Business Finance II

First session
1. Concept check quiz
1. You have an expected liability (cash outflow) of $500,000 in 10 years, and you use a discount rate of
10%.
a. How much would you need right now as savings to cover the expected liability?
b. How much would you need to set aside at the end of each year for the next 10 years to
cover the expected liability?
3. You have just taken a 30-year mortgage loan for $200,000. The annual percentage rate on the loan is
8%, and payments will be made monthly. Estimate your monthly payments.
5. A company is planning to set aside money to repay $100 million in bonds that will be coming due in 10
years. If the appropriate discount rate is 9%,
a. how much money would the company need to set aside at the end of each year for the next 10 years to
be able to repay the bonds when they come due?
b. how would your answer change if the money were set aside at the beginning of each year?
7. What is the value of stock in a company that currently pays out $1.50 per share in dividends and
expects these dividends to grow 6% a year forever? (You can assume that investors require a 13% return
on stocks of equivalent risk.)
9. You buy a 10-year zero-coupon bond, with a face value of $1000, for $300. What is the rate of return
you will make on this bond?
11. You have an relative who has accumulated savings of $ 250,000 over his working lifetime and now
plans to retire. Assuming that he wishes to withdraw equal installments from these savings for the next 25
years of this life, how much will each installment amount to if he is earning 5% on his savings?

Year Deficit Reduction
1 $ 25 Billion
2 $ 30 Billion
3 $ 35 Billion
4 $ 40 Billion
5 $ 45 Billion




13. A bill that is designed to reduce the nation's budget deficit passes both houses of legislature. Congress
tells us that the bill will reduce the deficit by $500 billion over 10 years. What it does not tell us is the
timing of the reductions.

If the federal government can borrow at 8%, what is the true deficit reduction in the bill?
15. Poor Bobby Bonilla! The newspapers claim that he is making $5.7 million a year. He claims that this
is not true in a present value sense and that he will really be making the following amounts for the next 5
years:

Year Amount
0 (now) $ 5.5 million (Sign up Bonus)
1 $ 4 million
2 $ 4 million
3 $ 4 million
4 $ 4 million
5 $ 7 million
a. Assuming that Bonilla can make 7% on his investments, what is the present value of his contract?
b. If you wanted to raise the nominal value of his contract to $30 million, while preserving the present
value, how would you do it? (You can adjust only the sign up bonus and the final year's cash flow.)
17. You bought a house for $250,000, borrowing $200,000 on a 30-year term loan (with monthly
payments). You have two options to finance the house. first option is paying interest rates at 10% in Bank
A. Second options is paying interest rates at 9% in Bank B. Bank B charges a fee of 3% of the value of
the loan. Your opportunity cost is 8%. Ignore tax effects.
a. How much are your monthly payments if borrowing from Bank A (at 10%)?
b. How would your monthly payments be if you borrow from Bank B (at 9%)?
6 $ 55 Billion
7 $ 60 Billion
8 $ 65 Billion
9 $ 70 Billion
10 $ 75 Billion
c. You plan to stay in this house for the next 5 years. Given the fee of Bank B (3% of the loan), which
loan would you prefer?
d. At which interest rate would be you be indifferent between borrowing from Bank A or B (assuming
again that you are going to stay in the house for five years)?
19. You have been hired to run a pension fund for TelDet Inc, a small manufacturing firm. The firm
currently has $5 million in the fund and expects to have cash inflows of $2 million a year for the first 5
years followed by cash outflows of $ 3 million a year for the next 5 years. Assume that interest rates are at
8%.
a. How much money will be left in the fund at the end of the tenth year?
b. If you were required to pay a perpetuity after the tenth year (starting in year 11 and going through
infinity) out of the balance left in the pension fund, how much could you afford to pay?
21. You have been asked to estimate the value of a 10-year bond with a coupon that will be low initially
but it is expected to grow later in the bond's life. The coupon is expected to be 5% of the face value of the
bond (which is $ 1000) for the first 5 years, and will increase by 1% every year for the next 5 years the
coupon rate will be 6% in year 6, 7% in year 7, 8% in year 8, 9% in year 9 and 10% in year 10. Estimate
the value of this bond if the market interest rate is 8%.



Helping material / guidelines
For financial reporting guidelines please visit
http://www.moneychimp.com/articles/financials/fundamentals.htm
For investment please see
http://www.invest-faq.com/articles/analy-beta.html

Helping notes and discussion Key Questions

In the next few pages, I have collected some basic information or guidelines for you which you must
know beforehand.
Helping note 1
This note explains briefly two concepts concerning the time-value-of-money, namely future and present
value. Careful application of these concepts will help you evaluate investment/financing situations such as
real estate, life insurance, monthly payments on a car, and many others.
Future Value
Future value is simply the sum to which a dollar amount invested today will grow given some
appreciation rate.
To compute the future value of a sum invested today, the formula for interest that is compounded monthly
is:
fv = principal * (1 + rrate/12) ** (12 * termy)
where
principal = dollar value you have now
termy = term, in years
rrate = annual rate of return in decimal (i.e., use .05 for 5%)
For interest that is compounded annually, use the formula:
fv = principal * (1 + rrate) ** (termy)
Example:
I invest 1,000 today at 10% for 10 years compounded monthly. The future value of this amount is
2707.04.
Note that the formula for future value is the formula from Case 1 of present value (below), but solved for
the future-sum rather than the present value.
Present Value
Present value is the value in today's dollars assigned to an amount of money in the future, based on some
estimate rate-of-return over the long-term. In this analysis, rate-of-return is calculated based on monthly
compounding.
Two cases of present value are discussed next. Case 1 involves a single sum that stays invested over time.
Case 2 involves a cash stream that is paid regularly over time (e.g., rent payments), and requires that you
also calculate the effects of inflation.
Case 1a: Present value of money invested over time. This tells you what a future sum is worth today,
given some rate of return over the time between now and the future. Another way to read this is that you
must invest the present value today at the rate-of-return to have some future sum in some years from now
(but this only considers the raw dollars, not the purchasing power).
To compute the present value of an invested sum, the formula for interest that is compounded annually is:
future-sum
pv = -----------------------
(1 + rrate) ** (termy)
where
future-sum = dollar value you want in termy years
termy = term, in years
rrate = annual rate of return that you can expect, in decimal
Example:
I need to have 10,000 in 5 years. The present value of 10,000 assuming an 8% annually compounded rate-
of-return is 6,580. I.e., 6,580 will grow to 10,000 in 5 years at 8%.
Case 1b: This formulation can also be used to estimate the effects of inflation; i.e., compute real
purchasing power of present and future sums. Simply use an estimated rate of inflation instead of a rate of
return for the rrate variable in the equation.
Example:
In 30 years I will receive 1,000,000 (a megabuck). What is that amount of money worth today (what is the
buying power), assuming a rate of inflation of 4.5%? The answer is 267,000.
Case 2: Present value of a cash stream. This tells you the cost in today's dollars of money that you pay
over time. Basically, the money you pay in 10 years is worth less than that which you pay tomorrow, and
this equation lets you compute just how much.
To compute the present value of a cash stream of monthly payments, the formula is:
month=12*termy paymt
pv = SUM --------------------------------
month=1 (1 + rrate/12) ** (month - 1)
where
month = month number
termy = term, in years
paymt = monthly payment, in dollars
rrate = rate of return on money that you can expect, in decimal
Example:
You pay $500/month in mortgage payments on your mobile home over 10 years. The lender's rate is 6%
per annum. Present value is $45,036...
Or is it? Work it out for yourself.
The Financial Markets
Key instruments of the financial markets are:
Equities or shares (termed "stocks" in the US). Stocks are ownership shares in a company. Here's
a common-sense introduction .
Mutual funds. A mutual fund, otherwise known as an investment company, is a corporation
which pools together investor's money generally to purchase stocks and bonds. Investors
participate in the mutual fund by purchasing shares of the entire pool of assets, thus diversifying
their investment. The pooled assets are invested by professional managers who buy and sell
securities on behalf of the investors.
Because mutual funds pass all gains, losses and tax obligations/benefits through to investors,
mutual funds receive preferential tax treatment under the U.S. Internal Revenue Code.
A closed-end fund has a fixed number of shares outstanding and is traded just like other stocks on
an exchange or over the counter. The more common open-end funds sell and redeem shares at
any time directly to shareholders. Sales and redemption prices of open-end funds are fixed by the
sponsor based on the fund's net asset value; closed-end funds may trade a discount (usually) or
premium to net asset value.
Bonds of various different varieties (e.g., they may be Eurobonds, domestic bonds, fixed interest
/ floating rate notes, etc.). Bonds are medium to long-term negotiable debt securities issued by
governments, government agencies, federal bodies (states), supra-national organisations such as
the World Bank, and companies. Negotiable means that they may be freely traded without
reference to the issuer of the security. That they are debt securities means that in the event that
the company goes bankrupt. bond-holders will be repaid their debt in full before the holders
of unsecuritised debt get any of their principal back.
Short term ("money market") negotiable debt securities such as T-Bills (issued by
governments), Commercial Paper (issued by companies) or Bankers Acceptances. These are
much like bonds, differing mainly in their maturity "Short" term is usually defined as being up to
1 year in maturity. "Medium term" is commonly taken to mean form 1 to 5 years in maturity, and
"long term" anything above that.
Over the Counter ("OTC") money market products such as loans / deposits. These products
are based upon borrowing or lending. They are known as "over the counter" because each trade is
an individual contract between the 2 counterparties making the trade. They are neither negotiable
nor securitised. Hence if I lend your company money, I cannot trade that loan contract to
someone else without your prior consent. Additionally if you default, I will not get paid until
holders of your company's debt securities are repaid in full. I will however, be paid in full before
the equity holders see a penny.
Spot Foreign Exchange. This is the buying and selling of foreign currency at the exchange rates
that you see quoted on the news. As these rates change relative to your "home currency" (dollars
if you are in the US), so you make or lose money.
Commodities. These include grain, pork bellies, coffee beans, orange juice, etc.
In order to better explain I have taken the US financial markets for illustration/explanation
purposes. The core of the US financial markets is the market for debt issued by the US government,
which issues US Treasury bills, notes and bonds.
US Treasuries
The US Treasury Department periodically borrows money and issues IOUs in the form of bills, notes, or
bonds ("Treasuries"). The differences are in their maturities and denominations:

Bill Note Bond
Maturity up to 1 year 1 - 10 years 10 - 30/40 years
Denomination $1,000 $1,000 $1,000
Minimum $10,000 $1,000 $1,000
Treasuries are auctioned. Short term T-bills are auctioned every Monday, and longer term bills, notes, and
bonds are auctioned at other intervals. A recording maintained by the Kansas City Federal Reserve will
tell you the purchase price, auction date, issue date, series number, coupon rate and effective annualized
yield for each of the most recent treasury auctions. To find out the results of the latest auction, dial the KC
Fed information line at (800) 333-2919 using a touch-tone phone. Press "1", then "4", then "1".
You don't have to wait for the recordings to complete before entering each digit. Unfortunately, this
number is not reachable from all areas of the country.
T-Notes and Bonds pay a stated interest rate semi-annually, and are redeemed at face value at maturity.
Exception: Some 30 year and longer bonds may be called (redeemed) at 25 years.
T-bills work a bit differently. They are sold on a "discounted basis." This means you pay, say, $9,700 for
a 1-year T-bill. At maturity the Treasury will pay you (via electronic transfer to your designated bank
checking account) $10,000. The $300 discount is the "interest." In this example, you receive a return of
$300 on a $9,700 investment, which is a simple rate of slightly more than 3%.
Treasuries can be bought through a bank or broker, but you will usually have to pay a fee or commission
to do this. They can also be bought with no fee using the Treasury Direct program, which is described
elsewhere in the FAQ.
In practice, the first T-bill purchase requires you to send a certified or cashiers check for the full face
value, and within a week or so, after the auction sets the interest rate, the Treasury will return the discount
($300 in the example above) to your checking account. For some reason, you can purchase notes and
bonds with a personal check.
Treasuries are negotiable. If you own Treasuries you can sell them at any time and there is a ready
market. The sale price depends on market interest rates. Since they are fully negotiable, you may also
pledge them as collateral for loans.
Treasury bills, notes, and bonds are the standard for safety. By definition, everything is relative to
Treasuries; there is no safer investment in the U.S. They are backed by the "Full Faith and Credit" of the
United States.
Interest on Treasuries is taxable by the Federal Government in the year paid. States and local
municipalities do not tax Treasury interest income. T-bill interest is recognized at maturity, so they offer a
way to move income from one year to the next.
The US Treasury also issues Zero Coupon Bonds. The ``Separate Trading of Registered Interest and
Principal of Securities'' (a.k.a. STRIPS) program was introduced in February 1986. All new T-Bonds and
T-notes with maturities greater than 10 years are eligible. As of 1987, the securities clear through the
Federal Reserve's books entry system. As of December 1988, 65% of the ZERO-COUPON Treasury
market consisted of those created under the STRIPS program.
However, the US Treasury did not always issue Zero Coupon Bonds. Between 1982 and 1986, a number
of enterprising companies and funds purchased Treasuries, stripped off the ``coupon'' (an anachronism
from the days when new bonds had coupons attached to them) and sold the coupons for income and the
non-coupon portion (TIGeRs or Strips) as zeroes. Merrill Lynch was the first when it introduced TIGR's
and Solomon introduced the CATS. Once the US Treasury started its program, the origination of
trademarks and generics ended. There are still TIGRs out there, but no new ones are being issued.
Agencies
Other US government debt obligations include US Savings Bonds (Series E/EE and H/HH) and bonds
from various US Government agencies, including the ones that are known by cutesy names like Freddie
Mac, as well as the Mae sisters, Fannie, Ginnie and Sallie. US Government Agency Bonds, in general,
pay slightly more interest but are somewhat less predictable than Treasuries. For example, mortgage-
backed-bond returns will vary if mortgages are redeemed early. Some agency bonds, technically, are not
general obligations of the United States, so may not be purchased by certain institutions and local
governments. The "common sense" of many people, however, is that the Congress will never allow any of
those bonds to default.
Munis US municipal bonds are free of Federal income taxes. The taxable equivalent yield is equal to the
tax free yield divided by the sum of 100 minus the current tax bracket. For example the taxable equivalent
yield of a 6.50% tax free bond for someone in the 32% tax bracket would be: 6.5/(100-32) = 0.0955882 or
9.56%
Risk & Return
Risk and Return
A security's return is often measured by its holding-period return: the change in price plus any
income received, expressed as a percentage of the original price. A better measure would take
into account the timing of dividends or other payments, and the rates at which they are reinvested.
The total return on an investment has two components: the expected return and the unexpected
return. The unexpected return comes about because of unanticipated events. The risk from
investing stems from the possibility of an unanticipated event.
The total risk of a security refers to the extent to which realized returns may deviate from the
expected return. A common measure is standard deviation, although for many investors the
downside risk is more important than the sheer dispersion of returns. For funds managers, the risk
of underperforming a benchmark may be the most relevant risk.
If one assumes returns are normally distributed, then variance (or its square root, standard
deviation) is a reasonable measure of risk, since a normal distribution is symmetrical and fully
described by its expected value and variance. There is evidence that stock-price returns are more
leptokurtic (fat-tailed) than would be predicted by the standard normal distribution.
Systematic risks (also called market risks) are unanticipated events that affect almost all assets to
some degree because the effects are economy wide. Unsystematic risks are unanticipated events
that affect single assets or small groups of assets. Unsystematic risks are also called unique or
asset-specific risks.
Investors face a trade-off between risk and expected return. Historical data confirm our intuition
that assets with low degrees of risk provide lower returns on average than do those of higher risk.
Shifting funds from the risky portfolio to the risk-free asset is the simplest way to reduce risk.
Another method involves diversification of the risky portfolio.
U.S. T-bills provide a perfectly risk-free asset in nominal terms only. Nevertheless, the standard
deviation of real rates on short-term T-bills is small compared to that of assets such as long-term
bonds and common stocks, so for the purpose of our analysis, we consider T-bills the risk-free
asset. Besides T-bills, money market funds hold short-term safe obligations such as commercial
paper and CDs. These entail some default risk but relatively little compared to most other risky
assets. For convenience, we often refer to money market funds as risk-free assets.
A risky investment portfolio (referred to here as the risky asset) can be characterized by its
reward-to-variability ratio. This ratio is the slope of the capital allocation line (CAL), the line that
goes from the risk-free asset through the risky asset. All combinations of the risky and risk-free
assets lie on this line. Investors would prefer a steeper sloping CAL, because that means higher
expected returns for any level of risk. If the borrowing rate is greater than the lending rate, the
CAL will be "kinked" at the point corresponding to investment of 100% of the complete portfolio
in the risky asset.
An investor's preferred choice among the portfolios on the capital allocation line will depend on
risk aversion. Risk-averse investors will weight their complete portfolios more heavily toward
Treasury bills. Risk-tolerant investors will hold higher proportions of their complete portfolios in
the risky asset.
The capital market line is the capital allocation line that results from using a passive investment
strategy that treats a market index portfolio such as the Standard & Poor's 500 as the risky asset.
Passive strategies are low-cost ways of obtaining well-diversified portfolios with performance
close to that of the market as a whole.
Interest Rate Risk
Even default-free bonds such as Treasury issues are subject to interest rate risk. Longer term
bonds generally are more sensitive to interest rate shifts than short-term bonds. A measure of the
average life of a bond is Macaulay's duration, defined as the weighted average of the times until
each payment made by the security, with weights proportional to the present value of the
payment.
Macauley's duration measures the time horizon when a bond's yield will be realized. During that
time, losses (gains) from price change will be offset by gains (losses) from reinvestment of
coupon interest.
Modified Duration is a direct measure of the sensitivity of a bond's price to a change in its yield.
Modified Duration is equal to Macauley's Duration/(1+yield).
Duration is only an approximation of the percentage price change of a bond for a 1% change in
yield. It assumes parallel changes in a flat yield curve, and only works for small changes (such as
10 basis points) in yield.
The longer the maturity, the lower the yield, and the smaller and less frequent the bond's coupon,
the greater is the duration. The Macauley's duration of a zero-coupon bond is equal to its
maturity.
Convexity measures the degree to which duration changes as the yield to maturity changes.
Positive convexity, which characterizes most straight (plain, non-callable) bonds, refers to the
fact that price sensitivity, as measured by duration, declines as the yield increases, and rises as the
yield decreases. Positive convexity is regarded as a desirable feature of a bond, particularly when
yields are volatile. Callable bonds such as US mortgage-backed securities have negative
convexity over some yield range.
Duration is additive, so the duration of a portfolio of bonds is the weighted sum of the duration of
the individual bonds. Because duration and convexity measure price risk, they can be helpful in
bond portfolio management.
Immunization strategies are characteristic of passive fixed-income portfolio management. Such
strategies attempt to render the individual or firm immune from movements in interest rates. This
may take the form of immunizing net worth or, instead, immunizing the future accumulated value
of a fixed-income portfolio. Immunization of a fully funded plan is accomplished by matching the
durations of assets and liabilities. To maintain an immunized position as time passes and interest
rates change, the portfolio must be periodically rebalanced.
A more direct form of immunization is dedication or cash flow matching. If a portfolio is
perfectly matched in cash flow with projected liabilities, rebalancing will be unnecessary.
Quantifying Credit Risk
For many years, academics and financial insitutions have sought to predict losses from credit risk.
The best-known methodogy is based on Altman's Z-score, which seeks to predicts defaults using
company financial data.
The newer CreditMetrics approach estimates volatility from upgrades, downgrades, and defaults.
Historical data are used to attribute a likelihood of possible credit events, including upgrades and
downgrades, not just defaults.
For example, CreditMetrics calculates the probability that a bonds current rating will shift to any
other rating within a given time. Each shift results in an estimated change in value (derived from
historical credit spread data or recovery rates in default). Each value out-come is weighted by its
likelihood to create a distribution of value across each credit state, from which each assets
expected value and volatility of value is computed.
To compute the volatility of portfolio value from the volatility of individual asset values requires
estimates of correlation in credit quality changes. Since these cannot be directly observed from
historical data, one approach is to infer these from historical asset correlation data derived from
equity price series. Several different approaches, including a simple constant correlation, can be
used.
Portfolio optimizations
The Portfolio Risk-Return Trade-Off
Investors face a trade-off between risk and expected return. Shifting funds from the risky
portfolio to the risk-free asset is the simplest way to reduce risk. Another method involves
diversification of the risky portfolio. This is the focus here.
A risky investment portfolio (referred to here as the risky asset) can be characterized by its
reward-to-variability ratio. This ratio is the slope of the capital allocation line (CAL), the line that
goes from the risk-free asset through the risky asset. All combinations of the risky and risk-free
assets lie on this line. Investors would prefer a steeper sloping CAL, because that means higher
expected returns for any level of risk. If the borrowing rate is greater than the lending rate, the
CAL will be "kinked" at the point corresponding to investment of 100% of the complete portfolio
in the risky asset.
An investor's preferred choice among the portfolios on the capital allocation line will depend on
risk aversion. Risk-averse investors will weight their complete portfolios more heavily toward
Treasury bills. Risk-tolerant investors will hold higher proportions of their complete portfolios in
the risky asset.
The capital market line is the capital allocation line that results from using a passive investment
strategy that treats a market index portfolio such as the Standard & Poor's 500 as the risky asset.
Passive strategies are low-cost ways of obtaining well-diversified portfolios with performance
close to that of the market as a whole.
Optimal Portfolio Diversification
The variance of a portfolio is a sum of the contributions of the component-security variances plus
terms involving the correlation among assets.
Even if correlations are positive, the portfolio standard deviation will be less than the weighted
average of the component standard deviations, as long as the assets are not perfectly positively
correlated. Thus, portfolio diversification is of value as long as assets are less than perfectly
correlated.
The contribution of an asset to portfolio variance depends on its correlation with the other assets
in the portfolio, as well as on its own variance. An asset that is perfectly negatively correlated
with a portfolio can be used to reduce the portfolio variance to zero. Thus, it can serve as a
perfect hedge.
The efficient frontier of risky assets is the graphical representation of the set of portfolios that
maximizes portfolio expected return for a given level of portfolio standard deviation. Rational
investors will choose a portfolio on the efficient frontier.
A portfolio manager identifies the efficient frontier by first establishing estimates for the expected
returns and standard deviations, and the correlations among them. The input data are then fed into
an optimization program that produces the investment proportions, expected returns, and standard
deviations of the portfolios on the efficient frontier.
In general, portfolio managers will identify different efficient portfolios because of differences in
the methods and quality of security analysis. Managers compete on the quality of their security
analysis relative to their management fees.
If a risk-free asset is available and input data are identical, all investors will choose the same
portfolio on the efficient frontier, the one that is tangent to the CAL. All investors with identical
input data will hold the identical risky portfolio, differing only in how much each allocates to this
optimal portfolio and to the risk-free asset. This result is characterized as the separation principle
of portfolio selection.
The single-index representation of a single-factor security market expresses the excess rate of
return on a security as a function of the market excess return: Ri = (xi + PiRm + ei) This equation
also can be interpreted as a regression of the security excess return on the market index excess
return. The regression line has intercept cLi and slope Pi, and is called the security characteristic
line.
In a single-index model, the variance of the rate of return on a security or portfolio can be
decomposed into systematic and firm-specific risk. The systematic component of variance equals
Beta times the variance of the market excess return. The firm-specific component is the variance
of the residual term in the index model equation.
The beta of a portfolio is the weighted average of the betas of the component securities. A
security with negative beta reduces the portfolio beta, thereby reducing exposure to market risk.
The unsystematic risk of a portfolio approaches zero as the portfolio becomes more diversified.
Optimizing Fixed-Income Portfolios
Duration measures the percentage price change of a bond for a 1% change in yield. Convexity
measures the degree to which duration changes as the yield to maturity changes.
Duration is additive, so the duration of a portfolio of bonds is the weighted sum of the duration of
the individual bonds. Because duration and convexity measure price risk, they can be helpful in
bond portfolio management.
Immunization strategies are characteristic of passive fixed-income portfolio management. Such
strategies attempt to render the individual or firm immune from movements in interest rates. This
may take the form of immunizing net worth or, instead, immunizing the future accumulated value
of a fixed-income portfolio. Immunization of a fully funded plan is accomplished by matching the
durations of assets and liabilities.
When the weighted duration of assets does not equal that of the liabilities, derivatives (such as
futures or swaps) can be employed to match asset with liability duration.
Duration changes as time passes and as yields change. Therefore to maintain an immunized
position, the portfolio must be periodically rebalanced.
A more precise form of immunization is dedication or cash flow matching. If a portfolio is
perfectly matched in cash flow with projected liabilities, rebalancing will be unnecessary.
Background knowledge/ concepts discussion and and Derivations
1. What is the difference between stock price maximization, firm value maximization and
stockholder wealth maximization?
Stock price maximization is the most restrictive of the three objective functions. It requires that
managers take decisions that maximize stockholder wealth, that bondholders be fully protected
from expropriation, that markets be efficient and that social costs be negligible.
Stockholder wealth maximization is slightly less restrictive, since it does not require that markets
be efficient.
Firm value maxmization is the least restrictive, since it does not require that bondholders be
protected from expropriation.
Thus, when we make the argument that an action by a firm (such as investing or financing)
increases firm value, this increase in firm value will necessarily translate into increasing
stockholder wealth and stock price only if the more restrictive assumptions hold. Conversely, an
action that increases the stock price in a world where the less restrictive assumptions do not hold,
may not necessarily increase firm value.
2. What is the objective function in corporate finance for a private firm?
The objective of maximizing stock prices is a relevant objective only for firms which are publicly
traded. How, then, can corporate finance principles be adapted for private firms? For firms which
are not publicly traded, the objective in decision making is the maximization of firm value. The
investment, financing and dividend principles we will develop in the chapters to come apply for
both publicly traded firms, which focus on stock prices, and private businesses, that maximize
firm value. Since firm value is not observable and has to be estimated, what private businesses
will lack is the feedback, sometimes unwelcome, that publicly traded firms get when they make
major decisions.
3. What is the objective function for a non-profit organization?
It is much more difficult to adapt corporate finance principles to not-for-profit organizations,
since their objective is often to deliver a service in the most efficient way possible, rather than to
make profits. The objective therefore has to be stated in terms of cost efficiency. For instance, the
objective of a public school system might be to deliver a quality education (defined in terms of a
skill set that every graduate should have) at the lowest cost. This does mean, however, that the
skill set has to be both specifically defined and measurable.
4. Are markets short term?
There are many who believe that stock price maximization leads to a short term focus for
manager - see for instance Michael Porters book on competitive strategy. The reasoning goes as
follows: Stock prices are determined by traders, short term investors and analysts, all of whom
hold the stock for short periods and spend their time trying to forecast next quarter's earnings.
Managers who concentrate on creating long term value, rather than short term results, will be
penalized by markets. Most of the empirical evidence that exists suggests that markets are much
more long term than they are given credit for:
(1) There are hundreds of firms, especially small and start-up firms, which do not have any
current earnings and cash flows, do not expect to have any in the near future, but which are still
able to raise substantial amounts of money on the basis of expectations of success in the future. If
markets were in fact as short term as the critics suggest, these firms should be unable to raise
funds in the first place.
(2) If the evidence suggests anything, it is that markets do not value current earnings and cash
flows enough and value future earnings and cash flows too much. Studies indicate that stocks
with low price-earnings ratios, i.e., high current earnings, have generally been underpriced
relative to stocks with high price-earnings ratios.
(3) The market response to research and development and investment expenditure is not
uniformly negative, as the 'short term' critics would lead you to believe. Instead, the response is
tempered, with stock prices, on average, rising on the announcement of R&D and capital
expenditures.
5. What is the German/Japanese alternative to stockholder wealth maximization and does it work?
In the German and Japanese systems of corporate governance, firms own stakes in other firms,
and often make decisions which are in the best interests of the industrial group they belong to,
rather than in their own best interests. In this system, the argument goes, firms will keep an eye
on each other, rather than ceding power to the stockholders. In addition to being undemocratic -
the stockholders are after all the owners of the firm, it suggests a profound suspicion of how
stockholders might use the power if they get it and is heavily skewed towards maintaining the
power of incumbent managers.
While this approach may protect the system against the waste that is a by-product of stockholder
activism and inefficient markets, it has its own disadvantages. Industrial groups are inherently
more conservative than investors in allocating resources, and thus are much less likely to finance
high risk and venture capital investments by upstarts who do not belong to the group. The other
problem is that entire groups can be dragged down by individual firms that have run into trouble.
Second session Discussion Issues and Derivations ( CAPM & Risk )
1. A Derivation of the Capital Asset Pricing Model
I. Establish the Objects of Choice: Mean versus Variance
Theme: Investors are risk averse. They measure reward using expected return and risk using
variance.
Underlying assumptions: The mean-variance assumption can hold only if (a) all investors have
quadratic utility function or (b) returns are normally distributed.
Implication: Portfolio A with higher expected return and the same variance as portfolio B will be
preferred to B
II. Benefits of Diversification
For any desired level of risk (s) there exists a portfolio of several assets which yields a higher
expected return than any individual security
E(R
p
) = S w
i
E(R
i
)
s
2
p
= S S w
i
w
j
Cov
ij

Efficient portfolios: maximize returns for any level of risk.
Implications: (a) Everybody should diversify (b) Investors should try to identify and hold
efficient portfolios (c) This method has very heavy computational requirements.
III. The Single Index Model: The Logical Limit of Diversification
Assumptions: (a) Riskfree lending and borrowing (b) Markets which are frictionless - there are no
transactions costs (c)Homogeneous expectations
Implications: (1) The risky portfolio than when combined with the riskless asset maximizes
returns is the market portfolio. (2) Everybody holds some combination of the market portfolio
and the risky asset. How much of each is held will be a function of the investor's risk aversion.(3)
Since all investors hold the same market portfolio it must contain all assets in the economy in
proportion to their value.
IV. The Risk of an Individual Asset
Step 1: Individuals diversify and hold portfolios
Step 2: The risk of a security is the risk it adds to the portfolio
Step 3: Everybody holds the market portfolio
Step 4: The risk of a security is the risk that it adds to the market portfolio.
Step 5: The covariance between an asset "i" and the market portfolio (Cov
im
) is a measure of this
added risk. The higher the covariance the higher the risk.
Step 6: This measure can be standardized by dividing by the market variance. b = Cov
im
/ s
2
m
.
Variants of the Capital Asset Pricing Model
I. No Riskless Asset
Basis: If no riskless asset exists investors can use a portfolio of risky assets which is uncorrelated with the
market portfolio instead as the riskless asset. This portfolio is called the zero-beta portfolio.
Properties of the Zero-beta portfolio
(1) Of all the the zero-beta portfolios this has the minimum variance
(2) The separation principle applies here with the two portfolios, the market portfolio and the zero-beta
portfolio, i.e. all investors hold combinations of the two.
(3) The expected return on any security can be expressed as a linear function of its beta.
E(R
i
) = E(R
z
) + b (E(R
m
) - E(R
z
))
where E(R
z
) is the expected return on a zero beta portfolio
II. Riskless Lending but no Riskless Borrowing
Basis:
(a) There is a piecewise linear relationship between expected return and beta for efficient portfolios.
(b) Efficient portfolios with the riskfree asset lie along the segment RfT and those containing only risky
assets lies along the segment TMC.
III. Existence of Non-Marketable Assets (such as Human Capital)
The separation principle still holds but,
(a) Investors hold different portfolios of risky assets depending upon the portfolios of non-marketable
assets that they possess.
(b) The market price of risk includes the variance of the market and the covariance between the market
portfolio and the portfolio of non-marketable assets
IV. Existence of Taxes
Model: The model considers differential taxes on dividends and capital gains in a one-period context
where investors maximize their one-period returns. The final model for expected return has a dividend
component
E(Ri) = a + b
i
(E(R
m
) - R
f
) + c (d
i
- R
f
)
where d
i
= Dividend yield on asset i
R
f
= After-tax riskfree rate
V. Existence of Heterogeneous Expectations and Information
Model: To get strong conclusions we have to assume that all investors have a certain class of utility
functions (Constant Absolute risk aversion) and complete markets (At least as many independent
securities as states).

Testing the CAPM: Issues and Discussion
Issue 1: The CAPM can never be tested because the market portfolio can never be observed
Central to the CAPM is the concept of a market portfolio which includes every asset in the economy. To
test the CAPM therefore one has to observe and be able to measure this efficient market portfolio. If one
cannot do so one cannot test the CAPM. One cannot use of an inefficient portfolio like the S&P 500 or
the NYSE 2000 or even every stock in the economy to estimate betas and test for linearity (like all the
studies have done) because
(a) The betas measured against an inefficient portfolio are meaningless measures and cannot be used to
accept or reject the CAPM which is really a theory about betas measured against the efficient market
portfolio
(b) For every inefficient portfolio there exists a set of betas which will satisfy the linearity condition.
Issue 2: The CAPM is difficult to test on individual assets
The noisiness in beta estimates and the fact that the CAPM yields expected returns for individual assets
over the long term makes it difficult to test the CAPM by trying to relate expected returns on individual
assets (such as stocks) to their betas. What most tests of the CAPM do instead is to look at portfolios of
stocks, based upon betas, and then compare these betas to expected returns in the next time period.

More on Factor Analysis and the Arbitrage Pricing Model
Central to applying the arbitrage pricing model is the use of a factor analysis. In a typical factor analysis,
we begin with pricing data on a large number of assets over very long time periods. In the factor analysis,
we look for factors that seem to move prices on large numbers of assets in unison. To prevent factors
from being double counted, we ensure that the factors that emerge are independent of each other. While
all of this occurs behind the screen of the factor analysis, what emerges as output from the analysis
includes:
(a) the number of common factors that appeared to affect asset prices over the period for which the data is
available
(b) the betas of each asset relative to each factor, again using the same data
(c) the "risk premiums" associated with each factor
These factor betas and factor premiums are then used, in conjunction with a riskfree rate to get an
expected return for an asset.
Estimating the Macro Economic Factors in a Multi-Factor Model
Once the number of factors have been identified in an arbitrage pricing model, the time series behavior of
each factor can be derived from the factor analysis. The search then begins for macro economic factors
that exhibit the same time series behavior. Once macro economic factors have been matched up with the
unnamed factors in the factor analysis, the betas of each asset are re-estimated against the identified
macro economic factors. The beta estimation may be done by running a multiple regression of stock
returns (for each stock) against changes in macro economic variables (such as interest rates, inflation rates
and GNP growth) over time. The coefficients on these regressions yield the betas, and risk premiums can
be estimated also from the historical data.
Building a Regression Model
Generally, regression models begin with the cross sectional differences in returns across stocks at any
point in time, and try to explain these differences using differences on measurable financial characteristics
of the firms issuing these assets. As an example, Fama and French, in their much quoted study, used
differences in market capitalization and price to book ratios to explain differences in returns across stocks.
The more difficult question is deciding which financial variables to use in explaining returns. The best
place to start is to look at the empirical evidence that has been accumulated over time on market
efficiency and the CAPM. This evidence suggests that
- Low market capitalization stocks seem to earn higher returns, on average, than high market
capitalization stocks
- Low PE, PBV and PS ratio stocks seem to earn higher returns, on average, than high PE, PBV and PS
ratio stocks
- High dividend yield stocks seem to earn higher returns, on average, than low dividend yield stocks
While the initial regression may include all of these variables, many of these variables tend to be
correlated with each other. Thus, low PE stocks tend to also be low PBV ratio stocks which pay high
dividends. In the interests of efficiency (and to prevent problems in the regression from independent
variables being correlated with each other), it makes sense to use the measure that is most highly
correlated with returns and drop the others. Thus, the use of price to book value ratios by Fama and
French.
Why not use bond betas to arrive at the cost of debt?
Given that we use stock betas to arrive at expected returns for stocks, the question may arise as to why we
do not use bond betas to get expected returns for bonds. The reason lies in the absence or presence of
symmetry in returns for each of these asset classes. Stocks, which have potentially unlimited upside
potential as well as significant downside potential, have much more symmetric returns than bonds. Thus,
they tend to fit in much more cleanly into the mean-variance framework than do bonds.
Corporate bonds have some upside potential, but it is limited by the fact that bonds can at best become
default-free. Thus, the upside potential for a AA rated bond is fairly limited. Consequently, the risk
measure that we have to use has to be a downside risk measure, which is what default risk and ratings
measure. Clearly, the lower the rating of a bond, the greater the upside potential, and thus, the greater the
likelihood that we can estimate bond betas and expected returns on them. For a junk bond, for instance, it
may be possible to estimate a beta like a stock beta and get an expected return from it.
Credit Scores as Alternatives to Bond Ratings
Bond ratings are a tool that we use to measure default risk and arrive at a cost of debt. Lenders (such as
banks) have historically used credit scores as a measure of default risk, especially when lending to
individuals and private businessess. A credit score is derived by measuring how a borrower scores on a
variety of measures, which over time have been correlated with default risk.
Riskfree Rate
1. Estimating the riskfree rate when the government is not default free
We have implicitly assumed in our discussion of risk free rates that the government is a default-
free entity and that it issues long term bonds. There are a number of economies where one or both
of these assumptions can be challenged. In some emerging market countries, where governments
in the past have failed to meet their promised obligations, the government is not viewed as default
free. There are many other markets where the government does not issue long term bonds, and the
best that one can obtain is a short term government rate.
There are three solutions to this problem. One is to bypass it entirely by doing the analysis in a
different currency (such as the U.S. dollar) where a riskfree rate is easy to obtain. The other is to
find the rate at which the largest and safest corporations in that country can borrow long term at
in the local currency and reduce that rate by a small default premium (say 20 or 30 basis points)
to arrive at a long term riskfree rate. The third solution exists only if there are long term forward
contracts on the local currency.Since interest rate parity drives forward contract pricing, the long
term local currency rate can be obtained from the price of the forward contract and the long term
interest rate on the foreign currency.
2. Real versus Nominal Riskfree Rates
Real riskfree rates do not include a premium for expected inflation and should be used if the cash
flows are estimated using a similar premise. In practice, it is a good idea to steer away from
nominal cash flows and discount rates when inflation hits double digits. One solution is to use a
different currency which is more stable; in high-inflation economies, it is common to do
investment analyses and valuations in U.S. dollars. The other is to use real cash flows and
discount rates.
Obtaining real risk free rates can be trivial if a inflation-protected government bond trades in the
market. In the United States, for instance, the rate on inflation-linked bonds that were introduced
in 1997, is the real risk free rate. Unfortunately, this option is generally unavailable in those high-
inflation economies where the need to use real riskfree rates is the greatest. In those markets the
real risk free rate has to be estimated indirectly. We would propose that the real risk free rate be
set equal the the expected long term real growth rate of that economy. While this rate may be
about 3% for the U.S. economy, it is likely to be higher for other economies such as Brazil and
China.
Risk Premium
1. Geometric versus Arithmetic Risk Premiums: Which is better?
The conventional wisdom is that the arithmetic mean is the better estimate. This is true if
(1) you consider each year to be a period (and the CAPM to be a one-period model)
(2) annual returns in the stock and bond markets are serially uncorrelated
As we move to longer time horizons, and as returns become more serially correlated (and
empirical evidence suggests that they are), it is far better to use the geometric risk premium. In
particular, when we use the risk premium to estimate the cost of equity to discount a cash flow in
ten years, the single period in the CAPM is really ten years, and the appropriate returns are
defined in geometric terms.
In summary, the arithmetic mean is more appropriate to use if you are using the Treasury bill rate
as your riskfree rate, have a short time horizon and want to estimate expected returns over that
horizon.
The geometric mean is more appropriate if you are using the Treasury bond rate as your riskfree
rate, have a long time horizon and want to estimate the expected return over that long time
horizon.
2. The Mechanics of Implied Equity Premiums
This approach assumes that the market, overall, is correctly priced. Consider, for instance, a very
simple valuation model for stocks:
Value =
This is essentially the present value of dividends growing at a constant rate forever (see the time
value appendix to chapter 5). Three of the four inputs in this model can be obtained externally -
the current level of the market (value), the expected dividends next period and the expected
growth rate in earnings and dividends in the long term. The only "unknown" is then the required
return on equity; when we solve for it, we get an implied expected return on stocks. Subtracting
out the riskfree rate will yield an implied equity risk premium.
To illustrate, assume that the current level of the S&P 500 Index is 900, the expected dividend
yield on the index is 2% and the expected growth rate in earnings and dividends in the long term
is 7%. Solving for the required return on equity yields the following:
900 = (.02*900) /(r - .07)
Solving for r,
r = (18+63)/900 = 9%
If the current riskfree rate is 6%, this will yield a premium of 3%.
The advantage of this approach is that it is market-driven and current, and does not require any
historical data. It is, however, bounded by whether the model used for the valuation is the right
one and the availability and reliability of the inputs to that model. For instance, in the above
example, some might take issue with the use of dividends and the assumption of "constant"
growth. Finally, it is based upon the assumption that the market is correctly priced.
3. Estimating equity risk premium for an emerging market or a market with limited history?
The risk premium should be a function of the volatility in the underlying economy and the
political risk associated with that particular market. Other things remaining equal, we would
expect markets which are riskier than the U.S. to have larger premiums than the U.S., especially
looking forward. While no direct measure of this risk may exist, most countries are rated by
ratings agencies based at least partially on these criteria. The advantages of these ratings are that
they can be associated with default premia, that allow us to quantify the effect on the risk
premium. The use of country bond ratings to estimate equity risk premiums for these countries
may be disquieting to some. In defense, it should be noted that there is a high correlation between
country bond premiums and country equity returns. Furthermore, many of the factors considered
by the ratings agencies in analysing country bond risk are also factors in evaluating country
equity risk.
It is true that the premium that emerges from looking at a country's rating reflects the default risk
on its debt and that the equity premium is likely to be higher, especially for near-term horizons.
The default premium from the rating can be scaled upwards, using the relative volatility of the
stock and the bond markets in that country. To illustrate, assume that Brazil has a BB rating, and
that the default premium is 2%. In addition, assume that the annualized standard deviation in the
Brazilian stock market is 34.3%, while the standard deviation in Brazilian government bond
prices is 10.9%. The risk premium for Brazil can then be estimated to be:
Equity Risk Premium for Brazil = US Risk Premium + Default Premium based on Rating (Equity
Standard Deviation/ Bond Standard Deviation) = 5.5% + 2% (34.3%/10.9%) = 11.8%. This
premium should be adjusted down as the time horizon lengthens.
An alternative approach exists when all of the country risk can be hedged away using market-
traded instruments (options, futures and forwards). The annual percentage cost of hedging away
the risk can be added on to the base country premium to arrive at the risk premium for a foreign
market. For instance, assume that you are a U.S. investor, with a base premium of 5.5% for
domestic investments, and that you can buy insurance against country-specific risk for 2% a year.
The total premium used for for this country will then be 7.5%.
Beta
1. Setting Regression Parameters for Beta Estimates: How far back? Daily, weekly or monthly
data?
There are two estimaton decisions the analyst must make in setting up the regression described
above. The first concerns the length of the estimation period. Most estimates of betas, including
those by Value Line and Standard and Poors, use five years of data, while Bloomberg uses two
years of data. The trade-off is simple: A longer estimation period provides more data, but the firm
itself might have changed in its risk characteristics over the time period. For instance, using data
from 1985 to 1994 to estimate betas for Microsoft might increase the amount of data available,
but it will lead to a beta estimate that is much higher than the true beta, since Microsoft was a
smaller and riskier firm in 1985 than it was in 1994.
The second estimation issue relates to the return interval. Returns on stocks are available on an
annual, monthly, weekly, daily and even on a intra-day basis. Using daily or intra-day returns will
increase the number of observations in the regression, but it exposes the estimation process to a
significant bias in beta estimates related to non-trading. For instance, the betas estimated for small
firms, which are more likely to suffer from non-trading, are biased downwards when daily returns
are used. Using weekly or monthly returns can reduce the non-trading bias significantly. To
illustrate, the beta for America Online, a small information services firm, was 1.20 using daily
returns from 1990 and 1994, while it was 1.80 using monthly returns. The latter is a much more
reliable estimate of the firms beta.
2. Why do beta estimates vary across services?
It is not uncommon to find very different beta estimates reported for a firm by different services
at the same point in time. There are several reasons for these differences
1. The services might not be looking at the same historical time period. Value Line and S&P, for
instance, use 5-year estimates, while Bloomberg, in its default calculation, uses a 2-year estimate.
2. The services also often using different return interevals to estimate betas. Bloomberg and
Value Line use weekly returns to get their beta estimates while S&P uses monthly returns; there
are services that even use daily returns.
3. The adjustments made to regression betas vary widely across the services. Bloomberg employs
the simple adjustment towards one for all the betas that it estimates, whereas a service like Barra
adjusts betas using a variety of fundamental information about the firm, such as its dividend
yield.
While these beta differences are troubling, note that the beta estimates delivered by each of these
services comes with a standard error, and it is very likely that all of the betas reported for a firm
fall within the range of the standard errors from the regressions.
3. What is the right market index to use in estimating betas?
In most cases, analysts are faced with a mind boggling array of choices among indices when it
comes to estimating betas. Some analysts use only the local index, but others are willing to
experiment. One common practice is to use the index that is most appropriate for the investor
who is looking at the stock. Thus, if the analysis is being done for a U.S. investor, the S&P 500
index is used. This is generally not appropriate. By this rationale, an investor who owns only two
stocks should use an index composed of only those stocks to estimate betas.
The right index to use in analysis should be determined by who the marginal investor in Aracruz
is - a good indicator is to look at the largest holders of stock in the company and the markets
where the trading volume is heaviest. If the marginal investor is, in fact, a Brazilian investor, it is
reasonable to use a well-constructed Brazilian index. If the marginal investor is a global investor,
a more relevant measure of risk may emerge by using the global index. Over time, you would
expect global investors to displace local investors as the marginal investors, because they will
perceive far less of the risk as market risk and thus pay a higher price for the same security. Thus,
one of the ironies of our notion of risk is that Aracruz will be less risky to an overseas investor
who has a global portfolio than to a Brazilian investor with all of his or her wealth in Brazilian
assets.
4. Historical Betas versus Expected Betas: Reversion and Financial Fundamentals
In much of corporate finance and valuation, our interest is in the beta looking forward and not the
beta looking back. A regression beta, even if well estimated, reflects the firm as it existed over the
period of the regression in terms of business and financial risk. If the firm has changed on either
dimension, it can be argued that the beta looking forward will be different from the historical
beta. There are three ways in which we can make this adjustment.
One simplistic way of adjusting historical betas is to assume that betas will move towards one in
the long term and adjust beta estimates towards one.
A more accurate way of estimating forward looking betas is to estimate them from the bottom up,
based upon the current business mix of the firm and estimating a weighted average of the sector
betas. This can then be levered up using the current or expected financial leverage of the firm.
A third approach is to relate betas to observable financial characteristics (such as the size of the
firm, its dividend yield and debt ratio) through statistical analysis (such as a regression). The
firm's specific financial characteristics will then yield a predicted beta for the firm.
5. Betas and Leverage: Derivation and Extensions
To estimate the relationship between leverage and betas, let us begin with the assumption that
debt bears no market risk (which is consistent with studies that have found that default risk is
non-systematic). Debt creates a tax benefit which is reflected on the asset side of the balance
sheet (In market value terms):
Assets

Liabilities

Assets A B(unlev) Debt D 0
Tax Benefit of Debt tD 0 Equity E B(levered)
6. Betas are weighted averages,
B(unlev) (E + D - tD)/(D+E) = B(levered)(E/(D+E))
Solve for B(levered),
B(levered) = B(unlev) (E + D - tD)/E= B(unlev) (1 + (1-t)D/E)

If debt has a beta (B(Debt))
B(unlev) (E + D - tD)/(D+E) + B(Debt)) (tD/(D+E)) = B(levered) (E/(D+E)) + B(Debt) D/(D+E)
B(levered)= B(unlev) (1 + (1-t)D/E) - B(Debt) (1-t) [D/(D+E)]
7. Accounting Betas
Changes in earnings at a division or a firm, on a quarterly or annual basis, can be regressed
against changes in earnings for the market, in the same periods, to arrive at an estimate of a
"market beta" to use in the CAPM. While the approach has some intuitive appeal, it suffers from
three potential pitfalls. First, accounting earnings tend to be smoothed out relative to the
underlying value of the company, resulting in betas that are "biased down", especially for risky
firms, or "biased up", for safer firms. In other words, betas are likely to be closer to one for all
firms using accounting data. Second, accounting earnings can be influenced by non-operating
factors, such as changes in depreciation or inventory methods, and by allocations of corporate
expenses at the divisional level. Finally, accounting earnings are measured, at most, once every
quarter, and often only once every year, resulting in regressions with few observations and not
much power.
8. Estimating Bottom-up Betas
The bottom-up beta for a firm, asset or project can be estimated as follows.
1. Identify the business or businesses that make up the firm, asset or project.
2. Estimate the unlevered beta(s) for the business or businesses that the firm is involved in.
3. To calculate the unlevered beta for the firm, take a weighted average of the unlevered betas,
using the market values of the different businesses that the firm is involved in. If the market value
is not available, use a reasonable proxy such as operating income or revenues.
4. Calculate the leverage for the firm, using market values if available. If not, use the target
leverage specified by the management of the firm or industry-typical debt ratios.
5. Estimate the levered beta for the firm (and each of its businesses) using the unlevered beta
from step 3 and the leverage from step 4.
Additional
Subject: Analysis - Beta and Alpha
Last-Revised: 22 Oct 1997
Contributed-By: Ajay Shah, R. Shukla (rkshukla at som.syr.edu), Bob Pierce (rbp at
investor.pgh.pa.us)
Beta is the sensitivity of a stock's returns to the returns on some market index (e.g., S&P 500).
Beta values can be roughly characterized as follows:
Beta less than 0
Negative beta is possible but not likely. People thought gold stocks should have negative betas
but that hasn't been true.
Beta equal to 0
Cash under your mattress, assuming no inflation
beta between 0 and 1
Low-volatility investments (e.g., utility stocks)
Beta equal to 1
Matching the index (e.g., for the S&P 500, an index fund)
Beta greater than 1
Anything more volatile than the index (e.g., small cap. funds)
Beta much greater than 1 (tending toward infinity)
Impossible, because the stock would be expected to go to zero on any market decline. 2-3 is
probably as high as you will get.
More interesting is the idea that securities MAY have different betas in up and down markets. Forbes
used to (and may still) rate mutual funds for bull and bear market performance.
Alpha is a measure of residual risk (sometimes called "selecting risk") of an investment relative to some
market index. For all the gory details on Alpha, please see a book on technical analysis.
Here is an example showing the inner details of the beta calculation process:
Suppose we collected end-of-the-month prices and any dividends for a stock and the S&P 500 index for
61 months (0..60). We need n + 1 price observations to calculate n holding period returns, so since we
would like to index the returns as 1..60, the prices are indexed 0..60. Also, professional beta services use
monthly data over a five year period.
Now, calculate monthly holding period returns using the prices and dividends. For example, the return for
month 2 will be calculated as:
r_2 = ( p_2 - p_1 + d_2 ) / p_1
Here r denotes return, p denotes price, and d denotes dividend. The following table of monthly data may
help in visualizing the process. (Monthly data is preferred in the profession because investors' horizons
are said to be monthly.)
Nr. Date Price Div.(*) Return
0 12/31/86 45.20 0.00 --
1 01/31/87 47.00 0.00 0.0398
2 02/28/87 46.75 0.30 0.0011
. ... ... ... ...
59 11/30/91 46.75 0.30 0.0011
60 12/31/91 48.00 0.00 0.0267

(*) Dividend refers to the dividend paid during the period. They are assumed to be paid on the date. For
example, the dividend of 0.30 could have been paid between 02/01/87 and 02/28/87, but is assumed to be
paid on 02/28/87.
So now we'll have a series of 60 returns on the stock and the index (1...61). Plot the returns on a graph
and fit the best-fit line (visually or using some least squares process):

The slope of the line is Beta. Merrill Lynch, Wells Fargo, and others use a very similar process (they
differ in which index they use and in some econometric nuances).
Now what does Beta mean? A lot of disservice has been done to Beta in the popular press because of
trying to simplify the concept. A beta of 1.5 does not mean that is the market goes up by 10 points, the
stock will go up by 15 points. It doesn't even mean that if the market has a return (over some period, say a
month) of 2%, the stock will have a return of 3%. To understand Beta, look at the equation of the line we
just fitted:
stock return = alpha + beta * index return
Technically speaking, alpha is the intercept in the estimation model. It is expected to be equal to risk-free
rate times (1 - beta). But it is best ignored by most people. In another (very similar equation) the intercept,
which is also called alpha, is a measure of superior performance.
Therefore, by computing the derivative, we can write:
Change in stock return = beta * change in index return
So, truly and technically speaking, if the market return is 2% above its mean, the stock return would be
3% above its mean, if the stock beta is 1.5.
One shot at interpreting beta is the following. On a day the (S&P-type) market index goes up by 1%, a
stock with beta of 1.5 will go up by 1.5% + epsilon. Thus it won't go up by exactly 1.5%, but by
something different.
The good thing is that the epsilon values for different stocks are guaranteed to be uncorrelated with each
other. Hence in a diversified portfolio, you can expect all the epsilons (of different stocks) to cancel out.
Thus if you hold a diversified portfolio, the beta of a stock characterizes that stock's response to
fluctuations in the market portfolio.
So in a diversified portfolio, the beta of stock X is a good summary of its risk properties with respect to
the "systematic risk", which are fluctuations in the market index. A stock with high beta responds strongly
to variations in the market, and a stock with low beta is relatively insensitive to variations in the market.
E.g. if you had a portfolio of beta 1.2, and decided to add a stock with beta 1.5, then you know that you
are slightly increasing the riskiness (and average return) of your portfolio. This conclusion is reached by
merely comparing two numbers (1.2 and 1.5). That parsimony of computation is the major contribution of
the notion of "beta". Conversely if you got cold feet about the variability of your beta = 1.2 portfolio, you
could augment it with a few companies with beta less than 1.
If you had wished to figure such conclusions without the notion of beta, you would have had to deal with
large covariance matrices and nontrivial computations.
Finally, a reference See Malkiel, A Random Walk Down Wall Street, for more information on beta as an
estimate of risk.

Cost of Debt
1. What is debt?
Some new securities, at first sight, are difficult to categorize as either debt or equity. To check
where on the spectrum between straight debt and straight equity these securities fall, answer the
following questions:
1. Are the payments on the securities contractual or residual?
- If contractual, it is closer to debt
- If residual, it is closer to equity
2. Are the payments tax deductible?
- If yes, it is closer to debt
- If no, if is closer to equity
3. Do the cash flows on the security have a high priority or a low priority if the firm is in financial
trouble?
- If it has high priority, it is closer to debt.
- If it has low priority, it is closer to equity.
4. Does the security have a fixed life?
- If yes, it is closer to debt
- If no, it is closer to equity
5. Does the owner of the security get a share of the control of management of the firm?
- If no, it is closer to debt.
- If yes, if is closer to equity
2. Which is a better estimate of the cost of debt - the rating-based interest rate or the yield to
maturity on an issued bond?
The yield to maturity on an issued bond has the advantage of being a market-determined rate. It
will be skewed by any special features that the bond may have and the degree to which the bond
is secured, relative to other debt. For instance, if the bonds issued by a firm have first priority on
the assets, the yield to maturity on these bonds will be lower than the company's true cost of debt,
which should represent the cost of the entire debt pool. That is why using the ratings and
estimating a cost of debt based on the rating may provide a better estimate of debt.
3. Estimating Synthetic Ratings
To estimate synthetic ratings we use the financial characteristics of the firm under question. As an
example, if a firm has an interest coverage ratio of 5.2, and other firms with similar interest
coverage ratios have an A rating, this firm's synthetic rating is A.
Weights
1. Gross Debt or Net Debt
Many analysts prefer to subtract the cash from the gross debt to arrive at a net debt figure. If net
debt is used, it is important that we be consistent in both our estimation of unlevered beta and in
our measure of the debt ratio.
The unlevered beta that should be used for the firm should then be just the unlevered beta without
the cash. When this beta is levered, it will be levered using the net debt ratio, and this estimate of
the levered beta will be slightly different from the estimate using gross debt. The difference arises
because netting out debt makes the assumption that the tax benefit from having debt is exactly
offset by the tax effects of earning interest on cash. It is generally not a good idea to net debt if
the debt is very risky (since netting is predicated on the asusmption that debt and cash are both
riskless) or if the interest rate earned on cash is substantially lower than the interest rate paid on
debt.
2. Estimating market value of debt when debt is not traded
The market value of debt is usually more difficult to obtain directly since very few firms have all
of their debt in the form of bonds outstanding trading in the market. Many of them have non-
traded debt, such as bank debt, which is specified in book value terms but not market value terms.
A simple way to convert book value debt into market value debt is to treat the entire debt on the
books as one coupon bond, with a coupon set equal to the interest expenses on all of the debt and
the maturity set equal to the face-value weighted average maturity of the debt, and to then value
this coupon bond at the current cost of debt for the company. Thus, the market value of $ 1billion
in debt, with interest expenses of $ 60 million and a maturity of 6 years, when the current cost of
debt is 7.5% can be estimated as follows:
Estimated Market Value of Debt =
3. Dealing with Operating Leases
Operating leases are treated as expenses in the income statement. Given that they are
commitments to make payments in the future, it is better to take the present value of the operating
leases at the unsecured cost of debt and to treat that amount is debt.
4. Estimating market value of equity
The market value of equity is generally the number of shares outstanding times the current stock
price. If there is more than one class of shares outstanding, the market values of all of these
securities should be aggregated and treated as equity. Finally, if there other equity claims in the
firm - warrants and conversion options in other securities - these should also be valued and added
on to the value of the the equity in the firm.
5. Dealing with Preferred Stock
Preferred stock shares some of the characteristics of debt - the preferred dividend is pre-specified
at the time of the issue and is paid out before common dividend -- and some of the characteristics
of equity - the payments of preferred dividend are not tax deductible. If preferred stock is viewed
as perpetual, the cost of preferred stock can be written as follows:
kps = Preferred Dividend per share/ Market Price per preferred share