Professional Documents
Culture Documents
2011
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This is an extract from a subject guide for an undergraduate course offered as part of the
University of London International Programmes in Economics, Management, Finance and
the Social Sciences. Materials for these programmes are developed by academics at the
London School of Economics and Political Science (LSE).
For more information, see: www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
Dr. P. Frantz, Lecturer in Accountancy and Finance, The London School of Economics and
Political Science
R. Payne, Former Lecturer in Finance, The London School of Economics and Political Science
Dr. J. Favilukis, Lecturer, The London School of Economics and Political Science
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the authors are unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide.
Contents
Contents
Introduction to the subject guide .......................................................................... 1
Aims of the course......................................................................................................... 1
Learning outcomes ........................................................................................................ 1
Syllabus......................................................................................................................... 2
Essential reading ........................................................................................................... 3
Further reading.............................................................................................................. 3
Online study resources ................................................................................................... 5
Subject guide structure and use ..................................................................................... 6
Examination advice........................................................................................................ 7
Glossary of abbreviations used in this subject guide ....................................................... 8
Chapter 1: Present value calculations and the valuation of physical investment
projects ................................................................................................................... 9
Aim .............................................................................................................................. 9
Learning outcomes ........................................................................................................ 9
Essential reading ........................................................................................................... 9
Further reading.............................................................................................................. 9
Overview ..................................................................................................................... 10
Introduction ................................................................................................................ 10
Fisher separation and optimal decision-making ............................................................ 10
Fisher separation and project evaluation ...................................................................... 13
The time value of money .............................................................................................. 14
The net present value rule ............................................................................................ 15
Other project appraisal techniques ............................................................................... 17
Using present value techniques to value stocks and bonds ........................................... 21
A reminder of your learning outcomes.......................................................................... 23
Key terms .................................................................................................................... 23
Sample examination questions ..................................................................................... 23
Chapter 2: Risk and return: meanvariance analysis and the CAPM.................... 25
Aim of the chapter....................................................................................................... 25
Learning outcomes ...................................................................................................... 25
Essential reading ......................................................................................................... 25
Further reading............................................................................................................ 25
Introduction ................................................................................................................ 25
Statistical characteristics of portfolios ........................................................................... 26
Diversification.............................................................................................................. 28
Meanvariance analysis ............................................................................................... 30
The capital asset pricing model .................................................................................... 34
The Roll critique and empirical tests of the CAPM ......................................................... 37
A reminder of your learning outcomes.......................................................................... 40
Key terms .................................................................................................................... 40
Sample examination questions ..................................................................................... 40
Solutions to activities ................................................................................................... 41
Chapter 3: Factor models ..................................................................................... 43
Aim of the chapter....................................................................................................... 43
Learning outcomes ...................................................................................................... 43
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92 Corporate finance
Contents
92 Corporate finance
iv
Learning outcomes
At the end of this course, and having completed the Essential reading and
activities, you should be able to:
explain how to value projects, and use the key capital budgeting
techniques (NPV and IRR)
understand the mathematics of portfolios and how risk affects the
value of the asset in equilibrium under the fundaments asset pricing
paradigms (CAPM and APT)
know how to use recent extensions of the CAPM, such as the Fama
and French three-factor model, to calculate expected returns on risky
securities
92 Corporate finance
Syllabus
Note: A minor revision was made to this syllabus in 2009.
Students may bring into the examination hall their own hand-held
electronic calculator. If calculators are used they must satisfy the
requirements listed in the Regulations.
If you are taking this course as part of a BSc degree, courses which must
be passed before this course may be attempted are 2 Introduction to
economics and 5A Mathematics 1 or 5B Mathematics 2 or 174
Calculus.
Project evaluation: Hirschleifer analysis and Fisher separation; the NPV rule
and IRR rules of investment appraisal; comparison of NPV and IRR; wrong
investment appraisal rules: payback and accounting rate of return.
Risk and return the CAPM and APT: the mathematics of portfolios; meanvariance analysis; two-fund separation and the CAPM; Rolls critique of the
CAPM; factor models; the arbitrage pricing theory; recent extensions of the
factor framework.
Derivative assets characteristics and pricing: definitions: forwards and futures;
replication, arbitrage and pricing; a general approach to derivative pricing
using binomial methods; options: characteristics and types; bounding and
linking option prices; the BlackScholes analysis.
Efficient markets theory and empirical evidence: underpinning and definitions
of market efficiency; weak-form tests: return predictability; the joint
hypothesis problem; semi-strong form tests: the event study methodology
and examples; strong form tests: tests for private information; long-horizon
return predictability.
Capital structure: the ModiglianiMiller theorem: capital structure irrelevancy;
taxation, bankruptcy costs and capital structure; weighted average cost
of capital; Modigliani-Miller 2nd proposition; the Miller equilibrium;
asymmetric information: 1) the under-investment problem, asymmetric
information; 2) the risk-shifting problem, asymmetric information; 3) free
cash-flow arguments; 4) the pecking order theory; 5) debt overhang.
Dividend theory: the ModiglianiMiller and dividend irrelevancy; Lintners
fact about dividend policy; dividends, taxes and clienteles; asymmetric
information and signalling through dividend policy.
Corporate governance: separation of ownership and control; management
incentives; management shareholdings and firm value; corporate governance.
Mergers and acquisitions: motivations for merger activity; calculating the gains
and losses from merger/takeover; the free-rider problem and takeover
activity.
2
Essential reading
There are a number of excellent textbooks that cover this area. However,
the following text has been chosen as the core text for this course due
to its extensive treatment of many of the issues covered and up-to-date
discussions:
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate Strategy.
(Boston, Mass.; London: McGraw-Hill, 2008) European edition
[ISBN 978007119027].
At the start of each chapter of this guide, we will indicate the reading that
you need to do from Hillier, Grinblatt and Titman (2008).
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed above. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the virtual learning environment (VLE) regularly for updated guidance on
readings.
Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the VLE and University of London
Online Library (see below).
Other useful texts for this course include:
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass., London: McGraw-Hill, 2008) ninth international edition [ISBN
9780071266758].
Copeland, T., J. Weston and K. Shastri Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) fourth edition
[ISBN 9780321223531].
Journal articles
Asquith, P. and D. Mullins The impact of initiating dividend payments on
shareholders wealth, Journal of Business 56(1) 1983, pp.7796.
Ball, R. and P. Brown An empirical evaluation of accounting income numbers,
Journal of Accounting Research 6(2) 1968, pp.15978.
Bhattacharya, S. Imperfect information, dividend policy, and the bird in the
hand fallacy, Bell Journal of Economics 10(1) 1979, pp.25970.
Blume, M., J. Crockett and I. Friend Stock ownership in the United States:
characteristics and trends, Survey of Current Business 54(11) 1974,
pp.1640.
Bradley, M., A. Desai and E. Kim Synergistic gains from corporate acquisitions
and their division between the stockholders of target and acquiring firms,
Journal of Financial Economics 21(1) 1988, pp.340.
Brock, W., J. Lakonishok and B. LeBaron Simple technical trading rules and
stochastic properties of stock returns, Journal of Finance 47(5) 1992,
pp.173164.
92 Corporate finance
Campbell, J. and R. Shiller The dividend-price ratio and expectations of future
dividends and discount ractors, Review of Financial Studies 1 1988.
Chen, N-F. Some empirical tests of the theory of arbitrage pricing, The Journal
of Finance 38(5) 1983, pp.1393414.
Chen, N-F., R. Roll and S. Ross Economic Forces and the Stock Market, Journal
of Business 59 1986, pp.383403.
Cochrane, J.H. Explaining the variance of price-dividend ratios, Review of
Financial Studies 5 1992, pp.24380.
DeBondt, W. and R. Thaler Does the stock market overreact?, Journal of
Finance 40(3) 1984, pp.793805.
Fama, E. The behavior of stock market prices, Journal of Business 38(1) 1965,
pp.34105.
Fama, E. Efficient capital markets: a review of theory and empirical work,
Journal of Finance 25(2) 1970, pp.383417.
Fama, E. Efficient capital markets: II, Journal of Finance 46(5) 1991,
pp.1575617.
Fama, E. and K. French Dividend yields and expected stock returns, Journal of
Financial Economics 22(1) 1988, pp.325.
French, K. Stock returns and the weekend effect, Journal of Financial
Economics 8(1) 1980, pp.5570.
Fama, E. and K. French The cross-section of expected stock returns, Journal of
Finance 47(2) 1992, pp.42765.
Fama, E. and K. French Common risk factors in the returns on stocks and
bonds, Journal of Financial Economics 33 1993, pp.356.
Fama, E. and J. MacBeth. Risk, return, and equilibrium: empirical tests,
Journal of Political Economy 91 1973, pp.60736.
Gibbons, M.R., S.A. Ross, and J. Shanken. A test of the efficiency of a given
portfolio, Econometrica 57 1989, pp.112152.
Grossman, S. and O. Hart Takeover bids, the free-rider problem and the theory
of the corporation, Bell Journal of Economics 11(1) 1980, pp.4264.
Healy, P. and K. Palepu Earnings information conveyed by dividend initiations
and omissions, Journal of Financial Economics 21(2) 1988, pp.14976.
Healy, P., K. Palepu and R. Ruback Does corporate performance improve after
mergers?, Journal of Financial Economics 31(2) 1992, pp.13576.
Jegadeesh, N. and S. Titman Returns to buying winners and selling losers,
Journal of Finance 48 1993, pp.6591.
Jarrell, G. and A. Poulsen Returns to acquiring firms in tender offers: evidence
from three decades, Financial Management 18(3) 1989, pp.1219.
Jarrell, G., J. Brickley and J. Netter The market for corporate control: the
empirical evidence since 1980, Journal of Economic Perspectives 2(1) 1988,
pp.4968.
Jensen, M. Some anomalous evidence regarding market efficiency, Journal of
Financial Economics 6(23) 1978, pp.95101.
Jensen, M. Agency costs of free cash flow, corporate finance, and takeovers,
American Economic Review 76(2) 1986, pp.32329.
Jensen, M. and W. Meckling Theory of the firm: managerial behaviour, agency
costs and capital structure, Journal of Financial Economics 3(4) 1976,
pp.30560.
Jensen, M. and R. Ruback The market for corporate control: the scientific
evidence, Journal of Financial Economics 11(14) 1983, pp.550.
Lakonishok, J., A. Shleifer and R. Vishny Contrarian investment, extrapolation,
and risk, Journal of Finance 49(5) 1994, pp.154178.
Lettau, M. and S. Ludvigson Consumption, aggregate wealth, and expected
stock returns, Journal of Finance 56 2001, pp.81549.
Levich, R. and L. Thomas The significance of technical trading-rule profits in
the foreign exchange market: a bootstrap approach, Journal of International
Money and Finance 12(5) 1993, pp.45174.
4
Books
Allen, F. and R. Michaely Dividend policy in Jarrow, R., W. Maksimovic and
W.T. Ziemba (eds) Handbook of Finance. (Amsterdam: Elsevier Science,
1995) [ISBN 9780444890849].
Haugen, R. and J. Lakonishok The Incredible January Effect. (Homewood, Ill.:
Dow Jones-Irwin, 1988) [ISBN 9781556230424].
Ravenscraft, D. and F. Scherer Mergers, Selloffs, and Economic Efficiency.
(Washington D.C.: Brookings Institution, 1987) [ISBN 9780815773481].
92 Corporate finance
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a sense
of community. It forms an important part of your study experience with the
University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
Self-testing activities: Doing these allows you to test your own
understanding of subject material.
Electronic study materials: The printed materials that you receive from
the University of London are available to download, including updated
reading lists and references.
Past examination papers and Examiners commentaries: These provide
advice on how each examination question might best be answered.
A student discussion forum: This is an open space for you to discuss
interests and experiences, seek support from your peers, work
collaboratively to solve problems and discuss subject material.
Videos: There are recorded academic introductions to the subject,
interviews and debates and, for some courses, audio-visual tutorials and
conclusions.
Recorded lectures: For some courses, where appropriate, the sessions from
previous years Study Weekends have been recorded and made available.
Study skills: Expert advice on preparing for examinations and developing
your digital literacy skills.
Feedback forms.
Some of these resources are available for certain courses only, but we are
expanding our provision all the time and you should check the VLE regularly
for updates.
Examination advice
Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Regulations for
relevant information about the examination, and the VLE where you
should be advised of any forthcoming changes. You should also carefully
7
92 Corporate finance
check the rubric/instructions on the paper you actually sit and follow
those instructions.
Remember, it is important to check the VLE for:
up-to-date information on examination and assessment arrangements
for this course
where available, past examination papers and Examiners commentaries
for the course which give advice on how each question might best be
answered.
This course will be evaluated solely on the basis of a three-hour
examination. You will have to answer four out of a choice of eight
questions. Although the Examiners will attempt to provide a fairly
balanced coverage of the course, there is no guarantee that all of the
topics covered in this guide will appear in the examination. Examination
questions may contain both numerical and discursive elements. Finally,
each question will carry equal weight in marking and, in allocating your
examination time, you should pay attention to the breakdown of marks
associated with the different parts of each question.
APT
CAPM
CML
IRR
MM
ModiglianiMiller
NPV
Chapter 1: Present value calculations and the valuation of physical investment projects
Learning outcomes
At the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
analyse optimal physical and financial investment in perfect capital
markets setting and derive the Fisher separation result
justify the use of the NPV rules via Fisher separation
compute present and future values of cash-flow streams and appraise
projects using the NPV rule
evaluate the NPV rule in relation to other commonly used evaluation
criteria
value stocks and bonds via NPV.
Essential reading
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate Strategy.
(Boston, Mass.; London: McGraw-Hill, 2008) Chapters 9 (Discounting
and Valuation), 10 (Investing in Risk-Free Projects), 11 (Investing in Risky
Projects).
Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapters 2 (Present Values), 3 (How to
Calculate Present Values), 5 (The Value of Common Stocks), 6 (Why NPV
Leads to Better Investment Decisions) and 7 (Making Investment Decisions
with the NPV Rule).
Copeland, T. and J. Weston Financial Theory and Corporate Policy. (Reading,
Mass.; Wokingham: Addison-Wesley, 2005) Chapters 1 and 2.
Roll, R. A critique of the asset pricing theorys texts. Part 1: on past and potential
testability of the theory, Journal of Financial Economics 4(2) 1977,
pp.12976.
92 Corporate finance
Overview
In this chapter we present the basics of the present value methodology
for the valuation of investment projects. The chapter develops the
NPV technique before presenting a comparison with the other project
evaluation criteria that are common in practice. We will also discuss the
optimality of NPV and give a number of extensive examples.
Introduction
For the purposes of this chapter, we will consider a firm to be a package
of investment projects. The key question, therefore, is how do the
firms shareholders or managers decide on which investment projects to
undertake and which to discard? Developing the tools that should be used
for project evaluation is the emphasis of this chapter.
It may seem, at this point, that our definition of the firm is rather limited.
It is clear that, in only examining the investment operations of the firm,
we are ignoring a number of potentially important firm characteristics.
In particular, we have made no reference to the financial structure or
decisions of the firm (i.e. its capital structure, borrowing or lending
activities, or dividend policy). The first part of this chapter presents what
is known as the Fisher separation theorem. What follows is a statement
of the theorem. This theorem allows us to say the following: under
certain conditions (which will be presented in the following section), the
shareholders can delegate to the management the task of choosing which
projects to undertake (i.e. determining the optimal package of investment
projects), whereas they themselves determine the optimal financial
decisions. Hence, the theory implies that the investment and financing
choices can be completely disconnected from each other and justifies our
limited definition of the firm for the time being.
Chapter 1: Present value calculations and the valuation of physical investment projects
Figure 1.1
The financial investment allows firms to borrow or lend unlimited
amounts at rate r. Assuming that the firm undertakes no physical
investment, we can define the firms consumption opportunities quite
easily. Assume the firm neither borrows nor lends. This implies that
current consumption (c0) must be identically m, whereas period 1
consumption (c1) is zero. Alternatively, the firm could lend all of its funds.
This leads to c0 being zero and c1 = m (1 + r). The relationship between
period 0 and period 1 consumption is therefore:
c1 = (1 + r)(m c0).
(1.1)
This implies that the curve which represents capital market investments is
a straight line with slope (1 + r). This curve is labeled CML on Figure 1.2.
Again, we have on Figure 1.2 plotted the optimal financial investments for
two different sets of preferences (assuming that no physical investment is
undertaken).
Figure 1.2
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Figure 1.3
12
Chapter 1: Present value calculations and the valuation of physical investment projects
where (I0) is the date 1 income from the firms physical investment.
Maximising this is equivalent to the following maximisation problem:
.
The prior objective is the NPV rule for project appraisal. It says that an
optimal physical investment policy maximises the difference between
investment proceeds divided by one plus the interest rate and the
investment cost. Here, the term optimal is being defined as that which
leads to maximisation of shareholder utility. We will discuss the NPV rule
more fully (and for cases involving more than one time period) later in
this chapter.
The assumption of perfect capital markets is vital for our Fisher separation
results to hold. We have assumed that borrowing and lending occur at the
same rate and are unrestricted in amount and that there are no transaction
costs associated with the use of the capital market. However, in practical
situations, these conditions are unlikely to be met. A particular example
is given in Figure 1.4. Here we have assumed that the rate at which
borrowing occurs is greater than the rate of interest paid on lending (as
the real world would dictate). Figure 1.3 shows that there are now two
points at which the capital market lines and the production opportunities
frontier are tangential. This then implies that agents with different
preferences will choose differing physical investment decisions and,
therefore, Fisher separation breaks down.
Figure 1.4
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(1.2)
such that:
(1.3)
The value for x defined in equation 1.3 is the present value of $1
received in one years time. This quantity is also termed the discounted
value of the $1.
14
Chapter 1: Present value calculations and the valuation of physical investment projects
You can see the present and future value concepts pictured in Figure 1.2.
If you recall, Figure 1.2 just plots the CML for a given level of initial funds
(m) assuming no funds are to be received in the future. The future value
of this amount of money is simply the vertical intercept of the CML (i.e.
m(1+r)), and obviously the present value of m(1+r) is just m.
The present and future value concepts are straightforwardly extended
to cover more than one period. Assume an annual compound interest rate
of r. The present value of $100 to be received in k years time is:
(1.4)
whereas the future value of $100 received today and evaluated k years
hence is:
FVK (100) = 100(1 + r)K.
(1.5)
Activity
Below, there are a few applications of the present and future value concepts. You should
attempt to verify that you can replicate the calculations.
Assume a compound borrowing and lending rate of 10 per cent annually.
a. The present value of $2,000 to be received in three years time is $1,502.63.
b. The present value of $500 to be received in five years time is $310.46.
c. The future value of $6,000 evaluated four years hence is $8,784.60.
d. The future value of $250 evaluated 10 years hence is $648.44.
(1.6)
Note that the cash flows to the project can be positive and negative,
implying that the notation employed is flexible enough to embody both
cash inflows and outflows after initiation.
Once we have calculated the NPV, what should we do? Clearly, if the NPV
is positive, it implies that the present value of receipts exceeds the present
value of payments. Hence, the project generates revenues that outweigh its
costs and should therefore be accepted. If the NPV is negative the project
should be rejected, and if it is zero the firm will be indifferent between
accepting and rejecting the project.
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92 Corporate finance
Chapter 1: Present value calculations and the valuation of physical investment projects
overall cost of capital. The firm can raise funds via equity issues and
debt issues, and it is likely that the costs of these two types of funds will
differ. Later on in this chapter and in those that follow, we will present
techniques by which the firm can compute the overall cost of capital for its
enterprise.
1,000
250
250
250
500
Table 1.1
A firm that has chosen a payback period of three years and is faced with
the project shown in Table 1.1 will reject it as the cash flow in years 1 to
3 (750) doesnt cover the initial outlay of 1,000. Note, however, that if the
firm used a payback period of four years, the project would be acceptable,
as the total cash flow to the project would be 1,250, which exceeds the
outlay. Hence, its clear that the crucial choice by management is of the
payback period.
We can also use the preceding example to illustrate the weaknesses
of payback. First, assume that the firm has a payback period of three
years. Then, as previously mentioned, the project in Table 1.1 will not be
accepted. However, assume also that, instead of being 500, the project
cash flow in year 4 is 500,000. Clearly, one would want to revise ones
opinion on the desirability of the project, but the payback rule still says
you should reject it. Payback is flawed, as a portion of the cash-flow
stream (that realised after the payback period is up) is always ignored in
project evaluation.
The second weakness of payback should be obvious, given our earlier
discussion of NPV. Payback ignores the time value of money. Sticking with
the example in Table 1.1, assume a firm has a payback period of four years.
Then the project as given should be accepted (as total cash flow of 1,250
exceeds investment outlay of 1,000). But whats the NPV of this project?
If we assume, for example, a required rate of return of 10 per cent, then
the NPV can be shown to be negative. (In fact the NPV is 36.78. As a
self-assessment activity, show that this is the case.) Hence application of
the payback rule tells us to accept a project that would decrease expected
shareholder wealth (as shown by application of the NPV rule). This flaw
could be eliminated by discounting project cash flows that accrue within
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92 Corporate finance
Figure 1.5
Calculation of the IRR need not be straightforward. Rearranging equation
1.7 shows us that the IRR is a solution to a kth order polynomial in r.
In general, the solution must be found by some iterative process, for
example, a (progressively finer) grid search method. This also points to
a first weakness of the IRR approach; as the solution to a polynomial,
the IRR may not be unique. Several different rates of return might satisfy
equation 1.7; in this case, which one should be used as the IRR? Figure 1.6
gives a graphical example of this case.
18
Chapter 1: Present value calculations and the valuation of physical investment projects
Figure 1.6
The graphical approach can also be used to illustrate another weakness
of the IRR rule. Consider a firm that is faced with a choice between two
mutually exclusive investment projects (A and B). The locus of NPV-rate of
return pairings for each of these projects is given on Figure 1.7.
The first thing to note from the figure is that the IRR of project A exceeds
that of B. Also, both IRRs exceed the hurdle rate, r*. Hence, both projects
are acceptable but, using the IRR rule, one would choose project A as
its IRR is greatest. However, if we assume that the hurdle rate is the
true opportunity cost of capital (which should be employed in an NPV
calculation), then Figure 1.7 indicates that the NPV of project B exceeds
that of project A. Hence, in the evaluation of mutually exclusive projects,
use of the IRR rule may lead to choices that do not maximise expected
shareholder wealth.
Figure 1.7
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92 Corporate finance
Equity
Debt
JCP
17.48
3.81
1.10
7.8
COST
24.08
2.22
1.10
15.5
HD
82.08
12.39
6.01
21.2
WMT
47.44
11.88
15.7
TGT
50.14
14.14
2.58
19.2
Walmarts (WMTs) equity value is excluded as this is the quantity we wish to estimate.
We can first calculate the market value of equity to earnings ratio for the average firm
in the industry (excluding Walmart), this is: [(17.48/1.1) + (24.08/1.1) + (82.08/6.01) +
(50.14/2.58)]/4 = 17.72
We now multiply this number by Walmarts earnings to get Walmarts equity value
estimate: 17.72*11.88=210.49. Walmarts actual equity value was $192.48 billion.
In the example above we used multiples to value equity, we sometimes
wish to the value of the full business (sometimes called enterprise value),
in this case we would need to use the full business value (for example,
debt plus equity) in the numerator instead of just equity value.
Notice that the debt to equity ratio of Costco (COST) was 9.2% while that
of Target (TGT) was 28.2%. In this example, we have ignored the effects
of leverage (debt in the capital structure), however as we will see in a later
chapter, leverage affects both firm value and the expected return on equity.
Therefore, firms with different leverage ratios that look otherwise similar
20
Chapter 1: Present value calculations and the valuation of physical investment projects
may have very different value to earnings ratios. We will learn how to
adjust the multiples method for the effects of leverage later.
The multiples method allows us to check whether the value of a
conglomerate is equal to the sum of its parts. To estimate the value of
each business division of a conglomerate we can calculate each divisions
earnings and multiply it by the average value to earnings multiple of stand
alone firms in the same sector. Adding up the value of all divisions gives
us an estimated value for the conglomerate, this estimate is on average
12% greater than the traded value of the conglomerate. This is called the
conglomerate discount. The reasons for the conglomerate discount
are not fully understood. It is possible that conglomerates are a less
efficient form of organisation due to inefficient capital markets. It is also
possible that the multiples method is inappropriate here because single
segment firms are too different from divisions of a conglomerate operating
in the same industry.
The strength of the multiples approach is that it incorporates a lot of
information in a simple way. It does not require assumptions on the
discount rate and growth rate (as is necessary with the NPV approach)
but just uses the consensus estimates from the market. A weakness is
the assumption that the comparable companies are truly similar to the
company one is trying to value; there is no simple way of incorporating
company specific information. However, its strength is also its biggest
weakness. By using market information, we are assuming that the market
is always correct. This approach would lead to the biggest mistakes
in times of biggest money making opportunities: when the market is
overvalued or undervalued.
The lesson of this section is therefore as follows. The most commonly
used alternative project evaluation criteria to the NPV rule can lead to
poor decisions being made under some circumstances. By contrast, NPV
performs well under all circumstances and thus should be employed.
Stocks
Consider holding a common equity share from a given corporation. To
what does this equity share entitle the holder? Aside from issues such as
voting rights, the share simply delivers a stream of future dividends to
the holder. Assume that we are currently at time t, that the corporation is
infinitely long-lived (such that the stream of dividends goes on forever)
and that we denote the dividend to be paid at time t+i by Dt+i. Also
assume that dividends are paid annually. Denoting the required annual
rate of return on this equity share to be re, then a present value argument
would dictate that the share price (P) should be defined by the following
formula:
.
(1.8)
92 Corporate finance
See Appendix 1.
(1.9)
(1.10)
The first term in 1.10 is the expected dividend yield on the stock, and the
second is expected dividend growth. Hence, with empirical estimates of
the previous two quantities, we can easily calculate the required rate of
return on any equity share.
Activity
Attempt the following questions:
1. An investor is considering buying a certain equity share. The stock has just paid a
dividend of 0.50, and both the investor and the market expect the future dividend to
be precisely at this level forever. The required rate of return on similar equities is 8 per
cent. What price should the investor be prepared to pay for a single equity share?
2. A stock has just paid a dividend of $0.25. Dividends are expected to grow at
a constant annual rate of 5 per cent. The required rate of return on the share
is 10 per cent. Calculate the price of the stock.
3. A single share of XYZ Corporation is priced at $25. Dividends are expected
to grow at a rate of 8 per cent, and the dividend just paid was $0.50. What is
the required rate of return on the stock?
Bonds
In principle, bonds are just as easy to value.
A discount or zero coupon bond is an instrument that promises
to pay the bearer a given sum (known as the principal) at the end of
the instruments lifetime. For example, a simple five-year discount bond
might pay the bearer $1,000 after five years have elapsed.
Slightly more complex instruments are coupon bonds. These not
only repay the principal at the end of the term but in the interim entitle
the bearer to coupon payments that are a specified percentage of
the principal. Assuming annual coupon payments, a three-year bond
with principal of 100 and coupon rate of 8 per cent will give annual
payments of 8, 8 and 108 in years 1, 2 and 3.
In more general terms, assuming the coupon rate is c, the principal is P
and the required annual rate of return on this type of bond is rb, the price
of the bond can be written as:4
.
22
(1.11)
4
In our notation a
coupon rate of 12
per cent, for example,
implies that c = 0.12;
the discount rate used
here, rb , is called the
yield to maturity of the
bond.
Chapter 1: Present value calculations and the valuation of physical investment projects
Key terms
capital market line (CML)
consumption
Fisher separation theorem
Gordon growth model
indifference curve
internal rate of return (IRR) rule
investment policy
net present value (NPV) rule
payback rule
production opportunity frontier (POF)
production possibility frontier (PPF)
time value of money
utility function
92 Corporate finance
2. Describe two methods of project evaluation other than NPV. Discuss the
weaknesses of these methods when compared to NPV. (10%)
3. The CEO and other top executives of a firm with no nearby commercial
airports make approximately 300 flights per year with an average
cost per flight of $5,000. The firm is considering buying a Gulfstream
jet for $15 million. The jet will reduce the cost of travel to $300,000
(including fuel, maintenance, and other jet-related expenses).
The firm expects to be able to resell the jet in five years for $12.5
million. The firm pays a 25% corporate tax on its profits and can offset
its corporate liabilities by using straight line depreciation on its fixed
assets. The opportunity cost of capital is 4%.
a. Should the firm buy this jet if it has sufficient taxable profits in
order to take advantage of all tax shields?
b. Should the firm buy this jet if it does not have sufficient taxable
profits in order to take advantage of new tax shields?
c. Suppose the firm could lease an airplane for the first year, with
an option to extend the lease. Within that year they would find
out whether the local government has decided to build an airport
nearby which would reduce travel costs. How would this change
your calculations?
4. Suppose that you have a 10,000 student loan with a 5 per cent
interest rate. You also have 1,000 in your zero interest checking
account which you do not plan to use in the foreseeable future. You are
considering three strategies: (i) payoff as much of the loan as possible,
(ii) invest the money in a local bank at 3.5 per cent interest, (iii) invest
in the stock market. The expected return on the stock market is 6 per
cent for the foreseeable future. Your personal discount rate is 4 per
cent for risk-free investments. For simplicity assume all investments are
perpetuities.
a. What is the NPV of strategy (i)?
b. What is the NPV of strategy (ii)?
c. What is the NPV of strategy (iii) if you are risk neutral?
d. What is the NPV of strategy (iv) if your subjective market risk
premium is 3 per cent?
24
Learning outcomes
At the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
discuss concepts such as a portfolios expected return and variance as
well as the covariance and correlation between portfolios returns
calculate portfolio expected return and variance from the expected
returns and return variances of constituent assets with confidence
describe the effects of diversification on portfolio characteristics
derive the CAPM using meanvariance analysis
describe some theoretical and practical limitations of the CAPM.
Essential reading
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate Strategy.
(Boston, Mass.; London: McGraw-Hill, 2008) Chapters 4 (The Mathematics
and Statistics of Portfolios) and 5 (Mean-Variance Analysis and the CAPM).
Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapters 8 (Introduction to Risk,
Return, and the Opportunity Cost of Capital) and 9 (Risk and Return).
Copeland, T. and J. Weston Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapters 5 and 6.
Roll, R. A critique of the asset pricing theorys texts. Part 1: on past and
potential testability of the theory, Journal of Financial Economics 4(2)
1977, pp.12976.
Introduction
In Chapter 1 we examined the use of present value techniques in the
evaluation of physical investment projects and in the valuation of primitive
financial assets (i.e. stocks and bonds). A key input into NPV calculations
is the rate of return used in the construction of the discount factor but,
thus far, we have said little regarding where this rate of return comes
from. Our objective in this chapter is to demonstrate how the risk of a
given security or project impacts on the rate of return required from it and
hence affects the value assigned to that asset in equilibrium.
25
92 Corporate finance
26
(2.1)
P = a x + b y + 2abxy.
(2.2)
2 2
2 2
The preceding results are readily extended to the case where more than
two random variables are linearly combined. Consider N random variables
denoted xi, where i runs from 1 to N. Denote their expected values and
variances as E(xi) and 2i. The covariance between xi and xj is ij. Again
we form a linear combination of the random variables, denoted again by
P, using an arbitrary set of constants denoted ai. The expected value and
variance of the random variable P are given by:
(2.3)
.
(2.4)
(2.5)
that is, the correlation between the two random variables is simply the
covariance, divided by the product of the respective standard deviations.
Clearly, knowledge of the correlation and the variances of the two random
variables allows one to retrieve the covariance between the two random
variables.
If we again define a linear combination of the two random variables, P,
using arbitrary constants a and b, the expression for the variance of the
27
92 Corporate finance
(2.6)
(2.8)
(2.9)
The portfolio variance has obviously increased, although it is still less than
the return variances of either component assets.
Activity
Assume that xy = 0.5. Calculate the portfolio return variance in this case, using the
data on portfolio weights and asset return variances given above.
Now, given the expected returns, return variances and covariances for
any set of assets, we should be able to calculate the expected return and
variance of any portfolio created from those assets. At the end of this
chapter, you will find activities that require you to do precisely this, along
with solutions to some of these activities.
Diversification
A point that we noted from the calculations of expected portfolio returns
and variances above was that, in all of our calculations, the variance of the
portfolio return was lower than that on any individual components asset
return.2 Hence, it seems as though, by forming bundles of assets, we can
eliminate risk. This is true and is known as diversification: through holding
portfolios of assets, we can reduce the risk associated with our position.
Why is this the case? The key is that, in our prior analysis and in real stock
return data, the correlations between returns are less than perfect. If two
returns are imperfectly correlated it implies that when returns on the first are
above average, those on the second need not be above average. Hence, to an
extent, the returns on such assets will tend to cancel each other out, implying
that the return variance for a portfolio of these stocks will be smaller than
the corresponding weighted average of the individual asset variances.
28
(2.10)
(2.11)
(2.12)
Now we ask the following question. How does the portfolio variance
change as the number of assets combined in the portfolio increases
towards infinity (i.e. N ). It is clear from equation 2.12 that, as the
number of assets held increases, the first term will shrink towards zero.
Also, as N increases the second term in equation 2.12 tends towards C.
Together, these observations imply the following:
1. The portfolio variance falls as the number of assets held increases.
2. The limiting portfolio return variance is simply the average covariance
between asset returns: this average covariance can be thought of as
the risk of the market as a whole, with the influence of individual asset
return variances disappearing in the limit.
The moral of the preceding statistical story is clear. Holding portfolios
consisting of greater and greater numbers of assets allows an investor
to reduce the risk that they bear. This is illustrated diagrammatically in
Figure 2.1.
Figure 2.1
29
92 Corporate finance
Meanvariance analysis
In the preceding two sections, we have demonstrated two important facts:
1. The expected return on a portfolio of assets is a linear combination of
the expected returns on the component assets.
2. An investor holding a diversified portfolio gains through the reduction
in portfolio variance, when asset returns are not perfectly correlated.
In this section, we use these facts to characterise the optimal holding of
risky assets for a risk-averse agent. Our fundamental assumption is that all
agents have preferences that only involve their expected portfolio return
and return variance. Utility is assumed to be increasing in the former
and decreasing in the latter. For illustrative purposes we begin using the
assumption that only two risky assets are available. The results presented,
however, generalise to the N asset case.
To begin, assume there is no risk-free aset. The investor can hence only
form their portfolio from risky assets named X and Y. These assets have
expected returns of E(Rx) and E(Ry) and return variances of 2x and 2y.
The first question the investor wishes to answer is how the characteristics
of a portfolio of these assets (i.e. portfolio expected return and variance)
change as the portfolio weights on the assets change. Given equation 2.6,
the answer to this question is obviously dependent on the correlation
between the returns on the two assets.
First assume that the assets are perfectly correlated and, further, assume
asset X has lower expected returns and return variance than asset Y. We
form a portfolio with weights on asset X and 1 on asset Y. Equation
2.6 then implies that the portfolio variance can be written as follows:
2P = (x + (1 )y)2.
(2.13)
Taking the square root of equation 2.13, it is clear that the portfolio
standard deviation is linear in . As the portfolio expected return is linear
in , the locus of expected returnstandard deviation combinations is a
straight line. This is shown in Figure 2.2.
Figure 2.2
If the correlation between returns is less than unity, however, the investor
can benefit from diversifying their portfolio. As previously discussed, in
this scenario, portfolio standard deviation is not a linear combination of
x and y. The reduction of portfolio risk through diversification will imply
that the meanstandard deviation frontier bows towards the y-axis. This
30
is also shown on Figure 2.2. The final curve on Figure 2.2 represents the
case where returns are perfectly negatively correlated. In this situation, a
portfolio can be constructed, which has zero standard deviation.
Activities
1. Assuming asset returns are perfectly negatively correlated, use equation 2.6 to find
the portfolio weights that give a portfolio with zero standard deviation. (Hint: write
down 2.6 with the correlation set to minus one and a = and b = 1 . Then
minimise portfolio variance with respect to .)
2. Assume that the returns on Microsoft and Bethlehem Steel have a correlation of 0.5.
Using the data provided earlier in the chapter, construct the meanvariance frontier
for portfolios of these two assets. Start with a portfolio consisting only of Microsoft
stock and then increase the portfolio weight on Bethlehem Steel by 0.1 repeatedly,
until the portfolio consists of Bethlehem Steel stock only.
From here on we will assume that return correlation is between plus and
minus one. The expected returnstandard deviation locus for this case
is redrawn in Figure 2.3. In the absence of a risk-free asset, this locus is
named the meanvariance frontier. As our investors preferences are
increasing in expected return and decreasing in standard deviation, it
is clear that their optimal portfolio will always lie on the frontier and to
the right of the point labelled V. This point represents the minimumvariance portfolio. They will always choose a frontier portfolio at or to
the right of V, as these portfolios maximise expected return for a given
portfolio standard deviation. In the absence of a risk-free asset, this set of
portfolios is called the efficient set.
Figure 2.3
We can now, given a set of preferences for the investor, find their optimal
portfolio. The condition characterising the optimum is that an investors
indifference curve must be tangent to the meanvariance frontier.3 Two
such optima are identified on Figure 2.3 at R and S. The investor locating
at equilibrium point R is relatively risk-averse (i.e. their indifference curves
are quite steep), whereas the equilibrium at S is that for a less risk-averse
individual (with correspondingly flatter indifference curves). Figure 2.3
also shows suboptimal indifference curves for each set of preferences.
Hence, as Figure 2.3 demonstrates, in a world of two risky assets and no
risk-free asset, the optimal portfolio of risky assets held by an investor
depends on their preferences towards risk and return. The same is true
31
92 Corporate finance
when there are N risky assets available. Figure 2.4 depicts the same type of
diagram for the N asset case.
Figure 2.4
Note that the meanvariance frontier is of the same shape as that in
Figure 2.3. However, unlike the two-asset case, the interior of the frontier
now consists of feasible but inefficient portfolios (i.e. those that do not
maximise expected return for given portfolio risk). The meanvariance
frontier now consists of those portfolios that minimise risk for a given
expected return, whereas those portfolios on the efficient set (i.e. on the
frontier but to the right of V) additionally maximise expected return for a
given level of risk.
We now reintroduce a risk-free asset to the analysis (i.e. we assume the
existence of an asset with return rf and zero returnstandard deviation).
A key question to address at this juncture is as follows. Assume that
we form a portfolio consisting of the risk-free asset and an arbitrary
combination of risky assets. How do the expected return and return
standard deviation of this portfolio alter as we vary the weights on the
risk-free asset and the risky assets respectively?
Denote our arbitrary risky portfolio by P. We combine P with the risk-free
asset using weights 1 a and a to form a new portfolio Q. The expected
return and variance of Q are given by:
E(RQ) = (1 a)rf + aE(RP) = rf + a[E(RP) rf ]
(2.14)
2Q = a22P .
(2.15)
In order to analyse the variation in the risk and expected return of the
portfolio Q with respect to changes in the portfolio weights, we construct
the following expression:
.
(2.16)
(2.17)
Figure 2.5
We now have all the components required to describe the optimal portfolio
choice of an investor faced with N risky assets and a risk-free investment.
Figure 2.6 replots the feasible set of risky asset portfolios. The key question
to answer is, what portfolio of risky assets should an investor hold? Using
the analysis from Figure 2.5, it is clear that the optimal choice of risky asset
portfolio is at K. Combining K with the risk-free asset places an investor on
a capital market line (labelled rf KZ), which dominates in utility terms the
CML generated by the choice of any other feasible portfolio of risky assets.4
The optimal portfolio choice and a suboptimal CML (labelled CML2) are
shown on Figure 2.6 along with the indifference curves of two investors.
Figure 2.6
Recall that we previously defined the efficient set as the group of portfolios
that both minimised risk for a given level of expected return and maximised
expected return for a given level of risk. With the introduction of the riskfree asset, the efficient set is exactly the optimal CML.
The key result that is depicted in Figure 2.6 is known as two-fund
separation. Any risk-averse investor (regardless of their degree of riskaversion) can form their optimal portfolio by combining two mutual funds.
The first of these is the tangency portfolio of risky assets, labelled K, and the
second is the risk-free asset. All that the degree of risk-aversion dictates is
the portfolio weights placed on each of the two funds. The investor with the
33
92 Corporate finance
(2.19)
(2.20)
Using the same method as shown in equation 2.16 to derive the risk
return trade-off at the point represented by portfolio I, we get:
.
(2.21)
(2.22)
The slope of the meanvariance frontier at K will be the ratio of 2.21 to
2.22 in the limit as a 0. Note that equation 2.21 does not depend on a.
Taking the limit of equation 2.22 as a 0 we get:
.
34
(2.23)
(2.26)
Definition
The market portfolio is the portfolio comprising all assets, where the
weights used in the construction of the portfolio are calculated as
the market capitalisation of each asset divided by the sum of market
capitalisations across all assets.
Two-fund separation gives us the fundamental result that all investors
hold efficient portfolios and, further, that all investors hold risky securities
in the same proportions (i.e. those proportions dictated by the tangency
portfolio (K)).7 For demand to be equal to supply in capital markets, it
must be the case that the market portfolio is constructed with identical
portfolio weights. The implication of this is simple: the market portfolio
and the tangency portfolio are identical. This allows us to express the
CAPM in the following form.
Under the prior assumptions, the following relationship holds for all
expected portfolio returns:
E(Rj ) = Rf + j [E(rM ) rf ],
(2.27)
where E(RM ) is the expected return on the market portfolio, and j is the
covariance of the returns on asset j with those on the market divided by
the variance of the market return.
Equation 2.27 gives the equilibrium relationship between risk and return
under the CAPM assumptions. In the CAPM framework, the relevant
35
92 Corporate finance
measure of an assets risk is its , and equation 2.27 implies that expected
returns increase linearly with risk.
To clarify the source of the CAPM equation, note that the identification of
the tangency portfolio and the linear -representation are implied by mean
variance analysis. The CAPM then imposes equilibrium on capital markets
and identifies the market portfolio as identical to the tangency portfolio.
Figure 2.7
(2.28)
(2.29)
The final term on the right-hand side of equation 2.29 is the variance of
the error term and represents diversifiable risk. This source of risk is also
known as unsystematic and idiosyncratic risk. As emphasised previously,
this risk is unrelated to market fluctuations and, therefore, does not affect
expected returns. The first term on the right-hand side of equation 2.29
represents undiversifiable risk, also known as systematic risk. This is risk
that cannot be escaped and hence increases equilibrium expected returns.
Activities8
1. An investor forms a portfolio of two assets, X and Y. These assets have expected
returns of 9 per cent and 6 per cent and standard deviations of 0.8 and 0.6
respectively. Assuming that the investor places a portfolio weight of 0.5 on each
asset, calculate the portfolio expected return and variance if the correlation between
returns on X and Y is unity.
2. Using the data from Question 1, recalculate the portfolio expected return and
variance, assuming that the correlation between returns is 0.5.
3. An investor forms a portfolio from two assets, P and Q, using portfolio weights of
one-third and two-thirds respectively. The expected returns on P and Q are
5 per cent and 7 per cent, and their respective return standard deviations are 0.4 and
0.5. Assuming that the return correlation is zero, calculate the expected return and
variance of the investors portfolio.
4. Assuming identical data to that in Question 3, recalculate the statistical properties of
the portfolio, assuming the return correlation for P and Q is 0.5.
The statement of the CAPM is identical to the proposition that the market
portfolio is meanvariance efficient. Hence, Roll pointed out that empirical
tests of the CAPM should seek to examine whether this is indeed the case.
However, he also noted that the market portfolio (or the return on the
market) is not observable to an econometrician, who wishes to conduct a
test. Empirical researchers generally use a broad-based equity index such
as the FTSE-100, S&P-500 or Nikkei 250 to proxy the market. But the true
market portfolio will contain other financial assets (such as bonds and
stocks not included in such indices) as well as non-financial assets such as
real estate, durable goods and even human capital. Hence, the validity of
tests of the CAPM depend critically on the quality of the proxy used for the
market portfolio.
Based on the above, Rolls critique is simply that, due to the fact that
the market portfolio is not observable, the CAPM is not testable. We can
understand this through the following arguments. First, it might be the
case that the market portfolio is efficient (and hence the CAPM is valid),
but our chosen proxy for the market is not efficient, and hence our
37
92 Corporate finance
empirical test rejects the CAPM. Second, our proxy for the market might
be efficient whereas the market portfolio itself is not. In this case our test
will falsely indicate that the CAPM is valid. Put simply, the fact that we
cant guarantee the quality of our proxy for the market implies that we
cant place any faith in the results that tests based upon it generate, and
hence its impossible to test the CAPM.
The Roll critique is clearly damaging in that it implies that we cant judge
the predictions of the CAPM against reality and trust the results. However,
many researchers have disregarded the prior discussion and estimated
the empirical counterpart of equation 2.27. From these estimates, such
researchers pass judgement on the CAPM.
E[eit ] = 0
E[Ft*eit ]= 0
(2.30)
(2.31)
(2.32)
(2.33)
Thus we can write the CAPM as a one-factor model where the excess
market return is the factor.
Suppose we were to regress the excess return on asset i on the excess
market return:
Rit Rf = Ai + Bi*(Rmt Rf )
(2.34)
38
The data are generally not supportive of the CAPM. The relationship
between an assets and its average return is usually positive, as the CAPM
suggests, but typically flatter than it should be, as can be seen in Figure 2.8.
In this figure the s are plotted against average returns for 17 portfolios
based on industry (such as food, chemicals or transportation). The dotted
line plots against *E[Rm Rf ], this is the CAPM predicted expected
return. The solid line plots the actual relationship between and industry
returns, this relationship is positive but flatter than the dotted line. That is
high stocks have returns that are lower than predicted by the CAPM while
low stocks have returns that are higher than predicted by the CAPM.
Furthermore, there are certain assets (to be discussed in the next chapter)
that appear to consistently have non-zero Ai in time series regressions.10
0.9
10
See pp.18586 of
Brealey and Myers
(2008).
0.85
0.8
0.75
E[R]
0.7
0.65
0.6
0.55
0.5
0.45
0.4
0.7
0.8
0.9
1.1
1.2
1.3
1.4
Figure 2.8
One possible explanation for the too flat relationship between and
average return is measurement error. Suppose we do not observe an assets
true , but rather its true plus some measurement error which is mean
zero. Then assets with very high observed are likely to be assets with very
positive measurement error; therefore their true is below their observed
, perhaps consistent with the low observed expected return. Similarly,
assets with very low observed are likely to be assets with very negative
measurement error and therefore their true is above the observed .
It is also possible that one factor is simply not enough to explain all of the
variation in expected returns. The CAPM implies that the a firms loading
on the market () is the only variable that should cause expected returns to
differ. Adding extra explanatory variables to regression 2.34 will not result
in significant coefficients. In the next chapter we will see that loadings on
other factors, including firm size, book-to-market ratios, P/E ratios and
dividend yields have been shown to explain ex-post realised returns.
Amalgamating the above evidence implies that, if you are willing to
disregard the Roll critique, you should probably conclude that the CAPM
does not hold. This has led certain authors to investigate other asset-pricing
pradigms such as the APT (which we discuss in the next chapter). An
alternative viewpoint would be to argue that such results tell us little or
nothing about the validity of the CAPM due to the insight of Roll (1977).
39
92 Corporate finance
Key terms
beta ()
capital asset pricing model (CAPM)
correlation
covariance
diversification
expected return
market portfolio
meanvariance analysis
Roll critique
security market line
standard deviation
systematic risk
two-fund separation
unsystematic risk
variance
24
12
28
15
Showing all your workings, compute the for ABCs equity. (7%)
4. Assume that the risk-free rate is 5 per cent. What is the expected return
on ABCs stock? (3%)
5. The risk-free rate is 4 per cent, firm A has a market of 2 and an
expected return of 16 per cent.
a. What is the expected return on the market according to the CAPM?
40
b. Draw a graph with on the x-axis and the expected return on the
y-axis. Indicate the risk-free rate, the market, and firm A. What is
the slope of the securities market line?
c. The standard deviation of the market return is 16 per cent and the
standard deviation of the return of firm A is 40 per cent. What is the
standard deviation of As idiosyncratic component?
6. You have 50 years of monthly data on short-term treasury rates and
portfolios of 10-year bond returns, an aggregate index of US equities,
a mutual fund focusing on tech firms, a mutual fund focusing on
commodities, a mutual fund focusing on manufacturing, and a hedge
fund index. Describe how you would test the CAPM and the results you
would expect to find.
Solutions to activities
1. The expected return on the equally weighted portfolio is 7.5 per cent.
The portfolio return variance is 0.49, and hence the portfolio return
standard deviation is 0.7.
2. Obviously, the expected return is the same as in Question 1. With
correlation of 0.5, the portfolio return variance is 0.37.
3. The expected return on the portfolio is 6.33 per cent, and the portfolio
has a return variance of 0.1289.
4. When the correlation changes to 0.5, the portfolio return variance
drops to 0.0844. The expected return on the portfolio doesnt change
from that calculated in Question 3.
41
92 Corporate finance
Notes
42
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
understand single-factor and multi-factor model representations
derive factor-replicating portfolios from a set of asset returns
understand the notion of arbitrage strategies and that well-functioning
financial markets should be arbitrage-free
derive arbitrage pricing theory and calculate expected returns using the
pricing formulas
know how to test multifactor models.
Essential reading
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate Strategy.
(Boston, Mass.; London: McGraw-Hill, 2008) Chapter 6 (Factor Models and
the APT).
Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapter 9 (Risk and Return).
Chen, N-F. Some empirical tests of the theory of arbitrage pricing, The Journal
of Finance 38(5) 1983, pp.1393414.
Chen, N-F., R. Roll and S. Ross Economic forces and the stock market, Journal
of Business 59 1986, pp.383403.
Copeland, T., J. Weston and K. Shastri Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapter 6.
Fama, E. and K. French The cross-section of expected stock returns, Journal of
Finance 47(2) 1992, pp.42765.
Fama, E. and K. French Common risk factors in the returns on stocks and
bonds, Journal of Financial Economics 33 1993, pp.356.
Fama, E. and J. MacBeth Risk, return, and equilibrium: empirical tests, Journal
of Political Economy 91 1973, pp.60736.
Gibbons, M.R., S.A. Ross and J. Shanken A test of the efficiency of a given
portfolio, Econometrica 57 1989, pp.112152.
Jegadeesh, N. and S. Titman Returns to buying winners and selling losers,
Journal of Finance 48 1993.
Overview
Empirically, expected returns appear to depend on several factors. For
this reason, multifactor models, such as the Fama and French three-factor
model are commonly used in practice to calculate expected returns. The
arbitrage pricing theory gives a theoretical basis for using such models.
As its name suggests, it rests on the notion that well-functioning financial
markets should be arbitrage-free. This, using a factor model of asset
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Introduction
As we saw in the previous chapter, the CAPM was not sufficient to explain
the cross-section of expected asset returns. The CAPM was a one-factor
model and we can improve on the CAPM by including additional factors.
However, the CAPM was derived from micro-economic foundations, why
should additional factors matter for risk?
The arbitrage pricing theory (APT) gives an alternative to the CAPM as a
method to compute expected returns on stocks. The basis for the APT is a
factor model of stock returns, and we will define and discuss these models
first. From there we will demonstrate how to derive expected returns using
the idea that the returns on stocks, which are exposed to a common set of
factors, must be mutually consistent, given each stocks sensitivity to each
factor.
To give structure to what we mean by mutually consistent, we need to
define the notion of an arbitrage. An arbitrage strategy is a strategy that
delivers non-negative returns in all states of the world, and strictly positive
returns in at least one state of the world. For example, a strategy that
yields an immediate, positive cash inflow and, further, is guaranteed not to
make a loss tomorrow. Faced with an investment strategy with this payoff
structure, any investor who prefers more to less would try to invest on an
infinite scale.
The idea that underpins the APT is that investment situations, such
as those described above, should not be permitted in well-functioning
financial markets. Then, if financial markets do not permit the existence
of arbitrage strategies, this places restrictions on the relationships between
the expected returns on assets given the factor structure underlying
returns.
Although the APT gives justification for why there may be multiple factors,
it does not identify specific factors. Factors should proxy for risk and may
be identified from economic fundamentals (such as the CAPM), or from
empirical observation. Eugene Fama and Ken French identified three
factors that do a relatively good job at explaining much of the variation
in expected stock returns. We will learn about their model, as well as
improvements on it, at the end of the chapter.
Single-factor models
Before using the notion of absence of arbitrage to provide pricing
relations, we need a basis for the generation of stock returns. Within
the context of the APT, this basis is given by the assumption that the
population of stock returns is generated by a factor model. The simplest
factor model, given below, is a one-factor model:
ri = i + i F + i
E(i) = 0.
(3.1)
In equation 3.1, the returns on stock i are related to two main components:
1. The first of these is a component that involves the factor F. This
factor is posited to affect all stock returns, although with differing
sensitivities. The sensitivity of stock is return to F is i. Stocks that
have small values for this parameter will react only slightly as F
changes, whereas when i is large, variations in F cause very large
movements in the return on stock i. As a concrete example, think of F
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Multi-factor models
A generalisation of the structure presented in equation 3.1 posits k factors
or sources of common variation in stock returns.
ri = i + 1iF1 + 2iF2 + .... + kiFk + i
E(i) = 0.
(3.2)
(3.3)
(3.4)
In general, if I have
a k-factor model I will
need k+1 stocks to
do this.
Finally, it must also be the case that the portfolio weights add up to unity,
so we must also satisfy the following equation:
X + Y + Z = 1.
Equations 3.3, 3.4 and 3.5 are three equations in three unknowns, and
we can find values for the portfolio weights which satisfy all three
simultaneously. This illustrates the fact that (as the portfolio factor
sensitivities were arbitrarily set at 0.5 and 1) we can derive any
constellation of factor sensitivities. A particularly interesting case is when
the portfolio is sensitive to one of the factors only. We call this a factorreplicating portfolio and discuss it below.
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Factor-replicating portfolios
An important application of the technology developed previously in this
chapter is the construction of a factor-replicating portfolio. A factorreplicating portfolio is a portfolio with unit exposure to one factor and
zero exposure to all others. For example, the portfolio replicating factor
1 in model 3.2 would have 1 = 1 and j = 0 for all j = 2 to k. We will use
factor-replicating portfolios to show that a factor structure for asset returns
implies a pricing model. In such a model, expected returns depend only
on s, or risk loadings.
Activity
Assume that stock returns are generated by a two-factor model. The returns on three
well-diversified portfolios, A, B and C, are given by the following representations:
rA = 0.10 + F1 0.5F2
rB = 0.08 + 2F1 + F2
rC = 0.05 + 0.5F1 + 0.5F2.
Determine the portfolio weights you need to place on A, B and C in order to construct
the two factor-replicating portfolios plus a portfolio which has zero exposure to both
factors. What are the expected returns of the factor-replicating portfolios and what is the
expected return of the risk-free portfolio?
The question to ask at this point is: why bother constructing factorreplicating portfolios? The reason is as follows. Suppose I want to build
a portfolio that has identical factor exposures to a given asset, X. Assume
a two-factor world and that asset X has exposure of 0.75 to factor 1
and 0.3 to factor 2. Assume also that I know the two factor-replicating
portfolios.
Building a portfolio with the same factor exposures as X is now simple.
Construct a new portfolio, Y, which has portfolio weight 0.75 on the
replicating portfolio for the first factor, portfolio weight 0.3 on the
replicating portfolio for the second factor and the rest of the portfolio
weight (i.e. a weight of 1 0.75 + 0.3 = 0.55) on the risk-free asset. Via
the results on the factor representations of a portfolio of assets and
the definition of a factor-replicating portfolio it is easy to see that Y is
guaranteed to have identical factor exposures to X.
The replication in the preceding paragraph forms the basis for the APT. For
absence of arbitrage we require all assets with identical factor exposures
to earn the same return. If they did not, then we would have the chance to
make unlimited amounts of money. For example, assume that the expected
return on the replicating portfolio Y was greater than that on asset X.
Then I should short X and buy Y. The risk exposures of the two portfolios
are identical and hence risks cancel out and I am left with an excess return
that is riskless (i.e. an arbitrage gain).
In order to progress, let us introduce some notation. Denote the riskfree rate with rf. Denote the expected return on the ith factor-replicating
portfolio with rf + i such that i is the risk premium associated with the
ith factor. Again, for simplicity, assume that the world is generated by a
two-factor model, and assume that I wish to replicate asset X, which has
sensitivity 1X to the first factor and 2X to the second factor. Finally, we will
assume that the primary securities being worked with are well-diversified
portfolios themselves. Hence, we will ignore any idiosyncratic risk in this
derivation.
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(3.6)
(3.7)
92 Corporate finance
E(rX) = rf + 1X 1+ 2X 2.
E(r2) = 1.71%
E(r3) = 5.14%.
This implies that the expected return on any asset in this world can be written as:
E(ri) = 5.14 + 3.151i 3.432i .
To check that this works, substitute (for example) portfolio Cs factor sensitivities into the
preceding expression. This gives:
E(rC) = 5.14 + 3.15 (0.5) 3.43 (0.5) = 5%,
and hence, agrees with the expected return implied by the original representation for
asset C. Check that the expected returns on assets A and B also come out correctly.
To analyse an arbitrage opportunity that might arise in markets, attempt
the following activity.
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Activity
Assume that a new well-diversified portfolio, D, is added to our world. This asset has
sensitivities of 3 and 1 to the two factors and an expected return of 15 per cent.
Using the equilibrium expected return equation given above, derive the equilibrium
expected return on an asset with identical factor exposures to D. Is there now an
arbitrage opportunity available? If so, dictate a strategy that could be employed to exploit
the arbitrage opportunity.
Value
Small
0.573
0.105
0.151
0.362
0.528
0.213
0.146
0.295
0.312
0.363
0.136
0.160
0.262
0.291
0.276
0.005
0.049
0.156
0.209
0.163
Big
0.014
0.022
0.038
0.013
1.020
Table 3.1
Since the CAPM could not adequately explain the cross-section of returns,
Fama and French looked for additional risk factors. Given the performance
of small and value stocks, it was natural to think those two characteristics
were related to risk. They constructed a zero cost portfolio which took a
long position in small stocks and a short position in large stocks and called
it SMB (small minus big). Similarly, they constructed a zero cost portfolio
which took a long position in value stocks and a short position in growth
stocks and called it HML (high minus low).
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Fama and French augmented the CAPM by these two additional factors,
creating what is known as the Fama and French three-factor model. As
before with the CAPM, multifactor models can be tested by a first stage
time series test, in which each assets return is regressed on the factors;
each should be near zero. The Fama and French three-factor model
performed much better than the CAPM on the 25 portfolios defined
above, Fama and French could not statistically reject that the 25 s
were different from zero. The Fama and French model is commonly
used as a replacement to the CAPM to assess risk as well as managerial
performance.
Narasimhan Jegadeesh and Sheridan Titman found another set of
portfolios whose returns could not be explained by the CAPM or the Fama
and French three-factor model. Jegadeesh and Titman sorted stocks into
portfolios based on their past performance, they held these portfolios for
a year and then reassigned stocks to new portfolios. They found that a
portfolio long in stocks that performed well in the past, and short in stocks
that performed poorly in the past, had positive s in both CAPM and
three-factor regressions, they called this portfolio MOM (momentum). The
momentum factor was added to the Fama and French three-factor model
by Mark Carhart. This augmented four-factor model does a somewhat
better job than the three-factor model at explaining the cross-section
of expected stock returns, it is also commonly used to assess risk and
managerial performance.
Summary
The APT gives us a straightforward, alternative view of the world from
the CAPM. The CAPM implies that the only factor that is important
in generating expected returns is the market return and, further, that
expected stock returns are linear in the return on the market. The APT
allows there to be k sources of systematic risk in the economy. Some
may reflect macroeconomic factors, like inflation, and interest rate risk,
whereas others may reflect characteristics specific to a firms industry or
sector.
Empirical research has indicated that some of the well-known empirical
problems with the CAPM are driven by the fact that the APT is really the
proper model of expected return generation. Chen (1983), for example,
argues that the size effect found in CAPM studies disappears in a multifactor setting. Chen, Roll and Ross (1986) argue that factors representing
default spreads, yield spreads and gross domestic product growth are
important in expected return generation. Fama and French (1992, 1995),
show that size and book-to-market factors can help explain the crosssection of stock returns while other factors, such as momentum, also
appear to be important. Work in this area is still progressing.
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derive arbitrage pricing theory and calculate expected returns using the
pricing formulas
know how to test multifactor models.
Key terms
arbitrage pricing theory
factor-replicating portfolio
factor sensitivity
multi-factor model
single-factor model
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Notes
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