CORPORATE FINANCE

By Hillier et. Al

Chapter 1: Introduction to Corporate Finance 2

Chapter 4: Discounted Cash Flow Valuation 17
Chapter 5: Bond Equity and firm valuation 30
Chapter 6: Net Present Value and other investment rules 38
Chapter 7: Making Capital Investment Decisions 43
Chapter 8: Risk Analysis, real options and Capital budgeting 50
Chapter 9: Risk and Return: Lessons from Market History 54
Chapter 10: Risk and Return:The Capital Asset Pricing Model 59
 CHAPTER 1: INTRODUCTION TO CORPORATE FINANCE
❖ Corporate finance is the study of three questions:
- In what long-lived assets should the firm invest?
• This is about the left side of the balance sheet.
• Capital budgeting = process of making and managing expenditures on long-lived assets.

- How can the firm raise cash for required capital expenditures?
• This is about the right side of the balance sheet
• Answer involves firm’s capital structure = the proportion of the firm’s financing from
current and long term debt and equity.

- How should short-term operating cash flows be managed ?

• This is about the upper portion of the balance sheet.
• Short-term management of cash flow is associated with a firm’s net working capital
and

Net working capital = Current Assets – Current Liabilities

Net working Capital - The cash (or things that turn into cash quickly) minus the debt that you have to
pay off quickly.
• This is the money that is left to work with on a day-to-day basis for a company.

A. Capital structure

❖ Financial arrangements determine how value of the firm is divided.

- People/institutions that lend money to the firm = creditors, bondholders or debt holders.
- Holders of equity = owners of the firm. We can think of a firm as a pie.

❖ The size of the pie is the value of the firm in the financial markets defined as:

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 CHAPTER 4: DISCOUNTED CASH FLOW VALUATION

I. Valuation: the one-period case

❖ Future value (FV) or compound value = the value of a sum after investing over one or more periods.
❖ Present value = answers the question how much money should I put in the bank today so that I will have
a certain amount next year?
- Present value of investment: C1
C1
PV =
1+r
❖ Frequently, business people want to determine the exact cost of benefit of a decision. This is the
Net Present Value.
- Computed with the formula: NPV = – Cost + PV

II. Valuation: the multi-period case

A. Future value and compounding

❖ Compounding = The process of leaving the money in the financial market and lending it for another year.

❖ General formula for an investment over many periods is called the future value of an investment and
is calculated as:
PV = C0 ⋅ (1 + r)T
- Where C0 is the cash to be invested at date 0
- r is the interest rate per period
- T is the number of period over which the cash is invested.

B. Present value and discounting

❖ Discounting = process of calculating the present value of a future cash flow. It is the opposite
of compounding.
❖ In the multi-period case, the formula for PV can be written as follows:
CT
PV =
(1 + r)T
- Often, the formula is written as: PV = CT × PV factor

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 III. Compounding periods

- Here C0 is the initial investment and r is the stated annual interest rate.
❖ Compounding over many years
- For an investment over one or more (T) years, the formula becomes:
- Future value with compounding:

Effective annual rate:

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 A. The annual percentage rate

❖ Annual percentage rate expresses the total cost of borrowing or investing as a percentage interest rate.
❖ The reason is that a credit agreement may not just include interest payments, but also management fees,
arrangement fees and other sundry costs that will affect the total charge for credit (TCC).
❖ To calculate it, we use the present value formula.

B. Continuous compounding

❖ We could compound semi-annually, quarterly, monthly, daily, hourly, each minute, or even more often.
❖ Limiting case would be to compound every infinitesimal instant, which is commonly called
continuous compounding.
Continuous compounding: Cn × er⋅T

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 IV. Simplifications

A. Perpetuity

❖ Perpetuity = constant stream of cash flows without end.

- Well-known case of an unending cash flow stream: the British bonds called consols.
- How can the price of a console be determined?
• Consider a console that pays a coupon of C (yearly interest) each year and will do so
forever.
• Applying the PV formula, we get:

- This is a geometric series and it has a finite sum.

❖ The present value of the consol is the present value of all of its future coupons. In other words, it is an
amount of money that, if an investor had it today, would enable him to achieve the same pattern of
expenditures that the consol and its coupons would.
- The amount that will give the investor C euros each year and the present value of the
consol is
C
simply: PV =
r
• C = coupon (the money that perpetuity will give you each year
• r – interest rate
❖ We can therefore say that the formula for present value of perpetuity is

B. Growing perpetuity

❖ Growing perpetuity happens when a rise in cash flows is expected to continue indefinitely.
❖ To calculate it, we use this beautiful long-ass shitshow of a formula:

- Where C is the cash flow to be received one period

- g is the rate of growth per period, expressed as a percentage
- r is the appropriate discount (interest) rate.
Fortunately there is an easier formula:

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 ❖ Three important points about this formula
- Numerator: not the cash flow at date t=0
- Discount rate and growth rate: r > g for the formula to work.
- Timing assumption: this formula assumes that cash flows are received and disbursed at regular and
discrete points in time.

C. Annuity

❖ Annuity = a level stream of regular payments that lasts for a fixed number of periods.
- To calculate the present value of an annuity we need to evaluate the following equation:

❖ All in all, here’s the formula for present value of annuity:

If you want to compute the Future Value of a stream of level payments (C) over T years you can
use the Annuity Factor (ATr). This factor indicates the present value of 1$ per year, for T years,
at an interest rate of r.

❖ We can also use a formula for the future value of an annuity

Annuity factor

D. Growing Annuity

❖ Growing annuity = a finite number of growing cash flows. Here’s the formula for present value of
growing annuity:
g as a % !!!

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PV of an Annuity in a nutshell:

The present value of an annuity is the current value of future payments from an annuity,
given a specified rate of return, or discount rate. The higher the discount rate, the lower
the present value of the annuity.

➔ The present value of an annuity refers to how much money would be

needed today to fund a series of future annuity payments.

USEFUL TRICKS WITH ANNUITY

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 CHAPTER 6: NET PRESENT VALUE AND OTHER INVESTMENT RULES

I. Payback period method

A. Defining the rule

❖ A particular cut-off date, say 2 years, is selected. → All investment projects that have payback
periods of 2 years or less are accepted, and all of those that pay off in more than 2 years – if at all –
are rejected.
❖ The payback period is the period that takes a firm to recover its original investment in a project

Example:
You take a date (for example, 4 years from now), and you invest into the projects that will have
paid back the initial investment by then, and you reject the projects that will not.

So, if for example, you have to invest €50,000 now, in a project that supplies you with a positive cash
flow of €200,000 in 5 years, you will not accept the investment, because you will not have the €50,000
back in 4 years yet.

B. Problems with the payback method

❖ Problem 1:Timing of Cash Flows within the Payback Period.

- The payback method does not consider the timing of the cash flows within the payback period.
- The payback method is inferior to NPV because the NPV discounts the cash flows properly.
❖ Problem 2: payments after the payback period.
- The payback method ignores all cash flows occurring after the payback period.
- The NPV method doesn’t have this flaw because it takes all cash flows into account.

❖ Problem 3: Arbitrary standard for payback period.

- Capital markets help us estimate the discount rate used in the NPV method. But there is no
comparable guide for choosing the payback cut-off date so the choice is somewhat arbitrary.

Summary of payback:
❖ It’s wrong.
❖ But because of its simplicity it is often used as a screen for making minor investment decisions.

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 II. The discounted payback period

❖ Under this approach, we first discount the cash flows. Then we ask how long it takes for the
discounted cash flows to equal the initial investment.
❖ But also some issues. Like playback, discounted payback first requires us to make a somewhat magical choice
of an arbitrary cut-off period, and then it ignores all cash flows after that date.

III. The average accounting return (AAR)

A. Defining the rule

❖ The Average Accounting Return:

Average Project Earnings after taxes and depreciation
AAR =
Average book value of the investment during its life

❖ Steps in using ARR method:

- Step 1: Determining Average Net Income. In any year:
Net income = Net cash flow – Depreciation and Taxes.
In order to calculate the average net income over X years, divide the sum of all net
incomes by X
- Step 2: Determining Average Investment:
• We use the initial investment and subtract every year the amount for depreciation.
• Calculating the average amount invested over X years you have to divide by X+1
years
So it will be: (500+400+300+200+100)/6 = 250
- Step 3: computing AAR

Example:

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❖ AAR takes no account of timing just as payback requires an arbitrary choice of the cut-off date, the AAR
method offers no guidance on what the right targeted rate of return should be.

IV. The internal rate of return method

❖ IRR is the rate that causes the NPV of the project to be zero. The general investment rule is
Accept the project if the IRR is greater than the discount rate. Reject the project if the IRR is less
than the discount rate.
❖ We also have:
- If IRR > Discount rates ➔ positive NPV.
- If IRR < Discount rates ➔ negative NPV.

V. Problems with the IRR approach

A. Two general problems affecting both independent and mutually exclusive projects

❖ Problem 1: investing or financing

- Rule: Accept the project when the IRR is less than the discount rate. Reject the project when the
IRR is greater than the discount rate.
- If a firm has $100 to spend, it can either:
• Invest it in a project A ➔ investing.
• Or lend it to a bank as a project B ➔ financing.
❖ Problem 2: Multiple Rates of Return
- A project can have varying rates of return.
- This can be due to inflows and outflows occurring right after the initial investment.
❖ NPV rule tells us to accept the project based on the discount rate.
❖ The guarantee against multiple IRRs: if there is only one sign change in the cash flows, there can
only be one IRR.

❖ Summary of the general rules:

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 B. Problems specific to mutually exclusive projects (IRR)

❖ The scale problem

- Example
• Consider two opportunities
A) Give me €1 now and I’ll give you €1.50 back at the end
B) Give me €10 and I’ll give you €11 back.
• Which one to choose? Project B because NPV is higher than A

• But accordant to IRR, we should choose A.

- IRR is that it ignores issues of scale.
- To handle the original example, we can:
• Compare NPVs of the two choices.
• Calculate incremental NPV from making the large-budget picture instead of the small-
budget picture.
• Compare the incremental IRR to the discount rate.
- Whatever you do, never compare the two IRRs

Timing problem:

However, you should cat compare the IRR of project A with the IRR of project B. All three approaches
give the same decision. We should not compare the I RRs of the two projects because we will choose
the wrong option - i.e. the small-budget project. Below is an example that illustrates the timing problem.
Note: calculating incremental cash flows - subtracting the smaller project's cash flows from the bigger
project's cash flows leaves an outflow of 0.

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The better project can be chosen with one of three methods:
1. Compare NPVs of the two projects - if the discount rate is below 10.55% then choose B as it
has a higher NPV but if it is higher than 10.55% then choose A as it has a higher NPV;
2. Compare incremental IRR to discount rate- subtract the cash flows of A from the cash flows of
Band then calculate the IRR;

The incremental IRR is 10.55%, if the relevant discount rate is below that, then project Bi s preferred.

3. Calculate NPV on incremental cash flows - if this is positive choose Band if negative choose A.
What to do if two projects have the same initial investment?

➔ You should do the subtraction so that the first non-zero cash flow is negative.

Good example of incremental IRR:

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 VI. The profitability index

❖ Profitability index = a tool for ranking projects because it allows you to quantify the amount of value
created per unit of investment.

A. Calculation of profitability index

❖ It is the ratio of the present value of the future expected cash flows after initial investment divided by the
amount of the initial investment.

PV of cash flows subsequent to initial investment

Profitability Index (PI) =
Initial investment

❖ Application of the profitability index - three situations:

- Independent projects: PI decision rule is
• Accept independent project if PI > 1
• Reject it if PI < 1.
- Mutually exclusive projects: the profitability index has the same issue with regards to timing as the
IRR method, it ignores differences of scale for mutually exclusive projects.
- Capital rationing – the situation when a firm does not have enough capital to take on all
projects with a positive NPV, so they use a combination of projects that yield the higher
NPV → In this case you use PI ratio to rank different projects!

VII. The Modified Internal Rate of Return (p.165)

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VIII. Margin of Safety (p.166)

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CHAPTER 5: BOND EQUITY AND FIRM VALUATION

I. Definition and example of a bond

❖ Bond = a certificate showing that a borrower owes a specified sum. The borrower has agreed to repay
the principal and an interest payment on designated dates.
❖ Many types of bonds and issuers include:
- Corporations,
- Private firms,
- Governments, the government bond market is one of the most liquid in the world.

II. How to value bonds

A. Pure discount bonds

❖ Pure discount bonds = simplest kind of bond. Promises a single payment at a fixed future date. If payment
is 1 year from now, it’s called a 1-year-discount bond.
❖ Maturity date of a bond = date when the issuer of the bond makes the last payment.
- The bond is said to mature or expire on the date of its final payment.
- Payment at maturity date is termed the bond’s face or par value.
❖ Often called zero coupons bonds because the holder perceives no cash payments until maturity.
❖ Consider a pure discount bond that pays a face value of in years where the interest rate is each year
(market interest rate).The present value of the face amount is calculated as:

Value of a pure discount

bond:

- F – face value of a bond

- R – Market interest rate

❖ Typical bonds offer payment not just at maturity but also at regular times in between. These payments are
called the coupons of the bond.
❖ The value of a bond is simply the present value of its cash flows.The value of a coupon
bond is simply the present value of its stream of coupon payments plus the present
value of its repayment of principal.

T
‣ where AR is the present value of an annuity of $1 per period for
periods at an interest rate per period of.
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 B. Consols

❖ Consols = bonds that never stop paying a coupon, have no final maturity date, and therefore never
mature. It is a perpetuity.

III. Bond concepts

A. Interest rates and bond prices

❖ Bond prices fall with a rise in interest rates and rise with a fall in interest rates.
❖ General principle is that a level coupon bond sells in the following way:
- At the face value ➔ Coupon rate = Market-wide interest rate.
- At a discount ➔ Coupon rate < Market-wide interest rate.
- At a premium ➔ Coupon rate > Market-wide interest rate.

B. Yield to maturity

❖ Bond’s yield to maturity = the discount rate that equates the price of the bond with the
discounted value of the coupons and face value. (“Bond has a yield (to maturity) of x%)

IV. The present value of equity

A. Dividends versus capital gains

❖ In this section, we aim to value ordinary shares.

❖ Equity provides two kinds of cash flows: pay dividends on a regular basis and shareholder receives the
sales price when they are sold
❖ To value equity, we need to know whether is it equal to
- The discounted present value of the sum of next period’s dividend plus next period’s share price
- The discounted present value of all future dividends.
❖ Both are right.
- If an individual buys equity and hold it for one year and is willing to pay P0 for the share today.

She calculates:

• Where Div1 is the dividend paid a the end of the year

• P0 is the PV of the equity investment.
• R is the appropriate discount rate for the equity.

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 - P1 comes from a buyer at the end of year 1 who is willing to purchase the equity for P1. This buyer
determines the price as follows:

❖ If we continue this, we can see that the value of a firm’s equity to the investor is equal to the present
value of all of the expected future dividends. This is:

❖ Common objection to this method: an investor will generally not look past his or her time horizon.

B. Valuation of different types of equities

❖ Zero growth:
- Value of an equity with a constant dividend is given by

- It is assumed that Div 1 = Div 2 = … = Div

❖ Constant growth

- Here, Div 1 is the dividend at the end of the first period.

- Th value of an equity security with dividends growing at a constant rate is

❖ Differential
growth

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 V. Estimates of parameters in the dividend growth model

A. Where does g come from

❖ We previously assumed that dividends grow at the rate g. We are looking to estimate that growth rate.
❖ In general:
Earnings next year = Earnings this year + Retained earnings this year x Return on retained earnings
❖ If we divide all of this by the earnings this year, it yields:

- The rendition ratio = ratio of retained earnings to earnings

- The left side is simply the 1 plus the growth rate in earnings, written as

- We can therefore simplify the first formula to:

1 + g = 1 + (Retention ratio × Return on retained earnings)
❖ Formula for firm’s growth rate:
g = Retention ratio × Return on retained earnings
*Dividend Payout Ratio: 1 – retention ratio

B. Where does R come from

❖ So far, R was taken as given.

❖ We calculated P0 as:

- In this formula, the first component, Div 1/P 0 is the dividend yield.
- The second part of the ratio is the growth rate g. It can be interpreted as the capital gains yield –
that is, the rate at which the value of the investment grows.
- Hence the formula for R is:
R = Dividend yield + Capital gains yield

In conclusion the share price of a dividend growth model can be calculated as :

𝐷𝑖𝑣1
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑠ℎ𝑎𝑟𝑒 𝑡𝑜𝑑𝑎𝑦 =
𝑅−𝑔

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 VI. Growth opportunities

❖ If a company has a level stream of earnings per share in perpetuity, it pays all of these earnings out as
dividends and we have:
❖ The value for a share of equity when firm operates as a cash cow is:

❖ Growth opportunities = opportunities to invest in profitable projects.

- Firms often think of in terms of sets of growth opportunities
- Suppose firm retains all of earnings at t=0 to invest in a particular capital budgeting project.
- NVPGO =. Net present value (per share) of the growth opportunity.
- Share price after firm commits to project:

❖ In this equation, it can be seen that share price is the sum of two different items:
- EPS/R ➔ value of the firm if it rested on its laurels.
- NPVGO is the additional value if the firm retains earnings to fund new projects.

➔ Computing Value of a firm in NPV model:

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 A. The no-dividend firm - The actual application of the dividend discount model is
difficult for firms of this type

VII. The dividend growth model VS the NPVGO model

❖ To illustrate main differences, an example with Manama books

- EPS = €10 at the end of first year
- Dividend payout ratio = 16%
- Return on retained earnings = 20%
❖ We wish to calculate the price per share using both the dividend growth model and the NPVGO model

A. The dividend growth model

❖ Dividends at t=1 are 0,4 x 10 = €4 per share.

❖ Retention ratio is 0,60 (1 – 0,40)
❖ Growth rate in dividends is 0,12 (= 0,60 x 0,20)

B. The NPVGO model

❖ We need to calculate on a per-share basis:
2. Net present value of a single growth opportunity
3. Net present value of all growth opportunities
4. The share price if the firm acts as a cash cow (value without growth opportunities)
❖ Value of the firm is the sum of 2 and 3.

1. Value per share of a single growth opportunity

- Out of EPS of €10 at t=1, firm retains €6.
- Firm earns €1,20 per year in perpetuity on that €6 investment
- NPV from the investment is:
€1,20
−6 + = €1,50
0,16

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 2. Value per share of all opportunities
- Growth rate of earnings and dividends are 12%.
- Retained earnings must also grow at 12%.
- Retained earnings at date 2 are €6,72 (= €6 x 1,12), retained earrings at date 3 are €7,5264 (= €6
x (1,12)2)…
- Projects will always earn 20% per year, firm earns €1.344 (= €6.72 × 0.20) in each future year.
- NPV per share generated from investment at date 2:
€1,344
−6,72 + = €1,68
0,16
- And so on, for every year, it is a growth perpetuity whose value is:
€1,50
NPVGO = = €37,50
0,16 − 0,12
- Firm’s policy of investing in new projects from retained earnings has an NPV of €37,50

3. Value per share of if the firm is a cash cow

- Dividends would be €10.
- No growth, value per share would be evaluated by perpetuity formula

❖ Summation: share price is the value a cash cow plus the value of the growth opportunities.
❖ Hence value is the same whether calculated by a discounted dividend approach or a growth opportunities
approach.

VIII. Firm valuation

A. Valuation of a firms’ cash flows

❖ One way to think about the question of how much a firm is worth is to calculate the present value
of its future cash flows.
❖ The value of the firm is found by multiplying the net cash flows by the appropriate present value factor. It is
simply the sum of the present values of the individual net cash flows.

B. The price-earnings ratio

❖ We previously found that:

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❖ If we divide on both sides by EPS, we get:

❖ The left side of the formula is the price-earnings ratio (PE ratio).
- Calculated as

- It is related to the net present value of growth opportunities

C. Buying back shares instead of paying dividends (FCFF)

❖ In some countries, firms repurchase equity from shareholders as a substitute for paying dividends ➔
makes dividend valuation models more difficult to implement because must not only value dividends but
also value the present value of future share repurchases.
❖ In order to incorporate to our firm valuation model we calculate Free Cash Flow to the Firm:
❖ Free can flow to the firm (FCFF) can be calculated from either the income statement or the
cashflow statement.

FCFF =Cash flow from operations + Cash flow from investing activities + Net interest
payment x (1-Tax rate)

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 CHAPTER 9: RISK AND RETURN: LESSONS FROM MARKET HISTORY

I. Returns

A. Monetary returns

❖ The return one gets on investment in shares comes in two components:

- Dividends income ➔ income component of return.
- Capital gain (loss) on the investment. It is calculated as:

Gain (loss) on investment = (Market price t1 − Market price t0) × Number of shares

❖ The total monetary retain on investment is the sum of the dividend income and the capital gain or loss.

Total Monetary Return = Dividend income + Capital Gain (loss)

B. Percentage returns

How much return do we get for each unit of currency invested.

- Notations:
• t is the date
• Pt is the price of the equity at the beginning of the year
• Div t+1 is the dividend paid on the equity during the year.
- The percentage income return is calculated as:

- The capital gain (loss) is the change in the price shares divided by the initial price, with Pt+1 the
price at the end of year 1:

- The total return on investment, labeled Rt+1 is:

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 II. Holding period returns

❖ The holding period return is the return on an asset or portfolio over the whole period during
which it was held. It is one of the simplest and most important measures of investment
performance.

➔ It shows what the value of an investment would have been if the money that you initially
invested had been left in the stock market and if the dividends every year would be
reinvested in more shares. Formula:

(1+R1) x (1+R2) x … x (1+RT)

III. Return statistics

❖ To summarize the history of the financial markets , we use two measures:

❖ Average return: helps describe and estimate the return that an investor could have realized in a
particular year over a period. It is a mean calculated as:

❖ The frequency distribution of the return is also used:

Average return on FTE stock between 1990 and 2010

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 IV. Average stock returns and risk-free returns

❖ Having compared average return on the market, compare it with the returns of other securities. Best
comparison is with the low-variability returns in government bond market.
❖ Governments issue treasury bills (most often pure discount). Thanks to its control over the price of taxes,
the government has virtually no debt ➔ risk-free return over a short time (one year or less).
❖ Excess return on a risky asset = difference between risky returns and risk-free returns.
- Excess because is it the additional return resulting from the riskiness of equities
- It is interpreted as equity risk premium
- This mean: The higher the risk on your investment the higher the average return
must be for you to accept the risk

❖ Equity risk premium relates to two securities:

- Long-term government bonds,
- Short-tern treasury bills.

V. Risk statistics

Risk can be measured as the spread of returns over a period (standard deviation) → If the
distribution is very spread out the returns that will occur are very uncertain

A. Variance

❖ Variance and square root are the more common measures of variability or dispersion.

❖ Formulas:

B. Normal distribution and its implications for standard deviation

❖ In the normal distribution, the

probability of having a
return that is above or
below the mean by a
certain amount depends
only on the standard
deviation.

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Other measures of risk:
❖ The semi variance is:

- n is the number of observations below the target

- rt is the observed return
- Target is the target reign (historical return)
❖ This measure has the advantage that only deceptions below the target are considered in the risk measure.
❖ Another measure of risk in investment returns is that of skewness
- Skewness= the extent to which a distribution is skewed to the left or right.
• Negative skew (skewness < 1)➔ negative returns
• Positive skew (skewness > 1)➔ positive returns.
- To measure it, divide the proportion of variation that is caused by upside deviations from the
means by the proportion of variation caused by downside deviations from the mean.

% 𝑣𝑎𝑟𝑎𝑡𝑖𝑜𝑛 𝑐𝑎𝑢𝑠𝑒𝑑 𝑏𝑦 𝑢𝑠𝑝𝑖𝑑𝑒 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑚𝑒𝑎𝑛

𝑠𝑘𝑒𝑤𝑛𝑒𝑠𝑠 𝑟𝑖𝑠𝑘 =
% 𝑣𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 𝑐𝑎𝑢𝑠𝑒𝑑 𝑏𝑦 𝑑𝑜𝑤𝑛𝑠𝑖𝑑𝑒 𝑑𝑒𝑤𝑖𝑎𝑡𝑖𝑜𝑛 𝑓𝑟𝑜𝑚 𝑚𝑒𝑎𝑛

❖ A second measure of risk is kurtosis

- A measure of the frequency of very negative and very positive returns.
- No formula because complicated af.

C. Value at risk (VaR)

❖ To calculate it:
- Step 1: Find the monthly mean and standard deviation of the fund’s returns
- Step 2: calculate the negative return that will occur 1 per cent of the time
- Step 3: calculate VaR

VaR = Value of portfolio x (-R1% monthly)

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Example:

VI. More on average returns

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 ❖ Example:
- Data:
• You buy a particular equity for $100.
• First year you own it, it falls to $50,
• Second year you own it, rises back to $100
- What is the average return on investment?
• If we calculate the returns year-by-year, lost 50% the first year and made 100% the second,
hence (–50 + 100)/2 = 25%

❖ 0% is the geometric average return, helps understand what was your average compound return per
year over a particular period.
❖ 25% is the arithmetic average return, helps understand what was your return in an average year
over a particular period.

Blume’s Formula
We use it to calculate T-year average return forecast for future years.

𝑇−1 𝑁−𝑇
𝑅(𝑇) = × 𝐺𝑒𝑎𝑚𝑒𝑡𝑟𝑖𝑐 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 + × 𝐴𝑟𝑡ℎ𝑚𝑒𝑡𝑖𝑐 𝑎𝑣𝑒𝑟𝑎𝑔𝑒
𝑁−1 𝑁−1

➔ Geometric and Arithmetic averages from N years of data to form a prediction of

T years average return!
Example:

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 CHAPTER 10: RISK AND RETURN:THE CAPITAL ASSET PRICING MODEL
(Most important info + formulas – the rest in textbook + summary)

Example of variance and expected value:

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COVARIANCE AND CORRELATION:
How to calculate covariance and correlation:

If the two returns are positively related to each other, they will have a positive covariance,
If they are negatively related to each other, the covariance will be negative.
If they are unrelated, the covariance should be zero

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Example:

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Return and risk for portfolios

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The efficient set for two assets:

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36 of 61 2019 - 2020
The efficient set for multiple securities

The shaded area represents all the possible combinations of expected return and
standard deviation for a portfolio. For example, in a universe of 100 securities, point 1
might represent a portfolio of, say, 40 securities. Point 2 might represent a portfolio of
80 securities. Point 3 might represent a different set of 80 securities, or the same 80
securities held in different proportions, or something else:

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Variance and Standard Deviation in a Portfolio of Many Assets

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Suppose we make the following three assumptions:

N – number of all securities

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The optimal portfolio

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Market Equilibrium

Beta – measures the responsiveness of a security to movements in the market portfolio

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The interpretation of beta: from Figure 10.10 is intuitive. The graph tells us that the
returns of Hicks are magnified 1.5 times over those of the market. When the market
does well, Hicks’ equity is expected to do even better. When the market does poorly,
Hicks’ equity is expected to do even worse. Now imagine an individual with a portfolio
near that of the market who is considering the addition of Hicks to her portfolio.
Because of Hicks’ magnification factor of 1.5, she will view this security as contributing
much to the risk of the portfolio.

Formula for beta:

THE CAPITAL ASSET PRICING MODEL (CAPM)

Economists frequently argue that the expected return on the market can be
represented as:

➔ It is generally argued that the place to start looking for the risk premium in the
future is the average risk premium in the past.

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This formula, which is called the capital asset pricing model (or CAPM for short), implies
that the expected return on a security is linearly related to its beta. Because the
average return on the market has been higher than the average risk-free rate over long
periods of time, is presumably positive. Thus, the formula implies that the expected
return on a security is positively related to its beta. The formula can be illustrated by
assuming a few special cases:

Equation for CAPM can be represented graphically by the upward-sloping line in Figure
10.11. Note that the line begins at RF and rises to when beta is 1. This line is frequently
called the security market line (SML).
As with any line, the SML has both a slope and an intercept. RF the risk-free rate, is
the intercept. Because the beta of a security is the horizontal axis, RM – RF is the slope.
The line will be upward-sloping as long as the expected return on the market is greater
than the risk-free rate.
➔ The beta of the portfolio is simply a weighted average of the betas of the two
securities!

Variations of the CAPM

This view has led to a variation of the CAPM, known as the Consumption Capital
Asset Pricing Model, or CCAPM. Systematic risk, or beta, in the CAPM measures the
covariance of security returns with market returns. However, in the CCAPM, beta is
slightly more complex. The CCAPM is expressed as follows:

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The Human Capital CAPM, or HCAPM
According to the HCAPM, the return on the expected market portfolio is a linear
combination (weighted by the relative investment of assets) of the expected return on
the underlying financial portfolio and the underlying non-financial portfolio. If δ
represents the fraction of total wealth that is invested in non-financial assets (or
human capital), Rnf and Rf represent the expected returns on non-financial and
financial assets respectively, the expected return on the market is equal to:

In this form, the expected return on a security is expressed as follows:

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Chapter 12: Risk, costs of capital and capital budgeting

The discount rate of a project should be the expected return on a financial asset of comparable
risk.

From the firm’s perspective, the expected return is the cost of equity capital. Under the CAPM, the
expected return on a security can be written as:

• The risk-free rate, RF

• The market risk premium, RM – RF
• The company beta, β.

Example:

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FORMULA FOR BETA:

Two ways of computing beta:

- Use the industry beta (operations of firm like the operations of the industry)
- Use the company beta (operations are different)

Determinants of BETA:

1. Cyclicality of Revenues

The revenues of some firms are quite cyclical. That is, these firms do well in the expansion phase of
the business cycle and do poorly in the contraction phase.

Empirical evidence suggests hi-tech firms, retailers and automotive firms fluctuate with the business
cycle.

Because beta is the standardized covariance of a security’s return with the market’s return, it is not
surprising that highly cyclical securities have high betas.

2. Operating Leverage

Business risk depends both on the responsiveness of the firm’s revenues to the business cycle and on
the firm’s operating leverage.

Firms that incur higher proportion of fixed costs to variable costs are said to have higher
operating leverage

EBIT of the firm with grater fixed costs is more response to changes in sales volume (technology B)

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 3. Financial Leverage and Beta

Financial leverage is the extent to which a firm relies on debt, and a levered firm is a firm with some
debt in its capital structure.

Because a levered firm must make interest payments regardless of the firm’s sales, financial leverage
refers to the firm’s fixed costs of finance.

➔ Higher beta is associated with firms that have a higher financial leverage

Imagine an individual who owns all the firm’s debt and all its equity. In other words, this
individual owns the entire firm. → What is the beta of her portfolio of the firm’s debt and equity?

As with any portfolio, the beta of this portfolio is a weighted average of the betas of the individual
items in the portfolio. Let D stand for the market value of the firm’s debt and E stand for the market
value of the firm’s equity. We have:

The beta of debt is very low in practice. If we make the common assumption that the beta of debt is
zero, we have:

Asset beta – the riskiness of the asset

➔ If a project’s beta differs from that of the firm, the project should be discounted at the rate
commensurate with its own beta.

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THE COST OF CAPITAL WITH DEBT

Suppose a firm uses both debt and equity to finance its investments. If the firm pays Rd for its
debt financing and Re for its equity. → The cost of equity is Re, as discussed in earlier sections.
The cost of debt is the firm’s borrowing rate, Rd, which we can often observe by looking at the yield to
maturity on the firm’s debt.

If a firm uses both debt and equity, the cost of capital is a weighted average of each.

Of course, interest is tax deductible at the corporate level, a point to be treated in more detail in a
later chapter. The after-tax cost of debt is:

WEIGHTED AVERAGE OF COST OF CAPITAL:

Example

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*We are using WACC as the discount rate for particular firm’s projects!

LIQUIDITY

Equities that are expensive to trade are considered less liquid than those that trade cheaply.

Costs of trade (security):

Brokerage fees - pay a broker to execute a trade.

The bid–ask spread - Suppose the broker provides a quote of 100.00–100.07. This means that you
can buy at £100.07 per share and sell at £100 per share. The spread of £0.07 is a cost to you
because you are losing £0.07 per share over a round-trip transaction (over a purchase and a
subsequent sale)

Market impact costs – The price drop associated with a large sale and the price rise associated with
a large purchase are the market impact costs.

ECONOMIC VALUE ADDED (EVA)

We use it to assess performance of a firm based on passed values.

The performance first if all can be measured by a company’s ROA:

𝐴𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑒𝑎𝑟𝑛𝑖𝑛𝑔

𝑅𝑂𝐴 =
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑜𝑟 𝑎𝑠𝑠𝑒𝑡 𝑏𝑎𝑠𝑒

If ROA is larger than the CC (cost of capital) the project should be accepted!

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EVA formula:

(ROA – Weighted average cost of capital) * Total Capital =

= Earnings after tax – (Weighted cost of capital * Total capital)

➔ EVA is a monetary value. Project should be accepted if EVA > 0

Thus, EVA can simply be viewed as earnings after capital costs. Although accountants subtract
many costs (including depreciation) to get the earnings number shown in financial reports, they do not
subtract out capital costs.

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 CHAPTER 7: MAKING CAPITAL INVESTMENT DECISIONS
I. An example of HOW TO DO CAPITAL BUDGETING IN PRACTICE

In any capital budgeting analysis the broad steps to follow are:

1) Calculation of depreciation for each year
2) Generation of the income statement to identity the tax that is due to be paid
3) Construction of the cash flow forecast to generate cash flows
4) Investment appraisal analysis using the techniques from chapter 6.

Here’s the project:

1) Calculation of depreciation for each year

In Europe, assets are depreciated by capital allowances or tax depreciation, which entails that assets
are depreciated by a certain percentage every year

Cost of facilities = $3.000.000

Capital allowances rate on plant and machinery is 20 per cent per annum

Year 1 2 3 4 5

Initial value 3 000 000 2 400 000 1 920 000 1 536 000 1 228 800

Depreciation 600 000 480 000 384 000 307 200 228 800

Residual value 2 400 000 1 920 000 1 536 000 1 228 800 1 000 000

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 2) Generation of the income statement to identity the tax that is due to be paid

Operating revenues and costs:

Year 1 2 3 4 5

Quantity 8 12 24 20 12
produced
Price 200 000 204 000 208 080 212 241,6 216 486,432

Sales Revenue 1 600 000 2 448 000 4 993 920 4 244 832 2 597 837,184

Cost per unit 100 000 110 000 121 000 133 100 146 410

Operating costs 800 000 1 320 000 2 904 000 2 662 000 1 756 920

Income statement:

Year 1 2 3 4 5

Sales 1 600 000 2 448 000 4 993 920 4 244 832 2 597 837,184

Operating costs 800 000 1 320 000 2 904 000 2 662 000 1 756 920

Depreciation 600 000 480 000 384 000 307 200 228 800

Income before 200 000 648 000 1 705 920 1 275 632 612 117,184
tax
Tax (at 20%) 40 000 129 600 341 184 255 126,4 122 423,4368

Net income 160 000 518 400 1 364 736 1 020 505,6 489 693,7

3) Cash flow forecast

❖ Net working capital = the difference between current assets and current liabilities

Changes in net working capital:

Year 0 1 2 3 4 5

Net working 100 000 100 000 160 000 250 000 210 000 0
capital
Change in net 100 000 0 60 000 90 000 -40 000 -210 000
working
capital
Cash flow -100 000 0 -60 000 -90 000 40 000 210 000

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❖ Investment cash flows = arise from any expenditure in assets that are required to undertake the
project.
- Production facilities
- Opportunity cost of not selling vacant lot
- Market research cost
- Investment in working capital

Investment cash flows (at end of year) consist of 4 parts:

Year 0 1 2 3 4 5

Manufacturing -3 000 000 1 000 000

facilities
Opportunity -1 500 000 1 500 000
cost
Net working -100 000 0 -60 000 -90 000 40 000 210 000
capital
Investment -4 600 000 0 -60 000 -90 000 40 000 2 710 000
cash flows

Operating cash flows (at end of year): cash flows arising from the investment itself. (They
need to be positive to be worthwhile);
- to generate the operating cash flow, depreciation is added to the net income;
- the net cash flow is obtained by adding up the investment and the operating cash flows

Year 1 2 3 4 5

Net income 160 000,00 518 400,00 1 364 736,00 1 020 505,60 489 693,75

Add 600 000,00 480 000,00 384 000,00 307 200,00 228 800,00
depreciation
Operating cash 760 000,00 998 400,00 1 748 736,00 1 327 705,60 718 493,75
flows

❖ Net cash flow

Net cash flows (at end of year):

Year 0 1 2 3 4 5

Investment -4 600 000 0 -60 000 -90 000 40 000 2 710 000
cash flows
Operating 760 000 998 400 1 748 736 1 327 706 718 494
cash flows
Net cash flow -4 600 000 760 000 938 400 1 658 736 1 367 706 3 428 494

4) Investment appraisal analysis

❖ Using NPV:
- NPV = £821,934.75
- IRR = 17.48 per cent.
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Note that you add the depreciation that you calculate in step 1 to the net income when you look at the
cash flows in step 3. This is because the net income that is given, is always the net income as an
accountant would see It.

More about Net Working Capital

An investment in net working capital arises when:

• Inventory is made or purchased;
• Trade receivables are made instead of cash;
• Cash is kept in the project to account for unforeseen expenses.

The investments in net working capital is reduced by credit purchases, which generate trade payables.

net working capital = trade receivables + cash + inventory - trade payables

II. Inflation and capital budgeting

A. Interest rates and inflation

❖ If a bank offers one-year interest rate of 10 per cent.

- If one deposits $1,000, they will receive $1,100 in one year.
- May seem great but can’t be sure until we have looked at the inflation rate.

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❖ Here we have:
- Real interest rate = 3.8%
- Nominal interest rate/interest rate = 10%

❖ In general the formula between real and nominal interest rates:

Nominal Interest rate = (1 + Real Interest rate) × (1 + Inflation rate)

1 + Nominal Interest rate

Real Interest rate = −1
1 + Inflation rate

❖ We can use the following approximation: Real Interest rate Nominal Interest rate Inflation rate

B. Cash flow and inflation

❖ Nominal cash flow = the actual money in cash to be received (or paid out).
❖ Real cash flow = the cash flow’s purchasing power.

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 ➔ Nominal cash flows must be discounted at the nominal rate.
➔ Real cash flows must be discounted at the real rate.

III. Alternative definitions of operating cash flow

Suppose we have the following estimates:

EBIT (Earnings before Interest and Tax)= Sales - Costs - Depreciation= €200
Taxes= EBIT x t, (corporate tax rate)= €56

There are now four ways to determine operating cash flows,

1. OCF = EBIT + Depreciation-Taxes;

We are considering the following project

Sales = $1,500
Costs = $700
Depreciation = $600
EBIT = $1,500 – $700 – $600

A. The bottom-up approach

Project net income = EBIT - Taxes;

OCF = Project net income + Depreciation;

- Start with the accountant's bottom line (net income) and add back any non-cash
deductions such as depreciation. This OCF only works when there is no interest
expense subtracted in the calculation of net income.

B. The top-down
approach

❖ We start at the top of the income statement with sales and work our way down to net cash flow by
subtracting costs taxes and other expenses.
❖ We have: OCF = Sales – Costs – Taxes

C. The tax shield approach

❖ In this alternative, we use the following formula:

OCF = (Sales – Costs) x (1 – tc) + Depreciation x tc
❖ Here, OCF has two components:
- What the project’s cash flow would be if there were no depreciation expense
- Depreciation tax shield = the depreciation deduction multiplied by the tax rate.

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THE EQUIVALENT ANNUAL COSTS METHOD
Sometimes you have to decide between projects with unequal lives; the one lasts for longer than the
other. You can then calculate the Equivalent Annual Cost of each project.

Suppose a firm must choose between two machines of unequal lives. Both machines can do the
same job, but they have different operating costs and will last for different time periods. A simple
application of the NPV rule suggests taking the machine whose costs have the lower present value.
This choice might be a mistake, however, because the lower cost machine may need to be replaced
before the other one.

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Note that the above formula gives you the value of the EAC assuming the first payment is made at
the end of this year, at t=1! Do not forget that the above formula is a rearrangement of the NPV
formula, which assumes the first cash flow arrives at t=1.

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CHAPTER 8: RISK ANALYSIS, REAL OPTIONS AND CAPITAL BUDGETING

I. Sensitivity analysis, scenario analysis and break-even analysis

A. Sensitivity analysis and scenario analysis

❖ Here, the question is How can the firm get the net present value technique to live up to its potential?
❖ Sensitivity analysis = examines how sensitive a particular NPV calculation is to changes in
underlying assumptions. Aka what-if analysis and bop (best, optimistic and pessimistic) analysis.
❖ When one sees a project with a positive NPV, they are tempted to agree to it. But we have to check out
the project’s underlying assumptions on
- Revenues, can be market share size of market, price per unit…
- Costs, two types:
• Variable costs = change as the output changes, and they are zero when production is zero.
• Fixed costs = not dependent on the amount of goods or services produced during
the period. Usually measured per unit of time. They are fixed over a predetermined
time period.
❖ Standard sensitivity analysis calls for an NPV calculation for all the possibilities of a single variable
along with expected forecast for all other variables. For example:

But it has some drawbacks

• May increase the false sense of security among managers
• It treats variables in isolation when in reality they are likely to be related.
❖ To avoid these issues, managers often perform scenario analysis = variant of sensitivity analysis,
examines a number of different likely scenarios, where each scenario involves a confluence of factors.

B. Break-even analysis

❖ Break even analysis = approach that determines the sales needed to break even.
❖ We calculate the break even point in terms of both accounting profit and present value:

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Formulas
The following formulas are used when conducting a break-even analysis:

Contribution per unit = Sales price - Variable cost

This is also known as the pre-tax contribution margin. Each additional unit that you sell contributes
this amount to pre-tax profit.

Sum of constant annual costs = Fixed costs+ Depreciation

ACCOUNTING BREAK-EVEN - how much units of product you should sale to be at the break-
even:

FC – fixed costs
VC – Variable costs

PRESENT VALUE BREAK-EVEN :

Here’s a project with different sales assumptions:

When using NPV break-even, first of all we have to find Equivalent Annual Costs (EAC).

➔ The EAC must be higher than the yearly depreciation value!

➔ In addition to the initial investment's EAC, the firm has fixed costs each year and receives a
depreciation tax shield. These are the taxes that the firm does not have to pay because the
depreciation is tax-deductible

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The present value break-even point, therefore, tells us the sales required to offset the costs:

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 II. Monte Carlo simulation

❖ It’s another attest to model real-world uncertainty. It analyses projects the way one might analyze
gambling strategies.

❖ Scenario analysis follows specific scenarios, such as changes in inflation, government

regulation, or the number of competitors.

❖ EXAMPLE:: Backyard Barbeques (BB), a manufacturer of both charcoal and gas grills, has a blueprint for a
new grill that cooks with compressed hydrogen.

❖ Step 1: specify the basic model

- First, break up cash flows into three components (key inputs):
• Annual revenue

• Annual costs,

• Initial investment.

❖ Step 2: Specify a distribution for each variable in the model

➔ Specify the probability that a variable takes on a certain value. Do this for each of the variables
- Revenue
• Consultant first models overall market size = the number of grills sold by the entire
industry.

• Then determines the distribution of next year’s market share:

• Next year’s Price per grill = $190 + $11 x Industrywide unit sales (± $3).

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 ❖ Step 3: the computer draws one outcome
- Here we randomly sample values for each component to generate a constructed random
observation for each key input in the analysis.
- This step generates the cash flow for each year from a single outcome.
❖ Step 4: repeat the procedure

The first three steps generate one outcome, but the essence of Monte Carlo simulation is
repeated outcomes. Depending on the situation, the computer may be called on to generate
thousands or even millions of outcomes.
❖ Step 5: calculate NPV

Given the distribution of cash flow for the third year in Figure 8.4, one can determine the expected
cash flow for this year. In a similar manner, one can also determine the expected cash flow for each
future year and then calculate the net present value of the project

III. Real options

❖ Real options = adjustments that a firm can make after a project is accepted.
- Because they are omitted from the NPV method, we can say that NPV underestimated the true
value of a project.

A. The option to expand

B. The option to abandon

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IV. Decision trees (timing options)

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