Week 1 Notes
Week 1 Notes
Week 1 Notes
• Two key decisions affect firm value: Investment decisions and Financial decisions
• Investment decisions: investing in real assets, plant and machinery, R&D, etc.
• Will managers always act in the best interest of owners: Not always
• Goods systems of corporate governance ensure that the interest and objectives of managers are well
• What would be that additional amount for which you would agree to delay your consumption of
• A dollar worth today is more than the dollar worth tomorrow: but how much more
Time value of money
• An investment of $100 into fixed deposit at 7% interest will grow to become $107 in one year and
• In second year, you earn interest on principal as well as on the interest earned in second year:
power of compounding
• Similarly $100, invested for 20 years at 10% will grow to become 100 ∗ 1.1020 = $672.75
Time value of money
Assume an interest rate of r and
a period of t. The future value of
$100 invested today, will be:
100 ∗ 1 + 𝑟 𝑡
• So, if appropriate interest is 7%, then the present value of $114.49 to be received two years from
114.49
• This can be simply computed as follows: Present Value (PV)= =$100
1.072
𝐶𝑡
• Therefore the formula of present value can also be written simply as follows: 𝑃𝑉 = .
1+𝑟 𝑡
Time value of money
A payment worth $100
to be received in 20 years at
an interest rate of 5% has a PV
100
of 1.0520 = $37.69
• Your advisor tells you that it is a sure thing with $42000 expected by the end of the year
420000
• The present value of this investment can be computed as 𝑃𝑉 = = $400000
1.05
𝐶1
𝐶0 +
1+𝑟
• In our previous office space example, now consider that you are not so certain about the revenues
• You consider it to be a risky venture and a 12% interest rate to be an appropriate opportunity cost
420000
• The new NPV computation: 𝑁𝑃𝑉 = 𝑃𝑉 − 370000 = − 370000 = 5000
1.12
• NPV of the project has come down as it has become riskier for you
• The present value of the office space has two aspects (1) The timelines of the cash flows; and (2) The risk of the
cash flow
Time value of money
• There is another decision rule for evaluating such projects: Rate of return rule
𝐏𝐫𝐨𝐟𝐢𝐭 𝟒𝟐𝟎𝟎𝟎𝟎−𝟑𝟕𝟎𝟎𝟎𝟎
• 𝐑𝐞𝐭𝐮𝐫𝐧 = 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 = = 𝟏𝟑. 𝟓%
𝟑𝟕𝟎𝟎𝟎𝟎
• Opportunity cost of capital> Project return then accept the project and vice-versa
• Net-present value rule (NPV) rule: Accept the investments that have positive NPVs
• Rate of return rule: Accept the investments that have rate of returns higher than their opportunity cost of
capital.
Computing NPVs with multiple cash flows
• Suppose that a cash flow stream spread over ‘t’ years is provided as follows, 𝐶𝑖 , 𝑓𝑜𝑟 𝑖 = 1 𝑡𝑜 𝑇. Also assume
𝐶 𝐶2 𝐶T 𝐶𝑡
• 1
𝑃𝑉 = 1+𝑟 + + ⋯+ = σ𝑇𝑡=1
1+𝑟 2 1+𝑟 𝑇 1+𝑟 𝑡
𝐶𝑡
• 𝑁𝑃𝑉 = 𝐶0 + 𝑃𝑉 = 𝐶0 + σ𝑇𝑡=1 1+𝑟 𝑡
Computing NPVs with multiple cash flows
20000 420000
• 𝑃𝑉 = + = 17900 + 334800 = 352700
1.12 1.122
− 17300.
Valuing perpetuities and annuities
• A perpetuity is a security that pays periodic cash flows over infinite time intervals
• Consider a perpetuity with annual cash flows amounting to ‘C’ and an appropriate discounting rate of r
𝐶
• The present value of this perpetuity is provided here: 𝑃𝑉 = 𝑟
• Consider a simple example as follows. You are a billionaire and would like to fund the education at your alma-
mater with $1 Mn each year in perpetuity, starting with next year. If the interest rate is 10%, you would need to
1
provide the following amount: 0.1 = $10𝑀𝑛
• In case you want this perpetuity to start right now immediately. Then you would need to shell-out an additional
years
diagram here
• Similarly, we can value an annuity that pays C amount at the end of year for each of the t years, starting from the
𝐶 1
year end. This will be : 𝑟 [1 − ]
1+𝑟 𝑡
Valuing perpetuities and annuities
• Consider an example of an annuity that pays $5000
five years
5000 1
• 𝑃𝑉 = 1 − 1.075 = $20501
0.07
Valuing perpetuities and annuities
• Often these cash flows do not remain constant and exhibit a certain growth rate.
𝐶
• If a perpetuity is growing at a rate of ‘g’ the simple formula for this perpetuity becomes: ; where r>g
𝑟−𝑔
• A $1Mn perpetuity, starting from the year end, that grows at an interest of 4%. If the appropriate discount rate is 10%,
1
the present value of this perpetuity will be = $16.67 𝑀𝑛
0.10−0.04
𝐶 1+𝑔 𝑡
• The simple formula for annuities (C) growing at a rate ‘g’ for ‘t’ years is provided below: 𝑃𝑉 = 𝑟−𝑔
[1 − 1+𝑟 𝑡
]
• Consider a 3-year $5000 annuity with 10% discount rate and a growth rate of 6%
5000 1.063
• Then its PV would be 𝑃𝑉 = 1− = $13146
0.10−0.06 1.103
A short lesson on compounding
• Sometimes cash flows are not received annually but at higher frequencies, e.g., quarterly, weekly, monthly
• If you get an interest of 10% per annum on $100. You will get an interest amount of $10
• However, if a 5% interest is paid at 6-monthly intervals you get an overall amount of 1.05*105= $110.25 by the
• Therefore, 10% interest compounded semi-annually results in an effective interest of 1.052 − 1 = 10.25%
𝑟 𝑚
• The compounding frequency increases to m periods, the resulting formula becomes: 1 + 𝑚
• Managers can maximize the firm-value by accepting projects with positive net present values (NPVs)
1 𝐶 𝐶2
• 𝑁𝑃𝑉 = 𝐶0 + 1+𝑟 + …..
1+𝑟 2
• 𝐶0 here is the initial investment, which is expected to be negative, that is outflow of cash. Discount rate ‘r’ is
obtained by examining the prevailing interest rates in financial markets, on the instruments with the same risk
Thanks!
Artificial Intelligence (AI) for Investments
Lesson 3: Making investment decisions
Introduction
In this lesson we will cover the following topics:
• Pitfalls of IRR
• That the current market value of your firm is $10 million, which includes $1 million cash that you plan
• You find the NPV of this project by discounting the cash flows, adding them up to compute there PV,
• Any decision rule that is affected by managers’ tastes, choice of accounting method, profitability of
• NPV(A+B) =NPV(A)+NPV(B)
• Profitability measures such as book rate of returns, heavily depend on the classification of various
• A washing machine is costing $800. You spend $300 a year on washing your clothes. As a thumb
• The payback rule states that a project should be accepted if its payback period is less than some cut-
off period
• This discounted payback rule examines that how many years it takes for the discounted cash flows to
• Let us examine our previous example, with the help of discounted cash flows
Discounted Payback
Project C0 C1 C2 C3 Period NPV at 10%
(years)
500 500 5,000
A -2,000 = 455 = 413 = 3757 3 +2,624
1.1 1.12 1.13
500 1,800
B -2,000 = 455 = 1488 - - -58
1.1 1.12
1,800 500
C -2,000 = 1636 = 413 - 2 +50
1.1 1.12
Alternatives to NPV rule – Internal rate of return
(IRR) method
• IRR rule comes from the simple return measure
C
1 C2 CT
• NPV = C0 + (1+IRR) + 1+IRR 2
+ ⋯+ 1+IRR T
=0
𝑪𝟎 𝑪𝟏 𝑪𝟐
-4000 +2000 +4000
2000 4000
• 𝑁𝑃𝑉 = −4000 + 1+𝐼𝑅𝑅 + = 0 ; solving for this, we get IRR= 28.08%
1+𝐼𝑅𝑅 2
Alternatives to NPV rule – Internal rate of return
(IRR) method
• If the opportunity cost of capital is less than the 28.08%
• Consider the project cash flows from projects A and B as shown here
• In project A, we are paying out $1000 initally, and getting $1500 later - Case of lending
• While in case of B, we are initially getting $1000 and paying back $1500 later- Case of borrowing
• When you lend money, you want a higher return and when you borrow money money you want a
lower return
Pitfalls of IRR
• Pitfall 2: Multiple rates of return
• Consider another project that involves an initial investment of $3 Billion and then produce a cash flow $1
• At the end of the project, the company will incur $6.5 billion of cleanup costs
𝑪𝟎 𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝟒
-3 1 1 1 1
𝑪𝟓 𝑪𝟔 𝑪𝟕 𝑪𝟖 𝑪𝟗
1 1 1 1 1
Pitfalls of IRR
• Pitfall 3: Mutually exclusive projects
• Firms often have to choose from mutually exclusive projects, since it may not be feasible to take all of
them
• In the project cash flows shown here, it seems IRR and NPV are contradicting each other
• In such cases, IRR can still be salvaged by examining incremental cash flows as shown here
• To see its utility, have a look at the project cash flows, NPV, and IRR estimates for two projects X and Y
• The higher IRR associated with X (15.58%) reflects the low risk and efforts involved as compared with Y
Capital investments with limited resources
• Capital is a scarce resource, thus it is not possible to select all the positive NPV
projects
• Thus, firms would like to select those projects that offer highest NPV per dollar of
investment
NPV
• Profitability index (PI) =
Initial Investment
Cash Flows ($ Mn)
Project C0 C1 C2 NPV at 10% PI
A -10 +30 +5 21 2.1
B -5 +5 +20 16 3.2
C -5 +5 +15 12 2.4
Capital investments with limited resources
• Let us add another project D, which needs $40 Mn investment in second year
• The firm can only raise $10 Mn in the second year: additional constraint of capital rationing
• The simple way of ranking projects as per PI may not work here
• This particular problem is rather simple, as A and D combined offer a higher NPV than B and C
combined
• However, more complex problems are solved with linear programming (LP) techniques
Summary and concluding remarks
• In addition to NPV, other rules are also employed to examine alternate investments
• These include book rate of return, payback period, and IRR method
• Book rate of return is simply computed as book income divided by book value of investment
• Payback method examines the project cash flows against a certain specific cut-off period
• Only those projects with payback period is less than cut-off period, are considered
• Lastly, IRR is the discount rate at which the firm NPV is zero
• As per the IRR rule, firms should accept those projects that have an IRR greater than opportunity cost of
capital
Thanks!
Artificial Intelligence (AI) for Investments
Lesson 4: Valuation of fixed income securities
Introduction
In this lesson we will cover the following topics:
• Consider a simple bond that pays 8.5% interest. If you have invested $100, you will get $8.50 annually, if the coupons are annual, and at
maturity you will also get the principal amount, i.e., total $108.5. Also assume a 3% discount rate
8.5 1 100
• PV (Bond)= ∗ 1− + = 31.59 + 88.85 = $120.44
0.03 1.034 1.034
Simple valuation of fixed income securities (FIS)
• Another very important concept for FIS is yield-to-maturity (YTM)
• In the previous example, if the bond under discussion, has a present value of $120.44 then what
• In this case, the answer is ytm=3%, since we assumed the discount rate of 3% at the beginning
Simple valuation of fixed income securities (FIS)
• Consider the example of a simple bond with the following cash-flow profile
• Coupons amounting to $24.375 are paid semi-annually and at the end of the period, a principal
payment of $1000 is paid at the end of 3-years
• In the previous example, where the semi-annual yield was 0.6003%, assume investors start
• The price of this bond will fall to reflect this change in yield, as per the computation shown here
term bonds
• Separate Trading of Registered Interest and Principal Securities (STRIPS) are special instruments,
created by stripping the cash flows from treasury instruments and government securities
• These are often called as zero-coupon bonds, and have the maturity same as duration
Duration of a bond
• Consider three bonds, one strip and two coupon paying bonds with cash flow profile as provided here
Price (%) Cash payments %
Bond Feb. 2015 Aug. 2015 Feb. 2016. . . . . . Aug. 2016 Feb. 2021
Strip for Feb. 2015 88.74 0 0... ...0 100.00
Feb. 2015 (4% p.a.) 111.26 2.00 2.00 . . . . . . 2.00 102.00
Feb. 2015 (11.25% p.a.) 152.05 5.625 5.625 . . . . . . 5.625 105.625
• The two coupon paying bonds offer a considerable proportion of their cash flows earlier than maturity.
Thus it is very easy to observe that the strip has the longest duration
• Bond with 11.25% coupon (i.e., 5.625% semi-annual coupon) offers a larger proportion of cash flows
earlier than maturity, as compared to the bond with lower coupon of 4% (i.e., 2% semi-annual coupon)
Duration of a bond
• However, we need a more concrete measure of duration
• The duration measure also indicates the sensitivity of a fixed income security to interest rate changes
• The simple measure of duration is computed as a weighted average of times, with weights being the
• Consider a bond with a maturity of T years. The corresponding cash flows in each of these years
𝑃𝑉 𝐶1 𝑃𝑉 𝐶2 𝑃𝑉 𝐶3 𝑃𝑉 𝐶𝑇
• 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 1 ∗ 𝑃𝑉
+2∗ 𝑃𝑉
+3∗ 𝑃𝑉
+ ⋯+ 𝑇 ∗ 𝑃𝑉
Duration of a bond
• Let us understand this through one example
• Consider a fixed income security with coupons of $8.5 paid at the end of each year and a final
𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
• 𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =
1+𝑦𝑖𝑒𝑙𝑑
Duration of a bond
• This modified duration measures the percentage change in price a one percentage change in yield (or
interest rates)
• For our bond of duration 3.6 years. This measure works out to 3.6/1.03= 3.49%
• Now consider a scenario where interest rates rise by 0.5% and fall by the same amount
interest rates
• This variation in interest rates over short-term and long-term and across periods, is often referred to
1
• A simple cash-inflow of $1 in the first year will have a value of 𝑃𝑉 = 1+𝑟 . Here 𝑟1 , would be called the one-
1
1
• Similarly, a loan that pays $1 at the end of two years, will have a present value of 𝑃𝑉 = 1+𝑟2 2
• For simple illustration purposes assume that 𝑟1 = 3% and 𝑟2 = 4%. A security that offers only these two cash
1 1
flows will have a present value of 𝑃𝑉 = 1.03 + = 1.895
1.04 2
1 1
• P𝑉 = + = 1.895
1+𝑦𝑡𝑚 1+𝑦𝑡𝑚 2
A 8% coupon-2year 80 1080
PV 77.29 998.52 - - 1,075.82 3.98%
C 6% coupon-4year 60 60 60 1060
PV 57.97 55.47 53.03 892.29 1,058.76 4.37%
D STRIP 1000
841.78 841.78 4.40%
Term structure of interest rates
• A 10-year strip with face-value of $1000 at then end of maturity is selling at $714.18
1
• 𝐹0 = = 0.71418; solving for this, 𝑟10 = 3.42%
1+𝑟10 10
• Expectations theory of term structure: Term-structure of interest rates reflect the expectation of interest
rates in future
• Assume that the spot rate for year 1, 𝑟1 is 5% and spot rate for year 2, 𝑟2 is 7%
• If you invest $100 for one year, you get $5 for interest. If you invest it for two years, you get 100 ∗ 1.072 , that
is, $114.49 after two years
1.072
• The extra return that you earn in second year can be computed as noted here. -1=9.0%
1.05
• This means that if you invest for two years, you will get 5% in year 1 and 9% in year 2
Term structure of interest rates
• If you expect that bond prices in the year 2 will yield more, then you would prefer to invest at 1-year spot and
• In equilibrium, long term spot rates are a combination of short-term spot and a series of forward rates
• Forward rates are future rates booked (contracted) today. For example, rate of interest for period T=1 to T=2
• Liquidity preference theory suggests that investors prefer to invest in short-term as they fear the additional
• These instruments include regular interest (or coupon) payments and at the maturity you get back the face-
• These instruments can be easily valued through discounting cash flow valuation method
• Also, it is appropriate to discount each of these cash flows with its on spot rate corresponding to the duration
• The spot rate is observed on the term structure of interest rates. The term structure of interest rates is
bond
• Duration reflects the average time associated with cash-flows of a fixed income security
• The expectations theory of interest rates suggests that rising interest rates reflect the future expectations of
investors
• The theory of liquidity preference suggests that investors prefer to hold short-term instruments as compared
to long-term instruments
Thanks!
Artificial Intelligence (AI) for Investments
Lesson 5: Valuation of common stocks
Introduction
In this lesson we will cover the following topics:
• Trading in modern financial markets: electronic communication networks and limit order books
market expectations
• Fundamental valuation methods provide estimates, independent of market valuation, and depend on
the assumptions
• Assume that 15% is the interest that you (or other investors) are expected from this stock and those
stocks having similar risk
𝐷𝐼𝑉1 +𝑃1
• 𝑃0 =
1+𝑟
Fundamental valuation of stocks-II
• Let us examine the price of stock next year 𝑃1 . Similar to 𝑃0 , we can also write this price 𝑃1 in terms of dividend 𝐷𝐼𝑉1 and
the discount rate r
𝐷𝐼𝑉2 +𝑃2
• 𝑃1 =
1+𝑟
• Subsequently, we can also write the current price (𝑃0 ) in terms of dividends for next two years, 𝐷𝐼𝑉1 and 𝐷𝐼𝑉2
𝐷𝐼𝑉1 𝐷𝐼𝑉2 𝑃2
• 𝑃0 = + +
1+𝑟 1+𝑟 2 1+𝑟 2
• Let us further consider the previous example of the company ABC. The investors are expecting a dividend of $5.50 in
𝑫𝑰𝑽𝒕
𝑷𝟎 = σ∞
𝒕=𝟏 𝟏+𝒓 𝒕
Dividend discount model and cost of equity
capital
• Assume a constant long-term growth rate of ‘g’ in dividends and an appropriate
discount rate ‘r’
• Assuming a dividend of 𝐷𝐼𝑉1 in the first year, this perpetuity can be valued using the
𝐷𝐼𝑉1
formula shown here: 𝑃0 =
𝑟−𝑔
• If the current price (𝑃0 ) is observed, this formula can be used to estimate ‘r’ as
𝐷𝐼𝑉1
shown here: 𝑟 = +𝑔
𝑃0
Dividend discount model and cost of equity
capital
• Firm XYZ has a share price of $42.45 at the start of the period, expected dividends starting from the year
end amount to $1.68 per share, payout ratio is 60%
𝐷𝐼𝑉1 1.68
• he dividend yield for this stock can be simply computed as Dividend yield= = 42.45 = 4.0%
𝑃0
DIV
• Plowback raio = 1 − payout ratio = 1 − = 1 − .60 = 0.40
EPS
𝐷𝐼𝑉1
• Then your overall estimate of cost of equity capital: r= + 𝑔 = 4.0% + 4.0%=8.0%
𝑃0
• Constant growth dividend discount formula employed earlier is extremely sensitive to changes in the values
of ‘g’ and ‘r’
Dividend discount model and cost of equity
capital
• Consider the example of a firm with equity of $25, 𝐷𝐼𝑉1 = $0.5 and 𝑃0 = $50.0. The firm has an ROE of 25%
0.5
• 𝑟 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 + 𝑔 = + 20% = 1% + 20% = 21%
50
• No firm can sustain a growth rate of 21% infinitely into future. In real life such growth rates drop gradually
over the years and attain that lower long-term growth that is sustainable
Dividend discount model and cost of equity
capital
• To simplify things here, assume that the firm ROE drops to 16% in the third year. Also that the payout ratio
increases to 50%
Years 1 2 3 4
• In the high-growth phase, we need to value the three dividend inflows in year 1, 2, and 3.
𝑃3 𝐷𝐼𝑉
4 1
• Steady state growth phase with cash flows in perpetuity: = (𝑟−𝑔) ∗
1+𝑟 3 1+𝑟 3
• Growth stocks offer capital gains; Contrast this to income stocks that offer regular income in the form of
cash dividends
• Consider the example of a company that doesn’t grow and pay most of the earnings as dividends ($10), it is
𝐷𝐼𝑉1 10
• Expected returns = dividend yield = = = 10.0%
𝑃0 100
𝐷𝐼𝑉1
• Also, if one discounts the dividends of this company, till perpetuity (𝑃0 = 𝑟
), one should be able to obtain
• The firm invests most of its earnings internally, investment of $10 at the end of year t=1
• The company also expects that this investment opportunity has a return of 10%, same as market
capitalization rate
𝐷𝐼𝑉1 1
• NPV of this project= −𝐶0 + = −10 + 0.10 = 0
𝑟
• Even if the firm distributed these cash flows to investors, they would’ve obtained the same 10% returns by
• The value of price can be distributed in two components. First component, the capitalized value of earnings
under no-growth policy; Second component, is the present value of growth opportunities (PVGO)
$8.33 and a payout ratio of 0.6. The company is expected to pay a divided of $5 in the next year, and
𝐷𝐼𝑉1 5
• 𝑃0 = = 15%−10% = $100
𝑟−𝑔
• The company is plowing back 40% of earnings with an ROE of 25%. Growth rate of the firm ‘g’=
0.40*25%=10%
𝐸𝑃𝑆 8.33
• Assume a no-growth policy: P ′ = = 0.15 = $55.56
𝑟
• The company plows back 40% of earnings. In the first year, this amount is 8.33-5=$3.33. This amount is
invested at a return of 25%, that is 3.33*25%=$0.83 earnings starting from year 2
0.83
• The present value of this investment at T=1 can be computed as shown here: −3.33 + 0.15 = $2.22
• Also, it is known to us that firm earnings are growing at 10%. Therefore, we can expect this $2.22 additional
earnings to also grow at the same rate of 10%. That means, in the second year, we will have additional
earnings of 2.22*1.10= $2.44 and 2.44*1.10=$2.69 in the third year and so on
• At 10% capitalization rate, let us compute the present value of all these incremental cash flows, starting
from year 1 at $2.22
𝟐.𝟐𝟐 𝐄𝐏𝐒𝟏
• 𝐏𝐕𝐆𝐎 = 𝟎.𝟏𝟓−𝟎.𝟏𝟎 = $𝟒𝟒. 𝟒𝟒 or 𝐏𝟎 = + 𝐏𝐕𝐆𝐎 = 𝟓𝟓. 𝟓𝟔 + 𝟒𝟒. 𝟒𝟒 = 𝟏𝟎𝟎
𝐫
A simple example of business valuation
• Let us start with some basic information and assumptions about this business
• The business has an appropriate discount rate of 10%. The business grows at a rapid pace of 20% per
annum for five years, the falls to 13% for years 6-7, and finally settles down at a 6% steady state growth
rate thereafter. Returns on asset (RoA) amount to a constant 12%. The plowback ratio is derived from the
expected growth of the business, using the formula g= RoA (or RoE)* Plowback ratio. Starting with a size of
$10Mn in the first year, the cash flows are provided here
Years 1 2 3 4 5 6 7 8 9 10
Growth (%) 20% 20% 20.0% 20.0% 20.0% 13% 13% 6% 6% 6%
Asset value ($Mn) 10.00 12.00 14.40 17.28 20.74 23.43 26.48 28.07 29.75 31.54
RoA* 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0%
Earnings ($Mn) 1.20 1.44 1.73 2.07 2.49 2.81 3.18 3.37 3.57 3.78
Plowback 167% 167% 167% 167% 108% 108% 50% 50% 50% 50%
Net investment ($Mn) 2.00 2.40 2.88 3.46 2.70 3.05 1.59 1.68 1.79 1.89
Free cash flows ($Mn) -0.80 -0.96 -1.15 -1.38 -0.21 -0.23 1.59 1.68 1.79 1.89
A simple example of business valuation
• There are two components to this value
1.59 1
• Steady state growth period value or horizon value: 𝑃𝑉 𝐻𝑜𝑟𝑖𝑧𝑜𝑛 𝑣𝑎𝑙𝑢𝑒 = ∗ =22.42
(0.10−0.06) 1.1 6
• If you observe in financial markets that the average PE ratio for a mature business with similar profile is 11
1
• 𝑃𝑉 𝐻𝑜𝑟𝑖𝑧𝑜𝑛 𝑣𝑎𝑙𝑢𝑒 = 11 ∗ 3.18 ∗ =19.75
1.1 6
• If you observe that average market to book asset values for the similar mature companies is 1.4
1
• 𝑃𝑉 𝐻𝑜𝑟𝑖𝑧𝑜𝑛 𝑣𝑎𝑙𝑢𝑒 = 1.4 ∗ 26.48 ∗ =20.93
1.1 6
Summary and concluding remarks
• The value of stock is equal to the discounted dividend payments expected to be received in perpetuity
𝐷𝐼𝑉𝑡
• 𝑃𝑉 = σ∞
𝑡=1 1+𝑟 𝑡
• However, investors often do not plan to hold the stock for eternity and have finite investment horizons
• These investment horizons involve returns in the form of dividends and capital gains
𝐷𝐼𝑉1
• The value of the stocks with infinite stream of growing dividends: 𝑃0 = 𝑟−𝑔
𝐸𝑃𝑆1
• Price in terms of capitalized value of earnings and PVGO and 𝑃0 = + 𝑃𝑉𝐺𝑂
𝑟
Thanks!
INDIAN INSTITUTE OF TECHNOLOGY KANPUR
• Expected returns on the stock reflect the dividend yields and the growth rate of dividends:
𝐷𝐼𝑉
𝑟 = 1+𝑔
𝑃0
• Variance = 225 + 225 = 450 and Standard Deviation (𝜎) = 450 = 21%
• An event is considered risky if there are many possibilities of outcomes associated
with it.
• As these possibilities increase, that is, the spread of possible outcomes increases, the
event is said to have become riskier.
• Standard deviation or variance is a summary measure of these possibilities, that is
spread in the possible outcome.
Measures of Risk
• The risk of an asset can be completely expressed, by writing all the possible outcomes
and the possible payoffs associated with each of the outcomes.
• If the outcome was certain, that is, it had no risk, then the standard deviation would
have been zero
• One of the challenges in performing such computations is the estimation of probability
associated with each outcome
• One way to go about this is to observe past variability
• For example, consider the historical volatilities of three different kinds of securities.
Portfolio Standard Deviation (𝛔) Variance (𝛔𝟐 )
Treasury Bills 2.8 7.7
Government Bonds 8.3 69.3
Common Stocks 20.2 406.4
• It appears that T-Bills are the least variable and common stocks are the most variable
Diversification of Risk
• One can compute the measure of variability for individual securities as well as a
portfolio of securities.
• The standard deviation of selected U.S. Common stocks (2004-08) such as
Amazon (50.9%), Ford (47.2%), Newmont (36.1%), Dell (30.9%), and
Starbucks (30.3%) was much less than the standard deviation of a market
portfolio, that is, 13% during this period.
• It is well known that individual stocks are more volatile than the market indices.
• The variability of market doesn’t reflect or is the same as the variability of
individual stock components.
• The simple answer to this question is that diversification reduces variability.
Diversification of Risk
Diversification of Risk
SD of Dell and Starbucks is approximately 30%
SD of portfolio = 20%
Diversification of Risk
Computing Portfolio Risk
• We now know that diversification reduces the risk of a portfolio
• Consider a portfolio comprising two stocks, A (60%) and B (40%)
• A has expected returns of 3.1%, and B has expected returns of 9.5%
• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑒𝑡𝑢𝑟𝑛 = 0.6 ∗ 3.1 + 0.40 ∗ 9.5 = 5.7%
• Standard deviation of A is observed as 15.8% for A and 23.7% for B
• Therefore, the standard deviation of this portfolio: 0.6*15.8% + 0.4*23.7% =
19.0%?
• This would be incorrect
Computing Portfolio Risk
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝑥12 𝜎12 + 𝑥22 𝜎22 + 2(𝑥1 𝑥2 𝜌12 𝜎1 𝜎2 )
𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝜎12 = 𝜌12 𝜎1 𝜎2
• Portfolio variance = 0.62 ∗ 15.82 + 2 ∗ 0.6 ∗ 0.4 ∗ 1 ∗ 15.8 ∗ 23.7 + 0.42 ∗ 23.72 = 359.5
• The standard deviation is 359.5 = 19%
• Let us now assume a correlation coefficient of 𝜌12 = 0.18
• Portfolio variance= 0.62 ∗ 15.82 + 2 ∗ 0.6 ∗ 0.4 ∗ 0.18 ∗ 15.8 ∗ 23.7 + 0.42 ∗ 23.72 = 212.1
• The standard deviation is 212.1 = 14.6%
Computing Portfolio Risk
• Let us consider a very hypothetical case of extreme negative correlation
𝜌12 = −1
• Portfolio variance = 0.62 ∗ 15.82 + 2 ∗ 0.6 ∗ 0.4 ∗ (−1) ∗ 15.8 ∗ 23.7 + 0.42 ∗
23.72 = 0!
• However, perfect negative correlations do not exist in real markets.
Computing Portfolio Risk
• Variances in diagonal boxes (𝑥 2 𝜎 2 )
• Covariance terms in off-diagonal
(𝑥𝑖 𝑥𝑗 𝜎𝑖𝑗 )
• Let us consider a case of N securities
and equal investment in all the
1
securities ( )
𝑁
• Portfolio variance can be computed in
the form of two components. That is,
variance component and covariance
component
Computing Portfolio Risk
• There will be N variance terms; then portfolio variance can be simply written
1
as 𝑁 ∗ 2 ∗ (𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒)
𝑁
1
• Remember 𝑤1 ∗ 𝑤2 ∗ 𝜎 2 . 𝐻𝑒𝑟𝑒
𝑤1 = 𝑤2 = ; 𝑎𝑛𝑑
𝜎 = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 =
𝑁
𝜎𝐴𝑣𝑔
• Also, 𝑁 2 − 𝑁 covariance terms where average covariance term =𝜎𝐶𝑜𝑣−𝐴𝑣𝑔
1
• The sum of covariance terms is 𝑁2 −𝑁 ∗ ∗ 𝜎𝐶𝑜𝑣−𝐴𝑣𝑔
𝑁2
1 1
• 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝑁 ∗ ∗ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑉𝑎𝑟𝑖𝑛𝑎𝑐𝑒 + 𝑁 2 − 𝑁 ∗ ∗
𝑁2 𝑁2
(𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒)
• As the number of securities, N, in the portfolio increase, the specific-risk term,
1
𝑁 ∗ 2 ∗ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑉𝑎𝑟𝑖𝑛𝑎𝑐𝑒 , approaches to a value of zero
𝑁
Computing Portfolio Risk
• Thus, the overall portfolio variance approaches the average covariance term
• This is also often referred to as portfolio diversification
• Thus, if these securities have very low correlation, then one can obtain a
portfolio with very low risk
• That is, just by increasing the number of securities in a portfolio, one can
eliminate the idiosyncratic (specific or diversifiable risk)
• The remaining risk is often called market risk or non-diversifiable risk
• That is why, this market risk (or average covariance or non-diversifiable risk) is
what constitutes the bedrock of risk, that is risk that is there after eliminating
all the specific risk
Impact of Individual Securities on Portfolio Risk
• Investors usually add many securities in their portfolio to diversify the stock-
specific idiosyncratic risk
• It is not the risk of a security held individually but in a portfolio that is important
• To measure the impact of a security to the risk of portfolio, one needs to
measure the market risk component of the security
• The market risk of a security is measured through its beta
• Stocks with beta of more than 1.0 tend to amplify the movements of market
• Stocks with beta between 0 to 1.0 tend to move in the same direction as
market, but are considered less sensitive
• The market portfolio has a beta of 1.0 and reflects the average movement of all
the stocks in the market
Impact of Individual Securities on Portfolio Risk
• Consider a stock A with beta of 1.41 over a
given time-horizon
• This means that, on average, when market
rises by 1%, stock A will rise by 1.41%
• The stock would also have some stock-
specific risk
• Examine the figure shown here: the standard deviation (total risk) of the
portfolio depends on the number of securities in the portfolio
• As the number of securities increase in the portfolio, more diversification is
achieved
Impact of Individual Securities on Portfolio Risk
• With addition of more and more securities, the
specific risk declines until all the stock specific
risk is eliminated and only market risk remains
• Market risk depends on the average beta of
the securities, that is, the portfolio beta
• If one selects a fairly large number of securities
from a market, you diversify all the
idiosyncratic risk
• Thus, you get the market portfolio with beta = 1.0
• If the market portfolio has a standard deviation of 20%, then this portfolio is
expected to have a standard deviation of close to 20%
Impact of Individual Securities on Portfolio Risk
Impact of Individual Securities on Portfolio Risk
• Beta of a stock ‘i' can be computed using the following formula. 𝛽𝑖 = 𝜎𝑖𝑚 /𝜎𝑚
2.
Here 𝜎𝑖𝑚 is the covariance between the stock returns and market returns. 𝜎𝑚 2
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Investment Performance and Return Distribution
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
INDIAN INSTITUTE OF TECHNOLOGY KANPUR
• The brown line connecting A and B represents all portfolio combinations with
correlation 𝜌 = 1.0
• With 𝜌 = −1.0 (red line), the stocks would move in exact opposite manner.
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Combining Stocks with Portfolios
• In practice, you invest in many
socks, by examining their historical
risk-return related properties.
• For example, consider a portfolio of
ten securities plotted here using risk-
return data.
• The shaded green region shows the
possible combinations of expected
return and standard deviation by
investing in a mixture of these
stocks.
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Combining Stocks with Portfolios
• Where would you want to be in that
shaded region?
• You would want to go up, that is,
increase the expected returns. You
would also want to go left, that is, to
reduce risk.
• As you move up and left, you end up at
the solid dark brown line.
• The portfolio on this solid dark outer surface is often referred to as an efficient
portfolio.
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Combining Stocks with Portfolios
• For a given level of risk, these
portfolios offer the highest return.
And for a given level of return, these
portfolios offer the lowest amount of
risk.
• Three such portfolios (A, B, and C)
are shown in the figure here.
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Combining Stocks with Portfolios
• Suppose that portfolio S has an expected return of 15% and a standard deviation of
16%.
• For risk-free instrument rf = 5% and risk = 0.
• If you decide to invest 50% in S and 50% in rf, the expected return and risk as
computed here.
1 1
• 𝑟 = ∗ 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑆 + ∗ 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 𝑜𝑛 𝑅𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 = 10%
2 2
• The formula for computation of risk: 𝑆𝐷 = 𝑥12 𝜎12 + 𝑥22 𝜎22 + 2𝑥1 𝑥2 𝜌12 𝜎1 𝜎2 [Here,
𝜎2 = 0]
1
• 𝜎 = ∗ 𝑆𝐷 𝑜𝑓 𝑆 = 0.5*15% = 8%
2
Combining Stocks with Portfolios
• Consider another scenario where you borrow at the risk-free rate
an amount equal to 100% of your initial wealth.
• You invest your initial 100% wealth along with these borrowings in
Portfolio S. That is double the amount of your initial wealth.
• Expected returns: 𝑟 = 2 ∗ 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑆 − ሺ1 ∗
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒ሻ = 25%
• Risk 𝜎 = 2 ∗ 𝑆𝐷 𝑜𝑓 𝑆 = 32%
Combining Stocks with Portfolios
• On the efficient region, you can always
find a portfolio S that is the best efficient
portfolio.
• How to find this portfolio?
• The steepest line (from rf) on the curve
representing efficient portfolios: tangent
line
• This tangent line has the highest ratio of risk-premium to standard deviation: Sharpe
Ratio
𝑅𝑖𝑠𝑘−𝑃𝑟𝑒𝑚𝑖𝑢𝑚 𝑟−𝑟𝑓
• 𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 = =
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜 𝜎
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Combining Stocks with Portfolios
• In a competitive market, it is
extremely difficult to find
undervalued securities.
• Professional investors often
investment in benchmark
indices (e.g., S&P 500).
• This is often referred to as the
passive strategy of investment.
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
INDIAN INSTITUTE OF TECHNOLOGY KANPUR
Introduction to CAPM
Introduction to CAPM
• We have previously examined the returns on different instruments.
• T-Bills have a beta = 0, and the market portfolio has a beta = 1.
• Difference between market risk (rm) and risk-free rate (rf) is often
referred to as market risk premium.
• Using these benchmarks, we can determine the risk-premium for
instruments for which beta is neither 0 nor 1.
Introduction to CAPM
• In 1960s, three economists, Sharpe,
Lintner, and Treynor came-up with
this model called Capital Asset
Pricing Model (CAPM) that provides
an extremely simple and easy to use
solution for the asset pricing
problem.
• In a competitive economy, the risk-
premium is directly proportional to
beta.
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Introduction to CAPM
• The risk-premium on an investment with beta of 0.5 should be half of that available
on the market.
• The expected risk-premium on an investment with beta of 2 is twice the risk-premium
expected on the market.
• The resulting relationship is shown here: 𝑟 − 𝑟𝑓 = 𝛽 ∗ ሺ𝑟𝑚 − 𝑟𝑓 ሻ
• Consider two stocks with beta of 0.30 (Stock A) and 2.16 (Stock B). You also
observe that the market is offering a current risk-premium of 7% ሺ𝑟𝑚 − 𝑟𝑓 ሻ and the
current treasury bill rate is 0.2%.
• 𝑟𝐴 = 𝑟𝑓 + 𝛽 ∗ 𝑟𝑚 − 𝑟𝑓 = 0.20% + 0.30 ∗ 7% = 2.30%
• 𝑟𝐵 = 𝑟𝑓 + 𝛽 ∗ 𝑟𝑚 − 𝑟𝑓 = 0.20% + 2.16 ∗ 7% = 15.32%
Introduction to CAPM
• CAPM can also be employed to estimate discount rates for risky projects and
companies.
• To estimate discount rates, different risk factors, appropriate benchmark for risk-free
rates needs to be estimated.
• The following principles are sacrosanct:
• Investors like higher expected returns and low risk.
• If the investors can lend and borrow at risk-free rate of interest, then one portfolio
is better than all the other portfolios.
• This best efficient portfolio depends on (a) expected returns, (b) standard
deviation, and (c) correlations across securities.
• In a well-diversified portfolio, only systematic risk matters.
Introduction to CAPM
• If stocks A and B (overvalued)
do not fall on this line, then you
will not buy them.
• Given the less demand and
excess supply, the prices of A
and B will fall until the expected
returns lie on SML.
• The same logic applies to
undervalued stocks as well.
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Introduction to CAPM
• Investors can hold a combination of
market portfolio M and risk-free rate
rf, to obtain an expected return 𝑅ത =
𝑟𝑓 + 𝛽 𝑟𝑚 − 𝑟𝑓
• In well-functioning liquid and efficient
markets, nobody will hold a stock
that offers anything less.
• Equilibrium is obtained from the arbitrage mechanism, which drives prices
towards efficient values, that is, towards this SML.
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
INDIAN INSTITUTE OF TECHNOLOGY KANPUR
Validity of CAPM
Validity of CAPM
• Any economic model aims to provide a simple view of actual and real-world
scenarios.
• There is a trade-off that the real thing may be far-away from the model if the
model is too simple.
• Otherwise, the complexity has to be increased to make it closer to the real
thing.
• Investors are rational, risk-averse individuals that require extra-return for
taking on additional risk.
• Investors do not worry about those risks that can be diversified.
• The power of CAPM lies in its extreme simplicity, and it also has some pitfalls.
Validity of CAPM
• Ten investors portfolio returns are
plotted.
• Investor 1 has a portfolio of mostly
small stocks and Investor 10 has a
portfolio of large-cap stocks.
• One can obtain by combining
Investor 1 (long) and investor (10) to
generate a zero-risk portfolio that
offers excess abnormal returns.
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Validity of CAPM
• The red line shows the cumulative
difference between small and large cam
firms.
• The green line shows the cumulative
difference between high book to value
(Value stocks) minus low book to value
stocks (Growth stocks).
• The figure does not fit well with CAPM
postulations: that is beta is the only
factor causing returns to differ across
instruments.
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Validity of CAPM
• Value stocks are underpriced cheap stocks. They may be
underpriced at current P/E ratios for different reasons.
• Growth stocks are not cheap stocks at current P/E levels.
• The returns on value stocks minus growth stocks, on average, are
often positive, and significant over long-term.
• This does not fit well with CAPM.
INDIAN INSTITUTE OF TECHNOLOGY KANPUR
• If the firm has no debt outstanding, then the company cost of capital is
just the expected rate of return on the firm’s stock
• The company cost of capital is not the correct discount rate if the new
projects are more or less risky than the firm’s existing business
• 𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 = 𝑃𝑉 𝐴𝐵 = 𝑃𝑉 𝐴 + 𝑃𝑉 𝐵
• The opportunity cost of capital depends on the use to which that capital is
put
• If the project is high-risk, the firm needs a higher prospective return than if
the project is low-risk
• That is different from the company cost of capital rule, which accepts any
project regardless of its risk as long as it offers a higher return than the
company’s cost of capital
Company and Project Cost of Capital
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 9
Company and Project Cost of Capital
• The true cost of capital depends on project risk, not on the company
undertaking the project
• Why is so much time spent estimating the company cost of capital?
• Second, the company cost of capital is a useful starting point for setting
discount rates for unusually risky or safe projects
• Many large companies use the company cost of capital not just as a
benchmark, but also as an all-purpose discount rate for every project
proposal
• The expected rate of return is just a weighted average of the cost of debt
(𝑟𝐷 = 7.5%) and the cost of equity (𝑟𝐸 = 15%)
• The weights are the relative market values of the firm’s debt and equity,
that is, D / V = 30% and E / V = 70%
Computing Company Cost of Capital
• The company cost of capital is not equal to the cost of debt or to the cost of
equity but is a blend of the two
• The marginal corporate tax rate 𝑇𝐶 = 35%
𝐷 𝐸
• WACC or Company cost of capital= 𝑟𝐷 ∗ 1 − 𝑇𝑐 ∗ + 𝑟𝐸 ∗ =
𝑉 𝑉
7.5% ∗ 1 − 0.35 ∗ 0.30 + 15 ∗ 0.70 = 12.00%
• This blended measure of the company cost of capital is called the
weighted-average cost of capital or WACC
Estimating the components of WACC
Estimating the components of WACC
• To calculate the weighted-average cost of capital, you need an estimate of
the cost of equity
• We will use the capital asset pricing model (CAPM) to estimate the cost of
equity
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 9
Estimating the components of WACC
• In the scatter diagram shown here, each dot represents the
return on a security and return on market
• Standard error of the estimated beta is computed to show
the extent of possible mismeasurement
• That is, you have 95% chance of being right in saying that
beta can fall in this interval
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 9
Estimating the components of WACC
• How to estimate the risk-free rate of interest (𝑟𝑓 )
• Should we use short-term treasury bill rate, daily over night rate, monthly
rate, one year interest rate or long-term interest rates
• Could a .2% three-month risk-free rate give the right discount rate for
cash flows 10 or 20 years in the future?
Estimating the components of WACC
• How to estimate the risk-free rate of interest (𝑟𝑓 )
• Financial managers can simply use a long-term risk-free rate in the CAPM
formula
• Or, they can compute the term premia (for investing in long-term
government bonds – T-Bills) =1.5%
• The difference in current Govt. bond yields (e.g., 3.3%) and this term
premia reflects that short-term T-Bill rates= 3.3%-1.5%=1.8%
• If the market risk-premium in 7%, beta is 1.16, then the cost of equity can
be computed as follows. 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛𝑠 = 𝑟𝑓 +
𝛽 𝑟𝑚 − 𝑟𝑓 = 1.8 + 1.16 ∗ 7.0 = 9.9%
Estimating the components of WACC
• Estimating cost of equity and WACC
• If the market risk-premium in 7%, beta is 1.16, then the cost of equity can
be computed as follows. 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛𝑠 = 𝑟𝑓 +
𝛽 𝑟𝑚 − 𝑟𝑓 = 1.8 + 1.16 ∗ 7.0 = 9.9%
• Let us calculate the WACC for a firm with cost of Debt of about 7.8%,
corporate tax-rate of 35%, and debt ratio (D/V) of 31.5%.
𝐷 𝐸
• 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥 𝑊𝐴𝐶𝐶 = 1 − 𝑇𝐶 ∗ 𝑟𝐷 ∗ + 𝑟𝐸 ∗ = 1 − 0.35 ∗ 7.8 ∗ 0.315 +
𝑉 𝑉
9.9 ∗ 0.685 = 8.4%
Estimating the components of WACC
• The cost of debt is always less than the cost of equity
• The WACC formula blends the two costs: Debt and Equity
• As the debt ratio D/V increases, the cost of the remaining equity also
increases
• As the debt ratio D/V increases, the cost of the remaining equity also
increases
• For example, let us consider a security with 𝛽𝐸 =1.16 and 𝛽𝐷 = 0.3. The
weights are the fractions of debt and equity financing, D/V= .315 and E/V
=.685
Estimating the components of WACC
• The after-tax WACC depends on the average risk of the company’s assets,
but it also depends on taxes and financing
• For example, let us consider a security with 𝛽𝐸 =1.16 and 𝛽𝐷 = 0.3. The
weights are the fractions of debt and equity financing, D/V= .315 and E/V
=.685
𝐷 𝐸
• Asset beta= 𝛽𝐴 = 𝛽𝐷 ∗ + 𝛽𝐸 ∗ = 0.3 ∗ 0.315 + 1.16 ∗ 0.685 = 0.89
𝑉 𝑉
• This asset beta is an estimate of the average risk of the firm’s business
Analyzing Project Risk
Analyzing Project Risk
• Suppose that a coal-mining corporation wants to assess the risk of investing
in commercial real estate
• The asset beta for coal mining is not helpful
• A company that wants to set a cost of capital for one particular line of
business typically looks for pure plays in that line of business
• ONGC would be a pure-play and suitable for estimating the cost of capital
• Many times good comparable pure plays are not available, then we go for
asset betas
Analyzing Project Risk
• What determines asset betas?
• Cyclicality: What is the strength of the relationship between the firm’s
earnings and aggregate market earnings
• We can measure this either by the earnings beta or by the cash-flow beta
• Fixed costs are cash outflows that occur regardless of whether the asset
is active or idle
• People think of the risks of a project as a list of things that can go wrong
• Company discovers a small hazard, which may cause a small chance that
project will have zero cash flow
• The appropriate way to deal with this situation is to prepare unbiased cash
flow forecasts that give due weight to all possible outcomes
Analyzing Project Risk
• Managers making unbiased forecasts are correct on average
• Sometimes their forecasts will turn out high, other times low, but their errors will
average out over many projects
• The appropriate way to deal with this situation is to prepare unbiased cash flow
forecasts that give due weight to all possible outcomes
• . If you forecast a cash flow of $1 million for projects like Z, you will overestimate
the average cash flow
Possible Probability- Unbiased
Probability
Cash Flow Weighted Forecast
1.2 0.25 0.3
1 0.5 0.5 $1 million
0.8 0.25 0.2
Analyzing Project Risk
• Managers making unbiased forecasts are correct on average
• If technological uncertainty introduces a 10% chance of a zero cash flow, the
unbiased forecast could drop
Possible Probability- Unbiased
Probability
Cash Flow Weighted Forecast
1.2 0.25 0.27
1 0.45 0.45 $0.90 million
0.8 0.225 0.18
0.0 0.10 0.00
0.90
• Thus, the new present value computation would be: 𝑃𝑉 = = $0.818 million
1.1
Analyzing Project Risk
• Managers often work out a range of possible outcomes for major projects,
sometimes with explicit probabilities attached
• The manager can still consider the good and bad outcomes as well as the
most likely one
• When the bad outcomes outweigh the good, the cash-flow forecast should
be reduced until balance is regained
• That cash flow is uncertain with the same risk as the market, so β=1
• Given 𝑟𝑓 =5% and 𝑟𝑚 − 𝑟𝑓 = 7%, you compute the present value as:
420,000/1.12 = $375,000
• What is that certain payoff you are willing to accept to sell the project in
future
𝐶𝑒𝑟𝑡𝑎𝑖𝑛 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤
• 𝑃𝑉 = = 375000, Certain cash flow= $393,750
1.05
Certainty Equivalents
• Discount rates are not constant and constantly change over the project life
as the project risk changes
• Thus, a certain cash flow of $393,750 has exactly the same present value
as an expected but uncertain cash flow of $420,000
• To compensate for both the delayed payoff and the uncertainty in real
estate prices, you need a return of 420,000 - 375,000 = $45,000
• One part of this difference compensates for the time value of money
• Method 2: Find the certainty-equivalent cash flow and discount at the risk-
free interest rate 𝑟𝑓
• What is the smallest certain payoff for which I would exchange the risky
cash flow, this is called certainty equivalent (CEQ)
Certainty Equivalents
• Thus, We now have two identical expressions for the PV of a cash flow
𝐶1 𝐶𝐸𝑄
• At period 1, 𝑃𝑉 = =
1+𝑟 1+𝑟𝑓
𝐶𝑡 𝐶𝐸𝑄
• For cash flows two, three, or t years away, 𝑃𝑉 = = 𝑡
1+𝑟 𝑡 1+𝑟𝑓
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 9
Certainty Equivalents
• Consider two simple projects
• Project A is expected to produce a cash flow of $100 million for each of
three years. The risk-free interest rate is 6%, the market risk premium is
8%, and project A’s beta is .75
• In year 2 project A has a risky cash flow of 100, and B has a safe cash
flow of 89.6
• For example, the correlation between successive price changes in Microsoft was -0.019
• For Philips, this correlation was also negative at - 0.030
• However, for BP and Sony, the correlations were positive at +0.004 and +0.026
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 13
What Is an Efficient Market
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 13
Theory of Market Efficiency
• Strong form of efficiency: tests of the strong form of the hypothesis have
examined the recommendations of professional security analysts
• Researchers examine whether mutual funds and pension funds can
outperform the market
• Evidence suggests that professionally managed funds fail to recoup the costs
of management
• It appears that in some years they do well and not so well in others
• It would be difficult to believe that some managers possess superior abilities
to others
Theory of Market Efficiency
• Research suggests that there are indeed anomalies that can be exploited and
contradict the notion of market efficiency
• What exactly is an anomaly?
• In an efficient market, it is not possible to find expected returns greater
(or less) than the risk-adjusted opportunity cost of capital
𝐶𝑡
• 𝑃 = σ∞
𝑡=1 ; future cash flows (Ct) and the opportunity cost of capital
1+𝑟 𝑡
(r)
• If price equals fundamental value, the expected rate of return is the
opportunity cost of capital, no more and no less
The Evidence Against Market Efficiency
• The principle tells us that you can’t identify a superior return unless you know what
the normal expected return is
• We need an asset pricing model to determine the relationship between the risk
and expected returns
• The most used asset pricing model is the CAPM
• Several CAPM violations have been found in the literature
• This includes the abnormally high returns on the stocks of small firms vis-à-vis
large firms
• Investors may demand higher returns for bearing the risk associated with small
stocks
The Evidence Against Market Efficiency
• Also, investors are slow in updating their beliefs in the presence of new
evidence
• Most investors are systematically biased due to overconfidence and consider
themselves better-than-average stock pickers
• Such biases help in anomalies and bubbles
• Limits to arbitrage: these are limits to which smart investors can carry out
arbitrage and drive prices toward efficient values
• Arbitrage is an investment strategy aimed to generate guaranteed superior
returns without any risk
• However, these are not as risk-free as the theory might suggest
Investor Psychology and Behavioral Finance
• For example, trading costs can be significant, and some trades are difficult to
execute
• To sell a stock short, you borrow shares from another investor’s portfolio, sell
them, and then wait hopefully until the price falls and you can repurchase the
stock back for less than you sold it for
• If you’re wrong and the stock price increases, then sooner or later, you will be
forced to repurchase the stock at a higher price (therefore at a loss) to return
the borrowed shares to the lender
• In addition, there are costs and fees to be paid, and in some cases, you will
not be able to find shares to borrow
INDIAN INSTITUTE OF TECHNOLOGY KANPUR