considerable amount of
risk—defined here as the possible variation in the ex post rate of return. The Treasury bill—a
complete safe security in the sense that the U.S. Treasury will always make good on its obliga-
tion—has price risk that translates to risky returns if sold before maturity.

EXCEL NOTE

The interest rate calculations above use the following formula:

1
⎛ T -bill price, month t ⎞ number of months held
rmonthly = 1 + monthly interest rate = ⎜ ⎟
⎝ T -bill purchase price ⎠
12
rannual = 1 + annual interest rate= (1+ rmonthly )

To calculate the number of months the T-bill has been held, we use the Excel function
Count. For example, to see how many months we’ve held the T-bill if we buy at the beginning
of June 2008 and sell at the beginning of September 2008, we use COUNT($A$4:A6). This
counts the number of cells between A6 and A4 (the months July, August, and September). The
clever use of the dollar signs ensures that when the formula is copied it always starts counting
from July.

What ex Ante Rate of Return Would You Have Earned

If You’d Bought the T-Bill During the Year?
In the previous exercise we calculated the ex post rate of return you would have earned if you
had bought the T-bill on 1 June 2008 and had sold it before the bill’s maturity on 1 June 2009.
There’s a second “game” we can play with the T-bill prices. Suppose you had bought the bill
at the beginning of August for 982.74 and suppose you intended to hold it for 10 months until
maturity in June 2009. What’s the annualized ex ante return you could expect? We can compute
this by first computing the monthly ex ante return and then annualizing this return in a manner
similar to our computation for the ex post returns.
1
⎛ 1,000 ⎞ 10
1 + ex-ante monthly rate of return = ⎜ ⎟
⎝ Price on 01August08 ⎠
1
⎛ 1,000 ⎞ 10
=⎜ ⎟ = 1.00174
⎝ 982.75 ⎠
12
Annualized ex-ante return = (1.00174 ) − 1 = 2.11%

If we do this for each of the months, we’ll see that throughout the year from June 2008 to
June 2009 the ex ante rate on Treasury bills fell.
266 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

A B C D E F G H
1 EX-ANTE ANNUALIZED RETURN, MONTH BY MONTH
Annualized ex-ante
return if
Date Bill price
bought at beginning
2 of month
3 Jun-08 977.04 2.35% <-- =($B$15/B3)^(12/COUNT(A4:$A$15))-1
4 Jul-08 980.25 2.20% <-- =($B$15/B4)^(12/COUNT(A5:$A$15))-1
5 Aug-08 982.75 2.11% <-- =($B$15/B5)^(12/COUNT(A6:$A$15))-1
6 Sep-08 986.27 1.86% <-- =($B$15/B6)^(12/COUNT(A7:$A$15))-1
7 Oct-08 990.90 1.38%
8 Nov-08 993.98 1.04% 2.50%
9 Dec-08 997.66 0.47% Ex-Ante Yields
10 Jan-09 998.26 0.42%
Feb-09 998.01 0.60% 2.00%
11
12 Mar-09 998.46 0.62%
13 Apr-09 999.14 0.52% 1.50%
14 May-09 999.88 0.15%
15 Jun-09 1,000.00 1.00%
16
17
18 0.50%
19 Month bought
20 0.00%
21

Apr-09
Jul-08

Jul-08

Aug-08

Sep-08

Nov-08

Feb-09
Jun-08

Dec-08
Oct-08

Jan-09

Mar-09
22
23
24

What’s the Message?

This example, which illustrates the riskiness of a “riskless” U.S. Treasury bill, illustrates that financial
risk depends on horizon: A financial asset can be riskless over one horizon and risky over another.
In our example, buying the Treasury bill at any point during the year and holding it until maturity
guarantees that the ex ante return will equal the ex post return. On the other hand, selling the bill
before its maturity involves risk—in this case the realized return (the ex post return) varies.

A Final Word: What Caused the Riskiness of the Treasury Bills?

We’ve shown that holding a T-bill during June 2008–June 2009 could have been pretty risky—if
you were thinking of selling the bill before maturity. The cause of this was, of course, the ter-
rible mayhem in financial markets during this period. To keep the banking system afloat, the
Federal Reserve Bank flooded the markets with money. Interest rates declined almost monthly.
The results are clear in our discussion of the risks of holding or buying a Treasury bill.

8.3. Risk in Stock Prices—McDonald’s Stock

A U.S. Treasury bill is a relatively simple security: The issuer is very well-known and has never
defaulted, the ex ante return can be derived from the price, and this return is guaranteed if you
hold the bill until maturity. A stock has none of these properties and is thus in every sense risk-
ier. The problem is how to quantify this risk.
Here’s an example—Figure 8.3 shows how the stock price of McDonald’s varied from 31
December 1998 to 31 December 2008.
The fact that the stock’s price goes up and down is an indication of the stock’s riskiness.
If we calculate the daily returns, we see a different kind of risk. Below we calculate the daily
return from holding McDonald’s stock—this is what you would earn in percentages if you
bought the stock at its closing price on day t and sold it at its closing price on day t + 1.
Pt +1
Dailyreturn, day t = −1
Pt
 CHAPTER 8 What Is Risk? 267

McDonald's–Stock Prices
70

60
31 Dec 1998-31 Dec 2008

50

40

30

20

10

0
31-Dec-98

31-Dec-99

30-Dec-00

30-Dec-01

30-Dec-02

30-Dec-03

29-Dec-04

29-Dec-05

29-Dec-06

29-Dec-07

28-Dec-08
FIGURE 8.3 The stock price of McDonald’s, 31 December 1998–31 December 2008. Over the decade
the stock price climbed from $31.69 to $60.58 per share, but with considerable volatility. The com-
pound annual growth rate of the share price was 6.32% (this computation assumes that dividends were
reinvested to purchase more stock).

If you plot the daily returns for 1 month, you get a very spiky pattern.

A B C D E F G H I J K L
1 McDONALD'S--DAILY STOCK PRICES DURING DECEMBER 2008
Stock Daily
2 price return
3 28-Nov-08 57.23
4 1-Dec-08 54.71 -4.40% <-- =B4/B3-1 McDonald's--Daily Returns for December
5 2-Dec-08 55.57 1.57% <-- =B5/B4-1
6 3-Dec-08 58.01 4.39% <-- =B6/B5-1
2008
7 4-Dec-08 59.26 2.15% <-- =B7/B6-1 5%
8 5-Dec-08 61.09 3.09% <-- =B8/B7-1 4%
9 8-Dec-08 59.34 -2.86% 3%
10 9-Dec-08 58.13 -2.04%
2%
11 10-Dec-08 60.06 3.32%
12 11-Dec-08 59.29 -1.28% 1%
13 12-Dec-08 59.02 -0.46% 0%
1-Dec-08

3-Dec-08

5-Dec-08

7-Dec-08

9-Dec-08

11-Dec-08

13-Dec-08

15-Dec-08

17-Dec-08

19-Dec-08

21-Dec-08

23-Dec-08

25-Dec-08

27-Dec-08

29-Dec-08

31-Dec-08

14 15-Dec-08 59.12 0.17% -1%

15 16-Dec-08 61.29 3.67% -2%
16 17-Dec-08 61.01 -0.46%
-3%
17 18-Dec-08 59.70 -2.15%
18 19-Dec-08 58.76 -1.57% -4%
19 22-Dec-08 59.81 1.79% -5%
20 23-Dec-08 59.08 -1.22%
21 24-Dec-08 59.69 1.03%
22 26-Dec-08 59.48 -0.35%
23 29-Dec-08 58.81 -1.13%
24 30-Dec-08 60.14 2.26%
25 31-Dec-08 60.58 0.73%
268 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

If you plot the daily returns for all 2,515 data points, you get a very “noisy” pattern.

11%

9%

7%

5%

3%

1%
January-99

January-00

January-01

January-02

January-03

January-04

January-05

January-06

January-07

January-08
-1%

-3%

-5%

-7%

McDonald's Daily Returns

-9%
1 Jan 1999- 31 Dec 2008
-11%
The largest and smallest returns are
indicated by the squares
-13%

Each dot represents the return on McDonald’s stock on a particular day. Although there
are dots all over the place, there seem to be slightly more dots above the x-axis than below it,
indicating that on average the return on McDonald’s stock was positive. The highest and low-
est daily returns over the period are indicated by the square markers: On 9 July 1999 the price
of McDonald’s stock went up by 9.68% and on 17 September 2002 the price went down by
12.82%.

The Distribution of McDonald’s Stock Returns

The previous two graphs show the return on McDonald’s stock on each specific date. These
graphs clearly show that the stock is risky—the returns vary from day to day—but they don’t
give much insight into the statistical nature of the riskiness of the stock. A different way to think
about the riskiness of McDonald’s stock is to look at the frequency distribution of the daily
returns: Of the 2,516 daily returns, how many were between 0.40 and 1.09%? The answer turns
out to be 416, which is 16.456% of the total number of returns. As another example, 36 of the
returns (1.424% of the total) were between −3.80 and −3.10%. In the spreadsheet below we’ve
used Excel’s Frequency function to calculate the whole frequency distribution of the returns
(see the Excel Note on page 270 for more on how to use this function). The plots of the returns
look very much like the normal distribution (the “bell curve”) you’ve probably studied in a sta-
tistics course.
 A B C D E F G H I J K L M
1 McDONALD'S--DAILY STOCK PRICES AND RETURNS, 31 Dec 1998 - 31 Dec 2008
Stock Daily
Date Some statistics about McDonald's stock prices
2 price return
3 31-Dec-98 31.69 Number of days 2515 <-- =COUNT(C4:C2519)
4 4-Jan-99 31.75 0.19% <-- =B4/B3-1 Minimum return -12.82% <-- =MIN(C4:C2519)
5 5-Jan-99 31.61 -0.44% <-- =B5/B4-1 Maximum return 9.67% <-- =MAX(C4:C2519)
6 6-Jan-99 32.1 1.55% <-- =B6/B5-1 Date of minimum return 17-Sep-02 <-- =INDEX(A:A,MATCH(G4,C:C,0))
7 7-Jan-99 32.13 0.09% <-- =B7/B6-1 Date of maximum return 9-Jul-99 <-- =INDEX(A:A,MATCH(G5,C:C,0))
8 8-Jan-99 33.21 3.36% <-- =B8/B7-1 Number of zero-return days 43 <-- =COUNTIF(C:C,"=0")
9 11-Jan-99 32.13 -3.25%
10 12-Jan-99 31.07 -3.30% Computing the frequency distribution
11 13-Jan-99 31.77 2.25% Bin How many?
12 14-Jan-99 31.38 -1.23% -13.00% 0 <-- {=FREQUENCY(C4:C2518,F12:F43)}
13 15-Jan-99 31.98 1.91% -12.25% 1
14 19-Jan-99 32.67 2.16% -11.50% 0 550
15 20-Jan-99 32.08 -1.81% -10.75% 0
500
16 21-Jan-99 31.64 -1.37% -10.00% 1
17 22-Jan-99 31.36 -0.88% -9.25% 0 450
18 25-Jan-99 31.3 -0.19% -8.50% 0 400
19 26-Jan-99 32.57 4.06% -7.75% 4 350
20 27-Jan-99 32.39 -0.55% -7.00% 0
300
21 28-Jan-99 32.23 -0.49% -6.25% 3
22 29-Jan-99 32.52 0.90% -5.50% 6 250
23 1-Feb-99 32.75 0.71% -4.75% 9 200
24 2-Feb-99 32.62 -0.40% -4.00% 18 150
25 3-Feb-99 33.57 2.91% -3.25% 32
100
26 4-Feb-99 33.32 -0.74% -2.50% 83
27 5-Feb-99 33.14 -0.54% -1.75% 150 50
28 8-Feb-99 33.37 0.69% -1.00% 295 0
29 9-Feb-99 33.11 -0.78% -0.25% 456
30 10-Feb-99 32.95 -0.48% 0.50% 533
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%

-9.00%
-8.00%
-7.00%
-6.00%
-5.00%
-4.00%
-3.00%
-2.00%
-1.00%
10.00%

-13.00%
-12.00%
-11.00%
-10.00%

31 11-Feb-99 33.83 2.67% 1.25% 429

32 12-Feb-99 33.55 -0.83% 2.00% 232
33 16-Feb-99 33.75 0.60% 2.75% 120
34 17-Feb-99 33.21 -1.60% 3.50% 65
35 18-Feb-99 34.22 3.04% 4.25% 30
36 19-Feb-99 35.3 3.16% 5.00% 19
37 22-Feb-99 35.33 0.08% 5.75% 11
38 23-Feb-99 35.36 0.08% 6.50% 6
39 24-Feb-99 35.07 -0.82% 7.25% 2
40 25-Feb-99 34.68 -1.11% 8.00% 3
41 26-Feb-99 35.07 1.12% 8.75% 3
42 1-Mar-99 35.71 1.82% 9.50% 3
43 2-Mar-99 37.08 3.84% 10.25% 1

269
270 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

EXCEL NOTE: THE FREQUENCY FUNCTION

The frequency distribution that gave rise to the bell curve for McDonald’s stock returns was calcu-
lated with an Excel function called Frequency. To use this function, consider the following exam-
ple, which gives the monthly returns on IBM stock between January 2007 and January 2009:

When you finish putting in range C4:C27 and F3:F22 as shown above, don’t click OK!
Instead, simultaneously press the keys [Ctrl]+[Shift]+[Enter]. This will put the frequency in the
spreadsheet as shown below.
F G
Frequency distribution
2 of returns
3 -22.0% 0
4 -10.0% 2
5 -9.0% 1
6 -8.0% 1
This table says that in the period January 2007–January
7 -7.0% 0
8 -6.0% 0
2009:
9 -5.0% 1 • There were 2 months when IBM stock had a return
10 -4.0% 1
between −22 and −10%.
11 -3.0% 1
12 -2.0% 0 • There was 1 month when IBM stock had a return
13 -1.0% 2 between −9 and −10%.
14 -0.5% 1 and so on . . .
15 0.0% 0
16 0.5% 0
17 2.0% 3
18 3.0% 1
19 4.0% 1
20 5.0% 2
21 7.0% 3
22 9.0% 4
 CHAPTER 8 What Is Risk? 271

Computing the Average and Standard Deviation

of the McDonald’s Returns
In the spreadsheet below we look at the end-year prices of McDonald’s between 1999 and
2008. On average, a McDonald’s shareholder got an annual return of 10.49% per year over the
period January 1999–January 2009. The standard deviation of the annual returns is 26.88%. The
standard deviation is a statistical measure of the variation of the stock’s returns—the greater the
standard deviation, the greater the riskiness of the stock.

A B C D E F G H
1 McDONALD'S–BEGINNING-YEAR STOCK PRICES, Jan 1999-Jan 2009
Stock
Date Return Statistics
2 price
3 4-Jan-99 31.75 Largest annual return 52.12% <-- =MAX(C3:C13)
4 3-Jan-00 32.85 3.46% <-- =B4/B3-1 Smallest annual return -36.65% <-- =MIN(C3:C13)
5 2-Jan-01 27.95 -14.92% <-- =B5/B4-1
6 2-Jan-02 22.29 -20.25% Average annual return 6.94% <-- =(B13/B3)^(1/10)-1
7 2-Jan-03 14.12 -36.65% Variance of annual returns 0.0723 <-- =VARP(C4:C13)
8 2-Jan-04 21.48 52.12% Standard deviation of annual returns 26.88% <-- =STDEVP(C4:C13)
9 3-Jan-05 28.09 30.77%
10 3-Jan-06 30.19 7.48%
11 3-Jan-07 40.48 34.08%
12 2-Jan-08 55.02 35.92%
13 2-Jan-09 62.10 12.87%
14
15 STATISTICAL REVIEW
Return minus Statistical note: The only consistent way of computing annual
MCD average returns is to use the continously compounded returns,
average,
return illustrated on page 273. This Excel sheet uses discrete returns,
16 squared
but these give contradictory results. (Compare, for example
17 3-Jan-00 3.46% 0.49% <-- =(B17-$B$28)^2
10.49% in cell B28 with 6.94% in cell G6 .)
18 2-Jan-01 -14.92% 6.45% <-- =(B18-$B$28)^2
19 2-Jan-02 -20.25% 9.45%
20 2-Jan-03 -36.65% 22.22%
21 2-Jan-04 52.12% 17.34%
22 3-Jan-05 30.77% 4.11%
23 3-Jan-06 7.48% 0.09%
24 3-Jan-07 34.08% 5.57%
25 2-Jan-08 35.92% 6.47%
26 2-Jan-09 12.87% 0.06%
27
28 Average 10.49% <-- =AVERAGE(B17:B26)
29 Variance 0.0723 <-- =SUM(C17:C26)/10
30 0.0723 <-- =VARP(B17:B26)
31 Standard deviation 26.88% <-- =SQRT(B29)

EXCEL NOTE: EXCEL AND STATISTICAL REVIEW

We delve deeper into statistics in Chapter 9. Here we remind you of the meanings of the terms:
• The average (also called the mean ) return for McDonald’s is computed either by summing
the annual returns and dividing by 10 or by taking the compound annual return over the
10 years. We’ve illustrated both ways in cell B28 and in cell G6. Note the inconsistency
between B28 and G6—this is caused by our use in this example of discrete returns. In
Section 8.4 we use continuously-compounded returns and the inconsistency disappears.
• The variance of McDonald’s annual returns is computed in three steps: (i) Subtract each
return from the average. (ii) Square the result; these “squared deviations from the average” are
shown in cells C17:C26. (iii) Average the sum of the squared deviations. This is illustrated in
cell B29. Cell G8 shows that the Excel function Varp gives the same result.
272 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

• Because the returns are in percentages, the variance has units “percent squared.” This is a
bit difficult to understand. The standard deviation of the returns is the square root of the
variance (this has units that are in percentages). Informally, you can think of the standard
deviation as representing the average percentage variability of the individual returns. Cell
B30 used the Excel function Sqrt to derive the standard deviation, and cell G9 uses the Excel
function Stdevp.

How Risky Are Other Assets?

To give you some feel for how risky different assets are, here is a table of the annualized
returns and standard deviations for various assets over the same period for which we computed
McDonald’s annual returns.

AVERAGE RETURN VERSUS STANDARD DEVIATION OF RETURNS

A somewhat arbitrary list of assets, 1999-2008
Average Standard Average Standard
return deviation return deviation
Abbott 4.25% 21.47% Marriott 2.51% 27.70%
Alcoa -3.43% 42.03% McGraw-Hill 0.71% 24.05%
Altria 8.65% 29.51% Microsoft -5.79% 35.88%
American Airlines -8.04% 75.72% Nasdaq -5.11% 30.98%
Boeing 4.49% 30.95% Nicor 4.06% 27.34%
Cisco -4.89% 43.06% Nordstrom -1.56% 42.24%
Coca Cola 0.10% 24.98% Northrop 7.80% 25.31%
Dell -15.50% 41.97% Procter & Gamble 5.16% 22.31%
Exxon 10.60% 18.06% PPG 1.24% 23.08%
Ford -22.92% 48.67% S&P 500 -3.22% 15.28%
GE -4.89% 24.22% Safeway -8.13% 28.46%
Hershey 4.40% 23.17% TEVA 21.33% 29.81%
IBM 0.43% 30.36% U.S. Steel 6.11% 55.83%
Johnson & Johnson 5.30% 19.39% Value Line Equity Fund -5.14% 18.09%
Kellogg 3.79% 20.82% Vanguard High-Yield 1.79% 8.59%
Kraft 0.74% 21.01% Vanguard Long-Term Treasury 5.44% 13.37%
Kroger -1.42% 25.22% Vanguard Windsor 1.93% 16.97%
Manpower 4.29% 32.37% Walmart 3.72% 22.89%

A closer look at the some of the highlighted financial assets can give you some better intuition
on the relation between financial risk and return:
• Vanguard’s Long-Term Treasury Fund is a mutual fund that invests in long-term U.S.
Treasury bonds. As you saw in Section 8.2, the absence of default risk in these bonds
does not mean that they are riskless: Their prices can vary considerably, and as a result
the holder of the Vanguard Long-Term Treasury Fund may experience uncertainty in
her returns. Nevertheless, our intuition tells us (correctly, as you’ll see in the succeed-
ing bullets) that this fund ought to be less risky than most stocks. During the decade of
1999–2008, the Vanguard Long-Term Treasury Fund gave an average annual return of
5.44% and this return had a standard deviation of 13.37%.
 CHAPTER 8 What Is Risk? 273

• Standard & Poor’s (S&P) 500 Index is a broad-based index of the largest U.S. stocks
and is often used as a measure of the performance of the U.S. stock markets. During the
decade of 1999–2008, the S&P 500 Index had an average annual return of −3.22% and a
standard deviation of 15.28%. You might have expected a clearer trade-off between the
Vanguard Long-Term Treasury Bond fund and the S&P 500, but in the case, the S&P
returned both lower returns with higher risk than the Vanguard Treasury fund. Of course
this is all with hindsight: We would generally perceive that the riskiness of the S&P is
greater than that of a fund of Treasury bonds, and we might reasonably expect that, going
forward, the ex ante returns (meaning the expected future returns) of the S&P would be
higher than those of Vanguard.4
• The riskiest stock in our sample was American Airlines and it was also one of the poor-
est performers, with an annualized negative return of −8.04%.5
There seems little relation between the standard deviation of the returns and the average returns.
In Chapter 10 we define another measure of asset risk, called beta, which works better as a
descriptor of risk.

8.4. Advanced Topic: Using Continuously Compounded

Returns to Compute Annualized Return Statistics
We discussed continuous compounding in Chapter 3. As explained, the continuously compounded
return is calculated using the Ln function. For reasons that are beyond the scope of this book, the
continuously compounded return is often a better method of computing return statistics (by “bet-
ter” we mean two things: there’s a theory behind the numbers, and this theory gives the same results
whether you’re computing the annual statistics from daily, weekly, or monthly data). In the spread-
sheet below, we’ve computed the continuously compounded return statistics for McDonald’s.

A B C D E F G H
1 McDONALD'S–DAILY STOCK PRICES AND RETURNS, 31 Dec 1998 - 31 Dec 2008
Stock Daily
2
Date
price return
Statistics based on continuous returns
3 31-Dec-98 31.69 Number of days 2515 <-- =COUNT(C4:C2519)
4 4-Jan-99 31.75 0.19% <-- =LN(B4/B3) Minimum daily return -13.72% <-- =MIN(C4:C2519)
5 5-Jan-99 31.61 -0.44% <-- =LN(B5/B4) Maximum daily return 9.23% <-- =MAX(C4:C2519)
6 6-Jan-99 32.1 1.54% <-- =LN(B6/B5)
7 7-Jan-99 32.13 0.09% <-- =LN(B7/B6) Average daily return 0.026% <-- =AVERAGE(C4:C2519)
8 8-Jan-99 33.21 3.31% <-- =LN(B8/B7) Variance of daily returns 0.0003 <-- =VARP(C4:C2519)
9 11-Jan-99 32.13 -3.31% Standard deviation of daily returns 1.82% <-- =SQRT(G8)
10 12-Jan-99 31.07 -3.35%
11 13-Jan-99 31.77 2.23% Average annual return 6.49% <-- =252*G7
12 14-Jan-99 31.38 -1.24% Variance of annual returns 0.0053 <-- =SQRT(252)*G8
13 15-Jan-99 31.98 1.89% Standard deviation of annual returns 7.26% <-- =SQRT(G12)
14 19-Jan-99 32.67 2.13%
15 20-Jan-99 32.08 -1.82%
16 21-Jan-99 31.64 -1.38%

The average daily continuously compounded return (cell G7) is 0.026%. To annual-
ize this return, we multiply by 252, the average number of business days per year.6 The

4
In the previous decade this was true: The S&P had an average return of 15.09% and the Vanguard
Treasury fund an average return of 2.43%; the standard deviations of the two funds were 13.18 and 7.94%,
respectively.
5
In the previous decade the numbers for American Airlines were 9.26 and 29.34%.
6
Over the 10-year period 1999–2008, there were 2,516 days on which McDonald’s stock was transacted.
This averages out to 252 days per year.
274 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

annualized average continuously compounded return is 6.49% (cell G11). Similarly, the
annualized return variance is 0.0053 (cell G12), and the annualized standard deviation of
returns is 7.26% (cell G13).7

Conclusion
In this chapter we have tried to give you some intuitions into the nature of financial risk by a
series of examples. Risk—the variability of returns from an asset over time—depends on a
number of factors. Broadly speaking, the characteristics of an asset’s risk are its horizon, its
safety, and its liquidity. As we’ve shown, even default-free assets like U.S. Treasury bills can be
risky because their prices can change over the asset’s horizon. With our example of McDonald’s
stock we’ve shown that some statistical sense can be made of the variability of the stock’s return
over time—using Excel’s Frequency function, we were able to show that McDonald’s stock
returns look very much like the familiar statistical bell curve.
Risk is the most important concept in finance: The variability of financial asset returns is
the main fact of financial life, but this risk is not easy to define or measure. In Chapters 10–13
we will develop a model to price risks; by this we mean a model that will help us determine
the risk-adjusted discount rate. The important innovation of this model is that risk depends on a
portfolio context—it is not just the asset’s returns by themselves that determine the asset’s riski-
ness, but the asset’s returns in the context of the portfolio of all the assets held by the investor.
Before we can develop this model, however, you might need a brush-up on your statistics
skills. This is the task we set ourselves in Chapter 9.

EXERCISES
1. Professor Smith was bragging about her abilities as an investor in the stock market: “In the last
month, I earned 8% on my portfolio,” she told her friends. “That’s nothing special,” commented
Mr. Jackson. “Last month I made 20% on my portfolio, without studying 15 years at university.”
Did Mr. Jackson really outperform Mrs. Smith?
2. Can a corporate bond have a lower expected return than a government bond? Can it have lower ex
post return?
3. It’s 1 January 2007 and you’re considering buying a $1,000 face-value U.S. Treasury bill that
matures in 1 year. The interest rate is 7% annually.
a. If you buy the T-Bill now, how much will you pay?
b. If the interest rate remains 7% annually, how much will the bill be worth on 1 February 2007?
1 March? 1 April? . . . 1 December?
4. Diana bought bonds issued by the ZZZ company, a small high-tech company from Newfoundland.
The bond is zero-coupon, has a face value of $1,000, and matures in 2 years. Diana intends to keep
the bond until maturity.
a. If the price of the bond is $756.14, what is the annual expected return of Diana’s bond?
b. One day after Diana bought her bond, ZZZ was purchased by the electronic giant ABA, which
has a very low default probability. Investors demand only a 6.5% annual return on ABA’s

7
Note that the continuously compounded average return of 6.49% is less than the discretely compounded
return of 6.94% computed in cell G6 on page 271. One reason for this is that continuous compounding
builds up faster than discretely compounded interest. As noted in Chapter 3, there are legitimate alterna-
tive ways to compute returns. To compare the returns of two assets, make sure that the basis of the com-
putation is the same.
 CHAPTER 8 What Is Risk? 275

bonds. What will be the new price of the ZZZ bonds and how much will Diana gain from the
takeover?
5. On 15 March 2002, you purchased a 2-year Treasury bond with face value of $10,000 and a 4%
coupon (payable semiannually). The price of the bond was $9,750. The bond promises a coupon
of $200 on 15 September 2002, 15 March 2003, 15 September 2003, and 15 March 2004 (on this
last date the bond will repay its face value).
a. Based on the following, compute the annualized IRR of the bond purchase.

A B C
1 Date Cash flow
2 15-Mar-02 -9,750
3 15-Sep-02 200
4 15-Mar-03 200
5 15-Sep-03 200
6 15-Mar-04 10,200
7
8 Semiannual IRR 2.67% <-- =IRR(B2:B6)

b. Immediately after receiving the $200 bond interest payment on 15 September 2002, you sold
the bond for $10,000. What was your ex post annualized yield? What was the ex ante annual-
ized yield of the buyer of the bond?
6. During a stamp collector convention the chairman spoke about the profitability of investing in
rare stamps. “Last year I invested $150,000 in rare stamps. These stamps are now worth $200,000
according to the catalog, meaning an annual return of 33%. For comparison the average return
in the stock market in the last 30 years was only 16%.” Find (at least) three problems with the
chairman’s argument.
7. A basic assumption of economics is that investors are risk averse, meaning when they view Asset
A as riskier than Asset B they will demand a higher expected return.
A “fair bet” is a bet whose expected return is zero. Here’s an example of a fair bet: Pay $1 to
get $2 if a coin flip yields heads or to get $0 if the coin flip yields tails. Note that this bet has an
expected return of zero.
Expected payoff = 0.5
) * $2
) + 0.5
) * $2
) = $1
↑ ↑ ↑ ↑
Probability Payoff Probability Payoff
of heads if heads of tails if tails
Expected payoff $1
Expected return = − 1 = − 1 = 0%
Cost of bet $1

Will a risk-aversive investor agree to a fair bet?

8. A risk-neutral investor is willing to make bets with an expected return of zero. Suppose a risk-
neutral investor is offered the chance to participate in a die-toss game. If the die comes up 1,
the payoff is $1, if the die comes up 2, the payoff is $2, . . . . What is the maximum price the risk-
neutral investor is willing to pay to play this game?
9. On Planet Apathy all investors are indifferent to risk. The annual expected returns of government
bonds are 5%. Does that mean that the average stock returns should be 5%?
10. One of the ways in which the United States helps foreign countries is to guarantee their bank
loans. Explain (in short) the benefits for foreign countries in getting those guaranties. (Footnote 1
is a good place to start your answer.)
11. During a finance lecture Prof. Johnson explained to his students the relation between higher risk
and higher expected returns. At the end of the lecture one of the students asked: “Yesterday I read
in the paper that the U.S. stock markets earned higher returns than 15 African stock markets in
276 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

the past decade. How is that fact consistent with high risk equaling higher returns?” How would
you advise Prof. Johnson to respond to his students? (Your answer should include the words ex
ante and ex post.)
12. On 1 January 2005, the U.S. government is issuing two series of bonds. The two series are
completely identical except for the fact that the volume of trade in the first series is anticipated
to be much higher than the volume in the second series. What do you expect will be the relation
between the prices of the two series?
13. DEF is a firm that is traded on NASDAQ. On 1 January 2010 the company issued 10,000 zero-
coupon bonds. Each bond has a face value of $100 and matures on 1 January 2015. The bonds are
the only debt of the company. A bond-rating company estimated the total value of DEF’s assets
on 1 January 2015 as follows:

Value of DEF assets

Probability on 1/1/05

0.2 2,000,000
0.3 1,750,000
0.4 1,200,000
0.1 750,000

Two years after the bond issue, on 1 January 2012, the bond-rating agency reexamined the DEF
Company and estimated the total value of the firm’s assets as follows.

Value of DEF
Probability assets on 1/1/2015

0.05 2,000,000
0.25 1,750,000
0.65 1,200,000
0.05 750,000

a. What will be the influence of the new estimation on the expected return on DEF bonds?
b. What will be the influence of the new estimation on the DEF stock price?
14. Can you think of a risk-based explanation for the following finding? Over the past 40 years
“small stocks”—defined as shares of firms with a low market value—had higher returns than
big stocks.
15. A well-known finance professor published a paper in which he argued that because of the high
volume of stock trade on the Internet, he expects stock returns to decline in future years. What is
the basis for the professor’s argument?
16. At the end of 1999 an investor bought 10,000 shares of Yakuna Corp. for ¥456 each in the Japanese
stock market (¥ is the symbol for Japanese yen). At that time $1 U.S. was worth ¥128.35. The
investor sold all the shares at the beginning of 2003 when the stock was worth ¥448; $1 was worth
¥108.33. Calculate the annual return in dollar terms and yen terms.
17. On 1 January 2010 an American investor bought $1,000,000 worth of Swiss francs (SFr) and put
it in a savings account for 1 year. The annual interest rate in Swiss francs was 6%. During that
period the interest rate in the United States was 2%. On the purchase date the exchange rate was
$1 = 1.56 SFr.
a. One year after the start of the savings in Switzerland, the exchange rate was 1.45 Sfr per U.S.
dollar. If the investor turned his savings back into dollars, what dollar rate of return did he
earn?
 CHAPTER 8 What Is Risk? 277

b. What should be the exchange rate on 1 January 2011 for the investment in SFr to be better than
the investment in U.S. dollars?
18. The disk that comes with this book has daily prices for AMD Corp.’s stock from 1 July 1994
through 26 July 2004.
a. Compute the daily stock returns and graph them.
b. Use Frequency to build a frequency distribution of the stock returns and graph this
distribution.
19. The disk that comes with this book contains data on annual stock prices for Ford Motor Company
for 1987–2003. Compute the average annual return and the standard deviation of annual returns
for Ford.

A B
FORD MOTOR
COMPANY
1 annual stock prices
Closing
2 Date price
3 2-Jan-87 0.5900
4 4-Jan-88 0.8900
5 3-Jan-89 1.3600
6 2-Jan-90 1.3500
7 2-Jan-91 1.1900
8 2-Jan-92 1.5600
9 4-Jan-93 2.6800
10 3-Jan-94 4.3000
11 3-Jan-95 3.4800
12 2-Jan-96 4.4100
13 2-Jan-97 5.2100
14 2-Jan-98 8.8700
15 4-Jan-99 25.9000
16 3-Jan-00 22.3100
17 2-Jan-01 25.1400
18 2-Jan-02 14.1800
19 2-Jan-03 8.7600
20 2-Jan-04 14.4500

20. The disk that comes with this book contains data on annual stock prices for Kellogg for 1987–2003.
Compute the average annual return and the standard deviation of annual returns for Kellogg.
278 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

A B
KELLOGG
annual stock
1 prices
Closing
2 Date price
3 2-Jan-87 5.68
4 4-Jan-88 5.48
5 3-Jan-89 7.66
6 2-Jan-90 8.27
7 2-Jan-91 11.26
8 2-Jan-92 17.91
9 4-Jan-93 20.37
10 3-Jan-94 18.47
11 3-Jan-95 19.90
12 2-Jan-96 29.03
13 2-Jan-97 27.59
14 2-Jan-98 38.01
15 4-Jan-99 34.14
16 3-Jan-00 20.93
17 2-Jan-01 23.52
18 2-Jan-02 28.70
19 2-Jan-03 32.00
20 2-Jan-04 37.35

21. Graph the annual stock returns of Kellogg and Ford on the same graph. Is one of the companies
more risky than the other? Explain.
CHAP TER

9 Statistics for Portfolios

CHAPTER CONTENTS
Overview 279
9.1. Basic Statistics for Asset Returns: Mean, Standard Deviation,
Covariance, and Correlation 280
9.2. Covariance and Correlation—Two Additional Statistics 284
9.3. Portfolio Mean and Variance for a Two-Asset Portfolio 287
9.4. Using Regressions 288
9.5. Advanced Topic: Portfolio Statistics for Multiple Assets 294
Conclusion and Summary 296
Exercises 296
Appendix 9.1: Downloading Data from Yahoo! 307
Appendix 9.2: Why Varp Instead of Var? 310

Overview
To understand and work through Chapters 10–13, you will need to know some statistics. If
you’re like a lot of finance students, you’ve had a statistics course and forgotten much of what
you learned there. This chapter is a refresher—it shows you exactly what you need to proceed
with the succeeding chapters, using Excel to do all the calculations. (Excel is a great statisti-
cal toolbox—someday all business-school statistics courses will use it. In the meantime you’re
stuck with this chapter.)

279
280 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Finance Concepts
• How to calculate stock returns and adjust them for dividends and stock splits
• Return mean, variance, and standard deviation for an asset
• Return mean and variance for a portfolio of two assets
• Regressions

Excel Functions and Techniques

• Average
• Var and Varp
• Stdev and Stdevp
• Covar and Correl
• Trendlines (Excel’s term for regressions)
• Slope, Intercept, Rsq

9.1. Basic Statistics for Asset Returns: Mean,

Standard Deviation, Covariance, and Correlation
In this section you will learn to calculate the return on a stock and its statistics: the mean
(interchangeably referred to as the average or expected return), the variance, and the standard
deviation.

Kellogg Stock and Its Returns

The following spreadsheet shows data for Kellogg Company (stock symbol K) stock during the
period 1998–2008. For each year, we show the closing price of K stock and the dividend the
company paid during the year.1 We also calculate the annual returns and their statistics; these
calculations are explained after the table.
Suppose you bought a share of Kellogg at the end of December 1998 for $34.13 and sold it
a year later, at the end of December 1999, for $30.81. During this year, Kellogg paid a per-share
dividend of $0.96. Your return from holding K throughout 1999 would have been
PK ,1999 + DivK ,1999 − PK ,1999 30.81 + 0.96 − 34.13
rK ,1999 = = = −6.89% .
PK ,1998 34.13

Here are several notes:

• We use rK,1999 to denote the return on K stock in 1999 and we use DivK,1999 to denote K’s
dividend in 1999.
• The numerator of rK,1999 is
PK ,1991 + DivK ,1991 − PK ,1990 = 30.81 + 0.96 − 34.13 = −2.35

1
The “closing price” is the price of the stock at the end of the day.
 CHAPTER 9 Statistics for Portfolios 281

A B C D E
PRICE AND DIVIDEND DATA FOR KELLOGG (K)
1 1998 - 2008
Annual
Date Price Dividend
2 return
3 31-Dec-98 34.13 0.92
4 31-Dec-99 30.81 0.96 -6.89% <-- =(B4+C4)/B3-1
5 29-Dec-00 26.25 0.99 -11.59%
6 31-Dec-01 30.10 1.01 18.51%
7 31-Dec-02 34.27 1.01 17.21%
8 31-Dec-03 38.08 1.01 14.06%
9 31-Dec-04 44.66 1.01 19.93%
10 30-Dec-05 43.22 1.06 -0.85%
11 29-Dec-06 50.06 1.14 18.46%
12 31-Dec-07 52.43 1.20 7.14%
13 31-Dec-08 42.73 1.30 -16.02%
14
15 Average return, E(rK) 6.00% <-- =AVERAGE(D4:D13)
2
16 Variance of return, σ K 0.0171 <-- =VARP(D4:D13)
17 Standard deviation of return, σK 13.06% <-- =STDEVP(D4:D13)

This is the gain on holding Kellogg during the year (in this case it’s a negative “gain”: a
loss of $2.35). The denominator of rK,1999 is the initial investment from buying Kellogg
stock at the beginning of the year.
• In cell D4 of the spreadsheet we’ve written rK,1999, the return for 1999, in a slightly dif-
ferent form as (C4+B4)/B3–1:
PK ,1999 + DivK ,1999 − PK ,1998 PK ,1999 + DivK ,1999
rK ,1999 = = −1
PK ,1998 PK ,1998

Cells D15, D16, and D17 give the return statistics for Kellogg:
• Cell D15: The average return over the decade is 6.00% per year. This number is also
called the mean return and it’s calculated with the Excel function =Average(D4:D13).
We often use the past returns to predict future returns. When we make this use of the
data, we also call the mean the expected return, meaning that we use the historic average
of Kellogg stock returns as a prediction of what the stock will return in the future. In this
book the terms mean, average, and expected return will be used almost interchangeably,
and we will sometimes use the notations E (rK ) or rK . The formal definition is
rK ,1998 + rK ,1999 + … + rK ,2008
Mean K return = E (rK ) = rK =
10

You might wonder at the number of expressions (mean, average, expected return) and the
number of symbols (E (rK ), rK ) for the same idea. We’ve introduced them all both for
convenience and because, in your further finance studies, you’re likely to see them used
synonymously.
282 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

• Cell D16: The variance of the annual returns is 0.0171. Variance and standard
deviation are statistical measures of the variability of the returns. The vari-
ance is calculated with the Excel function =Varp(D4:D13). (See the “Excel and
Statistical Note” box on page 283 for more information about this function and its
cousin, =Var(D4:D13). The variance is often denoted by the Greek symbol σ K2 (pro-
nounced “sigma squared of Kellogg”); sometimes it is written as Var (rk). The formal
definition of the variance is
2 2 2

Var (rK ) = σ 2
=
(rK ,1999 − rK ) + (rK ,2000 − rK ) + … + (rK ,2008 − rK )
K
10

• Cell D17: The standard deviation of the annual returns is the square root of the variance:
0.0171 = 13.06%. Excel has two functions, Stdevp and Stdev, to do this calculation
directly. Because we usually use Varp for the variance, we will use Stdevp for the stan-
dard deviation. It is common to use the Greek letter sigma for the standard deviation,
writing σ K (pronounced “sigma of Kellogg”).

Continuously Compounded Returns (Skip on First Reading)

Advanced finance computations often use the continuously compounded returns discussed in
Section 3.9. Using this computation, the return on Kellogg stock in 1999 would be

⎛P + DivK ,1999 ⎞ ⎛ 30.81 + 0.96 ⎞

rK ,1999 = Ln ⎜ K ,1999
PK ,1999 ⎟ = Ln ⎜ ⎟ = −7.14%
⎝ ⎠ ⎝ 34.13 ⎠

We use this form of return computation in the options chapters of Principles of Finance with
Excel (Chapters 21–23).

Downloaded Data from Commercial Sources Are

Adjusted for Dividends and Splits
The author’s two favorite data sources for stock price information are Yahoo!, which
is free, and the Center for Research in Security Prices (CRSP) database that originates
from the University of Chicago (many universities subscribe to CRSP—ask your data
manager).2 When you download data from these sources, they automatically adjust the
price data to account for dividends and for stock splits. So you don’t have to do the divi-
dend adjustments illustrated for Kellogg—the prices from Yahoo! and CRSP assume that
dividends are reinvested in buying new stock.3 In general, you can calculate returns from
the adjusted stock price data given by your data provider. They usually do the corrections
correctly.

2
For penniless students, Yahoo! is especially useful. An appendix to this chapter shows you how to down-
load financial data from Yahoo!.
3
If it’s all in the downloaded data, why the heck did we do all the work in this section? The answer, of
course, is that it helps to understand what the numbers are telling you.
 CHAPTER 9 Statistics for Portfolios 283

EXCEL AND STATISTICAL NOTE (SKIP UNTIL LATER,

OR PERHAPS FOREVER, IF YOU LIKE)
Excel has two variance functions, Varp and Var. The former measures the “population vari-
ance,” and the latter measures the “sample variance.” Similarly, Excel has two functions for the
standard deviation, Stdevp and Stdev. In this book we use only the functions Varp and Stdevp.
This box is a reminder but not an explanation of the difference between the two concepts.
If you have return data {rstock,1, rstock,2 ,..., rstock, N } for a stock, then the mean return is
1 N
rstock = ∑ rstock,t . The definitions of the two variance functions are
N t =1
1 N
∑
2
VarP ({rstock,1, rstock,2 ,..., rstock, N })= (rstock, j − ri )
N j =1
1 N
∑
2
Var ({rstock,1, rstock,2 ,..., rstock, N })= (rstock, j − ri )
N − 1 j =1

There’s a long story about the difference between these two concepts that we’ll leave for
someone else (like your statistics instructor) to explain. Suffice it to say that in the examples
covered in this book we’ll use VarP and its standard deviation equivalent StdevP.
Finally, you might wonder why there are two expressions—the variance and the standard
deviation—that measure variability. The answer has to do with the units of these expressions.
Each term in the variance is squared to make everything positive. But this means that the
units of the variance are “percent squared,” which is a bit difficult to understand. The stan-
dard deviation, the square root of the variance, reduces the squared percentages of the vari-
ance back to “percent.” This way the mean and the standard deviation have the same units.

Exxon Price and Return Data

Below we compute the returns for Exxon stock over the period 1998–2008.

A B C D
EXXON (XOM) STOCK PRICES
1 Adjusted for dividends and splits
2 Date Price Return
3 31-Dec-98 29.12
4 31-Dec-99 32.79 12.60% <-- =B4/B3-1
5 29-Dec-00 36.15 10.25%
6 31-Dec-01 33.40 -7.61%
7 31-Dec-02 30.44 -8.86%
8 31-Dec-03 36.72 20.63%
9 31-Dec-04 47.03 28.08%
10 30-Dec-05 52.57 11.78%
11 29-Dec-06 73.11 39.07%
12 31-Dec-07 90.87 24.29%
13 31-Dec-08 78.96 -13.11%
14
15 Average return, E(rXOM) 11.71% <-- =AVERAGE(C4:C13)
2
16 Variance of return, σ XOM 0.0267 <-- =VARP(C4:C13)
17 Standard deviation of return, σXOM 16.34% <-- =STDEVP(C4:C13)
284 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

9.2. Covariance and Correlation—Two Additional Statistics

So far we’ve looked at statistics—mean, variance, standard deviation—that relate to the returns
of an individual stock. In this section we examine two statistics—covariance and correlation—
that relate the returns of two stocks to each other. We use data for Kellogg (K) and Exxon
(XOM). In the following spreadsheet, we’ve put the returns for both stocks on one spreadsheet
and calculated the covariance and correlation (cells B17:B19).

A B C D
KELLOGG (K) AND EXXON (XOM)
1 ANNUAL RETURN DATA
2 Date Kellogg Exxon
3 31-Dec-99 -6.89% 12.60%
4 29-Dec-00 -11.59% 10.25%
5 31-Dec-01 18.51% -7.61%
6 31-Dec-02 17.21% -8.86%
7 31-Dec-03 14.06% 20.63%
8 31-Dec-04 19.93% 28.08%
9 30-Dec-05 -0.85% 11.78%
10 29-Dec-06 18.46% 39.07%
11 31-Dec-07 7.14% 24.29%
12 31-Dec-08 -16.02% -13.11%
13
14 Average return E(rK) and E(rXOM) 6.00% 11.71% <-- =AVERAGE(C3:C12)
2 2
15 Variance of returns, σ K and σ XOM 0.0171 0.0267 <-- =VARP(C3:C12)
16 Standard deviation of returns, σK and σXOM 13.06% 16.34% <-- =STDEVP(C3:C12)
17 Covariance of returns Cov(rK,rXOM) 0.0074 <-- =COVAR(B3:B12,C3:C12)
18 Correlation of returns ρK,XOM 0.3482 <-- =CORREL(B3:B12,C3:C12)
19 0.3482 <-- =B17/(B16*C16)

The covariance between two series is a measure of how much the series (in our case, the
returns on K and XOM) move up or down together. The formal definition is

1 ⎪⎧(rK ,1999 − rK )(rXOM ,1999 − rXOM ) + (rK ,2000 − rK )(rXOM ,2000 − rXOM ) + ⎪⎫
Cov (rK , rXOM ) = σ K , XOM =
10 ⎨⎩⎪… + (rK ,2008 − rK )(rXOM ,2008 − rXOM ) ⎬
⎭⎪

The idea behind the formula is to measure the deviations of each data point from its average
and to multiply these deviations. As you can see from cell B17, Excel has a function Covar
that, when applied directly to the returns in columns B and C, calculates the covariance.4
Another common measure of how much two data series move up or down together is the
correlation coefficient. The correlation coefficient is always between −1 and +1, which—as
you’ll see in the next subsection—makes it possible for us to be more precise about how the two
sets of returns move together. Roughly speaking, two sets of returns that have a correlation coef-
ficient of −1 vary perfectly inversely, by which we mean that when one return goes up (or down),
we can perfectly predict how the other return goes down (or up). A correlation coefficient of +1
means that the returns vary in perfect tandem, by which we mean that when one return goes up

4
The covariance is sometimes written as σK,XOM. One of the exercises at the end of this chapter has you
compute the covariance in the long, tedious way suggested by the formula. You’ll see that you get the same
result as that returned by Excel’s Covar function.
 CHAPTER 9 Statistics for Portfolios 285

(or down), we can perfectly predict how the other return goes up (or down). A correlation coeffi-
cient between −1 and +1 means that the two sets of returns vary together less than perfectly.
The correlation coefficient is defined as
Cov (rK , rXOM )
Correlation (rK , rXOM ) = ρK , XOM = .
σ K σ XOM

The Greek letter ρ (pronounced “rho”) is often used as a symbol for the correlation coefficient.
In the preceding spreadsheet, we calculate the correlation coefficient in two ways: In cell G16 of
the previous spreadsheet, we use the Excel function Correl to compute the correlation. Cell G17
Cov (rK , rXOM )
applies the formula (and, of course, gets the same result).
σ K σ XOM

Some Facts about Covariance and Correlation

Here are some facts about covariance and correlation. We state them without much attempt at
elaborate explanation or proof.
Fact 1. Covariance is affected by units; correlation isn’t. Here’s an example: In the spreadsheet
below, we’ve presented the annual returns as whole numbers instead of percentages (writing K’s 1999
return as −6.89 instead of −6.89%). The covariance (cell B17) is now 74.30, which is 10,000 times
our previous calculation. But the correlation coefficient (B18) remains the same as before, 0.3482.

A B C D
KELLOGG (K) AND EXXON (XOM)
1 Percentages presented as whole numbers
2 Date Kellogg Exxon
3 31-Dec-99 -6.89 12.60
4 29-Dec-00 -11.59 10.25
5 31-Dec-01 18.51 -7.61
6 31-Dec-02 17.21 -8.86
7 31-Dec-03 14.06 20.63
8 31-Dec-04 19.93 28.08
9 30-Dec-05 -0.85 11.78
10 29-Dec-06 18.46 39.07
11 31-Dec-07 7.14 24.29
12 31-Dec-08 -16.02 -13.11
13
14 Average return E(rK) and E(rXOM) 6.00 11.71 <-- =AVERAGE(C3:C12)
2 2
15 Variance of returns, σ K and σ XOM 170.55 266.96 <-- =VARP(C3:C12)
16 Standard deviation of returns, σK and σXOM 13.06 16.34 <-- =STDEVP(C3:C12)
17 Covariance of returns Cov(rK,rXOM) 74.30 <-- =COVAR(B3:B12,C3:C12)
18 Correlation of returns ρK,XOM 0.3482 <-- =CORREL(B3:B12,C3:C12)
19 0.3482 <-- =B17/(B16*C16)
20 Correlation is symmetric: ρK,XOM = ρXOM,K 0.3482 <-- =CORREL(C3:C12,B3:B12)

Fact 2. The correlation between Kellogg and Exxon is the same as the correlation between
Exxon and Kellogg. The same holds for the covariance: Cov (rK , rXOM ) = Cov (rXOM , rK ) The tech-
nical jargon for this is that “correlation and covariance are symmetric.” To see this in Excel,
note that cells B18 ( =Correl(B3:B12,C3:C12) ) and B20 ( =Correl(C3:C12,B3:B12) ) are
equal in the above spreadsheet.
286 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Fact 3. The correlation will always be between +1 and –1. The higher the correlation coef-
ficient is in absolute value, the more the two series move together. If the correlation is either -1
or +1, then the two series are perfectly correlated, which means that knowing one series allows
you to predict completely the value of the second series. If the correlation coefficient is between
−1 and +1, then the two series move in tandem less than perfectly.
Fact 4. If the correlation coefficient is either +1 or –1, this means that the two returns have a
linear relation between them. Because this is not easy to understand, we illustrate with a numer-
ical example: Adams Farm and Morgan Sausage are two shares listed on the Farmers Stock
Exchange. For reasons that are difficult to determine, each Morgan Sausage’s stock return is equal
to 60% of that of Adams Farm plus 3%. We can thus write rMorgan Sausage,t = 3% + 0.6 * rAdams Farm,t .
This means that the return on Morgan Sausage stock is completely predictable given the return
on Adams Farm stock. Thus, the correlation is either −1 or +1. Because when Adams Farm’s
return moves up so does the return of Morgan Sausage, the correlation is +1.5
The Excel spreadsheet that follows confirms that the correlation is +1.

A B C D

CORRELATION +1
Adams Farm and Morgan Sausage Stocks
rMorgan Sausage,t = 3% + 0.6*rAdams Farm,t
1
Morgan
Adams Sausage
Farm stock stock
2 Year return return
3 1990 30.73% 21.44% <-- =3%+0.6*B3
4 1991 55.21% 36.13%
5 1992 15.82% 12.49%
6 1993 33.54% 23.12%
7 1994 14.93% 11.96%
8 1995 35.84% 24.50%
9 1996 48.39% 32.03%
10 1997 37.71% 25.63%
11 1998 67.85% 43.71%
12 1999 44.85% 29.91%
13
14 Correlation 1.00 <-- =CORREL(B3:B12,C3:C12)
15
16 Annual Stock Returns, Adams Farm and Morgan
17 Sausage
18
50%
19
20 45%
21 40%
Morgan Sausage

22 35%
23 30%
24 25%
25 20%
26 15%
27 10%
28 5%
29 0%
30
10% 20% 30% 40% 50% 60% 70%
31 Adams Farm
32

5
The Farmers Stock Exchange has two other stocks whose returns are related by the equation
r Chicken Feed, t = 50% – 0.8 * r Poultry Delight,t. In this case, the negative coefficient (−0.8) tells us that the correl-
ation between the two sets of returns is −1. (See the end-of-chapter exercises.)
 CHAPTER 9 Statistics for Portfolios 287

Fact 4 can be written mathematically as follows: Suppose Stock 1 and Stock 2 are perfectly
correlated (meaning that the correlation is either +1 or −1). Then

← b> 0 if the correlation = +1

rStock1,t = a + b * rStock 2,t }
← b< 0 if the correlation = − 1

9.3. Portfolio Mean and Variance for a Two-Asset Portfolio

A portfolio is a set of stocks or other financial assets. Most people who own stock own more than one
stock; they own portfolios of stocks, and the risks they bear relate to the riskiness of their portfolio. In
the next chapter we’ll start our economic analysis of portfolios. In this section we’ll show you how to
compute the mean and variance of a portfolio composed of two stocks. Suppose that between 1998 and
2008 you held a portfolio invested 50% in Kellogg and 50% in Exxon. Column E of the spreadsheet
below shows what the annual returns would have been on this portfolio. For example, holding 50% of
your portfolio in K and 50% in XOM would have given you a portfolio return of 2.85% in 1999:

"#""$ * −
2.85% = !"50% 6.89% + !"50%
!""#""$ "#""$ *12.60%
!""#""$
↑ ↑ ↑ ↑
proportion of Return on proportion of Return on
K stock in K stock XOM stock in XOM stock
portfolio in 1999 portfolio in 1999

In cells E17:E21 we calculate the portfolio return statistics in the same way we calculated
the return statistics for the individual assets K and XOM.

A B C D E F
CALCULATING PORTFOLIO RETURNS
1 AND THEIR STATISTICS
2 Proportion of Kellogg 0.5
3 Proportion of Exxon 0.5 <-- =1-B2
4
Kellogg Exxon Portfolio
Date
5 return return return
6 31-Dec-99 -6.89% 12.60% 2.85% <-- =$B$2*B6+$B$3*C6
7 29-Dec-00 -11.59% 10.25% -0.67%
8 31-Dec-01 18.51% -7.61% 5.45%
9 31-Dec-02 17.21% -8.86% 4.17%
10 31-Dec-03 14.06% 20.63% 17.35%
11 31-Dec-04 19.93% 28.08% 24.00%
12 30-Dec-05 -0.85% 11.78% 5.46%
13 29-Dec-06 18.46% 39.07% 28.76%
14 31-Dec-07 7.14% 24.29% 15.71%
15 31-Dec-08 -16.02% -13.11% -14.56%
16
17 Mean 6.00% 11.71% 8.85% <-- =AVERAGE(E6:E15)
18 Variance 1.71% 2.67% 0.0147 <-- =VARP(E6:E15)
19 Standard deviation 13.06% 16.34% 12.10% <-- =STDEVP(E6:E15)
20 Covariance 0.0074
21 Correlation 0.3482
22
23 Direct calculation of portfolio mean and variance
24 Portfolio mean, E(rp) 8.85% <-- =B2*B17+B3*C17
25 Portfolio variance, Var(rp) 0.0147 <-- =B2^2*B18+B3^2*C18+2*B2*B3*C20
26 Portfolio standard dev., σp 12.10% <-- =SQRT(B25)
288 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Cells B24:B26 show that these portfolio statistics can be calculated directly from the sta-
tistics for the individual assets. To calculate the portfolio mean using these shortcuts, we first
need some notation: Let xK stand for the proportion of Kellogg stock in the portfolio and let xXOM
denote the proportion of Exxon stock in the portfolio. In our example xK = 0.5 and x XOM = 0.5
and the portfolio mean return is given by

Portfolio mean return = E (rp ) = xK E (rK ) + x XOM E (rXOM )

= xK E (rK ) + (1 − xK )E (rXOM )

Note the second line of the formula: If we only have two assets in the portfolio, then the
proportion of the second asset is “one minus” the proportion of the first asset: x XOM = 1 − xK.
The formula for the portfolio variance is given by

Portfolio variance = Var (rp ) = xK2 Var (rK ) + x XOM

2
Var (rXOM ) + 2 xK x XOM Cov (rK , rXOM ).

In the spreadsheet below we’ve built a table of the portfolio statistics using the formulas. In
the table we vary the proportion of Kellogg stock in the portfolio from 0 to 100% (which means,
of course, that the proportion of Exxon stock goes from 100 to 0%).

A B C D E F G H I J K
CALCULATING PORTFOLIO RETURNS
1 AND THEIR STATISTICS FROM THE FORMULAS
Kellogg Exxon
2 K XOM
3 Mean 6.00% 11.71%
4 Variance 1.71% 2.67%
5 Standard deviation 13.06% 16.34%
6 Covariance 0.0074 Portfolio Mean and Standard Deviation
7 12%
Portfolio expected return E(rp)

Portfolio
Portfolio Portfolio
Proportion of K standard 11%
Variance mean
in portfolio deviation
Var(rp) σp E(rp) 10%
8
9 0% 2.67% 16.34% 11.71%
9%
10 10% 2.31% 15.21% 11.14%
11 20% 2.01% 14.19% 10.57%
8%
12 30% 1.77% 13.32% 10.00%
13 40% 1.59% 12.61% 9.43% 7%
14 50% 1.47% 12.10% 8.85%
15 60% 1.40% 11.82% 8.28% 6%
16 70% 1.39% 11.78% 7.71%
17 80% 1.44% 11.98% 7.14% 5%
18 90% 1.54% 12.42% 6.57% 10% 11% 12% 13% 14% 15% 16% 17%
19 100% 1.71% 13.06% 6.00%
20 Portfolio standard deviation σp
21 =SQRT(B19)
22
23
24 =A19^2*$B$4+(1- =A19*$B$3+(1-
25 A19)^2*$C$4+2*A19*(1-A19)*$C$6 A19)*$C$3

The graph is one that you will see again (lots!) in Chapters 10 and 11. It plots the portfo-
lio standard deviation σp on the x-axis and the portfolio mean return E(r p) on the y-axis. The
parabolic shape of the graph is the subject of much discussion in finance, but this is a purely
technical chapter—the finance part of the discussion will have to wait until the following
chapters.

9.4. Using Regressions

Linear regression (for short, regression) is a technique for fitting a line to a set of data.
Regressions are used in finance to examine the relation between data series. In the chapters that
 CHAPTER 9 Statistics for Portfolios 289

follow we often need to use regressions; we introduce the basic concepts here. We do not dis-
cuss the statistical theory behind regressions, but instead we show you how to run a regression
and how to use it.
We’ve divided the discussion into three subsections: First we discuss the mechanics of
doing a regression in Excel, then we discuss the meaning of the regression, and finally we dis-
cuss alternative ways of doing the regression.

The Mechanics of Doing a Regression in Excel

In this subsection we discuss a simple regression example and make little attempt to explain the
economic meaning of the regression. Instead we focus on the mechanics of doing the regression
in Excel and leave the economic interpretation for the next subsection.
The table below gives the monthly returns for the S&P 500 Index (stock symbol SPX)
and for IBM (stock symbol IBM) for 2007 and 2008. The S&P 500 Index includes the
500 largest stocks traded on U.S. stock exchanges, and its performance is roughly indic-
ative of the performance of the U.S. stock market as a whole. We will use the regression
analysis to see whether we can understand the relation between S&P’s returns and IBM’s
returns—that is, if we can understand the effect of the U.S. stock market on the returns of
IBM’s stock.
Here are the data we examine. Note that we have graphed the data using an Excel XY scat-
ter graph (see Chapter 25 for details).

A B C D E F G H I J K L M

MONTHLY RETURNS ON S&P 500 AND IBM

1
January 2007 - December 2008
Price at beginning Return for the
of month month
2
3 Date S&P 500 IBM S&P 500 IBM
4 3-Jan-07 1438.24 95.08
5 1-Feb-07 1406.82 89.39 -2.18% -5.98% <-- =C5/C4-1
6 1-Mar-07 1420.86 90.66 1.00% 1.42% <-- =C6/C5-1
7 2-Apr-07 1482.37 98.31 4.33% 8.44%
8 1-May-07 1530.62 102.93 3.25% 4.70% IBM Monthly Returns vs S& P 500
9 1-Jun-07 1503.35 101.62 -1.78% -1.27%
10 2-Jul-07 1455.27 106.84 -3.20% 5.14%
2007-2008
11 1-Aug-07 1473.99 113.07 1.29% 5.83% 10%
12 4-Sep-07 1526.75 114.14 3.58% 0.95%
13 1-Oct-07 1549.38 112.52 1.48% -1.42% 5%
S&P Returns
14 1-Nov-07 1481.14 102.28 -4.40% -9.10% 0%
15 3-Dec-07 1468.36 105.12 -0.86% 2.78%
-20% -15% -10% -5% 0% 5%
16 2-Jan-08 1378.55 104.15 -6.12% -0.92% -5%
17 1-Feb-08 1330.63 111.14 -3.48% 6.71%
IBM returns

-10%
18 3-Mar-08 1322.70 112.39 -0.60% 1.12%
19 1-Apr-08 1385.59 117.82 4.75% 4.83% -15%
20 1-May-08 1400.38 126.85 1.07% 7.66%
21 2-Jun-08 1280.00 116.17 -8.60% -8.42% -20%
22 1-Jul-08 1267.38 125.43 -0.99% 7.97%
-25%
23 1-Aug-08 1282.83 119.77 1.22% -4.51%
24 2-Sep-08 1164.74 115.08 -9.21% -3.92%
25 1-Oct-08 968.75 91.48 -16.83% -20.51%
26 3-Nov-08 896.24 80.74 -7.48% -11.74%
27 1-Dec-08 903.25 83.27 0.78% 3.13%
28 2-Jan-09 825.88 90.68 -8.57% 8.90%
29
30 Total decline -42.58% -4.63% <-- =C28/C4-1
31 Largest monthly gain 4.75% 8.90% <-- =MAX(F5:F28)
32 Largest monthly loss -16.83% -20.51% <-- =MIN(F5:F28)

The months graphed were not happy months for American stocks! During these 2 years, the
S&P 500 declined almost 43% and IBM declined by almost 5%.
290 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

We want to draw a line through the points above, and we want this line to be to be the
“best” line in the sense that it is the closest line you could draw through the points.6 There are
several ways to do this in Excel (as usual). Here’s what we do:
• Click on the points of the graph so that Excel marks all of them. If you have a lot of data
points, Excel may mark only some of the points; just ignore this and proceed to the next
step. After you do this, you’ll see a graph like the one below (note that Excel shows us the
coordinates of the point we happened to point at—in this case the point where the SPX
return is −4.40% and the IBM return is −9.10%):

• With the points marked, right click the mouse and choose Add Trendline. This brings
up the following box, in which we leave the choice Linear regression. Note that we
have clicked the two boxes at the bottom of the box—“Display equation on chart” and
“Display R-squared value on chart.”

6
There’s a formal statistical definition of “best” and “closest,” but we’ll leave that to another
course.
 CHAPTER 9 Statistics for Portfolios 291

Clicking Close brings up the following chart.

292 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

The box with the regression results can be moved with the mouse. The text inside the box
can be formatted to the font and the size you desire.

What Does the Regression Mean?

The graph above shows the regression line as y = 0.915x + 0.020, R 2 = 0.422 . Because we’re
trying to understand the effect of the S&P Index on IBM stock, we can attach the following
meaning to the variables of the regression line:

• The “y” of the regression line stands for the monthly percentage return of IBM and the
“x” stands for the monthly percentage return of the S&P 500 index.
• The slope of the regression line is 0.915. This tells us that, on average, a 1% increase in
the S&P monthly return caused a 0.915% increase in the IBM monthly return.7 Of course
this also goes the other direction: On average, a 1% decrease in the S&P is related to a
0.915% decrease in IBM’s return.
• The fact that the slope of the regression is less than 1 means that IBM is somewhat
less sensitive to the S&P than an average stock: Variations (increases or decreases) in
the S&P return cause smaller variations in the IBM return. We return to this topic in
Chapter 11.
• The intercept of the regression line is 0.02. The intercept tells us that in months when
the S&P 500 doesn’t “move,” IBM’s return is 2%. This is a remarkable fact—it indicates
that during this period IBM had a “monthly excess return” over the S&P of 2%, which—
12
compounded annually—is (1 + 2% ) − 1 = 26.8%.
• The R2 (pronounced “r squared”) of the regression line says that 42.2% of the variabil-
ity in the IBM returns is explained by the variability of the S&P 500 returns. The other
58% of the return variability is presumably explained by factors that are unique to IBM.
You wouldn’t expect much more: If for some strange reason the R2 were 100%, this
would mean that all of IBM’s returns are explained by the S&P returns, which is clearly
nonsense.
The regression line thus allows you to make some interesting predictions about the IBM
return based on the S&P return. Suppose you’re a financial analyst and you think that this month
the S&P index will go up by 20%. Based on the regression, you’d expect IBM stock to increase

7
During the period 2007–2008, returns mostly declined! Therefore, another way of understanding the
coefficient 0.915 is that a decline of 1% in the S&P 500 was accompanied by a 0.915% decline in IBM
returns.
 CHAPTER 9 Statistics for Portfolios 293

by 0.915* 20% − 0.02 = 20.28% . Knowing that the R2 is approximately 42%, only about half of
the variability in IBM stock returns is explained by the S&P stock return, and you would thus
attach some degree of skepticism to this prediction.

Other Ways of Doing a Regression in Excel

As you might expect, in Excel there are other methods for calculating the slope, intercept, and
R2 of the regression equation. Excel has functions called Slope, Intercept, and Rsq. These func-
tions are illustrated below in cells F30, F33, and F36. Note that in these functions, the IBM
returns come before the S&P returns, so that we write, for example, Slope(IBM returns,S&P
returns).

A B C D E F G H I J K L M

MONTHLY RETURNS ON S&P 500 AND IBM

1
January 2007 - December 2008

Price at beginning Return for the

2 of month month
3 Date S&P 500 IBM S&P 500 IBM
4 3-Jan-07 1438.24 95.08
5 1-Feb-07 1406.82 89.39 -2.18% -5.98% <-- =C5/C4-1
6 1-Mar-07 1420.86 90.66 1.00% 1.42% <-- =C6/C5-1
7 2-Apr-07 1482.37 98.31 4.33% 8.44%
8 1-May-07 1530.62 102.93 3.25% 4.70% IBM Monthly Returns vs S&P 500
9 1-Jun-07 1503.35 101.62 -1.78% -1.27%
10 2-Jul-07 1455.27 106.84 -3.20% 5.14%
2007-2008
11 1-Aug-07 1473.99 113.07 1.29% 5.83% 10%
12 4-Sep-07 1526.75 114.14 3.58% 0.95%
13 1-Oct-07 1549.38 112.52 1.48% -1.42% 5%
S&P Returns
14 1-Nov-07 1481.14 102.28 -4.40% -9.10% 0%
15 3-Dec-07 1468.36 105.12 -0.86% 2.78%
-20% -15% -10% -5% 0% 5%
16 2-Jan-08 1378.55 104.15 -6.12% -0.92% -5%
17 1-Feb-08 1330.63 111.14 -3.48% 6.71%

IBM returns
-10%
18 3-Mar-08 1322.70 112.39 -0.60% 1.12%
19 1-Apr-08 1385.59 117.82 4.75% 4.83% -15%
20 1-May-08 1400.38 126.85 1.07% 7.66%
21 2-Jun-08 1280.00 116.17 -8.60% -8.42% -20%
y = 0.915x + 0.020
22 1-Jul-08 1267.38 125.43 -0.99% 7.97% R² = 0.422 -25%
23 1-Aug-08 1282.83 119.77 1.22% -4.51%
24 2-Sep-08 1164.74 115.08 -9.21% -3.92%
25 1-Oct-08 968.75 91.48 -16.83% -20.51%
26 3-Nov-08 896.24 80.74 -7.48% -11.74%
27 1-Dec-08 903.25 83.27 0.78% 3.13%
28 2-Jan-09 825.88 90.68 -8.57% 8.90%
29
30 Slope 0.9149 <-- =SLOPE(F5:F28,E5:E28)
31 0.9149 <-- =COVAR(F5:F28,E5:E28)/VARP(E5:E28)
32
33 Intercept 0.0204 <-- =INTERCEPT(F5:F28,E5:E28)
34 0.0204 <-- =AVERAGE(F5:F28)-F30*AVERAGE(E5:E28)
35
36 R-squared 0.4225 <-- =RSQ(F5:F28,E5:E28)
37 0.4225 <-- =CORREL(F5:F28,E5:E28)^2
294 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

The slope, intercept, and R2 can also be calculated directly using the Average, Covar,
Varp, and Correl (cells F31, F34, and F37 above). Look at the alternative definitions of each of
the regression variables:
• The regression slope can be computed with the Slope function (cell F30), but as shown
Covariance (S&P, IBM )
in cell F31 it is also equal to the .
Var (S&P )
• The regression intercept can be computed with the Intercept function, but as shown in
cell F34 it is also equal to Average (IBM ) − slope * Average (S&P ) .
• The regression R2 can be computed with the Rsq function, but as shown in cell F37 it is also
2
equal to the squared correlation between the S&P and IBM: ⎡⎣Correlation (S&P, IBM )⎤⎦ .

9.5. Advanced Topic: Portfolio Statistics for Multiple Assets

This section discusses a slightly more advanced topic. You can skip it on your first reading.
In Section 9.3 we discussed the calculation of the portfolio mean and variance for a two-asset
portfolio. In this section we discuss the calculation for a portfolio composed of more than two
assets.
To set the scene, we introduce some notation. Suppose that we have three stocks and that
for each stock i (i = 1,2,3) we have computed the mean E(ri ) and the variance σi2 = Var (ri ) of
the stock’s returns. Furthermore, suppose that for each pair of stocks i and j, we have calculated
the covariance of the returns Cov(ri ,rj ). Here’s an example.

A B C D E

PORTFOLIO RETURNS FOR A THREE-STOCK PORTFOLIO

1
Boeing Kellogg
2 Year ending BA K IBM
3 31-Dec-99 28.67% -7.31% 17.57%
4 29-Dec-00 61.21% -11.38% -20.83%
5 31-Dec-01 -40.42% 18.80% 43.00%
6 31-Dec-02 -13.40% 17.28% -35.45%
7 31-Dec-03 30.43% 14.56% 20.49%
8 31-Dec-04 24.89% 20.15% 7.19%
9 30-Dec-05 37.89% -0.93% -15.83%
10 29-Dec-06 28.40% 18.60% 19.77%
11 31-Dec-07 -0.11% 7.15% 12.84%
12 31-Dec-08 -50.07% -14.14% -20.79%
13
14 Average 10.75% 6.28% 2.79% <-- =AVERAGE(D3:D12)
15 Variance 0.1152 0.0166 0.0548 <-- =VARP(D3:D12)
16 Sigma 33.94% 12.87% 23.41% <-- =STDEVP(D3:D12)
17
18 Covariances Correlations
19 Cov(rBA,rK) -0.0043 Corr(rBA,rK) -0.0978 <-- =B19/(B16*C16)
20 Cov(rBA,rIBM) -0.0053 Corr(rBA,rIBM) -0.0669 <-- =B20/(B16*D16)
21 Cov(rK,rIBM) 0.0134 Corr(rK,rIBM) 0.4448 <-- =B21/(C16*D16)
 CHAPTER 9 Statistics for Portfolios 295

Now suppose we form a portfolio composed of the following proportions of each of the
stocks: xBA = 20%, xK = 50%, and xIBM = 1 – xBA – xK = 30%. Cells G3:G12 in the spreadsheet
below show you the returns of this portfolio, and cells H16:H18 compute the portfolio’s mean
return, variance, and standard deviation.

A B C D E F G H I

1 PORTFOLIO RETURNS FOR A THREE-STOCK PORTFOLIO

Boeing Kellogg Portfolio
2 Year ending BA K IBM return
3 31-Dec-99 28.67% -7.31% 17.57% 7.35% <-- =$B$14*B3+$C$14*C3+$D$14*D3
4 29-Dec-00 61.21% -11.38% -20.83% 0.30% <-- =$B$14*B4+$C$14*C4+$D$14*D4
5 31-Dec-01 -40.42% 18.80% 43.00% 14.21%
6 31-Dec-02 -13.40% 17.28% -35.45% -4.68%
7 31-Dec-03 30.43% 14.56% 20.49% 19.51%
8 31-Dec-04 24.89% 20.15% 7.19% 17.21%
9 30-Dec-05 37.89% -0.93% -15.83% 2.37%
10 29-Dec-06 28.40% 18.60% 19.77% 20.91%
11 31-Dec-07 -0.11% 7.15% 12.84% 7.40%
12 31-Dec-08 -50.07% -14.14% -20.79% -23.32%
13
Portfolio
0.20 0.50 0.30
14 proportions
15
16 Average 10.75% 6.28% 2.79% <-- =AVERAGE(D3:D12) Average 6.13% <-- =AVERAGE(H3:H12)
17 Variance 0.1152 0.0166 0.0548 <-- =VARP(D3:D12) Variance 0.0162 <-- =VARP(H3:H12)
18 Sigma 33.94% 12.87% 23.41% <-- =STDEVP(D3:D12) Sigma 12.73% <-- =STDEVP(H3:H12)
19
20 Covariances Alternative calculation of portfolio statistics
21 Cov(rBA,rK) -0.0043 <-- =COVAR(B3:B12,C3:C12) Average 6.13% <-- =$B$14*B16+$C$14*C16+$D$14*D16

<--
Cov(rBA,rIBM) -0.0053 <-- =COVAR(B3:B12,D3:D12) Variance 0.0162 =B14^2*B17+C14^2*C17+D14^2*D17+2*B14*
C14*B21+2*B14*D14*B22+2*C14*D14*B23
22
23 Cov(rK,rIBM) 0.0134 <-- =COVAR(D3:D12,C3:C12) Sigma 12.73% <-- =SQRT(H22)

If you look at cells H21:H23, you’ll see that there is a straightforward way of doing the
portfolio return calculations, based on the following formulas:

()
Average portfolio return (cell H21) = E rp = x BA E (rBA )+ xK E (rK )+ xIBM E (rIBM )
Portfolio variance (cell H22) = Var (r )= x p Var (rBA )+ xK2 Var (rK )+ xIBM
2
BA
2
Var (rIBM )
+2 x BA xK Cov (rBA , rK )+ 2 x BA xIBM Cov (rBA , rIBM )
+2 xK xIBM Cov (rBA , rIBM )

Portfolio standard deviation (cell H23) = Portfolio variance (cell H22)

These formulas generalize to any number of assets: If we have a portfolio composed of N

assets, and we know all the expected returns, variances, and covariances, then
• The portfolio’s expected return is the weighted average of the individual asset returns.
Denoting the portfolio weights by {x1, x2 ,..., x N }, the portfolio expected return is

E (rp ) = x1E (r1 ) + x2 E (r2 ) + ... + x N E (rN )

N
= ∑ xi E (ri )
i =1

• The portfolio’s variance of return is the sum of the following two expressions:
° The sum of each asset’s variance, weighted by the square of the asset’s portfolio pro-
portion: x12Var (r1 ) + x22Var (r2 ) + … + x N2 Var (rN ) .
° The sum of twice each of the covariances, weighted by the product of the asset
proportions:
296 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

2 x1x2Cov (r1, r2 ) + 2 x1x3Cov (r1, r3 ) + … + 2 x1x NCov (r1, rN )

+ 2 x2 x3Cov (r2, r3 )+ … + 2 x2 x NCov (r2, rN )
+ . . . + 2 x N −1x NCov (rN −1, rN )

Conclusion and Summary

Information about stocks—their prices, dividends, and returns—produces mounds of data.
Statistics is a way of dealing with these large masses of data. This chapter has given you the
necessary statistical techniques to do typical finance computations related to stocks. We’ve
shown how to compute stock returns from basic data about stock prices, dividends, and stock
splits. We’ve also shown how to compute the mean return (also called the average return), the
variance and standard deviation of returns, and the covariance between the returns of two dif-
ferent stocks.
Stocks are most often combined into portfolios, and this chapter has shown you how to com-
pute the mean and standard deviation of a portfolio’s return. It also introduced you to regression
analysis, which allows you to relate the returns of two stocks one to the other.
In succeeding chapters we will use these statistical techniques to do financial analysis of
individual stocks and stock portfolios.

EXERCISES
Note: The data for these problems is included in the CD-ROM that comes with the book.
1. Here is the stock price history of HighTech and LowTech corporations.
Calculate the following:

A B C
HighTech Corp. LowTech Corp.
1 Stock price Stock price
2 31-Dec-11 75.00 40.00
3 31-Dec-12 86.25 45.20
4 31-Dec-13 125.32 55.60
5 31-Dec-14 91.64 48.37
6 31-Dec-15 100.80 32.88
7 31-Dec-16 145.93 61.64
8 31-Dec-17 151.21 75.82
9 31-Dec-18 196.57 97.05
10 31-Dec-19 226.05 109.66
11 31-Dec-20 89.00 122.99

a. The annual returns for each stock.

b. The mean (average) return for the period of 10 years for each firm. Which stock has the higher
average return?
c. The variance and the standard deviation of returns for the period of 10 years for each firm.
Which stock is riskier?
 CHAPTER 9 Statistics for Portfolios 297

d. The covariance and correlation of the returns for each firm. Use two formulas to compute the
correlation: The Excel formula Correl and the definition

Cov (rA , rB )
Correlation (rA , rB ) = .
σ Aσ B

e. If you had to choose between the two stocks, which would you choose? Explain briefly.
2. Below you will find price data for three mutual funds.

A B C D
1 DATA ON THREE MUTUAL FUNDS
Scudder Value Line
Development Leveraged Fidelity
2 Date Fund Growth Fund Fund
3 4-Jan-93 24.34 17.47 9.47
4 3-Jan-94 24.20 20.32 11.39
5 3-Jan-95 20.87 19.15 11.19
6 2-Jan-96 30.35 24.45 15.25
7 2-Jan-97 30.94 26.95 18.46
8 2-Jan-98 31.28 32.08 23.44
9 4-Jan-99 33.32 47.19 31.04
10 3-Jan-00 36.06 49.12 35.36
11 2-Jan-01 33.89 47.23 33.82
12 2-Jan-02 20.01 37.31 28.46
13 2-Jan-03 13.79 26.87 21.55

a.Compute the annual returns on the funds for the period.

b.Compute the mean, variance, and standard deviation of the fund returns.
c.Graph the fund returns and the dates.
d.Calculate the correlations of the fund returns.
e.If the historical information correctly predicts future returns (is this reasonable?), which fund
would you choose?
3. Here is the monthly stock price data for Ford Corp. and GM Corp.

A B C D
1 PRICES FOR FORD AND GM STOCK
2 Date Ford GM
3 8-Nov-99 24.44 66.08
4 1-Dec-99 25.79 65.09
5 3-Jan-00 24.32 72.14
6 1-Feb-00 20.35 68.54
7 1-Mar-00 22.45 74.63
8 3-Apr-00 27.00 84.37
9 1-May-00 23.95 64.02
10 1-Jun-00 22.08 52.63
11 3-Jul-00 24.17 51.61
12 1-Aug-00 21.95 63.97
13 1-Sep-00 23.14 59.40
14 2-Oct-00 23.98 56.77
15 1-Nov-00 20.89 45.64
16 1-Dec-00 21.52 46.96
17 2-Jan-01 26.16 49.51
18 1-Feb-01 25.30 51.77
298 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Calculate the following:

• Monthly returns for each firm.
• Covariance between returns of Ford Corp. and GM Corp.
• Correlation between returns of Ford Corp. and GM Corp.
4. Using the returns of Ford and GM corporations you calculated in the previous question, perform a
regression of Ford’s returns versus GM’s returns. Report the following:
• The slope of the regression.
• The value of the intercept.
• The r-squared of the regression.
Is the mutual impact of the two company’s returns (one on the other) large or small?
Explain.
5. Here are stock price and dividend data for Kellogg Co.

A B C
KELLOGG PRICE
1 AND DIVIDEND DATA
Dividend
during
2 Price year
3 31-Dec-89 64.62
4 31-Dec-90 78.00 1.44
5 31-Dec-91 56.75 2.15
6 31-Dec-92 62.12 1.16
7 31-Dec-93 53.75 1.32
8 31-Dec-94 55.00 1.40
9 31-Dec-95 76.62 1.50
10 31-Dec-96 69.62 1.62
11 31-Dec-97 46.38 1.28
12 31-Dec-98 40.62 0.90
13 31-Dec-99 24.25 0.98
14 31-Dec-00 26.20 1.00
15 31-Dec-01 30.86 1.00
16 31-Dec-02 33.40 1.00

a. Calculate the dividend-adjusted returns for each of the years, their mean, and their standard
deviation.
b. Stock analysts like to talk about the dividend yield—the dividend divided into the stock price.
Dividends over the year
Compute the annual dividend yield for Kellogg (define it as )
Stock price at beginning of year
and compute its statistics (mean and standard deviation) over the period.
c. If you bought Kellogg stock and had no intention of ever selling it, why might you be interested
in the stock’s dividend yield?
 CHAPTER 9 Statistics for Portfolios 299

6. Below you will find stock price, dividend, and split data for IBM. Calculate the dividend and split-
adjusted returns for each of the years, their mean, and their standard deviation.
A B C D
IBM PRICE, DIVIDEND, AND SPLIT
1 DATA
Dividend
Closing during
2 price year Other information
3 31-Dec-89 98.62
4 31-Dec-90 126.75
5 31-Dec-91 90.00
6 31-Dec-92 51.50
7 31-Dec-93 56.50
8 31-Dec-94 72.12
9 31-Dec-95 108.50
10 31-Dec-96 156.88
11 31-Dec-97 98.75 2 for 1 split (May 97)
12 31-Dec-98 183.25
13 31-Dec-99 112.25 2 for 1 split (May 99)
14 31-Dec-00 112.00
15 31-Dec-01 107.89
16 31-Dec-02 78.20 0.30

7. Compute the covariance and correlation coefficient between IBM and Kellogg (previous two
questions). Are there any advantages to diversifying between IBM and Kellogg?
8. Here is the stock price and split data for HeavySteel Corp.

A B C
HEAVYSTEEL
1 CORPORATION
Closing stock Stock
2 price splits
3 31-Dec-01 11.24
4 31-Dec-02 11.98
5 31-Dec-03 10.23
6 31-Dec-04 11.02 2 for 1
7 31-Dec-05 12.56
8 31-Dec-06 13.45
9 31-Dec-07 15.36 1.5 for 1
10 31-Dec-08 16.01
11 31-Dec-09 17.23
12 31-Dec-10 15.23

a. Calculate the split-adjusted returns for each year and its statistics (mean and standard
deviation).
b. If you bought 100 shares of this stock in the beginning of 1990 and during the period of 10
years never sold or bought additional shares, how many shares would you have by the end of
2000?
300 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

9. A reverse split is just like a split, but only in a reverse direction. For example, in a 1 for 2 reverse
split, you receive 1 share for every 2 shares you hold. How would your answers to the previous
question change if you learned that in 1999 the firm did a 3 for 4 reverse split?
10. Here are two companies: Young Corp. and Mature Corp. Young Corp. grows very rapidly, does
not pay any dividends, and retains all its profits. Mature Corp. stopped growing a long time ago,
generates sizable cash flows, and pays out dividends.

A B C D

Young Corp. Mature Corp.

1
Dividend per
Share price Share price
2 share
3 31-Dec-05 32.56 78.50 0.00
4 31-Dec-06 34.50 82.50 0.00
5 31-Dec-07 38.98 84.50 1.00
6 31-Dec-08 44.50 81.60 0.00
7 31-Dec-09 40.20 79.60 1.50
8 31-Dec-10 39.50 80.96 1.50
9 31-Dec-11 38.45 82.65 0.00
10 31-Dec-12 37.50 83.69 2.00
11 31-Dec-13 43.58 82.79 2.00
12 31-Dec-14 50.30 81.97 0.00

Calculate the following:

• Young’s yearly returns.
• Mature’s yearly returns.
• Which is the better investment of the two? Give a brief explanation.
11. Chicken Feed and Poultry Delight are two stocks traded on the Farmers Stock Exchange. A
statistician has determined that the returns on the two stocks are related by the equation
rChicken Feed , t = 50% − 0.8 * rPoultry Delight , t . Show that the correlation between the two sets of returns is −1. Use
the following template.

A B C
Poultry
Delight Chicken
stock Feed stock
2 Year return return
3 1990 30.73%
4 1991 55.21%
5 1992 15.82%
6 1993 33.54%
7 1994 14.93%
8 1995 35.84%
9 1996 48.39%
10 1997 37.71%
11 1998 67.85%
12 1999 44.85%
13
14 Correlation
 CHAPTER 9 Statistics for Portfolios 301

12. Below you will find the annual returns of two assets. Fill in the blanks and graph the returns of
the portfolios (rows 13–27).

A B C
1 Asset 1 Asset 2
2 31-Dec-90 12.56% 7.56%
3 31-Dec-91 13.50% 8.56%
4 31-Dec-92 14.23% 4.56%
5 31-Dec-93 15.23% 2.12%
6 31-Dec-94 14.23% 1.23%
7 31-Dec-95 12.23% 0.26%
8 31-Dec-96 10.23% 3.25%
9 31-Dec-97 5.26% 4.89%
10 31-Dec-98 4.25% 5.56%
11 31-Dec-99 2.23% 6.45%
12
13 Average return
14 Return variance
15 Covariance
Portfolio Portfolio
Proportion of standard mean
16 asset 1 deviation return
17 0
18 0.1
19 0.2
20 0.3
21 0.4
22 0.5
23 0.6
24 0.7
25 0.8
26 0.9
27 1
302 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

13. Below are data on the returns of General Electric, Boeing, and Walmart.
Calculate the highlighted cells.
A B C D
MONTHLY RETURNS: BOEING (BA),
GENERAL ELECTRIC (GE),
1 WALMART (WMT)
Return for
2 month ending BA GE WMT
3 2-Feb-09 -28.69% -32.58% 4.42%
4 2-Mar-09 12.35% 17.26% 6.20%
5 1-Apr-09 11.83% 22.44% -3.33%
6 1-May-09 12.29% 6.33% -0.78%
7 1-Jun-09 -5.36% -13.18% -2.64%
8 1-Jul-09 0.94% 13.41% 2.93%
9 3-Aug-09 15.59% 3.68% 2.51%
10 1-Sep-09 8.64% 17.23% -3.56%
11 1-Oct-09 -12.48% -14.11% 1.19%
12 2-Nov-09 10.08% 11.66% 9.35%
13 1-Dec-09 3.23% -5.09% -1.54%
14 4-Jan-10 11.29% 6.10% -0.04%
15 1-Feb-10 4.83% 0.50% 1.20%
16 1-Mar-10 13.93% 12.53% 3.35%
17 1-Apr-10 -0.25% 3.53% -3.59%
18 3-May-10 -11.51% -14.26% -5.33%
19 1-Jun-10 -2.25% -11.95% -5.05%
20 1-Jul-10 3.00% 3.61% 2.79%
21
22 Average return
23 Standard deviation
24 Covariances
25 Cov(BA,GE)
26 Cov(BA,WMT)
27 Cov(GE,WMT)
28
29 Correlations
30 Corr(BA,GE)
31 Corr(BA,WMT)
32 Corr(GE,WMT)
33
34 Portfolio proportions
35 BA 0.5
36 GE 0.3
37 WMT 0.2
38
39 Portfolio mean return
40 Portfolio variance
41 Portfolio standard deviation

14. Go to http://finance.yahoo.com. Download monthly stock price data for Oracle Corporation
(ORCL), Microsoft Corporation (MSFT), Dell Corp. (DELL), and Gateway Corp. (GTW) for
2007 and 2008. Also, download the same data for S&P 500 index (SPX) for the same period.8
Answer the following questions:
a. What is the mean return, variance, and standard deviation of a portfolio consisting of the four
stocks, where wealth is allocated equally among each stock?
b. On average, would you be better off investing in this portfolio or investing in S&P 500 index,
during the period of 2 years?

8
Recall that when you download data from Yahoo! into Excel, it is already adjusted for stock splits and
dividends.
 CHAPTER 9 Statistics for Portfolios 303

15. Using information provided in the previous problem, perform a regression of the portfolio returns
versus S&P 500 index returns for a period of 24 months. Report the following: The slope of the
regression, its intercept, and I-squared. Explain what each of these numbers tell you.
16. (This is a hard question!) On the disk that comes with the book, you will fi nd 2 years of
monthly unadjusted and adjusted stock price data for AT&T Corp. (symbol: T). Calculate the
following:
a. Cumulative adjustment factor for AT&T stock.
b. What two interesting things happened in November 2002 and what happened to cumulative
adjustment factor in this month? (You will have to do an Internet search.)
17. Explain why each of the following statements is correct or incorrect:
a. Diversification reduces risk because prices of stocks do not usually move exactly together.
b. The expected return on a portfolio is a weighted average of the expected returns on the indi-
vidual securities.
c. The standard deviation of returns on a portfolio is equal to the weighted average of the stan-
dard deviations on the individual securities if these returns are completely uncorrelated.
18. Suppose that the annual returns on two stocks (A and B) are perfectly negatively correlated and
that rA = 0.05, rB = 0.15, σA = 0.1, and σB = 0.4. Assuming that there are no arbitrage opportunities,
what must the 1-year interest rate be?
19. Assume that an individual can either invest all of her resources in one of two securities A or B or,
alternatively, she can diversify her investment between the two. The distribution of the returns is
as follows.

A B C D
1 Security A Security B
2 Return Probability Return Probability
3 -10% 0.5 -20% 0.5
4 50% 0.5 60% 0.5

Assume that the correlation between the returns from the two securities is zero.
a. Calculate each security’s expected return, variance, and standard deviation.
b. Calculate the probability distribution of the returns on a mixed portfolio composed of equal
proportions of securities A and B. Also calculate the expected return, variance, and standard
deviation.
c. Calculate the expected return and the variance of a mixed portfolio composed of 75% security
A and 25% security B.
304 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

A B C D E F G H
Cumulative
Adj. Adjustment
1 Date Open High Low Close Volume Close* factor
2 Dec 02 $0.19 Cash Dividend
3 Dec 02 28.54 28.88 25.11 26.11 4,932,428 26.11
4 Nov 02 $8.48 Cash Dividend
5 Nov 02 1:5 Stock Split

6 Nov 02 12.94 28.25 12.84 28.04 13,146,915 28.04

7 Oct 02 12.1 13.64 10.45 13.04 14,453,869 65.2
8 Sep 02 $0.04 Cash Dividend
9 Sep 02 11.95 13.79 11.2 12.01 15,095,745 60.05
10 Aug 02 10.12 12.85 8.69 12.22 17,147,918 61.1
11 Jul 02 10.5 10.55 8.2 10.18 18,639,136 50.9
12 Jun 02 $0.04 Cash Dividend
13 Jun 02 11.85 12.4 9.09 10.7 29,520,930 53.5
14 May 02 13.2 14.3 11.76 11.97 17,814,400 59.85
15 Apr 02 15.74 15.85 12.66 13.12 15,936,609 65.6
16 Mar 02 $0.04 Cash Dividend
17 Mar 02 15.8 16.48 15 15.7 11,042,700 78.5
18 Feb 02 17.55 17.91 14.18 15.54 16,401,442 77.7
19 Jan 02 18.48 19.25 16.65 17.7 11,919,185 88.5
20 Dec 01 $0.04 Cash Dividend
21 Dec 01 17.35 18.75 15.8 18.14 14,846,490 90.7
22 Nov 01 15.33 17.85 14.75 17.49 10,987,857 87.45
23 Oct 01 19.15 20 15.17 15.25 15,015,643 76.25
24 Sep 01 $0.04 Cash Dividend
25 Sep 01 19.01 19.64 16.5 19.3 15,798,733 96.5
26 Aug 01 20.32 20.95 18.66 19.04 7,457,491 95.2
27 Jul 01 $5.52 Cash Dividend
28 Jul 01 21.75 23 18.1 20.21 16,556,647 101.05
29 Jun 01 $0.04 Cash Dividend
30 Jun 01 21.16 22.16 19.82 22 11,332,052 110
31 May 01 22.58 23.1 20.48 21.17 15,562,513 105.85
32 Apr 01 21.3 23.27 19.85 22.28 12,075,000 111.4
33 Mar 01 $0.04 Cash Dividend
34 Mar 01 22.8 24.6 20.6 21.3 12,662,459 106.5
35 Feb 01 23.95 24.53 20.2 23 12,220,989 115
36 Jan 01 17.37 25.15 17.25 23.99 20,407,609 119.95
37 Dec 00 $0.04 Cash Dividend
38 Dec 00 19.44 22.69 16.5 17.25 23,385,210 86.25
39 Nov 00 22.62 22.94 18.25 19.62 20,863,095 98.1
40 Oct 00 29 30 21.25 23.19 24,254,945 115.95
41 Sep 00 $0.22 Cash Dividend
42 Sep 00 31.62 32.94 27.25 29 19,280,690 145
43 Aug 00 30.94 32.94 29.62 31.62 17,828,760 158.1
44 Jul 00 31.81 35.19 30.5 30.94 19,562,070 154.7
45 Jun 00 $0.22 Cash Dividend
46 Jun 00 34.94 37.75 31.25 31.81 20,312,436 159.05
47 May 00 46.31 49 33.63 34.94 25,649,081 174.7
48 Apr 00 56.69 58.81 45.88 45.88 12,616,194 229.4
49 Mar 00 $0.22 Cash Dividend
50 Mar 00 49.38 61 47.5 56.31 13,692,547 281.55
51 Feb 00 52.75 53 44.31 49.38 10,648,485 246.9
52 Jan 00 50.81 56 47.5 52.75 11,964,045 263.75
53 Dec 99 $0.22 Cash Dividend
54 Dec 99 55.88 58.69 49.88 50.81 9,812,559 254.05
55 Nov 99 47.13 61 44.94 55.88 13,277,338 279.4
56 Oct 99 43.5 49.06 41.5 46.75 11,850,266 233.75
57 Sep 99 $0.22 Cash Dividend
58 Sep 99 45.38 48.81 41.81 43.5 10,775,514 217.5
59 Aug 99 52.13 52.81 44.25 45 12,892,813 225
60 Jul 99 55.94 59 51.75 52.13 9,257,600 260.65
61 Jun 99 $0.22 Cash Dividend
62 Jun 99 55.5 56.88 52.38 55.81 10,673,172 279.05
63 May 99 51 63 50.88 55.5 14,542,265 277.5
64 Apr 99 3:2 Stock Split
65 Apr 99 79.81 89.5 50.06 50.5 13,690,428 252.5
66 Mar 99 $0.33 Cash Dividend
67 Mar 99 82.12 89 75.87 79.81 9,906,500 266.03
68 Feb 99 91.94 95.12 82.12 82.12 8,755,210 273.73
69 Jan 99 76.5 96.12 76.5 90.75 10,024,863 302.5

20. The correlations between the returns of three stocks A, B, and C are given in the following table.

A B C D
1 Stock A B C
2 A 1.00 0.80 0.10
3 B 1.00 0.15
4 C 1.00

The expected rates of return on A, B, and C are 16, 12, and 15%, respectively. The corresponding stan-
dard deviations of the returns are 25, 22, and 25%.
 CHAPTER 9 Statistics for Portfolios 305

a. What is the standard deviation of a portfolio invested 25% in stock A, 25% in stock B, and
50% in stock C?
b. You plan to invest 50% of your money in the portfolio constructed in Question 20a and 50% in
the risk-free asset. The risk-free interest rate is 5%. What is the expected return on this invest-
ment? What is the standard deviation of the return on this investment?
21. You believe that there is a 15% chance that stock A will decline by 10% and an 85% chance that
it will increase by 15%. Correspondingly, there is a 30% chance that stock B will decline by 18%
and a 70% chance that it will increase by 22%. The covariance between the two stocks is 0.009.
Calculate the expected return, the variance, and the standard deviation for each stock. Then cal-
culate the correlation coefficient between their returns.
22. Outdoorsy people know that the crickets chirp faster when the temperature is warmer. Some evidence
for this can be found in a book published in 1948 by Harvard physics professor George W. Pierce.9
Pierce’s book includes the table below, which relates the average number of cricket chirps per minute
to the temperature at which the data were recorded. Plot the data in an Excel graph and use regression
to determine the (approximate) relation between the number of chirps per second and the tempera-
ture. If you detect 19 chirps per second, what would you guess the temperature to be? What about 22
chirps a second? (We know this problem has nothing to do with finance, but it’s interesting!)

A B
Chirps per Temperature
4 second in Farenheit
5 20.0 88.60
6 16.0 71.60
7 19.8 93.30
8 18.4 84.30
9 17.1 80.60
10 15.5 75.20
11 14.7 69.70
12 17.1 82.00
13 15.4 69.40
14 16.2 83.30
15 15.0 79.60
16 17.2 82.60
17 16.0 80.60
18 17.0 83.50
19 14.4 76.30

23. Economists have long believed that the more money printed, the higher will be long-term interest
rates. Evidence for this view can be found in the following table, which gives long-term govern-
ment bond rates for 31 countries and the corresponding growth rate of money supply for each
country.10
• Plot the data and use a regression to find the relation between the money growth and the long-
term bond interest rate.
• If a country has zero money growth, what is its predicted long-term bond interest rate?
• The monetary authorities in your country are considering increasing the money growth rate by 1%
from its current level. Predict by how much this will increase the long-term bond interest rate.
• Do you find the evidence in the table convincing? (Discuss briefly the R2 of the regression.)

9
Additional facts: Cricket chirping is produced by the rapid sliding of the cricket’s wings one over the
other. The higher the temperature, the faster the crickets slide their wings. George W. Pierce’s book is
called The Songs of Insects and was published by Harvard University Press.
10
The data were first presented in an article entitled “Money and Interest Rates,” by Cyril Monnet and
Warren Weber in the Federal Reserve Bank of Minneapolis Quarterly Review, Fall 2001. My thanks to
the authors for providing me with an Excel version of their data.
306 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

A B C D E F G
38 MONEY GROWTH AND BOND INTEREST RATES
Average long- Average long-
Average term Average term
money bond interest money bond interest
39 Country growth rate Country growth rate
40 US 5.65% 7.40% New Zealand 10.29% 8.81%
41 Austria 6.82% 7.80% South Africa 14.14% 11.11%
42 Belgium 5.20% 8.22% Honduras 16.20% 15.57%
43 Denmark 9.43% 10.36% Jamaica 19.88% 15.35%
44 France 8.15% 8.49% Netherlands Antilles 4.36% 9.40%
45 Germany 8.00% 7.20% Trinidad & Tobago 12.14% 9.10%
46 Italy 12.07% 10.66% Korea 15.12% 16.53%
47 Netherlands 7.89% 7.31% Nepal 15.55% 8.59%
48 Norway 10.64% 8.00% Pakistan 12.79% 7.88%
49 Switzerland 5.53% 4.54% Thailand 10.86% 10.62%
50 Canada 8.99% 8.52% Malawi 20.80% 17.62%
51 Japan 9.07% 6.16% Zimbabwe 13.49% 12.01%
52 Ireland 9.43% 10.38% Solomon Islands 15.89% 12.12%
53 Portugal 12.91% 10.79% Western Samoa 12.90% 13.17%
54 Spain 10.38% 12.72% Venezuela 28.47% 28.92%
55 Australia 9.15% 8.95%

24. Mabelberry Fruit and Sawyer’s Jam are two competing companies. An MBA student has done a
calculation and found that the return on Sawyer’s Jam stock is completely predictable once the
return on Mabelberry Fruit stock is known:
rSawyer ' s,t = 40% − 1.5* rMabelberry,t .

a. Given the Mabelberry Fruit stock returns below, compute the Sawyer’s Jam returns.
b. Regress Mabelberry Fruit stock returns on those of Sawyer’s Jam. Can you explain the R2?

A B
Mabelberry
Fruit stock
2 Year return
3 1990 30.73%
4 1991 15.00%
5 1992 -9.00%
6 1993 12.00%
7 1994 13.00%
8 1995 22.00%
9 1996 30.00%
10 1997 12.00%
11 1998 43.00%
12 1999 16.00%
 CHAPTER 9 Statistics for Portfolios 307

APPENDIX 9.1: DOWNLOADING DATA FROM YAHOO!11

Yahoo! provides free stock price and data that can be used to calculate returns. In this
appendix we show you how to access these data and download them into Excel.
Step 1: Go to http://www.yahoo.com and click on Finance.

Step 2: In the “Enter symbol” box, put in the symbol for the stock you want to look up
(we’ve put in MRK for Merck). You see that you can also look up symbols or put in multiple
symbols. When you have put in the symbols, click Go.

Step 3: This brings up the following screen. We choose Historical Prices to get Merck’s
price history.

11
Yahoo! occasionally changes its interface; the information in this appendix is correct as of July 2005.
308 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Step 4: In the next screen, we indicated the time period and frequency for the data we want.
Yahoo! provides a table with stock prices, dividends, and an Adjusted Closing Stock Price that
accounts for dividends and stock splits.
 CHAPTER 9 Statistics for Portfolios 309

Step 5: The bottom of the above table allows you to download the data in spreadsheet for-
mat. In most browsers the Excel spreadsheet opens automatically (see the results in Step 6).

Step 6: In the author’s browser Yahoo! offers to save a file called table.csv. We changed the
name of this file to Merck.csv and saved it on our hard disk.
310 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Step 7: The author’s browser offered to open the file immediately (it will open as an Excel
file). Here’s the way the opened Excel file looks.

Step 8: It is advisable to use the Excel command File|Save As to save the file as a standard
Excel file.
 CHAPTER 9 Statistics for Portfolios 311

APPENDIX 9.2: WHY VARP INSTEAD OF VAR?

Throughout P RINCIPLES OF FINANCE WITH EXCEL we use the Excel functions Varp and Stdevp
instead of their cousins Var and Stdevp. This appendix briefly discusses this choice.
Recall that the definition of these two functions relates to whether the data are taken from a
sample or whether the data are the whole population. Suppose we have return data {r1, r2 ,..., rN }
for a stock. Then Varp is the population variance and Var is the sample variance.
1 N
N∑
2
Population variance = Varp = (rt − r )
t =1
1 N
∑
2
Sample variance = Var = (rt − r )
N − 1 t =1

There are two reasons why we choose Varp instead of Var: The first reason is that in most
introductory statistics courses students are taught Varp (that is, divide by N) instead of Var
(divide by N − 1). Thus, the choice made in Principles of Finance with Excel corresponds with
what students have been previously taught.
The second reason for choosing Varp is that this choice makes the Excel Slope function
Covariance (rit , rMt )
consistent with the definition of β that we teach: βi = . To see this,
Variance (rMt )
reconsider the following example from Section 9.5 in which we calculate the βMirage for Mirage
from monthly data for Mirage and for the S&P 500 index.
In cells B28:B29 we compute the βMirage using the Excel function Slope(C3:C26,B3:B26)
and the Excel functions Covar(C3:C26,B3:B26)/VarP(B3:B26). These two definitions give
the same (and the correct) answer. In cells B31:B32 we compare the Excel Slope function with
the answer given by Covar(C3:C26,B3:B26)/Var(B3:B26). Note that the answers are different
(the second answer is incorrect).
To drive home this point, we compute βM in cells B34:B36. The Slope function gives the
correct answer, as does the definition Covar(B3:B26,B3:B26)/VarP(B3:B26). However, using
the function Var in cell B36 gives the wrong answer.
312 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

A B C D
1 WHY VARP INSTEAD OF VAR?
S&P 500 Mirage
Index Resorts
2 Date SPX MIR
3 Jan-97 6.13% 16.18%
4 Feb-97 0.59% 0.00%
5 Mar-97 -4.26% -15.42% The S&P index
6 Apr-97 5.84% -5.29% represents the
7 May-97 5.86% 18.63% market returns
8 Jun-97 4.35% 5.76%
9 Jul-97 7.81% 5.94%
10 Aug-97 -5.75% 0.23%
11 Sep-97 5.32% 12.35%
12 Oct-97 -3.45% -17.01%
13 Nov-97 4.46% -5.00%
14 Dec-97 1.57% -4.21%
15 Jan-98 1.02% 1.37%
16 Feb-98 7.04% -0.54%
17 Mar-98 4.99% 5.99%
18 Apr-98 0.91% -9.25%
19 May-98 -1.88% -5.67%
20 Jun-98 3.94% 2.40%
21 Jul-98 -1.16% 0.88%
22 Aug-98 -14.58% -30.81%
23 Sep-98 6.24% 12.61%
24 Oct-98 8.03% 1.12%
25 Nov-98 5.91% -12.18%
26 Dec-98 5.64% 0.42%
27
Mirage β
using
28 VarP 1.4693 <-- =SLOPE(C3:C26,B3:B26)
29 1.4693 <-- =COVAR(C3:C26,B3:B26)/VARP(B3:B26)
30
Mirage β
using
31 Var 1.4693 <-- =SLOPE(C3:C26,B3:B26)
32 1.4080 <-- =COVAR(C3:C26,B3:B26)/VAR(B3:B26)
33
Market β
using
34 Var 1.0000 <-- =SLOPE(C3:C26,C3:C26)
35 1.0000 <-- =COVAR(B3:B26,B3:B26)/VARP(B3:B26)
36 0.9583 <-- =COVAR(B3:B26,B3:B26)/VAR(B3:B26)
37
38 The beta of the market should = 1.
39 But using Covar(rM,rMirage)/Var(rM)
40 produces a beta < 1.
41
Conclusion: Best use VarP instead of Var!12

12
There’s a slightly more cynical answer to the difference between Var and VarP. “If the difference
between N and N − 1 ever matters to you, then you are probably up to no good anyway—e.g., trying to sub-
stantiate a questionable hypothesis with marginal data.” This wonderful quote is from the book Numerical
Recipes by William H. Press, Brian P. Flannery, Saul A. Teukolsky, and William T. Vettering (Cambridge
University Press, 1986, page 456).
CHAP TER

Portfolio Returns and the

10 Efficient Frontier

CHAPTER CONTENTS
Overview 313
10.1. The Advantage of Diversification—A Simple Example 315
10.2. Back to the Real World—Kellogg and Exxon 320
10.3. Graphing Portfolio Returns 321
10.4. The Efficient Frontier and the Minimum Variance Portfolio 327
10.5. The Effect of Correlation on the Efficient Frontier 330
Summary 333
Exercises 334
Appendix 10.1: Deriving the Formula for the Minimum Variance Portfolio 338
Appendix 10.2: Portfolios with Three and More Assets 338
Exercises for Appendix 10.2 343

Overview
How should you invest your money? What’s the best investment portfolio? How do you maxi-
mize your return without losing money? People often ask these knotty questions, and you may
even be reading this book to answer them. In this and the next chapter we explore some of the
answers to these questions. You will see that—although no one can tell you exactly how to

313
314 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

invest—we can shed considerable light on some important general investment principles. We
can also show you some rules of thumb about how not to invest.
Let’s go back to the questions with which we started the previous paragraph:
• How should you invest your money? Finance can’t tell you in what to invest, but it can
give you some guidelines. The most important is this: You should diversify your invest-
ment—spread it out among many assets to lower the risk. Using simple examples with
only two stocks, this chapter will show you how diversification can lower investment
risk.
• What is the best investment portfolio? It won’t surprise you that the finance answer to
this question tells you that there is no single best investment portfolio. It all depends
on your willingness to trade off return for additional risk.1 What may surprise you,
however, is that we can say a lot about how not to invest. In this chapter we develop the
notion of the efficient frontier—this is the set of all portfolios that you would consider
as investment portfolios. Inherent in the concept of the efficient frontier is that there are
many portfolios that are not good investments and these portfolios can be described
statistically.
• How do you maximize your return without losing money? To some extent the effi-
cient frontier answers this question: It shows us which portfolios are so bad that you
can improve both the return and the risk. Once we’ve gotten on the efficient frontier,
however, the risk–return trade-off begins to operate, and higher returns mean larger
risks.2

FIGURE 10.1 Vanguard Funds is a major manager of stock and bond funds. Here’s how the Vanguard
Web site defines diversification.

1
As you learned in Chapter 8, nearly all the interesting finance questions involve the word “risk.” Portfolio
choice is no different!
2
As the author’s father used to say: “It is better to be rich and healthy than poor and sick.” The investment
interpretation of this is that we would all like to have more return and risk less. The efficient frontier rep-
resents the set of difficult investment choices: Once you’re on the efficient frontier, it is impossible to get
more return without taking on more risk.
 CHAPTER 10 Portfolio Returns and the Efficient Frontier 315

In most of this chapter we examine the risk and return of portfolios composed of two finan-
cial assets. By choosing a combination of the two assets, you can achieve significant reductions
in risk.3 Much of the chapter relies on the statistics for portfolios discussed in the previous chap-
ter. Even our main example, which considers portfolios of Exxon (XOM) and Kellogg (K) stock,
is one we started in Chapter 9.
The close links in the materials of this chapter and the materials in Chapter 9 should not
blind you to their differences. Whereas Chapter 9 develops the statistical concepts necessary for
portfolio choice, this chapter looks at portfolio choice as an economic choice. In this chapter we
develop concepts that help us think more precisely about acceptable and unacceptable portfo-
lios. In the next chapter we carry this line of thought further.

Finance Concepts in This Chapter

• Mean and standard deviation of portfolio of two assets
• Portfolio risk and return
• Minimum variance portfolio
• The efficient frontier
• Mean-variance calculations for three-asset portfolios

Excel Concepts and Functions Used

• Average( ), Varp( ), Stdevp( )
• Regression
• Sophisticated graphing
• Solver

10.1. The Advantage of Diversification—A Simple Example

In this section we give an example that illustrates the benefits of diversification. In finance
jargon, diversification means investing in several different assets as opposed to putting all of
your money in one single asset. In our examples you will see when diversification pays off (and
when it doesn’t). The examples are much simpler than the real-world examples that follow in the
next sections, but they embody many of the intuitions of why investors invest in portfolios. In
particular, you will see how the correlation between asset returns is important in determining
the amount of risk reduction you can get through portfolio formation.
In each of the following examples you can invest in two assets, A and B. The return on each
asset is uncertain and is determined by the flip of a coin: If the coin comes up heads, the return
on both assets A and B is 20% and if the coin comes up tails, the assets return –8%. In dollar
terms, if you invest $100 in one of the two assets, you’ll get back $120 if the coin comes up heads
and $92 if it comes up tails.
Our example is largely concerned with the sequencing of the coin fl ips and the connec-
tion between them. In terms of the sequence of coin fl ips, here’s what the asset returns look
like.

3
Of course in the real world there are many investment assets. We use the two-asset case to develop the
requisite intuitions and ask you to take it on faith that the multiasset case is similar.
316 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Coin comes up heads, Asset A returns 20%

Asset B returns 20% Asset B returns 20%
Coin comes up heads, Coin flip determines
Asset A returns 20% the return on asset B
Coin comes up tails, Asset A returns 20%
Asset B returns -8% Asset B returns -8%
Coin flip
determines the
return on asset A
Coin comes up heads, Asset A returns -8%
Asset B returns 20% Asset B returns 20%
Coin comes up tails Coin flip determines
Asset A returns -8% the return on asset B
Coin comes up tails, Asset A returns -8%
Asset B returns -8% Asset B returns -8%

Case 1: Investing in a Single Risky Asset

Suppose you decide to invest your $100 wholly in asset A. If the coin comes up heads, you’ll
earn 20% on your investment, and if it comes up tails you will lose 8%. Your $100 investment
in asset A will have the following cash flow and return pattern.

A B C D E F G H I J
1 CASE 1: MEAN AND STANDARD DEVIATION OF RETURN FROM A SINGLE COIN FLIP
2 Coin flip:
3 heads Cash flow Return Return statistics
4 120 20% <-- =C4/A6-1 Average return 6.00% <-- =AVERAGE(E4,E8)
5 Variance 0.0196 <-- =VARP(E4,E8)
6 100 Standard deviation 14.00% <-- =SQRT(I5)
7
8 92 -8% <-- =C8/A6-1
9 Coin flip:
10 tails
11

Note the return statistics in column I: Asset A has average return of 6% and return standard
deviation of 14%.4

Case 2: The Case of the “Fair” Coin: Splitting Your

Investment between the Assets
In Case 1 you invested only in one asset. In Cases 2–5 you will invest in both assets A and B.
In Case 2 we suppose that the coin that determines the returns on asset A and the coin that
determines the returns on asset B are independent. In simple terms you can think of a single
coin that is flipped twice—once to determine the return of A and the second time to determine
the return of B. If the coin flip is fair then the results of the first coin flip have no influence on
the results of the second coin flip.
Now here’s the question we want to answer: Should you invest all your money in A? in B?
Or should you split your investment between the two? The answer has to do with the effects of
diversification. To examine this question more closely, let’s assume that you have decided to
invest $50 in each asset. Your final outcomes are given below.

4
You’ll note that we’ve used the Excel function Varp to compute the portfolio variance and not the func-
tion Var. The reasons for this choice—which we make throughout the book—were given in Appendix 9.2.
Similarly, we would use StDevp to compute the standard deviation and not StDev. We can also calculate
the standard deviation by taking the square root of the variance, which is what we’ve done in the current
example.
 CHAPTER 10 Portfolio Returns and the Efficient Frontier 317

A B C D E F G H I J K L
1 CASE 2: FLIPPING A FAIR COIN—TWO UNCORRELATED COIN TOSSES
2
3 Payoff Return Probability A comes up heads
4 120 20% 0.25 B comes up heads
5 Probability: 0.5*0.5=0.25
6 Payoff: $50*1.2 (A) + $50*1.2 (B) = $120
7
8 A comes up heads
9 B comes up tails
10 $100 invested: Probability: 0.5*0.5=0.25
11 $50 in A 106 6% 0.25 Payoff: $50*1.2 (A) + $50*0.92 (B) = $106
12 $50 in B
13 A comes up tails
14 106 6% 0.25 B comes up heads
15 Probability: 0.5*0.5=0.25
16 Payoff: $50*0.92(A) + $50*1.2 (B) = $106
17
18
19
A comes up tails
20
B comes up tails
21 92 -8% 0.25
Probability: 0.5*0.5=0.25
22
Payoff: $50*0.92 (A) + $50*0.92 (B) = $92
23
24 Return statistics
25 Average return 6.00% <-- =SUMPRODUCT(G4:G21,H4:H21)
26 Variance 0.0098 <-- =VARP(G4:G21)
27 Standard deviation 9.90% <-- =SQRT(D26)

As you can see, the average return from the investment in two assets (6%) is the same as the
average return in case 1, where we invested in only one asset. Note, however, that the standard
deviation went down from 14 to 9.9%—you earn the same but incur less risk.
Message: Diversification in uncorrelated assets improves your investment returns.
This message—that diversification pays off because it reduces risk—can be explored fur-
ther. In the next example we explore the returns when you have correlated assets.

Case 3: The Case of the Counterfeit Coin: A Correlation of +1

Now suppose you have the same situation as above; only this time your coin is counterfeit. You
do not know whether you will get heads or tails but you do know that whatever the result of the

A B C D E F G H I J K L
1 CASE 3: FLIPPING A COUNTERFEIT COIN—TWO COIN TOSSES WITH CORRELATION +1
2
3 Payoff Return Probability A comes up heads
4 120 20% 0.5 B comes up heads
5 Probability: 0.5*1=0.5
6 Payoff: $50*1.2 (A) + $50*1.2 (B) = $120
7
8
9
10 $100 invested:
11 $50 in A This can't happen: The coins
12 $50 in B are completely correlated, so
13 we can't have a heads in one
14 and a tails in the second.
15
16
17
18
19
A comes up tails
20
B comes up tails
21 92 -8% 0.5
Probability: 0.5*1=0.5
22
Payoff: $50*0.92 (A) + $50*0.92 (B) = $92
23
24 Return statistics
25 Average return 6.00% <-- =SUMPRODUCT(G4:G21,H4:H21)
26 Variance 0.0196 <-- =VARP(G4:G21)
27 Standard deviation 14.00% <-- =SQRT(D26)
318 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

“A” coin, the result of the “B” coin will be the same. In statistical terms this is a correlation of
+1. Will diversification improve your returns in this situation?
As you can see, the returns from splitting your investment between two assets are identi-
cal to the return of only investing in one asset (cells D25:D27). Both the average return and the
return standard deviation are the same as in case 1, where we flipped only one coin.
Message: When the asset returns are perfectly positively correlated, diversification will not
reduce your risk.

Case 4: The Case of the Counterfeit Coin—Correlation of −1

We’re still on the same example, and our coin is still counterfeit. But this time it’s counterfeit
with a perfectly negative correlation (−1): If coin “A” comes up heads, coin “B” will come up
tails. In statistical terms, the correlation between the two coins is −1. For this case we can find
a portfolio that completely eliminates all risk: By splitting our investment between assets A and
B, we get 6% expected return without any standard deviation.

A B C D E F G H I J K L
1 CASE 4: FLIPPING A COUNTERFEIT COIN—TWO COIN TOSSES WITH CORRELATION -1
2
3 Payoff Return Probability This can't happen: The coins
4 are completely correlated, so
5 we can't have a heads in one
6 and a heads in the second.
7
8 A comes up heads
9 B comes up tails
10 $100 invested: Probability: 0.5*1=0.5
11 $50 in A 106 6% 0.5 Payoff: $50*1.2 (A) + $50*0.92 (B) = $106
12 $50 in B
13 A comes up tails
14 106 6% 0.5 B comes up heads
15 Probability: 0.5*1=0.5
16 Payoff: $50*0.92 (A) + $50*1.2 (B) = $106
17
18
19
This can't happen: The coins
20
are completely correlated, so
21
we can't have a tails in one and
22
a tails in the second.
23
24 Return statistics
25 Average 6.00% <-- =SUMPRODUCT(G5:G20,H5:H20)
26 Variance 0 <-- =VARP(G5:G20)
27 Standard deviation 0.00% <-- =SQRT(D26)

Message: When the asset returns are perfectly negatively correlated, diversification can
completely eliminate all risk.

Case 5: The Partially Counterfeit Coin (the Real World?)

In the real world there’s often a connection between the stock prices of one company and those
of another. In the most general handwaving5 way, stock prices reflect two elements:
• How well a particular business is doing: In some industries this element leads to nega-
tive correlation. For example if Procter & Gamble (a major manufacturer of toothpastes,

5
The Web site http://c2.com defines “handwaving” as follows: “Handwaving is what people do when they
don’t want to tell you the details, either because they don’t want to get bogged down, they don’t know,
nobody knows, or they have sinister ulterior motives.”
 CHAPTER 10 Portfolio Returns and the Efficient Frontier 319

laundry soaps, and so on) is gaining market share, it is likely to be at the expense of
Unilever (another company in the same industry). This isn’t always true, however: If
Intel (a major manufacturer of computer chips) is doing well, then it may be that the
computer industry is expanding and that AMD (another player in the same industry) is
also doing well.
• How well the economy is doing: Stock prices are heavily affected by the performance
of the economy. This factor tends to be an across-the-board factor, leading to positive
correlation: When the stock market as a whole is up, most stock prices tend to be up and
vice versa. For stock prices, this factor tends to dominate the first: in general stock prices
move together, although their correlation is far from complete.
Note how careful we’ve been here in our language: We’ve used words like “tend to go
up”—stock prices are only partially, not perfectly, correlated.6
To model partial correlation with our coin toss example, we’ll assume that the “A” coin
result influences the result of the “B” coin, but not completely. If the “A” coin comes up heads
(this happens with a probability of 0.5), the probability of the “B” coin coming up heads is 0.7.
If the “A” coin comes up tails (probability 0.5), the probability that the “B” coin also comes up
tails is 0.7. Here’s the spreadsheet that summarizes the returns.
A B C D E F G H I J K
CASE 5: FLIPPING A PARTIALLY COUNTERFEIT COIN
1 TWO COIN TOSSES WITH IMPERFECT CORRELATION
2
3 Payoff Return Probability A comes up heads
4 120 20% 0.35 B comes up heads
5 Probability: 0.5*0.7=0.35
6 Payoff: $50*1.2 (A) + $50*1.2 (B) = $120
7
8 A comes up heads
9 B comes up tails
10 $100 invested: Probability: 0.5*0.3=0.15
11 $50 in A 106 6% 0.15 Payoff: $50*1.2 (A) + $50*0.92 (B) = $106
12 $50 in B
13 A comes up tails
14 106 6% 0.15 B comes up heads
15 Probability: 0.5*0.3=0.15
16 Payoff: $50*0.92(A) + $50*1.2 (B) = $106
17
18
19
A comes up tails
20
B comes up tails
21 92 -8% 0.35
Probability: 0.5*0.7=0.35
22
Payoff: $50*0.92 (A) + $50*0.92 (B) = $92
23
24 Return statistics
25 Average 6.00% <-- =SUMPRODUCT(G4:G21,H4:H21)
26 Variance 0.01372 <-- =H4*(G4-$D$25)^2+H11*(G11-D25)^2+H14*(G14-D25)^2+H21*(G21-D25)^2
27 Standard deviation 11.71% <-- =SQRT(D26)

Message: When the asset returns are partially correlated, diversification will reduce risk but
not completely eliminate it.

What’s the Point?

Although the two-asset, two-coin examples are simple and farfetched, the lessons you learn
from these examples also apply in the “real-world” cases of asset diversification:

6
Negative correlation in stock returns can also happen: See the example of General Motors and Microsoft
(Exercise 7 at the end of this chapter).
320 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

• If the correlation between asset returns is +1, then diversification will not reduce port-
folio risk.
• If the correlation between asset returns is −1, then we can create a risk-free asset—an
asset with no uncertainty about its returns (a bank savings account is an example)—using
a portfolio of the two assets.
• In the real-world asset returns are almost never fully correlated. When asset returns
are partially, but not completely, correlated (meaning that the correlation is between
−1 and +1), diversification can lower risk, although it cannot completely
eliminate it.

10.2. Back to the Real World—Kellogg and Exxon

In Chapter 9 we calculated the data for the annual returns on Kellogg (K) and Exxon (XOM)
stock for the 10 years 1999–2008. Here are our calculations.

A B C D
KELLOGG (K) AND EXXON (XOM)
1 ANNUAL RETURN DATA
2 Date Kellogg Exxon
3 31-Dec-99 -6.89% 12.60%
4 29-Dec-00 -11.59% 10.25%
5 31-Dec-01 18.51% -7.61%
6 31-Dec-02 17.21% -8.86%
7 31-Dec-03 14.06% 20.63%
8 31-Dec-04 19.93% 28.08%
9 30-Dec-05 -0.85% 11.78%
10 29-Dec-06 18.46% 39.07%
11 31-Dec-07 7.14% 24.29%
12 31-Dec-08 -16.02% -13.11%
13
14 Average return E(rK) and E(rXOM) 6.00% 11.71% <-- =AVERAGE(C3:C12)
2 2
15 Variance of returns, σ K and σ XOM 0.0171 0.0267 <-- =VARP(C3:C12)
16 Standard deviation of returns, σK and σXOM 13.06% 16.34% <-- =STDEVP(C3:C12)
17 Covariance of returns Cov(rK,rXOM) 0.0074 <-- =COVAR(B3:B12,C3:C12)
18 Correlation of returns ρK,XOM 0.3482 <-- =CORREL(B3:B12,C3:C12)
19 0.3482 <-- =B17/(B16*C16)

You can see that the average return of holding Kellogg stock (6% per year) is much lower
than the average return of holding Exxon stock (11.71%). On the other hand, the risk of holding
XOM—measured by either the variance or the standard deviation of the return—is higher than
the risk of Kellogg: This is the trade-off we would expect—K has lower return and lower risk
than XOM. Note that K and XOM returns are positively correlated (cell B18): On average, an
increase in K returns was accompanied by an increase in XOM returns. If you use Excel to plot
K returns on the x-axis and XOM returns on the y-axis, you can detect a slight “southwest to
northeast” pattern in the returns.
 CHAPTER 10 Portfolio Returns and the Efficient Frontier 321

Exxon 50%
vs Kellogg Returns
y = 0.435x + 0.091 40%
R² = 0.121
30%

Exxon ret urns

20%

10%

0%
-20% -15% -10% -5% 0% 5% 10% 15% 20% 25%
-10%
Kellogg returns
-20%

The trendline (which illustrates the regression of XOM on K) shows this trend.7

10.3. Graphing Portfolio Returns

In this section we graph the returns available to the investor from an investment in a portfolio
composed of K and XOM stock. We start by showing you several individual portfolios and end
the section by graphing the curve representing all possible portfolio returns.

Deriving the Risk-Return of an Individual Portfolio

Suppose we form a portfolio composed of 50% K and 50% XOM stock. Cells E8:E17 in the
spreadsheet below show the annual returns of this portfolio.
A B C D E F
1 A PORTFOLIO OF K AND XOM STOCK
2 Percentage in K 50%
3 Perecentage in XOM 50% <-- =1-B2
4
Portfolio
Date
5 Stock returns returns
6 Kellogg Exxon
7 31-Dec-99 -6.89% 12.60% 2.85% <-- =$B$2*B7+$B$3*C7
8 29-Dec-00 -11.59% 10.25% -0.67% <-- =$B$2*B8+$B$3*C8
9 31-Dec-01 18.51% -7.61% 5.45% <-- =$B$2*B9+$B$3*C9
10 31-Dec-02 17.21% -8.86% 4.17% <-- =$B$2*B10+$B$3*C10
11 31-Dec-03 14.06% 20.63% 17.35%
12 31-Dec-04 19.93% 28.08% 24.00%
13 30-Dec-05 -0.85% 11.78% 5.46%
14 29-Dec-06 18.46% 39.07% 28.76%
15 31-Dec-07 7.14% 24.29% 15.71%
16 31-Dec-08 -16.02% -13.11% -14.56%
17
18 Average return E(rK) and E(rXOM) 6.00% 11.71% 8.85% <-- =AVERAGE(E7:E16)
2 2
19 Variance of returns, s K and s XOM 0.0171 0.0267 0.0147 <-- =VARP(E7:E16)
20 Standard deviation of returns, s K and s XOM 13.06% 16.34% 12.10% <-- =STDEVP(E7:E16)
21 Covariance of returns Cov(rK,rXOM) 0.0074 <-- =COVAR(B7:B16,C7:C16)

7
As explained in Chapter 9, the regression R2 indicates the percentage of XOM’s return var-
iability explained by the variability in K’s returns. R2 is the correlation coefficient squared:
R2 = 0.121 = [Correlation (ReturnXOM, ReturnK)]2 = (0.3482)2. Although this R2 may appear quite low, it is
typical for many pairs of stocks.
322 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

As discussed in Chapter 9, the portfolio return statistics in cells E18:E20 can be derived
using formulas that involve only information about the individual asset returns, their variances,
and the covariance. There’s no need to do the extensive calculation in cells E7:E16:
• The average portfolio return of 8.85% is the weighted average of the K and the XOM
return. Write the percentage weight of K stock by wK and the percentage weight of XOM
stock by wXOM; it follows, of course, that wXOM = 1 – wK because the portfolio proportions
must sum to 100%. The formula for the average portfolio return is
average portfolio return, E (rp ) = wK E (rK ) + wXOM E (rXOM )
= wK E (rK ) + (1 − wK )E (rXOM )

• The variance of the portfolio return, 0.0147, is a more complicated function of the two
variances and the portfolio weights:
variance of portfolio return
Var (rp ) = wK2 Var (rK ) + wXOM
2
Var (rXOM ) + 2wK wXOM Cov (rK , rXOM )
!"""""""""#"""""""""$
↑ ↑
Each portfolio weight Twice the product of
is squared and multiplied the portfolio weights
times the variance times the covariance

Using these two formulas, you avoid the need for the long calculation of the portfolio
return, variance, and standard deviation in cells E18:E20. In the spreadsheet below we incorpo-
rate these formulas for the portfolio mean, variance, and standard deviation in cells B12:B14.

A B C D
PORTFOLIO STATISTICS
1 FOR A KELLOGG-XOM PORTFOLIO
2 K XOM
3 Average, E(rK) and E(rXOM) 6.00% 11.71%
4 Variance, Var(rK) and Var(rXOM) 0.0171 0.0267
5 Sigma, s K and s XOM 13.06% 16.34%
6 Covariance of returns, Cov(rK,rXOM) 0.0074
7
8 Portfolio return and risk
9 Percentage in K 50%
10 Percentage in XOM 50%
11
12 Expected portfolio return, E(rp) 8.85% <-- =B9*B3+B10*C3
13 Portfolio variance, Var(rp) 1.47% <-- =B9^2*B4+B10^2*C4+2*B9*B10*B6
14 Portfolio standard deviation, s p 12.10% <-- =SQRT(B13)
15
16
Portfolio Returns: Expected Return E(rp) and
Portfolio Expected
Standardstandard
Deviation σp
portfolio
17 10% deviation return
9%
Expected return E(rp)

8%
18 50% GM, 50% MSFT 12.10% 8.85% 50%
7%
19
6% Portfolio standard deviation
20
5% (12.10%) and expected return
21 (8.85%) from a portfolio
22 4% invested 50% in K and 50% in
23 3% XOM.
24 2%
25 1%
26 0%
27
0% 2% 4% 6% 8% 10% 12% 14%
28 Standard deviation σp
29
 CHAPTER 10 Portfolio Returns and the Efficient Frontier 323

The point here is that you don’t need to do an extensive calculation of annual portfolio
returns—it’s enough to know the return statistics for each stock, the portfolio proportions, and
the covariance of the stock returns.

Another Portfolio—Increasing the Weight of MSFT, Decreasing GM

Now suppose we graph another portfolio—this time a portfolio invested 25% in Kellogg and
75% in Exxon.

A B C D
PORTFOLIO STATISTICS
1 FOR A KELLOGG-EXXON PORTFOLIO
2 K XOM
3 Average, E(rK) and E(rXOM) 6.00% 11.71%
4 Variance, Var(rK) and Var(rXOM) 1.71% 2.67%
5 Sigma, σK and σXOM 13.06% 16.34%
6 Covariance of returns, Cov(rK,rXOM) 0.74%
7
8 Portfolio return and risk
9 Percentage in K 25%
10 Percentage in XOM 75%
11
12 Expected portfolio return, E(rp) 10.28% <-- =B9*B3+B10*C3
13 Portfolio variance, Var(rp) 1.89% <-- =B9^2*B4+B10^2*C4+2*B9*B10*B6
14 Portfolio standard deviation, σp 13.74% <-- =SQRT(B13)
15
16
Portfolio Returns: Portfolio
Expected Return
Expected p
E(r ) and Standard
Deviation
standard σp
portfolio
10.4%
17 10.2% deviation return
Expected return E(rp)

10.0% wK = 25%,wXOM = 75%,

σp=13.74%, E(rp)=10.28%
18 50% GM,9.8%
50% MSFT 12.10% 8.85%
19 25% GM,9.6%
75% MSFT 13.74% 10.28%
20 9.4%
21 9.2%
wK= 50%,wXOM= 50%,
22 9.0% σp=12.10%, E(rp)=8.85%
23 8.8%
24 8.6%
25
12% 13% 13% 14% 14%
26
27 Standard deviation of return σp
28
29

Note that the new portfolio’s performance is to the “northeast” of the first portfolio—it
has both higher returns and higher standard deviation. The new portfolio gives you greater
expected return, but has higher risk. This is what you would expect—higher return is achieved
at the price of higher risk. As you will see in the next subsection, this may not always be the
case.
324 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Varying the Portfolio Composition—Graphing All Possible Portfolios

Suppose we vary the composition of the portfolio, letting the percentage of K vary from 0 to
100%. In cells G19:H29 below we generate a table of portfolio returns E(rp) and standard devia-
tions σp.

A B C D E F G H
PORTFOLIO STATISTICS
1 FOR A KELLOGG-EXXON PORTFOLIO
2 K XOM
3 Average, E(rK) and E(rXOM) 6.00% 11.71%
4 Variance, Var(rK) and Var(rXOM) 1.71% 2.67%
5 Sigma, σK and σXOM 13.06% 16.34%
6 Covariance of returns, Cov(rK,rXOM) 0.74%
7
8 Portfolio return and risk
9 Percentage in K 50%
10 Percentage in XOM 50%
11
12 Expected portfolio return, E(rp) 8.85% <-- =B9*B3+B10*C3 =SQRT(F19^2*$B$4+(1-
13 Portfolio variance, Var(rp) 1.47% <-- =B9^2*B4+B10^2*C4+2*B9*B10*B6 F19)^2*$C$4+2*F19*(1-
14 Portfolio standard deviation, σp 12.10% <-- =SQRT(B13) F19)*$B$6)
15
16
17 Portfolio Returns: Expected Return and
12% Percentage Expected
18
Standard Deviation in K Sigma return
11%
Expected return E(rp )

19 0% 16.34% 11.71%
20 10% 10% 15.21% 11.14%
21 9% 20% 14.19% 10.57%
22 30% 13.32% 10.00%
8%
23 40% 12.61% 9.43%
24 7% 50% 12.10% 8.85%
25 6% 60% 11.82% 8.28%
26 70% 11.78% 7.71%
27 5% 80% 11.98% 7.14%
28 10% 11% 12% 13% 14% 15% 16% 17% 90% 12.42% 6.57%
29 100% 13.06% 6.00%
Standard deviation of return, σp
30
31
=F19*$B$3+(1-F19)*$C$3
32
 CHAPTER 10 Portfolio Returns and the Efficient Frontier 325

EXCEL NOTE: USING DATA TABLE TO SIMPLIFY

THE CALCULATIONS
The table in cells G19:H29 above was generated using formulas for the standard deviation and
expected return. Each cell contains a formula (note the use of absolute and relative cell ref-
erences in these formulas). You can simplify the building of the table using the Data table
technique discussed in Chapter 27. Data table is not an easy technique to master, but it makes
building tables much easier. Here’s an example.
A B C D E F G H I
PORTFOLIO STATISTICS FOR A K-XOM PORTFOLIO
1 Using Data Table
2 K XOM
3 Average, E(rK) and E(rXOM) 6.00% 11.71%
4 Variance, Var(rK) and Var(rXOM) 1.71% 2.67%
5 Sigma, σK and σXOM 13.06% 16.34%
6 Covariance of returns, Cov(rK,rXOM) 0.74%
7
8 Portfolio return and risk
9 Percentage in K 50%
10 Percentage in XOM 50%
11
12 Expected portfolio return, E(rp) 8.85% <-- =B9*B3+B10*C3
13 Portfolio variance, Var(rp) 1.47% <-- =B9^2*B4+B10^2*C4+2*B9*B10*B6
σ
14 Portfolio standard deviation, p 12.10% <-- =SQRT(B13) =B14
15
16
17 Portfolio Returns: Expected Return and =B12
12% Percentage Expected
18
Standard Deviation in K Sigma return
11%
Expected return E(rp )

19 12.10% 8.85%
20 10% 0% 16.34% 11.71%
21 9% 10% 15.21% 11.14%
22 20% 14.19% 10.57%
8%
23 30% 13.32% 10.00%
24 7% 40% 12.61% 9.43%
25 6% 50% 12.10% 8.85%
26 60% 11.82% 8.28%
27 5% 70% 11.78% 7.71%
28 10% 11% 12% 13% 14% 15% 16% 17% 80% 11.98% 7.14%
29 90% 12.42% 6.57%
Standard deviation of return, σp
30 100% 13.06% 6.00%
31

You create the data table by marking the cells F18:H29. The command Data|What-If
Analysis|Table brings up the dialog box to which you add the appropriate cell reference.
326 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Better Portfolios . . . Worse Portfolios . . .

Take a careful look at the graph in the preceding spreadsheet—it shows the standard deviation
σp of the portfolio returns on the x-axis and the corresponding expected portfolio return E(rp)
on the y-axis. Looking at the graph it is easy to see that some portfolios are better than others.
Consider, for example, the portfolio invested 90% in K and 10% in XOM (this portfolio is cir-
cled in the graph below). By investing in the portfolio indicated by the arrow, you can improve
the expected return without increasing the riskiness of the return. Thus, the circled portfolio is
not optimal. In fact, none of the portfolios on the bottom part of the graph is optimal: Each is
dominated by a portfolio on the top part of the graph that has the same standard deviation σp
and higher expected return E(rp).

Portfolio Returns: Expected Return

12% and Standard Deviation
11%
Expected return E(rp)

10%
9%
8%
7%
6%
5%
10% 11% 12% 13% 14% 15% 16% 17%

Standard deviation of return, !p

On the other hand, consider the two portfolios circled below.

Portfolio Returns: Expected Return

12% and Standard Deviation
11%
Expected return E(rp)

10%
9%
8%
7%
6%
5%
10% 11% 12% 13% 14% 15% 16% 17%

Standard deviation of return, !p

 CHAPTER 10 Portfolio Returns and the Efficient Frontier 327

There is a clear risk–return trade-off between these two portfolios—it is impossible to say
that one is unequivocally better than the other. The portfolio with the higher return also has
the higher standard deviation of returns. All of the portfolios on the top part of the graph have
this property. The top part of the graph is called the efficient frontier. The efficient frontier is
the area of hard portfolio choices—along the efficient frontier, portfolios with greater expected
return require you to undertake greater risk.
The efficient frontier slopes upward from left to right. What this means is that the choice
between any two portfolios on the efficient frontier involves a trade-off between higher
expected portfolio return, E(rp), and higher risk as indicated by a higher standard deviation of
the return, σp. An investor choosing only risky portfolios would choose a portfolio on the effi-
cient frontier.
In the next section we investigate some of the properties of the efficient frontier.

10.4. The Efficient Frontier and the Minimum Variance Portfolio

The efficient frontier is the set of all portfolios that are on the upward-sloping part of the
preceding graph. “Upward-sloping” means that portfolios on the efficient frontier involve
difficult choices—increasing expected portfolio return E(r p) has the cost of increasing port-
folio standard deviation σp. If you are choosing investment portfolios that are a mix of K
and XOM stock, then clearly the only portfolios you would be interested in are those on
the efficient frontier. These portfolios are the only ones that have a “northeast” risk–return
relation.
To calculate the efficient frontier, we have to find its starting point, the portfolio with the
minimum standard deviation of returns. In the jargon of finance, this portfolio is (somewhat
confusingly) called the minimum-variance portfolio; just recall that if the portfolio has mini-
mum variance it also has minimum standard deviation. The minimum variance portfolio is the
portfolio in the left-hand corner of the efficient frontier; the graph below indicates its approxi-
mate location.

The Minimum Variance Portfolio

12%
11%
Expected return E(rp)

10%
9%
8%
7%
6%
5%
10% 11% 12% 13% 14% 15% 16% 17%

Standard deviation of return, !p

328 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

We can find the minimum variance portfolio in two ways—either using the Solver or using
a bit of mathematics. We illustrate both methods.

The Minimum Variance Portfolio Using Excel’s Solver

Using the Solver (see Chapter 28), we can calculate the percentage of Kellogg in a portfolio that
has minimum variance. The screen below shows the Solver dialog box. In this box, we’ve asked
Solver to minimize the portfolio variance (cell B13) by changing the percentage of Kellogg
stock in the portfolio (cell B9).

Clicking on Solve gives the following.

A B C D

1 LOCATING THE MINIMUM VARIANCE PORTFOLIO

2 K XOM
3 Average, E(rK) and E(rXOM) 6.00% 11.71%
4 Variance, Var(rK) and Var(rXOM) 1.71% 2.67%
5 Sigma, σK and σXOM 13.06% 16.34%
6 Covariance of returns, Cov(rK,rXOM) 0.74%
7
8 Portfolio return and risk
9 Percentage in K 66.68%
10 Percentage in XOM 33.32%
11
12 Expected portfolio return, E(rp) 7.90% <-- =B9*B3+B10*C3
13 Portfolio variance, Var(rp) 1.38% <-- =B9^2*B4+B10^2*C4+2*B9*B10*B6
14 Portfolio standard deviation, σp 11.77% <-- =SQRT(B13)
15
Minimum variance portfolio
16 using formula 66.68% <-- =(C4-B6)/(B4+C4-2*B6)
 CHAPTER 10 Portfolio Returns and the Efficient Frontier 329

Thus, the minimum variance portfolio has 66.68% in Kellogg and 33.32% in
Exxon.8

Minimum Variance Portfolios Using Calculus

There’s actually a formula for the minimum variance portfolio:
Var (rXOM ) − Cov (rK , rXOM )
wK =
Var (rK ) + Var (rXOM ) − 2Cov (rK , rXOM )

The use of this formula is illustrated in cell B16 in the preceding spreadsheet. Using this
formula, which is derived in Appendix 10.1, is simpler than using Solver.

The Efficient Frontier and the Minimum Variance Portfolio

Now that we know the minimum variance portfolio, we can plot the efficient frontier, the set of
all portfolios with an economically meaningful return–risk trade-off. “Economically meaning-
ful return–risk tradeoff” means that along the efficient frontier additional portfolio return E(rp)
is achieved at the cost of additional portfolio standard deviation σp. The efficient frontier is all
portfolios that are to the right of the minimum variance portfolio.

A B C D E F G H I J K

1 THE EFFICIENT FRONTIER

2 K XOM
3 Average, E(rK) and E(rXOM) 6.00% 11.71%
4 Variance, Var(rK) and Var(rXOM) 1.71% 2.67%
5 Sigma, σK and σXOM 13.06% 16.34%
6 Covariance of returns, Cov(rK,rXOM) 0.74%
7
8 Minimum variance portfolio--analytic formula
9 Percentage in K 66.68% <-- =(D4-C6)/(C4+D4-2*C6)
10 Percentage in XOM 33.32% <-- =1-B9
11
12 Expected portfolio return, E(rp) 7.90% <-- =B9*C3+B10*D3
13 Portfolio variance, Var(rp) 0.0138 <-- =B9^2*C4+B10^2*D4+2*B9*B10*C6
14 Portfolio standard deviation, σp 11.77% <-- =SQRT(B13)
Efficient
Expected Return and Standard Deviation of Percentage Expected frontier
15 Portfolio Return--Showing Efficient Frontier in K Sigma return points
16
17 12% 0.00% 16.34% 11.71% 11.71%
18 10.00% 15.21% 11.14% 11.14%
Expected portfolio return, E(rp)

19 11% 20.00% 14.19% 10.57% 10.57%

20 10% 30.00% 13.32% 10.00% 10.00%
21 40.00% 12.61% 9.43% 9.43%
22 9% 50.00% 12.10% 8.85% 8.85%
23 8% 66.68% 11.77% 7.90% 7.90%
24 70.00% 11.78% 7.71%
25 7% 80.00% 11.98% 7.14%
26 6% 90.00% 12.42% 6.57%
27 100.00% 13.06% 6.00%
28 5%
10% 11% 12% 13% 14% 15% 16% 17% This is the portfolio percentage in K
29
that gives the minimum variance
30 Standard deviation of portfolio return, σp portfolio.
31
32

8
Although—as explained in Chapter 28—Solver and Goal Seek are in many cases interchangeable, this
is a calculation that Solver does easily, but that cannot be done in Goal Seek.
330 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

EXCEL TRICK

The graph of the efficient frontier just shown is an XY Scatter plot. The x-data are the data
for sigma in I17:I27. Cells J17:J27 give the data for the portfolio expected returns, and cells
K17:K27 give data for the expected returns only for efficient portfolios. The two data series,
J17:J27 and K17:K27, constitute the y-data for the XY scatter plot. Where they coincide, Excel
superimposes them, creating the effect seen in the graph.
To create the graph, mark the three columns I17:K27. Then go to the Insert tab and pick
XY (Scatter) as shown below. Proceed from there to build the graph.

10.5. The Effect of Correlation on the Efficient Frontier

When we looked at the “coin-flip” economy of Section 10.1, we concluded that the correlation
between asset returns made a big difference. In this section we examine the effect of stock
return correlation on portfolio returns, repeating the correlation experiment of Section 10.1 for
a more “real-world” example.
 CHAPTER 10 Portfolio Returns and the Efficient Frontier 331

First, recall what we concluded in Section 10.1:

• When the two coins have a perfect negative correlation of −1, we can create a risk-free
asset using combinations of the two assets. In this section you’ll see that a similar conclu-
sion is true for stock portfolios: Perfectly negatively correlated stock returns allow you
to create a risk-free asset.
• When the two coins have a perfect positive correlation of +1, it’s impossible to
diversify away any risk. You will see that a similar conclusion holds for stock
portfolios.
• When the two coins have correlation between −1 and +1, some of the risk can be elimi-
nated through diversification. Again, this is true for stock portfolios.
In our example we use some of the same numbers used in our Kellogg–Exxon exam-
ple, but we’ll allow the correlation between the returns on the two stocks to vary. We start
with the following example, in which the correlation coefficient between K and XOM is
ρK,XOM = 0.5.

A B C D E F G H I
THE EFFECT OF CORRELATION COEFFICIENT ON KELLOGG-EXXON PORTFOLIOS
1 In this example, the correlation = 0.50
2 K XOM
3 Average, E(rK ) and E(r XOM) 6.00% 11.71%
4 Variance, Var(rK ) and Var(rXOM) 0.0171 0.0267
5 Sigma, ( K and ( XOM 13.06% 16.34%
6 Correlation coefficient, ( K,XOM) 0.50
7 Covariance, Cov(r K,rXOM) 0.01 <-- =B6*B5*C5 G12)^2*$C$4+2*G12*(1-
8 G12)*$B$7)
9
10 The Effect of Correlation on the K-XOM
Percentage in Expected
Efficient Frontier Sigma
11 K return
12 In this example, correlation =0.50 0.0 16.34% 11.71%
13 0.1 15.40% 11.14%
12%
14 0.2 14.55% 10.57%
11%
15 0.3 13.82% 10.00%
16 10% 0.4 13.21% 9.43%
17 9% 0.5 12.76% 8.85%
18 8% 0.6 12.46% 8.28%
19 7% 0.7 12.35% 7.71%
20 6% 0.8 12.41% 7.14%
21 0.9 12.65% 6.57%
5%
22 1.0 13.06% 6.00%
23 10% 11% 12% 13% 14% 15% 16% 17%
24
25 =G12*$B$3+(1-G12)*$C$3

Correlation Coefficient = −1—Perfect Negative Correlation

When the correlation coefficient ρ GM,MSFT = −1, we can use our portfolio to create a riskless
asset. This was the message in the simple “coin toss” example with which we started this chap-
ter (Section 10.1), and it is still true here:
Perfect negative correlation between two risky assets allows the creation of a portfolio that
is risk free.
Here’s our example in Excel.
332 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

A B C D E F G H I
THE EFFECT OF CORRELATION COEFFICIENT ON KELLOGG-EXXON PORTFOLIOS
1 In this example, the correlation = -1.00
2 K XOM
3 Average, E(rK) and E(rXOM) 6.00% 11.71%
4 Variance, Var(rK) and Var(rXOM) 0.0171 0.0267
5 Sigma, σK and σXOM 13.06% 16.34%
6 Correlation coefficient, ρK,XOM) -1.00
7 Covariance, Cov(rK,rXOM) -0.02 <-- =B6*B5*C5
8
9
10 The Effect of Correlation on the K-XOM
Efficient Frontier Percentage in Expected
11 K Sigma return
12 In this example, correlation=0.50 0.0 16.34% 11.71%
13 0.1 13.40% 11.14%
12%
14 0.2 10.46% 10.57%
15 11% 0.3 7.52% 10.00%
16 10% 0.4 4.58% 9.43%
17 9% 0.556 0.00% 8.53%
18 8% 0.6 1.30% 8.28%
19 7% 0.7 4.24% 7.71%
20 6% 0.8 7.18% 7.14%
21 0.9 10.12% 6.57%
5%
22 1.0 13.06% 6.00%
23 0% 2% 4% 6% 8% 10% 12% 14% 16%
24

The minimum variance portfolio (highlighted in cells G17:I17) is achieved when the propor-
tion in Kellogg is 55.6%. When the correlation between the two stocks is −1, the minimum variance
portfolio is riskless—the portfolio’s return of 8.53% is achieved with zero standard deviation.
A little mathematics explains this result. The portfolio variance for this case can be
written
Var (rp ) = wK2 Var (rK ) + wXOM
2
Var (rXOM ) + 2wK wXOM ρK , XOM σ K σ XOM
= wK σ K + wXOM σ XOM − 2wK wXOM σK σ XOM
2 2 2 2

2
= wK2 σ K2 + (1 − wK ) σ XOM
2
− 2wK (1 − wXOM )σ K σ XOM
2
= (wK σ K − (1 − wK )σ XOM )

This means that we can—by choosing the appropriate weights wK and wXOM —set the portfolio
variance equal to zero:
2
Var (rp ) = (wK σ K − (1 − wK )σ XOM ) = 0
σ XOM
when wK =
σ K + σ XOM

In our case, this means that

σ XOM 0.0267
wK = = = 0.5557
σ K + σ XOM 0.0171 + 0.0267

This value is given in cell G18.

Correlation Coefficient = +1. The Case of Perfect Positive Correlation

When the correlation coefficient ρK,XOM = +1, diversification does not reduce risk.
Perfect positive correlation between two risky assets means that risk is not reduced in a
portfolio context.
 CHAPTER 10 Portfolio Returns and the Efficient Frontier 333

Here’s our example in Excel.

A B C D E F G H I
THE EFFECT OF CORRELATION COEFFICIENT ON KELLOGG-EXXON PORTFOLIOS
1 In this example, the correlation = 1.00
2 K XOM
3 Average, E(rK) and E(rXOM) 6.00% 11.71%
4 Variance, Var(rK) and Var(rXOM) 0.0171 0.0267
5 Sigma, σK and σXOM 13.06% 16.34%
6 Correlation coefficient, ρK,XOM) 1.00
7 Covariance, Cov(rK,rXOM) 0.02 <-- =B6*B5*C5
8
9
10 The Effect of Correlation on the K-XOM
Efficient Frontier Percentage in Expected
11 K Sigma return
12 In this example, correlation=1.00 0.00 16.34% 11.71%
13 0.10 16.01% 11.14%
12%
14 0.20 15.68% 10.57%
15 11% 0.30 15.36% 10.00%
16 10% 0.40 15.03% 9.43%
17 9% 0.50 14.70% 8.85%
18 8% 0.60 14.37% 8.28%
19 7% 0.70 14.04% 7.71%
20 6% 0.80 13.72% 7.14%
21 0.90 13.39% 6.57%
5%
22 1.00 13.06% 6.00%
23 13% 14% 15% 16% 17%
24

Note what we mean by “portfolios do not reduce risk”: The risk–return combinations for this
case are on a straight line. In the previous two cases (correlation = 0.50 and correlation = −1) the
portfolio frontier had a “northwest” portion; on a “northwest” portion of the frontier, we reduce
risk and increase return. For this case the frontier only has a “northeast portion”—there is no
way to reduce risk and increase return.
When the correlation between the two assets’ returns is +1, the standard deviation of the
portfolio return for this case is the weighted average of the asset standard deviations. A little
mathematics explains this result. The portfolio variance for this case can be written

Var (rp ) = wK2 Var (rK ) + wXOM

2
Var (rXOM ) + 2wK wXOM ρK , XOM σ K σ XOM
2 2 2 2
= wK σ K + wXOM σ XOM + 2wK wXOM σK σ XOM
!"""""""#"""""""$
↑
The correlation coefficient
ρK , XOM =1
2
= (wK σ K + (1 − wK )σ XOM )
This means that the standard deviation of the portfolio is the weighted average of the asset stan-
dard deviations:
σ (rp ) = wK σ K + (1 − wK )σ XOM

Thus, there is no real gain from diversification.

Summary
In this chapter we have discussed the importance of diversification for portfolio returns and
risks. We showed how to calculate the mean and variance and standard deviation of a portfolio’s
334 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

return. The efficient frontier is the set of those portfolios that offer the highest expected return
for a given standard deviation. We discussed this frontier and how it is affected by the correla-
tion between the asset returns.

EXERCISES
Note: Data for the problems are on the CD-ROM that accompanies the book.
1. The table below presents the year-end prices for the shares of Ford and PPG from 1989 to 2001.

A B C
PRICES FOR FORD
1 AND PPG STOCK
Ford PPG
2 Date stock price stock price
3 31-Dec-89 11.813 14.024
4 31-Dec-90 7.210 17.229
5 31-Dec-91 7.617 19.138
6 31-Dec-92 11.612 25.721
7 31-Dec-93 17.469 30.518
8 31-Dec-94 15.100 30.736
9 31-Dec-95 15.642 38.980
10 31-Dec-96 17.472 49.007
11 31-Dec-97 26.310 51.040
12 31-Dec-98 31.807 53.172
13 31-Dec-99 28.895 58.626
14 31-Dec-00 22.470 44.867
15 31-Dec-01 15.720 51.720

a. Calculate the following statistics for these two shares: average return, variance of returns, stan-
dard deviation of returns, covariance of returns, and correlation coefficient.
b. If you invested in a portfolio composed of 50% Ford and 50% PPG, what would be the portfolio
expected return? The standard deviation?
c. Comment on the following statement: “Ford has lower returns and higher standard deviation of
returns than PPG. Therefore, any rational investor would invest in PPG only and would leave
Ford out of her portfolio.”
2. You invest $500 in a stock for which the return is determined by a coin flip. If the coin comes up
heads the stock returns 10%, and if it comes up tails the investment returns −10%. What is the
average return, the return variance, and the return standard deviation of this investment if you flip
the coin one time?
3. You have $500 to invest. You decide to split it into two parts. The return on each $250 will be
determined by a coin toss, and the results of the two tosses are not correlated. If the coin comes
up heads the investment will return 10% and if it comes up tails it will return −10%. What is the
average return, the return variance, and the return standard deviation of this investment?
4. The previous question assumes that the correlation between the coin flips is 0. Repeat this question
with the following correlations:
a. If the first coin flip is heads, then the second coin flip will be heads as well and vice versa (cor-
relation of 1).
b. If the first coin flip is heads, then second coin flip will be tails and vice versa (correlation
of −1).
c. If the first coin flip is heads, then the second coin flip will be heads with a probability of 0.8. If
the first coin flip is tails, then the second coin fl ip will be tails with a probability of 0.6.
d. What can you conclude about the connection between the variance of the return from the coin
flips and the correlation between the flips?
 CHAPTER 10 Portfolio Returns and the Efficient Frontier 335

5. Consider the following statistics for a portfolio composed of shares of companies A and B.

A B C D E F
Company A Company B
1 stock stock
2 Average return 25% 48%
3 Variance 0.0800 0.1600
4 Sigma 28.28% 40.00%
5
6 Covariance of returns 0.00350
7 Correlation of returns 0.03094 <-- =B6/(B4*C4)
8
9 Portfolio
10 Proportion of A 0.9
11 Proportion of B 0.1
12 Portfolio average return 27.30% <-- =B10*B2+C2*B11
13 Portfolio standard deviation 25.89% <-- =SQRT(B10^2*B3+B11^2*C3+2*B10*B11*B6)

6. Calculate the average return and the variance of a portfolio composed of 30% GM and 70% MSFT
stocks, using the data described from page 323.

A B C
GM AND MSFT
1 RETURN STATISTICS, 1990-1999
GM MSFT
2 Date return return
3 31-Dec-90 -11.54% 72.99%
4 31-Dec-91 -11.35% 121.76%
5 31-Dec-92 16.54% 15.11%
6 31-Dec-93 72.64% -5.56%
7 30-Dec-94 -21.78% 51.63%
8 29-Dec-95 28.13% 43.56%
9 31-Dec-96 8.46% 88.32%
10 31-Dec-97 19.00% 56.43%
11 31-Dec-98 21.09% 114.60%
12 31-Dec-99 21.34% 68.36%

a. Suggest a portfolio combination that improves return while maintaining the same level of
risk.
b. Calculate the minimum variance portfolio for the portfolio composed of the two assets
described above.
7. During the decade 1990–1999, General Motors and Microsoft were negatively correlated (see data
in Exercise 6). Find the following two portfolios:
a. The minimum variance portfolio.
b. The efficient portfolio having an expected return of 4%.
336 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

8. The following spreadsheet presents data for stocks A and B.

A B C
RETURN STATISTICS
1 OF A AND B STOCK
2 Stock A Stock B
3 Average return 34% 25%
4 Variance 0.12 0.07
5 Standard deviation 34.64% 26.46%
6
7 Covariance of return, Cov(rA,rB) 0.0160
8 Correlation of return 0.1746 <-- =B7/(B5*C5)

a. What are the return and the standard deviation of a portfolio composed of 30% of stock A and
70% of stock B?
b. What are the return and the standard deviation of an equally weighted portfolio of stocks A
and B?
9. Suppose that the return statistics for A and B stock are given below. What is the standard deviation
of the portfolio minimum variance? (The answer requires only one calculation.)
10. ABC and XYZ are two stocks with the following return statistics.

A B C
RETURN STATISTICS
1 OF A AND B STOCK
2 Stock A Stock B
3 Average return 25% 15%
4 Variance 0.16 0.0484
5 Standard deviation 40.00% 22.00%
6
7 Covariance of return, Cov(rA,rB) -0.0880

a. Compute the expected return and standard deviation of a portfolio composed of 25% ABC
and 75% XYZ.

A B C
Standard
Expected deviation of
1 return return
2 ABC 15% 33%
3 XYZ 25% 46%
4 Covariance(ABC,XYZ) 0.0865
5 Correlation(ABC,XYZ) 0.5698

b. Compute the returns of all portfolios that are combinations of ABC and XYZ with the propor-
tion of ABC being 0, 10, . . . , 90, 100%. Graph these returns.
c. Compute the minimum variance portfolio.
11. Melissa Jones wants to invest in a portfolio composed of stocks ABC and XYX (from Question
10), that will yield a return of 19%. What is the weight of each stock in such a portfolio, and what
is the portfolio’s standard deviation? Answer the question both using Excel’s Goal Seek or Solver
and using the mathematical formulas in the chapter (page 322).
12. Your client asks you to create a two-asset portfolio having an expected return of 15% and return
standard deviation of 12%. The client specifies that the portfolio includes 60% of the stock
Merlyn (named for her beloved mother) that has an expected return of 13% and a standard devi-
ation of 10%.
 CHAPTER 10 Portfolio Returns and the Efficient Frontier 337

a. What should be the return statistics of the second stock you’ll combine in this portfolio,
assuming the stocks have zero correlation?
b. What should be the return statistics of the second stock you’ll combine in this portfolio,
assuming the stocks have covariance of 0.01?
13. What will be the weights, the expected return, the variance, and the standard deviation of a
minimum-variance portfolio combining the stocks below, using the mathematical way?
14. This question relates to the data in Exercise 13.
a. Calculate and graph the efficient frontier of the stock portfolios composed of stocks X and Y
in Exercise 13.

A B C D
1 RETURN STATISTICS OF X AND Y STOCK
2 X Y
3 Mean return 21.00% 14.00%
4 Variance 0.11 0.045
5 Sigma 33.17% 21.21%
6
7 Covariance of returns -0.0020
8 Correlation of returns -0.0284

b. Calculate and graph the efficient frontier of the stock portfolios composed of stocks X and Y in
Exercise 13, assuming the correlation between the two stocks is −1.
15. Consider the data for stock A and Stock B below. A portfolio composed of 90% of Stock A and
10% Stock B stock has expected return of 19.1% and standard deviation of 20.78%. Find another
portfolio with the same standard deviation and a higher return. (You can do this by trial and error,
but you can also use Solver.)

A B C
1 Stock A Stock B
2 Expected return 14.25% 62.72%
3 Variance 6.38% 14.43%
4 Sigma 25.25% 37.99%
5 Covariance of returns -5.52%

16. John and Mary are considering investing in a combination of ABC stock and XYZ stock. The
return on ABC is determined by a coin flip: If the coin is heads the return is 35% and if the coin
is tails the return on ABC is 10%. The return on XYZ stock is similarly determined, but by a
separate coin flip.
a. Compute the mean, variance, and standard deviation of the returns on ABC and XYZ.
b. What is the correlation of the returns? (Nothing to compute here, just think!)
c. John has decided to invest in a portfolio composed of 100% XYZ stock. Mary, on the other hand, is
investing in a portfolio composed of 50% ABC and 50% XYZ. Whose portfolio is better? Why?
17. Elizabeth and Sandra are considering investing in a combination of ABC stock and XYZ stock.
The return on both stocks is determined by a single coin flip: If the coin is heads the return on
both stocks is 35% and if the coin is tails the return is 10%.
a. Compute the mean, variance, and standard deviation of the returns on ABC
and XYZ.
b. What is the correlation of the returns? (Nothing to compute here, just think!)
c. Elizabeth has decided to invest in a portfolio composed of 100% XYZ stock. Sandra, on the
other hand, is investing in a portfolio composed of 50% ABC and 50% XYZ. Whose portfolio
is better?
338 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

APPENDIX 10.1: DERIVING THE FORMULA FOR THE MINIMUM

VARIANCE PORTFOLIO

In this appendix we derive the formula for the minimum variance portfolio. Recall the
formula for variance of the portfolio:

Var (rp ) = wK2 Var (rK ) + wXOM

2
Var (rXOM ) + 2wK wXOM Cov (rK , rXOM )

Substituting in wXOM = 1 − wK , this equation becomes

2
Var (rp ) = wK2 Var (rK ) + (1 − wK ) Var (rXOM ) + 2wK (1 − wK )Cov (rK , rXOM )

Setting the derivative of this equation equal to zero will give the formula for the minimum
variance portfolio:

dVar (rp )
= 2wK Var (rK ) − 2 (1 − wK )Var (rXOM ) + Cov (rK , rXOM )(2 − 4wK ) = 0
dwK
Var (rXOM ) − Cov (rK , rXOM )
⇒ wK =
Var (rK ) + Var (rXOM ) − 2Cov (rK , rXOM )

APPENDIX 10.2: PORTFOLIOS WITH THREE AND MORE ASSETS

I n this appendix we look at portfolios and their efficient frontiers when there are more
than two assets. The main points we make are as follows:
• In the multiasset context we can still calculate the efficient frontier, and it still has its
characteristic shape.
• The more risky assets there are, the more the portfolio variance is influenced by the
covariances between the assets.
We start by considering a three-asset problem. To describe three assets, we need to know
the expected return, the variance, and all the pairs of covariances. These data are described
below.

A B C D E
1 A THREE-ASSET PORTFOLIO PROBLEM
2 Stock A Stock B Stock C
3 Mean 10% 12% 15%
4 Variance 15% 22% 30%
5
6 Cov(rA,rB) 0.03
7 Cov(rB,rC) -0.01
8 Cov(rA,rC) 0.02
 CHAPTER 10 Portfolio Returns and the Efficient Frontier 339

Suppose we form a portfolio of risky assets composed of proportion x A in asset A, xB in

asset B, and xC in asset C. Because the portfolio is fully invested in risky assets, it follows that
xC = 1 - x A - x B .
Portfolio return statistics: The expected return of the portfolio is given by

E (rp ) = x A E (rA ) + x B E (rB ) + xC E (rC )

The calculation of the portfolio’s variance of return requires both the variances and the
covariances:
Var (rp ) = x A2 Var (rA ) + x B2Var (rB ) + xC2 Var (rC ) +
2 x A x BCov (rA , rB ) + 2 x A xCCov (rA , rC ) + 2 xB xCCov (rB , rC )

Note that there are three variances and three covariances. When—at the end of this section—we
show you the formula for a four-asset problem, there will be four variances and six covariances.
As the number of assets grows, so does the number of covariances (in fact their number grows
much faster than the number of variances). This is the meaning of the second bullet at the begin-
ning of this section—for multiasset portfolio problems, the portfolio variance is increasingly
influenced by the covariances.
Here’s an example of the mean return and variance calculation for our three-asset portfolio:
The portfolio statistics are calculated in cells B16:B18.

A B C D E F G H I J
1 A THREE-ASSET PORTFOLIO PROBLEM
2 Stock A Stock B Stock C
3 Mean 10% 12% 15%
4 Variance 15% 22% 30%
5
6 Cov(rA,rB) 0.03
7 Cov(rB,rC) -0.01
8 Cov(rA,rC) 0.02
9
10 Portfolio proportions
11 xA 0.2500
12 xB 0.3500
13 xC 0.4000 <-- =1-B12-B11
14
15 Market portfolio statistics
16 Mean 0.1270 <-- =B11*B3+B12*C3+B13*D3
17 Variance 0.0908 <-- =B11^2*B4+B12^2*C4+B13^2*D4+2*B11*B12*B6+2*B11*B13*B8+2*B12*B13*B7
18 Sigma 0.3013 <-- =SQRT(B17)

Calculating the Efficient Frontier with Three Assets

We can use Excel to calculate and graph the efficient frontier for this case.9 We’ll make use
of Excel’s Solver.
Step 1: We use Solver to find the minimum variance portfolio.

9
The procedure we’re about to explain is somewhat long-winded—for a much shorter though mathe-
matically more complicated procedure, see my book Financial Modeling (3rd edition, MIT Press, 2008).
340 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Here’s the result.

A B C D E F G H I J
1 A THREE-ASSET PORTFOLIO PROBLEM
2 Stock A Stock B Stock C
3 Mean 10% 12% 15%
4 Variance 15% 22% 30%
5
6 Cov(rA,rB) 0.03
7 Cov(rB,rC) -0.01
8 Cov(rA,rC) 0.02
9
10 Portfolio proportions
11 xA 0.4370
12 xB 0.3151
13 xC 0.2479 <-- =1-B12-B11
14
15 Market portfolio statistics
16 Mean 0.1187 <-- =B11*B3+B12*C3+B13*D3
17 Variance 0.0800 <-- =B11^2*B4+B12^2*C4+B13^2*D4+2*B11*B12*B6+2*B11*B13*B8+2*B12*B13*B7
18 Sigma 0.2828 <-- =SQRT(B17)

Step 2: We now specify sigma and use Solver to find a portfolio with the maximum return.
We do this by first adding a cell (“Target sigma,” cell B20) to the spreadsheet.
 CHAPTER 10 Portfolio Returns and the Efficient Frontier 341

A B C D E F G H I J
1 A THREE-ASSET PORTFOLIO PROBLEM
2 Stock A Stock B Stock C
3 Mean 10% 12% 15%
4 Variance 15% 22% 30%
5
6 Cov(rA,rB) 0.03
7 Cov(rB,rC) -0.01
8 Cov(rA,rC) 0.02
9
10 Portfolio proportions
11 xA 0.2500
12 xB 0.3500
13 xC 0.4000 <-- =1-B12-B11
14
15 Market portfolio statistics
16 Mean 0.1270 <-- =B11*B3+B12*C3+B13*D3
17 Variance 0.0908 <-- =B11^2*B4+B12^2*C4+B13^2*D4+2*B11*B12*B6+2*B11*B13*B8+2*B12*B13*B7
18 Sigma 0.3013 <-- =SQRT(B17)

Note that—starting from row 24—we’ve begun to build a table of the results. The first row
of this table is the minimum sigma portfolio. Now we’ll use Solver to add another row to this
table.
We do this by adding a constraint to Solver.

The constraint was added by clicking Add in the lower portion of the Solver dialog box.
342 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Here’s the result.

A B C D E F G H I J K
1 A THREE-ASSET PORTFOLIO PROBLEM
2 Stock A Stock B Stock C
3 Mean 10% 12% 15%
4 Variance 15% 22% 30%
5
6 Cov(rA,rB) 0.03
7 Cov(rB,rC) -0.01
8 Cov(rA,rC) 0.02
9
10 Portfolio proportions
11 xA 0.2533
12 xB 0.3544
13 xC 0.3923 <-- =1-B12-B11
14
15 Market portfolio statistics
16 Mean 0.1267 <-- =B11*B3+B12*C3+B13*D3
17 Variance 0.0900 <-- =B11^2*B4+B12^2*C4+B13^2*D4+2*B11*B12*B6+2*B11*B13*B8+2*B12*B13*B7
18 Sigma 0.3000 <-- =SQRT(B17)
19
20 Target sigma 0.3000

If we repeat this calculation many times for many target sigmas, we get the efficient
frontier.

A B C D E F G H I J K
24 TABLE OF SIGMA VERSUS MEAN
25 Target sigma Mean
26 0.2828 0.1187 <-- This is the minimum sigma portfolio
27 0.2900 0.1238
28 0.3000 0.1256 Efficient Frontier for Three Assets
29 0.3100 0.1288 0.16
30 0.3200 0.1307
Portfolio mean return

31 0.3300 0.1323 0.15

32 0.3400 0.1338
0.14
33 0.3500 0.1352
34 0.3600 0.1365 0.13
35 0.3700 0.1378
0.12
36 0.3800 0.1390
37 0.3900 0.1401 0.11
38 0.4000 0.1413
0.10
39 0.4100 0.1420
40 0.4200 0.1435 0.20 0.25 0.30 0.35 0.40 0.45 0.50
41 0.4300 0.1446 Portfolio sigma
42 0.4400 0.1456
43 0.4500 0.1467
44 0.4600 0.1477
45 0.4700 0.1487

Four Assets
This section has gone into depth about how to calculate returns and variances for a three-asset
portfolio. If we have four assets, we can do the same kinds of calculations (we leave this as
an exercise). What you have to know for this case is how to calculate the portfolio return and
variance.
 CHAPTER 10 Portfolio Returns and the Efficient Frontier 343

Call the assets A, B, C, and D, and denote the portfolio weights by x A , x B , xC , x D .

Portfolio return statistics: The expected return of the portfolio is given by
E (rp ) = x A E (rA ) + x B E (rB ) + xC E (rC ) + x D E (rD )

The calculation of the portfolio’s variance of return requires both the variances and the
covariances:
Var (rp ) = x A2 Var (rA ) + x B2Var (rB ) + xC2 Var (rC ) + x D2 Var (rD )
2 x A x BCov (rA , rB ) + 2 x A xCCov (rA , rC ) + 2 x A x DCov (rA , rD )
+2 x B xCCov (rB , rC ) + 2 x B x DCov (rB , rD )
+2 xC x DCov (rC , rD )

Note that there now there are four variances and six covariances.

EXERCISES FOR APPENDIX 10.2

All three problems relate to the following statistics for stocks ABC, QPD, and XYZ.

A B C D
1 RETURN STATISTICS FOR THREE STOCKS
2 ABC QPD XYZ
3 Average return 22.00% 17.50% 30.00%
4 Variance 0.2 0.05 0.17
5 Standard deviation 44.72% 22.36% 41.23%
6
7 Correlations
8 Corr(ABC,QPD) 0.05
9 Corr(ABC,XYZ) -0.1
10 Corr(QPD,XYZ) 0.5

A1. Find the average return and standard deviation of a portfolio composed of 50% stock
ABC, 20% stock QPD, and 30% stock XYZ.
A2. Find the minimum variance portfolio and its statistics.
A3. Find the portfolio having maximum return given that the portfolio standard deviation
is 30%.
CHAP TER

The Capital Asset Pricing Model

11 and the Security Market Line

CHAPTER CONTENTS
Overview 344
11.1. Summarizing the Chapter 345
11.2. Risky Portfolios and the Riskless Asset 350
11.3. Points on the CML—Exploring Optimal Investment Combinations 355
11.4. Advanced Section: The Sharpe Ratio and the Market Portfolio M 359
11.5. The Security Market Line (SML) 361
Summing Up 364
Exercises 365

Overview
In this chapter we discuss two powerful results about returns and risks in capital markets. One
result, termed the capital market line (CML), gives investors advice about how to invest. The
CML says that the best investment portfolio for any investor is a combination of two assets—a
risk-free asset such as a savings account and a risky asset that is representative of the risks of
the overall stock market (the S&P 500 index is often used as an example). The choice about
which proportion to invest in the risk-free asset and which proportion to invest in the risky asset
depends on the investor’s willingness to bear risks.

344
 CHAPTER 11 The Capital Asset Pricing Model and the Security Market Line 345

A second result, called the security market line (SML), links the return of any asset to its
market risk (also termed the asset’s systematic risk). The SML states that the expected return
of any asset depends on the asset’s sensitivity to the market. This sensitivity is termed beta and
is often written with the Greek letter β. Assets with higher β’s have higher risks and will earn
higher expected returns.
In this chapter we develop the concepts of the CML and SML. In Chapter 10 we discussed
the risk and return combinations offered by a portfolio of risky assets. In this chapter we add a
risk-free asset to the portfolio problem discussed in Chapter 10. Adding this asset gives inves-
tors new possibilities because it allows them to buy an asset that gives a nonrisky return: They
can invest in stocks, in the risk-free asset, or in some combination of the two. A portfolio com-
posed of risky assets and the risk-free asset allows investors to achieve returns that are greater
than the returns offered by only a portfolio of risky assets.
The addition of a risk-free asset to the portfolio of risky assets leads to four new concepts:
• The market portfolio (denoted by the letter M) is the best portfolio of risky assets avail-
able to all investors.
• The capital market line (CML) is the set of all optimal investment portfolios for an inves-
tor. The CML contains an important piece of investment advice: It tells us that every
investor’s optimal investment portfolio should be a combination of the risk-free asset and
the market portfolio.
• The beta (β) of a stock is a measure of the stock’s market risk.
• The security market line (SML) describes the relation between the expected returns of
any stock and its β.
Because the material in this chapter is not easy, we start the chapter with a summary of its
main results. At some point you might want to skip ahead to Chapters 12 and 13 to see how the
concepts are used in practice.

Finance Concepts Used

• Portfolios, risk-free asset
• Capital market line (CML)
• β, security market line (SML)
• Sharpe ratio

Excel Functions Used

• Varp, Stdevp, Sqrt
• Sophisticated graphing
• Solver

11.1. Summarizing the Chapter

Much of the material in this chapter is technical and somewhat harder than that in other chapters
in this book. To ease your understanding of the chapter materials, we start with a summary of
the chapter’s main results.
346 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

The big “takeaways” from this chapter are two concepts: the capital market line (CML) and
the security market line (SML). The CML tells us how an investor should optimally split his
investment between risky and nonrisky assets. The SML tells us how the expected return of any
asset is related to its risk and how this risk should be measured. In the next two subsections we
give examples of the use of the CML and the SML.
In discussing the CML and the SML it is helpful to have two pieces of notation. We denote
by r f the return of a risk-free asset; you can think of this as the interest rate paid by banks on
their savings accounts or as the interest paid by money-market funds.1 We denote by E(rM)
the expected return on the market, the rate of return on a portfolio of stocks that is representa-
tive of the riskiness of the whole stock market. Suppose, for example, that the risk-free rate in
the United States—a representative rate paid by banks on savings—is r f = 3%. At the same time,
the consensus of stock market analysts is that over the next 5 years the U.S. stock market will
have an annual return of E(rM) = 8%. In the examples below we will use both r f = 3% and E(rM) =
8% to illustrate the capital market line (CML) and the security market line (SML).

The Capital Market Line (CML)

The CML says that an investor’s optimal investment strategy is to split your capital between two
assets: a risk-free asset earning r f and a risky asset representing the risks of the overall market.
The CML states that the expected return of such a portfolio is given by the equation
CML : Expected return of an optimal portfolio
E (rp ) = rf + (% invested in Market portfolio )* ⎣⎡ E (rM ) − rf ⎦⎤

Here’s how you might use the CML: Suppose your friend Benjamin says to you: “I’ve got
$10,000 to invest. You’re a finance major. Help me pick some stocks.”
You should start by telling Benjamin not even to try to pick stocks! Much financial research
has shown that stock picking is largely futile; on average, even experienced “stock pickers” do
not earn superior returns. Instead of picking stocks, the CML advises you to ask Benjamin what
proportion of his money he wants to put at risk and what proportion he needs to keep absolutely
safe. There’s a trade-off here: The risky part of his investment will, on average, earn more than
the riskless part.
Suppose Benjamin answers that he’s willing to put 30% of his money at risk and wants the
remaining 70% in a safe investment. At that point you can give him the following good advice,
based on the CML:
• Invest the $7,000 in a money-market fund such as the Fidelity Cash Reserves Fund.
Money-market funds invest in very short-term bonds and earn interest virtually without
risk. They are very liquid (meaning you can withdraw your money at any time), and they
are very safe.
• Invest the $3,000 that he’s willing to put at risk in a mutual fund that represents the
average risk of the market. A typical fund might be Fidelity’s Spartan 500 Index Fund.

1
A money-market fund is a mutual fund that invests in a highly diversified portfolio of very short-term
bonds issued by the U.S. Treasury or by U.S. corporations that have high credit ratings. The bonds bought
by a money-market fund typically mature within 7–20 days, meaning that the fund is lending out its money
for a very short time in a highly liquid market. The return of a money market fund is representative of
the risk-free interest rate in the economy. For a more in-depth explanation, look at http://www.fool.com/
savings/shortterm/03.htm.
 CHAPTER 11 The Capital Asset Pricing Model and the Security Market Line 347

This fund invests only in the stocks of the S&P 500 index—an index that is broadly
representative of the riskiness of the American stock market.2
• The CML states that Benjamin’s expected portfolio return is related to the risk-free rate
r f and to the percentage of his investment in the market. Suppose that r f = 3% and sup-
pose that E(rM) = 8%. Then Benjamin can expect an annual portfolio return of 4.5%:

CML : Expected return of an optimal portfolio

E (rp ) = rf + (% invested in Market portfolio )* ⎣⎡ E (rM ) − rf ⎦⎤
= 3% + 30% * [8% − 3%] = 4.5%

Benjamin’s 70–30% strategy shows that he’s fairly risk averse. His risk aversion leads
Benjamin to an investment strategy that puts most of his money in a riskless investment and
only a small part in a risky investment. Benjamin will not be putting much of his money at risk,
but on the other hand he will earn less than he would if he undertook more risk.
Now suppose your parents ask you how to invest their $1,000,000 of savings. They suggest
to you that they’re investing for the long run and can bear more risks. Because they can bear more
risk than Benjamin, you might ask them what they think of a 20–80% investment strategy. You
might suggest to them that they invest $200,000 in Fidelity Cash Reserves and the remaining
$800,000 in the Spartan Index 500 Fund. In the long run they will earn more from their invest-
ments, but they will undertake more risks. The CML predicts that your parents will earn 7%:
CML : Expected return of an optimal portfolio
E (rp ) = rf + (% invested in Market portfolio )* ⎣⎡ E (rM ) − rf ⎦⎤
= 3% + 80% * [8% − 3%] = 7%

As you can see, the CML simplifies investment strategies by concentrating only on the split
between a riskless and a risky investment asset. It also predicts the expected return of the port-
folio.3 To sum up the investment advice contained in the CML:
• The best investment portfolios involve a simple split between the risk-free asset and the
market portfolio. These portfolios whose return–risk configuration is given by the CML
are the best portfolios available to the investor: Beyond the portfolios that are on the
CML, there aren’t portfolios that offer a superior return–risk combination.
• Beyond the simple choice of the investor’s split between a risk-free asset and the market port-
folio, there’s no point in thinking further! Investors cannot improve the performance of their
investment portfolios by the judicious picking of stocks. Neither can investment managers.

The Security Market Line (SML)

The CML deals only with the composition of optimal investment portfolios. But there are many
assets in the market—what about them? The SML says that the expected return of any stock or
portfolio is related to three factors:
1. The risk-free rate in the market r f .

2
The relevant URLs for the two funds mentioned can be found at the Fidelity Web site: http://www.fidelity.
com. Note that almost all mutual fund companies have money-market and index funds, so that the use of
the Fidelity funds is merely illustrative.
3
Anticipating the results of Section 11.3, the CML also suggests that the standard deviation of the returns
of the optimal investment strategy are given by σP = % invested in Market portfolio *σM.
348 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

2. The stock’s market risk. A stock’s risk is measured by a number called beta (β) that
measures the sensitivity of the stock’s return to the return of the market. If a stock
has a high β, then when the market goes up, the stock goes up even more (and of
course, the opposite: When the market goes down, the stock goes down even more).
The price movements of a low β stock exhibit less sensitivity to variations in the
market.
3. The expected return of the market, E(rM).
The SML states that the expected return of any asset is determined by the equation

SML : Expected return of any asset = E (rAsset )= rf + β Asset * ⎡⎣ E (rM )- rf ⎤⎦

Here are two examples of the use of the SML. Suppose that the risk-free rate r f = 3%
and that the market expected return is E(rM) = 8%. What’s are the expected returns of AMD
and Kellogg (stock symbol K) stock? A look at Yahoo! (see Figure 11.1) shows that AMD’s β
is β AMD = 1.81 and that Kellogg’s β is βK = 0.44 . Applying the SML shows that the market
expects Microsoft’s return to be 9.40% and Merck’s return to be 5.08%:

AMD's expected return, E (rAMD )= rf + β AMD * ⎡⎣ E (rM ) − rf ⎤⎦

= 3% + 1.81* [8% − 3% ]= 12.05%
Kellogg's expected return, E (rK )= rf + βK * ⎡⎣ E (rM ) − rf ⎤⎦
= 3% + 0.44 * [8% − 3%]= 5.20%

A B C
COMPUTING THE RETURNS ON
1 KELLOGG (K) AND AMD
2 Risk-free rate, rf 3%
3 Expected market return, E(rM) 8%
4
5 AMD beta, βAMD 1.81
6 AMD expected return, E(rAMD) 12.05% <-- =$B$2+B5*($B$3-$B$2)
7
8 Kellogg beta, βK 0.44
9 Kellogg expected return, E(rK) 5.20% <-- =$B$2+B8*($B$3-$B$2)

You might ask yourself whether AMD’s higher expected return means that AMD is a better
investment than Kellogg. The answer is no—AMD has a higher expected return because it is
riskier than Kellogg; the higher expected return reflects this higher risk.

Where Do We Go from Here?

This section has summarized the main results from this chapter. In the two succeeding chapters
we discuss the uses of these results for evaluating investments (Chapter 12) and for measuring
the cost of capital (Chapter 13). In the remainder of this chapter, we derive the CML and the
SML. The discussion is (unavoidably) somewhat technical, and you may decide to skip ahead
to Chapters 12 and 13.
 CHAPTER 11 The Capital Asset Pricing Model and the Security Market Line 349

FIGURE 11.1 Screen clips from Yahoo! showing β for AMD and Kellogg. The results can be obtained
by going to http://finance.yahoo.com, choosing the stock, and then going to Key Statistics.
350 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

11.2. Risky Portfolios and the Riskless Asset

Now that we’ve reviewed the main results of the chapter, here’s the nitty-gritty. We start by
considering a portfolio problem of the kind dealt with in Chapter 10. We will assume that
there are two risky assets, Stock A and Stock B, and also a risk-free asset—an asset that
gives an annual interest payment with certainty. You can think of this asset as being a sav-
ings account in a bank a government bond or a money-market fund. In the examples of this
section, we’ll suppose that the risk-free asset gives a 2% annual return, and we will denote
the return on the risk-free asset by r f. The fi rst few lines of the following spreadsheet give
you all the details.

A B C D E
1 TWO STOCKS AND A RISK-FREE ASSET
Risk-free
2 Stock A Stock B rf
3 Average return 7.00% 15.00% 2%
4 Variance 0.0064 0.0196
5 Sigma 8.00% 14.00%
6 Covariance of returns 0.0011
7 Correlation 0.1000
8
Expected Return and Standard Deviation of
9 Portfolio Return
10
11
Expected portfolio return, E(rp)

20%
12 18%
13 16%
14 14%
15 12%
16
10%
17
18 8%
19 6%
20 4%
21 2%
22 0%
23 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
24 Standard deviation of portfolio return, rp
25
26
27 Round dot portfolio
28 A 0.9
29 B 0.1
30 Portfolio mean 7.80% <-- =B28*$B$3+(1-B28)*$C$3
Portfolio standard <-- =SQRT(B28^2*$B$4+(1-
31 deviation, σp 7.47% B28)^2*$C$4+2*B28*(1-B28)*$B$6)

The curved line shows the portfolio mean E(rP) and standard deviation (“sigma-p”) σp of
combinations of Stock A and Stock B.4 The straight line shows the mean and standard deviation
of portfolio combinations of the risk-free asset (which returns r f = 2%) and a specific portfolio
of risky assets, denoted by round dot • ).

4
This was illustrated in Chapters 8 and 10.
 CHAPTER 11 The Capital Asset Pricing Model and the Security Market Line 351

Rows 28–31 give information about the round dot portfolio • . It is composed of 90% Stock
A and 10% Stock B, and it has expected return E (rp ) = 7.8% and standard deviation of return
σ p = 7.47% .

Computing a Point on the Straight Line

In the spreadsheet below we indicate two points on the straight line that connects the risk-free
rate r f and the round dot portfolio • . Each point represents an investment portfolio that is partly
invested in the risk-free asset and partly in the portfolio • . Take a look, and then after the
spreadsheet we’ll show you how to calculate the mean and standard deviation of the points on
the line.

A B C D E
1 TWO STOCKS AND A RISK-FREE ASSET
Risk-free
2 Stock A Stock B rf
3 Average return 7.00% 15.00% 2%
4 Variance 0.0064 0.0196
5 Sigma 8.00% 14.00%
6 Covariance of returns 0.0011
7 Correlation 0.1000
8
Expected Return and Standard Deviation of
9 Portfolio Return
10
11
Expected portfolio return, E(rp)

20%
12 18%
13 16%
14 14%
15 12%
16 H
10%
17
18 8%
19 6%
20 4%
21 2% K
22 0%
23 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
24 Standard deviation of portfolio return, σp
25
26

The “round-dot portfolio” • is composed of an investment 90% in A and 10% in B. What

about portfolio H? H is a portfolio invested 60% in the “round-dot portfolio” and 40% in the
risk-free asset. To compute the returns of this portfolio, we use the following equations:
E (rH ) = x
) E (rround − dot ) + (1 − x ) * rf = 60% * 7.8% + 40% * 2% = 5.48%
!""#""$
↑ ↑
Percent in Percent in
"round-dot" risk-free asset
portfolio
σH = x σround − dot = 60% * 7.47% = 4.48%
)
↑
Percent in
"round-dot"
portfolio
352 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

In a similar fashion portfolio K—invested 20% in the round-dot portfolio and 80% in the
risk-free asset—has statistics

E (rK ) = x E (rround − dot ) + (1 − x ) * rf = 20% * 7.8% + 80% * 2% = 3.16%

)
↑
!""#""$
Percent in ↑
"round-dot" Percent in
portfolio risk-free asset

σK = x σround − dot = 20% * 7.47% = 1.49%

)
↑
Percent in
"round-dot"
portfolio

A STATISTICAL NOTE

The equations used in the last calculation follow from our lessons in portfolio statistics in
Chapter 9. Suppose the investor invests a percentage of her wealth x in a portfolio A of risky
assets that has expected return E(rA ) and standard deviation of return σA. Suppose she invests
the rest of her wealth 1 − x in a risk-free asset that has expected return r f and standard deviation
of return 0. By the formula given in Chapter 10, the portfolio’s expected return is its weighted-
average return:
E (rp ) = x E (rA ) + (1 − x )rf .

The portfolio’s return variance is

2
Var (rp ) = x 2Var (rA ) + (1 − x ) Var (rf ) + 2 * x * (1 − x )* Cov (A, rf )
!""#""$ !""""#""""$ .
↑ ↑
= 0, since = 0, since
the risk-free the risk-free
asset is risk-free asset is
(duh!) risk-free
(duh!)
= x 2Var (rA ) = x 2σ A2

This means that the standard deviation of the portfolio’s return is σ p = Var (rp ) = xσ A.

Improving the Risk–Return Relation

We can choose portfolios that have a better risk–return relation than those on the line connect-
ing r f and the round-dot portfolio • by choosing another portfolio on the efficient frontier. The
line connecting the risk-free asset and the “big square” portfolio below is an improvement on
the line of the previous section.
 CHAPTER 11 The Capital Asset Pricing Model and the Security Market Line 353

A B C D E
1 TWO STOCKS AND A RISK-FREE ASSET
Risk-free
2 Stock A Stock B rf
3 Average return 7.00% 15.00% 2%
4 Variance 0.0064 0.0196
5 Sigma 8.00% 14.00%
6 Covariance of returns 0.00
7 Correlation 0.10
8
Expected Return and Standard Deviation of
9 Portfolio Return
10
Expected portfolio return, E(rp)

11 20%
12 18%
13 16%
14 14%
15 12%
16 10%
17 8%
18 6%
19
4%
20
21 2%
22 0%
23 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
24 Standard deviation of portfolio return, σp
25
26
27 Round-dot portfolio
28 A 0.9
29 B 0.1
30 Mean 7.80% <-- =B28*$B$3+(1-B28)*$C$3
<-- =SQRT(B28^2*$B$4+(1-
31 Sigma 7.47% B28)^2*$C$4+2*B28*(1-B28)*$B$6)
32
33 Big square portfolio
34 A 0.7
35 B 0.3
36 Mean 9.40% <-- =B34*$B$3+(1-B34)*$C$3
<-- =SQRT(B34^2*$B$4+(1-
37 Sigma 7.33% B34)^2*$C$4+2*B34*(1-B34)*$B$6)

Because the new line is higher than the old line, all the points on the line to the big square
n are better than the points on the line to the black circle l. For any point on the round-dot line
there’s always a point on the big square line that gives a higher return but has the same portfolio
standard deviation σp.
There must be a best line that starts off from the point 2% on the y-axis. This best line,
shown next, connects the risk-free rate rf = 2% to a point n on the efficient frontier.
354 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

A B C D E
TWO STOCKS AND A RISK-FREE ASSET
1 The best big square portfolio
Risk-free
2 Stock A Stock B rf
3 Average return 7.00% 15.00% 2%
4 Variance 0.0064 0.0196
5 Sigma 8.00% 14.00%
6 Covariance of returns 0.0011
7 Correlation 0.1000
8
Expected Return and Standard Deviation of
9 Portfolio Return
10 20%
Expected portfolio return, E(rp)

11 18%
12
16%
13
14 14%
15 12%
16 10%
17 8%
18 6%
19
20 4%
21 2%
22 0%
23 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
24 Standard deviation of portfolio return, σp
25
26
27 Round-dot portfolio
28 A 0.9
29 B 0.1
30 Mean 7.80% <-- =B29*$B$3+(1-B29)*$C$3
<-- =SQRT(B28^2*$B$4+(1-
31 Sigma 7.47% B28)^2*$C$4+2*B28*(1-B28)*$B$6)
32
33 Best big square portfolio
34 A 51.81%
35 B 48.19%
36 Mean 10.85% <-- =B34*$B$3+(1-B34)*$C$3
<-- =SQRT(B34^2*$B$4+(1-
37 Sigma 8.26% B34)^2*$C$4+2*B34*(1-B34)*$B$6)

The line as drawn has several properties:

• It starts from the risk-free rate (2%) on the y-axis.
• It goes to (and through) a stock portfolio n on the efficient frontier market by the
big square. As you can see in cells B35:B38, this portfolio is composed 51.81%
of Stock A and 48.19% of Stock B. It has an expected return of 10.85% and stan-
dard deviation of 8.26%. In Section 11.4 we’ll describe how we computed this
portfolio.
 CHAPTER 11 The Capital Asset Pricing Model and the Security Market Line 355

• It is tangent to the efficient frontier—meaning the line touches the efficient frontier
only at the big square portfolio and nowhere else. This means that with the excep-
tion of the big square portfolio n, every portfolio on the efficient frontier is below
the line.
• Finally (and this is the most important point), because the big square line is above the
efficient frontier (except for the one point n at which it touches the frontier), all the best
investment portfolios are on the line. This point is so important that we explore it in a
separate subsection.
The big square portfolio n is called the market portfolio. The market portfolio is the port-
folio of risky assets that allow investors to achieve maximal returns. The equation of the capital
market line is
⎡ E (rM ) − rf ⎤
E (rp ) = rf + σ p ⎢ ⎥
⎣ σM ⎦

The Capital Market Line

To emphasize the optimality, take another look at the “best big square line.” Note
that the line is above the efficient frontier everywhere (except at point of tangency,
which we now call the market portfolio M). We call this line the capital market line
(CML).
The CML is the set of optimal investment portfolios. Each point on the line is:
• A combination of some percentage invested in the risk-free asset
• Another percentage invested in the market portfolio M
In Section 11.4 we show how to compute the market portfolio M. In the next section we
explore the practical meaning of the CML.

11.3. Points on the CML—Exploring Optimal

Investment Combinations
What do portfolios on the CML—the line connecting the risk-free rate r f and the market port-
folio M—look like? What does the CML mean for an investor? To get a feel for this, we explore
several portfolios on the CML.

Portfolio 1: Investing in the Market Portfolio M and in the

Risk-Free Asset
Suppose you have $1,000 to invest. You can choose any combination of three assets—the risk-
free asset, Stock A, or Stock B. In Portfolio 1, you choose to invest $500 in the risk-free asset
and $500 in the market portfolio M—the portfolio composed of 51.81% Stock A and 48.19%
Stock B.
356 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

A B C
1 PORTFOLIO ON THE CAPITAL MARKET LINE (CML)
2 The market portfolio, M Percent
3 Stock A 51.81%
4 Stock B 48.19%
5 Expected return of market portfolio M 10.85%
6 Standard deviation of market portfolio M 8.26%
7
8 Investor portfolio
9 Invested in risk-free 50%
10 Invested in market portfolio M 50%
11
12 Portfolio return statistics–point on the CML
13 Expected portfolio return 6.43% <-- =B9*I19+B10*B5
14 Portfolio standard deviation 4.13% <-- =B10*B6

This looks a little complicated, but it’s really a version of the portfolio calculations we
did in Chapter 10. The investment is divided 50% into the risk-free asset and another 50% into
portfolio M, which has an expected return of 10.85% (cell B5) and standard deviation of 8.26%
(cell B6). According to the formula given in Section 11.2, the expected return and the standard
deviation of returns are calculated by
E (rp ) = xE (rM ) + (1 − x )rf
σ p = xσ M

As you can see in cells B13:B14, this gives E (rp ) = 6.43%, σ p = 4.13% . This portfolio is
indicated in the graph below. Note that the portfolio conforms to the CML equation given at the
end of the previous section:

⎡ E (rM ) − rf ⎤
E (rp ) = rf + σ p ⎢ ⎥
⎣ σM ⎦
⎡10.85% − 2% ⎤
= 2% + 4.13% * ⎢ ⎥ = 6.43%
⎣ 8.26% ⎦

Points on the Capital Market Line, CML

20%
Portfolio 2:
18%
-50% in rf, 150% in M
16%
Expected portfolio return E(rp)

The market
14% portfolio M

12%

10% Portfolio 1:
50% in rf, 50% in M
8%

6%

4%

2%

0%
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
Standard deviation of portfolio return, σp
 CHAPTER 11 The Capital Asset Pricing Model and the Security Market Line 357

Portfolio 2: Borrowing at the Risk-Free Rate rf to Buy

More of the Market Portfolio M
In Portfolio 1 you split your investment of $1,000 between the risk-free asset and the market
portfolio M. In Portfolio 2 we’ll investigate an investment strategy in which you borrow money
at the risk-free rate and invest more than $1,000 in the risky portfolio M. You do this by using
borrowed funds to increase your investment in M.
As before, you have $1,000 to invest, and as before you choose to invest some of your
money in the risk-free asset and the rest in the market portfolio M, composed of 51.81% Stock
A and 48.19% Stock B. However, in Portfolio 2 you choose to borrow $500 at the risk-free rate
and invest $1500 in the portfolio of Stock A and Stock B. As you can see in cells B13:B14 below,
this is a riskier portfolio (it has a standard deviation of 12.40%), but it also has a higher expected
return (15.28%).

A B C
1 PORTFOLIO ON THE CAPITAL MARKET LINE (CML)
2 The market portfolio, M Percent
3 Stock A 51.81%
4 Stock B 48.19%
5 Expected return of market portfolio M 10.85%
6 Standard deviation of market portfolio M 8.26%
7
8 Investor portfolio
9 Invested in risk-free -50%
10 Invested in market portfolio M 150%
11
12 Portfolio return statistics–point on the CML
13 Expected portfolio return 15.28% <-- =B9*I19+B10*B5
14 Portfolio standard deviation 12.40% <-- =B10*B6

Note that the portfolio conforms to the CML equation given at the end of the previous
section:
⎡ E (rM ) − rf ⎤
E (rp ) = rf + σ p ⎢ ⎥
⎣ σM ⎦
⎡10.85% − 2% ⎤
= 2% + 12.40% * ⎢ ⎥ = 15.28%
⎣ 8.26% ⎦

Comparing Portfolio 1 with Portfolio 2

Which portfolio is better—Portfolio 1 or Portfolio 2? Comparing their returns with their stan-
dard deviations shows that neither portfolio is better. Portfolio 2 has a much higher expected
return than Portfolio 1, but it also has higher risk. The choice between the portfolios depends on
how much risk the investor is willing to take.

Return standard
Expected return E(rp ) deviation σp

Portfolio 1 6.43% 4.13%

Portfolio 2 15.28% 12.40%
358 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

All the portfolios on the CML incorporate this choice: Each CML portfolio is a combina-
tion of an investment in the risk-free asset r f and the market portfolio M. Any portfolio on the
CML is optimal in the sense that it could possibly be a rational investor’s choice of his best
investment portfolio. Figure 11.2 shows some other points on the CML and their return–risk
trade-off.

Portfolio Proportions and Investment Returns on the Capital Market Line (CML)

Percentage invested in market E (rp ) = % in risk-free * rf σ p = % in market * σ M

portfolio M +% in market * E (rM )
σ p = 0% * σ M = 0
0% (invest all your wealth in E (rp ) = 100% * rf = 2%
risk-free asset r f)
50% (invest 50% of your E (rp ) = 50% * rf + 50% * E (rM ) σ p = 50% * σ M
wealth in market portfolio = 50% * 2% + 50% *10.85% = 50% * 8.26% = 4.13%
M and 50% in risk-free asset) = 6.43%

100% (invest all your wealth E (rp ) = 0% * rf + 100% * E (rM ) σ p = 100% * σ M

in market portfolio M) = 100% *10.85% = 100% * 8.26% = 8.26%
= 10.85%

125% (borrow 25% of your E (rp ) = −25% * rf + 125% * E (rM ) σ p = 125% * σ M

wealth to increase investment = −25% * 2% + 125% *10.85% = 125% * 8.26% = 10.33%
in risky assets M) = −0.5% + 13.57% = 13.06%

150% (borrow 50% of your E (rp ) = −50% * rf + 150% * E (rM ) σ p = 150% * σ M

wealth to increase investment = −50% *1% + 150% *10.85% = 150% * 8.26% = 12.39%
in risky assets M) = −1% + 16.28% = 15.28%
200% (borrow 100% of your E (rp ) = −100% * rf + 200% * E (rM ) σ p = 200% * σ M
wealth to increase investment = −100% * 2% + 200% *10.85% = 200% * 8.26% = 16.52%
in risky assets M) = −2% + 21.70% = 19.70%
FIGURE 11.2 Points on the CML. Each point represents a different combination of an investment in the
risk-free asset and the market portfolio M. As the proportion in the risk-free asset decreases, the propor-
tion invested in the market portfolio M increases. Increasing the proportion invested in M increases the
portfolio’s expected return E (rp ) but also increases the portfolio’s risk σ p . The calculations assume
that E (rM ) = 10.85%, r f = 2%, and σ M = 8.26%.

The CML: Summing Up

The CML indicates that all optimal investment portfolios should be split between a percent-
age investment in the risk-free asset and a percentage investment in the market portfolio M.
Suppose we denote these percentages by x M and xrf = 1 − x M . Then the investor’s portfolio
will have:
• Expected return E (rp ) = x M E (rM ) + (1 − x M )rf
• Standard deviation of return σ p = x M σ M
 CHAPTER 11 The Capital Asset Pricing Model and the Security Market Line 359

Portfolios on the CML are optimal in the sense that investors cannot find investment com-
binations that have a higher portfolio return E (rp) given the portfolio risk σ p .

11.4. Advanced Section: The Sharpe Ratio and the

Market Portfolio M
In this section we’ll show how to compute the market portfolio M. In the process we’ll introduce
a concept called the Sharpe ratio—this is one of the standard return–risk measures used in cap-
ital markets. As you’ll see, portfolio M is the portfolio that maximizes the Sharpe ratio.
To get some intuition, look at the spreadsheet below. It continues our example of Stocks A
and B and the risk-free rate of 2%. In cells B9:B10 we’re looking at a portfolio invested 30% in
Stock A and 70% in Stock B. The expected return of this portfolio is 12.60% and its standard
deviation is 10.32% (cells B12:B13).

A B C D E
PORTFOLIO RETURNS WITH A RISK-FREE ASSET
1 THE SHARPE RATIO
Risk-free
2 Stock A Stock B rf
3 Average return 7.00% 15.00% 2.00%
4 Variance of return 0.64% 1.96%
5 Sigma of return 8.00% 14.00%
6 Covariance of returns 0.0011
7
8 Portfolio return and risk
9 Percentage in stock A 30.00%
10 Percentage in stock B 70.00%
11
12 Expected portfolio return 12.60% <-- =B9*B3+B10*C3
13 Portfolio standard deviation 10.32% <-- =SQRT(B9^2*B4+B10^2*C4+2*B9*B10*B6)
14
15 Risk premium 10.60% <-- =B12-D3
16
17 Sharpe ratio 1.0271 <-- =(B12-D3)/B13
18
The Sharpe ratio is [E(rp) - rf ]/σp. It
denotes the ratio of portfolio
19 risk premium to portfolio risk.

The portfolio’s risk premium (sometimes called the portfolio excess return) is defined as
the difference between its expected return and the return of the risk-free asset:
portfolio risk premium = portfolio expected return − risk-free rate
= E (rp )− rf
= 12.60% − 2.00% = 10.60%

The ratio of this risk premium to the portfolio’s standard deviation is called the Sharpe ratio:
E (rp )− rf 12.60% − 2.00%
Sharpe ratio = = = 1.0271 .
σp 10.32%
360 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

The Sharpe ratio (named after William Sharpe, one of the developers of modern port-
folio theory and winner of the Nobel prize in economics in 1990) is a “return–
risk” ratio: The numerator is the extra return (over the risk-free rate) you get from
your portfolio, and the denominator is the cost of this extra return—its standard
deviation.
If you play a bit with the spreadsheet, you’ll see that there are other portfolios with higher
Sharpe ratios. Here’s an example.

A B C D E
8 Portfolio return and risk
9 Percentage in stock A 40.00%
10 Percentage in stock B 60.00%
11
12 Expected portfolio return 11.80% <-- =B9*B3+B10*C3
13 Portfolio standard deviation 9.28% <-- =SQRT(B9^2*B4+B10^2*C4+2*B9*B10*B6)
14
15 Risk premium 9.80% <-- =B12-D3
16
17 Sharpe ratio 1.0557 <-- =(B12-D3)/B13

Calculating the Market Portfolio M—The Portfolio with the

Highest Attainable Sharpe Ratio
We can use Excel’s Solver (see Chapter 28) to calculate the portfolio that gives the highest
Sharpe ratio. This portfolio is the market portfolio M.

Clicking Solve yields the answer.

 CHAPTER 11 The Capital Asset Pricing Model and the Security Market Line 361

A B C D E
PORTFOLIO RETURNS WITH A RISK-FREE ASSET
1 THE SHARPE RATIO
Risk-free
2 Stock A Stock B rf
3 Average return 7.00% 15.00% 2.00%
4 Variance of return 0.64% 1.96%
5 Sigma of return 8.00% 14.00%
6 Covariance of returns 0.0011
7
8 Portfolio return and risk
9 Percentage in stock A 51.81%
10 Percentage in stock B 48.19%
11
12 Expected portfolio return 10.85% <-- =B9*B3+B10*C3
13 Portfolio standard deviation 8.26% <-- =SQRT(B9^2*B4+B10^2*C4+2*B9*B10*B6)
14
15 Risk premium 8.85% <-- =B12-D3
16
17 Sharpe ratio 1.0716 <-- =(B12-D3)/B13

From now on, we’ll denote the portfolio with the maximum Sharpe ratio by M:
Given a risk-free asset and a set of risky assets (in the current example there are only two such
E (rM ) − rf
assets), the market portfolio M is the portfolio that maximizes the Sharpe ratio: .
σM
Portfolio M is the best combination of risky assets available to the investor.

11.5. The Security Market Line (SML)

The capital market line (CML) shows investors the return–risk relation for their optimal portfo-
lios. The risk–return relation for individual assets is described by a line called the security mar-
ket line (SML). The SML states that the expected return of an asset or portfolio is determined
by the asset’s systematic risk (called β), the risk-free rate, and the portfolio that maximizes the
Sharpe ratio.

Summing Up the SML First (Then We’ll Explain)

The SML says that the expected return of any asset i is related to the risk-free rate and the mar-
ket risk premium through the following relation:

Cov (ri , rM )
E (ri ) = rf +
Var (rM )
* ⎣⎡ E (rM ) − rf ⎦⎤
↑ ↑ ↑
Risk-free βi E (rM ) is the return
rate on the portfolio that
maximizesthe Sharpe
ratio
362 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Note that in the above equation “asset i” (represented by the letter “i”) can be a lot of things:
• Asset i can be just one risky asset. E (ri) can stand for the return of Stock A or the return
of Stock B.
• Asset i can be the combination of two risky assets. E (ri) can stand for the return of a
portfolio such as 60% in Stock A and 40% in Stock B.
• Asset i can be a combination of the risk-free asset and the two stocks, for example, 25%
in the risk-free, 30% in Stock A, and 45% in Stock B is a portfolio.
In short, the SML defines the risk–return relation for all assets in the market. The SML is
an important tool in investment management, and in the next two chapters we examine the uses
of the SML for evaluating the performance of portfolio managers (Chapter 12) and for comput-
ing the cost of capital for a firm (Chapter 13). In this section we illustrate why the SML holds.
To illustrate the SML, we use a few examples.

Example 1: The SML Works When Asset i Is Only Stock A

Lines 3–16 of the spreadsheet below repeat facts we’ve already given. In row 24 we compute
the covariance between asset i (in this case Stock A) and the market portfolio M. We use a
general fact about covariance: Suppose that i is composed of a percentage xiA of Stock A and
a percentage xiB = 1 − xiA of Stock B, and suppose that the market portfolio is composed of
a percentage xMA of Stock A and a percentage xMB = 1 − xMA of Stock B. Then the covariance
between ri and rM is
Cov (ri , rM ) = Cov (xiArA + xiBrB , xMArA + xMBrB )
= xiA x MAVar (rA ) + xiB x MBVar (rB ) + (xiA x MB + xiB x MA )* Cov (rA , rB )

Now suppose that x = 1, so that i refers to Stock A.

• Cell B22 indicates that E (ri) = 7.00%. This is the left-hand side of the SML.
• Cell B24 shows that Cov(ri,rM) = 0.0039.
Cov (ri , rM )
• In cell B25 we divide Cov(ri,rM) by Var(rM) to get the βi = = 0.5647 .
Var (rM )

• Cell B26 shows that rf + βi * ⎡⎣ E (rM ) − rf ⎤⎦ = 2% + 0.5647 * [10.85% − 2%] = 7.00% .

The equality between cells B22 and B26 shows that the SML works for the case where i is
only Stock A.

Although computed in different ways, cells B22 and B26 give the same result. This is the
SML:
)A ⎡⎣ E (rM ) − r f ⎤⎦
E (rA ) = r f + β
↑
Cov(rA,rM )
Var (rM )

7%
) = 2% + 0.5647 * [12% − 2%]
!"""""""""""#"""""""""""$
↑ ↑
SML, SML,
left-hand right-hand side
side cell B26
cell B22
 CHAPTER 11 The Capital Asset Pricing Model and the Security Market Line 363

A B C D E
1 THE SECURITY MARKET LINE (SML) ILLUSTRATION
Risk-free
2 Stock A Stock B rf
3 Average return 7.00% 15.00% 2.00%
4 Variance of return 0.0064 0.0196
5 Sigma of return 8.00% 14.00%
6 Covariance of returns 0.0011
7
8 Market portfolio M–this is the portfolio that maximizes the Sharpe ratio
9 Proportion of stock A, xMA 51.81%
10 Proportion of stock B, xMB = 1- xMA 48.19% <-- =1-B9
11
12 Expected market portfolio return, E(rM) 10.85% <-- =B9*B3+B10*C3
13 Market portfolio return variance, σ2M=Var(rM) 0.0068 <-- =B9^2*B4+B10^2*C4+2*B9*B10*B6
14 Market portfolio standard deviation σM=standard deviation(rM) 8.26% <-- =SQRT(B13)
15
16 Market excess return E(rM)-rf 8.85% <-- =B12-D3
17
18 "Proof" of SML: E(ri) = rf + bi *[E(rM) - rf]
19 Asset i
20 Percentage in stock A, xiA 100.00%
21 Percentage in stock B, xiB = 1- xiA 0.00% <-- =1-B20
Expected portfolio return E(ri)=xiA*E(rA)+xiB*E(rB)
22 SML, left-hand side 7.00% <-- =B20*B3+B21*C3
23
24 Cov(ri,rM) 0.0039 <-- =B20*B9*B4+B21*B10*C4+(B20*B10+B21*B9)*B6
25 Beta bi 0.5647 <-- =B24/B13
rf+bi *[E(rM)-rf]
26 SML,right-hand side 7.00% <-- =D3+B25*B16

Example 2: The SML Works for a Portfolio Composed Only of Stock B

We can repeat the calculations for the case where i is Stock B. As you can see in cell B25 below,
Stock B has βB = 1.4681. The equality of cells B22 and B26 means that the SML also works for
Stock B:
)B ⎡⎣ E (rM ) − r f ⎤⎦
E (rB ) = r f + β
↑
Cov(rA,rM )
Var (rM )

15%
"#""$ = 2%
!" + 1.4681* [12% − 2%]
!"""""""""""#"""""""""""$
↑ ↑
SML, SML,
left-hand right-hand side
side cell B26
cell B22
A B C D E
18 "Proof" of SML: E(ri) = rf + bi *[E(rM) - rf]
19 Asset i
20 Percentage in stock A, xiA 0.00%
21 Percentage in stock B, xiB 100.00%
Expected portfolio return E(ri)=xiA*E(rA)+xiB*E(rB)
22 SML, left-hand side 15.00% <-- =B20*B3+B21*C3
23
24 Cov(ri,rM) 0.0100 <-- =B20*B9*B4+B21*B10*C4+(B20*B10+B21*B9)*B6
25 Beta bi 1.4681 <-- =B24/B13
rf+bi *[E(rM)-rf]
26 SML,right-hand side 15.00% <-- =D3+B25*B16
364 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Example 3: The SML Works for Portfolios

In this section asset i is a portfolio composed of 80% Stock A and 20% Stock B. As in the previ-
ous examples, the equality between cells B22 and B26 means that the SML correctly describes
the return–risk relation for the asset.

A B C D E
18 "Proof" of SML: E(ri) = rf + bi *[E(rM) - rf]
19 Asset i
20 Percentage in stock A, xiA 80.00%
21 Percentage in stock B, xiB 20.00%
Expected portfolio return E(ri)=xiA*E(rA)+xiB*E(rB)
22 SML, left-hand side 8.60% <-- =B20*B3+B21*C3
23
24 Cov(ri,rM) 0.0051 <-- =B20*B9*B4+B21*B10*C4+(B20*B10+B21*B9)*B6
25 Beta bi 0.7453 <-- =B24/B13
rf+bi *[E(rM)-rf]
26 SML,right-hand side 8.60% <-- =D3+B25*B16

βs Add Up
Another way to have done the previous calculation is to use the portfolio β:
The portfolio β is the weighted average of the individual βs, β p = x Aβ A + x BβB .
For example, suppose we want to know the expected return from a portfolio invested 80%
in Stock A and 20% in Stock B. This portfolio will have a βp of
β p = x Aβ A + x BβB = 0.8 * 0.5647 + 0.2 *1.4681 = 0.7453 ,

and consequently its expected return should be determined by the SML using the βp.

Summing Up
The capital asset pricing model (CAPM) is a model of portfolio formation and asset pricing. The
model shows the following:
• How the expected return and standard deviation of portfolios are affected by the portfo-
lio composition.
• How the addition of a risk-free asset to the choices available to investors changes their
risk–return opportunity set.
• How to compute the market portfolio M. This is the portfolio that maximizes the Sharpe
E (rp )− rf
ratio: .
σp
• How to choose an optimal portfolio when you can invest in risky and risk-free assets.
This is the capital market line (CML), which states that all optimal portfolios are combi-
nations of the risk-free asset and the market portfolio.
• How to compute the beta (β) for a stock or portfolio. β is a risk-measure for an asset.
Cov (rp , rM )
For a portfolio p, βp is defined as β p = . (Recall that “portfolio” includes the
Var (rM )
case of individual assets.)
 CHAPTER 11 The Capital Asset Pricing Model and the Security Market Line 365

• How the expected return of any portfolio is related to the risk-free rate and the portfolio’s
β. This is the security market line (SML):

E (ri ) = rf + βi ⎣⎡ E (rm ) − rf ⎦⎤

In succeeding chapters we explore the implications of this model, using it to examine the
performance of portfolio managers and to calculate a firm’s cost of capital.

EXERCISES
Note: Data for some of the questions are on the disk that accompanies Principles of Finance with
Excel.
1. Walking down the street of Spartanburg (your hometown), you encounter two street hustlers. John,
the first hustler, is running a coin-toss game, which works like this: You pay John $0.80. He flips a
coin. If the coin comes up heads, he pays you $3, and if the coin comes up tails, you pay him $1.
a. What is your expected return from this game?
b. What is the standard deviation of your return from playing this game?
2. Still in Spartanburg, you encounter a street hustler named Mary. Her game is more complicated:
After you pay Mary $0.80, she throws a die. If the die comes up “1,” you pay Mary $2. If it comes
up “2,” you pay nothing and win nothing. If it comes up “3, 4, 5, 6,” Mary pays you $2.

MARY’S DIE TOSS GAME

Event Probability Winnings

1 0.1667 –2
2 0.1667 0
3 0.1667 2
4 0.1667 2
5 0.1667 2
6 0.1667 2

picture downloaded from:

http://www.turbosquid.com

a. What are the expected returns from playing this game?

b. What is the standard deviation of the returns?
c. Which game is riskier—Mary’s die throw or John’s coin toss (previous exercise?).
d. Which game would you prefer to play? Why?
366 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

3. What do Questions 1 and 2 have to do with investing in stocks?

4. Consider a stock with an expected return of 13% and standard deviation of return of 15% and a
risk-free asset with a return of 1%. What will be the average return and standard deviation of a
portfolio composed of 20% of the risk-free asset and 80% of the stock?
5. You’re considering investing in a combination of a stock and the risk-free asset. The stock has an
expected return of 17% and standard deviation of return of 11% and a risk-free asset with a return
of 3%.
a. Complete the table below and graph the expected portfolio return as a function of the portfolio
standard deviation.
b. Suppose you’re investing $1,000. What is the meaning of a portfolio invested 150% in the risky
asset?

A B C
1 Expected stock return 17%
2 Stock standard deviation 11%
3 Risk-free rate 3%
4
5
Portfolio Portfolio
standard expected
6 Proportion of stock in portfolio deviation return
7 0%
8 10%
9 20%
10 30%
11 40%
12 50%
13 60%
14 70%
15 80%
16 90%
17 100%
18 110%
19 120%
20 130%
21 140%
22 150%

6. Consider the following data of X and Y stocks and a risk-free asset.

A B C
1 RETURNS OF X AND Y STOCKS
2 X Y
3 Average return 19.00% 13.00%
4 Variance 0.09 0.015
5 covariance of return 0.01
6
7 Risk-free return 3.00%

a. What are the return and standard deviation of the minimum variance portfolio of X and Y
stocks?
b. What are the return and standard deviation of a portfolio composed of 30% of the minimum
variance portfolio and 70% of the risk-free asset? Repeat this question with weights of 50% for
the risk-free asset and the minimum variance portfolio.
c. Mary Jones asks you to create a portfolio composed of the risk-free asset and the minimum
variance portfolio. Mary wants an expected return of 9%. What will be the percentage of the
portfolio invested in the risk-free asset and in the minimum variance portfolio?
 CHAPTER 11 The Capital Asset Pricing Model and the Security Market Line 367

d. Kaid Benfield wants a portfolio composed of the risk-free asset and the minimum variance
portfolio. Find a portfolio for Kaid that has a standard deviation of returns of 5%.
7. What is the Sharpe ratio of the minimum variance portfolio of Question 6? Show another portfolio
composed of stocks X and Y that has a better Sharpe ratio.
8. Compute the Sharpe ratio for the following portfolios, assuming the risk-free asset is 4%. What is
the best portfolio according to the Sharpe ratio?

A B C
1 Portfolio statistics
Return
Average standard
2 return deviation
3 Portfolio 1 19.00% 9.00%
4 Portfolio 2 13.00% 1.50%
5 Portfolio 3 25.00% 10.00%
6 Portfolio 4 32.00% 15.00%
7 Portfolio 5 14.00% 2.10%
8 Portfolio 6 22.00% 3.20%
9 Portfolio 7 17.00% 5.50%
10 Portfolio 8 12.00% 0.96%
11 Portfolio 9 40.00% 20.00%
12 Portfolio 10 23.00% 23.00%
13
14 Risk-free return 4.00%

9. Below are given the end-year prices of the shares of IBM and Coca-Cola. Answer the following
questions.
a. For the years 1991–2002, calculate the following statistics for the two shares: annual return,
average return for the entire period, variance and standard deviation of returns, covariance of
returns, and correlation coefficient.
b. Calculate the returns and standard deviations for portfolios composed of these two stocks.
c. Find the market portfolio using the Sharpe ratio, assuming the risk-free asset return is 5%. Is
it the minimum variance portfolio? If not, calculate the Sharpe ratio of the minimum variance
portfolio as well.

A B C
Prices of IBM and
1 Coca-Cola Stock
2 Date Coke IBM
3 31-Dec-90 13.43 28.02
4 31-Dec-91 14.91 22.07
5 31-Dec-92 14.11 12.5
6 31-Dec-93 29.23 14.01
7 30-Dec-94 22.01 18.23
8 29-Dec-95 30 22.66
9 31-Dec-96 42.65 37.58
10 31-Dec-97 61.61 51.9
11 31-Dec-98 52.17 91.47
12 31-Dec-99 43.78 107.03
13 29-Dec-00 35.84 84.34
14 31-Dec-01 36.75 120.02
15 31-Dec-02 63.94 77.21

10. In the Golkoland stock market there are only two listed stocks, Xirkind and Yirkind. The risk-free
rate of return in Golkoland is 5% and the portfolio of Xirkind and Yirkind stocks that has the
highest Sharpe ratio is given here.
368 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

A B C
2 Xirkind Yirkind
3 Average return 19.84% 15.38%
4 Variance of returns 0.1575 0.1378
5 Standard deviation 39.68% 37.12%
6 Covariance of returns -1.10%
7 Correlation -7.47%
8 Risk-free return 5.00%
9
10 Highest Sharpe ratio
11 Weight of Xirkind 0.546
12 Weight of Yirkind 0.454
13
14 Portfolio return 17.81%
15 Portfolio variance 6.99%
16 Portfolio standard deviation 26.43%
17 Sharpe ratio 0.485

a. What is the market portfolio, M, in Golkoland?

b. What is the equation of the CML in Golkoland?
c. What does CML mean and why are we interested in it?
d. What is the expected return and standard deviation of a portfolio composed of 30% risk-free
asset and 70% market portfolio?
e. Suppose an investor wants the same return as the above portfolio, but invests only in a portfo-
lio composed of equal weights of Xirkind and Yirkind stocks. What will be the standard devi-
ation of the returns of his portfolio? How do you explain the difference in standard deviations
between this question and Question 10d?
11. The market portfolio of the Tierra del Fuego stock market has expected return
E (rM) = 22% and standard deviation of returns σM = 19%. The risk-free rate of interest is
r f = 7%.
a. What is the equation of the Tierra del Fuego CML?
b. Compute the following CML portfolios:
• A portfolio composed of 35% risk-free asset and 65% market portfolio.
• A portfolio composed of 120% market portfolio.
• A portfolio that yields a return of 15%.
• A portfolio that yields a return of 23%.
• A portfolio with standard deviation of 35%.
• A portfolio with standard deviation of 5%.
12. Find the equation of the capital market line (CML) for a stock market that has only two stocks.
The market portfolio is composed of 37.5% A and 62.5% Z.

A B C
RETURN STATISTICS OF
1 A AND Z STOCKS
2 A Z
3 Average return 31.00% 15.00%
4 Variance 0.3 0.08
5 Covariance of returns -0.05
6
7 Risk-free return 5.00%
 CHAPTER 11 The Capital Asset Pricing Model and the Security Market Line 369

13. Will the market portfolio of Question 12 change if the risk-free asset return is 3%? If yes, explain
why and calculate the new market portfolio. Answer this question again assuming the market
portfolio is 0%.
14. Below are given the return statistics of X and Y stocks.

A B C
RETURN STATISTICS OF
1 X AND Y STOCKS
2 X Y
3 Average return 19.00% 13.00%
4 Variance 0.09 0.015
5 Covariance of returns 0.01
6
7 Risk-free return 3.00%

a. Calculate the capital market line (CML) using these data.

b. Find the difference in standard deviation between a portfolio on the CML and a portfolio on
the efficient frontier, both with average return of 19%. What will be the weight of the risk-free
asset in the CML portfolio?
15. (More difficult exercise.) The Northern Peninsula stock market has only two listed stocks, Big
Mining and Shallow Mining. The market portfolio is composed of 40% Big Mining and 60%
Shallow Mining. Using the data below, find the β of each of the two stocks.

A B C D
1 NORTHERN PENINSULA STOCK MARKET
Big Shallow
2 Mining Mining
3 Expected return 15% 25%
4 Return standard deviation 25% 40%
5 Covariance of returns 0.05

16. Formula and Dormula are two stocks listed on the Chitango stock market. Their βs are 1.8 and 2.6,
respectively. What is the beta (β) of a portfolio invested 20% in Formula and 80% in Dormula?
17. Consider the following data:
E(rm ) = 0.18, βi = 1.05, R f = 0.07

What is the expected return of stock i?

18. Consider the following data:
E(rm ) = 0.22, E(ri ) = 0.33, R f = 0.09
What is the β of stock i?
19. Consider the following data:

E(rm ) = 0.25, βi = 0.85, E(ri ) = 0.22

What is the return of the risk-free asset?
20. Consider the following data:
E(rm ) = 0.2, Cov(ri , rm ) = 0.1, rf = 0.06, σ M2 = 0.15
What is the expected return of stock i?
370 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

21. Consider the following data:

E(ri ) = 0.15, Cov(ri , rm ) = 0.067, rf = 0.02, σ M2 = 0.089
What is the market return?
22. Consider the following data:

E(rm ) = 0.22, Cov(ri , rm ) = 0.27, E(ri ) = 0.14, σ M2 = 0.09

What is the return of the risk-free asset?
23. Suppose that there are only two stocks, Company A and Company B. The relevant statistics for
the portfolio are given below.

A B C D
1 Company A Company B
2 Expected return 8.00% 25.00%
3 Variance of return 0.0200 0.0900
4 Standard deviation of return 14.14% 30.00% <-- =SQRT(C3)
5
6 Covariance of returns -0.03500
7 Correlation of returns -0.82496 <-- =B6/(B4*C4)
8
9 Portfolio proportions
10 Company A 80%
11 Company B 20%
12
13 Portfolio expected return 11.400% <-- =B10*B2+B11*C2
14 Portfolio variance 0.0052 <-- =B10^2*B3+B11^2*C3+2*B10*B11*B6
15 Portfolio standard deviation 7.21% <-- =SQRT(B14)

Show that a portfolio invested 80% in Company A and 20% in Company B is not optimal by show-
ing a better portfolio.
24. Using the data provided in the previous question, calculate the market portfolio M, when the risk-
free rate of return is 8%. (Recall that the M portfolio is the portfolio that maximizes the Sharpe
ratio).
25. On the occasion of your birthday, your wealthy Aunt Hilda sends you a check for $5,000, under
the express condition that you invest the money in either (or all) of the following: government
bonds, Hilda’s Hybrids, Inc., and/or Hilda’s Hubby, Inc. The relevant statistics on each of these
investments are provided below.

A B C D
Hilda's Hilda's Government
1 Hybrids Hubby bond
2 Expected return 30.00% 16.25% 10.00%
3 Variance 28.58% 2.30%
4 Sigma 53.46% 15.17%
5
6 Covariance of returns 0.0343
7 Correlation of returns 0.4224 <-- =B6/(B4*C4)

a. Show the capital market line (CML) (that is, all the combinations of investment in the risk-free
asset and the two companies). Provide results in both chart and graph form. Assume that the
market portfolio M is composed of equal proportions of the two risky assets.
b. Supposing you decided to invest in the following proportions: 40% in government bonds
and 60% in portfolio M. Calculate the expected return and variance of returns for this
portfolio.
 CHAPTER 11 The Capital Asset Pricing Model and the Security Market Line 371

26. With reference to Exercise 25 above, you are feeling lucky and decide to take on a riskier port-
folio. In particular, in addition to your $5,000 gift, you are able to borrow another $1,000 at the
risk-free rate of 10%. You decide to invest this total of $6,000 in a portfolio containing a mix of
Hilda’s Hybrids and Hilda’s Hubby.
a. In what proportion will you invest your $6,000 if your objective is to create the “best combi-
nation” of these risky assets?
b. What will be the expected return and the expected risk for this more daring portfolio?
27.
a. Consider the data below. Compute the expected return and standard deviation of returns for a
portfolio composed of 75% Stock A and 25% Stock B.
Asset A Asset B
Mean return 30% 13%
Return sigma σ 40% 10%
Correlation ρAB 0.5

b. Stock C has a βC of 1.3 and the portfolio P composed of 75% C and 25% D has a βP = 1.8. What
is the βD of Stock D?
28. You have $1,000 to invest. The risk-free rate is r f = 6%. The market portfolio has expected return
E(rM) = 15% and σM = 20%.
a. What is the mean and standard deviation of your investment if you invest $500 in the risk-free
asset and $500 in the market portfolio?
b. Your sister also has $1,000 to invest, but wants to borrow another $1,000 to make an invest-
ment of $2,000 in the market portfolio M. What will be the mean and standard deviation of
her portfolio return?
c. Which portfolio is better, yours or your sister’s?
29. The table below provides the annual rates of return on ABC Corp., XYZ Corp., and the market
portfolio M.

A B C D
Market ABC XYZ
3 Year Portfolio Corp. Corp.
4 1 11.90% 14.40% 121.20%
5 2 0.40% -22.20% -33.90%
6 3 26.90% 47.50% 3.70%
7 4 -8.60% 7.70% 3.10%
8 5 22.80% 42.80% 17.20%
9 6 16.50% 30.70% -16.90%
10 7 12.50% 11.40% -32.80%
11 8 -10.06% -32.50% -30.40%
12 9 23.90% 30.50% 114.00%
13 10 11.10% 1.80% -3.70%
14 11 -8.50% -6.20% -33.00%
15 12 3.90% 22.30% -33.20%
16 13 14.30% 4.30% 21.60%
17 14 19.10% 6.50% 17.80%
18 15 -14.70% -37.80% 7.50%
19 16 -26.50% -27.60% -62.30%
20 17 37.30% 97.10% 65.40%
21 18 23.80% 45.85% -28.02%
22 19 -7.15% -11.25% -6.33%
23 20 12.16% -4.70% 26.67%
372 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

a. Calculate the βXYZ and the βABC. Use the formulas

Covariance (ABC returns, market returns )

β ABC =
Variance (market returns )
Covariance (XYZ returns, market returns )
β XYZ =
Variance (market returns )

b. Which company’s returns are better explained by the market’s returns? Explain by regressing
each company’s returns on the market returns (see Chapter 9).
30. Anders Smith proposes to invest in a portfolio of two stocks, X and Y. Information about the two
stocks is given below.

A B C
2 Stock X Stock Y
3 Expected return 20% 14%
4 Sigma of return 25% 15%
5 Correlation 0.4
6
7 General X-Y portfolio
8 Percentage of X Sigma Mean
9 0%
10 10%
11 20%
12 30%
13 40%
14 50%
15 60%
16 70%
17 80%
18 90%
19 100%

a. Fill in the highlighted box and compute the mean and standard deviation of each of the indi-
cated portfolios.
b. Plot the portfolios on a mean–standard deviation plot.
c. Suppose that Mr. Smith can also borrow and lend at an interest rate of 6%. Discuss how this
alters his investment opportunities. Calculate the portfolio M that maximizes the Sharpe ratio
and discuss briefly why Smith will always invest in this portfolio.
31. Assume that there are only three stocks in the market and that the optimal investment propor-
tions in each Stock A, B, and C is 1/3. Also assume that variance of Stock A is 10%, the variance
of Stock B is 8%, and the variance of Stock C is 20%. The covariance between Stock A and B is
0.08, the covariance between Stock B and C is –0.10, and the covariance between Stock A and C
is 0.04.
a. Calculate the covariance between each stock and the market portfolio.
b. Calculate the systematic risk beta (β) for each of the three stocks.
CHAP TER

Using the Security Market Line to

12 Measure Investment Performance

CHAPTER CONTENTS
Overview 373
12.1. Jack and Jill’s Investment Argument 374
12.2. Measuring the Investment Performance of Fidelity’s Magellan Fund 377
12.3. Aggressive versus Defensive Stocks 381
12.4. Diversification Pays 383
12.5. What Does Academic Financial Research Tell Us about
Investment Performance? 386
12.6. Back to Jack and Jill—Who’s Right? 387
Summary 390
Exercises 391

Overview
This and the next chapter show how to use the SML that was introduced in Chapter 11. The
current chapter discusses investment performance, and the next chapter discusses the use of the
model to measure the cost of capital.
“Investment performance” is finance jargon for the question “How well did an asset—
either a stock or a portfolio—perform?” Often the underlying question is really “How well did
my investment manager (or mutual fund manager) do in managing my money?” To determine
the investment performance of an asset, we have to account for the asset’s risk. Because we

373
374 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

anticipate that riskier assets should have higher returns to compensate for their risk, true invest-
ment performance measures should take account of the returns that investors earn in excess of
the returns warranted by the asset risks.
The SML provides us with one of the standard methods of measuring investment per-
formance. Using the SML to measure risk-adjusted performance, we can determine whether
a particular asset provided performance in excess of its risks (outperformance) or not
(underperformance).
In this chapter we show how to use the SML to measure investment performance.
• We show how to compute the β (“beta”) of a security by regressing the security’s excess
returns on those of the market portfolio. We often use the S&P 500 as the “market port-
folio.” β measures the riskiness of the security.
• We show how to compute the α (“alpha”) of a security. α measures the security’s risk-
adjusted performance.
• We discuss the difference between nondiversifiable risk (also called market risk) and
diversifiable risk (also called idiosyncratic risk or nondiversifiable risk) and show that
combining stocks in a portfolio reduces the diversifiable risk.

Finance Concepts Discussed

• Security market line (SML)
• α, β, R2
• Systematic (nondiversifiable, market) risk
• Nonsystematic (diversifiable) risk
• Performance evaluation

Excel Functions Used

• Average, Stdevp, Varp, Covar
• Intercept, Slope, Rsq
• Trendline (Excel’s regression tool)

12.1. Jack and Jill’s Investment Argument

To understand the issues behind performance measurement, we start with the story of Jack
and Jill. Sometime in August 2003, Jack and Jill were arguing about their investment strat-
egies. They had been together a long time, and like many couples they often had the same
argument/discussion. The one about investment strategies was one they’d replayed many
times.
Jill started off: “I invested in the NASDAQ in May 1990,” she said to Jack. “If you’d fol-
lowed my advice and invested in the NASDAQ instead of investing in that stodgy Fidelity
Puritan Fund, you’d be a lot better off. For every dollar I put into the NASDAQ, I’ve now got
$3.60, whereas you’ve only got $2.70 for each dollar you put into Puritan. The NASDAQ simply
outperforms Puritan.”
This line of argument infuriated Jack. Ever since he’d met Jill in their MBA program at
Squash Hill College, she’d insisted—in her typical incautious way—that she was much bet-
ter with money than he. It risked spoiling their otherwise lovely relationship. She claimed to
 CHAPTER 12 Using the Security Market Line to Measure Investment Performance 375

11.00
NASDAQ
10.00
Puritan Fund
9.00

8.00

7.00

6.00

5.00

4.00

3.00

2.00

1.00

0.00
May-90

May-91

May-92

May-93

May-94

May-95

May-96

May-97

May-98

May-99

May-00

May-01

May-02

May-03
FIGURE 12.1 The growth of $1 invested in the NASDAQ and the Puritan Fund in the period from May
1990 to August 2003. $1 invested in the NASDAQ grew over the period to $3.60, whereas $1 invested
in Fidelity’s Puritan Fund grew to $2.70.

be able to pick investments that outperform the market, even though she had a difficult time
defining this concept.1
If you consider the whole period from 1990 to 2003 (Figure 12.1), Jill had indeed done
better than Jack. Even though the NASDAQ was subject to bigger fluctuations than Puritan,
an investor like Jill who’d stuck with the NASDAQ throughout the period would have been
ahead of an investor like Jack who’d stuck with Puritan. An investor who had invested $1 in
the NASDAQ in May 1990 would have had $3.60 in August 2003, whereas an investor who
had invested $1 in the Puritan fund in May 1990 would have ended up with $2.70 in August
2003.
But Jack also had a valid point. “Listen, dear,” he said snootily to Jill. “Look what a bumpy
ride the NASDAQ took you on. Remember how cocky you were in late 1999 and what a bundle
of nerves you were in 2001? This outperformance stuff is a crock of spam.” He showed Jill the
wild gyrations of the NASDAQ between May 1999 and May 2001 (Figure 12.1).
“Also,” he reminded her, “the supposed outperformance of the NASDAQ hasn’t always
held. When we got our bonuses in December 1999, you put yours in the NASDAQ and I—OK,
I’m more conservative than you—put mine in Puritan. Then the market took a downward
turn and we both lost money, but in the downturn you lost a lot more than I.” He showed her
Figure 12.2. “For every dollar I put in at the end of 1999, I’ve now got 94 cents, whereas you’ve
got only 41 cents per dollar.”
“What comes down will go up again,” said Jill, ever the optimist.2 “I’ll bet you a Philadelphia
steak sandwich that sometime in the future I’ll be ahead.”

1
She hadn’t read this chapter!
2
One of the lessons of market efficiency is that past stock price performance doesn’t predict future stock
prices. Perhaps Jill should read Chapter 14, in which this is explained.
376 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

1.20
NASDAQ
Puritan Fund
1.00

0.80

0.60

0.40

0.20

0.00
December-99

April-00

August-00

December-00

April-01

August-01

December-01

April-02

August-02

December-02

April-03

August-03
FIGURE 12.2 The growth of $1 invested in the NASDAQ and the Puritan Fund in the period from
December 1999 to August 2003. Actually “growth” is a euphemism—both investments went down
over the period. $1 invested in the NASDAQ was worth $0.41 by August 2003, and $1 in the Puritan
was worth $0.94.

“Of course you’ll be ahead once in a while—the NASDAQ is riskier than Puritan. It
bounces around more, so at some point you’re bound to be ahead. But ‘slow and steady’ is my
motto. The Puritan Fund isn’t as risky, and because I’m not into risk, I’m happy with its lower
return. Remember how Professor Simons at Squash Hill College was always hammering home
the relation between risk and return?”
At this point Jill got tired of the argument. Both she and Jack had made their points, and
Jill sat back to read that day’s Wall Street Journal.

The Real Question

Jack and Jill’s argument about risk, return, performance, and outperformance is typical of the
pointless discussions in which many investors engage. Their discussion is misfocused because
they’ve ignored the risks of their investments. In finance we believe that investment perfor-
mance is related to the riskiness of the assets invested in—assets that are riskier should, on
average, provide greater returns to compensate investors for their risk. Thus, we are not sur-
prised that Jill did better with the NASDAQ (a risky investment) and that Jack had to settle
for lower returns with his Puritan Fund (a much less risky asset). The real question is whether
the NASDAQ returns were commensurate with the riskiness of the NASDAQ and the Puritan
returns were commensurate with the riskiness of Puritan.
So the problem with Jack and Jill’s argument is that they’re not asking the right question.
Let’s start with Jill’s argument that she’s made more money than Jack since 1990. She’s right,
of course, but a glance at Figure 12.1 will show you that the NASDAQ was much riskier than
the Puritan Fund—the variations in returns are much greater for the NASDAQ than for Puritan.
If the NASDAQ is riskier, then Jill’s greater earnings could just be her reward for undertaking
more risk.
 CHAPTER 12 Using the Security Market Line to Measure Investment Performance 377

The same point can be made about Figure 12.2. If the NASDAQ is riskier than the Puritan
Fund, it’s not surprising that in periods when the market goes down, the NASDAQ goes down
even more. When Jack says that he’s done better with the Puritan Fund in a down period, we’re
also not surprised.
So neither Jack nor Jill is asking the right question: The real question is whether the
NASDAQ performance is commensurate with the NASDAQ risk and whether Puritan
Fund performance is commensurate with the Puritan Fund risk. In the language of
the CAPM, the question is whether a security has risk-adjusted underperformance or
overperformance.
This chapter will show you how to answer this question. We will use the SML to answer
questions about performance versus risk. In Section 12.6 we return to Jack and Jill and answer
the question about who actually did better.

12.2. Measuring the Investment Performance of

Fidelity’s Magellan Fund
In this section we illustrate the use of the SML for measuring investment performance by using
it to measure the investment performance of Fidelity’s Magellan Fund (stock symbol FMAGX).
We will show that over the decade 1999–2008, Magellan outperformed the market on a risk-
adjusted basis.
We start by summarizing the SML. The SML shows the relation between an asset’s risk
and its expected return. An asset’s risk is measured by its β, which shows how sensitive the
asset’s return is to changes in the market return. The higher the asset’s β, the higher the return
investors expect from the asset.
In equation form the SML states that an asset’s expected return E(ri ) is given by the
equation
E (ri ) = rf + βi ⎡⎣ E (rM ) − rf ⎤⎦
Cov (ri , rM )
where βi =
σ M2

The letter “i” is used in E(ri ) to indicate that the SML is a risk–return relation for all risky
assets. Thus the i can stand for any asset, whether a stock, a bond, or a portfolio. In this chap-
ter we use i to represent either stocks or mutual funds (large diversified portfolios of stocks or
bonds).
The following spreadsheet contains the data necessary to measure the performance of
Magellan:
• Annual return data for Magellan (cells B4:B13) and the S&P 500 index (cells C4:C13)
and for the 10-year period from 1999 to 2008.3 The returns include dividends; the annual
return in year t is calculated by assuming that the investor bought the stock at the end of
year t − 1 and held it until the end of year t:

StockPricet − StockPricet −1 + Dividendt

returnt =
StockPricet −1

3
The stock data in this chapter come from Yahoo!. The interest rate data is based on a Web site maintained
by the St. Louis Federal Reserve Bank (http://research.stlouisfed.org/fred2/).
378 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

• Annual risk-free rate data (cells D4:D13). Because we are looking at annual data, the
risk-free rate is taken to be the return on a 1-year U.S. Treasury Bill.4
• Excess return data: The “excess return” is the difference between the return on the secu-
rity (be it the Magellan or the S&P) and the risk-free rate for the same period. For exam-
ple, someone who owned the S&P 500 Index throughout 1998 would have made 30.54%
on his investment (cell C4); in the same period he could have earned 5.66% by holding a
riskless U.S. Treasury security. Thus, over this period, the S&P Index returned 24.88%
more than the risk-free rate. This 24.88% is the excess return for the S&P for the period.
As you can see in columns F and G of the spreadsheet, during much of this period both
Magellan and the S&P had hefty positive excess returns.

A B C D E F G H

FIDELITY'S MAGELLAN FUND (FMAGX)

1
AND THE S&P500, 1999–2008

2 Excess returns
FMAX S&P
FMAGX S&P500 Risk-free
Year ending minus minus
return return interest
3 risk-free risk-free
4 4-Jan-99 39.24% 30.54% 5.66% 33.58% 24.88% <-- =C4-$D4
5 3-Jan-00 12.31% 8.97% 4.61% 7.70% 4.36% <-- =C5-$D5
6 2-Jan-01 -1.54% -2.04% 6.34% -7.88% -8.38%
7 2-Jan-02 -17.13% -17.26% 4.78% -21.91% -22.04%
8 2-Jan-03 -23.35% -24.29% 3.17% -26.52% -27.46%
9 2-Jan-04 30.00% 32.19% 1.70% 28.30% 30.49%
10 3-Jan-05 4.14% 4.43% 1.88% 2.26% 2.55%
11 3-Jan-06 13.63% 8.36% 3.18% 10.45% 5.18%
12 3-Jan-07 5.49% 12.36% 4.33% 1.16% 8.03%
13 2-Jan-08 5.19% -4.15% 4.76% 0.43% -8.91%
14
15 Average 6.80% 4.91% 4.04% 2.76% 0.87% <-- =AVERAGE(G4:G13)
16 Standard deviation 17.97% 17.20% 1.45% 18.09% 17.46% <-- =STDEVP(G4:G13)
17
18 Alpha 0.0189 <-- =INTERCEPT(F4:F13,G4:G13)
19 Beta 1.0011 <-- =SLOPE(F4:F13,G4:G13)
20 1.0011 <-- =COVAR(F4:F13,G4:G13)/VARP(G4:G13)
21 R-squared 0.9330 <-- =RSQ(F4:F13,G4:G13)
22
23 Regressing Magellan's Excess Return
24
25 on the S&P 500, 1998–2008
30%
26
27 20%
28
29 y = 1.0011x + 0.0189 10%
30 R² = 0.9330
31
32 0%
33 -35% -25% -15% -5% 5% 15% 25% 35%
34 -10%
Magellan return

35 S&P 500 return

36 -20%
37
38
39 -30%
40
41

4
Finance researchers often use monthly or even weekly return data, but annual data are often easier to
visualize. When we return to Jack and Jill in Section 12.6, we use monthly data.
 CHAPTER 12 Using the Security Market Line to Measure Investment Performance 379

During the period Magellan clearly had higher performance than the S&P 500: The
average return on Magellan was 6.80% (B15), whereas the average return on the S&P
was 4.91% (cell C15). The question we answer is whether Magellan had risk-adjusted
outperformance.
To answer this question, we regress Magellan’s excess returns on the excess returns of S&P
500. To perform this regression, we estimate the best line that passes through the points on the
graph.5 In essence, we are trying to explain the excess returns of Magellan as a linear function
of the excess returns of the S&P:

Regression line: rMagellan,t − rf ,t = Magellan + βMagellan * ⎡⎣rS & P,t − rf ,t ⎤⎦

!"""""#"""""$ !"""""#"""""$
↑ ↑
Magellan's excess S&P 500 excess
return in period t return in period t

The actual regression line that we compute is

Magellanexcessreturn = 1.89%
!""#""$ + 1.0011
!""#""$ * S & P excess return, R 2 = 93.3%
!""""#""""$
↑ ↑ ↑
This is Magellan's This is Magellan's The "r-squared" is
alpha ( Magellan )--its beta (β Magellan )--its a measure of how
performance over and riskiness versus well Magellan's excess
above the S&P index the S&P index returns are explained
by the S&P excess returns.

The regression calculation requires three statistics:

Statistic 1, Magellan’s βMagellan (β ): βMagellan measures the sensitivity of Magellan’s excess
returns to the S&P 500’s excess returns. β is the most common measure of a security’s market-
related risk. In the spreadsheet βMagellan is computed in three ways: In cells B19 and B20 and on
the graph.6 All three methods give βMagellan = 1.0011.
The β is the most common risk measure for a stock. Magellan’s βMagellan =1.0011 shows
that Magellan’s excess returns were roughly equally as risky as the S&P 500 excess returns: on
average a 1% increase in the S&P excess return was accompanied by a 1.0011% increase in the
excess return on Magellan stock. In the parlance of investment analysts, Magellan is a market-
neutral asset; moving very much in tandem with the S&P 500. In the same parlance, an asset
whose β < 1 is termed a defensive asset and an asset whose β > 1 is termed an aggressive asset.
We give examples of both defensive and aggressive assets below.
Statistic 2, Magellan’s αMagellan (alpha): αMagellan is a measure of the extra performance of
Magellan. Magellan’s alpha, αMagellan, is 1.89%. In the spreadsheet αMagellan is computed in two
ways: in cell B18 and on the graph. To understand the importance of αMagellan, take another look
at the regression line:

Magellanexcessreturn = 1.89%
!""#""$ + 1.0011
!""#""$ * S & P excess return
↑ ↑
Magellan's alpha ( Magellan ) Magellan's beta (β Magellan )

5
For details on how to perform a regression in Excel, see the discussion in Section 4 of Chapter 9 or the
Excel note that follows this section.
6
See the Excel note on the next page for a further explanation of how to compute β.
380 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Suppose that in a particular year the S&P 500 returns 10% in excess of the risk-free rate.
Then the regression predicts that Magellan would return 11.901%:

Magellan excess return = 1.89%

!""#""$ + 1.0011* S!"""""""
& P excess return
"#""""""" "$
↑ ↑
This is "free" ⎯ Is 10%
the annual return !""""""""""""#"""""""""""
"$
on Magellan after accounting ↑
for the movements 10.011% is the risk-adjusted
of the S&P index return on Magellan stock
= 1.89% + 1.011% = 11.901%

αMagellan tells you that if Magellan’s stock returns behave as predicted by this equation, you will,
on average, earn 1.89% annually more than the market risk-adjusted excess return. This means
that Magellan is a market-outperforming mutual fund!7
Statistic 3, Magellan’s R2 (“R-squared”): The Magellan returns were very highly corre-
lated with the S&P 500 returns: 93.3% of the variability in the Magellan returns was explained
by variations in the S&P 500. This number (known as the R2 of the regression) is calculated
by the Excel function Rsq(y-range,x-range) in cell B21 and also appears on the graph.8
Another interpretation of R2 is that it measures the degree to which the stock “tracks” the
S&P 500.
Magellan tracks the S&P highly, but most stocks don’t track the market index nearly as
well. In Sections 12.2 and 12.3 we will show that a diversified portfolio’s tracking of the market
index is generally much better than the tracking of the individual portfolio components.

EXCEL NOTE: COMPUTING THE THREE STATISTICS α, β, AND R2

The spreadsheet shows several ways of computing each of the statistics α, β, and R2:
• You can use an Excel XY chart and then use the Excel regression function Trendline
(see Chapter 9, page 289). The trendline equation (printed on the Excel chart) is
Magellan annual return = 1.0011* S&P annual return + 0.0189, R 2 = 0.933. 1.011 is Magellan’s
β (βMagellan) and 1.89% is called Magellan’s α (αMagellan).
• You can use the Excel functions Intercept(y-range,x-range), Slope(y-range,x-range),
Rsq(y-range,x-range) to compute αMagellan, βMagellan, and R2, respectively. This is illustrated in
cells B18, B19, and B21.
• You can use the Excel functions Covar and Varp to compute the βMagellan:
Covar (rMagellan , rSP )
βMagellan = .
Varp (rSP )

7
Or was a great fund—we’re making the strong assumption here that historical performance over the
1999–2008 period will predict future performance.
8
As you will see in some of the other chapter examples, an R2 of 90%, although not unusual for a highly
diversified mutual fund, is unusually high for a regression of the SML type, when the data in question
describe a single stock. It is much more usual for the R2 of a single stock to be around 10–40%.
 CHAPTER 12 Using the Security Market Line to Measure Investment Performance 381

ADVANCED EXCEL HINT:

In the cell formulas below the three statistics α, β, and R2 are calculated directly, with-
out computing the excess returns. For example, the Excel expression B3:B12-D3:D12 can be
written in the formulas for the excess return of the S&P 500. Similarly, B3:B12-D3:D12 is
understood by Excel to be the excess returns for Magellan. We use this method in the next
section.

A B C D E
VANGUARD'S MAGELLAN FUND AND THE
S&P500, 1999–2008
Computing the regression coefficients without
1 a direct computation of the excess returns
FMAGX S&P500 Risk-free
Date
2 return return interest
3 4-Jan-99 39.24% 30.54% 5.66%
4 3-Jan-00 12.31% 8.97% 4.61%
5 2-Jan-01 -1.54% -2.04% 6.34%
6 2-Jan-02 -17.13% -17.26% 4.78%
7 2-Jan-03 -23.35% -24.29% 3.17%
8 2-Jan-04 30.00% 32.19% 1.70%
9 3-Jan-05 4.14% 4.43% 1.88%
10 3-Jan-06 13.63% 8.36% 3.18%
11 3-Jan-07 5.49% 12.36% 4.33%
12 2-Jan-08 5.19% -4.15% 4.76%
13
14 Alpha 0.0189 <-- =INTERCEPT(B3:B12-D3:D12,C3:C12-D3:D12)
15 Beta 1.0011 <-- =SLOPE(B3:B12-D3:D12,C3:C12-D3:D12)
16 R-squared 0.9330 <-- =RSQ(B3:B12-D3:D12,C3:C12-D3:D12)

12.3. Aggressive versus Defensive Stocks

In this section we repeat the analysis of the previous section for three more stocks.
To compute the regression statistics we use the method illustrated in the Excel box on
page 380.

Kimberly-Clark
During the decade from 1998 to 2007, Kimberly-Clark (stock symbol KMB):
• Outperformed the market: KMB’s α = 2.25%, indicating that on an annual basis, KMB
earned 2.25% more than its risk-adjusted return would have warranted.
• Was a defensive stock: KMB’s β = 0.6301, indicating that a 1% increase/decrease in the
S&P 500 index led to a 0.63% increase/decrease in KMB’s stock.
The R-squared of KMB (R2 = 40.15%) indicates that 40% of KMB’s stock price variation
was caused by market movements. The remaining 60% of the variability was presumably caused
by variables uniquely related to Kimberly-Clark. This is what you would expect for an average
382 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

A B C D E

KIMBERLY-CLARK (KMB) AND THE S&P500,

1998–2007
Computing the regression coefficients without
1
a direct computation of the excess returns
KMB S&P500 Risk-free
Date
2 return return interest
3 4-Jan-99 -0.41% 30.54% 5.66%
4 3-Jan-00 29.47% 8.97% 4.61%
5 2-Jan-01 6.87% -2.04% 6.34%
6 2-Jan-02 -5.18% -17.26% 4.78%
7 2-Jan-03 -21.60% -24.29% 3.17%
8 2-Jan-04 30.99% 32.19% 1.70%
9 3-Jan-05 15.60% 4.43% 1.88%
10 3-Jan-06 -10.30% 8.36% 3.18%
11 3-Jan-07 25.39% 12.36% 4.33%
12 2-Jan-08 -2.48% -4.15% 4.76%
13
14 Alpha 0.0225 <-- =INTERCEPT(B3:B12-D3:D12,C3:C12-D3:D12)
15 Beta 0.6301 <-- =SLOPE(B3:B12-D3:D12,C3:C12-D3:D12)
16 R-squared 0.4015 <-- =RSQ(B3:B12-D3:D12,C3:C12-D3:D12)

stock—most of the variability of the stock’s return is not systematic (capital market jargon for
market-related risk) but idiosyncratic or nonsystematic (stock-specific risk). As we will see in
the next section, this idiosyncratic risk can be decreased through portfolio diversification.

General Electric
During the same decade, General Electric (GE) both outperformed the stock market (it had an
α = 3.18% annually) and was an aggressive stock, being riskier than the stock market (βGE =
1.3063). In addition, GE closely tracked the S&P 500, with an R-squared of 86%.

A B C D E

GENERAL ELECTRIC AND THE S&P500

1999–2008
Computing the regression coefficients without
1
a direct computation of the excess returns
GE S&P500 Risk-free
Date
2 return return interest
3 4-Jan-99 37.26% 30.54% 5.66%
4 3-Jan-00 29.35% 8.97% 4.61%
5 2-Jan-01 4.11% -2.04% 6.34%
6 2-Jan-02 -17.93% -17.26% 4.78%
7 2-Jan-03 -36.10% -24.29% 3.17%
8 2-Jan-04 49.35% 32.19% 1.70%
9 3-Jan-05 10.01% 4.43% 1.88%
10 3-Jan-06 -6.94% 8.36% 3.18%
11 3-Jan-07 13.36% 12.36% 4.33%
12 2-Jan-08 1.09% -4.15% 4.76%
13
14 Alpha 0.0318 <-- =INTERCEPT(B3:B12-D3:D12,C3:C12-D3:D12)
15 Beta 1.3063 <-- =SLOPE(B3:B12-D3:D12,C3:C12-D3:D12)
16 R-squared 0.8635 <-- =RSQ(B3:B12-D3:D12,C3:C12-D3:D12)
 CHAPTER 12 Using the Security Market Line to Measure Investment Performance 383

Dupont: Not Every Stock Is an Outperformer!

Lest you think that every stock outperforms the market, take a look at the somewhat less-than-
happy history of Dupont over the decade 1999–2008.

A B C D E

DUPONT (DD) AND THE S&P500, 1999–2008

Computing the regression coefficients without
a direct computation of the excess returns
1
DD S&P500 Risk-free
Date
2 return return interest
3 4-Jan-99 -7.68% 30.54% 5.66%
4 3-Jan-00 17.80% 8.97% 4.61%
5 2-Jan-01 -23.70% -2.04% 6.34%
6 2-Jan-02 4.36% -17.26% 4.78%
7 2-Jan-03 -11.44% -24.29% 3.17%
8 2-Jan-04 19.99% 32.19% 1.70%
9 3-Jan-05 11.91% 4.43% 1.88%
10 3-Jan-06 -14.98% 8.36% 3.18%
11 3-Jan-07 31.03% 12.36% 4.33%
12 2-Jan-08 -5.95% -4.15% 4.76%
13
14 Alpha -0.0225 <-- =INTERCEPT(B3:B12-D3:D12,C3:C12-D3:D12)
15 Beta 0.3949 <-- =SLOPE(B3:B12-D3:D12,C3:C12-D3:D12)
16 R-squared 0.1571 <-- =RSQ(B3:B12-D3:D12,C3:C12-D3:D12)

Dupont’s α = −2.25% indicates that in the absence of market movement, the return on
Dupont is 2.25% lower than the S&P. Dupont was a defensive stock, with a β = 0.3949. Looking
at the r-squared of the regression, we see that only about 16% of the movement in Dupont stock
was explained by market movements.

12.4. Diversification Pays

In the previous section we measured the risk-adjusted performance of three stocks by regressing
their excess returns on the excess returns of the S&P 500. In this section we repeat this exercise
for a portfolio of stocks—regressing the portfolio’s excess returns on those of the S&P 500.
Doing this enables us to make two points:
• First, we can use the regression to measure the risk-adjusted underperformance or over-
performance of a portfolio. This is similar to what we did for single stocks in the previ-
ous section.
• Second, we can use the regression to show that diversification pays by increasing the R2
of the regression—meaning that there is less nonsystematic risk in a diversified portfolio:
More of the returns are explained by the market portfolio (in this case the S&P 500).
In the example below we repeat annual return data for the Kimberly-Clark, General
Electric, Dupont, and the S&P 500. We also show, in cells B3:B5, the composition of a portfolio
of these stocks. Using the Excel functions described earlier, we calculate the α and β for each
of the stocks and the R2 of the regression that determines them (rows 19–21). As you will see,
one of the benefits of portfolio diversification is that in general a portfolio has a higher R2 than
the assets composing it.
384 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

A B C D E F G H I

A PORTFOLIO OF THREE STOCKS:

Kimberly Clark (KMB), General Electric (GE), Dupont (DD), 1999–2008
2 2
The R of the portfolio is significantly higher than the average R of the assets
1
2 Portfolio composition
3 KMB 33%
4 GE 33%
5 DD 33% <-- =1-B3-B4
6
KMB GE DD S&P500 Risk-free Portfolio
Date
7 return return return return interest returns
8 4-Jan-99 -0.41% 37.26% -7.68% 30.54% 5.66% 9.72% <-- =$B$3*B8+$B$4*C8+$B$5*D8
9 3-Jan-00 29.47% 29.35% 17.80% 8.97% 4.61% 25.54%
10 2-Jan-01 6.87% 4.11% -23.70% -2.04% 6.34% -4.24%
11 2-Jan-02 -5.18% -17.93% 4.36% -17.26% 4.78% -6.25%
12 2-Jan-03 -21.60% -36.10% -11.44% -24.29% 3.17% -23.05%
13 2-Jan-04 30.99% 49.35% 19.99% 32.19% 1.70% 33.44%
14 3-Jan-05 15.60% 10.01% 11.91% 4.43% 1.88% 12.51%
15 3-Jan-06 -10.30% -6.94% -14.98% 8.36% 3.18% -10.74%
16 3-Jan-07 25.39% 13.36% 31.03% 12.36% 4.33% 23.26%
17 2-Jan-08 -2.48% 1.09% -5.95% -4.15% 4.76% -2.45%
18
<-- =INTERCEPT(H8:H17-
Alpha 0.0225 0.0318 -0.0225 0.0000 0.0106
19 $F$8:$F$17,$E$8:$E$17-$F$8:$F$17)
<-- =SLOPE(H8:H17-
Beta 0.6301 1.3063 0.3949 1.0000 0.7771
20 $F$8:$F$17,$E$8:$E$17-$F$8:$F$17)
<-- =RSQ(H8:H17-
R-squared 0.4015 0.8635 0.1571 1.0000 0.5994
21 $F$8:$F$17,$E$8:$E$17-$F$8:$F$17)
22
23 Check
24 Portfolio alpha is the weighted average of stock alphas? 0.0106 <-- =$B$3*B19+$B$4*C19+$B$5*D19
25 Portfolio beta is the weighted average of stock betas? 0.7771 <-- =$B$3*B20+$B$4*C20+$B$5*D20
26 Portfolio r-squared is the weighted average of stock r-squareds? NO!!! 0.4740 <-- =$B$3*B21+$B$4*C21+$B$5*D21

Now suppose we form a portfolio composed of equal proportions of KMB, GE, and DD.
The portfolio proportions are described in cells B3:B5, and the portfolio returns appear in cells
H8:H17.
In cells H19:H22 we compute the regression of the portfolio excess returns on the S&P 500
excess returns. The portfolio returns are described by the regression:

2
Portfolio excess returnt = 0.0106 !""#""$ * S & P Excessreturnt , R = 0.5994
!""#""$ + 0.7771
↑ ↑
this is the this is the
portfolio P portfolio βP

Here are some things to note about this regression:

• The portfolio αP and βP are the weighted average β of the individual stock βs. In the
spreadsheet the β is calculated twice: In cell H20 the portfolio βP is calculated using
Excel’s Slope function, and in cell H25 βP is calculated using the weighted average of
each of the individual stock βs. If we denote the portfolio weights by xKMB, xGE , and
xDD, then, for example, the portfolio β (either cell H20 or cell H25) βP is given by
βP = xKMBβKMB + xGE βGE + x DD βDD . In the particular example illustrated, this formula
gives a portfolio β, βP = 0.7545:

βP = 0.3333
!""#""$ * 0.6301 + 0.3333
!""#""$ *1.3063 + + 0.3333*
!""#""$ 0.3949 = 0.7771
↑ ↑ ↑
Portfolio Portfolio Portfolio .
weight of weight of weight of
Kimberly-Clark, General Electric, Dupont,
xKMB xGE x DD
 CHAPTER 12 Using the Security Market Line to Measure Investment Performance 385

The same goes for αP, which can be calculated either using Excel’s Intercept function (cell H19)
or as an average of the individual stock αs (cell H24).
• Whereas a portfolio’s α (αP) and β (βP) are the weighted average of individual asset
αs and βs, the portfolio R2 is larger than the average R2. In our example, the R2 of the
three-asset portfolio, computed using the Rsq function in cell H21, is 59.94%, whereas
the portfolio weighted-average R2 of the three stocks (cell H26) is 47.4%. This almost
always true: The R2 of a well-diversified portfolio is higher than the weighted average
R2 of the portfolio assets. What this means is that much more of the return of a well-
diversified portfolio is explained by the market return than is the return of the individual
portfolio components. In other words, diversification pays by reducing the nonmarket,
nonsystematic, idiosyncratic risks associated with a portfolio. (Note that all three of
these italicized words are synonyms; in addition, the term diversifiable risk is also often
used for this concept.)

FIGURE 12.3 The Fidelity Fund has 218 stocks in its portfolio. The fund’s β = 1.03, which indicates that it approximately
tracks the returns of the S&P 500; on average a 1% increase in the S&P excess return was accompanied by a 1.03%
increase in the Fidelity Fund’s excess return (and of course, a 1% decrease in the S&P excess return meant a 1.03%
decrease in the Fidelity Fund). The Fidelity Fund’s R2 is 95%, which means that 95% of the variability in the Fund’s
returns is explained by the S&P 500. Fidelity’s Web site does not give information about the Fidelity Fund’s α.
Source: http://personal.fidelity.com/products/funds/mfl_frame.shtml?316153105

Intermediate Summary
By looking at the regressions we have illustrated in the previous two sections, we can distin-
guish between two kinds of risk.
386 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Market risk: Also called nondiversifiable or systematic risk. This is the risk measured by
the β —the sensitivity of an asset’s returns to the returns of the market portfolio. In the case of
General Electric we saw that its βGE = 1.3063, meaning that GE’s stock returns were very sensi-
tive to the excess returns on the S&P 500. The R2 = 86.35% indicates that 86% of the variabil-
ity in GE’s stock returns is caused by variability in the returns of the S&P 500. Because most
stocks are correlated with the market (meaning when the market goes up, the general tendency
of the most stock returns is also to rise and vice versa), market risk is well nigh inevitable. The
relatively low R2 of Kimberly-Clark means that only about 40% of the risk of the stocks is attrib-
utable to the market risk (and for Dupont R2 = 15.71% means that 84% of the stock’s variability
is due to nonmarket factors).
Idiosyncratic stock risk: Also called diversifiable or nonsystematic risk. This is the return
riskiness that is not attributable to the market return. GE’s idiosyncratic risk is very low (86% of
its return variation comes from the market), but the idiosyncratic risk for KMB and DD is much
higher: For these individual stocks the R2 is fairly low, which means that the nonmarket com-
ponents of return riskiness are much higher. Because the portfolio R2 of the equally weighted
portfolio is much higher than the average R2, the portfolio’s idiosyncratic risk is much lower
than the average idiosyncratic risk of the three individual assets. This is one of the benefits of
diversification—the portfolio returns “track” much better on the market return, meaning that
much more of the portfolio’s return is predictable by the market than is the case for the individ-
ual asset returns.
What our three-stock example shows is that when you diversify (that is, invest in a portfolio
of three stocks instead of one stock), the portion of returns caused by market risk increases and
the idiosyncratic portfolio risk of the portfolio becomes less than that for the individual stocks.
To put this another way, for a well-diversified portfolio, the portfolio βP is a good description of
the portfolio riskiness, even if the individual stocks’ βs do not describe their riskiness.

HOW BIG IS A WELL-DIVERSIFIED PORTFOLIO?

For a portfolio of stocks to be well diversified, it should be composed of many stocks with rela-
tively small proportions for each stock. How many? Usually 20–30 stocks suffice to give a high
R2. When the R2 is high (say, above 70%), most of the portfolio’s risk is market risk.

12.5. What Does Academic Financial Research Tell

Us about Investment Performance?
The efficient markets hypothesis (Chapter 14) tells us that it’s very difficult to make money using
only publicly available information. Thus, there’s no reason to believe that investment managers
can provide better investment performance than you would get in an otherwise well-diversified
portfolio put together by someone (like yourself) with no “investment expertise.” In fact, there
are two reasons for believing that investment managers may provide worse results:
• They charge fees. (To be fair—investing on your own also involves the payment of bro-
kerage fees, not to mention the opportunity costs of the time you would need to spend
gathering information.) In the case of the two Fidelity funds we researched in this chap-
ter, the fees are 0.40%, but mutual fund fees can go from as low as 0.05% to as high as
1.5 or even 2%.
 CHAPTER 12 Using the Security Market Line to Measure Investment Performance 387

• Many investment managers like to turn over their portfolios. This, in turn, incurs costs
for the mutual fund investors and lowers returns.
For these reasons, many knowledgeable academics (and a lot of other “streetwise” types)
prefer investing in index funds like the Vanguard Index 500 Fund, which we’ve used as an
example in this chapter. The aim of these index funds is to closely match the composition
of a market index like the S&P 500. These funds are able to provide a highly diversified
portfolio with low costs and minimal interference in the investment decision by a portfolio
manager.
A considerable amount of academic research bears out our conclusions. The average α of
mutual funds is negative, and there is little evidence that mutual funds are able to provide supe-
rior investment performance.9

Other Index Funds

Lest this chapter sound too much like an advertisement for Fidelity and Vanguard Funds, we
hasten to point out that the American investor has many index funds available. Here are just a
few examples (a search in Yahoo! finds at least 75 such funds).

SOME REPRESENTATIVE S&P 500 INDEX FUNDS

Annual Assets under Minimum
Stock
Provider Fund name expense management initial
symbol
ratio (June 2009) investment
FUSVX Fidelity Spartan U.S. Equity Fund 0.07% 4.53 B $100,000
VFIAX Vanguard Vanguard 500 Index Admiral 0.08% 23.35 B $100,000
VFINX Vanguard Vanguard 500 Index Investor 0.16% 40.27 B $3,000
USSPX USAA Investment USAA S&P 500 Index Member 0.23% 1.51 B $3,000
ADIEX RiverSource RiverSource S & P 500 Index Fund 0.34% 93.95 M $2,000
PEOPX Dreyfus Dreyfus S&P 500 Index 0.50% 2.02B $2,500
SXPBX DWS Investments DWS S&P 500 Index Fund 1.42% 2.07 M $1,000
PWSPX UBS UBS S&P 500 Index Fund 1.45% 15.23 M $1,000
SNPBX State Farm State Farm S&P 500 Index Fund 1.49% 10.23 M $250
RYSOX Rydex Investment Rydex S&P 500 Fund 1.51% 29.57 M $2,500

FIGURE 12.4 Some S&P 500 Index funds available to the investor. All the funds are basically alike,
tracking the S&P 500 Index. Not surprisingly, the largest funds tend to be those with the lowest
expense ratios.

12.6. Back to Jack and Jill—Who’s Right?

In the preceding sections we’ve shown how we can measure under- or overperformance by
regressing an asset’s excess returns on the market’s excess returns. Now let’s go back to Jack
and Jill. Recall that Jack was investing in the “stodgy” Puritan Fund, whereas Jill was a “go-go”
investor in the NASDAQ. Over the period 1990–2003, Jill has done better than Jack, but over
the period 1999–2003, she’s done a lot worse.
Who’s done better? Who’s right?
Running the regressions of the monthly excess returns of each portfolio on the S&P
500 shows that each portfolio has earned returns commensurate with its risks. The Puritan
Fund is much less risky than the NASDAQ (βNASDAQ = 1.4346, βPuritan = 0.5632). However,

9
For a good academic reference on this topic, try reading “Returns from Investing in Equity Mutual Funds
1971–1991,” by Burton G. Malkiel, Journal of Finance, June 1995.
388 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

neither investment has an α that is significantly different from zero, so there is no under- or
overperformance.
Both Jack and Jill are getting what they’re paying for—the correct risk-adjusted return.
That’s the nature of capital markets.

EXCESS RETURNS, FIDELITY PURITAN FUND vs. S&P500

May 1990 - August 2003
8%

Puritan
6%

y = 0.5632x + 0.0008 4%
2
R = 0.7468
2%

0%
-20% -15% -10% -5% 0% 5% 10% 15%

-2% S&P 500

-4%

-6%

-8%

-10%

-12%

EXCESS RETURNS, NASDAQ vs. S&P 500

May 1990 - August 2003

25%
Nasdaq

20%
y = 1.4346x + 0.0025
2
R = 0.6433 15%

10%

5%

0%
-20% -15% -10% -5% 0% 5% 10% 15%
-5% S&P 500

-10%

-15%

-20%

-25%

-30%

FIGURE 12.5 Analyzing the excess returns on the Puritan Fund and the NASDAQ reveals that over the
period 1990–2003, the NASDAQ is almost three times as risky as Puritan (βNASDAQ = 1.4346, βPuritan =
0.5632). Neither regression reveals αs that are significantly different from zero. In other words, both
Jack and Jill are getting returns commensurate with the risk they’re undertaking. There is no excess
performance in either of these investments. The lower R2 for the NASDAQ as opposed to Puritan
(64% versus 78%) indicates that the NASDAQ has somewhat more idiosyncratic risk.
 CHAPTER 12 Using the Security Market Line to Measure Investment Performance 389

EXCESS RETURNS, FIDELITY PURITAN FUND vs. S&P 500

December 1999-August 2003

8%

Puritan
6%
y = 0.5145x + 0.0012
2
R = 0.781
4%

2%

0%
-15% -10% -5% 0% 5% 10% 15%

-2% S&P 500

-4%

-6%

-8%

-10%

EXCESS RETURNS, NASDAQ vs. S&P 500

December 1999 - August 2003

25%
Nasdaq

20%

15%
y = 1.6865x + 0.0036
2
R = 0.6255 10%

5%

0%
-15% -10% -5% 0% 5% 10% 15%
-5%
S&P 500

-10%

-15%

-20%

-25%

-30%

FIGURE 12.6 An analysis of the excess returns on the Puritan Fund and the NASDAQ over
the period 1999–2003 reveals no substantial change in our previous conclusion. Although
there are minor changes in β and α, neither investment exhibits excess performance or
underperformance.
390 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Updating Jack and Jill to 2009

We originally met Jack and Jill in 2003. Six years later the author of this book is happy to report
that they are still together (in fact they’ve married and now have two young children). They still
maintain separate investment accounts, with Jill invested in the NASDAQ index and more con-
servative Jack invested in the Puritan Fund.
The chart below shows that our qualitative conclusions with respect to the NASDAQ versus
Puritan fund haven’t changed:
• Regressing the NASDAQ and Puritan returns on the S&P 500 shows that NASDAQ has
become somewhat less risky (βNASDAQ has decreased from 1.687 to 1.152 over the period
2003–2009) and that Puritan has become somewhat more risky (βPuritan has increased
from 0.514 to 0.706).
• There is still no evidence of outperformance for either of the funds: The α of the regres-
sions is indistinguishable from zero.

15%

Nasdaq and Puritan versus the S&P500

August 2003-June 2009 10%

Nasdaq regression
y = 1.152x + 0.002, R² = 0.852
5%
Puritan regression
y = 0.706x + 0.002, R² = 0.953
0%
-20% -15% -10% -5% 0% 5% 10%

-5% Nasdaq
Puritan

-10%

-15%

-20%

Summary
In this chapter we have shown how to find the beta (β) and the alpha (α) of a security and of
a portfolio. We’ve defined the concepts of market risk (nondiversifiable risk) and idiosyncratic
risk (diversifiable risk), and we’ve shown how forming a portfolio reduces the idiosyncratic
risk. Using the α to measure the investment performance, we’ve explored the performance of
various mutual funds and related this important issue to fund fees and the efficient markets
hypothesis.
 CHAPTER 12 Using the Security Market Line to Measure Investment Performance 391

In Chapter 13, we’ll show how the security market line (SML) can be used to compute the
cost of capital for a firm.

EXERCISES
Note: Data for the problems can be found on the disk that accompanies Principles of Finance with
Excel.
1. Find the βi for stock i based on the following data: E(rM) = 15%, E(ri) = 12%, r f = 7%.
2. Suppose that for asset i, βi = 1, E(ri) = 21%. What is the market return E(rM)?
3. Suppose that for asset i, E(rM) = 21%, βi = 0.7, E(ri) = 25%. What is the return of the risk-free asset?
4. Consider the following data: E(rM) = 25%, Cov(ri , rM) = 0.07, r f = 8%, Var(rM) = 0.1. What is the
expected return of stock i, E(ri)?
2
5. Consider the following data: E(ri ) = 15%, Cov(ri , rM ) = 0.06, σ M = 0.06. What is E(rM), the
expected market return?
6. Consider the following data: E(rM) = 10%, Cov(ri , rM) = 0.2, E(ri) = 18%, Var(rM) = 0.09. What is the
return of the risk-free asset, r f ?
7. Consider the following data concerning S&P 500, FedEx, and the return on 1-year U.S. Treasury
Bills.

A B C D
1 FEDEX AND S&P 500
S&P Total FedEx 1-year
2 Year return return T-bill
3 1990 -3.10% -4.46% 7.89%
4 1991 30.47% 24.18% 5.86%
5 1992 7.62% 9.19% 3.89%
6 1993 10.08% 10.67% 3.43%
7 1994 1.32% -3.61% 5.32%
8 1995 37.58% 24.04% 5.94%
9 1996 22.96% 8.76% 5.52%
10 1997 33.36% 25.95% 5.63%
11 1998 28.58% 14.01% 5.05%
12 1999 21.04% 30.89% 5.08%
13 2000 -9.10% -4.26% 6.11%
14 2001 -11.89% -7.20% 3.49%
15 2002 -22.10% -21.27% 2.00%

a. Compute the excess returns for S&P 500 and for FedEx.
b. Show by graphing the excess return of FedEx against that of S&P 500. Use Excel to compute
the regression line and the R2.
c. Is FedEx stock an aggressive or defensive stock?
8. Consider the following data concerning S&P 500, IBM, and the return on 1-year U.S. Treasury
Bills.
a. Compute the excess returns for the S&P 500 and for IBM.
b. Show by graphing the excess return of IBM against that of the S&P 500. Use Excel to compute
the regression line and the R2.
c. Does IBM have excess performance over S&P 500?
d. Is IBM an aggressive or defensive stock?
392 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

A B C D
1 IBM AND S&P500
S&P Total IBM 1-year
2 Year return Return T-bill
3 1990 -3.10% 17.46% 7.89%
4 1991 30.47% -23.87% 5.86%
5 1992 7.62% -56.85% 3.89%
6 1993 10.08% 11.40% 3.43%
7 1994 1.32% 26.33% 5.32%
8 1995 37.58% 21.75% 5.94%
9 1996 22.96% 50.59% 5.52%
10 1997 33.36% 32.28% 5.63%
11 1998 28.58% 56.67% 5.05%
12 1999 21.04% 15.71% 5.08%
13 2000 -9.10% -23.83% 6.11%
14 2001 -11.89% 35.28% 3.49%
15 2002 -22.10% -44.11% 2.00%

9. Using the data from Exercises 7 and 8, assume you invested in a portfolio composed of 30% IBM
stock and 70% FedEx stock.
a. Compute the excess return of the portfolio.
b. Compute the portfolio βP. Show three different ways to calculate the portfolio βP:
• Using Excel’s Slope function.
• Using the formula βP = Cov (rP , rM )/ Var (rM ) .
• By averaging the βs of the two portfolio components, IBM and FedEx.
c. Compute the portfolio αP. Show two different ways to calculate the portfolio αP:
• Using Excel’s Intercept function.
• By taking the weighted average of the αs of the two portfolio components IBM and FedEx.
10. Consider the data of another stock—3M Corp.

A B C D

S&P 1-year
2 Year return 3M return T-bill
3 2001 -0.85% 19.23% 5.78%
4 2002 -17.78% 2.43% 4.46%
5 2003 -26.25% 13.52% 1.85%
6 2004 29.55% 25.84% 1.16%
7 2005 5.90% 8.23% 1.21%
8 2006 9.76% -12.65% 2.80%
9 2007 13.40% 4.49% 4.55%
10 2008 -2.43% 9.27% 4.84%
11 2009 -48.82% -36.46% 2.62%
12 2010 28.64% 43.63% 0.28%

a. Does 3M have excess performance?

b. Graph the excess returns of 3M against those of S&P 500. Use Excel to compute the regression
line and the R2.
11. Using the data for S&P 500, FedEx, IBM, and 3M from Exercises 7, 8, and 10 above, compute
the portfolio alpha, αp, and the portfolio beta, βp, of a portfolio composed of 30% 3M stock, 50%
FedEx stock, and 20% IBM stock. Explain the diversification advantages of this portfolio.
 CHAPTER 12 Using the Security Market Line to Measure Investment Performance 393

12. Consider the following data regarding 10 stocks, the S&P 500, and the annual risk-free rate. Your
friend who works in an investment bank tells you that an equally weighted portfolio composed
of these 10 stocks yields risk-adjusted excess returns when compared to the S&P 500. Check
whether she’s right.

A B C D E F G H I J K L M
1 ANNUAL RETURN DATA FOR TEN STOCKS, S&P500, AND RISK-FREE RATE
Johnson Bank of 1-year
2 Year & Johnson Apple America PepsiCo Reebok Kellogg Gillette FedEx IBM 3M S&P 500 T-bill
3 1990 21.09% 19.90% -66.07% 19.75% -48.20% 11.50% 24.51% -4.46% 17.46% 11.03% -3.10% 7.89%
4 1991 48.39% 27.09% 61.57% 26.47% 106.99% 54.42% 58.11% 24.18% -23.87% 14.04% 30.47% 5.86%
5 1992 -10.76% 5.82% 26.73% 20.29% 3.60% 2.09% 1.36% 9.19% -56.85% 8.81% 7.62% 3.89%
6 1993 -9.34% -71.48% -1.44% -1.51% -11.53% -16.23% 4.69% 10.67% 11.40% 10.85% 10.08% 3.43%
7 1994 22.27% 28.80% -4.51% -12.05% 28.36% 2.37% 22.80% -3.61% 26.33% 1.49% 1.32% 5.32%
8 1995 46.47% -20.16% 46.87% 43.30% -32.59% 28.44% 33.10% 24.04% 21.75% 25.03% 37.58% 5.94%
9 1996 16.63% -42.32% 36.74% 4.58% 40.34% -16.30% 39.99% 8.76% 50.59% 25.04% 22.96% 5.52%
10 1997 29.51% -46.31% 24.12% 21.46% -37.53% 41.37% 25.60% 25.95% 32.28% 1.20% 33.36% 5.63%
11 1998 25.43% 113.64% 1.29% 12.02% -66.07% -37.45% -4.92% 14.01% 56.67% -11.70% 28.58% 5.05%
12 1999 11.77% 92.07% -15.09% -14.82% -59.71% -10.20% -14.90% 30.89% 15.71% 34.43% 21.04% 5.08%
13 2000 13.31% -123.96% -4.61% 34.07% 120.54% -16.02% -12.09% -4.26% -23.83% 20.79% -9.10% 6.11%
14 2001 13.10% 38.65% 35.56% -1.77% -3.12% 13.69% -5.59% -7.20% 35.28% -1.92% -11.89% 3.49%
15 2002 -8.20% -42.41% 13.59% -14.26% 10.38% 12.97% -7.50% -21.27% -44.11% 4.22% -22.10% 2.00%

13. Consider the following annual data regarding Fidelity Balanced Fund (FBALX), the S&P 500
stock index fund, and the T-bill rate. Did the fund manager outperform the market?

A B C D E F G
RETURN DATA FOR FBALX FUND, S&P500 AND
1 THE RISK-FREE RATE
S&P 500 FBALX
FBALX S&P 1-year excess excess
2 Year return return T-bill return return
3 2001 10.65% -1.04% 5.78% -6.82% 4.88%
4 2002 -1.32% -17.85% 4.46% -22.30% -5.78%
5 2003 -9.75% -26.47% 1.85% -28.31% -11.59%
6 2004 28.14% 29.53% 1.16% 28.37% 26.98%
7 2005 7.37% 5.86% 1.21% 4.66% 6.17%
8 2006 15.38% 9.71% 2.80% 6.92% 12.59%
9 2007 8.54% 13.33% 4.55% 8.77% 3.99%
10 2008 2.45% -2.47% 4.84% -7.32% -2.39%
11 2009 -37.04% -48.89% 2.62% -51.51% -39.66%
12 2010 26.86% 28.60% 0.28% 28.32% 26.57%
CHAP TER

The Security Market Line and

13 the Cost of Capital

CHAPTER CONTENTS
Overview 394
13.1. The CAPM and the Firm’s Cost of Equity—An Initial Example 395
13.2. Using the SML to Calculate the Cost of Capital—Calculating
the Parameter Values 399
13.3. A Worked-Out Example—Hilton Hotels 404
13.4. Computing the WACC Using an Asset β, βAsset 411
13.5. Don’t Read This Section! 412
Summary 413
Exercises 414

Overview
This is the second of two chapters that show the use of the security market line (SML). In
Chapter 12 we discussed the use of the SML for performance measurement, and in this chapter
we discuss how to use the SML to calculate the cost of capital for a firm.1

1
If you need a lightning review of the SML, look at the first section of Chapter 12.

394
 CHAPTER 13 The Security Market Line and the Cost of Capital 395

The weighted average cost of capital (WACC) is the minimum return that a firm must earn
to satisfy its shareholders and bondholders. As discussed in Section 6.6, the WACC has two
major uses:

• Using WACC in capital budgeting: When evaluating a project whose risk is comparable
to the riskiness of the company’s current activities, the WACC is the appropriate discount
rate for the project’s cash flows.
• Using WACC to value a company: The value of a company is based on the PV of its
future FCFs discounted at the WACC.

In this book we previously discussed the WACC in Chapter 6, where we used the Gordon
model to calculate the cost of equity. In this chapter we use the SML to calculate the cost of
equity. These two models—the Gordon model and the SML—are the major approaches to com-
puting the cost of equity for a firm.

Finance Concepts Discussed in This Chapter

• The use of security market line (SML) to calculate the cost of equity rE for a firm.
• Calculating the firm’s weighted average cost of capital (WACC). Note that the computa-
tion of the WACC was also discussed in Chapter 6, where we used the Gordon model to
calculate the firm’s cost of equity rE.
• Calculating the market value of the firm’s debt and equity, the firm’s tax rate TC, and
the firm’s cost of debt rD. Our discussion of these issues in this chapter is in many ways a
repeat of a similar discussion in Chapter 6.
• The concept of asset beta, βAssets, and its use as an alternative method to calculate the
firm’s WACC.

Throughout this chapter we assume that you know how to calculate the β of a stock (this
issue was discussed in the previous chapter). In actual fact, you often don’t have to compute the
β of a firm’s shares—the information is publicly available (in this chapter, for example, we use
data on β provided by Yahoo!).

Excel Functions Used

• NPV
• Average

13.1. The CAPM and the Firm’s Cost of Equity—An Initial Example
Abracadabra, Inc. is considering a new project, which has the following free cash flows (FCF).2

2
An extended discussion of the free cash flow (FCF) is given in Chapters 6 and 7. Figure 13.1 reviews the
concept in tabular form.
396 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

A B
2 Year FCF
3 0 -1,000
4 1 1,323
5 2 1,569
6 3 3,288
7 4 1,029
8 5 1,425
9 6 622
10 7 3,800
11 8 3,800
12 9 3,800
13 10 2,700

To decide whether to accept or reject the project, the company needs to calculate the risk-
adjusted discount rate for these cash flows. The company decides that the riskiness of the new
project is very much like the riskiness of Abracadabra’s current activities; the financing for the
project is also similar to that of the firm. In this case the appropriate discount rate is the weighted

Defining the Free Cash Flow (FCF)

Profit after taxes This is the basic measure of the profitability of the business, but it is an accounting
measure that includes financing flows (such as interest), as well as noncash expenses
such as depreciation. Profit after taxes does not account for either changes in the firm’s
working capital or purchases of new fixed assets, both of which can be important cash
drains on the firm.

+ Depreciation This noncash expense is added back to the profit after tax.

+ After-tax interest FCF is an attempt to measure the cash produced by the business activity of the firm and
payments (net) available to both equity and debtholders. To neutralize the effect of interest payments
on the firm’s profits, we
Add back the after-tax cost of interest on debt (after-tax because interest payments are
tax deductible),
Subtract out the after-tax interest income on cash and marketable securities.

– Increase in current When the firm’s sales increase, more investment is needed in inventories, accounts
assets receivable, etc. This increase in current assets is not an expense for tax purposes (and is
therefore ignored in the profit after taxes), but it is a cash drain on the company.

+ Increase in current An increase in sales often causes an increase in financing related to sales (such as
liabilities accounts payable or taxes payable). This increase in current liabilities—when related to
sales—provides cash to the firm. Because it is directly related to sales, we include this
cash in the FCF calculations.

– Increase in fixed An increase in fixed assets (the long-term productive assets of the company) is a use of
assets at cost cash, which reduces the firm’s FCF.

FCF = sum of the above

FIGURE 13.1 The free cash flow (FCF) is the amount of cash generated by a firm’s business activities. Discounting
the FCFs at a firm’s weighted average cost of capital (WACC) gives the enterprise value of the firm. The concept of
FCF was introduced in Chapter 6. It appears in several other places in this book: In the context of accounting and
financial planning models, we used the FCF in Chapter 7 to value a firm. In Chapter 16 we return to the concept
of FCF in the context of stock valuation.
 CHAPTER 13 The Security Market Line and the Cost of Capital 397

average cost of capital (WACC); this is the average cost of financing the firm’s activities. Assuming
that Abracadabra has both equity and debt, the formula for the WACC is given by

E D
WACC = rE *
E+D
+ rD * (1 − TC ) * E + D
⎛ proportion ⎞ 1 − TC = ⎞ ⎛ proportion ⎞
⎛ rE = ⎞ ⎜ ⎟ ⎛ rD = ⎞ ⎛⎜ ⎟ ⎜ ⎟
= ⎜ cost of ⎟ * ⎜ of firm ⎟ + ⎜ cost of ⎟ * ⎜ 1 − corporate ⎟ * ⎜ of firm ⎟
⎜⎜ ⎟⎟ ⎜ financed by ⎟ ⎜⎜ ⎟⎟ ⎜ financed by ⎟
⎝ equity ⎠ ⎜ equity ⎟ ⎝ debt ⎠ ⎝⎜ tax rate ⎠⎟ ⎜ debt ⎟
⎝ ⎠ ⎝ ⎠

We can use the SML to calculate the cost of equity for Abracadabra. Here are our assump-
tions for this problem:

• The firm’s stock has beta β = 1.4.

• The expected market return is E(rM ) = 10%.
• The risk-free rate r f = 4%.
• Abracadabra’s equity has a market value E = $10,000.
• Abracadabra’s debt has a market value D = $15,000.
• Abracadabra can borrow new funds at a cost of rD = 6%.
• Abracadabra’s corporate tax rate is TC = 40%.

The first three assumptions mean that Abracadabra’s cost of equity rE as given by the SML
is 12.4%:

rE = rf + β * ⎡⎣ E (rM ) − rf ⎤⎦
= 4% + 1.4 * [10% − 4%] = 12.4%

Then Abracadabra’s weighted average cost of capital (WACC) is

E D
WACC = rE * + rD * (1 − TC ) *
E+D E+D
10,000 15,000
= 12.4% * + 6% * (1 − 40% )*
10,000 + 15,000 10,000 + 15,000
= 7.12%

The WACC of 7.12% is the discount rate we will use to determine whether Abracadabra should
undertake the project.
The following spreadsheet shows our calculations for the WACC (rows 20–36) and the
NPV calculation for the project (rows 2–16).
398 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

A B C
VALUING ABRACADABRA'S INVESTMENT
we calculate the WACC using the SML to
1 compute the cost of equity rE
2 Year FCF
3 0 -1,000
4 1 1,323
5 2 1,569
6 3 3,288
7 4 1,029
8 5 1,425
9 6 622
10 7 3,800
11 8 3,800
12 9 3,800
13 10 2,700
14
15 Weighted average cost of capital, WACC 7.12% <-- =B36
16 Project NPV 14,424 <-- =NPV(B15,B4:B13)+B3
17
18
19 Computing Abracadabra's Weighted Average Cost of Capital (WACC)
20 Market value of equity, E 10,000
21 Market value of debt, D 15,000
22 Market value of equity + debt, E+D 25,000
23
24 Corporate tax rate, TC 40%
25
26 Abracadabra's stock beta, β 1.4
27
28 Facts about market
29 E(rM) 10%
30 rf 4%
31
32 Abracadabra's cost of capital
33 Cost of equity using SML, rE 12.40% <-- =B30+B26*(B29-B30)
34 Cost of debt, rD 6.00%
35
36 Weighted average cost of capital (WACC) 7.12% <-- =B20/B22*B33+B21/B22*B34*(1-B24)

When the project free cash flows are discounted at the WACC, the net present value
is $14,424 (cell B16). Because the NPV is positive, Abracadabra should undertake the
project.

Comparing the SML and the Gordon Model for Calculating the WACC
The weighted average cost of capital is the most widely used discount rate for computing the
value of corporate projects and for computing the value of the firm. The WACC depends criti-
cally on the cost of equity rE. In this chapter we compute the cost of equity using the security
market line (SML), whereas in Chapter 6 we computed the cost of equity using the Gordon
dividend model.
 CHAPTER 13 The Security Market Line and the Cost of Capital 399

The Gordon dividend model and the SML are only two practical ways of calculating the
cost of equity.3 Both models have their advantages and disadvantages—the Gordon model is
simple to calculate but is very sensitive to assumptions about the firm’s equity payout—the total
dividends plus stock repurchases of the firm. The SML requires relatively more calculations, but
is more widely used. The SML also requires us to make assumptions about the expected return
on the market E(rM ). This problem is discussed in the next section.
So which model should you use in practice? The best answer is to use both models and to
compare the results. This way each model can serve as a “reality check” on the other. We apply
this logic in Chapter 16, which discusses stock valuation. There we apply both models and com-
pare the results to see whether we have arrived at an appropriate WACC.

13.2. Using the SML to Calculate the Cost of Capital—

Calculating the Parameter Values
The Abracadabra example of the previous section gives the broad outlines of calculating the
cost of capital using the SML, but it leaves a number of questions unanswered:
• How do we calculate the market value of a firm’s equity, E?
• How do we calculate the expected return on the market E(rM )?
• How do we calculate the risk-free rate, r f?
• How do we calculate the market value of a firm’s debt, D?
• How do we calculate the firm’s cost of borrowing, rD?
• How do we calculate the firm’s corporate tax rate TC?
We discuss each of these questions in turn. Although we occasionally provide an illustra-
tion, we save a full-blown example for the following section.

The Market Value of a Firm’s Equity, E

This is easy: For a firm whose shares are sold on the stock market, the market value of the equity
(E in our WACC equation) is the number of shares times the market value per share.

The Expected Return on the Market E(rM )

There are two ways to calculate the expected return on the market: (1) We can use the historical
market return or (2) we can use a version of the Gordon dividend model to derive E(rM ) from
current market data. Neither method is perfect, although we prefer the latter.

E(rM ) Using the Historic Returns

A standard technique is to use a broad-based index—usually the S&P 500 Index—to proxy
for the market portfolio. To do this, you need some data. Below we show you the returns on
Vanguard’s 500 Index Fund. This is an index mutual fund that is invested in the S&P 500
Index.4 The average return on the S&P is 8.70% for the period 1994–2008 (cell F20). This

3
The academic finance literature has come up with other models for calculating the cost of equity, but in
practice these models are very difficult to apply and are rarely used.
4
We discuss index funds in Chapter 12, Section 12.4.
400 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

A B C D E F G
RETURNS ON THE S&P 500 INDEX, 1984–2004
1 Uses return data for the Vanguard 500 Index Fund
500 Index
Capital Income Fund S&P 500
2 Year return return Total return return
3 1984 1.54% 4.68% 6.22% 6.27%
4 1985 26.09% 5.14% 31.23% 31.75%
5 1986 14.04% 4.02% 18.06% 18.68%
6 1987 2.27% 2.43% 4.70% 5.26%
7 1988 11.55% 4.67% 16.22% 16.61%
8 1989 26.67% 4.70% 31.37% 31.69%
9 1990 -6.84% 3.52% -3.32% -3.10% These are the S&P returns
10 1991 26.28% 3.94% 30.22% 30.47% including dividends as given
11 1992 4.45% 2.97% 7.42% 7.62% by Vanguard on its Web site.
12 1993 7.06% 2.84% 9.90% 10.08% The difference between the total
13 1994 -1.51% 2.69% 1.18% 1.32% return on Vanguard's Index 500
14 1995 34.35% 3.09% 37.44% 37.58% portfolio and the total return on
15 1996 20.53% 2.35% 22.88% 22.96% the S&P is largely due to the
16 1997 31.11% 2.08% 33.19% 33.36% management fees of the
17 1998 27.00% 1.61% 28.61% 28.58% Vanguard 500 Index Fund.
18 1999 19.70% 1.37% 21.07% 21.04%
19 2000 -9.95% 0.90% -9.05% -9.10%
20 2001 -13.11% 1.08% -12.03% -11.89%
21 2002 -23.36% 1.22% -22.14% -22.10%
22 2003 26.52% 1.98% 28.50% 28.68%
23 2004 8.74% 2.00% 10.74% 10.88%
24
25 Average 11.10% 2.82% 13.92% 14.13% <-- =AVERAGE(F3:F23)
26 Standard deviation 15.79% 1.28% 16.26% 16.30% <-- =STDEVP(F3:F23)
27
28 S&P 500 Return, 1984-2004
29 40%
30 35%
31 30%
32 25%
33 20%
34 15%
35 10%
36 5%
37 0%
38
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004

-5%
39 -10%
40 -15%
41 -20%
42 -25%
43
44

historical average return is often used as a proxy for the expected market return in the SML.
The Vanguard 500 Index Fund data show the breakdown of these returns between capital gains
(6.77% per year) and dividends (1.84% annually).

E(rM ) Using Current Market Data

This technique is less widely used, although we prefer it. 5 The technique is based on the
Gordon dividend model that gives the expected return on a stock as a function of the
stock’s current equity payout Div0, the current market value of the firm’s equity P0, and
the expected growth rate of g of the equity payout. The equity payout is defined as the
sum of the firm’s dividends and its stock repurchases (see Chapter 6, page 198, for a full
explanation):

5
The technique was first published in Corporate Finance: A Valuation Approach by Simon Benninga and
Oded Sarig, McGraw–Hill, 1997.
 CHAPTER 13 The Security Market Line and the Cost of Capital 401

Gordon Dividend Model

Div0 (1 + g )
rE = +g
P0
where
Div0 = current equity payout of firm (total dividends + stock repurchases)
P0 = current market value of equity
g = anticipated equity payout growth rate

To use the Gordon model to calculate the expected return on the market, we restate the
model in terms of the price-earnings ratio: Assume that every year the firm pays out a percent-
age b of its earnings to its shareholders, in the form of both dividends and stock repurchases.
Then we can rewrite the formula above as

Div0 (1 + g ) b * EPS0 (1 + g )
rE = +g= +g
P0 P0
where EPS0 is the firm's current earnings per share

Manipulating this formula a bit, we get

b * (1 + g )
rE = +g
P0 /"#"""
!"" EPS$0
↑
this is the firm's
P/E (price-earnings)
ratio

We now apply this logic to the market as a whole. We regard a market index such as
the S&P 500 (symbolized by M) as a stock having its own payout ratio b and growth rate
of equity payouts g. We then use the above formula to compute the expected market return
E (rM ) .6 Here’s an example using data for the S&P 500 Index on 30 September 2009. We have
had to “guesstimate” the estimated growth of dividends and the dividend payout ratio. We also
show the historical series for the price-earnings data; the average over 1988–2009 is 19.41.

6
A sensitive reader may note that there’s some confusion of symbols here. The formula
b * (1 + g )
rE = + g uses rE to stand for the cost of equity for a stock. Because the “cost of equity” is a
P0 / EPS0
synonym for the “expected return from equity,” when we apply the formula to the market portfolio M
(in this case, the S&P 500), by logic we should have called this rM. Instead, we use E (rM ). Our excuse
is that the symbol E (rM ) is so widely used that we cannot give it up.
402 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

A B C
USING THE PRICE-EARNINGS
1 RATIO TO COMPUTE E(rM)
2 S&P 500 P/E on 31dec01 21
3 Estimated growth of equity payout, g 6%
4 Payout ratio, b 50%
5
6 E(rM) 8.52% <-- =B4*(1+B3)/B2+B3

Price-Earnings Ratio of S& P 500, 1988–2009

Multi-year average: 19.41
30

28

26

24

22

20

18

16

14

12

10
Dec-88

Dec-89

Dec-90

Dec-91

Dec-92

Dec-93

Dec-94

Dec-95

Dec-96

Dec-97

Dec-98

Dec-99

Dec-00

Dec-01

Dec-02

Dec-03

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

FIGURE 13.2 The Excel example shows how to use the P/E ratio of the S&P 500 to compute E(rM ). The graph
(source: www.marketattributes.standardandpoors.com ) shows the P/E of the S&P 500 from 1988-2009.
Source: www.marketattributes.standardandpoors.com

Dividend payout is defined as the total expended by firms on both cash dividends and
repurchases of shares (we discussed this topic a bit in Chapter 6, when calculating the cost of
equity for Courier Corp. using the Gordon model). Although the cash dividends are a mat-
ter of record, the amount of repurchases is more debatable. Current estimates put the sum of
dividends and repurchases at around 50% of corporate earnings. Figure 13.3, for example, is
a graph showing the relation between share repurchases and dividends for the S&P 500 Index
through 2005.
Dividend growth is the market anticipation of the growth of total dividends (broadly
defined as cash dividends plus repurchases) for the future. If we assume that dividends will
grow at the rate of growth of the economy, 6% is a reasonable long-term estimate.
 CHAPTER 13 The Security Market Line and the Cost of Capital 403

FIGURE 13.3 The dividend payout ratio (lower line) and the total payout ratio (dividends + repurchases) in the
United States.
Source: Douglas Skinner, “The Evolving Relation Between Earnings, Dividends, and Stock Repurchases,” Journal
of Financial Economics, March 2008.

Computing the Risk-Free Rate rf

The risk-free rate r f should be the short-term Treasury rate. This rate is available from a variety
of places, including Yahoo! (see example in next section).

Computing the Value of the Firm’s Debt, D

In principle, D should be the market value of the firm’s debt. However, in practice, this value is
usually very difficult to calculate. Standard practice is to use the book value of the firm’s debt
minus the value of its cash reserves; we refer to this concept as net debt.

Computing the Firm’s Borrowing Rate, rD

The rate rD used in the WACC formula ought to be the firm’s marginal cost of borrowing, the
rate at which it can borrow additional funds through sales of bonds or from banks. In many
cases, however, the marginal cost of borrowing is very difficult to calculate. Two common
“quick fixes” are as follows:

• Compute rD from the firm’s average borrowing rate.

• Compute rD by “eyeballing” the firm’s current borrowing rate from information given in
the financial statements.

Both approaches are illustrated in Section 13.3.

404 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

Computing the Corporate Tax Rate, TC

The tax rate TC used in the WACC formula ought to be the firm’s marginal tax rate, the rate the
firm would have to pay on an addition dollar of income. This rate is very difficult to determine,
and two “quick fixes” are common:

• In many cases the firm’s average tax rate is an acceptable proxy for TC. This is the case
for Hilton Hotels in Section 13.3.
• In some cases we might prefer to use information about the average corporate tax rate
in the economy. This rate is approximately 37%.7 For a firm whose own historical tax
rate is not a good predictor of its future tax rate, this number might be a preferable
substitute.

13.3. A Worked-Out Example—Hilton Hotels

We illustrate the approach to calculating the WACC using data for Hilton Hotels Corp. (symbol
HLT). As discussed previously, we need seven parameters to calculate the WACC for this (or
any other) company:
• E, the market value of the company’s equity today. This is simply the number of shares
times the current stock price.
• D, the market value of the company’s debt today. We will use the book value (that is, the
accounting value) of the company’s debt as a proxy for this number.
• rE , the cost of equity for the company. In this chapter we use the SML to calculate the cost
of equity. Using the SML means that the cost of equity is dependent on the following:
• The β of the firm’s equity. In the previous chapter we computed this β. In practice,
it is often available without computation (as in this example; read on).
• r f, the risk-free rate.
• E(rM), the expected return on the market.
• rD, the cost of debt for the company. In principle, this should be the marginal cost (the
company’s cost of obtaining new debt). In practice, we often use the company’s average
cost of existing debt.
• TC, the company’s tax rate. In principle, this should be the company’s marginal tax rate
(the rate on an additional dollar of earnings). In practice we often use the company’s
average tax rate.
Much of the data are available on Yahoo!; Figure 13.4 shows the Yahoo! screen leading to
Hilton Hotel’s “key statistics,” which are shown in Figure 13.5.

7
The Federal tax rate in the United States is 35% (see Chapter 2). Because companies also pay state and
local taxes, the tax rate for most companies is somewhere between 35 and 40%.
 CHAPTER 13 The Security Market Line and the Cost of Capital 405

FIGURE 13.4 The Yahoo! screen, indicating the Key Statistics. This choice gives the updated
financial information for the firm used below. (Yahoo!’s presentation of fi nancial materials changes
occasionally, so that you may have to look elsewhere for the financial profile.)

From Yahoo!’s Profile, here are some data for Hilton as of 21 January 2005.
From these data we learn the following:

• Hilton’s equity βE = 0.956.

• The current value of a share of Hilton is $22.49. The number of shares outstanding is
386.03 million. The market value of Hilton’s equity is the product of these two numbers,
giving E = $8.68 billion.
• The book value of Hilton’s debt is D = $3.743 billion. With a bit of work, this number can
be calculated from Yahoo!: According to Yahoo!:

• The book value of equity per share is $6.388.

• The debt/equity ratio of Hilton is 1.518. This is the ratio of the book value of the
firm’s debt to the book value of its equity.

Because Hilton has 386.03 million shares outstanding, its total book value of equity is
386.03* 6.388 = 2,466 . Multiplying this number by the debt-to-equity ratio gives the total debt
of Hilton as $3,743. From this number we subtract the $219 million in cash held by the company
to arrive at net debt D = $3,524.8

8
Cash is subtracted from the firm’s debt because Hilton could, in principle, use the cash to pay off some
of its debt.
406 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

FIGURE 13.5 Yahoo!’s profile for Hilton Hotels. Highlighted numbers are used in the computation of
Hilton’s WACC.
 CHAPTER 13 The Security Market Line and the Cost of Capital 407

A B C
HILTON HOTELS CORPORATION (HLT)
1 using Yahoo! for much of the information
2 Equity beta 0.956 <-- Yahoo
3
4 Shares outstanding (million) 386.03 <-- Yahoo
5 Market value per share 22.49 <-- Yahoo
6 Market value of equity ($ million), E 8,682 <-- =B5*B4
7
8 Book value of equity per share 6.388 <-- Yahoo
9 Total book value of equity 2,466 <-- =B8*B4
10 Debt/Equity ratio 1.518 <-- Yahoo
11 Book value of debt 3,743 <-- =B10*B9
12 Cash on hand 219 <-- Yahoo
13 Net debt ($ million), D 3,524 <-- =B11-B12

We still need the two firm-related parameters (rD, TC ) and two market parameters
(r f , E(rM )). For these, we’ll have to work a bit. We can access the Hilton financial state-
ments by clicking on the accounting information at the bottom of the first column of
Figure 13.5. The quarterly income statements and balance sheets thus obtained are shown
in Figure 13.6.
408 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

FIGURE 13.6 Income statement and balance sheet information for Hilton.
 CHAPTER 13 The Security Market Line and the Cost of Capital 409

Hilton’s Cost of Debt, rD, is 5.55%

We compute the cost of Hilton’s debt rD by taking its interest payments and dividing by the
average debt over the quarter and then annualizing. We download from Yahoo! information
about the company’s quarterly balance sheets and income statements (Figure 13.6). In the last
quarter for which there are reports, the company paid $53,000 in interest. The debt at the end
of this quarter was $3,744,000 and the debt at the end of the previous quarter was $4,058,000.
This gives a quarterly interest rate of 1.36% (cell B8 below) and an annualized interest rate of
5.55%:

53,000
Quarterly interest paid = = 1.36%
Average (3,744,000 and 4,058,000 )
4
Annualized interest rate = rD = (1 + 1.36% ) − 1 = 5.55%

A B C D E
1 HILTON'S COST OF DEBT, rD
2 Quarter 30-Sep-04 30-Jun-04 31-Mar-04
3 Interest expense 53,000 86,000 70,000
4 Long-term debt 3,730,000 3,720,000 3,801,000
Short-term debt and
5 current portion of long-term debt 14,000 338,000 338,000
6 Debt at end of quarter 3,744,000 4,058,000 4,139,000 <-- =D5+D4
7
8 Quarterly interest expense 1.36% 2.10% <-- =C3/AVERAGE(C6:D6)
9 Annualized 5.55% 8.66% <-- =(1+C8)^4-1

Note that Hilton’s interest rate has decreased from the previous quarter, in which the annu-
alized interest rate was 8.66%. In the previous quarter the company had much more expensive
short-term debt.

Hilton’s Tax Rate TC Is Approximately 35%

From the income statements in Figure 13.6 we can also compute the company’s tax rate. The aver-
age quarterly tax rate for the last three quarters is 34.93%. This is the rate we will use for TC.

A B C D E
1 HILTON'S TAX RATE TC
2 Quarter 30-Sep-04 30-Jun-04 31-Mar-04
3 Earnings before tax 96,000 118,000 61,000
4 Provision for taxes 35,000 40,000 21,000
5 Tax rate 36.46% 33.90% 34.43% <-- =D4/D3
6
7 Average tax rate, TC 34.93% <-- =AVERAGE(B5:D5)

The Risk-Free Rate in the Economy, rf , is 2.21%

We get this number from Yahoo!, as shown in Figure 13.7.
410 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

FIGURE 13.7 Yahoo! screen with interest rates. The rf for use in the SML is the short-term Treasury bond rate, 2.21%.

The Expected Return on the Market E(rM ) Is Approximately 8.52%

We use the method illustrated in Section 13.3, using the S&P 500 P-to-E ratio for 30 September
2004. We further assume that the growth of the equity payout is 7% and that the payout ratio of
dividends plus repurchases is 50%. This gives E (rM ) = 10.1%.

A B C
1 COMPUTING E(r M ) FOR 30SEP04
2 S&P 500 P/E on 30Sep2004 17.25
3 Estimated growth of equity payout, g 7%
4 Payout ratio, b 50%
5
6 E(rM) 10.10% <-- =B4*(1+B3)/B2+B3

So What’s Hilton’s WACC?

The WACC for Hilton is 7.98%. The computations are summarized below:
 CHAPTER 13 The Security Market Line and the Cost of Capital 411

A B C
HILTON HOTELS CORPORATION (HLT)
1 Using Yahoo for much of the information
2 Equity beta 0.956 <-- Yahoo
3
4 Shares outstanding (million) 386.03 <-- Yahoo
5 Market value per share 22.49 <-- Yahoo
6 Market value of equity ($ million), E 8,682 <-- =B5*B4
7
8 Book value of equity per share 6.388 <-- Yahoo
9 Total book value of equity 2,466 <-- =B8*B4
10 Debt/Equity ratio 1.518 <-- Yahoo
11 Book value of debt 3,743 <-- =B10*B9
12 Cash on hand 219 <-- Yahoo
13 Net debt ($ million), D 3,524 <-- =B11-B12
14
15 Risk-free rate, rf 2.21%
16 Expected market return, E(rM) 10.10%
17
18 Computation of WACC
19 Percentage of equity, E/(E+D) 0.7113 <-- =B6/(B6+B13)
20 Percentage of debt, D/(E+D) 0.2887 <-- =1-B19
21 Cost of equity, rE 9.75% <-- =B15+B2*(B16-B15)
22 Cost of debt, rD 5.55%
23 Tax rate, TC 34.93%
24 WACC 7.98% <-- =B19*B21+(1-B23)*B20*B22

13.4. Computing the WACC Using an Asset β, βAsset

A somewhat different approach to computing the WACC is to use the asset β approach. In this
approach we need both the equity β, βE , and the βD for Hilton. The asset β is defined as the
weighted average β of the debt and equity βs:

E D
β Asset = βE * + βD * (1 − TC ) *
E+D E+D
⎛ proportion ⎞ ⎛ proportion ⎞
⎛ equity ⎞ ⎜ of equity ⎟ ⎛ debt ⎞ ⎛ corporate ⎞ ⎜⎜ of debt ⎟⎟
⎜ ⎟
=⎜ ⎟* +⎜ ⎟ * ⎜1 − ⎟*
⎝ beta ⎠ ⎜ in firm ⎟ ⎝ beta ⎠ ⎝ tax rate ⎠ ⎜ in firm ⎟
⎜ value ⎟ ⎜ value ⎟
⎝ ⎠ ⎝ ⎠

Having computed the ßAsset, we now compute the WACC using the SML:

WACC = rf + β Asset * ⎣⎡ E (rM ) − rf ⎦⎤

To illustrate this approach for Hilton, we note that all the necessary calculations have been
done in the previous section—with the exception of the computation of the debt βD. We compute
this ß by assuming that the SML holds for debt as well as equity:

cost of debt = rD = rf + β
)D * ⎡⎣ E (rM ) − rf ⎤⎦
↑
This is the
beta of
Hilton's debt
rD − rf
⇒ βD =
E (rM ) − rf
412 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

In the spreadsheet below you can see that Hilton’s debt β is 0.528 (cell B8).9 This means that
its asset β is 0.78 (cell B15), which gives the WACC as 8.20% (cell B17).

A B C
HILTON HOTELS CORPORATION (HLT)
1 Computing the WACC with the asset beta
2 Equity beta, E 0.956 <-- Yahoo
3
4 Risk-free rate, rf 2.21%
5 Expected market return, E(rM) 10.10%
6
7 Cost of debt 5.55%
8 Debt beta, D 0.423 <-- =(B7-B4)/(B5-B4)
9
10 Corporate tax rate 34.93%
11
12 Percentage of equity, E/(E+D) 0.7113
13 Percentage of debt, D/(E+D) 0.2887
14
15 Asset beta, Asset 0.76 <-- =B2*B12+(1-B10)*B13*B8
16
17 WACC 8.20% <-- =B4+B15*(B5-B4)

13.5. Don’t Read This Section!

A final question that may have occurred to you: Why is it that we get a different cost of capital
using the traditional WACC approach and using the asset β (βAsset ) approach? We’re going to
answer this question in this section, but we warn you that reading the section may be bad for
your health.10
Still here? The answer is that for cost of capital purposes, you should adjust the SML for
corporate taxes. In addition, there are two SMLs—one for equity and one for debt. Here are the
appropriate formulas:

Equity SML: rE = rf * (1 − TC ) + βE * ⎣⎡ E (rM ) − rf * (1 − TC )⎦⎤

Debt SML: rD = rf + βD * ⎡⎣ E (rM ) − rf * (1 − TC )⎤⎦

Note that the two SMLs have the same tax-adjusted market risk premium ⎡⎣ E (rM ) − rf * (1 − TC )⎤⎦
but have different intercepts—the equity SML has intercept rf * (1 − TC ) , whereas the debt SML
has intercept r f.11
If we apply this approach to Hilton, and if we assume that the cost of debt is rD = 5.55%,
then we get the debt ßD as
rD − rf 5.55% − 2.21%
βD = = = 0.3851
E (rM ) − rf * (1 − TC ) 10.10% − 2.21% * (1 − 34.93% )

9
Hilton’s βD = 0.423 may seem high, especially when compared to its equity beta βE = 0.956. Clearly the
market thinks that Hilton’s debt is quite risky.
10
And—in all honesty—the difference between the two calculations in the previous part of the chapter is
not big enough to make much of a difference.
11
The two-SML model is derived in Corporate Finance: A Valuation Approach by Simon Benninga and
Oded Sarig, McGraw–Hill, 1997.
 CHAPTER 13 The Security Market Line and the Cost of Capital 413

Now, as you can see in the spreadsheet below, the WACC is the same, whether you compute
it with the traditional method or with the asset βAsset.

A B C
HILTON HOTELS CORPORATION (HLT)
1 Using the two-SML model
2 Risk-free rate, rf 2.21%
3 Expected market return, E(rM) 10.10%
4 Corporate tax rate 34.93%
5
6 WACC using traditional method
7 Equity beta 0.956 <-- Yahoo
8 Cost of equity 9.72% <-- =B2*(1-B4)+B7*(B3-B2*(1-B4))
9 Cost of debt 5.55%
10
11 Percentage of equity, E/(E+D) 0.7113
12 Percentage of debt, D/(E+D) 0.2887
13 WACC 7.96% <-- =B11*B8+B12*(1-B4)*B9
14
15 WACC using the asset beta and the two-SML model
16 Equity beta, E 0.956
17 Debt beta, D 0.3851 <-- =(B9-B2)/(B3-B2*(1-B4))
18 Asset beta, Asset 0.7523 <-- =B11*B16+B17*(1-B4)*B12
19 WACC 7.96% <-- =B2*(1-B4)+B18*(B3-B2*(1-B4))
20

Note: In this method rE = rf*(1 - TC) + E*[E(rM) - (1-TC)*rf] and

rD = rf + D*[E(rM) - (1-TC)rf] . The method is more theoretically correct; it also produces
full agreement between the traditional WACC approach and the asset beta approach.

However, for practical purposes the differences between this method and that illustrated
in the first part of the chapter are usually not significant.
21

Summary
The computation of the weighted average cost of capital (WACC) is critical for corporate valua-
tion. In this book we have already seen the importance of the WACC in Chapter 6.12
The WACC depends critically on our estimate of the cost of equity rE . There are only
two practical approaches for computing the cost of equity—the Gordon dividend model,
discussed in Chapter 6, and the SML. This chapter has dealt in great detail with using
the SML to compute the cost of equity and the resulting WACC. We’ve illustrated the use
of the equity βE for computing the cost of equity rE . We have also shown how you can
use a combination of the equity beta, βE , the debt βD , and the asset βAsset to compute the
WACC.
Through the use of a detailed example for Hilton Hotels, we have shown where to get the
data required to make all these calculations.

12
The issue of stock valuation is discussed in somewhat more detail in Chapter 16, which sums up the var-
ious approaches to this important topic.
414 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

EXERCISES
1. Consider the following data concerning ASAP Company:

Debt, D = 500,000
Equity, E = 300,000
Cost of debt, rD = 6%
Cost of equity, rE = 11%
Corporate tax, TC = 25%

Find ASAP’s weighted average cost of capital.

2. Consider the following data, concerning Elizabeth company:

E(rm ) = 21%
Cost of debt, rD = 8%
Corporate tax rate, Tc = 25%
βElizabeth stock = 0.7
Debt, D = 1,000,000
Value of equity, E = 1,000,000
Risk-free rate, rf = 4%

Find the company’s WACC.

3. Consider the following data concerning Abby Company. Abby’s stock is not currently listed on a
stock exchange.

E(rM ) = 20%
Cost of debt, rD = 10%
Corporate tax rate, TC = 30%
Cov(rAbby , rM ) = 0.13
Value of debt, D = 1,500,000
rf = 7%
Var(rM ) = 0.11
Value of equity, E = 3,000,000

a. Find Abby’s WACC.

b. Suppose Abby issues its stock in an initial public offering (IPO). After the IPO the company has
3,500,000 shares, worth $2.50 each. What is its WACC after the IPO?
4. Consider the following data concerning Ever-Lasting Company:

E(rM ) = 18%
Cost of debt, rD = 7.5%
Corporate tax rate, TC = 30%
βEverLasting = 1
Market value of debt, D = 1,250,000
Market value of equity, E = 2,000,000

Find the company’s WACC.

 CHAPTER 13 The Security Market Line and the Cost of Capital 415

5. Consider the following data:

EPS0 = $0.55
P0 = $22
g = 0.06
b = 45% (dividend payout ratio)

Find the price-to-earnings ratio (P/E) and the cost of equity using the Gordon model.
6. Consider the following data:

rD = 10%
TC = 30%
D = 2,500,000
E = 2,000,000
EPS0 = $2.5
P0 = $16
g = 0.075
b = 55% (dividend payout ratio)

Find the P/E ratio and the company’s WACC.

7. Use the following data to compute the WACC for Cobra, Inc. at year-end 2002:
• Cobra has 1,500,000 shares. The share price at the end of 2002 was $12.00.
• Cobra’s debt at year end 2002 is $44,500,000 and its debt at year end 2001 was $35,000,000. The
amount of interest paid in 2002 by the company was $400,000.
• Cobra’s corporate tax rate is 36%.
• The risk-free rate of interest at the end of 2002 is rf = 2.16%.
Data for the S&P 500 (the market portfolio in this case) and for Cobra returns are given below
(these data are on the disk that comes with Principles of Finance with Excel).

A B C D
1 Calculating Cobra's WACC
S&P 500 Cobra Risk-free
2 Year return return rate
3 1990 -3.10% -16.00% 7.92%
4 1991 30.47% 89.12% 6.64%
5 1992 7.62% 25.33% 4.15%
6 1993 10.08% 28.95% 3.50%
7 1994 1.32% -12.34% 3.54%
8 1995 37.58% 102.33% 7.05%
9 1996 22.96% 51.98% 5.09%
10 1997 33.36% 25.61% 5.61%
11 1998 28.58% 5.05% 5.24%
12 1999 21.04% 50.25% 4.51%
13 2000 -9.10% -15.33% 6.12%
14 2001 -11.89% -18.22% 4.81%
15 2002 -22.10% -38.00% 2.16%

8. Use the Yahoo! profile for Microsoft (MSFT) (given below).

a. What is Microsoft’s P/E ratio, its ß, and its debt-to-equity ratio? (Use the trailing P/E ratio.13)

13
The trailing P/E ratio is the ratio of today’s price to the previous year’s earnings per share. The “forward
P/E” is the ratio of today’s price to anticipated future earnings per share.
416 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

b. Find MSFT’s recent stock price and its number of shares and use them to compute MSFT’s
market equity value. Does this accord with the Yahoo! computation?
c. Assume that rf = 3% and the E (rM ) = 8%. Compute MSFT’s cost of equity rE.

9. Use the Yahoo! profile for Tyson Food’s (TSN) (given below). Compute Tyson’s WACC using the
company’s ß and other information you find on the profile. Assume that r f = 3% and E (rM ) = 8%.
 CHAPTER 13 The Security Market Line and the Cost of Capital 417

Last year the company paid $186,000 in taxes on $523,000 of pretax income. Its cost of debt
rD = 7.76%.
418 PART TWO PORTFOLIO ANALYSIS AND THE CAPITAL ASSET PRICING MODEL

10. Calculate General Electric’s tax rate for 2002, 2003, and 2004, using the data below.

A B C D
GENERAL ELECTRIC COMPANY
1 Income statements, 2002-2004
2 2002/12/31 2003/12/31 2004/12/31
3 Total Operating Revenue $132,226,000,000 $134,641,000,000 $152,866,000,000
4 Cost of Goods Sold $52,856,000,000 $51,206,000,000 $61,759,000,000
5 Interest Expense $10,151,000,000 $10,892,000,000 $12,036,000,000
6 Income Before Tax $18,972,000,000 $20,291,000,000 $20,480,000,000
7 Net Income $14,167,000,000 $15,236,000,000 $16,819,000,000

11. Use the data below to calculate Amgen’s weighted average cost of capital (WACC) for year-end
2002. Assume that E (rM ) = 8% and r f = 4%.

A B
1 Calculating Amgen's WACC
2 E(rM) 8.00%
3 rf 2.00%
4 Tax rate 44.74%
5 Beta 0.82
6 Stock price, end-2002 58.34
7
8 Outstanding shares 1,290,000,000
9 Book value per share 14.70
10 Total book value of equity 18,963,000,000
11 Debt to equity ratio (book) 16.07%
12 Amgen's debt 3,047,700,000
13 Amgen's total value 3,047,700,058
14
15 Interest paid, 2002 44,200,000
16 Debt, end-2002 3,047,700,000
17 Debt, end-2001 223,000,000

12. Use the data from Question 11 to calculate Amgen’s WACC using an asset βasset .
13. Compute Boeing’s year end 2002 weighted average cost of capital (WACC) using the following
template.
A B C
1 Calculating Boeing's WACC
2 E(rM) 7.50%
3 rf 3.00%
4 Stock price 53.92
5 Stock beta 0.72
6 Market value of equity
7
8 Outstanding shares 840,900,000
9 Book value per share $8.28
10 Book value of equity
11 Debt to equity ratio 2.09
12 Boeing's debt
13 Market value, debt + equity
14
15 2002 2001
16 Income before tax 3,180,000,000 3,564,000,000
17 Income tax expense 861,000,000 738,000,000
18 Annual tax rate 27.08% 20.71%
19
20 Interest paid, 2002 730,000,000
21 Debt, end-year 2002 12,589,000,000
22 Debt, end-year 2001 10,866,000,000
23 Average debt, 2001-2002
24 Boeing's cost of debt
25
26 Boeing's cost of equity
27
28 Boeing's WACC
 CHAPTER 13 The Security Market Line and the Cost of Capital 419

14. Use the data above to calculate Boeing’s WACC using an asset βasset.
15. The current risk-free rate is r f = 4% and the expected rate of return on the market portfolio is
E (rM ) = 10%. The Brandywine Corp. has two divisions of equal market value. The debt-to-
equity ratio of the company is 3/7, and the company’s bonds are risk free. For the past few years,
the Brandy division has been using a discount rate of 12% in capital budgeting decisions and the
Wine division a discount rate of 10%. You have been asked by their managers to report on whether
these discount rates are properly adjusted for the risk of the projects in the two divisions.
a. What are the betas of typical projects implicit in the discount rates used by the two
divisions?
b. You estimate that the stock beta of Brandywine is β = 1.6. Is this consistent with the stock
ßimplicit in the discount rates used by the two divisions?
c. You estimate that the stock β of the Korbell Brandy Corp. is 1.8. Korbell is purely in the
brandy business, its debt-to-equity ratio is 2/3, and its bond β is 0.2. Based on this information
(and on your estimate of Brandywine’s stock β ), what discount rate would you recommend for
projects in the Brandy and in the Wine divisions of Brandywine?
16. Sun, Inc. has an equity beta of 0.5. Its capital structure consists of equal amounts of equity and
risk-free debt. The debt has a pretax yield of 6% and the expected rate of return on the market
index is 18%. Sun, Inc. is considering expanding into Snow, Inc. This new business is expected
to generate an after-tax internal rate of return of 25%. Vacation, Inc. is already in this new busi-
ness; its equity beta is 2.0 and it uses a blend of 10% (risk-free) debt and 90% equity in its capital
structure. If the new project is to be funded with 50% debt, should Sun, Inc. enter the Snow, Inc.
business? Assume that both companies have a marginal tax rate of 50% and that the business risk
of Vacation, Inc. is comparable to the risk of Sun, Inc.’s venture.
17. A company is deciding whether to issue stock to raise money for an investment project that has the
same risk as the market and an expected return of 15%. If the risk-free rate is 5% and the expected
return on the market is 12%, the company should proceed with the investment.
a. This is false. The company should not take this project.
b. Regardless of the company’s β.
c. Unless the company’s β is greater than 1.25.
d. Unless the company’s β is less than 1.25.
18. The project whose cash flows are given below has a β = 1.6. If the market return E (rM ) = 15%
and the risk-free rate r f = 7%, should the firm undertake the project?

A B
1 Year Cash flow
2 0 -100
3 1 60
4 2 50
5 3 40

19. A share of a stock with a ß = 0.75 now sells for $50. Investors expect the stock to pay a year-end
dividend of $3. The T-bill rate is 4%, and the market risk premium is 8%. What is the investors’
expectation of the price of the stock at the end of the year?
20. Reconsider the stock in Exercise 19. Suppose investors actually believe the stock will sell for $54
at year end. Is the stock a good or bad buy? What will investors do? At what point will the stock
reach an equilibrium at which it again is perceived as fairly priced?
This page intentionally left blank
 PA R T

3
VALUING SECURITIES

T wo of the three chapters of Part 3 of PRINCIPLES OF FINANCE WITH EXCEL look at how to
value bonds (Chapter 15) and stocks (Chapter 16).
Section 3 starts with Chapter 14, which examines market efficiency. Roughly speaking,
market efficiency is a group of concepts which look at how information is incorporated in finan-
cial markets. Does the bundling of assets into one package affect their prices? This question
is known as price additivity, and when you read Chapter 14, you’ll see that the answer to this
question is not trivial. Does the knowledge of the price history of a stock affect your ability to
predict the future price of the stock (market efficiency says “no”)?
The market efficiency discussed in Chapter 14 provides you with the necessary background
for the valuation of bonds and stocks. Details specific to bond markets are given in Chapter 15;
this chapter also discusses preferred stocks, which are very similar to bonds.
In Chapter 16 we apply the concepts of cash flow discounting and market efficiency to
the valuation of stocks. Chapter 16 discusses and compares the four most commonly-used
techniques for stock valuation.
This page intentionally left blank
CHAP TER

14 Efficient Markets—Some General

Principles of Security Valuation
CHAPTER CONTENTS
Overview 423
14.1. Efficient Markets Principle 1: Competitive Markets Have a Single Price
for a Single Good 425
14.2. Efficient Markets Principle 2: Bundles Are Priced Additively 426
14.3. Additivity Is Not Always Instantaneous:
The Case of Palm and 3Com 435
14.4. Efficient Markets Principle 3: Cheap Information Is Worthless 440
14.5. Efficient Markets Principle 4: Transaction Costs Are Important 443
Conclusion 444
Exercises 444

Overview
Finance often requires a lot of calculation, which is why this book concentrates on solving
financial problems with a powerful tool like Excel. But sometimes understanding the way that
financial markets work requires only wisdom and very little calculation. This chapter discusses
some general principles of valuation that can save you from a lot of nonsense and in many cases
require almost no calculation. Having discussed these very important general principles, we
then move on to deal with the valuation of bonds (Chapter 15) and stocks (Chapter 16).

423
424 PART THREE VALUING SECURITIES

Here’s an example of the kind of nonsense that you’ll learn to avoid by reading and
understanding this chapter: Your college roommate Clarence has just given you a “hot tip” on
Federated Underwear (FU) stock : Clarence is sure that you should immediately buy the stock.
“It’s going to go up. I know it,” he says excitedly. “My father says that FU has been fluctuat-
ing between $15 and $25 for the past year. Every time it gets close to $15, it goes up, and when it
gets close to $25, it goes down again. Yesterday FU closed at $15.05. Buy it and wait—the stock
is sure to go up, and then you’ll sell it at $25 and make a killing.”
After reading this chapter, you’ll know to tell Clarence: “My friend, your advice is a perfect
example of a technical trading rule. And Chapter 17 of my college finance textbook, Principles
of Finance with Excel, explains that these rules are a clear violation of the principle of weak-
form market efficiency, which almost always holds. If you want to bet your money on such
foolishness, go ahead. I’m going to spend my hard-earned cash on a night out at the Efficient
Markets Disco.”
In the broadest sense the general principles discussed in this chapter all deal with the role of
information in determining asset prices. When translated into simple language, these principles
sound pretty dumb. They say things like: “Information is important.” “Transaction costs matter.”
“One plus one equals two.” When applied to asset markets the valuation principles discussed in
this chapter often enable you to make surprising statements about what things are worth.
Here are four basic principles of valuation discussed in this chapter.
Efficient Markets Principle 1. Single price for a single good. In financial markets equiva-
lent financial assets have the same price. Section 14.1 uses cross-listed stocks—stocks that trade
in two financial markets, like IBM stock on the New York Stock Exchange and IBM stock on
the Pacific Stock Exchange—as a nontrivial example of this principle.
Efficient Markets Principle 2. Price additivity The price of a bundle of securities should
be the sum of the prices of each of the securities. It is difficult to overestimate the importance
of this principle. One of its predictions is that there are no “money machines”—it costs money
to make money. Another prediction is that knowing the prices of the components of a financial
asset will help you price the whole asset.
Efficient Markets Principle 3. Information is critical. Finding out previously unknown
information can be a very profitable exercise. Conversely, it is difficult to make money from
facts that everyone knows. The more widely information is known, the less you can make money
from the information. Principle 3 is usually split into three parts:
• The principle of weak-form efficiency: Market prices incorporate all current and past
price information. If this principle holds (and almost all economists believe that it does),
then it is not possible to make money based on the pattern of past prices of a traded secu-
rity. This means that “money making” rules that are based on price patterns—“buy a
stock if it’s gone up 3 days in a row, sell it if it’s gone down 3 days running”—are futile.
The weak-form version of the efficient markets hypothesis should make you skeptical
about a lot of investment strategies. An example is investment advisors who claim to be
able to tell market trends from price patterns. These so-called “technical traders” are
giving advice that violates the weak-form efficient markets hypothesis, and this advice
should be ignored.
• The principle of semistrong form efficiency: Market prices incorporate all publicly
known information. Financial markets are awash in publicly available information. Can
you make money by carefully reading the financial statements of IBM? Probably not—
IBM has many shareholders and is followed by hundreds of stock analysts. If the analysts
are doing their job even moderately well, the information that can be gleaned from the
IBM financial statements is already incorporated in the company’s stock price. Most
 CHAPTER 14 Efficient Markets—Some General Principles of Security Valuation 425

economists believe that markets are more or less semistrong efficient. As you’ll see in
this chapter, it depends on how difficult it is to derive the information and how many
investors carefully follow a particular stock.
• The principle of strong form efficiency: Market prices incorporate all information that
exists (public or private) about a security. In addition to IBM’s publicly available finan-
cial statements and the analyses of stock analysts, there’s also lots of private information
about the company. For example, people working for the company know a lot about the
sales, production, and costs of their individual units. Is this information also incorpo-
rated in IBM’s stock price? Almost no economists believe this. This means that knowing
privately available information can provide you with profits.1 Markets are not strong
form efficient.
Efficient Markets Principle 4. Transaction costs are important and can screw up every-
thing. This is an important truth about markets. Transaction costs—by this we mean not only
the costs of buying and selling securities, but also the cost of ferreting out information—make
it more difficult to trade. And it’s trade—the buying and selling of financial assets like stocks
and bonds—that makes market prices reflect the true value of assets.

Finance Concepts Discussed in This Chapter

• Efficiency
• Additivity
• Short sales
• Open-end and closed-end mutual funds

Excel Functions Used

• This chapter has some Excel, but nothing sophisticated.

14.1. Efficient Markets Principle 1: Competitive Markets Have

a Single Price for a Single Good
A competitive market is a market with a large number of buyers and sellers, none of whom
can influence the price of the goods bought and sold in the market. Financial markets are good
examples of competitive markets: There are a large number of buyers and sellers for most stocks
sold on major stock exchanges, there are many banks competing for your bank accounts and for
your mortgage, and so on.
The principle that competitive markets have a single price for a single good is basic to econom-
ics and is drilled home in most introductory economics courses. Under some circumstances, this
principle seems to be ridiculously obvious. For example, in the Asheville, North Carolina, farmer’s
market (the author’s home town), there are many stands selling apples. Many of the vendors sell
Granny Smith (GS) apples. The GS apples sold by the vendors are of approximately the same size
and quality. The result: The price of apples of the same type is approximately the same at all the
stands. Why? Suppose one vendor deviates from the equilibrium price of GS apples by selling below
the price of the other vendors. Then he’ll attract a lot of buyers. Being competitive, he will raise his

1
Beware: Stock trading on the basis of insider information is also illegal.
426 PART THREE VALUING SECURITIES

price and the other GS vendors (also competitive) will lower their prices until, equilibrium being
restored, the market price for GS apples is the same at all GS stands.

Cross-Listed Stocks—An Application of the One-Price Principle

The one-good, one-price principle also has applications in stock markets. Here’s an example:
IBM stock is traded both on the New York Stock Exchange (NYSE) and the Pacific Stock
Exchange (PSE). When both exchanges are open, the prices of IBM stock are basically the same
in both exchanges. This isn’t surprising: If the price of IBM in New York is $120 and its price
is $118 in San Francisco, brokers would obviously try to arbitrage (that is, make money from
unreasonable differences in prices) by buying IBM stock in San Francisco and selling it in New
York. Because transaction costs are very low and because trade in stocks is instantaneous, this
will drive the prices together.2
There’s more to this than meets the eye: The NYSE opens before the PSE, but the PSE stays
open later. This means that information about IBM that arrives late in the day will be incorpo-
rated in the PSE stock price but will hit the NYSE price only the next morning. In some cases
this phenomenon is even more extreme—for example, there’s a large group of Israeli shares
that is traded both in Tel Aviv and on the NASDAQ in the United States. The trading overlap
between the two markets is only 1 hour per day (between 9:30 and 10:30 am Eastern time, both
NASDAQ and Tel Aviv are open—after this, Tel Aviv closes and all trading in the dual-listing
stocks is on the NASDAQ ). During this trading overlap, cross-listed stocks have the same price
in both markets, but when only one market is open this need not be so.

14.2. Efficient Markets Principle 2: Bundles Are Priced Additively

Prices are additive when the market price of A + B is equal to the market price of A plus the
market price of B. This sounds so obvious that it’s hard to believe that it could be interesting
(and, indeed, once you understand it, it’s pretty boring!).
For an initial example, we go back to the Asheville farmer’s market. Our previous example
dealt with Granny Smith apples, but some of the vendors also sell Red Delicious (RD) apples.
As we speak, the price of GS apples is $2 per pound and the price of RD apples is $3 per pound.
Simon, a somewhat peculiar vendor, sells bags of apples containing both GS and RD apples:
Each bag weighs 2 pounds and contains 1 pound of GS and 1 pound of RD apples. How should
he price these bags? Obviously at $5 per bag.
Why? Not so trivial, actually. Suppose Simon prices the bags at $4.50. Then anyone want-
ing 1 pound of GS and 1 pound of RD will obviously buy with Simon. If Simon is sensitive to
supply and demand, he’ll note the demand for his mixed bags of apples and raise the price; at
the same time, other apple stands—seeing their demand weaken—will lower the prices of their
apples.
Furthermore, if Simon persists in selling his bags of apples at $4.50, Sharon—a sharp
cookie (or should we say “sharp apple”?)—will buy bags of apples from Simon. She’ll then take
the apples out of the bag and sell them at her apple stand for the market price of $2 for GS and

2
Note how we’ve already slipped in the importance of transaction costs (“Principle 4: Transaction costs
are important”). The sentence in the text suggests that transaction costs may include not only the direct
cost of buying and selling (commissions, labor costs, etc.), but also the time involved in transporting a
good from one market to another. Luckily for this example, stock markets have pretty low transaction
costs, especially for brokers and dealers.
 CHAPTER 14 Efficient Markets—Some General Principles of Security Valuation 427

$3 for RD. In the language of finance—Sharon is arbitraging the price. In the language of her
grandmother, Sharon is buying cheap and selling dear.
On the other hand, suppose Simon prices the bags at $5.50. People will probably stop
buying with him, even if they want bags with equal combinations of GS and RD—they can
buy them cheaper elsewhere. Eventually Simon will have to lower his price. If, contrary to
expectations, it turns out that Simon does a brisk business in apple bags for $5.50, then other
smart apple stand owners will start selling their own bags of apples; because they can put
together a bag for less than what Simon charges, the price of the mixed bags will go back
down.
There might actually be room for Simon to sell his apple bags for $5.05 because he’s saving
his customers the trouble of going to two apple stands. In the language of finance, he’s saving
them the transactions cost of buying the apples separately. They ought to be willing to pay him
for this service.
The principle of price additivity is often summed up by the statement that there are no
money machines in financial markets: You cannot simply make money by buying a complex
financial asset (like Simon’s bags of apples), taking it apart (separate bags of GS and RD), and
selling the separate bags. The converse is also true: The “money machine” of combining GS and
RD apples into one bag won’t work.3
Now that you understand the principle of additivity as applied to the Asheville farmer’s
market, here are some nontrivial finance applications.

RICHARD GERE THE ARBITRAGEUR

In the movie Pretty Woman (1990), Richard Gere plays an “arbitrageur”: Gere buys up compa-
nies and then breaks them up and sells the parts for a profit. To quote a Web site that discusses
this movie, “This is presented in the movie, as such things are in the press generally, as a use-
less, evil thing, that destroys jobs and wrecks business—the ‘greed’ of the 80’s. In the movie,
Julia Roberts even compares it to stealing cars and selling the parts. In fact, it is a useful thing,
which easily creates jobs and increases production. A company can be broken up and sold for
a profit only if it is worth less than what the sum of what its parts are worth individually. But if
a company is worth less than the sum of its parts, then breaking up the company frees capital
that can be used for other investment purposes, including creating jobs in other companies or
industries.” (http://www.friesian.com/trade.htm)

Additivity, Example 1: The Term Structure Prices Bonds

The principle of bundle pricing is often applied to the pricing of bonds. A bond gives you a
series of payments over time. Each of these payments is a separate financial package. If we
can price each financial package, then we should be able to price the bond. For the moment
we confine ourselves to a simple bond example, saving more complicated ones for the next
chapter.

3
In a broader sense, all of the efficient markets principles in this chapter say that there are no easy ways to
make money on financial markets. If you want to make money, you’ll have to do some meaningful work.
428 PART THREE VALUING SECURITIES

Here’s an example. Suppose there are two bonds in the financial market, Bond A and
Bond B:
• Bond A sells today for $100 and pays off $110 in 1 year. The bond’s IRR is
110
10.00% = −1 .
100
• Bond B also sells today for $100. This bond has a payoff only at the end of 2 years, at

1/ 2
⎛ 125 ⎞
which point it pays $125. The IRR of the bond is 11.80% = ⎜ ⎟ −1 .
⎝ 100 ⎠
Now suppose that you’re trying to price a Bond C, which has a payoff of $23 in 1 year and
$1,023 in 2 years. The price-additivity principle says that the way to price this bond is to apply
the IRRs calculated above separately to each year’s bond payment. In a formula,

23 1,023
Bond price = + = 839.31
1.10 (1.1180 )2

In this formula we’ve discounted the first bond payment of $23 by the market interest rate
on the 1-year bonds, and we’ve discounted the second bond payment of $1,023 by the IRR
derived from Bond B. Here’s the spreadsheet.

A B C D
1 PRICE ADDITIVITY IN BONDS
2 Bond A: maturity in one year
3 Price today 100
4 Payoff in one year 110
5 IRR 10.00% <-- =B4/B3-1
6
7 Bond B: maturity in two years
8 Price today 100
9 Payoff in one year 0
10 Payoff in two years 125
11 IRR 11.80% <-- =(B10/B8)^(1/2)-1
12
13
14 Bond C: A bond with payments at end of year 1 and year 2
Present value of
15 Date Payment payment
16 1 23 20.91 <-- =B16/(1+B5)
17 2 1023 818.40 <-- =B17/(1+B11)^2
18 Bond price? 839.31 <-- =SUM(C16:C17)

Figure 14.1 presents the logic in a picture.

 CHAPTER 14 Efficient Markets—Some General Principles of Security Valuation 429

Pricing a Bond by Additivity—Schematic

Year 0 Year 1 Year 2

Bond A -100.00 110.00
IRR 10.00%

Bond B -100.00 125.00

IRR 11.80%

Bond C 23.00 1,023.00

Present value
of payment -839.31 20.91 818.40

Bond C price=value of Use Bond A's IRR to Use Bond B's IRR to
year 1 plus value of price the first payment price the second
year 2 payments. from Bond C. payment from Bond C

FIGURE 14.1. Bond C is priced by taking the IRR of Bond A and applying it to the first-year payment of C and by
taking the IRR of Bond B and applying it to the second-year payment of Bond C. In the jargon of bond markets,
both Bond A and Bond B are known as zero-coupon bonds. A zero coupon bond is a bond with only two cash
flows: the initial price of the bond and the final payoff. See Chapter 15 for more details.

To sum up, we’ve used market discount rates derived from bonds with only one payment to
additively price a bond with multiyear payments.

Additivity, Example 2: Open-End Mutual Funds

The Web page of the U.S. Securities and Exchange Commission (SEC) defines a mutual fund
as follows:
A mutual fund is a company that brings together money from many people and invests it in
stocks, bonds or other assets. The combined holdings of stocks, bonds or other assets the
fund owns are known as its portfolio. Each investor in the fund owns shares, which represent
a part of these holdings.
http://www.sec.gov/investor/tools/mfcc/mutual-fund-help.htm

Figure 14.2 gives some more information from the SEC about mutual funds.
430 PART THREE VALUING SECURITIES

MUTUAL FUNDS

A mutual fund is a company that pools money from many investors and invests the money in
stocks, bonds, short-term money-market instruments, or other securities. Legally known as an
“open-end company,” a mutual fund is one of three basic types of investment company. The two
other basic types are closed-end funds and Unit Investment Trusts (UITs).
Here are some of the traditional and distinguishing characteristics of mutual
funds:
• Investors purchase mutual fund shares from the fund itself (or through a broker for
the fund), but are not able to purchase the shares from other investors on a secondary
market, such as the New York Stock Exchange or NASDAQ Stock Market. The price
investors pay for mutual fund shares is the fund’s per share net asset value (NAV) plus
any shareholder fees that the fund imposes at purchase (such as sales loads).
• Mutual fund shares are “redeemable.” This means that when mutual fund investors
want to sell their fund shares, they sell them back to the fund (or to a broker acting for
the fund) at their approximate NAV, minus any fees the fund imposes at that time (such
as deferred sales loads or redemption fees).
• Mutual funds generally sell their shares on a continuous basis, although some funds
will stop selling when, for example, they become too large.
• The investment portfolios of mutual funds typically are managed by separate entities
known as “investment advisers” that are registered with the SEC.
Mutual funds come in many varieties. For example, there are index funds, stock funds, bond
funds, money market funds, and more. Each of these may have a different investment objective
and strategy and a different investment portfolio. Different mutual funds may also be subject to
different risks, volatility, and fees and expenses.
All funds charge management fees for operating the fund. Some also charge for their distribu-
tion and service costs, commonly referred to as “12b-1” fees. Some funds may also impose sales
charge or loads when you purchase or sell fund shares. In this regard, a fund may offer different
“classes” of shares in the same portfolio, with each class having different fees and expenses.

FIGURE 14.2 Description of mutual funds from the SEC Web site.
Source: http://www.sec.gov/answers/mutfund.htm

Does it matter if you bundle securities together in a mutual fund? How should the price
of such a fund be determined? The principle of pricing additivity gives us a way to handle this
problem—it suggests that the price of a mutual fund should be determined by the market prices
of all of the fund’s assets.
 CHAPTER 14 Efficient Markets—Some General Principles of Security Valuation 431

As a simple example, suppose you start a new company, the Super-Duper Fund, that sells a
mutual fund of a very specific type.
• Super-Duper currently has 10,000 shareholders, each of whom has invested $100—so
that the total assets of the company are $1,000,000.
• Super-Duper’s money is currently invested 50% in shares of IBM (currently trading at
$100 and 50% in shares of Intel (currently trading at $50). The Super-Duper fund cur-
rently owns 5,000 shares of IBM and 10,000 shares of Intel.
• The number of shares in the fund is flexible.4 Right now, there are 10,000 shares, but this
number can go up or down:
• If a shareholder wants to sell, you promise to liquidate his proportional part
of the fund’s assets. So if Uncle Joe from Winona, who owns one Super-Duper
share worth $100, wants to sell his share in the company, Super-Duper will
sell ½ share of IBM and 1 share of Intel and repay him his $100. Now the fund
will have $999,900 in assets, still invested 50% in IBM and 50% in Intel.
• If any new shareholders want to join, Super-Duper will buy—per $100 of new
funds that come into the company—$50 of IBM and $50 of Intel.5
Suppose that today no one sells or buys shares in the fund. The asset value of the Super-
Duper fund today is $1,000,000. Now suppose that tomorrow the price of IBM is $110 and the
price of Intel is $48. Then the value of a fund share is $103 (cell C14 below).

A B C D
1 SUPER-DUPER OPEN END MUTUAL FUND
Tomorrow
before new
2 Today fundholders
3 Number of Super-Duper shares 10,000 10,000
4
5 Portfolio
6 Price of IBM 100 110
7 Price of Intel 50 48
8
9 Portfolio composition
10 Shares of IBM 5,000 5,000
11 Shares of Intel 10,000 10,000
12
13 Total fund value 1,000,000 1,030,000 <-- =C10*C6+C11*C7
14 Value of 1 fund share 100 103 <-- =C13/C3
15
Tomorrow: New shares are created at
16 after new fundholders the current fund share
17 Number of Super-Duper shares 10,500 price, so the fund is now
18 Total fund value 1,081,500 <-- =B17*C14 worth
19 10,500*$103=$1,081,500 .
20 Portfolio composition
21 Shares of IBM 4,915.91 <-- =B18*50%/C6
22 Shares of Intel 11,265.63 <-- =B18*50%/C7

4
In the jargon of mutual funds, this makes it an open-end fund. Our next example considers a closed-end
fund.
5
Actually, Super-Duper Fund does all this at the end of the day. So if Uncle Joe wants to sell his share and
Aunt Maude wants to invest an additional $100, Super-Duper has a wash, and it can save on the transaction
costs of buying and selling. Every penny helps!
432 PART THREE VALUING SECURITIES

Now suppose that at the close of the day tomorrow another 500 individuals buy shares of
the fund. This means that they pay 500 * $103 = $51,500 to buy shares in the fund. Assuming
that the fund sticks to its current policy of splitting its investment equally between IBM and
Intel, the total fund value of $1,081,500 (cell B18 above) will now be invested in 4,915.91 shares
of IBM and 11,265.63 shares of Intel.
In an open-end mutual fund the number of shares is flexible. New shareholders buy into
the fund at the per-share value of the fund, and shareholders in the fund who want to cash out
cash out at the per-share value of the fund. At any point in time, the per-share value of the fund
is given by the formula

fund net asset value (NAV )

open-end fund per -share value =
number of shares in fund
market value of fund ' s portfolio − fund expenses
=
number of shares in fund

Note that we’ve introduced a new bit of jargon: A mutual fund’s net asset value (NAV) is the
market value of the fund’s portfolio minus fund expenses.
The additivity principle applied to open-end mutual funds means: An open-end mutual
fund is priced at the sum of the values of the share portfolio held by the fund.

Mutual Fund Costs: Some Technical Details

The fund has some expenses that are charged to the fund holders and deducted from the value
of the fund. These include the costs of buying and selling shares. Another fund cost is the cost
of paying the managers: Typically fund managers charge their clients a percentage cost. If your
fund charges 1% (in the United States this is typical), then this cost ($10,000 per year in our
example) has to be taken out of the value of the fund.
Our Super-Duper Fund doesn’t charge shareholders to buy or sell shares in the fund.
However, an important class of mutual funds charge shareholders to buy shares in their funds.
These so-called front-end load mutual funds are more expensive than no-load funds. Suppose,
for example, that Super-Super-Duper were to charge a 7% front-end load. Then you would pay
$107 (=$100 + 7% front-end load) to buy a share of the fund. Front-end loads are obviously
expensive; mutual fund salespeople sometimes justify these extra charges as an appropriate price
to pay for the expertise of better fund management, but there is almost no evidence to show that
this is true.6

Example 3: Closed-End Mutual Funds—When Additivity Fails

Value-additivity doesn’t always work. In this subsection we give an example of closed-end
mutual funds. A closed-end mutual fund is an investment company with a fixed number of
shares. Like open-end mutual funds, closed-end mutual funds invest in a portfolio of stocks. As

6
Recall that in Chapter 12 we discussed a technique for judging mutual fund performance using the
CAPM. Finance researchers employing this and more sophisticated techniques find little evidence that
front-load mutual funds outperform no-load mutual funds.
 CHAPTER 14 Efficient Markets—Some General Principles of Security Valuation 433

opposed to an open-end mutual fund, however, where the number of shares can be expanded
or contracted, a closed-end mutual fund has a fixed number of shares that are sold on the stock
market. The company issues no more new shares, and the market price fluctuates with supply
and demand for the fund’s shares. Closed-end funds are investment companies for which value
additivity usually fails.
Here’s an example. The Chippewa Fund is a closed-end fund that looks a lot like the
Super-Duper Fund. Like Super-Duper, Chippewa has 10,000 shares. Chippewa’s share portfolio
currently consists of $500,000 of IBM stock and $500,000 of Intel stock, and its shares are
registered on the Chippewa Stock Exchange. The fund has no other assets.
What should be the price of a Chippewa Fund share? It seems that it should be equal to the
per-share value of the fund’s assets—in our case $100 per share (as you saw in our discussion of
open-end mutual funds, the finance jargon is the net asset value of the Chippewa Fund is $100
per share). But checking the newspapers, you find that the share price of the Chippewa Fund is
$90, below its NAV. A back check of the prices of the Chippewa Fund shows you that Chippewa
almost always sells for less than its NAV. In fact, a finance-knowledgeable friend has told you
that almost all closed-end funds sell for less than their NAV.
The reasons why closed-end funds sell at a discount are not well understood.7 What is well
understood, however, is that it is difficult to arbitrage a closed-end fund discount—meaning
that it is difficult for investors to make money out of the discount and, by making money,
cause the discount to disappear. Suppose, for example, that shares of Chippewa fund trade
below $100 net asset value, say at $90. Then both existing and potential fund shareholders
have a problem: On the one hand, the existing shareholders are holding $100 market-value
shares worth only $90. If the closed-end fund were to break up, existing shareholders would
get the NAV of $100. So all the shareholders would in principle favor breaking up the fund,
but no individual shareholder would want to sell his individual shares before such a breakup.
A potential new shareholder is faced with the same problem: He gets $100 (market value) of
shares for $90, but he has no guarantee that the value of the closed-end fund will ultimately
get back to the market value.
This whole scenario may sound somewhat improbable, but in fact there are many closed-
end mutual funds. Figure 14.3 gives an actual example: Tri-Continental Corp. is a closed-end
fund registered on the New York Stock Exchange. On 23 November 2001 the fund’s shares were
worth 11.18% less than the market value of the fund’s portfolio. This closed-end fund discount
is pervasive throughout the closed-end fund industry.

7
A readable survey of closed-end fund discounts is a paper by Elroy Dimson and Carolina Minua-
Paluello, “The Closed-End Fund Discount,” which is available on the Web. In their introduction, they
write, “Closed-end funds are characterized by one of the most puzzling anomalies in finance: the closed-
end fund discount. Shares in American funds are issued at a premium to net asset value (NAV) of up to 10
percent, while British funds are issued at a premium amounting to at least 5 percent. This premium repre-
sents the underwriting fees and start-up costs associated with the flotation. Subsequently, within a matter
of months, the shares trade at a discount, which persists and fluctuates . . . . Upon termination (liquidation
or ‘open-ending’) of the fund, share price rises and discounts disappear.”
434 PART THREE VALUING SECURITIES

Tri-Continental Corporation—A Closed-End Fund

FIGURE 14.3 Tri-Continental Corp. is a closed-end fund whose shares are registered on the New York
Stock Exchange. On 23 November 2001, Tri-Continental’s assets—the market value of the shares
contained in its portfolio—totaled $3,207,840,000. Because the fund has 131,077,105 shares, this
works out to a net asset value (NAV) per share of

3,207,840,000
NAV = = $22.89
131,077,105 .

However, on the same date, the fund’s shares sold for $20.33, a discount of 11.18%. The Tri-
Continental discount is pervasive. In the past 10 years the discount has averaged 14.57%.
Source: http://www.closed-endfunds.com
 CHAPTER 14 Efficient Markets—Some General Principles of Security Valuation 435

Summing Up Additivity
As long as market participants can freely arbitrage, we expect value additivity to hold: The
value of a basket of goods or financial assets should equal the sum of the values of the com-
ponents. Arbitrage in this case means the ability of market participants to create and sell their
own bundles of goods or assets or to break up existing bundles and sell the components. This is
true whether we’re discussing the cost of a bag of apples in the Asheville farmers’ market or the
price of an open-end mutual fund. But there are also situations, like a closed-end fund, where
arbitrage is difficult. For these cases, like the closed-end funds just discussed, we would not
expect value additivity to hold.
We’re not quite done with additivity: In the next section we discuss an interesting case
where value additivity was clearly violated, but where—eventually—market prices came to
reflect value additivity.

14.3. Additivity Is Not Always Instantaneous:

The Case of Palm and 3Com
During the 1990s, 3Com developed the Palm Pilot, a handheld personal information manager
that became a raging success. In March 2000, 3Com sold 5.7% of its Palm subsidiary to the pub-
lic. After this “equity carveout” there were separate stock market listings for Palm (still 94.3%
owned by 3Com) and for the parent company 3Com. On 3 March 2000, the closing stock price
for Palm was $80.25 per share and the closing stock price for 3Com was $83.06 per share. As
you’ll see, this situation represents an interesting violation of the principle of value additivity.
In the spreadsheet below we calculate the market value of Palm (cell B5) and of 3Com
(cell B10).

A B C
3COM AND PALM
This spreadsheet reflects market prices on
3 March 2000, the day after the issue of 5.7%
1 of Palm stock held by 3Com
2 Palm
3 Price per share 80.25
4 Number of shares outstanding 562,258,065
5 Market value 45,121,209,716 <-- =B4*B3
6
7 3Com
8 Price per share 83.06
9 Number of shares outstanding 349,354,000
10 Market value 29,017,343,240 <-- =B9*B8
11
12 Value of Palm stock held by 3Com (94.3%) 42,549,300,762 <-- =94.3%*B5
13 Value of non-Palm 3Com activities -13,531,957,522 <-- =B10-B12

If you look at these numbers you’ll see a startling failure of value additivity:
• 3Com owns most of Palm, but Palm’s value is bigger than 3Com’s! To be more precise,
the 94.3% of Palm stock still owned by 3Com is worth $42.5 billion (cell B12), but all of
3Com is worth only $29.0 billion (cell B10).
436 PART THREE VALUING SECURITIES

• Using these numbers, the market seems to value all of the non-Palm activities of 3Com at
a negative $13.5 billion!!!! The only way this would be possible is if these activities were
big money losers (which wasn’t the case).
Why did additivity fail in this big way? Why didn’t market participants arbitrage the 3Com
and Palm stock prices so that additivity would be restored (below we explain how such an arbi-
trage would work)? One possible reason is that markets are (temporarily) relatively stupid: The
enthusiasm for the initial public offering (IPO) of Palm at the beginning of March 2000 was
so overwhelming that investors (temporarily, as you’ll see below) forgot that 3Com still owned
most of Palm. So they mispriced the relative values of Palm and 3Com, producing the weird
case shown above. If they had thought a bit, they would have realized that a share of 3Com
should be worth at least 1.52 times the price of a share of Palm.

A B C
16 Minimum logical value of 3Com shares, compared to Palm
17 Number of shares of Palm held by 3Com 530,209,355 <-- =94.3%*B4
18 Number of 3Com shares 349,354,000
19 Number of Palm shares per 3Com share 1.52 <-- =B17/B18

Actually, if they knew how to read a balance sheet, they would conclude that the price of a 3Com
share should be even more. In 3Com’s last quarterly statement, just 1 week before the Palm IPO,
its balance sheet showed almost $3 billion in cash and short-term investments. Assuming that
these items were not needed for production of 3Com’s products, they are worth $8.53 per 3Com
share.

A B C
22 On 25 Feb 2000, from 3Com's balance sheet
23 Cash and equivalents 1,812,503,000
24 Short-term investments 1,166,026,000
25 2,978,529,000 <-- =B24+B23
26
27 Cash and investments per 3Com share 8.53 <-- =B25/B9

So the minimum value for a 3Com share should have been

3Com share price ≥ 1.52 * Palm share price + $8.53

Short-Selling as a Way of Correcting Market Mispricing

Short-selling is a technique of borrowing a stock, selling it, and repaying it later.8 Suppose you
could freely short-sell Palm stock. Then you could make money from the above situation by short-
ing Palm stock and buying 3Com stock. We’ll explain the arbitrage technique in a second, but the
logic is as follows: Palm stock is overpriced (relative to 3Com stock) and 3Com stock is underpriced

8
The actual procedures for implementing a short sale are not simple. A well-written academic survey is
a recent paper by Gene D’Avolio, “The Market for Borrowing Stock,” http://papers.ssrn.com/sol3/papers.
cfm?abstract_id=305479. There’s also a wonderful article in the 1 December 2003 issue of the New Yorker
Magazine by James Surowiecki. Entitled “Get Shorty,” the article can be found on the Web at http://
newyorker.com/talk/content/?031201ta_talk_surowiecki.
 CHAPTER 14 Efficient Markets—Some General Principles of Security Valuation 437

(relative to Palm stock), so you should buy the cheap stock (3Com) and sell the overpriced stock
(Palm).
The arbitrage with which an investor could profit from the market mispricing is as
follows:
• Borrow a share of Palm stock and sell it. Selling borrowed stock is called short-selling.
In the example below, an arbitrageur short-sells one share of Palm for $80.25.
• Buy the equivalent value of 3Com stock. At the time of the arbitrage we explore below,
3Com was selling for $83.06 per share. The arbitrageur—having just shorted Palm for
$80.25, spends this money to buy 0.966 shares of 3Com (0.966 * $83.06 = $80.25).
If you’re right about the mispricing of the Palm versus 3Com shares, you should make
money under any price scenario. In the example below the arbitrageur shorted 1 share of Palm on
3 March and used the proceeds to buy 0.966 shares of 3Com. Suppose that the arbitrageur undid
his position on 10 March (meaning he bought 1 share of Palm and sold 0.966 shares of 3Com).
If on 10 March the prices of Palm and 3Com were in line with her additive valuation, then the
arbitrageur would make money. In the example below, the share price of Palm on 10 March is $99
and the share price of 3Com is $159.01. As you can see, the arbitrageur makes $60.01.

A B C
1 3COM AND PALM: ARBITRAGING THE MISPRICING
3 March 2000 — short -sell 1 Palm share
2 and buy $ 80.25/$83.06 = 0.9662 3 Com shares
3 Cash flow 0.00 <-- =80.25-0.9662*83.06
4
10 March 2000 — buy 1 Palm share
5 and sell $ 80.25/$83.06 = 0.9662 3 Com shares
6 Suppose Palm price is 99.00
7 Logical minimum 3Com price 159.01 <-- =1.52*B6+8.53
8 Profit 60.01 <-- =B7-B6

If you play with the spreadsheet, you’ll see that as long as you’re right about the price rela-
tion between Palm and 3Com, you’ll make money—whether the price of Palm goes up (as in
the previous example) or down. For example, suppose that shares of Palm go down in price and
that they sell for $60 on 10 March.

A B C
1 3COM AND PALM: ARBITRAGING THE MISPRICING
3 March 2000 — short-sell 1 Palm share
2 and buy $80.25/$83.06 = 0.9662 3Com shares
3 Cash flow 0.00 <-- =80.25-0.9662*83.06
4
10 March 2000 — buy 1 Palm share
5 and sell $80.25/$83.06 = 0.9662 3Com shares
6 Suppose Palm price is 60.00
7 Logical minimum 3Com price 99.73 <-- =1.52*B6+8.53
8 Profit 39.73 <-- =B7-B6
438 PART THREE VALUING SECURITIES

As you can see from this arbitrage example, short-selling is essential to making the prices
“behave” in an additive way. Because short-selling involves selling borrowed stock, one expla-
nation of the lack of additivity in 3Com–Palm prices is that initially there were just too few
Palm shares around for arbitrageurs to sell.

What Happened Later?

The graph below shows the relation between Palm’s stock price and 3Com’s (column C of the
spreadsheet calculates the ratio 3Com ' s stock price ). As you can see, the ratio climbed in
Palm ' s stock price
the days following the Palm IPO, reaching the 1.52 point on 9 May 2000. From then until the
end of July 2000, the ratio remained above this ratio—presumably the word had gotten out and
enough investors understood the intricacies of the 3Com–Palm relationship to force the prices
into an appropriate pattern.

A B C D E F G H I J K L M
CALCULATING THE RATIO OF 3COM'S STOCK
1 PRICE TO PALM'S STOCK PRICE
Daily data, 2 March 2000 - 24 December 2001
Remaining Palm stock was distributed to shareholders
2 on 27 July 2000
3
Palm 3Com Ratio of
4 Date price price 3Com/Palm
5 2-Mar-00 95.063 81.813 0.861 <-- =C5/B5
6 3-Mar-00 80.250 83.063 1.035
7 6-Mar-00 63.125 69.563 1.102
8 7-Mar-00 66.875 72.250 1.080 3Com Stock Price Versus Palm's Price
9 8-Mar-00 64.750 70.438 1.088 The data is for the ratio : 3Com /Palm
10 9-Mar-00 69.375 68.063 0.981
11 10-Mar-00 70.000 68.938 0.985 3.00
12 13-Mar-00 64.313 64.313 1.000
13 14-Mar-00 57.750 54.813 0.949 2.50
14 15-Mar-00 55.750 61.063 1.095
15 16-Mar-00 55.563 64.500 1.161 2.00
16 17-Mar-00 55.250 68.000 1.231
17 20-Mar-00 55.250 68.563 1.241 1.50
18 21-Mar-00 48.375 64.109 1.325
19 22-Mar-00 51.563 63.875 1.239 1.00
20 23-Mar-00 58.188 69.688 1.198
0.50
21 24-Mar-00 57.000 67.000 1.175
22 27-Mar-00 55.375 67.188 1.213 0.00
23 28-Mar-00 54.813 67.625 1.234
2-Mar-00

15-May-00

27-Jul-00

9-Oct-00

20-Dec-00

7-Mar-01

18-May-01

1-Aug-01

18-Oct-01

24 29-Mar-00 49.688 63.188 1.272

25 30-Mar-00 46.500 58.813 1.265
26 31-Mar-00 44.875 55.625 1.240
27 3-Apr-00 40.313 49.750 1.234
28 4-Apr-00 38.250 44.563 1.165

On 28 July 2000, the ratio dropped precipitously, from 1.815 to 0.347. What happened?
After markets closed on 27 July, 3Com distributed all remaining Palm shares to its sharehold-
ers. There was no longer any compelling reason for 3Com’s share price to be related to Palm’s.
As you can see in the graph above, since that time the ratio of the prices has been all over the
place.
 CHAPTER 14 Efficient Markets—Some General Principles of Security Valuation 439

A B C D E F G

CALCULATING THE RATIO OF 3COM'S STOCK

1 PRICE TO PALM'S STOCK PRICE
Daily data, 2 March 2000 - 24 December 2001
Note that remaining Palm stock was distributed to shareholders
2 on 27 July 2000
3
Ratio of
4 Date Palm 3Com 3Com/Palm
99 17-Jul-00 39.500 66.813 1.691 Palm's stock
100 18-Jul-00 37.313 64.063 1.717 price
101 19-Jul-00 34.875 62.750 1.799
102 20-Jul-00 36.750 66.625 1.813 3Com's stock
103 21-Jul-00 38.313 68.000 1.775 price
104 24-Jul-00 36.625 66.188 1.807 3Com sells for
105 25-Jul-00 36.563 67.938 1.858 1.815 times Palm
106 26-Jul-00 36.688 67.875 1.850
107 27-Jul-00 35.563 64.563 1.815 <-- =C107/B107
108 28-Jul-00 37.250 12.938 0.347 <-- =C108/B108
109 31-Jul-00 39.000 13.563 0.348
110 1-Aug-00 39.375 13.688 0.348
111 2-Aug-00 39.125 14.438 0.369

What Happened on 27 July 2000?

On 27 July 2000 (the divestiture of all Palm stock by 3Com), the price of 3Com dropped precipi-
tously. By that date investors—well informed about the coming divestiture of Palm—realized
that the divestiture of the stock by 3Com would lower 3Com’s value. And so it did.

100

90

80

70

60 Palm price
3Com price
50

40

30

20

10

0
2-Mar-00

15-May-00

27-Jul-00

9-Oct-00

20-Dec-00

7-Mar-01

18-May-01

1-Aug-01

18-Oct-01

FIGURE 14.4 The prices of 3Com and Palm stock, 2 March 2000–24 December 2001. A partial spin-off of Palm
was initiated by 3Com on 3 March 2000 and completed on 27 July 2000 (on this date there was a precipitous
decline in 3Com’s stock price).
440 PART THREE VALUING SECURITIES

Palm and 3Com—What’s the Point?

Additivity is a basic efficiency feature of financial markets. As in the case of closed-end funds,
it may not hold where the structural features of the funds make arbitrage difficult, or—as in
the case of Palm and 3Com—it may take some time for markets to figure out what’s happening
and to initiate the arbitrage that will lead to additivity. One fundamental way to correct nonad-
ditivity is to short-sell, but sometimes (as discussed on page 436) a short-sale may be difficult.
Difficulties in short-selling can lead to failure of additivity.

14.4. Efficient Markets Principle 3: Cheap Information Is Worthless

Financial markets are awash in information, and it is important for you to have some opinions
about how this information affects market prices. In this section we discuss three hypotheses
that relate to how information is incorporated into financial markets. The finance jargon for
these hypotheses is as follows: Weak-form efficiency, semistrong form efficiency, and strong
form efficiency.
In one form or another all three of these hypotheses state that information is important and
that cheap and easily accessible information is likely to be worthless. The cheaper and more
easily accessible the information, the less it’s worth.
Read the previous paragraph again. It sounds contradictory!
• Information is important? This seems obvious. Whether it’s the cost of a bank loan or
information about whether Upward Slopes Ski Site is making money, the more informed
you are about a financial asset, the more you should be able to judge its worth.
• Cheap and easily accessible information is likely to be worthless? If it’s so important,
why isn’t it worth anything? The reason is that many people think that it’s important, and
so they’re all trying to figure out what the information is and how it affects the value of
the asset. With so much energy expended on finding out the effect of the information and
with the information so cheap, you’re likely to find that the whole price impact of the
information has already been extracted and is already reflected in the market price.

Weak-Form Efficiency: Almost Always True

The hypothesis of weak-form efficiency says that you cannot predict the future price of a finan-
cial asset by carefully examining the asset’s past prices and its current price. Because everyone
has easy and cheap access to the past prices of IBM stock, there’s nothing left to be learned
from these prices—all possible information contained in these prices is already incorporated
in the current market price of IBM. Everyone knows past prices and, therefore, if you could
make a profitable prediction based on a stock’s price history, so could everyone else. In trying to
implement this profitable information, you and other investors would drive its profitability out of
existence. This sounds obvious (and it is), but it’s a principle often overlooked by investors.

Technical Analysis—Do Previous Prices Predict Future Prices?

Its proponents claim that technical analysis is the art or science of using historical stock price
patterns to predict the future stock price. Finance professors think that technical analysis is
neither an art nor a science, but simply voodoo. They base this belief on the weak-form efficient
markets hypothesis and on tons of academic research.
 CHAPTER 14 Efficient Markets—Some General Principles of Security Valuation 441

Here’s a simple example of technical analysis: Based on an analysis of ABC’s historical

stock price, you’ve concluded that it fluctuates in a band between $25 and $35. When the price
gets close to $25 it inevitably goes up, and when the price gets close to $35 the stock price goes
down. This leads you to develop the following money-making strategy:
• Buy ABC when the price gets to $25.50; because this is very close to $25, the price will
have a very high probability of moving up. In any case you’ll have little to lose because
the price can’t go below $25.
• Sell ABC when the price gets to $34.50; because this is very close to $35, the price has
a very high probability of moving down. In any case at $34.50 you have very little to
gain.
This sounds like a money-making strategy, but on the other hand it’s self-defeating: If all
investors try to implement this strategy (and why shouldn’t they, because your analysis is
based on publicly available information?), then the “price band” will narrow—no one will
want to buy ABC stock when it gets close to $34.50 or to sell it when it gets close to $25.50.
Now everyone will try to implement a profit strategy based on the new price band. And so on
and so on . . . .
The conclusion: There is no price band! It may be that ABC’s share price has been between
$25 and $35 in the past, but this says nothing about its share price in the future.
In fact, you could make a broader conclusion: As long as there are many people trading in
a market, a strategy based only on past and current prices cannot be profitable.

Technical Trading Rules—Another Violation of Weak-Form Efficiency

A technical trading strategy is a rule for buying and selling a stock based on the stock’s previ-
ous price movements.9 The weak-form efficiency hypothesis says that technical trading rules
won’t work.
The ABC example above (where ABC’s stock was assumed to trade in a band between $25
and $35) is a simple example of a technical trading rule. Figure 14.5 gives a more sophisticated
example.
The down trendline explains the downturn in Budget Group’s stock price by connecting
four “price peaks.” The prediction and the associated trading rule is as follows:
• When the stock price of Budget Group gets close to the down trendline, it will move
down. To exploit this information, you should buy when the price is below the trendline
and sell when it is above the line.
• If the stock price of Budget Group breaks through the down trendline, “a change of trend
could be imminent.” This is the technical analyst’s escape hatch—the information con-
tained in the prices is true except when it’s not true.

Semistrong Form Efficiency: Sometimes True

Semistrong form efficiency predicts that not just past prices, but all publicly available
information, is incorporated in current security prices. This suggests, for example, that the

9
There are lots of good Web sites on technical trading. Here are a couple: http://technicaltrading.com/ and
http://www.stockcharts.com/education/What/TradingStrategies/MurphysLaws.html.
442 PART THREE VALUING SECURITIES

FIGURE 14.5 Technical analysis of Budget stock.

http://www.stockcharts.com:85/education/What/ChartAnalysis/trendlines.html

analysis of a fi rm’s financial statements is not going to help you make better investment
decisions.
Semistrong market efficiency seems to be true . . . occasionally. It’s a lot of work to under-
stand all the publicly available information about a stock, and it’s quite common to see cases
where information existed, but it wasn’t incorporated into the stock price. The 3Com–Palm
story discussed in Section 14.3 is a case in point. Only after some rigorous analysis of the rela-
tion between 3Com and Palm and analysis of the cash reserves of 3Com could we conclude that
Palm was overpriced relative to 3Com. There has to be a lot at stake to motivate investors to
engage in this kind of research. If it’s worthwhile, then we would expect semistrong efficiency
to prevail.

Strong Form Efficiency: Usually Not True

The strong form efficient markets hypothesis says that all information is incorporated into secu-
rities prices. Hardly anyone believes that this is true. In fact, it’s often illegal because all infor-
mation includes proprietary information and inside knowledge—by law, insiders are forbidden
to trade on their information if it hasn’t been revealed to the public.
 CHAPTER 14 Efficient Markets—Some General Principles of Security Valuation 443

14.5. Efficient Markets Principle 4: Transaction Costs Are Important

Transaction costs are all the various costs of buying and selling a security and also the costs
(monetary or otherwise) of understanding a security. When you buy a stock for $50, you pay
a brokerage commission. In the United States this commission is typically ½ percent. So the
purchase of a share of stock costs you $50.25 and its sale delivers you $49.75.

A B C
3 Buy commission 0.50%
4 Sell commission 0.50%
5
6 Stock price $50.00
7
8 Purchase price 50.25 <-- =B6*(1+B3)
9 Selling price 49.75 <-- =B6*(1-B4)

The result: If you think that the stock is worth $50.15, it won’t be worth your while to buy it:
Even though the stock’s price today is $50, less than what you think it’s worth, transaction costs
make it more expensive to buy the stock ($50.25) than you think it’s worth.
Similarly, suppose you own a share of the stock and suppose you think it’s worth only
$49.80. In the absence of transaction costs, it would be logical to sell the stock, but with a ½
percent transactions cost, you would be getting less than you think the stock is worth.
Here’s a more interesting example: Below are the prices of sugar in London and in New
York on 25 July 2003.

A B C

COMPARING SUGAR PRICES

1 IN LONDON AND NEW YORK
2 New York (dollars/pound) 0.0693
3 London (dollars/tonne) 208.30
4 pounds per tonne 2,200
5 London (dollars/pound) 0.0947 <-- =B3/B4
6
7 One container of sugar
8 Contains 21 tons
9 in pounds 46,200 <-- =21*B4
10 "Arbitrage profit" 1,172.64 <-- =(B5-B2)*B9

New York sugar is selling for 6.93 cents per pound, whereas sugar in London is selling
for $208.30 per “tonne.” Could there be an opportunity here to make money? In comparing
the prices, you have to make sure the units are the same; for example—a tonne is a metric ton,
1,000 kilograms (which equals 2,200 pounds). As you can see, the London price translates to
9.47 cents per pound.
It looks like there’s an arbitrage opportunity here: If we buy sugar in New York and sell it in
London, we can make over 2.5 cents per pound. Because a 20-foot container can hold 21 tons of
sugar (or 46,200 pounds; see cell B9 above), it looks like we could make almost $1,173 profit per con-
tainer. And because a ship can hold hundreds of containers, this must be a surefire way to get rich!
But hold on—this couldn’t be. We must have forgotten the transaction costs:
444 PART THREE VALUING SECURITIES

• It costs money to ship sugar from New York to London. It costs approximately $1,000 to
ship a container of sugar from New York to London. This alone would almost eliminate
the arbitrage profit.
• It takes time to ship sugar from New York to London—somewhere between 10 days and
3 weeks, depending on the availability of shipping. So even if the freight costs are less
than $1,173, this isn’t an arbitrage—it’s a kind of educated gamble on the price differen-
tials between the two cities.10
So, there might be a profit here, but it’s not certain. The transaction costs, the cost and the
time needed to ship the sugar from New York to London, will eat up most of the profits. Of
course, this is what you would expect in an efficient market: You can’t make money from things
that are easy to do.

Conclusion
Financial economists use the words “efficient markets” to describe a variety of rules about
financial asset prices that are so simple that they almost always have to be true. In this chapter
we’ve explored several of these asset pricing rules:
• One price for one asset. In an efficient financial market, assets that are the same ought to
have the same value and price.
• Price additivity of asset bundles: In an efficient market bundling two or more assets
together—whether it’s different kinds of apples in a bag or stocks in a mutual fund—
doesn’t change their value.
• Informational effects on prices: Generally known information cannot be worth much,
and the more widely the information is known, the less it is worth. We explored three
versions of this principle. The weak-form efficiency principle says that the future asset
price cannot be predicted from knowledge of historical asset prices and the current asset
price. The semistrong form efficiency principle says that publicly known information—
not just prices, but published accounting data and other information that can (with some
work) be derived from the information—is worthless. Economists believe that semistrong
efficiency holds frequently but not always. The strong form efficiency principle, which
almost no one believes, says that all information—whether public or not—is worthless.
• Transaction costs: These pesky critters can screw up the previous three principles because
they interfere with arbitrage. Arbitrage, the buying and selling of assets with a riskless
profit, is the mechanism by which the three above principles are forced to hold. Transaction
costs, the cost of buying and selling an asset, or the cost of finding out information about
the asset can make it more difficult to arbitrage and hence cause market inefficiencies.

EXERCISES
1. One of the earliest tests of market efficiency was to examine the returns of stocks around the pub-
lication of their earnings reports. The following graph below the price of XYZ stock 7 days before
and after the earnings announcement date (date = 0). Assume that the only new information during

10
What we need is a forward or a futures contract: These are contracts that enable us to fix a price today for sugar
delivered in London at some point in the future. Such contracts exist, but they’re beyond the scope of this book.
For a good text, see John Hull, Options, Futures, and other Derivatives, 7th edition, Prentice Hall, 2008.
 CHAPTER 14 Efficient Markets—Some General Principles of Security Valuation 445

this period is the publication of the earnings report showing higher profits than expected. Does the
price pattern of XYZ stocks support the concept of market efficiency?

XYZ Price Around the Announcement Date

$13.00
$12.50
$12.00
$11.50
Price

$11.00
$10.50
$10.00
$9.50
$9.00
-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7
Date

2. In the three graphs below, are the principles of market efficiency violated? If so, which principle
and why?

Cumin Stock Price Around Dividend Announcement Date

$14.00

$13.00

$12.00

$11.00

$10.00

$9.00
-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7
Date

Tangerine Stock Price Around Earnings Announcement

Date

$14.00
$13.00
$12.00
$11.00
$10.00
$9.00
-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7
Date
446 PART THREE VALUING SECURITIES

Persimmon Stock Price Around Annual Report Date

$16.00
$15.00
$14.00
$13.00
$12.00
$11.00
$10.00
$9.00
-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7
Date

3. Which of the following results support/contradict market efficiency?

a. Stocks that perform best in January perform worst in February.
b. Only 35% of mutual funds earned higher returns than the S&P 500.
c. Firms that announce a dividend cut continue to underperform similar stocks 6 months after the
announcement date.
d. When the founder of a company unexpectedly retires from his management position the firm’s
stocks tends to go up.
e. During the month of January stocks earn higher returns than in other months.
4. Are the following statements true or false? Explain.
a. Studying a company is a waste of effort because all information is incorporated in the com-
pany’s stock prices.
b. A price drop of 60% in 1 day implies that the market is inefficient.
c. Arbitrageurs are key players in preserving market efficiency.
d. The higher the transaction costs, the more mispricing is expected.
5. On 27 October an arbitrageur in London was following the exchange rates in Asheville. At that
time $1 was traded for €0.8051 and £0.4111 (you can’t change directly pounds into Euros and vice
versa at Asheville). At the same time in London €1 was traded for €1.9608 and $2.4390.
a. Show a strategy that will enable the arbitrageur to make arbitrage profits.
b. Assume that the arbitrageur invests £100,000 in the strategy. How much money will he gain
from implementing it?
6. Continuing with the previous problem: If the transaction costs in London are 0.25% per transac-
tion and 0.5% in Asheville, is the strategy still profitable? What is the maximum transaction cost
(assuming that they are twice as much in Ashville as in London) that will make the strategy break
even?
7. Teva is a pharmaceutical company traded both on the Tel Aviv stock exchange and on the NASDAQ.
At 9:30 Eastern time (when both exchange markets are open) Teva was traded for $25.75 on the
NASDAQ and for 112 New Israeli Shekel (NIS) in Tel Aviv. At the same time $1 was traded for
4.48 NIS. Show a strategy that enables arbitrageurs to earn profits. When do you think that the
profit opportunities will cease to exist?
8. On 17 July 2010 ABC Corp. reported an increase of 2 cents in earnings per share (EPS).
Nevertheless, the price of the stock dropped by $1.50. In contrast, on the same day, the DEF com-
pany reported a decrease of 3 cents in its EPS, but the stock price rose by $2.20. A journalist wrote
 CHAPTER 14 Efficient Markets—Some General Principles of Security Valuation 447

that “since this is the only new information received on 17 July about ABC and DEF, this proves
that the stock market is inefficient.” Is the journalist’s statement is correct?
9. In February 2022 a messenger arrived in Lower Fantasia and gave the correct prices of all stocks
that traded in the country. A journalist argued that the accurate price disclosure eliminates all
risk in investing in stocks; hence, their returns should be equal to the risk-free rate. Assume that
the messenger did not know the future, but “only” the average future FCFs and the appropriate
discount rate. Is the journalist right in his assessment? Discuss.
10. The chief executive officer (CEO) of Monkey Business Corp. (MBC) and his nephew were arrested
after it was found that the nephew bought $1,000,000 worth of MBC stocks shortly before the
price of the stocks jumped by 45%. Assuming that the allegations are true, what type of market
efficiency does the above contradict?
11. The workers of a large factory in Michigan received information according to which the price of
the Monkey Business Corp. stock is about to rise by more than 50%. According to the rumors, the
source of the information is the nephew (not the one that was arrested) of the CEO. Your sister
is working in that factory and advised you to buy MBC stocks. Would you follow her advice?
Explain.
12. Two years after the MBC Company went public, it was found that the company tampered with the
accounting reports. As a result of this finding, the price of the company’s stocks fell by 80% the
next day. Does the sharp fall in price violate market efficiency?
13. One of the puzzling phenomena of financial markets is the “weekend effect.” According to this
phenomena, stock returns on Monday are lower than every other day of the week. The following
graph presents the returns of the stock market dependent on the day of the week.
a. Do the results contradict market efficiency?
b. Do you have a reasonable explanation as to why the anomaly persists and does not disappear
as a result of the arbitrageurs’ actions?

Weekend Effect: Average Stock Returns on

Specific Days of the Week

0.15%

0.10%

0.05%
return

0.00%
Monday Tuesday Wednesday Thursday Friday
-0.05%

-0.10%

-0.15%

14. “Beat the Market” (BTM) is an open mutual fund. The fund’s portfolio consists of 10,000 Yahoo!,
Inc. stocks traded for $36.14, 15,000 stocks of Google, Inc. traded for $191.94, and 20,000 stocks
of General Electric traded for $33.95. There are currently 32,000 BTM shares.
448 PART THREE VALUING SECURITIES

a. If the price of a BTM share is $122.48 does the price additivity rule hold?
b. The following day the price of Google drops by 5%, the price of General Electric drops by 2%,
and the price of Yahoo! remains the same. The price of BTM was $117. Does the price additiv-
ity rule hold?
15. The DEF company recruited one of the best CEOs in the country to its service in an unanticipated
move. However, the price of the DEF stocks fell once the company announced the change in man-
agement. Assume that the new CEO was the only new information about the company (and that
he is indeed better than the old CEO). Does the fall of stock prices indicate market inefficiency?
16. Assume that markets are efficient. Do you expect that the average return of mutual funds will be
higher, lower, or equal to the market return?
17. “Due to the unexpected positive earnings report the price of GLZ shares rose on each trading day
in the past week.”
a. Explain why this sentence contradicts market efficiency
b. What type of market efficiency does the sentence contradict? Try to distinguish between two
possibilities.
c. What should have been the market response if market efficiency holds?
18. In country A short-selling is allowed, whereas in country B it is illegal. If all other things are
equal where do you anticipate more frequent mispricing? Explain.
19. In Upper Fantasia a well-known professor showed that during the past 50 years stocks whose
prices rose for 3 consecutive days will tend to go down on the fourth day. Assuming that the pro-
fessor’s finding is true, what do you expect will happen after the publication of this result?
20. The “new issue puzzle” is a phenomenon according to which the returns from investing in fi rms
that issue stocks is lower than other stocks 5 years after the date of the issue. Ritter (who origi-
nally reported the phenomenon) argues that it is because investors are too optimistic about the
performance of issuing stocks.
a. Is Ritter’s explanation consistent with market efficiency?
b. Can you think about an explanation that is consistent with market efficiency that will explain
the new issue puzzle?
21. An entrepreneur is marketing new software that estimates the prices of stocks according to a new
model.
a. Do you think that brokerage houses should buy the new software?
b. What would you advise the entrepreneur to do with his software?
22. One pound of apples is sold for $2.50 in Asheville and for $4.20 in Alaska. Does this fact violate
the one-price rule?
23. Recent research in Lower Fantasia found that companies whose stocks register a large increase in
prices in a given quarter tend to have an increase in profits after 6 months. Does this fact contra-
dict market efficiency?
24. The same research conducted in Upper Fantasia found that stocks that have high increase in their
profits tend to have low returns in the year after the announcement date. Try to give a reasonable
explanation for this finding; does your explanation contradict market efficiency?
25. One of the puzzling results of recent academic literature is that stocks with high β do not earn
higher returns than stocks with low β. Does this fact contradict market efficiency?
26. A recent finding shows that low-rated bonds have earned lower returns in the past 60 years than
government bonds. Does this fact contradict market efficiency?
CHAP TER

15 Bond Valuation

CHAPTER CONTENTS
Overview 449
15.1. Computing the Y TM of a Bond 455
15.2. U.S. Treasury Bills 461
15.3. U.S. Treasury Bonds and Notes 463
15.4. A Corporate Bond Example: Giant Industries 465
15.5. Callable Bonds 470
15.6. Preferred Stock 471
15.7. Deriving the Yield Curve from Zero-Coupon Bonds 473
Conclusion 476
Exercises 476

Overview
When businesses, governments, or municipalities borrow money, they issue bonds. The fun-
damental characteristic that distinguishes a bond from other kinds of securities such as stocks,
preferred stock, and options is that the borrower is very specific about the promised payments
on the bond. All bonds specify the precise dates and the amounts that the issuer/borrower
promises to repay the bond’s purchaser/lender.

449
450 PART THREE VALUING SECURITIES

In this chapter we apply the discounting techniques discussed in Chapters 1 and 2 to value
bonds. In the remainder of this overview to Chapter 15 we’ll show you some examples of vari-
ous kinds of bonds and acquaint you with some basic bond terminology.

The XYZ Corp. Bond

To get the bond terminology straight, Figure 15.1 gives some details for an imaginary bond
offering by XYZ Corporation, a highly reliable borrower.

XYZ CORPORATION

Offer to sell $10,000,000 of bonds

Date of sale: December 15, 2009

Offer price: $1,000 (bonds sold at par value)
Face value: $1,000
Bond maturity date: December 15, 2016
Coupon rate: 7%, paid annually on December 15 (meaning coupon payments of $70 on
December 15 of 2010, 2011, . . . , 2016)
Principal repayment: December 15, 2016
Tricky details, covenants and other conditions: See boilerplate on other side

FIGURE 15.1 On December 15, 2009, XYZ Corp. sold $10 million of bonds paying a 7% coupon. The italicized
terms are explained in the text.

The terminology (underlined) is as follows:

• The XYZ bond has a face value and a coupon rate. The $10 million of bonds issued by
XYZ Corp. are issued as individual bonds of $1,000 face value; each such bond pays a
coupon rate of 7%. The periodic interest payments are based on the product of the cou-
pon rate and the face value. The XYZ bonds pay interest only once a year; because the
coupon rate is 7% and the face value is $1,000, this means that the coupon payments are
$70 annually. (As you will see in Section 15.1, most corporate bonds pay interest semi-
annually; if this were true for the XYZ bonds, they would pay $35 on December 15 and
June 15 of each year.)
• The XYZ bond has a principal repayment on the last day of the bond’s maturity (the
bond’s maturity date). On this day, December 15, 2016, a $1,000 face-value XYZ bond
will pay its holder a final repayment of principal of $1,000 in addition to the interest pay-
ment of $70 due for 2019.
 CHAPTER 15 Bond Valuation 451

• The bond’s offer price is the initial price at which it is sold to the public. The XYZ
bonds are offered at par, meaning that the initial sale price is equal to the bond’s face
value.
• Tricky details, covenants, and other conditions: XYZ promises to make a set of con-
tractual payments in exchange for the loan of $1,000 made to it by the purchaser. Often
the bond-issuing company agrees to abide by certain restrictions on its behavior; these
restrictions, termed bond covenants, might specify that XYZ will pay no dividends until
the bond issue is redeemed or perhaps that it will refrain from certain other actions.1 The
“boilerplate” in which all these conditions are specified also specifies what happens if
XYZ defaults, that is, if it fails to keep its promises. The boilerplate also specifies what
constitutes default.2

Some Other Corporate Bonds

Figure 15.2 shows you some of the corporate bonds issued in the week of 21 July 2003. By look-
ing at the table, you can learn the following facts about bonds:
• Not all the bonds are issued at par. The GMAC bonds, for example, are issued at $107.25
for every $100 of face value. In Section 15.1 we discuss the effect of issuance not at par
on the analysis of the bond.
• Bonds differ in their ratings. Bonds are rated according the credit worthiness of their
issuers. Figure 15.3 shows you the ratings used by the two primary bond-rating agencies,
Moody’s and Standard and Poors. The ratings are based on the agency’s estimation of the
issuing company’s ability to pay off the bonds and play an important role in determin-
ing the interest rate that the company pays on its bonds. The “investment grade” bonds
in the top half of Figure 15.2 are issued by companies whose ability to repay the funds
borrowed is highly regarded by the rating agencies. The “high yield bonds” (often called
“junk bonds”) in the bottom half of the table are issued by companies whose credit rat-
ings are lower.
• Some bonds are callable. A bond is callable if the issuer has the right to refund the bond’s
principal before maturity. For example: The Bank of America bonds in Figure 15.2
promise to pay 6.85% interest annually until 15 May 2026. However, these bonds are
callable after 15 May 2006: After this date, Bank of America can refund the bonds by
forcing bondholders to return their bonds to the company for their face value. We discuss
callable bonds in Section 15.5.
• The price, coupon, and maturity of the bond affect the internal rate of return (IRR) of the
bond holder. In bond markets the jargon for IRR is yield to maturity (YTM). If the bond
is callable, we can also calculate a yield to call (YTC). These concepts are discussed in
Sections 15.1 and 15.5.

1
A detailed example of covenants is given in Section 15.6 where we discuss the Giant Industries bonds.
2
This is not as trivial as it might sound. If a coupon payment is late by 2 days, does this violation of the
contract automatically mean bankruptcy? Suppose one of the bond covenants is violated? Do bond holders
have recourse (can they do something if the covenants are violated)?
452 PART THREE VALUING SECURITIES

FIGURE 15.2 A partial list of corporate bonds issued in the third week of July 2003.
 CHAPTER 15 Bond Valuation 453

Long-Term Senior Debt Ratings

Investment-Grade Ratings Speculative-Grade Ratings
S&P Moody’s Interpretation S&P Moody’s Interpretation

AAA Aaa Highest quality BB+ Ba1 Likely to fulfill

BB Ba2 obligations;
BB- Ba3 ongoing
uncertainty
AA+ Aa1 High quality B+ B1 High-risk
AA Aa2 B B2 obligations
AA- AA3 B- B3
A+ A1 Strong payment CCC+ Caa Current
A A2 capacity CCC vulnerability to
A- A3 CCC- default
BBB+ Baa1 Adequate C Ca In bankruptcy
BBB Baa2 payment D D or default or
BBB- Baa3 capacity with other
marked
shortcomings

FIGURE 15.3 Standard and Poors (S&P) and Moody bond-rating classifications.

U.S. Government Debt

The market for U.S. government debt is without question the largest and most important bond
market in the world. In June 2009, the U.S. Treasury had $11.4 trillion in outstanding bonds
(see Figure 15.4). Almost every week the U.S. Treasury sells stupendous amounts of debt to the
public (see Figure 15.5 for a fairly standard weekly announcement, in which the government
sells $34 billion of short-term debt).
The U.S. Treasury classifies its debt into three main categories: bills, notes, and bonds.
• Treasury bills are short-term bonds sold by the government. Treasury bills have no explicit inter-
est rate; they are sold at a discount. For example, a 1-year Treasury bill with a $100 face value
might be sold for $90. The Treasury bill has no explicit interest rate: The purchaser of this bill
pays $90 today and gets back $100 in 1 year. We discuss the pricing of T-bills in Section 15.2.
• The U.S. Treasury uses the word notes to describe coupon bonds that have maturities up
to 10 years. It uses the word bonds to describe coupon bonds that have greater maturities.
Because there is no analytical difference between U.S. Treasury notes and bonds—both refer
to bonds that have coupon payments—we will analyze them together in Section 15.3.

UNITED STATES GOVERNMENT DEBT

Debt Held by the Intragovernmental Total Public Debt
Date
Public Holdings Outstanding
31-Dec-01 3,394,398,958,214 2,549,039,605,223 5,943,438,563,436
31-Dec-02 3,647,939,770,384 2,757,767,686,464 6,405,707,456,848
31-Dec-03 4,044,243,829,240 2,953,720,418,579 6,997,964,247,818
31-Dec-04 4,408,389,327,643 3,187,753,474,781 7,596,142,802,424
30-Dec-05 4,714,821,211,003 3,455,603,330,310 8,170,424,541,314
29-Dec-06 4,901,046,516,368 3,779,177,863,718 8,680,224,380,086
31-Dec-07 5,136,302,727,073 4,092,869,932,146 9,229,172,659,218
31-Dec-08 6,369,318,869,477 4,330,485,995,136 10,699,804,864,612
1-Jun-09 7,097,861,677,672 4,282,104,511,903 11,379,966,189,575

FIGURE 15.4 The debt of the U.S. government. On 1 June 2009, the U.S. government had $7.1 trillion of debt
outstanding in the form of bonds owned by the public. A further $4.3 trillion dollars of debt comprised debts of
one government agency to another. The total government debt was $11.4 trillion.
SOURCE: http://www.treasurydirect.gov/NP/BPDLogin?application=np.
454 PART THREE VALUING SECURITIES

FIGURE 15.5 On March 6, 2003, the U.S. Treasury announced the sale of $34 billion of Treasury bills. Similar sales
are generally held weekly. Note that $27 billion of the proceeds will go toward refunding existing debt.

What Do We Do in This Chapter?

In this chapter you will learn to analyze a bond based on its yield to maturity (YTM). The YTM
is a concept much like the internal rate of return (IRR) discussed first in Chapters 2 and 3. You
will learn to analyze the different kinds of bonds: Treasury bills, Treasury bonds, corporate
bonds, and callable bonds. We end the chapter with a brief discussion of preferred stock, a secu-
rity that—despite its name—is very much like a bond.
Finance Concepts
• Basic definitions, example of bond value, and YTM
• U.S. Treasury markets: discussion of the types of bonds and yield conventions
• Discussion of T-bills
• Treasury bonds
• Strips
• The U.S. Treasury yield curve
• Corporate bond markets: Example of Giant Industries
• Callable bonds
• Preferred stock

Excel Functions and Concepts

• IRR
• XIRR
• Rate
• Yield
 CHAPTER 15 Bond Valuation 455

15.1. Computing the Yield To Maturity (YTM) of a Bond

The most common tool for the analysis of bonds is the YTM. YTM of the bond is the IRR of
the bond’s cash flows. Suppose we observe the bond’s market price P and we know its stream of
future promised payments C1, C2, . . . , CN. Then the YTM is defined as the internal rate of return
(IRR) of the bond price and its future payments, which is the rate of return that sets the present
value of the bond’s future promised payments equal to its current price:

C1 C2 C3 CN
P= + 2
+ 3
+…+ N
(1+YTM ) (1+YTM ) (1+YTM ) (1+YTM )

In this section we illustrate how to compute the YTM. In addition to the IRR function that
you already know, the Excel XIRR and Yield functions enable you to compute the YTM in more
complicated cases. We use the XYZ Corp. bond from the previous section as our example.

Back to the XYZ Bond

Suppose that it’s the morning of 15 December 2009, and you have been asked to value the XYZ
bond illustrated in the overview to this chapter (page 450). Using Excel’s IRR function, you
determine that the YTM of the bond is 7.00%.

A B C
1 YIELD TO MATURITY
2 Market price of bond 1,000.00
3
Bond cash
Date
4 flow
5 15-Dec-09 -1,000.00
6 15-Dec-10 70.00
7 15-Dec-11 70.00
8 15-Dec-12 70.00
9 15-Dec-13 70.00
10 15-Dec-14 70.00
11 15-Dec-15 70.00
12 15-Dec-16 1,070.00
13
14 YTM of bond 7.00% <-- =IRR(B5:B12)

Are the XYZ bonds a good buy? This depends on whether the market interest rate on
equivalently risky bonds is bigger or smaller than 7%. If the market is paying more than 7%
for bonds of companies that—in terms of risk—are like XYZ Corp., then the XYZ bonds
are not a good buy. On the other hand, if the market is paying less than 7%, they are a good
buy.3

3
Having read Chapter 14 on efficient markets, you naturally suspect that the market price pretty much
reflects the risk-adjusted return on the XYZ bonds.
456 PART THREE VALUING SECURITIES

Just for the sake of argument, suppose that on 15 December 2009, the market interest rate
for bonds like the XYZ Corp. bond is 6.5%. You can use the NPV of the future payments on the
bond to determine how much you should be willing to pay for them.

A B C D E F G
1 VALUING THE XYZ CORPORATION BONDS
2 Market interest rate 6.50%
3
Bond Market Bond
4 Year cash flow interest rate value
5 1 70 0.00% 1,490.00 <-- =NPV(E5,$B$5:$B$11)
6 2 70 1.00% 1,403.69 <-- =NPV(E6,$B$5:$B$11)
7 3 70 2.00% 1,323.60 <-- =NPV(E7,$B$5:$B$11)
8 4 70 3.00% 1,249.21 <-- =NPV(E8,$B$5:$B$11)
9 5 70 4.00% 1,180.06
10 6 70 5.00% 1,115.73
11 7 1,070 6.00% 1,055.82
12 7.00% 1,000.00
13 Value of the bond 1,027.42 <-- =NPV(B2,B5:B11) 8.00% 947.94
14 9.00% 899.34
15 10.00% 853.95
16 XYZ Bond Value 11.00% 811.51
17 1,450 12.00% 771.81
18 1,350 13.00% 734.64
19 14.00% 699.82
1,250
Bond value

20
21 1,150
22 1,050
23 950
24 850
25 750
26 650
27 0% 2% 4% 5% 7% 9% 11% 12% 14%
28 Market interest rate
29
30

If the market values the bond using the 6.5% interest rate, then it would be worth $1,030.44.
If you could buy the bond for $1,000, you should do so. Making a table (cells E5:F19) in Excel
shows that the bond is worth more than $1,000 if the market interest rate is less than 7% and vice
versa.
As you can see, the basics of bond analysis using the YTM are very similar to standard IRR
analysis and quite simple. However, for bonds there are three factors that sometimes complicate
the pricing calculations. In the rest of this section we discuss these factors.

Complicating Factor 1: Uneven Spacing of Bond Payments

The calculation of both the PV of the bond’s future payments and the YTM can be compli-
cated by the fact that the payments are not evenly spaced. Suppose, for example, that you buy
the XYZ bond on 15 May 2010 and that its market price on that date is $1,050. To compute
the YTM of the bond, we have to compute the IRR of its payments. But the problem is that the
payments are not evenly spaced. As you can see in Figure 15.6, the time between the purchase
date of the bond and the first coupon payment is 214 days, whereas all the other payments are
365 or 366 days.
 CHAPTER 15 Bond Valuation 457

Payment pattern of XYZ bond purchased on 15 May 2010 and held to maturity

15-May-10 15-Dec-10 15-Dec-11 15-Dec-12 15-Dec-13 15-Dec-14 15-Dec-15 15-Dec-16

-1,050 70 70 70 70 70 70 1,070

214 days 365 days 366 days 365 days 365 days 365 days 366 days
leap year leap year

FIGURE 15.6 If you buy the XYZ bond on 15 May 2010, the first coupon payment will be received in
214 days. Subsequent coupon payments will be received with spacing of 1 year. Excel’s XIRR func-
tion computes the YTM for the bond.

Excel’s IRR function will not correctly compute the YTM of this bond—IRR assumes
that all the payments are spaced at equal intervals, whereas in our example the first interval
(214 days) is very different from the subsequent payment intervals. Fortunately Excel has a
function called XIRR that correctly computes the IRR for uneven spacing of payments. The
use of this function is discussed in a separate Excel box below.4 Here is its implementation for
our problem.

A B C
YIELD TO MATURITY
1 For uneven date spacing
2 Market price of bond 1,050.00
3
Bond cash
4 Date flow
5 15-May-01 -1,050.00
6 15-Dec-01 70.00
7 15-Dec-02 70.00
8 15-Dec-03 70.00
9 15-Dec-04 70.00
10 15-Dec-05 70.00
11 15-Dec-06 70.00
12 15-Dec-07 1,070.00
13
14 YTM of bond 6.58% <-- =XIRR(B5:B12,A5:A12)

As you can see, when you buy the bond on 15 May 2010, the YTM is 6.58% annually.

4
For more information on dates and date functions in Excel, see Chapter 29.
458 PART THREE VALUING SECURITIES

EXCEL NOTES: THE XIRR FUNCTION

To use XIRR, you have to put in the dates on which the payments are received. In the previous
example, cells A5:A12 contain these dates. Once you’ve got the dates in, you can use XIRR as
illustrated below (the XIRR function computes the effective annual YTM).

You may not see XIRR in your list of Excel functions. In this case,

• Go to the Excel 2007 office button and click Excel options and then Add-Ins.
• In the drop-down box at the bottom of the Add-Ins page indicate

and click Go.

• Click on the Analysis ToolPak box.
 CHAPTER 15 Bond Valuation 459

Complicating Factor 2: Semiannual Interest

Corporate and government bonds often pay interest twice a year rather than annually. We are
thus faced with a problem of annualizing the interest rate on the bond. This corresponds to the
concept of effective annual interest rate (EAIR) discussed in Chapter 3.
Here is an example. Suppose that the ABC Corp. issues a bond at the same time as XYZ
Corp. Like the XYZ bond, ABC’s bond pays a 7% coupon on its face value of $1,000, is issued
on 15 December 2009, and matures on 15 December 2016. The only difference between the two
bonds is that ABC’s interest payment is semiannual: Instead of paying $70 once a year, the ABC
bond pays $35 twice a year, on 15 June and 15 December.
We can use either IRR or XIRR to compute the YTM of the ABC bond.

A B C

YTM WITH SEMIANNUAL COUPON PAYMENTS

1
2 Market price of bond 1000.00
3
ABC bond
Date
4 cash flow
5 15-Dec-09 -1,000.00 <-- =-B2
6 15-Jun-10 35.00
7 15-Dec-10 35.00
8 15-Jun-11 35.00
9 15-Dec-11 35.00
10 15-Jun-12 35.00
11 15-Dec-12 35.00
12 15-Jun-13 35.00
13 15-Dec-13 35.00
14 15-Jun-14 35.00
15 15-Dec-14 35.00
16 15-Jun-15 35.00
17 15-Dec-15 35.00
18 15-Jun-16 35.00
19 15-Dec-16 1,035.00
20
21 Semiannual IRR 3.50% <-- =IRR(B5:B19)
Annualized IRR
22 This is the YTM! 7.12% <-- =(1+B21)^2-1
23
YTM using
24 XIRR 7.12% <-- =XIRR(B5:B19,A5:A19)

In cell B21 we use IRR to calculate the internal rate of return of the bond price and its payments.
Because the basic period is a half year, the annualized IRR is (1 + 3.50%)2 − 1 = 7.12
(cell B22). In cell B24 we use the XIRR function to compute the annualized YTM directly.

Complicating Factor 3: Accrued Interest

In U.S. bond markets the “price” quoted for a bond is usually not the amount you will be asked
to pay for the bond because it doesn’t include the interest that has accrued on the bond. Sound
confusing? Here’s an example.
Suppose you’re going to buy the XYZ bond on 3 April 2010. You call a bond dealer, who
quotes you a price of $1,050 for the bond. To this quoted price is added the bond’s accrued
interest, the proportional part of the bond’s annual coupon payment (see Figure 15.7).
460 PART THREE VALUING SECURITIES

A B C D E
1 ACCRUED INTEREST AND YTM COMPUTATIONS
2 Bond purchase date 3-Apr-01
3 Previous coupon date 15-Dec-00 Number of days since last coupon 109 <-- =B2-B3
4 Next coupon date 15-Dec-01 Number of days between coupons 365 <-- =B4-B3
5 Coupon payment over the period 70.00
6
7 Quoted bond price 1050.00
8 Accrued interest 20.90 <-- =B5*D3/D4
9 Actual bond price paid 1070.90 <-- =B7+B8
10
Bond
11 Year cash flow
12 3-Apr-01 -1,070.90
13 15-Dec-01 70.00
14 15-Dec-02 70.00
15 15-Dec-03 70.00
16 15-Dec-04 70.00
17 15-Dec-05 70.00
18 15-Dec-06 70.00
19 15-Dec-07 1,070.00
20
21 YTM of bond, using XIRR 6.06% <-- =XIRR(B12:B19,A12:A19)
22 YTM of bond, using Yield 6.06% <-- =YIELD(A12,A19,7%,105,100,1,3)

In the spreadsheet above, the accrued interest is $20.90 (cell B8). This is computed as
109/365 times the annual bond coupon of $70. The actual price paid for the bond is $1,070.90
(cell B9), and using XIRR we can compute the bond’s YTM as 6.06% (cell B21).
In cell B22 we illustrate Yield, yet another Excel function that computes the YTM.
This function is explained in the Excel box on the next page. Yield is somewhat more com-
plicated to use than XIRR, but its advantage is that it does the accrued interest calculation
automatically.

COMPUTING THE
ACCRUED INTEREST
15 Dec 2009 3 Apr 2010 15 Dec 2011
last bond next
coupon purchase coupon
date date date

109 days

365 days

$70 Coupon
for this period

109
Accrued interest * 70 = 20.90
365

FIGURE 15.7 Computing the accrued interest. The accrued interest is jargon for the unpaid part of the bond coupon
since the last interest payment. In U.S. bond markets, the accrued interest is added to the quoted bond price to com-
pute the amount actually paid for the bond. In most European bond markets, there is no separate accrued interest
calculation and the quoted bond price is the actual price paid for the bond.
 CHAPTER 15 Bond Valuation 461

EXCEL NOTES: THE YIELD FUNCTION

The Yield function contains seven cells to fill (Settlement, Maturity, Rate, Pr, Redemption,
Frequency, and Basis). Excel’s dialog box for this function can’t accommodate all the argu-
ments on one screen, so it includes a “slider” so you can navigate between the arguments. The
two screens above show all the arguments.

The yield function used in B22.

• The Settlement is the date that the bond is purchased (cell A12). Note that Excel trans-
lates this date to 36984; to understand this translation, refer to Chapter 29.
• Maturity is the maturity date of the bond.
• Rate is the annual coupon rate on the bond.
• Pr is the price per $100 face value. In our example a $1,000 face-value ABC bond is
selling for $1,050; this is $105 for each $100 of face value.
• Redemption is the redemption value per $100 face value.
• Frequency is the number of coupon payments per year.
• Basis is the number of days in a year (sounds stupid, but there are different conven-
tions). The answer of “3” used here tells Excel to use the actual number of days

15.2. U.S. Treasury Bills

U.S. government bonds are variously defined as Treasury bills, Treasury notes, and Treasury
bonds. In this section we analyze U.S. Treasury bills, and in the next section we examine
U.S. Treasury bonds and notes.5
Treasury bills are short-term securities sold by the U.S. Treasury. T-bills mature in 1 year
or less from their issue date. They have no coupon payments. Instead, you pay less than the face
value and get the face value at maturity. Here’s an example: Suppose you purchase a 26-week
T-bill with face value $10,000 for $9,750. In 26 weeks (182 days) you will get $10,000. The fol-
lowing spreadsheet illustrates two methods for computing the YTM of the T-bill. (The discus-
sion of these two methods follows the spreadsheet.) Remember that the YTM is nothing more

5
There’s a very good Web site operated by the U.S. government that explains more about Treasury securi-
ties: http://www.treasurydirect.gov/instit/research/faqs/faqs_basics.htm.
462 PART THREE VALUING SECURITIES

than the annualized IRR; thus these calculations are very reminiscent of our discussion of the
effective annual interest rate (EAIR) in Chapter 3.

A B C
COMPUTING THE YIELD TO MATURITY (YTM)
1 ON TREASURY BILLS
2 Purchase price 9,750.00
3 Face value 10,000.00
4 Time to maturity (days) 182 <-- =26*7
5 Time to maturity (years) 0.49863 <-- =B4/365
6
7 Method 1: Compound the daily return
8 Daily interest rate 0.0139% <-- =(B3/B2)^(1/B4)-1
9 YTM--the annualized rate 5.2086% <-- =(1+B8)^365-1
10
11 Method 2: Calculate the continuously compounded return
12 Continuously compounded 5.0775% <-- =LN(B3/B2)*(1/B5)
13
14 Future value in one year using each method
15 Method 1 10,257.84 <-- =B2*(1+B9)
16 Method 2 10,257.84 <-- =B2*EXP(B12)

Method 1: YTM of the Treasury Bill Is the Compounded Daily Return

One way to calculate the T-bill YTM is to compound the daily interest rate paid by the T-bill. To
182
do this, we first find the daily interest rate paid by the T-bill: 10,000 = 9,750 * (1 + rdaily ) .
1/182
⎛ 10,000 ⎞
Solving this equation gives 1 + rdaily = ⎜ ⎟ , which solves to give rdaily = 0.0139% .
⎝ 9,750 ⎠
Compounding this rate to give an annual rate shows that the T-bill pays 5.2086% annually:
365
(1+0.0139% ) − 1 = 5.2086% .

Method 2: YTM of the Treasury Bill Is the Continuously

Compounded Return
This is the method preferred by most finance academics and by many finance professionals.6
We assume that the purchase price grows at continuously compound rate r:

10,000 = 9,750 * e(182 / 365)r = 9,750 * e0.49863r

10,000
⇒ e0.49863r =
9,750
⎛ 10,000 ⎞
ln ⎜
9,750 ⎟⎠
⇒r = ⎝ = 5.0775%
0.49863

Which Method Is Correct?

Both methods are correct! We know this is confusing, but then so are many other things in life.
The principle is that any method that gives the same future value using the annualized interest
is a valid periodic interest rate. In the spreadsheet cells B14:B15 you can see that both methods
indeed give the same FV.
6
Continuous compounding and discounting was explained in Section 2.6. If you’re not comfortable with
continuous discounting and compounding, just skip Method 2
 CHAPTER 15 Bond Valuation 463

15.3. U.S. Treasury Bonds and Notes

Treasury bonds and notes have a coupon rate and a fixed maturity date at which the bond’s
principal is repaid.7 Here’s an example: On 15 August 2008 the United States Treasury issued a
10-year, 4% Treasury note.8 The notes were sold at a price of 99.389034, so that if you bought
$1,000 face value of this security at issue you would have paid $993.89034. You would expect to
be paid a $20 coupon every half year (15 February 2009, 15 August 2009, 15 February 2010, . . . )
until, on the bond’s maturity date of 15 August 2018, you would be paid $1,020 (the repayment
of the bond’s principal plus the last half year’s coupon payment).
If you bought the bond at issue and intended to hold it until maturity, your anticipated cash
flows would be as follows.
Cell B32 gives the semiannual IRR for the bond, 2.0375%. When we annualize this semi-
annual IRR, we find the yield to maturity (YTM) (cell B33).

A B C
UNITED STATES TREASURY BOND, 4.075%
MATURING 15 AUGUST 2018
1 Bought at issue date
2 Face value of bonds bought 1,000.00
3 Price 993.89
4 Coupon rate 4.000%
5 Issue date 15-Aug-08
6 Maturity date 15-Aug-18
7
8 Cash flows to purchaser at bond issue
9 Date Cash flow
10 15-Aug-08 -993.89 <-- =-B3
11 15-Feb-09 20.00 <-- =$B$4*$B$2/2
12 15-Aug-09 20.00 <-- =$B$4*$B$2/2
13 15-Feb-10 20.00
14 15-Aug-10 20.00
15 15-Feb-11 20.00
16 15-Aug-11 20.00
17 15-Feb-12 20.00
18 15-Aug-12 20.00
19 15-Feb-13 20.00
20 15-Aug-13 20.00
21 15-Feb-14 20.00
22 15-Aug-14 20.00
23 15-Feb-15 20.00
24 15-Aug-15 20.00
25 15-Feb-16 20.00
26 15-Aug-16 20.00
27 15-Feb-17 20.00
28 15-Aug-17 20.00
29 15-Feb-18 20.00
30 15-Aug-18 1,020.00 <-- =$B$4*$B$2/2+B2
31
32 IRR (semiannual interest) 2.0375% <-- =IRR(B10:B30)
33 Annualizing the semiannual IRR 4.1165% <-- =(1+B32)^2-1
34 YTM using XIRR 4.1139% <-- =XIRR(B10:B30,A10:A30)

7
The nomenclature for interest-paying Treasury securities distinguishes between “Treasury Notes” and
“Treasury Bonds.” Notes have an initial maturity of 10 years or less, whereas Bonds have an initial matu-
rity longer than 10 years. Because there is no analytical difference between the two, we shall refer to them
both as “bonds” (with a lowercase “b”).
8
The notes, issued on 15 December 2008, mature on 15 November 20018, so that the actual maturity is
9 years, 11 months.
464 PART THREE VALUING SECURITIES

2 2
YTM of T -bond = (1 + semi-annual IRR ) − 1 = (1 + 2.0375% ) − 1 = 4.1165%

We can also compute the YTM on the T-bond directly using XIRR (cell B33).9

Time Moves On—Purchasing the 4% T-Note on 16 December 2008

Suppose you purchased $1,000 face value of the bond on 16 December 2008. In this case you
would have paid $1,072.98 for the bond (this price, as shown in the Excel spreadsheet below,
includes the accrued interest). Had you intended to hold the bond to maturity, you would antic-
ipate getting the following:
• $20 on 15 February 2009, 15 August 2009, 15 February 2010, . . . , 15 February 2018.
• $1,020 on 15 August 2018.
In the spreadsheet that follows we calculate the YTM of the bond using three calculations
(cells B31:B33):
Cell B33 shows that the YTM computed with the XIRR function is 3.301%. Cell B34
shows that Excel’s Yield function computes the YTM as 3.275%. This is different from cell B31,
because Yield follows the conventions of the U.S. bond markets in computing the semiannual
A B C D E F

UNITED STATES TREASURY BOND, 6%, MATURING 15 AUGUST 2009

1 Bought on 16 December 2008
2 Face value of bonds bought 1,000.00
3 Coupon rate 4.00%
4 Today's date 16-Dec-08
5 Market price 1,059.61 Last coupon date 15-Aug-08
6 Accrued interest 13.37 <-- =E12 Next coupon date 15-Feb-09
7
8 Actual price paid 1,072.98 <-- =B5+B6 Days since last coupon 123 <-- =E4-E5
9 Days between coupons 184 <-- =E6-E5
10 Date Cash flow
11 16-Dec-08 -1,072.98 <-- =-B8 Semiannual coupon 20 <-- =B3/2*B2
12 15-Feb-09 20.00 <-- =$B$3*$B$2/2 Accrued interest 13.37 <-- =E8/E9*E11
13 15-Aug-09 20.00
14 15-Feb-10 20.00
15 15-Aug-10 20.00
16 15-Feb-11 20.00
17 15-Aug-11 20.00
18 15-Feb-12 20.00
19 15-Aug-12 20.00
20 15-Feb-13 20.00
21 15-Aug-13 20.00
22 15-Feb-14 20.00
23 15-Aug-14 20.00
24 15-Feb-15 20.00
25 15-Aug-15 20.00
26 15-Feb-16 20.00
27 15-Aug-16 20.00
28 15-Feb-17 20.00
29 15-Aug-17 20.00
30 15-Feb-18 20.00
31 15-Aug-18 1,020.00
32
33 XIRR (annualized IRR) 3.301% <-- =XIRR(B11:B31,A11:A31)
34 Excel's Yield function 3.275% <-- =YIELD(A11,A31,B3,B5/10,100,2,3)
35 Excel's Yield annualized 3.302% <-- =(1+B34/2)^2-1

yield doubled. Cell B35 translates the Yield result to a true annualized interest rate:

9
XIRR gives a slightly different answer than the calculation in cell B32 because it takes account of the
actual days between each payment. See Chapter 26 for more details.
 CHAPTER 15 Bond Valuation 465

2 2
⎛ Excel ' s Yield from cell B34 ⎞ ⎛ 3.275% ⎞
Cell B35: ⎜ 1 + ⎟ − 1 = ⎜ 1+ − 1 = 3.302 .
⎝ 2 ⎠ ⎝ 2 ⎟⎠

The very small difference between cells B35 and B33 is attributable to the fact that XIRR
is based on the daily interest rate (see Footnote 9).

FIGURE 15.8 Much information about bonds is available on http://bonds.yahoo.com/. The Treasury Note reported
above pays $2.50 interest on 15 August and 15 February until the 15 August 2011 maturity date. The price of the bond
of $106.61 does not include accrued interest. The current yield is the annual bond coupon divided by the bond price:
5 /106.61 = 4.689% .

15.4. A Corporate Bond Example: Giant Industries

In this section we present a case example of a corporate bond. Giant Industries (stock symbol
GI) is a petroleum refiner and marketer in the American Southwest. The firm’s shares are listed
on the New York Stock Exchange. Here’s what the company had to say about the bonds in its
1999 annual report.
466 PART THREE VALUING SECURITIES

GIANT INDUSTRIES

The following paragraph (mildly edited) appears in GI’s 1999 annual report. The “Lexicon”
explains some of the terminology.
The Company’s capital structure includes $150,000,000 of 9% senior subordinated notes
due 2007 (the “9% Notes”) and $100,000,000 of 9 3/4% senior subordinated notes due 2003
(the “9 3/4% Notes,” and collectively with the 9% Notes, the “Notes”). The Indentures support-
ing the Notes contain restrictive covenants that, among other things, restrict the ability of the
Company and its subsidiaries to create liens, to incur or guarantee debt, to pay dividends, to
repurchase shares of the Company’s common stock, to sell certain assets or subsidiary stock,
to engage in certain mergers, to engage in certain transactions with affiliates, or to alter the
Company’s current line of business. On December 31, 1999, the Company was in compliance
with the restrictive covenants relating to these Notes.
The Company had been precluded from making restricted payments from the third quarter
of 1998 until June 30, 1999, because it did not satisfy a financial ratio test contained in one of the
covenants relating to the 9 3/4% Notes. This included the payment of dividends and the repur-
chase of shares of the Company’s common stock. The terms of the Indenture also had restricted
the amount of money the Company could otherwise borrow during this period. The Company
is no longer subject to these restrictions, as the Company currently satisfies the requirements of
the covenant’s financial ratio test.

LEXICON:
Senior unsecured obligations: The debt in question has first claim on the company’s assets in
case of default. On the other hand, debt payment is not secured by a claim to a specific set of
the company’s assets (this would be the case if the company had borrowed money using one of
its refiners as security).
Indenture: The terms under which the bond is issued. In the GI bond case, this will be a sizable
document available from the company or its investment bankers.
Covenants: Restrictions on the company’s actions.
Preferred stock: Corporate stock whose holders are guaranteed payment of dividends and a
share of asset distribution before the holders of common stock. Preferred stock typically has a
guaranteed annual dividend. It may be cumulative preferred stock, in which case the company
has to make up any dividends missed.
Retirement of capital stock: The repurchase of stock (whether common or preferred) from
shareholders.
Transactions with affiliates: Purchases or sales between subsidiaries of the company.
Interest in arrears: Interest payments missed by the company.

FIGURE 15.9 How Giant Industries reported its 9% senior subordinated notes.

Summarizing:
• The face value of the bonds is $150 million. The bonds were issued 1 September 1997.
After deducting expenses, the company netted $146.8 million from the bond issue. The
bonds mature on 1 September 2007.
 CHAPTER 15 Bond Valuation 467

• The coupon rate on the bonds is 9%. This interest is paid semiannually. Thus the purchaser
9%
of $1,000 face value of bonds would get two payments per year of *1,000 = 45.00 .
2
What Did the Bonds Cost the Company?
We start by considering the effective annual interest rate (EAIR) of the bond issue to GI. We do
this by setting up a table of GI cash flows from the bonds.

A B C
GIANT INDUSTRIES 9% BONDS
ISSUER PERSPECTIVE
1 1 Sept. 1997 (issue date)
2 Principal amount ($ million) 150.0
3 Net received by Giant Industries 146.8
4 Coupon rate 9.00%
5 Maturity date 1-Sep-07
6 Issue date 1-Sep-97
7
Cash flow
8 Date to GI
9 1-Sep-97 146.8 <-- =B3
10 1-Mar-98 -6.75 <-- =-$B$4*$B$2/2
11 1-Sep-98 -6.75 <-- =-$B$4*$B$2/2
12 1-Mar-99 -6.75
13 1-Sep-99 -6.75
14 1-Mar-00 -6.75
15 1-Sep-00 -6.75
16 1-Mar-01 -6.75
17 1-Sep-01 -6.75
18 1-Mar-02 -6.75
19 1-Sep-02 -6.75
20 1-Mar-03 -6.75
21 1-Sep-03 -6.75
22 1-Mar-04 -6.75
23 1-Sep-04 -6.75
24 1-Mar-05 -6.75
25 1-Sep-05 -6.75
26 1-Mar-06 -6.75
27 1-Sep-06 -6.75
28 1-Mar-07 -6.75
29 1-Sep-07 -156.75 <-- =-$B$4*$B$2/2-B2
30
31 Semiannual IRR of payments 4.67% <-- =IRR(B9:B29)
32 YTM--annualized semiannual IRR 9.55% <-- =(1+B31)^2-1
33 YTM computed with XIRR 9.55% <-- =XIRR(B9:B29,A9:A29)

We’ve written down the semiannual cash flows for the whole bond issue. Excel’s IRR
function shows that the IRR (we could also call this the semiannual yield to maturity) of
the bonds is 4.67% (cell B31). The compounded effective annual cost of the bonds to GI is
given in cell B32: 9.55%. The YTM as computed by Excel’s XIRR function (cell B33) is the
same.

The Bonds from the Buyer’s Perspective

The previous subsection analyzed the GI bonds from the perspective of the issuing company
and showed that when we account for the issuing costs of $3.2 million, the bonds cost the com-
pany 9.55% annually. We now examine the yield from the perspective of a buyer of the bonds.
468 PART THREE VALUING SECURITIES

Suppose you had bought $1,000 face value of the bonds at issue.10 As the next spreadsheet shows
(cells B30:B32), you would have expected to earn an annualized interest rate of 9.20% on your
bonds if: (1) you anticipated holding them to maturity and (2) GI did not default on the bonds.
A B C
GIANT INDUSTRIES 9% BONDS
BUYER PERSPECTIVE
1 1 Sept. 1997 (issue date)
2 Face value of bonds bought 1,000.00
3 Coupon rate 9.00%
4 Maturity date 1-Sep-07
5 Issue date 1-Sep-97
6
7 Date Cash flow
8 1-Sep-97 -1,000.00 <-- =-B2
9 1-Mar-98 45.00 <-- =$B$3*$B$2/2
10 1-Sep-98 45.00 <-- =$B$3*$B$2/2
11 1-Mar-99 45.00
12 1-Sep-99 45.00
13 1-Mar-00 45.00
14 1-Sep-00 45.00
15 1-Mar-01 45.00
16 1-Sep-01 45.00
17 1-Mar-02 45.00
18 1-Sep-02 45.00
19 1-Mar-03 45.00
20 1-Sep-03 45.00
21 1-Mar-04 45.00
22 1-Sep-04 45.00
23 1-Mar-05 45.00
24 1-Sep-05 45.00
25 1-Mar-06 45.00
26 1-Sep-06 45.00
27 1-Mar-07 45.00
28 1-Sep-07 1,045.00 <-- =$B$3*$B$2/2
29
30 Semiannual IRR of payments 4.50% <-- =IRR(B8:B28)
31 YTM--annualized semiannual IRR 9.20% <-- =(1+B30)^2-1
32 YTM computed with XIRR 9.20% <-- =XIRR(B8:B28,A8:A28)

Note that there’s a spread between what the bonds cost the company (9.55% YTM) and
what they yield to the purchaser (9.20% YTM). The difference in the YTMs reflects the fact that
it cost Giant Industries $3.2 million to issue the bonds, so that its costs are higher than the yield
received by investors in the bonds.

Buying the Bonds on the Open Market after Issue

Thus far we have only considered the purchase of the bonds at issue. We now suppose that the
date is 7 December 2000, and that you purchase $1,000 (face value) of the bonds on the open
market. Looking on a Web site that reports bond prices, you see that the price of the bonds on
this date was $932.50; to this price, we have to add the accrued interest:
Actual price paid = 932.50 + accrued interest
days between Sept. 1, 2000 and Dec.7,2000
= 932.50 + * semi − annual bond coupon
days between Sept. 1, 2000 and March 1, 2001
97
= 932.50 + * 45.00 = 932.50 + 24.12 = 956.62
181
10
Our example assumes that you paid no commissions or other transactions costs to buy the bonds.
Typically these costs would be $25–$50 for a $1,000 bond purchase.
 CHAPTER 15 Bond Valuation 469

Because the time between the bond payments is unevenly spaced, the computation of the
YTM requires the use of XIRR. Using this function shows that the YTM is 10.68% (cell B26
below).
A B C D E F
GIANT INDUSTRIES 9% BONDS
BUYER PERSPECTIVE
1 7 Dec. 2000
2 Face value of bonds bought 1,000.00 Accrued interest calculation
3 Coupon rate 9.00%
4 Today's date 7-Dec-00
5 Quoted price 932.50 Last coupon date 1-Sep-00
6 Accrued interest 24.12 <-- =E12 Next coupon date 1-Mar-01
7 Actual price paid 956.62
8 Days since last coupon 97 <-- =E4-E5
9 Date Cash flow Days between coupons 181 <-- =E6-E5
10 12/7/2000 -956.62 <-- =-B7
11 3/1/2001 45.00 <-- =$B$3*$B$2/2 Semiannual coupon 45.00 <-- =B3/2*B2
12 9/1/2001 45.00 Accrued interest 24.12 <-- =E8/E9*E11
13 3/1/2002 45.00
14 9/1/2002 45.00
15 3/1/2003 45.00
16 9/1/2003 45.00
17 3/1/2004 45.00
18 9/1/2004 45.00
19 3/1/2005 45.00
20 9/1/2005 45.00
21 3/1/2006 45.00
22 9/1/2006 45.00
23 3/1/2007 45.00
24 9/1/2007 1,045.00 <-- =$B$3*$B$2/2+B2
25
26 YTM using XIRR 10.68% <-- =XIRR(B10:B24,A10:A24)
27 YTM using Excel's Yield function 10.41% <-- =YIELD(A10,A24,B3,B5/10,100,2,3)
28 Excel's Yield annualized 10.68% <-- =(1+B27/2)^2-1

Note that Excel’s Yield function in cell B27 gives the doubled semiannual yield
as it is often reported in U.S. bond markets. As in the Treasury bond example in
Section 15.3, annualizing this yield (cell B28) gives the same answer as the YTM
reported by XIRR.

FIGURE 15.11 A description of a callable bond issued by General Electric.

SOURCE: http://www.quantumonline.com.
470 PART THREE VALUING SECURITIES

15.5. Callable Bonds

Many bonds are callable. This means that the bond issuer has the right to refund the bonds after
a given date. As an example of a callable bond, we consider the notes (remember that “notes” is
just another word for “bond”) issued by General Electric that are described in Figure 15.11.
The GE notes pay interest of 5.875%. This interest is paid quarterly, so that per $25 of par
value, the bonds pay annual interest of $1.46875 (= 5.875%*$25); this works out to $0.3672
quarterly. The notes are callable at par on or after 20 February 2008. The notes mature on 18
February 2033.
Below we compute the IRR on these bonds, assuming that they are sold on 18 August 2003
for $27.00 and held until maturity. (Note that the Excel clip hides rows 19–122; see Chapter 7,
pages 228–9, for instructions on how to do this.)
A B C
1 GENERAL ELECTRIC BONDS
2 Face value 25.00
3 Coupon rate 5.875%
4 Maturity date 18-Feb-33
5 Current date 18-Aug-03 <-- The date the bonds are sold
6 First call 20-Feb-08
7 Bond price on current date 27.00
8
9 Computing the Yield to (First Call (YTC)
10 Date Cash flow
11 18-Aug-03 -27.00 <-- =-B7
12 18-Nov-03 0.3672 <-- =$B$3*$B$2/4
13 18-Feb-04 0.3672 <-- =$B$3*$B$2/4
14 18-May-04 0.3672
15 18-Aug-04 0.3672
16 18-Nov-04 0.3672
17 18-Feb-05 0.3672
18 18-May-05 0.3672
123 18-Aug-31 0.3672
124 18-Nov-31 0.3672
125 18-Feb-32 0.3672
126 18-May-32 0.3672
127 18-Aug-32 0.3672
128 18-Nov-32 0.3672
129 18-Feb-33 25.3672 <-- =$B$3*$B$2/4+B2
130
131 Using XIRR 5.44% <-- =XIRR(B11:B129,A11:A129)
132 Annualizing the quarterly IRR 5.44% <-- =(1+IRR(B11:B129,3%))^4-1
133
134 Using Yield 5.34% <-- =YIELD(B5,B4,B3,B7*4,B2*4,4,3)
135 4 times the YTM 5.34% <-- =4*IRR(B11:B129,3%)

The spreadsheet shows several ways of computing the notes’ yield. Using the XIRR func-
tion (cell B131) gives a yield of 5.44%. Using the Yield function, the notes’ yield is 5.34%
(cell B134).
Each of these numbers can be derived using Excel’s IRR function. Because the bond pay-
ments are quarterly, IRR computes the quarterly interest rate on the bonds. Cell B132 annualizes
4
this quarterly rate by calculating (1 + quarterly IRR ) − 1; this is equivalent to the yield
computed by XIRR in cell B131. Cell B135 multiplies the quarterly IRR by 4 to get the
same number as computed by Yield.
Here are two comments on this spreadsheet:
1. The EAIR paid by the GE notes is the number computed by XIRR and not the number
computed by Yield. So why do we use Yield? Because the convention in American bond
markets is to compute annual rates of return by multiplying the periodic rates as in cell
 CHAPTER 15 Bond Valuation 471

B135. If you’re going to understand how bond rates are quoted in the United States, you
have to understand the difference between the rates computed by XIRR and that computed
by Yield.
2. The equivalence between cells B131 and B132 and between cells B134 and B135 works
so nicely because our example starts on 18 August 2003, which is exactly the start of a
quarter. For other starting dates, the equivalence would not work exactly. In this case
XIRR always gives the correct EAIR.
To see the effect of the call provision of the bond, we calculate the YTC. This is the YTM,
assuming that the bond is actually called by GE at the first call date. The spreadsheet below
shows the calculations.11
E F G
9 Computing the Yield to First Call (YTC)
10 Date Cash flow
11 18-Aug-03 -27.00 <-- =-B7
12 18-Nov-03 0.3672 <-- =$B$3*$B$2/4
13 18-Feb-04 0.3672 <-- =$B$3*$B$2/4
14 18-May-04 0.3672
15 18-Aug-04 0.3672
16 18-Nov-04 0.3672
17 18-Feb-05 0.3672
18 18-May-05 0.3672
19 18-Aug-05 0.3672 <-- =$B$3*$B$2/4
20 18-Nov-05 0.3672
21 18-Feb-06 0.3672
22 18-May-06 0.3672
23 18-Aug-06 0.3672
24 18-Nov-06 0.3672
25 18-Feb-07 0.3672
26 18-May-07 0.3672
27 18-Aug-07 0.3672
28 18-Nov-07 0.3672
29 20-Feb-08 25.3672
30
31 Using XIRR 3.97% <-- =XIRR(F11:F29,E11:E29)
32 Annualizing the quarterly IRR 3.99% <-- =(1+IRR(F11:F29))^4-1
33
34 Using Yield 3.93% <-- =YIELD(B5,B6,B3,B7*4,100,4,3)
35 4 times the YTM 3.93% <-- =4*IRR(F11:F29)

15.6. Preferred Stock

In addition to shares and bonds, companies sometimes issue preferred stock. Preferred stock
is a security that promises a fixed payment to the shareholders. Although it is called “stock,”
preferred has many of the properties of a bond—the dividend is fixed and resembles the coupon
payments on bonds. In addition, preferred stock can be callable.

11
The slight difference between cell F31 and cell F32 has to do with the fact that XIRR is based on daily
interest rates, whereas IRR assumes that all quarters are of equal length.
472 PART THREE VALUING SECURITIES

FIGURE 15.12 A description of Alabama Power Company’s 5.20% preferred stock.

SOURCE: http://www.quantumonline.com.

In this section we analyze the preferred stock issued by Alabama Power Company
(Figure 15.12). The 5.20% preferred stock issued by the Alabama Power Company has the fol-
lowing features:
• The par value of the stock is $25.00.
• The preferred stock’s dividend is 5.20% of its par value, which is 5.20% * 25 = $1.30
annually. One quarter of this annual dividend, $0.325, is paid four times a year, on
1 January, 1 April, 1 July, and 1 October.
• The preferred stock is listed on the New York Stock Exchange. The price varies with
market interest rates and the market’s estimation of Alabama Power’s credit worthi-
ness—its ability to make good its promise to pay the dividends on the preferred stock.
The market price of the preferred stock on 1 July 2003 was $26.10.

Computing the Yield Assuming No Call

An investor who buys the Alabama Power preferred stock on 1 July 2003 pays the market price
of $26.10 and gets a quarterly dividend of $0.325. If the investor assumes that the stock will
never be called—that is, that the dividend will be paid forever—then the annualized yield on
the stock is 5.07%:
A B C
ALABAMA POWER PREFERRED STOCK
1 annualized yield assuming no call
2 Annual dividend 1.30 <-- =5.2%*25
3 Quarterly dividend 0.325 <-- =B2/4
4 Market price, 1 July 2003 26.10
5
6 Quarterly yield 1.25% <-- =B3/B4
7 Annualized yield 5.07% <-- =(1+B6)^4-1
 CHAPTER 15 Bond Valuation 473

Cell B6 computes the quarterly yield of 1.25%. In cell B7 we annualize this yield as
explained in Chapter 2.

Computing the Yield to First Call (YTC)

Although in principle the preferred stock will pay its dividends indefinitely, Alabama Power
Company can call the stock at any time starting 19 August 2008. If the stock is called, the
company is obliged to pay the preferred stockholders the par value of $25 plus the accrued pre-
ferred dividend. This concept is very much like the concept of the accrued interest discussed in
Section 15.1 (page 455). For example, if the Alabama Power Company calls the preferred on 19
August 2008, it has to pay the preferred holders $25.17:
Days between 19 Aug 2008 and 1 July 2008
$25
) + Days between 1 Oct 2008 and 1 July 2008 * $0.325
!""#""$ =
↑ !"""""""""""""""""""#"""""""""""""""""""$ ↑
Par ↑ Quarterly
value Percentage of the quarter between dividend
call date and last dividend date
49
$25 + * $0.325 = $25.17
92
Suppose that the investor believes that Alabama Power will call the preferred stock at the
first legal call date. Then his anticipated yield is 4.30%, as shown below in cell B37.

A B C
ALABAMA POWER PREFERRED STOCK
1 computing the yield to first call
2 Call date 19-Aug-08
3 Last dividend date 1-Jul-08
4 Next dividend date 1-Oct-08
5 Par value 25.00
6 Quarterly dividend 0.325 <-- =(5.2%*25)/4
7
8 Days since last dividend 49 <-- =B2-B3
9 Days between last dividend and next dividend 92 <-- =B4-B3
10 Accrued dividend on call date 0.173 <-- =B8/B9*B6
11 Paid by company to shareholders at call 25.17 <-- =B5+B10
12
13 Date Cash flow
14 1-Jul-03 -26.10
15 1-Oct-03 0.325
16 1-Jan-04 0.325
17 1-Apr-04 0.325
18 1-Jul-04 0.325
19 1-Oct-04 0.325
20 1-Jan-05 0.325
21 1-Apr-05 0.325
22 1-Jul-05 0.325
23 1-Oct-05 0.325
24 1-Jan-06 0.325
25 1-Apr-06 0.325
26 1-Jul-06 0.325
27 1-Oct-06 0.325
28 1-Jan-07 0.325
29 1-Apr-07 0.325
30 1-Jul-07 0.325
31 1-Oct-07 0.325
32 1-Jan-08 0.325
33 1-Apr-08 0.325
34 1-Jul-08 0.325
35 19-Aug-08 25.17 <-- =B11
36
37 Yield to first call 4.30% <-- =XIRR(B14:B35,A14:A35)

15.7. Deriving the Yield Curve from Zero-Coupon Bonds

A zero-coupon bond is a bond that makes no coupon payments between the time of the bond’s
issue and the bond’s maturity. For example, the Treasury bills discussed in Section 15.1 are
474 PART THREE VALUING SECURITIES

zero-coupon bonds. Zero coupons have the pleasant property that they allow us to identify
the time-specific discount for each payment. Here’s an example that is similar to that given in
Section 17.2.

A B C D
USING ZERO-COUPONS TO DETERMINE
1 BOND DISCOUNT RATES
2 Zero-coupon bond A: maturity in one year
3 Price today 100
4 Payoff in one year 105
5 IRR 5.00% <-- =B4/B3-1
6
7 Zero-coupon bond B: maturity in two years
8 Price today 99
9 Payoff in two years 110
10 IRR 5.41% <-- =(B9/B8)^(1/2)-1
11
12 Zero-coupon bond C: maturity in three years
13 Price today 101
14 Payoff in three years 122
15 IRR 6.50% <-- =(B14/B13)^(1/3)-1
16
17 Coupon bond D: A bond with payments at end of years 1, 2, 3
Present value of
18 Date Payment payment
19 1 50 47.62 <-- =B19/(1+B5)
20 2 50 45.00 <-- =B20/(1+B10)^2
21 3 1,050 869.26 <-- =B21/(1+B15)^3
22 Bond price 961.88 <-- =SUM(C19:C21)

Bonds A, B, and C have no intermediate payments. The IRR of each bond is thus the dis-
count rate for a specific payment at time t. For example: $100 paid out in 2 years would be
discounted by 5.41%, the rate determined by Bond B.
Now look at Bond D. This bond is a regular coupon bond—it pays $50 at dates 1 and 2
and at date 3 it pays $1,050 (the face value plus the interest). In cells A19:C22 we use the zero-
coupon yield curve to determine the price of the bond as $961.88.
Suppose $961.88 is indeed the market price of Bond D. Note that the bond’s yield to matu-
rity will be different from each of the pure-discount yields determined above.

A B C
24 Determining the yield to maturity (YTM) of bond D
25 Date Payment
26 0 -961.88
27 1 50.00
28 2 50.00
29 3 1,050.00
30 YTM 6.44% <-- =IRR(B26:B29)
 CHAPTER 15 Bond Valuation 475

U.S. Treasury Strips

In the United States brokers often split up the payments on U.S. Treasury bonds and sell them
off separately. The bonds created in this way are zero-coupon bonds and are referred to as
strips. As an example, suppose a broker bought Bond D from the previous example. She could
sell off the year 1 coupon of $50 as a separate security, the year 2 coupon of $50 as a separate
security, and the year 3 payment of $1050 as a separate security. Each of these zero-coupon
“strip securities” would have a separate price.
Zero-coupon strips allow customers with specialized payment needs to buy a security that
makes a payment on a specific date. For example, if you know that you have to make a payment
in 2 years, then you could buy 2-year Treasury strips. This eliminates all intermediate interest
rate risks.
We can use strip prices to identify a yield curve. This is a graph that shows the zero-coupon
interest rate on bonds for each date. Using Treasury strip data from 12 June 2009, here’s an
example of zero-coupon Treasury yield curve.

A B C D E F G H I J K L
1 PRICES AND YIELDS OF U.S. TREASURY STRIPS
2 Current date 12-Jun-09
3
Days till Annual
Maturity Price
4 maturity yield
5 15-Aug-09 100.02 64 <-- =A5-$B$2 -0.1140% <-- =(100/B5)^(365/C5)-1
6 15-Nov-09 100.08 156 <-- =A6-$B$2 -0.1869%
7 15-Feb-10 99.86 248 0.2064%
8 15-Aug-11 98.26 794 0.8102%
9 15-May-12 96.72 1068 1.1463%
10 15-Aug-12 95.69 1160 1.3959%
11 15-Aug-12 94.87 1160 1.6709% <-- =(100/B11)^(365/C11)-1
12 15-Feb-13 94.38 1344 1.5832%
13 15-Feb-13 93.77 1344 1.7623%
14 15-Aug-13 92.95 1525 1.7652%
15 15-Nov-13 92.27 1617 1.8326% 5%
TREASURY STRIP YIELD CURVE
16 15-Nov-13 91.02 1617 2.1466%
17 15-Feb-14 90.65 1709 2.1187% 4%
18 15-Feb-14 90.85 1709 2.0706%
19 15-May-14 89.73 1798 2.2242%
20 15-Aug-14 88.53 1890 2.3807% 3%
21 15-Nov-15 83.55 2347 2.8345%
22 15-Feb-16 82.13 2439 2.9900%
23 15-Nov-16 78.69 2713 3.2768% 2%
24 15-May-17 76.28 2894 3.4739%
25 15-Feb-18 72.80 3170 3.7229% 1%
26 15-Aug-18 71.27 3351 3.7580%
27 15-Nov-18 70.28 3443 3.8096%
28 15-Aug-19 67.09 3716 3.9983% 0%

Aug-28
29 15-Feb-20 64.90 3900 4.1291%
Aug-09
Aug-10
Aug-11
Aug-12
Aug-13
Aug-14
Aug-15
Aug-16
Aug-17
Aug-18
Aug-19
Aug-20
Aug-21
Aug-22
Aug-23
Aug-24
Aug-25
Aug-26
Aug-27
30 15-May-20 63.91 3990 4.1805%
-1%
31 15-Aug-20 62.83 4082 4.2431%
32 15-Aug-20 62.87 4082 4.2372%

The graph gives actual prices and maturities for Treasury strips on 12 June 2009. The
maturities (column C) are calculated in days. (There are many rows of data that we haven’t
shown but that are on the CD-ROM that comes with this book.) Here’s a sample calculation
(cells A8:D8): On 12 June 2009 a zero-coupon Treasury strip with maturity 15 August 2012
sells for $94.87. This bond promises $100 on maturity. There are 1,160 days between 12 June
2009 and 15 August 2012. To compute the annualized yield for the bond, we find 1 plus the daily
1/1
interest rate, ⎛⎜ 100 ⎞⎟ . Raising this number to the power 365 (the number of days per
⎝ 94.87 ⎠
year) and subtracting 1 gives the annualized yield in cell E11:
365 /1160
⎛ 100 ⎞
yield to maturity = ⎜ ⎟ − 1 = 1.6709%
⎝ 94.87 ⎠
476 PART THREE VALUING SECURITIES

Conclusion
This chapter discusses the pricing bonds and the determination bond yield to maturity (YTM).
Pricing a bond is largely an exercise in applying the present value concepts discussed in
Chapters 1–4. The yield on a bond is the annualized internal rate of return of its payments.
Bond pricing and yield computations are also applicable to callable bonds and to preferred
stock. We have given examples of each of these securities. Finally, the chapter discussed zero-
coupon securities.

EXERCISES
1. On 1 August 2001, you are offered the following bond:
• Face value: $1,000.00
• Coupon rate: 12%
• Coupon payments: Once a year on August 1, 2002, 2003, . . . , 2012
• Bond price: $1,252.00
• Bond’s face value repaid on last coupon date
Use Excel’s IRR function to compute the bond’s yield to maturity (YTM).
2. On 10 September 2001, you are offered the following bond:
• Face value: $1,000.00
• Coupon rate: 12%
• Coupon payments: Once a year on August 1, 2002, 2003, . . . , 2012
• Bond price: $1,252.00
• Bond’s face value repaid on last coupon date
Use Excel’s XIRR function to compute the bond’s yield to maturity (YTM).
3. Consider the following two bonds.

Bond A Bond B
Term to maturity: 10 years from today Term to maturity: 20 years from today
Face value: $1,000 Face value: $1,000
Coupon: 10%, interest payments to be made in 1 year Coupon: 10%, interest payments to be made in 1 year
from today, 2 years from today, . . . , 10 years from from today, 2 years from today, . . . , 20 years from today
today Repayment of bond: On last coupon date
Repayment of bond: On last coupon date

Make a table comparing the bond prices when the market interest rate varies from 5, 6, . . . ,
17%. Use the template provided here, which is on the CD-ROM that accompanies Principles
of Finance with Excel. In the template you see that when the market interest rate is 10%, both
bonds are valued at $1,000.
Can you conclude that “the longer-term bond’s price is more sensitive to changes in the
market interest rate?” Explain using a graph.
 CHAPTER 15 Bond Valuation 477

A B C D E F G
1 COMPARING TWO BONDS
2 Bond A Bond B Market interest rate 10%
3 Coupon rate 10% 10% Price of Bond A $1,000.00 <-- =NPV(F2,B8:B17)
4 Maturity 10 20 Price of Bond B $1,000.00 <-- =NPV(F2,C8:C27)
5 Face value 1,000.00 1,000.00
6
7 Year Bond A Bond B Data table: Effect of market interest rate on bond prices
8 1 100.00 100.00 Interest rate Bond A price Bond B price
9 2 100.00 100.00
10 3 100.00 100.00 0%
11 4 100.00 100.00 1%
12 5 100.00 100.00 2%
13 6 100.00 100.00 3%
14 7 100.00 100.00 4%
15 8 100.00 100.00 5%
16 9 100.00 100.00 6%
17 10 1,100.00 100.00 7%
18 11 100.00 8%
19 12 100.00 9%
20 13 100.00 10%
21 14 100.00 11%
22 15 100.00 12%
23 16 100.00 13%
24 17 100.00 14%
25 18 100.00 15%
26 19 100.00 16%
27 20 1,100.00 17%

4. You have been offered a U.S. Treasury bill. The face value of the bill is $10,000 and the price is
$8,925. The bill matures in ½ year. Compute the YTM of the bill using both discrete and contin-
uously compounded interest.
5. You have been offered a U.S. Treasury bill. The bill has face value of $10,000 and price of $9,456.
It matures in 210 days. Compute: (a) the daily interest rate and the corresponding annualized inter-
est rate and (b) the continuously compounded interest rate.
6. On 20 February 2001 you are offered a U.S. Treasury note. Here are the terms of the note:
• The note has face value of $100,000 and a 6.5% coupon rate. The note matures on 15 October
2006.
6.5% *100,000
• The semiannual interest on the note (that is, = $3,250) is paid on
2
15 April and 15 October of each year. The last interest payment was 15 October 2000 and the
next interest payment is on 15 April 2001.
• Other interest payments are on 15 October 2001, 15 April 2002, . . . , 15 October 2006. On this
last date the bond’s principal of $100,000 is also returned.
• On 20 February 2001 the bond was priced at $109,477.71. This price was computed as follows:

$107,152.00
!"""""#"""""$ + Accrued Interest of $2,285.71 = $109,477.71
!""""#
" """""$
↑ ↑
In the jargon of In the jargon of
bond markets this is bond markets this is
called the "bond price" called the "invoice price"

a. Confirm the calculation of the accrued interest.

b. Use XIRR calculate the annualized yield to maturity (YTM).
Note: Use the following template.
478 PART THREE VALUING SECURITIES

A B C
1 TREASURY BOND CALCULATION
2 Computing the accrued interest
3 Current date 20-Feb-01
4 Previous interest payment date 15-Oct-00
5 Next interest payment date 15-Apr-01
6 Semiannual coupon 3,250.00
7
8 Days since last coupon date
Days between last coupon
9 date and next coupon date
10
11 Accrued interest
12
13 Computing the YTM
14 Bond price 107,152.00
15 Accrued interest
16 Invoice price (bond price + accrued)
17
Bond
18 Date cash flow
19 20-Feb-01
20 15-Apr-01
21 15-Oct-01
22 15-Apr-02
23 15-Oct-02
24 15-Apr-03
25 15-Oct-03
26 15-Apr-04
27 15-Oct-04
28 15-Apr-05
29 15-Oct-05
30 15-Apr-06
31 15-Oct-06
32
33 YTM

7. On 26 February 2001 a UtilityCorp 8.2% bond maturing 15 January 2007 is priced at

103.790 per $100 of face value (this price does not include the accrued interest). The
bond was originally issued in 1992. The bond pays interest semiannually, on 15 January
and 15 July of each year. Compute the accrued interest and the YTM of the bond.
8. You are given the following information on three traded bonds making annual coupon
payments.

A B C D E
Face Coupon Yield to
1 Bond value rate Maturity maturity
2 A $1,000 0.00% 1 5.00%
3 B $1,000 5.00% 2 5.85%
4 C $1,000 10.00% 2 6.00%

a. What are the prices of the above three bonds?

b. What is the zero-coupon bond yield for a 1-year bond?
c. What is the zero-coupon bond yield for a 2-year bond based on the price of Bond B?
 CHAPTER 15 Bond Valuation 479

d. What is the zero-coupon bond yield for a 2-year bond based on the price of Bond C?
e. Challenge question: Create an arbitrage strategy from buying and/or selling a combination of
the three bonds.
9. Use the data in the following table to create two graphs. The data are on the disk that comes with
the book.
• A graph of the yields on 10-year U.S. Treasury bonds, AAA corporate, Baa corporate from
1976–2009.
• A graph of the risk premium over 10-year Treasury bonds for the AAA and Baa bonds for each
year.

A B C D

BOND YIELDS: 10-YEAR

TREASURY BONDS, AAA
CORPORATES, Baa
CORPORATES, 1976–2009
1
10-Year
AAA Baa
2 Treasury
3 1976 7.61% 8.43% 9.75%
4 1977 7.42% 8.02% 8.97%
5 1978 8.41% 8.73% 9.49%
6 1979 9.43% 9.63% 10.69%
7 1980 11.43% 11.94% 13.67%
8 1981 13.92% 14.17% 16.04%
9 1982 13.01% 13.79% 16.11%
10 1983 11.10% 12.04% 13.55%
11 1984 12.46% 12.71% 14.19%
12 1985 10.62% 11.37% 12.72%
13 1986 7.67% 9.02% 10.39%
14 1987 8.39% 9.38% 10.58%
15 1988 8.85% 9.71% 10.83%
16 1989 8.49% 9.26% 10.18%
17 1990 8.55% 9.32% 10.36%
18 1991 7.86% 8.77% 9.80%
19 1992 7.01% 8.14% 8.98%
20 1993 5.87% 7.22% 7.93%
21 1994 7.09% 7.97% 8.63%
22 1995 6.57% 7.59% 8.20%
23 1996 6.44% 7.37% 8.05%
24 1997 6.35% 7.27% 7.87%
25 1998 5.26% 6.53% 7.22%
26 1999 5.65% 7.05% 7.88%
27 2000 6.03% 7.62% 8.37%
28 2001 5.02% 7.08% 7.95%
29 2002 4.61% 6.49% 7.80%
30 2003 4.01% 5.66% 6.76%
31 2004 4.27% 5.63% 6.39%
32 2005 4.29% 5.23% 6.06%
33 2006 4.80% 5.59% 6.48%
34 2007 4.63% 5.56% 6.48%
35 2008 3.66% 5.63% 7.44%
36 2009 3.26% 5.31% 7.29%

10. On 15 August 2006, Corporate Junk issues $100 million of 10-year bonds. The bonds have a cou-
pon of 10%, payable semiannually on 15 February and 15 August of each year. They are issued at
par. Corporate Junk’s expenses related to the bond issue are $4 million. Compute the annualized
yield to the bond investors and the annualized cost to the company.
480 PART THREE VALUING SECURITIES

11. On 18 October 2006 the Corporate Junk bond issue (see previous exercise) is selling for $103. Use
XIRR to compute the investor’s yield to maturity of the bonds.
12. On 15 August 1996 the U.S. Treasury issued a bond maturing on 15 February 2026. The bond has
a coupon rate of 6%, payable semiannually on 15 February and 15 August. If a $100 face-value
bond is selling for $117.25 on 23 January 2005, compute the bond’s yield to maturity.
13. On 15 May 1985 the U.S. Treasury issued a bond maturing 15 November 2014. The bond had a
coupon rate of 11.75%, payable semiannually on 15 November and 15 May. On 23 January 2005 a
$1,000 face-value bond was selling for $1356.20. This price does not include the accrued interest.
The bond is callable at par starting 15 November 2009. Compute the following:
a. The bond’s yield to maturity (YTM).
b. The bond’s yield to first call (YTC).
14. Consolidated Edison’s 4.65% Series C cumulative preferred stock trades on the New York Stock
Exchange. The stock has face value $100 and pays its dividend four times per year, on the fi rst of
February, May, July, and November. The stock is not redeemable. If the share price on 2 February
2005 is $85, what is the preferred stock’s yield?

15. Reconsider the Consolidated Edison preferred in Exercise 14. Suppose that the stock trades for
$87.50 on 3 January 2005. What is its yield? (Don’t forget that the price does not include the
accrued dividend.)
16. Genworth Financial’s 5.25% Series A cumulative preferred stock has a par value of $50 and inter-
est rate of 5.25% payable quarterly on the first day of March, June, September, and December.
The stock is callable at par from 1 June 2011. If the stock trades at $45.50 on 2 June 2005, what
is its yield to first call (YTC)?
 CHAPTER 15 Bond Valuation 481

17. On the disk with this book is the file below.

a. Complete the file to derive the continuous yields of the zero coupon Treasury strips. Graph the
yields to derive the yield curve on 21 January 2005.
b. Why do you think that the yields of very short-term zero strips (the fi rst two) are negative?

A B C D E F
U.S. TREASURY STRIP DATA
1 21 January 2005
2
3 Current date 21-Jan-05
Yahoo! Days to Years to Continuous
4 Price Maturity yield maturity maturity yield
5 100.17 15-Feb-05 -2.956%
6 100.15 15-Feb-05 -2.642%
7 99.57 15-May-05 1.421%
8 99.56 15-May-05 1.457%
9 98.8 15-Aug-05 2.188%
10 98.85 15-Aug-05 2.087%
11 98.04 15-Nov-05 2.481%
12 98.04 15-Nov-05 2.477%
13 97.33 15-Feb-06 2.572%
14 97.35 15-Feb-06 2.554%
15 97.34 15-Feb-06 2.563%
16 96.52 15-May-06 2.736%
17 96.57 15-May-06 2.696%
18 95.73 15-Aug-06 2.820%
18. Be ambitious! Go to Yahoo!, download the zero-coupon data for a recent date, and repeat the previous exercise.
CHAP TER

16 Valuing Stocks

CHAPTER CONTENTS
Overview 482
16.1. Valuation Method 1: The Current Market Price of a Stock Is the Correct
Price (the Efficient Markets Approach) 484
16.2. Valuation Method 2: The Price of a Share Is the Discounted Value of the
Future Anticipated FCFs 486
16.3. Valuation Method 3: The Price of a Share Is the PV of Its Future
Anticipated Equity Cash Flows Discounted at the Cost of Equity 494
16.4. Valuation Method 4, Comparative Valuation: Using Multiples to Value
Shares 496
16.5. Intermediate Summary 498
16.6. Computing Target’s WACC, the SML Approach 499
16.7. Computing Target’s Cost of Equity, r E, with the Gordon Model 504
Summing Up 505
Exercises 506

Overview
In Chapter 15 we discussed the valuation of bonds. The current chapter deals with the valuation
of stocks. Whereas the valuation of bonds is a relatively straightforward matter of computing the

482
 CHAPTER 16 Valuing Stocks 483

yield to maturity, the valuation of stocks is much more difficult. The difficulty lies both in the
greater uncertainty about the cash flows that need to be discounted to arrive at a stock valuation
and in the computation of the correct discount rate.
In this chapter we discuss four basic approaches to stock valuation:

• Valuation method 1, the efficient markets approach. In its simplest form the efficient
markets approach states that the current stock price is correct. A somewhat more sophis-
ticated use of the efficient markets approach to stock valuation is that a stock’s value is
the sum of the values of its components. We explore the implications of these statements
in Section 16.1.
• Valuation method 2, discounting the future free cash flows (FCF). Sometimes
called the discounted cash flow (DCF) approach to valuation, this method values the
fi rm’s debt and its equity together as the present value of the fi rm’s future FCFs. The
discount rate used is the weighted average cost of capital (WACC). This method is the
valuation approach favored by most finance academics. We discuss this approach in
Section 16.2 and the calculation of the WACC in Section 16.6. In this chapter we do
not discuss the concept or the computation of the FCF—this was done previously in
Chapters 6 and 7.
• Valuation method 3, discounting the future equity payouts. A firm’s shares can also
be valued by discounting the stream of anticipated equity payouts at an appropriate cost
of equity rE. The concept of equity payout (the sum of a firm’s total dividends plus its
stock repurchases) was previously discussed in Chapter 6.
• Valuation method 4, multiples. Finally we can value a firm’s shares by a compara-
tive valuation based on multiples. This very common method involves ratios such as
the P/E ratio, earnings before interest, taxes, depreciation, and amortization (EBITDA)
multiples, and more industry-specific multiples such as value per square foot of storage
space or value per subscriber.

With the exception of the multiple method 4, almost all of the material in this chapter
is also discussed elsewhere in this book. The efficient markets approach to valuation is also
discussed in Chapter 14. Discounting free cash flows (FCFs) is discussed in Chapters 6 and 7.
The Gordon dividend model (which values a firm’s equity by discounting its anticipated divi-
dend stream) is also discussed in Chapter 6. WACC computations are found in Chapters 6 and
13. The purpose of this chapter is to bring together these dispersed materials into a (hopefully
coherent) whole.

Finance Concepts Discussed in This Chapter

• Discounted cash flow (DCF), free cash flow (FCF)

• Cost of capital, cost of equity, cost of debt, weighted average cost of capital
(WACC)
• Equity premium
• Beta (β), equity beta βE, asset beta βAsset
• Two-stage growth models
484 PART THREE VALUING SECURITIES

Excel Functions Used

• Sum, NPV, If
• Data table

16.1. Valuation Method 1: The Current Market Price of a Stock Is the

Correct Price (the Efficient Markets Approach)
The simplest stock valuation is based on the efficient markets approach (Chapter 14). This
approach says that the current market price of a stock is the correct price. In other words, the
market has already done the difficult job of stock valuation, and it’s done this correctly, incor-
porating all of the relevant information There’s a lot of evidence for this approach, as you saw
in Chapter 14.
This valuation method is very simple to apply:
• Question: “IBM looks a bit expensive to me—its price has been going up for the
last 3 months. What do you think: Is IBM’s stock price currently underpriced or
overpriced?”
• Answer: “At Podunk U., we learned that markets with a lot of trading are in general
efficient, meaning that the current market price incorporates all of the readily available
information about IBM. So I don’t think IBM is either underpriced or overpriced. It’s
actually correctly priced.”
Here’s another example of the use of this approach.
• Question: “I’ve been thinking of buying IBM, but I’ve been putting it off. The price has
gone up lately, and I’m going to wait until it comes down a bit. It seems a bit high to me
right now.” What do you think?
• Answer: “At Podunk U. we would call you a contrarian. You believe that if the price of
a stock has gone up, it will go back down (and the opposite). But this technical approach
(see Chapter 14) to stock valuation doesn’t seem to work very well. So if you want to buy
IBM, go ahead and do so now. There’s nothing in the price runup of the last couple of
months that indicates that there will now be a price rundown.”

Some More Sophisticated Efficient Markets Methods

Efficient markets valuations don’t always have to be as simplistic as the above exam-
ples. In Chapter 14 we looked at additivity, a fundamental principal of efficient mar-
kets. The principle of additivity says that the value of a basket of goods or financial assets
should equal the sum of the values of the components. Additivity can often be used to value
stocks.
Here’s a very simple example: ABC Holding Corp., a publicly traded company, owns
shares in two publicly traded companies. Besides owning these subsidiaries, ABC does
little else.
 CHAPTER 16 Valuing Stocks 485

ABC HOLDING COMPANY

Owns:
60% of XYZ Widgets
50% of QRM Smidgets

ABC has 30,000 shares outstanding

XYZ Widgets QRM Smidgets

Market value of shares: $1,000,000 Market value of shares: $875,000

FIGURE 16.1 Ownership structure of ABC Holding Company.

What should be the value of a share of ABC Holding? The obvious way to determine the
value is in the following spreadsheet, which computes the share value of ABC to be $34.58.

A B C D E
1 ABC HOLDING COMPANY
2 Number of ABC shares 30,000
3

Percentage Market value

of shares of ABC
owned by Market holdings
4 ABC owns shares in ABC value in company
5 XYZ Widgets 60% 1,000,000 600,000 <-- =B5*C5
6 QRM Smidgets 50% 875,000 437,500 <-- =B6*C6
7 Total value of ABC holdings 1,037,500 <-- =D6+D5
8
9 Per share value of ABC Holdings 34.58 <-- =D7/B2

Note what this model is and is not telling you:

• Is telling you: If the market values of XYZ and QRM are correct, then
the market value of ABC should be $1,037,500. In per-share terms,
486 PART THREE VALUING SECURITIES

ABC share 60% * [ XYZ value ] + 50% * [QRM value ]

= = $34.58
price number of ABC shares

• Is not telling you: The formula tells you a relation among the three share prices.
It tells you whether the share prices are relatively correct, but it does not tell you
whether they are absolutely correct. As an example, after doing much work and
research and applying the methods of the previous section, you come to the conclu-
sion that, although the market valuation of QRM is correct, the market value of XYZ
ought to be $1,600,000. Then you would conclude that the share price of ABC ought
to be $46.58.

A B C D E
1 ABC HOLDING COMPANY
2 Number of ABC shares 30,000
3
Percentage Market value
of shares of ABC
owned by Market holdings
4 ABC owns shares in ABC value in company
5 XYZ Widgets 60% 1,600,000 960,000 <-- =B5*C5
6 QRM Smidgets 50% 875,000 437,500 <-- =B6*C6
7 Total value of ABC holdings 1,397,500 <-- =D6+D5
8
9 Per share value of ABC Holdings 46.58 <-- =D7/B2

Note that if ABC has some of its own overheads and if it doesn’t always pass through all
the dividends of its subsidiaries, its market value will be lower than the sum of the values of
XYZ and QRM, because the market price of ABC will reflect not only the cost of the shares of
its subsidiaries, but also its own overheads. This looks a lot like the closed-end fund valuation
problem discussed in Chapter 14.

16.2. Valuation Method 2: The Price of a Share Is the Discounted

Value of the Future Anticipated FCFs
Valuation method 1 of the previous section says that there is nothing to be gained by second-
guessing market valuations. In many cases, however, the finance expert (you!) will want to
do a basic valuation of a company and derive the value of a share from the discounted value
of the future anticipated free cash flows (FCFs). This method, often called the discounted
cash flow (DCF) method of valuation, was discussed and illustrated in Chapters 6 and 7.
Figure 16.2 reminds you of the definition of FCF and Figure 16.3 gives a flow diagram of the
FCF valuation method.
 CHAPTER 16 Valuing Stocks 487

Defining the Free Cash Flow (FCF)

This is the basic measure of the profitability of the business, but it is
an accounting measure that includes financing flows (such as inter-
Profit after taxes est), as well as noncash expenses such as depreciation. Profit after
taxes does not account for either changes in the firm’s working capital
or purchases of new fixed assets, both of which can be important cash
drains on the firm.
+ Depreciation This noncash expense is added back to the profit after tax.
FCF is an attempt to measure the cash produced by the business activity
of the firm. To neutralize the effect of interest payments on the firm’s
profits, we
+ After-tax interest payments (net) • Add back the after-tax cost of interest on debt (after-tax
because interest payments are tax deductible),
• Subtract out the after-tax interest payments on cash and
marketable securities.
When the firm’s sales increase, more investment is needed in inven-
– Increase in current assets tories, accounts receivable, etc. This increase in current assets is
not an expense for tax purposes (and is therefore ignored in the
profit after taxes), but it is a cash drain on the company.
An increase in the sales often causes an increase in financing
related to sales (such as accounts payable or taxes payable). This
+ Increase in current liabilities increase in current liabilities—when related to sales—provides
cash to the firm. Because it is directly related to sales, we include
this cash in the FCF calculations.

– Increase in fixed assets at cost An increase in fixed assets (the long-term productive assets of the
company) is a use of cash that reduces the firm’s FCF.
FCF = sum of the above

FIGURE 16.2 Defining the free cash flow (FCF). We have previously discussed FCFs and their use in valuation in
Chapters 6 and 7.
488 PART THREE VALUING SECURITIES

Predict firm's future free cash flows

(FCF). In Chapters 6 & 7 we did this
using a pro forma model.

Compute the firm's weighted average cost of capital

(WACC):
E D
WACC=rE +r (1–TC) Alternatively
E+D D E+D

Where rE is the cost of equity, rD is the

cost of debt, and TC is the firm's tax rate

Discount some of the free cash flows and the terminal value
Discount all future free cash flows to get the enterprise to get the enterprise value of the firm:
value of the firm: Enterprise value
FCFt
Enterprise value= Σ
t =1 (1+WACC)
t
*(1+WACC)0.5 =
N
Σ
FCF t
+
Terminal value
*(1+WACC)0.5
t (1+WACC)N
t=1 (1+WACC)

We've multiplied by (1+WACC)0.5 because cash flows are The terminal value is what the firm will be worth on date N.
assumed to occur in midyear. We've multiplied by (1+WACC)0.5 because cash flows are
assumed to occur in midyear.

Add initial cash balances to enterprise value to get total

value of the firm's assets:

Total asset value=Enterprise value+Initial cash

Subtract debt value from firm value to get total equity

value:
Equity value=Total asset value–Debt value

Divide equity value by the number of

shares to derive the share value:
Total equity value
Share value=
Number of shares

FIGURE 16.3 Flow diagram for a FCF valuation: Calculating a firm’s share value.

Valuation 2: Example 1—A Basic Example

It is 31 December 2010 and you are trying to value Arnold Corp, which finished 2010 with a
FCF of $2 million. The company has debt of $10 million and cash balances of $1 million. You
estimate the following financial parameters for the company:
• The future anticipated growth rate of the FCF is 8%.
• The WACC of Arnold is 15%.
• Arnold Corp. has 1,000,000 shares outstanding.
You can now estimate the value of Arnold: The enterprise value of Arnold is the present
value of future anticipated FCFs discounted at the WACC:
 CHAPTER 16 Valuing Stocks 489

⎡∞ FCFt ⎤
Enterprise value = ⎢ ∑
0.5
t
⎥ * (1 + WACC )
⎢⎣ t =1 (1 + WACC ) ⎥⎦ !"""""#
↑
"""""$
!"""""""#"""""""$ This factor "corrects"
↑ for the fact that FCFs occur
This is the PV throughout the year.
formula, assuming that
FCFs occur at year-end

⎡ ∞ FCF2010 (1 + g )t ⎤
= ⎢∑
0.5
t
⎥ * (1 + WACC )
⎢⎣ t =1 (1 + WACC ) ⎥⎦
!""""""""#""""""""$
↑
Future FCFs are expected
to grow at rate g.

⎡ FCF2010 (1 + g )⎤ 0.5
=⎢
WACC − g ⎥ * (1 + WACC )
⎣!"""""""#"""""""⎦$
↑
This formula was
given in Chapter 2

Doing the computations in an Excel spreadsheet shows that the enterprise value of Arnold
Corp. is $33,090,599 and that the estimated per-share value is $24.09.
A B C
1 VALUING ARNOLD CORP.
2 2003 FCF (base year) 2,000,000
3 Future FCF growth rate 8%
4 WACC 15%
5 End-2003 debt 10,000,000
6 End-2003 cash 1,000,000
7 Number of shares outstanding 1,000,000
8
9 Enterprise value 33,090,599 <-- =B2*(1+B3)/(B4-B3)*(1+B4)^0.5
10 Add cash 1,000,000 <-- =B6
11 Subtract debt -10,000,000 <-- =-B5
12 Value of equity 24,090,599 <-- =SUM(B9:B11)
13 Share value 24.09 <-- =B12/B7

Valuation Method 2: Example 2—Two FCF Growth Rates

In the valuation of Arnold Corp. in the previous subsection we assumed a FCF growth rate that
is unchanging over the future. This assumption is often suitable for a mature, stable company,
but it may not be appropriate for a company that is currently experiencing very high growth
rates. In this subsection we show how to perform an FCF valuation of a company for which we
assume two FCF growth rates—a high FCF growth rate for a number of years followed by a
subsequent lower FCF growth rate.
Xanthum Corp. has just finished its 2010 financial year. The company’s 2010 FCF was
$1,000,000. Xanthum has been growing very fast; you anticipate that for the coming 5 years the
annual FCF growth rate will be 35%. After this time, you anticipate that the FCF growth will
slow to 10% per year, because the market for Xanthum’s products will become mature.
Xanthum has 3,000,000 shares outstanding and a WACC of 20%. It currently has $500,000 of
cash on hand that is not needed for operations; Xanthum also has $3,000,000 of debt. To value the
company, we apply the same valuation scheme as before, but this time we use the two FCF growth
rates.
490 PART THREE VALUING SECURITIES

⎡ ⎤
⎢ ⎥
⎢ 5 ∞ ⎥
⎢ FCFt FCFt ⎥ * (1 + WACC )0.5
Enterprise value = ∑
⎢ t = 1 (1 + WACC )t ∑
+ t ⎥
t = 6 (1 + WACC )
!""""""#""""""$
⎢ !"""""""#"""""""$ !"""""""#"""""""$ ⎥ ↑
This factor "corrects"
⎢ The PV of↑ the "high ↑
The PV of the "normal
⎥ for the fact that FCFs occur
⎣⎢ growth" FCFs growth" FCFs ⎦⎥ throughout the year.

There’s a valuation formula that can be derived using techniques described in the appendix
to Chapter 2:
Enterprise value =
⎡ ⎤
⎢ ⎥
⎢ ⎥
⎢ ⎛ ⎛ 1 + ghigh ⎞5 ⎞ ⎥
⎢ ⎜1− ⎜ ⎟ ⎥
⎢ FCF2010 (1 + ghigh )⎜ ⎝ 1 + WACC ⎠⎟ ⎟
5
⎛ 1 + ghigh ⎞ ⎛ 1 + gnormal ⎞⎥ 0.5
⎢ 1 + WACC ⎜ 1 + ghigh ⎟ + FCF2010 ⎜ 1 + WACC ⎟ ⎜⎝ WACC − gnormal ⎟⎠ ⎥ * (1 + WACC )
⎢ ⎜ 1− ⎝
⎟ !""""""""""""""""" ⎠
"#""""""""""""""""" "$ ⎥
⎢ ⎜ 1 + WACC ⎟ ↑ ⎥
⎢ !""""""""""""""""#""""""""""⎝ """"""$⎠ In the spreadsheet this is called
⎥
"term 2"
⎢ ↑
In the spreadsheet this is called ⎥
⎢ 1+ ghigh ⎥
⎣ "term 1" and
1+ WACC
is called "term1 factor"
⎦

The spreadsheet below shows that Xanthum’s enterprise value is $29,621,547 (cell B15) and that its
per-share value is $9.04 (cell B21).

A B C
1 VALUING XANTHUM CORP.
2 2003 FCF (base year) 1,000,000
3
4 High growth rate, ghigh 35%
5 Normal growth rate, gnormal 10%
6 Number of high growth years 5
7 Term 1 factor: (1+ghigh)/(1+WACC) 113% <-- =(1+B4)/(1+B9)
8
9 WACC 20%
10 End-2003 debt 3,000,000
11 End-2003 cash 500,000
12
13 Term 1: PV of high-growth cash flows 7,218,292 <-- =B2*B7*(1-B7^B6)/(1-B7)
14 Term 2: PV of normal-growth cash flows 19,822,357 <-- =B2*B7^B6*(1+B5)/(B9-B5)
15 Enterprise value 29,621,547 <-- =SUM(B13:B14)*(1+B9)^0.5
16 Add cash 500,000 <-- =B11
17 Subtract debt -3,000,000 <-- =-B10
18 Value of equity 27,121,547 <-- =SUM(B15:B17)
19
20 Number of shares, end 2003 3,000,000
21 Share value 9.04 <-- =B18/B20
 CHAPTER 16 Valuing Stocks 491

Valuation Method 2: Example 3—Using the

Terminal Value in a Real-Estate Project
In the previous two examples we discounted an infinitely lived stream of cash flows. Sometimes
it makes more sense to discount a finite number of cash flows and then attribute a terminal value
to the project.
Here’s an example: Your Aunt Sarah has quite a bit of money. She’s been offered a share in a
partnership that is being set up by a local real estate agent. The partnership will buy an existing
building, called the Station Building, for $20 million. The agent is selling 25 shares, for $800,000
⎛ $20,000,000 ⎞
each ⎜ $800,000 = 25 ⎟ . Aunt Sarah has asked you to do some financial analysis to
⎝ ⎠
determine whether this is a fair price for a partnership share in the Station Building.
Here’s what you discover:
• All income from the Station Building partnership will flow through to the shareholders,
who will pay taxes on the income at their personal tax rates. Aunt Sarah’s tax rate is
40%.
• Station Building will be depreciated over 40 years, giving an annual depreciation of
$500,000 per year.
• The building is fully rented out and brings up annual rents of $7 million. You do not
anticipate that these rents will increase over the next 10 years.
• Maintenance, property taxes, and other miscellaneous expenses for Station Building cost
about $1 million per year.
• The agent who is putting together the partnership has proposed selling Station Building
after 10 years. He estimates that the market price of the building will not change much
over this period—meaning that the market price of Station Building in year 10 is antici-
pated to be $20 million, like its price today.
• A reliable financial consultant has told you that the appropriate discount rate for cash
flows from buildings like Station Building is 18%. You decide to use this as your WACC
for discounting the cash flows.
In your valuation of the Station Building shares, you see that the annual free cash flow
(FCF) to Aunt Sarah is $152,000 (cell B16 in the spreadsheet below). This FCF will be available
to her in years 1–10 and is based on the building’s profit before taxes of $5,500,000, which will
be spread equally among the partners.
The terminal value of the building is $20,000,000, which on a per-share basis is $800,000
(cell B19). At the time the building is sold in year 10, its accumulated depreciation is $5,000,000,
so that its book value is $15,000,000. To compute Aunt Sarah’s cash flow from this terminal
value, we deduct the per-share book value of the building ($600,000, cell B20) from the sale
price to arrive at taxes of $80,000 on the profit from the sale of the building (cell B22). The
cash flow from the sale is the $800,000 sale price minus the taxes, or $720,000, as shown in
cell B23.
492 PART THREE VALUING SECURITIES
A B C D E F G
1 STATION BUILDING PARTNERSHIP—SHARE VALUATION
2 Building cost 20,000,000
3 Depreciable life (years) 40
4 Annual rents 7,000,000
5 Annual expenses 1,000,000
6 Annual depreciation 500,000 <-- =B2/B3 Profit and loss, Station Building as a whole
7 Aunt Sarah's tax rate 40% Annual rent 7,000,000
8 WACC 18% Minus annual expenses -1,000,000
9 Shares issued 25 Minus annual depreciation -500,000
10 Share price 800,000 Anticipated annual building profit before taxes 5,500,000 <-- =SUM(F7:F9)
11
12 Profit and loss, Aunt Sarah's share
13 Anticipated annual building profit before taxes 220,000 <-- =F10/B9 Terminal value, year 10, Station Building as a whole
14 Profit after taxes 132,000 <-- =(1-B7)*B13 Anticipated building market price 20,000,000 <-- =B2
15 Building depreciation, per share 20,000 <-- =B6/B9 Accumulated depreciation, year 10 5,000,000 <-- =B6*10
16 Free cash flow 152,000 <-- =B14+B15 Book value of building, year 10 15,000,000 <-- =B2-F15
17
18 Terminal value, year 10, Aunt Sarah's share
19 Anticipated building market price 800,000 <-- =F14/B9
20 Book value in year 10, per share 600,000 <-- =F16/B9
21 Profit from sale of building 200,000 <-- =B19-B20
22 Tax on profit 80,000 <-- =B7*B21
23 Terminal value: cash flow from sale 720,000 <-- =B19-B22
24
Aunt Sarah's
anticipated
25 Year FCF
26 1 152,000 <-- =$B$16
27 2 152,000
28 3 152,000
29 4 152,000
30 5 152,000
31 6 152,000
32 7 152,000
33 8 152,000
34 9 152,000
35 10 872,000 <-- =$B$16+B23
36
Share value: Present value of Aunt Sarah's
37 free cash flows $820,667.53<-- =NPV(B8,B26:B35)

Cells B26:B35 show Aunt Sarah’s anticipated FCFs from the building partnership, includ-
ing the terminal value. Discounting these cash flows at the WACC of 18% values a partnership
share at $820,667.53. Conclusion: Aunt Sarah should invest in the building!

Valuation Method 2: Example 4—Using the Terminal Value to Get

around Large FCF Growth Rates
Our second example of using the terminal value involves the Formanis Corp. Formanis is in a
growth industry and has had formidable FCF growth rates for the past several years, and you
anticipate that these rates will continue for years 1–5. However, after year 5 you anticipate a big
slowdown in Formanis’s FCF growth, as its industry matures.
Here are the relevant facts about Formanis:
• The company’s FCF for the current year is $1,000,000.
• You anticipate that the FCF for years 1–5 will grow at a rate of 25% per year.
• You anticipate a growth rate of FCFs of 6% per year for years 6, 7, . . . (termed the “long-
term growth rate” in the following spreadsheet).
• The company has 5 million shares outstanding.
• The appropriate WACC = 15%.
The valuation formula is

FCF1 FCF2 FCF3 FCF4 FCF5

Formanis value = + + + +
(1 + WACC ) (1 + WACC ) (1 + WACC ) (1 + WACC ) (1 + WACC )5
2 3 4

1 FCF5 * (1 + long-term growth rate )

+ *
5
(WACC − long-term growth rate
(1 + WACC ) !"" """""""""""""#""""""""""""""")$
↑
This is the terminal value:
an explanation is given in Chapter 6
 CHAPTER 16 Valuing Stocks 493

To value Formanis, we first predict the FCFs for years 1–5 (cells B9:B13 of the spread-
sheet). The present value of these FCFs is $6,465,787 (cell B20). The terminal value represents
the year-5 present value of the Formanis cash flows for years 6, 7, . . . . To compute the terminal
value, we assume that Formanis’s cash flows for these years grow at the long-term growth rate:

Terminal value = year -5 PV of Formanis FCFs, years 6,7,...

FCF6 FCF7 FCF8
= + + + ...
(1 + WACC ) (1 + WACC ) (1 + WACC )3
2

2
FCF5 * (1 + long-term growth rate ) FCF5 * (1 + long-term growth rate )
= +
(1 + WACC ) (1 + WACC )2
3
FCF5 * (1 + long-term growth rate )
+ + ...
(1 + WACC )3
FCF5 * (1 + long-term growth rate )
=
(WACC − long-term growth rate )
In cell B17 below the terminal value—assuming a long-term FCF growth rate of 6%—is
$35,942,925.

A B C
1 FORMANIS CORPORATION
2 Current FCF 1,000,000
3 Anticipated growth rate, years 1-5 25%
4 WACC 15%
5 Long-term growth rate, after year 5 6%
6 Number of shares outstanding 5,000,000
7
Anticipated
8 Year FCF
9 1 1,250,000 <-- =$B$2*(1+$B$3)
10 2 1,562,500 <-- =B9*(1+$B$3)
11 3 1,953,125 <-- =B10*(1+$B$3)
12 4 2,441,406
13 5 3,051,758
14
15 Terminal value calculation
16 FCF in year 5 3,051,758 <-- =B13
17 Terminal value 35,942,925 <-- =B16*(1+B5)/(B4-B5)
18
19 Valuing Formanis Corporation
20 Present value of FCFs, years 1-5 6,465,787 <-- =NPV(B4,B9:B13)
21 Present value of terminal value 17,869,986 <-- =B17/(1+B4)^5
22 Value of Formanis 24,335,774 <-- =B21+B20
23 Per share value $4.87 <-- =B22/B6

The value of Formanis (cell B22) is $14,930,518. The per-share value of Formanis is $2.99
(cell B23).
The terminal value method illustrated for Formanis is often used:
• It allows the stock analyst to distinguish between short-term growth and long-term
growth. Often short-term growth is a function of market performance, whereas
494 PART THREE VALUING SECURITIES

long-term growth is determined by macroeconomic factors. For example, in a new

and rapidly developing market, we might anticipate high short-term growth rates.
But we would also anticipate that as the market matures and becomes more satu-
rated, the long-term growth rates would approximate the growth of the economy as
a whole.
• From an Excel point of view, the terminal value method allows us to do interesting
sensitivity analysis. For example, here is the per-share value of Formanis for a variety
of long-term growth rates and WACCs; we use the Data Table technique described in
Chapter 27.

A B C D E F
Sensitivity analysis: Per-share value of Formanis
with different WACC and long-term growth.
26 Year 1-5 growth rate = 25%.
27 =B23 Long-term growth rate ↓
28 $4.87 0% 2% 4% 6%
29 WACC → 15% 3.32 3.67 4.16 4.87
30 20% 2.36 2.52 2.73 2.99
31 25% 1.80 1.89 1.99 2.12
32 30% 1.44 1.49 1.55 1.62

Varying the year 1–5 growth rate gives different values. In the table below, for example,
we’ve assumed that year 1–5 growth is 20%.

A B C D E F
Sensitivity analysis: Per-share value of Formanis
with different WACC and long-term growth.
26 Year 1-5 growth rate = 20%.
27 =B23 Long-term growth rate ↓
28 $4.05 0% 2% 4% 6%
29 WACC → 15% 2.79 3.08 3.48 4.05
30 20% 2.00 2.13 2.30 2.51
31 25% 1.54 1.61 1.69 1.80
32 30% 1.24 1.28 1.33 1.38

16.3. Valuation Method 3: The Price of a Share Is the

PV of Its Future Anticipated Equity Cash Flows
Discounted at the Cost of Equity
In the previous section we “backed into” the equity valuation of the firm by first calculating the
value of the firm’s assets (the enterprise value plus initial cash balances) and then subtracting
from this number the value of the firm’s debts. In this section we present another method for cal-
culating the value of the firm’s equity—we directly discount the value of the firm’s anticipated
payouts to its shareholders.
 CHAPTER 16 Valuing Stocks 495

As an example consider Haul-It Corp., which has a steady record of paying dividends and
repurchasing shares. The company has 10 million shares outstanding. Here’s a spreadsheet with
the valuation model.

A B C D E F G
HAUL-IT CORPORATION—EQUITY PAYOUT
1 HISTORY AND SHARE VALUATION
2 1998 1999 2000 2001 2002
3 Repurchases $1,440,000 $2,410,000 $3,500,000 $6,820,000 $4,830,000
4 Dividends $3,950,000 $3,997,000 $4,238,000 $4,875,000 $5,100,000
5 Total cash paid to equity holders $5,390,000 $6,407,000 $7,738,000 $11,695,000 $9,930,000
6
Compound annual
7 growth, 1998-2002 16.50% <-- =(F5/B5)^(1/4)-1
8
9 Haul-It's cost of equity, rE 25.00%
10
11 Valuation
12 Current equity payout $9,930,000 <-- =F5
13 Anticipated future growth 16.50%
14
15 Value of total equity 136,164,862 <-- =B12*(1+B13)/(B9-B13)
16 Number of shares outstanding 10,000,000
17 Value per share 13.62 <-- =B15/B16
18
19
Haul-It Corporation—Payouts to Equity Holders
20
21 $14,000,000
Repurchases
22
23 $12,000,000
Dividends
24
$10,000,000
25 Total cash paid to equity holders
26 $8,000,000
27
28 $6,000,000
29
30 $4,000,000
31
32 $2,000,000
33
$0
34
35 1998 1999 1999 2000 2000 2001 2001 2002 2002
36
37

Between 1998 and 2002, Haul-It’s payouts to its equity holders have increased at an impres-
sive rate of 16.50% per year (cell B7). The company’s cost of equity rE is 25% (cell B9).1
Assuming that future equity payout growth equals historical growth, Haul-It is valued at $136
million (cell B15), which gives a per-share value of $13.62.
The equity value of the company is the discounted value of the future anticipated equity
payouts:

1
At this point we do not discuss how we arrived at this cost of equity. For a recapitulation of cost of capital
techniques, see Chapters 6 and 13.
496 PART THREE VALUING SECURITIES

Equity payout2003 Equity payout2004 Equity payout2005

Equity value = + 2
+ 3
+ ....
1 + rE (1 + r ) (1 + r )
E E
2 3
Equity payout2002 (1 + g ) Equity payout2002 (1 + g ) Equity payout2002 (1 + g )
= + 2
+ 3
+ ....
1 + rE (1 + rE ) (1 + rE )
Equity payout2002 (1 + g ) 9,930,000 (1.165 )
= = = 136,164,862
rE − g 25.00% − 16.50%

Dividing the equity value by the number of shares outstanding gives the estimated value
per share:
Equity value 136,164,862
Value per share = = = 13.62
Shares outstanding 10,000,000

Why Do Finance Professionals Shun Direct Equity Valuation?

Valuation method 3, the direct valuation of equity, is so simple that it may surprise you that it is
rarely used. There are several reasons for this, none of which we can fully explain at this point
in the book:
• The direct equity valuation method depends on projected equity payouts (that is, divi-
dends plus share repurchases), whereas method 2 depends on projected FCFs. Whereas a
firm’s equity payouts are a function of management decisions about dividends and stock
repurchases, FCFs are a function of the firm’s operating environment—its sales, costs,
capital expenditures, and so on. Because many components of the FCFs are determined
by the firm’s operating environment rather than management decisions about dividends,
analysts are generally more comfortable predicting FCFs.
• The FCF method 2 discounts future FCFs at the firm’s weighted average cost of capital
(WACC). The equity payout method 3 discounts future equity payouts at the firm’s cost
of equity rE. For reasons we will explain in Chapters 17 and 18, the cost of equity rE is
very sensitive to the firm’s debt-to-equity ratio, whereas the WACC is not as sensitive to
the debt-to-equity ratio.2

16.4. Valuation Method 4, Comparative Valuation:

Using Multiples to Value Shares
The last valuation technique we discuss is based on a comparison of financial ratios for different
companies. This valuation technique is often referred to as using “multiples.” The technique is
based on the logic that financial assets that are similar in nature should be priced the same way.

A Simple Example: Using the Price/Earnings (P/E) Ratio for Valuation

The P/E ratio is the ratio of a firm’s stock price to its earnings per share:
stock price
P/E = .
earnings per share

2
For reasons explained in Chapters 17 and 18, the WACC may in fact be completely invariant to a firm’s
leverage. If this is so, we can value a firm based on method 2 without worrying about its leverage.
 CHAPTER 16 Valuing Stocks 497

When we use the P/E for valuation, we assume that similar firms should have similar P/E
ratios.
Here’s an example: Shoes for Less (SFL) and Lesser Shoes (LS) are both shoe stores
located in similar communities. Although SFL is bigger than LS, having double the sales and
double the profits, the companies are in most relevant respects similar—management, finan-
cial structure, etc. However, the market valuation of the two companies does not reflect their
similarity: The P/E ratio of SFL is significantly lower than that of LS, as can be seen in the
spreadsheet below.
Based on the similarity between the two companies, SFL appears underpriced relative to
LS—its P/E ratio is less. A market analyst might recommend that anyone interested in investing
in the shoe store business should invest in SFL rather than LS.3

A B C D
SHOES FOR LESS (SFL) AND LESSER SHOES (LS)
1 comparing P/E ratios
SFL: LS:
Shoes Lesser
2 for Less Shoes
3 Sales 30,000 15,000
4 Profits 3,000 1,500
5 Number of shares 1,000 1,000
6 Share price 24 18
7 Equity value 24,000 18,000 <-- =C6*C5
8 EPS: Earnings per share 3 1.5 <-- =C4/C5
9 P/E: Price-earnings ratio 8.00 12.00 <-- =C6/C8

Kroger (KR) and Safeway (SWY)

Both of these firms are in the supermarket business. Some of the data from these profiles are in
the spreadsheet below, which shows five multiples for these two fi rms.

A B C D E F
SAFEWAY (SWY) AND KROGER (KR)—COMPARISON BASED ON MULTIPLES
1 Based on Yahoo! Profiles, 12 September 2002
Who's more
2 KR SWY highly valued?
3 Stock price 18.09 26.91 <-- Yahoo
4 Earnings per share (EPS) 1.37 2.60 <-- Yahoo
5 Price/Earnings (P/E) ratio 13.20 10.35 <-- =C3/C4 Kroger <-- =IF(B5>C5,"Kroger","Safeway")
6
7 Book value of equity per share 4.79 11.41 <-- Yahoo
8 Equity market to book ratio 3.78 2.36 <-- =C3/C7 Kroger <-- =IF(B8>C8,"Kroger","Safeway")
9
10 Number of shares outstanding (million) 788.8 466.5 <-- Yahoo
11 Market value of equity (billion) 14.27 12.55 <-- =C10*C3/1000
12
13 Debt/Equity (based on book values) 2.22 1.32 <-- Yahoo
Debt (billion)
14 this number is not in Yahoo 8.39 7.03 <-- =C10*C7*C13/1000
15 Cash (billion) 0.185 0.051 <-- Yahoo
16 Net debt 8.20 6.98 <-- =C14-C15
17
Book value of equity + debt (billion) - cash
18 (book value of enterprise) 11.98 12.30 <-- =C10*C7/1000+C14-C15
Market value of equity + debt (billion) - cash
19 (market value of enterprise) 22.47 19.53 <-- =C11+C14-C15
20 Enterprise value, market to book 1.88 1.59 <-- =C19/C18 Kroger <-- =IF(B20>C20,"Kroger","Safeway")
21
Earnings before interest, taxes, depreciation
22 and amortization (EBITDA) in billion$ 3.53 2.64 <-- Yahoo
23 Market enterprise value to EBITDA 6.37 7.40 <-- =C19/C22 Safeway <-- =IF(B23>C23,"Kroger","Safeway")
24
25 Sales 50.7 34.7 <-- Yahoo
26 Market enterprise value to Sales 0.44 0.56 <-- Yahoo Safeway <-- =IF(B26>C26,"Kroger","Safeway")

3
A more radical strategy might be to buy shares of SFL and to short shares of LS. See Chapter 14 and its
discussion of Palm and 3Com shares for a discussion of this strategy.
498 PART THREE VALUING SECURITIES

• P/E ratio: This is the most common multiple used. Based on this ratio of the stock price
to the EPS, KR is more highly valued than SWY. The problem with using this multiple is
that it is influenced by many factors, including the firm’s leverage. We prefer enterprise
value ratios such as the following.
• Equity market-to-book ratio: This is the ratio of the market value of the firm’s equity
to the book value (its accounting value). If the book value accurately measures the cost
of the assets, then a higher equity market-to-book value reflects a greater valuation
of the equity. However, the accounting numbers are heavily influenced by the age of
the assets, the depreciation, and other accounting policies, so that this ratio is not so
accurate.
• Enterprise value-to-book ratio: The enterprise value is the value of the firm’s
equity plus its net debt (defined as book value of debt minus cash). Row 18 above
measures the firm’s net debt by subtracting the cash balances from the book value of
the debt. The enterprise market to book ratio shows that KR is valued more highly
than SWY.
• Enterprise value-to-EBITDA ratio: Earnings before interest, taxes, depreciation, and
amortization (EBITDA) is a popular Wall Street measure of the ability of a firm to pro-
duce cash. In spirit it is similar to the free cash flow (FCF) concept discussed in this
chapter, although it ignores changes in net working capital and capital expenditures. The
market enterprise value-to-EBITDA ratio shows that SWY is actually more highly val-
ued than KR.
• Market enterprise value-to-sales ratio: This one of the many other ratios we could use
to compare these two firms. As a percentage of its sales, SWY is more highly valued than
KR; this perhaps reflects SWY’s ability to extract more cash for its shareholders from
each dollar of sales. Or perhaps it reflects greater shareholder optimism about the future
sales growth rate.

Using Multiples to Value Firms—Summary

The multiple method of valuation is a highly effective way of comparing the values of several
companies, as long as the companies being compared are truly comparable. Comparability
is complicated, however, and you should be careful: Truly comparable firms will have similar
operational characteristics such as sales and costs, as well as similar financing.4

16.5. Intermediate Summary

In Sections 16.1–16.4 we’ve examined four stock valuation methods:
• Valuation method 1, the efficient markets approach, is based on the assumption that
market prices are correct.

4
We’re getting ahead of ourselves, as we did in the previous footnote. The point is that it doesn’t make
sense to compare the stock price of two operationally similar firms if one firm is financed with a lot of debt
and the other firm is financed primarily with equity. This point is a result of the discussion in Chapters 17
and 18. For more details see Chapter 10 of Corporate Finance: A Valuation Approach by Simon Benninga
and Oded Sarig, McGraw–Hill, 1997.
 CHAPTER 16 Valuing Stocks 499

• Valuation method 2, the free cash flow (FCF) approach, values the fi rm by discounting
the future anticipated FCFs at the weighted average cost of capital (WACC). Sections
16.6 and 16.7 show several methods of determining the WACC.
• Valuation method 3, the equity payout approach, values all of the firm’s shares by dis-
counting the future anticipated payouts to equity. The discount rate is the firm’s cost of
equity rE.
• Valuation method 4, the multiples approach, gives a comparative valuation of firms based
on ratios such as the price/earnings (P/E) ratio.
In the next sections we discuss some issues related to valuation methods 2 and 3:
We discuss the computation of the WACC) and the cost of equity rE (Sections 16.6 and
16.7).

16.6. Computing Target’s WACC, the SML Approach

Valuation method 2 depends on the WACC, which was previously discussed in Chapters 6 and
13. In this section we briefly repeat some of the things said in Chapter 13 and show how to com-
pute the firm’s WACC using the SML.
The basic WACC formula is

E D
WACC = rE + r (1 − TC )
E+D D+E D

To estimate the WACC we need to estimate the following parameters:

rE = the cost of equity

rD = the cost of the firm's debt
E = market value of the firm's equity
= number of shares * current market value per share
D = market value of the firm's debt
this is usually approximated by the book value of the firm's debt
TC = the firm's marginal tax rate

To illustrate the computation of the WACC, we use data for Target Corp., a large discount
retailer. Figure 16.4 gives the relevant financial information for Target. Using the Target data,
we devote a short subsection to each of the WACC parameters, leaving the cost of equity rE until
last because it is the most complicated.
500 PART THREE VALUING SECURITIES

A B C
1 TARGET CORPORATION
2 Income statement 2001 2002
3 Revenues 39,826 43,917
4 Cost of sales 27,143 29,260
5 Selling, general and administrative expenses 8,461 9,416
6 Credit card expense 463 765
7 Depreciation 1,079 1,212
8 Interest expense 473 588
9 Earnings before taxes 2,207 2,676
10 Income taxes 839 1,022
11 Net earnings 1,368 1,654
12
13 Balance sheet
14 Assets 2001 2002
15 Cash and cash equivalents 499 758
16 Accounts receivable 3,831 5,565
17 Inventory 4,449 4,760
18 Other current assets 869 852
19 Total current assets 9,648 11,935
20
21 Land, plant, property, and equipment
22 At cost 18,442 20,936
23 Accumulated depreciation 4,909 5,629
24 Net land, plant, property and equipment 13,533 15,307
25
26 Other assets 973 1,361
27 Total assets 24,154 28,603
28
29 Liabilities and shareholder equity
30 Accounts payable 4,160 4,684
31 Accrued liabilities 1,566 1,545
32 Income taxes payable 423 319
33 Current portion of long-term debt and notes payable 905 975
34 Total current liabilities 7,054 7,523
35
36 Long-term debt 8,088 10,186
37 Deferred income taxes 1,152 1,451
38 Shareholders equity
39 Common stock 1,173 1,332
40 Accumulated retained earnings 6,687 8,111
41 Total equity 7,860 9,443
42 Total liabilities and shareholder equity 24,154 28,603
43
44 Other relevant information
45 Shares outstanding 908,164,702
46 Stock beta 1.16
47 Stock price, 1 February 2003 28.21

FIGURE 16.4 Financial information for Target Corp. We use this

information to determine Target’s cost of equity rE and its weighted
average cost of capital (WACC).

Computing the Market Value of Target’s Equity, E

Target has 908,164,702 shares outstanding (cell C45, Figure 16.4). On 1 February 2003, the
day of the company’s annual report for its 2002 financial year, the stock price of Target was
$28.21 per share. Thus the market value of the company’s equity is 908,164,702 * $28.21 =
$25,619,326,243. We will use this market value of equity in our computation of Target’s WACC
(see next spreadsheet).

Computing the Market Value of Target’s Debt, D

The Target balance sheets differentiate between short-term debt (“current portion of long-term
debt and notes payable”—row 33 of Figure 16.4) and long-term debt (row 36). For purposes of
computing the debt for a WACC computation, both of these numbers should be added together.
This gives debt for Target as follows.
 CHAPTER 16 Valuing Stocks 501

A B C D
6 2002 2001
7 Current portion of long-term debt and notes payable 975 905
8 Long-term debt in 2002 and 2001 (columns B and C) 10,186 8,088
9 Total debt, D 11,161 8,993 <-- =C8+C7

Estimating the Cost of Debt, rD

A simple method to compute the cost of debt rD is to calculate the average interest cost over the
year. In 2002 Target paid $588 interest (cell B8, Figure 16.4) on average debt of $10,077. This
gives rD = 5.84%.

A B C D
13 Interest paid, 2002 588
14 Average debt over 2002 10,077 <-- =AVERAGE(B9:C9)
15 Interest cost, rD 5.84% <-- =C13/C14

Target’s Income Tax Rate, TC

In 2002 Target paid taxes of $1,022 on earnings of $2,676 (cells B10 and B9, respectively, of
Figure 16.4). Its income tax rate was therefore 38.19%.

A B C
17 Earnings before taxes, 2002 2,676
18 Income taxes 1,022
19 Corporate tax rate, TC 38.19% <-- =C18/C17

Computing Target’s Cost of Equity, rE, Using the SML

The SML equation for computing Target’s cost of equity rE is given by

rE = rf + βE * ⎡⎣ E (rM ) − rf ⎤⎦ ,

Yahoo! gives Target’s β as 1.16. In February 2003, the risk-free rate r f was 2% and
the expected return on the market E(rM) was 9.68%.5 This gives Target’s cost of equity as
r E = 10.91%.

A B C D
21 Equity beta, βE 1.16
22 Risk-free rate, rf 2%
23 Expected market return, E(rM) 9.68%
24 Cost of equity, rE 10.91% <-- =B22+B21*(B23-B22)

Putting It All Together

Now that we’ve done all the calculations, we can compute Target’s WACC:

E D
WACC = r + r (1 − TC )
E+D E D+E D
25,619 11,161
= 10.91% + 5.84% (1 − 38.19% )
25,619 + 11,161 25,619 + 11,161
= 8.69%

5
To see how E(rM) was derived, see the boxed discussion on page 502.
502 PART THREE VALUING SECURITIES

Here it is in a spreadsheet.

A B C D
TARGET CORP.'S WACC USING
1 SML FOR COST OF EQUITY
2 Number of shares (million) 908
3 Market value per share, 1 February 2002 28.21
4 Market value of equity 1 February 2002, E 25,619 <-- =B3*B2
5
6 2001 2002
7 Current portion of long-term debt and notes payable 905 975
8 Long-term debt in 2002 and 2001 (columns B and C) 8,088 10,186
9 Total debt, D 8,993 11,161 <-- =C8+C7
10
11 Market value of Target, E+D 36,780 <-- =C9+B4
12
13 Interest paid, 2002 588
14 Average debt over 2002 10,077 <-- =AVERAGE(B9:C9)
15 Interest cost, rD 5.84% <-- =C13/C14
16
17 Earnings before taxes, 2002 2,676
18 Income taxes 1,022
19 Corporate tax rate, TC 38.19% <-- =C18/C17
20
21 Equity beta, βE 1.16
22 Risk-free rate, rf 2%
23 Expected market return, E(rM) 9.68%
24 Cost of equity, rE 10.91% <-- =C22+C21*(C23-C22)
25
<-- =B4/C11*C24+(1-
26 WACC 8.69% C19)*C9/C11*C15

Computing the Expected Return on the Market, E (rM )

The most controversial part of estimating the cost of capital using the CAPM is the estimation
of the expected return on the market E(rM). We discussed this issue and some methods of
estimation in Chapter 13. To recapitulate, we advocate using a P/E multiple model for estimating
the equity premium. This model, presented in Chapter 13 and briefly reviewed in the box below,
gives us E(rM) = 9.68%.

P/E MULTIPLE MODEL FOR ESTIMATING E(rM )

We start with the payout form of the Gordon dividend model:

D0 (1 + g ) b * EPS0 (1 + g )
rE = +g= +g
P0
!"""""#""""" P"#""""""""
$ !"""""""0 $
↑ ↑
Gordon dividend b is the dividend payout
model ratio, EPS0 is the current
firm earnings per share
b * (1 + g )
= +g
P0 / EPS0
 CHAPTER 16 Valuing Stocks 503

This model is now used to measure the E(rM) using current market data:
b * (1 + g )
E ( rM ) = +g
P0 / EPS0
where
b = market payout ratio (in U.S. around 50%)
g = growth rate of market earnings (educated guess)
P0 / EPS0 = market price/earnings ratio

Here’s an Excel example.

A B C
1 ESTIMATING E(rM) USING THE P/E RATIO
2 Market P/E ratio 20.00
3 Market dividend payout ratio, b 50%
4 Estimated growth of market earnings, g 7%
5
6 E(rM) 9.68% <-- =B3*(1+B4)/B2+B4
7 Risk-free rate, rf 2.00%
8 Market risk premium, E(rM) - rf 7.68% <-- =B6-B7

We use these values—representative of market parameters in the United States in early 2003—
in our determination of the Target Corp. cost of equity rE.

A B C D E F G H I J K L M N O
1 ANNUALIZED REAL RETURNS ON EQUITIES, BONDS, AND BILLS, 1900-2000
2
Equity
Equity Premium in 16 Countries, 1900-2000
3 Equities Bonds Bills premium
4 Australia 7.50% 1.10% 0.40% 7.10% <-- =B4-D4
5 Belgium 2.50% -0.40% -0.30% 2.80% <-- =B5-D5 8.0%
6 Canada 6.40% 1.80% 1.70% 4.70%
7 Denmark 4.60% 2.50% 2.80% 1.80% 7.0%
8 France 3.80% -1.00% -3.30% 7.10% 6.0%
9 Germany 3.60% -2.20% -0.60% 4.20% 5.0%
10 Ireland 4.80% 1.50% 1.30% 3.50%
11 Italy 2.70% -2.20% -4.10% 6.80% 4.0%
12 Japan 4.50% -1.60% -2.00% 6.50% 3.0%
13 Netherlands 5.80% 1.10% 0.70% 5.10% 2.0%
14 South Africa 6.80% 1.40% 0.80% 6.00%
15 Spain 3.60% 1.20% 0.40% 3.20% 1.0%
16 Sweden 7.60% 2.40% 2.00% 5.60% 0.0%
17 Switzerland 5.00% 2.80% 1.10% 3.90%
Germany

Italy
France

Ireland
Canada

Denmark

Japan

South Africa

Spain
Netherlands

United States
Australia

Sweden

United Kingdom
Belgium

Switzerland

18 United Kingdom 5.80% 1.30% 1.00% 4.80%

19 United States 6.70% 1.60% 0.90% 5.80%
20 Average 5.11% 0.71% 0.18% 4.93%
21
Source : Elroy Dimson, Paul Marsh, Mike Staunton, Triumph of the
22 Optimists , Princeton University Press, 2002.

FIGURE 16.5 The equity premium is defined as the difference between the stock market rate of return and the return
on risk-free bonds. In our SML-based computation of Target’s weighted average cost of capital (WACC), we used
the market price/earnings (P/E) as the basis for the equity risk premium E(rM)–r f . The historic equity premium is
often used instead of this market-based equity premium.
504 PART THREE VALUING SECURITIES

16.7. Computing Target’s Cost of Equity, rE, with the Gordon Model
An alternative to the CAPM for computing the cost of equity rE is the Gordon model, which
we’ve previously discussed in Chapter 6. The Gordon model says that the equity value is
the discounted value of future anticipated dividends. The standard version of the Gordon
model is

Div0 (1 + g )
rE = +g
P0
where
Div0 = current equity payout of firm (total dividends + stock repurchases)
P0 = current market value of equity
g = anticipated equity payout growth rate

For reasons explained in Chapter 6, we think the Gordon model should be used with the
total equity payout, defined as total dividends plus stock repurchases. Below is the calculation
for Target Corp.’s WACC using the Gordon model. The spreadsheet is the same as that of the
previous section, except for the following:
• Rows 32–36 show Target’s equity payouts—the sum of its dividends and share repur-
chases—in each of the past 5 years. The compound annual growth rate of the equity
payouts is 8.89% per year (cell D38).
• Rows 22–25 show the Gordon model calculation of the cost of equity rE. This is com-
puted as

Div0 (1 + g ) 232 * (1 + 8.89% )

rE = +g= + 8.89% = 9.88%
P0 25,619
where
Div0 = current equity payout
P0 = current market value of equity
g = anticipated equity payout growth rate
 CHAPTER 16 Valuing Stocks 505

A B C D E
TARGET CORP.'S WACC USING
1 GORDON MODEL FOR COST OF EQUITY
2 Number of shares (million) 908
3 Market value per share, 1 February 2002 28.21
4 Market value of equity 1 February 2002, E 25,619 <-- =B3*B2
5
6 2002 2001
7 Current portion of long-term debt and notes payable 975 905
8 Long-term debt 7,523 7,054
9 Total debt, D 8,498 7,959 <-- =C8+C7
10
11 Market value of Target, E+D 34,117 <-- =B9+B4
12
13 Interest paid, 2002 588
14 Average debt over 2002 8,229 <-- =AVERAGE(B9:C9)
15 Interest cost, rD 7.15% <-- =B13/B14
16
17 2002
18 Earnings before taxes 2,676
19 Income taxes 1,022
20 Corporate tax rate, TC 38.19% <-- =B19/B18
21
22 Current equity value 25,619
23 Current equity payout, Div0 232 <-- =D36
24 Growth rate of equity payout 8.89% <-- =D38
25 Cost of equity, rE, using Gordon model 9.88% <-- =B23*(1+B24)/B22+B24
26
27 WACC 8.52% <-- =B4/B11*B25+(1-B20)*B9/B11*B15
28
29
30 Dividends and stock repurchases
Total equity
31 Year Dividends Repurchases payout
32 1998 165 0 165
33 1999 178 0 178
34 2000 190 585 775
35 2001 203 20 223
36 2002 218 14 232
37
38 Growth rate 8.89% <-- =(D36/D32)^(1/4)-1

Using the Gordon model estimate of the cost of equity, Target’s WACC is 8.52%
(cell B27).

Summing Up
This chapter has discussed a grab-bag of share valuation methods. Three of these methods
could be termed “fundamental valuations.” Valuation method 1, the simplest of the fundamental
valuation methods, is based on the assumption of market efficiency and says that a firm’s stock
is worth its current market price. Simple as it is, this approach has a lot of power and support in
the academic community: If market participants have done their work, then the current price of
a share reflects all publicly available information, and there’s nothing else to do.
Valuation method 2, discounted cash flow (DCF) valuation, is the method preferred by
most finance academics and many finance practitioners. This method is based on discount-
ing the firm’s projected future free cash flows (FCFs) at an appropriate weighted average cost
of capital (WACC). The discounted value arrived at in this way is called the firm’s enterprise
value. To arrive at the valuation of the firm’s equity, we add cash and marketable securities to
the enterprise value and subtract the value of the firm’s debt. Dividing by the number of shares
gives the per-share valuation.
506 PART THREE VALUING SECURITIES

Valuation method 3, the direct equity valuation, discounts the projected payouts to equity
holders (defined as the sum of dividends plus share repurchases) by the firm’s cost of equity rE.
The resulting present value is the value of the firm’s equity. Although it appears simpler and
more direct than the FCF valuation, direct equity valuation is usually shunned by finance pro-
fessionals. This is primarily because the cost of equity is heavily dependent on a firm’s debt-to-
equity financing mix, whereas the WACC is not nearly as dependent (and perhaps independent)
on the debt-to-equity mix.
Valuation method 4, multiple valuation, is widely used. This method of valuation arrives
at a relative valuation of the firm by comparing a set of relevant multiples for comparable firms.
When used correctly, multiple valuations can be a powerful tool, but it is often difficult to arrive
at a correct “peer group” for a particular firm.

EXERCISES
1. OwnItAll (OIA) is a holding company whose sole business is to own a portfolio of shares. The
company has 200 million shares outstanding, listed on the PSE.
a. Given the current portfolio of OIA, what should be its share price? (There’s a template on the
disk that comes with the book.)
A B C
1 OIA PORTFOLIO
Number of Share
2 Stock shares price
3 IBM 1,500,000 92.89
4 Ahold 5,250,000 8.23
5 Kellogg 385,259 45.29
6 General Motors 12,000,000 36.64
7 Microsoft 1,000,000 26.18
8 AT&T 98,000,000 19.89
9 SBC 12,000,000 23.42
10 Merck 15,000,000 28.02
11 Nicor 2,000,000 36.42
12 Duke Power 25,000,000 26.14

b. The actual market price of OIA’s shares is $25 per share. What can you conclude from this
fact?
2.
a. Walters, Inc. has an anticipated next-year FCF of $10 million. This cash flow is anticipated to
grow at an annual rate of 5%. If the FCFs occur at year end and if the WACC of Walters is 15%,
what is the enterprise value of the company?
b. How would your answer change if the cash flows occur mid-year?
3.
a. Houda Motors has just announced results that show that the FCF for the past year is $23 mil-
lion. An experienced analyst believes that the growth rate of the FCF for the next 10 years will
be 25% per year and that after 10 years the growth rate will be 7% annually. Houda’s WACC is
18%, and the company has 100 million shares outstanding. Value the shares assuming that the
FCFs occur at year end. Houda has no debt and no excess cash reserves.
b. Suppose that the FCFs occur mid-year. What would your answer be now?
4. You are considering buying a building in downtown Asheville. The building is selling for $10 mil-
lion, and you anticipate an annual FCF of $1 million. At the end of 10 years, the building will be
half depreciated, and at this point you think you can sell the building for $15 million. If your cost
of capital is 17%, does the building have positive NPV? Assume a 20% capital gains tax on the
 CHAPTER 16 Valuing Stocks 507

sale of the building in 10 years; income taxes and depreciation tax shields have been included in
the annual FCF of $1 million.
5. You are considering buying a 500-unit apartment complex in suburban Springfield. The current
owner of the apartment complex is asking $25 million. Use the facts below to value the apartment
complex:
• On average, each unit produces $15,000 of pretax income per year.
• The vacancy rate in Springfield averages 8%.
• Operating expenses per unit are $2,000 annually. These expenses are incurred regardless of
whether the units are occupied.
• Income and expenses occur at year end.
• Your tax rate is 40% on pretax income and 20% on capital gains.
• Your discount rate is 18%.
• Real-estate prices in the Springfield area have been increasing at 6% per year, and you antici-
pate that this rate will continue for the foreseeable future. You anticipate selling the apartment
complex at the end of 10 years.
6. In the previous problem, suppose that the cash flows from rentals (including expenses and depre-
ciation) occur mid-year. Suppose that the resale cash flow of the complex occurs at the end of 10
years. Recalculate the NPV.
7. Consider the Springfield apartment complex once more (Exercises 5 and 6). Suppose that:
• Cash flows from rentals (including expenses and depreciation) occur mid-year.
• Next year’s anticipated rental per unit is $15,000 and expenses are $2,000. In years 2–9 these
numbers are expected to increase by 2% annually.
• Other facts about the complex are unchanged.
a. What is the NPV of the purchase?
b. Create a Data Table for the NPV as a function of the annual rent/expense increase (0, 1, 2, . . . ,
5%) and the discount rate (8, 10, 12, . . . , 24%).
8. Hectoritis Corp. currently has an FCF of $13 million. A reputable analyst estimates that
this FCF is anticipated to increase by 12% per year for the next 5 years. The analyst esti-
mates that at the end of 5 years the company’s terminal value will be based on the year-5
FCF and a long-term FCF growth rate of 4%. Suppose the Hectoritis β= 1.5, the rf = 3%, the
market risk premium E (rM ) –rf = 14%, and Hectoritis has 8 million shares outstanding. How
should the analyst value the shares of the company? Assume all cash flows occur at year end.
9. Challenge problem: The past 5 years’ results for Niccair Corp. are given below. Value the compa-
ny’s stock based on a model of FCF growth of your own design and the following additional facts.
(This is not an easy problem and it has no explicit answer—valuation is often like that!)
• Niccair’s 2003 year-end debt is $750 million.
• Niccair’s 2003 year-end cash is $50 million.
• The company has a cost of debt of rD = 5%.
• The company has 44,080,000 shares outstanding; the end-2003 share price is $37.
• Niccair’s share β = 0.437, r f = 3%, and E (rM ) = 12%.

A B C D E F
1 NICCAIR CORPORATION, 1999 – 2003
2 31-Dec-03 31-Dec-02 31-Dec-01 31-Dec-00 31-Dec-99
3 Net income $105,300,000 $128,000,000 $122,100,000 $35,800,000 $116,300,000
4 Depreciation $161,700,000 $155,000,000 $148,800,000 $145,100,000 $141,600,000
5 Changes in net working capital (12,600,000) 268,300,000 491,300,000 233,000,000 213,400,000
6 Capital expenditures (181,300,000) (192,500,000) (185,700,000) (158,400,000) (154,000,000)
7 Net interest paid before taxes (41,100,000) (34,600,000) (46,900,000) (50,600,000) (45,500,000)
8 Tax rate 37.84% 31.03% 32.62% 16.94% 34.56%
508 PART THREE VALUING SECURITIES

10. Go to Yahoo! and look up your two favorite drug store chains. Compare the following multiples
for the two companies: P/E and Sales/Market Cap. Is one of the chains underpriced vis-à-vis the
other?
11. (Challenge). The table below (which appears on the disk that accompanies Principles of Finance
with Excel) shows P/E ratios and other information for the retail industry.
a. In rows 25–27 use Excel to run a regression of the P/E ratio as the y-variable versus each of the
columns as the x-variable. One of the regressions is shown:

P E = a + b * Market cap
= 21.390 + 0.009 * Market cap, R 2 = 0.003
Now run regressions of P/E on ROE, long-term debt to equity, . . . .
b. Which regression has the most explanatory power? Do you have an explanation?

A B C D E F G
Long-Term Price to Year-on-year
Market cap
P/E ROE % Debt to Equity Book revenue
(billion $)
1 Equity Value growth (%)
2 Wal-Mart Stores, Inc. (WMT) 22.89 222 22.72 0.75 4.95 9.88
3 Target Corporation (TGT) 23.52 44.3 16.73 0.77 3.57 11.01
4 Kohl's Corporation (KSS) 23.75 15.7 15.26 0.31 3.34 14.62
5 (WMMVY.PK) 30.56 15 13.02 0 3.85 12.69
6 J.C. Penney Company, Inc. (JCP) 21.46 11.9 10.76 0.97 2.35 2.98
7 Sears, Roebuck & Co. (S) 30.74 10.8 5.97 0.73 1.77 -8.37
8 May Department Stores (MAY) 17 9.8 14.4 1.64 2.33 17.04
9 Federated Department Str. (FD) 14.25 9.3 12.24 0.7 1.68 0.14
10 Coles Myer Ltd. (ADR) (CM) 20.47 8.9 14.24 0.24 2.81 25.9
11 Kmart Holding Corporation (KMRT) 8.75 8.4 45.84 0.13 2.74 -13.75
12 Neiman-Marcus Group, (NMGA) 15.08 3.2 16.11 0.33 2.21 10.89
13 Dollar Tree Stores, Inc. (DLTR) 17.4 3 17.12 0.25 2.8 8.83
14 Dillard's, Inc. (DDS) 36.34 2.1 2.69 0.81 0.96 -3.59
15 Grupo Elektra S.A. de C.V (EKT) 11.12 2 30.85 2.78 3.09 22.21
16 Saks Incorporated (SKS) 41.19 1.9 2.37 0.77 0.99 0.99
17 Tuesday Morning Corporati (TUES) 19.68 1.2 45.22 0.51 7.39 7.04
18 ShopKo Stores, Inc. (SKO) 13.37 0.5282 6.72 0.76 0.88 -1.59
19 Bon-Ton Stores, Inc. (BONT) 14.15 0.2487 7.62 1.12 1.06 65
20 Retail Ventures, Inc. (RVI) 22.26 0.2252 4.74 1.8 1.04 2.81
21 Gottschalks Inc. (GOT) 19.73 0.1047 5.17 1.34 0.99 1.76
22 Duckwall-ALCO Stores, Inc (DUCK) 28.95 0.0832 2.61 0.2 0.74 1.32
23
24 Regression: P/E = a + b*other
25 a, intercept 21.390
26 b, slope 0.009
27 R2 0.003
28
29 Key
30 Market cap = (number of shares)*(price per share)
31 ROE = Return on Equity = (Net income)/(Book value of Equity)
32 Long-term debt to equity = (Book value of debt)/(Book value of equity)
33 Price to equity book value = (Market cap)/(Book value of equity)
Year-on-year revenue growth = growth rate of sales, most recent quarter versus
34 same quarter one year ago
 PA R T

4
CAPITAL STRUCTURE AND
DIVIDEND POLICY

A company can finance itself with either money raised from its shareholders (equity)
or with money borrowed from banks or financial markets (debt). Does the mix of financing
affect the value of the company? Chapters 17 and 18 examine this thorny question, which has
been the subject of much debate in the finance profession. As these chapters show, the valuation
effects of capital structure depend primarily on the taxes that the company and its shareholders
pay. Chapter 17 explores this question in detail, using a series of simple examples. Chapter 18
summarizes the results and tells you what to think.
Capital structure is closely related to a firm’s dividend policies. When a firm pays more
dividends, it uses shareholder cash and implicitly increases the debt to equity ratio of the fi rm.
But there’s more to dividends than just debt/equity. Many corporate managers believe that their
dividends impart important information to shareholders and the market about the health and the
prospects of the company. Chapter 19 examines these questions to come up with an answer to
the question: Does dividend policy matter?
This page intentionally left blank
CHAP TER

17 Capital Structure and the

Value of the Firm
CHAPTER CONTENTS
Overview 512
17.1. Capital Structure When There Are Corporate Taxes—ABC Corp. 514
17.2. Valuing ABC Corp.—The Effect of Leverage When There
Are Corporate Taxes 517
17.3. Why Debt Is Valuable in Lower Fantasia—Buying a Turfing
Machine 521
17.4. Why Debt Is Valuable in Lower Fantasia—Relevering Potfooler, Inc. 525
17.5. Potfooler Exam Question, Second Part 527
17.6. Considering Personal as Well as Corporate Taxes—The Case of XYZ
Corp. 530
17.7. Valuing XYZ Corp.—The Effect of Leverage When There Are Corporate
and Personal Taxes 536
17.8. Buying a Sturfing Machine in Upper Fantasia 540
17.9. Relevering Smotfooler, Inc., an Upper Fantasia Company 542
17.10. Is There Really an Advantage to Debt? 546
Summary and Conclusion—United Widgets Corp. 548
Exercises 552

511
512 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

Overview
“Capital structure” is finance jargon for how a firm should be financed—what mixture of debt
and equity should be used by the shareholders of a firm to finance the firm’s activities. To start
you off thinking about this tricky question, we offer the example of Mortimer and Joanna, who
are competing to buy the same supermarket.

The Fair City Supermarket—Does Financing Affect the Price?

Mortimer and Joanna live in Fair City. Each heads a group of investors that wants to buy a
supermarket located in the center of town. Both Mortimer and Joanna have superb records as
supermarket managers. As manager of a supermarket, they’re pretty much the same—meaning
that the supermarket they manage will have the same sales, cost of goods sold, etc. However,
although the management aspect of Mortimer’s group and Joanna’s group is pretty much the
same, there’s a big financial difference between the two competing groups: Mortimer’s inves-
tors want to borrow 50% of the money needed to purchase the supermarket, whereas Joanna’s
investors hate debt and have decided to put up the whole cost of purchasing the supermarket
without borrowing a penny.
The question: Which group of investors—Mortimer’s or Joanna’s—can afford to make the
higher bid for the supermarket? This is the question examined in this chapter. At this point in
the chapter we offer no answers to this question, but merely want to give you insight into how
possible answers might look.

Example 1: Both Groups Make the Same Bid

Suppose that both Mortimer and Joanna’s groups bid $1 million for the supermarket. In this case
the balance sheets would look like this.

Mortimer’s Supermarket Group Half equity (50%) and half debt (50%)

Supermarket $1,000,000 Debt $500,000

Equity $500,000

Total assets $1,000,000 Total debt and equity $1,000,000

Joanna’s Supermarket Group Only equity (100%)

Supermarket $1,000,000 Debt $0

Equity $1,000,000

Total assets $1,000,000 Total debt and equity $1,000,000

Why would both groups make a similar bid for the supermarket? The line of reasoning that
might lead to this conclusion is the following:
A supermarket is a supermarket is a supermarket, no matter how it’s financed. If Mortimer’s
group think the supermarket is worth $1 million, then so will Joanna’s group (and vice versa).
The fact that one group finances with debt and equity whereas the other group finances only
with equity is irrelevant to their valuation of the supermarket.
 CHAPTER 17 Capital Structure and the Value of the Firm 513

Example 2: Mortimer’s Group Bids More

Is it possible that Mortimer’s group should rationally decide that—because of the group’s greater
proportion of debt financing—the supermarket is worth more than what Joanna’s group is will-
ing to pay? One of Mortimer’s investors thinks that their group can afford to bid more for the
supermarket than Joanna. His line of reasoning is as follows:
The fact that we’re financing with debt means that it’s cheaper for us to finance the super-
market. The interest paid on debt is an expense for tax purposes, which means that debt is
cheaper than equity. In addition, because equity is more risky than debt, equity holders in
any case want a higher return than debtholders. So our greater use of debt means that we can
afford to pay more for the supermarket.
If this logic is correct, then it’s possible that Mortimer’s group would bid $1,200,000 for the
supermarket, whereas Joanna’s group would only bid $1,000,000. In this case the two balance
sheets would look like this.

Mortimer’s Supermarket Group Half equity (50%) and half debt (50%)

Supermarket $1,200,000 Debt $600,000

Equity $600,000

Total assets $1,200,000 Total debt and e`quity $1,200,000

Joanna’s Supermarket Group Only equity (100%)

Supermarket $1,000,000 Debt $0

Equity $1,000,000

Total assets $1,000,000 Total debt and equity $1,000,000

Of course there’s no question what would happen in this case: The sellers of the supermar-
ket would prefer to sell to Mortimer’s group, which is offering a higher price.

Which Example Is More Representative? Example 1 or Example 2?

As you’ll see in the chapter, both examples could be representative of how things actually
work in the world. In this chapter we frame the capital structure question (Example 1 versus
Example 2) primarily in terms of the following two questions:
• Does the choice of financing affect the total cash that can be extracted from the firm?
If Mortimer’s group, with its higher proportion of debt financing, can extract more cash
from the supermarket, then it might be logical for them to be willing to pay more for the
supermarket.
• Should the choice of financing affect the discount rate the firm uses to evaluate projects?
This is where risk, the magic word in finance, comes into play.1 In simple words, is the
correct discount rate to be used for the supermarket by Mortimer’s group different from

1
Recall the opening words of Chapter 8: “Risk is the magic word in finance. Whenever finance people
can’t explain something, we try to look confident and say ‘it must be the risk.’”
514 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

that which should be used by Joanna’s group? Does the choice of a financing mix affect
the weighted average cost of capital (WACC)?
As you will see in this chapter, the answers to both these questions relate primarily to taxa-
tion. It will turn out that depending on the tax system, either Example 1 or Example 2 could be
a representation of how things work.2

Finance Concepts in This Chapter

• Debt versus equity financing
• Valuation effects of leverage
• Corporate versus personal taxation
• Modigliani–Miller model
• Miller’s “Debt and Taxes”

Excel Functions Used

• If
• NPV

17.1. Capital Structure When There Are Corporate Taxes—ABC Corp.

We start our exploration of the effects of capital structure by examining the story of ABC Corp.
This well-known company is located in Lower Fantasia. Lower Fantasia has an unusual tax
code: In Lower Fantasia, whereas companies are taxed on their corporate income, individuals
are not taxed on their personal income.
Our hero, Arthur ABC, is trying to figure out: (a) whether to buy ABC Corp., a well-
known company in Lower Fantasia, and (b) if he buys the company, how to fi nance the
purchase.

Buying ABC Corp. Using Only Equity

This turns out to be fairly simple. ABC has an expected annual FCF of $1,000 per year; this free
cash flow (FCF) is anticipated to recur, year after year, at the same level. Arthur—who has an
MBA from Eastern Lower Fantasia State University (their football team is called the “elfs”)—
has computed the cost of capital for the purchase as rU = 20%. The symbol “U” as a subscript for
the discount rate rU stands for “unlevered” and is meant to remind you that in this case rU is the
discount rate appropriate for the case where Arthur buys ABC Corp. with only equity (meaning
his own money, without borrowing).

2
It’s even possible that another variant of Example 2 would hold in which Mortimer’s group would bid less
than Joanna’s. This is pretty unlikely, as you’ll see in the remainder of the chapter.
 CHAPTER 17 Capital Structure and the Value of the Firm 515

This rU = 20% is a cost of capital that reflects only the business risks of ABC Corp. If
purchased only with equity, therefore, the company is thus worth 1,000/20% = 5,000.3 In what
follows we will use the symbol VU for the “unlevered value of the firm.” VU is what a company
is worth if it is financed only with equity. In our case,

∞ ∞
FCFt $1,000 $1,000
VU = ∑ t
=∑ t
= = $5,000.
t =1 (1 + rU ) t =1 (1 + 20%) 20%

Buying ABC Using Debt

Arthur has a wonderful source of debt financing: his mother. This wealthy old lady is in fact
his business partner, but their joint deals are structured so that she’s always the lender and
Arthur the equity owner. There’s another unusual feature to the old lady’s lending—she gives
out perpetual debt—her loans require only an annual payment of interest, but no repayment of
principal.4 The cost of debt to Arthur, denoted by rD, is the interest rate charged by his mother
on her loans to him. In this case rD = 8%.
Together, Arthur and his mom are exploring two alternative financing arrangements:
• In Alternative A, Arthur buys ABC Corp. for cash; immediately thereafter, the com-
pany borrows $3,000 from Mom and repays it to Arthur. (Corporate finance deals in
Lower Fantasia are a bit complicated!) In this case ABC Corp. is a levered company.
(“Leverage” in this context means that the company has debt on its balance sheets.)
• In Alternative B, Arthur borrows $3,000 from Mom and then buys ABC Corp. for cash.
In this case, ABC Corp. is an unlevered “all-equity” company (no debt on its balance
sheets) and Arthur is levered.
The fundamental difference between these two alternatives is that the Lower Fantasia tax
code has a corporate income tax but no personal income taxes. Under the tax code, interest paid
by corporations is an expense for tax purposes, but this is not true for interest paid by individu-
als, who aren’t taxed on their personal income.
From Figure 17.1 you can see that the total family income produced by Alternative A is
more than that produced by Alternative B.

3
The FCF is already after corporate taxes, and the discounted FCF value of the firm is thus
∞
FCF FCF
∑ t
=
20%
t =1 (1 + 20% )
4
Throughout this chapter you’ll note that we often assume that cash flows have infinite duration. This
makes the valuations easier, but doesn’t affect the principles.
516 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

Alternative A: Company borrows from Arthur's Mom Alternative B: Arthur borrows from Mom

ABC Corp.–Levered ABC Corp. – no debt

Company has $3,000 of 8% perpetual debt from
Arthur's mother. Corporate income tax rate, FCF = $1000 [This is after corporate taxes]
TC = 40%.
Equity income = $1000
FCF = $1000 [This is after corporate taxes]
Paid to Arthur ABC, sole owner
Equity income after interest payment
= $1000 - 8%*3,000*(1-40%) = $856.
Paid to Arthur ABC, sole owner

Arthur ABC is sole owner of all Arthur's mother gets $240 Arthur ABC is sole owner of all ABC's Arthur's mother pays no
ABC's equity. Pays no personal interest from ABC Corp. equity. Borrowed $3000 of perpetual personal tax and gets $240
taxes. Pays no personal taxes. debt from Mom at 8%. No personal tax, interest from Arthur.
but owes Mom interest.
Annual after-tax income: Annual after-tax income: Annual after-tax income:
$856 8%*$3000 = $240: Annual after-tax income: 8%*$3000 = $240
$1,000 - 8%*$3,000 = $760

Family income: Arthur + Mom Family income: Arthur + Mom

Arthur: $ 856 Arthur: $ 760
Mom: $ 240 Mom: $ 240
Total: $ 1096 Total: $ 1000

FIGURE 17.1 Financing Arthur’s purchase of ABC Corp.: Cash flows resulting from two methods of financ-
ing the purchase. The tax code in Lower Fantasia provides for a corporate tax rate TC = 40%. There are no
taxes on personal income.

From the family point of view, it is clear that the first alternative is better than the second.
In this alternative the family (Arthur + Mom) has an annual income of $1,096, as opposed
to the $1,000 in the second alternative. A little thought will reveal why the first alterna-
tive is preferable—ABC Corp. has a tax advantage over Arthur with respect to borrowing.
It can deduct its interest expenses from its income taxes, so that its net income taxes are
only 8% * 3,000 * (1 − 40%) = $144. This compares with Arthur’s cost for the same loan of
8%* 3,000 = 240.
To flesh this out a bit, let’s write out some equations:

Total family income from ABC ( Arthur + Mom)

= cash produced by firm = FCF − rD * Debt * (1 − TC ) + rD * Debt
144 42444 3 1 424 3
↑ ↑
Cost of debt Income from
to ABC Corp debt to Mom

= FCF + rD * Debt * TC

Thus, the total cash produced by the firm for its stockholders and bondholders increases
with the amount of debt the firm has. Note that the total cash produced by the firm does not
increase if Arthur borrows the money from his mother.5

5
Looking at Figure 17.1, it’s clear why this is so—when Arthur borrows from Mom, the interest is a wash:
Arthur has an interest expense of $240 and Mom has interest income of $240, for a net $0. When the
company borrows from Mom, the company has an interest expense of (1—40%) * 8% * 3,000 = $144, but
Mom has interest income of $240, for a net of $96.
 CHAPTER 17 Capital Structure and the Value of the Firm 517

17.2. Valuing ABC Corp.—The Effect of Leverage When

There Are Corporate Taxes
Recall that we stated in Section 17.1 that ABC Corp’s FCFs are worth $5,000 if the company
has no leverage:
VU = Unlevered value of ABC
= PV ( future FCFs, discounted @ unlevered discount rate )
∞
1,000 Annual FCF 1,000
=∑ t
= = = 5,000
t =1 (1.20 )
rU 20%

So how much is the levered version of ABC Corp worth (this is the company that borrows
$3,000 from Arthur’s mom)? We use the additivity principle explained in Chapter 14:
VL = Levered value of ABC
= Unlevered value of ABC + PV (additional debt-related CFs )
∞
8%* 3,000 * 40% 96
= 5,000 + ∑ t
= 5,000 +
t =1 (1.08 ) 0.08
= 5,000 + 1,200 = 6,200

THE ADDITIVITY PRINCIPLE IN THIS CONTEXT

The additivity principle (Chapter 14) says that the value of the sum of two cash flow streams
is the sum of their values. In the context of this problem, the two cash flow streams are: (1) the
stream of FCFs that derive from the firm’s business activities and (2) the stream of tax shields
on the interest paid by the firm.
To value these streams using the additivity principle, we discount each at its appropriate
risk-adjusted discount rate. The rate for the FCFs is rU and the rate for the tax shields—which
we assume to be riskless—is the interest rate on the debt rD.

ABC Corp is worth more as a levered firm than as an unlevered firm because it produces more
cash for its owners. The additional cash produced—generated by the fact that the company can deduct
the cost of its interest payments from its taxes, whereas Arthur cannot—is worth $1,200. In symbols,

VL = VU + PV (additional debt -related CFs )

⎧ ∞
FCFt ∞
1,000 1,000
⎪ U ∑
V = t
= ∑ t
=
20%
= 5,000
⎪ t = 1 (1 + rU ) t = 1 (1.20 )
⎪
= ⎨ The unlevered value of the firm is
⎪ the present value of its free cash flows
⎪ discounted at an appropriate (unlevered)
⎪ cost of capital r
⎩ U

⎧ ⎛ Interest tax⎞ ∞ TC * Interestt ∞

8% * 3,000 * 40% 96
⎪ ⎜⎝ shields
PV ⎟⎠ ∑= t
= ∑ = = 1,200
⎪⎪ t =1 (1 + rD ) t =1 (1.08)t 8%
+⎨ The tax shields created
⎪
⎪ by the debt are discounted at the interest
⎪⎩ rate.
= 6,200
518 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

The Cost of Equity, rE(L), and the Weighted Average

Cost of Capital with Leverage
The cost of equity is the discount rate for the cash flows accruing to shareholders. In Chapters
6 and 13 we discussed the derivation of the cost of equity, stressing its relation to the riskiness
of the equity cash flows. In this chapter we use the symbol rE(L), with the “L” showing that that
the cost of equity is related to the leverage of the firm. As you will see, greater leverage leads to
a larger rE (L); the reason for this is that the equity cash flows are riskier when shareholders have
promised larger amounts to debtholders.
We now proceed to the computation of rE (L) for ABC Corp. The levered version of ABC
Corp. is worth $6,200, of which D = $3,000 is debt. Thus the equity of the company is worth
$3,200. We denote the market value of the equity by E. To calculate the firm’s cost of equity
rE (L), we first compute the cash flows that the equity owners receive:
Annual equity cash flow = FCF − after -tax interest paid by ABC
= 1,000 − 8% * 3,000 * (1 − 40% ) = 856

The discounted value of this annual equity cash flow of $856 is the value of the equity; this
defines the cost of equity rE(L):
∞
equity cash flowt
E = Equity value = ∑ t
t =1 (1 + rE )
∞
856 856
3,200 = ∑ t =
t =1 (1 + rE ) rE
856
⇒ rE (L ) = = 26.75%
3,200

With a little mathematical flimflammery, we can show that

D
rE (L ) = rU + [rU − rD ] (1 − TC )
E
3,000
= !"20% + [20% − 8%] (1 − 40%) = 26.75%
"#""$
↑
3,200
!""""""""""""#""""""""""""$
rU is the discount ↑
rate for the FCFs, When ABC borrows, its shareholders
which represents bear an additional financial risk. The
the firm's business term above represents the financial risk
risk premium for the equity holders

We can now compute the WACC:

E D
WACC = rE (L ) + r (1 − TC )
E+D D E+D
3,200 3,000
= 26.75% + 8% (1 − 40% )
3,200 + 3,000 3,200 + 3,000
= 16.13%

With a little more flimflammery we can show that discounting the FCFs at the WACC gives
the total value of the firm:
∞ ∞
FCFt 1,000 1,000
∑ t
=∑ t
=
16.13%
= 6,200
t =1 (1 + WACC ) t =1 (1 + 16.13%)
 CHAPTER 17 Capital Structure and the Value of the Firm 519

Here’s all of this summarized in a spreadsheet. Note from the title of the spreadsheet
that we’ve given this model a name; we’ve called it the “Modigliani–Miller model with
only corporate tax.” To see why the name, refer to the box “Some history of finance (1)” on
page 521.

A B C
COMPUTING THE WACC IN MODIGLIANI-MILLER MODEL WITH ONLY
1 CORPORATE TAXES
2 Annual FCF 1,000
3 rU, unlevered cost of capital 20%
4 D, debt (perpetual) 3,000
5 rD, the cost of debt (interest rate) 8%
6 TC, corporate tax rate 40%
7
8 Value of firm
9 VU, unlevered value = FCF/rU 5,000.00 <-- =B2/B3
10 Value of tax shield on interest = TC*rD*D/rD = TC*D 1,200.00 <-- =B6*B4
11 VL, levered value of firm = VU + TC*D 6,200.00 <-- =B10+B9
12
13 E, value of equity = VL - D 3,200.00 <-- =B11-B4
14
15 Cash flow to equity = FCF - (1-TC)*interest 856.00 <-- =B2-(1-B6)*B5*B4
16 Return on equity, rE(L)= [FCF - (1-TC)*interest]/E 26.75% <-- =B15/B13
17
18 WACC = rE(L)*E/(E+D) + rD*(1-TC)*D/(E+D) 16.13% <-- =B16*B13/B11+(1-B6)*B5*B4/B11
19
20 Two checks
21 Return on equity, rE(L)= rU + (rU - rD)*[D/E]*(1-TC) 26.75% <-- =B3+(B3-B5)*B4/B13*(1-B6)
22 Value of firm, VL = FCF/WACC 6,200.00 <-- =B2/B18

We complete this section by restating its major conclusions. If only corporate income
is taxed, leverage (borrowing) increases the value of the fi rm. This increase in value, rep-
resented by the present value of the tax shields on the debt, increases the cost of equity rE
and decreases the WACC. The present value of the debt tax shields accrues to the fi rm’s
equity holders: In the above example, if the corporate tax rate were TC = 0%, debt of $3,000
would have decreased the value of the equity to $2,000. Instead, with TC = 40%, the value
of the equity is decreased by the value of the debt but increased by the value of the debt tax
shields:
Equity value of levered firm = VL − D = VU − D + TC D
A summary table is given in Figure 17.2.
SUMMARY TABLE—CORPORATE VALUATION WHEN ONLY CORPORATE INCOME IS TAXED

Item Formula Why

VU = value of unlevered firm FCFt The value of the unleveraged firm is the PV of future FCFs
VU =
(1 + rU ) t discounted at rU , the unlevered cost of capital.
t= 1

VL = VU + P V (interest tax shields) The value of the leveraged firm is VU plus the present value
N of future interest tax shields. The cell to the left contains
TC ∗ interestt
= VU + the formula for the value of the levered firm when there are
t= 1
(1 + r D ) t
N interest payments on the debt.

VL = value of levered firm VL = VU + P V (interest tax shields) The cell to the left contains the formula for the leveraged firm
when the firm issues perpetual debt.
TC ∗ interest
= VU +
t= 1
(1 + r D ) t
= VU + TC ∗ D

E = value of equity VU − (1 − TC ) ∗ D The equity value of the levered firm is the value of the
levered firm minus the value of the firm’s debt:
E = VL − D = VU + D ∗ TC − D = VU − (1 − TC ) D
520 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

D = value of debt D The value of the debt is the value of the debt. (OK, this ain’t
so original!)

r E (L) = cost of equity of the D The cost of equity r E is the discount rate for equity cash
leveraged firm r E (L) = rU + [rU − r D ] (1 − TC ) flows. In a leveraged firm it includes a financial risk
E
premium:
D
[rU − r D ] (1 − TC )
E
WACC = weighted average
FCF You can correctly value the whole firm by discounting its
cost of capital WACC =
VL FCFs at the WACC. This is the valuation principle
employed in Chapters 6, 7, and 13.

FIGURE 17.2 Corporate value and cost of capital corporate income is taxed at rate TC and when there are no personal taxes.
 CHAPTER 17 Capital Structure and the Value of the Firm 521

SOME HISTORY OF FINANCE (1)

The valuation model summarized in Figure 17.2 is often called the Modigliani–Miller model,
after Professors Franco Modigliani and Merton Miller, both winners of the Nobel Prize in
Economics. In two path-breaking articles published in 1958 and 1963, Modigliani and Miller
showed that the value of the firm would not be affected by the method in which the firm was
financed, except where the tax code explicitly favors one form of financing. In the example
of ABC Corp. in Section 17.2, the tax code gives corporations a tax break on debt financing,
whereas individuals (who are untaxed) get no such break; it is therefore optimal for the firm to
finance with more debt and less equity.
Students of finance know this result as the “MM model.” It has been widely studied and
even more widely misunderstood.
In Section 17.7 we consider a variation of the MM model that takes account of not only
corporate taxes but also personal taxes. Although the logic is the same, the conclusions are very
different. This model—less widely studied and even more misunderstood—is known as the
Miller model, after Merton Miller, who expounded it in a famous academic article that appeared
in the Journal of Finance in 1977. (See the box “Some History of Finance (2)” on page 534.

17.3. Why Debt Is Valuable in Lower Fantasia—Buying a

Turfing Machine
It’s easier to understand the theory of the previous section by looking at some numerical
examples. In this and the following two sections we discuss several such examples. Each of
these examples makes the point that under the Lower Fantasia tax regime—in which corporate
income is taxed at a rate TC, but in which there are no taxes on personal income—companies
that finance with debt can increase their market value.
The tax regime in Lower Fantasia is characterized by a tax on corporate income but no
other taxes. In the previous section we showed that this tax regime means that the value of com-
panies in Lower Fantasia is increased when they lever themselves.
We start with an example that shows the effect of financing on a capital budgeting
decision.

Buying a Machine
Wonderturf Corp., a company in Lower Fantasia, is considering purchasing a new turf-
ing machine. The turfing machine costs $100,000; it has a 10-year life, during which it is
straight-line depreciated to zero salvage value. In each of the 10 years of the machine’s
life, it will produce sales of $40,000. These sales will cost $15,000 to produce. The result
is that the machine has an annual free cash flow (FCF) of $19,000 per year (see cell B10
below):

Annual Wonderturf FCF = (1 − TC )* (Sales − Expenses − Depreciation ) + Depreciation

= (1 − 40% )* (40,000 − 15,000 − 10,000 ) + 10,000
= $19,000
522 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

A B C
1 THE WONDERTURF TURFING MACHINE
2 TC, corporate tax rate 40%
3
4 Machine cost, year 0 100,000
5
6 Free cash flow (FCF) calculation
7 Additional sales, annually 40,000
8 Additional annual cost of sales 15,000
9 Annual depreciation 10,000 <-- =B4/10
10 Annual FCF, years 1-10 19,000 <-- =(1-B2)*(B7-B8-B9)+B9
11
12 rU, discount rate for machine FCFs 15%
13
Machine
14 Year FCF
15 0 -100,000 <-- =-B4
16 1 19,000 <-- =$B$10
17 2 19,000
18 3 19,000
19 4 19,000
20 5 19,000
21 6 19,000
22 7 19,000
23 8 19,000
24 9 19,000
25 10 19,000
26
27 Machine NPV -4,643 <-- =B15+NPV(B12,B16:B25)

The Wonderturf financial wizards have determined that an appropriate risk-adjusted dis-
count rate for the turfing machine’s free cash flows is rU = 15%. Discounting the machine’s FCFs
at this rate shows that it has a negative NPV of −$4,643 (cell B27). Thus, the conclusion is that
Wonderturf should not acquire the turfing machine.
However, there’s more to this story—read on!

Wonderturf Gets a Loan to Buy the Machine

Having heard from Wonderturf that they don’t intend to buy the machine, the turfing machine’s
manufacturer offers the company a loan of $50,000. The loan’s conditions are as follows:
• Interest on the loan is rD = 8%. This is also the market interest rate.
• The loan’s payments in years 1–9 consist of interest only: 8% * 50,000 = 4,000. This
interest is an expense for tax purposes for Wonderturf, so that the after-tax cost of the
interest to the company is (1–40%) * 4,000 = $2,400.
• At the end of year 10, Wonderturf must repay the loan principal. In this year, the after-tax
cost of the loan to the company is therefore $52,400 (the loan principal plus the after-tax
interest).
 CHAPTER 17 Capital Structure and the Value of the Firm 523

The Excel table below shows that the loan to Wonderturf has a positive NPV of $10,736.
D E F
12 Loan to buy machine 50,000
13 rD, loan interest rate 8%

14 Loan CFs
15 50,000 <-- =E12
16 -2,400 <-- =-(1-$B$2)*$E$13*$E$12
17 -2,400
18 -2,400
19 -2,400
20 -2,400
21 -2,400
22 -2,400
23 -2,400
24 -2,400
25 -52,400 <-- =-(1-$B$2)*$E$13*$E$12-E12
26
27 Loan NPV 10,736 <-- =E15+NPV(E13,E16:E25)

The Wonderturf financial wizards now conclude that it is worthwhile buying the turfing
machine if Wonderturf takes the loan. Their logic is as follows:
Value (Wonderturf machine + financing ) = Value (Wonderturf machine) + Value ( financing )
= − $4,643 + $10,736
= $6,093

Here’s a spreadsheet that shows their calculations.

A B C D E F
1 THE WONDERTURF TURFING MACHINE
2 TC, corporate tax rate 40%
3
4 Machine cost, year 0 100,000
5
6 Free cash flow (FCF) calculation
7 Additional sales, annually 40,000
8 Additional annual cost of sales 15,000
9 Annual depreciation 10,000 <-- =B4/10
10 Annual FCF, years 1-10 19,000 <-- =(1-B2)*(B7-B8-B9)+B9
11
12 rU, discount rate for machine FCFs 15% Loan to buy machine 50,000
13 rD, loan interest rate 8%
Machine
14 Year FCF Loan CFs
15 0 -100,000 <-- =-B4 50,000 <-- =E12
16 1 19,000 <-- =$B$10 -2,400 <-- =-(1-$B$2)*$E$13*$E$12
17 2 19,000 -2,400
18 3 19,000 -2,400
19 4 19,000 -2,400
20 5 19,000 -2,400
21 6 19,000 -2,400
22 7 19,000 -2,400
23 8 19,000 -2,400
24 9 19,000 -2,400
25 10 19,000 -52,400 <-- =-(1-$B$2)*$E$13*$E$12-E12
26
27 Machine NPV -4,643 <-- =B15+NPV(B12,B16:B25) Loan NPV 10,736 <-- =E15+NPV(E13,E16:E25)
28
29 NPV: Machine + Loan 6,093 <-- =B27+E27

As you can see in cell B29, the total value of the machine + loan combination is $6,093.
524 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

Where Does the Positive Loan NPV Come From?

The preceding analysis shows that the loan to Wonderturf has an NPV of $10,736. If we analyze
this number, we will see that this is exactly the PV of the tax shields on the loan interest:

NPV (loan ) = 50,000 −

(1 − 40% )* 4,000 − (1 − 40% )* 4,000 − ...
2
1.08 (1.08 )
−
(1 − 40% )* 4,000 − (1 − 40% )* 4,000 − 50,000
9 10
(1.08 ) (1.08 )
We now split this expression into two parts:
4,000 4,000 ... 4,000 4,000 − 50,000
NPV (loan ) = 50,000 − − − − 9 −
1.08 (1.08 )2 (1.08 ) (1.08 )
10

40% * 4,000 40% * 4,000 ... 40% * 4,000 40% * 4,000

+ + 2 + + 9 + 10
1.08 (1.08 ) (1.08 ) (1.08 )
The first line above has value 0 (recall from Chapter 5 that a loan and all its repayments
have zero NPV when the discount rate is the loan-borrowing rate). The second line above is the
PV of the tax shields on the loan interest. Their value is $10,736:

40% * 4,000 40% * 4,000 ... 40% * 4,000 40% * 4,000

NPV (loan ) = 10,736 = + 2 + + 9 + 10
1.08 (1.08 ) (1.08 ) (1.08 )
Thus the NPV of the loan is the present value of the tax shields on the loan interest
payments.

The Wonderturf Result Is Not Surprising!

The formulas above state that the value of a levered company is the sum of the value of the
unlevered company plus the value of the debt tax shields:
VL = VU + PV (interest tax shields )
∞
T * Interestt
= VU + ∑ C
t =1 (1 + rD )t
This is precisely what we’ve done with our analysis of the Wonderturf turfing machine. For
this machine,
VL = the value of the machine when purchased with a loan
∞
T * Interest
= V )U + ∑ C 1+ r t t
↑ t =1 ( D)
!""""""#""""""$
The value of
the machine's ↑
cash flows The value of the
tax shields from the
loan interest
= −4,643 + 10,736 = 6,093
 CHAPTER 17 Capital Structure and the Value of the Firm 525

17.4. Why Debt Is Valuable in Lower Fantasia—Relevering

Potfooler, Inc.
For our second example of the effect of financing on firm value, we use a question from a
Finance 101 final exam at Eastern Lower Fantasia State University. As you’ll see it’s a fairly
long question, with many interrelated parts.6
Here’s the question: Potfooler, Inc. is a well-known Lower Fantasia company. Here are
some facts about the company:
• Potfooler expects to have an annual free cash flow (FCF) of $2 million at the end of years
1, 2, 3, . . . forever. Recall that the FCF is the after-tax amount of cash that the company
generates from its business activities.
• Potfooler currently has 100,000 shares outstanding on the Lower Fantasia stock exchange.
The Potfooler share price is $100 per share.
• Potfooler currently has no debt. However, a financial analyst has suggested that the com-
pany issue $3,000,000 of perpetual debt and use the proceeds to repurchase shares. The
analyst explains that perpetual debt is debt that has only an annual interest payment and
has no return of principal.7 He suggests that this would be worthwhile for the company,
because of the relation VL = VU + TCD. The current interest rate on debt in Lower Fantasia
is 8%, and the interest payments on the debt will be made annually.
Students on the finance exam were asked to answer the following questions.
Question 1: What is the current market value of Potfooler?
Answer: Potfooler currently has 100,000 shares outstanding, each of which is worth $100.
Thus the company’s equity value is currently $10,000,000 = $100 * 100,000. Because the company
has no debt, this is also its market value. In short, VU = $10,000,000 .
Question 2: After Potfooler issues $3,000,000 of debt, what will be its market value?
Answer: Because Lower Fantasia has only a corporate income tax, the relation VL = VU + TC D
holds. This means that after the company issues its debt, its market value will be
VL = VU + TC D = 10,000,000 + 40%* 3,000,000 = 11,200,000.
Question 3: After Potfooler issues debt of $3,000,000 and uses the proceeds to repurchase
shares, what will be the company’s total equity value, E?8
Answer: After Potfooler issues the debt and repurchases the shares, the total value of its
equity, E, plus the total value of its debt, D, have to sum to the company’s total market value VL .
In short,
VL = E + D = 11,200,000
But D = $3,000,000, and therefore:
E = VL ! D = 11,200,000 ! 3,000,000 = 8,200,000

6
The author’s colleagues at Eastern Lower Fantasia State University love this question because it’s easy to
grade. If a student makes a mistake on any part of the question, then the answers on all subsequent parts
of the question will also be wrong.
7
Such debt is sometimes called a consol. Consols are easy to value, because a bond with a perpetual
annual payment of C is worth C/r when the discount rate is r.
8
Note that up to this point in the exam, we haven’t stated the price at which Potfooler repurchases the
shares. This comes later.
526 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

Question 4: At what price will Potfooler repurchase its shares?

Answer: By issuing $3 million of debt, Potfooler has raised its total market value by $1,200,000
(from $10 million to $11.2 million). This increase in value belongs to all the shareholders.
Because there are 100,000 shares outstanding before the share repurchase, this means that each
share’s price increases by $1,200,000/100,000 = $12. Thus the answer to this question is that the
share price for repurchase is $112: Of this amount $100 is the share price before the repurchase,
and $12 is the increase in the share price as a result of the debt issue.
Question 5: How many shares will Potfooler repurchase?
Answer: According to the previous question, Potfooler will repurchase its shares at $112 per
share. Because the company has issued $3 million in debt to repurchase the shares, this means
that it will repurchase $3,000,000/$112 = 26,785.71.
Question 6: What was Potfooler’s cost of equity before the repurchase of shares?
Answer: Potfooler has an annual FCF of $2,000,000. Thus its unlevered cost of equity,

FCF 2,000,000
rE (U ) = = = 20% .
VU 10,000,000

Question 7: What is Potfooler’s cost of equity after the repurchase of the shares on the
open market?
Answer: Potfooler issues $3 million in 8% debt to repurchase shares. Thus its annual inter-
est bill is 8% * 3,000,000 = $240,000. Because interest is an expense for tax purposes, the
company’s shareholders will have an annual expected cash flow of

Annual equity cash flow, after debt issuance = FCF − (1 − TC )* interest

= 2,000,000 − (1 − 40% )* 240,000
= 1,856,000

The value of the equity after the share repurchase is $8,200,000, so that the cost of equity
of the levered company is

1,856,000
rE (L ) = = 22.63%.
8,200,000

Question 8: What is Potfooler’s WACC before the repurchase of the shares?

Answer: Recall the definition of the WACC:

E D .
WACC = rE * + r * (1 − TC )*
E+D D E+D

The answer to Question 8 is easy: Because Potfooler, before the share repurchase, has only
equity, its WACC = rU = 20%.
 CHAPTER 17 Capital Structure and the Value of the Firm 527

Question 9: What is Potfooler’s WACC after the repurchase of the shares?

Answer:

E D
WACC = rE (L )* + r * (1 − TC )*
E+D D E+D
8,200,000 3,000,000
= 22.63% * + 8% * (1 − 40% ) = 17.86%
8,200,000 + 3,000,000 8,200,000 + 3,000,000

Question 10: Why is rE (L ) > rU ?

Answer: Before Potfooler issued its bonds, the only risk borne by shareholders was the busi-
ness risk inherent in the company’s FCF. After the company issues its bonds, shareholders have
to bear two kinds of risk: business risk and financial risk. Thus rE (L) represents a discount rate
for cash flows that are riskier than the discount rate for the FCFs, rU. Because riskier cash flows
have higher discount rates, it follows that rE (L) > rU .
Question 11: Why does the market value of Potfooler increase after the issuance of the debt
and repurchase of the equity?
Answer: By issuing the debt, the shareholders of Potfooler get an additional annual cash
flow—the tax shield on the debt interest. This tax shield is riskless, and its value is
∞
TC * Interest payment
Present value interest tax shield = ∑
t =1 (1 + rD )t
TC * Interest payment TC * rD * D
= = = TC * D
rD rD

The PV of the tax shield accounts for the increase in Potfooler’s market value:
VL = V
)U + !"T"#"
C D"$
.
↑ ↑
Potfooler's value The PV of
before the debt additional
issuance interest tax
shields

Question 12: Why does the WACC decrease after the repurchase?
Answer: After the company issues its debt, it gains an additional cash flow (the tax shield
on the interest). This cash flow is riskless. Thus the average risk of the company’s total cash
flows—its FCF plus the interest tax shield—decreases. Because the WACC represents the aver-
age riskiness of the company, it decreases.

17.5. Potfooler Exam Question, Second Part

Having answered the long exam question of the previous section, students at Eastern Lower
Fantasia State University were asked to put the calculations for Questions 1–9 into an Excel
spreadsheet. Here’s the answer.
528 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

A B C
1 POTFOOLER-DEBT ISSUED TO REPURCHASE SHARES
2 Unlevered company
3 Annual free cash flow (FCF) $2,000,000
4 Number of shares 100,000
5 Price per share $100
6 Total equity value $10,000,000 <-- =B5*B4
7
8 Question 1: VU, unlevered value of Potfooler $10,000,000 <-- =B6
9
10 Levered company
11 Debt issued $3,000,000
12 Interest rate on debt 8%
13 TC, Lower Fantasia corporate tax rate 40%
14 Question 2: VL, levered value of Potfooler, VL = VU + TC*D $11,200,000 <-- =B8+B13*B11
15 Question 3: Equity value after share repurchase, E = VL - D $8,200,000
Incremental firm value from exchanging
16 equity by debt = VL - VU = TC*D $1,200,000 <-- =B13*B11
17 Incremental firm value on a per-share basis $12 <-- =B16/B4
18 Question 4: New share value, after repurchase $112 <-- =B5+B17
19
Question 5: Number of shares repurchased =
20 [debt used for repurchase]/[new share value] 26,785.71 <-- =B11/B18
Number of shares remaining after
repurchase = original number of shares
21 minus number of shares repurchased 73,214.29 <-- =B4-B20
Check: Market value of remaining shares =
22 number of remaining shares * new share value $8,200,000 <-- =B21*B18
23
Question 6: Potfooler's cost of equity when unlevered,
24 rU=FCF/VU 20.00%
25
26 Annual interest costs, before taxes $240,000 <-- =B11*B12
27 Annual equity cash flow, after interest = FCF - (1-TC)*interest $1,856,000 <-- =B3-(1-B13)*B26
Question 7: Potfooler's cost of equity when levered,
28 rE(L)=[FCF-(1-TC)*interest]/[value of equity, E] 22.63% <-- =B27/B22
29
30 Question 8: Potfooler's WACC before the debt issuance = rU 20.00%
31
Question 9: Potfooler's WACC after the debt issuance
32 = rE(L)*E/(E+D)+rD*(1-TC)*D/(E+D)
33 Percentage of equity in Potfooler = E/(E+D) 73.21% <-- =B22/B14
34 Percentage of debt in Potfooler = D/(E+D) 26.79% <-- =B11/B14
35 WACC = rE(L)*E/(E+D)+rD*(1-TC)*D/(E+D) 17.86% <-- =B28*B33+B12*(1-B13)*B34

This spreadsheet enables us to do some interesting analysis.

What Happens If the Corporate Tax Rate TC = 0%?

When TC = 0, leverage doesn’t change the value of the firm. If you put TC = 0% into cell B13 of
the previous spreadsheet, you’ll get a demonstration of this. The spreadsheet is given next, and
the analysis follows after the spreadsheet.
 CHAPTER 17 Capital Structure and the Value of the Firm 529

A B C
1 POTFOOLER–DEBT ISSUED TO REPURCHASE SHARES, corporate tax rate = 0%
2 Unlevered company
3 Annual free cash flow (FCF) $2,000,000
4 Number of shares 100,000
5 Price per share $100
6 Total equity value $10,000,000 <-- =B5*B4
7
8 Question 1: VU, unlevered value of Potfooler $10,000,000 <-- =B6
9
10 Levered company
11 Debt issued $3,000,000
12 Interest rate on debt 8%
13 TC, Lower Fantasia corporate tax rate 0%
14 Question 2: VL, levered value of Potfooler, VL = VU + TC*D $10,000,000 <-- =B8+B13*B11
15 Question 3: Equity value after share repurchase, E = VL - D $7,000,000
Incremental firm value from exchanging
16 equity by debt = VL - VU = TC*D $0 <-- =B13*B11
17 Incremental firm value on a per-share basis $0 <-- =B16/B4
18 Question 4: New share value, after repurchase $100 <-- =B5+B17
19
Question 5: Number of shares repurchased =
20 [debt used for repurchase]/[new share value] 30,000.00 <-- =B11/B18
Number of shares remaining after
repurchase = original number of shares
21 minus number of shares repurchased 70,000.00 <-- =B4-B20
Check: Market value of remaining shares =
22 number of remaining shares * new share value $7,000,000 <-- =B21*B18
23
Question 6: Potfooler's cost of equity when unlevered,
24 rU=FCF/VU 20.00%
25
26 Annual interest costs, before taxes $240,000 <-- =B11*B12
27 Annual equity cash flow, after interest = FCF - (1-TC)*interest $1,760,000 <-- =B3-(1-B13)*B26
Question 7: Potfooler's cost of equity when levered,
28 rE(L)=[FCF-(1-TC)*interest]/[value of equity, E] 25.14% <-- =B27/B22
29
30 Question 8: Potfooler's WACC before the debt issuance = rU 20.00%
31
Question 9: Potfooler's WACC after the debt issuance
32 = rE(L)*E/(E+D)+rD*(1-TC)*D/(E+D)
33 Percentage of equity in Potfooler = E/(E+D) 70.00% <-- =B22/B14
34 Percentage of debt in Potfooler = D/(E+D) 30.00% <-- =B11/B14
35 WACC = rE(L)*E/(E+D)+rD*(1-TC)*D/(E+D) 20.00% <-- =B28*B33+B12*(1-B13)*B34

• The total value of the company doesn’t change (cell B14) when the amount of debt (cell
B11) changes. In a formula,
VL = VU + !"T"#"
C D"$ = VU
↑
When TC =0%,
this term is zero

• The company’s equity becomes more risky. That is, rE (L) > rU . You can see this in cell
B28: rE (L) = 25.14% after the debt is issued as opposed to rU = 20%.
• The company’s share price doesn’t change. After the issuance of the debt and the repur-
chase of the equity, the share price is still $100 (cell B18).
530 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

• The company’s WACC doesn’t change. The average riskiness of the company’s cash
flows remains the same:

E D
WACC = rE (L )* + r * (1 − TC )*
E+D D E+D
7,000,000 3,000,000
= 25.14%* + 8%* (1 − 0%)
7,000,000 + 3,000,000 !"""#"""$ 7,000,000 + 3,000,000
↑
Remember that
in this version of the
question TC = 0%
= 20% = rU

Relate the Company’s Value to Different Levels of Debt

By making a Data Table (see Chapter 27), we can make the following table and graph.

B C D E
Cost of
Value of levered firm, equity
38 Debt issued VL = VU + TC*D rE(L) WACC
39
40 0 10,000,000 20.00% 20.00%
41 1,000,000 10,400,000 20.77% 19.23%
42 2,000,000 10,800,000 21.64% 18.52%
43 3,000,000 11,200,000 22.63% 17.86%
44 4,000,000 11,600,000 23.79% 17.24%
45 5,000,000 12,000,000 25.14% 16.67%
46 6,000,000 12,400,000 26.75% 16.13%
47 7,000,000 12,800,000 28.69% 15.63%
48 8,000,000 13,200,000 31.08% 15.15%
49 9,000,000 13,600,000 34.09% 14.71%
50
51
52 Levered value VL as a function of firm debt
53
54 14,000,000
55 13,000,000
56
57 12,000,000
58
11,000,000
59
Debt
60 10,000,000
61
0

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

7,000,000

8,000,000

9,000,000

62
63
64
65

17.6. Considering Personal as Well as Corporate Taxes—The

Case of XYZ Corp.
In our story about ABC Corp. (Section 17.2), the capital structure decision mattered because
Lower Fantasia taxes corporations but not individuals. The result is that shareholders (like
Arthur) benefit from having companies borrow instead of doing the borrowing themselves.
 CHAPTER 17 Capital Structure and the Value of the Firm 531

In this section we tell the story of Upper Fantasia, a country very much like Lower Fantasia, but
with a somewhat different tax system. Upper Fantasia has three kinds of taxes:

• Corporations are subject to a 40% corporate tax rate. We denote this tax rate by TC.
• Individual income derived from shares (this refers to dividends and capital gains on
shares—in the jargon of the Upper Fantasia tax code, this is called “equity income”) is
subject to a 10% tax rate. The equity tax rate is denoted by TE.
• All ordinary income (this term includes individual income derived from bonds; however,
it does not include equity income) is subject to a 30% tax rate. We denote this tax rate
by TD. When individuals pay interest, they get to deduct the interest payments from their
ordinary income.

As before, our mythical entrepreneur, Arthur XYZ, is trying to figure out how to finance
his purchase of XYZ Corp. His mom (bless her!) is always available to lend him money. The
questions about the debt are the same as before:

• Should the purchase of the company be financed with debt?

• If so, who should borrow—the company or Arthur?
Figure 17.3 explains the cash flows.

Alternative A: Company borrows from Arthur's Mom Alternative B: Arthur borrows from Mom

XYZ Corp. -- Levered XYZ Corp. -- no debt

Company has $3,000 of 8% perpetual debt
from Arthur's mother. Corporate income tax, FCF = $1000 [This is after corporate taxes.]
TC = 40%.
Equity income = $1000
FCF = $1000 [This is after corporate taxes]
Paid to Arthur XYZ, sole owner
Equity income after interest payment
= $1000 - 8%*3,000*(1-40%) = $856
Paid to Arthur XYZ, sole owner

Arthur XYZ is sole owner of XYZ's equity. Arthur's mother gets $240 Arthur XYZ is sole owner of XYZ's equity. Borrowed
Arthur's mother. gets $240
XYZ pays Arthur $856. Personal tax on equity interest from XYZ Corp. Personal $3000 of perpetual debt from Mom at 8%. Personal
interest from Arthur. Personal tax
income, TE = 10%. tax on interest income, TD = 30%. tax on equity income, TE = 10%. Interest is an ordinary-
on interest income, TD = 30%.
income expense; tax rate on ordinary income,
Annual after-tax income: Annual after-tax income: TD = 30%. Annual after-tax income:
$856*(1-10%) = $770.40 8%*$3000*(1-30%) = $168
Annual after-tax income: = 8%*$3000*(1-30%) = $168
=$1000*(1-10%)- 8%*3000*(1-30%)= 732.

Family income: Arthur + Mom Family income: Arthur + Mom

Arthur: $ 770.40 Arthur: $ 732.00

Mom: $ 168.00 Mom: $ 168.00
Total: $ 938.40 Total: $ 900.00

FIGURE 17.3 Financing Arthur’s purchase of XYZ Corp.: The tax code in Upper Fantasia has a corporate
income tax rate TC = 40%, a personal tax rate on equity income TE = 10%, and a personal tax rate on all other
income TD = 30%.

When the company borrows the money, the total family income is $938.40. This compares
to the total income of $900 when Arthur borrows the money from Mom. So it’s better in this
case for the company to borrow the money.
532 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

To understand what’s happening, we create a spreadsheet. We’ll have more to say about
this spreadsheet (and the economics underlying it) later, but in the meantime, we stress its final
conclusion:
• Because the total family income (the combined income of Arthur XYZ and his mom) is
larger when the company borrows than when Arthur borrows (cell B27 versus cell C27),
the company should lever itself and not Arthur.
• The advantages of corporate borrowing are considerably less in this case than in the
previous case of ABC Corp. In the previous case corporate leverage of $3,000 added $96
to the family cash flows each year; in the current case it adds only $38.40. The difference
is, of course, the fact that we now have taxes on personal income, which were absent in
the ABC Corp. example.

A B C D
FINANCING ARTHUR'S PURCHASE OF XYZ
Upper Fantasia tax code: Corporate income tax, TC = 40%,
Personal taxes: Tax on equity income, TE = 10%,
1 tax on all other income, TD = 30%
2 Computing the family income
3 TC, corporate tax rate 40%
4 TE, personal equity tax rate 10%
5 TD, personal debt tax rate on ordinary income 30%
6 rD, interest rate 8%
7 D, Debt 3,000
8 FCF, free cash flow (already after corporate taxes) 1,000
9
Company Arthur
10 borrows borrows
11 FCF, after personal tax 1,000.00 1,000.00
12 Corporate debt 3,000.00 0.00
13 Corporate pre-tax interest payment 240.00 0.00
14 Corporate after-tax interest payment 144.00 0.00 <-- =C13*(1-$B$3)
15 Payout to equity owners 856.00 1,000.00 <-- =C11-C14
16
17 Arthur's income
18 Pre-tax equity income from XYZ 856.00 1,000.00 <-- =C15
19 Post-tax equity income from XYZ 770.40 900.00 <-- =C18*(1-$B$4)
20 Arthur's debt 0.00 3,000.00
21 Arthur's pre-tax interest payment 0.00 240.00 <-- =$B$6*C20
22 Arthur's after-tax interest payment 0.00 168.00
23 Arthur's post-tax income 770.40 732.00 <-- =C19-C22
24
25 Mom's pre-tax income 240.00 240.00 <-- =C20*B6
26 Mom's post-tax income 168.00 168.00 <-- =C25*(1-$B$5)
27 Total family income 938.40 900.00 <-- =C23+C26
28
29 Who should borrow--Arthur or company? Company <-- =IF(B27>C27,"Company",IF(B27<C27,"Arthur","Indifferent"))
30
31 Net advantage of corporate debt
32 (1-TD)-(1-TE)*(1-TC) 0.16

To understand this better, we need some equations:

 CHAPTER 17 Capital Structure and the Value of the Firm 533

Total cash produced by firm = FCF − rD * Debt * (1 − TC )* (1 − TE ) + rD * Debt * (1 − TD )

14444244443 144 42444 3
↑ ↑
Dividend to Arthur Income from
144444 424444443 debt to Mom
↑
Arthur's after-tax dividend

= FCF + rD * Debt * ⎡⎣(1 − TD ) − (1 − TE )* (1 − TC )⎤⎦

14444 4244444 3
↑
Net tax corporate tax-advantage of debt

In this case = (1 − TD ) − (1 − TC )* (1 − TE ) = (1 − 30% ) − (1 − 10% )* (1 − 40% ) = 16%

The term that makes all the difference is

1 − TD )
(!""#""$ − (1 − TE ) 1 − TC )
(!""#""$
!""#""$
↑ ↑ ↑
After-tax After-tax After-tax
ordinary income equity income corporate income
(including interest) !""""""""#""""""""$
↑
Net after-tax personal
income from pre-tax corporate
cash flows

If this term is positive, as in the previous example (see cell B32), then XYZ Corp. should
borrow; if it’s negative—as in the next example (in which the corporate tax rate is TC = 20%),
then Arthur should borrow and not the firm.

A B C D
FINANCING ARTHUR'S PURCHASE OF XYZ
Upper Fantasia tax code: Corporate income tax, TC = 20%
(instead of 40% in previous example)
Personal taxes: Tax on equity income, TE = 10%,
1 Tax on all other income, TD = 30%
2 Computing the family income
3 TC, corporate tax rate 20%
4 TE, personal equity tax rate 10%
5 TD, personal debt tax rate on ordinary income 30%
6 rD, interest rate 8%
7 D, Debt 3,000
8 FCF, free cash flow (already after corporate taxes) 1,000
9
Company Arthur
10 borrows borrows
11 FCF, after personal tax 1,000.00 1,000.00
12 Corporate debt 3,000.00 0.00
13 Corporate pre-tax interest payment 240.00 0.00
14 Corporate after-tax interest payment 192.00 0.00 <-- =C13*(1-$B$3)
15 Payout to equity owners 808.00 1,000.00 <-- =C11-C14
16
17 Arthur's income
18 Pre-tax equity income from XYZ 808.00 1,000.00 <-- =C15
19 Post-tax equity income from XYZ 727.20 900.00 <-- =C18*(1-$B$4)
20 Arthur's debt 0.00 3,000.00
21 Arthur's pre-tax interest payment 0.00 240.00 <-- =$B$6*C20
22 Arthur's after-tax interest payment 0.00 168.00
23 Arthur's post-tax income 727.20 732.00 <-- =C19-C22
24
25 Mom's pre-tax income 240.00 240.00 <-- =C20*B6
26 Mom's post-tax income 168.00 168.00 <-- =C25*(1-$B$5)
27 Total family income 895.20 900.00 <-- =C23+C26
28
29 Who should borrow--Arthur or company? Arthur <-- =IF(B27>C27,"Company",IF(B27<C27,"Arthur","Indifferent"))
30
31 Net advantage of corporate debt
32 (1-TD)-(1-TE)*(1-TC) -0.02
534 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

SOME HISTORY OF FINANCE (2)

The Modigliani–Miller model dates from two articles published in 1958 and 1963. In 1977
Merton Miller (half of the MM team) reconsidered the problem of capital structure. He still
focused on taxation, but this time considered the case where both corporate and personal
income were taxed.
Miller’s reasoning, incorporated in our example of XYZ Corp., was that the corporate tax
rate TC gives an advantage to corporations wishing to finance with debt. On the other hand,
for individuals equity income is generally taxed at a lower rate TE than the tax rate TD on debt
income. The primary reason for this is that the major part of income from equity is received
by shareholders as capital gains; not only are these taxed at a lower tax rate, but also the taxes
on capital gains are postponable (as a shareholder, you can decide when to sell your shares and
realize your capital gains). This postponability lowers the TE below the statutory rate (see some
discussion in Chapter 21). Thus, Miller reasoned, there is a trade-off:
• On the corporate level, the deductibility of interest means that corporations produce
higher before-personal-tax payouts to stakeholders (bondholders and shareholders)
when they have more debt financing.
• On the personal level, giving stakeholders (bondholders and shareholders) more interest
income instead of equity income means taxing them at higher personal rates.

This trade-off is summarized in the expression (1 − TD ) − (1 − TC )(1 − TE ) :

1 − TD )
(!""#""$ − 1 − TC )* (1 − TE )
(!"""""" "#"""""""$
↑ ↑
Payments to debtholders are Equity income is taxed twice:
only taxed at the personal tax of once at the firm level (since
the debtholder, since the firm makes these payments to shareholders are paid
payments out of pre-tax income out of after-tax earnings), and then again at the
personal level
!"""""""""""""""""""""""""#"""""""""""""""""""""""""$
↑
On the other hand, TE < TD , so that there is a trade-off ...
 CHAPTER 17 Capital Structure and the Value of the Firm 535

XYZ Corp.

After-tax cost of debt: (1-TC)rD

Each $ of before tax interest paid:

1) Decreases shareholder income by (1-TC)
2) Increases Arthur's Mom's interest payments by $1.

Shareholder Arthur Bondholder Mom

Equity income taxed at TE Interest income taxed at TD

Each $ of before-tax interest paid by XYZ Each $ of interest paid by the company
decreases Arthur's income from the increases Mom's income by (1-TD)
company by (1-TC)*(1-TE)

Family income: Arthur + Mom

Each $ of before-tax interest paid by XYZ increases Mom's

income by (1-TD) and decreases Arthur's by (1-TC)*(1-TE).

Net effect: (1-TD) - (1-TE)*(1-TC).

If this is positive, it's good for the family and the firm should
increase its borrowing; if its negative, it's bad for the family
and the firm should decrease its borrowing.

Miller suggested that in equilibrium

(1-TD) - (1-TE)*(1-TC) = 0

FIGURE 17.4 Cash flows of Arthur + Mom’s family income. In this flow diagram, Arthur is the
shareholder of XYZ Corp., and Mom is the bondholder of XYZ (meaning she lends the company
money). Each $1 of interest income paid to Mom by XYZ Corp. changes the family income by
(1 − TD )− (1 − TE )* (1 − TC ) . If this term is positive, then XYZ Corp.’s borrowing from Mom
adds to the family income; if it is negative, then XYZ Corp.’s borrowing detracts from the
family income.
536 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

17.7. Valuing XYZ Corp.—The Effect of Leverage When There Are

Corporate and Personal Taxes
We redo the calculations in Section 17.2, but this time use all the taxes—the corporate tax rate
TC, the personal tax rate on equity income TE , and the personal tax rate on ordinary income
(including interest) TD. Without leverage XYZ Corp.’s FCFs are worth $5,000:

VU = Unlevered value of XYZ

= PV ( future FCFs, discounted @ unlevered discount rate )
∞
1,000 Annual FCF 1,000
=∑ t
= = = 5,000
t =1 (1.20 )
rU 20%

We use the additivity principle to value the levered version of XYZ Corp.:

VL = VU + PV (additional debt-related CFs )

⎧ ∞
FCFt ∞
1,000 1,000
⎪VU = ∑ t
= ∑ t
=
20%
= 5,000
⎪ t = 1 (1 + rU ) t = 1 (1.20 )
⎪
= ⎨ The unlevered value of the firm is
⎪ the present value of its free cash flows
⎪ discounted at an appropriate (unlevered)
⎪ cost of capital r
⎩ U

⎧ ⎛ Interest tax⎞ ∞ ⎣⎡(1 − TD ) − (1 − TC )* (1 − TE )⎦⎤ * Interestt

⎪ PV ⎜ ⎟⎠ = ∑
⎪ ⎝ shields
t
t =1 (1 + (1 − TD )rD )
⎪ ∞
8%* 3,000 * 16% 38.4
+⎨
⎪ = ∑ t
=
5.6%
= 685.71
t = 1 (1 + 8%* (1 − 30% ))
⎪
⎪ The tax shields created
⎪ by the debt are discounted at the
⎪
⎩ consumer's after-tax interest rate.
= 5,685.71

XYZ Corp. is worth more as a levered firm than as an unlevered firm because it produces
more cash for its owners when it is levered. The additional cash produced—generated by the
fact that the company has a cheaper cost of debt than Arthur—is worth $685.71, which is the
present value of the future tax shields on the interest:

∞ ⎡ 1−T
⎛ Interest tax⎞ ( D )− (1 − TC )* (1 − TE )⎦⎤ * Interest
PV ⎜ ⎟ =∑⎣
⎝ shields ⎠ t =1 (1 + (1 − TD )rD )
t

⎡(1 − TD ) − (1 − TC )* (1 − TE )⎤⎦
=⎣ * Interest
(1 − TD )rD
⎡(1 − TD ) − (1 − TC )* (1 − TE )⎤⎦ Interest
=⎣ *
(1 − TD ) rD
⎡(1 − TD ) − (1 − TC )* (1 − TE )⎤⎦
=⎣ *D
(1 − TD )
 CHAPTER 17 Capital Structure and the Value of the Firm 537

⎡ ⎤
We use the letter T to denote the debt-valuation factor: T = ⎣(1 − TD ) − (1 − TC )* (1 − TE )⎦ .
(1 − TD )
9
T is the capitalized advantage of debt.

What About the Cost of Capital—rE and WACC with Leverage?

The levered version of XYZ Corp. is worth $5,685.71, of which $3,000 is debt. Subtracting the
value of the debt from the total worth of the company, we see that the equity of the company
is worth $2,685.71. To calculate the firm’s cost of equity rE , we first compute the after-tax cash
flows accruing to the equity owners:

annual after-corporate-tax equity cash flow = [FCF − after -tax interest paid by XYZ ]
= ⎡⎣1,000 − 8% * 3,000 * (1 − 40% )⎤⎦ = 856.00

The discounted value of this annual equity cash flow of $856.00 is the value of the equity;
this defines the cost of equity rE:

∞
equity cash flowt
Equity value = ∑
t =1 (1 + rE )t
∞
856.00 856.00
2,685.71 = ∑ t
=
t =1 (1 + rE ) rE
856.00
⇒ rE = = 31.87%
2685.71
With a little mathematical flimflammery, we can show that

D
rE = rU + ⎣⎡rU * (1 − T ) − rD * (1 − TC )⎦⎤
E
3,000
= 20%
) + ⎡⎣20% (1 − 22.86% ) − 8% (1 − 40% )⎤⎦ = 31.87%
↑
2,685.71
!"""""""""""""""""""#"""""""""""""""""""$
rU is the discount ↑
rate for the FCFs, When XYZ borrows, its shareholders
which represents bear an additional financial risk. The
the firm's business term above represents the financial risk
risk premium for the equity holders

We can now compute the WACC:

E D
WACC = rE + r (1 − TC )
E+D D E+D
2,685.71 3,000
= 31.87% + 8% (1 − 40%)
2,685.71 + 3,000 2,685.71 + 3,000
= 17.59%
With a little more flimflammery we can show that discounting the FCFs at the WACC gives
the total value of the firm:

∞ ∞
FCFt 1,000 1,000
∑ t
=∑ t
=
17.59%
= 5,685.71
t =1 (1 + WACC ) t =1 (1 + 17.59%)

9
To relate this to the previous case with only corporate taxes, note that when TE = TD = 0, T = TC.
538 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

Here’s all of this summarized in a spreadsheet.

A B C
COMPUTING THE WACC IN THE MILLER MODEL
1 with corporate and personal taxes
2 FCF, annual free cash flow (already after corporate taxes) 1,000
3 rU, unlevered cost of capital 20%
4 D, Debt 3,000
5 rD, interest rate 8%
6 TC, corporate tax rate 40%
7 TE, personal equity tax rate 10%
8 TD, personal debt tax rate on ordinary income 30%
9
10 Tax advantage of debt, (1-TD)-(1-TC)*(1-TE) 16.00% <-- =(1-B8)-(1-B6)*(1-B7)
11 T= [(1-TD)-(1-TC)*(1-TE)]/(1-TD), tax factor 22.86% <-- =B10/(1-B8)
12
13 Value of firm
14 VU, unlevered value 5,000.00 <-- =B2/B3
15 Value of tax shield on interest 685.71 <-- =B10*B5*B4/((1-B8)*B5)
16 VL, levered value of firm 5,685.71 <-- =B15+B14
17
18 E, value of equity 2,685.71 <-- =B16-B4
19
20 Cash flow to equity 856.00 <-- =B2-(1-B6)*B5*B4
21 Return on equity, rE(L) 31.87% <-- =B20/B18
22
23 WACC 17.59% <-- =B21*B18/B16+(1-B6)*B5*B4/B16
24
25 Three checks
26 Return on equity, rE(L) = rU+ [rU*(1-T) - rD*(1-TC)]*D/E 31.87% <-- =B3+(B3*(1-B11)-B5*(1-B6))*B4/B18
27 Value of firm, VL = FCF/WACC 5,685.71 <-- =B2/B23
28 Value of firm, VL = VU + T*D 5,685.71 <-- =B14+B11*B4

Summarizing This Section

We complete this section by restating its major conclusions. If corporate income is taxed and if
the tax system differentiates between income derived from equity and ordinary income, then
leverage (borrowing) may increase or decrease the value of the firm, depending on the sign of
the tax factor (1 − TD ) − (1 − TE )* (1 − TC ) .
A summary table is given in Figure 17.5.
 SUMMARY TABLE—CHANGING LEVERAGE WHEN CORPORATE AND PERSONAL INCOME ARE TAXED
Symbols: Corporate tax rate TC, personal tax rate on equity income TE, personal tax rate on ordinary income TD

(1 − TD ) − (1 − TC ) ∗ (1 − TE )
Tax advantage of debt = (1 − TD ) − (1 − TC ) ∗ (1 − TE ) ; Tax factor T =
(1 − TD )
Item Formula W hy
N
VU = value of unleveraged firm FCFt The value of the unleveraged firm is the PV of
VU =
(1 + rU ) t future FCFs discounted at rU , the unleveraged
t= 1
cost of capital.
VL = value of the leveraged firm VL = VU + P V ( net interest tax shields) The value of the leveraged firm is VU plus the
N present value of future interest tax shields.
[(1 − TD ) − (1 − TE ) ( 1 − TC )] ∗ interestt
= VU + When there are both corporate and personal
t= 1
(1 + r D (1 − TD ) ) t taxes, the PV of the tax shields is given by
Another way to write this is VL = VU + T ∗ D, N
[(1 − TD ) − (1 − TE ) ( 1 − TC )] ∗ interestt
(1 − TD ) − (1 − TE ) ∗ (1 − TC ) (1 + r D (1 − TD ) ) t
where T = t= 1
1 − TD

VL = VU + P V ( net interest tax shields) The cell to the left contains the formula for the
N value of the leveraged firm when the firm
[(1 − TD ) − (1 − TE ) ( 1 − TC )] ∗ interest
= VU + issues perpetual debt. This formula is the same
t= 1
(1 + r D (1 − TD ) ) t
as the parallel formula in Figure 17.2 for the
= VU + T ∗ D, case where TE = TD = 0.
(1 − TD ) − (1 − TE ) ( 1 − TC )
where T = In the general case where personal taxes are
(1 − TD ) perhaps not zero,
(1 − TD ) − (1 − TE ) ( 1 − TC )
T = can be
(1 − TD )
positive, negative, or zero.
E = value of equity E = VU − (1 − T ) D The equity value of the leveraged firm
E = VL − D = VU − (1 − T ) D
D = value of debt D
D
r E (L) = cost of equity of the r E (L) = rU + [rU (1 − T ) − r D (1 − TC )]
E
leveraged firm

WACC = weighted average cost FCF

WACC =
CHAPTER 17 Capital Structure and the Value of the Firm 539

of capital VL

FIGURE 17.5 Corporate value and cost of capital when corporate income is taxed at rate TC, personal ordinary income is taxed at rate TD, and personal equity
income is taxed at rate TE .
540 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

17.8. Buying a Sturfing Machine in Upper Fantasia

In this section and the next we return to the examples of Sections 17.3 and 17.4. This time we
do these examples for a company in Upper Fantasia, where, as you will recall, there are three
tax rates:
• In Upper Fantasia corporate income is taxed at the rate TC = 40%.
• Personal income from equity (meaning dividends and capital gains) is taxed at rate
TE = 10%.
• Personal income from all other sources is taxed at rate TD = 30%.

Sonderturf Considers Buying a Sturfing Machine

Sonderturf Corp., a company in Upper Fantasia, is considering purchasing a new sturfing
machine. The sturfing machine costs $100,000; it has a 10-year life, during which it is straight-
line depreciated to zero salvage value. In each of the 10 years of the machine’s life, it will pro-
duce sales of $40,000. These sales will cost $15,000 to produce. The result is that the machine
has an annual FCF of $19,000 per year.
The Sonderturf financial wizards have determined that an appropriate risk-adjusted dis-
count rate for the sturfing machine’s FCFs is rU = 15%. Discounting the machine’s FCFs at
this rate shows that it has a negative NPV of −$4,643. Thus the conclusion is that Sonderturf
should not acquire the sturfing machine. (For details of these calculations, refer to Section 17.3,
page 521.)

Sonderturf Gets a Loan to Buy the Machine

Having heard the bad news from Sonderturf, the sturfing machine’s manufacturer offers the
company a loan of $50,000. The loan’s conditions are exactly the same as those of the loan in
Section 17.3 that was offered to Sonderturf in Lower Fantasia: In years 1–9, Sonderturf will
pay only interest ($4,000), and in year 10 it will pay interest of $4,000 as well as repay the loan
principal.
It follows from Figure 17.4 that the value of the loan is

⎛ loan in Upper Fantasia, where there are corporate income ⎞

PV ⎜ taxes TC , taxes on equity income TE , ⎟=
⎜ ⎟
⎝ and taxes on ordinaryincome TD ⎠
10 ⎡ 1 − T
( D ) − (1 − TE )(1 − TC )⎤⎦ * Interestt
PV (net interest tax shields ) = ∑ ⎣ t
t =1 (1 + rD (1 − TD ))
10 ⎡ 1 − 30% − 1 − 10% 1 − 40% ⎤ * $4,000
( ) ( )( )⎦
=∑⎣ t = $4,801
t =1 (1 + rD (1 − 30%))
The Sonderturf financial wizards conclude that the company should now purchase the
machine, taking the loan to finance part of the purchase. They calculate that
 CHAPTER 17 Capital Structure and the Value of the Firm 541

NPV (machine + loan ) = NPV (machine ) + NPV (loan )

= NPV (machine ) + PV (loan interest tax shields
!"""""""""""#"""""""""""$
↑
In Upper Fantasia the tax shield
takes account of corporate as well as
personal taxes:
10 ⎡ 1-T - 1-T
⎣( D ) ( E )(1-TC )⎤⎦*Interestt
∑
t=1 (1+(1-TD )*rD )t
= −$4,643 + $4,801
= $158
The calculations are shown in the following Excel spreadsheet.

A B C D E F
1 THE SONDERTURF STURFING MACHINE
2 TC, corporate tax rate 40%
3 TE, personal tax rate on equity 10%
4 TD, personal tax rate on debt 30%
5
6 Machine cost, year 0 100,000
7
8 Free cash flow (FCF) calculation
9 Additional sales, annually 40,000
10 Additional annual cost of sales 15,000
11 Annual depreciation 10,000 <-- =B6/10
12 Annual FCF, years 1-10 19,000 <-- =(1-B2)*(B9-B10-B11)+B11
13
14 Discount rate for machine FCFs 15% Loan to buy machine 50,000
15 rD, loan interest rate 8%
Net annual advantage of debt
16 financing, (1-TD)-(1-TE)*(1-TC) 16% <-- =(1-B4)-(1-B3)*(1-B2)
17
Tax
Machine advantage
18 Year FCF of interest
19 0 -100,000 <-- =-B6
20 1 19,000 <-- =$B$12 640 <-- =$E$16*$E$15*$E$14
21 2 19,000 640 <-- =$E$16*$E$15*$E$14
22 3 19,000 640
23 4 19,000 640
24 5 19,000 640
25 6 19,000 640
26 7 19,000 640
27 8 19,000 640
28 9 19,000 640
29 10 19,000 640
30
31 Machine NPV -4,643 <-- =B19+NPV(B14,B20:B29) Loan NPV 4,801 <-- =E19+NPV(E15*(1-B4),E20:E29)
32
33 NPV: Machine + Loan 158 <-- =B31+E31

In Upper Fantasia Debt Is Not Always Valuable!

The Lower Fantasia tax system—which has only a corporate tax TC but no other taxes on per-
sonal income—always makes it more valuable to fi nance with debt. You can see this from the
following formula drawn from Figure 17.2, which holds in Lower Fantasia:
∞
TC * Interestt
VLLower Fantasia = VU + PV (interest tax shields ) = VU + ∑ t > VU .
t =1 (1 + rD )
The same formula in Upper Fantasia—with its more complicated (but more realistic) tax system
that combines a corporate income tax TC with a personal tax on equity income TE and a personal
tax on ordinary income TD —is given by
N ⎡ 1−T
( D ) − (1 − TE )* (1 − TC )⎤⎦ * Interestt
VLUpper Fantasia = VU + PV (interest tax shields ) = VU + ∑ ⎣ t
t =1 (1 + (1 − TD )rD )
542 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

The last expression need not always be positive. For example,

N
⎣⎡(1 − TD ) − (1 − TE )* (1 − TC )⎤⎦ * Interestt
∑ t > 0 if (1 − TD ) − (1 − TE )* (1 − TC ) > 0
t =1 (1 + (1 − T )r ) D D

N
⎣⎡(1 − TD ) − (1 − TE )* (1 − TC )⎤⎦ * Interestt
∑ t = 0 if (1 − TD ) − (1 − TE )* (1 − TC ) = 0
t =1 (1 + (1 − T )r ) D D

N
⎣⎡(1 − TD ) − (1 − TE )* (1 − TC )⎤⎦ * Interestt
∑ t < 0 if (1 − TD ) − (1 − TE )* (1 − TC ) < 0
t =1 (1 + (1 − T )r ) D D

The conclusion is that in Upper Fantasia, financing with debt need not make a project more
valuable. Suppose, for example, that TC = 40%, TE = 3%, and TD = 50%. Then the spreadsheet
below shows that financing the sturfing machine with debt decreases the NPV.
A B C D E F
THE SONDERTURF STURFING MACHINE
1 different taxes make debt disadvantageous!
2 TC, corporate tax rate 40%
3 TE, personal tax rate on equity 3%
4 TD, personal tax rate on debt 50%
5
6 Machine cost, year 0 100,000
7
8 Free cash flow (FCF) calculation
9 Additional sales, annually 40,000
10 Additional annual cost of sales 15,000
11 Annual depreciation 10,000 <-- =B6/10
12 Annual FCF, years 1-10 19,000 <-- =(1-B2)*(B9-B10-B11)+B11
13
14 Discount rate for machine FCFs 15% Loan to buy machine 50,000
15 rD, loan interest rate 8%
Net annual advantage of debt
16 financing, (1-TD)-(1-TE)*(1-TC) -8% <-- =(1-B4)-(1-B3)*(1-B2)
17
Tax
Machine advantage
18 Year FCF of interest
19 0 -100,000 <-- =-B6
20 1 19,000 <-- =$B$12 -328 <-- =$E$16*$E$15*$E$14
21 2 19,000 -328 <-- =$E$16*$E$15*$E$14
22 3 19,000 -328
23 4 19,000 -328
24 5 19,000 -328
25 6 19,000 -328
26 7 19,000 -328
27 8 19,000 -328
28 9 19,000 -328
29 10 19,000 -328
30
31 Machine NPV -4,643 <-- =B19+NPV(B14,B20:B29) Loan NPV -2,660 <-- =E19+NPV(E15*(1-B4),E20:E29)
32
33 NPV: Machine + Loan -7,304 <-- =B31+E31

17.9. Relevering Smotfooler, Inc., an Upper Fantasia Company

In Section 17.4 we offered a question from a Finance 101 exam at Eastern Lower Fantasia State
University. This section offers a similar question from an exam at Upper Fantasia University
(their football team is called the Ufus).
Here’s the question: Smotfooler, Inc. is a well-known Upper Fantasia company. Here are
some facts about the company:
• Smotfooler expects to have an annual FCF of $2 million at the end of years 1, 2, 3, . . . for-
ever. Recall that the FCF is the after-tax amount of cash that the company generates from
its business activities.
 CHAPTER 17 Capital Structure and the Value of the Firm 543

• Smotfooler currently has 100,000 shares outstanding on the Upper Fantasia stock
exchange. The Smotfooler share price is $100 per share.
• Smotfooler currently has no debt. However, a financial analyst has suggested that the
company issue $3,000,000 of perpetual debt and use the proceeds to repurchase shares.
The current interest rate on debt in Upper Fantasia is 8%, and the interest payments on
the debt will be made annually.
• Tax rates in Upper Fantasia are TC = 40%, TD = 30%, TE = 10%.
Students on the finance exam were asked to answer the following questions.
Question 1: What is the current market value of Smotfooler?
Answer: Smotfooler currently has 100,000 shares outstanding, each of which is worth
$100. Thus the company’s equity value is currently $10,000,000 = $100 * 100,000. Because the
company has no debt, this is also its market value. In short, VU = $10,000,000 .
Question 2: After Smotfooler issues $3,000,000 of debt, what will be its market value?
Answer: Because Upper Fantasia has a corporate income tax and personal income taxes, the
relation VL = VU + T D holds, where

T=
(1 − TD ) − (1 − TC )* (1 − TE ) = (1 − 30% ) − (1 − 40% ) (1 − 10% ) = 22.86% .
(1 − TD ) (1 − 30% )
(See also cell B7 on the following spreadsheet.)
This means that after the company issues its debt, its market value will be

VL = VU + T D = 10,000,000 + 22.86%* 3,000,000 = 10,685,714 .

Question 3: After Smotfooler issues debt of $3,000,000 and uses the proceeds to repur-
chase shares, what will be the company’s total equity value, E?
Answer: After Smotfooler issues the debt and repurchases the shares, the total value of its
equity, E, plus the total value of its debt, D, have to sum to the company’s total market value
VL . In short,
VL = 10,685,714 = E + D
But D = $3,000,000, and therefore:
E = 10,685,714 − 3,000,000 = 7,685,714

Question 4: At what price will Smotfooler repurchase its shares?

Answer: By issuing $3 million of debt, Smotfooler has raised its total market value by $685,714
(from $10 million to $10,685,714). This increase in value belongs to all the shareholders. Because
there are 100,000 shares outstanding before the share repurchase, this means that each share’s
price increases by $685,714/100,000 = $6.86. Thus the answer to this question is that the share price
for repurchase is $106.86. Of this amount, $100 is the share price before the repurchase and
$6.86 is the increase in the share price as a result of the debt issue.
Question 5: How many shares will Smotfooler repurchase?
Answer: According to the previous question, Smotfooler will repurchase its shares at $106.86
per share. Because the company has issued $3 million in debt to repurchase the shares, this
means that it will repurchase $3,000,000/$106.86 = 28,074.87.
544 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

Question 6: What was Smotfooler’s cost of equity before the repurchase of shares?
Answer: Smotfooler has an annual FCF of $2,000,000. Thus its unlevered cost of equity,
FCF 2,000,000
rE (U ) = rU = = = 20%.
VU 10,000,000

Question 7: What is Smotfooler’s cost of equity after the repurchase of the shares on the
open market?
Answer: Smotfooler issues $3 million in 8% debt to repurchase shares. Thus its annual
interest bill is 8% * $3,000,000 = $240,000. Because interest is an expense for tax purposes, the
company’s shareholders will have an annual expected cash flow of

Annual equity cash flow, after debt issuance = FCF − (1 − TC )* interest

= 2,000,000 − (1 − 40% )* 240,000
= 1,856,000
The value of the equity after the share repurchase is $7,685,714, so that the cost of equity
of the levered company is
1,856,000
rE (L ) = = 24.15% .
7,685,714

Note from Figure 17.4. that there’s another way to do this calculation:

D
rE (L ) = rU + ⎡⎣rU (1 − T ) − rD (1 − TC )⎤⎦ =
E
3,000,000
= 20% + ⎣⎡ 20% (1 − 22.86%) − 8% (1 − 40%)⎦⎤ = 24.15%
7,685,714

Question 8: What is Smotfooler’s WACC before the repurchase of the shares?

Answer: Recall the definition of the WACC:
E D
WACC = rE (L )* + r * (1 − TC )* .
E+D D E+D
The answer to Question 8 is easy: Because Smotfooler, before the share repurchase, has
only equity, its WACC = rU = 20%.
Question 9: What is Smotfooler’s WACC after the repurchase of the shares?
Answer:
E D
WACC = rE (L )* + r * (1 − TC )*
E+D D E+D
7,685,714 3,000,000
= 24.15%* + 8%* (1 − 40%) = 18.72%
7,685,714 + 3,000,000 7,685,714 + 3,000,000
 CHAPTER 17 Capital Structure and the Value of the Firm 545

Question 10: Why is rE (L) > rU ?

Answer: Before Smotfooler issued its bonds, the only risk borne by shareholders was the busi-
ness risk inherent in the company’s FCF. After the company issues its bonds, shareholders have
to bear two kinds of risk: business risk and financial risk. Thus rE (L) represents a discount rate
for cash flows that are riskier than the discount rate for the FCFs, rU. Because riskier cash flows
have higher discount rates, it follows that rE (L) > rU.
Question 11: Why does the market value of Smotfooler increase after the issuance of the
debt and repurchase of the equity?
Answer: By issuing the debt, Smotfooler increases the amount of cash it produces by
⎡⎣(1 − TD ) − (1 − TC )* (1 − TE )⎤⎦ * Interest payment for 3every year in which it has debt. This
additional cash flow is riskless. Because the holders of riskless cash flows in Upper Fantasia use
a discount rate of (1 − TD )* rD to value the cash flows, it follows that

∞ ⎡ 1−T
( D ) − (1 − TC )* (1 − TE )⎤⎦ * Interest payment
Value of additional debt -related cash flows = ∑ ⎣ t
t =1 (1 + (1 − TD )rD )
=
(1 − TD ) − (1 − TC )* (1 − TE ) Interest payment
(1 − TD )rD
=
(1 − TD ) − (1 − TC )* (1 − TE ) * r D = T *D
(1 − TD )rD D )
↑
T=

(1−TD )−(1−TC )*(1−TE )

(1−TD )

The PV of the tax shield accounts for the increase in Smotfooler’s market value:
VL = V
)U + !"T"#"
D"$ .
↑ ↑
Smotfooler's value The PV of
before the debt additional
issuance debt-related
cash flows

Question 12: Does debt always increase corporate value in Upper Fantasia?
Answer: No. It depends on the sizes of the three tax rates TC, TD, and TE. In the following
example, there is a net tax disadvantage to debt—by issuing debt, Smotfooler lowers its market
value and raises its WACC.
546 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

A B C
SMOTFOOLER—DEBT ISSUED TO REPURCHASE SHARES
1 Smotfooler is located in Upper Fantasia
2 Upper Fantasia tax system
3 TC, Upper Fantasia corporate tax rate 40%
4 TE, Upper Fantasia personal tax rate on equity income 10%
5 TD, Upper Fantasia personal tax rate on ordinary income 30%
6 Annual debt advantage: (1-TD)-(1-TE)*(1-TC) 16% <-- =(1-B5)-(1-B4)*(1-B3)
7 PV of debt advantage: T = [(1-TD)-(1-TE)*(1-TC)]/(1-TD) 22.86% <-- =B6/(1-B5)
8
9 Unlevered company
10 Annual free cash flow (FCF) $2,000,000
11 Number of shares 100,000
12 Price per share $100
13 Total equity value $10,000,000 <-- =B12*B11
14
15 Question1: VU, unlevered value of Smotfooler $10,000,000 <-- =B13
16
17 Levered company
18 Debt issued $3,000,000
19 Interest rate on debt 8%
20 Question 2: VL, levered value of Smotfooler, VL= VU+ T*D $10,685,714 <-- =B15+B7*B18
21 Question 3: Equity value after share repurchase, E = VL- D $7,685,714
Incremental firm value from exchanging
22 equity by debt = VL - VU = T*D $685,714 <-- =B20-B15
23 Incremental firm value on a per-share basis $7 <-- =B22/B11
24 Question 4: New share value, after repurchase $106.86 <-- =B12+B23
25
Question 5: Number of shares repurchased =
26 [debt used for repurchase]/[new share value] 28,074.87 <-- =B18/B24
Number of shares remaining after
repurchase = original number of shares
27 minus number of shares repurchased 71,925.13 <-- =B11-B26
Check: Market value of remaining shares =
28 number of remaining shares * new share value $7,685,714 <-- =B27*B24
29
Question 6: Smotfooler's cost of equity when unlevered,
30 rU=FCF/VU 20.00%
31
32 Annual interest costs, before taxes $240,000 <-- =B18*B19
33 Annual equity cash flow, after interest = FCF - (1-TC)*interest $1,856,000 <-- =B10-(1-B3)*B32
Question 7: Smotfooler's cost of equity when levered,
34 rE(L)=[FCF-(1-TC)*interest]/[value of equity, E] 24.15% <-- =B33/B28
Note: See formula in row 44 below for another
35 way to compute the levered cost of equity
36
37 Question 8: Smotfooler's WACC before the debt issuance = rU 20.00%
38
Question 9: Smotfooler's WACC after the debt issuance
39 = rE(L)*E/(E+D)+rD*(1-TC)*D/(E+D)
40 Percentage of equity in Smotfooler = E/(E+D) 71.93% <-- =B28/B20
41 Percentage of debt in Smotfooler = D/(E+D) 28.07% <-- =B18/B20
42 WACC = rE(L)*E/(E+D)+rD*(1-TC)*D/(E+D) 18.72% <-- =B34*B40+B19*(1-B3)*B41
43
44 Additional formula: rE(L)=rU+[rU*(1-T)-rD*(1-TC))*D/E 24.15% <-- =B30+(B30*(1-B7)-B19*(1-B3))*B18/B21

17.10. Is There Really an Advantage to Debt?

In this chapter we’ve laid out the theory of capital structure. We can answer the question of the
importance of capital structure in several ways.

Method 1: What are the relevant tax rates TC , TD, and TE?
As you can see, the value of XYZ Corp. is critically dependent on two factors:
• rU, the risk-adjusted rate of return for the FCFs. This rate is unaffected by the capital structure,
because the FCFs are operating cash flows and do not depend on the financing of the firm.

• (1 − TD ) − (1 − TC )(1 − TE ) —the relative after-tax costs of debt versus equity income.

 CHAPTER 17 Capital Structure and the Value of the Firm 547

Looking at this second parameter, we examine several cases. In the case below, the anticipated
dividend yield of 2% is taxed at 40%, whereas the anticipated capital gains yield of 6% is taxed at
10%. The equity tax rate is 17.5%, and the net tax advantage of debt over equity is 8.02%:

A B C
1 WHAT ARE THE RELATIVE TAX EFFECTS
2 Corporate tax rate, TC 37%
3
4 Anticipated equity tax Tax rate
5 Dividend yield 2.00% 40%
6 Capital gains yield 6.00% 10%
7
8 Net after-tax yield 6.60% <-- =B5*(1-C5)+B6*(1-C6)
9 Before tax yield 8.00% <-- =B5+B6
10
11 Personal tax rate on equity income, TE 17.50% <-- =1-B8/B9
12 Personal tax rate on ordinary income, TD 40.00%
13
Tax advantage of debt
14 over equity: (1-TD)-(1-TC)*(1-TE) 8.02% <-- =(1-B12)-(1-B2)*(1-B11)

With a somewhat different yield and tax configuration there is actually a net tax disadvan-
tage to debt.
A B C
1 WHAT ARE THE RELATIVE TAX EFFECTS
2 Corporate tax rate, TC 37%
3
4 Anticipated equity tax Tax rate
5 Dividend yield 0.00% 40%
6 Capital gains yield 6.00% 0%
7
8 Net after-tax yield 6.00% <-- =B5*(1-C5)+B6*(1-C6)
9 Before tax yield 6.00% <-- =B5+B6
10
11 Personal tax rate on equity income, TE 0.00% <-- =1-B8/B9
12 Personal tax rate on ordinary income, TD 40.00%
13
Tax advantage of debt
14 over equity: (1-TD)-(1-TC)*(1-TE) -3.00% <-- =(1-B12)-(1-B2)*(1-B11)
548 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

A B C
1 WHAT ARE THE RELATIVE TAX EFFECTS
2 Corporate tax rate, TC 37%
3
4 Anticipated equity tax Tax rate
5 Dividend yield 5.00% 0%
6 Capital gains yield 0.00% 0%
7
8 Net after-tax yield 5.00% <-- =B5*(1-C5)+B6*(1-C6)
9 Before tax yield 5.00% <-- =B5+B6
10
11 Personal tax rate on equity income, TE 0.00% <-- =1-B8/B9
12 Personal tax rate on ordinary income, TD 0.00%
13
Tax advantage of debt
14 over equity: (1-TD)-(1-TC)*(1-TE) 37.00% <-- =(1-B12)-(1-B2)*(1-B11)

Below you will see a third case in which only corporate income is taxed. In this case there
is an overwhelming advantage to debt financing.

Method 2: What’s the Evidence in Firm Behavior?

Instead of asking whether tax rates support a net tax advantage, we can also look at different
firms. We can ask whether in a particular industry there is a consistent behavior toward debt.
The answer is no, as you will see in Chapter 18. We interpret this “inconsistent” behavior as
evidence in favor of the argument that there is no net tax advantage to debt—that is, that firm
financial policy does not affect its market value.

Method 3: What Does Sophisticated

Finance Research Say?
Chapter 18 looks at the latest academic research on the capital structure question. Our reading
of this research is that the importance of debt over equity financing has been heavily overem-
phasized in finance textbooks. There may be a small advantage of debt over equity, but it is
overwhelmed by the overall uncertainty of valuing a firm.

Summary and Conclusion—United Widgets Corp.

United Widgets is a new company set up by John and Cindy, who are pondering the effect of
the equity-to-debt financing mix. The question they have in mind is does it matter whether the
company is financed with share capital (equity) or with money borrowed from a bank (debt)?
The risk–return trade-off between the two financing alternatives is complex:
• The providers of equity financing are promised a share of the firm’s profits (if there are
any). If there are no profits, then shareholders will not get any dividends; although they
will surely be disappointed, they cannot use the nonpayment of dividends to force the
firm into bankruptcy.
 CHAPTER 17 Capital Structure and the Value of the Firm 549

• The providers of debt financing are promised a series of fixed payments. If United
Widgets cannot keep the commitment of making the fixed payments, then the company
may become insolvent. Bankruptcy will affect the shareholders of the company, denying
them their share in United Widgets.
• Debt financing is generally cheaper than equity financing: The riskiness of the inter-
est payments promised by United Widgets to its lenders is less than the riskiness of the
dividend payments promised by the company to its shareholders. In addition, interest is
a tax-deductible expense for United Widgets, whereas dividends have to be paid out of
after-tax income. Shareholders, being at greater risk than lenders, will therefore demand
a higher expected return than debtholders. The relative cheapness of debt versus equity
appears to make debt preferable as a financing mechanism. But:
• Debt financing makes equity financing even more risky. The risky dividend stream that
comes from the company is endangered even further when shareholders promise debt-
holders a series of future payments. The higher the amount of debt the firm has, the more
risky the equity financing becomes.10
Realizing all these factors, John and Cindy ask themselves the following questions:
• Does the debt-to-equity mix affect the amount of cash that can be extracted from United
Widgets?
• Does the mix of equity and debt affect the discount rate that United Widgets should use
for discounting project cash flows? As we have seen in Chapters 6, 14, and 16, the rele-
vant discount rate is the weighted average cost of capital (WACC).
• Does the debt-to-equity mix affect the cost of equity?
The next pages give schematic answers to these questions.
Chapter 18 explores some empirical results and tries to give you a “take” on how to apply
the theoretical answers developed in this chapter.

10
John and Cindy briefly considered financing their firm with only debt. But this is impossible!
 Financing United Widgets—Capital Structure and
Its Effects on Cost of Capital and Firm Valuation
UNITED WIDGETS EFFECT OF DEBT/EQUITY MIX ON WEIGHTED
AVERAGE COST OF CAPITAL (WACC)
John and Cindy set up a new United Widgets is financed 1. If there are no taxes, the debt–equity mix does not affect the
company–United Widgets, with equity (meaning money widget machine discount rate.
Inc. They decide to buy a put up by John and Cindy
widget machine because and their friends) and debt 2. If there are only corporate taxes and no personal taxes, then
financial analysis shows that (money borrowed from the more debt means that the widget discount rate decreases.
the NPV of the machine’s bank). 3. If both personal and corporate incomes are taxed, widget
cash flows is positive. machine discount rates can increase/decrease/stay the same
when the debt–equity mix changes.

Does the debt– EFFECT OF DEBT/EQUITY MIX ON TOTAL CASH

equity financing mix EXTRACTED FROM COMPANY
550 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

change the discount

rate used to evaluate 1. If there are no taxes, the debt–equity mix does not affect
widget machines? the total amount of cash extracted from the company.
2. If there are only corporate taxes and no personal taxes, then
Does the debt– more debt means more cash extracted from the company;
equity financing mix happens because the tax system subsidizes debt (interest is an
change the total expense for tax purposes).
cash extracted from 3. If both personal and corporate incomes are taxed, the cash
the company? extracted from the company can go up or down: Companies
enjoy a tax subsidy on their interest payments (since interest is
an expense for tax purposes). But shareholders pay lower taxes
on earnings from equity (because of an advantageous capital
gains tax) than on interest earnings from debt.
 EFFECT OF DEBT/EQUITY MIX ON COST OF EQUITY AND WACC
More debt in the debt–equity mix always makes equity riskier! The equity owners have to pay debtholders before they pay
themselves and this increases their risk.
The effect of capital structure on WACC depends on the mix of corporate and personal taxes:
1. If there are no taxes, WACC is unaffected by capital structure: the increase in the cost of equity as the debt–equity
mix increases exactly offsets the savings of cheaper debt.
2. If there are only corporate taxes, WACC decreases when more debt is used to finance the firm.
3. If there are both corporate and personal taxes, WACC can increase/decrease/stay the same. Empirical evidence
(Chapter 18) seems to indicate that it doesn’t change much.

E D
WACC = r E (L) + r D (1 − TC )
E+ D E+ D

where:
r E (L) = cost of equity (increase when debt–equity ratio ↑)
r D = cost of debt
E = market value of firms equity
D = market value of firms debt
TC = corporate tax rate

FIGURE 17.6 Summarizing the effects of capital structure on the cost of capital and valuation.
CHAPTER 17 Capital Structure and the Value of the Firm 551
552 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

EXERCISES
1. Go back to the supermarket example from the beginning of the chapter. Assume that the supermar-
ket after-tax operating income is $120,000 each year. If Mortimer’s group took a $500,000 loan
at a 9% annual interest rate and its tax rate is 30%, what will be the return on equity (ROE) for

⎛ Profit after tax ⎞

Mortimer’s group and Joanne’s group, ⎜ ROE = ⎟⎠ ?
⎝ Equity
Mortimer's Supermarket Group
Half equity (50%) and half debt (50%)
Supermarket $1,000,000 Debt $500,000
Equity $500,000
Total assets $1,000,000 Total debt and equity $1,000,000

Joanna's Supermarket Group

Only equity (100%)
Supermarket $1,000,000 Debt $0
Equity $1,000,000
Total assets $1,000,000 Total debt and equity $1,000,000

2.
a. Repeat Exercise 1 with the following balance sheets (assume that the debt still bears a 9%
interest rate).
b. Show in a Data Table and an Excel chart the sensitivity of the ROE to the equity-to-debt
ratio.
Half equity (50%) and half debt (50%)
Supermarket $1,200,000 Debt $600,000
Equity $600,000
Total assets $1,200,000 Total debt and equity $1,200,000

Joanna’s Supermarket Group

Only equity (100%)
Supermarket $1,000,000 Debt $0
Equity $1,000,000
Total assets $1,000,000 Total debt and equity $1,000,000

3. You are interested in buying a warehouse for your firm. The warehouse costs $350,000 and using
it will save the firm $50,000 annually forever. The firm can borrow any amount of money at an 8%
annual interest rate; all money borrowed is “perpetual debt”—meaning that the firm pays only the
annual interest payment and never returns the debt principal. The firm’s tax rate is 40%.
What will be the firm’s additional annual income and its return on equity (ROE) on the invest-
ment in the following four cases?
a. The firm finances the purchase with equity only.
b. The firm finances the purchase with 75% equity and 25% debt.
c. The firm finances the purchase with 50% equity and 50% debt.
d. The firm finances the purchase with 20% equity and 80% debt.
4.
a. Repeat Exercise 3 and show the total annual amounts received by the firm’s shareholders and
debt holders.
b. Show in a Data Table and an Excel chart the change in the total amount received by the firm’s
shareholders and debtholders as a function of the equity invested in the project.
 CHAPTER 17 Capital Structure and the Value of the Firm 553

5. Eddy is the sole owner of his firm. He now wishes to purchase the company next door for $600,000.
His calculations show that the annual income before tax from the purchase is $80,000.
He is considering two financing alternatives: The first is to ask for a personal loan of $300,000
and pay the remaining amount from his savings. The second alternative is to finance the purchase
by having his firm take the $300,000 loan. Assuming the interest rate on the loan is 9% (for infinite
duration) and the corporate tax rate is 40%, what will be the total amount received by the firm’s
shareholders and debtholders in each scenario, assuming that only the interest paid by Eddy’s firm
is an expense for tax purposes?
6. Returning to the previous exercise, what is the value of the firm Eddy wishes to buy under the two
financing alternatives?
7. Annie owns a “shell firm”—a firm that is incorporated but has no activity whatsoever. Annie’s
shell firm is about to buy another firm for $900,000. The firm she is purchasing has an annual free
cash flow (FCF) of $120,000 each year.
a. Annie’s bank is willing to give her a perpetual loan equal to half of the purchase amount at 8%
interest. Assuming Annie’s firm has no debt and its tax rate is TC = 30%, what will be her firm’s
value after the purchase in the following scenarios?
• In case it will finance the purchase with equity only.
• In case it takes the loan.
b. What will be the firm’s value in case the loan is repaid in 20 equal repayments?
8. Section 17.3 gives two formulas for the cost of equity rE(L) of a levered firm for the case when there
are only corporate taxes:

Annual equity cash flow

rE (L ) =
Value of equity

D
rE (L ) = rU + [rU − rD ] (1 − TC )
E

Use both of these formulas to find the cost of equity rE(L) for the following cases:
a. The cost of equity rE(L) for the firm Eddy is buying in Exercise 5.
b. The cost of equity rE(L) of Amadeus Supermarket in Exercise 1.
c. The cost of Equity rE(L) of Annie’s firm from Exercise 7.
9. Section 17.3 gives two formulas for the weighted average cost of capital (WACC) of a levered firm
for the case when there are only corporate taxes:
E D
WACC = rE (L ) + r (1 − TC )
E+D D E+D

FCF
WACC =
VL
Use both of these formulas to find the WACC for the following cases:
a. The WACC for the firm Eddy is buying in Exercise 5.
b. The WACC of Amadeus Supermarket in Exercise 1.
c. The WACC of Annie’s firm from Exercise 7.
10. Sandy-Candy, a hot new chewing gum company, is for sale for $2,000,000. Henry is interested
in buying the company and is exploring various financing alternatives. He knows that the interest
rate on debt is rD =9%, the corporate tax rate is TC = 36%, and the cost of capital of the purchase is
rU = 12%. Henry estimates that Sandy-Candy has a free cash flow (FCF) of $300,000 each year.
a. What will be the market value of Sandy-Candy if Henry does not take a loan?
554 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

b. What will be the market value of Sandy-Candy if Henry takes a $1,200,000 loan? Assume
that the loan is paid for out of Sandy-Candy’s earnings and that the interest is an expense for
tax purposes.
c. What will be Sandy-Candy’s cost of equity rE for the two cases above?
d. What will be Sandy-Candy’s WACC for the two cases above?
11. Debby, the owner of Oxford Corp., has decided that it’s time to make some changes to the firm’s
capital structure. She estimates that Oxford’s FCF is $150,000 each year and that this FCF can
be expected to recur annually forever. The company has no debt and 30,000 shares outstanding,
each of which is currently worth $50.
Debby wants Oxford to borrow $600,000 of perpetual debt and use the proceeds to repur-
chase shares. Assuming the interest rate on debt is rD = 6% and the corporate tax rate is
TC = 30%, calculate the following changes.
a. What is Oxford’s market value before it issued debt?
b. What is Oxford’s market value after it issued debt?
c. What will be Oxford share price after the debt issuance?
d. How many shares will be repurchased?
e. What is Oxford’s equity value after the repurchase of the shares?
f. What is Oxford’s cost of equity after the repurchase and dividend payment?
g. What is Oxford’s WACC after the repurchase and dividend payment?
12. XYZ Corp. is about to borrow $100,000. The terms of the loan specify an annual equal repayment
of principal in each of the next 8 years. The loan rate is rD = 8%, and XYZ has a corporate tax rate
of TC = 40%. If the loan interest is an expense for tax purposes for XYZ and if there are no other
taxes besides corporate taxes, what will be the increase in XYZ’s market value?
13. Go back to the exercise of buying the turfing machine (Section 17.3). Repeat the exercise assum-
ing the loan is repaid in 10 equal payments. What is the NPV of the investment now?
14.
a. According to a recent tax reform in Lower Fantasia, the personal tax rate on all ordinary
income except capital gains from stocks was changed from 0 to 25%. Capital gains will hence-
forth be taxed at 15%. The Lower Fantasia corporate tax rate remains unchanged at 40%.
Assuming you plan to take a loan, what will be better—to borrow using your firm or take a
personal loan? Show the net advantage of corporate debt in this case.
b. Will your answer to Exercise 14a change if the corporate tax rate becomes 20%?
15.
a. Eddy, from Exercise 5, needs your help again. He didn’t purchase the firm because the bank
didn’t approved him the loan, but now his dad is willing to step in and help him by loaning him
the same amount ($300,000). In addition, after the recent elections he’s now facing a personal
tax rate of 40% (equal to the corporate tax rate) and a 15% tax on equity income. What should
he do—finance the purchase using a firm or take a personal loan? Calculate the total amount
received by the stakeholders (shareholders and debtholders).
b. Assuming Eddy purchases the firm next door using his own firm, calculate the value of the
firm, his cost of equity, and the WACC (assume his unlevered discount rate is 12%).
16. Assume that the corporate tax rate is TC = 30% and the equity income tax rate is TE = 10%. What
is the ordinary income tax rate TD for which an investor will be indifferent between choosing a
personal loan or a loan using a firm?
17.
a. Repeat Exercise 11 (Oxford Corp.) assuming the ordinary income tax rate is TD = 34% and the
personal equity tax rate is TE = 15%.
 CHAPTER 17 Capital Structure and the Value of the Firm 555

b. For this case calculate the “net advantage of corporate debt” and calculate the expression

T=
(1 − TD )− (1 − TE )(1 − TC ) .
(1 − TD )
18. You are interested in buying a machine that will produce sales of $50,000 in each of the next 6
years. The machine costs $120,000 and has a 6-year life. It is straight-line depreciated to a zero
salvage value. In addition, the machine activity costs $18,000 annually. The discount rate you
decided to use for the machine’s FCF is 12%.
You are considering taking a 9%, 6-year loan to finance the purchase of the machine. The
loan amount will be $70,000. The loan terms specify annual payments of interest only in years
1–5 and the repayment of the whole principal in year 6. Assuming that the corporate tax rate
is TC = 40%, the personal tax rate (on ordinary income) is TD = 22%, and the equity tax rate is
TE = 15%, answer the following questions.
a. What is the machine FCF?
b. What is the NPV of the machine if it is financed with equity only?
b. Calculate the “net advantage of corporate debt,” T.
c. What is the NPV of the machine if it is financed with a mix of equity and debt?
19.
a. Fill in the following Excel sheet.
A B C
1 FILL IN THE TAX EFFECTS
2 Corporate tax rate, TC 36%
3
4 Anticipated equity tax Tax rate
5 Dividend yield 2.50% 40%
6 Capital gains yield 5.00% 10%
7
8 Net after-tax yield ??
9 Before tax yield ??
10
11 Personal tax rate on equity income, TE ??
12 Personal tax rate on ordinary income, TD ??
13
Tax advantage of debt over equity:
14 (1-TD)-(1-TC)*(1-TE) ??

b. Show in a graph the change in “net advantage of corporate debt” as a function of the personal
tax rate.
CHAP TER

18 The Evidence on Capital Structure

CHAPTER CONTENTS
Overview 556
18.1. Summarizing the Theory 558
18.2. How Do Firms Capitalize? 560
18.3. Measuring a Firm’s Asset Beta (βAsset) and WACC: An Example 563
18.4. Computing the Asset Beta (βAsset) for the Grocery Industry 564
18.5. Academic Evidence 566
Summing Up 566

Overview
In this chapter we discuss whether the capital structure of a company—with what mix of equity
and debt it finances itself—affects the company’s weighted average cost of capital (WACC).
Chapter 17 discussed the theory of capital structure, which concerns itself with the effects
of financing on the valuation of assets. Capital structure theory asks whether firms that are
more highly leveraged are worth more than firms with less leverage, all other factors being the
same.
In Chapter 17 we suggested that the importance of capital structure depends on how it
affects the ability of the corporation to extract cash from its operating and its financial activi-
ties. If, by increasing its leverage, a corporation can increase the total amount of cash it pays to
its shareholders and bondholders, then it should do so. If, on the other hand, increasing leverage
does not change the amount of cash paid to shareholders and bondholders, then increased lever-
age is not worthwhile.

556
 CHAPTER 18 The Evidence on Capital Structure 557

In Chapter 17 we related the corporate ability to extract cash from a corporation’s activities
to the trade-off between personal and corporate taxation: Corporate borrowing is tax deductible
(because interest is an expense for tax purposes); this tends to favor corporations with more rather
than less debt in their capital structures. On the other hand, a corporation with more debt in its capi-
tal structure channels more of its income to bondholders rather than to shareholders, and bondhold-
ers have a higher tax rate on their interest income than do shareholders on their equity income.
To see why the Chapter 17 discussion of leverage is important, suppose for a moment that
firms with more debt are worth more than similar but less-levered firms. Then we would suggest
the following steps to corporate managers:
• Corporate managers should strive to increase the amount of debt used in financing cor-
porate activities. If, for example, a firm builds a new plant, then it should try to borrow
the maximum amount it can to build the plant.
• Corporate managers should minimize the amount of cash they have on hand (subject,
of course, to operational and safety considerations). If leverage (that is, paying interest
on debt) adds to value, then holding cash (that is, having an asset that earns interest) is a
detriment to value.
• Corporate managers should increase the corporate dividend payments. By paying out
dividends, managers decrease the amount of cash on hand and thus increase the effective
leverage of the firm.
• For the same reason, corporate managers should increase share repurchases, which
decrease the amount of cash on hand and thus increase effective leverage.
The bullets above tell a manager how she should operate if leverage is a positive value
driver. If, on the other hand, leverage is a negative value driver—meaning that more leverage
decreases corporate value—then the manager should take the opposite actions. And if—as we
suggested at the end of Chapter 17—leverage is a neutral value drive because the tax benefits of
corporate leverage are offset by the tax disadvantages of leverage at the personal taxation level,
then none of the above matters.
As you can see, leverage theory can have significant operative implications.

WHAT’S THE CONCLUSION?

To anticipate the conclusions of this chapter, we see no evidence that leverage adds value to a
firm. Nor do we find significant evidence that a firm’s weighted average cost of capital (WACC)
is affected by its financing mix of debt versus equity. The operative conclusions are as follows:
• Firms should proceed as if the financing mix of their assets cannot add or subtract
value.
• The WACC is unaffected by leverage.
• The best way to measure the WACC is by taking the average WACC of a firm’s
industry.

What Do We Do in This Chapter?

Chapter 17 was largely theoretical. In this chapter, on the other hand, we discuss the market
evidence on capital structure. We ask whether we see—in market prices, cost of capital, and
market risk measures—evidence for or against the positive effects of more debt on the value
558 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

of firms. In Section 18.1 we summarize the results of Chapter 17. The upshot of these results is
that the effects of financing on valuation depend largely on the tax system. Roughly speaking, if
firms, by borrowing, can increase the total cash flow available to shareholders and bondholders,
then the firms should move toward a more leveraged capital structure.
The remaining sections of the chapter present some empirical evidence of the effects of
capital structure on the cost of capital. As you will see, the evidence seems to indicate that there
is little significant effect of capital structure on the WACC.

Finance Concepts Discussed

• What are some facts about capital structure (how do firms capitalize)?
• Does capital structure affect the value of the firm?
• Does capital structure affect the cost of capital?
• Are there other important considerations, such as bankruptcy costs or control?
• How do you measure the firm’s unlevered cost of capital r U?
• How do you compute the WACC for an industry?

Excel Functions Used

• Average
• Stdev
• Regression (trendline)

18.1. Summarizing the Theory

The theory of capital structure outlined in the previous chapter says that the effect of capi-
tal structure on the value of the firm is primarily caused by tax considerations. Very roughly
speaking, if firms enjoy interest tax deductibility that is unavailable to their shareholders, then
firms should borrow and increase their debt-to-equity ratios. This theory—the Modigliani–
Miller theory (Chapter 17, Sections 17.3–17.5)—should be contrasted with the Miller model
(Chapter 17, Sections 17.6–17.9), which postulates that the advantage of corporate debt is to
some extent offset by the tax advantage of equity to investors.
These are complex concepts that we illustrated with two examples (Arthur ABC and Arthur
XYX) in the previous chapter. We sum up the conclusions of Chapter 17.
1. Leverage adds value to a firm if the capitalized value of the interest tax shields is
positive:

VL = VU + PV (Capitalized interest tax shields )

∞ ⎡(1 − T ) − (1 − T )* (1 − T )⎤ * Interest
= PV (FCFs, discounted at rU ) + ∑ ⎣
D E C ⎦ t

t =1 1 + (1 − T )r
D D
 CHAPTER 18 The Evidence on Capital Structure 559

Here,

FCF = the firm' s free cash flows

rU = the firm' s unlevered cost of equity
rD = the firm' s cost of debt
TC = the corporate tax rate
TE = the personal tax rateonequityincome
TD = the personal tax rateonordinaryincome (including interest )

2. Assuming that a firm is contemplating a permanent change ∆Debt in its capital structure,
the value of the additional tax shields produced by the debt are given by the equation

∞ ⎡ 1−T
( D )− (1 − TE )* (1 − TC )⎤⎦ * Interest
PV (Capitalized interest tax shields ) = ∑ ⎣
t =1 1 + (1 − TD )rD
⎡(1 − TD ) − (1 − TE )* (1 − TC )⎤⎦ * rD * ∆Debt
=⎣
(1 − TD )rD
⎡(1 − TD ) − (1 − TE )* (1 − TC )⎤⎦ * ∆Debt
=⎣ = T * ∆Debt
(1 − TD )
⎡(1 − TD ) − (1 − TE )* (1 − TC )⎤⎦
where T = ⎣
(1 − TD )

3. In the classic Modigliani–Miller theory, which invokes only corporate taxes, T = TC , so

that debt always adds to value. In Miller’s more complex model, which takes into account
both personal and corporate taxes, T can be positive, negative, or zero, depending on the
sign of (1 − TD ) − (1 − TE )(1 − TC ). Miller hypothesized that (1 − TD ) − (1 − TE )(1 − TC ) = 0 ;
if this is so, then there would be no advantage to debt over equity financing.
4. Leverage affects both the WACC and the cost of equity r E. In the table below we give
some formulas for the WACC, the cost of equity r E, and the cost of capital of an unlevered
firm rU:

Weighted average cost of E + D * (1 − T ) If debt adds value (i.e., T > 0), lever-
WACC = * rU
capital E+D age decreases the WACC

More debt always makes equity more

D risky and increases the cost of equity
Cost of equity of a levered rE = rU + ⎡⎣rU * (1 − T ) − rD * (1 − TC )⎤⎦ r E. The amount by which the equity
firm, rE E
becomes more risky depends on the
relative sizes of T and TC.

Cost of unlevered Often we estimate a firm’s cost of

capital, rU r * D * (1 − TC ) + rE * E equity rE; this formula lets you back
rU = D
E + D * (1 − T ) out what would be the cost of capital
rU of the firm if it had no leverage.
560 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

5. Contrary to the formula in Conclusion 2 above, the value of debt interest tax shields is
not the only factor in determining the effect on firm value of a change in debt. Three
other prominent factors discussed by academics and practitioners are bankruptcy costs,
the costs of financial control (change name), and the option effects associated with debt.
These costs are difficult to quantify, but they certainly exist:
a. Costs of financial distress (“bankruptcy costs”): Increasing a firm’s leverage also
makes it more likely that a firm will have a greater future probability of getting into
financial trouble. The present value of the costs of getting out of this trouble (they
should be called “costs of financial distress,” but they are usually call termed bank-
ruptcy costs) should be deducted from the benefits of additional leverage.1
b. Costs of financial control. Borrowers will usually lend the firm more money only if
they can exercise more control. Often this control involves debt covenants. These are
restrictions imposed by the lender on the firm. For example, the Giant Industries bond
issue discussed in Section 15.4 (page 466) has the following covenants:
“The Indentures . . . contain restrictive covenants that, among other things, restrict the
ability of the Company and its subsidiaries to create liens, to incur or guarantee debt,
to pay dividends, to repurchase shares of the Company’s common stock, to sell certain
assets or subsidiary stock, to engage in certain mergers, to engage in certain transac-
tions with affiliates or to alter the Company’s current line of business.”
c. Option effects of debt: The shareholders in a heavily indebted firm have less to
lose than those in a low-leverage firm. They may thus feel free to take more risks.
Increased leverage may thus affect the riskiness of the firm’s free cash flow (FCF). As
an example, Bob and Jerry each own a similar building; the market value of each of
their buildings is $100,000. The buildings are in need of a very expensive repair. Bob
owns his building outright, whereas Jerry has a $99,000 mortgage on his building.
Bob is much more likely to do the repairs because he has more to lose; Jerry might
well reason that in the worst case if something happens to his building, he’ll default
on his mortgage and let the bank take care of the problems.2
6. Finally, it may be that firms are limited in their borrowing by the kinds of assets they
own. If lenders require loan collateral, then firms with many fixed assets may be more
easily able to borrow than firms with more “ephemeral” assets. Thus, even if Modigliani
and Miller are right, and firms want to borrow as much as possible, it may be that soft-
ware firms (with fewer tangible assets) are less able to borrow than real estate firms.

18.2. How Do Firms Capitalize?

One way to think about capital structure is to look the actual capital structures for different
companies and industries. As an example, consider Abbott Laboratories, a major American

1
Empirical research in finance estimates bankruptcy costs as generally less than 10% of the face value of
debt at the time of bankruptcy. If the Modigliani–Miller full tax shield on debt were to hold, it is unlikely
that bankruptcy costs of this magnitude would retard corporate desires for more leverage. A recent
paper (Timothy Fisher and M. Jocelyn Martel, “On Direct Bankruptcy Costs and the Firm’s Bankruptcy
Decision”. http://ssrn.com/abstract=256128) gives interesting information on the size of bankruptcy and
liquidation costs in Canada.
2
Lenders know all about option effects. It causes them to restrict their lending and also to impose cov-
enants on the borrowers.
 CHAPTER 18 The Evidence on Capital Structure 561

pharmaceutical firm: On 20 March 2002, Abbott’s balance sheets showed debt of approximately
$8.7 billion and equity of $10.7 billion. Using these book values debt and equity, Abbott had a
book value debt-to-equity ratio of 0.81:

Debt 8.7
Abbott Labs , book value, debt-equity ratio = = = 0.81
Equity 10.7
The book value of Abbott’s equity understates its market value. On 20 March 2002, Abbott
had 1,563,436,372 shares outstanding; the market price per share was $51.80. Multiplying these
two numbers together gives the market value of Abbott’s equity as $81 billion, so that Abbott
had a market value debt-to-equity ratio of 0.108:
Debt 8.7
Abbott Labs , market value, debt-equity ratio = = = 0.108
Equity 81.0
Finance professionals uniformly prefer market values to book values, so that this is our
estimate for Abbott’s debt-to-equity ratio.

The Debt-to-Equity Ratio of Pharmaceutical Firms

In the spreadsheet below we calculate the debt-to-equity ratio in both book and market values
for major pharmaceutical companies.
A B C D E F G H I J K L
DEBT/EQUITY RATIOS FOR PHARMACEUTICALS
1 November 2009
D/E D/E 1.40
Book Market
2 value value 1.20
3 Abbott 0.3258 0.0853 D/E
4 Astra-Zeneca 0.1773 0.0526 1.00
Book value
5 Bristol-Myers Squibb -0.0049 -0.0015
0.80 D/E
6 Eli Lilly 0.3494 0.0839
Market value
7 Endo Pharmaceuticals -0.1180 -0.0606 0.60
8 GlaxoSmithKline 1.1357 0.1637
9 Johnson & Johnson -0.0544 -0.0160 0.40
10 Merck -0.6040 -0.1852
11 Pfizer -0.1982 -0.0898 0.20
12 Teva 0.2060 0.0858
13 0.00
Abbott

Bristol-Myers Squibb

Eli Lilly

Merck

Pfizer
Johnson & Johnson
Astra-Zeneca

Endo Pharmaceuticals

Teva
GlaxoSmithKline

14 Average 0.1215 0.0118

-0.20
15 Standard deviation 0.4553 0.1034
16 -0.40
17
18 -0.60
19
20 -0.80
21

Several things are clear from these data:

• The average market debt-to-equity ratio for these firms is approximately zero. If there is
a value advantage to debt over equity, it appears that the pharmaceuticals have not real-
ized this advantage.
• The variability in book debt-to-equity ratios is very large. It does not appear that drug
companies appear to be striving for a common book debt-to-equity ratio.
Can we learn something from these data for pharmaceutical firms? To the author of this
book, it appears that there is no evidence that pharmaceuticals are striving for any target debt-
to-equity ratio. If, as we showed in Chapter 17 and Section 18.1, firm targeting of debt-to-
equity ratios depends on the tax system, then the lack of a clear debt-to-equity pattern for
pharmaceuticals indicates that the tax effects of debt-to-equity ratios are relatively neutral. In a
word, the debt-to-equity ratios of the pharmaceutical sector are consistent with Merton Miller’s
562 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

hypothesis that (1 − TD ) − (1 − TE )* (1 − TC ) = 0 , so that there are no net tax benefits to

either maximizing or minimizing the corporate debt-to-equity ratio.

The Debt-to-Equity Ratio of Other Industries

How does the pharmaceutical industry compare with retail grocery stores? As the graph below
shows, grocery chains appear to have much higher debt-to-equity ratios than pharmaceuti-
cal firms. Having said this, the variation in debt-to-equity ratios for groceries is enormous.
However, for grocery stores as for drug companies, there appears to be no evidence of a general
trend.
A B C D E F G H I J K

DEBT/EQUITY RATIOS FOR SUPERMARKETS

1 November 2009
D/E D/E
Book Market 8.00
2 value value D/E
7.00
3 Kroger 1.2377 0.4759 Market value
4 Safeway 0.7171 0.5430 6.00 D/E
5 Whole Foods 0.1942 0.0835
5.00 Book value
6 Supervalu 3.0435 2.6028
7 Casey's 0.0144 0.0070
4.00
8 Winn-Dixie -0.1419 -0.2023
9 Ingles 2.0126 2.0753 3.00
10 A&P 6.0131 1.4723
11 Ingles 2.1653 2.1291 2.00
12 Pantry 2.3696 3.1391 1.00
13 Ruddick 0.4126 0.2617
14 0.00
15 Average 1.6398 1.1443

Ruddick
Pantry
Kroger

Safeway

A&P
Supervalu

Casey's

Winn-Dixie

Ingles

Ingles
Whole Foods

-1.00
16 Standard deviation 1.8019 1.1777
17
18
19

Here are similar data for steel manufacturers.

A B C D E F G H I J K

DEBT/EQUITY RATIOS FOR STEEL PRODUCERS

1 November 2009
D/E D/E
Book Market 1.50
2 value value D/E
Market value
3 Gerdau Ameristeel 0.6533 0.5278
4 Nucor -0.3266 -0.3266 1.00 D/E
5 Arcelor Mittal 0.3575 0.3778 Book value
6 A.K. Steel 0.0742 0.1309
7 U.S. Steel 0.3861 0.3091 0.50
8
9 Average 0.2289 0.2038
10 Standard deviation 0.3721 0.3290 0.00
11
Nucor

Arcelor Mittal

A.K. Steel
Ameristeel

U.S. Steel
Gerdau

12
13 -0.50
14
15
16 -1.00
17

In short, as viewed from the data, there does not appear to be a trend in debt-to-equity
ratios, whether measured in book or in market values. This is evidence in favor of tax neu-
trality with respect to debt-to-equity policy and against theories (like the Modigliani–Miller
theory of capital structure with only corporate taxes) that claim that debt financing enhances
firm value.
 CHAPTER 18 The Evidence on Capital Structure 563

18.3. Measuring a Firm’s Asset Beta (βAsset) and WACC: An Example

In the previous section we concluded that there is little in actual firm financing patterns to indi-
cate a preference for debt. This seeming indifference to debt raises doubts as to whether debt
actually makes a difference in the valuation of the firm. Another way to measure the valuation
effects is to look at the firm’s asset beta and to ask whether this βAssets is affected by the firm’s
debt-to-equity ratio.
In this section we show how we measure the asset βAssets for Ford Motor Company. As dis-
cussed in Section 16.4, we use this βAssets to compute the Ford’s WACC using the formula

WACC = rf + β Assets * ⎣⎡ E (rM ) − rf ⎦⎤ .

Our primary interest in this section is not the WACC, however. Rather, we want to carefully
show you how to use public sources of information (in this case Yahoo!) to compute a firm’s
debt β, debt-to-equity ratio, and asset beta

Ford’s Cost of Debt and Debt beta, βD

At the end of the third quarter of 2009, Ford reported the following numbers for its cash, its
debt, and its net interest expenses. From the numbers, we conclude that the average interest rate
paid by the company is 6.39%.
A B C D
COMPUTING THE ASSET BETA FOR FORD
December 2009
1 (most numbers are in $billion)
2 30-Sep-09 30-Jun-09
3 Cash and equivalents 48.37 24.01
4 Short-term debt 15.21 0.00
5 Long-term debt 132.02 133.07
6 Net debt 98.86 109.06 <-- =C5+C4+-C3
7
8 Quarterly net interest expen 1.62
9 Implied annual interest rate 6.39% <-- =(1+B8/AVERAGE(B6:C6))^4-1

Yahoo! gives Ford’s equity βE as 2.77. To compute Ford’s debt βD, we use the computation
cost of debt = rD = rf + βD * ⎣⎡ E (rM ) − rf ⎦⎤
rD − rf
βD =
E (rM ) − rf

This is the SML for debt. Because we know that rD = 6.39%, we can solve for βD. In
December 2009 the short-term U.S. Treasury rate was r f = 0.25% and E (rM ) − rf = 8.75%. Thus
the above equation solves for βD = 0.70.

A B C D
12 Risk-free rate 0.25% <-- Short-term Treasury rate
Market risk premium
13 E(rM) - rf 8.75%
14 Debt beta 0.70 <-- =(B9-B12)/B13
564 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

Ford’s Tax Rate

The quarterly income statements for 30 September 2009 report income before taxes of $1.22
billion and taxes of $140 million. Thus Ford’s tax rate is 11.44%.

A B C
16 Income before taxes 1.22
17 Taxes 0.14
18 Tax rate 11.44% <-- =B17/B16

Computing Ford’s Asset beta, βAsset

The formula for the asset βAsset is

E D
β Asset = βE * + βD * (1 − TC )*
E+D E+D
where
βE = equity beta
βD = debt beta
E D
= percent of equity; = percent of debt
E+D E+D

This computation is implemented below and gives Ford’s asset β as 1.19.

A B C D
21 Cash and equivalents 48.37
22 Debt 132.02
23
24 Net debt 83.65 <-- =B22-B21
25 Market value of equity 29.86
26 Equity + net debt 113.51 <-- =B24+B25
27
28 Tax rate 11.44%
29 Equity beta, βE 2.77 <-- Reported by Yahoo
30 Debt beta, βD 0.70 <-- =B14
31 Asset beta, βAsset 1.19 <-- =B29*B25/B26+B30*(1-B28)*B24/B26

18.4. Computing the Asset beta, βAsset, for the Grocery Industry
In the previous section we showed how to calculate the βAsset for Ford. Below we show the results
of calculations for the grocery chain industry. The average asset β for this industry is almost 1,
and there is no significant relation between the asset βs and the firms’ leverage.
 CHAPTER 18 The Evidence on Capital Structure 565

ASSET BETA AND LEVERAGE IN THE GROCERY SECTOR

Data: November 2009
Equity Debt
beta beta Asset
E/(E+D) D/(E+D) βE βD Tax rate beta
Kroger 67.76% 32.24% 0.35 0.79 34.64% 0.40
Safeway 64.81% 35.19% 0.65 0.69 36.07% 0.58
Whole Foods 92.29% 7.71% 1.17 1.39 35.09% 1.15
Supervalu 27.76% 72.24% 1.06 0.74 -2.16% 0.84
Casey's 99.30% 0.70% 0.48 0.76 34.12% 0.48
Winn-Dixie 125.36% -25.36% 0.98 -0.03 7.80% 1.24
Ingles 40.45% 59.55% 0.94 0.96 34.18% 0.76
A&P 40.45% 59.55% 2.15 2.77 0.00% 2.52
Pantry 24.16% 75.84% 0.33 1.31 0.00% 1.07
Ruddick 79.26% 20.74% 0.67 0.51 38.46% 0.60

Average 0.9628 <-- =AVERAGE(G3:G12)

Sigma 0.6168 <-- =STDEV(G3:G12)

Grocery: Asset Beta versus D/(D+E)

3.00

2.50 A&P
Asset beta

2.00

1.50
Winn-Dixie Whole Foods
1.00 Pantry
Ingles Supervalu
0.50 Ruddick Safeway
Casey's Kroger

0.00
-30% -20% -10% 0% 10% 20% 30% 40% 50% 60% 70% 80%
Debt/Assets ratio

For the grocery industry, we can conclude that the asset β is not affected by the capital
structure. This is Miller’s position:
• If the Modigliani–Miller results are representative, then the WACC will decrease when
the amount of debt increases. The effect on the βAssets will be that βAssets should decrease
as leverage increases.
• If the Miller results are representative, then the WACC will be unaffected by the amount
of debt. The effect on the βAssets will be that βAssets should stay constant as leverage
increases.
In the event, βAssets seem to be unaffected by the debt-to-assets ratio. So, at least for the gro-
cery industry, Miller’s theory seems to do better at explaining things than the MM theory.
566 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

18.5. Academic Evidence

In the previous section we’ve looked at a specific example—the U.S. auto–truck industry—to
try to gauge whether capital structure affects the asset βAsset of these firms. Our conclusion is
that, for this industry, they don’t: The asset βAsset, and hence the WACC, is not affected by the
capital structure.
Recent academic research seems to come to the same conclusion.3
• When Eugene Fama and Kenneth French regress firm value on leverage, they conclude
that leverage doesn’t matter.4
• John Graham, in a survey published in 2001, concludes that “at the margin the tax costs
and tax benefits [of leverage] might be of similar magnitude.”5 To show you how con-
fusing this is, Graham concludes that—using another method—the tax benefit of debt
is approximately 9% for the years 1995–1999.6 This probably represents the costs of
bankruptcy.
• Ivo Welch, in a paper written in 2002, finds no evidence whatsoever that firms look for
an optimal structure.7 He finds that firms tend to make few changes in their debt, so that
the actual capital structure (i.e., the ratio of debt to the market value of equity) is largely
driven by the market prices of the firm’s shares. There is little evidence, according to
Welch, of any optimizing in the debt decision.

Summing Up
The theory of capital structure suggests that the capital structure decision is largely driven by
the differential taxation of debt and equity. The empirics of capital structure suggest that it
doesn’t matter very much in determining the value of the firm.
For practical purposes,
• You can assume that the weighted WACC of a firm is invariant to the firm’s capital
structure.
• This means that the WACC of a firm can be measured by taking the average WACC of
the firm’s industry. It also means that the βAsset of a firm’s industry is representative of the
industry’s overall risks and is not a function of the capital structure of the industry.
• The best way to value a firm is to use the WACC to discount the firm’s anticipated
future FCFs (recall that these are operating cash flows and do not include interest and
other financing). We have illustrated this approach in a number of chapters of this book:
Chapters 6, 7, and 13.

3
Be warned that this is still controversial. Every finance professor seems to have an opinion on this matter!
If you want a good grade in the course, disagree with the book and not with your professor.
4
“Taxes, Financing Decisions, and Firm Value,” Journal of Finance 1998, pp. 819–843.
5
“Taxes and Corporate Finance: A Review,” Review of Financial Studies, 2003.
6
Ibid, pages 26–27.
7
Ivo Welch, “Columbus’ Egg: The Real Determinants of Capital Structure,” Yale School of Management
working paper, 2002.
CHAP TER

19 Dividend Policy

CHAPTER CONTENTS
Overview 567
19.1. The Financial Theory of Dividends 572
19.2. Taxes Can Make a Big Difference! 575
19.3. Dividends (Satisfaction Now) versus Capital Gains (Enjoy Later) 580
19.4. Do Dividends Signal? 580
19.5. What Do Corporate Executives Think about Dividends? 582
Summing Up 583
Exercises 585

Overview
When John started his college finance course in the fall semester of 2004, his grandmother gave
him 100 shares of General Motors (GM) stock. “Owning shares is the best way to understand
the stock market,” she said to him. “When you own a stock, you’ll start following the com-
pany.” The succeeding months proved her right—stock ownership was very educational. John
started to follow both the stock market and GM. Some of the fruits of his learning are in this
introduction.
The present of 100 GM shares was a substantial gift: At the time his grandmother gave John
the stock, a share of GM was trading for $41.10, so that Grandma’s present was worth $4,110.
During the months following the gift, GM’s stock price went as high as $43.14 on 8 September

567
568 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

2004 and as low as $37.04 on 25 October 2004 (Figure 19.1). John also followed the news about
the company, which was mostly depressing (Figure 19.2).
Then on 29 October 2004, John read that GM had declared a $0.50 dividend per share
(Figure 19.3). Because he owned 100 shares, he realized that this meant that he was about to get $50
from GM. Reading the announcement, John saw that he had to learn some new terminology:
• The dividend payment date was 10 December 2004. This is the date on which the divi-
dend would actually be paid out to the GM shareholders.
• The dividend is payable to holders of record as of 8 November 2004. This means that
only shareholders listed with GM on this date got the dividend.
• Because it takes 2 business days to register a change in ownership of a share, the divi-
dend is actually only paid to shareholders who own the stock at the close of trading on
4 November 2004.1 This date is referred to as the ex-dividend date of the stock.

44

43

42

Ex-dividend
41
date, 4 Nov 04
Dividend paid,
10 Dec 04
40

39

38
Dividend
announced,
29 Oct 04
37

36
30-Aug-04

6-Sep-04

13-Sep-04

20-Sep-04

27-Sep-04

4-Oct-04

11-Oct-04

18-Oct-04

25-Oct-04

1-Nov-04

8-Nov-04

15-Nov-04

22-Nov-04

29-Nov-04

6-Dec-04

13-Dec-04

20-Dec-04

27-Dec-04

FIGURE 19.1 GM’s stock price, September–December 2004.

John spent some time thinking about the whether the dividend was a good thing or a bad
thing. He soon realized that there were a considerable number of factors. In succeeding subsec-
tions we show John’s thinking about the various factors affecting the dividend.

The Dividend as Information

During the fall of 2004, the news about GM was almost unremittingly bad (see Figure 19.2). The
company’s sales were dropping, its health care costs were 10 times those of Honda, its bonds

1
8 November 2004 was a Monday. Two business days before this Monday was Thursday, 4 November
2004.
 CHAPTER 19 Dividend Policy 569

were rumored to be downgraded, and it was forced to offer enormous rebates and incentives to
potential car buyers.
The dividend did not do much to counteract this pessimism about the company. Looking back
over the dividend history of GM, John saw that the company had paid a $0.50 per share dividend
each February, May, August, and November going back to 1997. Had GM raised its dividend, John
would have perhaps been able to interpret the dividend as a piece of positive information about GM.
And had the company cut its dividend, this might have been interpreted as bad news. But keeping
the dividend steady could hardly be interpreted as a meaningful signal about the company.

The Dividend and Ordinary Income Taxes

The GM dividend would be part of John’s taxable income. As a relatively low-income stu-
dent, John’s income tax rate was only 15%, but still this meant that John would have to pay
15% * $50 = $7.50 in taxes on the dividend, so that his net receipts from the dividend would
be $42.50 instead of $50. John realized that for his grandmother, whose tax rate was 40%, the
dividend would be much more costly—had she received the dividend, it would have cost her $20
in taxes, so that she would receive only $30 in net dividends.
On the other hand, John saw on Yahoo! (Figure 19.4) that 77% of GM stock was owned
by pension funds and mutual funds, which do not directly pay income taxes on their dividend
income. So perhaps, he thought, GM’s dividend policy is based on the assumption that for most
shareholders, taxes on dividends are irrelevant.

The Dividend and Capital Gains Taxes: Dividend Reinvestment

versus Retention by the Company
John actually planned to reinvest his dividends into GM stock. This meant that on receiving
the dividend on 10 December 2004, he would spend his after-tax dividend of $42.50 on buying
new shares of GM. Because the GM share price on 10 December was $38.93, John would buy
$42.50/$38.93 = 1.0917 shares of GM stock.
John contrasted his reinvestment of dividends with the alternative of GM not paying out
dividends at all. If GM had not paid out a dividend and retained the income, he assumed that
the stock price should increase by $0.50 per share. In this case he would have been better off in
at least two ways:
• First of all, if the company had not paid out the dividend, John would have netted $0.50
per share instead of the $0.425 per share he actually got after income taxes. The com-
pany would have saved him the ordinary income taxes on his dividends.
• Had GM not paid out the dividends and had John ultimately sold his shares of GM, the
gain of $0.50 per share would be taxed as a capital gain instead of as ordinary income.
Because capital gains tax rates are lower than ordinary tax rates, John would have ben-
efited a second way from the dividend retention.
Combining these three factors—information, income taxes, and capital gains taxes—John
realized that he needed some financial theory to help him understand dividends. The remainder
of this chapter explores this theory.

Finance Concepts Discussed

• Dividends
• Retained earnings
• Capital gains versus ordinary income
570 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

Excel Functions Used

We use a lot of Excel spreadsheets to put order in things, but truth to tell, this chapter uses hardly
any sophisticated Excel concepts. The one function used is Sum.

NEWS ABOUT GENERAL MOTORS—A SELECTION OF HEADLINES

Cadillac: Better But Not Best Yet, at Forbes.com (Tue, Dec 14)
Ford, GM Earnings Outlooks Trimmed, at Forbes.com (Mon, Dec 13)
GM Signs up its One Millionth XM Satellite Radio Subscriber, PR Newswire (Mon, Dec 13)
Delphi Hurt By Lower GM Output, Troubled Suppliers, at Forbes.com (Fri, Dec 10)
General Motors bonds fall on word of job cuts, at MarketWatch (Thu, Dec 9)
GM to cut 12,000 jobs in Europe, at MarketWatch (Thu, Dec 9)
GM recalling 640 Saab 9-3 cars for free repair, at Forbes.com (Thu, Dec 9)
Open Letter to General Motors’ CFO, at RealMoney by TheStreet.com (Thu, Dec 9)
GM should refinance at least half its 2005 and 2006 maturities while rates remain low. The company’s future is
threatened by any increase in bond yields.
GM’s Desperation Gets Noisier, Motley Fool (Thu, Dec 9)
Yesterday, General Motors (NYSE: GM - News) beat its own previous personal best for crazy sales incentives (read
about those here) and went for broke, instituting a “Red Tag” sale and bumping incentives on some 2004 models up
to—better sit down for this—$7,500. And this is not just some gimmick to move the last few 2004 models off the lot,
either. The company is apparently also offering rebates of up to $4,500 on select 2005 models as well—considerably
more than the average $3,500 in incentives (on both 2004 and 2005 models) the company offered in November.
GM Sputters Toward 2005 Breakdown, at RealMoney by TheStreet.com (Thu, Dec 9)
GM Beefs Up Incentives After Poor Nov., Associated Press (Thu, Dec 9)
GM Europe Pledges to Avoid Plant Closures, Associated Press (Wed, Dec 8)
Saturn sees improved view, at MarketWatch (Wed, Dec 8)
Fiat may force GM to buy struggling unit, at FT.com (Mon, Dec 6)
Automakers Telling the Same Tale, Motley Fool (Fri, Dec 3)
SUV registrations slowing across country, at MarketWatch (Thu, Dec 2)
Ford, GM to Lower Production in 2005, Associated Press (Wed, Dec 1)
GM Sales Fall 13.1 Percent in November, Associated Press (Wed, Dec 1)
NEWS: Commentary: Sorry Detroit. The Garage Is Full at BusinessWeek Online (Wed, Dec 1)
Why the gloom? For the past three years, as auto makers have thrown ever better deals at buyers, sales have
remained essentially flat at around 16.7 million vehicles. Even if sales hit about 16.8 million, as analysts expect,
that won’t be enough to help Detroit. Ford and General Motors (GM) are already having a tough time making
money selling cars, while Chrysler (DCX) has only recently gotten a lift from some hot models.
GM to Lay Off About 1,000 at N.J. Plant, Associated Press (Tue, Nov 30)
2004 Was Record Year for Auto Recalls, Associated Press (Tue, Nov 30)
Junk Alert at Forbes.com (Mon, Nov 29)
The way things are trending lately, I believe that at least one rating agency will downgrade the auto giants to junk
by this time next year. But don’t let that stop you from buying Ford’s and GM’s bonds, with their nice yields.
What’s gone wrong with the big two car companies? Just about everything: loss of market share, humongous
retiree costs, union difficulties, restructuring, rising raw materials prices, excessive inventory, lackluster new
products. And what’s right with them? They are big car companies, and they won’t disappear. Ford and GM are
two of the largest corporate bond issuers, with $168 billion and $284 billion, respectively, in consolidated debt
(that is, with finance arms included). That means almost every sizable public pension fund and bond mutual fund
holds their paper. A downgrade to junk would disqualify some of these investors, and they would have to sell their
bonds eventually. But they will not be forced to do so suddenly. Prices, after a brief downdraft, will rebound.
Someone buying now and holding for years (better still, to maturity) can afford to shrug off the downgrade.
Automakers Rein In Growth As Downgrades Loom, at Forbes.com (Wed, Nov 24)
GM prepares for healthcare cost inflation, at FT.com (Thu, Nov 11)
 CHAPTER 19 Dividend Policy 571

US carmakers set to launch new incentives, at FT.com (Mon, Nov 8)

Ford, GM October Sales Skid, at TheStreet.com (Wed, Nov 3)
GM Stuck in Reverse, at TheStreet.com (Thu, Oct 14)
Can’t Ignore GM’s Side of Economy, at RealMoney by TheStreet.com (Thu, Oct 14)
The national implications of the hapless auto industry must somehow get on the national agenda, pronto.
General Motors axes 12,000 jobs in Europe, at FT.com (Thu, Oct 14)
Big Autos Lag Other Transports, RealMoney by TheStreet.com (Tue, Oct 5)
Interest rates push US drivers into cheaper cars, at FT.com (Sun, Oct 3)
Auto Sales Mixed as Ford Raises Incentives, at TheStreet.com (Fri, Oct 1)
GM aims for further cost cuts across company, at FT.com (Wed, Sep 29)
Welcome to the Bankruptcy Economy, at TheStreet.com (Wed, Sep 22)
At General Motors . . . the average cost of providing health care and pension benefits is around $1,360 a car.
That’s more per car than General Motors spends for steel. At Honda’s U.S. operations, the health care and
pension-benefit cost is only $107 a car.
Ford, GM Have Low Reliability Ratings, at RealMoney by TheStreet.com (Wed, Sep 15)
Tough Month for Automakers, at TheStreet.com (Wed, Sep 1)

FIGURE 19.2 Some headlines about GM, September–December 2004. During the fall of 2004, most of
the news about the company was bad. The company went bankrupt on 1 June 2009.
SOURCE: http://finance.yahoo.com.

FIGURE 19.3 GM’s dividend press release, 29 October 2004.

572 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

FIGURE 19.4 77% of GM stock is owned by pension funds and mutual funds that do not directly pay
taxes on their income, so that tax considerations in the payment of dividends for GM may not be
critical.

19.1. The Financial Theory of Dividends

To help us consider the pure financial theory of dividends, we consider the story of John and
Mary, both of whom own wholly identical taxi companies that differ only in their dividend
policies. Each company owns the same number of taxis and has the same income and expenses.
Here are the balance sheets for the two companies.

JOHN'S TAXI COMPANY, MARY'S TAXI COMPANY

Assets Liabilities and equity
Cash 5,000 Debt 10,000
Taxis 20,000 Equity
Stock 5,000
Accumulated retained earnings 10,000
Total assets 25,000 Total liabilities and equity 25,000

John Pays Himself a Dividend

Suppose that John wants some cash and decides to declare a dividend of $3,000. Here’s the way
his balance sheet looks (Mary’s balance sheet is unchanged).

JOHN'S TAXI COMPANY—after dividend

Assets Liabilities and equity
Cash 2,000 Debt 10,000
Taxis 20,000 Equity
Stock 5,000
Accumulated retained earnings 7,000
Total assets 22,000 Total liabilities and equity 22,000
 CHAPTER 19 Dividend Policy 573

There are two changes in John’s balance sheet:

• The cash balances decrease from $5,000 to $2,000, reflecting the dividend paid.
• The accumulated retained earnings decrease from $10,000 to $7,000. This is what is
meant by the expression that “dividends are paid out of retained earnings.” We don’t like
this expression, because dividends are paid out of cash; the decrease in retentions simply
reflects the matching change made in the balance sheet.
Here are some questions you could ask about this situation.
Question 1: What are the valuation effects of the dividend?
Did the dividend paid by John change the value of his taxi business vis-à-vis Mary’s business?
Obviously not—they both still have the same number of taxis, and Mary has just kept her cash
in the business instead of, as John did, pulling it out. A good way to see this is to write the bal-
ance sheets in terms of net debt—subtracting the cash from the debt.

JOHN'S or MARY'S TAXI COMPANY—net debt

Assets Liabilities and equity
Net debt = Debt - cash 5,000
Taxis 20,000 Equity
Stock 5,000
Accumulated retained earnings 10,000
Total assets 20,000 Total liabilities and equity 20,000

JOHN'S TAXI COMPANY—after dividend

Assets Liabilities and equity
Net debt = Debt - cash 8,000
Taxis 20,000 Equity
Stock 5,000
Accumulated retained earnings 7,000
Total assets 20,000 Total liabilities and equity 20,000

The asset side of the balance sheet is still worth the same, whether or not the dividend has
been paid. On the other hand, the liabilities and equity side of the balance sheet is different—
John has more debt and less equity than Mary.
Question 2: Perhaps it’s just a capital structure question?
The above balance sheets for the two companies show that although they are both the same on
the asset side, the dividend has changed the capital structure of the companies. So perhaps the
dividend question is related to the capital structure problem discussed in Chapters 17 and 18. If
so, this suggests the following:
• Dividends might matter if capital structure matters: An after-dividend company (like
John’s) will have a higher debt-to-equity ratio than a before-dividend company (like
Mary’s).
• If companies with a higher debt-to-equity ratio have a higher valuation, then companies
should pay dividends.
Now this book takes a definite stand on this question: In the previous chapters we’ve sug-
gested that the capital structure question is ultimately a question of balancing personal against
corporate taxation. We’ve also suggested that the economic evidence suggests that on balance
the taxes are pretty much of a wash, so that capital structure doesn’t matter.
574 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

Although this argument suggests that dividends do not affect the valuation of a company,
there’s another tax aspect to this question—the trade-off between ordinary income taxes and
capital gains taxes. We discuss this in the next section.
In the meantime, as long as Mary and John’s taxi companies aren’t taxed and as long as
Mary and John aren’t taxed on a personal level, the debt-to-equity aspects of the dividend deci-
sion shouldn’t affect the valuation of their companies.
Question 3: Does the dividend affect the enterprise value?
Here’s another way of thinking about this question: Suppose that both John and Mary are think-
ing about selling their taxi companies. Suppose that the “taxi part” of the business is valued
at $40,000, which is, of course, more than its value on the balance sheet, and suppose that this
valuation doesn’t include the cash balances on the books. John and Mary have slightly different
strategies about how to sell the business: John intends to first pay himself a dividend and then
sell the business, whereas Mary intends to sell the business first without taking a dividend. Here
are the calculations.

A B C D E F G
1 Mary sells her taxi company for $40,000 John sells his taxi company for $40,000
2 Sale price 40,000 Sale price 40,000
3 Pay back net debt 5,000 Pay back net debt 8,000
4 Net to equity 35,000 <-- =B2-B3 Net to equity 32,000 <-- =F2-F3
5 Book value of equity 15,000 Book value of equity 12,000
6 Taxable gain 20,000 <-- =B4-B5 Taxable gain 20,000 <-- =F4-F5
7 Taxes on gain (0%) 0 <-- =0*B6 Taxes on gain (0%) 0 <-- =0*F6
8 Net to Mary from sale 35,000 <-- =B4-B7 Net to John from sale 32,000 <-- =F4-F7
9
10 Add back dividend 0 Add back dividend 3,000
11 Taxes on dividend (0%) 0 <-- =0%*B10 Taxes on dividend (0%) 0 <-- =0%*F10
12 Total 35,000 <-- =B8+B10-B11 Total 35,000 <-- =F8+F10-F11

The bottom line on these two calculations is the same—John and Mary each make a total of
$35,000 on the sale, so that it doesn’t matter whether they pay themselves a dividend.2 Note the
differences:
• Mary has less net debt to repay (John has taken out $3,000 in a dividend, so he has less
cash left in the business).
• Mary’ book value of equity is greater. When we add capital gains taxes (next example),
this will mean that Mary has lower taxable gains. But with a 0% tax rate, it doesn’t
matter.

2
Although, to anticipate the next section, the assumption that there are no taxes is critical to this
argument.
 CHAPTER 19 Dividend Policy 575

WHO CARES WHERE THE MONEY IS AS LONG AS IT’S THERE?

This is really what it’s all about—who cares whether the money is in the taxi company or in the
individual bank account of the owner? Of course you can think of several answers to this ques-
tion that make it appear that it does matter:
• Taxes: If the company and its owners pay different tax rates, perhaps dividends are
worthwhile. If capital gains taxes are lower than ordinary income taxes, perhaps—as
suggested in the overview to this chapter—companies should retain the dividend and
not pay it out.
• Trust: If there are multiple owners of the company, maybe you want the money in your
hands as opposed to leaving it in the company. Economists call this “agency costs”—an
agent being someone you’ve hired to do your work for you (that is, the manager). The
agency cost argument for paying dividends suggests that you and your manager may
have different goals; if the manager’s goal includes wasting your money, then maybe
you should get the money out of his hands by paying a dividend.

19.2. Taxes Can Make a Big Difference!

In Section 19.1 we looked at dividend policy in a world with no taxes. Using John and Mary’s
taxi businesses, we made two points:
• The value of the taxi part of the business—the enterprise value—is not affected by the
dividend policy of John and Mary’s taxi business.
• The proceeds—dividends plus gains from selling the business—to John and Mary are
exactly the same, independent of their dividend policy.
Now look at the second point again, and suppose that we introduce taxes. We’ll assume that
dividends are taxed as “ordinary income” at a rate of 30% and that the gains from selling the
business are taxed at a capital gains tax rate of 15%.
We’ll start with Mary, who sells her taxi company for $40,000. As the following calcula-
tion shows, Mary’s net from the sale of the company is $32,000.
576 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

A B C D
1 MARY'S TAXI COMPANY
2 Assets Liabilities and equity
3 Net debt = Debt - cash 5,000
4 Taxis 20,000 Equity
5 Stock 5,000
6 Accumulated retained earnings 10,000
7 Total assets 20,000 Total liabilities and equity 20,000
8
9 Capital gains tax 15%
10 Ordinary income tax rate 30%
11
12 Mary sells her taxi company for $40,000
13 Sale price 40,000
14 Pay back net debt 5,000
15 Net to shareholders (Mary) 35,000 <-- =B13-B14
16 Book value of equity 15,000 <-- =SUM(D5:D6)
17 Taxable gain 20,000 <-- =B15-B16
18 Taxes on capital gain (15%) 3,000 <-- =$B$9*B17
19 Net to Mary from sale 32,000 <-- =B15-B18
20
21 Add back dividend 0
22 Taxes on dividend (30%) 0 <-- =$B$10*B21
23 Total 32,000 <-- =B19+B21-B22

Now John: He also sells his company, but he has first paid himself a dividend. His net is
lower.

F G H I
1 JOHN'S TAXI COMPANY—after dividend
2 Assets Liabilities and equity
3 Net debt = Debt - cash 8,000
4 Taxis 20,000 Equity
5 Stock 5,000
6 Accumulated retained earnings 7,000
7 Total assets 20,000 Total liabilities and equity 20,000
8
9 Capital gains tax 15%
10 Ordinary income tax rate 30%
11
12 John sells his taxi company for $40,000
13 Sale price 40,000
14 Pay back net debt 8,000
15 Net to equity 32,000 <-- =G13-G14
16 Book value of equity 12,000 <-- =SUM(I5:I6)
17 Taxable gain 20,000 <-- =G15-G16
18 Taxes on capital gain (15%) 3,000 <-- =$G$9*G17
19 Net to John from sale 29,000 <-- =G15-G18
20
21 Add back dividend 3,000
22 Taxes on dividend (30%) 900 <-- =$G$10*G21
23 Total 31,100 <-- =G19+G21-G22
 CHAPTER 19 Dividend Policy 577

The reason for the difference between John’s net of $31,100 and Mary’s net of $32,000 is
that dividends are taxed at a higher rate than capital gains. By not paying herself a dividend,
Mary has saved herself $900 = 30% * 3,000 of taxes on her dividends.3
This analysis suggests that dividends might matter if there is both a dividend tax and a
capital gains tax: If the dividend tax is higher than the capital gains tax, the firm shouldn’t pay
dividends.4

What If John Really Needs the Money? Solution 1: Pay a Bonus

Suppose for some reason John really needs the money now. Then he should pay himself a bonus,
which is a tax-deductible expense for the company. When John pays himself a bonus, it comes
out of cash but gets tax deductibility. Here’s what happens to the cash balances.

Initial cash balances $5,000

After-tax cost of bonus to company $1,800 The company pays John a $3,000 bonus,
which is an expense for tax purposes.
At the company’s 40% corporate tax
rate, the after-tax cost of the bonus is
(1 − 40%)* 3,000 .
Cash on hand after bonus $3,200

Figure 19.5 shows how the profits for John come out with a dividend and with a bonus.
We’ve assumed that John pays a 25% ordinary income tax on both the dividend and the bonus.
A B C D E F G H I
1 JOHN'S TAXI COMPANY—after dividend JOHN'S TAXI COMPANY—after bonus
2 Assets Liabilities and equity Assets Liabilities and equity
3 Cash 2,000 Debt 10,000 Cash 3,200 Debt 10,000
4 Taxis 20,000 Equity Taxis 20,000 Equity
5 Stock 5,000 Stock 5,000
6 Accumulated retained earnings 7,000 Accumulated retained earnings 8,200
7 Total assets 22,000 Total liabilities and equity 22,000 Total assets 23,200 Total liabilities and equity 23,200
8
9 Corporate tax rate 40% Corporate tax rate 30%
10 Capital gains tax 15% Capital gains tax 15%
11 Ordinary income tax rate 25% Ordinary income tax rate 25%
12
13 John sells his taxi company for $40,000 John sells his taxi company for $40,000
14 Sale price 40,000 Sale price 40,000
15 Pay back net debt 8,000 <-- =D3-B3 Pay back net debt 6,800 <-- =I3-G3
16 Net to equity 32,000 <-- =B14-B15 Net to equity 33,200 <-- =G14-G15
17 Book value of equity 12,000 <-- =SUM(D5:D6) Book value of equity 13,200 <-- =SUM(I5:I6)
18 Taxable gain 20,000 <-- =B16-B17 Taxable gain 20,000 <-- =G16-G17
19 Taxes on capital gain (15%) 3,000 <-- =$B$10*B18 Taxes on capital gain (15%) 3,000 <-- =$B$10*G18
20 Net to John from sale 29,000 <-- =B16-B19 Net to John from sale 30,200 <-- =G16-G19
21
22 Add back dividend 3,000 Add back bonus 3,000
23 Taxes on dividend (25%) 750 <-- =$B$11*B22 John's taxes on bonus (25%) 750 <-- =$G$11*G22
24 Total 31,250 <-- =B20+B22-B23 Total 32,450 <-- =G20+G22-G23

FIGURE 19.5 John’s cash flow (cells B24 and G24) with a dividend and with a bonus. Because dividends, cor-
porate income, and capital gains are taxed at different rates, John is better off paying himself a bonus instead
of paying himself a dividend.

3
In any case, both John and Mary are going to pay the same capital gains taxes. This is because a dividend,
paid out of cash, reduces the firm’s equity and increases the firm’s net debt. The result, as you can confi rm
from the examples, is that the capital gain to the firm’s shareholders is independent of the dividend.
4
Of course this assumes that you trust the firm to guard shareholder money wisely. If the “agency costs”
are too high, shareholders would prefer to get their money as fast as possible, even if in the form of more
highly taxed dividends.
578 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

This little trick (the tax deductibility of the bonus) is actually more profitable than Mary’s
not paying a dividend at all (compare John’s net of $32,450 to Mary’s net of $32,000). However,
whether a bonus is better than no bonus depends on the corporate versus the ordinary income
tax rate. In the example below, John’s ordinary income tax rate is 45%, which is more than his
corporate tax rate. At these rates he’d be better off by not paying himself a bonus (or a dividend)
and selling the company.

F G H I
1 JOHN'S TAXI COMPANY—after bonus
2 Assets Liabilities and equity
3 Cash 3,200 Debt 10,000
4 Taxis 20,000 Equity
5 Stock 5,000
6 Accumulated retained earnings 8,200
7 Total assets 23,200 Total liabilities and equity 23,200
8
9 Corporate tax rate 30%
10 Capital gains tax 15%
11 Ordinary income tax rate 45%
12
13 John sells his taxi company for $40,000
14 Sale price 40,000
15 Pay back net debt 6,800 <-- =I3-G3
16 Net to equity 33,200 <-- =G14-G15
17 Book value of equity 13,200 <-- =SUM(I5:I6)
18 Taxable gain 20,000 <-- =G16-G17
19 Taxes on capital gain (15%) 3,000 <-- =$B$10*G18
20 Net to John from sale 30,200 <-- =G16-G19
21
22 Add back bonus 3,000
23 John's taxes on bonus (45%) 1,350 <-- =$G$11*G22
24 Total 31,850 <-- =G20+G22-G23

What If John Really Needs the Money?

Solution 2: Repurchase Stock
Maybe John needs the money but can’t for some reason pay himself a bonus. In this case, he
should—instead of paying himself a dividend—get the company to repurchase some stock from
him. Suppose that John convinces the management of the company (himself!) to buy back
$3,000 of stock. Suppose that after this repurchase of equity, John sells the company. Finally,
suppose that all of the $3,000 repurchase of stock is taxed to John as a capital gain (this is very
unlikely—read the note that follows the spreadsheet). In this case, John would still be better off
than if he had paid himself a dividend.
 CHAPTER 19 Dividend Policy 579

F G H I
1 JOHN'S TAXI COMPANY—after repurchase
2 Assets Liabilities and equity
3 Cash after repurchase 2,000 Debt 10,000
4 Taxis 20,000 Equity
5 Stock 5,000
6 Accumulated retained earnings 10,000
7 Total assets 22,000 Total liabilities and equity 25,000
8
9 Corporate tax rate 30%
10 Capital gains tax 15%
11 Ordinary income tax rate 45%
12
13 John sells his taxi company for $40,000
14 Sale price 40,000
15 Pay back net debt 8,000 <-- =I3-G3
16 Net to equity 32,000 <-- =G14-G15
17 Book value of equity 15,000 <-- =SUM(I5:I6)
18 Taxable gain 17,000 <-- =G16-G17
19 Taxes on capital gain (15%) 2,550 <-- =$B$10*G18
20 Net to John from sale 29,450 <-- =G16-G19
21
22 Add back repurchase of stock 3,000
23 John's taxes on repurchase (15%) 450 <-- =$G$10*G22
24 Total 32,000 <-- =G20+G22-G23

Note: To minimize taxes, John should consult his accountant before repurchasing the stock.
It is highly unlikely that the whole repurchase would be taxed as a dividend. It could be struc-
tured as a payout of capital (in which case there would be no taxes). The accountant might also
be able to value John’s basis in the stock (what he originally paid for it, plus the accumulated
capital gains). Here’s an example.
F G H
27 Accountant reasoning?
28 Assets Liabilities and equity
29 Net debt
30 Enterprise value 40,000 Equity, market value
31 Total assets 40,000 Total liabilities and equity
32
33 Amount spent on repurchase 3,000
As a percent of market value
34 of equity 8.57% <-- =G33/I30
35
36 Book value of equity 15,000
37 basis = 8.57% of book equity 1,286 <-- =G34*G36
38
39 Taxable gain on repurchase 1,714 <-- =G33-G37
40 Taxes on gain at capital gains tax 257 <-- =G10*G39
41 Net from repurchase 2,743 <-- =G33-G40
42
43
44 John sells his taxi company for $40,000
45 Sale price 40,000
46 Pay back net debt 8,000 <-- =I29+G33
47 Net to equity 32,000 <-- =G45-G46
48 Book value of equity 13,714 <-- =G36-G37
49 Taxable gain 18,286 <-- =G47-G48
50 Taxes on capital gain (274286%) 2,743 <-- =$B$10*G49
51 Net to John from sale 29,257 <-- =G47-G50
52
Total: net from sale + net from
53 repurchase 32,000 <-- =G51+G41
580 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

The accountant reckons as follows:

• Before the payout of cash, the company is worth $40,000, which makes the market value
of the equity $35,000.
• By paying out $3,000 in cash for stock in the company, John has effectively repurchased
8.57% of the company’s equity. Because the book value of the company’s equity is
$15,000, John has a capital gain of $1,714 (= 3,000−8.57% * 15,000) on the repurchase.
This capital gain will be taxed at 15% (= $257), so that John will net $2,743 from the
repurchase.
• Now when John sells the company for $40,000, he will first have to pay off its net debt
of $8,000 (the repurchase used $3,000 of cash and raised the net debt from $5,000 to
$8,000). This leaves him with a market value of equity of $32,000, which has book value
of $13,714 (= $15,000−8.57%*15,000). This gain also gets taxed at the capital gains tax
rate of 15%.
• This leaves John with $32,000.

19.3. Dividends (Satisfaction Now) versus Capital Gains

(Enjoy Later)
Up to this point we’ve established that if you’re going to sell your company, ordinary income
taxes on dividends make it unwise to first pay yourself a dividend. But what if you’re not going
to sell the company right away? Should you leave the money in the company, for that golden day
when you’re going to sell it and benefit from the lowered capital gains taxes? Or should you pay
yourself a dividend?
It all depends, of course, on the level of trust you have in the managers of your company. In
the case of John and Mary, this is easy—they manage their own companies, and they wouldn’t
do anything to harm themselves. In this case they should leave the money in the company, where
it can earn the same returns as if they paid it out.

19.4. Do Dividends Signal?

Sections 19.1 and 19.2 have developed the theory that from a purely financial point of view, divi-
dends are unnecessary. For investors, the decision on whether a company should pay dividends
is at best neutral, and—given the gap between taxes on dividend income and taxes on corporate
gains—usually leans toward the nonpayment of dividends. There are two alternatives to divi-
dends, both of which are more financially attractive than the dividend itself:
• The company can choose simply not to pay out the dividend. By retaining the income as
cash on its own books, the company translates the potential dividend into a future capital
gain for its investors. When ultimately realized by the investor, this capital gain is taxed
at a lower rate than ordinary income.
 CHAPTER 19 Dividend Policy 581

• The company can choose to use the potential dividend cash flow to repurchase its own
shares. This translates the dividends into immediate cash gains for those shareholders
who sell their shares back to the company (cash gains that are taxed at a favorable capital
gains tax rate). Shareholders who do not tender their shares gain an increased proportion
of the firm’s future earnings.
There remains the possibility that dividends are a signal to the investor about the health of
the company. The signaling theory of dividends makes two assertions:
• All other things being equal, higher dividends are a signal of more financial strength
than lower dividends.
• Changes in dividends are indicative of the future financial health of the company. An
increase in dividends is indicative that the future prospects of the firm are improved and
vice versa.

Is a Dividend Increase Always Good News?

On the other hand, not all increases in dividends seem to be good news. When Microsoft
announced on 16 January 2003 that it would initiate a dividend, the stock price dropped the next
day by 7%. According to a Business Week article,
That may have been mostly because management’s outlook for the current quarter was weak,
but it’s also likely that some investors saw the dividend as a sign that Microsoft had run out
of options for growth, says Don Luskin, chief investment officer at research boutique Trend
Macrolytics. “The risk is that paying a dividend could signal that tech has matured and is no
longer the racy growth sector it once was,” says Paul Shread, an analyst at Internet.com.5
Current financial research indicates that dividend changes, whether they be increases or
decreases, tend to be less informative than once thought. Although stock market analysts inter-
pret a decrease in a company’s dividend as a bad signal about the company and an increase in
the dividend as a good signal, the actual behavior of profits after a dividend change does not
follow this signaling interpretation.6

5
http://www.businessweek.com/technology/content/jan2003/tc20030128_1051.htm.
6
See Chen, Shevlin, and Tong (2004). There is also some evidence that companies that pay dividends
outperform those that don’t in down markets. See Kathleen Fuller and Michael Goldstein, “Do Dividends
Mean More in Declining Markets?” (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=687067). This is
discussed in http://www.forbes.com/2003/09/25/cz_vj_0925soapbox.html by Vahan Janjigian.
582 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

THE COCA-COLA COMPANY INCREASES ANNUAL DIVIDEND BY

12 PERCENT
43rd Consecutive Annual Increase
Atlanta, February 17, 2005—The Board of Directors of The Coca-Cola Company today
approved the Company’s 43rd consecutive annual dividend increase, raising the quarterly divi-
dend 12 percent from 25 cents to 28 cents per common share. This is equivalent to an annual
dividend of $1.12 per share, up from $1 per share in 2004.
The dividend is payable April 1, 2005, to shareowners of record as of March 15, 2005.
This reflects the Board’s confidence in the Company’s long-term cash flow. In 2004, the
Company generated $6 billion in cash from operations—a 9-percent increase over 2003. The
Company returned more than $4 billion of that to shareowners, through $2.4 billion in divi-
dends and $1.7 billion in share repurchase.
The Coca-Cola Company is the world’s largest beverage company. Along with Coca-Cola,
recognized as the world’s most valuable brand, the Company markets four of the world’s top five
soft drink brands, including Diet Coke, Fanta and Sprite, and a wide range of other beverages,
including diet and light soft drinks, waters, juices and juice drinks, teas, coffees and sports drinks.
Through the world’s largest beverage distribution system, consumers in more than 200 countries
enjoy the Company’s beverages at a rate exceeding 1 billion servings each day. For more informa-
tion about The Coca-Cola Company, please visit our website at www.coca-cola.com.

FIGURE 19.6 When Coca-Cola announced a dividend increase on 17 February 2005, the company cited
its “confidence in its long-term cash flow.” The company was using the dividends to send a signal to the
financial markets, but it may not have worked: On the day of the announcement, Coke’s stock price fell by
26 cents.

19.5. What Do Corporate Executives Think about Dividends?

A long line of financial research indicates that companies are extremely reluctant to change
their dividend policy. Corporate executives apparently think that changing a firm’s dividend
policy is an important signal. In a recent survey of 384 corporate executives, researchers at
Duke and Cornell found that they ranked the importance of maintaining the current dividend
level on a par with other major corporate investment decisions. Share repurchases, on the other
hand, were thought to come out of the residual cash flows after investment and dividend spend-
ing. However, the researchers report, “Many managers . . . favor repurchases because they are
viewed as being more flexible than dividends and can be used in an attempt to time the equity
market or to increase EPS. Executives believe that institutions are indifferent between dividends
and repurchases and that payout policies have little impact on their investor clientele. In general,
management views provide little support for agency, signaling, and clientele hypotheses of pay-
out policy. Tax considerations play a secondary role.” 7
The way that companies relate to their dividends bears this out. Note the subhead on the
Coca-Cola press release notifying the markets of an increase in dividend (Figure 19.6): “43rd
Consecutive Annual Increase.” Here are two more examples:
• IBM takes great pride in having paid quarterly dividends since 1916 (Figure 19.7). If the
company were to change this policy, it would quite naturally be indicative of a major sea
change at IBM.

7
“Payout Policy in the 21st Century,” Alon Brav, John R. Campbell, John R. Graham, and Roni Michaeli.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=358582.
 CHAPTER 19 Dividend Policy 583

• GM, with which we started this chapter, is quite reluctant to change its dividend policy, even
though the financial health of the company is not good. The company evidently understands that
a decrease in the quarterly dividend would be interpreted as bad news by the financial markets.

FIGURE 19.7 Corporations consider dividend maintenance very important. When IBM announced its
regular quarterly dividend, the company proudly noted that this it had paid “357 consecutive quarterly
dividends, starting in 1916.”

Summing Up
Dividends have a financial and an informational function. If we ignore their informational func-
tion, the payment of dividends presents a problem: Given a tax regime in which dividends are
taxed at ordinary income tax rates, whereas nonpayment of dividends or stock repurchases are
taxed at lower capital gains tax rates, it is difficult to explain why firms pay dividends. Most
shareholders would be better off if the dividend payment were either retained in the firm or
diverted to share repurchases. As shown in Figure 19.8, this purely financial consideration per-
haps explains the increasing role of share repurchases in firm dividend policies.
The informational role of dividends is more complicated. Firms are highly reluctant to
change their dividend payout patterns—a company with no dividends tends to continue a no-
payout policy, whereas companies with moderate dividend growth strive to continue their
growth rates. Both corporate executives and financial markets tend to interpret a change in the
dividend payout as having informational content. Most firms believe that dividend increases
will be interpreted as good news about future fi rm prospects and vice versa.
However, we have shown examples in this chapter where dividend changes have contrary
effects to expectations: When Microsoft implemented a dividend, the markets interpreted this
as a negative signal about the company’s future prospects. When Coca-Cola increased its divi-
dend, citing “confidence in its long-term cash flow,” the stock price fell.
We can conclude from this that for firms whose shares are traded on stock markets, the divi-
dend decision is a complicated, not totally understood, phenomenon that combines purely finan-
cial and tax considerations with complicated signaling and perhaps psychological motives.
584 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

Share Repurchases Substitute for Dividends

by Vahan Janjigian
The total return on equities is composed of two components: dividends and capital gains. Since the
1980s, however, the proportion coming from dividends has been shrinking. Furthermore, dividend
yields (i.e., dividend per share divided by stock price) and payout ratios (i.e., dividend per share
divided by earnings per share) have been falling steadily. Many experienced investors take this as
prima facie evidence that stocks remain overvalued despite a tremendous two-year sell-off.
Value investors in particular believe that steadily rising cash dividends are an indication of
financial health. These investors often shun stocks that lack a long history of dividend payments.
But others, such as growth investors, believe dividends are not very meaningful.
A recent article in the Journal of Finance, a leading scholarly publication, provides evidence
that the demise of the cash dividend is just an illusion. The authors, Gustavo Grullon and Roni
Michaely, argue that focusing only on dividends ignores an increasingly important form of cash
payout to stockholders: share repurchases. Cash dividends have been increasing at an annually
compounded rate of only 6.3% since 1980. Yet cash spent on share repurchases has been rising at
a much more rapid clip of 18.4% compounded annually. Furthermore, cash spent on share repur-
chases now exceeds that spent on dividends. And total cash paid out (i.e., dividends plus repur-
chases) as a percentage of earnings has actually been rising during the period studied.
Our tax code explains much of this behavior. When corporations pay dividends, investors are
forced to pay taxes. In fact, dividends are taxed at the ordinary rate. But when corporations initiate
share repurchases, investors can avoid taxes altogether by choosing not to sell. Yet if they do sell,
they are taxed at the capital gains tax rate, which is much lower than the ordinary tax rate.
This was the case thirty years ago as well. So why weren’t share repurchases as popular then?
Grullon and Michaely argue that share repurchases didn’t really start growing in popularity until a
1982 regulatory reform, which made it less likely that repurchasing firms would be accused by the
SEC of trying to manipulate their stock prices.
There are a number of lessons to be drawn from this study. First, those who argue that stocks
remain overvalued simply because dividend yields or dividend payout ratios are historically low
are being shortsighted. They should instead focus on total cash payouts. Second, there should
be no doubt that, good or bad, regulatory reforms affect firm behavior. Well-managed firms will
do what is best for shareholders. As long as cash dividends are unfavorably taxed, investors will
prefer capital gains. And as long as regulators allow it, good corporate boards will deliver what
shareholders want.
Which brings us to a very important point. Dividends are paid from after-tax dollars. Taxing
investors again for receiving those dividends imposes a very heavy burden. Regulators should
eliminate this double taxation. Dividends should either be treated as a tax-deductible expense for
corporations, or tax-exempt income for individuals.

FIGURE 19.8 Since the 1980s, cash dividends have been increasing at a much slower rate than share repurchases. The
explanation is in the much lower tax rates on capital gains versus ordinary income.
 CHAPTER 19 Dividend Policy 585

EXERCISES
1. The following sheet shows the balance sheet for John’s Supermarket. John is the sole owner of the
supermarket.
A B C D
1 JOHN'S SUPERMARKET
2 Assets Liabilities and equity
3 Cash 500,000 Debt 600,000
4
5 Equity
6 Supermarket 1,250,000 Stock 800,000
7 Accumulated retained earnings 350,000
8 Total assets 1,750,000 Total debt and equity 1,750,000

a. Show the supermarket balance sheet in terms of net debt.

b. Assuming John decides to pay himself a $250,000 dividend: Show both the original balance
sheet and the net debt balance sheet after the dividend payment.
2. John (from Exercise 1) needs your help again. After paying the dividend of $250,000, he decides
to accept an offer to sell the supermarket for $1,800,000. The conditions of the sale are that John
gets to keep the cash on the company’s books, but that he is responsible for paying back the com-
pany’s debt.
a. Assuming no taxes of any kind, what will John net from his dividend and from his sale of the
company?
b. If John had sold the supermarket for $1,800,000 before the $250,000 dividend, what would
have been his net gain?
c. Back to the case of a $250,000 dividend: What will be John’s net if there were a 30% tax on the
dividend payment and a 20% tax rate on gains from the supermarket sale?
d. With a 30% tax on dividends and a 20% capital gains tax, what would be John’s net if he sold
the supermarket without first paying a $250,000 dividend?
3. David has a cosmetics shop he’s trying to sell for $200,000. The shop’s balance sheet is given
below. David has a 40% tax on ordinary income (including dividend payments), a 30% corporate
tax rate, and a 25% tax rate on capital gains. Before selling the store, he wants to pay himself a
dividend of $55,000, equal to his accumulated retained earnings. According to his belief, “My
selling price is the same whether I’ll pay the dividend (to myself) or not. So why not pay myself a
dividend first? I’ll have more money that way!”
Is David right? Present the calculations for both the dividend and the nondividend case.

A B C D
1 David's Cosmetics Shop
2 Assets Liabilities and equity
3 Cash 60,000 Loan from bank 50,000
4 Inventory 25,000
5 Equity
6 Shop 100,000 Stock 80,000
7 Accumulated retained earnings 55,000
8 Total assets 185,000 Total debt and equity 185,000

4.
a. How will your answer to Exercise 3 change if instead of paying himself a dividend David pays
himself a bonus of $55,000?
b. How will your answer to Exercise 4a change if both the corporate tax rate and the ordinary
income tax are 40%?
586 PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

5. How will your answer to Exercise 3 change if instead of paying himself a dividend the shop will
repurchase shares from David for $55,000 (assume capital gain tax rate on stock repurchase)?
6. Mallory wants to sell her fishing business. She’s trying to decide whether to sell the business as is,
to pay herself a dividend of $5,000 combined with a bonus of $10,000, or to repurchase $15,000 of
shares. Assuming Mallory will be paid $220,000 anyway, what will you recommend she do?
The balance sheet of the business is given below.
A B C D
1 Mallory's Fishing Business
2 Assets Liabilities and equity
3 Cash 20,000 Loan from bank 25,000
4 Inventory 25,000
5 Equity
6 Ship 100,000 Stock 110,000
7 Warehouse 30,000 Accumulated retained earnings 40,000
8
9 Total assets 175,000 Total debt and equity 175,000

7. HighTech.Com is a company whose sales and profits have been steadily increasing. The company
has never paid a dividend. The company’s management is trying to decide whether to use its large
cash balances to pay a dividend to shareholders or to repurchase shares. Can you give them some
advice?
8. Simon’s Hotels is a company founded in 1995. The company owns a chain of hotels and has thus far
not paid dividends, instead using its excess cash to pay down large levels of debt used to buy hotels.
The company’s debt has now reached acceptable levels. Can you advise management whether it
should implement a dividend? How do you think a dividend will be interpreted by the market?
 PA R T

5
OPTIONS AND OPTION
VALUATION

The market for options has grown tremendously in the past two decades, and options
form an important component of many capital market investments. In addition option concepts
are a critical component of much thinking about the way markets work and investments are
made. One example is the compensation given to managers in the form of stock options.
Part 5 of Principles of Finance with Excel gives an introduction to basic option concepts
and valuation. A fuller treatment of these concepts will have to wait for a course dedicated to
options, but Part 5 should give you the necessary background.
Chapter 20 introduces basic option concepts and terminology. Using a series of examples,
this chapter will tell you about option cash flows, buying and selling options, and the payoffs
from option strategies.
Chapter 21 tells you some basic facts about options prices. In more advanced textbooks
these go by the name of “arbitrage restrictions” on option prices.
Chapters 22 and 23 discuss two option pricing models. Chapter 22 shows you how to use
the Black-Scholes formula, the most famous option pricing model. The mathematics that under-
lie the Black-Scholes model can be daunting, but we’ve kept things simple. As Chapter 22
shows, on a mechanical level the Black-Scholes is easy to learn to use.
Chapter 23 discusses the other best-known option pricing model, the binomial model. The
binomial model provides good intuitions about how options—as combinations of stocks and
bonds—can be priced.
This page intentionally left blank
CHAP TER

20 Introduction to Options

CHAPTER CONTENTS
Overview 589
20.1. What’s an Option? 594
20.2. Why Buy a Call Option? 597
20.3. Why Buy a Put Option? 599
20.4. General Properties of Option Prices 600
20.5. Writing Options, Shorting Stock 602
20.6. Option Strategies—More Complicated Reasons to Buy Options 605
20.7. Another Option Strategy: Spread 610
20.8. The Butterfly Option Strategy 612
Summary 614
Exercises 614

Overview
The financial assets we have discussed so far in this book are bonds (Chapter 15) and stocks
(Chapter 16). In Chapters 20–23 we discuss another kind of financial asset—options. As you
will see in these chapters, an option is different in many respects from a stock or a bond:
• The value of an option is derived from the value of another asset, usually a stock. For this
reason options are sometimes called derivative assets.
• The buyer of an option buys upside gains but has only limited downside losses.
589
590 PART FIVE OPTIONS AND OPTION VALUATION

• Options are more complicated than bonds or stocks. To understand options we will have
to introduce you to some new terminology and some new ways of thinking about finan-
cial assets.

A Simple Example of an Option

To give some meaning to these somewhat mysterious statements, we start with a simple exam-
ple.1 It is 1 January 2011, and the price of an ounce of gold is $800. You have a very strong
hunch that the price of gold will be $1,200 in 3 months. Your hunches have never failed you,
so this must be a sure-fire way to make some money. Taking your total savings of $800, you
go to your local jewelry mart to buy some gold. But with your paltry savings you can buy only
1 ounce of gold, and you can make a maximum of only $400—only a 50% return on your initial
investment.
However, the jeweler has another offer for you: For $50, he is willing to sell you a con-
tract that gives you the right to buy 1 ounce of gold in 3 months for $800. You realize that this
contract—a call option on gold—gives you the opportunity of making much more money than
actually buying physical gold.
Here’s your calculation:
• Using your $800 savings, you can buy 16 call options.
• In 3 months you can use the call options to buy 16 ounces of gold for $800 per ounce. If
your hunch is correct, the gold price in 3 months will be $1,200 per ounce, so you can
make $400 per ounce of gold purchased.
• Your total profit using the gold call options will be $5,600 = $6,400 – $800—a profit of
700% (= 6,400
800
− 1 ) on your initial investment. This compares to the profit of 50% you will
make if you use your $800 savings to buy 1 ounce of physical gold.

Downside: Suppose your hunch is wrong, and the price of gold in 3 months is $600. Now
compare the profits of buying 1 ounce of physical gold to the profits of buying 16 call options:
• If you bought 1 ounce of physical gold, you would have lost 25% of your initial $800
investment.
• If you bought 16 options and the price of gold on 31 March 2011 is $600 per ounce, the
options will be worthless. In this case you would have lost 100% of your initial $800
investment.

CALL OPTION ON 1 OUNCE OF GOLD

Price on 1 January 2011: $50

If presented at Asheville Jewelry Mart on or before 31 March 2011, this

piece of paper gives you the right to buy 1 ounce of gold for $800. After
31 March 2006, this piece of paper is worthless.
The owner of this piece of paper can sell it to anyone else at any
time.
FIGURE 20.1 The gold call option certificates sold by the Asheville Jewelry
Mart.

1
Even this simple example is nontrivial. Options are like that!
 CHAPTER 20 Introduction to Options 591

Peacemount Stock Options—An Example

Our gold example should convince you that options are an interesting way to make (and lose!)
money. In this subsection we give an example of a stock option. Stock options give their hold-
ers the right to either buy or sell a stock in the future for a predetermined price. Stock options
come in two flavors: A call option on a stock allows you to make money if the stock price
goes up without losing too much if the stock price goes down. A put option on a stock allows
you to make money if the stock’s price goes down without losing too much if the stock’s price
goes up.
Take a look at Figure 20.2, which shows a call option (the right to buy a share of stock) on
one share of a fictional company called Peacemount. On 26 November 2010 it would cost you $3
to buy this option. Having bought, you then have the right for the next 3 months to buy a share
of Peacemount stock for $36.
Why buy this option? By spending $3 now, you lock in $36 as the maximum price
Peacemount stock will cost you in the next 3 months. If the price of the stock goes up in the
next 3 months, this will save you a lot of money. If, for example, Peacemount stock is sell-
ing on 26 February 2011 for $50, then using your call option, you can buy the stock for $36.
You will have a profit of $11 (buying the stock for $36 instead of $50 saves you $14; from
this amount you have to deduct the $3 cost of the option). If, on the other hand, Peacemount
stock declines below $36, then you will not exercise the option but you will only lose your
$3 investment. In option market jargon, the call option offers upside gains but only limited
downside losses.
There’s another reason to buy the option: You might be able to sell it at some time during
the next 3 months and make a profit. Suppose that in 1 week the price of Peacemount stock is
$45. Then the price of the call option should be at least $9, because the owner of the option
could immediately make a profit of $9 by exercising it.2 Note that in this example the price of
the stock increases by 25% (from $36 to $45), whereas the price of the option increases by at
least 200%. This makes the option a very interesting speculation. In option market jargon, the
call option’s market price is very sensitive to the price of the underlying asset (in our case: the
price of Peacemount stock).
In addition to call options, this chapter also discusses put options. Whereas a call option
is the right to buy a share of stock in the future, a put option is the right to sell a share of stock.
An example is given in Figure 20.3: For $2.50 you could, on 26 November 2010, buy the right
to sell one share of Peacemount stock for $36 during the next 3 months.
Why might you be interested in buying this put option? One reason is that, for holders of
Peacemount stock, the put option places a floor on your losses. Suppose you currently own a
share of Peacemount stock. On 26 November 2010 shares of Peacemount are selling for $35.50.
If you buy the put option today for $2.50, you guarantee yourself that at any point during the
next 3 months you will realize at least $33.50 from your stock. To see this, suppose that on 26
February 2004 the price of Peacemount is $20. Instead of selling your share on the open mar-
ket, you will use (“exercise”) the put option to sell the share for $36. Accounting for the cost of
the option, your net receipts will be $33.50 ($36 for the share minus the $2.50 cost of the put
option).

2
Whoever holds the option can purchase a share of Peacemount for $36. The stock price is now $45, so the
immediate realizable profit is $9.
592 PART FIVE OPTIONS AND OPTION VALUATION

CALL OPTION ON PEACEMOUNT STOCK

Price on 26 November 2006: $3

If presented at the Asheville Stock Exchange on or before 26 February 2011, this piece of
paper gives you the right to buy one share of Peacemount stock for $36. After 26 February
2011 this piece of paper is worthless. The holder of this piece of paper can sell it to someone
else at any time.

Some additional information:

• On 26 November 2010, shares of Peacemount stock sold for $35.50.
• Peacemount’s stock price has experienced considerable variations during the past 3
months:

Peacemount Stock Price

36.00

35.50

35.00

34.50

34.00

33.50

33.00

32.50
25-Sep-10
17-Jun-10

27-Jul-10

15-Oct-10

4-Nov-10
16-Aug-10

5-Sep-10
7-Jul-10

24-Nov-10

FIGURE 20.2 A call option on Peacemount stock. The option gives the holder the right to buy a share
of Peacemount on or before 26 February 2011 for $36. The market price of the option on 26 November
2010 is $3.
 CHAPTER 20 Introduction to Options 593

PUT OPTION ON PEACEMOUNT STOCK

Price on 26 November 2010: $2.50

If presented at the Asheville Stock Exchange on or before 26 February 2011, this piece of paper
gives you the right to sell one share of Peacemount stock for $36. After 26 February 2011 this piece
of paper is worthless. The holder of this piece of paper can sell it to someone else at any time.

FIGURE 20.3. A (hypothetical) put option on Peacemount stock. The option gives the holder the right
to sell a share of Peacemount on or before 26 February 2011 for $36. The market price of the option
on 26 November 2010 is $2.50.

What’s Next?
This chapter shows you basic option definitions and introduces you to option cash flows. In addition,
we show you how option strategies—the ability to combine options and stocks in portfolios—can
change the payoff patterns available to investors. When you finish this chapter, you will understand
why stock options are really interesting securities and why you might want to invest in them.

Finance Concepts Discussed

• Call and put options
• Option strategies: protective puts, spreads, butterflies

BASIC OPTION TERMINOLOGY AND SYMBOLS

Name Definition Symbol

Call option The right to buy a stock or other asset at C

a predetermined price on or before some
future date
Put option The right to sell a stock or other asset at P
a predetermined price on or before some
future date
Exercise price The predetermined price of the X
option—the price at which the
stock/asset can be purchased in the
future; also called the strike price
Exercise date The last date on which the option can be T
exercised; past this date the option is
worthless
Underlying asset The stock or other asset that can be S
purchased with an option (in our
previous examples, gold or one share S0: stock price today
of Peacemount stock) ST: stock price on
the exercise date

FIGURE 20.4 Option pricing involves a lot of terminology. Here are some very basic terms.
594 PART FIVE OPTIONS AND OPTION VALUATION

Excel Functions Used

• Max
• Min

20.1. What’s an Option?

A call option on a stock is the right to buy a stock on or before a given date at a predeter-
mined price. The spreadsheet below gives prices for options on IBM stock on 8 May 2009, a
day on which IBM stock itself sold for $101.49. We will use these prices in the examples that
follow.

A B C

8 MAY 2009: OPTIONS

ON IBM, EXPIRING 17
JULY 2009
1
Exercise Call Put
2 price price price
3 45 60.80 0.05
4 55 50.80 0.10
5 65 40.80 0.15
6 70 35.80 0.25
7 75 31.30 0.40
8 80 20.99 0.70
9 85 16.40 1.18
10 90 13.30 2.05
11 95 9.10 3.30
12 100 6.40 5.20
13 105 4.00 7.70
14 110 2.24 11.00
15 115 1.10 15.20
16 120 0.52 19.70
17 125 0.25 21.30
18 130 0.10 29.70

Row 12 of the above spreadsheet shows that a call option on IBM with an exercise price of
$100 sold on 8 May for $6.40. Suppose you purchased this call option. Figure 20.5 shows the
option’s cash flow pattern.
 CHAPTER 20 Introduction to Options 595

CALL OPTION CASH FLOW PATTERN

8-May-09 17-Jul-09

Pay: $6.40 If IBM's stock price > $100,

you'll exercise your call
to buy the stock for $100.
Your gain on 17 July:
Actual stock price – $100

In principle, you have the right to buy

IBM stock for $100 on any date before If IBM's stock price < $100,
17 July. In actual fact, you will only you will not exercise your
want to exercise the call option at its call option.
terminal date (see Chapter 21). Your gain on 17 July: 0.

FIGURE 20.5 The cash flows from buying an IBM call option on 8 May 2009 for $6.40 and possibly
exercising it on 17 July 2009. The option has exercise price X = $100.

Now let’s see what happens on 17 July:

• Suppose the IBM stock price on 17 July is $135. In this case you get to buy one share of
IBM for $100. Your gain is $135 – $100 = $35.
• If the IBM stock price on 17 July is $90, you would not exercise your call option to buy
a share of IBM for $100 (why should you? you could buy it on the open market for less).
The option expires unexercised, and your gain is $0.

IBM Put Options

What about the IBM put option with an exercise price of $100? It was selling, on 8 May 2009,
for $5.20. The put option gives you the right to sell a share of IBM on or before the terminal date
for its exercise price. The put option’s cash flow pattern is shown in Figure 20.6.

PUT OPTION CASH FLOW PATTERN

8-May-09 17-Jul-09

Pay: $5.20 If IBM's stock price < $100,

you'll exercise your put
to sell the stock for $100.
Your gain on 17 July:
$100 - Actual stock price

In principle, you have the right to sell

IBM stock for $100 on any date before If IBM's stock price > $100,
21 September. In actual fact, you will you will not exercise your
only rarely want to exercise the put put option.
option before its terminal date (see
Your gain on 17 July: 0.

FIGURE 20.6 The cash flows from buying a IBM put option on 8 May 2009 for $5.20 and possibly
exercising it on 17 July 2009. The option has exercise price X = $100.
596 PART FIVE OPTIONS AND OPTION VALUATION

If IBM’s stock price on 17 July is $85, you will exercise your put option and sell a share of
IBM for $100, thus gaining $15.3 On the other hand, if IBM’s share price on 17 September is
$130, you will not exercise the put option (why sell a share using the option for $100 when you
can sell it on the open market for $130?).

OPTION WEB SITES

All the data in this chapter were gathered from public sources on the Web. Many of these Web
sites have superb data and also educational features. Here are some Web sites we especially
enjoy.
• The Web site of the Chicago Board of Options Exchange: http://www.cboe.com
• Yahoo!: http://biz.yahoo.com/opt/

European versus American Options

IBM’s stock options are American stock options—they can be exercised on or before the option
maturity date T. A European stock option can be exercised only on its maturity date T. Clearly,
an American stock option is worth at least as much as a European stock option: American
options offer more flexibility than European options.
• Two notes about American versus European stock options: The terminology has nothing
to do with geography. Most traded options, whether in the United States, Europe, or Asia,
are American and not European.
• A remarkable fact about American call options is the following: In many cases an
American call option is worth exactly the same as an equivalent European call option.
This happens if the stock on which the option is written does not pay a dividend before
the option expiration date T. We discuss the reasons for this in Chapter 21.

In the Money, out of the Money, at the Money

A call option is said to be “in the money” if the current stock price is larger than the option’s
exercise price. Look at the IBM July calls in Figure 20.8. The call with the exercise price of $90
(selling for $13.30) has an exercise price less than IBM’s current stock price of $101.49. Thus
this call is in the money—the stock price is greater than the call’s exercise price.
The call with exercise price $110 (selling for $2.24) is out of the money—its exercise price
is more than IBM’s current share price. If the call’s exercise price is equal to the current stock
price, it is termed an at-the-money call. The call with an exercise price of $100 is almost at the
money, and option traders would refer to it loosely as the at-the-money call.
A put is said to be in the money if the put’s exercise price is greater than the current stock
price. The IBM $120 put (selling for $19.70) is in the money and the $80 put (selling for $0.70)
is out of the money. There is no precise at-the-money put, but traders would refer to the $100
exercise put (selling for $5.20) as the at-the-money put.

3
What if you don’t own a share of IBM on 17 July? No problem: You buy a share on the open market for
$85 and use your option to sell it for $100.
 CHAPTER 20 Introduction to Options 597

MORE OPTION TERMINOLOGY

Terminology Definition

European option The option is exercisable only on the exercise date T.

American option The option is exercisable on or before the exercise date T. Most
options traded on exchanges are American options. Although in
principle an American option should be worth more than a
European option, in many cases this is not true (see Chapter 21).
At-the-money option An option whose exercise price X is equal to the underlying stock’s
current stock price S0. “In-the-money” is often loosely used to
describe an option whose exercise price X is approximately equal
to the current stock price S0.
In-the-money option An option from which money can be made by immediate exercise.
A call option is in the money if the current stock price S0 is
greater than the option’s exercise price X. A put option is in the
money if the current stock price S0 is less than the option’s
exercise price X.
Out-of-the-money option An option from which no money can be made by immediate
exercise. A call option is out of the money if X > S0. A put
option is out of the money if S0 > X.

FIGURE 20.7 Option pricing involves a lot of terminology. Here are some basic terms.

20.2. Why Buy a Call Option?

Here are two simple reasons why you might want to buy a call option.
Reason 1: A call option allows you to delay the purchase of a stock: It’s 8 May 2009, and
you’re thinking about buying a share of IBM for its current market price of $101.49. As an alternative,
you can buy a July call option with X = $100. This option will cost you $6.40. Here’s your thinking:
• If, on 17 July 2009, IBM’s stock price is > $100.00, you’ll exercise the option and
purchase the share for $100. If you’re careful, you’ll realize that there are several
“subpossibilities”:
• IBM’s 17 July stock price = $130. Now you’ve made out like a bandit: You spent
$6.40 for the option, but you bought the stock for $100, saving $30.00. Your net
profit is $23.60 ($30.00 – $6.40 cost of the option).
• If IBM’s 17 July stock price = $105.00, you’ll still exercise the option and purchase
the stock for $100.00. You’ve saved $5.00 on the purchase price of the stock, but
this time you will have lost a bit of money, because the option cost you $6.40. Your
net profit will be –$1.40.
• If on 17 July IBM’s stock is selling for less than $100, you will not exercise your call
option. If you still want to purchase the stock, you’ll buy it on the open market. In all
cases, you will have lost only the $6.40 cost of the option.

Reason 2: A call option allows you to make a bet on the stock price going up. This bet is:
(a) low cost, (b) high upside potential, and (c) one sided.
 ANALYZING THE PROFIT FROM A CALL OPTION

Price Exercise the option? In percentage

of IBM on Your profit or loss
17 July
2009
$90 No—the option gives you the right to –$6.40 Profit on exercise – option cost
buy IBM for $100, but the market price =
Option cost
is less, so you would not exercise the
option –6.40
= –100%
6.40
$100 Yes/no—doesn’t matter (you’re buying –$6.40 Profit on exercise –option cost
the stock at its market price) =
Option cost
–6.40
= –100%
6.40
$105 Yes—the option lets you buy the stock Profit on exercise – option cost
for $100, but the market price is $100. =
Profit on exercise – option cost Option cost
So you should exercise (even though
you’ve lost money—see next column) =(105 – 100) – 6.40 = –1.40 5 – 6.40
= –22%
6.40
$120 Yes Profit on exercise – option cost
Profit on exercise – option cost =
Option cost
=(120 – 100) – 6.40 = 13.60 20 – 6.40
= 213%
6.40
$140 Yes Profit on exercise – option cost
Profit on exercise – option cost =
Option cost
=(140 – 100) – 6.40 = 33.60 40 – 6.40
= 525%
6.40

FIGURE 20.8: Analyzing the profit from a call option. If the stock price is down on 17 July, your loss is limited to $6.40. However, if the price goes above $100,
your percentage gains from the option can be very large. The call option is a “one-sided” bet on the stock price going up—if the stock price goes up, you make
money; if the stock price goes down, you lose a limited amount of money.
 CHAPTER 20 Introduction to Options 599

Suppose you buy the IBM call option above: You spend $6.40 on 8 May 2009 to purchase
an option that—on 17 July—gives you the right to purchase IBM stock for $100. Your purpose
is to bet on the price of IBM stock in July. As you can see in Figure 20.8,
• This bet has a low cost: You’ve put up only $6.40 to make it.
• You will never lose more than the $6.40. This is what we mean when we say that the bet
is one sided: You can only lose a limited amount of money.
• The bet has high upside potential: The profits, both in dollars and as a percentage of the
money you put up, rise very rapidly when the stock price in July exceeds $100.
You can summarize all of this in a spreadsheet.

A B C D E F G H
PROFIT FROM BUYING AN IBM CALL
Bought for $6.40 on 8 May 2009; Exercise price: X=$100
1 Exercise date: 17 July 2009
2 Call price, 9 May 2009 6.40
3 Call exercise price, X 100.00
4
ST: Market price Will put Dollar
of IBM buyer exercise profit/loss Dollar Profit/Loss on IBM Call
5 17 July 2009 the call? to call buyer
6 0 no -6.40 <--100
=MAX(A6-$B$3,0)-$B$2
7 80 no -6.40 80
8 90 no -6.40
9 100 indifferent -6.40 60
10 110 yes 3.60
11 120 yes 13.60 40
12 130 yes 23.60
13 140 yes 33.60 20
14 150 yes 43.60 0
15 160 yes 53.60
16 170 yes 63.60 0 50 100 150 200
-20
17 180 yes 73.60 IBM stock price on 17 July 2009
18 190 yes 83.60 <-- =MAX(A18-$B$3,0)-$B$2

20.3. Why Buy a Put Option?

As in the case of the call, there are two simple reasons to buy a put.
Reason 1: The put option allows you to delay the decision to sell the stock.
It’s 8 May 2009, and you own a share of IBM stock. You’re considering selling the stock; its
current market price is $101.49. As an alternative, you can buy a July put option with X = $100.
This put option will cost you $5.20. Here’s your thinking:
• If, on 17 July 2009, IBM’s stock price is < $100, you’ll exercise the put option and sell
the share for $100. As in the case of the call option discussed earlier, there are several
“subpossibilities”:
• IBM’s 17 July stock price = $50. Now you’ve made a lot of money: You spent $5.20
for the option, but you sold the stock for $100, which is $50.00 more than its mar-
ket price. Your net profit is $44.80 ($50.00 – $5.20 cost of the option).
• If IBM’s 17 July stock price = $95.00, you’ll still exercise the put option and sell
the stock for $100.00. Compared with the market price, you’ve made $5.00 on the
sale of the stock, but this time you will have lost a bit of money, because the option
cost you $5.20. Your net profit will be –$0.20.
• If on 17 July IBM’s stock is selling for more than $100, you will not exercise your put
option. If you still want to sell the stock, you’ll sell it on the open market. In all cases,
you will be out only the $5.20 cost of the option.
600 PART FIVE OPTIONS AND OPTION VALUATION

Reason 2: A put option allows you to make a bet on the stock price going down.
If you buy a put for $5.20 and wait until 17 July to exercise, here are your profits:

⎧ IBM stock priceon 17 Jul09 ≤ 100

⎪100 − ST − 5.20 In this case you exercise the put and
⎪ make ST − 100 minus the cost of the put
⎪⎪
Put profits = ⎨
⎪ IBM stock priceon 17 Jul09 > 100
⎪
⎪ −5.20 In this case you do not exercise the put;
⎪⎩ your loss is the cost of the put

Here is a summary in a spreadsheet.

A B C D E F G H
PROFIT FROM BUYING AN IBM PUT
Bought for $5.20 on 8 May 2009; Exercise price: X=$100
1 Exercise date: 17 July 2009
2 Put price, 9 May 2009 5.20
3 Put exercise price, X 100.00
4
ST : Market price Will put Dollar
of IBM buyer exercise profit/loss Dollar Profit/Loss on IBM Put
5 17 July 2009 the put? to put buyer
6 0 yes 94.80 100
<-- =MAX($B$3-A6,0)-$B$2
7 50 yes 44.80 80
8 60 yes 34.80
9 90 yes 4.80 60
10 100 indifferent -5.20
11 110 no -5.20 40
12 130 no -5.20
13 140 no -5.20 20
14 150 no -5.20 0
15 160 no -5.20
16 170 no -5.20 0 50 100 150 200
-20
17 180 no -5.20 IBM stock price on 17 July 2009
18 190 no -5.20 <-- =MAX($B$3-A18,0)-$B$2

20.4. General Properties of Option Prices

In this section we review three general properties of option prices. We look at the effects of
option time to maturity, exercise price, and the stock price. Our discussion is informal and
intuitive.

Property 1: Options with More Time to Maturity Are Worth More

The longer you have to exercise an option, the more it should be worth. The intuition here is
clear: Suppose you have a July 2009 call option to buy IBM stock for $100 and also an October
2009 call option to buy IBM for $100. Because IBM options are American options, the October
call gives you all the opportunities associated with the September call—and then some. Thus
the October call should be worth more than the September call.
Here are some data for the IBM options. Note that the prices of the options increase with
maturity.
 CHAPTER 20 Introduction to Options 601

A B C D E F G H I J K L
IBM OPTIONS:
EFFECT OF EXPIRATION DATE ON
1 OPTION PRICE 18
IBM Options: Effect of Option Maturity on
Expiration Exercise 16
the Option Price
Call price Put price
2 date price, X
3 14
15-May-09 100 2.55 1.10
4 19-Jun-09 100 5.00 3.60 12
5 17-Jul-09 100 6.40 5.20 10
6 16-Oct-09 100 9.50 8.51
8
7 15-Jan-10 100 11.00 11.00
8 21-Jan-11 100 16.30 16.70 6 Call price
9 4 Put price
10
2
11
12 0

Jun-09

Oct-09

Jan-10

Mar-10

Jun-10

Oct-10

Jan-11
May-09

Apr-10
May-10
Jul-09
Aug-09
Sep-09

Nov-09

Feb-10

Jul-10
Aug-10
Sep-10

Nov-10
Dec-09

Dec-10
13
14
15

Property 2: Calls with Higher Exercise Prices Are Worth Less; Puts with
Higher Exercise Prices Are Worth More
Suppose you had two October 2009 calls on IBM: One call has an exercise price of $100 and
the second call has an exercise price of $120. The second call is worth less than the first. Why?
Think about calls as bets on the stock price: The first call is a bet that the stock price will go
over $100, whereas the second call is a bet that the stock price will go over $120. You’re always
more likely to win the first bet (IBM will go over $100) than the second bet.
From the table below you can see that IBM’s option prices conform to this property.

A B C D E F G H I J K
8 MAY 2009: OPTIONS ON IBM, EXPIRING 16 OCTOBER 2009
1
Exercise Call Put
2 price price price IBM October 2009 Options
3 50 50.40 0.25 60
4 55 47.30 0.45
5 60 41.30 0.40
50
6 65 41.00 0.68
7 70 33.30 1.20
40
Option price

8 75 26.85 1.65
9 80 22.70 2.30
85 18.40 3.30 30
10
11 90 14.70 4.64
95 12.00 6.30 20 Call
12
100 9.50 8.51 price
13
14 105 6.76 11.00 10 Put
110 5.00 14.60 price
15
16 115 3.40 15.20 0
17 120 2.15 20.90 50 60 70 80 90 100 110 120 130 140 150
18 125 1.40 22.80 Exercise price
19 130 0.83 26.20
20 135 0.50 34.90
21 140 0.30 39.80
22 145 0.25 43.20

Here we’ve looked at all the options that expire on the same date (October 2009). As you can
see, the higher the option exercise price, the lower the call price and the higher the put price.
602 PART FIVE OPTIONS AND OPTION VALUATION

Property 3: When the Stock Price Goes Up, Call Option Prices Go Up
and Put Option Prices Go Down
The reason for this behavior is obvious, if you think of an option as a bet: Suppose you buy a
IBM X = 100 October 2009 call option. We can view this option as a bet that IBM’s stock price
in October will be above $100. The probability of your winning this bet is higher if IBM’s cur-
rent stock price is higher and hence so is the call option’s price. Thus, for example, if you’re
willing to pay $9.50 for the X = 100 October call when IBM’s current stock price is $101.49, you
would be willing to pay more for the same call when IBM’s stock price is $105.
The logic for puts is the same, although the result is opposite: The higher the stock price,
the lower the put option price.

20.5. Writing Options, Shorting Stock

Our discussion thus far has been from the point of view of the option purchaser. For example,
in Section 20.2 we derived the profit pattern from buying an IBM 100 call for $6.40 on 8 May
2009 and waiting until the call maturity on 17 July 2009. Similarly, in Section 20.3 we looked
at the profit from buying an IBM 100 put.

Writing Calls
There’s another side to this story: When you buy a call, someone else sells the call. In the jargon
of options markets, the call seller is writing a call.
Call buyer: On 8 May 2009 buys, for $6.40, the right to buy one share of IBM stock for
$100 on or before 17 July 2009.
Call writer: On 8 May 2009 sells, for $6.40, the obligation to sell one share of IBM stock
for $100—as per demand of the call option buyer—on or before 17 July 2009.
Here’s the way the call writer’s profit pattern looks.

CALL OPTION CASH FLOW PATTERN—the call writer

8-May-09 17-Jul-09

Receives: $6.40 If IBM's stock price > $100

(denote this by ST > 100),
the call will be exercised.
The call writer has to sell
one share of IBM stock
for $100.
In principle, the call buyer has the right to buy Call writer's loss: ST - $100
IBM stock for $100 on any date before 17
July. In actual fact, the call buyer will only
want to exercise the call
If IBM's stock price < $100,
option at its terminal date (see Chapter 21).
( denote this by ST < 100 ),
the call will not be exercised.
Call writer's loss: 0

FIGURE 20.9 The cash flows from writing an IBM call option on 8 May 2009 for $6.40 and possibly
having it exercised against the writer on 17 July 2009. The option has exercise price X = $100.
 CHAPTER 20 Introduction to Options 603

Here’s the profit graph from writing a call option.

A B C D E F G H
PROFIT FROM WRITING AN IBM CALL
Sold for $6.40 on 8 May 2009; Exercise price: X=$100
1 Exercise date: 17 July 2009
2 Call price, 9 May 2009 6.40
3 Call exercise price, X 100.00
4
ST : Market price Will call Dollar
of IBM buyer exercise profit/loss Dollar Profit/Loss on IBM
5 17 July 2009 the call? to call writer
6 0 no 6.40 20
<-- =$B$2-MAX(A6-$B$3,0)Written Call
7 80 no 6.40
8 90 no 6.40 0
9 100 indifferent 6.40 0 50 100 150 200
10 110 yes -3.60 -20
11 120 yes -13.60 IBM stock price on 17 July 2009
12 130 yes -23.60 -40
13 140 yes -33.60
14 150 yes -43.60 -60
15 160 yes -53.60
16 170 yes -63.60 -80
17 180 yes -73.60
18 190 yes -83.60 <---100
=$B$2-MAX(A18-$B$3,0)

Writing Puts
There’s a similar story for puts.
Put buyer: On 8 May 2009 buys, for $5.20, the right to sell one share of IBM stock for $100
on or before 17 July 2009.
Put writer: On 8 May 2009 sells, for $5.20, the obligation to buy one share of IBM stock
for $100—as per demand of the put option buyer—on or before 17 July.
Here’s the way the put writer’s profit pattern looks.

PUT OPTION CASH FLOW PATTERN—the put writer

8-May-09 17-Jul-09

Receives: $5.20 If IBM's stock price < $100

( denote this by ST < 100 ),
the put will be exercised.
The put writer has to buy
one share of IBM stock
for $100.
In principle, the put buyer has the right to sell Put writer's loss: $100 - ST
IBM stock for $100 on any date before 17 July.
In actual fact, the put writer will rarely want to
exercise the put option before its terminal date
If IBM's stock price > $100,
(see Chapter 21).
( denote this by ST > 100 ),
the put will not be exercised.
Put writer's loss: 0

FIGURE 20.10 The cash flows from writing an IBM put option on 8 May 2009 for $5.20 and possibly
having it exercised against the writer on 17 July 2009. The option has exercise price X = $100.
604 PART FIVE OPTIONS AND OPTION VALUATION

Here’s a graph of the profit pattern from writing a put.

A B C D E F G H
PROFIT FROM WRITING AN IBM PUT
Sold for $5.20 on 8 May 2009; Exercise price: X=$100
1 Exercise date: 17 July 2009
2 Put price, 9 May 2009 5.20
3 Put exercise price, X 100.00
4
ST : Market price Will put Dollar
of IBM buyer exercise profit/loss Dollar Profit /Loss on IBM
5 17 July 2009 the put? to put writer 20 Written Put
6 0 yes -94.80 <-- =$B$2-MAX($B$3-A6,0)
7 50 yes -44.80 0
8 60 yes -34.80 0 50 100 150 200
-20
9 90 yes -4.80
10 100 indifferent 5.20
-40
11 110 no 5.20
12 130 no 5.20 -60
13 140 no 5.20
14 150 no 5.20 -80
15 160 no 5.20
16 170 no 5.20 -100
17 180 no 5.20 IBM stock price on 17 July 2009
18 190 no 5.20 <-- =$B$2-MAX $B$3-A18,0

Short-Selling a Stock
Short-selling a stock (“shorting”) is the stock equivalent of writing an option. Here’s how short-
ing a stock compares to buying a stock.
Stock buyer: On 8 May 2009 buys one share of IBM stock, for $101.49. When you sell the
stock—call the date T—you’ll get the stock price ST. Of course you will have also earned any
dividends that IBM will have paid up to and including date T. Ignoring the time value of money,
your profit from buying the stock is

ST + IBM dividends − 101.49

Stock shorter: On 8 May 2009 contacts his broker and borrows one share of IBM stock,
which he then sells, thus receiving $101.49. At some future date T, the short-seller of the stock
will purchase a share of IBM on the open market, paying the then-current market price ST. If
along the way IBM has paid any dividends, the short-seller will be obliged to pay these divi-
dends to the person he’s borrowed the stock from. His total profit will be

101.49 − (ST + IBM dividends ).

In the option chapters in this book, we will generally assume that stocks don’t pay any
dividends between the time you buy them and the time you sell them. This means that the profit
from buying or shorting a stock can be represented as follows.
 CHAPTER 20 Introduction to Options 605

A B C D E F G H I
PROFIT FROM BUYING OR SHORTING IBM STOCK
Market price on 8 May 2009: $101.49
Assumption: Position liquidated on 17 July 2009
1 no dividends paid in interim
2 IBM stock price, 8 May 2009 101.49
3
ST : Market price
Stock buyer's Stock shorter's
of IBM
4 17 July 2009
profit profit Profit/Loss from Buying or Shorting IBM
5 0 -101.49 101.49 stock
110
6 50 -51.49 51.49
90
7 60 -41.49 41.49
70
8 90 -11.49 11.49
50

Profit/Loss
9 100 -1.49 1.49
30
10 110 8.51 -8.51
10
11 130 28.51 -28.51
-10
12 140 38.51 -38.51
13 150 48.51 -48.51 -30 0 50 100 150 200

14 160 58.51 -58.51 -50

Stock buyer's profit
15 170 68.51 -68.51 -70
16 180 78.51 -78.51 -90 Stock shorter's profit
17 190 88.51 -88.51 -110
x-axis: ST, IBM's stock price on 17Jul09
18
19

SHORT-SELLING

A long position in a stock involves buying the stock on a particular date and possibly selling the
stock on a later date. When you have a long position in a stock, you can choose to hold on to the
stock forever (in this case you will collect the dividends that the stock pays).
A short position in a stock involves selling borrowed stock on a particular date and buying
the stock on a later date to give the shares back to the stock lender. Buying the stock to return
the shares to the lender is called closing out the short position. When you have a short position
in a stock you must close out the position at some future date.
The profits from short and a long position in a stock are diametrically opposite. When
you take a long position in a stock, you will profit if the stock price goes up. When you take a
short position in a stock, you profit if the stock price goes down. To see this, suppose that on
31 October 2010, you borrow 100 shares of DipseyDoodle (DD) stock. DD is currently selling
for $100 and you anticipate that the share price will drop. Having borrowed the shares, you sell
them for $10,000 (100 shares times the current price of $100). One month later, DD stock is sell-
ing for $80 a share, and you close out your short position: You purchase 100 shares of DD stock
for $8,000 and return the shares to the lender. Your short-selling bet on DD stock’s decline has
paid off, and you’ve made $2,000. (Of course, if DD had gone up, you would have lost money.)
Good articles describing short sales can be found at the following Web sites:
• Motley Fool: http://www.fool.com/FoolFAQ/FoolFAQ0033.htm
• “Short (finance):” http://en.wikipedia.org/wiki/Short_(finance)

20.6. Option Strategies—More Complicated Reasons to Buy Options

In the previous section we studied the profit and loss from buying and selling calls, puts, and
shares. In this and the following two sections we look at the profit involved in more complicated
option strategies. “Option strategy” refers to the profits that result from holding a combination
of options, shares, and bonds.
606 PART FIVE OPTIONS AND OPTION VALUATION

A Simple Option Strategy: Buy a Stock and Buy a Put

We begin with a very simple (but useful) strategy: Suppose we decide, on 8 May 2009, to pur-
chase one share of IBM stock and to purchase a July put on the stock with exercise price $100
and expiration date July. The total cost of this strategy is $106.69: $101.49 for the share of IBM
and $5.20 for each put.
Such a strategy effectively insures your stock returns by guaranteeing that on 17 July you
will have at least $100 in hand. Your worst-case net profit will be a loss of $6.69.
Stock Strategy Cash in Net profit
price on 17 hand
July
2009
Less Exercise put option and $100 $100 – ($101.49 + $5.20) =
than $100 sell your share of IBM –$6.69
for $100.
More Let the put option expire IBM stock price ST – ($101.49 + $5.20) =
than $100 (don’t use it) on 17 July, ST ST – $106.69
In a spreadsheet, here’s the way this strategy looks.
A B C D E F
1 STOCK + PUT: OPTION STRATEGY PROFITS
2 Stock price, 8 May 2009 101.49
3 Cost of put option 5.20
4 Put exercise price, X 100.00
5
Market price of IBM Exercise Profit/loss Profit/loss Total
6 17 July 2009 the put on the put on the stock profit/loss
7 0 yes 94.80 -101.49 -6.69 <-- =C7+D7
8 15 yes 79.80 -86.49 -6.69
9 30 yes 64.80 -71.49 -6.69
10 45 yes 49.80 -56.49 -6.69
11 60 yes 34.80 -41.49 -6.69
12 75 yes 19.80 -26.49 -6.69
13 90 yes 4.80 -11.49 -6.69
14 100 no -5.20 -1.49 -6.69
15 120 no -5.20 18.51 13.31
16 135 no -5.20 33.51 28.31
17 150 no -5.20 48.51 43.31
18 165 no -5.20 63.51 58.31
19 180 no -5.20 78.51 73.31
20
21 Formula in cell D7:
Formula in cell C7:
22 =A7-$B$2
=MAX($B$4-A7,0)-$B$3
23
24
25 110
26 90
27
28 70
29 50
30 30
31
32 10
33 ?10
34 0 50 100 150 200
?30 Profit/loss
35
?50 on the put
36
37 ?70 Profit/loss
38 on the stock
?90
39 Total profit/loss
40 ?110
41
 CHAPTER 20 Introduction to Options 607

Buying a stock or a portfolio and buying a put on the stock or portfolio is often called a
portfolio insurance strategy. Portfolio insurance strategies are very popular among investors.
They guarantee a minimum return on the investment in the shares (at an extra cost, of course:
you have to buy the puts).

ANTICIPATING A BIT—PUT-CALL PARITY

You’ll note that the graph of the stock + put strategy looks a lot like the graph of a call
(Section 20.2). This may lead you to surmise that the payoffs of the combination stock + put
is somehow equivalent to the payoffs of a call. However, this isn’t quite true, as you’ll see in
the next chapter. There we discuss the put–call parity theorem and show that—for a put and
call written on the same stock, with the same expiration date, and having the same exercise
price X,
stock + put = call + PV(X)

A More Complicated Strategy: Stock + Two Puts

Suppose you purchased one share of stock and bought two puts, each costing $5.20 and each
having an exercise price of $100. Here’s what your payoff pattern would look like.
Stock Strategy Cash in Net profit
price on 17 hand,
July 17 July
ST < $100 Exercise both put 2*100 – ST 2*100 –ST – ($101.49 +
options. Give someone $10.40)=
else your share of IBM $108.91 –ST
for $100. Buy an
additional share in the
market for ST and sell it
to the put writer for ST .
More than Let the put options IBM stock price ST – ($101.49 + $10.40)=
$100 expire (don’t use them) on 17 July, ST ST – $110.89

If we make an Excel table, here’s what it looks like.

608 PART FIVE OPTIONS AND OPTION VALUATION

A B C D E F
1 STOCK + 2 PUTS: OPTION STRATEGY PROFITS
2 Stock price, 8 May 2009 101.49
3 Cost of put option 5.20
4 Put exercise price, X 100.00
5
Market price of IBM Exercise Profit/loss Profit/loss Total
6 17 July 2009 the put on the puts on the stock profit/loss
7 0 yes 189.60 -101.49 88.11 <-- =C7+D7
8 15 yes 159.60 -86.49 73.11
9 30 yes 129.60 -71.49 58.11
10 45 yes 99.60 -56.49 43.11
11 60 yes 69.60 -41.49 28.11
12 75 yes 39.60 -26.49 13.11
13 90 yes 9.60 -11.49 -1.89
14 100 no -10.40 -1.49 -11.89
15 120 no -10.40 18.51 8.11
16 135 no -10.40 33.51 23.11
17 150 no -10.40 48.51 38.11
18 165 no -10.40 63.51 53.11
19 180 no -10.40 78.51 68.11
20
21 Formula in cell D7:
Formula in cell C7:
22 =A7-$B$2
=2*(MAX($B$4-A7,0)-$B$3)
23
24
25 100
26
Stock + 2 Puts
27 80
28
29
60
30
31
Profit

32 40
33
34 20
35
36 0
37
38 0 50 100 150 200
-20
39 IBM stock price, 17 July 2009
40
41

Comparing Strategies
What’s better as a strategy: buying a share of IBM and buying one put or buying a share of IBM
and buying two puts? Look at the graphs of the two strategies.
 CHAPTER 20 Introduction to Options 609

A B C D E F G H I J
STOCK + PUT COMPARED TO
1 STOCK + 2 PUTS 100.00
2 Stock price, 8 May 2009 101.49
3 Cost of put option 5.20
4 Put exercise price, X 100.00 80.00
5 Stock + Put
Market price of IBM
Stock + Put Stock + 2 Puts 60.00 Stock + 2 Puts
6 17 July 2009
7 0 -6.69 88.11
8 15 -6.69 73.11
40.00
9 30 -6.69 58.11
10 45 -6.69 43.11
11 60 -6.69 28.11
20.00
12 75 -6.69 13.11
13 94.80 -6.69 -6.69
14 100 -6.69 -11.89
0.00
15 120 13.31 8.11
16 135 28.31 23.11 0 50 100 150 200
17 150 43.31 38.11
-20.00
18 165 58.31 53.11
19 180 73.31 68.11
20
21
Formula in cell B7:
22 Formula in cell C7:
=A7-$B$2+MAX($B$4-A7,0)-$B$3
23 =A7-$B$2+2*(MAX($B$4-A7,0)-
24 $B$3)

The choice between the two strategies involves trade-offs (that’s the nature of market efficiency:
in an efficient market no asset ever completely dominates another asset).
• The stock + put strategy has higher profit when the IBM July stock price > 94.80, but it
has a lower profit for IBM ST < 94.80.
• The stock + two put strategy costs more (you can see this by noting that its payoff when
ST = 100 is less than that of the stock + put strategy). On the other hand, it has positive
profits both for very low and for high ST .
Which strategy should you choose? It depends on your prediction of the future: If you think
that IBM is going to make a big move, up or down, then stock + two puts is for you, because this
strategy makes profits on “big moves” of the stock price (whether up or down). If you think, on
the other hand, that IBM might go up, but you want protection when and if its price goes down
(that is, no bets for you), then stock + put is your choice.

Another Strategy: One Share of Stock + One,

Two, Three, or Four Puts
There’s almost nothing to say here, except to show you the graphs.
610 PART FIVE OPTIONS AND OPTION VALUATION

A B C D E F G H
1 STOCK + SEVERAL PUTS PUT: OPTION STRATEGY PROFITS
2 Stock price, 8 May 2009 101.49
3 Cost of put option 5.20
4 Put exercise price, X 100.00
5
Market price of IBM Exercise Profit/loss Profit/loss Total profit: Total profit: Total profit: Total profit:
6 17 July 2009 the put on single put on the stock 1 put 2 puts 3 puts 4 puts
7 0 yes 94.8 -101.49 -6.69 88.11 182.91 277.71
8 15 yes 79.8 -86.49 -6.69 73.11 152.91 232.71
9 30 yes 64.8 -71.49 -6.69 58.11 122.91 187.71
10 45 yes 49.8 -56.49 -6.69 43.11 92.91 142.71
11 60 yes 34.8 -41.49 -6.69 28.11 62.91 97.71
12 75 yes 19.8 -26.49 -6.69 13.11 32.91 52.71
13 90 yes 4.8 -11.49 -6.69 -1.89 2.91 7.71
14 100 no -5.2 -1.49 -6.69 -11.89 -17.09 -22.29
15 120 no -5.2 18.51 13.31 8.11 2.91 -2.29
16 135 no -5.2 33.51 28.31 23.11 17.91 12.71
17 150 no -5.2 48.51 43.31 38.11 32.91 27.71
18 165 no -5.2 63.51 58.31 53.11 47.91 42.71
19 180 no -5.2 78.51 73.31 68.11 62.91 57.71
20
300
21
22
23 250
24 Total profit:
25 200 1put
26
Total profit:
27 150
2 puts
28
29 Total profit:
100
30 3 puts
31
50 Total profit:
32
4 puts
33
34 0
35 0 50 100 150 200
36 -50
37

20.7. Another Option Strategy: Spread

A spread strategy involves buying one option on a stock and writing another option. In the
example below on 8 May 2009,
• We buy one X = 80 July call on IBM. This option costs $20.99.
• We write one X = 110 July call on IBM. This option costs 2.24; because we’re writing the
option, this is income on 8 May.
In the following spreadsheet we examine this strategy’s payoffs and graph them.
 CHAPTER 20 Introduction to Options 611

A B C D E F
BULL SPREAD: A MODERATE BET ON
1 STOCK PRICE INCREASE
2 Cost of July, X=80 call 20.99
3 Number of X=80 calls purchased 1
4
5 Cost of July X=110 call 2.24
6 Number of X=80 calls purchased -1
7
Exercise Profit/loss Exercise Profit/loss
Market price of IBM Total
X=80 on X=80 X=110 on X=110
17 July 2009 written call profit
8 call? bought call call?
9 0 no -20.99 no 2.24 -18.75
10 15 no -20.99 no 2.24 -18.75
11 30 no -20.99 no 2.24 -18.75
12 45 no -20.99 no 2.24 -18.75
13 60 no -20.99 no 2.24 -18.75
14 80 no -20.99 no 2.24 -18.75
15 90 yes -10.99 no 2.24 -8.75
16 100 yes -0.99 no 2.24 1.25
17 110 yes 9.01 no 2.24 11.25
18 120 yes 19.01 yes -7.76 11.25
19 150 yes 49.01 yes -37.76 11.25
20 165 yes 64.01 yes -52.76 11.25
21 180 yes 79.01 yes -67.76 11.25
22
23 15.00
24
25 10.00
26
27 5.00
28
29 0.00
30 0 20 40 60 80 100 120 140 160 180
31 -5.00
32
-10.00
33
34 -15.00
35
36 -20.00
37
38 -25.00
39

There’s another way to think about the strategy profits: On 17 July 2009 (the option expira-
tion date) we will have
−20.99 + Max [SIBM ,17Jul 09 − 80,0 ]+ 2.24 − Max [SIBM ,17Jul 09 − 110,0 ]
!"""""""""#"""""""""$ !""""""""""#""""""""""$
↑ ↑
This is the option payoff on 17Jul09 Writing an option means
from buying a call with X = $80 taking a loss if IBM's stock
!""""""""""""""#""""""""""""""$ price > $110
↑ !"""""""""""""#"""""""""""""$
This is the profit from buying ↑
the X = $80 option This is the profit from writing the X = $110 option

⎧ 0 SIBM ,17Jul 09 < 80

⎪
= −18.75 + ⎨SIBM ,17Jul 09 − 80 80 ≤ SIBM ,17Jul 09 ≤ 110
⎪ 30 SIBM ,17Jul 09 > 110
⎩
612 PART FIVE OPTIONS AND OPTION VALUATION

In this case the spread is a not-too-risky bet on the stock price going up. If it goes up, you
profit (moderately); if the stock price goes down, your loss is limited to $18.75. This kind of a
spread is called a bull spread—you’re bullish on the stock (meaning that you think the stock
price will go up).
Here’s a bear spread: In this case we write the X = 80 call and buy the X = 110 call. As you
can see from the graph below, the bear spread is a bet that the stock price will decline.
A B C D E F
BEAR SPREAD: A MODERATE BET ON
1 STOCK PRICE DECREASE
2 Cost of July, X=80 call 20.99
3 Number of X=80 calls purchased -1
4
5 Cost of July X=110 call 2.24
6 Number of X=80 calls purchased 1
7
Exercise Profit/loss Exercise Profit/loss
Market price of IBM Total
X=80 on X=80 X=110 on X=110
17 July 2009 profit
8 call? bought call call? written call
9 0 no 20.99 no -2.24 18.75
10 15 no 20.99 no -2.24 18.75
11 30 no 20.99 no -2.24 18.75
12 45 no 20.99 no -2.24 18.75
13 60 no 20.99 no -2.24 18.75
14 80 no 20.99 no -2.24 18.75
15 90 yes 10.99 no -2.24 8.75
16 100 yes 0.99 no -2.24 -1.25
17 110 yes -9.01 no -2.24 -11.25
18 120 yes -19.01 yes 7.76 -11.25
19 150 yes -49.01 yes 37.76 -11.25
20 165 yes -64.01 yes 52.76 -11.25
21 180 yes -79.01 yes 67.76 -11.25
22
23 25.00
24
25 20.00
26
27 15.00
28
29 10.00
30
31 5.00
32
0.00
33
34 0 20 40 60 80 100 120 140 160 180
-5.00
35
36 -10.00
37
38 -15.00
39

20.8. The Butterfly Option Strategy

The last option strategy we consider in this chapter is a butterfly, the combination of three
options. In the butterfly illustrated below,
• We buy one IBM, July X = 80, call for $20.99.
 CHAPTER 20 Introduction to Options 613

• We write two IBM, July X = 100, calls for $6.40 each.

• We buy one IBM, July X = 120, call for $0.52.
• Here’s the resulting profit pattern.
A B C D E F G H I J K L

GRAPHING THE PROFIT FROM A BUTTERFLY IN IBM OPTIONS

Strategy: Buy 1 July 80 Call,
Write 2 July 100 Calls, Buy 1 July 120 Call
1
2 Call prices
3 X Price
4 80 20.99
5 100 6.40
6 120 0.52
7
Payoff on Payoff on Payoff on
July IBM Total
July X=80 July X=100 July X=120
stock price profit
8 call call call
9 0 -20.99 12.8 -0.52 -8.71
10 10 -20.99 12.8 -0.52 -8.71 Butterfly Profit Pattern
11 20 -20.99 12.8 -0.52 -8.71
12 30 -20.99 12.8 -0.52 -8.71
1X=80 Call Bought, 2 X=100 Calls Written,
13 40 -20.99 12.8 -0.52 -8.71 1X=120 Call Bought
12
14 50 -20.99 12.8 -0.52 -8.71
15 80 -20.99 12.8 -0.52 -8.71 9
16 85 -15.99 12.8 -0.52 -3.71
17 90 -10.99 12.8 -0.52 1.29 6

Total profit
18 95 -5.99 12.8 -0.52 6.29
3
19 100 -0.99 12.8 -0.52 11.29
20 105 4.01 2.8 -0.52 6.29 0
21 110 9.01 -7.2 -0.52 1.29
22 115 14.01 -17.2 -0.52 -3.71 -3 0 25 50 75 100 125 150 175 200

23 120 19.01 -27.2 -0.52 -8.71 -6

24 150 49.01 -87.2 29.48 -8.71
25 160 59.01 -107.2 39.48 -8.71 -9
26 200 99.01 -187.2 79.48 -8.71 IBM stock price, July 2009
27

Why buy a butterfly? Looking at the graph, you can see that it’s a bet on the stock price not
moving very much. If IBM’s July stock price is close to $100, we’ll make money from our but-
terfly. If it deviates (up or down) by a lot, we’ll lose money, but only moderately.
Of course, if we reverse the option positions in the butterfly, we’ll get a bet on the stock
price moving a lot (big movements either up or down will lead to profits; small movements in
the stock price will lead to losses).

A B C D E F G H I J K L

THE OPPOSITE BUTTERLY—A BET ON LARGE STOCK PRICE MOVEMENTS

Strategy: Write 1 July 80 Call,
Buy 2 July 100 Calls, Write 1 July 120 Call
1
2 Call prices
3 X Price
4 80 20.99
5 100 6.40
6 120 0.52
7
Payoff on Payoff on Payoff on
July IBM Total
July X=80 July X=100 July X=120
stock price profit
8 call call call
9 0 20.99 -12.8 0.52 8.71
10 10 20.99 -12.8 0.52 8.71 Butterfly Profit Pattern
11 20 20.99 -12.8 0.52 8.71 1X=80 Call Written, 2 X=100 Calls Bought,
12 30 20.99 -12.8 0.52 8.71
13 40 20.99 -12.8 0.52 8.71
1X=120 Call Written
9
14 50 20.99 -12.8 0.52 8.71
15 80 20.99 -12.8 0.52 8.71 6
16 85 15.99 -12.8 0.52 3.71
17 90 10.99 -12.8 0.52 -1.29 3
Total profit

18 95 5.99 -12.8 0.52 -6.29

0
19 100 0.99 -12.8 0.52 -11.29
20 105 -4.01 -2.8 0.52 -6.29 -3 0 25 50 75 100 125 150 175 200
21 110 -9.01 7.2 0.52 -1.29
22 115 -14.01 17.2 0.52 3.71 -6
23 120 -19.01 27.2 0.52 8.71 -9
24 150 -49.01 87.2 -29.48 8.71
25 160 -59.01 107.2 -39.48 8.71 -12
IBM stock price, July
2009
26 200 -99.01 187.2 -79.48 8.71
27
614 PART FIVE OPTIONS AND OPTION VALUATION

Summary
Stock options are securities that make it possible to bet on an increase in the stock price (calls)
or a decrease in the price (puts). In this chapter we’ve looked at the basics of option markets.
We’ve discussed definitions (calls, puts, American versus European options) and profit patterns
of both individual options and combinations of options.
In the next chapter we discuss some facts about stock option prices.

EXERCISES
Note: Templates for many of these problems are on the CD-ROM that comes with this book.
1. On 8 August 2009 Kellogg’s stock closed at $52. For $2.90 you can buy a call option on Kellogg’s
with an exercise price of $45. The option expires 18 December 2009.
a. What right does this call option give you?
b. Suppose you buy the call option and hold it until the expiration date. If the price of Kellogg’s on
18 December 2009 is $52, will you exercise the option? What will be your profit?
c. If the price of Kellogg on 18 December 2009 is $38, will you exercise the option? What will
be your profit?
2. It is mid-July 2008. Intel stock is currently trading at $30, and you think that the price of the stock
will go down by 22 October 2008. For $3 you can buy a put on Intel stock that expires in October
and has an exercise price of $25.
a. What right does this put option give you?
b. What happens if the stock does not go below $25 by the time your option expires?
c. Suppose you buy the option and hold it until the expiration date. If the price of Intel on 22
October 2008 is $20, what will be your profit from the option? What if the price is $38?
3. It is 18 July 2009 and you’ve just bought one call option on ForeverYours stock. The option cost
you $6, expires on 18 September 2009, and has an exercise price of $20.
a. Complete the following Excel table.
b. Make a graph that shows the profit (column C) on the y-axis and the stock price on 18 September
2009 (column A) on the x-axis.

A B C
ForeverYours Exercise
stock price, the call Profit
1 18 Sep 09—ST option?
2 0
3 5
4 10
5 15
6 20
7 25
8 30
9 35
10 40
11 45
12 50

4. It is 18 July 2009 and you’ve just bought one put option on ItStinks stock. The option cost you $3,
expires on 13 March 2008, and has an exercise price of $35.
 CHAPTER 20 Introduction to Options 615

a. Complete the following Excel table.

b. Make a graph that shows the profit (column C) on the y-axis and the stock price on 13 March
2008 (column A) on the x-axis.
A B C
ItStinks Exercise
stock price, the put
1 13 Mar 08—ST option? Profit
2 0
3 5
4 10
5 15
6 20
7 25
8 30
9 35
10 40
11 45
12 50

5.

a. On 28 August 2009 Ford’s stock price was $7.73 per share. Call options on Ford expiring on 18
September 2009 with an exercise price of $6.00 sold for $1.74. Should a call with an exercise
price of $6.00 expiring on 15 January 2009 sell for more than $1.74? Explain.
b. Look at the following table. Is there an option that is clearly mispriced?

Ford Call Options

Expiring 15 Jan10
Exercise Call option
Price X Price
2.50 5.20
5.00 3.90
7.50 2.90
10.00 2.16
12.50 1.20
15.00 1.30
17.50 0.39
20.00 0.26
22.50 0.16
25.00 0.05

6.

a. On 1 September 2009 the stock price of Toyota Motor Corp. (TM) was $85.80 per share. Put
options on TM expiring on 18 September 2009 with an exercise price of $80 sold for $0.55.
Should a put with an exercise price of $80 expiring on the 15 January 2010 sell for more than
$0.55? Explain.
b. Look at the following table. Is there an option that is clearly mispriced?
616 PART FIVE OPTIONS AND OPTION VALUATION

TM Put Options
Expiring 15 Jan
2010
Exercise Put option
price X price
50.00 0.20
55.00 0.30
60.00 0.65
65.00 1.05
70.00 1.60
75.00 2.70
80.00 4.20
85.00 6.30
90.00 8.20
95.00 8.00
100.00 16.20
105.00 21.20
110.00 24.65

7. The price of IBM stock on 1 June 2009 was $108.00.

a. If you purchased the stock on 1 June and sold it on 1 September 2009 for $117.10, what would
have been your profit?
b. If you shorted IBM stock on 1 June and closed out your short position on 1 September 2009,
what would have been your profit?

8. It is 15 December 2006, and John is considering buying 100 shares of GoodLuck stock (the stock
price is currently $40 per share). On the same date, Mary is considering shorting 100 shares of
GoodLuck stock. If both John and Mary intend to close out their positions on 1 April 2007, fill in
the following table and graph their profits.

A B C
GoodLuck stock
1 price, 15 Dec 06 $ 40.00
2
Mary's profit
GoodLuck stock John's profit from
from shorting
price on 1 Apr 07 buying 100 shares
3 100 shares
4 $0.00
5 $10.00
6 $20.00
7 $30.00
8 $40.00
9 $50.00
10 $60.00
11 $70.00
12 $80.00
13 $90.00
14 $100.00
 CHAPTER 20 Introduction to Options 617

9. You’ve decided to add 100 shares of ABC Corp. to your portfolio. ABC stock is currently trading at
$50 a share. As an alternative to buying the shares now, you’re considering buying 1,000 call options
on ABC. Each option has an exercise price of $50 and expires in 3 months. The options cost $5 each.
a. Compare the two strategies by filling in the following table and graphing the percentage profits
of each strategy against the stock price ST in 3 months.
b. Which strategy is riskier?

A B C D E
Investment today in
1 buying 100 shares $ 5,000
Investment today in
buying 1,000 call
2 options $ 5,000
3
Dollar profit Dollar profit from Percentage profit Percentage profit
ABC stock price in 3
from buying 100 buying 1,000 call from buying 100 from buying 1,000
months, ST
4 shares options now shares call options now
5 0
6 10
7 20
8 30
9 40
10 50
11 60
12 70
13 80
14 90
15 100

10. On 1 August 2009 Microsoft (MSFT) stock is trading at $24.4 per share. The price of a call option
on MSFT expiring April 2010 is $2.71 for options with X = $24 and $1.15 for options with X = $27.
a. You think that shares of MSFT will rise in price in the future, and you want to speculate in the
stock. Compare (graphically) the following two alternatives: purchasing 1,000 MSFT options
with an exercise price of $24 versus purchasing 1,000 MSFT options with a strike of $27.
b. Compare the two strategies. Which is preferable?

Use the following template.

618 PART FIVE OPTIONS AND OPTION VALUATION

A B C
Exercise
1 price Call price
2 24 2.71
3 27 1.15
4
5 Investment
6 A: 1000 options, X=24 2,710 <-- =B2*1000
7 B: 1000 options, X=27 1,150 <-- =B3*1000
8
Percentage Percentage
Stock price on the
profit on profit on
expiring date, ST
9 strategy A strategy B
10 0.0
11 10.0
12 20.0
13 22.0
14 24.0
15 26.0
16 27.0
17 28.0
18 30.0
19 35.0
20 40.0
21 45.0
22 50.0
23 55.0
24 60.0

11. On 25 September 2009 McDonald’s (MCD) stock is trading at $57 per share. The price of a put
option on MCD expiring 9 October 2009 is $0.30 for options with X = $55 and $1.10 for options
with X = $57.5.
a. You think that shares of MCD will fall in price in the immediate future, and you want to spec-
ulate on the stock. Compare (graphically) the following two alternatives: purchasing 1,000
MCD options with an exercise price of $55 versus purchasing 1,000 MCD put options with a
strike of $57.50.
b. Compare the two strategies. Which is preferable?
Use the following template.
 CHAPTER 20 Introduction to Options 619

A B C
Exercise
1 price Put price
2 55 0.3
3 57.5 1.1
4
5 Investment
6 A: 1000 options, X=55 300 <-- =B2*1000
7 B: 1000 options, X=57.50 1100 <-- =B3*1000
8
Percentage Percentage
Stock price in
profit on profit on
3 months, ST
9 strategy A strategy B
10 0.0
11 20.0
12 40.0
13 45.0
14 50.0
15 55.0
16 56.0
17 56.5
18 57.0
19 57.5
20 58.0
21 59.0
22 60.0
23 65.0
24 70.0

12. A put option written on ENERGY-R-US Corp.’s stock is selling for $2.50. The option has an exer-
cise price of $20 and 6 months to expiration. The current market price for a share of ENERGY-
R-US is $26. Determine the profit from a strategy of buying the stock and buying the put; graph
these profits. Use the following template.

A B C D
1 Energy-R-Us, stock 26.00
2 Put price, X = 20 2.50
3
Profit
Stock price, ST Profit
from Total profit
in 6 months from put
4 stock
5 0
6 5
7 10
8 15
9 20
10 25
11 30
12 35
13 40
14 45
15 50
620 PART FIVE OPTIONS AND OPTION VALUATION

13. Using the data from the previous problem, compare the following three strategies:
• Purchase one share of stock and one put on the stock.
• Purchase one share of stock and two puts on the stock.
• Purchase of one share of stock and three puts on the stock.
14. Using the data and the template below, suppose you bought a Toyota Motors call with exercise
(strike) price X = 50 and wrote a TM call with exercise price X = 45. Graph the profit of this
strategy at option expiration. Why might this be an attractive strategy?

A B C D
1 Call Prices
2 X Price
3 45 4.10
4 50 1.65
5
TM stock price, ST Profit on Profit on
Total
at option X=45 call X=50 call
profit
expiration (written) (bought)
6
7 20
8 25
9 30
10 35
11 40
12 45
13 50
14 55
15 60
16 65

15. Using the data from the previous problem, compute and graph the profit from a strategy in which
you buy a TM call with exercise price X = 45 and write a call with exercise price X = 50. Explain
why this strategy might be attractive.
16. The following options are traded on WOW Corp.’s stock. State the property of option prices that
is violated and show that you can design a strategy to profit from this mispricing.4

Option Exercise Expiration Price

Price Date
Call 40 1-Jan-11 $13.50
Call 40 1-Jan-11 $12.95

17. The following options are traded on Smow Corp.’s stock. State which property of option prices is
violated and show that you can design a strategy to profit from this mispricing.

Exercise Expiration
Option Price Date Price
Put 50 1-Mar-12 $4.25
Put 60 1-Mar-12 $4.00

18. David wants to buy a call option written on RAIDER Corp. stock. Patrick is willing to sell David
a call option on RAIDER Corp. stock with an exercise price of $50 for $8.20. The option will
mature in exactly 1 year. The current market price for RAIDER Corp. stock is $50.

4
Such a strategy is called an arbitrage strategy and is discussed at length in the next chapter.
 CHAPTER 20 Introduction to Options 621

a. Determine and graph the payoffs of both David and Patrick’s respective positions.
b. For what stock price ST is the profit of both David and Patrick zero?
19. Portfolio insurance describes a position in which an investor buys put options to insure that the
value of his portfolio does not fall below a certain point. Suppose Jerry has a portfolio that con-
sists of 100 shares of RTY stock. The current market price of RTY is $35 per share. The following
options are also being traded on RTY stock.
Call price 8.20

RAIDER stock
price Patrick's David's
at option profit profit
expiration, ST
0
10
20
30
40
50
60
70
80
90
100

a. What options must Jerry buy if he wants to insure that the value of his portfolio will not drop
below $2,000?
b. How much will this cost?
Exercise Call Put
Expiration date price price price
1-Jun-13 20 18.00 0.10
1-Jun-13 25 11.35 0.45
1-Jun-13 35 3.50 3.20
1-Jun-13 40 0.75 5.65

20. A covered call position entails entering into a long position in stock and writing a call option with
a high strike price. The purpose of such a position is to finance a portion of the stock purchase
from the sale of the call option.
Sam thinks that STF Corp. stock, currently priced at $80/share, will go up in price by about $15
in the next 6 months. He would like to buy 10,000 shares of STF today and cash in on his bullish
sentiment. To cut the initial costs of his purchase, he would like to enter into a covered call posi-
tion. The following options are traded on STF Corp.
Suppose Sam writes 10,000 of the $90 calls. Show Sam’s profit. Use the following template.

Expiration Exercise Call

date price price
1-Aug-11 70.00 18.95
1-Aug-11 80.00 7.65
1-Aug-11 90.00 2.70
1-Aug-11 100.00 0.50

21. Answer the following questions by referring to the facts in the previous problem.
622 PART FIVE OPTIONS AND OPTION VALUATION

STF stock price 80.00

Number of shares purchased 10,000.00

Profit from option

Profit from position, 10,000 Profit from
Stock price of STF in 6 stock options with X = covered call
months, ST position $90 strategy
50
60
70
80
90
100
110
120

a. Compare the profits from a covered call strategy using the $90 calls with one using the $100
calls.
b. Which of the two covered call strategies would you recommend?
22. Given the three calls below, design a butterfly strategy that pays off if the stock does not make a
major move from its current value of $60. Graph the strategy profits. Use the following template.

Call prices
X Price
50 22.00
60 15.00
70 10.00

Payoff and profits

Stock price
at option Payoff on Payoff on Payoff on
expiration, ST X = 50 call X = 60 call X = 70 call Total profit
30.0
35.0
40.0
45.0
50.0
52.5
55.0
57.5
60.0
62.5
65.0
67.5
70.0
72.5
75.0
80.0
85.0
90.0

23. Given the data from the previous problem, design a butterfly strategy that pays off if the stock
price makes a large move from its current price of $60. Graph the strategy profits.
CHAP TER

21 Option Pricing Facts

CHAPTER CONTENTS
Overview 623
21.1. Fact 1: Call Price of an Option, C0 > Max[S 0 – PV(X),0] 625
21.2. Fact 2: It’s Never Worthwhile to Exercise a Call Early 628
21.3. Fact 3: Put–Call Parity, P0 = C0 + PV(X) – S 0 629
21.4. Fact 4: Bound on an American Put Option Price: P0 > Max[X – S 0,0] 632
21.5. Fact 5: Bounds on European Put Option Prices: P0 > Max[PV(X) – S0,0] 632
21.6. Fact 6: You Might Find It Optimal to Early Exercise an American Put on
a Nondividend Paying Stock 633
21.7. Fact 7: Option Prices Are Convex (Somewhat Advanced) 633
Summary 637
Exercises 637

Overview
In Chapter 20 we discussed basic option concepts: definitions of a call and a put, the reasons
why you might want to buy or sell an option, and the profits resulting from various options
strategies. In this chapter we discuss some basic facts about option pricing. Our emphasis is on
a set of propositions known as arbitrage restrictions on option prices. These restrictions specify
relations between the prices of puts and calls and the prices of either the stock underlying the
options or a risk-free asset.

623
624 PART FIVE OPTIONS AND OPTION VALUATION

By understanding the option pricing restrictions in this chapter, you can often easily judge
whether an option is mispriced. Here’s an example: Suppose you’re considering buying a call
option on Exxon stock, which is currently selling for S 0 = $69 a share. Suppose the option
expires in 1 year and has exercise price X = $60. The interest rate is r = 5%. The option is
priced at C 0 = $10. Is it a good buy or not? Our first option pricing fact (Section 21.1) will enable
you to say that the option is underpriced and that it is definitely a good buy. As you will see in
Section 21.1, the price of the option should be at least $11.86.

NOTATION

Throughout the chapter we use the following notation:

S = The price of the stock. When we want to be precise about the price of the stock on a specific
date, we will sometimes write S 0 for the price of the stock today (time 0) and ST for the price
of the stock on the option exercise date T.
X = The option exercise price
r = The interest rate
C = The call option price. When we want to be precise about the call price on a specific date, we
will sometimes write C0 for the price of the stock today (time 0) and CT for the price of the stock
on the option exercise date T. Occasionally we will even use the full word, writing Call0.
P = The put option price. When we want to be precise about the call price on a specific date,
we will sometimes write P0 for the price of the stock today (time 0) and PT for the price of the
stock on the option exercise date T. Occasionally we will even use the full word, writing Put0.

Dividends: Throughout the chapter we assume that the stock on which the options are
written does not pay dividends before the option maturity date.1 This is not an overly restrictive
assumption: Stocks that pay dividends tend to do so at regular intervals (quarterly, semiannu-
ally, or annually). Holders of options on these stocks are thus reasonably sure when the stocks
will pay dividends. There are thus long periods of time when market participants can be assured
that a stock will not pay a dividend.
For example, Exxon pays a regular quarterly dividend in February, May, August, and
November. An investor who purchases an option on Exxon in March with an April maturity
knows that in the intervening period no dividends will be paid on the stock.
Many other stocks have never paid a dividend and investors in these stocks’ options can be
reasonably assured that the dividend pricing restriction imposed in this chapter is not restrictive.
Stocks that fall into this category include many of the high-tech stocks whose options tend to
attract the most investor interest.

Finance Concepts Discussed in This Chapter

• Option pricing restrictions
• No early exercise of calls
• Put–call parity
• Early exercise of American puts
• Option price convexity

1
The one exception is Section 21.6, where we briefly discuss the effect of dividends.
 CHAPTER 21 Option Pricing Facts 625

Excel Functions Used

• Max
• Sum
• If

21.1. Fact 1: Call Price of an Option, C0 > Max[S0 – PV(X),0]

It’s 18 May 2009, and you’re considering buying a call option on Exxon (stock symbol XOM).
Currently the XOM share itself is selling for S 0 = $69; you want to buy a call on XOM with an
exercise price X = $60 and with time to maturity T = 1 year. Furthermore, we’ll suppose that the
option is an American call option and can be exercised at any time on or before T.
We will examine Fact 1 in two stages. We start with a “dumb fact,” something that is obvi-
ous once we say it, and then proceed to demonstrate Fact 1 for you.

Dumb Fact: For an American Call, Call price, C0 ≥ Max[S0 – X,0].

Now it’s probably clear to you that the Exxon option should be selling for at least
$9 = S 0 – X = $69 – $60. To see this, suppose that the option is selling for $2. We’ll devise an
arbitrage strategy—a strategy that will make us money risklessly.

Arbitrage strategy to profit from call price C0 = $2 when stock

price is S0 = $69 and X = $60
Cash flow (negative numbers
Action taken today indicate costs)

Buy the option for price Co –$2

Immediately exercise the option, buying –$60
the stock for price S 0
Immediately sell the stock on the open +$69
market
Arbitrage profit +$7

So the “dumb fact”—that an American call option should sell for more than the difference
between the stock price and the exercise price—is pretty obvious.

DEFINITION: ARBITRAGE STRATEGY

An arbitrage strategy is a combination of assets—usually short or long positions in the stock,

calls and puts on the stock, and a risk-free security—which produces nonnegative cash flows at
all points in time. If you can design an arbitrage strategy for a given set of asset prices (as we do
below), it shows that at least one of the prices is wrong.
626 PART FIVE OPTIONS AND OPTION VALUATION

Smart Fact: Call price, C0 > Max[S0 – PV(X),0]

This is a lot less obvious than the previous fact. It’s also a lot more powerful.2 The dumb fact
above says that the option should sell for at least $9. As the spreadsheet below shows, the smart
fact says much more; for example, if the interest rate is 9%, then the smart fact says that the
option should sell for at least $11.86.

A B C
1 FACT 1: Lower bound on call price
2 Exxon stock price, 17 May 2009, S0 69
3 Option exercise price, X 60
4 Option exercise time, T (in years) 1
5 Interest rate, r 5%
6
7 Lower bound on call price
8 Dumb fact, call price, C0 > Max[S0 - X,0] 9 <-- =MAX(B2-B3,0)
9 Fact 1: call price, C0 > Max[S0 - PV(X),0] 11.86 <-- =MAX(B2-B3/(1+B5)^B4,0)

To prove the smart fact, let’s assume that you can buy the call for $5. We’ll show that there
exists an arbitrage strategy, and we will therefore conclude that the option price is too low.
The arbitrage strategy involves a set of actions at time 0 (today) and at time T (the option
expiration date).

At time 0 (today):
• Short one share of the stock, get S 0.
• Invest in a riskless security paying off the call’s exercise price at time T. This security
will cost its present value, PV(X).
• Buy a call on the option. This will cost C 0.

At time T:
• Purchase the stock on the open market at the time-T price to close the short position.
Closing the short position will cost ST.
• Collect from our investment in the riskless security. This will give an inflow of X.
• Exercise the option if this is profitable. If the stock price ST > X, this will give an inflow
of ST – X. If the stock price ST < X, it will not pay to exercise the option.
Here’s an example, which assumes that the stock price at time 0 is S 0 = 69, the interest
rate is r = 5%, the exercise price is X = 60, and the time to maturity is T = 1. This specific
example assumes that the call price at time 0 is C 0 = 5. In the spreadsheet below we show
the payoffs from the above strategy, assuming that the price of the stock at time T is ST = 33
(cell B17).

2
How smart? Robert Merton, who first established this and lots of other facts about options, subsequently
won the Nobel Prize for economics, in part for his work on option pricing.
 CHAPTER 21 Option Pricing Facts 627

A B C

ARBITRAGE PROOF OF FACT 1

1 Assumes that stock price at time T = $33.00
2 Exxon stock price, 17 May 2009, S0 69.00
3 Option exercise price, X 60.00
4 Option exercise time, T (in years) 1
5 Interest rate, r 5.00%
6

Below examine if this price

7 Call price at time 0 (today) 5 <-- violates the arbitrage restriction
8
9 ARBITRAGE STRATEGY
10 Actions at time 0 (today)
11 Short the stock, get S0 69.00 <-- =B2
12 Buy a bond which pays of X at time T, pay PV(X) -57.14 <-- =-B3/(1+B5)^B4
13 Buy a call, pay C0 -5.00 <-- =-B7
14 Total cash flow at time 0 6.86 <-- =SUM(B11:B13)
15
16 Cash flow at time T
17 ST, stock price at time T 33.00
18
19 Repay the shorted stock, pay ST -33.00 <-- =-B17
20 Collect money from the bond, get X 60.00 <-- =B3
21 Exercise the call? Get Max(ST - X,0) 0.00 <-- =MAX(B17-B3,0)
22 Total cash flow at time T 27.00 <-- =SUM(B19:B21)

In cells B19:B22 we calculate the cash flow at time T=1 from the strategy. In the example
above, Exxon stock at T is selling for ST = $33. In this case, we would have a positive time T
cash flow of $27 (cell B22).
In the example below, we assume that Exxon stock at T is ST = $90. In this case you exercise
the call (giving you a positive cash flow of $30), but the total payoff from the strategy is now $0.
A B C
ARBITRAGE PROOF OF FACT 1
1 Assumes that stock price at time T = $90.00
2 Exxon stock price, 17 May 2009, S0 69.00
3 Option exercise price, X 60.00
4 Option exercise time, T (in years) 1
5 Interest rate, r 5.00%
6

Below examine if this price

7 Call price at time 0 (today) 5 <-- violates the arbitrage restriction
8
9 ARBITRAGE STRATEGY
10 Actions at time 0 (today)
11 Short the stock, get S0 69.00 <-- =B2
12 Buy a bond which pays of X at time T, pay PV(X) -57.14 <-- =-B3/(1+B5)^B4
13 Buy a call, pay C0 -5.00 <-- =-B7
14 Total cash flow at time 0 6.86 <-- =SUM(B11:B13)
15
16 Cash flow at time T
17 ST, stock price at time T 90.00
18
19 Repay the shorted stock, pay ST -90.00 <-- =-B17
20 Collect money from the bond, get X 60.00 <-- =B3
21 Exercise the call? Get Max(ST - X,0) 30.00 <-- =MAX(B17-B3,0)
22 Total cash flow at time T 0.00 <-- =SUM(B19:B21)
628 PART FIVE OPTIONS AND OPTION VALUATION

By changing the stock price ST, you can see that our strategy always produces no worse than
a zero cash flow at time T. This makes it an arbitrage strategy:
• At time 0, the cash flow is $6.86 > 0.
• At time T, the cash flow is either positive (if the stock price ST < 60) or zero.
You can’t lose from this strategy!! In a rational world this means that something is wrong with
the asset prices. In this case, it’s clear what’s wrong—the call price is too low.
To see this, consider the case where the call price is $14. As you can see below (cell B14), this
means that the initial cash flow from the arbitrage strategy is negative. If the stock price at time T
is less than $60, say ST = $55, then you will make a future profit (cell B22 below), but this profit is
no longer an arbitrage profit (recall that arbitrage occurs when you can never lose money—how-
ever, in this example, with a $14 call price, you start off with an initial negative cash flow).

A B C

Below examine if this price

7 Call price at time 0 (today) 14.00 <-- violates the arbitrage restriction
8
9 ARBITRAGE STRATEGY
10 Actions at time 0 (today)
11 Short the stock, get S0 69.00 <-- =B2
12 Buy a bond which pays of X at time T, pay PV(X) -57.14 <-- =-B3/(1+B5)^B4
13 Buy a call, pay C0 -14.00 <-- =-B7
14 Total cash flow at time 0 -2.14 <-- =SUM(B11:B13)
15
16 Cash flow at time T
17 ST, stock price at time T 55.00
18
19 Repay the shorted stock, pay ST -55.00 <-- =-B17
20 Collect money from the bond, get X 60.00 <-- =B3
21 Exercise the call? Get Max(ST - X,0) 0.00 <-- =MAX(B17-B3,0)
22 Total cash flow at time T 5.00 <-- =SUM(B19:B21)

The cash flow at T (cell B22) is positive, but the initial cash flow (cell B14) is now negative. This
makes more sense: Negative initial cash flows in this arbitrage strategy start when the call price
is > $11.86. If this is true, then you have to invest money today to have a nonnegative cash flow
in the future. Note that 11.86 = S 0 – PV(X) = 69 – 60/1.05.

We’ve proved our first option pricing fact: Call price, C0 > Max ⎡⎣ S0 − PV (X ),0 ⎤⎦ . The
proof wasn’t mathematically difficult, but it involves some sophisticated thinking. Option arbi-
trage propositions are like that.

21.2. Fact 2: It’s Never Worthwhile to Exercise a Call Early3

Suppose that on 17 May 2009 you bought an Exxon call option for C 0 = $14 (note that this price
does not violate Fact 1’s price restriction). Furthermore, suppose that the option expires 1 year
from today, on 17 May 2010. Recall that the current price of Exxon is S 0 = $69.

3
To be completely accurate, Fact 2 holds when the interest rate is positive and the call is written on a stock
that does not pay a dividend before the option maturity date T.
 CHAPTER 21 Option Pricing Facts 629

Now suppose that after 8 months (approximately 2/3 of a year), you want to get rid of the
option. To make the problem interesting, we’ll assume that the price of Exxon has risen to St =
$80. You have two possibilities:
• You could exercise the option. In this case you would collect $20 =
Max [St − X ,0 ] = Max [80 − 60,0 ].
• You could also sell the option on the open market. Of course, we don’t know what the
option’s price would be, but Fact 1 tells us that in no case will the price be less than
⎡ X ⎤
Max ⎡⎣ St − PV (X ),0 ⎤⎦ = Max ⎢ St − 1/ 3
,0 ⎥
⎢⎣ (1 + r ) ⎥⎦
⎡ 60 ⎤
= Max ⎢80 − 1/ 3
,0 ⎥ = 20.97
⎢⎣ (1 + 5% ) ⎥⎦
X
The present value 1 + r 1/ 3 expresses the fact that there is 1/3 of a year left before the
( )
option’s exercise.
What should you do? Clearly, you should sell rather than exercise the call.

A B C D E F
1 FACT 2: No early exercise of calls
2 Exxon stock price, 17 May 2009, S0 69.00
3 Option exercise price, X 60.00
4 Option exercise time, T (in years) 1
5 Interest rate, r 5.00%
6 Call price at time 0 14.00
7
8 Time line
9 t=0 t=2/3 T=1
10
11 Buy option for $14.00 Consider selling the option
12 or exercising it.
13
14 Stock price, St 80.00
15
16 Payoff from option exercise 20.00 <-- =MAX(D14-B3,0)
17 Minimum value of option
18 according to Fact 1 20.97 <-- =MAX(D14-B3/(1+$B$5)^(1-2/3),0)
19
20 Exercise option or sell it? sell <-- =IF(D18>=D16,"sell","exercise")

21.3. Fact 3: Put–Call Parity, P0 = C0 + PV(X) – S0

Put–call parity states that for European options put price is determined by the call price, the
stock price, and the risk-free rate of interest.4 Here’s an example: Suppose that we’re considering
a 1-year put option on the Exxon stock we’ve been discussing throughout this chapter. Recall
that Exxon stock is currently selling for S 0 = $69. Put–call parity tells us the price of a put on
Exxon with the same exercise price X = $60 and the same time to maturity T = 1.

4
Again, recall that the assumption is that the stock pays no dividends before the option maturity date T.
630 PART FIVE OPTIONS AND OPTION VALUATION

A B C
1 FACT 3: Put–Call Parity
2 Exxon stock price, 17 May 2009, S0 69.00
3 Option exercise price, X 60.00
4 Option exercise time, T (in years) 1
5 Interest rate, r 5.00%
6
7 Call price, Call0 15.00
8 Put price, Put0, by put–call parity 3.14 <-- =B7+B3/(1+B5)^B4-B2

Another interpretation of put–call parity is that the put price plus the stock price always
equals the call price plus the present value of the exercise price:
Put0 + S0 = Call0 + PV (X ) .
This means that given any three of the following four variables— Put0 , S0 , Call0 , X —the fourth
variable is determined.

An Arbitrage Proof of Put–Call Parity (Can Be Skipped on

First Reading)
We can prove put–call parity using arbitrage, as specified in the spreadsheet below. We assume
that the stock price is S 0 = $69, the exercise price is X = $60, the time to exercise is T = 1 year,
the interest rate is r = 5%, and the call price is Call0 = $15. Given these facts, put–call parity
says that the put price should be Put0 = $3.14 (cell B8).
In cell B11 we suppose that the put price is $1, different from its put–call parity value; we
then show that this makes an arbitrage profitable.

A B C
1 Arbitrage Proof of Put–Call Parity
2 Exxon stock price, 17 May 2009, S0 69.00
3 Option exercise price, X 60.00
4 Option exercise time, T (in years) 1
5 Interest rate, r 5.00%
6
7 Call price, Call 0 15.00
8 Put price, Put 0, by put–call parity 3.14 <-- =B7+B3/(1+B5)^B4-B2
9
10 Arbitrage proof of put–call parity
If this price differs from the
price in cell B8, we will show
that there is a profitable
11 Put price today (t=0), Put 0 1.00 arbitrage strategy.
12
13 Actions at time 0 (today)
14 Buy stock, pay S0 -69.00 <-- =-B2
15 Buy put, pay Put0 -1.00 <-- =-B11
16 Write call, get Call0 15.00
17 Take a loan of PV(X) at risk-free interest, get PV(X) 57.14 <-- =B3/(1+B5)^B4
18 Total cash flow at time 0 2.14 <-- =SUM(B14:B17)
19
20 Cash flow at time T
21 ST, stock price at time T 90.00
22
23 Sell stock, get ST 90.00 <-- =B21
24 Exercise the put? Get Max(X - ST,0) 0.00 <-- =MAX(B3-B21,0)
25 Cash flow from written call. Pay Max(ST - X, 0) -30.00 <-- =-MAX(B21-B3,0)
26 Repay loan. Pay X -60.00 <-- =-B3
27 Total 0.00 <-- =SUM(B23:B26)
 CHAPTER 21 Option Pricing Facts 631

Here’s the arbitrage strategy we designed.

At time 0 (today):
• Buy one share of Exxon stock for S 0 = $69.
• Buy one put with exercise price X = $60 for Put0 = $1.
• Write one call with X = $60, collecting (today) Call0 = $15.
• Take a loan of PV(X) = $57.14; the loan has a 1-year maturity (like the options). At the
current interest rate of 5% you will have to pay off X = $60 in 1 year.

At time T we close out all our positions:

• Sell our share of Exxon at the prevailing market price ST.
• Exercise the put, if this is profitable. Exercising the put gives you Max (X − ST ,0 ) .
• Have the call exercised against us, if this is profitable for the call buyer. As the call
writer, you can’t make money from having the call exercised. The cash flow to the call
writer is −Max (ST − X ,0 ) .
• Repay the loan. This is a negative cash flow, –X.
Our example above shows that the cash flow at T = 1 will be zero if ST = $90. The cash flow
will also be zero if ST = $35.

A B C
20 Cash flow at time T
21 ST, stock price at time T 35.00
22
23 Sell stock, get ST 35.00 <-- =B21
24 Exercise the put? Get Max(X - ST,0) 25.00 <-- =MAX(B3-B21,0)
25 Cash flow from written call. Pay Max(ST - X, 0) 0.00 <-- =-MAX(B21-B3,0)
26 Repay loan. Pay X -60.00 <-- =-B3
27 Total 0.00 <-- =SUM(B23:B26)

As you can see, no matter what the Exxon stock price in 1 year, the cash flow at T = 1 from this
strategy will be zero. However, the strategy has a positive initial cash flow of $2.14. Clearly this
is an arbitrage!
Symbolically, the future cash flow is given by
S)T + Max [X − ST ,0 ] − Max [ST − X ,0 ]− X
)
!""""""#""""""$ !""""""#""""""$ Loan repayment
Stock value Put payoff Cash flow to call
writer at T =1

⎧ ST + X − ST − X if ST < X
=⎨
⎩ST − (ST − X ) − X if ST ≥ X
=0
A little thought will reveal that—given the stock price S 0 = 69, the interest rate r = 5%,
the exercise price X = 60 of both the put and the call, and the call option price of $15—the put
option price must be $3.14 to prevent arbitrage. This follows from the put-price parity relation:
60
Put = Call + PV (X ) − S = 15 + − 69 = 3.14
1.05
632 PART FIVE OPTIONS AND OPTION VALUATION

21.4. Fact 4: Bound on an American Put Option Price:

P0 > Max[X – S0,0]
Suppose you’re contemplating buying an American put on Exxon stock. The stock’s price today
is S 0 = $69 and the option exercise price is X = $80. Clearly, the option should sell for at least
$11. If not, you could easily devise an arbitrage, as illustrated in the spreadsheet below.

A B C
1 FACT 4: Lower bound on American put price
2 Exxon stock price, 17 May 2009, S0 69.00
3 Put option exercise price, X 80.00
4 Option exercise time, T (in years) 1
5
6 Fact 4: Lower bound of American put: P0 > Max[X - S0, 0] 11.00 <-- =MAX(B3-B2,0)
7
8 Arbitrage strategy
9 American put option price 3.00
10 Buy option, pay P0 -3.00
11 Buy stock now, pay S0 -69.00
12 Exercise put option immediately: deliver stock and get X 80.00
13 Immediate profit 8.00 <-- =SUM(B10:B12)

If the American put option is mispriced (that is, its price is less than $11), you can make
money by buying the option, buying the stock, and exercising the option immediately. This
arbitrage profit will not exist if the option’s price is greater than $11.

21.5. Fact 5: Bounds on European Put Option Prices:

P0 > Max[PV(X) – S0,0]
Fact 5 is the “put parallel” for Fact 1 about calls.5

A B C
1 FACT 5: Lower bound on European put price
2 Exxon stock price, 17 May 2009, S0 69.00
3 Put option exercise price, X 80.00
4 Option exercise time, T (in years) 1
5 Interest rate, r 5.00%
6
7 Lower bound on call price
8 Lower bound of American put: P0 > Max[X - S0, 0] 11.00 <-- =MAX(B3-B2,0)
9 Fact 5: P0 > Max[PV(X) - S0,0] 7.19 <-- =MAX(B3/(1+B5)^B4-B2,0)

We’ll skip the proof of Fact 5. If you’re interested, it’s on the disk that comes with the book.

5
There’s a crucial difference in the parallel between Facts 1 and 5: Fact 1 applies to all calls, whether
European or American. Fact 5 applies only to European puts. Of course in both cases the assumption is
that the stock pays no dividends before option maturity.
 CHAPTER 21 Option Pricing Facts 633

AMERICAN VERSUS EUROPEAN PUTS

Fact 5 says that the price of a European put can actually be much lower than the price of an
American put. Consider the preceding example, in which we look at the price of a put option on
Exxon stock (currently selling for S 0 = $69) with T = 1 and X = 80. If our put was an American
put, then it couldn’t sell for less than $11. On the other hand, a European put, which cannot be
exercised until date T, can sell for anything more than $7.19.

21.6. Fact 6: You Might Find It Optimal to Early Exercise

an American Put on a Nondividend Paying Stock
Recall that you’ll never find it optimal to early exercise an American call on a nondividend pay-
ing stock. But this is not necessarily true for a put option. Here’s an example.
Suppose that you’re currently holding an option on PFE stock. You bought the option some
time ago, when PFE stock’s price was still healthy. However, at the current date, the stock has
taken a plunge and is selling for $1 per share. Your American put option has an exercise price
of X = $100 and expires in 1 year. The interest rate is 10%. If you exercise the option now,
you’ll have a net payoff of $99 ($100 minus the current value of the stock of $1), which—if you
invest it in bonds with an interest rate of 10%—will be $99 *1.10 = $108.90 in 1 year. This is
more than anyone would have if they waited for a year until exercise.
Therefore, any rational holder of an American put option will choose to early exercise the
option if the current stock price is very low.

21.7. Fact 7: Option Prices Are Convex (Somewhat Advanced)

Suppose we have three calls, each with a different exercise price but with the same time to exer-
cise T, written on the same stock. Suppose that the exercise price of the first call is X = $15, the
exercise price of the second call is X = $20, and the exercise price of the third call is X = $25.
Call price convexity says that for three such “equally spaced” calls, the middle call price must
be less than the average of the two extreme call prices. In an equation,
Call price (X = 15 ) + Call price (X = 25 )
Call price (X = 20 ) <
2
To see the meaning of convexity, we return to the butterfly spread example from Chapter 20.
Recall that in this example, the convexity relation says that

Call price (X = 80 ) + Call price (X = 120 ) 20.99 + 0.52

Call price (X = 100 ) < = = 10.76
2 2

Because the IBM call with X = $100 is selling for $6.40, it fulfills the convexity
relation.
634 PART FIVE OPTIONS AND OPTION VALUATION

A B C
THREE IBM JULY 2009
1 CALLS
2 X Call price
3 80 20.99
4 100 6.40
5 120 0.52
6
Convexity: Is the middle call priced less than
the average of the high and the low call?
7
Average of high
8 and low call 10.76 <-- =(B3+B5)/2

Why Do Call Prices Have To Be Convex?

In this subsection we use the butterfly strategy from Section 20.8 to show you why call prices
always have to be convex. Recall that a butterfly strategy consists of buying one low-priced and
one high-priced call and selling two medium-priced calls.
Suppose that the call option prices for IBM were different from those actually seen in the
market. In the example below, we show how our butterfly would have looked had the X = $100
call been priced at $13 instead of $6.40.

A B C D E F G H I J K L
WHEN DOES A BUTTERFLY INDICATE AN ARBITRAGE OPPORTUNITY?
Strategy: Buy 1 July X=80 Call, Write 2 July X=100 Calls,
1 Buy 1 July X=120 Call
2 Call prices
3 X Price
4 80 20.99
5 100 13.00 <-- The actual price is $6.40. To illustrate arbitrage, we assume $13
6 120 0.52
7 =MAX(A10-80,0)-$B$4
8 Butterfly payoff and profits
Payoff on Payoff on Payoff on =-2*(MAX(A10-100,0)-$B$5)
July IBM Total
July X=80 July X=100 July X=120
stock price profit
9 call call call
10 0 -20.99 26 -0.52 4.49 <-- =D10+C10+B10
11 10 -20.99 26 -0.52 4.49 =MAX(A10-120,0)-$B$6
12 20 -20.99 26 -0.52 4.49
13 30 -20.99 26 -0.52 4.49
14 40 -20.99 26 -0.52 4.49
15 50 -20.99 26 -0.52 4.49 Butterfly Profit Pattern
16 60 -20.99 26 -0.52 4.49
301 X=80 Call Bought, 2 X=100 Calls Written, 1X=120
17 70 -20.99 26 -0.52 4.49
18 80 -20.99 26 -0.52 4.49
Call Bought
25
19 90 -10.99 26 -0.52 14.49
20 100 -0.99 26 -0.52 24.49 20
Total profit

21 110 9.01 6 -0.52 14.49

22 120 19.01 -14 -0.52 4.49 15
23 130 29.01 -34 9.48 4.49
24 140 39.01 -54 19.48 4.49 10
25 150 49.01 -74 29.48 4.49
26 160 59.01 -94 39.48 4.49 5
27 170 69.01 -114 49.48 4.49
28 0
29 -10 10 30 50 70 90 110 130 150 170
30 IBM stock price, July 2009
31
 CHAPTER 21 Option Pricing Facts 635

Note that the total profit graph is completely above the x-axis. This means that no matter
what the stock price in July, you will make a profit. This is clearly not logical—something is
wrong with these prices!
You get the same thing if you assume that the X = $80 call option is priced at $10 instead
of its actual market price of $20.99.

A B C D E F G H I J K L
WHEN DOES A BUTTERFLY INDICATE AN ARBITRAGE OPPORTUNITY?
Strategy: Buy 1 July X=80 Call, Write 2 July X=100 Calls,
1 Buy 1 July X=120 Call
2 Call prices
3 X Price
4 80 10.00 <-- The actual price is $20.99. To illustrate arbitrage, we assume $10
5 100 6.40
6 120 0.52
7 =MAX(A10-80,0)-$B$4
8 Butterfly payoff and profits
Payoff on Payoff on Payoff on =-2*(MAX(A10-100,0)-$B$5)
July IBM Total
July X=80 July X=100 July X=120
stock price profit
9 call call call
10 0 -10.00 12.8 -0.52 2.28 <-- =D10+C10+B10
11 10 -10.00 12.8 -0.52 2.28 =MAX(A10-120,0)-$B$6
12 20 -10.00 12.8 -0.52 2.28
13 30 -10.00 12.8 -0.52 2.28
14 40 -10.00 12.8 -0.52 2.28 Butterfly Profit Pattern
15 50 -10.00 12.8 -0.52 2.28 1 X=80 Call Bought, 2 X=100 Calls Written, 1 X=120
16 60 -10.00 12.8 -0.52 2.28 25 Call Bought
17 70 -10.00 12.8 -0.52 2.28
18 80 -10.00 12.8 -0.52 2.28
20
19 90 0.00 12.8 -0.52 12.28
20 100 10.00 12.8 -0.52 22.28 Total profit
21 110 20.00 -7.2 -0.52 12.28 15
22 120 30.00 -27.2 -0.52 2.28
23 130 40.00 -47.2 9.48 2.28 10
24 140 50.00 -67.2 19.48 2.28
25 150 60.00 -87.2 29.48 2.28
26 160 70.00 -107.2 39.48 2.28 5
27 170 80.00 -127.2 49.48 2.28
28 0
29 -10 10 30 50 70 90 110 130 150 170
30 IBM stock price, July 2009
31

What’s Wrong?
Playing around a bit with the numbers will convince you that a condition necessary for the but-
terfly graph to straddle the x-axis is
Call price (X Low ) + Call price (X High )
Call price (X Middle ) < ,
2
where X Low , X Middle , X High are three equally spaced exercise prices.
This condition—in the jargon of the options markets referred to as the convexity property
of call prices—says that for three equally spaced calls, the middle call price must be less than
the average of the two extreme call prices. Another way of saying this is that the line connecting
two call prices always lies above the graph of the call prices.
636 PART FIVE OPTIONS AND OPTION VALUATION

Call price: Declines

as exercise price
Call price increases

Straight line connecting two call

prices: always above the call pricing
line (this is the convexity )

Call exercise price, X

FIGURE 21.1 The curved line illustrates the actual call prices for various exercise
prices. Call price convexity means that the line connecting two call prices is always
above the actual call pricing curve.

Put prices are also convex.

Put price (X Low ) + Put price (X High )
Put price (X Middle ) <
2
We leave put butterflies as an exercise and let you prove this on your own. Here’s the way
put prices look.

Straight line connecting two put

Put price

prices: always above the put Put price:

pricing line (this is the convexity) Increases as
exercise price
increases

Put exercise price, X

FIGURE 21.2 The curved line illustrates the actual put prices for various exercise
prices. Put price convexity means that the line connecting two put prices is always
above the actual put pricing curve.
 CHAPTER 21 Option Pricing Facts 637

Summary
In this chapter we have derived restrictions on option prices that stem from their being related
to other securities in the market. These arbitrage restrictions help us bound option prices (that
is, establish minimum prices for put and call options) as well as establish relations between
the prices of various options and the underlying security (as in the case of the put–call parity
theorem).
In this chapter we have dealt with seven such option-pricing restrictions, but there are many
more that deal with cases involving dividends and transactions costs. Understanding the seven
restrictions discussed in this chapter will help you understand not only the pricing of options
(we will have more to say on this topic in the next chapter), but also the way option traders
think—they are constantly busy trying to figure out how to arbitrage option prices.

EXERCISES
1. You want to buy one American call option contract on Dell Computer Corp., expiring in 6 months,
with a strike price of $25. The current stock price is at $24.80. Can the option price be lower than
$0.60? Assume that the interest rate is 8%.
2. Assume that you can buy the above call for $0.50 (which is less than the theoretical minimum).
How can you exploit the mispricing to make a riskless gain?
3. Your generous uncle gives you 10,000 units of the above option as a birthday gift. The option
expires in 6 months and the interest rate is 8%. The stock price has risen to $28. Will you exercise
the option early or rather sell it? Explain.
4. Cash dividends affect option prices through their effect on the underlying stock price. Because the
stock price is expected to drop by the amount of the dividend on the ex-dividend date, high cash
dividends imply lower call premiums. Suppose you own a call option with a strike price of 90 that
expires in 1 week. The stock is currently trading at $100 and is expected to pay a $2.00 dividend
tomorrow. The call option has a value of $10. What are you going to do: hold the option or exercise
the option early?
5. The Fashion Corp. has stock outstanding that is currently selling for $83 per share. Both a put and
a call with a strike price of $80 and an expiration of 6 months are trading. The put option premium
is $2.50, and the risk-free rate is 8%. If put–call parity holds, what is the call option premium?
6. The current market price of a 2-month European put option on a non-dividend-paying stock with
strike price of $50 is $4. The stock price is $47 and the risk-free interest rate is 6%.
a. If a 2-month call option with the same strike price is currently selling for $1, what opportunities
are there for an arbitrageur? How can you exploit arbitrage?
b. Would the above market prices still provide an arbitrage opportunity if the option has a 1-month
maturity and the stock price is $46.755?
7. In general, what is the problem of using Wall Street Journal prices to search for violations of the
put–call parity relationship?
8. Recall from Chapter 20 that a butterfly is an options strategy built on four trades at one expiration
date and three different strike prices. For call options, one option each at the high and low strike
prices are bought, and two options at the middle strike price are sold. Consider the following
spreads:
• Spread composed of calls: Buy one ABC Jun $180 call for $20, sell two ABC Jun $200 calls each
at $10, and buy one ABC Jun $220 call for $5.
• Spread composed of puts: Buy one ABC Jun $180 put, sell two ABC Jun $200 puts, and buy one
ABC Jun $220 put.
638 PART FIVE OPTIONS AND OPTION VALUATION

Use put–call parity to show that the cost of a butterfly spread created from the calls is identical
to the cost of the butterfly spread created from European puts.
9. (Challenge). You have the following information, 25 calendar days before the March 2011 option
expiration day.

Strike Put/Call Price

1025 Call 19.8

1025 Put 14.5
1040 Call 12.5
1040 Put 22.17

In the absence of arbitrage, what is the annualized risk-free rate?

10. A European put and call option both expire in 1 year and have the same exercise price of $20. The
options are currently traded at the same market price of $3. Assume that the annual interest rate
is 8%. What is the current stock price? In general, if a European put and call have the same price
and expire at the same time, what can you say about the relationships between the stock price and
the exercise price? S > X? S < X? S = X?
11. You consider buying an American put option on Dell Computer Corp., expiring in 6 months, with
a strike price of $25. The current stock price is at $18. What is the minimum price the put will sell
for? If you can buy the above put for $5 (which is less than the theoretical minimum), how can you
exploit the mispricing to make a riskless gain?
12. ABC is a non-dividend-paying stock. Suppose that S = $17, X = $20, and r = 5% per annum.
a. Can a European put option that expires in 6 months trade at $2.50? Note that a European put
option may sometimes be worth less than its intrinsic value.
b. Consider a situation where the European put option is traded at $2.40. Show how you can gain
from arbitrage.
13. Suppose that you are currently holding an American put option on National Australia Bank that
has an exercise price of $45. The option expires in 6 months. The share price is currently traded
at $23.00.
a. Consider a situation where the American put option is traded at $21. Show how you can gain
from arbitrage.
b. What is your net payoff if
i. you exercise the put option today (assume that you invest your proceeds in bonds with an
interest rate of 8%)?
ii. you hold the option until its expiration date?
14. You are trying to decide whether to early exercise a put option you hold that expires in 6 months.
The put’s exercise price is X = $50 and the interest rate is r = 20%. Consider two cases:
a. S = $20
b. S = $3
In which case are you better off exercising the option?
15. Three calls are written on a stock whose current price is S = 100. The X = 80 call option has a
price of 35 and the X = 120 call has a price of 10. What is the maximum price of the X = 100
option?
 CHAPTER 21 Option Pricing Facts 639

16. A butterfly spread is created using the following put options: The investor buys a put option with
a strike price of $55 and pays $10, buys a put with a strike price of $65 and pays $5, and sells two
puts with an intermediate strike price of $60.
a. Use convexity to determine the upper bound for the X = 60 put price.
b. Assume that the X = 60 put price is $8. Graph the profit pattern at maturity for the butterfly
using Excel (let the stock prices at maturity range between $40 and $90). Does the graph indi-
cate an arbitrage opportunity?
17. At the expiration date the put call parity Put0(X) = Call0(X) + PV(X) – S 0 has the following form:
PutT(X) = CallT(X) + X – ST or ST = CallT(X) – PutT(X) + X. Verify this equation using Excel: Let
ST range from $20 to $100 and the exercise price X = $60. The option values at expiration are
Put(X) = Max(ST - X,0), Call(X) = Max(X - ST,0).
18. Cisco (CSCO) stock sells for $25. The at-the-money CSCO 24 April call sells for $3 3/8 and the
at-the-money CSCO 24 April put sells for $1 3/4. The call, the put, and a Treasury Bill all mature
in 4 months. Today’s price for a Treasury bill that pays off $100 in 4 months is $94.92. Assume
that CSCO does not pay dividends in this period. Use the put–call parity relation to find the arbi-
trage profit today, if exists.
CHAP TER

Option Pricing—The Black–Scholes

22 Formula

CHAPTER CONTENTS
Overview 641
22.1. The Black–Scholes Model 642
22.2. Historical Volatility: Computing σ from Stock Prices 644
22.3. Implied Volatility: Calculating σ from Option Prices 646
22.4. An Excel Black–Scholes Function 648
22.5. Doing Sensitivity Analysis on the Black–Scholes Formula 651
22.6. Does the Black–Scholes Model Work? Application to Intel Options 653
22.7. Real Options (Advanced Topic) 655
Summary 658
Exercises 658
Appendix: Getting Option Information from Yahoo! 660

640
 CHAPTER 22 Option Pricing—the Black–Scholes Formula 641

Overview
In the two previous chapters on option pricing, we’ve discussed some facts about options, but
we haven’t discussed how to determine the price of an option. In this chapter we show how to
price options using the Black–Scholes formula. The Black–Scholes formula is the most impor-
tant option-pricing formula. The formula is in wide use in options markets. It has also achieved
a certain degree of notoriety, in the sense that even nonfinance people (lawyers, accountants,
judges, bankers . . . ) know that options are priced using Black–Scholes. They may not know how
to apply it, and they certainly wouldn’t know why the formula is correct, but they know that it
is used to price options.
In our discussion of the Black–Scholes model, we’ll make no attempt whatsoever to give a
theoretical background to the model. It’s hopeless, unless you know a lot more math than 99%
of all beginning finance students will ever know.1
The next chapter discusses the other major model for pricing options, the binomial option-
pricing model. The binomial model gives some insights into how to price an option, and it’s also
used widely (although not as widely as the Black–Scholes equation). Most books discuss the
binomial model—which, in a theoretical sense, underlies the Black–Scholes formula—fi rst and
then discuss Black–Scholes. However, because we have no intention of making the theoretical
connection between the binomial model and Black–Scholes, we’ve chosen to reverse the order
and deal with the more important model first.

What Does “Pricing an Option” Mean?

Suppose we’re discussing a call option on IBM stock that is sold on 8 May 2009. On this date,
IBM’s stock price is S 0 = $101.49. Suppose that the call option has an exercise price X = $90 and
expires on 17 July 2009. Here is what you have learned so far in this book:
• From Chapter 20, you know the basic option terminology. You know what an exercise
price X is, you know the difference between a call and a put, etc.
• From Chapter 20, you also know what the payoff pattern and profit pattern of the call
option looks like—by itself and in combination with other assets.
• From Chapter 21, you know that there are some pricing restrictions on the call option. A
simple restriction (“Fact 1” from Chapter 21, page 625) says that Call0 > Max[S0 – PV(X),0].
A more sophisticated restriction (“Fact 3,” put–call parity, page 629) says that once
we know the price of IBM stock, the call price, and the interest rate, the put price is
determined by the relation Put0 + S0 = Call0 + PV (X ) .
All of these facts are—by themselves—interesting. However, they don’t tell us what the
price of the call option should be. This is the subject of this chapter—the Black–Scholes for-
mula tells us what the market price of the option should be.

Chapter Notation
We recall the notation we’re using throughout Chapters 20–23.

1
A bitter truth, perhaps. But get this—your professor probably can’t prove the Black–Scholes equation
either (don’t ask him, he’ll be embarrassed). On the other hand, you know how to drive a car but may not
know how an internal combustion engine works, you know how to use a computer but can’t make a central
processing unit chip, . . .
642 PART FIVE OPTIONS AND OPTION VALUATION

NOTATION

Throughout the chapter we use the following notation:

S = The price of the stock. When we want to be precise about the price of the stock on a
specific date, we will sometimes write S 0 for the price of the stock today (time 0) and ST for
the price of the stock on the option exercise date T.
X = The option exercise price
r = The interest rate
C = The call option price. When we want to be precise about the call price on a specific
date, we will sometimes write C 0 for the price of the option today (time 0) and CT for the
price of the option on the stock on exercise date T. Occasionally we will even use the full
word, writing Call0.
P = The put option price. When we want to be precise about the put price on a specific
date, we will sometimes write P0 for the price of the put option today (time 0) and PT for
the price of the put on the stock on exercise date T. Occasionally we will even use the full
word, writing Put0.

Finance Concepts in This Chapter

• Black–Scholes formula
• Put–call parity
• Stock price volatility
• Implied volatility
• Real options

Excel Functions Used

• Exp
• Date
• Ln
• Stdevp
• Varp
• Data Table

22.1. The Black–Scholes Model

In 1973, Fisher Black and Myron Scholes proved a formula for pricing European call and put
options on non-dividend-paying stocks. Their model is probably the most famous model of
 CHAPTER 22 Option Pricing—the Black–Scholes Formula 643

modern finance.2 The Black–Scholes model uses the following formula to price calls on the stock:

C0 = S0 N (d1 ) − Xe −rT N (d2 ),

where
ln(S0 / X ) + (r + σ 2 2)T
d1 =
σ T
d2 = d1 − σ T

Don’t let this formula frighten you! We’re going to show you how to use Excel to implement
the Black–Scholes formula, and you won’t really have to understand the mechanics or the math.
However, if you want some explanations, C0 denotes the price of a call, S0 is the current price of the
underlying stock, X is the exercise price of the call, T is the call’s time to exercise, r is the interest
rate, and σ is the standard deviation of the stock’s return. N( ) denotes a value of the cumulative
standard normal distribution. It is assumed that the stock will pay no dividends before date T.
The spreadsheet below prices an option on a stock whose current price is S 0 = 100. The
option’s exercise price is X = 90 and its time to maturity is T = 0.5 (one-half year). The interest
rate is r = 4%, and sigma (σ, the stock’s volatility—a measure of the stock’s riskiness; more
about this later) is σ = 35%.

A B C
1 The Black-Scholes Option-Pricing Formula
2 S0 100 Current stock price
3 X 90 Exercise price
4 T 0.50000 Time to maturity of option (in years)
5 r 4.00% Risk-free rate of interest
6 Sigma 35% Stock volatility
7
8 d1 0.6303 <-- (LN(S0/X)+(r+0.5*sigma^2)*T)/(sigma*SQRT(T))
9 d2 0.3828 <-- d1-sigma*SQRT(T)
10
11 N(d1) 0.7357 <-- Uses formula NormSDist(d1)
12 N(d2) 0.6491 <-- Uses formula NormSDist(d2)
13
14 Call price, C0 16.32 <-- S0*N(d1)-X*exp(-r*T)*N(d2)
15 Put price, P0 4.53 <-- call price - S0 + X*Exp(-r*T): by Put-Call parity
16 4.53 <-- X*exp(-r*T)*N(-d2) - S*N(-d1): direct formula

By the put–call parity theorem (see Chapter 21, page 629), a put with the same exercise
date T and exercise price X written on the same stock will have price P0 = C0 − S0 + PV (X ) .
Because the Black–Scholes option pricing formula is based on continuous compounding (see
Chapter 3 and the note on page 646), we have to write the PV(X) term as PV (X ) = Xe −rT , so that
it becomes P0 = C0 − S0 + Xe −rT . We’ve used this formula in cell B15. Cell B16 includes another
version of put pricing—a direct formula that follows from the Black–Scholes formula.

What Do the Black–Scholes Parameters Mean? How to Calculate Them?

The Black–Scholes option pricing model depends on five parameters:
• S 0, the current price of the stock. By this we always mean the stock price on the date
we’re calculating the option price.
• X, the exercise price of the option (this is also called the strike price).

2
The 1997 Nobel Prize for Economics was awarded to Myron Scholes and Robert Merton for their role in
developing the option pricing formula. Fisher Black, who died in 1995, would have undoubtedly shared in
the prize had he still been alive.
644 PART FIVE OPTIONS AND OPTION VALUATION

• T, the time to the option’s expiration (sometimes called the option maturity). In the
Black–Scholes formula, T is always given in annual terms—meaning an option with
3 months to expiration has T = 0.25 and an option with 51 days until expiration has
T = 51/365 = 0.1397

You can use Excel’s Date function (see Chapter 26) to compute the time T to option expi-
ration. In the example below, the current date is 2 February 2010 and the option’s expiration
date is 19 July 2010. These two dates are entered using Excel’s Date function (cells B2 and B3).
Subtracting the two cells gives the number of days between the dates (cell B4). T is computed
in cell B5.

A B C
COMPUTING T USING EXCEL
1 DATE FUNCTION
2 Current date 8-Feb-10 <-- =DATE(2010,2,8)
3 Expiration date 19-Jul-10 <-- =DATE(2010,7,19)
4 Days between dates 161 <-- =B3-B2
5 T, time in years to expiration 0.4411 <-- =B4/365
6
Note: We formatted cell B4 to give a number, by right-clicking on the
cell and then using
7 Format Cells|Number|General

• r, the risk-free interest rate. This is also given in annual terms. Meaning, if the interest
rate is 6% per year and if an option has T = 0.25, then we write r = 6% in the Black–
Scholes formula. We generally use the Treasury bill rate for a maturity that is closest to
the option maturity.
• σ is a measure of the riskiness of the stock. σ is an important variable in determining the
option price, and it is not a simple concept to explain. We discuss it at length in Sections
22.2 and 22.3. However, here are some facts to help you get your bearings on σ:

• If the stock is riskless, then σ = 0%. A stock is riskless if its future price is
completely predictable.
• An “average” U.S. stock has σ between 10 and 25%.
• A risky stock may have a σ of as much as 80 or 100%.

22.2. Historical Volatility: Computing σ from Stock Prices

There are two main ways to compute σ: One method is to calculate σ by looking at the series of
past stock returns; this computation is sometimes called the historical σ or the historical vola-
tility. Alternatively, we can calculate the implied σ by looking at options prices; this calculation
is often called the implied volatility. This section describes the computation of the historical
volatility, and the next section describes how to compute the implied volatility.
Below we show the annual stock prices for IBM for the decade from 1999–2009. Column
C shows the continuously compounded return for the prices: rtcontinuous = In (Pt / Pt–1 ). (Continuously
 CHAPTER 22 Option Pricing—the Black–Scholes Formula 645

compounded interest was first discussed in Chapter 3; for a reminder see the note in this chapter
on page 646.) σ is the standard deviation of these annual returns (cell C18). As you can see, the
σ computed from these prices is σ = 16.70%.
A B C D
IBM STOCK PRICES AND RETURNS
1 1999 – 2009
Stock Annual
Date
2 price return
3 4-Jan-99 82.78
4 3-Jan-00 101.89 20.77% <-- =LN(B4/B3)
5 2-Jan-01 102.14 0.25%
6 2-Jan-02 98.87 -3.25%
7 2-Jan-03 72.19 -31.45%
8 2-Jan-04 92.31 24.59%
9 3-Jan-05 87.57 -5.27%
10 3-Jan-06 76.93 -12.95%
11 3-Jan-07 95.08 21.18%
12 2-Jan-08 104.15 9.11%
13 2-Jan-09 90.68 -13.85%
14
15 Average return 0.91% <-- =AVERAGE(C4:C13)
16 Return variance 2.79% <-- =VARP(C5:C14)
17 Return standard deviation 16.70% <-- =STDEVP(C6:C15)

In the world of option pricing it is not usual to compute σ from annual data. Most traders
prefer daily, weekly, or monthly data. The use of nonannual data requires some adjustment to
the calculations. We show these adjustments in the example below, where we calculate IBM’s σ
from monthly data. A discussion of what we did follows the spreadsheet.

A B C D

IBM STOCK PRICES

1
Monthly data for 2008
Monthly
Date Price
2 return
3 2-Jan-08 104.15
4 1-Feb-08 111.14 6.50% <-- =LN(B4/B3)
5 3-Mar-08 112.39 1.12% <-- =LN(B5/B4)
6 1-Apr-08 117.82 4.72%
7 1-May-08 126.85 7.38%
8 2-Jun-08 116.17 -8.80%
9 1-Jul-08 125.43 7.67%
10 1-Aug-08 119.77 -4.62%
11 2-Sep-08 115.08 -3.99%
12 1-Oct-08 91.48 -22.95%
13 3-Nov-08 80.74 -12.49%
14 1-Dec-08 83.27 3.09%
15 2-Jan-09 90.68 8.52%
16
17 Monthly return statistics
18 Average return -1.15% <-- =AVERAGE(C4:C15)
19 Return variance 0.87% <-- =VARP(C4:C15)
20 Return standard deviation 9.32% <-- =STDEVP(C4:C15)
21
22 Annualized return statistics
23 Average return -13.85% <-- =12*C18
24 Return variance 10.43% <-- =12*C19
25 Return standard deviation 32.29% <-- =SQRT(C24)
646 PART FIVE OPTIONS AND OPTION VALUATION

The standard deviation of the monthly returns is 9.32% (cell C20). The annualized standard
deviation required for the Black–Scholes formula is 32.29% (cell C25). Note that because

annual variance = 12* monthly variance

annual standard deviation = 12* monthly variance
= 12 * monthly standard deviation

In general, if we’re calculating from nonannual data,

σ, annual standard deviation =

12 * monthly standard deviation
52 * weekly standard deviation
260 * daily standard deviation

(The use of 260 in calculating the annualized σ from weekly data may be a bit confusing:
Because there are 52 weeks per year and 5 business days per week, many traders assume that
there are 260 business days per year. However, others use 250 and 365.)

NOTE: CONTINUOUS VERSUS DISCRETE RETURNS—A REMINDER

The Black–Scholes formula uses continuously compounded returns, whereas in most of this
book we use discretely compounded returns. We discussed the difference between these two
concepts in Chapter 3. Suppose you have an investment that is worth Pt at time t and worth
Pt+1 one period later. There are two ways to define the return on the investment. The discrete
P ⎛P ⎞
return is rtdiscrete = t + 1 − 1, and the continuously compounded return is rtcontinuous = ln ⎜ t + 1 ⎟ .
Pt ⎝ Pt ⎠
The example below shows the difference.

A B C
1 DISCRETE VERSUS CONTINUOUS RETURNS
2 Computing the returns from prices
3 Pt 100
4 Pt+1 120
5
6 Discrete return 20.00% <-- =B4/B3-1
7 Continuously compounded return 18.23% <-- =LN(B4/B3)

22.3. Implied Volatility: Calculating σ from Option Prices

In the previous section we computed the annualized standard deviation of returns σ from his-
torical stock prices. In this section we compute σ from option prices.
When we calculate the implied volatility from option prices, we use the Black–Scholes
formula to fi nd the σ that gives a specifi c options price. Suppose, for example, that a share
of ABC Corp. is currently selling for S 0 = $35 and that a 6-month at-the-money call option
 CHAPTER 22 Option Pricing—the Black–Scholes Formula 647

on ABC Corp. is selling for C 0 = $5.25. (Recall that an at-the-money option has exercise
price X equal to the current stock price S.) Suppose the interest rate is 6%. The spreadsheet
below shows that σ must be greater than 35% (because the call prices increases with σ and
because σ = 35% gives a call price of $3.94, we’ll have to make σ larger to get a call price
of $5.25).

A B C
1 The Black–Scholes Option-Pricing Formula
2 S0 35 Current stock price
3 X 35 Exercise price
4 T 0.5000 Time to maturity of option (in years)
5 r 6.00% Risk-free rate of interest
6 Sigma 35.00% Stock volatility
7
8 d1 0.2450 <-- (LN(S/X)+(r+0.5*sigma^2)*T)/(sigma*SQRT(T))
9 d2 -0.0025 <-- d1-sigma*SQRT(T)
10
11 N(d1) 0.5968 <-- Uses formula NormSDist(d1)
12 N(d2) 0.4990 <-- Uses formula NormSDist(d2)
13
14 Call price, C0 3.94 <-- S*N(d1)-X*exp(-r*T)*N(d2)
15 Put price, P0 2.90 <-- call price - S + X*Exp(-r*T): by Put-Call parity
16 2.90 <-- X*exp(-r*T)*N(-d2) - S*N(-d1): direct formula

Using Goal Seek, we can compute the σ that gives the market price; it turns out to be
σ = 48.71%. Here’s the Goal Seek dialog box.
648 PART FIVE OPTIONS AND OPTION VALUATION

And here’s the final result.

A B C
1 The Black–Scholes Option-Pricing Formula
2 S0 35 Current stock price
3 X 35 Exercise price
4 T 0.50000 Time to maturity of option (in years)
5 r 6.00% Risk-free rate of interest
6 Sigma 48.71% Stock volatility
7
8 d1 0.2593 <-- (LN(S/X)+(r+0.5*sigma^2)*T)/(sigma*SQRT(T))
9 d2 -0.0851 <-- d1-sigma*SQRT(T)
10
11 N(d1) 0.6023 <-- Uses formula NormSDist(d1)
12 N(d2) 0.4661 <-- Uses formula NormSDist(d2)
13
14 Call price, C0 5.25 <-- S*N(d1)-X*exp(-r*T)*N(d2)

What’s Used in Practice—Implied σ or σ from Historical Prices?

The answer is a bit of both. Smart traders compare the implied volatility with the historical vol-
atility and try to form estimates of what the stock volatility actually is. There are whole Web
sites devoted to this subject and lots of proprietary software.

22.4. An Excel Black–Scholes Function

The spreadsheet PFE2, Chapter22.xlsm that accompanies this chapter includes two Excel
functions that compute the Black–Scholes call and put prices. These functions are not part of
the original Excel package; they have been defined by the author. Here’s an example of how to
use them.

A B C
1 BLACK–SCHOLES OPTION FUNCTIONS
The functions in this spreadsheet—Calloption and Putoption—
2 were defined by the author.
3 S0 100 Current stock price
4 X 90 Exercise price
5 T 0.5000 Time to maturity of option (in years)
6 r 4.00% Risk-free rate of interest
7 Sigma 35% Stock volatility
8
9 Call price, C0 16.32 <-- =calloption(B3,B4,B5,B6,B7)
10 Put price, P0 4.53 <-- =putoption(B3,B4,B5,B6,B7)
 CHAPTER 22 Option Pricing—the Black–Scholes Formula 649

The function Calloption(stock price, exercise price, time to maturity, interest, sigma)
is a defined macro that is attached to the spreadsheet.3 When you first open the spreadsheet
Excel will display the following message, which asks whether you really want to open this
macro.

In this case the correct answer is Enable this content. More information on enabling macros
is given in the document Adding Getformula to your spreadsheet.docx, which is on the disk
that accompanies Principles of Finance with Excel.

The dialog box for these functions is self-explanatory.

3
As you can see in the spreadsheet, putoption has the same format for the variables.
650 PART FIVE OPTIONS AND OPTION VALUATION

An Implied Volatility Function

The spreadsheet also comes with two functions that compute the implied volatility for a call
and a put option. The function CallVolatility(stock price, exercise price, option maturity,
interest rate, Call_price) calculates the σ that gives the Black–Scholes price given the other
parameters. The spreadsheet also includes a function called PutVolatility, which computes the
implied volatility for a put option.4 Both functions are illustrated below.

A B C
1 TWO IMPLIED VOLATILITY FUNCTIONS
2 Using CallVolatility to compute the implied volatility for a call
3 S0 35 Current stock price
4 X 35 Exercise price
5 T 0.50000 Time to maturity of option (in years)
6 r 6.00% Risk-free rate of interest
7 Target 5.25 <-- This is the current call price we want to match
8 Implied call volatility 48.71% <-- =CallVolatility(B3,B4,B5,B6,B7)
9
10 Using PutVolatility to compute the implied volatility for a call
11 S0 35 Current stock price
12 X 35 Exercise price
13 T 1.00000 Time to maturity of option (in years)
14 r 6.00% Risk-free rate of interest
15 Target 3.44 <-- This is the current put price we want to match
16 Implied put volatility 32.49% <-- =putVolatility(B11,B12,B13,B14,B15)

4
In the spirit of this chapter, we do not explain how these functions work. For details see my book Financial
Modeling, 3rd edition (MIT Press, 2008).
 CHAPTER 22 Option Pricing—the Black–Scholes Formula 651

22.5. Doing Sensitivity Analysis on the Black–Scholes Formula

We can use Excel to do a lot of Black–Scholes sensitivity analysis. In this section we give two
examples, leaving other examples for the chapter exercises.

Example 1: The Sensitivity of the Black–Scholes Call Price to

the Current Stock Price S
The following Data|Table (see Chapter 27) shows the sensitivity of the Black–Scholes call
value to the current stock price S 0. It compares the Black–Scholes call value to the call’s intrin-
sic value Max(S 0 – X,0).

A B C D E F G

BLACK–SCHOLES PRICE SENSITIVITY TO

1 CURRENT STOCK PRICE S 0
Stock price Black-
at time 0, Scholes Intrinsic
2 S0 price value
3 S0 100 Current stock price
4 X 90 Exercise price 65 0.97 0.00
5 T 0.5000 Time to maturity of option (in years) 70 1.82 0.00
6 r 4.00% Risk-free rate of interest 75 3.08 0.00
7 Sigma 35% Stock volatility 80 4.81 0.00
8 85 7.02 0.00
9 Call price, C0 16.3154 <-- =calloption(B3,B4,B5,B6,B7) 90 9.70 0.00
10 Put price, P 0 4.5333 <-- =putoption(B3,B4,B5,B6,B7) 95 12.81 5.00
11 100 16.32 10.00
12 105 20.15 15.00
13 Cells F3 and G3 are part of the headers of the data table. 110 24.26 20.00
14 Cell F3 contains the formula =B9 cell G3 contains the 115 28.58 25.00
15 formula 120 33.08 30.00
16 =MAX(B3-B4,0) 125 37.71 35.00
17 130 42.44 40.00
18 135 47.25 45.00
19 Black–Scholes Option Price (curved line)140 52.11
compared 50.00
20
21
to Intrinsic Value when S0 is varied
22
23
24
25
26
27 Black-Scholes
28 price
29
30 Intrinsic
31 value
32
33 65 75 85 95 105 115 125 135 145
34
35 Stock price at date 0, S 0
36
652 PART FIVE OPTIONS AND OPTION VALUATION

The call option’s intrinsic value Max (S 0 – X,0) shows what it would be worth if exercised
immediately. The option’s Black–Scholes price shows what the option would be worth on the
open market. Note that the Black–Scholes price for the call option is always greater than the
intrinsic value—it is not worthwhile to early exercise the call option.

Example 2: The Sensitivity of the Black–Scholes Price to

Different Estimates of σ
To show the sensitivity of Black–Scholes price to the σ, we graph below the call prices for two
options varying only in their volatility. We let the price of the stock S0 vary and show the price
of the call option when σ = 20% and when σ = 50%.

A B C D E F G
1 BLACK–SCHOLES PRICE SENSITIVITY TO SIGMA
Black-
Stock Black-Scholes
Scholes
price at price, sigma =
price, sigma
time 0, S 0 50%
2 = 20%
3 S0 90 Current stock price
4 X 90 Exercise price 10 0.00 0.00
5 T 1.0000 Time to maturity of option (in years)
20 0.00 0.01
6 r 4.00% Risk-free rate of interest 30 0.00 0.15
7 Sigma 20% Stock volatility 40 0.00 0.77
8 50 0.01 2.23
9 Call price, C0 8.9325 <-- =calloption(B3,B4,B5,B6,B7) 60 0.19 4.80
10 Put price, P0 5.4036 <-- =putoption(B3,B4,B5,B6,B7) 70 1.16 8.53
11 80 3.89 13.39
12 90 8.93 19.24
13 Cells F3 and G3 are part of the headers of the data table. 100 16.06 25.93
14 Cell F3 contains the formula =calloption(B3,B4,B5,B6,20%) 110 24.61 33.30
15 cell G3 contains the formula 120 33.96 41.24
16 =calloption(B3,B4,B5,B6,50%) 130 43.69 49.62
17 140 53.59 58.34
18 90 150Varied 63.55 67.34
Black-Scholes Option Price when Sigma is
19 80 160 73.54 76.56
20
21 70
Black-Scholes
22 60 price, sigma = 20%
23
24 50 Black-Scholes
25 price, sigma = 50%
40
26
27 30
28 20
29
30 10
31 0
32 0 20 40 60 80 100 120 140
33
Stock price at date 0, S 0
34

The higher the stock’s σ, the higher the Black–Scholes option price.
 CHAPTER 22 Option Pricing—the Black–Scholes Formula 653

22.6. Does the Black–Scholes Model Work? Application to Intel Options

In this section we do two experiments to examine whether and how well the Black–Scholes
model works. First we compare the Black–Scholes option prices for a set of put and call options
on Intel stock to the actual market prices. Then we compare the implied volatilities for the same
options.
Our conclusion: Black–Scholes works pretty well!

Test 1: Comparing Actual Market Prices to Black–Scholes Prices

At the close of trading on 16 October 2009, Intel’s stock price was $20.18. An at-the-money
call option with expiration date 16 April 2010 was trading at $1.62 and an at-the-money put was
trading at $1.67. Our “test” of Black–Scholes consists of the following:

• We compute the implied volatility for these two options (cells B10 and B11) below.
• We then use these implied volatilities to compute the prices of all traded options.
• We compare the pricing using the implied volatility to the actual market prices.

The Black–Scholes model passes this test: It appears to do a good job of pricing options
within a reasonable range of the current market price.

A B C D E F
INTEL OPTION DATA, 16 October 2009
1 Call and put pricing using at-the-money implied volatility
2 S0, current Intel stock price 20.18
3 At-the-money X 20
4 Price of at-the-money call 1.62
5 Price of at-the-money put 1.67
6 Current date 16-Oct-09
7 Expiration date 16-Apr-10
8 T, time to expiration 0.4986 <-- =(B7-B6)/365
9 Interest rate 0.75%
10 Implied call volatility 26.40% <-- =CallVolatility(B2,B3,B8,B9,B4)
11 Implied put volatiity 31.83% <-- =PutVolatility(B2,B3,B8,B9,B5)
12
Price call Price put
with at- Put option with at-
Call option money market money
13 Exercise price market price volatility price volatility
14 15 5.30 5.31 0.29 0.16
15 16 4.50 4.40 0.43 0.30
16 17 3.60 3.56 0.64 0.52
17 18 2.89 2.81 0.89 0.81
18 19 2.19 2.16 1.30 1.19
19 20 1.62 1.62 1.67 1.67
20 21 1.16 1.18 2.28 2.23
21 22 0.82 0.84 2.90 2.88
22 23 0.57 0.59 3.60 3.59
23 24 0.37 0.40 4.01 4.37
654 PART FIVE OPTIONS AND OPTION VALUATION

Test 2: Comparing Implied Volatilities for All Puts and Calls

In this test we use the market prices of traded options and compute the implied volatility for
each option.

A B C D E F G
INTEL OPTION DATA, 16 October 2009
1 Comparing the implied volatility for April 2010 calls and puts
2 S0, current Intel stock price 20.18
3 Current date 16-Oct-09
4 Expiration date 16-Apr-10
5 T, time to expiration 0.4986 <-- =(B4-B3)/365
6 Interest rate 0.75%
7
Implied Put Implied
Call option Open call option Open put
8 Exercise price price interest volatility price interest volatility
9 15 5.30 290 25.70% 0.29 1,025 37.38%
10 16 4.50 451 30.27% 0.43 1,244 35.91%
11 17 3.60 721 27.46% 0.64 10,164 35.00%
12 18 2.89 910 28.16% 0.89 4,821 33.54%
13 19 2.19 2,648 26.94% 1.30 5,301 33.84%
14 20 1.62 5,285 26.40% 1.67 7,753 31.83%
15 21 1.16 8,219 25.98% 2.28 2,162 32.65%
16 22 0.82 4,823 25.94% 2.90 191 32.24%
17 23 0.57 9,778 25.99% 3.60 671 31.96%
18 24 0.37 1,674 25.58% 4.01 449 23.20%
19
20 Implied Volatility for Intel Call and Put options
21 Option expiration: 16 April 2010
40%
22 Current date: 16 October 2009
23
24
35%
Implied volatility

25
26
27
28 30%
29
30
31 25%
Implied call volatility
32
33 Implied put volatility
34 20%
35 15 17 19 21 23 25
36
37 Option exercise price
38

The results are both encouraging and discouraging:

• The implied volatilities for the calls are pretty close together, as are the implied volatili-
ties for the puts. This is good news.
• On the other hand, the implied volatilities for the puts are uniformly larger than the implied
volatilities for the calls. This is strange, because in the Black–Scholes formulation, the
 CHAPTER 22 Option Pricing—the Black–Scholes Formula 655

implied volatility refers to the volatility of the stock’s return and hence has nothing to do
with whether we’re discussing a put or a call option. One interpretation of this difference
in volatilities is that option purchasers were more interested in insurance (buying puts)
than in speculating positively on the future price of Intel (buying calls).
• On the third hand,5 the actual difference between the implied volatilities for the calls and
the puts is not that great (about 6%).
This is not the place to summarize the vast finance literature on implied volatilities. For our
purposes, the Black–Scholes model works pretty well. That’s enough!

22.7. Real Options (Advanced Topic)

Thus far in this chapter we have discussed the use of the Black–Scholes model to price call
or put options on shares. Such options are sometimes termed financial options because the
option is written on a stock, which is a financial asset. A growing field in finance discusses real
options. A real option is an option that becomes available as the result of an investment oppor-
tunity. Here are some examples of real options:
• Caulk Shipping is considering the purchase of a license to operate a ferry service from
Philadelphia to Camden. The license requires the company to operate one boat on the
ferry line, but allows Caulk Shipping the possibility of operating as many as 10 ferry
boats on the line. This possibility—the option to expand the ferry service—should
be taken into account when Caulk Shipping evaluates the economics of buying the
license.
• Jones Oil is considering the purchase of a plot that is known to contain a large quantity of
oil. Tom Shale, the company’s financial analyst, has computed the NPV of the lease—he
assumes that once the oil drilling equipment is in place, the company will pump the oil
out of the ground at the maximum feasible rate. However, Tom also realizes that the
financial analysis of the plot purchase should include an important real option: If the
future oil price is low, Jones Oil can stop pumping the oil and wait until the price gets
higher. This option to delay has obvious value.
• Merrill Widgets is considering the purchase of six new widget machines to replace
machines that are currently in place. The new machines employ an innovative produc-
tion technology and are much more sophisticated than the old machines. Simona Mba,
the company’s financial analyst, has determined that the NPV of replacing a single
machine is negative and thus recommends against the replacement. Roberta Merrill,
the company’s owner, has a slightly different logic: She wants to purchase one widget
machine to learn about the machine’s possibilities; after a year she will then decide
whether to buy the remaining five widget machines. The purchase of a single new wid-
get machine gives Merrill Widgets the option to learn. The company’s financial analy-
sis should value this option. Below we return to this case and show how to value the
option to learn.

5
Harry Truman is reported to have gotten so sick of hearing economists say “On the one hand, . . . But on
the other hand, . . . ” that he asked his chief of staff to get him a “one-handed economist.” History does
not record whether he succeeded. The economist in this section’s bullets has at least three hands. Harry
Truman would not have liked him.
656 PART FIVE OPTIONS AND OPTION VALUATION

A Simple Example of the Option to Learn

In the rest of this section we will show how the Black–Scholes model can be used to value
Merrill Widget’s option to learn. Recall that the company is considering replacing each of its
existing six widget machines with new machines. The new machines cost $1,000 each and have
a 5-year life. Simona Mba, the company’s financial analyst, has estimated the expected per-ma-
chine cash flows; these flows are defined as the incremental cash flow of replacing a single old
machine by a new machine and include the after-tax savings from introducing new machines,
the tax shield on incremental depreciation from replacing an old by a new machine, and the sale
of the old machine. It is important to emphasize that management does not know the exact real-
ization of these annual cash flows, but only their expected values. The expected cash flows for
the new machine are given below.

A B C D E F G
3 Y ea r 0 1 2 3 4 5
4 C F of s ingle m ach in e -100 0 2 20 3 00 4 00 2 00 1 50

Simona estimates the risk-adjusted cost of capital for the project at 12%. Using the expected
cash flows and a cost of capital of 12% for the project; Simona has concluded that the replace-
ment of a single old machine by a new machine is unprofitable because the NPV is negative:

220 300 400 200 150

−1,000 + + + + + = −67.48
1.12 (1.12 )2 (1.12 )3 (1.12 )4 (1.12 )5

Now comes the (real options) twist. Roberta Merrill, the company’s owner, says, “I want
to try one of the new machines for a year and learn the true realization of its cash flows. At the
end of the year, if the experiment is successful, I want to replace five other similar machines on
the line with the new machines. If I do not try one of the new machines, I will never know their
true cash flows.”
Does this change our previously negative conclusion about replacing a single machine? The
answer is yes. To see this, we now realize that what we have is a package:
• Replacing a single machine today. This has a NPV of –67.48.
• The option of replacing five more machines in 1 year. We can view each such option as
a call option on an asset that has current value of

220 300 400 200 150

S= + + + + = 932.52
1.12 (1.12) (1.12) (1.12) (1.12)5
2 3 4

and an exercise price X = 1,000. Of course these call options can be exercised only if
we purchase the first machine now; in effect the real options model will be pricing the
learning costs.
Let’s suppose that the Black–Scholes option pricing model can price this call option. We fur-
ther suppose that the risk-free rate is 6% and the standard deviation of the cash flows is σ = 40%.
The equation below shows that the value of the each of the options to acquire one machine in 1
year is $143.98. It now follows that the value of the whole project is $652.39 (cell B11):

Project value = NPV of first machine + 5 options to acquire

= −67.48 + 5 * 143.98 = 652.39
 CHAPTER 22 Option Pricing—the Black–Scholes Formula 657

A B C D E F G
1 MERRILL WIDGET—THE OPTION TO LEARN
2 Year 0 1 2 3 4 5
3 CF of single machine -1000 220 300 400 200 150
4
5 Discount rate for machine cash flows 12%
6 Riskless discount rate 6%
7 NPV of single machine -67.48
8
9 Number of machines bought next year 5
10 Option value of single machine purchased in one more year 143.98 <-- =B24
11 NPV of total project 652.39 <-- =B7+B9*B10
12
13 Black-Scholes Option Pricing Formula
14 S0 932.52 <-- =NPV(B5,C3:G3), PV of machine CFs
15 X 1000.00 Exercise price = Machine cost
16 r 6.00% Risk-free rate of interest
17 T 1 Time to maturity of option (in years)
18 Sigma 40% <-- Volatility
19 d1 0.1753 <-- (LN(S/X)+(r+0.5*sigma^2)*T)/(sigma*SQRT(T))
20 d2 -0.2247 <-- d1 - sigma*SQRT(T)
21 N(d1) 0.5696 <--- Uses formula NormSDist(d1)
22 N(d2) 0.4111 <--- Uses formula NormSDist(d2)
23 Option value = BS call price 143.98 <-- S*N(d1)-X*exp(-r*T)*N(d2)

Thus, buying one machine today, and in the process acquiring the option to purchase five more
machines in 1 year, is a worthwhile project.
One critical element here is the volatility. The lower the volatility (i.e., the lower the uncer-
tainty), the less worthwhile this project is. By building a data table we can examine the relation
between the standard deviation σ and the project value.

B C D E F G H I
26 Data Table
27 σ 652.39 <-- =B11, Table header
28 1% -63.48
29 10% 97.16 1400 Project Value as Function of Sigma
30 20% 283.09 1200
31 30% 468.40
1000
32 40% 652.39
33 50% 834.59 800
34 60% 1014.54 600
35 70% 1191.81 400
36 200
37
0
38
-2000% 20% 40% 60% 80%
39
Sigma
40

The value of the project as a whole comes from our uncertainty about the actual cash flows
1 year from now. The less this uncertainty is (measured by σ), the less valuable the project. In
this particular example a very low uncertainty (σ > 4.75%) with respect to the machine cash flow
returns is sufficient to justify its purchase.6

6
Estimating the σ for real option cash flows is problematic because little market data exist (similar to
stocks) to guide us. Many authors use estimates in the range of 30–50% for the standard deviation of real
option returns; this is somewhat higher than the average standard deviation of U.S. market returns for
equity, which are in the range of 15–30%. To explore this issue, consult one of the three leading books in
the area: Lenos Trigeorgis, Real Options: Managerial Flexibility and Strategy in Resource Allocation,
MIT Press, 1996; Martha Amram and Nalin Kulik, Real Options, Harvard Business School, 1998; or Tom
Copeland and Vladimir Antikarov, Real Options: A Practitioner’s Guide, Texere, 2001.
658 PART FIVE OPTIONS AND OPTION VALUATION

Real Options: Where Do We Go from Here?

Real options are increasingly used in finance to value corporate investments. The example of
Merrill Widgets given earlier is only a small example of the use of the real options technique.
For deeper discussions, we suggest you consult one of the books mentioned in Footnote 6.

Summary
This chapter has given you a quick and hopefully practical insight into how to use the Black–
Scholes model. The Black–Scholes model is remarkably good at pricing options and is widely
used. It is also easy to use, provided you don’t get too hung up on the details of where the for-
mula comes from (in this chapter we’ve left these hang-ups behind us and concentrated exclu-
sively on implementational details).

EXERCISES
1. Use the Black–Scholes model to price the following:
• A call option on a stock whose current price is S = 50, with exercise price X = 50, T = 0.5,
r = 10%, σ = 25%.
• A put option with the same parameters.
2. A call option on a stock is priced at $5.35. The option has an exercise price of X = $40. The current
stock price S = $33, the option’s time to maturity is 6 months, and the interest rate r = 6%. Use the
Black–Scholes model to determine the implied volatility, the σ used to price the option. (Excel
hint: use Goal Seek, Chapter 28.)
3. A put option on a stock is priced at $5. The option has an exercise price of X = $25. The stock’s cur-
rent price is S = $25, the option’s time to maturity is 1 year, and the interest rate is r = 5%. Use the
Black–Scholes model to determine the option’s implied volatility, the σ used to price the option.
(Excel hint: use Solver, Chapter 28.)
4. A call option with one-half year to maturity is written on a stock whose current price is $40. The
option’s exercise price is $38, the interest rate is 4%, and the stock’s volatility is 30%.
a. Find the call option price using the Black–Scholes model.
b. Make a table showing the option’s price for volatilities ranging from 10, 20, . . . , 60%. (Excel
hint: by far the easiest way to do this is to use Data Table, explained in Chapter 27.)
5. A put option with one-half year to maturity is written on a stock whose current price is $40. The
option’s exercise price is $38, the interest rate is 4%, and the stock’s volatility is 30%.
a. Find the put option price using the Black–Scholes model.
b. Make a table showing the option’s price for maturities ranging from T = 0.2, 0.4, . . . , 2.0. (Excel
hint: by far the easiest way to do this is to use Data Table, explained in Chapter 27.)
6. Use the data from Exercise 1 and Data|Table to produce graphs that show the following:
• The sensitivity of the Black–Scholes call price to changes in the initial stock price S.
• The sensitivity of the Black–Scholes put price to changes in σ.
• The sensitivity of the Black–Scholes call price to changes in the time to maturity T.
• The sensitivity of the Black–Scholes call price to changes in the interest rate r.
• The sensitivity of the put price to changes in the exercise price X.
7. Consider the data below. Produce a graph comparing a call’s intrinsic value (defined as Max(S—X,0))
and its Black–Scholes price for S = 20, 25, . . . , 70. From this graph you should be able to deduce that it
is never optimal to exercise early a call priced by the Black–Scholes.
 CHAPTER 22 Option Pricing—the Black–Scholes Formula 659

A B C
3 S 50 Current stock price
4 X 50 Exercise price
5 T 0.50000 Time to maturity of option (in years)
6 r 10.00% Risk-free rate of interest
7 Sigma 25% Stock volatility

8. Produce a graph comparing a put’s intrinsic value (= Max(X-S,0)) and its Black–Scholes price.
From this graph you should be able to deduce that it may be optimal to early exercise a put priced
by the Black–Scholes formula.
9. Use the Excel Solver to find the stock price for which the maximum difference exists between the
Black–Scholes call option price and the option’s intrinsic value. Use the following values: S = 45,
X = 45, T = 1, σ = 40%, r = 8%.
10. The table below gives June option prices for Pfizer (PFE) on 4 March 2005. On this date PFE’s
stock price was $26.85 and the interest rate was 2.60% annually. Compute the implied volatility
for all traded puts and calls using the functions Callvolatility and Putvolatility. (If no price is
given, the option was not traded.)

A B C D
PFIZER (PFE) OPTION
1 PRICES, 4 MARCH 2005
2 Stock price 26.85
3 Current date 4-Mar-05
4 Interest rate 2.60%
5
6 Expiration Exercise Call Put
7 17-Jun-05 22.50 4.70 0.25
8 17-Jun-05 25.00 2.55 0.65
9 17-Jun-05 27.50 1.00 1.60
10 17-Jun-05 30.00 0.30 3.50
11 17-Jun-05 32.50 0.05
12 17-Jun-05 37.50 10.70

11. As shown in Chapter 21 and in Exercise 7 above, the call option value is always greater than its
immediate exercise value (S – X) for S > X. However, the value of the European put is sometimes
less that its intrinsic value (X – S) for S < X. Use the put option pricing model to find such an
example.
12. The probability that a European call option on the stock will be exercised is N(d2) (same expres-
sion as in Black–Scholes option pricing formula). What is the probability that a European call
option on a stock with an exercise price of $40 and a maturity date in 6 months will be exercised?
The current stock price is at $38, the interest rate is at 5%, and the stock return volatility is at
25%.
13. Consider a European put and a European call, both traded on a stock whose current price is $80
per share. The stock’s return has volatility σ = 40%, the time to maturity of both options is 9
months, and the interest rate r = 6%. For what exercise price X are the Black–Scholes put and call
prices equal?
14. A put option with 1 year to maturity is written on a stock. The current underlying stock price
is $20. The option’s exercise price is $18, the interest rate is 3.74%, and the stock’s volatility is
32.7%. The price of a call option written on the same stock with the same exercise price and time
to maturity is $4.30. Use the Black–Scholes model to determine whether put–call parity holds.
660 PART FIVE OPTIONS AND OPTION VALUATION

15. The stock price of ABC Corp. is currently S = $50. What is the price of a European call option
that expires in 2 months and has an exercise price of $60? Assume the yearly interest rate is 5.5%,
and the monthly volatility of the stock prices is 7.8%.
16. The price of a share of ABC Corp. stock is currently S = $55. Assume that the yearly interest is
2%, and the stock’s volatility is 0.4.
a. Determine the prices of European call and put options with a exercise price of $55 and expi-
ration in 3 months.
b. Verify put–call parity.
17. A 1-month European call option is currently selling for $3.00. The exercise price of the option
is $40, and the current stock price is S = $43. The monthly interest rate is 0.5% and the monthly
volatility of the stock return is at 7%. According to the Black–Scholes formula, is the market price
correct?
18. Consider an option trading on a stock with a year to maturity. The implied volatility of the option
at the opening is 25% and at closing it is 22%. Assume that the stock price hasn’t changed. What
do you conclude about the option price? Has it increased or decreased?
19. If the volatility of a stock is 30% and assuming 250 trading days a year, what is the standard devi-
ation of the return in 1 trading day?

APPENDIX: GETTING OPTION INFORMATION FROM YAHOO!

Yahoo! finance (http://finance.yahoo.com) has excellent facilities for getting option prices.
1. Go to Yahoo! finance and put in the stock symbol for which you want prices. In the
example below we’ve put in AT&T, whose symbol is T. Click Get Quotes.
 CHAPTER 22 Option Pricing—the Black–Scholes Formula 661

2. When you’re on the AT&T page, pick Options.

3. Yahoo! gives all the options by expiration date (note the exact expiration date, marked
with the arrow).
CHAP TER

23 The Binomial Option-Pricing Model

CHAPTER CONTENTS
Overview 662
23.1. The Binomial Pricing Model 665
23.2. What Can You Learn from the Binomial Model? 669
23.3. Multiperiod Binomial Model 671
23.4. Advanced Topic: Using the Binomial Model to Price an American
Put 675
Conclusion 678
Exercises 678

Overview
In Chapter 22 we discussed the Black–Scholes formula, the most common method for pricing
options. In this chapter we discuss the other major technique for determining option prices, the
binomial option-pricing model. This model gives some insights into how to price an option, and
it’s also used widely (although not as widely as the Black–Scholes equation).
The basis of the binomial model is a very simple description of stock price uncertainty.
Here’s an example: Suppose the current stock price of MicroDigits (MD) is $100. What can you

662 662
 CHAPTER 23 The Binomial Option-Pricing Model 663

say about the MD stock price 1 year from now? The binomial model assumes that the price of
the stock in 1 year will either go up by a certain percentage or down by a certain percentage.
Here’s an example.

A B C D
BINOMIAL MODEL FOR MICRODIGITS
1 (MD) STOCK PRICE
2 Up 30%
3 Down -10%
4
5 MD stock price one year from now
6 130 <-- =100*(1+B2)
7 100
8 90 <-- =A7*(1+B3)
9
Date1
Date 0 one year
10 today from now
11
12 MD stock price returns
13 0.3 <-- =C6/A7-1
14
15 -0.1 <-- =C8/A7-1
Date1
Date 0 one year
16 today from now

In the example above the MD stock price will either go up by 30% or down by 10% 1 year
from today. This means that the return on the stock will be either 30 or −10% (cells C13 and
C15).
It is difficult to believe that such a simple description of stock price uncertainty could be
useful. However, if we extend the model to more periods, it turns out that the binomial model
can describe a wide range of stock price behavior. In the example below we assume that the
price of MD stock goes up in each of the next 2 years by 30% or goes down by 10%. This means
that there are three possible outcomes for the stock price at Date 2: It can be either $169, $117,
or $81.

A B C D E F
TWO-PERIOD BINOMIAL MODEL FOR MICRODIGITS (MD)
1 STOCK PRICE
2 Up 30%
3 Down -10%
4
5 169 <-- =C6*(1+B2)
6 130
7 100 117 <-- =C6*(1+B3)
8 90
9 81 <-- =C8*(1+B3)
Date 1 Date 2
Date 0 one year two years
10 today from now from now

If we extend the model to more periods, we’ll get a wide range of possible prices and
returns. In the following spreadsheet we look at stock prices after 10 periods.
664 PART FIVE OPTIONS AND OPTION VALUATION

A B C D E F G H I J K
1 MULTIPERIOD BINOMIAL MODEL FOR MICRODIGITS (MD) STOCK PRICE
2 Up 30%
3 Down -10%
4
5 Date
6 0 1 2 3 4 5 6 7 8 9 10
7 1378.58
8 1060.45
9 815.73 954.40
10 627.49 734.16
11 482.68 564.74 660.74
12 371.29 434.41 508.26
13 285.61 334.16 390.97 457.44
14 219.70 257.05 300.75 351.87
15 169.00 197.73 231.34 270.67 316.69
16 130.00 152.10 177.96 208.21 243.61
17 100.00 117.00 136.89 160.16 187.39 219.24
18 117.00 105.30 123.20 144.15 168.65
19 81.00 94.77 110.88 129.73 151.78
20 72.90 85.29 99.79 116.76
21 65.61 76.76 89.81 105.08
22 59.05 69.09 80.83
23 53.14 62.18 72.75
24 47.83 55.96
25 43.05 50.36
26 38.74
27 34.87

If you plot the stock return and the probabilities of the returns after 10 years, you get a
graph such as the one below.1

0.25

0.2

If the annual "up" return is 30% and the annual

"down" return is –10%, then after 10 periods, the
Probability

probability of a return of 357% is 11.72%.

0.15
The probability of a return of –50% is 1%.

0.1

0.05

0
-100% 0% 100% 200% 300% 400% 500% 600% 700% 800% 900% 1000% 1100% 1200% 1300%
Return

1
The mathematics required to produce such a graph are outside the scope of this book. For further details
see my book Financial Modeling, 3rd edition (MIT Press, 2008).
 CHAPTER 23 The Binomial Option-Pricing Model 665

A Pedagogical Note
Most finance books first discuss the binomial option model and then discuss Black–Scholes.
Their reasoning is that this order is logical because in principle the Black–Scholes pricing for-
mula can be derived from the binomial model. In this book we’ve reversed the order, because we
despair of telling you exactly how Black–Scholes is derived from the binomial. Instead, we’ve
treated the two models as entirely different topics with different pedagogical goals: Black–
Scholes is the most commonly used option-pricing model; as a finance person you should be
familiar with this model and understand how to manipulate it (note that we haven’t said that
you need to understand it!). The binomial model is more educational but less useful (at least on
the level of this book): It gives some insights into how options are priced through a process of
replication. It can also be used to understand topics such as the pricing of American options and
real options.
One of the uses we show for the binomial option pricing model is the use of the model
to price American options (Section 23.4). These options cannot be priced using the Black–
Scholes formula, which prices only European options. In an advanced options course
you will learn to use the binomial option pricing model to price other, more complicated
options.

Finance Concepts in This Chapter

• Binomial model
• Replicating portfolio

Excel Functions Used

• Max

23.1. The Binomial Pricing Model

To illustrate the use of the binomial model, we start with the following very simple example:

• You’re trying to calculate the value of a call option on ABC stock. The option expires in
1 year and has an exercise price of $110.
• ABC stock sells today for $100. A wise person has informed you that in 1 year, the price
of the stock will either be $130 or $90.2 We will refer to these possibilities as the “up”
and the “down” states.
• The 1-year interest rate is 6%. You can borrow or lend at this rate.

Here’s a spreadsheet picture that incorporates all of this information (the spreadsheet also shows
the payoffs on a put written on ABC stock—we’ll get to that in a moment).

2
This wise person forgot to tell you the probabilities attached to these two events, but it turns out not to
matter. Surprised? You should be. But read on.
666 PART FIVE OPTIONS AND OPTION VALUATION

A B C D E F G H I J
1 PRICING OPTIONS ON ABC STOCK—THE BINOMIAL MODEL
2 Up 30%
3 Down -10%
4
5 Initial stock price 100
6 Interest rate 6% ABC's stock price
7 Exercise price 110 in the "up" state
8
9 ABC's stock price Bond price
10 130 <-- =$B$11*(1+B2) 1.06 <-- =$G$12*(1+$B$7)
11 100 1
12 90 <-- =$B$11*(1+B3) 1.06 <-- =$G$12*(1+$B$7)
13 ABC's stock price
14 in the "down" state Call payoff in
15
the "up" state
16 Call option payoffs Put option payoffs
17 20 <-- =MAX(D10-$B$7,0) 0 <-- =MAX($B$7-D10,0)
18 ??? ???
19 0 <-- =MAX(D12-$B$7,0) 20 <-- =MAX($B$7-D12,0)
20
21 Call payoff in the
22 "down" state

We’re going to price the call option by showing that there is a combination of the bonds
and stocks that gives exactly the same payoffs as the call option. To show this, we use some
basic high school algebra: Suppose we buy a portfolio of A shares of the stock and buy B bonds.
Then the payoff of the portfolio in the up state is 130 A + 1.06 B and the payoff of the portfolio
in the down state is 90 A + 1.06 B . Now let’s find A and B so that these two payoffs equal the
call option payoffs:

130 A + 1.06 B = 20
90 A + 1.06 B = 0 .

This system of equations solves to give

130 A + 1.06B = 20
90 A + 1.06B = 0
20 − 0 0 − 90 A −90 * 0.5
A= = 0.5, B = = = −42.4528
130 − 90 1.06 1.06

So now we know that buying half a share of ABC (cost $50) and borrowing $42.4528 will
give you payoffs in 1 year that are exactly the same as the payoffs of the call option. The expen-
diture on this portfolio of {buy one-half share, borrow $42.4528} should be the same as the
expenditure on the call option. Thus the call option’s price should be $7.5472:

!"""#"""$ − 42.4528
call option price = 0.5*100 !"""#"""$ = 7.5472
!""#""$
↑ ↑ ↑
the cost of the the financing the market price
stock in the provided by of the call
"replicating borrowing in the option
portfolio" "replicating
portfolio" .
 CHAPTER 23 The Binomial Option-Pricing Model 667

THE REPLICATING PORTFOLIO

The portfolio we just derived—A = 0.5 shares and B = −$42.4528 borrowed—gives the same
payoffs as the call option. For this reason it is often called the replicating portfolio.

What’s Going On?—Market Efficiency at Work

Option pricing in the binomial model is a wonderful example of the first two principles of effi-
cient markets discussed in Chapter 17. The first principle (“Competitive markets have a single
price for a single good”) implies that the combination of the stock + borrowing (which in terms
of payoffs has exactly the payoffs of the call option) should be priced like the call option. The
second principle, price additivity (“The price of a bundle of securities should be the sum of the
prices of each of the securities”) is also illustrated here—the price of the call option is the cost
of the stock ($45) minus the borrowing to finance this cost.
For option-pricing theorists this method of pricing options is an example of arbitrage—the
principle that if you can construct an asset’s payoffs in two ways, each of these ways should have
the same market value (which is, of course, Chapter 17’s first principle of efficiency).
It can all be summed up as follows.

A B C D E F G H I J
1 PRICING OPTIONS ON ABC STOCK—THE BINOMIAL MODEL
2 Up 30%
3 Down -10%
4
5 Initial stock price 100
6 Interest rate 6% ABC's stock price
7 Exercise price 110 in the "up" state
8
9 ABC's stock price Bond price
10 130 <-- =$B$11*(1+B2) 1.06 <-- =$G$12*(1+$B$7)
11 100 1
12 90 <-- =$B$11*(1+B3) 1.06 <-- =$G$12*(1+$B$7)
13 ABC's stock price
14 in the "down" state Call payoff in
15
the "up" state
16 Call option payoffs Put option payoffs
17 20 <-- =MAX(D10-$B$7,0) 0 <-- =MAX($B$7-D10,0)
18 ??? ???
19 0 <-- =MAX(D12-$B$7,0) 20 <-- =MAX($B$7-D12,0)
20
21 Call payoff in the
22 "down" state
23 The call replicating portfolio
24 Stock, A 0.5000 <-- =(D17-D19)/(D10-D12)
25 Bonds, B -42.4528 <-- =(D19-D12*B24)/(1+B6)
26 Call price 7.5472 <-- =B24*B5+B25

Using the Binomial Model to Price a Put on ABC Stock

We now use the binomial model to price a put on ABC with an exercise price of $110. The put
payoffs are shown below.
668 PART FIVE OPTIONS AND OPTION VALUATION

G H I J
14
Put payoff in the
15 "up" state
16 Put option payoffs
17 0 <-- =MAX($B$7-D10,0)
18 ???
19 20 <-- =MAX($B$7-D12,0)
20
Put payoff in the
21
"down" state
22

The replicating portfolio is:

130 A + 1.06 B = 0
90 A + 1.06 B = 20 .

These equations solve to give

−20 −130 A −130 * (−0.5 )

A= = −0.5, B = = = 61.3208
130 − 90 1.06 1.06

The solution to the replicating portfolio indicates that short-selling A = −0.5 shares and
investing in B = $61.3208 bonds gives the same payoffs as the put option. This means that the
price of the put is $11.3208:

put option price = −0.5*100 + 61.3208

!"""#"""$ !"""#"""$ = 11.3208
!""#""$
↑ ↑ ↑
cash provided by cash used to buy the market price
the short sale of bonds in the of the put
stock in the "replicating option
"replicating portfolio"
portfolio"

Put–Call Parity—Another Way of Pricing the Put

In Chapter 21 we learned the put–call parity principle:

Put price + Stock price = Call price + PV (Exercise price )

Applying this principle in our problem, we get

Put price = Call price + PV (Exercise price) − Stock price

110
= 7.5472 + − 100 = 11.3208
1.06

Here’s the whole spreadsheet, one more time.

 CHAPTER 23 The Binomial Option-Pricing Model 669

A B C D E F G H I J
1 PRICING OPTIONS ON ABC STOCK—THE BINOMIAL MODEL
2 Up 30%
3 Down -10%
4
5 Initial stock price 100
6 Interest rate 6% ABC's stock price
7 Exercise price 110 in the "up" state
8
9 ABC's stock price Bond price
10 130 <-- =$B$11*(1+B2) 1.06 <-- =$G$12*(1+$B$7)
11 100 1
12 90 <-- =$B$11*(1+B3) 1.06 <-- =$G$12*(1+$B$7)
13 ABC's stock price
14 in the "down" state Put payoff in the
15
"up" state
16 Call option payoffs Put option payoffs
17 20 <-- =MAX(D10-$B$7,0) 0 <-- =MAX($B$7-D10,0)
18 ??? ???
19 0 <-- =MAX(D12-$B$7,0) 20 <-- =MAX($B$7-D12,0)
20
Put payoff in the
21
"down" state
22
23 The call replicating portfolio
24 Stock, A 0.5000 <-- =(D17-D19)/(D10-D12)
25 Bonds, B -42.4528 <-- =(D19-D12*B24)/(1+B6)
26 Call price 7.5472 <-- =B24*B5+B25
27
28 The put replicating portfolio
29 Stock, A -0.5000 <-- =(I17-I19)/(D10-D12)
30 Bonds, B 61.3208 <-- =(I17-D10*B29)/(1+B6)
31 Call price 11.3208 <-- =B29*B11+B30
32
33 Pricing the put by put-call parity
34 Call price 7.5472 <-- =B26
35 PV(exercise) 103.7736 <-- =B7/(1+B6)
36 Stock price 100 <-- =B5
37 Put price 11.3208 <-- =B34+B35-B36

23.2. What Can You Learn from the Binomial Model?

The binomial option-pricing model is very instructive. It is an easy way to price options, and
it can also tell you something about a more complicated option-pricing model. Here are a few
lessons you can learn from the binomial model.
• A call “looks like” a portfolio composed of the purchase of a stock and the short sale of
a bond. The call’s replicating portfolio is

A * SUp + B * (1 + r ) = Call payoffUp

A * SDown + B * (1 + r ) = Call payoffDown
where:
SUp and SDown are the stock prices in the "up" and "down" states
Call payoffUp and Call payoff Down are the call payoffs

In terms of the call’s replicating portfolio, it turns out that A (the stock) is always positive and B
(the bond) is always negative. This indicates the purchase of a stock financed by borrowing. In
a sense the Black–Scholes formula has the same property:
670 PART FIVE OPTIONS AND OPTION VALUATION

BS call price = S * N (d1 ) − Xe −rT N (d2 )

!"""#"""$ !""""#""""$
↑ ↑
Purchase of Borrowing at
stock the risk free rate
(positive number) (negative number )

• A put looks like a portfolio composed of the short sale of a stock and the purchase of a
bond. The put’s replicating portfolio is

A * SUp + B * (1 + r ) = Put payoffUp

A * SDown + B * (1 + r ) = Put payoff Down
where:
SUp and SDown are the stock prices in the "up" and "down" states
Put payoffUp and Put payoff Down are the put payoffs

In terms of the put’s replicating portfolio, it turns out that A (the stock) is always negative and
B (the bond) is always positive. This indicates the purchase of bonds financed by a short sale of
the stock. In a sense, the Black–Scholes formula has the same property:

BS put price = −S * N (−d1 ) + Xe −rT N (−d2 )

!""""#""""$ !""""""#""""""$
↑ ↑
Short sale of Investing at
stock the risk free rate
(negative number) (positive number )

• The probabilities of the up and the down states don’t appear explicitly in the calculation
of the option price. To see what this means, look at the way we solved for the call option
price at the beginning of this chapter:

130 A + 1.06B = 20
90 A + 1.06B = 0

These equations solve to give:

20 − 0 0 − 90 A −90 * 0.5
A= = 0.5, B = = = −42.4528
130 − 90 1.06 1.06

The resulting call option price:

call option price = 0.5* $100 − $42.4528

!"""#"""$ !"""#"""$ = 7.5472
!""#""$
↑ ↑ ↑
Cost of the Financing Market price
stock in the provided by of the call
"replicating borrowing in the option
portfolio" "replicating
portfolio"

This calculation of the call option price when the option exercise price is $110 relies on three
facts: (i) the current stock price is $100, (ii) the stock price next period is either 130 or 90, and
 CHAPTER 23 The Binomial Option-Pricing Model 671

(iii) the interest rate is 6%. Nowhere in this calculation have we made any reference to the prob-
abilities that the stock price will be $130 or $90.3
• The binomial model is extendible—it can be used to price many options in a multiperiod
setting. In the next section we show a multiperiod binomial model.

23.3. Multiperiod Binomial Model

The binomial model can be extended to multiple periods. Here’s an example that extends the
previous example.

A B C D E F G H I J K L
1 THREE-DATE BINOMIAL OPTION PRICING
2 Up 30%
3 Down -10%
4
5 Initial stock price 100
6 Interest rate 6%
7 Exercise price 110
8
9 Stock price Bond price
10 169.00 1.1236
11 130 1.06
12 100 117.00 1 1.1236
13 90 1.06
14 81.00 1.1236
15 Date 0 Date 1 Date 2 Date 0 Date 1 Date 2
16
17
18 Call option price Put option price
19 59.00 <-- =MAX(E10-$B$7,0) 0.00 <-- =MAX($B$7-E10,0)
20 ???-1 ???-1
21 ???-0 7.00 <-- =MAX(E12-$B$7,0) ???-0 0.00 <-- =MAX($B$7-E12,0)
22 ???-2 ???-2
23 0.00 <-- =MAX(E14-$B$7,0) 29.00 <-- =MAX($B$7-E14,0)
24 Date 0 Date 1 Date 2 Date 0 Date 1 Date 2

In this example, the stock price goes up by 30% or down by 10% in each period. Starting
with a stock price of $100 at Date 0, the stock price at Date 1 will be either $130 or $90, and the
stock price at Date 2 will be $169, $117, or $81.

• $169: This happens if it goes up twice—that is, 169 = 100 * (1.30 )(1.30 ).
• $117: This happens if the stock price goes up once and down once—that is,
117 = 100 * (1.30 )* (0.90 ). Note that it doesn’t matter if the stock price goes up first and
then down or the reverse.
• $81: This happens if the stock price goes down twice—that is, 81 = 100 * (0.90 )(0.90 ) .

In each period the risk-free interest rate is 6%, so that $1 invested in the bond will grow to
$1.1236 at date 2.

3
Of course you could quibble a bit and insist that the stock price today must incorporate these probabilities
in some sense, and you’d be right. But even here you have to be careful—for example, it would be wrong to
say that the stock price is the discounted expected future payoff of the stock. To explain this all would take
us too far afield—suffice it to say that if investors are risk averse, they’ll price the stock below its expected
future discounted payoff. The amount of this discount depends on the risk aversion.
672 PART FIVE OPTIONS AND OPTION VALUATION

The Call Option’s Terminal Payoffs

At the end of the second period, the option’s payoffs are given by

⎧ Max (169 − 110,0 ) = 59

⎪
Max (stock price at date 2 − 110,0 ) = ⎨ Max (117 − 110,0 ) = 7
⎪ Max (81 − 110,0 ) = 0
⎩

We now have to value the option. We proceed by doing three valuations—these are labeled in
the diagram as “???-1,” “???-2,” and “???-0.” The put option has the same labels—we’ll figure
out in a while how to price these.

Determining “???-1” for the Call

We proceed as we did for the one-period binomial option-pricing model. Setting up the one-
period stock and bond prices and option payoffs, we get the following.

A B C D E F G H
26 Finding ???-1 for the call
27
28 Stock price Bond price
29 169.00 1.1236
30 130 1.06
31 117.00 1.1236
32
33 Call option price
34 59.00
35 ???-1
36 7.00
37
38 The call replicating portfolio
39 Stock, A 1.0000 <-- =(D34-D36)/(D29-D31)
40 Bonds, B -97.8996 <-- =(D36-B39*D31)/H29
41 Call price 26.2264 <-- =B39*B30+B40*F30

Setting up the equations (we use A to denote the number of shares and B to denote the bonds in
the replicating portfolio),

169 A + 1.1236B = 59
117 A + 1.1236B = 7

Solution:
59 − 7
A= =1
169 − 117
7 − 117 * A
B= = −97.8996
1.1236

Call option price = 130 * A + 1.06 * B = 26.2264

These calculations are done in cells B39:B41.

 CHAPTER 23 The Binomial Option-Pricing Model 673

Determining “???-2” for the Call

Again we proceed as we did for the one-period binomial option-pricing model. Setting up the
one-period stock and bond prices and option payoffs, we get the following.

A B C D E F G H
44 Finding ???-2 for the call
45
46 Stock price Bond price
47 117.00 1.1236
48 90 1.06
49 81.00 1.1236
50
51 Call option price
52 7.00
53 ???-2
54 0.00
55
56 The call replicating portfolio
57 Stock, A 0.1944 <-- =(D52-D54)/(D47-D49)
58 Bonds, B -14.0174 <-- =(D54-B57*D49)/H47
59 Call price 2.6415 <-- =B57*B48+B58*F48

Determining “???-0” for the Call

Once more, we set up a simple binomial model, but this time we use the two values derived
above—the prices of the call option at date 1.

A B C D E F G H
62 Finding ???-0 for the call
63
64 Stock price Bond price
65 130.00 1.0600
66 100 1
67 90.00 1.0600
68
69 Call option price
70 26.2264
71 ???-0
72 2.6415
73
74 The call replicating portfolio
75 Stock, A 0.5896 <-- =(D70-D72)/(D65-D67)
76 Bonds, B -47.5703 <-- =(D72-B75*D67)/H65
77 Call price 11.3919 <-- =B75*B66+B76*F66

The result—we’ve calculated the option price today as $11.3919.

Pricing the Put—The Long Way

As you can see from the diagram, the put has date 2 payoffs as follows.

G H I J K L
18 Put option price
19 0.00 <-- =MAX($B$7-E10,0)
20 ???-1
21 ???-0 0.00 <-- =MAX($B$7-E12,0)
22 ???-2
23 29.00 <-- =MAX($B$7-E14,0)
24 Date 0 Date 1 Date 2
674 PART FIVE OPTIONS AND OPTION VALUATION

We can use the same logic (and even the same equations) to price the put. The results,
shown below with no explanations, show that the put price at date 0 is 9.2916.

A B C D E F G H
80 PRICING THE PUT
81 Finding ???-1 for the put
82
83 Stock price Bond price
84 169.00 1.1236
85 130 1.06
86 117.00 1.1236
87
88 Put option price
89 0.00
There's actually no need to do any
90 ???-1
calculations for ???-1: The price
91 0.00 ???-1 is the value of a security
92 which has zero payoffs one period
93 The put replicating portfolio hence. By any logic this price
should be zero.
94 Stock, A 0.0000 <-- =(D89-D91)/(D84-D86)
95 Bonds, B 0.0000 <-- =(D91-B94*D86)/H84
96 Put price 0.0000 <-- =B94*B85+B95*F85
97
98
99 Finding ???-2 for the put
100
101 Stock price Bond price
102 117.00 1.1236
103 90 1.06
104 81.00 1.1236
105
106 Put option price
107 0.00
108 ???-2
109 29.00
110
111 The put replicating portfolio
112 Stock, A -0.8056 <-- =(D107-D109)/(D102-D104)
113 Bonds, B 83.8822 <-- =(D109-B112*D104)/H102
114 Put price 16.4151 <-- =B112*B103+B113*F103
115
116
117 Finding ???-0 for the put
118
119 Stock price Bond price
120 130.00 1.0600
121 100 1
122 90.00 1.0600
123
124 Put option price
125 0.0000
126 ???-0
127 16.4151
128
129 The put replicating portfolio
130 Stock, A -0.4104 <-- =(D125-D127)/(D120-D122)
131 Bonds, B 50.3293 <-- =(D127-B130*D122)/H120
132 Put price 9.2916 <-- =B130*B121+B131*F121
 CHAPTER 23 The Binomial Option-Pricing Model 675

Pricing the Put Using Put–Call Parity

We can also use put–call parity to price the put. As discussed in Section 21.3, put–call
parity says:

Put price + Stock price = Call price + PV (Exercise price )

Applying this principle to the two-date option, we get

Put price = Call price + PV (Exercise price) − Stock price

110
= 11.3919 + − 100 = 9.2916
(1.06 )2

A B C D E F
135 Pricing the put with put-call parity
136 Initial stock price 100
137 Interest rate 6%
138 Exercise price 110
139 Call price 11.3919
140 Put price 9.2916 <-- =B139+B138/(1+B137)^2-B136

23.4. Advanced Topic: Using the Binomial Model to

Price an American Put
The binomial model is cute and easy to understand. But why do we need it? The answer is com-
plex and mostly beyond the scope of this book:

• Whereas the Black–Scholes formula prices only European options, the binomial model
can be used to price American options. This use of the binomial model is illustrated in
the next subsection.
• Properly implemented, the binomial model can help us prove the Black–Scholes formula.
This use of the binomial model is too advanced for this book.
• The binomial model can be used to price more complex options than those priced with
Black–Scholes, which prices only European options. For example, we can use the bino-
mial model to price options where the exercise price changes over time or where the
interest rate varies.
• We can also use the binomial model to price options where the “up” and the “down”
movements of the stock price vary over time. Many finance people believe, for example,
that the volatility of the stock price return varies with the price itself—that the percent-
age up and the down movements for a stock are larger when the stock price is small. This
can be handled by the binomial model, but not by Black–Scholes.
676 PART FIVE OPTIONS AND OPTION VALUATION

“WEIRD” OPTIONS AND THE BINOMIAL MODEL

The binomial model is especially useful in determining the price of weird options. Here are two
examples of such options.
An Asian option is an option whose payoff is determined by the average price of the stock
over a certain period before the option’s maturity. One specification of an Asian call option
might be as follows:
• On 29 January 2005 you buy an Asian call option on IBM with a maturity of 1 year. The
option’s payoff on 29 January 2006 is the difference between the average daily closing
IBM stock price in the 30 days preceding the option’s maturity and the option’s exercise
price X = $120. This option cannot be priced using the Black–Scholes model, but it can
be priced using the binomial model.
A barrier option is an option whose payoff depends on whether the stock price reaches a
certain point during the life of the option. Here’s an example:
• On 29 January 2005 you buy a 1-year knock-in barrier option on IBM, which is cur-
rently selling at $93. The option specifies that you have the right to buy a share of IBM
on 29 January 2006 for an exercise price of $100, provided that at some point during the
year IBM’s stock price exceeds $130 (this is the “knock-in barrier”). If the price of IBM
during the coming year does not exceed $130, your option is worthless. Barrier options
cannot be priced using the Black–Scholes model, but they can be priced using the bino-
mial model.
There are many more of these weird options. A good place to start for some background is
http://www.risk-glossary.com.

Using the Binomial Model to Price American Options

To illustrate one more sophisticated use of the binomial model, we’ll show you how it can be
used to price an American put option. Recall that American options can be exercised early. We
go back to our two-date example and focus on the put price (highlighted).

A B C D E F G H I J K L
1 THREE-DATE BINOMIAL OPTION PRICING—American options
2 Up 30%
3 Down -10%
4
5 Initial stock price 100
6 Interest rate 6%
7 Exercise price 110
8
9 Stock price Bond price
10 169.00 1.1236
11 130 1.06
12 100 117.00 1 1.1236
13 90 1.06
14 81.00 1.1236
15
16 Call option price Put option price
17 59.00 <-- =MAX(E10-$B$7,0) 0.00 <-- =MAX($B$7-E10,0)
18 ???-1 ???-1
19 ???-0 7.00 <-- =MAX(E12-$B$7,0) ???-0 0.00 <-- =MAX($B$7-E12,0)
20 ???-2 ???-2
21 0.00 <-- =MAX(E14-$B$7,0) 29.00 <-- =MAX($B$7-E14,0)
 CHAPTER 23 The Binomial Option-Pricing Model 677

We’ll price the put just as we did the call in the previous section. However, this time we
assume that the put is an American put—meaning that it can be exercised early.4
We start by pricing the put at the up-state of date 1 (this is marked “???-1” in the spread-
sheet). This is actually fairly simple: At ???-1 the put owner has future payoffs of zero, no matter
what happens. This means that the put should be worth zero, and that’s exactly what the spread-
sheet tells us.

A B C D E F G H
24 Finding ???-1 for the put
25
26 Stock price Bond price
27 169.00 1.1236
28 130 1.06
29 117.00 1.1236
30
31 Put option price There's actually no need to do
32 0.00 any calculations for ???-1: The
price ???-1 is the value of a
33 ???-1 security which has zero payoffs
34 0.00 one period hence. By any logic
35 this price should be zero.
36 The put replicating portfolio
37 Stock, A 0.0000 <-- =(D32-D34)/(D27-D29)
38 Bonds, B 0.0000 <-- =(D34-B37*D29)/H27
39 Put price ???-1 0.0000 <-- =B37*B28+B38*F28

At ???-2 the situation is more complicated. The put has a future payoff that is positive. We
can use the binomial model to solve for the put price.

A B C D E F G H
42 Finding ???-2 for the put
43
44 Stock price Bond price
45 117.00 1.1236
46 90 1.06
47 81.00 1.1236
48
49 Put option price
50 0.00
51 ???-2
52 29.00
53
54 The put replicating portfolio
55 Stock, A -0.8056 <-- =(D50-D52)/(D45-D47)
56 Bonds, B 83.8822 <-- =(D52-B55*D47)/H45
57 European put price ???-2 16.4151 <-- =B55*B46+B56*F46
58 American put price ???-2 20.0000 <-- =MAX(B7-B46,B55*B46+B56*F46)

But now the early exercise feature of the put comes in (remember—it’s an American
put). The put value of $16.4151 (cell B57 above) is the value of a put that has payoffs only next
period. Instead of waiting until next period, we can exercise the put today: The stock price
is $90 and the put exercise is $110, which means we can collect $20 immediately if we early

4
There is usually no problem pricing American call options: Recall from Chapter 21 that the price of an
American call on a non-dividend-paying stock is the same as the price of a European call. So the real prob-
lem in pricing American options relates to puts.
678 PART FIVE OPTIONS AND OPTION VALUATION

exercise the put. So the actual put value—given the early exercise feature—is $20 and not
$16.4151 (cell B58):
Using this value of $20, we can price the put at date 0.

A B C D E F G H
60 Finding ???-0
61
62 Stock price Bond price
63 130.00 1.0600
64 100 1
65 90.00 1.0600
66
67 Put option price
68 0.0000
69 ???-0
70 20.0000
71
72 The put replicating portfolio
73 Stock, A -0.5000 <-- =(D68-D70)/(D63-D65)
74 Bonds, B 61.3208 <-- =(D70-B73*D65)/H63
75 American put price ???-0 11.3208 <-- =MAX(B7-B64,B73*B64+B74*F64)

In Section 23.3 we priced a European put with the same exercise price X = $110. There we
concluded (page 671) that the value of the European put is $9.2916. When we reprice the put
as an American put, we see that its price is $11.3208, higher than the European put price. This
happens because we will want to early exercise the put at ???-2.

Conclusion
The binomial option pricing model can be used to price options under more general conditions
than those that hold for the Black–Scholes model. This chapter has revealed only the tip of this
financial iceberg, showing you how to implement the model in a one-date and a two-date frame-
work. We’ve also indicated how the model can be used to price American options and weird
options such as Asian options or barrier options.

EXERCISES
1. A stock selling for $25 today will, in 1 year, be worth either $35 or $20. If the interest rate is 8%,
what is the value today of a 1-year European call option on the stock with exercise price $30?
2. In Exercise 1, calculate the value today of a 1-year European put option on the stock with exercise
price $30. Show that put–call parity holds: That is, using your answer from this problem and the
previous problem, show that

X
call price + = stock price today + put price
1+ r

3. In a binomial model a European put option is written on a stock selling today for $30. The exercise
price of the put option is 40. The put option’s payoffs are 20 and 5. The price of the put is $9.50.
What is the riskless interest rate? Assume that the basic period is 1 year.
4. All reliable analysts agree that a share of ABC Corp., selling today for $50, will be priced at either
$65 or $45 1 year from now. They further agree that the probabilities of these events are 0.6 and
 CHAPTER 23 The Binomial Option-Pricing Model 679

0.4, respectively. The market risk-free rate is 6%. What is the value of a call option on ABC whose
exercise price is $50 and that matures in 1 year?
5. A stock is currently selling for $60. The price of the stock at the end of the year is expected either
to increase by 25% or decrease by 20%. The riskless interest rate is 5%. Calculate the price of a
European put on the stock with exercise price $55. Use the binomial option pricing model.
6. Fill in all the cells labeled ??? in the following spreadsheet.

Up 30%
Down -10%

Initial stock price 60

Interest rate 6%
Exercise price 70

Stock price Bond price

??? ???
??? ???
60 ??? 1 ???
??? ???
??? ???
Date 0 Date 1 Date 2 Date 0 Date 1 Date 2

Call option price European Put option price

??? ???
??? ???
??? ??? #REF! ???
??? ???
??? ???
Date 0 Date 1 Date 2 Date 0 Date 1 Date 2

American Put option price

???
???
??? ???
???
???
Date 0 Date 1 Date 2

7. Consider the following two-period binomial model, in which the annual interest rate is 9% and in
which the stock price goes up by 15% per period or down by 10%:

Stock price Bond price

66.1250 1.1881
57.50 1.09
50 51.7500 1 1.1881
45.00 1.09
40.5000 1.1881

a. Price a European call on the stock with exercise price 60.

b. Price a European put on the stock with exercise price 60.
c. Price an American call on the stock with exercise price 60.
d. Price an American put on the stock with exercise price 60.
8. Consider the following two-period binomial model:
• In each period the stock price either goes up by 30% or decreases by 10%.
• The one-period interest rate is 25%
680 PART FIVE OPTIONS AND OPTION VALUATION

Stock price Bond price

50.70 1.5625
39.00 1.25
30 35.10 1 1.5625
27.00 1.25
24.30 1.5625

a. Consider a European call with X = 30 and T = 2. Fill in the blanks in the tree.

Call option price

???
???
??? ???
???
???

b. Price a European put with X = 30 and T = 2.

c. Now consider an American put with X = 30 and T = 2. Fill in the blanks in the tree.
American put option price
???
???
??? ???
???
???

9. A prominent securities firm recently introduced a new financial product. This product, called
“The Best of Both Worlds” (BOBOW for short), costs $10. It matures in 5 years, at which point
it repays the investor the $10 cost plus 120% of any positive return in the S&P 500 Index. There
are no payments before maturity.
For example, if the S&P 500 is currently at 1,500, and if it is at 1,800 in 5 years, a BOBOW
owner will receive back $12.40 = $10 * [1 + 1.2 * (1,800/1,500 − 1)]. If the S&P is at or below 1,500
in 5 years, the BOBOW owner will receive back $10.
Suppose that the annual interest rate on a 5-year, continuously compounded, pure-discount
bond is 6%. Suppose further that the S&P 500 is currently at 1,500 and that you believe that in
5 years it will be at either 2,500 or 1,200. Use the binomial option-pricing model to show that
BOBOWs are worth more than their current price of $10.
10. A call option is written on a stock whose current price is $50. The option has maturity of 2 years,
and during this time the annual stock price is expected to increase by 25% or to decrease by 10%.
The annual interest rate is constant at 6%. The option is exercisable at date 1 at a price of $55 and
at date 2 for a price of $60. What is its value today? Will you ever exercise the option early?
11. A stock is currently selling for $60. A put option has maturity of 2 years, and during this time the
annual stock price is expected to increase by 30% or to decrease by 10%. The riskless interest
annual rate is 6%. The put option is currently selling for $9. Is the option more likely an American
or a European put option? Use the binomial option pricing model to determine.
12. A call option is written on a stock whose current price is $100. The option has maturity of 2 years,
and during this time the annual stock price is expected to increase by 30% or to decrease by 10%.
The annual interest rate is constant at 6%. The option’s exercise price is $110. Extend the binomial
option pricing to incorporate a $3.00/share dividend that will be paid out in period 2. In other
words, all of the period 2 stock prices will be reduced by $3.00. Determine the current prices of
the call. Compare with the nondividend case that appears in this chapter.
13. A 2-year American put option is written on a stock whose current price is $42. You expect that in
each year the stock price either goes up by 15% or decreases by 5%. The one-period interest rate
is 5%. The option’s exercise price is $45. Will you ever exercise the option early?
 PA R T

6
BACKGROUND TO EXCEL

P RINCIPLES OF FINANCE WITH EXCEL uses Excel throughout as the tool to understanding and
implementing financial analysis. Part 6 serves two purposes:
• It serves as an introduction and reminder of the basics of Excel.
• It reviews the principal Excel techniques used in the book.
Section 6 starts off with Chapter 24, which reviews Excel basics. These are all the things that
you probably knew all along but might have forgotten. Topics include opening Excel, saving
your work, copying (both relative and absolute), and basic graphing.
Chapter 25 gets into more detail on graphs in Excel. After reading this chapter, you’ll know
how to make Excel charts look better, how to graph non-contiguous data, and how to make
graph titles that change when the inputs change, and more.
Chapter 26 has brief discussions on most of the functions used in Principles of Finance
with Excel.
Excel’s Data Table, the topic of Chapter 27, is a fabulous technique to do sensitivity
analysis. Data Table is a bit complicated, but once you master it, you’ll never understand how
you functioned without it.
Chapter 28 discusses Goal Seek and Solver. These are two very useful Excel tools to find
model solutions. Most students are aware of Goal Seek, but many Excel users are not aware
that Solver is almost as easy to use and more useful. Chapter 28 shows you how to use both of
these tools.
Chapter 29 discusses dates in Excel. Topics include the manipulation of dates and times in
Excel and the use of Excel’s date functions in financial analysis.
This page intentionally left blank
CHAP TER

24 Introduction to Excel

CHAPTER CONTENTS
Overview 683
24.1. Getting Started 684
24.2. Formatting the Numbers 688
24.3. Copying with Absolute References—Building a More Sophisticated
Model 690
24.4. Saving the Spreadsheet 695
24.5. Your First Excel Graph 697
24.6. Initial Settings 699
24.7. Using a Function 702
24.8. Printing 704
Summary 705
Exercises 705

Overview
This chapter introduces you to Excel and shows you how to do the most important initial opera-
tions. Excel is not difficult to learn to use, provided you’re willing make many mistakes along
the way and you take an occasional look at the online Help (press function key F1).

683
684 PART SIX BACKGROUND TO EXCEL

Contents of This Chapter

• Turning Excel on
• Saving, creating a new directory
• Copying—relative versus absolute
• Formatting numbers
• Making a graph
• Fiddling with the default settings for Excel
• Using a few functions
• Printing

24.1. Getting Started

You’ve started your computer and clicked the Excel icon on your desktop (or

maybe it’s not on your desktop—maybe you got there through the Office button ).
You’re facing a blank spreadsheet, and you want to play. Let’s write a spreadsheet describing
how $1,000 deposited in the bank at 15% will grow over time.

A B C
1 COMPOUND INTEREST
2 Year Bank balance
3 0 1000
4 1
5 2
6 3
7 4
8 5
9 6
10 7
11 8
12 9
13 10

After you’ve finished typing in the above, put the cursor in cell B4. We’re going to make a
formula that describes how much money will be in the bank at the end of year 1. When you’re in
cell B4, type in the following formula and then press [Enter] (no spaces, please!):
=B3*(1+15%)
Here’s what the spreadsheet should look like.
 CHAPTER 24 Introduction to Excel 685

A B C
1 COMPOUND INTEREST
2 Year Bank balance
3 0 1000
4 1 1150
5 2
6 3
7 4
8 5
9 6
10 7
11 8
12 9
13 10

If you put the cursor on cell B4 and look at the formula bar (next to the fx symbol), you’ll
see what you’ve written in the spreadsheet.

Copying the Formula

So, if you deposit $1,000 in the bank today and the bank gives you 15% interest, you’ll have
$1,150 at the end of year 1. If you’ve read Chapter 2 of this book, you know that at the end of
year 2 you’ll have 1,150 * (1 + 15%) in the bank. Instead of typing in this formula, we’ll use
686 PART SIX BACKGROUND TO EXCEL

Excel’s copy ability to put it in cell B5:

• The lower right-hand corner of the frame around cell B4 has a little black square; we call
this the “handle” of the cell.

• Put the cursor on the handle of cell B4. Hold down the left mouse button and drag down
until you get to cell B13. At this point your spreadsheet will look like this.

Release the left mouse button.

 CHAPTER 24 Introduction to Excel 687

A B C
1 COMPOUND INTEREST
2 Year Bank balance
3 0 1000
4 1 1150
5 2 1322.5
6 3 1520.875
7 4 1749.00625
8 5 2011.357188
9 6 2313.060766
10 7 2660.01988
11 8 3059.022863
12 9 3517.876292
13 10 4045.557736

Note how Excel copied the cell formulas:

• The formula in cell B4 says: “Take the contents of the cell above and multiply by
(1 + 15%).”
• When we drag down the cell formula in B5 says “Take the contents of the cell above and
multiply by (1 + 15%).”
This kind of copying is called relative copying in Excel: The cell formulas change in the
direction of the copy (that is, in the direction that you dragged the cell handle). There’s also
absolute copying, which we’ll explain in Section 24.4.

EXCEL HINT

Instead of dragging cell B4, there’s an even simpler way to copy. If you put your cursor on
the handle and double-click with the left mouse button, the formula in cell B4 will be copied
through the last row of the adjacent filled column, in this case from cell B5 through B13.

Entering Formulas by Pointing (a Better Way)

So far we’ve written the formula in cell B4. But it’s usually a better idea to use the mouse
and point at the relevant cells. Pointing and clicking formulas avoids a lot of mistakes. In the
previous example,
688 PART SIX BACKGROUND TO EXCEL

Put the cursor on cell B4

Type “=”

With the mouse, put the cursor in cell B3 and

click the left mouse button.

Write in the rest of the formula—* (1 + 15%).

Click the left mouse button anywhere outside
of the cell being edited or press [Enter].

24.2. Formatting the Numbers

The spreadsheet we’ve constructed so far is cute but ugly. Why do we need so many decimal
places? Why aren’t there commas in the numbers? How about indicating that these are dollar
amounts?
We can make all these changes using Excel’s extensive formatting facilities.
 CHAPTER 24 Introduction to Excel 689

FORMATTING NUMBERS IN EXCEL

Before: Mark the numbers to be formatted. Click the right mouse button and choose
Format Cells. Here’s what we chose.

After the formatting, here’s how the numbers look.

A B C
1 COMPOUND INTEREST
2 Year Bank balance
3 0 $1,000.00
4 1 $1,150.00
5 2 $1,322.50
6 3 $1,520.88
7 4 $1,749.01
8 5 $2,011.36
9 6 $2,313.06
10 7 $2,660.02
11 8 $3,059.02
12 9 $3,517.88
13 10 $4,045.56

In other chapters we’ll use the Format Cells command to change the way dates and text
and fonts appear in Excel. The important thing to note about this command is that it changes
the way cell contents appear, but not the actual cell contents. For example, suppose your cell
contents read 3287.65898992; now suppose that you made them look like dollars with a comma
and two decimal places, so that the cell reads $3,287.66. The actual contents of the cell haven’t
changed—there are still eight decimal places, but it only shows two of them.
690 PART SIX BACKGROUND TO EXCEL

24.3. Copying with Absolute References—Building a More

Sophisticated Model
The spreadsheet of the previous section is cute, but it doesn’t allow us to change the interest
rate at which the money accumulates. We fix this by writing the following spreadsheet; in this
spreadsheet we’ve got a separate cell (B2) to indicate the interest rate. By changing this cell
we’ll change all the accumulations.

A B C
1 COMPOUND INTEREST
2 Interest 7%
3
4 Year
5 0 $1,000.00
6 1
7 2
8 3
9 4
10 5
11 6
12 7
13 8
14 9
15 10

Go to cell B6 . Type the formula “=B5*(1+$B$2)” in this cell. The dollar signs on $B$2
indicate that when we copy this formula, this particular cell reference will not change. In the jar-
gon of Excel: $B$2 is an absolute reference, whereas B5 is a relative reference—it will change
to B6, B7, . . . as we go down the column.

A B C
1 COMPOUND INTEREST
2 Interest 7%
3
4 Year
5 0 $1,000.00
6 1 $1,070.00 <-- =B5*(1+$B$2)
7 2
8 3
9 4
10 5
11 6
12 7
13 8
14 9
15 10

Copying as we did in the previous section (click on B6, put the cursor on the B6 handle and
drag), we obtain the following.
 CHAPTER 24 Introduction to Excel 691

The result is a table much like that of the previous section.

A B C
1 COMPOUND INTEREST
2 Interest 7%
3
4 Year
5 0 $1,000.00
6 1 $1,070.00 <-- =B5*(1+$B$2)
7 2 $1,144.90 <-- =B6*(1+$B$2)
8 3 $1,225.04 <-- =B7*(1+$B$2)
9 4 $1,310.80 <-- =B8*(1+$B$2)
10 5 $1,402.55 <-- =B9*(1+$B$2)
11 6 $1,500.73 <-- =B10*(1+$B$2)
12 7 $1,605.78 <-- =B11*(1+$B$2)
13 8 $1,718.19 <-- =B12*(1+$B$2)
14 9 $1,838.46 <-- =B13*(1+$B$2)
15 10 $1,967.15 <-- =B14*(1+$B$2)

(We’ve formatted the numbers as currency.)

The difference between this spreadsheet and the previous one is that we can change
the interest rate simply by changing the contents of cell B2. In this example the interest rate
is 10%:

A B C
1 COMPOUND INTEREST
2 Interest 10%
3
4 Year
5 0 $1,000.00
6 1 $1,100.00 <-- =B5*(1+$B$2)
7 2 $1,210.00 <-- =B6*(1+$B$2)
8 3 $1,331.00 <-- =B7*(1+$B$2)
9 4 $1,464.10 <-- =B8*(1+$B$2)
10 5 $1,610.51 <-- =B9*(1+$B$2)
11 6 $1,771.56 <-- =B10*(1+$B$2)
12 7 $1,948.72 <-- =B11*(1+$B$2)
13 8 $2,143.59 <-- =B12*(1+$B$2)
14 9 $2,357.95 <-- =B13*(1+$B$2)
15 10 $2,593.74 <-- =B14*(1+$B$2)
692 PART SIX BACKGROUND TO EXCEL

EXCEL HINT

Never use a number if you can use a cell reference! Compare the previous example with this one:
If, as in the previous section, you “hard-wire” the 15% interest rate in cells B6:B15, you have to
change each of these cells to change the interest rate assumption. On the other hand, if you put
the interest rate in a cell (as in this section’s example), you need only change the contents of that
cell to recalculate the whole spreadsheet.
In Excel, numbers are always inferior to formulas!

Pointing and Using the F4 Key

Let’s go back to the stage in this example where we were putting the formula “=B5*(1+$B$2)”
into cell B5. We’ve already suggested that it’s better to enter formulas by pointing and clicking
than by typing. Now we’ll teach you another little trick, the use of the F4 key to “dollarize” cell
references—that is, to make them absolute references instead of relative references. Here’s what
you do:
• Put the cursor in cell B6. Type “=” and point at cell B5 (the one that contains $1,000).
You can either point with the mouse (clicking when you’re on B5) or you can point with
the arrow keys.

• Now type an asterisk, an opening parenthesis, a 1, and a + : *(1+ . Then point at cell B2
containing the interest rate and click.
 CHAPTER 24 Introduction to Excel 693

• Next press function key F4. This puts the dollar signs into the cell reference B2 in cell B6.

• Finally, close the parentheses by typing a “)”. Press [Enter].

• Copy cell B6 as before.

Correcting Errors—Editing the Cell

Suppose you made a mistake and forgot to “dollarize” the B2 cell reference, so that the contents
of cell B6 are “=B5*(1+B2).” This isn’t good—the cell contents should read “=B5*(1+$B$2).” To
make the appropriate change, we edit the formula in cell B6 and we use the F4 key:
• Put the cursor on B6 and press the left mouse button twice. This opens the formula for
editing.

• Move the cursor until it’s somewhere on the B2 in the formula (it doesn’t matter where).
Press the F4 key and your cell reference will be “dollarized.”

• Now press [Enter] and copy as before.

694 PART SIX BACKGROUND TO EXCEL

THREE EXCEL HINTS ABOUT EDITING

1. You can also edit the cell contents by putting the cursor on the cell and pressing the F2
function button.
2. If you can’t edit the formula in the cell, someone may have changed the default

settings on your Excel spreadsheet. Go to the Office button , click Excel

Options|Advanced, and check the “Allow editing directly in cells” box.

3. You can always edit a cell formula in the formula bar.

 CHAPTER 24 Introduction to Excel 695

24.4. Saving the Spreadsheet

What’s the next step? We suggest that you save the spreadsheet.1 An appropriate place to save it
is in that Junk directory that you’re going to create right now.
• Click the Office button and then click Save.

• Excel will probably suggest a directory called Documents.

1
As a rule of thumb, we suggest that you save all the time. Someday, your computer is going to crash right
after you’ve spent a long time working and before you’ve saved your work.
696 PART SIX BACKGROUND TO EXCEL

• Click My documents, and then click the New Folder icon that looks like this.

• When you click New Folder, you’ll get the opportunity to name your new folder.

In the Name box, type “junk.” The author’s computer always has a directory called “junk”—
it’s the directory containing all the files that you can get rid of without thinking twice (a file
called “junk” in the junk directory is a double whammy—absolutely worthless!). Now you’ll
find yourself in the junk subdirectory.
 CHAPTER 24 Introduction to Excel 697

Type something informative in the box called File Name. We’ll call our spreadsheet “Learning
Excel.”
Now you’ll see the name of the spreadsheet on the top of the sheet.

Every time you subsequently save the workbook (either by Office button|Save or by
pressing [Ctrl] + S or by clicking the save icon in the form of the little disk ), the
workbook with all its changes will be saved under the same name in the same place.

24.5. Your First Excel Graph

You’re going to want to graph the compound interest example. Take your mouse, put it in cell
A5; click the left button, and move down until you get to cell B15.
698 PART SIX BACKGROUND TO EXCEL

Now go to Insert|Scatter and choose one of the chart types there. Our favorite chart (used
most in this book) is Scatter with straight lines and markers.

Having pressed this button, you’ll get a chart on your spreadsheet.

A B C D E F G H I J
1 COMPOUND INTEREST
2 Interest 10%
3
4 Year
5 0 $1,000.00 $3,000.00
6 1 $1,100.00
7 2 $1,210.00 $2,500.00
8 3 $1,331.00
9 4 $1,464.10 $2,000.00
10 5 $1,610.51
11 6 $1,771.56
$1,500.00
12 7 $1,948.72
Series1
13 8 $2,143.59
14 9 $2,357.95 $1,000.00
15 10 $2,593.74
16 $500.00
17
18 $0.00
19
0 2 4 6 8 10 12
20
21
 CHAPTER 24 Introduction to Excel 699

This graph has lots of features we don’t like, but they can all be fixed (Chapter 28 again).
Instead of fixing things, play with the spreadsheet—change the interest rate and see what
happens.

A B C D E F G H I J
1 COMPOUND INTEREST
2 Interest 25%
3
4 Year
5 0 $1,000.00 $10,000.00
6 1 $1,250.00 $9,000.00
7 2 $1,562.50
$8,000.00
8 3 $1,953.13
9 4 $2,441.41 $7,000.00
10 5 $3,051.76 $6,000.00
11 6 $3,814.70
$5,000.00
12 7 $4,768.37
Series1
13 8 $5,960.46 $4,000.00
14 9 $7,450.58 $3,000.00
15 10 $9,313.23
16 $2,000.00
17 $1,000.00
18 $0.00
19
0 2 4 6 8 10 12
20
21

24.6. Initial Settings

Before you make intensive use of Excel, it’s worthwhile to change a few of the initial settings
to suit your needs and preferences. In this section we’ll show you our suggestions (they’re all
reversible).

Make Excel Less Jumpy

The default installation of Excel has the cursor go down one cell each time you press [Enter].

This is great for accountants, who have to enter lots of data. But we’re finance people, and
we make lots of mistakes! We want to stay on the cell we just entered, so we can correct it, and
so we want to turn this feature off.
700 PART SIX BACKGROUND TO EXCEL

How? Press Office Button|Excel Options|Advanced. Clear the Move selection after
enter box. In the picture below, this box is still clicked (this is the default).

The Number of Sheets in a Workbook

The default installation for Excel starts each new workbook with three spreadsheets.2 This
means that the bottom of your screen looks like this.

2
Nomenclature: Microsoft calls an Excel file (the thing you saved as “Learning Excel.xls”) a workbook.
The individual sheets of the workbook are called spreadsheets or worksheets. Like many Excel users, we
often mix up this nomenclature.
 CHAPTER 24 Introduction to Excel 701

These three sheets (you can even add more by clicking on the fourth tab, the one after Sheet3)
can be very handy. But the fact remains that most users use only one sheet per workbook. We
suggest that you change the defaults so that Excel starts a new workbook with only one spread-
sheet (you can always add more). To do this, go Office Button|Excel Options|Popular and
click on Include this many sheets:

In the picture above we’ve changed the Sheets in new workbook to “1.”

Naming a Sheet
To name a sheet, double-click on the sheet tab. You can now type in the name you want for the
sheet.

Before After

Adding More Sheets

To add more sheets, right-click on a tab and choose Insert and then choose to insert a new
worksheet.
702 PART SIX BACKGROUND TO EXCEL

Inserting a new sheet by clicking on an existing tab. You can also choose Delete to delete the tabbed worksheet.

You can also delete a sheet by right-clicking on a tab and choosing Delete. This is an irre-
versible action, so we suggest you save the workbook before doing this.

24.7. Using a Function

Excel contains many functions. In this section we illustrate a few of these.3 We’ll go back to the
spreadsheet in Section 24.3. In cell B17 we’ll calculate the average value of the cells B5:B15
(this has very little economic meaning . . . ). The final product will look like this.
A B C
1 COMPOUND INTEREST
2 Interest 7%
3
4 Year
5 0 $1,000.00
6 1 $1,070.00 <-- =B5*(1+$B$2)
7 2 $1,144.90 <-- =B6*(1+$B$2)
8 3 $1,225.04 <-- =B7*(1+$B$2)
9 4 $1,310.80 <-- =B8*(1+$B$2)
10 5 $1,402.55 <-- =B9*(1+$B$2)
11 6 $1,500.73 <-- =B10*(1+$B$2)
12 7 $1,605.78 <-- =B11*(1+$B$2)
13 8 $1,718.19 <-- =B12*(1+$B$2)
14 9 $1,838.46 <-- =B13*(1+$B$2)
15 10 $1,967.15 <-- =B14*(1+$B$2)
16
17 Average $1,434.87 <-- =AVERAGE(B5:B15)

To do this, perform the following steps:

• In cell A17 we type “Average.” This is known as “annotating the spreadsheet.” In simple
English, tell yourself what you’re doing, because otherwise you’ll forget.

3
The discussion in this section is really preliminary and intended to give you a taste of how Excel func-
tions work. In this book we use many Excel functions. Chapter 26 discusses most of the functions used in
the book and Chapter 29 discusses Excel’s date functions.
 CHAPTER 24 Introduction to Excel 703

In cell B17, we type “=Average(”, and then click the fx sign on the toolbar:

You’ll see a function dialog box.

Your cursor is already in a box labeled Number1. Put the mouse on cell B5, click the left
mouse button, and drag the cursor to B15. When you release the mouse button, here’s what
you’ll see.
704 PART SIX BACKGROUND TO EXCEL

Now press OK in the dialog box. Here’s the result.

A B C
1 COMPOUND INTEREST
2 Interest 7%
3
4 Year
5 0 $1,000.00
6 1 $1,070.00
7 2 $1,144.90
8 3 $1,225.04
9 4 $1,310.80
10 5 $1,402.55
11 6 $1,500.73
12 7 $1,605.78
13 8 $1,718.19
14 9 $1,838.46
15 10 $1,967.15
16
17 Average $1,434.87 <-- =AVERAGE(B5:B15)

Suppose you didn’t want to average all the numbers, but only those from years 5 to 10.
There are two ways to do this:
• You can double-click on cell B17 and change the range in the formula to
=Average(B10:B15).
• You can also click on cell B17 and click the fx sign on the toolbar and make the appropri-
ate changes in the dialog box.

Practice Makes Perfect

The exercises to this chapter let you practice with a few functions that work like Average.

24.8. Printing
You’ve just completed your beautiful first spreadsheet and you want to print it. Go to Office
Button|Print. This brings up a screen with a printer name.
 CHAPTER 24 Introduction to Excel 705

Before printing, click the Preview button. On the Sheet tab, you can choose to print the
spreadsheet using Gridlines and Row and column headings (these are the settings we’ve used
for most of the spreadsheets in this book).

Click Print to print your spreadsheet.

Summary
In this chapter we’ve explored the preliminaries of Excel—how to set up a spreadsheet, save it,
type in a formula, use a function, and print your results. The following chapters explore more
advanced Excel techniques.

EXERCISES
1. Excel has a function called Sum, which works like Average. Set up the spreadsheet below and use

A B
1 28
2 15
3 22
4 <-- Use Sum to add the numbers

it to add the numbers in cells A1:A3.

2. In a new spreadsheet, follow the instructions below.

A B
1 28
2 15
3 22
4 <-- Use Sum(A1:A3)/3 to find the average
706 PART SIX BACKGROUND TO EXCEL

3. In another spreadsheet, show that you can use the function Average to get the same result.
A B
1 28
2 15
3 22
4 <-- Use Sum(A1:A3)/3 to find the average
5
6 <-- Use Average(A1:A3)

4. The Excel function Count counts the number of cells containing numbers. Use this function in the
spreadsheet below.
A B
1 15
2 -11
3 John
4 23
5 <-- Use Count(A1:A4)

5. The Excel function CountA counts the number of all the cells in the a given range. Experiment
with this function in the spreadsheet below.

A B
1 15
2 -11
3 John
4 23
5 <-- Use CountA(A1:A4)

6. Below are some statistics on the monthly rainfall in the city of Dunedin, New Zealand (the num-
bers are on the disk that comes with the book). Use Sum and Average to compute the total annual
and average monthly rainfall.

A B C D E F G H I J K L M N O
1 MONTHLY RAINFALL IN THE CITY OF DUNEDIN, NEW ZEALAND (in centimeters)
Total Average
2 Jan F eb Mar A pr May Jun Jul Aug Sep Oct Nov Dec annual monthly
3 1980 115 79 83 74 57 195 72 89 39 56 117 45 1021
4 1981 17 47 107 40 20 142 163 49 49 62 24 82
5 1982 142 48 37 45 68 39 33 47 32 147 42 140
6 1983 99 65 113 78 140 78 84 35 81 64 38 93
7 1984 107 22 126 33 83 36 69 59 86 38 52 77
8 1985 28 17 29 23 35 35 89 39 29 63 51 85
9 1986 41 179 101 49 60 79 75 48 22 69 89 83
10 1987 59 89 150 24 136 88 25 21 71 47 47 67
11 1988 147 90 25 38 60 44 62 40 13 27 40 61
12 1989 55 48 81 31 39 95 39 35 20 96 64 100
13 1990 34 44 18 62 48 21 34 137 19 96 42 55
14 1991 77 178 49 99 33 52 38 124 54 41 45 68
15 1992 52 88 26 65 52 39 56 123 88 80 68 112
16 1993 126 35 79 62 94 25 21 47 72 41 73 109
17 1994 140 69 170 23 42 115 99 14 45 13 78 57
18 1995 41 37 91 12 41 121 42 40 97 92 72 61
19 1996 56 52 33 108 55 75 58 61 14 143 132 95
20 1997 120 117 44 122 48 20 60 43 30 62 88 85
21 1998 10 101 60 52 66 24 26 44 58 109 33 66
22 1999 42 12 65 43 17 58 83 32 52 41 59 80
 CHAPTER 24 Introduction to Excel 707

7. Referring to the Dunedin rainfall data from the previous exercise:

a. Use the Excel function Max to compute the largest monthly rainfall in each of the years
1980–1999.
b. Compute the largest monthly rainfall for all of the months in the table.
8.
a. Complete the following spreadsheet, showing how much will be in your bank account if you
deposit an initial deposit (cell B2) today and it draws annual interest given in cell B1.
b. Graph the results of the bank account.

A B
1 Interest 8%
2 Initial deposit $155
3
In bank
4 Year account
5 0
6 1
7 2
8 3
9 4
10 5
CHAP TER

25 Graphs and Charts in Excel

CHAPTER CONTENTS
Overview 708
25.1. The Basics of Excel Charts 709
25.2. Creative Use of Legends 714
25.3. Graphing Noncontiguous Data 715
25.4. Line Charts with Titles on the x-Axis 716
25.5. Graph Titles That Update 720
Summary 722
Exercises 722

Overview
In this short chapter, we’ll discuss the basics of Excel graphing, assuming that—by and large—
you already know how to make a chart in Excel.1 We will also discuss some less well-known
techniques that have to do with charts:
• Making a graph with noncontiguous data series

1
In “Excelese,” graphs are called “charts.” We will use both words interchangeably.

708
 CHAPTER 25 Graphs and Charts in Excel 709

• Changing the axis parameters of a chart

• Making a chart where the title changes when the data changes

25.1. The Basics of Excel Charts

Every Excel chart has its origins in the data on a spreadsheet.

A B C D
1 MERCK & CO. 1991–2000
Proceeds
Purchase from
of exercise
treasury of stock
2 Dividends stock options
3 1991 893 184 48
4 1992 1,064 863 52
5 1993 1,174 371 83
6 1994 1,434 705 139
7 1995 1,540 1,571 264
8 1996 1,729 2,493 442
9 1997 2,040 2,573 413
10 1998 2,253 3,626 490
11 1999 2,590 3,582 323
12 2000 2,798 3,545 641

To create a graph that shows the dividends paid each year, we mark the relevant data and
then go to Insert|Charts|Scatter.
710 PART SIX BACKGROUND TO EXCEL

We’ve chosen the XY Scatter Chart option that connects the data with lines. Clicking this
option creates our chart.

A B C D E F G H I J K L
1 MERCK & CO. 1991–2000
Proceeds
3,000
Purchase from
of exercise of
treasury stock 2,500
2 Dividends stock options
3 1991 893 184 48 2,000
4 1992 1,064 863 52
5 1993 1,174 371 83 1,500
6 1994 1,434 705 139 Series1
7 1995 1,540 1,571 264
1,000
8 1996 1,729 2,493 442
9 1997 2,040 2,573 413
10 1998 2,253 3,626 490 500
11 1999 2,590 3,582 323
12 2000 2,798 3,545 641 0
13 1990 1992 1994 1996 1998 2000 2002
14
15

This isn’t bad, but we want to make a few additions and corrections:
• We’ll get rid of the “Series 1” legend by simply clicking on it and deleting.
• We want to adjust the x-axis so that it goes from 1991 to 2000 and not—as in the case
above—from 1990 to 2002.
• We want to add titles to the axes and a title to the chart as a whole.
We start by double-clicking on the chart itself. This brings up the Chart Tools toolbar.
From this toolbar we choose the circled option.
 CHAPTER 25 Graphs and Charts in Excel 711

This makes the chart look like this.

You can now click on all the titles and change them appropriately (while you’re at it, get rid
of the Series 1 legend).

A B C D E F G H I J K L
1 MERCK & CO. 1991-2000
Proceeds
Purchase from Merck Dividends, 1991-2000
of exercise of
treasury stock 3,000
2 Dividends stock options
2,500
3 1991 893 184 48
Dividends

4 1992 1,064 863 52 2,000

5 1993 1,174 371 83
1,500
6 1994 1,434 705 139
7 1995 1,540 1,571 264 1,000
8 1996 1,729 2,493 442
9 1997 2,040 2,573 413 500
10 1998 2,253 3,626 490 0
11 1999 2,590 3,582 323
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
12 2000 2,798 3,545 641
13 Year
14
15

To change the format of the x-axis, click on the axes numbers (note the box around the axis
numbers in the illustration below). Then right-click on the box and choose Format Axis.
712 PART SIX BACKGROUND TO EXCEL

This brings up the following menu, to which we’ve already made the changes we want—
changing the axes years from 1991 to 2000:
 CHAPTER 25 Graphs and Charts in Excel 713

Here’s the resulting chart.

714 PART SIX BACKGROUND TO EXCEL

A B C D E F G H I J K L
1 MERCK & CO. 1991-2000
Proceeds
Purchase from Merck Dividends, 1991-2000
of exercise of
treasury stock 3,000
2 Dividends stock options
2,500
3 1991 893 184 48

Dividends
4 1992 1,064 863 52 2,000
5 1993 1,174 371 83
1,500
6 1994 1,434 705 139
7 1995 1,540 1,571 264 1,000
8 1996 1,729 2,493 442
9 1997 2,040 2,573 413 500
10 1998 2,253 3,626 490 0
11 1999 2,590 3,582 323
1990 1992 1994 1996 1998 2000 2002
12 2000 2,798 3,545 641
13 Year
14
15

There are many options left, but we trust that you’ll figure these out for yourself.

25.2. Creative Use of Legends

If you build your XY chart with data that includes legends, then Excel will generally transfer
them in the proper way to the graph. Here’s an example: We’ve marked the data to include the
column headings.

Here’s the resulting graph after a little massaging.

 CHAPTER 25 Graphs and Charts in Excel 715

A B C D E F G H I J K L
1 MERCK & CO. 1991-2000
Proceeds
4,000
Purchase from
of exercise 3,500
treasury of stock
2 Dividends stock options 3,000
3 1991 893 184 48
4 1992 1,064 863 52 2,500
5 1993 1,174 371 83 2,000
6 1994 1,434 705 139
7 1995 1,540 1,571 264 1,500 Dividends
8 1996 1,729 2,493 442
9 1997 2,040 2,573 413 1,000
10 1998 2,253 3,626 490 Purchase of treasury
500 stock
11 1999 2,590 3,582 323
12 2000 2,798 3,545 641 0
13
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
14
15

25.3. Graphing Noncontiguous Data

Suppose you want to make a graph of columns A, C, and D of the Merck data. To mark these
three columns:
• Mark the first column (that is, click the left mouse button and “paint” cells A3:A12).
• Press the [Ctrl] key and mark columns C and D (again, clicking the left mouse button).
At this point your spreadsheet looks like this.

You can now follow the regular graphing procedure to create the following chart.
716 PART SIX BACKGROUND TO EXCEL

4,000 Merck Treasury Stock and Option

3,500
Exercise
3,000

2,500
Purchase of treasury
2,000 stock

1,500 Proceeds from

exercise of stock
1,000 options

500

0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

25.4. Line Charts with Titles on the x-Axis

Excel offers a bewildering variety of chart types. In this section we will show you the line
chart, leaving other variations for you to explore. We will use data for the average minimum
and maximum temperatures in New York City. We want to create a chart with the month labels
on the x-axis.
A B C D E F G H I J K L M
1 AVERAGE MONTHLY MAXIMUM AND MINIMUM TEMPERATURES—NEW YORK CITY
2 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Avg max
3 temp (F) 38 40 50 61 72 80 85 84 76 65 54 43
Avg min
4 temp (F) 25 27 35 44 54 63 68 67 60 50 41 31
5
6
7 90
8 80
9
10 70
11 60
12
13 50
Avg max temp (F)
14 40
15 Avg min temp (F)
16 30
17 20
18
19 10
20 0
21
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
22
23

To construct the chart, first mark the data you want to graph, including the x-axis data and
the months. Then go to Insert|Charts|Line and choose the appropriate type of graph.
 CHAPTER 25 Graphs and Charts in Excel 717

Clicking the left mouse button does the rest.

What’s the Difference between a Line Chart and an XY (Scatter) Chart?

Line charts use equal spacing for the x-axis legend, whereas XY charts space the x-axis legend
depending on the distance between the points. The following example explains this perhaps
obscure sentence.

A B C D E F G H I J K
1 Line versus XY charts
2 x y
3 0 13 35
4 6 22
5 8 31 30
6 15 -8 25
7 22 14
8 97 6 20
9
10 15
11
10
12
13 5
14
15 0
16 0 6 8 15 22 97
-5
17
18 -10
19

Note that even though the x-axis values are very unevenly spaced (0, 6, 8, 15, 22, 97), the
line chart puts them at equal intervals on the x-axis. It is only the XY (Scatter) chart that spaces
the x-axis labels according to their values.

Creating the Previous Chart

There are two ways to create the previous chart.
The “tricky way” is to eliminate the “x” in cell A2 and to mark the range A2:B8. Going to
Insert|Charts|Line does the rest.
718 PART SIX BACKGROUND TO EXCEL

The nontricky way is to first choose only the y data in B3:B8. Creating the line chart in the
usual fashion gives you the following.

A B C D E F G H I J
1 Line versus XY charts
2 y
3 0 13 35
4 6 22 30
5 8 31
6 15 -8 25
7 22 14
8 97 6 20
9 15
10 Series1
11 10
12
13 5
14
0
15
16 1 2 3 4 5 6
-5
17
18 -10
19

Now double-click the chart and go to Select Data.

 CHAPTER 25 Graphs and Charts in Excel 719

In the resulting dialog box, choose to edit the x-axis labels and introduce the data in A2:A8.
720 PART SIX BACKGROUND TO EXCEL

25.5. Graph Titles That Update

This slightly more advanced section makes use of the Text function, which is discussed in
Chapter 26. You want to have the graph title change when a parameter on the spreadsheet
changes. For example, in the next spreadsheet, you want the graph title to indicate the growth
rate.

A B C D E F G H I J K
1 GRAPH TITLES THAT UPDATE AUTOMATICALLY
2 Growth 12%
3
4 Year Cash flow
Cash Flow Graph When
5 1 100.00 Growth = 12.0%
6 2 112.00 <-- =B5*(1+$B$2)
7 3 125.44 250
8 4 140.49
9 5 157.35 200
10 6 176.23
11 7 197.38 150
12
100
13
14 50
15
16 0
17
1 2 3 4 5 6 7
18
19

Once we have completed the necessary steps explained below, a change in the growth rate
will change both the graph and its title.

A B C D E F G H I J K
1 GRAPH TITLES THAT UPDATE AUTOMATICALLY
2 Growth 25%
3
4 Year Cash flow
Cash Flow Graph When
5 1 100.00 Growth = 25.0%
6 2 125.00 <-- =B5*(1+$B$2)
7 3 156.25 450
8 4 195.31 400
9 5 244.14 350
10 6 305.18 300
11 7 381.47 250
12 200
13 150
14 100
15 50
16 0
17
1 2 3 4 5 6 7
18
19

To make graph titles update automatically, carry out the following steps:
• Create the graph you want in the format you want it. Give the graph a “proxy title.” (It
makes no difference what; you’re going to eliminate it soon.) At this stage your graph
might look like this.
 CHAPTER 25 Graphs and Charts in Excel 721

A B C D E F G H I J K
1 GRAPH TITLES THAT UPDATE AUTOMATICALLY
2 Growth 25%
3
4 Year Cash flow
450 Chart Title
5 1 100.00 400
6 2 125.00 <-- =B5*(1+$B$2) 350
7 3 156.25
300
8 4 195.31
9 5 244.14 250
10 6 305.18 200
11 7 381.47
12 150
13 100
14
50
15
16 0
17 1 2 3 4 5 6 7
18
19
20 Cash Flow Graph When Growth = 25.0%

• Create the title you want in a cell. In the example above, cell D20 contains the formula:
=“Cash Flow Graph when Growth = “&TEXT(B2,”0.0%”).
• Click on the graph title to mark it, and then go to the formula bar and insert an equals
sign to indicate a formula. Then point at cell D20 with the formula and click [Enter].
In the picture below, you see the chart title highlighted and in the formula bar “=Titles
that update!$D$20” indicating the title of the graph. Note that “Titles that update” is the
name of the spreadsheet.
722 PART SIX BACKGROUND TO EXCEL

Summary
There’s lots more you can do with Excel charts, but we’ve covered the essentials. The exercises
to this chapter will show you some more variations.

EXERCISES
Note: All data for the exercises are on the CD-ROM that accompanies Principles of Finance with
Excel.
1. The CD gives the monthly prices for the Dutch grocery chain Ahold from April 1991 through
August 2004. Graph these prices so that the resulting spreadsheet looks like the following
spreadsheet.

A B C D E F G H I J K
PRICE OF AHOLD STOCK
1 April 1991 - August 2004
2 Stock price PRICE OF AHOLD STOCK
3 8-Apr-91 5.32
4 1-May-91 5.23 April 1991- August 2004
5 3-Jun-91 4.94 40
6 1-Jul-91 5.03
7 1-Aug-91 5.09 35
8 3-Sep-91 5.43 30
9 1-Oct-91 5.40 25
10 1-Nov-91 5.37
20
11 2-Dec-91 5.68
12 2-Jan-92 5.39 15
13 3-Feb-92 5.80 10
14 2-Mar-92 5.69
5
15 1-Apr-92 5.86
16 1-May-92 6.06 0
17 1-Jun-92 6.19
1

4
r-9

r-9

r-9

r-9

r-9

r-9

r-9

r-9

r-9

r-0

r-0

r-0

r-0

r-0
18 1-Jul-92 6.14
Ap

Ap

Ap

Ap

Ap

Ap

Ap

Ap

Ap

Ap

Ap

Ap

Ap

Ap
19 3-Aug-92 6.32
8-

8-

8-

8-

8-

8-

8-

8-

8-

8-

8-

8-

8-

8-
20 1-Sep-92 6.26
21 1-Oct-92 5.50
22 2-Nov-92 6.02

2. Using the data for Ahold from the previous exercise, determine the monthly stock returns and
graph them. The monthly return for a stock that has price Pt in month t and price Pt–1 in month t–1
is (Pt / Pt–1) – 1 (When you compute the returns, you’ll have “noncontiguous data,” so you’ll have
to use the technique described in Section 25.3).

A B C D E F G H I J K
RETURNS ON AHOLD STOCK
1 April 1991 - August 2004
Monthly
80%
2 Stock price return Ahold Stock Returns
3 8-Apr-91 5.32
60%
4 1-May-91 5.23 -1.69% <-- =B4/B3-1
5 3-Jun-91 4.94 -5.54% <-- =B5/B4-1 40%
6 1-Jul-91 5.03 1.82% <-- =B6/B5-1
7 1-Aug-91 5.09 1.19% 20%
8 3-Sep-91 5.43 6.68%
9 1-Oct-91 5.40 -0.55% 0%
10 1-Nov-91 5.37 -0.56%
1-May-91

1-May-92

1-May-93

1-May-94

1-May-95

1-May-96

1-May-97

1-May-98

1-May-99

1-May-00

1-May-01

1-May-02

1-May-03

1-May-04

11 2-Dec-91 5.68 5.77% -20%

12 2-Jan-92 5.39 -5.11%
13 3-Feb-92 5.80 7.61% -40%
14 2-Mar-92 5.69 -1.90%
15 1-Apr-92 5.86 2.99% -60%
16 1-May-92 6.06 3.41%
17 1-Jun-92 6.19 2.15% -80%
18 1-Jul-92 6.14 -0.81%

3. The CD with the book gives the prices for Ahold and for the S&P 500. Use these data to produce
the following graph (see note following the graph).
 CHAPTER 25 Graphs and Charts in Excel 723

A B C D E F G H I J
AHOLD'S STOCK PRICE
1 VERSUS THE S&P 500
2 Ahold S&P 500
3 8-Apr-91 5.32 375.34 1600
4 1-May-91 5.23 389.83
1400
5 3-Jun-91 4.94 371.16
6 1-Jul-91 5.03 387.81 1200
7 1-Aug-91 5.09 395.43
1000
8 3-Sep-91 5.43 387.86
9 1-Oct-91 5.40 392.45 800
10 1-Nov-91 5.37 375.22 Ahold
600
11 2-Dec-91 5.68 417.09
S&P 500
12 2-Jan-92 5.39 408.78 400
13 3-Feb-92 5.80 412.70 200
14 2-Mar-92 5.69 403.69
15 1-Apr-92 5.86 414.95 0

8-Apr-91
8-Apr-92
8-Apr-93
8-Apr-94
8-Apr-95
8-Apr-96
8-Apr-97
8-Apr-98
8-Apr-99
8-Apr-00
8-Apr-01
8-Apr-02
8-Apr-03
8-Apr-04
16 1-May-92 6.06 415.35
17 1-Jun-92 6.19 408.14
18 1-Jul-92 6.14 424.21
19 3-Aug-92 6.32 414.03
20 1-Sep-92 6.26 417.80
21 1-Oct-92 5.50 418.68
22 2-Nov-92 6.02 431.35
23 1-Dec-92 6.24 435.71

Note: This graph is obviously unsatisfactory—Ahold’s price is so much less than the S&P’s that the
Ahold price series appears to be zero. See the next exercise for one solution to this problem.
4. Transform the S&P and Ahold price data so that the beginning price of each is 100 and graph
these series.
A B C D E F G H I J K L M N
1 AHOLD'S STOCK PRICE VERSUS THE S&P 500
Ahold S&P 800
2 Ahold S&P 500 adjusted adjusted
3 8-Apr-91 5.32 375.34 100.00 100.00 700
4 1-May-91 5.23 389.83 98.31 103.86 <-- =F3*C4/C3 600
5 3-Jun-91 4.94 371.16 92.86 98.89 <-- =F4*C5/C4
6 1-Jul-91 5.03 387.81 94.55 103.32 <-- =F5*C6/C5 500
7 1-Aug-91 5.09 395.43 95.68 105.35 400 Ahold
8 3-Sep-91 5.43 387.86 102.07 103.34 adjusted
9 1-Oct-91 5.40 392.45 101.50 104.56 300
10 1-Nov-91 5.37 375.22 100.94 99.97 S&P
200
11 2-Dec-91 5.68 417.09 106.77 111.12 adjusted
12 2-Jan-92 5.39 408.78 101.32 108.91 100
13 3-Feb-92 5.80 412.70 109.02 109.95
0
14 2-Mar-92 5.69 403.69 106.95 107.55
8-Apr-91
8-Apr-92
8-Apr-93
8-Apr-94
8-Apr-95
8-Apr-96
8-Apr-97
8-Apr-98
8-Apr-99
8-Apr-00
8-Apr-01
8-Apr-02
8-Apr-03
8-Apr-04
15 1-Apr-92 5.86 414.95 110.15 110.55
16 1-May-92 6.06 415.35 113.91 110.66
17 1-Jun-92 6.19 408.14 116.35 108.74
18 1-Jul-92 6.14 424.21 115.41 113.02
19 3-Aug-92 6.32 414.03 118.80 110.31
20 1-Sep-92 6.26 417.80 117.67 111.31
21 1-Oct-92 5.50 418.68 103.38 111.55
22 2-Nov-92 6.02 431.35 113.16 114.92
23 1-Dec-92 6.24 435.71 117.29 116.08
24 4-Jan-93 6.34 438.78 119.17 116.90

5. You want to graph the function y = ax3 – 2x3 + x – 16. The variable a can take on a variety of values
(in the example below, a = 0.4). Make a graph of this function with a title that indicates the value
of a, as illustrated below. (You may want to refer to Section 25.4.)
724 PART SIX BACKGROUND TO EXCEL

A B C D E F G H
1 a 0.4
2
3 x y=a*x^3-2*x^2+x-16
4 -6 -180.4 <-- =$B$1*A4^3-2*A4^2+A4-16
5 -5 -121.0
6
7
-4
-3
-77.6
-47.8
Graph of y=a*x^3-2*x^2+x-16
8 -2 -29.2 when a = 0.40
9 -1 -19.4
10 0 -16.0 150
11 1 -16.6 100
12 2 -18.8
13 3 -20.2 50
14 4 -18.4
0
15 5 -11.0
16 6 4.4 -6 -4 -2 -50 0 2 4 6 8
17 7 30.2
-100
18 8 68.8
19 9 122.6 -150
20
21 -200
22

6. The CD that comes with this book contains a spreadsheet with monthly rainfall in San Diego from
1850 to 2008. Create the graph shown below.

A B C D E F G H I J K L M N
MONTHLY RAINFALL IN SAN DIEGO, 1850- 2008
1 Source: http://www.custompuzzlecraft.com/Weather/sandiegoweather.html (my thanks to John S. Stokes III for putting this together)
Annual
2 Jan. Feb. March April May June July August Sept. Oct. Nov. Dec. total
3 1850 0 1.13 1 0.09 0 0.68 0 0 0 0.19 2.82 1.93 7.84
4 1851 0.03 1.51 0.34 0.87 0.71 0.01 0 0 0.02 0.01 0.25 3.74 7.49
5 1852 0.58 1.84 1.87 0.85 0.32 0 0 0.4 0 0.06 1.45 4.5 11.87
6 1853 0.5 0.2 1.52 0.25 2.1 0.05 0 0.21 0 0 1.28 1.77 7.88
7 1854 0.99 2.56
30
1.88 Annual Rainfall in San Diego
0.89 0.18 0.01 0.07 1.36 0.09 0.27 0.04 3.29 11.63
8 1855 1.97 3.59 1.3 1.52 0.06
1850-2008 0 0 0.04 0 0.11 2.15 0.41 11.15
9 1856 1.27 1.86 25 1.59 2.17 0.29 0 0 0 0.07 0 1.22 1.3 9.77
10 1857 0.26 1.76 0 0.04 0.08 0.03 0 0.02 0.01 0.49 2.16 1.3 6.15
11 1858 1.52 0.44 20 1.24 0.17 0 0.19 0 0.04 0.1 0.47 0.28 3.1 7.55
12 1859 0 1.89 0.2 0.36 0.17 0 0.02 0 0 0.18 1.49 1.79 6.1
13 1860 0.72 1.49 15 0.15 0.65 0.04 0.05 0.14 0 0 0 2.88 2.99 9.11
14 1861 0.82 0.79 0.05 0.04 0 0.19 0 0 1.59 0.05 1.19 3.2 7.92
15 1862 5.56 1.39 10 0.97 1.05 0.16 0.48 0.11 0 0 0.89 0.05 0.93 11.59
16 1863 0.32 1.09 0.33 0.13 0.02 0 0 0 0.36 0 0.73 0.04 3.02
17 1864 0.04 2.5 0.2 0.01 1.25 0.01 0.11 0 0 0.04 2.41 1.04 7.61
5
18 1865 1.28 3 0 0.56 0 0.01 1.29 0 0 0.02 0.52 0.84 7.52
19 1866 5.05 3.43 1.47 0.11 0.09 0 0 0.1 0 0 0.24 1.82 12.31
20 1867 1.32 0.85 0 7.88 0.48 0.04 0 0 0.3 0 0.34 0.45 3.06 14.72
21 1868 3.37 1.63 0.73
1850 1870 1.21890 0.15
1910 0
1930 0.51
1950 1970 0 1990 0.05
2010 0 2 1.52 11.16
22 1869 2.88 1.88 1.98 0.53 0.33 0 0.05 0 0 0.05 2.32 0.94 10.96
23 1870 0.54 0.77 0.33 0.2 0.28 0 0.04 0.07 0 1.54 0.18 0.42 4.37
CHAP TER

26 Excel Functions

CHAPTER CONTENTS
Overview 725
26.1. Financial Functions 726
26.2. Math Functions 735
26.3. Conditional Functions 742
26.4. Text Functions 744
26.5. Statistical Functions 747
26.6. Match and Index 749
Summary 750
Exercises 750

Overview
In this chapter we discuss the principal Excel functions a financial analyst needs to know. There
is some overlap between the discussion here and in other chapters (for example, the NPV func-
tion is discussed in Chapter 2). We also discuss some functions that are not used in this book,
but that are so handy that we include them for reference.
A word about nomenclature: To differentiate an Excel function from the surrounding text,
we usually (although not in the table above!) denote it with boldface type. Most Excel func-
tions depend on some variable, but we do not always indicate these variables. For example, the

725
726 PART SIX BACKGROUND TO EXCEL

variables for the NPV function are the interest rate and the range to be discounted; when we
want to make this explicit, we write NPV(interest,range).
One more note: The functions in each class are not always discussed alphabetically. Where
there’s a logical order, we use this (for example, we discuss NPV before IRR).

26.1. Financial Functions

NPV( )
This function is extensively discussed in Chapter 2. The Excel definition of NPV( ) differs
somewhat from the standard finance definition. In the finance literature, the NPV of a sequence
of cash flows C0 , C1, C2, . . . , Cn at a discount rate r refers to the expression
n n
Ct Ct
∑ t
or C0 + ∑ t
.
t =0 (1 + r ) t =1 (1 + r )
The term C0 typically represents the cost of the asset purchased and is therefore negative.
The Excel definition of NPV( ) always assumes that the first cash flow occurs after one period.
The user who wants the standard finance expression must therefore calculate NPV(r,{C1, . . . ,
Cn}) + C0. Here is an example.
A B C D E F G
1 EXCEL'S NPV FUNCTION
2 Discount rate 10%
3 Year 0 1 2 3 4 5
4 Cash flow -100 35 33 34 25 16
5
6 NPV $11.65 <-- =NPV(B2,C4:G4)+B4

IRR( )
The IRR of a sequence of cash flows C0 , C1, C2, . . . , Cn is an interest rate r such that the NPV of
the cash flows is zero:
n
Ct
∑
t = 0 (1 + r )
t
=0.

The Excel syntax for the IRR( ) function is IRR(cash flows, guess). Here cash flows rep-
resents the whole sequence of cash flows, including the first cash flow C0, and guess is a starting
point for the algorithm that calculates the IRR.
First a simple example—consider the cash flows given above.

A B C D E F G
8 EXCEL'S IRR FUNCTION
9 Year 0 1 2 3 4 5
10 Cash flow -100 35 33 34 25 16
11
12 IRR 15.00% <-- =IRR(B10:G10,0)
13 15.00% <-- =IRR(B10:G10)
 CHAPTER 26 Excel Functions 727

Note that guess is not necessary when there is only one IRR. Thus in cell B13 (where we
haven’t indicated a guess) we get the same answer as in cell B12 (guess = 0).
The choice of guess can, however, make a difference when there is more than one IRR.
Consider, for example, the following cash flows.

A B C D E F G
1
Cash
2 Year flow NPV of Cash Flows
3 0 -11,000 30,000
4 1 15,000 25,000
5 2 15,000 20,000
6 3 15,000 15,000

NPV ($)
7 4 15,000 10,000
8 5 15,000 5,000
9 6 15,000 -
(5,000)0% 24% 48% 72% 96% 120% 144% 168%
10 7 15,000
(10,000)
11 8 15,000
(15,000)
12 9 15,000
Discount rate
13 10 -135,000
14
15 IRR 1.86% <-- =IRR(B3:B13,0), guess = 0
16 IRR 135.99% <-- =IRR(B3:B13,2), guess = 2

The graph (created from table that is not shown) shows that there are two IRRs because the
NPV curve crosses the x-axis twice. To find both IRRs, we have to change the guess (although
the precise value of guess is still not critical). In the example below we have changed both
guesses, but still get the same answer.
A B C
15 IRR 1.86% <-- =IRR(B3:B13,0.1)
16 IRR 135.99% <-- =IRR(B3:B13,0.8)

Note: A given set of cash flows typically has more than one IRR if there is more than one
change of sign in the cash flows—in the above example, the initial cash flow is negative, and CF1–
CF9 are positive (this accounts for one change of sign); but then CF10 is negative, making a second
change of sign. If you suspect that a set of cash flows has more than one IRR, the first thing to do
is to use Excel to make a graph of the NPVs, as we did above. The number of times that the NPV
graph crosses the x-axis identifies the number of IRRs (and also their approximate values).1

FV( )
The FV function, FV, calculates the FV of a series of deposits. Below we discuss several cases
of this function. For a finance discussion of this function and the meaning of the numbers it
produces, you should refer to Chapter 2 (page 18).

The Future Value of a Series of Annual Investments: Using FV and the

Type Parameter
Suppose you intend to make five annual deposits of $1,000 each to a 5% savings account. The
first deposit is made today. How much will you have at the end of 5 years? In the following
spreadsheet, we do this computation in two ways (cells C13 and C14).

1
For more examples of multiple IRRs, see Chapter 4.
728 PART SIX BACKGROUND TO EXCEL

A B C D
SAVING FOR THE FUTURE
1 FV Type PARAMETER = 1
2 Annual deposit to savings 1,000
3 Interest rate 5%
4
Value at end
5 Year Deposit of year 5
6 0 1,000 1,276.28 <-- =B6*(1+$B$3)^(5-A6)
7 1 1,000 1,215.51
8 2 1,000 1,157.63
9 3 1,000 1,102.50
10 4 1,000 1,050.00
11 5
12
13 Total at end of 5 years 5,801.91 <-- =SUM(C6:C11)
14 5,801.91 <-- =FV(B3,5,-B2,,1)

In the table in cells A6:C11, we take each annual deposit of $1,000 and compute its future
value at the end of year 5. Summing these values (cell C13) gives $5,801.91.
In cell C14 we use the FV function. Here’s the dialog box, with an explanation of the use
of Type.

Note that we’ve set Type equal to 1: The five payments are made at the beginning of the
period: today and in each of years 1, 2, 3, and 4.
 CHAPTER 26 Excel Functions 729

The FV function allows Type to be 0 when the payments are made at the end of the period.
To illustrate this, suppose you intend to make five annual deposits of $1,000 each to a 5% sav-
ings account, with the first deposit to be made 1 year from now. How much will you have at the
end of 5 years? In the spreadsheet below, we again do this computation in two ways (cells C13
and C14).

A B C D
SAVING FOR THE FUTURE
1 FV Type PARAMETER = 0
2 Annual deposit to savings 1,000
3 Interest rate 5%
4
Value at end
5 Year Deposit of year 5
6 0 0 0.00 <-- =B6*(1+$B$3)^(5-A6)
7 1 1,000 1,215.51 <-- =B7*(1+$B$3)^(5-A7)
8 2 1,000 1,157.63
9 3 1,000 1,102.50
10 4 1,000 1,050.00
11 5 1,000 1,000.00
12
13 Total at end of 5 years 5,525.63 <-- =SUM(C6:C11)
14 5,525.63 <-- =FV(B3,5,-B2,,0)

To end this discussion, here are two additional points:

• If you don’t enter a value for the Type in the FV function, Excel assumes that Type
equals 0 (meaning the deposits are made at the end of the period).
• It is easy to confuse the “beginning” and “end” of period distinction and blind use of
the FV function can lead to errors. The obvious way to avoid such errors is to build an
extensive Excel table as illustrated above.
One final note: The FV function also allows for an optional Pv parameter. This param-
eter allows you to use the FV function to compute loan payments. We prefer not to use this
parameter—if we need to compute loan payments, we use the PMT function illustrated later.2

PV( )
The Excel PV function calculates the PV of an annuity (a series of fixed periodic payments).
Here is an example.

A B C
1 THE PV FUNCTION
2 Payments made at the end of the period
3 Rate 10%
4 Number of periods 10
5 Payment 100
6 Present value (614.46) <-- =PV(B3,B4,B5)

2
The use of the Pv parameter of the FV function is nicely illustrated in note by Linda Johnson on the fol-
lowing Web site: http://pubs.logicalexpressions.com/pub0009/LPMArticle.asp?ID=385.
730 PART SIX BACKGROUND TO EXCEL

10
100
Thus $614.46 = ∑ t
. Here are two things to note about the PV( ) function:
t =1 (1.10 )
• Writing PV(B3,B4,B5) assumes that payments are made at dates 1, 2, . . . , 10. If the pay-
ments are made at dates 0, 1, 2, . . . , 9, you should write the following.

A B C
8 Payments made at the beginning of the period
9 Rate 10%
10 Number of periods 10
11 Payment 100
12 Present value (675.90) <-- =PV(B9,B10,B11,,1)

• Irritatingly, when the payments are positive as in the above example, the PV( ) function
(and the PMT( ) function—see below) gives the PV as a negative number (there is a logic
here, but it’s not worth explaining). To get a positive PV in cell B12, we would either
write - PV(B3,B4,B5) or let the payment be negative by writing PV(B3,B4,-B5).

PMT( )
This function calculates the payment necessary to pay off a loan with equal payments over a
fixed number of periods. For example, the first calculation below shows that a loan of $1,000, to
be paid off over 10 years at an interest rate of 8%, will require equal annual payments of interest
and principal of $149.03. The calculation performed is the solution of the following equation:
n
X
∑ = initial loan principal,
t= 1 (1 + r )t
Where X is the payment

A B C
1 THE PMT FUNCTION
2 Payments made at the end of the period
3 Rate 8%
4 Number of periods 10
5 Principal 1000
6 Payment ($149.03) <-- =PMT(B3,B4,B5)
7
8 Payments made at the beginning of the period
9 Rate 8%
10 Number of periods 10
11 Principal 1000
12 Payment ($137.99) <-- =PMT(B9,B10,B11,,1)

Loan tables can be calculated using the PMT( ) function. These tables—explained in detail
in Chapter 2—show what part of each payment is interest and what part is repayment of the loan
principal. In each period, the payment on the loan (calculated with PMT( )) is split:
• We first calculate the interest owing for that period on the principal outstanding at the
beginning of the period. In the table below, at the end of year 1, we owe $80 (= 8% *
$1,000) of interest on the loan principal outstanding at the beginning of the year.
 CHAPTER 26 Excel Functions 731

• The remainder of the payment (for year 1, $69.03) goes to reduce the principal
outstanding.

A B C D E
1 LOAN TABLE
2 Interest 8%
3 Number of periods 10
4 Principal 1,000
5 Annual payment 149.03 <-- =-PMT(B2,B3,B4)
6
7 Split of payment between
Principal at Repayment of
8 Year beginning of year Payment Interest principal
9 1 1,000.00 149.03 80.00 69.03
10 2 930.97 149.03 74.48 74.55
11 3 856.42 149.03 68.51 80.52
12 4 775.90 149.03 62.07 86.96
13 5 688.95 149.03 55.12 93.91
14 6 595.03 149.03 47.60 101.43
15 7 493.60 149.03 39.49 109.54
16 8 384.06 149.03 30.73 118.30
17 9 265.76 149.03 21.26 127.77
18 10 137.99 149.03 11.04 137.99

Note that the repayment of principal at the end of year 10 is exactly equal to the principal
outstanding at the beginning of the year (i.e., the loan has been paid off).

Using the IPMT and PPMT to Compute the Interest and Principal
Payments of the Loan Table
Columns D and E of the loan table in the previous example can be computed by these two func-
tions. In the following example we compute the interest and principal components in year 4.

A B C
1 USING IPMT AND PPMT
2 Interest 8%
3 Number of periods 10
4 Principal 1,000
5 Annual payment 149.03 <-- =PMT(B2,B3,-B4)
6
7 Year 3
8 Interest payment 68.51 <-- =IPMT(B2,B7,B3,-B4)
9 Principal payment 80.52 <-- =PPMT(B2,B7,B3,-B4)

Using the FV Parameter of the PMT Function

The PMT function can also compute the periodic payment necessary to achieve a given FV.
Here’s an example: Suppose you want make 10 annual payments into your savings account so
that you have $10,000 in 10 years. Suppose the interest rate is 6%. What should your annual
payment be? In the spreadsheet below we show two ways of solving this problem.
732 PART SIX BACKGROUND TO EXCEL

A B C D
SAVING FOR THE FUTURE
1 Using the PMT function to compute a future value
2 Annual deposit to savings account $ 715.74
3 Interest rate 6%
4
Deposit to Total in
5 Year account account
6 0 $ 715.74 $ 715.74 <-- =B6
7 1 $ 715.74 $ 1,474.42 <-- =B7+C6*(1+$B$3)
8 2 $ 715.74 $ 2,278.63 <-- =B8+C7*(1+$B$3)
9 3 $ 715.74 $ 3,131.09
10 4 $ 715.74 $ 4,034.69
11 5 $ 715.74 $ 4,992.51
12 6 $ 715.74 $ 6,007.81
13 7 $ 715.74 $ 7,084.01
14 8 $ 715.74 $ 8,224.79
15 9 $ 715.74 $ 9,434.02
16 10 $ - $ 10,000.06 <-- =B16+C15*(1+$B$3)
17
18 Using PMT to do the calculation $715.74 <-- =PMT(B3,10,,-10000,1)

The table in cells A6:C16 shows you exactly what’s happening: By using trial and error or
Goal Seek (Chapter 28) you can compute the number in cell B2: You need $715.74 deposited
today and in each of the next 9 years to achieve your goal of $10,000 at the end of 10 years.
The PMT function in cell B18 can do the same calculation. Here’s the way the dialog box
for this function looks. Note the use of Type = 1, because the payments are made at the begin-
ning of each year. Note also that we haven’t put any entry into the Pv box.
 CHAPTER 26 Excel Functions 733

RATE( )
RATE calculates the IRR of a series of constant payments. In the example below
RATE(B4,B5,-B3) in cell B6 computes 10.56%, which is the IRR:
100 100 100
−600 + + +…+ =0
(1.1056 ) (1.1056 )2
(1.1056 )
10

A B C D
THE RATE FUNCTION
1 Compare to IRR
2 RATE used for payments made at the end of the period
3 Initial payment 600
4 Number of periods 10
5 Annual payment 100
6 Rate of return 10.56% <-- =RATE(B4,B5,-B3)
7
8 RATE used for payments made at the beginning of the period
9 Initial payment 600
10 Number of periods 10
11 Annual payment 100
12 Rate of return 13.70% <-- =RATE(B10,B11,-B9,,1,20%)
13
14 What does RATE do? Computing the IRR
Payment Payment
at end of at beginning
15 Year period of period
16 0 -600 -500
17 1 100 100
18 2 100 100
19 3 100 100
20 4 100 100
21 5 100 100
22 6 100 100
23 7 100 100
24 8 100 100
25 9 100 100
26 10 100
27
28 IRR 10.56% 13.70% <-- =IRR(C16:C26)

Like PV and PMT, Rate gives the possibility of specifying whether the cash flows occur at
the end of the period (the default) or at the beginning. If you look in cell B12, Rate(B10,B11,-
B9,,1,20%) computes 13.70%; this is the IRR of an initial payment of $600 and 10 payments of
$100 made at the beginning of the period (the beginning of the period is indicated by the “1” at
the end of the formula. The 20% in the function is a Guess like that which is also allowed in
the IRR function.
Here’s the dialog box that created this result.
734 PART SIX BACKGROUND TO EXCEL

Think for a second what this means for an IRR:

100 100 100 100
−600 + !"100 + + + +…+ =0
"#""$
↑ (1.1370 ) (1.1370 ) (1.1370 )
2 3
(1.1370 )
9

First payment
made at "beginning"
of period--meaning,
made at time 0

Effectively, then RATE(B10,B11,-B9,,1,20%) refers to an initial payment of $500 and

nine subsequent payments of 100.

RATE versus IRR

If you look at the above example, you will see (rows 16–28) that IRR and RATE give the same
values. There are, of course, trade-offs:
• RATE is shorter; IRR requires you to specify all the cash flows.
• On the other hand, IRR can handle cash flows that vary over time.

NPER( )
This function calculates the number of periods to repay a loan given a fixed amount. For exam-
ple, you borrow $1,000 from the bank, which charges you a 10% annual interest rate. You intend
to repay the loan with $250 per year. How long will it take you to repay the loan?
 CHAPTER 26 Excel Functions 735

A B C D E
1 HOW LONG TO PAY OFF THIS LOAN?
2 Loan amount 1,000.00
3 Interest rate 10%
4 Annual payment 250
How long to pay
5 off the loan? 5.3596 <-- =NPER(B3,B4,-B2)
6
Principal Payment
at beginning at end Repayment
7 Year of year of year Interest of principal
8 1 1,000.00 250.00 100.00 150.00
9 2 850.00 250.00 85.00 165.00
10 3 685.00 250.00 68.50 181.50
11 4 503.50 250.00 50.35 199.65
12 5 303.85 250.00 30.39 219.62
13 6 84.24 250.00 8.42 241.58

As you can see from the loan table, it takes somewhere between 5 and 6 years to repay the
loan.3 NPER(B3,B4,-B2) gives the exact number of periods as 5.3596.

26.2. Math Functions

Using Exp to Calculate FVs
Suppose you invest $100 at 10% for 3 years. As explained in Chapter 2, if interest is com-
pounded annually, the FV after 3 years will be as follows.
A B C
1 ANNUAL COMPOUNDING
2 Initial investment 100
3 Years invested, t 3
4 Interest rate, r 10%
5 Future value, FV 133.1 <-- =B2*(1+B4)^B3

Suppose the 10% is compounded semiannually (meaning: you get 5% each half year).
Then there will be six compounding periods—3 years * 2 periods/year. Your FV will be Initial
Investment * (1 + 5%)6 = 134.0096.
A B C
7 Initial investment 100
8 Years invested, t 3
9 Compounding periods per year, n 2
10 Interest rate, r 10%
11 Future value, FV 134.0096 <-- =B7*(1+B10/B9)^(B8*B9)

Denote the number of years by t, the interest rate by r, and the number of compounding
periods per year by n. As the number of compounding periods increases, the FV tends toward
100 * er*t, where e is the number 2.71828.4 In Excel this is written 100 * Exp(r * t). This is illus-
trated in the table and graph below.

3
Why? At the end of year 5 (which is also the beginning of year 6), there’s still $84.24 of principal
outstanding. But if you pay back $250 at the end of year 6, then you’ve paid back too much.
nt
4 ⎛ r⎞
In mathematical notation: lim ⎜ 1 + ⎟ = ert .
n →∞
⎝n ⎠
736 PART SIX BACKGROUND TO EXCEL

A B C D E F
15 Years invested, t 3
16 Interest rate, r 10%
17
Number of compounding Future
18 periods per year, n value
19 1 133.100 <-- =$B$14*(1+$B$16/A19)^($B$15*A19)
20 2 134.010 <-- =$B$14*(1+$B$16/A20)^($B$15*A20)
21 3 134.327 <-- =$B$14*(1+$B$16/A21)^($B$15*A21)
22 4 134.489
23 5 134.587 Future Value as Function of Number
24 6 134.653 135.00 of Compounding Periods per Year
25 7 134.700
8 134.735 134.80
26
27 9 134.763 134.60
28 10 134.785 134.40
29 20 134.885
134.20
30
31 134.00
32 133.80
33 133.60
34
133.40
35
36 133.20
37 133.00
38 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
39
As n gets large, this
40 converges to 134.9859 <-- =B14*EXP(B16*B15)

Nomenclature: When the number of compounding periods becomes infinite, the invest-
ment is said to be continuously compounded. Otherwise (that is, when there are a finite number
of compounding periods per year), the investment is said to be discretely compounded.

Using Exp to Calculate PVs

Earlier we illustrated how $100 grows to 100 * Exp(r * t) when it is compounded continuously
for t years at interest rate r. Suppose you’re going to get $100 in 3 years. What is the PV of
this $100 if the relevant interest rate is r? The answer depends on the number of compounding
periods:
• If the investment is discretely compounded n times per year, then its PV is
−n*t
100 ⎛ r⎞
n*t
= 100 * ⎜ 1 + ⎟
⎛ r⎞ ⎝ n⎠
⎜1 + ⎟
⎝ n⎠
• If the investment will be continuously compounded, then its PV is
100
= 100 * exp (−r * t )
exp (r * t )

Here is an Excel spreadsheet.

 CHAPTER 26 Excel Functions 737

A B C
1 DISCRETE VERSUS CONTINUOUS DISCOUNTING
2 Future value 100
3 What year received, t 3
4 Compounding periods per year, n 2
5 Interest rate, r 10%
6
7 Present value, discrete discounting 74.62154 <-- =B2/(1+B5/B4)^(B4*B3)
8
9 Present value, continuous discounting 74.08182 <-- =B2*EXP(-B5*B3)

You can use the above spreadsheet to show that as n gets very large, the two values in B56 and
B58 converge. For example, when n = 100, we obtain the following.

A B C
1 DISCRETE VERSUS CONTINUOUS DISCOUNTING
2 Future value 100
3 What year received, t 3
4 Compounding periods per year, n 100
5 Interest rate, r 10%
6
7 Present value, discrete discounting 74.09293 <-- =B2/(1+B5/B4)^(B4*B3)
8
9 Present value, continuous discounting 74.08182 <-- =B2*EXP(-B5*B3)

LN
This function (the “natural logarithm” to differentiate it from the “logarithm base 10” that you
learned in high school) is often used to calculate continuously compounded rates of return.5
Suppose you invest in a stock that is worth $25 and suppose that 1 year later the stock is worth
$40. What rate of return r have you earned? If you use discrete compounding, the rate of return
P1 40
is r = P − 1 = 25 − 1 = 60% .
0
Now suppose that your alternative is to earn continuously compounded interest r. Then the
rate of return has to solve the equation
P1
P0 exp (r ) = P1 ⇒ exp (r ) = .
P0

The function that solves this equation is the natural logarithm ln:
⎛P ⎞
r = ln ⎜ 1 ⎟ .
⎝ P0 ⎠
The following spreadsheet shows an example using Excel.

5
In this book we’ve used it extensively in the option chapters, Chapters 20–24.
738 PART SIX BACKGROUND TO EXCEL

A B C
USING LN TO COMPUTE CONTINUOUSLY
1 COMPOUNDED RATES OF RETURN
2 Price of stock, t=0 25
3 Price of stock, t=1 40
4 Discretely compounded rate of return, r 60.00% <-- =B3/B2-1
5 Continously compounded rate of return, r 47.00% <-- =LN(B3/B2)

When t ≠ 1, the problem looks like this:

Pt
P0 exp (r * t ) = Pt ⇒ exp (r * t ) =
P0
has solution:
1 ⎛P ⎞
r = ln ⎜ t ⎟
t ⎝ P0 ⎠

For example, suppose you invested in Intel stock on 25 October 1999, buying the stock for
its closing price of $38.6079, and suppose you sold it at the end of the day, 24 July 2000, for
$64.4379. As the calculation below shows, you would have earned a continuously compounded
return of 68.49% on your stock.

A B C D
7 Intel stock
8 Purchase date and price 25-Oct-99 38.6079
9 Sale date and price 24-Jul-00 64.4379
10
11 Elapsed time, t 0.7479 <-- =(B9-B8)/365
12 Continuously compounded rate of return, r 68.49% <-- =1/B11*LN(C9/C8)

Note that this calculation is easier than the calculation of the annualized daily return—it
has one fewer step.

A B C D
14 Daily return, annualized
15 Purchase date and price 25-Oct-99 38.6079
16 Sale date and price 24-Jul-00 64.4379
17
18 Elapsed days 273 <-- =(B16-B15)
19 Daily return 0.1878% <-- =(C16/C15)^(1/B18)-1
20 Annualized 98.35% <-- =(1+B19)^365-1

A Short Finance Note

We can’t resist a short finance note on the difference between the continuously compounded
annual return of 68.49% and the discretely compounded annual return of 98.35%.
• Both of these returns cause $38.6079 to grow over a period of 273 days to $64.4379. So
they’re both—in an economic sense—the same number.
 CHAPTER 26 Excel Functions 739

• The daily returns are very close: The continuously compounded daily return is calcu-
annual continuously compounded return
lated by and the discretely compounded daily
365
1
⎛ Stock price, day 273 ⎞ 273
return is calculated by ⎜ ⎟ − 1 . These numbers are very close.
⎝ Stock price, day 0 ⎠

A B C
22 Note
23 Daily, continuously compounded return 0.1876% <-- =B12/365
24 Daily, discretely compounded return 0.1878% <-- =B19

However, when you compound them for 365 days, the differences are very large.

Round, RoundDown, RoundUp, Trunc

The Excel functions Round, RoundDown, and RoundUp do exactly what they say. All three
functions require you to specify the number of decimal places to which you want to round off
the number. The function Trunc cuts off a number after a specified number of places (if you do
not specify, Trunc gives you the integer part of a number). Here are examples using the Excel
function Pi as a basis.
A B C
1 ROUNDING NUMBERS IN EXCEL
2 Number 3.1415926535898 <-- =PI()
3
4 Round, no decimal places 3.00000000 <-- =ROUND(B2,0)
5 Round, 3 decimal places 3.14200000 <-- =ROUND(B2,3)
6
7 RoundDown, no decimal places 3.00000000 <-- =ROUNDDOWN(B2,0)
8 RoundDown, 3 decimal places 3.14100000 <-- =ROUNDDOWN(B2,3)
9
10 RoundUp, no decimal places 4.00000000 <-- =ROUNDUP(B2,0)
11 RoundUp, 4 decimal places 3.14160000 <-- =ROUNDUP(B2,4)
12
13 Truncate, no decimal places 3.00000000 <-- =TRUNC(B2)
14 Truncate, 5 decimal places 3.14159000 <-- =TRUNC(B2,5)

There’s a difference between using these functions and merely formatting a number so that
it looks rounded or truncated. Here’s an example.

A B C
16 Number 4.5632
17 Rounded to 2 decimals 4.56 <-- =ROUND(B16,2)
18 Formatted to 2 decimals 4.56 <-- =B16
19
20 10 times cell B20 45.6 <-- =10*B17
21 10 times cell B21 45.632 <-- =10*B18
740 PART SIX BACKGROUND TO EXCEL

In cell B18 we used the “decrease decimal” button on the Home tab to

change the representation of the number. However, as you can see in cell B21, this button does
not change the number, whereas Round actually changes the number.6

Sqrt
This function calculates the square root of a number. In this book, we’ve used square roots to
calculate the standard deviation (see Chapter 12) of returns.

A B C
1 SQRT
2 Number 3
3 Square root 1.732051 <-- =SQRT(B2)
4 Equivalent way 1.732051 <-- =B2^(1/2)

Note that you can use the carat (^) as an alternative way of calculating the square root. In Excel’s
notation, a ^ b raises a to the power b (meaning a ^ b = a b ). Because a square root is equivalent
to the power ½, you can also use this notation (see cell B4 above).

Sum
The Excel function Sum adds numbers in a range of cells.

A B
1 SUM
2 1
3 2
4 3
5 4
6 5
7 15 <-- =SUM(A2:A6)

SumIf
SumIf allows you to add only numbers that fulfill a specific condition. Here’s an example in
which we add only those scores that are greater than 30.

A B
9 Score
10 30
11 50
12 80
13 90
14 20
15 220 <-- =SUMIF(A10:A14,">30")

6
Excel also has functions Roundup and Rounddown that do what their names suggest. We’ll leave you to
explore these functions on your own.
 CHAPTER 26 Excel Functions 741

The function SumIf also allows you to have the conditional column some other place. In
the following example, we add the numbers in D10:D14 for which the corresponding number in
E10:E14 is greater than 40 (highlighted here).

D E F
9 Score 1 Score 2
10 30 55
11 50 89
12 80 22
13 90 65
14 20 35
15 170 <-- =SUMIF(E10:E14,">40",D10:D14)

The function wizard really helps when you use this function. Here it is for the above example.
You’ll note that Range is the column of criteria (“Score 2”) and Sum_range is the column to be
added. If you don’t specify Sum_range, Excel assumes that it’s the same as Range.

SumProduct
This function pairwise multiplies the entries in two columns and adds the results. It’s some-
times useful in statistics (do we have an example?). Here’s a simple example that calculates the
expected return of a portfolio. There are four assets, each with a different expected return. To
calculate the expected portfolio return, we have to multiply the expected return in column B by
the portfolio proportion of each asset (column C). SumProduct does this nicely.
742 PART SIX BACKGROUND TO EXCEL

A B C D E F
Expected Portfolio
18 Asset return proportion
19 1 20% 15%
20 2 8% 22%
21 3 15% 38%
22 4 12% 25%
23
24 Expected portfolio return 13.46% <-- =SUMPRODUCT(B19:B22,C19:C22)

26.3. Conditional Functions

If( ), VLookup( ), and HLookup( ) are three functions that allow you to put in conditional
statements.
The syntax of Excel’s If statement is If(condition,output if condition is true, output if
condition is false). In the example below, if the initial number in B3 < 3, then the desired output
is 15. If B3 > 3, then the output is 0.

A B C
1 THE IF FUNCTION
2 Initial number 2
3 If statement 15 <-- =IF(B2<=3,15,0)

You can make If print text also, by enclosing the desired text in double quotes.

A B C
5 Initial number 2
6 If statement Less than or equal to 3 <-- =IF(B5<=3,"Less than or equal to 3","More than 3")

VLookup and HLookup

Because VLookup( ) and HLookup( ) both have the same structure, we will concentrate on
VLookup( ) and leave you to figure out HLookup( ) for yourself. VLookup( ) is a way to intro-
duce a table search in your spreadsheet. Here is an example: Suppose the marginal tax rates on
income are given by the table below—for income less than $8,000, the marginal tax rate is 0%;
for income above $8,000, the marginal tax rate is 15%, etc. Cell B9 illustrates how the function
VLookup is used to look up the marginal tax rate.

A B C
1 VLOOKUP FUNCTION
Tax
2 Income rate
3 0 0%
4 8,000 15%
5 14,000 25%
6 25,000 38%
7
8 Income 15,000
9 Tax rate 25% <-- =VLOOKUP(B8,A3:B6,2)

The syntax of this function is VLookup(lookup_value,table,column). The first column of

the lookup table, A3:A6, must be arranged in ascending (increasing) order. The lookup_value
 CHAPTER 26 Excel Functions 743

(in this case the income of 15,000) is used to determine the applicable row of the table. The row
is the first row whose value is < the lookup_value; in this case, this is the row that starts with
14,000. The column entry determines from which column of the applicable row the answer is
taken; in this case the marginal tax rates are in column 2.
Here’s the Excel function wizard for this table.

The First Column of VLookup Must Be Sorted

The first column of the VLookup table must be sorted, meaning it must be in increasing order
(either numerical or alphabetical). To see what this means, we have a slightly complicated exam-
ple: The data in columns A and B below were imported from a database; column A gives the
date and column B gives an interest rate on a particular date.

A B C D E F
1 FIRST COLUMN OF VLOOKUP MUST BE SORTED
Interest
2 Date rate Month Day Year
3 JAN. 07,1991 6.721 JAN 07 1991
4 FEB. 07,1991 6.145 Feb 07 1991
5 FEB. 11,1991 6.03 FEB 11 1991
6 MAR. 04,1991 6.287 MAR 04 1991
7 APR. 01,1991 5.985 APR 01 1991
8 JUN. 08,1991 5.777 JUN 08 1991
9 AUG. 15,1991 5.744 AUG 15 1991
10 OCT. 22,1991 5.868 OCT 22 1991
11
12
=LEFT(A10,3) =MID(A10,6,2) =RIGHT(A10,4)
13
744 PART SIX BACKGROUND TO EXCEL

We would like to give each date a standard Excel value. That is, instead of “Jan. 07, 1991,”
we’d like to write the following.

A B
Standard Excel date Number
18 format equivalent
19 7-Jan-91 33245

(The equivalence between Excel dates and numbers is discussed in Chapter 29.)
To write the date in the standard Excel format, we use the functions Left, Mid, and Right
to parse the dates in column A into month, day, and year (see next section). We now need to
identify each month with its number (i.e., Jan = 1, Feb = 2, etc.). We can use VLookup to do this,
but only if the VLookup table has its left column in alphabetical order.

A B C D E F G H I J K
1 FIRST COLUMN OF VLOOKUP MUST BE SORTED
Interest Which Date
2 Date rate Month Day Year month? value
3 JAN. 07,1991 6.721 JAN 07 1991 1 <-- =VLOOKUP(D3,$J$6:$K$17,2) 1/7/1991 <-- =DATE(F3,H3,E3)
4 FEB. 07,1991 6.145 Feb 07 1991 2
5 FEB. 11,1991 6.03 FEB 11 1991 2 VLookup table
6 MAR. 04,1991 6.287 MAR 04 1991 3 Apr 4
7 APR. 01,1991 5.985 APR 01 1991 4 Aug 8
8 JUN. 08,1991 5.777 JUN 08 1991 6 Dec 12
9 AUG. 15,1991 5.744 AUG 15 1991 8 Feb 2
10 OCT. 22,1991 5.868 OCT 22 1991 10 Jan 1
11 Jul 7
12 Jun 6
13 =LEFT(A10,3) =MID(A10,6,2) =RIGHT(A10,4) Mar 3
14 May 5
15 Nov 11
16 Oct 10
17 Sep 9

This gives a rather strange-looking table (cells J6:K17), but you can convince yourself that
this works.

26.4. Text Functions

Excel distinguishes between numbers and text. To sound dense, you can add, subtract, etc. num-
bers, but you can’t do this for text. On the other hand, Excel allows you to concatenate text (if
this sounds mysterious, read on).

Concatenation: Combining Text from Several Cells

In the example below, we’ve written “twelve” in cell A2 and “cows” in cell B2. In cell A4, we
tried to write =A3+B3; we intended this to come out “Twelvecows”, but Excel won’t accept this,
because neither the contents of A2 (“Twelve”) nor those of B2 (“cows”) is a number. We can
combine the text as in cell A5, by writing =A3&B3.
A B
2 Twelve cows
3
4 #VALUE! <-- =A2+B2
5 Twelvecows <-- =A2&B2
6
7 Twelve blue cows <-- =A2&" blue "&B2
 CHAPTER 26 Excel Functions 745

In cell A7, we’ve added the word “blue” plus some spaces, putting the additional text/spaces
inside quotation marks.

Text
Now look at the example below.

A B C
10 Number of cows 1200
11
12 Text 1200 cows <-- =TEXT(B10,"0")&" cows"
13
14 1200.00 cows <-- =TEXT(B10,"0.00")&" cows"
15 1,200.0 cows <-- =TEXT(B10,"0,000.0")&" cows"
16 120,000.00% cows <-- =TEXT(B10,"0,000.00%")&" cows"

In cell B12 we want to create a text that contains the number of cows (cell B10) and the
word “cows”. The Excel function Text(B10,”0”) turns the number 1200 into a text form that
can then be used in the formula in cell B12. The second part of the Text function—where we’ve
currently written “0”—is used to indicate the appearance of the text. Cells B14:B16 give some
other examples.

Left, Right, Mid, Len

The first three functions allow you to pick out parts of texts. In the example below, we’ve used
these functions to pick out parts of the text in cell A18.

A B
18 15 pink flamingos went to the zoo
19
20 15 <-- =LEFT(A18,2)
21 pink flamingos <-- =MID(A18,4,14)
22 zoo <-- =RIGHT(A18,3)
23 33 <-- =LEN(A18)

The function =Left(A19,2) picks out the 2 leftmost characters of cell A19. The
function =Mid(A19,4,14) picks out the 14 characters of cell A19, starting with the 4th character.
And the function =Right(A19,3), well . . . you’ll figure that one out yourself.
As illustrated in cell A23, the function Len tells you the number of characters in the text.
You might ask why a finance book needs to consider these functions. The following data
give prices for some options on General Motors and were downloaded from the Web site of
the Chicago Board of Options Exchange. When we downloaded the data, here’s what they
looked like.
746 PART SIX BACKGROUND TO EXCEL

A B C D
GENERAL MOTORS OPTION DATA
Downloaded from Chicago Board of Options Exchange
1 Web Site
2 Calls Last Sale Puts Last Sale
3 01 Aug 60.00 (GM HL-E) 3.5 01 Aug 60.00 (GM TL-E) 0.5
4 01 Aug 60.00 (GM HL-A) 3.4 01 Aug 60.00 (GM TL-A) 0.4
5 01 Aug 60.00 (GM HL-P) 3 01 Aug 60.00 (GM TL-P) 0.4
6 01 Aug 60.00 (GM HL-X) 2.9 01 Aug 60.00 (GM TL-X) 0.6
7 01 Aug 60.00 (GM HL-8) 3.4 01 Aug 60.00 (GM TL-8) 0.5
8 01 Aug 65.00 (GM HM-E) 0.45 01 Aug 65.00 (GM TM-E) 2.85
9 01 Aug 65.00 (GM HM-A) 0.45 01 Aug 65.00 (GM TM-A) 1.8
10 01 Aug 65.00 (GM HM-P) 0.45 01 Aug 65.00 (GM TM-P) 2.4
11 01 Aug 65.00 (GM HM-X) 1.15 01 Aug 65.00 (GM TM-X) 2.25
12 01 Aug 65.00 (GM HM-8) 0.4 01 Aug 65.00 (GM TM-8) 2.7
13 01 Aug 70.00 (GM HN-E) 0.05 01 Aug 70.00 (GM TN-E) 7.9
14 01 Aug 70.00 (GM HN-A) 0.05 01 Aug 70.00 (GM TN-A) 6.3
15 01 Aug 70.00 (GM HN-P) 0.05 01 Aug 70.00 (GM TN-P) 0
16 01 Aug 70.00 (GM HN-X) 0.2 01 Aug 70.00 (GM TN-X) 7.5
17 01 Aug 70.00 (GM HN-8) 0.05 01 Aug 70.00 (GM TN-8) 6.8
18
19
20 Other information
21
22 Option expiration year and month
23 Option exercise price

The information in columns A and C gives information about the option, including the
expiration year and month, the exercise price, and a parenthetical item that shows you the stock
on which the option is written, the option symbol, and the exchange on which the option traded.
For example,
GM HN-E a General Motors call option with exercise price 70 expiring in August 2001
and trading on the Chicago Board of Options Exchange
GM TL-A the stock symbol for a General Motors put option with exercise price 60, expir-
ing in August 2001 and trading on the American Stock Exchange

Now suppose we want to separate the dates, the option’s symbol, and the exchange on
which the option traded.

C D E F G H I J K
2 Puts Last Sale Date Symbol Exchange
3 01 Aug 60.00 (GM TL-E) 0.5 01Aug TL E
4 01 Aug 60.00 (GM TL-A) 0.4
5 01 Aug 60.00 (GM TL-P) 0.4
6 01 Aug 60.00 (GM TL-X) 0.6
7 01 Aug 60.00 (GM TL-8) 0.5 =LEFT(C3,2)&MID(C3,4,3)
=MID(C3,LEN(C3)-4,2)
8 01 Aug 65.00 (GM TM-E) 2.85
9 01 Aug 65.00 (GM TM-A) 1.8
10 01 Aug 65.00 (GM TM-P) 2.4
11 01 Aug 65.00 (GM TM-X) 2.25
=MID(C3,LEN(C3)-1,1)
12 01 Aug 65.00 (GM TM-8) 2.7
13 01 Aug 70.00 (GM TN-E) 7.9

In Chapter 29 (which explains how to use times and dates in Excel), we use this information
to design a function that gives us the option’s expiration date.
 CHAPTER 26 Excel Functions 747

26.5. Statistical Functions

Many of Excel’s statistical functions have already been discussed in previous chapters.

Average Finds the average of a range of cells Chapters 8 and 9

Covar The covariance of two sets of data Chapter 9
Correl The correlation coefficient of two Chapter 9
sets of data
Frequency An array function that computes the Chapter 8
frequency distribution
Intercept, Slope, Rsq Compute the intercept, slope, and Chapters 9 and 12
R2 of a regression
Max, Min The maximum and minimum of a Chapter 8, Chapters 20–23
set of numbers
Stdev, StdevP The standard deviation Chapters 8 and 9
Var, VarP The variance Chapters 8 and 9

Median, Large, and Rank

In this subsection we discuss three more statistical functions: Median, Large, and Rank. We
illustrate the following example, which gives the grades for 11 students.

A B C
1 Median, Large, Rank
2 Student Grade
3 1 100
4 2 50
5 3 75
6 4 32
7 5 98
8 6 86
9 7 72
10 8 63
11 9 41
12 10 88
13 11 92
14
15 Average 72.45 <-- =AVERAGE(B3:B13)
16 Median 75 <-- =MEDIAN(B3:B13)
17 Large 92 <-- =LARGE(B3:B13,3)
18 Rank 7 <-- =RANK(B9,B3:B13)

The median is the grade that splits the list in two: There are five grades higher than 75 and
five lower. The median is different from the average, as you can see.
The Excel function Large tells you the kth largest number in the set of grades.
748 PART SIX BACKGROUND TO EXCEL

The Excel function Rank tells you where a particular number places in the range of grades. In
the example given the grade 72 is the seventh among the set of grades in B3:B13.

Count, CountIf, CountA

All three of these functions count cells. The difference (we’ll illustrate) is that:
• Count counts the number of cells that contain values and ignores the cells that contain
text.
• CountA counts all nonblank cells in a range, whether they contain values or text.
• CountIf counts cells that fulfill a particular condition.
Now we’ll illustrate.
 CHAPTER 26 Excel Functions 749

A B C
1 COUNT, COUNTIF, COUNTA
2 List
3 1
4 2
5 3
6 4
7 Terry
8 Oliver
9 Noah
10 Sara
11 Zvi
12
13 Count 4 <-- =COUNT(A3:A11)
14 CountA 9 <-- =COUNTA(A3:A11)
15 CountIf 2 <-- =COUNTIF(A3:A11,">2")

26.6. Match and Index

We use these functions in a minor way in Chapter 8 to locate the specific dates on which
McDonald’s stock achieved its maximum and minimum price.

Using Index to Locate a Value in an Array

In the example below, we use Index to locate the value in row 5 and column 6 of an 8 x 8
array.

A B C D E F G H
1 USING INDEX TO LOCATE A NUMBER IN AN ARRAY
2 34 43 90 19 60 16 83 10
3 85 52 89 56 9 21 17 10
4 66 6 48 18 19 20 36 64
5 20 96 70 18 16 73 55 9
6 38 10 68 52 63 97 62 40
7 38 19 90 85 46 62 38 11
8 25 35 58 55 91 25 77 79
9 73 59 82 49 55 10 67 88
10
11 Row 5
12 Column 6
13 Number? 97 <-- =INDEX(A2:H9,B11,B12)

Using Match to Find Where a Specific Value Occurs

The data below are the price of Citicorp on the first trading day of September 2007–September
2009. The minimum price over this period was $1.50. Using Match(Lookup_value,Lookup_
array,MatchType) we can locate this value on row 18 of the set of prices.
750 PART SIX BACKGROUND TO EXCEL

A B C D E F
1 USING MATCH TO LOCATE A VALUE IN AN ARRAY
Citicorp
closing
2 Date price
3 4-Sep-07 43.55
4 1-Oct-07 39.10 Minimum price 1.5 <-- =MIN(B3:B27)
5 1-Nov-07 31.48 Maximum price 43.55 <-- =MAX(B3:B27)
6 3-Dec-07 27.83
7 2-Jan-08 26.94 Where is the minimum? 18 <-- =MATCH(E4,B3:B27,0)
8 1-Feb-08 22.67 Where is the maximum? 1 <-- =MATCH(E5,B3:B27,0)
9 3-Mar-08 20.48
10 1-Apr-08 24.16 Date of the minimum price? 2-Feb-09 <-- =INDEX(A3:A27,E7)
11 1-May-08 21.20 2-Feb-09 <-- =INDEX(A3:A27,MATCH(E4,B3:B27,0))
12 2-Jun-08 16.23
13 1-Jul-08 18.41 Date of the maximum price? 4-Sep-07 <-- =INDEX(A3:A27,E8)
14 1-Aug-08 18.71
15 2-Sep-08 20.21
16 1-Oct-08 13.62
17 3-Nov-08 8.27
18 1-Dec-08 6.69
19 2-Jan-09 3.55
20 2-Feb-09 1.50
21 2-Mar-09 2.53 The syntax of Match is Match(Lookup_value,Lookup_array,MatchType).
22 1-Apr-09 3.05
23 1-May-09 3.72 A note on the third parameter of Match (called MatchType):
24 1-Jun-09 2.97 If MatchType = 0 or is omitted, then Match finds the exact match of the LookupValue.
25 1-Jul-09 3.17 If MatchType = 1 , then Match finds the smallest number larger than the LookupValue.
26 3-Aug-09 5.00 If MatchType = -1 , then Match finds the smallest number larger than the LookupValue.
27 1-Sep-09 4.57

Combining Match and Index

On what date did the minimum price for Citicorp occur? We can combine Index and Match as
shown in the example above to determine 2 February 2009 as the date of the minimum price
for Citicorp.

Summary
Excel has hundreds of functions. This chapter has illustrated the major functions used in this
book (and then some). We rely on you, as an educated reader, to figure the rest out for yourself.

EXERCISES
1.
a. Use NPV to compute the present value of the project below.

A B
1 Discount rate 15%
2
3 Year Cash flow
4 1 100
5 2 200
6 3 300
7 4 400
8 5 500

b. Suppose the project costs $600. What is its net present value?
 CHAPTER 26 Excel Functions 751

2.
a. Use NPV to compute the net present value for the project below.

A B
1 Discount rate 15%
2
3 Year Cash flow
4 0 -600
5 1 100
6 2 200
7 3 300
8 4 400
9 5 500

b. Use Data Table (see Chapter 27) to compute the present value of the project for discount rates
of 0%, 4%, . . . , 48%. Graph the results and estimate the project’s IRR.
3. Use the IRR function to compute the internal rate of return of the project in the previous
problem.
4. Use the FV function in the following exercises.
a. What is the value at the end of 10 years of $200 deposited in the bank today and at the begin-
ning of each of the next 9 years at an annual interest rate of 3%?
b. What is the future value at the end of 10 years of $200 deposited in the bank at the end of years
1, 2, . . . , 10. Assume a 3% interest rate.
5. You’re 25 years old, and you want to save for the future. You intend to deposit $1,000 in the bank
today. In each of the next 44 years you intend to make a similar deposit. If the interest rate is 5%
annually, how much will you have when you reach the age of 70?
6. Your mom is 50 and wants to put away some money for retirement. She would like to make
monthly deposits in the bank, starting today and at the beginning of every month between now
and the month before her retirement at age 70. (To save you irritation, the total number of deposits
is 15 * 20 = 300.) If the interest rate is 6% annually (0.5% per month), how much should she save
each month to have $200,000 on the day she retires? Use the FV function.
7.
a. Your mom is 50 and wants to put away some money for retirement. She would like to make
monthly deposits in the bank, starting today and at the beginning of every month between
now and the month before her retirement at age 70. (To save you irritation, the total number
of deposits is 15 * 20 = 300.) If the interest rate is 6% annually (0.5% per month), how much
should she save each month to have $200,000 on the day she retires? Use the PMT function.
b. Use Data Table (Chapter 27) to repeat the above calculation for annual interest rates of 0%,
1%, . . . , 12%.
8.
a. You’ve taken a $60,000, 30-year mortgage to finance the purchase of your new house. The
mortgage has an interest rate of 10% annually and requires monthly flat payments of interest
and principal (by “flat” we mean that all the payments are equal). Use PMT to compute the
monthly payment.
b. Design a loan table showing that the payment you computed in the first part of this problem
indeed pays off the mortgage.
9. You are considering buying a bond that pays $112.50 at the end of this and each of the subsequent
10 years. The interest rate is 12%. Use the PV function to value the bond.
10. You’ve offered to finance Joe’s purchase of a $20,000 car. Joe offers to repay you $500 per month
for the next 48 months.
752 PART SIX BACKGROUND TO EXCEL

a. Use Rate to compute the monthly interest rate he’s offering. Confirm your answer using
IRR.
b. What is the annual interest rate?
11. You are taking a $12,000 loan at 6%. If the maximum annual payment you can make is $2,000,
how long will it take you to pay off the loan (hint: use NPER)? Build a loan table that confirms
your answer.
12. Your money market fund pays 3% interest annually, compounded continuously.
a. If you deposit $100,000 into the fund today, and if the 3% interest rate holds for the next 10
years, how much will you have in 10 years?
b. b. What is your effective annual interest rate (EAIR) on the fund? (Although you don’t need it
to answer this question, you may want to remind yourself what the EAIR is—see Chapter 3.)
13. Your bank account pays 5.2% interest annually, compounded continuously. You have $25,000 in
the account today, and you intend to withdraw this amount 3 years and 4 months from today. How
much will you have in the account at that time?
14. Compute the continuously compounded present value of the following set of cash flows, using a
discount rate of 15%.

A B
1 Continuously compounded discount rate 15%
2
3 Date Cash flow
4 1 15,000
5 2 22,000
6 3 14,750
7 4 3,222
8 5 6,333
9 6 18,000
10 7 280,000

15. Compute the continuously compounded PV of the following set of cash flows, using a discount
rate of 15%. (This problem requires some familiarity with dates in Excel—see Chapter 29.)

A B
1 Continuously compounded discount rate 15%
2 Date today 1-Jan-06

3 Date Cash flow

4 31-Jan-06 15,000
5 31-Jan-07 22,000
6 17-Jul-07 14,750
7 31-Dec-07 3,222
8 14-Mar-08 6,333
9 11-Nov-08 18,000
10 13-Mar-09 280,000

16. You’ve been offered a financial asset that costs $1,000 today and pays back $1,100 in 1 year.
a. Compute the discretely compounded rate of return on the asset.
b. Compute the continuously compounded rate of return on the asset.
17. The CD-ROM that accompanies this book contains a spreadsheet with IBM stock prices and
dividends from February 1990 through August 2004. Part of this spreadsheet is given below; note
that column D of the spreadsheet shows the stock return for the period over which the dividend
is paid (usually this period is a quarter). Use SumIf to find the total of all dividends paid during
periods when the stock return was greater than 25%.
 CHAPTER 26 Excel Functions 753

A B C D E
IBM IBM Stock
1 Date Dividends Stock price return
2 Feb-90 103.87
3 May-90 1.21 120.00 15.53% <-- =C3/C2-1
4 Aug-90 1.21 101.87 -15.11% <-- =C4/C3-1
5 Nov-90 1.21 113.62 11.53% <-- =C5/C4-1
6 Feb-91 1.21 128.75 13.32% <-- =C6/C5-1
7 May-91 1.21 106.12 -17.58%
8 Aug-91 1.21 96.87 -8.72%
9 Nov-91 1.21 92.50 -4.51%
10 Feb-92 1.21 86.87 -6.09%

18. Use SumProduct to compute the return of the portfolio given below. The portfolio is composed of
three stocks with weights as indicated.

A B C
Percentage Stock
1 Stock of portfolio return
2 A 40% 15%
3 B 25% 22%
4 C 35% 13%

19. The end-semester grades for Finance 101 are given below.

A B C
Number Letter
1 Student grade grade
2 Mary 85
3 John 68
4 Jennifer 72
5 Mo 100
6 Simon 57
7 Noah 91
8 Terry 78
9 Sara 81
10 Zvi 45
11 George 93

The professor for the course has to assign each student a letter grad based on his or her average.
The professor’s grading key is as follows.

Grade range
≥ 0 and < 50 F
≥ 50 and < 60 D
≥ 60 and < 70 C
≥ 70 and < 85 B
≥ 85 A

Use VLookup to assign grades to each student.

20. On the CD-ROM that comes with the book is a list of companies in the Dow Jones 30 Industrials
(DJ30) and their share prices on 27 August 2004. Part of the list is given below.
754 PART SIX BACKGROUND TO EXCEL

a. What is the average price of a DJ30 stock?

b. What is the median price?
c. Use Large to determine the largest of the stock prices. Do the same using Max.
d. Use Large to determine the smallest of the stock prices. Do the same using Min.
e. Use Rank to determine the relative ranking of Microsoft’s stock price among the DJ30.

A B
DOW JONES 30 INDUSTRIALS
1 Stock prices on 27 August 2004
2 3M Corporation 81.63
3 Alcoa Inc 32.99
4 Altria Group inc 49.15
5 American Express Company 50.07
6 American Intl Group Inc 70.96
7 Boeing Co. 52.08
8 Caterpillar Inc. 73.74
9 Citigroup, Inc. 46.75
10 E.I. du Pont de Nemours and Company 42.60

21. Using the list of DJ30 companies from the previous exercise, determine the following.
a. Use CountA to determine the number of companies in the list in column A.
b. Use Count to determine the number of share prices in the list in column B.
c. Use CountIf to determine the number of companies whose share price is greater or equal
to $30.
CHAP TER

27 Data Tables

CHAPTER CONTENTS
Overview 755
27.1. A Simple Example 755
27.2. Summary: How to Do a One-Dimensional Data Table 757
27.3. Some Notes on Data Tables 759
27.4. Two-Dimensional Data Tables 762
Exercises 763

Overview
Data tables are Excel’s most sophisticated way of doing sensitivity analysis. They are a bit tricky
to implement, but the effort of learning them is well worth it!

27.1. A Simple Example

If we deposit $100 today and leave it in a bank drawing 15% interest for 10 years, what will be
its future value? As the example below shows, the answer is $404.56.

755
756 PART ONE CAPITAL BUDGETING AND VALUATION

A B C
1 DATA TABLE EXAMPLE
2 Interest rate 15%
3 Initial deposit 100
4 Years 10
5 Future value $404.56 <-- =B3*(1+B2)^B4

Now suppose we want show the sensitivity of the future value to the interest rate. In cells
A10:A16 we have put interest rates varying from 0 to 60%, and in cell B9 we have put =B5,
which refers to the initial calculation of the future value.

A B C
1 DATA TABLE EXAMPLE
2 Interest rate 15%
3 Initial deposit 100
4 Years 10
5 Future value $404.56 <-- =B3*(1+B2)^B4
6
7
8 Interest rate
9 $404.56 <-- =B5
10 0%
11 10%
12 20%
13 30%
14 40%
15 50%
16 60%

To use the data table technique we mark the range A9:B16 and then use the command
Data|What-If Analysis|Data Table.

After you click on Data Table, here’s the way the screen looks.
 CHAPTER 27 Data Tables 757

The dialog box asks whether the parameter to be varied is in a row or a column of the
marked table. In our case, the interest rate to be varied is in column A of the table, so we
move the cursor from Row input cell to Column input cell and indicate where in the original
example the interest rate occurs.

When you click OK you get the result.

A B C
1 DATA TABLE EXAMPLE
2 Interest rate 15%
3 Initial deposit 100
4 Years 10
5 Future value $404.56 <-- =B3*(1+B2)^B4
6
7
8 Interest rate
9 $404.56 <-- =B5
10 0% 100
11 10% 259.3742
12 20% 619.1736
13 30% 1378.585
14 40% 2892.547
15 50% 5766.504
16 60% 10995.12

27.2. Summary: How to Do a One-Dimensional Data Table

• Create an initial example.
• Set up a range with:
• Some variable in the initial example that will be changed (like the interest rate in
the above example).
758 PART SIX BACKGROUND TO EXCEL

A B C D
1 DATA TABLE EXAMPLE
2 Interest rate 15%
3 Initial deposit 100
4 Years 10
5 Future value $404.56 <-- =B3*(1+B2)^B4
6
7 Blank cell when variable is in column
8 Interest rate
9 $404.56 <-- =B5
10 0%
11 5%
12 10%
13 15%
14 20%
15 25%
16 30%

• A reference to the initial example (like the =B5 in the above). Note that you will
always have a blank cell next to this reference. Note the blank cells when the vari-
able is in a column.
Here’s the blank cell when the variable is in a row.

E F G H I J K L
6
7 Blank cell when variable is in row
8
9 0% 5% 10% 15% 20% 25% 30%
10 $404.56
11
12 =B5
13

• Bring up the Data|Table command and indicate in the dialog box:

• Whether the variable is in a column or a row.
• Where in the initial example the variable occurs.

Variable in column Variable in row

Either way, the result will be a sensitivity table.

 CHAPTER 27 Data Tables 759

A B C D E F G H I J K L
1 DATA TABLE EXAMPLE
2 Interest rate 15%
3 Initial deposit 100
4 Years 10
5 Future value $404.56 <-- =B3*(1+B2)^B4
6
7 Blank cell when variable is in column Blank cell when variable is in row
8 Interest rate
9 $404.56 <-- =B5 0% 5% 10% 15% 20% 25% 30%
10 0% 100 $404.56 100 162.8895 259.3742 404.5558 619.1736 931.3226 1378.585
11 5% 162.8895
12 10% 259.3742 =B5
13 15% 404.5558
14 20% 619.1736
15 25% 931.3226
16 30% 1378.585

27.3. Some Notes on Data Tables

Data Tables are Dynamic
You can change either your initial example or the variables and the table will adjust. Here’s an
example where we’ve changed the interest rates we want to vary (compare with the previous
example).

A B C
1 DATA TABLE EXAMPLE
2 Interest rate 15%
3 Initial deposit 100
4 Years 10
5 Future value $404.56 <-- =B3*(1+B2)^B4
6
7
8 Interest rate
9 $404.56 <-- =B5
10 0% 100
11 10% 259.3742
12 20% 619.1736
13 30% 1378.585
14 40% 2892.547
15 50% 5766.504
16 60% 10995.12

Here’s another example: We change the function we’re calculating, putting =FV(B2,B4,-
B3,,1) in cell B5, as explained in Chapter 2, this function calculates the future value of 10
annual $100 deposits starting today and accumulating interest at 15% for 10 years.1 Note that
we’ve also changed the text in cell A5 from “initial deposit” to “annual deposit” to reflect what’s
now happening.

1
As we also explained in Chapters 2 and 26, we put the minus sign before B3 because otherwise—for
reasons beyond logic—Excel produces a negative future value. Note that if we had typed FV(B2,B4,-B3)
the assumption is that there are 10 deposits starting 1 year from now.
760 PART SIX BACKGROUND TO EXCEL

When we click OK, both the computation in cell B5 and the data table update.
A B C
1 DATA TABLE EXAMPLE
2 Interest rate 15%
3 Initial deposit 100
4 Years 10
5 Future value $2,334.93 <-- =FV(B2,B4,-B3,,1)
6
7
8 Interest rate
9 2334.928 <-- =B5
10 0% 1000
11 10% 1753.117
12 20% 3115.042
13 30% 5540.535
14 40% 9773.913
15 50% 16999.51
16 60% 29053.64

You Can Only Erase the Whole Table but You Cannot
Erase Part of a Table
If you try to erase part of a data table, you’ll get an error message.
 CHAPTER 27 Data Tables 761

You Can Hide the Cell Header but Not Erase It

The formula at the top of the table’s second column (cell B9 in our case, containing the reference
to cell B5) is called the “column header.” This formula controls what the data table calculates. If
you want to print a table, you often want to hide the column header. In the example below, we’ve
put the cursor on cell B9. We right-click on the cell, go the command Format|Cells, and go to
Number|Custom. Typing a semicolon in the Type box hides the cell.

Here’s the result.

A B C
8 Interest rate
9 <-- =B5
10 0% 1000
11 10% 1753.117
12 20% 3115.042
13 30% 5540.535
14 40% 9773.913
15 50% 16999.51
16 60% 29053.64
762 PART SIX BACKGROUND TO EXCEL

27.4. Two-Dimensional Data Tables

In the example below we return to the FV example discussed above. We want to vary our initial
example with respect to both the interest rate and the initial deposit. The data table is set up in
cells B9:H15.
A B C D E F G H I
1 DATA TABLE EXAMPLE
2 Interest rate 15%
3 Annual deposit 100
4 Years 10
5 Future value $2,334.93 <-- =FV(B2,B4,-B3,,1)
6
7 Two-dimensional table, showing sensitivity of future value to both interest rate and deposit size
8
9 $2,334.93 0% 5% 10% 15% 20% 25%
10 50
11 =B5 100
12 150
13 200
14 250
15 300

This time we indicate in the Data|Table command that there are two variables.

This creates a two-dimensional table.

B C D E F G H
9 $2,334.93 0% 5% 10% 15% 20% 25%
10 50 500.00 660.34 876.56 1,167.46 1,557.52 2,078.31
11 100 1,000.00 1,320.68 1,753.12 2,334.93 3,115.04 4,156.61
12 150 1,500.00 1,981.02 2,629.68 3,502.39 4,672.56 6,234.92
13 200 2,000.00 2,641.36 3,506.23 4,669.86 6,230.08 8,313.23
14 250 2,500.00 3,301.70 4,382.79 5,837.32 7,787.60 10,391.53
15 300 3,000.00 3,962.04 5,259.35 7,004.78 9,345.13 12,469.84
 CHAPTER 27 Data Tables 763

EXERCISES
1. The spreadsheet below shows the value of the function f(x) = x2 + 3x – 16 for x = 3. Create the
indicated data table and use it to graph the function in the range (–10,14).

A B C D
3 x 3
4 f(x) 2 <-- =B3^2+3*B3-16
5
6
7 Data table
8 2 <-- =B4
9 -10
10 -8
11 -6
12 -4
13 -2
14 0
15 2
16 4
17 6
18 8
19 10
20 12
21 14

2. The example below calculates the NPV and IRR for an investment.
a. Create a one-dimensional data table showing the sensitivity of the NPV and IRR to the year-1
cash flow (currently $10,000). Use a range of $9,000–12,000 in increments of $500.
b. Create a two-dimensional data table showing the sensitivity of NPV to the year-1 cash flow and
to the discount rate. Use the same range for the cash flow as above and use discount rates from
8 to 20%, with increments of 2%.

A B C D E
3 Discount rate 15%
4 Cost 50,000
5 Cash flow growth 6%
6
7 Year Cash flow
8 0 (50,000.00) <-- =-B4
9 1 10,000.00
10 2 10,600.00 <-- =B9*(1+$B$5)
11 3 11,236.00 <-- =B10*(1+$B$5)
12 4 11,910.16
13 5 12,624.77
14 6 13,382.26
15 7 14,185.19
16 8 15,036.30
17 9 15,938.48
18 10 16,894.79
19
20 NPV 11,925.54 <-- =NPV(B3,B9:B18)+B8
21 IRR 20.41% <-- =IRR(B8:B18)
764 PART SIX BACKGROUND TO EXCEL

3. Project A and Project B cash flows are given in the spreadsheet below. Re-create the Data Table in
cells A21:C37 and create the graph. Note that the Data Table headers in cells B21:C21 have been
hidden (see Section 27.3 for details on how to do this).
What is the crossover point of the two lines? (You can use the data table to do this, but you can
also refer to Chapter 4 for a better solution.)
A B C D E F G H I
1 TWO INVESTMENTS AND THEIR NPVs
2 Discount rate 15%
3
Project A Project B
4 Year cash flow cash flow
5 0 -1,000 -1,000
6 1 220 300
7 2 220 300
8 3 220 300
9 4 220 300
10 5 220 300
11 6 220 100
12 7 220 100
13 8 220 100
14 9 220 100
15 10 220 100
16
17 NPV 104.13 172.31 <-- =NPV($B$2,C6:C15)+C5
18 IRR 17.68% 20.64% <-- =IRR(C5:C15)
19
20 NPV A NPV B
21 <-- The data table headers have been hidden; see Chapter 27 for details
22 0% 1,200.00 1,000.00 1,400.00
23 2% 976.17 840.95
24 4% 784.40 701.45 1,200.00
25 6% 619.22 578.48
26 8% 476.22 469.55 1,000.00
27 10% 351.80 372.61
800.00
28 12% 243.05 285.98
29 14% 147.55 208.23 600.00
30 16% 63.31 138.18
NPV A
31 18% -11.30 74.84 400.00
32 20% -77.66 17.37 NPV B
33 22% -136.90 -34.95 200.00
34 24% -189.99 -82.74
35 26% -237.74 -126.51 0.00
36 28% -280.84 -166.71 0% 5% 10% 15% 20% 25% 30% 35%
-200.00
37 30% -319.86 -203.73
38 -400.00
39

4. Finance texts always have tables that give the present value (PV) factor for an annuity:
N
1
PV factor for annuity of $1 for N years at interest r = ∑ t
t =1 (1 + r ) .
As illustrated below in Excel, these present value factors are created with the PV
function.
 CHAPTER 27 Data Tables 765

A B C D E F G H I J K
1 ANNUITY TABLE
2 r, interest 9%
3 N, number of periods 5
4 PV factor 3.8897 <-- =PV(B2,B3,-1)
5
6
Number of
7 periods PRESENT VALUE OF AN ANNUITY OF $1 FOR N PERIODS
8 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
9 1
10 2
11 3
12 4
13 5
14 6
15 7
16 8
17 9
18 10

Use Data Table to create the table in the template above.

5. (Do this example only if you’ve studied Chapters 20–23 on option pricing.) The Black–Scholes
option-pricing model, defined in Chapter 22, prices call and put options based on five parameters:
• S, the stock price today
• X, the option’s exercise price (also called the option’s strike price)
• T, the option’s expiration date
• r, the interest rate
• α, the riskiness of the stock
These inputs and the resulting call and put prices are highlighted below.
Your assignment: Use Data Table to create tables showing the sensitivity of the call and put
prices to the various inputs. Here are some suggestions.
a. Using the parameters shown below, what are the call and put prices given σ = 10%, 15%,
20%, . . . , 80%?
b. Using the parameters shown below, what are the call and put prices when T = 0.1, 0.2, 0.3, . . . , 1?

A B C
1 The Black-Scholes Option-Pricing Formula
2 S 100 Current stock price
3 X 90 Exercise price
4 T 0.50000 Time to maturity of option (in years)
5 r 4.00% Risk-free rate of interest
6 Sigma 35% Stock volatility
7
8 d1 0.6303 <-- (LN(S/X)+(r+0.5*sigma^2)*T)/(sigma*SQRT(T))
9 d2 0.3828 <-- d1-sigma*SQRT(T)
10
11 N(d1) 0.7357 <-- Uses formula NormSDist(d1)
12 N(d2) 0.6491 <-- Uses formula NormSDist(d2)
13
14 Call price 16.32 <-- S*N(d1)-X*exp(-r*T)*N(d2)
15 Put price 4.53 <-- call price - S + X*Exp(-r*T): by Put-Call parity
CHAP TER

28 Using Goal Seek and Solver

CHAPTER CONTENTS
Overview 766
28.1. Installing Solver 767
28.2. Using Goal Seek and Solver: A Simple Example 768
28.3. What’s the Difference between Solver and Goal Seek? 771
28.4. Setting the Accuracy of Solver and Goal Seek 773
Exercises 773

Overview
Goal Seek and Solver are Excel tools that produce targeted results from your models (the tech-
nical jargon is “calibrate your model”). If this sentence sounds a bit dense, read on—you’ll see
that these tools are extremely useful.
Although Solver is a much more sophisticated tool than Goal Seek, we won’t use many
of its more advanced capabilities. For our purposes, Goal Seek and Solver are thus largely
interchangeable—they can both do most of the financial tasks that we require and are not diffi-
cult to use. When you get used to them, you’ll probably find that Solver is preferable, because it
“remembers” its arguments (at this stage you won’t understand this, but read on).

766
 CHAPTER 28 Using Goal Seek and Solver 767

28.1. Installing Solver

Both Goal Seek and Solver come with the standard Excel package, but Solver has to be
installed. If it is not on your computer, do the following:
• Open Excel. Click the Office button and go to Excel Options and then Add-Ins.

• Having clicked Add-Ins, you choose the option Excel Add-ins from the drop-down
box.

• Scroll down to Solver Add-in and click the box. That should do it.
768 PART SIX BACKGROUND TO EXCEL

28.2. Using Goal Seek and Solver: A Simple Example

We’ll start with a high school algebra example: Suppose we’re trying to graph the equation
y = − x 3 + 2 x 2 − 3 x + 121. We can do this in Excel as follows.

A B C D E F G
1 SIMPLE EXAMPLE
2 x 5.166147 Table
3 y 21.00001 <-- =-B2^3+2*B2^2-3*B2+121 x y
4 -9 1039 <-- =-E4^3+2*E4^2-3*E4+121
5 -8 785 <-- =-E5^3+2*E5^2-3*E5+121
6 1500 -7 583 <-- =-E6^3+2*E6^2-3*E6+121
7 -6 427 <-- =-E7^3+2*E7^2-3*E7+121
8 1000 -5 311
9 -4 229
10 -3 175
11 500 -2 143
12 -1 127
13 0 121
0
14 1 119
-10 -5 0 5 10 15
15 2 115
16 -500 3 103
17 4 77
18 5 31
-1000 6 -41
19
20 7 -145
21 -1500 8 -287
22 9 -473
23 10 -709
24 11 -1001
 CHAPTER 28 Using Goal Seek and Solver 769

Note that we’ve put the function in twice: In cells B2:B3, we’ve got a simple example of the
function (one value of x and its corresponding y value); in the table to the right, we’ve got the
table for the graph (many values of x and many values of y).
Now we want to find the x such that the corresponding y is 21. You can tell from the table
that the value will be somewhere between 5 and 6. To solve for it, we go to the Excel command
Data|What-If Analysis|Goal Seek.

This brings up a dialog box, which we fill in as below.

Clicking OK indicates that the answer is approximately 5.166147.

770 PART SIX BACKGROUND TO EXCEL

Clicking OK again accepts this answer.

A B C
1 SIMPLE EXAMPLE
2 x 5.166147
3 y 21.00001 <-- =-B2^3+2*B2^2-3*B2+121

Doing the Same Thing with Solver

We can do the same calculation with Solver. On the same spreadsheet, we go to the command
Data|Solver.

This brings up a dialog box that we fill in as follows (note that we changed the question a bit—
this time we’re asking for the x value that gives a y = –58).

Clicking Solve gives the answer.

 CHAPTER 28 Using Goal Seek and Solver 771

Clicking OK accepts the answer.

28.3. What’s the Difference between Solver and Goal Seek?

Solver and Goal Seek serve much the same purpose. Nevertheless, there are several differences
between them.

Solver Remembers, Goal Seek Forgets

Suppose you’ve got another question: For which x will y = 158? If you use Goal Seek to answer
this question, you’ll have to re-enter all the values into the dialog box. But if you use Solver,
you’ll see that it comes up with the previous set of values—you only have to change the entry
into the Value of box.

This “memory” of Solver carries over even if you save the file and reopen it later.
772 PART SIX BACKGROUND TO EXCEL

Solver Is More Flexible

Again we use an algebra example, but this time we use the function y = x 2 − 7 x − 14. This func-
tion is a simple parabola.

A B C D E F
1 SECOND EXAMPLE
2 x 5 Table
3 y -24 <-- =B2^2-7*B2-14 x y
4 -9 130
5 -8 106
6 140 -7 84
7 -6 64
8 120 -5 46
9 -4 30
10 100 -3 16
11 80 -2 4
12 -1 -6
13 60 0 -14
14 1 -20
15 40 2 -24
16 20 3 -26
17 4 -26
18 0 5 -24
19 -10 -5 0 5 10 15 6 -20
20 -20 7 -14
21 -40 8 -6
22 9 4
23 10 16
24 11 30

Now suppose we want to find x such that y = 21. As you can see above, there are two such
x’s: One is between –3 and –4, and the other is between 10 and 11. If you use Goal Seek, you
cannot specify which x to find.
With Solver, however, you can specify constraints on the variables.
 CHAPTER 28 Using Goal Seek and Solver 773

Here we’ve used Add to enter two constraints on x. Clicking Solve gives the correct
answer.

A B C
1 SECOND EXAMPLE
2 x 10.37386
3 y 21 <-- =B2^2-7*B2-14

28.4. Setting the Accuracy of Solver and Goal Seek

Both Solver and Goal Seek compute to a given decimal accuracy. You can change this setting

in Excel by going to the Office button and pressing Excel Options|Formulas|Iterative

Calculations and changing the Maximum Change.

EXERCISES
1. Consider the present value calculation of a financial asset whose cash flows are given below. Use
Goal Seek to find the discount rate such that the present value of the asset’s cash flows is $800.

A B C
1 Discount rate 12.00%
2
3 Year Cash flow
4 1 100
5 2 200
6 3 300
7 4 400
8 5 500
9
10 Present value $1,000.18 <-- =NPV(B1,B4:B8)

2. A financial asset costs $500 and produces cash flows in years 1, 2, . . . , 5. The year-1 cash flow is
$100 and subsequent cash flows grow at a rate of 5%. As you can see below, the asset’s internal rate
of return (IRR) is 3.32%.
Use Solver to find a growth rate such that the IRR is 10%.
774 PART SIX BACKGROUND TO EXCEL

A B C
1 Year 1 cash flow 100.00
2 Cash flow growth rate 5.00%
3
4 Year Cash flow
5 0 -500.00
6 1 100.00 <-- =B1
7 2 105.00 <-- =B6*(1+$B$2)
8 3 110.25 <-- =B7*(1+$B$2)
9 4 115.76
10 5 121.55
11
12 Internal rate of return 3.32% <-- =IRR(B5:B10)

3. (This problem requires some knowledge of portfolio calculations covered in Chapter 9.) Below you
will find data on the returns, E (rA ) and E (rB ) ,and standard deviations, σA and σB, of Stocks A
and B. The number σ is the correlation coefficient of the returns of A and B.
For a portfolio composed of proportion x A of Stock A and xB of Stock B, the portfolio expected
return and standard deviation are given by

Expected portfolio return, E (rP ) = x A E (rA )+ x B E (rB )

Portfolio standard deviation, σ P = x A2 σ A2 + xB2 σ B2 + 2 x A xBρσ Aσ B

Because the portfolio proportions have to add to 100%, xB = 1 − xB.

A sample calculation of a portfolio expected return and standard deviation is given in cells
B15:B16.

A B C
1 Stock A
2 Expected return, E(rA) 12%
3 Return standard deviation, σA 15%
4
5 Stock B
6 Expected return, E(rB) 22%
7 Return standard deviation, σB 25%
8
9 Correlation of A and B returns, ρ 0.50
10
11 Portfolio
12 Proportion of A, xA 25%
13 Proportion of B, xB 75% <-- =1-B12
14
15 Portfolio expected return, E(rP) 19.500% <-- =B12*B2+B13*B6
16 Portfolio standard deviation, σP 20.88% <-- =SQRT(B12^2*B3^2+B13^2*B7^2+2*B12*B13*B9*B3*B7)

a. Use Solver to compute the proportions x A and xB for a portfolio that has the minimum standard
deviation σP.
 CHAPTER 28 Using Goal Seek and Solver 775

b. Use Solver and a constraint to compute the proportions x A and xB for a portfolio that has the
minimum standard deviation σP and a return of at least 18%.
4.
a. Graph the function y = −2 x 2 − 2 x + 14 for the x = −4.0, −3.75, −3.50, . . . , 3.0. What are the
approximate values of x for which y = 0?
b. Using Goal Seek on the function, find x such that y = 0. Which of the two values of x does
Goal Seek find?
c. Use Solve with an appropriate constraint to find the second value of x for which the function
y = −2 x 2 − 2 x + 14 has value 0.
CHAP TER

29 Working with Dates in Excel

CHAPTER CONTENTS
Overview 776
29.1. Typing Dates in a Spreadsheet 777
29.2. Times in a Spreadsheet 779
29.3. Time and Date Functions in Excel 781
29.4. The Functions XIRR, XNPV 782
29.5. A More Sophisticated Example—Calculating Option Expiration Dates 785
Exercises 786

Overview
One of the most powerful features of Excel is its ability to work with dates. We made use of this
feature in Chapter 15 on bond calculations and in Chapter 22 on the Black–Scholes model. In
this short technical chapter we explain how to use dates in Excel.

Excel Concepts Covered in This Chapter

• Entering dates and times into spreadsheets
• “Stretching out” dates and times over multiple cells
• Formatting cells for dates
• Functions: Now, Today, Month, XNPV, XIRR, Date, Weekday, VLookup

776
 CHAPTER 29 Working with Dates in Excel 777

29.1. Typing Dates in a Spreadsheet

Read the quote from the Excel help in Figure 29.1 on the next page and you will know almost
everything you need to know about entering dates into your spreadsheet. The basic fact you
need to know is that Excel translates dates into a number. Here’s an example: Suppose you
decide to type a date into a cell.

When you hit Enter, Excel decides that you’ve entered a date. Here’s the way it appears.

Note that in the formula bar (indicated by the arrow above), Excel interprets the date entered
as 8/29/2010.1
Right-click on the cell; go to Format Cells and then to Number|General.

1
The way this appears and is interpreted depends on the Regional Settings entered in the Windows Control
Panel. Our settings in this book follow the U.S. conventions.
778 PART SIX BACKGROUND TO EXCEL

You see that Excel interprets this date as the number 40419, the number 1 being January 1,
1900.

A B
1 40419
2

FROM THE EXCEL HELP: ABOUT DATES AND DATE SYSTEMS

Microsoft Excel stores dates as sequential numbers that are called serial values. By default,
January 1, 1900, is serial number 1, and January 1, 2008, is serial number 39448 because it is
39,448 days after January 1, 1900. Excel stores times as decimal fractions because time is con-
sidered a portion of a day.
Because dates and times are values, they can be added, subtracted, and included in other
calculations. You can view a date as a serial value and a time as a decimal fraction by changing
the format of the cell that contains the date or time to General format.
Because the rules that govern the way that any calculation program interprets dates are
complex, you should be as specific as possible about dates whenever you enter them. This will
produce the highest level of accuracy in your date calculations.
FIGURE 29.1 Excel’s Help explains dates.

Spreadsheet dates can be subtracted: In the spreadsheet below we’ve entered two dates and
subtracted them to find the number of days between the dates.
B C D E
5 2-Dec-00
6 8-Mar-99
7 Days between 635 <-- =C5-C6

(Cell C7 initially showed a date, but was then reformatted with Format|Cells|
Number|General.)

C D E
11 16-Nov-47
12 29-Apr-48 <-- =C11+165

You can also add a number to a date to find another date. What, for example, was the date
165 days after 16 November 1947?

Stretching out Dates

In the two following cells we’ve put in two dates and then “stretched” the cells out to add more
dates with the same difference between them.
 CHAPTER 29 Working with Dates in Excel 779

Write in two dates; mark both Grab the handle (arrow on previous The result: More dates added
cells drawing) and pull. with same spacing (in this case,
6 months).

29.2. Times in a Spreadsheet

Hours, minutes, etc., can also be typed into a cell. In the cell below, we’ve typed in 8:22.

When we hit Enter, Excel interprets this as 8:22 AM.

Excel recognizes 24-hour times and also recognizes the symbol a for AM and p for PM.
As entered When you press Enter

Note that the p is separated from the time by a

space. (Of course AM is represented by an a.)
780 PART SIX BACKGROUND TO EXCEL

EXCEL RECOGNIZES 24-HOUR CLOCK

As entered When you hit Enter

You can subtract times just like you subtract dates; cell B5 below tells you that 7 hours and
32 minutes have elapsed between the two times (ignore the “AM” in B5).

B C D
3 3:48 PM
4 8:16 AM
5 7:32 AM <-- =B3-B4

When you reformat the cells above with Format|Cells|Number|General, you can see that
times are represented in Excel as fractions of a day.

B C D
3 0.658333
4 0.344444
5 0.313889 <-- =B3-B4

If you type in a date and a time and reformat, you can also see this.

Here’s what you typed.

Here’s how it appears when you hit Enter.

If you reformat this to General,

 CHAPTER 29 Working with Dates in Excel 781

29.3. Time and Date Functions in Excel

Excel has a whole set of time and date functions. Here are several functions that we find useful.
Note that several of these functions require empty parentheses:
• Now( ) reads the computer clock and represents the date and the time.
• Today( ) reads the computer’s clock and prints the date.
• Date(yyyy,mm,dd) gives the date entered.
• Weekday( ) gives the day of the week.
• Month( ) gives the month.
Here are the first three functions in a spreadsheet.

A B C D E
2 Serial representation Date/time format
3 36944.8493184028000 2/22/2001 20:23 <-- =NOW()
4 36944 2/22/2001 <-- =TODAY()
5 36245 3/26/1999 <-- =DATE(1999,3,26)
6
7 Different formatting of Now( )
8 February 22, 2001 <-- =NOW()
9 2/22/01 8:23 PM <-- =NOW()
10 8:23 PM <-- =NOW()
11
12 When was day 1?
13 1 <-- =DATE(1900,1,1)

The use of Weekday and Month is self-explanatory.

A B C
3 3-Nov-01 7 <-- =WEEKDAY(A3)
4 7 <-- =WEEKDAY("3nov2001")
5 In Weekday, 1=Sunday, 2=Monday, etc.
6
7 11 <-- =MONTH(A3)
8 12 <-- =MONTH("22dec2003")

Calculating the Difference between Two Dates—The Function DATEDIF

This Excel function computes the difference between two dates in various useful ways.

A B C
1 DATEDIF COMPUTES DIFFERENCE BETWEEN TWO DATES
2 Date1 3-Apr-47
3 Date2 22-Dec-02
4
5 Explanation
6 55 <-- =DATEDIF(B2,B3,"y") Number of years between dates
7 668 <-- =DATEDIF(B2,B3,"m") Number of months between dates
8 20352 <-- =DATEDIF(B2,B3,"d") Number of days between dates
9 19 <-- =DATEDIF(B2,B3,"md") Number of days in excess of full number of months
10 8 <-- =DATEDIF(B2,B3,"ym") Number of months in excess of full number of years
11 263 <-- =DATEDIF(B2,B3,"yd") Number of days in excess of full number of years
782 PART SIX BACKGROUND TO EXCEL

If Date1 is the author’s birth date and Date2 is today, then the author is currently 62 years and
117 days old (cells A6 and A11).

29.4. The Functions XIRR, XNPV

These two functions calculate the IRR and the NPV for a series of cash flows received on spe-
cific dates. They are especially useful for calculating IRR and NPV when the dates are unevenly
spaced.2 If you do not have these functions, you will have to activate the Analysis ToolPak.

You do this by going to the Office button , clicking Excel Options at the bottom of
the box, and then going to Add-Ins.

Then choose the Analysis ToolPak.

After , Excel Options, Add-Ins, choose
Excel Add-Ins from the drop-down box.

(While you’re here, also choose Solver. As

explained in Chapter 28, every financial analyst
needs this add-in.)

XIRR
Here’s an example: You pay $600 on 16 February 2001 for an asset that repays $100 on 5 April
2001, $100 on 15 July 2001, and then $100 on every 22 September from 2001 until 2009. The

2
Excel’s IRR function assumes that the first cash flow occurs today, the next cash flow occurs one period
hence, the following cash flow two periods hence, etc. Excel’s NPV function assumes that the fi rst cash
flow occurs one period from now, the next cash flow in two periods, etc. We call this “even spacing of cash
flows.” When this is not the case, you’ll need the XIRR and XNPV functions.
 CHAPTER 29 Working with Dates in Excel 783

dates are not evenly spaced, so that you cannot use IRR. With XIRR (cell B16 below), you can
compute the annualized internal rate of return (IRR) (the effective annual interest rate, EAIR,
as defined in Chapter 3).

A B C
1 THE EXCEL FUNCTION XIRR
2 Date Payment
3 16-Feb-01 -600
4 05-Apr-01 100
5 15-Jul-01 100
6 22-Sep-01 100
7 22-Sep-02 100
8 22-Sep-03 100
9 22-Sep-04 100
10 22-Sep-05 100
11 22-Sep-06 100
12 22-Sep-07 100
13 22-Sep-08 100
14 22-Sep-09 100
15
16 XIRR 21.97% <-- =XIRR(B3:B14,A3:A14)

The XIRR works by discounting each cash flow at the daily rate. In our example the first
cash flow of $100 occurs 48 days from now, the second in 149 days, . . . . The XIRR transforms
21.97% to a daily rate and uses it to discount the cash flows:

100 100 100

−600 + 48 / 365
+ 149 / 365
+ ... + =0
(1.2197 ) (1.2197 ) (1.2197 )3140 / 365

A B C D E
19 HOW DOES XIRR WORK?
20 Date Payment Days from initial date PV
21 16-Feb-01 -600 -600
22 05-Apr-01 100 48 97 <-- =B22/(1+$B$34)^(C22/365)
23 15-Jul-01 100 149 92 <-- =B23/(1+$B$34)^(C23/365)
24 22-Sep-01 100 218 89
25 22-Sep-02 100 583 73
26 22-Sep-03 100 948 60
27 22-Sep-04 100 1314 49
28 22-Sep-05 100 1679 40
29 22-Sep-06 100 2044 33
30 22-Sep-07 100 2409 27
31 22-Sep-08 100 2775 22
32 22-Sep-09 100 =H15-$H$4 3140 18
33
34 IRR? 21.97% <-- =XIRR(B21:B32,A21:A32) 0 <-- =SUM(D21:D32)

XNPV
This function computes the NPV for unevenly spaced cash flows. In the following example we
use the function to compute the NPV on the same example we used for XIRR.
784 PART SIX BACKGROUND TO EXCEL

A B C
1 THE EXCEL FUNCTION XNPV
2 Date Payment
3 16-Feb-01 -600
4 05-Apr-01 100
5 15-Jul-01 100
6 22-Sep-01 100
7 22-Sep-02 100
8 22-Sep-03 100
9 22-Sep-04 100
10 22-Sep-05 100
11 22-Sep-06 100
12 22-Sep-07 100
13 22-Sep-08 100
14 22-Sep-09 100
15
16 Discount rate 15%
17 XNPV 97.29 <-- =XNPV(B16,B3:B14,A3:A14)

Note that XNPV requires you to indicate all the cash flows (starting with the initial cash
flow), as opposed to NPV, which starts from the first cash flow.

XNPV and NPV Can Give Different Answers

The functions XNPV and NPV can give slightly different answers. Here’s an example.

A B C
1 XNPV VERSUS NPV
2 Discount rate 12%
3
4 Date Cash flow
5 1-Jan-06 -1,000
6 1-Jan-07 250
7 1-Jan-08 250
8 1-Jan-09 250
9 1-Jan-10 250
10 1-Jan-11 250
11 1-Jan-12 250
12 1-Jan-13 250
13
14 NPV 140.94 <-- =B5+NPV(B2,B6:B12)
15 XNPV 140.68 <-- =XNPV(B2,B5:B12,A5:A12)

In cell B14 we calculate the NPV using the NPV function and in cell B15 we do the same
calculation using XNPV. Why the different answers? XNPV does the calculation using the
daily interest rate (1 + 12%)(1 / 365) − 1 = 0.03105% and based on the number of days between
each date. NPV, on the other hand, uses the annual interest rate of 12%. Because 2008 and 2012
are leap years, the XNPV calculation is slightly lower.3

3
For the same reason, IRR and XIRR can give slightly different results.
 CHAPTER 29 Working with Dates in Excel 785

29.5. A More Sophisticated Example—Calculating Option

Expiration Dates
In this section we show how to use several Excel functions to compute the date an option expires
(see Chapters 20–22 for why this might be important). The actual option expiration date is the
third Friday of the month. The calendar below illustrates what we mean—the relevant day for
each month is highlighted.
How do we find this day? We start with Excel’s Weekday function. This function takes the
text form of the date and tells you the day of the week. Similarly, Excel’s Month function tells
you the month of a particular date. Here are some examples.

A B C
1 18-Nov-10 5 <-- =WEEKDAY(A1)
2 5 <-- =WEEKDAY("18nov2010")
3 In Weekday, 1=Sunday, 2=Monday, etc.
4
5 11 <-- =MONTH(A1)
6 12 <-- =MONTH("22dec2016")
786 PART SIX BACKGROUND TO EXCEL

Now suppose we know the month and the year (as in cells B5 and C5 below). In cell D5 we
have included a text formula that creates “1Nov2001” from the combination of the month and
the year (text formulas are discussed in Chapter 28 on graphs).

A B C D E

A FUNCTION THAT LOOKS UP THE OPTION EXPIRATION DATE

1 Looks up the third Friday of the month
2 Month Year Month-Year
3 Nov 2010 1Nov2010 <-- ="1"&B3&TEXT(C3,0)
4
5 Day of the week of the first day of month 2 <-- =WEEKDAY(D3)
6 Key: 1=Sun, 2=Mon, ... 7= Sat
7
8 Date of option expiration 19 <-- =VLOOKUP(B5,B12:C18,2)
9
10 Lookup table
Excel's Relevant
Day of the week Weekday Friday
function date
11
12 Sunday 1 20
13 Monday 2 19
14 Tuesday 3 18
15 Wednesday 4 17
16 Thursday 5 16
17 Friday 6 15
18 Saturday 7 21

In cell B5 we use Weekday to tell us that 1 November 2010 is a Monday. Now it’s only a mat-
ter of counting: If 1 November is a Monday, so are 8 November and 15 November. So the third
Friday of the month is 19 November. Cell B8 uses the VLookup function (see Chapter 26) and
the table in cells B12:C18 to give us the correct date.

EXERCISES
1. Enter a series of annual dates into Excel, starting with 31 January 2008 and ending with 31 January
2015. The final product should look like this.

A
1 31-Jan-08
2 31-Jan-09
3 31-Jan-10
4 31-Jan-11
5 31-Jan-12
6 31-Jan-13
7 31-Jan-14
8 31-Jan-15
 CHAPTER 29 Working with Dates in Excel 787

2. Enter a series of hourly times into Excel, starting with midnight and ending with 11 AM. The final
product should look like this.

A
1 12:00 AM
2 1:00 AM
3 2:00 AM
4 3:00 AM
5 4:00 AM
6 5:00 AM
7 6:00 AM
8 7:00 AM
9 8:00 AM
10 9:00 AM
11 10:00 AM
12 11:00 AM

3.
a. Prof. Smith was born on 15 February 1964. Today is 18 March 2007. Subtract the two dates to
compute Prof. Smith’s age in days.
b. Divided by 365 to compute Smith’s age in years.
c. Use Weekday to determine the day of the week when Smith was born.
d. Use Datedif to determine the number of months of Smith’s age.
4.
a. On 15 February 2005 a bond of XYZ Corp. is selling for $923. The bond has a $60 coupon
payment on 15 May 2005 and each 6 months afterward until 15 November 2008, when it pays

A B
Bond
cash
1 Date flow
2 15-Feb-05 -923
3 15-May-05 60
4 15-Nov-05 60
5 15-May-06 60
6 15-Nov-06 60
7 15-May-07 60
8 15-Nov-07 60
9 15-May-08 60
10 15-Nov-08 1,060

$1,000 plus the $60 coupon. Use XIRR to compute the bond’s IRR.
b. On 28 February 2005, the bond’s price is $951. What is its IRR now?
5. A project whose discount rate is 13% has the cash flows indicated below. Use XNPV to compute
the project’s net present value.
788 PART SIX BACKGROUND TO EXCEL

A B
1 Discount rate 13.00%
2
Project
3 Date cash flow
4 1-Nov-03 -1,000.00
5 13-Jan-04 -523.00
6 18-Jul-04 -1,500.00
7 31-Dec-04 1,500.00
8 17-May-05 2,200.00
9 19-Dec-05 1,200.00
10 22-Aug-05 -435.00
11 15-Jan-06 2,000.00

6. In this exercise you will show how XNPV is based on daily interest rates. In the spreadsheet below,
fill in all the cells marked ??? and show that the sum of the entries E5:E10 gives the same result
as cell B12.

A B C D E F
1 Discount rate 8%
2 Daily interest rate ???
3
Present value
Days based on days
4 Date Cash flow between dates from initial date
5 15-Mar-22 -1,500 ???
6 18-Apr-23 250 ??? ???
7 22-Jun-23 155 ??? ???
8 15-Nov-24 610 ??? ???
9 16-Feb-25 222 ??? ???
10 19-Oct-25 100 ??? ???
11
12 NPV -380.076 <-- =XNPV(B1,B5:B10,A5:A10) ??? <-- =sum(E5:E10)

7. Use the number of dates between dates to explain why the calculations of the IRR in cell B12 and
in cell B13 are different.

A B C
1 IRR vs. XIRR
2 Date Cash flow
3 1-Jan-06 -1,000
4 1-Jan-07 250
5 1-Jan-08 250
6 1-Jan-09 250
7 1-Jan-10 250
8 1-Jan-11 250
9 1-Jan-12 250
10 1-Jan-13 250
11
12 IRR 16.327% <-- =IRR(B3:B10)
13 XIRR 16.317% <-- =XIRR(B3:B10,A3:A10)
INDEX

12b-1 fees, 430 due, 28

equivalent annuity cash flow (EAC), 147–151
3COM, 435–440 present value (PV), 30–31, 64–65
Anticipated dividend yield, 195
Abbott Labs, capital structure, 560–561 Anticipated inflation, 169
Absolute copying, 9, 687 Antikarov, Vladimir, 657n.6
Absolute references, 19 Arbitrage, 426n–427, 437–438, 444
Absolute referencing, 221–222 pricing options, 667
Academic research, 386–387 restrictions, 623
Accelerated depreciation, 117, 130–131 strategy, 620n.4, 625–628
Accounting profit, 10 Asian option, 676
Accounting statements, financial planning model, 215–218 Asset
Accounts payable, 218 investing in risky, 316
Accounts receivable, 217 splitting investment, 316–317
Accrued interest, bonds, 459–460 statistics of, returns, 280–283
Accumulation, future value, 21–22 Australia, high exit fees, 102n.16
Accuracy, Solver and Goal Seek, 773 Auto
Acquisitions, 6 internal rate of return (IRR) problem, 141–143
Additivity, 424, 426–435, 444 lease, 84–89
case of Palm and 3COM, 435–440 lease vs. loan from bank, 89
closed-end mutual funds, 432–434 purchase with bank loan, 87–88
open-end mutual funds, 429–432 residual, 86–87
principle, 517 saving for buying, 47–50
short-selling, 436–438 Auto jump down, 13
term structure price bonds, 427–429 Average
After-tax cash, 10 McDonald’s returns, 271
After-tax cash flows, 115 vs. standard deviation, 272
After-tax cost of debt, 193 Average funding cost, 185
After-tax funding cost, 189, 190 Average portfolio return, 322
Agency costs, 575, 577n.4
Aggressive stocks, 381–383 Balance sheet, 216, 220–221, 242
Algebraic formulas, present value, 63–67 equations, 223
American option, 596 Hilton Hotels, 408
binomial model pricing, 675–678 Bank
call, 625 borrowing from, 70–71, 142–143
put option price, 632, 633 car lease vs. car loan, 89
Amortization table, 76 certificate of deposit (CD), 170–171
Amortize, 45–46 loan for car purchase, 87–88
Amram, Martha, 657n.6 mortgage points, 75–76
Annual discount rate, 155, 157 Barrier option, 676
Annual inflation rates, 163 Bear spread, 612
Annual interest Beginning of year, 26–27
monthly vs., 71–72 Benninga, Simon, 400n.5, 412n.11, 498n.4
rate, 72, 409 Beta (β) assets
Annualized IRR, 160 capital structure, 563–564
Annualized return, continuously compounded, 273–274 Ford Motor Company, 563–564
Annual percentage rate (APR), 71, 72, 90 grocery industry, 564–565
and EAIR, 91 risk measure, 379
Annual percentage yield (APY), 260 stock, 345, 348, 364–365
Annual return weighted average cost of capital (WACC),
Exxon and Kellogg, 284, 320–321 411–412
zeta function, 257n.1 Bills, U.S. Treasury, 453, 461–463
Annuity, 28, 31 Binomial option-pricing model, 662–665
constant growth, 66–67 American options, 676–678

789
790 INDEX
Binomial option-pricing model—continued Call option, 591, 592
Asian option, 676 binomial option-pricing model, 662–678
barrier option, 676 Black–Scholes model, 641–658
description, 665–669 gold, 590
information, 669–671 IBM, 594–595
market efficiency, 667 purchasing, 597–599
multiperiod, 664, 671–675 terminology and symbols, 593
pricing American put, 675–678 volatility, 654–655
pricing the put, 673–675 writing, 602–603
put-call parity, 668, 669, 675 Campbell, John R., 582n.7
replicating portfolio, 667 Capital asset pricing model (CAPM), 255
terminal payoffs, 672 capital market line (CML), 346–347
two period, 663 firm’s cost of equity, 395–399
Black, Fisher, 642, 643n.2 Hilton Hotels, 404–411
Black–Scholes model, 642–644 investment combinations, 355–359
application, 653–655 security market line (SML), 345, 347–348, 361–364
continuous vs. discrete returns, 646 Sharpe ratio, 359–361
equation, 643 Capital budgeting, 1–2, 105, 141
Excel function, 648–650 foregone opportunities, 126–127
option to learn, 656–657 Goal Seek, 153
parameters, 643–644 inflation, 162–168
pricing an option, 641 inflation-adjusted, 173–176
real options, 655–658 internal rate of return (IRR) problem, 141–143
sensitivity analysis, 651–652 lease vs. purchase, 151–154
volatility, 644–648, 650, 654–655 life spans, 146–151
Boilerplate, 450, 451 marginal cash flows, 114–115
Bonds, 4, 10, 430 mid-year discounting, 154–161
accrued interest, 459–460 multiple IRR, 143–146
buyer’s perspective, 467–468 salvage values, 122–126
buying on open market, 468–469 sunk costs, 114–115
callable, 451, 470–471 taxes, 115–122
corporate, 451–453, 465–469 Capital expenditures, 227
covenants, 451 Capital gains
money-market funds, 346n.1 dividend and, taxes, 569, 576, 577, 578, 579
payments, 456–457 postponable, 534
preferred stock, 466, 471–473 Capital investment, 116
price, 428 Capital market line (CML), 255, 344, 345
ratings, 451, 453 investment combinations, 355–359
semiannual interest, 458–459 portfolio, 346–347
spacing of payments, 456–457 portfolio proportions and investment returns, 358
terminology, 450–451 Capital structure, 509, 512
term structure price, 427–429 academic evidence, 566
uneven spacing of payments, 456–457 β assets, 563–564
U.S. Treasury, 453 book value, 561–562
U.S. Treasury bills, 461–463 corporate managers, 557
U.S. Treasury bonds and notes, 463–465 corporate taxes, 514–516, 517–520, 530–539
yield to maturity (YTM), 455–461 corporate tax rate, 528–530, 531
zero-coupon, 473–475 cost of capital, 537–538, 550–551
Bonus payment, 577–578 debt, 515–516, 521–530, 546–548, 550–551
Book value, 123–124, 209, 231, 232 debt-to-equity ratio, 561–562
capital structure, 561–562 dividends, 573–574
valuation, 234–235 equity for purchasing, 514–515
vs. terminal value, 120 evidence, 556–566
Borrowing rate, computing firm’s, 403 firms capitalizing, 560–562
Brav, Alon, 582n.7 firm valuation, 517–520, 550–551
Bull spread, 611, 612 free cash flow (FCF), 514–521, 525–527
Business environment, financial decisions in, 4–6 leveraged value, 515, 517–520, 524, 525–527, 530,
Business Week, 581 537–538, 557
Butterfly option strategy, 612–613, 634–636 market value, 561–562
net present value (NPV), 522–524
Cadbury, 4, 5 present value of tax shield, 517, 520, 524, 527, 536,
Calculus, minimum variance portfolio, 329 539–541, 545
Callable bonds, 451, 470–471 relevering, 525–527, 542–546
 Index 791
taxes, 530–539, 540–542 Continuously compounded returns, 282, 646
theory, 558–560 annualized return, 273–274
unlevered value, 514–515, 517, 520, 524, 543–544 Continuous return, 96–97
weighted average cost of capital (WACC), 518–520, Conventional cash flow pattern, 143, 144
526–527, 530, 537–538, 544, 550–551 Convexity property, call prices, 633–636
Car buying, savings, 47–50 Copeland, Tom, 657n.6
Cash, 217, 220 Copying
Cash balances, reconciling, 230–231 in-house or outsourcing, 127–130
Cash flow, 10 relative or absolute, 9
calculating, 117 Corporate bonds, 451–453
consolidated statement of, 230–231 Giant Industries, 465–469
dealer’s, 143 Corporate executives, dividends, 582–583
differential, 129–130 Corporate Finance: A Valuation Approach (Benninga &
in-house vs. outsourcing, 128–129 Sarig), 400n.5, 412n.11, 498n.4
internal rate of return (IRR), 39–42 Corporate taxes
mid-year, 158–161 capital structure, 514–516, 517–520, 530–539
mid-year valuation, 238 leverage and, 517–520
net present value (NPV), 35–36 Modigliani–Miller model, 519, 521
nominal and real, 162, 166, 167 Corporate tax rate, 191n.5, 577, 578, 579
present value of nonannuity, 34 capital structure, 528–530, 531
timing, 160 computing, 404
value of debt-related, 545 Hilton Hotels, 409
Cash inflow, 10 Correlation
Cash outflow, 10 efficient frontier, 330–333
Cell editing, Excel, 693, 694 negative, 318–319
Center for Research in Security Prices (CRSP), 282 positive, 319
Certificate of deposit (CD) regression, 294
Discover Bank, 259–260 statistic, 284–287
savings to buy, 187–188 Correlation coefficient, 284–285
Treasure Inflation Protected Security (TIPS) vs., 170–171 negative correlation, 331–332
Charts, 708n.1. See also Graphs positive correlation, 332–333
basics of Excel, 709–714 Cost, 69
line, 716–719 calculating, of mortgage, 73–77
Circular references, 224–225 interest rate, 70–73
“Closed-End Fund Discount, The” (Dimson & minimizing, of financing, 11
Minua–Paluello), 433n.7 mutual fund, 432
Closed-end funds, 430 Cost of capital, 190n.3
Closed-end mutual funds, 432–434 capital structure, 550–551
Closing out, short position, 605 leverage, 537–538
Coca-Cola Company, 582, 583 security market line (SML) to calculate,
College education, saving for, 50–54 399–404
College saving, value drivers, 11–12 Cost of debt, 190, 192, 209
Columbus State University, credit card, 95–96 Ford Motor Company, 563
Competitive markets, 424, 425–426 Hilton Hotels, 409, 411–412
Compounding, 736, 737 Target Corp., 501
continuous, and discounting, 93–97 Cost of equity, 190, 192, 193, 209, 401n.6, 501
more-than-once-a-year, and EAIR, 90–93 CAPM and, 395–399
Compound interest, 18 Gordon, formula for Courier Corp., 196–200
Excel, 684–694, 697–699, 702–704 Gordon dividend model, 193–196
Computer, lease vs. purchase, 151–154 leverage, 518–519, 520
Concatenation, 744–745 relevering, 526
Conditional functions, 742–744 Target’s, with Gordon model, 504–505
Condo investment total equity payout, 198–199
capital budgeting, 115–122 Coupon payments, 450
mid-year cash flows, 158–161 Coupon rate, 450
Consol, 525n.7 Courier Corporation, 4, 5
Consolidated statement of cash flows, 230–231 calculating weighted average cost of capital (WACC),
Constant growth annuity, 66–67 200–202
Constant payment, future value (FV), 64 Gordon cost of equity formula, 196–200
Consumer price index (CPI), 162, 162n.4, 163, 169 sensitivity analysis, 207, 208
Continuous compounding, 736, 737 tax rate, 201, 202
and discounting, 93–97 using FCFs and WACC to value, 206–207
yield to maturity of Treasury bill, 462 valuation, 203–204, 205, 206–208
792 INDEX
Covariance Differential cash flows, discounting, 129–130
four assets, 342–343 Dimson, Elroy, 433n.7
regression, 294 Discounted cash flow (DCF)
statistic, 284–287 summary, 235–238
three assets, 339 theory, 241–243
Covenants, 451, 466 valuation, 215, 483, 486–494, 505
Credit card valuation model, 231–235
Columbus State University, 95–96 Discounted dividends, 67
monthly compounding, 90 Discounting
Crossover point, 113 continuous compounding and, 93–97
Cumulative inflation, 163–164 differential cash flows, 129–130
Cumulative preferred stock, 466 mid-year, 154–161
Current assets, 216, 217–218, 223 Discount points, 78–79
Current liabilities, 216–217, 218, 223 Discount rate, 2, 106n.1, 120n.5, 184
choosing, 34, 189
Daily interest, 10 funding cost as, 187–190
Daily returns, McDonald’s stock, 266–268 net present value (NPV), 37–38
Data table, 121–122 present value, 29–30
example, 755–757 principles, 185
Excel, 324–325, 755–762 risk-adjusted, 186
notes, 750–761 terminology, 38–39
one-dimensional, 757–759 Discover Bank, safety, 259–261
two-dimensional, 762 Discrete compounding, 736, 737
Dates Discrete returns, 96–97
Excel, 776–786 Distribution
option expiration, 785–786 Excel, 270
D’Avolio, Gene, 436n.8 McDonald’s stock, 268–269
Debt, 218, 219 Diversifiable risk, 385
advantage, 546–548 Diversification
capital structure, 521–530, 550–551 advantage of, 315–320
computing value of firm’s, 403 advantages, 383–386
firm valuation, 560 counterfeit coin case, 317–319
Ford Motor Company, 563 definition, 314
perpetual, 515 finance, 11
purchasing using, 515–516, 549 security market line (SML), 383–386
relevering, 525–527, 542–546 single risky asset, 316
Target Corp., 500–501 splitting investment between assets, 316–317
U.S. government, 453, 454 Dividend growth, definition, 402
Debtholders, 193 Dividend payment date, 568
Debt-to-equity ratio Dividend payout, definition, 402
pharmaceuticals, 561–562 Dividends, 223, 567–569, 624
steel producers, 562 bonus payments, 577–578
supermarket, 562 capital gains vs., 580
Decision making, individual financial, 4 capital gains taxes, 569, 576, 577, 578, 579
Decision parameters, 6 capital structure, 573–574
Defensive stocks, 381–383 Coca-Cola Company, 582
Deferred establishment fees, 102n.16 corporate executives, 582–583
Depreciation, 116–117 enterprise value, 574
accelerated, 117, 130–131 financial theory, 572–575
equation, 222–223 General Motors (GM) stocks, 567–569
noncash expense, 118 income taxes, 569
Derivative assets, 589–593 (See also Options) information, 568–569
Destination charge, 84 present value of future anticipated, 194–195
Dialog box reinvestment vs. retention, 569
Excel, 23–26 repurchasing stock, 578–580, 584
function, 703 signaling theory, 580–581
FV with end-period payments, 27–28 stocks, 282
IRR function, 40, 145 taxes, 575–580
NPER function, 55 valuation, 573
NPV function, 33 “Do Dividends Mean More in Declining Markets?” (Fuller &
PMT function, 45, 74 Goldstein), 581n.6
PV function, 32 Dollarizing, 225n.3
short way, 25 Dupont, stock, 383, 384
 Index 793
Early repayment fees, 102n.16 growth rate, 197
Early termination fees, 102n.16 inflation, 163
Editing, Excel, 693, 694 income statement, 222–223
Effective annual interest rate (EAIR), 69, 458 initial rate of return (IRR), 107, 175, 176
APR and, 91 interest rate, 265
compounding and, 90–93 minimum variance portfolio, 327–329, 338
continuous compounding and discounting, 93–97 net present value (NPV), 35–36, 106, 113, 148, 175, 186,
loans, 70–73 524, 541
mortgages, 73–81 open-end mutual funds, 432
Effective interest rate, 43 portfolio mean return, 288, 322
Efficient frontier, 314, 326, 334 portfolio risk premium, 359
correlation, 330–333 present value (PV), 30, 31, 87, 536, 540
Excel, 330 price-earnings ratio, 401, 496
minimum variance portfolio, 327–329 project value, 105–107
three assets, 339–342 quarterly interest paid, 409
Efficient markets real interest, 165
case of Palm and 3COM, 435–440 salvage value, 125
competitive markets, 424, 425–426 security market line (SML), 347–348, 361–364, 412
hypothesis, 386–387 Sharpe ratio, 359
information, 424–425, 440–442 standard deviation, 646, 774
price additivity, 424, 426–435 stock valuation, 486–494, 496, 499, 501
principles, 424–425 terminal value, 120, 234, 237, 241, 243, 493
semistrong form efficiency, 424–425, 441–442 Treasury Inflation Protected Security (TIPS), 169–170
short-selling, 436–438 valuation, 237–238, 242, 496, 537–538, 543–545, 551
stocks, 483, 484–486 variance, 282, 283, 288, 295–296, 310, 322, 332, 338,
strong form efficiency, 425, 442 339, 343
technical analysis, 0, 440–441 weighted average cost of capital (WACC), 191, 200, 209,
technical trading rules, 424, 441 499, 501, 518, 520, 530, 537, 539, 544, 551, 563
transaction costs, 425, 426n.2, 443–444 yield to maturity (YTM), 455, 462, 464, 475
weak-form efficiency, 424, 440 Equity
End-lease residual payment, 84 Hilton Hotels, 404–411
End of period, 26–27 market-to-book ratio, 498
Enterprise value, 206, 207, 233, 234, 241, 243, 488–489, payouts and stock valuation, 483, 494–496
498, 505 premium, 503
dividends, 574, 575 purchasing using, 514–515, 549
Equations valuation, 231, 234, 237–238, 242, 496, 537–538, 543–544,
annualized interest rate, 409 550–551
β asset, 379, 411–412, 563, 564 Target Corp., 500
binomial option-pricing model, 665–671 Equivalent annuity cash flow (EAC), 147–151
Black–Scholes model, 643, 646 European option, 596
bond price, 428, 455 put option price, 632, 633
capital asset pricing model (CAPM), 395–399 Ex ante return, 260–261, 263, 265–266, 273
capital market line (CML), 346–347, 355–358 Excel, 7–9
capital structure, 558–559 absolute copying, 687
consumer price index, 169 absolute references, 221–222, 690–694
correlation, 285 basics of charts, 709–714
covariance, 284 Black–Scholes model, 648–650
crossover point, 113 calculating future values, 19
depreciation, 116–117, 222–223 cell editing, 693, 694
discount rate, 29 circular references, 224–225
effective annual interest rate (EAIR), 72, 90–92 college saving, 53
enterprise value, 206, 207, 234, 243, 489–490 concatenation, 744–745
equity value, 242, 496, 537, 520, 539 conditional functions, 742–744
equivalent annuity cash flow (EAC), 148, 151 copying formula, 685–687
ex-ante return, 265 count cells, 748–749
expected return, 377, 379–380 Data table, 121–122, 324–325, 755–762
ex-post return, 264 dates and, 776–786
fair share value, 194–195 dialogue boxes, 703
firm value, 233, 235, 236, 241, 242, 515, 520, 524 editing, 693, 694
Formanis value, 492–493 efficient frontier, 330
free cash flow (FCF), 488, 515, 521 Exp, 735–736
future value, 18 F4 key, 692–693
Gordon dividend model, 193–196, 197, 199, 401, 502–504 financial functions, 726–735
794 INDEX
Excel—continued NASDAQ vs. S&P 500, 388, 389
financial models, 11–13 portfolio, 359, 384
formatting, 688–689 Ex-dividend date, 568
formulas, 684–688 Exercise, 591, 628–629
frequency function, 270 Exercise date, 593
functions and dialog boxes, 23–26, 703 Exercise price, 593, 643
FV function, 22–23, 727–729 Exercise prices, options, 601
General Motors (GM), 570–571 Expected return, 190n.3, 260–261, 399, 410
getting started, 684–688 capital market line (CML), 346–347
Goal Seek, 48, 49–50, 766–773 mean return, 281
graphs, 697–699, 708–721 portfolio, 295, 326, 365
Gridlines, 705 security market line (SML), 377
hiding and grouping rows, 228–229 Target Corp., 502
HLookup, 742–743 Expenses, 116
initial settings, 699–702 financial planning model, 215–218
IPMT and PPMT functions, 76–77, 731 foregone opportunities, 126–130
IRR, 145, 726–727, 734 prepaid, 217
LN, 737–738 salvage value, 122–126
match and index, 749–750 tax shields, 117–118
mathematical notation, 18 Expiration dates, option, 785–786
math functions, 735–742 Ex post return, 263–265
mechanics of regression, 289–292, 293–294 Exxon (XOM)
minimum variance portfolio, 328 annual return, 284, 320–321
Month, 781 option pricing, 624–632
monthly IRR with Rate, 80 portfolio statistics for Kellogg-XOM, 322–325
naming sheet, 701 stock returns, 283
Now, 781
NPER, 734–735 F4 key, 692–693
NPV function, 32, 35, 107, 726, 784 Face value, 450
PMT function, 44–46, 730–732 Fair share value today, 194–195
prerequisites, 8–9 Fair value, 4
printing, 704–705 Fama, Eugene, 566
PV function, 31, 729–730 Farmers Stock Exchange, 286
RATE, 733–734 Fees and expenses, 430
relative copying, 687 Fidelity Cash Reserves Fund, 346, 347
relative reference, 221–222, 690 Fidelity Funds, 385, 387
Round, 739–740 Fidelity Magellan Fund, 377–381
Row and column headings, 705 Fidelity Puritan Fund
Solver, 766–773 excess returns, 388, 389
spreadsheets, 695–697, 700n.2 performance, 374–377, 387–390
Sqrt, 740 regression, 390
statistical functions, 747–749 Finance, 3–7
statistics, 271–272, 380–381 jargon, 28
Sum, 8, 740 NPV concept, 55, 107
SumIf, 740–741 principles of, 9–11
SumProduct, 741–742 Financial alternatives, computing cost, 10–11
terminal value, 241 Financial assets, risk, 258–262
text functions, 744–746 Financial decision making, individual, 4
Today, 781 Financial decisions
turning Excel on, 684 business environment, 4–6
using function, 702–704 risk, 7
variance functions, 283 time dimension of, 10
versions, 8, 14 Financial Modeling (Benninga), 650n.4, 664n.1
VLookup, 742–744 Financial models, 11–13
Weekday, 781 Financial options, 655–658
workbook, 700n.2 Financial outcomes, 6–7
worksheets, 700n.2 Financial planning model, 2, 6, 214–215
XIRR function, 159, 161, 457–458, 782–784 accounting statements, 215–218
XNPV function, 156–157, 782–784 accounting vs., concepts, 216–217
yield function, 461 balance sheet, 216
Excess returns building, 218–223
Fidelity Puritan Fund, 388, 389 consolidated statement of cash flows, 230–231
Magellan fund, 378–380 current assets, 216, 217–218
 Index 795
current liabilities, 216–217, 218 option data, 746
extending, 225–226 stock dividends, 567–569
free cash flow (FCF), 226–228 General Motors Acceptance Corporation (GMAC), 259–261
income statement, 216 Getformula, 14–15
sensitivity analysis, 238–240 “Get Short,” (Surowiecki), 436n.8
value drivers, 218, 219 Giant Industries, 465–469
Financial risk, 4, 255 Goal Seek
Financial theory, dividends, 572–575 car buying, 48, 49–50
Financing college saving, 52–53
minimizing cost of, 11 Excel, 766–773
price, 512–513 lease, 153
Financing alternatives, 69 Solver vs., 771–773
Firm value, 232, 241, 242 Gold, call option on, 590
accounting definition, 234–235 Goldstein, Michael, 581n.6
equation, 233 Gordon, Myron, 193
finance definition, 231 Gordon dividend model, 67, 401
Fisher, Timothy, 560n.1 cost of equity, 193–196, 209
Flannery, Brian P., 312n.12 Courier Corp., 196–200
Ford Motor Company, β assets, 563–564 expected return on market, 502–503
Foregone opportunities Target’s cost of equity, 504–505
capital budgeting, 126–127 weighted average cost of capital (WACC), 398–399
in-house copying or outsourcing, 127–130 Graham, John, 566, 582n.7
Formanis value, 492–493 Graphs
Formatting numbers, Excel, 688–689 basics of Excel charts, 709–714
Formulas charts, 708n.1
Excel, 684–688 Excel, 697–699
modeling, 12 legends, 714–715
Free cash flows (FCFs), 115, 117 n.4, 215 line charts, 716–719
capital structure, 514–521, 525–527 noncontiguous data, 715–716
Courier Corp., 203–204, 205, 206–207 portfolio returns, 321–327
definition, 204, 227, 396, 487 updating titles, 720–721
financial planning, 226–228 XY scatter chart, 710, 717–719
flow diagram, 488 Grocery stores
long-term, growth rate, 236–237 β asset, 564–565
stock valuation, 483, 486–494, 505 debt-to-equity ratio, 562
two growth rates, 489–490 Growth rate
valuation, 235–236 alternative calculations, 197–198
French, Kenneth, 566 future dividends, 195
Frequency distribution Grullon, Gustavo, 584
Excel, 270 Guess, 145
McDonald’s stock, 268–269
Fuller, Kathleen, 581n.6 Handwaving, 318n.5
Functions. See also Excel Hilton Hotels, 404–411
Excel, 23–26 cost of debt, 409, 411–412
using, in Excel, 702–704 data using Yahoo!, 404–408
Function wizard, Excel, 23–25 tax rate, 409
Funding cost two-SML model, 412–413
after-tax, 189, 190 weighted average cost of capital (WACC), 410–411
discount rate, 187–190 Historic returns, expected return on market, 399–400
weighted average cost of capital (WACC), 190–193 Holders of record, 568
Future value (FV), 1, 17–28, 55 Horizon, risk, 259, 262–266, 274
accumulation, 21–22 Hull, John, 444n.10
constant payment, 64
Excel function, 22–23, 727–729 IBM, 424, 425, 426, 433, 440, 583
Exp to calculate, 735–736 butterfly strategy, 612–613
PMT function for, problems, 46–47, 731–732 call option, 597–599
terminology, 20–21 option prices, 600–602, 633–635
options, 594–596
General Electric (GE) option strategies, 605–610
callable bonds, 470–471 put option, 599–600
stock, 382, 384 spread, 610–612
General Motors (GM) volatility, 644–646
Excel functions, 570–571 writing options, 602–605
796 INDEX
Idiosyncratic risk, 374, 385, 386 amortization, IRR, 42–44
Income, 116 analysis, 167
Income statement, 216, 220–221 argument, 374–377
equations, 222–223 capital market line (CML), 346–347
Hilton Hotels, 408 condo, 115–122
Income tax, dividend and, 569, 576, 577, 578, 579 data table, 121–122
Indenture, 466 internal rate of return (IRR), 41–42, 107–108
Index funds, 387, 430 net present value (NPV), 38, 105–107
Inflation performance, 373–374, 377–381
capital budgeting, 173–176 proportions, 4
cumulative, 163–164 security market line (SML), 347–348
definition, 165 sensitivity analysis, 121
interest rates and cash flows, 162–168 terminal value, 119–120
Treasure Inflation Protected Security (TIPS),
169–172 Janjigian, Vahan, 581n.6, 584
using TIPS to predict, 172–173 Johnson, Linda, 729n.2
Inflation rate, 163, 176
Information Kellogg (K)
binomial option-pricing model, 669–671 annual return, 284, 320–321
dividend, 568–569 computing returns, 348
efficient markets, 424–425, 440–442, 444 portfolio statistics for K–Exxon, 322–325
finance, 11 stock and returns, 280–282
option, from Yahoo!, 660–661 Kimberly–Clark, stock, 381–382, 384
Intercept Knight, Frank H., 262
Magellan Fund, 380–381 Knock-in barrier option, 676
regression line, 292, 293–294 Kraft, 4, 5
Interest Kroger (KR), 497–498
accrued, 459–460 Kulik, Nalin, 657n.6
semiannual, 458–459
Interest free loan, 72–73 Lease
Interest rate auto, 84–89
annual percentage yield (APY) and, 260 car, vs. loan from bank, 89
calculations, 265 computer, 151–154
examples, 70–73 simple example, 81–82
real and nominal, 162, 164–166 vs. purchase, 81–83, 151–154
terminology, 38–39 Legends, graphs, 714–715
Internal rate of return (IRR), 1, 17, 38, 39–42, 56, 68, 69, 105, Lessee, 81
110–114 Lessor, 81
annualized IRR, 160 Leverage, 515, 557, 558–560
bond, 451 corporate and personal taxes, 536–539
choosing between investments, 41–42 firm valuation and corporate taxes, 517–520
computing real, 175 relevering, 525–527, 542–546
description, 40–41 value of debt, 525–527
Excel function, 145, 726–727, 734 Levered value, 517, 520
good vs. bad projects, 141–143 Life spans
investment amortization, 42–44 capital budgeting, 146–151
investment decisions, 41, 42, 185 light bulb, 148–151
judging investments, 107–108 Light bulbs, life spans, 148–151
loan tables, 42–44 Limited liability, 193
mid-year, 159 Linear regression, 288
monthly IRR with Rate, 80 Line charts, 716–719
multiple, 143–146 Liquidity, risk, 261, 274
net present value (NPV) or, 108–109 Liquidity considerations, 7n.1
Rate, 733–734 Loan
real and nominal IRR, 175–176 amortization tables, 45–46
semiannual IRR, 160 computing annual “flat” payments, 44–46
two IRRs, 145–146 interest free, 72–73
yes-no criterion, 109–110 time to pay off, 54–55
Internal Revenue Service (IRS), 45–46 Loan tables
Intuition, risk, 258 IPMT and PPMT, 731
Inventories, 217 IRR, 42–44
Investments, 4 Long-term debt, 200, 218
academic research and performance, 386–387 Luskin, Don, 581
 Index 797
McDonald’s stock Moody’s bond rating, 451, 453
annualized return, 273–274 Mortgage
average and standard deviation, 271–272 calculating cost of, 73–77
daily return, 266–268 longer-term, 80–81
distribution, 268–269 monthly payments, 77–81
horizon, 259 payments with IPMT and PPMT, 76–77
risk, 266–273 simple, 73–75
safety, 259, 261 Mortgage points, bank charging, 75–76
Magellan Fund, Fidelity, 377–381 Multiperiod binomial model, 671–675
Malkiel, Burton G., 387n.9 Mutual funds, 429–430
Manufacturer’s suggested retail price (MSRP), 84, 84n.8 closed-end, 432–434
Marginal cash flows, capital budgeting, 114–115 costs, 432
Marginal cost of borrowing, 403 open-end, 429–432
Marginal tax rate, 209
Marketable securities, 217 NASDAQ, 426, 430
Market data, expected return, 400–402, 410 excess returns, 388, 389
Market efficiency, 11 performance, 374–377, 387–390
binomial model, 667 regression, 390
Market enterprise value-to-sales ratio, 498 Natural logarithm (LN), 737–738
“The Market for Borrowing Stock,” (D’Avolio), 436n.8 Negative correlation
Market mispricing, 436–438 correlation coefficient, 331–332
Market portfolio (M), 345, 355 investment, 318–319
borrowing at risk-free rate for, 357 Net asset value (NAV), 430, 433n.7, 434
investing in, and risk-free asset, 355–356 Net present value (NPV), 1, 17, 33, 35–39, 55, 69, 105
Sharpe ratio and, 359–361 analysis with salvage value, 124, 125, 126
Market risk, 374, 386 capital structure, 522–524
Market value, 123–124, 200n.9 discount rate, 37–38
capital structure, 561–562 Excel function, 32, 35, 726, 784
firm’s debt, 192, 209, 403 Excel vs. finance, 37, 55, 107
firm’s equity, 399 future cash flows, 35–36
Martel, M. Jocelyn, 560n.1 internal rate of return (IRR) or, 108–109
Match and index, 749–750 investment decisions, 42, 185
Mathematical notation, 18 investments, 38
Math functions, Excel, 735–742 judging investments and projects, 105–107
Maturity date, 450 mid-year discounting, 154–156
Maturity time, option price, 600–601 project ranking, 110–114
Mean, 280–281 yes-no criterion, 109–110
two-asset portfolio, 287–288 New York Stock Exchange (NYSE), 424, 426, 430,
Mergers, 6 433, 434
Merton, Robert, 626n.2, 643n.2 Nobel Prize for Economics (1997), 643n.2
Michaeli, Roni, 582n.7, 584 Nominal cash flow, 165, 166–167
Microsoft, 583 Nominal interest rates, 164–166
Microsoft Excel, 7–9 Nominal return certainty
Mid-year discounting, 154–161 vs. real return certainty, 171, 172
Mid-year valuation, 238 Nonannuity cash flows, 34
Miller, Merton, 521, 534 Noncash expense, 122–123
Miller model, 521, 534, 538, 565 depreciation, 118
Minimum variance portfolio Noncontiguous data, graphing, 715–716
calculus, 329 Nonconventional cash flow pattern, 143, 144
deriving formula, 338 Nondiversifiable risk, 374, 386
efficient frontier and, 327–329 Nonsystematic risk, 385, 386
Excel, 328 Notes, U.S. Treasury, 453, 463–465
Minua–Paluello, Carolina, 433n.7 Numbers, formatting in Excel, 688–689
MM model, 521, 565
Modeling, rules, 11–13 Offer price, 451
Modigliani, Franco, 521 Oil, real and nominal prices, 168
Modigliani–Miller model, 519, 521, 534, 558, 559, 560n.1, “On Direct Bankruptcy Costs and the Firm’s Bankruptcy
562, 565 Decision,” (Fisher and Martel), 560n.1
Money-market fund, 346n.1, 430 Open-end mutual funds, 429–432
Monnet, Cyril, 304n.10 Open market, buying bonds, 468–469
Monthly interest, 11 Operating current assets, 216
vs. annual interest, 71–72 Operating current liabilities, 217
Monthly payments, mortgage, 77–81 Option maturity, 644
798 INDEX
Options, 589–593 Population variance, 310–312
American vs. European, 596, 597, 632, 633 Portfolio, 429
arbitrage strategy, 620n.4 correlation, 330–333
at-the-money, 596, 597 deriving risk-return, 321–323
bear spread, 612 diversification, 314, 315–320, 383–386
binomial option-pricing model, 662–678 efficient frontier, 314, 327–329, 327–333
Black–Scholes model, 641–658 four assets, 342–343
bull spread, 611, 612 graphing, returns, 321–327
butterfly option, 612–613, 634–636 market, 345, 355–356, 359–361
call options, 590, 591, 592, 597–599 mean and variation for two-asset, 287–288
call price, 625–628 minimum variance portfolio, 327–329
convexity property, 633–636 replicating, 667
description, 594–596 return variance, 352
European vs. American options, 596 risk-return relation, 352–355
exercise prices, 601 risky, and riskless asset, 350–355
exercising call early, 628–629 security market line (SML), 347–348, 361–364
expiration dates, 785–786 Sharpe ratio, 359–361
IBM, 594–596 statistics for Kellogg–Exxon, 322–325
information from Yahoo!, 660–661 statistics of multiple assets, 294–296, 339, 343
in-the-money, 596, 597 three assets, 338–342
notation, 642 Portfolio context, 274
out-of-the-money, 596, 597 Positive correlation
pricing, 641 correlation coefficient, 332–333
properties of prices, 600–602 investment, 319
put-call parity, 607, 629–631 Predicted free cash flows (FCFs), Courier Corp., 203–204, 205
put options, 591, 593, 599–600 Preferred stock, 466, 471–473
short-selling stock, 604–605 Prepaid expenses, 217
spread, 610–612 Present value (PV), 17, 28–34, 55, 68–69
stock and put, 606–607 algebraic formulas, 63–67
stock and two puts, 607–609 annuity, 30–31, 64–65
stock prices and, 602 constant growth annuity, 66–67
strategies, 605–613 discount rate, 29–30
terminology and symbols, 593 Excel function, 31, 729–730
time to maturity, 600–601 Exp to calculate, 736
trade-offs, 609 firm valuation, 517, 520, 524, 527, 536, 539–541, 545,
volatility, 644–648, 650, 654–655 558–559
writing calls, 602–603 nonannuity cash flows, 34
writing puts, 603–604 perpetuity, 31
Options, Futures, and other Derivatives (Hull), 444n.10 series of growing payments, 66
Option to delay, 655 Press, William H., 312n.12
Origination fee, 75n.3, 78–79, 80 Price, 167
Outsourcing vs. in-house copying, 127–130 additivity, 424, 426–435, 444
financing, 512–513
Pacific Stock Exchange (PSE), 424, 426 market, vs. Black–Scholes, 653
Palm Pilot, 435–440 range, 210
Payments, series of growing, 66 risk, 274
Payoff pattern, 641 Treasury bills, 262–266
Penalty rate, 95n.13 Price-earnings ratio (P/E), 401, 402, 415n.13
Pension plans, savings, 53–54 expected return on market, 502–503
Perpetual debt, 515 stock valuation, 483, 496–498
Perpetuity, present value (PV) of, 31 Principle repayment, 450
Pharmaceutical firms, debt-to-equity ratio, 561–562 Principles, finance, 9–11
Photocopying, in-house or outsourcing, 127–130 Printing, Excel, 704–705
Pierce, George W., 304 Private benefits, 233n.5
Plug, balance sheet, 220 Profit after taxes, 223
PMT formula, college saving, 53 Profit before taxes, 223
PMT function Profit pattern, 641
Excel, 44–46, 730–732 Pro forma models, 214–215, 219
future value problems, 46–47 Projects
mortgage, 73–74 net present value (NPV) rule for, 105–107
negative Pmt variable, 26 rankings, 110–114, 185
saving for car, 50 Purchasing
Points, 75n.3, 78–79, 80 call option, 597–599
 Index 799
lease or, 81–83, 151–154 liquidity, 261
machine example and taxes, 540–542 riskiness of stock, 644
put option, 599–600 safety, 259–261, 262–266
Puritan Fund stock prices, 266–273
excess returns, 388, 389 uncertainty, 262
Fidelity, 374–377, 387–390 Risk-adjusted discount rate (RADR), 186
regression, 390 Risk-adjusted outperformance, 379
Put-call parity, 607, 629–631 Risk-adjusted performance, 374
arbitrage proof, 630 Risk-free asset, 355–356
binomial model, 668, 675 Risk-free interest rate, 644
Put option, 591, 593 Risk-free rate
American, price, 632, 633 borrowing for market portfolio, 357
binomial pricing, 673–674 computing, 403
early exercise of American, 633 economy, 409–410
European, prices, 632, 633 Riskless asset, risky portfolios and, 350–355
IBM, 595–596 Risk measure, beta (β), 379
purchasing, 599–600 Risk premium, portfolio, 359
terminology and symbols, 593 Risk-return relation, portfolios, 352–355
volatility, 654–655 Rogers, Will, 115n.2
writing, 603–604 Rounding functions, 739–740
Run-of-the-mill financial decisions, 6
Quarterly discount rate, 155
Quoted interest rates, 70 Safety
risk, 259–261, 274
R2 security and horizon, 262–266
Magellan Fund, 380, 381 Safeway (SWY), 497–498
regression line, 293–294, 321n.7 St. Louis Federal Reserve Bank, 377n.3
well-diversified portfolio, 385 Sales growth, 218, 219
Rate, Excel, 733–734 Salvage value, 119
Rate of return, 43 capital budgeting, 122–126
Ratings, bond, 451, 453 net present value (NPV) analysis with, 124, 125, 126
Real cash flow, 165, 166–167, 174 Sample variance, 310–312
Real discount rate, 174 Sarig, Oded, 400n.5, 412n.11, 498n.4
Real interest rates, 164–166 Savings
Realized return, 260–261 car buying, 47–50
Real options, 655–658 plans, 21–22
Real Options (Amram & Kulik), 657n.6 Scholes, Myron, 642, 643n.2
Real Options: A Practitioner’s Guide (Copeland & Security market line (SML), 255, 345, 395
Antikarov), 657n.6 calculating cost of capital, 399–404
Real Options: Managerial Flexibility and Strategy in investment performance, 373–374, 377–381
Resource Allocation (Trigeorgis), 657n.6 portfolio, 347–348, 361–364
Real return certainty, nominal return certainty vs., 171, 172 WACC using two-SML model, 412–413
Regressions weighted average cost of capital (WACC), 398–399,
mechanics in Excel, 289–292, 293–294 499–503
using, 288–294 Semiannual interest, bonds, 458–459
variables, 292–293 Semiannual IRR, 160
Regular annuity, 28 Senior unsecured obligations, 466
Relative copying, 9, 687 Sensible financial decisions, 6
Relative referencing, 221–222 Sensible set of financial alternatives, 6
Relevering, valuation, 525–527, 542–546 Sensitivity analysis
Replicating portfolio, 667 Black–Scholes formula, 651–652
Repurchasing stock, 199–200, 578–580, 584 Courier valuation, 207, 208
Required return, 190n.3 financial planning model, 238–240
Residual investment, 121
auto lease, 86–87 Series of growing payments, 66
present value (PV), 87–88 Shareholder fees, 430
Retirement, 53–54 Share price valuation method, 232
Retirement of capital stock, 466 Sharpe, William, 360
“Returns from Investing in Equity Mutual Funds 1971–1991” Sharpe ratio, 359–361
(Malkiel), 387n.9 Short-selling, 436–438, 604–605
Risk, 6–7, 11, 185, 186, 257–258 Short-term debt, 218
financial assets, 258–262 Shread, Paul, 581
horizon, 259, 262–266 Simple mortgage, 73–75
800 INDEX
Skinner, Douglas, 403 Straight-line depreciation, 116–117
Slope Strike price, 643
Magellan Fund, 380–381 Strips, U.S. Treasury, 475
regression line, 292, 293–294 Sum, Excel function, 8, 740–742
Solver Sunk costs, capital budgeting, 114–115
Excel, 766–773 Supermarkets, debt-to-equity ratio, 562
Goal Seek vs., 771–773 “The Super Project,” 127n.7
installation, 767–768 Surowiecki, James, 436n.8, 605
Spacing, bond payments, 456–457 Systematic risk, 386
Spartan Index 500 Fund, 347
Spillovers, 12 Target Corp., 499–503
Splits, stocks, 282 Taxable gain, 124
Spreadsheet, 700n.2 Taxes, 223, 575
dates, 777–779 capital budgeting, 115–122
Getformula, 14–15 capital structure, 530–539
saving, in Excel, 695–697 corporate, and capital structure, 514–516
times, 779–780 debt, 546–548
Spread strategy, option, 610–612 dividend policy, 575–580
Square root, 740 dividends and income, 569
Standard & Poor’s (S&P), bond rating, 451, 453 lease vs. purchase, 151–154, 189
Standard & Poor’s 500 Index, 273, 347, 399, 400, 401 machine purchase, 540–542
Standard deviation, 272 neutrality, 562
average return vs., 272 payable, 218
McDonald’s returns, 271 valuation and leverage, 536–539
portfolio, 295, 326 Tax rate, 192, 209
statistics, 280–283 corporate, 404
Statistics Courier, 201, 202
asset returns, 280–283 Ford Motor Company, 564
covariance and correlation, 284–287 Hilton, 409–410
Excel, 271–272, 747–749 Target Corp., 501
Hilton Hotels, 405, 406 Tax shields, 117–118, 123, 151, 524
portfolio, for multiple assets, 294–296, 339, 343 present value, 517, 520, 524, 527, 536, 539–541, 545,
portfolio’s return variance, 352 558–559
Statutory tax rates, 209 Technical analysis, prices, 440–441
Steel producers, debt-to-equity ratio, 562 Technical trading rules, 424, 441
Sticker price, 84n.8 Terminal payoff, call option, 672
Stocks, 10, 220. See also McDonald’s stock; Options Terminal value, 119–120, 130–131, 236–237, 243
aggressive vs. defensive, 381–383 book value vs., 120
beta (β), 345, 364–365, 374 Excel, 241
binomial option-pricing model, 662–678 stock valuation, 491–494
Black–Scholes model, 641–658 Term structure price bonds, 427–429
dividends and splits, 282 Teukolsky, Saul A., 312n.12
diversification, 383–386 Text functions, 744–746
efficient markets, 483, 484–486 Time
European vs. American options, 596 Excel functions, 781–782
Exxon returns, 283 spreadsheet, 779–780
fair value, 4 Time dimension, financial decisions, 10
funds, 430 Time to maturity, option price, 600–601
future anticipated free cash flows (FCFs), 483, 486–494 Time value. See Valuation
future equity payouts, 483, 494–496 Time-value-of-money, 2
idiosyncratic risk, 385, 386 Timing difference, 10
Kellogg returns, 280–282 Total equity payout, 198–199
market risk, 348 Trade-offs, 609
options, 589–613, 591–593 Transaction costs, 425, 426n.2, 443–444
preferred, 466, 471–473 Treasury bills, 453. See also U.S. Treasury bill
price-earnings ratio (P/E), 483, 496–498 Treasury Inflation Protected Security (TIPS), 169–172
prices and option prices, 602 comparing, and bank certificate of deposit, 170–171
repurchasing, 199–200, 578–580, 584 five-year TIPS, 171
riskiness, 644 predicting inflation, 172–173
risk in prices, 266–273 ten-year TIPS, 170
short-selling, 604–605 Trial and error
terminal value, 491–494 college education, 51–52
valuation methods, 482–506 saving for car, 49
 Index 801
Tricky details, 451 portfolio return, 322, 352
Trigeorgis, Lenos, 657n.6 statistics, 280–283
Truman, Harry, 655n.5 three assets, 339
Trust, 575 two-asset portfolio, 287–288
Trust Center Settings, 14 Vettering, William T., 312n.12
Truth in Lending Act, 91 Volatility
Two-asset portfolio, 287–288 historical, 644–646
implied, 646–648, 650
Uncertainty, risk or, 262 puts and calls, 654–655
Underfunded, 51
Underlying asset, 593 Wealth increment, 106
United States, government debt, 453, 454 Wealth maximization, 6–7
Unit Investment Trusts (UITs), 430 Weber, Warren, 304n.10
Unlevered value, 517, 520 Weighted average cost of capital (WACC), 185, 209, 255,
firm, 514–515, 536–539 395, 559
U.S. Securities and Exchange Commission (SEC), mutual β assets, 563–564
fund, 429–430 computing, using β asset, 411–412
U.S. Treasury cost of equity, 396–398
bonds and notes, 463–465 Courier Corp., 200–202
debt, 453, 454 discount rate for projects, 202–203
strips, 475 funding cost, 190–193
U.S. Treasury bills Gordon model, 398–399
bonds, 461–463 Hilton Hotels, 404–411
risk, 262–266 leverage, 518–519, 520, 526–527, 537–538, 544, 557
U.S. Treasury Web site, 169n.6 security market line (SML), 398–399, 499–503
sensitivity analysis, 240
Valuation uses, 202–209
bonds, 449–475 valuation, 235, 550–551
book value, 234–235 valuing Courier Corp. using, 203–204, 205
capital structure, 550–551 Welch, Ivo, 566
Courier Corp., 203–204, 205, 206–208 Widget machine, inflation-adjusted capital budgeting, 173–176
computing firm’s debt, 403 Workbook, 700n.2
discounted cash flow (DCF), 215, 235–238 Worksheets, 700n.2
discounted cash flow (DCF) model, 231–235, 241–243
dividends, 573 XIRR function, 159, 161, 457–458, 782–784
efficient markets, 424–444 XNPV function, 156–157, 782–784
firm’s equity, 237–238 XY scatter chart, 710, 717–719
firm’s shares, 194–195
future value (FV), 17–28 Yahoo!, 282
Goal Seek, 48, 49–50, 52–53, 60 downloading data, 306–310
internal rate of return (IRR), 39–44 Hilton Hotel, 404–408
leverage and taxes, 536–539 option information, 660–661
net present value (NPV), 35–39 screen clips showing β, 349
PMT function, 44–46, 44–47 Yes-no criterion, 109–110, 131, 185
present value (PV), 28–34 Yield assuming no call, 472–473
sensitivity analysis, 207, 208 Yield curve
share price valuation method, 232 U.S. Treasury strips, 475
stocks, 482–506 zero-coupon bonds, 473–475
trial and error method, 49, 51–52 Yield function, Excel, 461
Value, 10, 68–69 Yield to call (YTC), 451
Value drivers, 11–12 Yield to first call (YTC), 473
financial planning model, 218, 219, 226 Yield to maturity (YTM), 451
Vanguard Funds, 387, 399, 400 bonds, 455–461
Vanguard’s Long-Term Treasury Fund, risk and return, Treasury bill, 462
272, 273
Variance, 271 Zero-coupon bonds, 473–475
definitions, 283 Zero-interest car loan, 141–143
four assets, 342–343 Zero interest financing, 11
population, 310–312 Zero interest loan, 4
portfolio, 295–296 Zeta function, annual returns, 257n.1