10/24/23

Learning Outcomes
Financial 1. Knowledge
- Understanding the role of financial
Management 1 management within an organizational
context
- Calculate and evaluate investment
activities in a company
Lecturer: Dr. Nguyen Hong Thoa
2. Skills
College of Economics, CTU
Developing a broad range of financial
Email: [email protected] skills which are of particular relevance
to the roles of enabler and innovator
and business partner.
3. Attitudes
- Have ethical, disciplines in tax compliance
and other regulations related to financial
management.
- Have honest and objective attitudes in
conducting and solving issues in corporate
finance
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Assesment of Course Course Structure
1 Chapter 1: Overview of Financial Management
2 Chapter 2: Financial statement analysis
3 Chapter 3: Time value of Money
20 +++ 10 70 100
4 Chapter 4: Risk and return
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Midterm Exam Extra Grade Team Works Final Exam Congratulations!!
Chapter 5: Securities valuation
Multiple Classroom discussion on Multiple You got it!
6
Choice + Essay assignments the assigned Choice + Essay
topics Chapter 6: Cost of Capital
7 Chapter 7: Capital budgeting and investment
decision
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Reference
Ø Brigham, E. F. and Houston, J. F. (2007).
Fundamental of Financial Management. Mason,
Thomson/South-Western.
Ø Brealey, Myers, and Marcus. (2023). Fundamentals
of Corporate Finance. 11th ed. New York, NY:
McGraw-Hill Professional.
Chapter 1
An Overview of Financial Management
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1.1. What is Financial management? 1.1. What is Financial management?
Ø Finance within an Organization:
Ø Financial Management is the backbone of every business
whether small or vast. The success or failure of a business
depends upon the management of finances. However, the term
'Financial Management' is not limited to the procurement or
allocation of money.
Ø It includes planning, directing, monitoring, organizing, and
controlling of the monetary resources of an organization
Ø Main issues in financial management:
• Factors determining company’s stock price
• Managers’ choices to add value
• Ensuring sufficient cash levels
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1.1. What is Financial management? 1.1. What is Financial management?
Ø Forms of Organizations: Ø Forms of Organizations:
• Sole Proprietorship (Doanh nghiệp tư nhân): An unincorporated Sole Proprietorship
business owned by one individual. Partnership Corporation
• Partnership (Công ty hợp danh): An unincorporated business owned
by two or more persons. Who owns the business? The manager Partners Stockholders
• Corporation (Công ty cổ phần): A legal entity created by a state,
separate and distinct from its owners and managers, having unlimited Are managers and owners No No Usually
life, easy transferability of ownership, and limited liability. separate?
• Limited Liability Company (LLC) (Công ty TNHH): A relatively
What is the owner’s liability? Unlimited Unlimited Limited
new type of organization that is a hybrid between a partnership and a
corporation. Limited Liability Partnership (LLP): similar to an LLC
Are the owner and business
but used for professional firms in the fields of accounting, law, and taxed separately?
No No Yes
architecture. It has limited liability like corporations but is taxed like
partnerships.
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1.1. What is Financial management?
Sole Proprietorship
Ø Forms of Organizations:
• Advantages:
• Ease of formation
• Subject to few regulations
• No corporate income taxes
• Disadvantages:
• Limited life
• Unlimited liability
• Difficult to raise capital
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Partnership Corporation
• Advantages:
• Unlimited life
• A partnership has roughly the same advantages
• Easy transfer of ownership
and disadvantages as a sole proprietorship.
• Limited liability
• Ease of raising capital
• Disadvantages:
• Double taxation
• Cost of set-up and report filing
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Goals of the Corporation Agency Relationships
• The primary goal is shareholder wealth maximization, • An agency relationship exists whenever a
which translates to maximizing stock price. principal hires an agent to act on their behalf.
• Do firms have any responsibilities to society at large?
• Is stock price maximization good or bad for society? • Within a corporation, agency relationships exist
• Should firms behave ethically? between:
• Shareholders and managers
• Shareholders and creditors
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Shareholders versus Managers Shareholders versus Creditors
• Managers are naturally inclined to act in their • Shareholders (through managers) could take
own best interests. risky actions to maximize stock price, but are
• But the following factors affect managerial detrimental to creditors.
behavior: • In the long run, such actions will raise the cost
• Managerial compensation plans of debt and ultimately lower stock price.
• Direct intervention by shareholders
• The threat of firing
• The threat of takeover
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1.2. Roles of Financial management 1.2. Roles of Financial management
Ø Choice of sources of funds: There are various choices for a Ø Disposal of Surplus: The profit earned by the company needs
company when it comes to raising funds. It can either be to be divided among the shareholders in the form of a dividend
through shares debentures and loan from public deposits or on their shares. Thus, the finance manager declares the dividend
different financial institutions. The financial manager has to rate and after distributing the profits, the remaining part is
choose wisely while selecting the source of funds. He should retained by the company which is utilized for its expansion.
give preference to internal sources.
Ø Management of cash: Cash management is very essential as it
ensures constant working capital in the company. Various
miscellaneous payments, remunerations, current liabilities, etc
should usually be paid in cash by the finance manager.
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1.3. Elements of Financial management 1.3. Elements of Financial management
Ø Investment Decisions versus Financial Decisions:
Ø Investment Decisions: is the primary element of financial management. It
involves decisions related to investment in current and fixed assets. It is also
termed as working capital decisions and capital budgeting.
Ø Dividend Decisions: Proper distribution of profits among the shareholders
and the management of the company is essential. The decisions regarding
the profit division are taken by the finance manager. Usually, the dividend
rate is decided for the shareholders and some profits are retained in the
company for its growth.
Ø Financial Decisions: There are various circumstances under which a
company would require raising of finance either from internal or
external factors. Thus, the finance manager has to come up with the
different decisions for raising finances depending upon the source, cost
or the period of financing.
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1.3. Elements of Financial management 1.4. Objectives of Financial management
Ø Investment Decisions versus Financial Decisions Finance Management aims at the successful run of the business by managing
Ex: Are the following investment Decisions or financing decisions? the finances. There are certain objectives of financial management which
are listed below:
a. Intel spends $7 billion to develop a new microprocessor.
Ø Ensure regular supply of funds in the company.
b. BMW borrows €350 million from Deutsche Bank.
Ø Ensure optimum utilization of funds so as to gain maximum benefit in
c. Royal Dutch Shell constructs a pipeline to bring natural gas onshore minimum cost.
from a production platform in Australia.
Ø Ensure that the shareholders receive a regular return on their money
d. Avon spends €200 million to launch a new range of cosmetics in invested. This is dependent upon the market price of the share and profit
European markets. earnings of the company.
e. Pfizer issues new shares to buy a small biotech company. Ø Maintain a proper balance between the company’s debt and equity.
So, these were the fundamentals of financial management. Every finance
professional must be aware of these basics in order to plan and implement
effective financial management in an organization.
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1.5. Who is Financial Manager Who Is the Financial Manager?
• Chief Financial Officer (CFO).
• Financial policy.
• Corporate planning.
• Treasurer.
• Cash management.
• Raising of capital.
• Banking relationships.
• Controller.
• Preparation of financial statements.
• Accounting and taxes.
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1.5. Who is Financial Manager 1.5. Who is Financial Manager?
Ex: Fritz and Frieda went to business school together 10 years
ago. They have just been hired by a midsize corporation that
wants to bring in new financial managers. Fritz studied
finance, with an emphasis on financial markets and
institutions. Frieda majored in accounting and became a CPA
five years ago. Who is more suited to be treasurer and who
controller? Briefly explain.
(1) Cash raised from investors.
(2) Cash invested in firm.
(3) Cash generated by operations.
(4a) Cash reinvested.
(4b) Cash returned to investors.
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Summary of Chapter 1
What are the two major decisions made by financial managers?
What are the advantages and disadvantages of forming a
corporation?
Who are the principal financial managers in a corporation?
How do corporations ensure that managers act in the interest of
stockholders?
Is value maximization ethical?
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 2.1. Overview of Financial Statements
Income Statement
Balance Sheet (Báo cáo KQHĐKD)
(Bảng Cân Đối Kế toán)
02
01
Notes to the financial
04 statements
(Thuyết minh BCTC)
Cash Flow Statement
Chapter 2 (Báo cáo Lưu chuyển tiền tệ)
03
Financial Statements Analysis
1 2
2.1. Overview of Financial Statements 2.1. Overview of Financial Statements
2.1.1. Balance Sheet:
2.1.1. Balance Sheet: Example. Target’s balance sheet (figures in $ millions).
Ø Financial statement that shows the value of the firm’s assets and liabilities Assets 31/12/2020 31/12/2019 Liabilities and shareholders’ Equity 31/12/2020 31/12/2019
at a particular time. Current assets
Cash and marketable securities 2,577 1,556 Current liabilities
Ø Measured from an accounting perspective. Receivables 498 632 Debt due for repayment 161 1,052
Inventories 8,992 9,497 Accounts payable 9,920 9,761
The Main Balance Sheet Items Other current assets 835 834 Other current liabilities 4,406 4,201
Total current assets 12,902 12,519 Total current liabilities 14,487 15,014
Fixed Assets Long-term debt 11,338 10,223
Tangible fixed assets Other long-term liabilities 5,121 4,756
Property, plant, and equipment 48,183 46,185
Less accumulated depreciation 19,664 18,687 Total liabilities 30,946 29,993
Net tangible fixed assets 28,519 27,498
Shareholders’ equity
Intangible asset (goodwill) 686 699 Common stock and other paid-in capital 6,268 6,085
Other assets 672 574 Retained earnings 5,565 5,212
Total shareholders’ equity 11,833 11,297
Total Assets 42,779 41,290
Total liabilities and shareholders’ equity 42,779 41,290
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 Book Values and Market Values Book Values and Market Values 2
• Book Values Example: your firm has equity worth $6 billion, debt worth $4
• Value of assets or liabilities according to the balance sheet. billion, assets worth $10 billion. The market values your firm’s
100 million shares at $75 per share and the debt at $4 billion.
• Market Values
Q: What is the market value of your assets?
• The value of assets or liabilities if resold in a market.
Equity and asset “market values” are usually higher than
their “book values.”
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2.1. Overview of Financial Statements 2.1. Overview of Financial Statements
2.1.2. The Income Statement:
2.1.2. The Income Statement: Example. Target’s income statement, year ending February 1, 2020.
Ø Financial statement that shows the revenues, expenses, and net income of a $ Million % of Sales
firm over a period. Net sales 78,112 100.0%
Cost of goods sold 54,864 70.2%
Ø Measured from an accounting perspective. Selling, general & administrative expenses 16,233 20.8%
Depreciation 2,357 3.0%
Ø Earnings Before Interest and Taxes (EBIT) Earnings before interest and income taxes (EBIT) 4,658 6.0%
EBIT = total revenues − costs − depreciation Other income 21 0.0%
Interest expense 477 0.6%
Taxable income 4,202 5.4%
Taxes 921 1.2%
Net income 3,281 4.2%
Allocation of net income
Dividends 1,330 1.7%
Addition to retained earnings 1,951 2.5%
Source: Derived from Target annual reports. Q: What is Target’s EBIT?
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 2.1. Overview of Financial Statements 2.1. Overview of Financial Statements
Profits versus Cash Flows: Differences 2.1.3. The Statement of Cash Flows:
Ø Profits subtract depreciation (a non-cash expense). Ø Financial statement that shows the firm’s cash receipts and cash payments
Ø Profits ignore cash expenditures on new capital (the expense is capitalized). over a period of time.
Ø Profits record income and expenses at the time of sales, not when the cash Ø It starts with profits and converts to cash flows.
exchanges actually occur. Ø Free Cash Flow (FCF)
Ø Profits do not consider changes in working capital. • Cash available for distribution to investors after firm pays for new
investments or additions to working capita.
• Free cash flow = interest payments to debt investors + shareholders’
operating cash flow − capital expenditures.
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2.1. Overview of Financial Statements 2.1. Overview of Financial Statements
2.1.3. The Statement of Cash Flows: 2.1.3. The Statement of Cash Flows: (cont.) Q: Target’s FCF= ???
Target’s statement of cash flows 2020 (figures in millions of dollars). Cash flows from investments:
Capital expenditure (3,027)
Cash provided by operations:
Sales (acquisitions) of long-term assets 63
Net income 3,281
Other investing activities 20
Depreciation 2,604 Cash provided by (used for) investments (2,944)
Changes in working capital items Cash provided for (used by) financing activities:
Decrease (increase) in accounts receivable 134 Increase (decrease) in short-term debt 2,069
Decrease (increase) in inventories 505 Increase (decrease) in long-term debt 1,739
Decrease (Increase) In other current assets 229 Dividends (1,330)
Increase (decrease) in accounts payable 159 Issues (repurchases) of stock (1,415)
Other (77)
Increase (decrease) in other current liabilities 205
Cash provided by (used for) financing activities (3,152)
Total decrease (increase) in working capital 1,232
Net increase (decrease) in cash and cash equivalents 1,021
Cash provided by operations 7,117
Source: Calculated from data in Target’s Annual Report.
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 2.1. Overview of Financial Statements 2.2. Objectives and role of Financial Statements analysis
2.1.3. Notes to the financial statements 1. Financial performance assessment: Evaluate profitability, liquidity, and
solvency to understand your enterprise’s financial health.
Ø Notes to the financial statements disclose the detailed assumptions made by
2. More informed decisions: Analyze financial data and industry trends to make
accountants when preparing a company’s: income statement, balance
sound choices regarding investments, expansions, and strategic initiatives.
sheet, and the statement of cash flows. The notes are essential to fully
understanding these documents. 3. Managing risks better: Identify potential risks, vulnerabilities, and implement
measures to mitigate them effectively.
• The first notes in the series explain the “basis for accounting”—if cash
or accrual rules were used to prepare the documents—and the methods 4. Optimal use of resources: Optimize resource allocation, improve cost
used to report amortization/depreciation expenses. management, and enhance overall profitability.
• The rest of the notes explain, in greater detail, how the figures have been 5. Tracking progress: Monitor financial indicators over time to track
calculated. This gives the reader the information needed to do deeper performance, identify trends, and take corrective actions if necessary.
analysis. 6. Better communication with stakeholders: Present financial reports and
analyses to stakeholders, demonstrating transparency and building trust.
Ø Required statement for Vietnam, but optional statement for the other
countries 7. Compliance and regulations: Ensure compliance with financial regulations,
accounting standards, and reporting requirements.
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2.2. Objectives and role of Financial Statements analysis 2.2. Objectives and role of Financial Statements analysis
Market Value and Market Value Added (MVA – Giá trị thị trường gia tăng)
Ø Market Capitalization: Total market value of equity, equal to share
price times number of shares outstanding:
Market capitalization = (#shares) ! (price per share).
Ø Market Value Added: Market capitalization minus book value of equity.
MVA = market capitalization − equity book value.
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 2.2. Objectives and role of Financial Statements analysis 2.3. Financial Statements analysis
Economic Value Added (EVA – Giá trị kinh tế gia tăng) 2.3.1. Ratio analysis:
• which give us an idea of the firm’s ability to pay off
Ø EVA: The profit after deducting all costs, including the cost of capital, Liquidity ratios debts that are maturing within a year.
is called the company’s economic value added or EVA
EVA = After-tax operating income – (Cost of capital ! Total capitalization). Asset management • which give us an idea of how efficiently the firm is
• After-tax operating income = (1 − tax rate) ! interest expense + net income. ratios using its assets.
• Total capitalization = long-term debt + shareholder’s equity. Debt management • which give us an idea of how the firm has financed its
assets as well as the firm’s ability to repay its long-term
ratios debt.
Q: Target’s Market value, MVA, EVA?
Target’s common stock closed fiscal 2019 at a price of $109.53 per share. There were • which give us an idea of how profitably the firm is
Profitability ratios operating and utilizing its assets.
500 million shares outstanding
• which bring in the stock price and give us an idea of
Market value ratios what investors think about the firm and its future
prospects.
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Liquidity ratios (Nhóm tỷ số khả năng thanh khoản) Liquidity ratios (Nhóm tỷ số khả năng thanh khoản)
ØCurrent ratio (Khả năng thanh toán hiện thời): It indicates the extent to Ø Quick/Acid test ratio (Khả năng thanh toán nhanh): Used to examine
which current liabilities are covered by those assets expected to be whether firm has adequate cash or cash equivalents to meet current
converted to cash in the near future. obligations without resorting to liquidating non cash assets such as
!"##$%& '(($&(
inventories
Current ratio = !"##$%& '(($&( . /%0$%&1#*$(
!"##$%& )*+,*-*&*$( Quick/Acid test ratio =
!"##$%& )*+,*-*&*$(
• Higher ratio ensures firm does not face problems in meeting increased
working capital requirements • Inventories are typically the least liquid of a firm’s current assets; and if sales slow
• Low ratio implies repeated withdraws from bank to meet liquidity down, they might not be converted to cash as quickly as expected. Also, inventories
are the assets on which losses are most likely to occur in the event of liquidation.
requirements • As a thumb rule ideal QR = 1; should not be less than 1
• High CR as compared to other firms implies advantage of lower interest
rates from banks
Q: Target’s CR, QR?
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 Asset management ratio (Nhóm tỷ số quản lý tài sản) Asset management ratio (Nhóm tỷ số quản lý tài sản)
Ø Inventory Turnover Ratio (ITO – Số vòng quay hàng tồn kho): This ratio ØReceivables Turnover (Vòng quay các khoản phải thu): measures the firm’s
measure the number of times merchandise is sold and replaced during the year sales as a multiple of its receivables.
!1(& 12 3114( (1-4 :+-$( ;$<$*0+,-$(
ITO = Receivables Turnover = =
'0$#+3$ /%0$%&1#*$( '0$#+3$ ;$<$*0+,-$( '%%"+- :+-$(/567
• Higher ratio ensures that firms don’t tie up more capital than they need in raw materials • High ratio often indicates an efficient credit department that is quick to follow up on late
and finished goods. They hold only a relatively small level of inventories of raw materials payers.
and finished goods, and they turn over those inventories rapidly. • However, a high ratio may indicate that the firm has an unduly restrictive credit policy and
• Low ratio implies that it is holding too much inventory. Excess inventory is, of course, offers credit only to customers who can be relied on to pay promptly.
unproductive and represents an investment with a low or zero rate of return. With such a
low turnover, the firm may be holding obsolete goods that are one point in time. ØDay Sales Oustanding (DSO – Kỳ thu tiền bình quân): represents the average
length of time the firm must wait after making a sale before receiving cash.
Ø Average days in inventory (Số ngày hang hoá lưu kho): how many days of
output are represented by inventories. ;$<$*0+,-$( ;$<$*0+,-$(
DSO = =
567 '0$#+3$ :+-$( >$# 4+? '%%"+- :+-$(/567
Average days in inventory =
/89
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Asset management ratio (Nhóm tỷ số quản lý tài sản) Debt management ratios (Nhóm tỷ số quản lý nợ)
Ø Fixed Asset Turnover ratio (Tỉ lệ vòng quay tài sản): measures how effectively ØDebt Ratio (Tỷ số nợ): measures the percentage of funds provided by creditors .
the firm uses its plant and equipment 81&+- C$,&
Debt Ratio =
81&+- '(($&
:+-$(
Fixed Asset Turnover Ratio = • Total debt includes all current liabilities and long-term debt.
@$& A*B$4 '(($&(
• Creditors prefer low debt ratios because the lower the ratio, the greater the cushion
Ø Total Asset Turnover ratio (Tỉ lệ vòng quay tài sản): This ratio shows how against creditors’ losses in the event of liquidation.
much sales are generated by each dollar of total assets, and therefore it measures • Stockholders, on the other hand, may want more leverage because it can magnify expected
how hard the firm’s assets are working. earnings
:+-$( • Times-Interest-Earned Ratio (TIE – Số lần thanh toán lãi vay): measures the
Total Asset Turnover Ratio = extent to which operating income can decline before the firm is unable to meet
'0$#+3$ 81&+- +(($&(
its annual interest costs.
;$<$*0+,-$( DE/8
Q: Calculate Target’s Inventory Turnover Ratio, Average days in TIE = =
'0$#+3$ :+-$( >$# 4+? /%&$#$(& <F+#3$(
inventory, Receivables Turnover, Day Sales Oustanding, Fixed
Asset Turnover ratio, Total Asset Turnover ratio Q: Calculate Target’s Debt Ratio, TIE
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 Profitability ratios (Nhóm tỷ số sinh lời) Profitability ratios (Nhóm tỷ số sinh lời)
Ø Operating Margin (Doanh thu biên): gives the operating profit per dollar of sales: Ø Return on Total Assets (ROA - Tỷ suất sinh lời trên tài sản)
9>$#+&*%3 /%<1G$ (DE/8) @$& /%<1G$
Operating Margin = ROA =
:+-$( 81&+- '(($&(
Ø Profit Margin (Lợi nhuận biên): gives the net income per dollar of sales: Ø Basic Earning Power (BEP) Ratio (Sức sinh lời cơ sở)
DE/8
@$& /%<1G$ BEP =
Profit Margin = 81&+- '(($&(
:+-$(
• This ratio shows the raw earning power of the firm’s assets before the influence of
• a high return on sales is good taxes and debt, and it is useful when comparing firms with different debt and tax
• Notes: If a firm sets a very high price on its products, it may get a high return on each sale situations.
but fail to make many sales. That strategy might result in a high profit margin, low sales,
and hence a low net income. Ø Return on Equity (ROE - Tỷ suất sinh lời trên Vốn cổ phần)
@$& /%<1G$
ROE =
DJ"*&? +& (&+#& 12 ?$+#
Q: Calculate Target’s operating margin, profit margin, ROA, BEP, ROE
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Market value ratios (Nhóm tỷ số giá trị thị trường cổ phiếu) 2.3. Financial Statements analysis
2.3.2. Dupont analysis:
Ø Price/earnings (P/E) ratio: shows how much investors are willing to pay per dollar
of reported profits.
K#*<$ >$# (F+#$ • ROE reflects the effects of all of the other ratios, and it is the single best
P/E ratio = accounting measure of performance.
D+#%*%3( >$# (F+#$
• P/E ratios are relatively high for firms with strong growth prospects and little risk • The DuPont system links financial ratios together to explain how they work
• but P/E ratios are low for slowly growing and risky firms. together to determine the ROE.
Ø Market-to-Book Ratio: Ratio of market value of equity to book value of equity.
L+#M$& 0+-"$ 12 $J"*&?
Market-to-book ratio =
E11M 0+-"$ 12 $J"*&?
• M/B ratios typically exceed 1.0, which means that investors are willing to pay more for
stocks than the accounting book values of the stocks.
• Successful companies’ values rise above their historical costs, whereas unsuccessful
ones have low M/B ratio
Q: Calculate Target’s P/E ratio, M/B ratio
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 2.3. Financial Statements analysis 2.3. Financial Statements analysis
2.3.2. Dupont analysis: 2.3.2. Dupont analysis:
Operating profit margin versus asset turnover for 45 industries (2019).
The trade-off between turnover and profit margin:
• Industries with high average turnover ratios tend
to have lower average profit margins.
How much profit how effectively the • Conversely, high margins are typically associated
how much the
the company gets company makes use with low turnover.
company is leveraged
out of its revenues of its assets
• If a company's ROE goes up due to an increase in the net profit margin or asset turnover,
this is a very positive sign for the company.
• However, if the equity multiplier is the source of the rise, and the company was already
appropriately leveraged, this is simply making things riskier. If the company is getting
over-leveraged, the stock might deserve more of a discount despite the rise in ROE.
• Source: U.S. Census Bureau, Quarterly Report for Manufacturing and Trade Corporations, Fourth Quarter 2019.
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 Topics Covered
3.1 Future Values and Compound Interest.
3.2 Present Values.
3.3 Multiple Cash Flows.
3.4 Level Cash Flows: Perpetuities and
Annuities.
3.5 Effective Annual Interest Rates.
Chapter 3 3.6 Inflation & The Time Value of Money.
TIME VALUE OF MONEY
1 2
3.1 Future Values and Compound Interest 1 3.1 Future Values and Compound Interest 1
Ø Future Value: Ø Time lines show timing of cash flows.
• Amount to which an investment will grow after earning
interest.
0 1 2 3
ØSimple Interest:
i%
• Interest earned only on the original investment.
CF0 CF1 CF2 CF3
ØCompound Interest.
• Interest earned on interest (and the original investment).
Tick marks at ends of periods, so Time 0 is today; Time 1
is the end of Period 1; or the beginning of Period 2.
3 4
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3.1 Future Values and Compound Interest 2 3.1 Future Values and Compound Interest 3
Ø Example — Simple Interest. ØExample — Simple Interest.
• Interest earned at a rate of 6% for five years on a • Interest earned at a rate of 6% for five years on a
principal balance of $100. principal balance of $100.
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3.1 Future Values and Compound Interest 4 3.1 Future Values and Compound Interest 5
ØExample — Compound Interest. ØFuture Value = FV
• Interest earned at a rate of 6% for five years on the
previous year’s balance.
FV = $100 × 1 + r t
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 3.1 Future Values and Compound Interest 6 3.1 Future Values and Compound Interest 7
ØExample — Future Value.
• What is the future value of $100 if interest is
compounded annually at a rate of 6% for five years?
FV = $100 ´ (1 + r )t
FV = $100 ´ (1 + .06)5 = $133.82
§ Access the text alternative for these images.
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3.2 Present Values
11
Manhattan Island Sale 1
ØPeter Minuit bought Manhattan Island for $24 in 16 26.
Was this a good deal?
• To answer, determine what $24 is worth in the year
2021, compounded at 8%.
§ Note: The value of Manhattan Island land is well below this figure.
§ Access the text alternative for these images.
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 3.2 Present Values 2 3.2 Present Values 3
ØDiscounted Cash Flow (DCF).
ØPresent value = PV.
• Method of calculating present value by discounting future
cash flows.
Future value after t periods
PV =
(1 + r )t
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3.2 Present Values 4 3.2 Present Values 5
ØExample. ØDiscount Factor = DF = PV of $1.
• You just bought a new computer for $3,000. The 1
payment terms are 2 years same as cash. If you can DF =
(1 + r )t
earn 8% on your money, how much money should
you set aside today to make the payment due in two ØDiscount factors can be used to compute the present value
years? of any cash flow.
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 3.2 Present Values 6 The Statement of Cash Flows
ØDrawing a timeline helps to calculate the present value of
the payments ($8,000 now, $12,000 in two years).
§ Access the text alternative for these images. § Access the text alternative for these images.
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Time Value of Money (Applications) 1 Time Value of Money (Applications) 2
ØThe PV formula has many applications. Given any variables ØExample.
in the equation, you can solve for the remaining variable. • The U.S. Treasury borrowed money for 10 years,
selling each I O U for $777.40. What is the interest
rate?
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 Time Value of Money (Applications) 3 3.3 Multiple Cash Flows 1
oValue of Free Credit. ØExample: Future Value of Multiple Cash Flows
oImplied Interest Rates. • You invest $1,200 in the bank now, and another
oInternal Rate of Return. $1,400 in 1 year. At 8% rate of interest, how much
will you be able to spend on a computer in 2 years?
oTime necessary to accumulate funds.
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3.3 Multiple Cash Flows 2 3.3 Multiple Cash Flows 3
ØPresent Value of Multiple Cash Flows: PVs can be added ØExample.
together to evaluate multiple cash flows. • Your auto dealer gives you the choice to pay $15,500
cash now or make three payments: $8,000 immediately
C1 C2 and $4,000 at the end of the next two years. If your cost
PV = + + ...
(1 + r )1 (1 + r ) 2 of money is 8%, which do you prefer?
C1 C2
PV = C0 + +
(1 + r )1 (1 + r ) 2
$4,000 $4,000
= $8,000 + +
(1 + .08)1 (1 + .08) 2
= $15,133.06 < $15,500.00
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 Calculations: Part 1 – Spreadsheets
25 26
3.3 Multiple Cash Flows 4
ØExample. Your auto dealer gives you the choice to pay $15,500 cash now or
make three payments: $8,000 immediately and $4,000 at the end of the next
two years. If your cost of money is 8%, which do you prefer?
Finding the Present Value of Multiple Cash Flows by Using a Spreadsheet
A B C D
1 Time until CF Cash Flow Present Value Formula in Column C
2 0 8000 $8,000.00 =PV ($B$6,A2,0,−B2)
3 1 4000 $3,703.70 =PV ($B$6,A3,0, −B3)
4 2 4000 $3,429.36 =PV ($B$6,A4,0, −B4)
5 SUM: $15,133.06 =SUM(C2:C4)
6 Discount rate: .08
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3.4 Perpetuities and Annuities 1 3.4 Perpetuities and Annuities 2
ØPerpetuity. (Dòng tiền niên kim vĩnh viễn/Dòng tiền đều vô ØPV of Perpetuity Formula.
hạn )
• A stream of level cash payments that never ends. C
PV =
ØAnnuity. (Dòng tiền niên kim/Dòng tiền cuối kỳ) r
• Level stream of cash flows at regular intervals with a
finite maturity. •C = cash payment.
•r = interest rate.
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 3.4 Perpetuities and Annuities 3 3.4 Perpetuities and Annuities 4
ØExample. ØExample.
• In order to create an endowment, which pays • If the first perpetuity payment will not be received
$100,000 per year forever, how much money must until three years from today, how much money
be set aside today in the rate of interest is 10%? needs to be set aside today?
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3.4 Perpetuities and Annuities 5 3.4 Perpetuities and Annuities 6
ØPV of Annuity Formula. ØPV of Annuity Factor (PVAF).
• The present value of $1 a year for each of t years.
é1 1 ù
PV = C ê - t ú
ë r r (1 + r ) û é1 1 ù
PVAF = ê - t ú
• C = cash payment. ë r r (1 + r ) û
• r = interest rate.
• t = Number of years cash payment is received.
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 3.4 Perpetuities and Annuities 7 3.4 Perpetuities and Annuities 8
ØExample : You are purchasing a car. You are scheduled to
ØExample.
make 3 annual installments of $8,000 per year. Given a rate
• You are purchasing a car. You are scheduled to make 3 of interest of 10%, what is the price you are paying for the
annual installments of $8,000 per year. Given a rate of car (that is what is the PV)?
interest of 10%, what is the price you are paying for the
car (that is, what is the PV)?
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3.4 Perpetuities and Annuities 9 3.4 Perpetuities and Annuities 10
ØApplications. ØExample — Future value of annual payments.
• Value of payments. • You plan to save $3,000 every year for 4 years. Given
an 8% rate of interest, what will be the FV of your
• Implied interest rate for an annuity.
account?
• Calculation of periodic payments.
- Mortgage payment.
- Annual income from an investment payout.
- Future Value of annual payments.
FV = [C ´ PVAF] ´ (1 + r )t
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 3.4 Perpetuities and Annuities 11 3.4 Perpetuities and Annuities 12
ØExample: You are purchasing a home and are scheduled to ØExample— Future value of annual payments.
make 30 annual installments of $10,000 per year. Given an • You plan to save for 50 years and then retire. Given a
interest rate of 5%, what is the price you are paying for the 10% rate of interest, if you desire to have $500,000 at
house (that is, PV)? retirement, how much must you save each year?
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3.4 Perpetuities and Annuities: Annuities Due 1 3.4 Perpetuities and Annuities: Annuities Due 2
ØAnnuity Due. ØExample.
• Level stream of cash flows starting immediately. • Suppose you invest $429.59 annually at the beginning
of each year at 10% interest. After 50 years, how
ØHow does it differ from an ordinary annuity?
much would your investment be worth?
PVAnnuity Due = PVAnnuity × (1 + r).
FVAD = FVAnnuity × (1 + r).
ØHow does the future value differ from an ordinary annuity?
FVAnnuity Due = FVAnnuity × (1 + r).
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 3.5 Effective Interest Rates 1 3.5 Effective Interest Rates 2
ØEffective Annual Interest Rate. ØAnnual Percentage Rate (APR).
• Interest rate that is annualized using compound interest.
APR = MR ´12
ØAnnual Percentage Rate.
• Interest rate that is annualized using simple interest. ØEffective Annual Interest Rate (EAR).
EAR = (1 + MR)12 - 1
ØWhere: MR = monthly interest rate.
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3.5 Effective Interest Rates 3 3.6 Inflation 1
ØExample. ØInflation.
• Given a monthly rate of 1%, what is the Effective Annual • Rate at which (overall) prices increase.
Rate(EAR)? What is the Annual Percentage Rate (APR)? ØNominal Interest Rate.
• Rate at which money invested grows.
ØReal Interest Rate.
• Rate at which purchasing power grows.
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 3.6 Inflation 2 3.6 Inflation 3
§Annual U.S. Inflation Rates from 1900 – 2015. ØExact relationship.
1 + nominal interest rate
1 + real interest rate =
1 + inflation rate
ØApproximation formula.
ØReal interest rate ≈ nominal interest rate − inflation rate.
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3.6 Inflation 4 3.6 Inflation 5
ØExample. If the interest rate on one-year government bonds ØRemember:
is 6.0% and the inflation rate is 2.0%, what is the real • Current dollar cash flows must be discounted by the
interest rate? nominal interest rate.
• Real cash flows must be discounted by the real interest
rate.
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 Topics covered
01 Rates of Return: A Review
02 Stand-Alone Risk
03 Portfolio Risk
Chapter 4: Risk and Rate of returns
Instructor: Nguyễn Hồng Thoa 04 Risk & return: CAPM/SML
1 2
4.1 Rates of Return 1 4.1 Rates of Return 2
• Example.
• Returns come in two forms—dividends (or interest) and capital gains. Suppose
you purchase a share of Microsoft stock at the beginning of 2020 for $158.78. dividend
You collect a dividend of $2.09 and sell it at the end of the year for $222.42. Dividend yield =
What is the percentage return on your investment? (Inflation rate 1.4%) initial share price
capital gain
capital gain + dividend Capital gain yield =
Percentage return = initial share price
initial share price
3 4
3 4
 4.1 Rates of Return 4 Market Indexes
• Nominal versus Real • Market Index.
• Measure of the investment performance of the overall market.
1 + nominal rate of return • Dow Jones Industrial Average (The Dow).
1 + real rate of return =
1 + inflation rate • Index of the investment performance of a portfolio of 30 “blue-
chip” stocks.
• Standard & Poor’s Composite Index (S&P 500).
• Index of the investment performance of a portfolio of 500 large
stocks.
5
5 6
The Value of a $1 Investment in 1900 4.2 Stand-Alone Risk: Measuring Risk 1
• Variance.
• Average value of squared deviations from mean.
• A measure of volatility.
• Standard Deviation (!)
• Square root of variance.
• Another measure of volatility.
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8
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 4.2 Stand-Alone Risk: Measuring Risk 2 4.2 Stand-Alone Risk: Measuring Risk 3
• Coin-toss game; calculating variance and standard deviation. • Coin-toss game; calculating variance and standard deviation.
Suppose that you are offered the opportunity to play the following game: You Probability Percent Rate of Deviation from Squared
start by investing $100. Then two coins are flipped. For each head that comes distributions Return Expected Return Deviation
up, your starting balance will be increased by 20%, and for each tail that
25% +40 +30 900
comes up, your starting balance will be reduced by 10%.
25% +10 0 0
25% +10 0 0
25% −20 −30 900
1
9 10 0
4.2 Stand-Alone Risk: Measuring Risk 4 4.2 Stand-Alone Risk 1
o Six key items for statistical measures of stand-alone risk:
• Coin-toss game; calculating variance and standard deviation.
b. Expected rates c. Standard
It is the same as the first except that each head means a 35% gain and of return (r!)
each tail means a 25% loss. deviation (#)
a. Probability f. Sharpe ratio
distributions
d. Historical, or past e. Coefficient of
realized, rates of return variation (CV)
(r)
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 4.2 Stand-Alone Risk 2 4.2 Stand-Alone Risk 3
a. Probability distributions a. Probability distributions
The tighter (or more peaked) the
probability distributions shown in Figure
8-3, the more likely the actual outcome
will be close to the expected value and,
consequently, the less likely the actual
return will end up far below the expected
return. Thus, the tighter the probability
distribution, the lower the risk.
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4.2 Stand-Alone Risk 4 4.2 Stand-Alone Risk 5
")
b. Expected rates of return (! c. Standard deviation (#): The smaller the standard deviation, the
tighter the probability distribution and, accordingly, the lower the risk.
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 4.2 Stand-Alone Risk 6 4.2 Stand-Alone Risk 7
d. Historical, or past realized, rates of return (r)̅ e. Coefficient of variation (CV): The coefficient of variation shows the risk
• If we had actual historical data instead per unit of return, and it provides a more meaningful risk measure when the
• Past results are often repeated in the future, the historical $ is often used as expected returns on two alternatives are not the same.
an estimate of future deviation of returns
f. Sharpe ratio: a measure of standalone risk that compares the asset’s realized
excess return to its standard deviation over a specified period. An investment with a
higher ratio has performed better than one with a lower ratio.
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4.2 Stand-Alone Risk 8 Attitudes and behaviour towards risks
Question: Historical returns for Stocks A and B over the past 5 years
are listed below. The risk-free rate is 3%.
Source: Polieconomics
•Risk aversion: risk-averse investors dislike risk and require higher rates of return as an inducement
to buy riskier securities.
•Risk Premium (RP): the difference between the expected rate of return on a given risky asset and
that on a less risky asset.
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 4.3 Portfolio risk: Risk and Diversification 1 4.3 Portfolio risk: Risk and Diversification 2
Standard Standard
Ticker Company deviation(%) Ticker Company deviation(%)
Portfolio rate of (fraction of portfolio in first asset)
X U.S. Steel 76.4 UNP Union Pacific 21.4 =
PCG 55.4 DIS Disney 21.2 return ! (rate of return on first asset)
Pacific Gas &
Electric GOOG Google/Alphabet 20.1 +
MRO Marathon Oil 48.9 SBUX Starbucks 18.7 (fraction of portfolio in second asset)
NEM Newmont Mining 36.7 WMT Walmart 17.7 ! (rate of return on second asset)
AMZN Amazon 28.3 XOM ExxonMobil 19.4
BA Boeing 27.4 PFE Pfizer 16.6
CPB Campbell Soup 22.6 MCD McDonald’s 14.4
IBM IBM 22.5 KO Coca-Cola 12.6
F Ford 22.1 S&P 12.0
INTC Intel 22.1 500
2 2
21 1
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4.3 Portfolio risk: Risk and Diversification 3 4.3 Portfolio risk: Risk and Diversification 4
Two Asset Example: Gold and Auto stocks. Two Asset Example: Assume 25% in Gold and 75% in Auto.
Auto Stock Gold Stock
Rate of Deviation from Squared Rate of Deviation from Squared
Scenario Return (% ) Expected Return (%) Expected Return (% ) Rate of Return (%)
Deviation Return (% ) Deviation
Recession -8 -13 169 +20 +19 361
+2
Scenario Probability Auto Stock Gold Stock Portfolio Return (%)*
Normal +5 0 0 +3 4
Recession 1/ 3 −8 +20 −1.0
Boom +18 +13 169 -20 -21 441
Normal 1/ 3 +5 +3 +4.5
Expected return ( -8 + 5 + 18) / 3 = 5% ( -20 + 3 + 20 ) / 3 = 1% Boom 1/ 3 +18 −20 +8.5
Variance (169 + 0 + 169 ) / 3 = 112.7 ( 361 + 4 + 441) / 3 = 268.7 Expected 5 1 4
Standard deviation 268.7 = .164 or 16.4%
return
112.7 = .106 or 10.6%
Variance 112.7 268.7 15.2
Standard 10.6 16.4 3.9
deviation
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4.3 Portfolio risk: Risk and Diversification 5 4.3 Portfolio risk: Risk and Diversification 6
Two Asset Example: Sensitivity analysis. Two Asset Example: Sensitivity analysis graph.
Portfolio Weights Portfolio Rate of Return (%)
Blan Expected Standard
k Gold Autos Recession Normal Boom Return Deviation
A 0.0 1.0 −8.0 5.0 18.0 5.0 10.6
B 0.2 0.8 −2.4 4.6 10.4 4.2 5.2
C 0.4 0.6 3.2 4.2 2.8 3.4 0.6
D 0.6 0.4 8.8 3.8 −4.8 2.6 5.6
E 0.8 0.2 14.4 3.4 −12.4 1.8 11.0
F 1.0 0.0 20.0 3.0 −20.0 1.0 16.4
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4.3 Portfolio risk: Risk and Diversification 7 4.3 Portfolio risk 1
Expected Portfolio Returns (&r! ): The expected return on a portfolio, r&! ,
• Diversification.
• Strategy designed to reduce risk by spreading the portfolio across is the weighted average of the expected returns of the individual assets
many investments. in the portfolio, with the weights being the per- centage of the total
portfolio invested in each asset :
• Specific Risk.
• Risk factors affecting only that firm,
• Also called diversifiable risk.
• Market Risk.
• Economy-wide sources of risk that affect the overall stock market.
• Also called systematic risk.
Stand-alone risk = Diversifiable risk + Market risk
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 4.3 Portfolio risk 2 4.3 Portfolio risk 3
Expected Portfolio Returns (&r! ) Correlation: the tendency of two variables to move together.
Covariance
Correlation Coefficient, ': a measure of the degree of relationship
between two variables.
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4.3 Portfolio risk 3 4.3 Portfolio risk 4
Correlation: the tendency of two variables to move together. • ( = −1.0: the returns on Stocks W and M are perfectly negative correlated
• ( = 1.0: the returns on Stocks W and M are perfectly positive correlated
Covariance:
• ( = 0: the returns on Stocks W and M are independent
Diversification is completely useless for reducing risk if the stocks in the
portfolio are perfectly positively correlated.
Correlation Coefficient, ': a measure of the degree of relationship
between two variables. • #" decreases as stocks added, because they would not be perfectly
correlated with the existing portfolio.
• Expected return of the portfolio would remain relatively constant.
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 4.3 Portfolio risk 4 4.3 Portfolio risk 4
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4.3 Portfolio risk 5 4.3 Portfolio risk: The Beta Coefficient 1
• Beta measures a stock’s market risk. It shows a stock’s volatility
• When a stock is held by itself, its risk can be measured by the
relative to the market.
standard deviation of its expected returns.
• Beta shows how risky a stock is if the stock is held in a well-
• However, " is not appropriate when the stock is held in a
diversified portfolio.
portfolio, as stocks generally are.
How are betas calculated?
How do we measure a stock’s relevant risk in a • Run a regression of past returns on Stock i versus returns on the market.
portfolio context? • The slope of the regression line is defined as the beta coefficient.
• Portfolio beta equals the weighted average of the betas of the securities in
the portfolio.
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 4.3 Portfolio risk: The Beta Coefficient
4.3 Portfolio risk: The Beta Coefficient
3
Illustration of Beta Calculation:
2
_
How are betas calculated? ri Regression line:
ri = -2.59 + 1.44 r^M
20 .
15 . Year rM ri
10 1 15% 18%
2 -5 -10
5
3 12 16
_
-5 0 5 10 15 20
rM
-5
. -10
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4.3 Portfolio risk: The Beta Coefficient 4 4.3 Portfolio risk: The Beta Coefficient 5
Betas calculated with price data from January 2015 to December 2019.
• If beta = 1.0, average stock. Ticker Company Beta Ticker Company Beta
X U.S. Steel 3.03 INTC Intel 0.91
• If beta > 1.0, stock riskier than average.
MRO Marathon Oil 2.35 PFE Pfizer 0.65
• If beta < 1.0, stock less risky than average. AMZN Amazon 1.51 PCG Pacific Gas &
0.55
BM IBM 1.33 Electric
• Most stocks have betas in the range of 0.5 to 1.5. BA Boeing 1.19 SBUX Starbucks 0.51
F Ford 1.09 MCD McDonald’s 0.45
UNP Union Pacific 1.07 CPB Campbell Soup 0.43
GOOG Google/Alphabet 1.01 KO Coca-Cola 0.43
DIS Disney 1.00 WMT Walmart 0.35
XOM ExxonMobil 1.00 NEM Newmont Mining −0.01
Average 0.99
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 4.3 Portfolio risk: The Beta Coefficient 7
_
ri HT b = 1.30
Can a beta be negative? 40
Yes, if ri, m is negative. Then in a “beta graph” the b=0
20
regression line will slope downward. Though, a T-Bills
negative beta is highly unlikely.
_
-20 0 20 40 rM
Coll.
-20 b = -0.87
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4.4 Risk & Return: CAPM/SML 1 4.4 Risk & Return: CAPM/SML 2
Market risk premium: the additional return over the risk-free rate needed to Capital Asset Pricing Model (CAPM).
compensate investors for assuming an average amount of risk.
Example: The return on the stock market is 10%; the risk-free rate of return is
3%. What is the risk premium for Stock X that has a beta of 0.5? What is the
expected return of that stock?
Capital Asset Pricing Model (CAPM).
• Theory of the relationship between risk and return.
• It states that the expected risk premium on any security equals its beta
times the market risk premium.
Risk premium on the market = rm - rf
Risk premium on any asset = r - rf
Expected return on any asset = rf + b ´ (rm - rf )
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 4.4 Risk & Return: CAPM/SML 3

4.4 Risk & Return: CAPM/SML 4

Security Market Line
Example. Graph stock X as well as a stock Y (β =.2) and the market
portfolio. (Note: horizontal axis = β, vertical axis = expected return.
SML equation = rf + β(rm − rf)
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4
45 46 6
4.4 Risk & Return: CAPM/SML 4 4.4 Risk & Return: CAPM/SML 4
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4
47 7
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 4.4 Risk & Return: CAPM/SML 4 4.4 Risk & Return: CAPM/SML 5
Verifying the CAPM empirically
• The CAPM has not been verified completely.
• Statistical tests have problems that make verification almost
impossible.
• Some argue that there are additional risk factors, other than the
market risk premium, that must be considered.
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4.4 Risk & Return: CAPM/SML 6
More thoughts on the CAPM
• Investors seem to be concerned with both market risk and total
risk. Therefore, the SML may not produce a correct estimate of r# .
• CAPM/SML concepts are based upon expectations, but betas are
calculated using historical data. A company’s historical data may
not reflect investors’ expectations about future riskiness.
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51
 Topics covered
01 Valuation of Bonds
02 Valuation of Stocks
Chapter 5: Securities Valuation
Instructor: Nguyễn Hồng Thoa
1 2
5.1 Valuation of Bonds 5.1.1 Bond Pricing
5.1.1 Bond Pricing. • Bond.
5.1.2 Interest Rates and Bond Prices. • Security that obligates the issuer to make specified payments to the
5.1.3 Bond Yields. bondholder.
5.1.4 Bond Rates of Returns.
5.1.5 The Yield Curve. • Face Value (a.k.a. Par Value or Principal Value).
• Payment at the maturity of the bond.
5.1.6 Nominal and Real Rates of Interest.
5.1.7 Corporate Bonds and the Risk of Default. • Coupon.
• The interest payments made to the bondholder.
• Coupon Rate.
• Annual interest payment as a percentage of face value.
3 4
 5.1.2 Interest Rates and Bond Prices 1 5.1.2 Interest Rates and Bond Prices 2
• WARNING. • The price of a bond is the present value of all cash flows
• The coupon rate IS NOT the discount rate used in the Present Value generated by the bond (that is, interest and principal)
calculations. discounted at the required rate of return.
• The coupon rate merely tells us what cash flow the bond will produce.
cpn cpn (cpn+par)
• Since the coupon rate is listed as a %, this misconception is quite common. PV = + + ... + +
(1 + r )1 (1 + r ) 2 (1 + r )t
• cpn is commonly used as an abbreviation for coupon.
5 6
5.1.2 Interest Rates and Bond Prices 3 5.1.2 Interest Rates and Bond Prices 4
• Cash flows to an investor in the 7.50% coupon bond • Example.
maturing in 2024. • What is the price of a 7.50 % annual coupon bond,
with a $1,000 face value, maturing in 4 years?
Assume a required return of 3.00%.
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7 8
 5.1.2 Interest Rates and Bond Prices 8 5.1.2 Interest Rates and Bond Prices 9
• Example. • Here are the cash flows to an investor in the 7.50%
• How do calculations if there are semi-annual coupon bond maturing in 2024. The bond pays semi-
coupons rather than annual coupon payments? annual coupons, $37.50 twice each year.
• Twice as many payments, cut in half, over the same time
period.
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5.1.2 Interest Rates and Bond Prices 10 5.1.2 Interest Rates and Bond Prices 11
• Example. Example: How did the calculation change, given semi-annual
• What is the price of the 7.50% coupon bond maturing coupons versus annual coupon payments?
in 4 years, if the annual required rate of return is 3.00%
AND the coupons are paid semi-annually?
Time Periods Discount Rate
Paying coupons twice a Since the time periods are
year, instead of once, now half years, the
doubles the total number discount rate is also
of cash flows to be changed from the annual
discounted in the PV rate to the half year rate.
formula.
11 12
 5.1.2 Interest Rates and Bond Prices 13 5.1.2 Interest Rates and Bond Prices 14
Example: Returning to our annual 7.50% coupon bond, The 7.50% bond’s price is inversely related to interest rates.
maturing in 4 years, what is the price of this bond if
interest rates fall from 3.00% to 2.00%?
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5.1.2 Interest Rates and Bond Prices 15 5.1.2 Interest Rates and Bond Prices 16
• Interest Rate Risk: A change in interest rates impacts long-term The interest rate on 10-year U.S. Treasury bonds, 1900–2020.
bonds more than short-term bonds.
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 5.1.3 Bond Yields 1 5.1.3 Bond Yields 2
• Yield To Maturity (YTM = r) Example: What is the YTM of a 7.5% annual coupon bond, with a
• The rate of return earned on a bond if it is held to maturity. $1,000 face value, which matures in 3 years? The market price of the
• If you are given the price of a bond (P V), the coupon (P M T), and its par value (F V), the bond is $1,167.27.
yield to maturity can be found by solving for r.
PMT PMT ( PMT + FV )
PV = + + .... +
(1 + r )1 (1 + r ) 2 (1 + r )t
• Yield To Call (YTC)
• The rate of return earned on a bond when it is called before its maturity date.
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5.1.4 Bond Rates of Return 1 5.1.4 Bond Rates of Return 2
• Rate of Return. Example: A bond increases in price from $963.80 to
• Total income per period per dollar invested. $1,380.50 and pays a coupon of $21.875 during the same
period. What is the rate of return?
total income coupon income + price change
Rate of return = =
investment investment
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 5.1.4 Bond Rates of Return 3 5.1.5 The Yield Curve 1
• Term Structure of Interest Rates.
• A listing of bond maturity dates and the interest rates that
correspond with each date.
• Yield Curve.
• Plot of relationship between bond yields to maturity and time
to maturity.
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21 22
5.1.5 The Yield Curve 2 5.1.6 Nominal and Real Rates of Interest 1
• The yields on U.S. Treasury bonds in August 2020. show • In the presence of inflation, an investor’s real interest
that investors received a higher yield on longer term bonds. rate is always less than the nominal interest rate.
1 + nominal rate
1 + real rate =
1 + inflation rate
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 5.1.6 Nominal and Real Rates of Interest 2 5.1.6 Nominal and Real Rates of Interest 3
Example. If you invest in a security that pays 8% interest
annually and inflation is 4%, what is your real interest
rate?
1.08
1 + real rate =
1.04
Real interest rate = .0385 or 3.85%
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1.5.7 Corporate Bonds and Default Risk 1 1.5.7 Corporate Bonds and Default Risk 2
Standard
• Default or Credit Risk. Moody’s
& Poor’s
Safety
• The risk that a bond issuer may default on its bonds. The strongest rating; ability to repay interest and principal is very
Aaa AAA
strong.
• Default premium. Aa AA Very strong likelihood that interest and principal will be repaid.
Strong ability to repay, but some vulnerability to changes in
• The additional yield on a bond that investors require for bearing A A
circumstances.
default/credit risk.
Adequate capacity to repay; more vulnerability to changes in
Baa BBB
economic circumstances.
• Investment grade. Ba BB Considerable uncertainty about ability to repay.
• Bonds rated Baa or above by Moody’s or BBB or above by Likelihood of interest and principal payments over sustained periods
Standard & Poor’s. B B
is questionable.
Caa CCC Bonds that may already be in default or in danger of imminent
Ca CC default.
• Junk bonds.
• Bond with a rating below Baa or BBB. C C Little prospect for interest or principal on the debt ever to be repaid.
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 1.5.7 Corporate Bonds and Default Risk 3 1.5.7 Corporate Bonds and Default Risk 4
• Protecting against Default Risk. • Yield spreads between corporate Baa and Aaa bonds.
• Seniority.
• Security (collateral).
• Protective Covenants.
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1.5.7 Corporate Bonds and Default Risk 5 5.2 Valuation of Stocks
5.2.1 Stocks and the Stock Market.
• Not all corporate bonds are “plain vanilla.”
5.2.2 Market Values, Book Values, and Liquidation Values.
• Zero-coupon bonds.
5.2.3 Valuing Common Stocks.
• Floating-rate bonds.
5.2.4 Simplifying the Dividend Discount Model.
• Convertible bonds.
5.2.5 Valuing a Business by Discounted Cash Flow.
5.2.6 Preferred Stocks
5.2.7 Market Anomalies and Behavioral Finance.
31 32
 5.2.1 Stocks and the Stock Market 1 5.2.1 Stocks and the Stock Market 2
• Primary Market. • Common Stock.
• Market for the sale of new securities by corporations. • Ownership shares in a publicly held corporation.
• Secondary Market.
• Initial Public Offering (IPO). • Market in which previously issued securities are traded among
• First offering of stock to the general public. investors.
• Dividend.
• Primary Offering. • Periodic cash distribution from the firm to the shareholders.
• The corporation sells shares in the firm.
• P/E Ratio.
• Ratio of stock price to earnings per share.
33 34
5.2.1 Stocks and the Stock Market 3 5.2.1 Stocks and the Stock Market 4
• Example You wish to purchase 100 shares of FedEx (Bid price =
• Bid Price $167.41, Ask Price = $167.43), how much would you expect to pay for
• The prices at which the shares? What is the P/E Ratio and Dividend Yield of your purchase?
investors are willing to
buy shares.
• Ask Price
• The prices at which
current shareholders are
willing to sell their
shares.
• Access the text alternative for slide
images.
35 36
 5.2.1 Stocks and the Stock Market 5 5.2.2 Market Values, Book Values, and Liquidation Values 1
• Share price history for FedEx • Book Value.
• Net worth of the firm according to the balance sheet.
• Liquidation Value.
• Net proceeds that could be realized by selling the firm’s assets and
paying off its creditors.
• Market Value Balance Sheet.
• Financial statement that uses market value of all assets and
liabilities.
• Access the text alternative for slide
images.
37 38
5.2.2 Market Values, Book Values, and Liquidation Values 2 5.2.2 Market Values, Book Values, and Liquidation Values 3
Market Value versus Book Value, July 2020
The difference between a firm’s actual market value and its’
Market-to-
Stock Book Value Book-Value liquidation or book value is attributable to its “going-concern value.”
Ticker Price per Share Ratio
• Factors of “Going Concern Value.”
FedEx FDX 129.28 70.03 1.8
• Extra earning power.
Johnson & Johnson JNJ 146.75 22.82 6.4
Campbell Soup CPB 49.87 8.57 5.8 • Intangible assets.
PepsiCo PEP 128.69 8.53 15.1 • Value of future investments.
Walmart WMT 123.10 22.55 5.5
Microsoft MSFT 182.33 14.07 13.0
Amazon AMZN 2,442.37 107.03 22.8
DowDuPont DOW 37.54 15.26 2.5
American Electric Power AEP 82.85 37.66 2.2
US Steel X 8.02 17.06 0.5
39 40
 5.2.3 Valuing Common Stocks 1 5.2.3 Valuing Common Stocks 2
Valuation by Comparables, May 2020
Stock Valuation Methods.
Market-to-Book Value Ratio Price−Earnings Ratio*
• Valuation by comparables.
• Ratios. Company Industry Company Industry
FedEx 1.8 7.3 12.4 23.7
• Multiples.
Johnson & Johnson 6.4 4.9 18.9 21.3
• Intrinsic Value. Campbell Soup 5.8 2.9 17.3 22.8
• Present value of future cash payoffs from a stock or other security. PepsiCo 15.1 10.0 24.4 22.5
• Dividend Discount Model. Walmart 5.5 4.0 23.2 23.2
Microsoft 13.0 6.6 32.3 31.2
Amazon 22.8 9.4 138.9 17.4
Dow 2.5 3.5 40.5 20.0
American Electric Power 2.2 1.9 20.6 22.0
US Steel 0.5 2.3 12.4 8.0
41 42
5.2.3 Valuing Common Stocks 3 5.2.3 Valuing Common Stocks 4
Intrinsic Value
Example What is the intrinsic value of a share of stock if
expected dividends are $3 per share and the expected price
Div1 + P1 in 1 year is $81 per share? Assume a discount rate of 12%.
V0 =
1+ r
V0 = The intrinsic value of the share.
Div1 = The expected dividend per share at the end of the year.
P1 = The predicted stock price in year 1.
r = The discount rate for the stock’s expected cash flows.
43 44
 5.2.3 Valuing Common Stocks 5 5.2.3 Valuing Common Stocks 6
Expected Return Example: Using the prior example, what is the expected
• The percentage yield that an investor forecasts from a specific return assuming the stock price started the year at $75?
investment over a set time period.
• Sometimes called the holding period return (HPR).
Div1 + P1 - P0
Expected return = r =
P0
45 46
5.2.3 Valuing Common Stocks 7 5.2.3 Valuing Common Stocks 8
• The formula can be broken into two parts: • Example: Using the prior example, what is the expected
• Dividend yield + Capital appreciation dividend yield and capital gain?
Div1 P1 - P0
Expected return = r = +
P0 P0
47 48
 5.2.3 Valuing Common Stocks 9 5.2.3 Valuing Common Stocks 10
• Dividend Discount Model. • Example: Current dividend forecasts for X Y Z Company are $3.00,
• Discounted cash-flow model which states that today’s stock price $3.24, and $3.50 (next three years). At the end of three years, you
equals the present value of all expected future dividends. anticipate selling your stock at a market price of $94.48. What is
the price of the stock given a 12% expected return?
Div Div Div t + Pt
P0 = 1
+ 2
+!+
(1 + r )1 (1 + r )2 (1 + r )t
t - Time horizon for your investment.
49 50
5.2.3 Valuing Common Stocks 11 5.2.4 Simplifying the Dividend Discount Model 1
Value for Different Time Horizons If we forecast no growth, and plan to hold out stock indefinitely,
we will then value the stock as a PERPETUITY.
Div1 EPS1
Perpetuity = P0 = or
r r
Assumes all earnings are
paid to shareholders.
51 52
 5.2.4 Simplifying the Dividend Discount Model 2 5.2.4 Simplifying the Dividend Discount Model 3
• Constant-Growth DDM • Example: What is the value of a stock that expects to pay a
• A version of the dividend growth model in which dividends grow at $0.86 dividend next year, and then increase the dividend at a
a constant rate (Gordon Growth Model). rate of 4.75% per year, indefinitely? Assume a 7.0%
expected return.
Div1
P0 =
r -g
• Given any combination of variables in the equation, you
can solve for the unknown variable.
53 54
5.2.4 Simplifying the Dividend Discount Model 4 5.2.4 Simplifying the Dividend Discount Model 5
• If a firm pays a lower dividend → the stock price may • Growth can be derived from applying the return on equity to the percentage
increase because future dividends may be higher. of earnings plowed back into operations.
• Payout Ratio.
• Fraction of earnings paid out as dividends. g = sustainable growth rate = ROE ! plowback ratio
• Plowback Ratio.
• Fraction of earnings retained by the firm. • Present Value of Growth Opportunities (PVGO).
• Sustainable Growth Rate. • Net present value of a firm’s future investments.
• The firm’s growth rate if it plows back a constant fraction of earnings
• Assumes constant ROE and debt ratio.
55 56
 5.2.4 Simplifying the Dividend Discount Model 6 5.2.4 Simplifying the Dividend Discount Model 7
• Example: Aqua America has an ROE of 12.5% and a book • Example: If Aqua America decides not to reinvest any earnings,
value per share of $11.10. It intends to plowback 38% of its
what is the value of the stock and what is the PVGO of the firm
earnings and the opportunity cost of capital is 7.0%. What is the
stock price? that is lost?
57 58
5.2.4 Simplifying the Dividend Discount Model 8 5.2.4 Simplifying the Dividend Discount Model 9
• Example: A company forecasts a $5.00 dividend next year, which • Example: If the company did not plowback some earnings, the
represents 100% of its earnings. This provides investors with a 12% stock price would remain at $41.67. With the plowback, the price
expected return. Suppose it decides to plowback 40% of the earnings rose to $75.00.
at the firm’s current ROE of 20%. What is the value of the stock The difference ($75.00 - 41.67 = $33.33) is called the Present Value
before and after the plowback decision? of Growth Opportunities (PVG O).
No Growth With Growth
59 60
 5.2.5 Valuing a Business by Discounted Cash Flow 1 5.2.5 Valuing a Business by Discounted Cash Flow 2
Valuing Non-Constant Growth. • Example: What is the value of a stock with the following dividends,
an 8.5% discount rate, and a growth rate of 6% (beginning in year 6)?
Year 1 2 3 4 5
Dividends $2.16 2.38 2.61 2.87 3.16
PVH stands in for the total present value of the project’s free cash flows in periods H + 1, H + 2, and so on.
61 62
5.2.6 Preferred Stock 1 5.2.6 Preferred Stock 2
• Hybrid security.
• Similar to bonds in that preferred stockholders receive a
fixed dividend that must be paid before dividends can be
paid on common stock.
• However, unlike interest payments on bonds, companies
can omit dividend payments on preferred stock without
fear of pushing the firm into bankruptcy.
63 64
 5.2.6 Preferred Stock 3 5.2.6 Market Anomalies and Behavioral Finance 1
Example: What’s the expected return of preferred stock with Vp = $50 • Efficient Market.
and annual dividend = $5? • Market in which prices reflect all available information.
• Weak Form Efficiency.
• Market prices reflect all historical information.
• Semi-Strong Form Efficiency.
• Market prices reflect all publicly available information.
• Strong Form Efficiency.
• Market prices reflect all information, both public and private.
65 66
5.2.6 Market Anomalies and Behavioral Finance 2
5.2.6 Market Anomalies and Behavioral Finance 3
What’s the Efficient Market Hypothesis? (EMH) Another Tools: Fundamental Analysts.
EMH: Securities are normally in equilibrium and are “fairly priced.” One cannot “beat
the market” except through good luck or better information. • Investors who attempt to find mispriced securities by analyzing
1. Weak-form EMH: fundamental information, such as accounting data and business
Can’t profit by looking at past trends. A recent decline is no reason prospects.
to think stocks will go up (or down) in the future. Evidence supports
weak-form EMH, but “technical analysis” is still used.
Weak-form • Research the value of stocks using NPV and other measurements
EMH
2. Semistrong-form EMH:
of cash flow.
All publicly available information is reflected in stock prices, so
doesn’t pay to pore over annual reports looking for undervalued
stocks. Largely true, but superior analysts can still profit by finding
and using new information. Semistrong- Strong-form
form EMH EMH
3. Strong-form EMH:
All information, even inside information, is embedded in stock
prices. Not true--insiders can gain by trading on the basis of insider
information, but that’s illegal.
67 68
 5.2.6 Market Anomalies and Behavioral Finance 4 5.2.6 Market Anomalies and Behavioral Finance 5
Market Anomalies: Market Anomalies:
• Existing Anomalies. The Book-to-Market Factor.
• The Momentum Factor.
• The Book-to-Market Factor.
• Old Anomalies.
• The Small Firm Effect.
• The January Effect.
• The P E Effect.
• The Neglected Firm Effect.
• The Value Line Effect.
69 70
5.2.6 Market Anomalies and Behavioral Finance 6
Behavioral Finance:
• Attitudes towards risk.
• Beliefs about probabilities.
• Sentiment.
71
 Topic 01 Get a modern PowerPoint Presentation that is beautifully designed.
Covered 02 Get a modern PowerPoint Presentation that is beautifully designed.
03 Get a modern PowerPoint Presentation that is beautifully designed.
04 Get a modern PowerPoint Presentation that is beautifully designed.
Chapter 6: COST OF CAPITAL 05 Get a modern PowerPoint Presentation that is beautifully designed.
Instructor: Nguyễn Hồng Thoa
1 2
TOPICS COVERED 6.1 Cost of capital 1
6.1 Cost of capital: Review • Cost of capital.
6.2 The weighted-average cost of capital (WACC). • The return the firm’s investors could expect to earn if
6.3 Interpreting the WACC. they invested in securities with comparable degrees of
6.4 Measuring capital structure. risk.
6.5 Estimating expected returns.
• Capital structure.
6.6 Valuing entire businesses.
• The mix of long-term debt and equity financing.
4
3
3 4
 6.1 Cost of capital 2 6.1 Cost of capital 3
• Example: Geothermal inc. Has the following structure. Given • Example: Geothermal’s debtholders account for 30% of the capital structure,
that geothermal pays 8% for debt and 14% for equity, what is but they get a smaller share of income because their 8% return is guaranteed by
the company cost of capital? the company. The stockholders bear more risk and receive, on average, greater
return. If you buy all the debt and all the equity, you get all the income.
Market value of assets $647 100%
Market value of equity $453 70%
Market value of debt $194 30%
5
6
5 6
6.1 Cost of capital 4 6.1 Cost of capital 5
• From company cost of capital, rassets , TO WACC. • From company cost of capital, rassets.
D E
rassets = ´ rdebt + ´ requity
total income ( D ´ r ) + ( E ´ requity )
debt V V
rassets = =
value of investments V
• D = Market value of debt.
æD ö æE ö
rassets = ç ´ rdebt ÷ + ç ´ requity ÷ • E = Market value of equity = # shares × price per share.
èV ø èV ø
• V=D+E
rdebt = YTM on bonds.
7
requity = CAPM = rf + b (rm - rf ). 8
7 8
 6.2 The weighted-average cost of capital 1 6.2 The weighted-average cost of capital 2
• Weighted average cost of capital (WACC). Weighted average cost of capital = WACC.
o The expected rate of return on a portfolio of all the firm’s securities, éD ù éE ù
WACC = ê ´ (1 - Tc ) rdebt ú + ê ´ requity ú
adjusted for tax savings due to interest payments. ëV û ëV û
o Taxes are an important consideration because interest payments are • D = Market value of debt.
deducted from income before tax is calculated. • E = Market value of equity = # shares × price per share.
• V = D + E.
After-tax cost of debt = pretax cost × (1− tax rate)
rdebt = YTM on bonds.
= rdebt ´ (1 - Tc ).
requity = CAPM = r + b (r - r ).
f m f
Tc = firm's average tax rate.
9 10
9 10
6.2 The weighted-average cost of capital 3
6.2 The weighted-average cost of capital 4
• Example: Given that geothermal inc. Pays 8% for debt and 03
14% for equity, what is the WACC? 02 Calculate a
01 weighted average
• Interest is tax deductible. Calculate the of the after-tax 04 WACC
Determine the return on the debt
• At 21% tax rate, debt only costs 6.32% (8.00% × 0.79). value of each
required rate of and the return on
security as a
proportion of the return on each the equity.
firm’s market security.
value.
Three steps to calculating cost of capital.
11
11 12
 6.2 The weighted-average cost of capital 5 6.2 The weighted-average cost of capital 6
Weighted average cost of capital with preferred stock. • Example: Executive fruit has issued debt, preferred stock
éD ù éP ù éE ù
WACC = ê ´ (1 - Tc ) rdebt ú + ê ´ rpreferred ú + ê ´ requity ú and common stock. The market value of these securities are
ëV û ëV û ëV û $4 million, $2 million, and $6 million, respectively. The
D = Market value of debt. required returns are 6%, 12%, and 18%, respectively.
P = market value of preferred stock. Q: determine the WACC for executive fruit, inc.
E = market value of equity = # shares × price per share.
V = D + P + E.
rdebt = YTM on bonds.
requity = CAPM = rf + b (rm - rf ).
rpreferred = preferred dividend price of preferred. 13 14
Tc = firm's average tax rate.
13 14
6.2 The weighted-average cost of capital 7 WACC FOR SELECTED FIRMS 1
• Example. Expected Interest Proportion Proportion
Return on Rate on of Equity of Debt WACC
Ticker Company Beta equity (%) debt (%) (E/V) (D/V) (%)
• Step 1
X U.S. Steel 3.03 22.2 5.7 0.34 0.66 10.5
MRO Marathon
2.35 17.4 2.3 0.40 0.60 8.1
Oil
AMZN Amazon 1.51 11.5 1.5 0.96 0.04 11.1
• Step 2
IBM IBM 1.33 10.3 1.6 0.65 0.35 7.2
BA Boeing 1.19 9.3 2.9 0.81 0.19 8.0
F Ford 1.09 8.6 3.5 0.22 0.78 4.1
• Step 3 UNP Union
1.07 8.5 1.9 0.84 0.16 7.4
Pacific
GOOG Google/
1.01 8.1 1.5 0.99 0.01 8.0
Alphabet
DIS Disney 1.00 8.0 1.9 0.86 0.14 7.1
15 16
15 16
 WACC FOR SELECTED FIRMS 2 WACC FOR SELECTED FIRMS 3
Expected Interest Proportion Proportion
Return on Rate on of Equity of Debt WACC • Note:
Ticker Company Beta equity (%) debt (%) (E/V) (D/V) (%)
XOM ExxonMobil 1.00 8.0 1.5 0.84 0.16 6.9
1. Expected return on equity = 1% + Beta × 7%.
INTC Intel 0.91 7.3 1.6 0.89 0.11 6.7
2. Interest rate on debt is estimated as yield to maturity in September 2020 on
PFE Pfizer 0.65 5.6 1.5 0.85 0.15 4.9
PCG Pacific Gas & comparably rated corporate bonds (with ratings found on the FINRA website).
0.55 4.9 2.9 0.45 0.55 3.5
Electric
SBUX Starbucks 0.51 4.5 2.1 0.90 0.10 4.3 3. D is the book value of the firm’s debt, and e is the market value of equity.
MCD McDonald’s 0.45 4.1 2.1 0.78 0.22 3.6
CPB Campbell
0.43 4.0 2.9 0.73 0.27 3.5
4. WACC = ( D V ) ´ (1 - .21) ´ rdebt + ( E V ) ´ requity.
Soup
KO Coca-Cola 0.43 4.0 1.6 0.88 0.12 3.7
WMT Walmart 0.35 3.5 1.5 0.86 0.14 3.1
NEM Newmont
−0.01 0.9 2.3 0.88 0.12 1.0
Mining 17 18
17 18
WACC FOR SELECTED FIRMS 3 6.3 INTERPRETING WACC 1
• Example: Hot Rocks Corp., One of Geothermal’s competitors, has issued long- • The WACC is an appropriate discount rate only for a project that is a carbon
term bonds with a market value of $50 million and an expected return of 9%. It copy of the firm's existing business.
has 4 million shares outstanding trading for $10 each. At this price, the shares
offer an expected return of 17%. What is the weighted-average cost of capital for
hot rocks’ assets and operations? Assume hot rocks pays no taxes.
1.Hot Rocks’ 4 million common shares are worth $40 million. Its market-value
balance sheet is:
19 20
19 20
 6.3 INTERPRETING WACC 2 6.3 INTERPRETING WACC 2
• Changing capital structure. Example: Costas thermopolis now points out that geothermal proposes to
finance its expansion entirely by borrowing at an interest rate of 8%. He
• There are two costs of increased debt financing.
argues that this is, therefore, the appropriate discount rate for the project’s
• The explicit cost of debt is the rate of interest bondholders cash flows. Is he right?
demand; increasing debt → increased interest demanded. Costas is wrong. The project is an expansion of the firm’s existing line of
• The implicit cost is the required increase in return from equity business and pre- sumably has some risk. Therefore, the appropriate discount
due to increased risk. rate is the company’s weighted- average cost of capital, not just the rate at
which it can borrow. Costas is ignoring the implicit cost of debt: that if the
firm borrows to finance its expansion, leverage will be higher, the equity will
be riskier, and equityholders will demand a higher expected rate of return.
21 22
21 22
6.4 MEASURING CAPITAL STRUCTURE 1 6.4 MEASURING CAPITAL STRUCTURE 2
• In estimating WACC, do not use the book value of securities.
• Market value of bonds – PV of all coupons and par value
• In estimating w a c c, use the market value of the securities.
discounted at the current YTM.
• Book values often do not represent the true market value of a
firm’s securities. • Market value of equity - market price per share multiplied
by the number of outstanding shares.
23 24
23 24
 6.4 MEASURING CAPITAL STRUCTURE 3 6.4 MEASURING CAPITAL STRUCTURE 4
• Big oil book value liabilities and equity (mil) • Big oil book value liabilities and equity (mil)
Bank debt $200 25.0% Bank debt (mil) $200.0 12.6%
LT bonds $200 25.0% LT bonds $185.7 11.7%
Common stock $100 12.5% Total debt $385.7 24.3%
Retained earnings $300 37.5% Common stock ($12 per share) $1,200.0 75.7%
Total $800 100.0% Total $1,585.7 100.0%
• If the long-term bonds pay an 8% coupon and mature in 12
years, what is their market value assuming a 9% YTM?
25 26
25 26
6.5 REQUIRED RATES OF RETURN 1 6.5 REQUIRED RATES OF RETURN 2
BONDS. • Example: Big oil has a beta of .85. The risk-free rate is 6% and
rd = YTM. the market risk premium is 7%. The yield to maturity on its
debt is 9% and the tax rate is 21%.
COMMON STOCK.
re = CAPM = rf + b ( rm - rf ).
27 28
27 28
 6.5 REQUIRED RATES OF RETURN 3 6.5 REQUIRED RATES OF RETURN 4
• Dividend discount model cost of equity. • Expected return on preferred stock.
• Perpetuity growth model: • Price of preferred stock:
Div1 Div1
P0 = P0 =
re - g rpreferred
• Solve for re : • Solve for rpreferred :
Div1 Div1
re = +g rpreferred =
P0 P0
29 30
29 30
6.5 REQUIRED RATES OF RETURN 5 FCF AND PV
• Example: You have identified a group of oil companies with • Free cash flows (FCF) should be the theoretical basis for all present value
similar businesses and capital structures to big oil. The average (PV) calculations.
estimated beta of their common stocks is 1.1. Use this “industry
• FCF is a more accurate measurement of PV than either dividends or
beta” to reestimate the expected rate of return on big oil’s common
stock, assuming, of course, that the CAPM is true. Recalculate big earnings per share.
oil’s weighted-average cost of capital. • The market price does not always reflect the PV of FCF.
• When valuing a business for purchase, always use FCF.
31 32
31 32
 6.6 VALUING A BUSINESS 1 6.6 VALUING A BUSINESS 2
• Valuing a business. Valuing a business or project.
o The value of a business or project is usually computed FCF FCF FCF PVH
PV = 1
+ 2
+ ... + H
+
(1 + WACC ) (1 + WACC ) (1 + WACC ) (1 + WACC )
1 2 H H
as the discounted value of f c f out to a valuation
horizon (H). !"""""""""""#"""""""""""
$ !""#""$
o The valuation horizon is sometimes called the terminal PV (free cash flows PV ( horizon value )
value and is calculated like a perpetuity.
FCFH +1
Where horizon value = PVH =
WACC - g
FCF1 FCF2 FCFH PVH
PV = + + ... + +
(1 + WACC ) (1 + WACC ) (1 + WACC ) (1 + WACC )
1 2 H H
33 34
33 34
6.6 VALUING A BUSINESS 3 6.6 VALUING A BUSINESS 4
• Example – deconstruction company.
• Example – deconstruction company: The capital structure for
1 2 3 4 5 6
deconstruction company is 60% equity and 40% debt. The
1. Sales $1,400.0 $1,680.0 $2,016.0 $2,318.4 $2,666.2 $2,932.8
required rate of return on equity is 12% and that the business 2. Costs 1,190.0 1,428.0 1,713.6 1,970.6 2,266.2 2,492.9
could borrow at an interest rate of 5%. What is the WACC if the 3. EBITDA* = 1 − 2 210.0 252.0 302.4 347.8 399.9 439.9
tax rate is 21%? 4. Depreciation 100.8 121.0 145.2 166.9 160.0 140.8
5. Profit before tax = 3 − 4 109.2 131.0 157.2 180.8 240.0 299.1
6. Tax at 21% 22.9 27.5 33.0 38.0 50.4 62.8
7. Profit after tax = 5 − 6 86.3 103.5 124.2 142.9 189.6 236.3
8. Operating cash flow = 4 + 7 187.1 224.5 269.4 309.8 349.5 377.1
9. Investment in fixed assets and
net working capital 180.0 289.0 346.8 348.4 102.0 −19.2
35 36
10. Free cash flow = 8 − 9 7.1 −64.5 −77.4 −38.6 247.5 396.3
*EBITDA = Earnings before interest, taxes, depreciation, and amortization.
35 36
 6.6 VALUING A BUSINESS 5
• Example – deconstruction company: Using the WACC and
the FCFS, calculate the value of deconstruction company.
37
37
 Topics Covered
Chapter 7 7.1 An Overview of Capital Budgeting
Capital Budgeting and Investment Decision 7.2 The major capital budgeting decision criteria
7.3 Conclusions on capital budgeting methods
Should we
build this
plant?
2
1 2
7.1 An Overview of Capital Budgeting 1 7.1 An Overview of Capital Budgeting 2
Capital budgeting: the process of planning expenditures on assets Project categories:
with cash flows that are expected to extend beyond 1 year. • Replacement: needed to continue current operations
• Analysis of potential additions to fixed assets. • Replacement: cost reduction
• Long-term decisions; involve large expenditures. • Expansion of existing products or markets
• Very important to firm’s future. • Expansion into new products or markets
• Safety and/or environmental projects
• Other projects
• Mergers
3 4
3 4
 7.1 An Overview of Capital Budgeting 3 7.1 An Overview of Capital Budgeting 4
Steps to generate projects: What is the difference between independent and mutually
1. Estimate CFs (inflows & outflows). exclusive projects?
2. Assess riskiness of CFs. • Independent projects: projects with cash flows that are not
3. Determine k = WACC (adj.). affected by the acceptance or nonacceptance of other projects.
4. Find NPV and/or IRR. • Mutually exclusive projects: a set of projects where only one can
be accepted.
5. Accept if NPV > 0 and/or IRR > WACC.
5 6
5 6
7.1 An Overview of Capital Budgeting 5 7.1 An Overview of Capital Budgeting 6
An Example of Mutually Exclusive Projects Normal Cash Flow Project: Cost (negative CF) followed by a series of
positive cash inflows. One change of signs.
Nonnormal Cash Flow Project: Two or more changes of signs. Most
common: Cost (negative CF), then string of positive CFs, then cost to
close project. Nuclear power plant, strip mine.
BRIDGE vs. BOAT to get
products across a river.
7 8
7 8
 7.1 An Overview of Capital Budgeting 7 7.2 The major capital budgeting decision criteria
Normal Cash Flow Project vs Nonnormal Cash Flow Project 1. Net present value (NPV)
2. Internal rate of return (IRR)
Inflow (+) or Outflow (-) in Year
3. Profitability Index
0 1 2 3 4 5 N NN 4. The Payback Rule
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
10
9 10
1. Net present value (NPV) 1 1. Net present value (NPV) 2
Net Present Value. • Example. Suppose we can invest $50 today & receive
• Present value of cash flows minus initial investments. $60 later today. What is our increase in value?
Opportunity Cost of Capital.
• Expected rate of return given up by investing in a project.
11
12
11 12
 1. Net present value (NPV) 3 1. Net present value (NPV) 4
• Example: Suppose we can invest $50 today and receive Valuing an Office Building
$60 in one year. What is our increase in value given a Step 1: Forecast cash flows.
10% expected return?
Cost of building = C0 = 350,000.
Sale price in Year 1 = C1 = 400,000.
Step 2: Estimate opportunity cost of capital.
If equally risky investments in the capital market.
offer a return of 7%, then.
Cost of capital = r = 7%.
• This is the definition of NPV.
13
14
13 14
1. Net present value (NPV) 5 1. Net present value (NPV) 6
Valuing an Office Building
C1 C2 Ct
NPV = C0 + + + ... +
• Step 3: Discount future cash flows. (1 + r )
1
(1 + r )
2
(1 + r )
t
C1 $400,000
PV = = = $373,832 • C0 = Initial cash flow (often negative).
(1 + r ) (1 + .07 )
• C1 = Cash flow at time 1.
• Step 4: Accept if PV of payoff exceeds investment. • C2 = Cash flow at time 2.
• Ct = Cash flow at time t.
NPV = -$350,000 + 373,832 • t = Time period of the investment.
= $23,832 • r = Opportunity cost of capital.
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 1. Net present value (NPV) 7 1. Net present value (NPV) 8
A summary of the NPV decision rules: • Example. You might purchase an office building. You
• Managers increase shareholders’ wealth by accepting have tenants that will generate $25,000 per year in cash
projects that are worth more than they cost. flows for 3 years. At the end of 3 years, you think you
can sell the building for $450,000. How much would
• Therefore, they should accept all projects with a positive you be willing to pay for the building, if your
net present value. opportunity cost of capital is 7%?
• Independent projects: if NPV exceeds zero, accept the
project.
• Mutually exclusive projects: accept the project with the
highest positive NPV.
• If no project has a positive NPV, reject them all.
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1. Net present value (NPV) 8 1. Net present value (NPV) 9
• Example: If the building is being offered for sale at a
price of $375,000, would you buy the building? What is
the added value generated by your purchase and
management of the building?
• Access the text alternative for slide images. 19 20
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 2. Internal Rate of Return 1 2. Internal Rate of Return 2
• Internal Rate of Return (IRR). • Example: You can purchase a building for $350,000. At
• Discount rate at which NPV = 0. the end of the year, you will sell the building for
$400,000. What is the rate of return on this investment?
• It is the rate of return generated by the cash flows and
their timing.
• Rate of Return Rule.
• Invest in any project offering a rate of return that is
higher than the opportunity cost of capital.
C1 - investment
Rate of return =
investment
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21 22
2. Internal Rate of Return 3 2. Internal Rate of Return 4
• Example: Consider the earlier building for $375,000. It
generates $25,000 in rental cash flows for 3 years. At the
end of 3 years, you will sell the building for $450,000.
What is its IRR?
$25,000 $25,000 $475,000
0 = -$375,000 + + +
(1 + IRR ) (1 + IRR ) (1 + IRR )
1 2 3
IRR = 12.56%
• Access the text alternative for slide images. 23 24
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 2. Internal Rate of Return 5 2. Internal Rate of Return 6
• Example. You have 2 proposals to choose between office-block proposals:
• You initially intended to invest $350,000 in the building and then sell it at the end of
the year for $400,000.
• Under the revised proposal, you planned to invest $375,000, rent out the offices for
three years at a fixed annual rent of $25,000, and then sell the building for $450,000.
• The initial proposal (I) has a cash flow that is different than the revised proposal (R).
Using IRR, which do you prefer?
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2. Internal Rate of Return 7 2. Internal Rate of Return 8
• Example. You have two proposals to choose between.
The initial proposal has a cash flow that is different than
the revised proposal. Which do you prefer?
Project C0 C1 C2 C3 IRR NPV @ 7%
Initial proposal –350 400 14.29% $23,832
Revised proposal –375 25 25 475 12.56% $57,942
• Access the text alternative for slide images. 27 28
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 2. Internal Rate of Return 9 2. Internal Rate of Return 11
Pitfall 3 – Multiple Rates of Return.
Pitfall 1 – Mutually Exclusive Projects.
• Certain cash flows can generate NPV = 0 at more than one
• IRR sometimes ignores the magnitude of the project. discount rate.
• The previous two projects (I and R) illustrate that problem.
• Pitfall 2 – Lending or Borrowing?
• With some cash, the NPV of the project increases as the discount
rate increases.
• This is contrary to the normal relationship between PV and
discount rates.
29 • Access the text alternative for slide images. 30
29 30
2. Internal Rate of Return 9 2. Internal Rate of Return 10
A summary of the IRR decision rules: Modified Internal Rate of Return (MIRR)
• Independent projects: if IRR exceeds the project’s WACC, • MIRR is the discount rate that causes the PV of a project’s terminal
accept the project. If IRR is less than the project’s WACC, value (TV) to equal the PV of costs. TV is found by compounding
reject it. inflows at WACC.
• Mutually exclusive projects: accept the project with the • MIRR assumes cash flows are reinvested at the WACC.
highest IRR, provided that IRR is greater than WACC. • When there are nonnormal CFs and more than one IRR, use MIRR.
Reject all projects if the best IRR does not exceed WACC.
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 2. Internal Rate of Return 11 3. Profitability Index 1
Modified Internal Rate of Return (MIRR): Our conclusion is that Profitability Index: Ratio of net present value to initial investment.
the MIRR is better than the regular IRR; however, this question remains:
Is MIRR as good as the NPV? Here are our conclusions: NPV
Profitability index =
• For independent projects with normal cash flows, the NPV, IRR, and initial investment
MIRR always reach the same accept/reject conclusion, so in these • Note: Be sure to enter the magnitude of the initial investment only.
circumstances the three criteria are equally good.
Example: Our initial proposal to construct an office building
• However, if projects are mutually exclusive and they differ in size,
conflicts can arise. In such cases, the NPV is best because it selects involved an invest- ment of $350,000 and had an NPV of
the project that maximizes value. $23,832. What is profitability index?
• Our overall conclusions are that (1) The MIRR is superior to the
regular IRR as an indicator of a project’s “true” rate of return. (2)
NPV is better than IRR and MIRR when choosing among
competing projects.
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3. Profitability Index 2 3. Profitability Index 4
Any project with a positive profitability index must also have a
positive NPV, so it would seem that either criterion must result in Capital Rationing.
identical decisions. Why go to the trouble of calculating the • Limit set on the amount of funds available for investment.
profitability index?
Soft Rationing.
• Limits on available funds imposed by management.
Hard Rationing.
• Limits on available funds imposed by the unavailability of
funds in the capital market.
When there is a shortage of funds, the firm needs to pick those projects
that have the highest profitability index. 35 36
35 36
 3. Profitability Index 5 4. Payback Rule 1
Pitfalls of the Profitability Index Payback Period.
The profitability index is sometimes used to rank projects even when
• Time until cash flows recover the initial investment of the project.
there is neither soft nor hard capital rationing. In this case the unwary
user may be led to favor small projects over larger projects that have Payback Rule.
higher NPVs.
• Accept a project if its payback period is less than a specified
cutoff period.
• The following example will demonstrate a major problem with
this statement.
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4. Payback Rule 2 4. Payback Rule 4
Discounted Payback Period.
• Time until the present value of cash flows recover the initial
investment of the project.
• It will never accept a negative N P V project.
• Like Payback Period, this method runs the risk of rejecting
good long-term projects.
• Compare projects F and G. Project F has a two-year payback and a large positive NPV.
• Project G also has a two-year payback but a negative NPV.
• Project F is clearly superior, but the payback rule ranks both equally. This is because
payback does not consider any cash flows that arrive after the payback period.
• A firm that uses the payback criterion with a cutoff of two or more years would accept
both F and G despite the fact that only F would increase shareholder wealth.
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 4. Payback Rule 5
7.3 Conclusions on capital budgeting methods 1
Criterion Definition Investment Rule Comments
Accept project if NPV is The “gold standard” of investment criteria. Only criterion necessarily
Example: A machine costs $700 and will generate annual cash Net present Present value of cash positive. For mutually consistent with maximizing the value of the firm. Provides
flows of $100 for 20 years. What is the payback period? If the value flows minus initial exclusive projects, choose appropriate rule for choosing between mutually exclusive
(NPV) investment the one with the highest investments. Only pitfall involves capital rationing, when one cannot
interest rate is 7.1%, what is the discounted payback period? What is (positive) NPV. accept all positive-NPV projects.
the project NPV? Should the project be accepted? If used properly, results in same accept-reject decision as N P V in
Internal
The discount rate at Accept project if IRR is the absence of project interactions. However, beware of the following
rate of
which project NPV greater than opportunity pitfalls: I R R cannot rank mutually exclusive projects—the project
return
equals zero cost of capital. with higher IRR may have lower NPV. The simple IRR rule cannot
(IRR)
be used in cases of multiple IRRs or an upward-sloping NPV profile.
Accept project if
profitability index is greater Results in same accept-reject decision as NPV in the absence of
Ratio of net present
Profitabilit than 0. In case of capital project interactions. Useful for ranking projects in case of capital
value to initial
y index rationing, accept projects rationing, but potentially misleading in the presence of interactions or
Investment
with highest profitability in comparing projects of different size.
index.
Time until the sum of
Accept project if payback A quick and dirty rule of thumb, with several critical pitfalls. Ignores
Payback project cash flows
period is less than some cash flows beyond the acceptable payback period. Ignores
period equals the initial
41 specified number of years. discounting. Tends to improperly reject long-lived projects.42
Investment
41 42
7.3 Conclusions on capital budgeting methods 2 7.3 Conclusions on capital budgeting methods 2
• NPV is the single best criterion because it provides a direct measure
of value the project adds to shareholder wealth.
• IRR and MIRR measure profitability expressed as a percentage rate
of return, which is useful to decision makers. Further, IRR and MIRR
contain information concerning a project’s “safety margin.
• The modified IRR has all the virtues of the IRR, but it incorporates
a better reinvestment rate assumption and avoids the multiple rate of
return problem. So if decision makers want to know projects’ rates of
return, the MIRR is a better indicator than the regular IRR.
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 7.3 Conclusions on capital budgeting methods 2 7.3 Conclusions on capital budgeting methods 2
• Profitability Index: The profitability index was designed to select
projects with the most bang per buck—the greatest NPV per dollar In summary, the different measures provide different types of
spent. That’s the right objective when bucks are limited. When they are information. Because it is easy to calculate all of them, all should be
not, a bigger bang is always better than a smaller one, even when more considered when capital budgeting decisions are being made. For
bucks are spent. This is another case where project comparisons can go most decisions, the greatest weight should be given to the NPV, but it
awry once we abandon the NPV rule. would be foolish to ignore the information provided by the other
• Payback and discounted payback provide indications of a project’s criteria.
liquidity and risk. A long payback means that investment dollars will
be locked up for a long time; hence, the project is relatively illiquid. In
addition, a long payback means that cash flows must be forecasted far
out into the future, and that probably makes the project riskier than one
with a shorter payback.
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 QUESTIONS & PROBLEMS
Chapter 2

2.1. Construct a balance sheet for Sophie’s Sofas given the following data. What is shareholders’
equity?
Cash balances = $10,000
Inventory of sofas = $200,000
Store and property = $100,000
Accounts receivable = $22,000
Accounts payable = $17,000
Long-term debt = $170,
2.2. A firm’s income statement included the following data. The firm’s average tax rate was 20%.
Cost of goods sold $8,000
Income taxes paid $2,000
Administrative expenses $3,000
Interest expense $1,000
Depreciation $1,000
a. What was the firm’s net income?
b. What must have been the firm’s revenues?
c. What was EBIT?
2.3.The year-end 2021 balance sheet of Brandex Inc. listed common stock and other paid-in capital
at $1,100,000 and retained earnings at $3,400,000. The next year, retained earnings were listed
at $3,700,000. The firm’s net income in 2022 was $900,000. There were no stock repurchases
during the year. What were the dividends paid by the firm in 2022?
2.4.South Sea Baubles has the following (incomplete) balance sheet and income statement.

BALANCE SHEET AT END OF YEAR (Figures in $ millions)

Assets 2021 2022 Liabilities and Shareholders’ Equity 2021 2022
Current assets $ 90 $140 Current liabilities $50 $60
Net fixed assets 800 900 Long-term debt 600 750
INCOME STATEMENT, 2022 (Figures in $ millions)
Revenue $1,950
Cost of goods sold 1,030
Depreciation 350
Interest expense 240
 a. What is shareholders’ equity in 2021, 2022?
b. What is net working capital in 2021, 2022?
c. What are taxes paid in 2022? Assume the firm pays taxes equal to 21% of taxable income.
d. What is cash provided by operations during 2022? Pay attention to changes in net working
capital, using Table 3.4 as a guide.
e. Net fixed assets increased from $800 million to $900 million during 2022. What must have
been South Sea’s gross investment in fixed assets during 2022?
f. If South Sea reduced its outstanding accounts payable by $35 million during the year, what
must have happened to its other current liabilities?
2.5. Butterfly Tractors had $14 million in sales last year. Cost of goods sold was $8 million,
depreciation expense was $2 million, interest payment on outstanding debt was $1 million, and
the firm’s tax rate was 21%.
a. What was the firm’s net income?
b. What was the firm’s cash flow?
c. What would happen to net income and cash flow if depreciation were increased by
$1 million?
d. Would you expect the change in depreciation to have a positive or negative impact
on the firm’s stock price?
e. What would be the impact on net income if depreciation was $1 million and interest
expense was $2 million?
f. What would be the impact on cash flow if depreciation was $1 million and interest
expense was $2 million?
2.6. Here is a simplified balance sheet for Locust Farming:
Locust has 657 million shares outstanding with a market price of $83 a share.
Current assets $42,524 Current liabilities $29,755
Long-term assets 46,832 Long-term debt 27,752
Other liabilities 14,317
Equity 17,532
Total $89,356 Total $89,356
a. Calculate the company’s market value added.
b. Calculate the market-to-book ratio.
c. How much value has the company created for its shareholders as a percent of
shareholders’ equity, that is, as a percent of the net capital contributed by shareholders)?

2.7.Here are simplified financial statements for Phone Corporation in 2020:

INCOME STATEMENT (Figures in $ millions)

Net sales $13,193
Cost of goods sold 4,060
Other expenses 4,049
Depreciation 2,518
Earnings before interest and taxes (EBIT) $ 2,566
Interest expense 685
Income before tax $ 1,881
Taxes (at 21%) 395
Net income $ 1,486
Dividends 1,040
BALANCE SHEET (Figures in $ millions)
End of Year Start of Year
Assets
Cash and marketable securities $ 89 $ 158
Receivables 2,382 2,490
Inventories 187 238
Other current assets 867 932
Total current assets $ 3,525 $ 3,818
Net property, plant, and equipment 19,973 19,915
Other long-term assets 4,216 3,770
Total assets $27,714 $27,503
Liabilities and shareholders’ equity
Payables $ 2,564 $ 3,040
Short-term debt 1,419 1,573
Other current liabilities 811 787
Total current liabilities $ 4,794 $ 5,400
Long-term debt and leases 7,018 6,833
Other long-term liabilities 6,178 6,149
Shareholders’ equity 9,724 9,121
Total liabilities and shareholders’ equity $27,714 $27,503

Calculate the following financial ratios for Phone Corporation using the methodologies listed for
each part:

a. Return on equity (use average balance sheet figures)

b. Return on assets (use average balance sheet figures)
c. Return on capital (use average balance sheet figures)
d. Days in inventory (use start-of-year balance sheet figures)
e. Inventory turnover (use start-of-year balance sheet figures)
f. Average collection period (use start-of-year balance sheet figures)
g. Operating profit margin
h. Long-term debt ratio (use end-of-year balance sheet figures)
 i. Total debt ratio (use end-of-year balance sheet figures)
j. Times interest earned
k. Current ratio (use end-of-year balance sheet figures)
l. Quick ratio (use end-of-year balance sheet figures)
2.8. Keller Cosmetics maintains an operating profit margin of 5% and asset turnover ratio of 3.
a. What is its ROA?
b. If its debt-equity ratio is 1, its interest payments and taxes are each $8,000, and EBIT is
$20,000, what is its ROE?
2.9. True or false? Explain.
a. A company’s debt‒equity ratio is always less than 1.
b. The quick ratio is always less than the current ratio.
c. For a profitable company, the return on equity is always less than the return on assets.
2.10. Dưới đây là bản tóm tắt một số thông tin liên quan đến công ty HiEco như sau:
Chỉ tiêu 2020 2021 2022
Phải thu khách hàng 15.975 14.272 12.700
Hàng tồn kho 24.670 15.284 13.500
Tổng tài sản ngắn hạn 44.795 32.971 29.410
Tổng tài sản 79.341 67.200 65.432
Vay và nợ ngắn hạn 27.891 20432 21.120
Phải trả người bán 5.505 3.157 3.000
Thuế và các khoản phải nộp nhà nước 950 830 790
Nợ dài hạn 3.435 2.643 2.500
Vốn chủ sở hữu 18.422 18.422 18.422
Doanh thu thuần 82.500 72.000 67.000
Giá vốn hàng bán 57.625 51.840 48.575
Lợi nhuận thuần 4.415 2.490 1.935
Anh (chị) hãy phân tích và nhận xét các tỷ số: Khả năng thanh toán ngắn hạn, số vòng quay hàng
tồn kho, kỳ thu tiền bình quân, ROA và ROE của công ty HiEco trong 2 năm 2021 và 2022.
Group Assignments.
1. Collect Financial Statements of a firm
Tip: Annual reports are at Yahoo! Finance (finance.yahoo.com) or Google Finance
(finance.google.com) or vietstock.vn
2. Calculate Market Value versus Book Value of the firm. Show the difference is market value
added by the management.
3. Calculate Financial ratios of the firm. Compare and explain difference in ratios with the
average of industry or rival firms
4. Dupont analysis. Conclusion of the firm
 QUESTIONS & PROBLEMS
Chapter 3
1. You deposit $1,000 in your bank account.
a. If the bank pays 4% simple interest, how much will you accumulate in your account
after 10 years?
b. How much will you accumulate if the bank pays compound interest?
2. If you earn 6% per year on your bank account, how long will it take an account with $100
to double to $200?
3. You can buy property today for $3 million and sell it in five years for $4 million. (You
earn no rental income on the property.)
a. If the interest rate is 8%, what is the present value of the sales price?
b. Is the property investment attractive to you?
c. Would your answer to part (b) change if you also could earn $200,000 per-year rent
on the property? The rent is paid at the end of each year.
4. A factory costs $400,000. You forecast that it will produce cash inflows of $120,000 in
year 1, $180,000 in year 2, and $300,000 in year 3. The discount rate is 12%.
a. What is the value of the factory?
b. Is the factory a good investment?
5. A famous quarterback just signed a $15 million contract providing $3 million a year for
five years. A less famous goalkeeper signed a $14 million five-year contract providing $4
million now and $2 million a year for five years. The interest rate is 10%. Who is better
paid?
6. A local bank advertises the following deal: “Pay us $100 a year for 10 years and then we
will pay you (or your beneficiaries) $100 a year forever.” Is this a good deal if the interest
rate is 6%?
7. British government 4% perpetuities once paid £4 interest each year forever. Another bond,
2.5% perpetuities, paid £2.50 a year forever.
a. What was the value of 4% perpetuities if the long-term interest rate was 6%?
b. What was the value of 2.5% perpetuities?
8. Professor’s Annuity Corp. offers a lifetime annuity to retiring professors. For a payment of
$80,000 at age 65, the firm will pay the retiring professor $600 a month until death.
a. If the professor’s remaining life expectancy is 20 years, what is the monthly interest
rate on this annuity?
b. What is the effective annual interest rate?
c. If the monthly interest rate is .5%, what monthly annuity payment can the firm offer
to the retiring professor?
9. You can buy a car that is advertised for $24,000 on the following terms: (a) pay $24,000
and receive a $2,000 rebate from the manufacturer; (b) pay $500 a month for four years
for total payments of $24,000, implying zero percent financing. Which is the better deal
if the interest rate is 1% per month?
10. I now have $20,000 in the bank earning interest of .5% per month. I need $30,000 to make
a down payment on a house. I can save an additional $100 per month. How long will it take
me to accumulate the $30,000?
11. Your landscaping company can lease a truck for $8,000 a year (paid at year-end) for six
years. It can instead buy the truck for $40,000. The truck will be valueless after six years.
The interest rate your company can earn on its funds is 7%.
a. What is the present value of the cost of leasing?
b. Is it cheaper to buy or lease?
c. What is the present value of the cost of leasing if the lease payments are an annuity
due, so the first payment comes immediately?
d. Is it now cheaper to buy or lease?
12. If you borrow $1,000 and agree to repay the loan in five equal annual payments at an
interest rate of 12%, what will your payment be?
What will your payment be if you make the first payment on the loan immediately instead
of at the end of the first year?
13. Consider a four-year amortizing loan. You borrow $1,000 initially and repay it in four
equal annual year-end payments.
a. If the interest rate is 8%, what is the annual payment?
b. Fill in the following table, which shows how much of each payment is interest
versus principal repayment (that is, amortization) and the outstanding balance on
the loan at each date.
Loan Year-End Interest Due Total Year-End Amortization of
Time
Balance ($) on Loan Balance ($) Payment ($) Loan ($)
0 1,000 _____ _____ _____
1 _____ _____ _____ _____
2 _____ _____ _____ _____
3 _____ _____ _____ _____
4 0 0
14. You believe you will need to have saved $500,000 by the time you retire in 40 years in
order to live comfortably. If the interest rate is 6% per year, how much must you save each
year to meet your retirement goal?
15. A couple thinking about retirement decide to put aside $3,000 each year in a savings plan
that earns 8% interest. In five years they will receive a gift of $10,000 that also can be
invested.
a. How much money will they have accumulated 30 years from now?
 b. If their goal is to retire with $800,000 of savings, how much extra do they need to
save every year?
16. You borrow $1,000 from the bank and agree to repay the loan over the next year in 12
equal monthly payments of $90. However, the bank also charges you a loan initiation fee
of $20, which is taken out of the initial proceeds of the loan. What is the effective annual
interest rate on the loan, taking account of the impact of the initiation fee?
17. You take out an $8,000 car loan that calls for 48 monthly payments starting after one month
at an APR of 10%.
a. What is your monthly payment?
b. What is the effective annual interest rate on the loan?
c. Now assume the payments are made in four annual year-end installments. What
annual payment would have the same present value as the monthly payment you
calculated?
18. If investors are to earn a 3% real interest rate, what nominal interest rate must they earn if
the inflation rate is (a) zero? (b) 4%? (c) 6%?
19. Good news: You will almost certainly be a millionaire by the time you retire in 50 years.
Bad news: The inflation rate over your lifetime will average about 3%.
a. What will be the real value of $1 million by the time you retire in terms of today’s
dollars?
b. What real annuity (in today’s dollars) will $1 million support if the real interest rate
at retire- ment is 2% and the annuity must last for 20 years?
20. You plan to retire in 30 years and want to accumulate enough by then to provide yourself
with $30,000 a year for 15 years.
a. If the interest rate is 10%, how much must you accumulate by the time you retire?
b. How much must you save each year until retirement in order to finance your
retirement consumption?
c. Now you remember that the annual inflation rate is 4%. If a loaf of bread costs $1
today, what will it cost by the time you retire?
d. You really want to consume $30,000 a year in real dollars during retirement and
wish to save an equal real amount each year until then. What is the real amount of
savings that you need to accumulate by the time you retire?
e. Calculate the required preretirement real annual savings necessary to meet your
consumption goals.
f. What is the nominal value of the amount you need to save during the first year?
(Assume the savings are put aside at the end of each year.)
g. What is the nominal value of the amount you need to save during the 30th year?
21. Suppose that:
a. You’ve just graduated college, and you are contemplating your lifetime budget.
You think your general living expenses will average around $50,000 a year. For the
 next eight years, you will rent an apartment for $16,000 a year. After that, you will
want to buy a house that should cost around $250,000. In addition, you will need
to buy a new mobile phone roughly once every 10 years, costing around $30,000
each. In 25 years, you will have to put aside around $150,000 to put a child through
college, and in 30 years you’ll need to do the same for another child. In 50 years,
you will retire and will need to have accumulated enough savings to support
roughly 20 years of retirement spending of around $35,000 a year on top of your
Social Security benefits. The interest rate is 5% per year. What average salary will
you need to earn to support this lifetime consumption plan?
b. Whoops! You just realized that the inflation rate over your lifetime is likely to
average about 3% per year, and you need to redo your calculations. As a rough cut,
it seems reasonable to assume that all relevant prices and wages will increase at
around the rate of inflation. What is your new estimate of the required salary (in
today’s dollars)?
 QUESTIONS & PROBLEMS
Chapter 4

4.1 A stock is selling today for $40 per share. At the end of the year, it pays a dividend of $2
per share and sells for $44.
a. What is the total rate of return on the stock?
b. What are the dividend yield and percentage capital gain?
c. Now suppose the year-end stock price after the dividend is paid is $36. What are the
dividend yield and percentage capital gain in this case?
4.2 Consider the following scenario analysis:
Rate of Return
Scenario Probability Stocks Bonds
Recession 0.20 −5 % +14 %
Normal economy 0.60 +15 % +8 %
Boom 0.20 +25 % +4 %
a. Is it reasonable to assume that Treasury bonds will provide higher returns in recessions
than in booms?
b. Calculate the expected rate of return and standard deviation for each investment.
c. Which investment would you prefer?
4.3 Use the data in the scenario analysis from Problem 4.2 and consider a portfolio with weights
of 0.60 in stocks and 0.40 in bonds.
a. What is the rate of return on the portfolio in each scenario?
b. What are the expected rate of return and standard deviation of the portfolio?
c. Would you prefer to invest in the portfolio, in stocks only, or in bonds only? Explain the
benefit of diversification.
4.4 Portfolio Risk and Return. Suppose that the S&P 500, with a beta of 1.0, has an expected return
of 10% and T-bills provide a risk-free return of 4%.
a. How would you construct a portfolio from these two assets with an expected return of 8%?
Specifically, what will be the weights in the S&P 500 versus T-bills?
b. How would you construct a portfolio from these two assets with a beta of .4?
c. Find the risk premiums of the portfolios in parts (a) and (b), and show that they are
proportional to their betas.
4.5 You are considering acquiring a firm that you believe can generate expected cash flows of
$10,000 a year forever. However, you recognize that those cash flows are uncertain.
 a. Suppose you believe that the beta of the firm is 0.4. How much is the firm worth if the
risk- free rate is 4% and the expected rate of return on the market portfolio is 11%?
b. By how much will you overvalue the firm if its beta is actually 0.6?
4.6 True or false? Explain or qualify as necessary.
a. Investors demand higher expected rates of return on stocks with more variable rates of
return.
b. The capital asset pricing model predicts that a security with a beta of zero will provide an
expected return of zero.
c. An investor who puts $10,000 in Treasury bills and $20,000 in the market portfolio will
have a portfolio beta of 2.0.
d. Investors demand higher expected rates of return from stocks with returns that are highly
exposed to macroeconomic changes.
e. Investors demand higher expected rates of return from stocks with returns that are very
sensitive to fluctuations in the stock market.
f. The CAPM implies that if you could find an investment with a negative beta, its expected
return would be less than the interest rate.
g. If a stock lies below the security market line, it is undervalued.
4.7 A mutual fund manager expects her portfolio to earn a rate of return of 11% this year. The
beta of her portfolio is 0.8.
a. If the rate of return available on risk-free assets is 4% and you expect the rate of
return on the market portfolio to be 14%, what expected rate of return would you demand
before you would be willing to invest in this mutual fund?
b. Is this fund attractive?
4.8 The Treasury bill rate is 4%, and the expected return on the market portfolio is 12%. According
to the capital asset pricing model:
a. What is the risk premium on the market?
b. What is the required return on an investment with a beta of 1.5?
c. If an investment with a beta of .8 offers an expected return of 9.8%, does it have a positive
NPV?
d. If the market expects a return of 11.2% from stock X, what is its beta?
 QUESTIONS & PROBLEMS
Chapter 5
5.1 A 30-year Treasury bond is issued with face value of $1,000, paying interest of $60 per year.
If market yields increase shortly after the T-bond is issued, what happens to the bond’s:
a. coupon rate?
b. price?
c. yield to maturity?
5.2 A General Power bond carries a coupon rate of 8%, has nine years until maturity, and sells at
a yield to maturity of 7%. (Assume annual interest payments.)
a. What interest payments do bondholders receive each year?
b. At what price does the bond sell?
c. What will happen to the bond price if the yield to maturity falls to 6%?
5.3 A 30-year-maturity bond with face value of $1,000 makes annual coupon payments and has a
coupon rate of 8%. What is the bond’s yield to maturity if the bond is selling for:
a. $900?
b. $1,000?
c. $1,100?
5.4 You buy an 8% coupon, 10-year-maturity bond for $980. A year later, the bond price is
$1,200. (Assume annual coupon payments.)
a. What is the new yield to maturity on the bond?
b. What is your rate of return over the year?
5.5 A bond has 10 years until maturity, a coupon rate of 9%, and sells for $1,100. Interest is paid
annually.
a. If the bond has a yield to maturity of 9% one year from now, what will its price
be at that time?
b. What will be the rate of return on the bond?
c. If the inflation rate during the year is 3%, what is the real rate of return on the
bond?
5.6 Here is a small part of the order book for Mesquite Foods:
 a. Georgina Sloberg submits a market order to sell 100 shares. What price will she receive?
b. Norman Pilbarra submits a market order to buy 400 shares. What is the maximum price
that he will pay?
c. Carlos Ramirez submits a limit bid order at 105. Will it execute immediately?
5.7 a. Favorita Candy’s stock is expected to earn $2.40 per share this year. Its P/E ratio is 18.
What is the stock price?
b. BMM Industries pays a dividend of $2 per quarter. The dividend yield on its stock is
reported at 4.8%. What is the stock price?
5.8 Integrated Potato Chips just paid a $1 per share dividend. You expect the dividend to grow
steadily at a rate of 4% per year.
a. What is the expected dividend in each of the next three years?
b. If the discount rate for the stock is 12%, at what price will the stock sell?
c. What is the expected stock price three years from now?
d. If you buy the stock and plan to sell it three years from now, what are your expected cash flows
in (i) year 1; (ii) year 2; (iii) year 3?
e. What is the present value of the stream of payments you found in part (d)? Compare your
answer to part (b).
5.9 a. Arts and Crafts Inc. will pay a dividend of $5 per share in one year. It sells at $50 a
share, and firms in the same industry provide an expected rate of return of 14%. What must be
the expected growth rate of the company’s dividends?
b. A stock sells for $40. The next dividend will be $4 per share. If the rate of return
earned on reinvested funds is a constant 15% and the company reinvests a constant 40% of
earnings in the firm, what must be the discount rate?
5.10 Here are data on two stocks, both of which have discount rates of 15%:
 a. What is the dividend payout ratio for each firm?
b. What is the expected dividend growth rate for each stock?
c. What is the value of each stock?
5.11 Better Mousetraps has come out with an improved product, and the world is beating a path
to its door. As a result, the firm projects growth of 20% per year for four years. By then, other
firms will have copycat technology, competition will drive down profit margins, and the
sustainable growth rate will fall to 5%. The most recent annual dividend was DIV0 = $1 per
share.
a. What are the expected values of (i) DIV1, (ii) DIV2, (iii) DIV3, and (iv) DIV4?
b. What is the expected stock price four years from now? The discount rate is 10%.
c. What is the stock price today?
d. Find the dividend yield, DIV1/P0.
e. What will next year’s stock price, P1, be?
f. What is the expected rate of return to an investor who buys the stock now and
sells it in one year?
 QUESTIONS & PROBLEMS
Chapter 6

6.1 The common stock of Buildwell Conservation & Construction Inc. (BCCI) has a beta of .9.
The Treasury bill rate is 4%, and the market risk premium is estimated at 8%. BCCI’s capital
structure is 30% debt, paying a 5% interest rate, and 70% equity. Buildwell pays tax at 21%.
a. What is BCCI’s cost of equity capital?
b. What is its WACC?
c. If BCCI is presented with a normal project with an internal rate of return of 12%, should it
accept the project?
6.2 The total book value of WTC’s equity is $10 million, and book value per share is $20. The
stock has a market-to-book ratio of 1.5, and the cost of equity is 15%. The firm’s bonds have a
face value of $5 million and sell at a price of 110% of face value. The yield to maturity on the
bonds is 9%, and the firm’s tax rate is 21%. Find the company’s WACC.
6.3 The total market value of the equity of Okefenokee Condos is $6 million, and the total value
of its debt is $4 million. The treasurer estimates that the beta of the stock cur- rently is 1.2 and that
the expected risk premium on the market is 10%. The Treasury bill rate is 4%, and investors believe
that Okefenokee’s debt is essentially free of default risk.
a. What is the required rate of return on Okefenokee stock?
b. Estimate the WACC assuming a tax rate of 21%.
c. Estimate the discount rate for an expansion of the company’s present business.
d. d. Suppose the company wants to diversify into the manufacture of rose-colored glasses.
The beta of optical manufacturers with no debt outstanding is 1.4. What is the required rate of
return on Okefenokee’s new venture? (You should assume that the risky project will not enable
the firm to issue any additional debt.)
6.4 Universal Foods has a debt-to-value ratio of 40%, its debt is currently selling at a yield of 6%,
and its cost of equity is 12%. The corporate tax rate is 40%. The com- pany is now evaluating a
new venture into home computer systems. The internal rate of return on this venture is estimated
at 13.4%. WACCs of firms in the personal computer industry tend to average around 14%.
a. What is Universal’s WACC?
b. Will Universal make the correct decision if it discounts cash flows on the proposed
venture at the firm’s WACC?
6.5 In 2020, Caterpillar Inc. had about 540 million shares outstanding. Their book value was
$25.36 per share, and the market price was $153.70 per share. The company’s balance sheet
shows that the company had $26.7 billion of long-term debt, which was currently selling near par
value. (LO13-3)
 a. What was Caterpillar’s book debt-to-value ratio?
b. What was its market debt-to-value ratio?
c. Which of these two measures should you use to calculate the company’s cost of capital?
6.6 Cost of Debt. Micro Spinoffs Inc. issued 20-year debt a year ago at par value with a coupon
rate of 8%, paid annually. Today, the debt is selling at $1,050. If the firm’s tax bracket is 21%,
what is its cost of debt (expressed as a percent)?
6.7 Cost of Preferred Stock. Pangbourne Whitchurch has preferred stock outstanding. The
stock pays a dividend of $4 per share and sells for $40. The corporate tax rate is 21%. What is
the cost of the preferred stock (expressed as a percent)?
6.8 Cost of Equity. Reliable Electric is a regulated public utility, and it is expected to provide
steady dividend growth of 5% per year for the indefinite future. Its last dividend was $5 per
share; the stock sold for $60 per share just after the dividend was paid. What is the company’s
cost of equity (expressed as a percent)?
6.9 Icarus Airlines is proposing to go public, and you have been given the task of estimating the
value of its equity. Management plans to maintain debt at 30% of total firm value, and you believe
that at this capital structure the company’s debtholders will demand a return of 6% and
stockholders will require 11%. The company is forecasting that next year’s oper- ating cash flow
(depreciation plus profit after tax at 21%) will be $68 million and that investment in plant and net
working capital will be $30 million. Thereafter, operating cash flows and invest- ment
expenditures are forecast to grow in perpetuity by 4% a year. (LO13-5)
a. What is the total value of Icarus?
b. What is the value of the company’s equity?
6.10 You need to estimate the value of Laputa Aviation. You have the follow- ing forecasts (in
millions of dollars) of its profits and of its future investments in new plant and working capital:
Long-term debt outstanding $300,000
Current yield to maturity on debt 8%
Number of shares of common stock 10,000
Price per share $50
Book value per share $25
Expected rate of return on stock 15%
Year
1 2 3 4
Earnings before interest, taxes, depreciation, and
$80 $100 $115 $120
amortization (EBITDA)
Depreciation 20 30 35 40
Pretax profit 60 70 80 80
Tax at 30% 18 21 24 24
Investment 12 15 18 20
From year 5 onward, EBITDA, depreciation, and investment are expected to remain unchanged
at year 4 levels. Laputa is financed 50% by equity and 50% by debt. Its cost of equity is 15%, its
debt yields 7%, and it pays corporate tax at 30%.
a. Estimate the company’s total value.
b. What is the value of Laputa’s equity?
 QUESTIONS & PROBLEMS
Chapter 7
7.1. Two projects with the following cash flows:

Year Project A Project B

0 −$200 −$200
1 80 100
2 80 100
3 80 100
4 80

a. If the opportunity cost of capital is 11%, which of these projects is worth pursuing?
b. Suppose that you can choose only one of these projects. Which would you choose? The
discount rate is still 11%.
c. Which project would you choose if the opportunity cost of capital is 16%?
d. What are the internal rates of return on projects A and B?
e. In light of your answers to Problems 2, 3, and 4, is the project with the higher IRR the
better project?
f. If the opportunity cost of capital is 11%, what is the profitability index for each project?
g. Is the project with the highest profitability index also the one with the highest NPV?
h. What is the payback period of each project?
i. Is the project with the shortest payback period also the one with the highest NPV?

7.2 NPV versus IRR. Here are the cash flows for two mutually exclusive projects:

Project C0 C1 C2 C3
A −$20,000 +$8,000 +$8,000 +$ 8,000
B −20,000 0 0 +25,000
a. At what interest rates would you prefer project A to B? (Hint: Try drawing the NPV
profile of each project.)
b. What is the IRR of each project?
7.3 Consider projects A and B:
Cash Flows (dollars)
Project C0 C1 C2 NPV at 10%
A −30,000 21,000 21,000 +$6,446
B −50,000 33,000 33,000 +7,273
 a. Calculate IRRs for A and B.
b. Which project does the IRR rule suggest is better?
c. Which project is really better?
7.4 Consider projects A and B with the following cash flows:
C0 C1 C2 C3
A −$36 +$20 +$20 +$20
B −50 +25 +25 +25

a. Which project has the higher NPV if the discount rate is 10%?
b. Which has the higher profitability index?
c. Which project is most attractive to a firm that can raise an unlimited amount of funds to
pay for its investment projects?
d. Which project is most attractive to a firm that is limited in the funds it can raise?
7.5 A project that costs $2,500 to install will provide annual cash flows of $600 for the next six
years.
a. The firm accepts projects with payback periods of less than five years. What is this
project’s payback period?
b. Will it be accepted?
c. Should this project be pursued if the discount rate is 2%? (What is its NPV?)
d. What if the discount rate is 12%?
e. Will the firm’s decision change as the discount rate changes?