Annuity  Assumes investors are well diversified, thus risk premium potential is

PV of annuity X = amount of Payment 1 1

proportional to a measure of market risk (Beta)
beginning r = Interest rate/yield 𝑃𝑉(𝑋, 𝑛, 𝑟) = 𝑋 × [1 − ] Expected return on stock = Risk-free rate + Beta of stock * Market risk
𝑟 (1+𝑟)𝑛
next period: n = time premium
PV of a 𝑟𝐸 = 𝑟𝑓 + 𝛽𝑖 ∗ [𝐸(𝑟𝑀 ) − 𝑟𝑓 ]
g = growth rate 1 1+𝑔 𝑛
growing 𝑃𝑉(𝑋, 𝑔, 𝑛, 𝑟) = 𝑋 × [1 − ( ) ]
r>g 𝑟−𝑔 1+𝑟
annuity at g Cost of Debt (𝒓𝑫) -> return to creditors
Yield to Maturity  Single discount rate that equates the PV of the bond’s remaining CF to its
Perpetuity (YTM) current price
𝑋 1 1 𝑝𝑎𝑟 𝑣𝑎𝑙𝑢𝑒
PV of perpetuity beginning next period: 𝑃𝑉 =
𝑟
𝑃𝑟𝑖𝑐𝑒 = (𝐶𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 ∗ 𝑝𝑎𝑟 𝑣𝑎𝑙𝑢𝑒) ∗ [1 − (1+𝑦)𝑛] + 𝑛
𝑦 (1+𝑦)
𝑋
PV of a growing perpetuity at g 𝑃𝑉 =  Find y
𝑟−𝑔
𝑟𝐷 = 𝑦 − 𝑝 ∗ 𝐿 = 𝑌𝑇𝑀 − 𝑃𝑟𝑜𝑏(𝑑𝑒𝑓𝑎𝑢𝑙𝑡) ∗ 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑠 𝑟𝑎𝑡𝑒
Cash-Flow
Binomial Model
𝐸𝐵𝐼𝑇(1 − 𝜏𝑐 ) = (𝑆𝑎𝑙𝑒𝑠 − 𝐶𝑂𝐺𝑆 − 𝑆𝐺𝐴
EBIT(1-𝜏𝑐 ) 𝜏𝑐 = 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒/𝐸𝐵𝑇 Call: right to buy at strike price
− 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) ∗ (1 − 𝜏𝑐 )
Put: right to sell
Operating CF EBIT(1-𝜏𝑐 ) + Depreciation
FCFF 𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇(1 − 𝜏𝑐 ) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝐸𝑥 − 𝐶ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝑊𝐶 1. Given, dt, volatility and 𝑅𝑓
FCFF (incl. 𝐹𝐶𝐹𝐹(+𝑙𝑖𝑞) = 𝐹𝐶𝐹𝐹 + 𝑙𝑖𝑞𝑢𝑖𝑑𝑎𝑡𝑖𝑜𝑛 𝑣𝑎𝑙𝑢𝑒 − 𝑇𝑐 ∗ (𝑙𝑖𝑞𝑢𝑖𝑑𝑎𝑡𝑖𝑜𝑛 𝑣𝑎𝑙𝑢𝑒
 𝑢 = 𝑒 𝜎√𝑑𝑡
liquidation value) − 𝐵𝑉 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠)
𝐹𝐶𝐹𝐹  𝑑 = 1⁄𝑢
FCFF discounted 𝐹𝐶𝐹𝐹 (𝑑𝑖𝑠𝑐. ) = 𝑟 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒 (𝑅𝑓∗𝑑𝑡) −𝑑
𝑡(1+𝑟)  𝑝𝑢 = (contin.)
𝑢−𝑑
𝐹𝐶𝐹𝐹 (𝑑𝑖𝑠𝑐. 𝑐𝑢𝑚𝑢𝑙. 𝑡0) = 𝐹𝐶𝐹𝐹 𝑑𝑖𝑠𝑐. 𝑎𝑡 𝑡0 1+𝑅𝑓 −𝑑
FCFF disc. 𝐹𝐶𝐹𝐹 (𝑑𝑖𝑠𝑐. 𝑐𝑢𝑚𝑢𝑙. ) = 𝑑𝑖𝑠𝑐. 𝑐𝑢𝑚𝑢𝑙. 𝑎𝑡 𝑡 − 1 + 𝑐𝑢𝑚𝑢𝑙. 𝐹𝐶𝐹𝐹 𝑎𝑡 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑡  𝑝𝑢 = (discrete)
𝑢−𝑑
cumulative *The FCFF disc. cumul. from the last year is equal to the NPV (and also equal  𝑝𝑑 = 1 − 𝑝𝑢
to all the sum of FCFF discounted, as the NPV formula suggests) 2. Build tree for underlying asset
3. Compute payoffs at maturity T (S at T-K is S0)
CF based Criteria  𝐶𝑎𝑙𝑙 = 𝑀𝑎𝑥(0; 𝑆𝑇 − 𝐾)
Payback Period 𝐹𝐶𝐹𝐹 𝑑.𝑐.(𝑦𝑒𝑎𝑟 𝑜𝑓 𝑐ℎ𝑎𝑛𝑔𝑒)  𝑃𝑢𝑡 = 𝑀𝑎𝑥(0; 𝐾 − 𝑆𝑇 ) -> negative = 0 (will not be executed)
𝑃𝑃 = 𝑡 𝑎𝑡 𝑦𝑒𝑎𝑟 𝑜𝑓 𝑐ℎ𝑎𝑛𝑔𝑒 + Year of change = last neg.
(PP) 𝐹𝐶𝐹𝐹 𝑑 (𝑦𝑒𝑎𝑟 𝑜.𝑐.+1) 4. Discount back payoffs at maturity + repeat until you get value at t=0
𝐹𝐶𝐹𝐹 𝐹𝐶𝐹𝐹 (𝑡0) 𝐹𝐶𝐹𝐹 (𝑡1) 𝐹𝐶𝐹𝐹 (𝑡2) 𝑝𝑢 ∗𝐶 𝑢+(1−𝑝𝑢)∗𝐶 𝑑
NPV 𝑁𝑃𝑉 = Σ
(1+𝑟)𝑡
=
(1+𝑟)0
+
(1+𝑟)1
+
(1+𝑟)2
+⋯  (continuous)
𝑒 ( 𝑅𝑓 ∗𝑑𝑡)
Profitability Index 𝑝𝑢 ∗𝐶 𝑢+(1−𝑝𝑢)∗𝐶 𝑑
𝑃𝐼 = 𝑁𝑃𝑉/𝐶𝑎𝑝𝐸𝑥  (discrete)
(PI) (1+𝑅𝑓 )𝑡
Cash Flow: -/+/- do not compute; if NPV positive IRR higher than cost of 5. Calculate expected payoff
capital (r)  𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑙𝑙 𝑜𝑝𝑡𝑖𝑜𝑛 = (𝐶1 ∗ 𝑝𝑢 ) + (𝐶2 ∗ 𝑝𝑑 )/(𝑅𝑓 + 1)
IRR
“The IRR is the rate the equals NPV to 0. So if NPV>0 then IRR>cost of  𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑢𝑡 𝑜𝑝𝑡𝑖𝑜𝑛 = (𝑃1 ∗ 𝑝𝑢 ) + (𝑃2 ∗ 𝑝𝑑 )/(𝑅𝑓 + 1)
capital.” Black-Scholes Model
 comparing projects with different lives  Assumes that rate of return of underlying asset follows random walk
𝑁𝑃𝑉
Equivalent Annuity =1 1  not sufficient for comparison when different discount rates 𝐶𝑎𝑙𝑙0 = 𝑁(𝑑1 ) ∗ 𝑆0 − 𝑁(𝑑2 ) ∗ 𝑃𝑉(𝐾) N(d) = cumulative normal S = current share price
∗[1−(1+𝑟)𝑛] 𝐸𝐴
𝑟
(r) – Perpetuity 𝑆
ln( 0 ) distribution  = volatility (st.d. of r)
𝑟 𝑃𝑉(𝐾) 𝜎√𝑡
𝑑1 = + K = exercise price *d2: use positive
𝜎√𝑡 2
Cost of Equity (𝒓𝑬) -> return to shareholders t = time to maturity in value, then 1-value
𝑑2 = 𝑑1 − 𝜎√𝑡* years
Dividend Discount 𝐷𝑖𝑣1+𝑃1 Constant long-term growth: from table
𝑃𝑟𝑖𝑐𝑒 = 𝑃0 = ( )
Model (DDM) 1+𝑟𝐸
𝑃0 =
𝐷𝑖𝑣1
+
𝐷𝑖𝑣2
+⋯ 𝑃𝑉(𝐾) = 𝐾 ∗ 𝑒 (−𝑅𝑓∗𝑑𝑡)
𝐷𝑖𝑣1+𝑃1 𝐷𝑖𝑣1 𝑃1−𝑃0
𝑟𝐸 = −1 = + 1+𝑟𝐸 (1+𝑟𝐸 )2
𝑃0 𝑃0 𝑃0 𝐷𝑖𝑣1
Div Yield Capital 𝑟𝐸 =
𝑃0
+ 𝑔 Put-Call Parity
Gain 𝑃𝑢𝑡 = 𝐶𝑎𝑙𝑙 − 𝑆0 + 𝑃𝑉(𝐾) // Call +PV(K)=Put +S
Total Payout Model 𝑃0 = 𝑇𝑜𝑡𝑎𝑙 𝑃𝑎𝑦𝑜𝑢𝑡/ (𝑟𝐸 − 𝑔)/ 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠
Capital Asset Pricing  Establishes relationship between price of a security and its risk Modigliani-Miller Model
Model (CAPM)  CAPM used to determine the cost of capital (r): minimum return required MM II rE = Cost of levered Equity
by investors for a certain level of risk MM I 𝐷 rU = Cost of unlevered Equity
𝑟𝐸 = 𝑟𝑈 + (𝑟𝑈 − 𝑟𝐷 ) E = Market value of Equity
𝐸
 Value of levered Firm = Value of D = Market Value of Debt
unlevered Firm (zero debt) 𝑉 𝐿 =
𝑉𝑈
With 𝜏𝑐 : 𝑉 𝐿 = 𝑉 𝑈 + 𝑃𝑉(𝐼𝑇𝑆)
𝐹𝐶𝐹
𝑉𝑈 =
𝑟𝑈
𝐸 𝐸 1 𝐷/𝐸
 rU = pre-tax WACC = rA ; 𝑟𝑈 = 𝑟 + 𝑟 or 𝑟 + 𝑟
𝐸+𝐷 𝐸 𝐸+𝐷 𝐷 1+𝐷/𝐸 𝐸 1+𝐷/𝐸 𝐷
WACC with Corporate Taxes EXAMPLES
𝐸 𝐸 𝐸
𝑟𝑈 = 𝑟𝐸 + 𝑟𝐷 − 𝑟𝐷 𝜏𝑐 reduction due to interest tax shield (ITS)
𝐸+𝐷 𝐸+𝐷 𝐸+𝐷
What is the value (BS) of a call option? [=40%, S=5.75, YTM=30months/2.5 years, Rf=2% (cont.),
PV of the Interest Tax Shield K=6.55]
Calculate PV(K) 𝑃𝑉(6.55) = 6.55 × 𝑒 −0.02×2.5 = 6.23
Annual ITS = 𝜏𝑐 (Corporate tax rate) * (Interest
Regular Case Calculate d1 and d2 5.75
Payment) 𝑑1 =
ln(
6.23
)
+
0.4√2.5
= 0.189 ; 𝑑2 = 0.189 − 0.4√2.5 = −0.443
Special Case #1: Firm borrows debt 𝜏𝑐 (𝑅𝐷 𝐷) 0.4√2.5 2
𝑃𝑉(𝐼𝑇𝑆) = = 𝜏𝑐 𝐷 -> debt is perpetuity Compute N(d1) and N(d2) Table Normal: N(d1) = .5793; N(d2) = .3300
D and keeps level of D permanently 𝑅𝐷
Calculate Call-Option-Price 0.5793 × 5.75 − 0.3300 × 6.23 = 1.275
Special Case #2: Interest payments 𝑃𝑉(𝐼𝑇𝑆) = 𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 × 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 × (1 −
1 1
)
are known 𝑟 (1+𝑟)𝑡
What is the value of a put option?
𝐸 𝐷 Build tree and calculate up and K - Maturity Value 1, K – Maturity Value 2 … (If negative = 0)
(1) 𝑃𝑟𝑒 − 𝑇𝑎𝑥 𝑤𝑎𝑐𝑐 = 𝑟𝐸 + 𝑟𝐷 down values at maturity
𝐸+𝐷 𝐸+𝐷
𝐹𝐶𝐹 Calculate values from period 𝑝𝑢 ∗𝐶 𝑢+(1−𝑝𝑢)∗𝐶 𝑑 𝑝𝑢 ∗𝐶 𝑢+(1−𝑝𝑢)∗𝐶 𝑑
𝑉𝑈 = before through formula (continuous) (discrete)
𝑃𝑟𝑒 𝑡𝑎𝑥 𝑤𝑎𝑐𝑐−𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑜𝑓 𝐹𝐶𝐹/𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 𝑒 ( 𝑅𝑓 ∗𝑑𝑡) (1+𝑅𝑓 )𝑡
𝐸 𝐷
Special Case #3: Target D/E Ratio (2) 𝑟𝑤𝑎𝑐𝑐 = 𝑟 + 𝑟 (1 − 𝜏𝑐 ) ; Do it until reach today’ value
𝐸+𝐷 𝐸 𝐸+𝐷 𝐷
𝐿 𝐹𝐶𝐹
𝑉 =
𝑟𝑤𝑎𝑐𝑐 −𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑜𝑓 𝐹𝐶𝐹
𝐿 𝑈
Compute the up and down factors (u, d) of the binomial model implied in this tree
(3) 𝑃𝑉(𝐼𝑇𝑆) = 𝑉 − 𝑉 and provide an estimate of the annual volatility
Compute u and d 𝑏𝑜𝑜𝑚 𝑢𝑝 𝑣𝑎𝑙𝑢𝑒 𝑑𝑜𝑤𝑛 𝑣𝑎𝑙𝑢𝑒
𝑢= 𝑑=
𝑆 𝑆
Valuation with Corporate Taxes (Tc) I Constant D/E Ratio Use formula
WACC Method 𝐸 𝐷 𝑢 = 𝑒 √𝑑𝑡
(1) Determine FCFs and rwacc : 𝑟𝑤𝑎𝑐𝑐 = 𝑟 + 𝑟 (1 − 𝜏𝑐 ) Find 
𝐸+𝐷 𝐸 𝐸+𝐷 𝐷 ln(u) = √𝑑𝑡  =
ln(𝑢)
L 𝐹𝐶𝐹1 𝐹𝐶𝐹2 𝐹𝐶𝐹3
(2) Compute V0 : 𝑉0𝐿 = + + +⋯ √𝑑𝑡
1+𝑟𝑤𝑎𝑐𝑐 (1+𝑟𝑤𝑎𝑐𝑐 )2 (1+𝑟𝑤𝑎𝑐𝑐 )3
L
! FCF0+V0 = NPV of project Apply the Flow-to-Equity (FTE) method to assess the quality of the project
𝐸
APV Method (1) Determine unlevered value of firm: 𝑟𝑈 = 𝑝𝑟𝑒𝑡𝑎𝑥 𝑊𝐴𝐶𝐶 = 𝑟𝐸 + Compute data and calculate rwacc
𝐸+𝐷
(adjusted PV) 𝐷 Create a table 1. FCF; 2. PV (
𝐹𝐶𝐹1 𝐹𝐶𝐹2
+ (1+𝑟
𝐹𝐶𝐹3
+ (1+𝑟 ); 3. Debt; 4. Cost of Debt; 5. Net
𝑟 1+𝑟𝑤𝑎𝑐𝑐 𝑤𝑎𝑐𝑐 )
2
𝑤𝑎𝑐𝑐 )
3
𝐸+𝐷 𝐷 Cost of Debt (Debt(1-𝜏𝑐 )); 6. Net Borrowing (Dt y1 – Dt y2 …); 7. FCFE; 8.
𝐹𝐶𝐹1 𝐹𝐶𝐹2 𝐹𝐶𝐹3
(2) Compute VU : 𝑉 𝑈 = + + +⋯ NPV
1+𝑟𝑈 (1+𝑟𝑈 )2 (1+𝑟𝑈 )3
(3) Estimate annual interest payments: 𝑡 = 𝑟𝐷 × 𝐷𝑡−1
𝐼𝑇𝑆1 𝐼𝑇𝑆2 𝐼𝑇𝑆3 Compare Two Products with different life (given data: Life, Cost of Capital, NPV)
(4) Compute PV (ITS): 𝑃𝑉(𝐼𝑇𝑆) = + 2
+ 3
+⋯ Say which project to invest if one shot Choose the project with higher NPV
1+𝑟𝑈 (1+𝑟𝑈 ) (1+𝑟𝑈 )
(5) Determine VL: 𝑉 𝐿 = 𝑉 𝑈 + 𝑃𝑉(𝐼𝑇𝑆) Calculate Equivalent Annuity of both 𝑁𝑃𝑉
projects 1 1
FTE Method (1) Calculate FCFE t= FCFt - (1-𝜏𝑐 ) x Interest Paymentst + Net Borrowingt // 𝑟
∗ [1 −
(1 + 𝑟)𝑛
]
(Flow-to- FCFE t= Net Incomet + Depreciationt - CapEx t – Increase in NWCt+ Net Choose the project with higher Eq. “In case of repetition, I would choose project X”
Equity) Borrowingt [with Net Borrowing at t = D t – D t-1] Ann
𝐷
(2) Compute FCFE and rE (𝑟𝐸 = 𝑟𝑈 + (𝑟𝑈 − 𝑟𝐷 )) Should the company invest in this project (Given Balance Sheet, Cost of Cap., Expected Cash
𝐸
*rE = Equity 𝐹𝐶𝐹𝐸1 Flows, Risk Free Rate and Exp. Market Premium)
cost of capital (3) Determine NPV(FCFE) at rE*: 𝑁𝑃𝑉(𝐹𝐶𝐹𝐸) = 𝐹𝐶𝐹𝐸0 + + Compute data and calculate rwacc 1 𝐷/𝐸
1+𝑟𝐸 𝑟 + 𝑟 Don’t forget: (D – Cash)/E
1+𝐷/𝐸 𝐸 1+𝐷/𝐸 𝐷
𝐹𝐶𝐹𝐸2
2
+… Continue using Wacc Method
(1+𝑟𝐸 )