CA- current assets

FA- fixed assets

RE- retained earnings

CL- current liabilities

CFFA- cash flow from assets

NWC- net working capital

NOWC- net operating working capital

OCF- operating cash flow

NCS- net capital spending

ROA- return on assets

ROE- return on equity

BEP- basic earning power

DSO- days sales outstanding

Lecture 1: Financial Management Overview

Finance is a discipline concerned with determining value and making decisions based on that value
assessment. The finance function allocates resources, including the acquiring, investing and
managing of resources.

Scope of study for finance

Investments

- Study of financial transactions from the perspective of investors outside the firm

Financial markets and intermediaries

- Study of market where financial securities are bought and sold

- The study of financial institutions (such as commercial banks investment banks and insurance
companies) that facilitate the flow of money from savers to demanders of money

Corporate finance

- What long-term investment should the firm take on? (Capital budgeting decision)
- Where will we get the long-term financing to pay for the investment? (Capital structure decision)
- How will we manage the everyday financial activities of the firm? (Working capital management
decision)

Investment vehicle model

- Investors provide financing to the firm in exchange for financial securities (various claims on the
firm’s cash flows).
- The firm invests these funds in assets.
- Income generated by the firm’s assets is distributed to the investors

Balance sheet model

- Also known as the accounting model of the firm

- Investment decisions are represented on the asset side (left) of the balance sheet
- Financing decisions are presented on the liabilities and equity side (right) of the balance sheet

Financial manager

- The top financial manager within a firm is usually the Chief Financial Officer (CFO)
- Treasurer: oversees cash management, credit management, capital expenditures and financial
planning
- Controller: oversees taxes, cost accounting, financial accounting and data processing.

Forms of business organisation (learn in biz law)

- Sole proprietorship
- Partnership
- Corporation

Corporation

- It is created via the Articles of Incorporation which set out the purpose of the business, establish
the number of shares that can be issued and set the number of directors to be appointed
- Private companies: firm’s shares are usually closely held by a relatively small number of
shareholders. Shares are not traded on any exchange
- Public companies: firm’s shares are listed on a stock exchange, whereby the company’s share are
widely dispersed and traded in the secondary markets.

Corporations: 2 main sources of external financing

Debt

- Lenders: by lending money to the corporation, debt holders become the corporation’s creditors
and lenders
- Relationship determined by contract: a debt contract is a legally binding agreement. It specifies
principal, interest, maturity date and specific protective covenants
- Security and seniority: in case of bankruptcy, debt holders collect before equity holders.
However, different debt holders have different priority claim to the cash flows and assets of a
bankrupt firm, according to their respective debt contracts

Equity (share)

- Shareholder’s ownership rights- by buying shares in the corporation, shareholders become the
owners of the firm. Shareholders are the residual claimants of the firm
- Shareholder’s payoffs- receive monetary returns in the following ways:
- Dividend per share- paid to investors from the corporations after tax dollars
- Capital gain- from the sale of shares (ownership rights) at a price higher than they were
purchased for.

Goal of financial management

- The primary goal is shareholder wealth maximisation

- Maximising the value of the firm, wealth of its owners, the price of its stock and its contribution
to the economy
- Ultimately, the value of the firm is determined by the investors in the financial market.

3 aspects of cash flows that affect asset value and thus stock prices

- Amount of cash flows expected by shareholders

- Timing of the cash flow stream
- Riskiness of the cash flow stream
- All three determine the stock’s intrinsic value

Intrinsic value VS market value

- Intrinsic value is an estimate of a stock’s ‘true’ value based on accurate risk and return data
- Market value is based on perceived information as seen by the marginal investor

Financial management decisions

- Capital budgeting- what long-term investments or projects should the business take on?
- Capital structure- how should we pay for our assets? Should we use debt or equity?
- Woking capital management- how do we manage the day-to-day finances of the firm?

Agency problem

- Principal hires an agent to represent their interest

- Stockholders hire managers, via the board of directors, to run the company
- Conflict of interest between principal and agent

Agency costs

- Direct agency costs: expenditures that benefit management: car and accommodation, big office,
high pay & monitoring cost: auditors, audit committee, corporate governance
- Indirect agency costs: lost opportunities which would increase firm value in the long run, if
accepted

How to handle the agency problem?

- Compensation plans that tie the fortunes of the managers to the fortunes of the firm
- Monitoring by lenders, stock market analysts and investors
- The threat that poorly performing managers will be fired
- The growing awareness of the importance of good corporate governance
- In large corporations, the separation of management and ownership provides the ease of share
ownership transfer.

Money market vs capital market

Money market

- Debt securities of one year maturity or less are traded: treasury securities, commercial paper,
bills, inter-bank loans
- Loosely connected dealer markets
- Banks are major players

Capital markets

- Where equity and long-term debt claims are traded

- Usually auction markets like the Singapore exchange

Primary market VS secondary market

Primary market

- For government and corporations initially issued securities

- Public offering- where securities are offered to public at large; needs underwriting, more
regulatory requirements, costly

Secondary market

- Where existing financial claims are traded

- Dealer market (OTC over the counter market)
- Auction market (SGX, NYSE)
- Where getting market value of securities is easier
Lecture 2: Financial Statement Analysis

Annual report & 4 basic financial statements

- Balance sheet
- Income statement
- Statement of retained earnings
- Statement of cash flows

Financial statements are used for:

1. Credit decision
2. Risk analysis
3. Financial distress prediction
4. Management evaluations
5. Investment selection

Balance sheet

- Resources must equal claims- A = L + E

- Order of listing- highest to lowest liquidity
- Valuing of items- generally at historical cost. Exceptions: marketable securities and inventories

Book value: historical costs less accumulated depreciation

Market values: determined by current trading values in the market

- Market value of shareholder’s equity = market capitalisation = share price x number of

outstanding shares

Enterprise value: value of the underlying business assets and separate from the value of non-
operating cash and marketable securities that the firm may have

- Enterprise value = market value of equity + debt - cash

- In theory, it’s the cost of a company if someone were to acquire it

Market-to-book equity ratio

Book debt-equity ratio

Income statement
- Revenues, expenses and taxes associated with those revenues for some financial periods

Statement of retained earnings

- Beginning, net income, dividend paid, ending

Authorised capital stock: shares can issue legally

- Unissued capital stock: shares not issued to outsiders

- Issued capital stock: shares issued to outsiders
 Outstanding capital stock: shares held by outsiders
 Treasury stock: shares bought back & held by the company

Importance of cash flow

- Cash is king: firms generate cash and they spend it

- Sources of cash:
 Decrease in assets (decrease in A/R, increase in cash)
 Increase in equity & liabilities (increase in debt, increase in cash)
- Uses of cash:
 Increase in assets (increase in inventory, decrease in cash)
 Decrease in equity & liabilities (decrease in debt, decrease in cash)

Statement of cash flows (indirect is more common in SG because it is easier)

Summarises the sources and uses of cash over a period under 3 major categories (O I F):

- Operating activities: includes net income and changes in most current accounts (A/R, A/P,
inventory)
- Investing activities: includes changes in fixed assets
- Financing activities: includes changes in notes payable, long term debt, equity accounts and
dividends

Assets = Liabilities + Equity

(Current assets + net fixed assets) = (current liabilities + long term debt) + (common stock + retained
earnings)

Net working capital (NWC) = current assets – current liabilities

Net working capital + net fixed assets = long term debt + common stocks + retained earnings

Net working capital = cash + other current assets – liabilities

Cash = retained earnings + current liabilities – other current assets (excluding cash) – net fixed assets
+ long term debt + common stock

Cash flow from assets (CFFA) also known as Free Cash Flows

Free cash flow is the cash flow in excess of that required to fund profitable capital projects
Operating working capital is working capital stemming from operating policies (A/R, inventory, A/P
etc) and removed from our financing decisions. (Thus we exclude non-operating working capital such
as Notes Payable).

Cash flow from assets (CFFA) = operating cash flow (OCF) – net capital spending (NCS) – changes in
net operating working capital (NOWC)

Operating cash flow (OCF) = EBIT (1- Tax rate) + depreciation

Tax rate = taxes / taxable income

Net capital spending (NCS) = ending net fixed assets – beginning net fixed assets + depreciation

Changes in net operating working capital (NOWC) = ending NOWC – beginning NOWC = (cash + A/R +
inventory – A/P) - (cash + A/R + inventory – A/P)

When there is no interest expense:

CFFA = cash flow to creditors + cash flow to stockholders (refer to below for formulas)

When there is interest expense:

CFFA + interest tax shield = cash flow to creditors + cash flow to stockholders

- Interest payments are deducted from EBIT (earnings before interests and taxes) before the
calculation of tax
- This means that interest payments function to reduce the amount of taxes paid. Thus although
interest payments are paid out in cash, they result in the company paying less tax than it
otherwise should. The reduction in the amount of tax paid is referred to as the Interest Tax
Shield
- Dividend payments are not tax deductible and do not reduce the amount of taxes paid. Thus
dividends payments are paid out in cash, with no offsetting tax shield.

Interest tax shield = interest expense x interest tax rate

Interest tax rate = taxes / taxable income

Cash flow to creditors (B/S & I/S) = interest paid – net new borrowing (long term debt & notes
payable) (ending – beginning)

Cash flow to stockholders (B/S & I/S) = dividends paid – net new equity raised (common stock)
(ending – beginning)

Ratio analysis

Ratios are not very helpful by themselves- they need to be compared to something
- Time-trend analysis (over time): used to see how the firm’s performance is changing through
time
- Peer group analysis (with others): compare to similar companies or within industries

5 major categories of ratios:

1. Liquidity ratios (short-term solvency): measure the firm’s ability to pay bills in the short run
2. Long-term solvency ratios (financial leverage): show how heavily the company is in debt
3. Asset management ratios (turnover/efficiency): measure how productively the firm is using its
assets
4. Profitability ratios: measure the firm’s return on its investments (PM, ROA, ROE)
5. Market value ratios: provide indications on the firm’s prospects an how the market values the
firm

Liquidity ratios

Liquidity is the (1) ability to convert assets to cash quickly (2) without a significant loss in value.

Current ratio = current assets / current liabilities = ___x

Quick ratio = (CA – inventory) / CL = ___x

Cash ratio = cash / CL = ___x

NWC to total assets = NWC / TA = ___x

Interval measure = CA / average daily operating cost = ___days

Average daily operating cost = COGS + other expenses on a daily basis

Long-term solvency ratios

Also known as financial leverage ratios, it relates to the extent that a firm relies on debt financing
rather than equity.

Total debt ratio = total debt / total assets = ___%

Debt-equity ratio = (total assets – total equity) / total equity

Equity multiplier = total assets / total equity = 1 + debt-equity ratio

Long-term debt ratio = long term debt / (long term debt + total equity)

Times interest earned ratio = EBIT / interest expense = ___x

Cash coverage ratio = (EBIT + depreciation) / interest expense

Asset management ratios

Also known as activity ratios, they measure how effectively the firm’s assets are being managed.

Inventory ratios measure how quickly inventory is produced and sold

Receivable ratios provide information on the success of the firm in managing its collection from
credit customers

Fixed asset and total asset turnover ratios show how effective the firm is in using its assets to
generate sales
Inventory turnover = COGS / inventory = ___x

Days’ sales in inventory = 365 / inventory turnover = ___days

Receivables turnover = sales / receivables = ___x

Days sales outstanding (DSO) or account receivable days or average collection period = account
receivables / average daily sales = 365 / receivables turnover = ___days

FA turnover = sales / net fixed assets = ___x

TA turnover = sales / total assets = ___x

Profitability ratios

Measure how successfully a business earns a return on its investment

Shows the combined effects of liquidity, asset management and debts on operating results

Profit margin = net income / sales = ___%

Basic earning power (BEP) = EBIT / total assets = ___%

Return on assets (ROA) = net income / total assets = ___%

Return on equity (ROE) = net income* / total common equity (basically total equity) = ___%

*if there is preferred dividend, should deduct it from net income

Profit margin = net income / net sales

ROA is lowered by debt- interest expense lowers net income, which also lowers ROA.

However, the use of debt lowers equity, and if equity is lower more than net income, ROE would
increase

Problem with ROE

- ROE and shareholder wealth are correlated, but problems can arise when ROE is the sole
measure of performance
- ROE does not consider risk
- ROE does not consider the amount of capital invested
- Might encourage managers to make investment decisions that do not benefit shareholder
- ROE focuses only on return. A better measure is one that considers both risk and return.

Market value ratios (the higher the better)

A set of ratios that relate the firm’s stock price to its earnings, cash flows and book value per share

P/E: how much investors are willing to pay for $1 of earnings

M/B: how much investors are willing to pay for $1 book value equity

P/E = price / earnings per share = ___x

M/B = market price per share / book value per share = ___x

Dupont system
Some profitability and efficiency measures can be linked in useful ways

ROE = net income (NI) / total common equity (TE)

Multiply by TA / TA and then rearrange

ROE = (NI / TE) x (TA / TA) = (NI / TA) x (TA / TE) = ROA x equity multiplier (EM)

Multiply by (sales / sales) and then rearrange

ROE = (NI / TA) x (TA / TE) x (sales / sales) = (NI / sales) x (sales / TA) x (TA / TE)

ROE = PM x TATO x EM

Profit margin (PM): measure of the firm’s operating efficiency- how well does it control costs  net
income / sales

Total asset turnover (TATO): measure of the firm’s asset use of efficiency- how well does it manage
its assets  (sales or revenue) / total asset

Equity multiplier (EM): measure of the firm’s financial leverage  total assets / total equity

Potential problems/limitations of ratio analysis:

- Comparison with industry average is difficult if the firm operates many different divisions
(diversified firm)
- ‘Average’ performance is not necessarily good. Use the leader’s performance
- Seasonal factors can distort ratios
- Window dressing techniques can make statements and ratios look better
- Different accounting and operating practices can distort comparisons
- Sometimes it is difficult to tell if a ratio is ‘good’ or ‘bad’
- Often, different ratios give different signals, so it is difficult to tell, on balance, whether a
company is in a strong or weak financial condition
Lecture 3: Time Value of Money

$1 received today is preferred to $1 received some time in the future (if interest rate is positive).
Why?

- Lost earnings: can invest the money to earn interest

- Loss of purchasing power: because of the presence of inflation
- Trade-off depends on the rate of return

Timeline

Present value (PV)

- The value of something today. On a timeline t=0. Present value is also referred to as the market
value of a cash flow to be received in the future
- Translating a value that comes at some point in the future to its value in the present is referred
to as discounting.

Future value (FV)

- The value of a cash flow sometime in the future. On a timeline t > 0

- Translating a value to the future is referred to as compounding

Annuity/ordinary annuity- one in which the first cash flow occurs one period from now. Same cash
flow at same regularity with a maturity date (end of the period)

Annuity due- an annuity in which the first cash flow occurs immediately (at the beginning of the
period)

Perpetuity- a set of equal payments that are paid forever

Growing perpetuity- a set of payments which grow at a constant rate each period and continue
forever (can grow in numbers or % as long as constant)

Principal- the original amount borrowed in a loan context

Interest- compensation for the opportunity cost of funds and the uncertainty of repayment of the
amount borrowed. Also known as: discount rate / cost of capital / opportunity cost of capital /
required return

Simple interest- interest earned only on the original investment

Compound interest- in addition to interest earned on the original investment, interest is also earned
on interest previously received (on the original investment)

Compound interest & future value formula:

Present value formula:

PV of an ordinary annuity:

FV of an ordinary annuity:

Perpetuity

If the periodic payment is $C, then the present value of the perpetuity is:

Growing perpetuity

If the first payment is $C1, then the present value of the perpetuity is:

r: interest rate g: growth rate C1 usually have to manually count

Present Value of Growing Annuity

PV of Growing Annuity =
Future Value of Growing Annuity

Annual percentage rate (APR)

- This is the annual rate that is quoted by law

- By definition, APR = period rate x the number of periods per year
- Period rate = APR / number of periods per year
- NOTE THAT YOU SHOULD NEVER DIVIDE THE EFFECTIVE RATE BY THE NUMBER OF PERIODS PER
YEAR- it will not give you the period rate.

Always need to make sure that the interest rate and the time period match

Effective Annual Rate (EAR)

Implied rate of interest / discount rate

We can re-arrange the basic PV and FV equations and then solve for the implied interest rate i:

Additional slides

Different types of loans

- Pure discount loans

- Interest only loans
- Loans with fixed principal payments
- Amortised loans

Pure discount loans

- No interest; principal paid to maturity; issued at discount which means their purchase price is
less than principal
- T bills are excellent examples of pure discount loans. The principal amount is repaid at some
future date, without any periodic interest payments
Interest only loan

- Interest paid throughout the load period; principal paid at maturity

- Consider a 3 year, interest only loan with a 7% interest rate, principal amount is $10000.
- Year 1 and 2: $700. Year 3: $10700
- This cash flow stream is similar to the cash flows on corporate bonds

Loan with fixed principal payment

- Interest and fixed amount of principal paid throughout the load period
- Consider a $50000, 10 year loan at 8% interest. The loan agreement requires the firm to pay
$5000 in principal each year plus interest of that year.

Amortised loans

Each equal payment covers the interest expense plus reduces principal
Lecture 4: Risk & Return- Part 1

Different kinds of stocks/investments:

- Standard & Poor’s 500 (S&P 500)

- Small stocks
- World portfolio
- Corporate bonds
- Treasury bills (T bills)

Investment returns measure the financial results of an investment. Returns can be historical or
prospective (anticipated).

Dollar terms: amount received – amount invested

Percentage terms: (amount received – amount invested) / amount invested

When an investor buys a stock or a bond, their return comes in 2 forms:

- Any dividend or interest payment (income) received, and

- A capital gain or a capital loss (due to change in price)

Dividend yield = dividend / initial share price

Capital gain yield = capital gain / initial share price

To convert from nominal rate to real rate of return:

1 + real return = (1 + nominal return) / (1 + inflation rate)

Approximation: real return = nominal return – expected inflation

Expected returns are returns that take into account uncertainties that are present in different
scenarios.

similar to weighted average

If using historical data of an asset to estimate average return, can just find the arithmetic average:

We benchmark the expected returns to the required rate of returns.

Rate of returns depends on the risk of the investment. High risk = high rate of returns.

Risk is the uncertainty associate with future possible outcomes. Investment risk refers to the
potential for the investment return to fluctuate- go up or down- in value from year to year.
 Risk lover VS risk adverse

To measure the uncertainty / variability / volatility, we calculate the variance or SD of the possible
returns:

Summation of (scenario – average) 2 (probability), then

square root to find SD.

Standard deviation measures total risk, also called

stand-alone risk of an investment. The higher the SD,
the higher the probability that actual returns will be far away from the expected return. Thus SD
measures dispersion around an expected value.

Stand-alone risk is the risk an investor would face if he held only one asset.

Variance or SD can be estimated using historical data:

Coefficient of variation (CV) is widely used to measure relative variability.

CV is a standardised measure of dispersion about the expected value that shows the risk per unit of
return.
Lessons from capital market history:

- There is a reward for bearing risk

- The greater the potential reward, the greater the risk
- This is called the risk-return trade-off

Financial markets allow companies, governments and individuals to increase their utility by matching
borrowers with savers.

- Savers have the ability to invest in financial assets so that they can defer consumption and earn
a return to compensate them for doing so.
- Borrowers have better access to the capital that is available so that they can invest in productive
assets
- Financial markets also provide us with information about the returns that are required for
various levels of risk

Risk aversion- assumes investors dislike risk and require higher rates of return to encourage them to
hold riskier securities.

The ‘extra’ return earned for taking on risk is referred to as risk premium.

Risk premium = mean return – risk free rate

In most developed markets, where the government can be viewed as default free, T bills (short
term) are considered to be risk free. For investment analysis on longer term projects, the risk free
rate should be the long term government bond rate.

The riskier the investment, the higher the risk premium- investors require more incentive to invest in
risky investments.
PORTFOLIO

Expected portfolio return:

Portfolio risk / SD

Alternative:

The SD of a portfolio can be lower than any of its investments because the investments have
negative covariance which arises from the negative correlation between the stocks.

Covariance- measure how two assets’ rates of return vary together over the same mean time period.

Correlation coefficient between 2 stocks measures the extent to which 2 stocks move together.

Thus the variance of a portfolio depends on the correlation coefficients between the assets included
in the portfolio.

Note that the correlation coefficient standardises the unit of covariance measure- puts it in the scale
of -1 to 1.

Two stocks can be combined to form a riskless portfolio if p = -1.0

Risk is not reduced if the 2 stocks have p = +1.0

In general, stocks have p = 0.65, so risk is lowered but not eliminated.

As p  -1, risk gets eliminated

As p  +1, no risk gets eliminated

Total risk = company-specific risk (unsystematic risk) + market risk (systematic risk)

Company-specific risk can be diversified away but market risk cannot.

Company-specific risk- lawsuits, unsuccessful marketing program, losing a major contract etc. these
bad events in one firm can be offset by good events in another firm, so their effects are eliminated in
a portfolio.

Market risk- war, inflation, recessions and high interest rates etc. Most stocks are affected by these
factors. Thus market risk cannot be diversified away completely by combining stocks into a portfolio.

If a portfolio is well-diversified, the firm-specific risk is close to 0 and the variance will come from
basically the market risk. Therefore market risk remains in all portfolios. Some investments will be
more sensitive to market factors than others and will therefore have higher market risk.

Measuring market risk- beta

The market risk of an investment is measured by the covariance of investment’s returns and the
returns of the market, it is then divided by the market portfolio variance to calculate a relative
measure called beta.

Beta is a measure of an asset’s market risk.

Since beta measures a stock’s market risk, it shows a stock’s volatility relative to the market.

It indicates how risky a stock is if the stock is held in a well-diversified portfolio.

Geometric mean:
- Is what is actually earned per year on average compounded annually. It is also known as the
mean holding period return or average compound return earn per year over multi-year period.

Arithmetic mean

- It is what an investor earned in a typical year

Lecture 5: Risk & Return Part 2

The volatility of a portfolio is the total risk of the portfolio, as measured by the portfolio SD.

If the combined stocks are positively correlated (NOT completed related), risk level will drop a bit.

If the combined stocks are negatively correlated, risk level will drop a lot.

Diversification

- Portfolio diversification is the investment in several different asset classes or sectors

- Diversification is not just about holding a lot of assets, it is about holding a lot of assets in
different industries  that is clearly more diversified
- Diversification can substantially reduce the variability of returns without an equivalent reduction
in expected returns.
- This reduction in risk arises because worse-than-expected returns from one asset are offset by
better-than-expected returns from another.
- However, there is a minimum level of risk that cannot be diversified away and that is the
systematic (market) risk.

Total risk = systematic risk + unsystematic risk (cannot just pluck in the numbers because this
equation is not for math usage, but rather for understanding)

- The SD of returns is a measure of total risk

- For well diversified portfolios, unsystematic risk is very small such that:
- The total risk measure (SD) for a well-diversified is essentially equivalent to the systematic risk.
- Only unsystematic risk can be diversified  if a portfolio is effectively diversified, there will be
a drop in the SD

In finance theory, the best measure of the risk of a security when held in a large portfolio is the beta

(β) of the security, defined as follows:

- Beta measures the responsiveness of security to movements in the market portfolios. Beta is the
slope of the regression line of the asset’s returns on the market portfolio’s returns.

- Depending on the time period, beta will change. Therefore, we have to compare 2
stocks/markets in the same time period.
Security market line (SML)

- The SML describes the risk return relationship between the beta of a security and its required
rate of return. Thus the SML directly translates beta into an estimate of required rate of return.
It is the most common method of estimating the required rate of return.

- The reward-to-risk ratio is the slope of the line

- For every unit of beta (market risk taken), the required additional return over the risk free rate is
RM – R f
- Since the beta for the market is ALWAYS equal to 1, slope = R M – Rf = market risk premium
- In equilibrium, all assets and portfolios must have the same reward-to-risk ratio. Equilibrium
means expected return = required return

Capital asset pricing model (CAPM)

- CAPM defines the relationship between risk and required return:

- Rf  pure time value of money  measured by the risk-free rate
- Bi (RM – Rf)  reward for bearing systematic risk  measure by systermatic risk measure (beta)
and market risk premium
- If we know an asset’s systematic risk measure (beta), we can use the CAPM to determine its
required return (which can be used to price the asset)

Beta

- Beta = 1 implies the asset has the same systematic risk as the overall market
- Beta < 1 implies the asset has less systematic risk than the overall market
- Beta > 1 implies the asset has more systematic risk than the overall market

To measure total risk  use SD

To measure systematic risk  use beta

To measure higher expected returns  the one with the higher beta (higher risk, higher returns)
Portfolio beta

Give the large number of assets (m) in a portfolio, we would multiply each asset’s beta by its
portfolio weight and then sum up the results to get the portfolio’s beta:

Weighted average

- For a fairly priced asset, the expected return is on the SML.

- For an under-priced asset, it would be above the SML.
- For an over-priced asset, it would be below the SML.

Estimating beta

Many analysts use the returns of S&P 500 (or the MSCI) as a ‘proxy’ for the market portfolio returns
(to be used in the CAPM). The returns of the company of interest are then regressed onto the S&P’s
returns to find the company’s beta.

Impacted of inflation change on SML

Inflation increases, SML shifts upwards.

Impact of a risk aversion change

- If investor becomes more risk adverse  SML becomes more steep
- If investor becomes more risk loving  SML becomes less steep

Markowitz portfolio theory

- Combining stocks into portfolios can reduce SD below the level obtained from a simple weighted
average calculation
- A portfolio that provides the greatest expected return for a given level of SD, or equivalently, the
lowest risk for a given expected return is called an efficient portfolio
- The line representing all efficient portfolio is called the efficient frontier
- Markowitz efficient market frontier is not efficient once a risk-free asset is available at which to
lend or borrow

Efficient frontier of a 2 asset portfolio

Efficient set for many securities

Given the opportunity set, we can identify the minimum variance portfolio. The section of the
opportunity set above the minimum variance portfolio is the efficient frontier.

Capital market line (CML) - also known as the new efficient frontier
If there is riskless borrowing and lending, then we draw the steepest line from the risk-free rate
tangent to the efficient frontier. Investors are able to allocate their money across the risk-free asset
and the market portfolio with optimal result.

Both CML and SML contain only efficient portfolios.

The market portfolio

- The market portfolio is the portfolio at the tangent line of the risk free asset with the efficient
frontier of all risky assets available.
- All risky assets are included in this portfolio in proportion to their market value
- Because it contains all the risky assets, it is a completely diversified portfolio, which means that
all the unsystematic risk is diversified away
- The market portfolio has a beta of 1

Efficient set for many securities with a risk free asset

With the capital market line/capital allocation line identified, all investors choose a point long the
line- some combination of the risk-free asset and the market portfolio M.

- Risk lovers will pick a higher point on the CML (green x)

- Risk adverse people will pick a lower point on the CML (yellow x)
Lecture 6: Bond Valuation

Finance was described as a discipline concerned with determining values and making optimal
decisions based on those values.

In finance, valuation involves comparing the benefits (PV of cash inflows) and cost (the PV of cash
outflows) associated with a proposed asset or project decision.

Bond

- A long-term debt instrument sold to raise money

- Government and companies can turn to the public to borrow money by issuing bonds
- One who buy the bonds is a creditor of the company, not the owner (unlike stockholders who
are owners)
- Coupon: a bond’s periodic interest payment
- Coupon rate: the stated annual coupon interest rate of the bon. It is equal to the annual coupon
payment divided by the par value of the bond.
- Coupon payment = (stated annual coupon rate*par value) / (number of coupon payments per
year)
- Par value: the face value of the bond (its principal amount) assigned to the issuer; this amount
will be repaid at the end of the term. It is generally $1000 unless otherwise stated
- Term: the time remaining until the principal repayment date

Bond maturity

- Bond have finite lifetimes. The issuers of the bond determine the bond’s lifetime before they sell
the bonds to investors. The date on which a bond comes due is called the maturity date

Bond Terminology

- Callability: a feature whereby the issuer can redeem the bond before it matures. A bond with
this feature is a callable bond. *** Companies will call back their bonds because the current
interested rate has fallen- so they rather call back expensive bonds and reissue them at a
cheaper interest rate.
- Putability: the buyer can redeem the bond before it matures- Putable bond.
- Seniority: preference in lender position over other lenders and debts are sometimes labelled as
senior or junior to indicate seniority
- Debenture: a bond backed by the issuer’s general credit and ability to repay and not by an asset
or collateral (basically an unsecured bond).
- Basis point: a unit of measure, used to express in yields or interest rates. Most often used to
express differences between yields. The basis point unit is 0.01% = 0.0001.
- Convertibility: option to exchange a bond for a specified amount of stock in the same issuing
company. Bonds with this feature are called convertible bonds. Conversion must occur over
specified times, prices and under specified conditions, all of which are indicate in writing at the
time of bond issue.
- Protective covenants: the part of the indenture or loan agreement that limits certain actions a
company might otherwise wish to take during the term of a loan (basically giving assurance to
investors).
Sinking fund:

- A pool of money set aside by the corporation to help repay a bond issue. To lessen its risk of
being short of cash at the time of bond maturity, the company agrees to create a sinking fund.
- Sinking fund provisions usually allow the company to repurchase its bonds periodically and at a
specified sinking fund price (usually the bond’s par value) or the prevailing current market price
- Essentially it is a provision to pay off a loan over its life rather than all at maturity
- Reduces risk to creditor. Shorten average maturity
- It is managed by a bond trustee (third party) for the purpose of repaying the bonds

Bond indenture: the contract between the company and the bondholders and includes all the rules
and regulations

Bond value = PV of coupons + PV of par = PV annuity + PV of lump sum

*** Yield to Maturity (YTM)

- Rate earned if a bond is held to maturity

- Rate which discounts all future bond cash flows to their current value (price)
- The ‘market’ rate for the bond in question, r d, is the interest rate required in the market on the
bond.
- YTM is sometimes called the bond’s yield.
Finding bond yields

- YTM is the yield which equates the present value of all cash flows from a bond to the price of a
bond.
- This key information is used for comparisons with other potential investments of the same risk
level.
- Why not just look at coupon rate to determine the bond’s yield?  Coupon rate is stuck: hard to
compare coupons because the coupon rates are determined at different time.

Relationship of YTM and bond prices

- As interest rates increase, the PV of bond decreases, vice versa

- So, as YTM increases, bond prices decrease, vice versa
- The actual future change in bond prices could involve both discounts and premiums depending
on future movements in market interest rates
- Bond prices fluctuate as interest rates change, so a bond can trade above or below the par value
based on what interest rates are.
- If I hold a bond to maturity, I am guaranteed to get my principal back

Computing YTM

- YTM is the rate implied by the current bond price

- Finding the YTM usually requires mathematical trial and error if you do not have a financial
calculator
- If I have a FC, enter N, PV (remember the –ve sign), PMT and FV and the compute to find I/Y

Bond pricing theorems

- Bonds of similar risk (and maturity) will be priced to yield about the same return (same YTM),
regardless of the coupon rate.
- If you know the price of one bond, you can estimate its YTM and use that to find the price of the
2nd bond.
- This is a useful concept and can be transferred to valuing assets other than bonds.

Effect of time on bond prices

Bond ratings: AAA (lowest risk, lowest returns) to C (highest risk, highest returns).

Government bonds:

- T-bills: pure discount bonds (zero coupon bonds) with original maturity of one year or less
- T-notes: coupon debt with original maturity between 1 and 10 years
- T-bonds: coupon debt with original maturity greater than 10 years

Government bond VS taxable bond

- A taxable bond has a yield of 8% and a non-taxable municipal government bond has a yield of
6%.
- If I am in the 20% tax bracket, which bond will I prefer?
- 8% (1-0.2) = 6.4%
- The after-tax return on the corporate bond is 6.4%, compared to a 6% return on the municipal
- What tax rate would I be indifferent between the 2 bonds? Answer: 25%

Floating rate bonds (floaters)

- The coupon rate floats depending on some index value- eg. Adjustable rate mortgages, inflation-
linked treasuries
- There is less price risk with floating rate bonds- since the coupon floats, so it is less likely to differ
substantially from the YTM
- Floating coupon rates may have a ‘collar’- the rate cannot go above a specified ceiling or below a
specified floor.

Bond markets

- Generally assets will trade in a market such that price of the asset reflects the valuation of the
marginal investor.
- Some bonds are ‘listed’ and traded on the public market exchanges. Primarily traded in the over-
the-counter (OTC) market.

Determinants of bond yields: inflation and interest rate

- Real rate of interest: rate reflecting the real increase in change in purchasing power of $ invested
- Nominal rate of interest: quoted rate of interest, reflects actual money increase versus money
invested
- Nominal rate of interest includes our desired real rate of return plus an adjustment for expected
inflation
- (1+rn) = (1+rr)(1+i)
- Also called the fisher effect- rn = rr+i (approx)

Term structure of interest rates

- Tern structure is the relationship between time to maturity and yields, for bonds for the same
risk and holding all else equal.
- ‘All else equal’ means we remove the effect of default risk, different coupons etc and are able to
focus on the relationship between maturity and yields.
- Normal yield curve- upward-sloping, long term yields are higher than short term yields
- Inverted yield curve- downward-sloping, long term yields are lower than short term yields.
Only inflation premium differs between normal and inverted yield.

Summary of factors that affect bond yields

- Real rate of interest

- Expected future inflation
- Interest rate risk
- Default risk
- Taxability
- Lack of liquidity
Lecture 7: Stock Valuation

Stockholders: 2 ways to receive cash returns

- The company pays dividends

- You sell your shares, either to another investor in the market (secondary market) or back to the
company (when a firm repurchases shares)
- As with bonds, the value of the stock is the present value of these expected cash flows

Stocks: dividends

- Generally, dividends are cash disbursements to shareholders

- Firms are not required to pay dividends to their shareholders (at the discretion of the board of
directors).
- Dividends are NOT a liability of the firm until a dividend has been declared by the board
- Consequently, a firm cannot go bankrupt for not declaring dividends
- Dividend payments are not considered a business expense, therefore, they are not tax
deductible
- Dividends received by individuals are taxed as ordinary income. In Singapore since January 2004,
dividends are taxed once at the corporate level

Value: several kinds

- Book value: the price paid to acquire the asset (including betterments), less accumulated
depreciation
- Market value: the price of an asset as determined in a competitive marketplace (based on
current prices)
- Intrinsic value: what an asset is really worth. In finance, estimated by the present value of the
expected future cash flows discounted at the decision maker’s required rate of return for CAPM
or its true required rate of return

Determinants of intrinsic value:

- Size and timing of the expected future cash flows

- The individual’s require rate of return (which is determined by a few factors such as risk/return
preferences, returns on competing investments, expected inflation, tax rates, etc)
- Note that intrinsic value of an asset can be, and often is, different for each individual (that’s
what makes markets work). If markets are efficient, market value should equal intrinsic value for
the marginal investor

Stock value: developing the model

- You could continue to delay when you would sell the stock
- You would find that the price of the stock is really just the present value of all expected future
dividend (this is because soon the selling stock price when discounted to PV will be so small that
it becomes negligible)
Estimating dividends: special cases

- Constant dividend (zero growth dividend): (1) firm will pay a constant dividend forever (2) the
price is computed using the perpetuity formula
- Constant dividend growth (stable growth): the firm will increase the dividend by a constant
percent every period
- Supernormal growth (non-constant growth): dividend growth is not consistent initially, but
settles down to constant growth eventually

Scenario 1: firm pays constant dividends

- If dividends are expected at regular intervals forever, then this is like preferred stock and is
valued as a perpetuity:

Scenario 2: constant dividend growth

- Dividends are expected to grow at a constant percent per period

- A stock whose dividends are expected to grow forever at the same constant rate, g

- With a little algebra, it reduces to:

- The stable model is best suited for firms experiencing long-term stable growth
- Generally, stable firms are assumed to grow at the rate equal to the long-term nominal growth
rate of the economy (inflation plus real growth in GDP)

Limitations to dividend growth model

- If rE < g, stock price is negative

- If rE = g, stock price is infinite
- Neither of the above makes economic sense
- We cannot use the model unless (1) rE > g and (2) g is expected to be constant forever
Stock price sensitivity to dividend growth g:

Stock price sensitivity to require return r E:

Return components: for constant growth scenario only

If you rearrange the model to rate of return form:

Scenario 3: non-constant growth

- Remember we have to find the PV of all expected future dividends

- We can no longer use constant growth model
- However, growth becomes constant after 2 years (example), so we can incorporate the constant
growth formula
- Draw a time line- it helps to visually see the cash flows

Stock price of a growing dividend will be higher than the stock price of constant dividend
Market equilibrium

- In equilibrium, stock prices are stable and only change with relevant new information
- There is no general tendency for people to buy versus to sell
- In equilibrium, expected returns must equal required returns:

Expected returns VS required returns

- Expected returns are obtained by estimating dividends and expected capital gains. It is the
expected
- Required returns are obtained from CAPM

How is equilibrium established?

Why do stock prices change?

- rE could change: rE = rf + B (rM – rf)  rf = r* + inflation premium

- g could change due to an macroeconomic or firm specific situation

Determinants of intrinsic value and stock prices

- Stock’s intrinsic value- ‘true’ investor returns and ‘true’ risk

- Stock’s market price- ‘perceived’ investor returns and ‘perceived’ risk
- Market equilibrium: intrinsic value = stock prices

Features of preferred stock and dividend

Preferred dividends

- Stated dividend must be paid before dividends can be paid to common stockholders
- Not a liability of the firm and can be deferred indefinitely
- Most are cumulative- any missed preferred dividends have to be paid before common dividends
can be paid

Preferred stock generally do not carry voting rights

Corporate value model

- Also known as free cash flow model

- It suggests the value of entire firm equals the present value of the firm’s free cash flows. Thus
we are essentially using the discounted cash flow (DCF) method to find value today.
- Recall that CFFA (or free cash flow) is the firm’s after-tax operating income less the net capital
investment in fixed assets and investment in operating working capital:
- CFFA = OCF – NCS – changes in NOWC

Applying the corporate value model:

- Find the market value (MV) of the firm, by finding the PV of the firm’s future CFFAs
- Subtract market value of firm’s debt and preferred stock to get market value of common stock
- Divide market value of common stock by the number of shares outstanding to get intrinsic stock
price (value) per share

Using the corporate value model

- This method is often preferred to the dividend growth model, especially when considering the
number of firms (eg Apple and Google) that does not pay dividends and/or when dividends are
hard to forecast
- Similar to dividend growth model, as it assumes at some point free cash flow will grow a
constant rate
- Terminal value (TVN) represents value of firm at the point that growth becomes constant
rD = yield to maturity & rE = expected rate of return
Week 8: Capital Budgeting 1

Capital budgeting

- Recall that current expenditures are short-term in nature and are completely expensed in the
year incurred
- Capital expenditure are expenditure on fixed assets that will be used for production over a
period of years. As such, in accounting terms these expenditures are capitalised and then
depreciated over a period of years
- Capital budgeting refers to the process of deciding how to allocate the firm’s scarce capital
resources (land, labour and capital) to its various investment alternatives. It considers whether a
project is worth undertaking (worth its capital expenditures)
- The over-riding rule of capital budgeting is to accept all projects for which the cost is less than,
or equal to, the benefits:
- Accept if: cost <= benefits
- Reject if: cost >= benefits

Outline

- Net present value (NPV)

- Payback rule
- Discounted payback
- Average accounting return
- Internal rate of return (IRR) and modified IRR (MIRR)
- Profitability index
- Practice of capital budgeting

What are good decision criteria?

- Since the value must take into account what cash flow is received, when it is received and the
likelihood associated with receiving those cash flows, we need to ask ourselves the following
questions when evaluating decision criteria
- Does the decision rule adjust for the time value of money?
- Does the decision rule adjust for risk?
- Does the decision rule provide information on whether we are creating value for the firm?

METHOD 1: NPV decision making recipe

- Estimate the expected future cash flows: amount and timing (using a timeline)
- Estimate the required return for projects of this risk level: may have to use CAPM
- Find the present value of the cash flows and subtract the initial investment

Net present value

- It should be clear that the difference between the intrinsic value of a project and its cost is the
NPV  intrinsic value – cost = NPV
- If PV(cash inflows) > PV(cash outflows), this means that taking on the project will increase the
value of the firm
- Thus a +ve NPV means that the project is expected to add value to the firm and will therefore
increase the wealth of the owners
- Since our goal is to increase owner’s wealth, NPV is a direct measure of how well this project will
meet our goal

Evaluating NPV as capital budgeting decision criteria

- YES: (1) account for time value of money (2) account for risk of cash flows (3) provide an
indication about the increase in value
- Thus we considered NPV rule for our primary decision criteria

METHOD 2: payback period

- Payback period is the number of years to recover initial costs  how long does it take to get the
initial cost back in the nominal sense?
- The payback decision recipe: (1) estimate the cash flows (2) add the future cash flows to the
initial cost until the initial investment has been recovered
- Payback period decision rule: accept if the payback period is less than some pre-set limit
(determined arbitrarily)

Evaluating payback as a decision criteria:

- MAYBE: accounts for risk of the cash flow a little bit

- NO: (1) doesn’t account for time value of money (2) doesn’t provide an indication about the
increase in value
- Thus, we do not consider the payback rule for our primary decision criteria
- Advantages: (1) quick and easy to calculate (2) easy to understand (3) adjusts for uncertainty of
later cash flows (4) biased toward liquidity
- Disadvantages: (1) ignores time value of money (2) requires an arbitrary cut-off point (3) ignores
cash flows beyond the cut-off date (4) biased against long-term projects, such as R&D and new
projects

METHOD 3: discounted payback period

- Compute the present value of each cash flow and then determine how long it takes to payback
on a discounted basis
- Compare with a specified required period
- Discounted payback rule: accept the project if it pays back on a discounted basis within the
specified time (again arbitrarily selected)

Evaluating discounted payback decision criteria

- YES: (1) accounts for time value of money (2) accounts for risk of the cash flows
- NO: doesn’t provide an indication about the increase in value
- Thus, we do not consider the discounted payback rule for our primary decision criteria
- Advantages: (1) includes time value of money (2) easy to understand (3) adjusts for uncertainty
of later cash flows (4) biased toward liquidity
- Disadvantages: (1) may reject positive NPV investments (2) requires an arbitrary cut-off point (3)
ignores cash flows beyond the cut-off date (4) biased against long-term projects, such as R&D
and new projects
(Discounted) Payback period- serious deficiencies

If using payback period method, then have to take cash flow B even though the NPV of A is obviously
better

METHOD 4: average accounting return (AAR)

- There are many different definitions for average accounting return

- Average net income / average book value  used in the book
- Note that the average book value depends on how the asset is depreciated
- Need to have a target cut-off rate
- Average accounting return decision rule: accept the project if the AAR is greater than a pre-set
rate (determined arbitrarily)

Evaluating AAR as a decision criteria test

- NO: (1) doesn’t take into account time value of money (2) doesn’t account for risk of cash flows
(3) doesn’t provide an indication about the increase in value  although got % over book value
- Thus we do not consider the AAR rule for our primary decision rule
- Advantages: (1) easy to calculate (2) needed information will usually be available
- Disadvantages: (1) not a true rate of return  time value of money is ignored (2) uses an
arbitrary benchmark cut-off rate (3) based on accounting net income and book values, not cash
flows and intrinsic/market values

METHOD 5: internal rate of return (IRR)

- Definition: IRR is the return that makes the NPV = 0

- This is the most important alternative to NPV
- It is often used in practice and is intuitively appealing  outside world no. 1 method
- It is based entirely on the estimated cash flows and is independent of interest rates found
elsewhere
- General IRR rule: accept the project if the IRR is greater than the required returns

NPV profile
Evaluating IRR as a decision criteria

- YES: (1) accounts for time value of money (2) accounts for risk of cash flows (3) provides an
indication about the increase in value
- Thus we consider the IRR rule for our primary decision criteria
- Advantages: (1) knowing a return is intuitively appealing (2) it is a simple way to communicate
the value of a project to someone who doesn’t know all the estimation details
- If the IRR is high enough, you may not need to estimate a required return, which is often a
difficult task

Summary of capital budgeting decisions

NPV vs IRR

- NPV and IRR will generally give us the same decision except:
- Mutually exclusive projects: (1) initial investments are substantially different (2) timing of cash
flows is substantially different
- Non-conventional cash flows- cash flow signs change more than once
- In the real world, companies will look at IRR and payback period because these 2 methods do
not need the required rate of return (which is hard to get)

Difference between independent and mutually exclusive projects

- Independent: cash flows of one are unaffected by the acceptance of the other
- Mutually exclusive: if the cash flows of one can be adversely impacted by the acceptance of the
other (usually due to limitation of available funds)
IRR and non-conventional cash flows

- When a project’s cash flows change sign more than once, there can be more than one IRR
- When you solve for IRR you are solving for the root of an equation and when you cross the x-axis
more than once, there will be more than one return that solves the equation
- If you have more than one IRR, which one do you use to make your decision?

Summary of decision rules

- The NPV is positive at a required return of 15%, so I should accept

- If I used the financial calculator, some models will give an IRR of 10.11% which would tell me to
reject
- I need to recognise that there are non-conventional cash flows and look at the NPV profile

IRR and mutually exclusive projects

- Mutually exclusive projects: if you choose one, you can’t choose the other  you can choose to
attend grad school next year at either Harvard or Stanford, but not both
- Intuitively I will make the following decision rules: (1) NPV- choose the project with the higher
NPV (2) IRR- choose the project with the higher IRR
- If my discount rate is going to be above 11.8%, choose B (because when interest rate is above
11.8%, NPV(B) is higher than NPV(A))
- If my discount rate is going to be below 11.8%, choose A

Reasons why NPV profiles cross

- Size (scale) differences: at discount rate = 0, the NPV of a smaller project B is less than (hence
below the) larger project A (on the y axis)
- Timing differences: the project with faster payback provides more CF in early years for
reinvestment. It is less sensitive to changes in discount rate. If r is high, early CF is especially
good, NPV(B) > NPV(A)

Reinvestment rate assumptions

- NPV method assumes CFs are reinvested at company’s weighted average cost of capital (WACC),
the opportunity cost of capital
- IRR method assumes CFs are reinvested at IRR
- Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method
is the best. NPV method should be used to choose between mutually exclusive projects
- Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed

Since managers tend to prefer the IRR to the NPV method, is there a better IRR method?

- Yes, modified internal rate of return (MIRR). There are a number of different MIRR methods such
as discounting approach, reinvestment approach & combination approach (we will focus on this
one)
- Under the combination method, the MIRR is the discount rate that causes the PV of a project’s
terminal value (TV) to equal to the PV of its costs. TV is found by compounding positive project
inflows at WACC to the date of maturity. PV of costs is found by discounting negative project
cash flows to time zero using WACC
- MIRR assumes cash flows are reinvested at the WACC

Calculating MIRR

1. Compound all the +ve CF to the last time period

2. Discount all –ve CF to time period 0
3. With number of periods, PV and FV. Solve for I/Y

Why use MIRR vs IRR?

- MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the
problem of multiple IRR
- Managers like rate of return comparisons, and MIRR is better for this than IRR

When to use the MIRR instead of the IRR?

- When there are non-normal CFs and more than one IRR, then use MIRR

Conflicts between NPV and IRR

- NPV directly measures the increase in value to the firm

- Whenever there is a conflict between NPV and another decision rule, use NPV
- IRR is unreliable in the following situations: (1) non-conventional cash flows (2) mutually
exclusive projects
- Use MIRR if I really want to use IRR

METHOD 6: profitability index

- Measures the benefit per unit cost, based on the time value of money
- Also known as a benefit/cost ratio
- PI = total PV of future CFs / initial investment
- Profitability index decision rule: accept if PI > 1  means NPV > 0
- This measure can be very useful in situations where we have limited capital (1 period capital
rationing)
- Advantages: (1) closely related to NPV, generally leading to identical decisions (2) easy to
understand and communicate (3) maybe useful when available investment funds are limited
- Disadvantages: may lead to incorrect decisions in comparisons of mutually exclusive investments
(when compared to NPV)
Week 9: Capital Budgeting 2

NPV analysis: best decision method

- Concluded that NPV was the best capital budgeting decision method to apply. Recall that NPV
involves the evaluation of various capital investment proposals by examining:
- The cash inflows and outflows
- Estimating the required rate of return and using that to find the PV of the cash inflows and
outflows
- Evaluating the projected CFs gives management a valid criterion for choosing those projects or
activities that promise the most value accretion to the organisation

Cash flows in a typical project

- Increase in net working capital = decrease in net working capital  100% recovery

Relevant cash flows

- In finance, costs and benefits associated with a capital budgeting project are measured in terms
of cash flows rather than accounting earnings
- In accounting, upfront cash outflows to purchase and set up equipment are not recognised as
expenses in year 0. Instead, the cash outlay appears as a depreciation expense over the course
of its useful life. However, depreciation expenses do not correspond to the actual cash outflow
- This accounting and tax treatment of capital expenditures is one of the key reasons why
accounting earnings are not an accurate representation of actual cash flows
- Taxes are relevant and must be considered. All cash flows must be measured on an after-tax
basis
- Changes in net operating working capital (NOWC) (relevant)
- Incremental: cash flows must be on an incremental (or marginal) basis  firm’s cash flows with
the project minus the firm’s cash flows without the project. The cash flows that should be
included in a capital budgeting analysis are only those that will occur if the project is accepted.
‘Will this cash flow occur only if we accept the project?’

Types of cash flow effects

- Sunk costs: cost that have been accrued in the past. They cannot be altered by present decisions
and thus are not relevant
- Opportunity cost: costs of options which must be foregone by taking the project (relevant). Eg.
Use land to build factory, but if don’t build factory, can sell the land. I give up a benefit by
keeping it
- Side effects (externalities): (1) positive side effects- benefits to other firm projects (2) negative
side effects: cost of other projects- erosion/cannibalisation
- Financing cost (ignore in estimating cash flows, thus exclude interest expense and the tax effect
of interest expense) (??)

Specific issues: financing effects

- A firm’s WACC is defined as follows:

-
- rD is the firm’s required rate of return on debt = yield to maturity
- rE is the firm’s required rate of return on equity = CAPM
- TC is the marginal corporate tax rate
- D E and V are the market values of the firm’s debt, equity and total value (D+E) respectively
- Weighted average cost of capital takes into account the firm’s after-tax equity and debt
financing costs in the market value weightage in which they are held
- When considering a corporate project and when using the corporate valuation model, dividends
and interest expense should not be included in the estimation of relevant cash flows
- This is because when evaluating projects and when using the corporate valuation model,
financing effects are taken into consideration in the discount rate used. When discounting the
cash flows of a firm and/or a firm’s projects, we use the firm’s WACC
- Thus, recall that NPV represents the addition to value/wealth from undertaking a particular
project/acquisition/investment. It corresponds with the objective of maximising value

-
- When –C is the investment cost and Ci is the net cash flow in period i, and r is the appropriate
risk adjusted discount rate. When valuing a firm’s total net cash flows and/or its project net cash
flows, then the appropriate r is the firm’s WACC

Overall incremental project cash flows

- Net initial investment outlay: remember to consider impact on NOWC  year 0

- Future operating cash flows (on an after tax basis)
- Cash outflows later required to support the initial investment outlay: eg. Cash outflows
associated with a major overhaul. Changes in operating working capital over the life of project
- Terminal cash flows: net salvage value received upon termination of the project, remember to
include return on NOWC (recovery)  last year

Pro forma statements and cash flow

- Capital budgeting relies heavily on pro forma (i.e. projected) accounting statements, particularly
income statements
- Computing operating cash flows: OCF = EBIT + depreciation – (EBIT x tax rate) = EBIT(1 – tax rate)
+ depreciation
- Additional capital spending and changes in NOWC: CFFA also known as FCF (free cash flow??)
and as net cash flow from operations = OCF – NCS – changes in NOWC

Example of a pro forma income statement

Example: projected capital requirements

- Basically to find cash flows = CFFA + investment outlays

- Now that we have the net cash flows, we can apply the evaluation techniques taught in week 8.
Assume discount rate is 20%
- NPV = 10,648 > 0 IRR = 25.8% > 20%  accept the project

Depreciation expenses

- The depreciation expense used for capital budgeting should be the depreciation schedule
required for tax purposes
- Straight-line depreciation is commonly used (FIN2004 uses this)
- Accelerated depreciation is an alternative: for example, depreciation schedule for different
assets are provided under MACRS (modified accelerated cost recovery systems) used in the US

Depreciation: be sure to reflect taxes

- Depreciation itself is a non-cash expense, consequently, it is only relevant because it affects

taxes (it results in lower tax payable)
- Depreciation tax shield = D*T  D = depreciation expense T = marginal corporate tax rate

Computing depreciation

- Straight line depreciation:

- If full depreciation: D = initial cost / years
- If take salvage value into account: D = (initial cost – salvage) / years
- Accumulated depreciation = D* number of years in use
- Book value (B) = initial cost – accumulated depreciation

Net salvage value

- If the salvage value is different from the book value of the asset, then there will be a tax effect
- (1) If S > B  gain on sale
- Tax on salvage value received = (S – B)*T where T = applicable tax rate
- After-tax salvage value: S – T(S – B)
- (2) If B > S  loss on sale
- -T(S – B) is a tax saving (cash inflow) and again:
- After-tax salvage value: S - -T|S – B| = S + T|S – B|

Net capital spending (NCS)

- NCS = ending net fixed assets – beginning net fixed assets + depreciation
- NCS is money spend on fixed assets less money received from sale of existing fixed assets
- NCS can be negative  sell more than I buy

Replacement projects (need to look at incremental flows)

- For a replacement rather than a new project, how would the analysis change?
- Remember we are interested in the incremental cash flows
- If we buy the new machine, then we will sell the old machine
- The incremental cash flows would be the difference in cash flows between the old machine and
new machine
- Thus our cash flow estimates must reflect ALL the cash flow consequences of selling the old
machine today instead of in 5 years
- If the old machine is sold today, the firm will not receive the salvage value at the end of the
machine’s life. This is the opportunity cost of the replacement project. Thus it is important to
 record the actual salvage value cash inflow to be received upon sale of the old equipment while
also taking into account that this results in forfeiting obtaining the salvage value of the
equipment sometime in the future
- The relevant annual depreciation expense would be the change (new equipment depreciation –
old equipment depreciation)

Example: replacement problem

 OCF = 17400 + 21000 = 38400

- Note: if we do not sell the machine today, then we will have after-tax salvage of 10,000 in 5
years. Since we do sell the machine today, we LOSE the 10,000 cash inflow in 5 years 
opportunity cost
- NPV = 56,690 > 0 IRR = 32.66% > 10%  replace the equipment

Methods of computing OCF

- OCF = EBIT + depreciation – EBIT*tax rate = EBIT(1 – tax rate) + depreciation

- We can always find OCF with the above formula. The methods described below will also give us
the same results for OCF
1. Bottom up approach (when there is NO interest expense)
- OCF = NI + depreciation
- NI = sales – costs – depreciation – taxes
- Taxes = tax rate x (sales – costs – depreciation)
2. Top-down approach (when there is NO interest expense)
- OCF = sales – costs – taxes
- Don’t subtract non-cash deductions or interest expense
3. Tax shield approach (can use even when there is interest expense)
- OCF = (sales – costs)(1 – T) + depreciation*T

Mutually exclusive unequal life projects

- Suppose our firm is planning to expand and we have to select 1 of 2 machines. They differ in
terms of economic life
- How do we decide which machine to select?

-
- NPV1 = $1,432 NPV2 = $1,664
- Does this means #2 is better?
- Not necessarily- the 2 NPVs can’t be compared simply as they are  because they have non-
equal useful lives
- If we assume that each project will be replaced an infinite times in the future, we can convert
each NPV to an annuity  calculate equivalent annual annuities (EAA) or replacement chains
- Note that the projects’ EAA can be compared to determine which is the best project
- EAA: simply find an equivalent annuity to the lump-sum NPV
- Machine 1: PV = 1432, N = 3, I/Y = 14  PTM = 617  receive $617 per year
- Machine 2: PV = 1664, N = 6, I/Y = 14  PTM = 428  receive $428 per year
- We reduced the problem with different time horizons to an issue of finding ‘equivalent’
annuities and comparing
- Decision rule: select the highest EAA  choose machine 1
- Note: if we are comparing costs, we choose the lowest EAA

Another EAA example

Week 10: financial planning and forecasting

Managers use pro forma financial statements to

- Assess whether the firm’s anticipated performance is in line with the firm’s own general targets
and with investor’s expectations
- Estimate the effects of proposed operating changes
- Anticipate the firm’s future financing needs
- Estimate future cash flows from assets, which determine the company’s overall value
- Set appropriate targets for compensation plans

What is financial planning?

- Systematically thinking about the future and possible problems

- Evaluating the impact of alternative investment and financing choices
- Projecting future consequences of present decisions and fund needs
- Implementing the plan
- Evaluating and adjusting the plan

Elements of financial planning

- Investment in new assets: determined by capital budgeting decision

- Degree of financial leverage: (how much are they using borrowed funds) determined by capital
structure decision
- Liquidity requirements: determined by net working capital decision
- Cash paid to shareholders: dividend policy decisions

The planning process

- Planning horizon: divide decisions into short run decisions (usually 12 months) and long run
decisions (usually 2-5 years)
- Aggregation: combine capital budgeting decisions into one big project
- Assumptions and scenarios: (1) make realistic assumptions about important variables (2) run
several scenarios where you vary the assumptions by reasonable amounts
- Determine at least a worst case, normal case and best case scenario

Role of financial planning

- Examining interactions: helps management see the interactions between decisions

- Exploring options: gives management a systematic framework for exploring its opportunities
- Avoiding surprises: helps management identify possible outcomes and plan accordingly
- Ensure feasibility and internal consistency: helps management determine if goals can be
accomplished and if the various stated (and unstated) goals of the firm are consistent with one
another

Financial statements

- Total assets = liabilities + owner’s equity (basically equity)

- Net income = revenue – COGS – expenses – taxes
- How are they related?  owner’s equity increases by addition to retained earnings
- From statement of RE:
- Net income = addition to retained earnings + dividends
- Addition to RE = net income – dividends
- Dividends = net income – addition to RE

Financial planning model ingredients

- Sales forecast: many cash flows depend directly on the level of sales (often estimated using a
growth rate in sales)
- Pro forma statements: setting up the plan as projected financial statements allows for
consistency and ease of interpretation
- Asset requirements: how much additional fixed assets will be required to meet sales projections
- Financial requirements: how much financing will we need to pay for the required assets
- Plug variable: management decision about what type of financing will be used (makes the
balance sheet balance)
- Economic assumptions: explicit assumptions about the coming economic environment

Example: historical financial statements

Basically, both D and E will increase by 15% also  so that D + E will hit 1150. The remainder of the
net income will go into dividends

In this case, don’t want to give dividends at all, all will go into retained earnings that go into equity
 then debt will be reduced to the level of 1150 – (600 + 460) = 90

METHOD 1: percent of sales approach

- Some items tend to vary directly with sales, while others do not
- Income statement:
- Cost may vary directly with sales
- If this is the case, profit margin is constant
- Dividends are a management decision and generally do not vary directly with sales- this affects
the retained earnings that go on the balance sheet
- Balance sheet:
- Initially assume that all assets, including fixed, vary directly with sales
- Accounts payable will also normally vary directly with sales
- Notes payable, long-term debt and equity generally do not because they depend on
management decisions about capital structure
- The change in retained earnings portion of equity will come from the dividend decisions

EXAMPLE:

Income statement

Balance sheet

Assets ≠ liabilities + equity

External financing needed

- The firm needs to come up with an additional $200 in debt or equity to make the balance sheet
balance
- TA – (TL + OE) = 10450 – 10250 = 200
- Borrow more short term (notes payable)
- Borrow more long term (LT debt)
- Sell more common stock
- Decrease dividend payout, which increase addition to RE

METHOD 2: AFN equation (also called EFN)  additional funds needed equation

- Determining additional funds needed, using the AFN equation

-
- A*  spontaneous assets
- S0  original amount of sales
- Change in S  change in sales
- L*  spontaneous liability (accounts payable)
- M  profit margin  net income / sales
- S1  new level of sales
- RR  retention ratio

Important assumption to using AFN equation

- Firm must be operating at full capacity  any increase in sales will increase FA
- Constant profit margin  M must be fixed
- Dividend payout ratio / retention ratio is constant  RR must be fixed

Example: operating at less than full capacity

- Suppose that the company is currently operating at 80% capacity

- Full capacity sales = 5000/0.8 = 6250
- Estimated sales = 5550, so would still only be operating at 88%
- Therefore, no additional fixed assets would be required
- Pro forma total assets = 6050 (amount of operating working capital needed) + 4000 (no change
in FA) = 10050
- Total L + E = 10250
- We find that we in fact do not need additional funds but rather have generated funds from
operations. Where will those funds be used is to be decided
- To balance the account equation: A < L + E:
- Repay some short term debt (decrease notes payable)
- Repay some long term debt (decrease LT debt)
- Buy back stock (derease owner’s equity)
- Pay more dividends (reduce addition to RE)
- Increase cash account

Growth and external financing

- At low growth levels, internal financing (retained earnings) may exceed the required investment
in assets
- As the growth rate increases, the internal financing will not be enough and the firm will have to
go to the capital markets for money
- Examining the relationship between growth and external financing required is a useful tool in
long-range planning

Growth and performance

- When a company is growing faster than it can finance internally, any distributions to
shareholders will cause it to seek greater additional financing
- It is important not to confuse the need for external financing with poor performance
- Most growing firms need additional financing to fuel that growth as their expenditures to grow
will naturally precede the income generated from that growth

The internal growth rate and sustainable growth rate

- The formulas regarding the internal growth rate and sustainable growth rate all rely on the
assumption that all liabilities are non-spontaneous  they do not increase with sales. Thus the
AFN equation becomes:
- AFN = spontaneous increase in assets – increase in retained earnings

The internal growth rate

- The internal growth rate tells us how much the firm can grow assets using retained earnings as
the only source of financing

-
- If grow less than 6.74%, AFN = 0
- If growth more than 6.74%, AFN > 0  cannot solely rely on internal financing

The sustainable growth rate

- The sustainable growth rate tells us how much the firm can grow by using internally generated
funds and issuing debt to maintain a constant debt ratio

-
- If grow more than SGR  debt ratio and AFN will increase

Determinants of growth: ROE & b

- Profit margin: operating efficiency

- Total asset turnover: asset use efficiency
- Financial leverage: choice of debt ratio
- Dividend policy: choice of how much to pay to shareholders versus reinvesting in the firm
- Recalling DuPont identity: ROE = profit margin x total asset turnover x equity multiplier
Week 11: working capital management

Introduction to working capital

- Firms need cash to pay for all their day-to-day activities. They have to pay wages, pay for raw
materials, pay bills and so on. The money available to them to do this is known as the firm’s
working capital
- A company can be endowed with assets and profitability but short of liquidity if its assets cannot
readily be converted to cash
- Positive working capital is required to ensure that a firm is able to continue its operations and
that it has sufficient funds to satisfy both maturing short term debt and upcoming operational
expenses
- Working capital management refers to choosing and controlling the levels and mix of cash,
marketable securities, receivables and inventories, as well as different types of short-term
financing

Working capital terminology

- Gross working capital: total current assets

- Net working capital: current assets – current liabilities
- Net operating working capital (NOWC): current assets – non-interest bearing current liabilities

-
- Working capital policy: deciding the level of each type of current asset to hold, and how to
finance current assets  cash management, inventory management, receivables management

Sources and uses of cash

Sources

- Increasing long term debt, equity or current liability

- Decreasing fixed assets or current assets (other than cash)

Uses

- Decreasing long term debt, equity or current liabilities

- Increasing current assets (other than cash) or fixed assets

TOPIC 1: OPERATING CYCLE

Operating cycle

- Operating cycle: time between purchasing inventory and collecting the cash from selling the
inventory
- Inventory period: time required to purchase and sell the inventory
- Accounts receivables period (DSO): time to collect on credit sales
- OPERATING CYCLE = INVENTORY PERIOD + ACCOUNTS RECEIVABLES PERIOD
- Accounts payable period (payment deferral period): time between purchase of inventory and
payment for the inventory
- Accounts payable period = 365 / payables turnover
- Payables turnover = total purchases from suppliers/average payable = (COGS + ending inventory
– beginning inventory)/average payable
- NOTE: average payable have to take the average of 2 year’s values

Cash cycle (cash conversion cycle)

- Difference between when we receive cash from the sale and when we have to pay for the
inventory
- Time period for which we need to finance our inventory
- Minimising the cash cycle minimises the amount of external financing the firm has to raise to
fund current operations
- CASH CYCLE = OPERATING CYCLE – ACCOUNTS PAYABLE PERIOD

-
Ways to minimise cash cycle:

- Lengthen accounts payable period

- Shorten accounts receivable period
- Shorten inventory period

NOTE: accounts payable can be longer than operating cycle  negative cash cycle (usually big ass
companies that can do it)

CASH CYCLE

- Recall the cash cycle focuses on the length of time between when a company makes payment to
its creditors and when a company receives payment from its customers
- CASH CYCLE = INVENTORY PERIOD + ACCOUNT RECEIVABLES PERIOD – ACCOUNTS PAYABLE
PERIOD
- Inventory period = days per year/inventory turnover = 365 / inventory turnover
- Accounts receivable period = days per year/receivables turnover

Carrying vs shortage cost

- Managing short-term assets involves a trade-off between carrying costs and shortage costs
- Carrying cost: increase with increased levels of current assets, the costs to store and finance the
assets
- Shortage cost: decrease with increased levels of current assets, the cost to replenish assets 
trading or order costs OR costs related to safety reserves (lost sales and customers and
production stoppages)

Why do we hold on to cash?

- Transactions: must have some cash to operate

- Precaution: ‘safety stock’. Reduced by line of credit and marketable securities
- Compensating balances: for loans and/or services provided
- Speculation: to take advantage of bargains and to take discounts

The goal of cash management

- To meet the above objectives, especially to have enough cash for transactions, and yet not have
excess cash  have enough cash, but not too much cash
- To minimise the need for cash transactions balance (in particular), precautionary, compensating
balances and speculation/opportunities

Reduce need for ‘safety stock’ of cash

- Increase forecast accuracy

- Hold marketable securities
- Negotiate a line of credit  emergency break-glass cash

TOPIC 2: FLOAT

What is ‘float’?

- Float is the difference between cash as shown on the firm’s books and on its bank’s book
- If SKI collects cheques in 2 days but those to whom SKI writes cheque don’t process them for 6
days, then SKI will have 4 days of net float
- If a firm with 4 days of net float writes and receives $1m of cheques per day, it would be able to
operate with $4m less capital than if it had zero net float

Understanding float

- Float  difference between cash balance recorded in the account cash account and the cash
balance recorded at the bank
- Disbursement float  generated when a firms write cheques  available balance at bank –
book balance > 0
- Collection float  cheques received increase book balance before the bank credits the amount
 available balance at bank – book balance < 0
- Net float = disbursement float + collection float

Example: types of float

Measuring float

- Size of float depends on the dollar amount and the time delay
- Delay = mailing time + processing delay + availability delay
- Suppose you mail a monthly cheque for $1000 and it takes 3 days to reach its destination, 1 day
to process and 1 day before the bank makes the cash available

Cost of float

- Cost of collection float  opportunity cost of not being able to use the money
Cash collection

- One of the goals of float management is to try and reduce the collection delay  basically
collect the $$ as fast as possible

Cash disbursements

- Slowing down payments can increase disbursement float  but may not be ethical or optimal to
do this
- Controlling disbursement: (1) zero balance account  cheque account and saving account (2)
controlled disbursement account  set a limit for the account (3) remote disbursement account
 set a cheque account in ulu country
- Stretch out accounts payable as long as possible. If a bill is due on the 13th, don’t pay it on the
10th. If a company has enough clout, they can negotiate longer terms with vendors
- Turn receivables as quickly as possible. Make it easy for customers to pay. Lockboxes, prepaid
envelopes, discounts etc may be utilised

Lockbox  remove mailing time, remove processing time

- Incoming cheques sent to PO boxes

- Local banks collect and deposit cheques into account
- Banks provide daily record
- Reduces time of processing cheques
- Particularly relevant for companies and customers separated by great distances

EXAMPLE: LOCKBOX
TOPIC 3: CASH BUDGET

Cash budget

- The primary cash management tool

- Purpose: forecasts cash inflow, outflows and ending cash balances. Used to plan loans needed or
funds available to invest
- Timing: daily, weekly or monthly. Depending upon purpose of forecast. Monthly for annual
planning, daily for actual cash management

What are some other potential cash inflows besides collections?

- Proceeds from the sale of fixed assets

- Proceeds from stock and bond sales
- Interest earned
- Court settlements
How could bad debts be worked into the cash budget?

- Collections would be reduced by the amount of the bad debt losses

- For example, if the firm had 3% bad debt losses, collections would total only 97% of sales
- Lower collections would lead to higher borrowing requirements or a lower surplus

SKI’s forecasted cash budget

- Assuming that the target cash balance is $1500, the cash budget indicates the company is
holding too much cash
- SKI could improve its value by either investing cash in more productive assets, or by returning
cash to its shareholders

Why might SKI want to maintain a relatively high amount of cash?

- If sales turn out to be considerably less than expected, SKI could face a cash shortfall. A company
may choose to hold large amounts of cash if it does not have much faith in its sales forecast, or if
it is very conservative
- The cash may be used, in part, to fund future investments

CASH MANAGEMENT EXAMPLE!!!

Receivables management

- The cash flows from granting credit

Credit management: key issues

- Granting credit increases sales

- Cost of granting credit: (1) chance that customers will not pay (2) financing receivables
- Credit management examines the trade-off between increased sales and the cost of granting
credit

Accumulation of receivables
- The amount of accounts receivable outstanding at any given time is determined by 2 factors: (1)
volume of credit sales (2) average length of time between sales and collections
- Account receivables = credit sales per day x length of collection period

Monitoring the receivables position

- Days sale outstanding (DSO) = receivables / sales per day

- Sales per day = annual sales / 365
- Aging schedules: breaks down firm’s receivables by age of account  can tell who is late and
late by how long  can aid in late collection policy

TOPIC 4: CREDIT POLICY

Elements of credit policy

- Credit period: eg 60 days to pay

- Discounts for early payments
- Credit standards: rules and measurements to determine who I can give credit to
- Collection policy: how fast should I call my customers to collect payment and how fierce do I
get?

Terms of sale

- Basic form: 2/10 net 45

- 2% discount if paid in 10 days
- Total amount due in 45 days if discount not taken

Terms of sale

1. Credit period
- How long to pay? Example: 3/15, net 40
- Shorter period reduces DSO and average A/R, but it may discourage sales
2. Cash discounts
- Lower prices
- Attracts new customers and reduces DSO
3. Credit standards
- Tighter standards tend to reduce sales, but reduce bad debt expense
- Fewer bad debts reduce DSO
4. Collection policy
- How tough?
- Tougher policy will reduce DSO but may damage customer relationships

Example: cash discounts

- Finding the implied interest rates when customers do not take the discount
-
- Unless the company can benefit more from investing the $98 at day 10, but it is going to be very
hard to earn 23.45% EAR

Does SKI face any risk if it tightens its credit policy?

-
- Yes, a tighter credit policy may discourage sales. Some customers may choose to go elsewhere if
they are pressured to pay their bills sooner

If SKI succeeds in reducing DSO without adversely affecting sales, what effect would this have on its
cash position?

- Short run: if customers pay sooner, this increases cash holdings

- Long run: over time, the company would hopefully invest the cash in more productive asset, or
pay it out to shareholders. Both of these actions would increase firm’s value

Credit policy effect

Revenue effect

- Delay in receiving cash from sales

- May be able to increase price
- May increase total sales

Cost effects

- Cost of sale is still incurred even though the cash from the sales has not been received
- Cost of debt: recall that the firm must finance receivables
- Probability of non-payment: some percentage of customers will not pay for products purchased
 bad debts
- Cash discounts: some customers will pay early and pay less than the full sales price

EXAMPLE: evaluating a proposed policy

EXAMPLE: SHORT TERM BORROWING (cost of bank loans: compensating balance)
Week 12: Options

Learning objectives

- Understand options terminology

- Be able to distinguish options positions
- Be able to determine option payoffs and pricing bounds
- Understand the 5 determinants of option value

Derivative securities- overview

- A ‘derivative instrument’ is one for which the ultimate payoff to the investor depends directly on
the value of another security or commodity. Types of derivatives:
 Options: calls and puts
 Forwards and futures
 Extended derivatives: swap contract / convertible securities / other embedded derivatives
(call feature of a bond)
- As we will see, derivatives can be used both for risk-management as well as speculation via their
large leverage ratio potential. An example of risk-management: an airline can use an energy
derivative to manage the risk of changes in the price of fuel

Derivative securities

- The underlying assets can include agricultural commodities, energy and petroleum, metals,
currencies, common stocks and stock indexes and even some other derivatives
- Agricultural commodities: corn, soybeans, wheat, (live) cattle, pork, lumber, dairy, even orange
juice
- Energy products: crude oil, refined oil, natural gas, electricity
- Metals: steel, copper, silver, gold, platinum
- Currencies: euro, Chinese yuan, japan yen
- Stocks, bonds and indexes: S&P 500, Dow Jones, Nasdaq 100, global indexes

Global derivatives markets: exchange-traded vs OTC

- Exchange-traded derivatives are standardised contracts traded on regulated exchanges that

provide clearing and regulatory safeguards to investors
- OTC (over the counter) derivatives are customised contracts provided directly by dealers to end-
users to other dealers

Options generally

- A CALL option is a security that gives its owner the right (but not the obligation) to purchase a
given asset (usually a stock) on a given date (or given the type of option, any time before a given
date) for a predetermined price (referred to as exercise or strike price)
- A PUT option, in contrast to a call option, gives its owner the right to sell an asset on a given date
at a predetermined price
- European options: can be exercised only at the expiration date
- American options: can be exercised at any time before expiration

Options generally (cont):

- Options are ‘side bets’ between investors- investors trade options on common stock among
themselves, and these option trades do not involve the firms on whose shares the trades or bets
are based
- So if an investor sells a call (also referred to as ‘writes a call’), then he promises to provide the
buyer of the call with shares of the underlying firm, if asked to do so by the option buyer on the
date of maturity
- Similarly, the seller or writer of the put option has the obligation to buy (if the put option
holder/buyer wants to exercise the put option)

Options terminology

- Buy / long
- Sell / short / write
- Call
- Put
- Exercise price is also called the strike price
- Premium of the option is also called price of the option
- Maturity option also referred to as expiration of the option
- There are 4 option positions: call buyer, call seller, put buyer, put seller

Notation for options discussion

- S: price of underlying asset generally

- S0: price of underlying asset today
- ST: price of underlying asset at option expiration date
- X/K/E: exercise or strike price of the option
- r: interest rate (the risk free rate)
- C0: the price of a call option today
- CT: the price of a call option at the option’s expiration date

Payoff at maturity:

- Since the owner of a call option has the right but not the obligation to buy the asset for X dollars
(strike price), they will only do so if the asset’s market price exceeds X dollars
- If X < S, we can buy the stock by exercising the option at a price that is lower than the price
prevailing in the market. Thus, we should exercise the option. The value of the option in this
case, equals the difference between the value of the stock at the day of exercise (market price)
and the price paid for the stock (by exercising): C = S – X
- If X > S, we can buy the stock in the market at a price lower than the price required by exercising
the option. Thus, we should let the option expire and not exercise it. The value of the option is
then zero.
- Payoff of call at maturity: C = MAX( S – X , 0)
- PROFITS to call holder: payoff – premium. Where premium is the cost of the option at purchase

Call value at maturity date as function of stock price

- The 45 degree line shows that once the market price of stock rises above the exercise price, the
call holder gains dollar for dollar in their payoff if the stock price goes up and loses dollar for
dollar if it falls.
Payoff description

- ‘In the money option’: refers to the situation when, if the date of expiration would have been
today, the option holder would have exercised their option holder would have exercised their
option, meaning S > X for call options (and vice versa for put option, X > S)
- ‘At the money option’: refers to the situation when, if the date of the expiration would have
been today, the holder would have been indifferent to exercising their option, meaning S = X
- ‘Out of the money’ option: refers to the situation when, if the date of expiration would have
been today, the holder would have given up the right to exercise the option, meaning S < X for
the call options (and vice versa for put options, S > X)

Payoff and profit of CALL options at expiration ( CALL BUYER/HOLDER)

- Call holder can have unlimited revenue/payoff

Payoff and profit to call writer at expiration ( CALL SELLER/WRITER)

- Call writer can have unlimited loss as well

Payoff and profit of put option at expiration ( PUT HOLDER/BUYER)

- PUT WRITER is just the inverse of PUTHOLDER about the x-axis

Payoffs and profits at expiration – PUTS

- Payoff to put holder

 If S > X  0
 If S < X  X – S
- Profit to put holder
 Payoff – premium
- Payoff to put writer/seller
 If S > X  0
 If S < X  -(X – S)
- Profits to put writer/seller
 Payoff + premium

3 different investment strategies: stock, call options, call options + T bills

- You have $10000 to invest. You can invest in 3 different ways. Stock is selling for $100/share.
Calls are selling for $10 a call with a strike price of $100. The risk free rate is 3%

-
Rate of return of 3 strategies

-
- As the graph highlights, the ‘all options’ strategy is essentially a leveraged investment. There is a
disproportionately higher increase in return for a smaller increase in price in the underlying asset

Options generally

- Any set of payoffs contingent on the value of some underlying asset, can be constructed with a
mix of simple options on that asset. By adding and subtracting various combinations of calls and
puts (at various exercise price), we can create a variety of financial instruments with an endless
range of payoff positions

Value of a protective put position at option expiration

- Buy a stock & buy the put on the stock

-
- Protective put strategy

Profits: protective put vs stock investment

- Having a protective put strategy puts a protective cap to the maximum I can lose

Put call parity

- Investment 1: protective put (stock position and a put option on that position) (STOCK + PUT)
- Investment 2: buy a call option on the same stock and treasury bills with face value equal to the
exercise price (CALL + T BILLS)
- These 2 payoffs are identical
- Therefore, they must cost the same
- S0 + P = C + X/(1 + r)T
- If the prices are not equal, arbitrage will be possible

Protective put strategy: buy a call and buy a zero-coupon bond: payoffs at expiry

Comparing the strategies for put call parity

- Stock + put
 If X > S  exercise put and receive X
 If S > X  let put expire and have S
- Call + PV(X)
 PV(X) will be worth X at expiration of the option
 If X > S  let call expire and have investment X
 If S > X  exercise call using the investment and have S

Put call parity

- Cost of 1st strategy = cost of 2nd strategy

- Price of underlying stock + price of put = price of call + PV of exercise price
- S + P = C + PV(X)
- P = C + PV(X) – S

Option values

- Intrinsic value: payoff that could be made if the option was immediately exercised
 CALL: stock price – exercise price  S – X
 PUT: exercise price – stock price  X – S
- But in each case intrinsic value is zero or greater
- Time value of an option (not similar to the time value of money): the difference between option
price and the intrinsic value  option price – intrinsic value
- Most of the time value is ‘volatility value’

Call option value bonds

- Upper bound: call price must be less than or equal to the stock price
- Lower bound: call price must be greater than or equal to the stock price minus the exercise price
or zero, whichever is greater
- If either of these bounds are violated, there is an arbitrage opportunity

Call option value before expiration is highlighted in pink (intrinsic value in black)

Options value determinants

-
- The value of a call option C0 must within:
- MAX( S – X , 0) < C < S

Options valuation

- The value of a call option increases as stock price increases (holding the exercise price constant)
- The value of a call option increases with both the rate of interest and the time of maturity. The
option’s price today is paid today but the exercise price isn’t paid until the option is exercised,
thus the longer the option maturity and the higher interest rates, the more valuable the delay in
payment of the exercise price
- The value of a call option increase both with the volatility of the share price and the time to
maturity. Option holders gain from volatility because their payoffs are not symmetric. If the
stock price falls below the exercise price, the call option will have zero value, but for every $ the
stock price rises above the exercise price, the call will be worth an extra $.