GCP Final Review

Global Capital Market Finals Review
Equity
Debt securities – predefined fixed cash flows (If unpaid, debt holders can take control of the
company)
Equity securities – value left over after paying out all liabilities (limited liability, max loss is zero)
Equity is risker than debt  higher required rate of return
Capital Structure Theory (Modigliani-Miller hypothesis)

 Case 1: Capital structure do not influence the EV of firm, WACC remain the same
 Case 2: More debt is more valuable because tax shield provided by debt
 Case 3: ambiguous and depends on agency cost problem
Equity holders ensure the firm runs in the best possible manners by:
 Appointing a Board of director that meets at least quarterly; management technically
reports to the Board, some investors play an activist role
 Analyzing all public information about company and investor days
 Sell-side analyst (usually from larger corporation) publish reports for investors
Financial Model:
∞
E [ Ct ]
V =∑ t
t =1 (1+WACC )
V = firm value Ct= Net cash flow projections at time t (to pay both debt and equity holder)
Equity Valuation Methods:
1. Dividend Discount Model: the only CF the investor will get are the periodic dividend
∞
E [ Dt ]
P 0= ∑ ¿ t
t =1 (1+ r )
Dt= CF to shareholders at time t r*= constant expected return on equity
E [ Dt +1 + Pt +1 ]
= E[Dt] = E [ r t +1 ] = −1
Pt
D
 No Growth Dividend Model: P0=
r¿
Ex. Value of stock = Value of all projects
# of new shares * New share price = Cost of new project
x = new share price; y = # of newly issued stocks
 Gordon Growth Model
k
E [ Dt ] Pk
P 0= ∑ ¿ t
+
t =1 (1+ r ) (1+ r ¿ )k
D D ( 1+ g )
P0= ¿ 1 = 0¿
r −g r −g
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D1 D2 D2 (1+ g)
if k =2: P 0= ¿ 1
+ ¿ 2
+ 2
(1+r ) (1+ r ) ( 1+ r ¿ ) (r ¿ −g)
2. Comparable Company Analysis/ Ratio Analysis

EV
 Common:
EBITDA
Net Debt EBIT
 Debt Holders: , Interest Coverage Ratios
EBITDA Interest Expense
 Equity Holders: P/E Ratios
a ( 1+ g )
∧P 0
D1 aX 0 (1+ g ) P0 ¿
r −g a
P 0= ¿ = ¿ =¿ = = ¿
r −g r −g X0 X1 r −g
X1 aX 0 ( 1+ g ) X 1 [ g−( 1−a ) r ¿ ] 1 g−( 1−a ) r
¿
P0= ¿ + PVGO= ¿ =¿ PVGO= =¿ P = +
r r −g (r ¿ −g)r ¿ 0
r ¿ (r ¿−g)r ¿
a= dividend payout ratio Xt =firm’s earning = E[Earnt] PVGO = Present Value of Growth Opportunity
∆ Earn Inv ∆ Earn
Growth rate=g= = ×
Earn Earn Inv
Portfolio Theory:
 Utility function (Indifference Curve):
2
U=E [ R p ] −0.5 × A × σ p
E[Rp]= Expected return of portfolio

2
σ p = Variance of portfolio
A = degree of investor’s risk aversion
U increases toward the top left 
Investors would prefer points on top-left corner
 Multiple Asset Portfolio(Diversification):

N N
Returnon the portfolio :r p =∑ wi r i 1=∑ wi
i=1 i=1
N N N
Variance of thereturn onthe portfolio:Var ( r p )=∑ wi σ i +2 ∑ ∑ wi w j cov ( r i , r j )
2 2
i=1 i=1 j>i
cov ( r i ,r j )= ρij σ i σ j
 Minimum Variance Portfolio
If the added asset is not perfectly correlated with the first asset, the portfolio could obtain a
higher expected return for the same risk OR given return with lower risk
2 ( 1−ρ2 ) σ 12 σ 22
Minimum Varience Portfolio=min σ = p
σ 12 −2 ρ σ 1 σ 2 + σ 22
2
¿ σ2 − ρ σ1σ 2
Weight for Minimum Varience Portfolio=w = 2 2
σ 1 −2 ρ σ 1 σ 2 +σ 2
There are decreasing returns for diversification. As N → ∞ ,
[ ] [ ][ ]
N N N
2
σ p=
1 1
N N i=1 i
∑ σ
2
+ 1−
1 1
N N ( N −1 ) i=1 j>i [ ]
∑ ∑ cov ( r i , r j) = N1 [ Average Varience ] + 1− N1 [ Average Covarience ]
Variance of the portfolio returns = Average covariance of returns
Risk of Portfolio = Systematic/Market/Non-diversifiable risk
 Optimal Portfolio
o One risky asset + one risk-free asset
[ 2
]
(1) E [ r p ]=wr+ (1−w ) r f =r f +wE [ r −r f ] ( 2) σ p2=E ( r p −E [ r p ] ) =w2 σ 2 (3) σ p =|w| σ
Capital Allocation Line: set of feasible portfolios in two-asset world
E [ r−r f ]
E [ r p ]=r f + σp
σ
E [ r−r f ] = Excess return per unit of risk
Slope=Shape Ratio=
σ
Intercept = risk-free rate
E ( r ) −r f (plugging (1) and (2) into Utility
Optimal Porfolio : w¿ =
A σ2
Equation) = tangency point of investors indifference curve with CAL
o Many risky asset + one risk-free asset (Mean- Variance-Efficient portfolio)

1. Derive the mean-variance efficient frontier by finding the portfolio that
minimizes variance for every expected return level
2. Find the portfolio with the highest Sharpe Ratio on the efficient frontier (CAL that
form a tangent with the efficient frontier)
CAL going through the market portfolio is called Capital Market Line
3. Find a particular investor’s optimal portfolio by max utility function
o Shape Ratio to CAPM
dSR
> 0 if SR new ≥ SR p ρ should add until SR new =SR p ρ
dw
E [ r new −r f ] E [ r p −r f ] cov ( r new , r p )
= ρ=¿ E [ r new −r f ] = 2
E [ r p −r f ]=CAPM !
σ new σp σp
 Capital Asset Pricing Model(CAPM): an equilibrium model that predicts return of asset
cov ( r i , r Mkt )
E [ r i−r f ]=β i E [ r Mkt −r f ] β i= 2
σ Mkt
o CAPM Assumptions: single period investment, perfectly competitive market,
perfect information, diversified portfolio
o The risk premium on the market depends on the average risk aversion
o CAPM Predictions:
1. All investors will hold the same portfolio for risky asset – the market
portfolio. The market portfolio contains all securities, each individual
security as % of total market value.
2. The expected return on a stock is a linear function of its beta:
Security Market Line: relation between E [ r i ]∧β i
E [ r i ] =r f + β i E [ r Mkt −r f ]
Slope = how much extra return an investor
needs for a unit increase in market exposure
β i = sensitivity of asset’s return to market
cov ( r i ,r Mkt ) = to what extent return move with the
market
o Estimating Betas (and Alphas): run regression of the individual’s historical returns
on that of market returns (known rf, ri, rMkt)
Slope = β i
Regression residual = ε i = idiosyncratic risk
Intercept = α i = how well model prices security
Large α i → mispricing/inappropriate model
CAPM assumes no mispricing  implies α i=0

CAPM assumes well-diversified portfolio  implies ε i ∧σ́ i2=0  systematic
risks are priced compensated, but idiosyncratic risks are not
 Multi-factor Model
o Arbitrage Pricing Theory(APT)
k k
r i=ai+ ∑ β ij F j+ ε i E ( r i )=r f + ∑ β ij RP j
j =1 j=1
F
β ij Var (¿ ¿ j )+ σ´i2
2
k
Var ( r i ) =∑ ¿
j=1
r i=¿ return on security i
¿ β ij = sensitivity of asset i’s return to the jth factor = factor loading
k =¿ # of systematic factors
F j = Systematic factors
RP j = excess return compensation for a unit exposure to factor j
1. Estimate β ij by running time series regression, security by security, of
historical security returns on the factor
2. Using estimated β ij , run cross-sectional regression of r i on β ij ,
period by period to estimate RP j
3. Find out whether the security have positive or negative ai
o Fama-French Models
o Model inputs
N (N + 1)
Markowitz Portfolio: N expected returns, N residual variance,
2
covariance
N ( N +1)
2N+
2
Factor model: N expected returns, Nk Betas, N residual variance, k Factor
variance
2 N + k ( N +1)
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Global Capital Market Finals Review

Capital Structure Theory (Modigliani-Miller hypothesis)

Equity Valuation Methods:

2. Comparable Company Analysis/ Ratio Analysis

E[Rp]= Expected return of portfolio

 Multiple Asset Portfolio(Diversification):

i=1 i=1 j>i

o Many risky asset + one risk-free asset (Mean- Variance-Efficient portfolio)

3. Find a particular investor’s optimal portfolio by max utility function

CAPM assumes no mispricing  implies α i=0

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