Bonds/Debts

When a company (or government) borrows money from the investor (public
Bond
or bondholders) and agrees to pay it back later
Par Value The amount of money that the company borrows. Usually it is $1,000.
This is like interest. The company makes regular payments to the
Coupon Payments
bondholders, like every 6 months or every year.
The legal document. A written agreement between the company and the
bond holder. (Trustees represent bondholders. They talk about how much
Indenture the coupon payments will be, and when the money (par value) will be paid
back to the bondholder. Other provisions, example, restricting company
from doing things that will not be in the interest of bondholders, etc, etc.
Maturity Date Date when the company pays the par value back to the bondholder.
Market Interest Rate This change every day.

The thing about bonds is that the coupon interest rate (coupon payments) is fixed and it does not
change. Bonds last a long time, example for 10 years. So in the meantime, the market interest rate
(the interest rates in general) goes up and down. If the coupon payments are for 10% and then the
market interest rates fall from 10% to 8%, then that bond at 10% is valuable, right. The bond is
paying 10% while the overall interest rate is only 8%.

Exactly how much is it worth? I mean what is the present value of a bond?

The Present Value The Present Value of the Coupon The Present Value of the Par Value
= +
of a Bond Payments (an annuity) (time value of money)
Example:
Par Value = $ 1,000
Maturity Date is in 5 years
Annual Coupon Payments of $100, which is 10% of par value
Market Interest rate of 8%
The Present Value of the Coupon Payments (An annuity) = $399.27
The Present Value of the Par Value (Time value of money) = $680.58
The Present Value of a Bond = $ 399.27 + $ 680.58 = $1,079.86

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Stocks
Stock is a share in the ownership of a company. Stock represents a claim on the company's assets
and earnings. As you acquire more stock, your ownership stake in the company becomes greater.

Debt vs. Equity

Why does a company issue stock? Why would the founders share the profits with thousands of
people when they could keep profits to themselves?

The reason is that at some point every company needs to raise money. To do this, companies can
either borrow it from somebody or raise it by selling part of the company, which is known as issuing
stock. A company can borrow by taking a loan from a bank or by issuing bonds. Both methods fit
under the umbrella of "debt financing."

On the other hand, issuing stock is called "equity financing." Issuing stock is advantageous for the
company because it does not require the company to pay back the money or make interest
payments along the way. All that the shareholders get in return for their money is the hope that the
shares will someday be worth more. The first sale of a stock, which is issued by the private company
itself, is called the initial public offering (IPO).

It is important that you understand the distinction between a company financing through debt and
financing through equity. When you buy a debt investment such as a bond, you are guaranteed the
return of your money (the principal) along with promised interest payments.

This is not the case with an equity investment. By becoming an owner, you assume the risk of the
company not being successful. Just as a small business owner isn't guaranteed a return, neither is a
shareholder. As an owner your claim on assets is lesser than that of creditors. This means that if a
company goes bankrupt and liquidates, you, as a shareholder, do not get any money until the banks
and bondholders have been paid out; we call this absolute priority. Shareholders earn a lot if a
company is successful, but they also stand to lose their entire investment if the company is not
successful.

Risk
It must be emphasized that there are no guarantees when it comes to individual stocks. Some
companies pay out dividends, but many others do not. And there is no obligation to pay out
dividends even for those firms that have traditionally given them. Without dividends an investor can
make money on a stock only through its appreciation in the open market. On the downside, any
stock may go bankrupt, in which case your investment is worth nothing.

Although risk might sound all negative, there is also a bright side. Taking-on greater risk demands a
greater return on your investment. This is the reason why stocks have historically outperformed
other investments such as bonds or savings accounts. Over the long term, an investment in stocks
has historically had an average return of around 10%-12%.

Value of a stock is the present value of the future dividends expected to be generated by the stock.
^ D1 D2 D3 D
P0 ...
(1 k s ) (1 k s )
1 2
(1 k s ) 3
(1 k s )

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If growth rate, g, is constant, the dividend growth formula converges to:
^ D 0 (1 g) D1
P0
ks - g ks - g

For variable growth model, the formula will be:

^ D1 D2 D3 D Pn
P0 ... n
(1 k s ) (1 k s )
1 2
(1 k s ) 3
(1 k s ) n

Where: Pn = Dn ( 1+ gLT)
(ks gLT)

For zero growth stock, the formula is:

^ D1
P0
ks

Different Types of Stock

Common Stocks
Common stock is, well, common. When people talk about stocks in general they are most likely
referring to this type. In fact, the majority of stock issued is in this form. Common shares represent
ownership in a company and a claim (dividends) on a portion of profits. Investors get one vote per
share to elect the board members, who oversee the major decisions made by management.

Over the long term, common stock, by means of capital growth, yields higher returns than almost
every other investment. This higher return comes at a cost since common stocks entail the most risk.
If a company goes bankrupt and liquidates, the common shareholders will not receive money until
the creditors, bondholders, and preferred shareholders are paid.

Preferred Stocks
Preferred stock represents some degree of ownership in a company but usually doesn't come with
the same voting rights. (This may vary depending on the company.) With preferred shares investors
are usually guaranteed a fixed dividend forever. This is different than common stock, which has
variable dividends that are never guaranteed. Another advantage is that in the event of liquidation
preferred shareholders are paid off before the common shareholder (but still after debt holders).

Preferred stock may also be callable, meaning that the company has the option to purchase the
shares from shareholders at anytime for any reason (usually for a premium). Some people consider
preferred stock to be more like debt than equity. A good way to think of these kinds of shares is to
see them as being in between bonds and common shares.

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RISK
The chance that an investments actual return will be different than expected. This includes the
possibility of losing some or all of the original investment. It is usually measured by calculating the
standard deviation of the historical returns or average returns of a specific investment.

A fundamental idea in finance is the relationship between risk and return. The greater the amount of
risk that an investor is willing to take on, the greater the potential return. The reason for this is that
investors need to be compensated for taking on additional risk. For example, a government bond is
considered to be one of the safest investments and, when compared to a corporate bond, provides a
lower rate of return. The reason for this is that a corporation is much more likely to go bankrupt than
the government. Because the risk of investing in a corporate bond is higher, investors are offered a
higher rate of return.

RETURN
The gain or loss of a security in a particular period. The return consists of the income and the capital
gains relative on an investment. It is usually quoted as a percentage.

The general rule is that the more risk you take, the greater the potential for higher return - and loss.

RISK-RETURN TRADEOFF
The principle that potential return rises with an increase in risk. Low levels of uncertainty (low risk)
are associated with low potential returns, whereas high levels of uncertainty (high risk) are
associated with high potential returns. In other words, the risk-return trade-off says that
invested money can render higher profits only if it is subject to the possibility of being lost.

Because of the risk-return trade-off, you must be aware of your personal risk tolerance when
choosing investments for your portfolio. Taking on some risk is the price of achieving returns;
therefore, if you want to make money, you can't cut out all risk. The goal instead is to find an
appropriate balance - one that generates some profit, but still allows you to sleep at night.

RISK AVERSE
Describes an investor who, when faced with two investments with a similar expected return (but
different risks), will prefer the one with the lower risk. A risk-averse person dislikes risk.

RISK LOVER
An investor who is willing to take on additional risk for an investment that has a relatively low
expected return. This contrasts with the typical investor mentality - risk aversion. Risk adverse
investors tend to take on increased risks only if they are warranted by the potential for higher
returns.

There is always a risk/return trade-off when investing. Lower returns are usually associated with
lower risk investments. Higher potential returns are associated with investments of higher risk, as
most investors expect to be compensated for taking on additional risk. Risk lovers, however, go
against this principle: they acquire investments of higher risk with a lower expected return.

RISK NEUTRAL
A description of an investor who purposely overlooks risk when deciding between investments. A risk
neutral investor is only concerned with an investment's expected return.

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RISK TOLERANCE
The degree of uncertainty that an investor can handle in regards to a negative change in the value of
their portfolio.

An investor's risk tolerance varies according to age, income requirements, financial goals, etc. For
example, a 70-year-old retired widow would generally have a lower risk tolerance than a single 30-
year-old executive.

SYSTEMATIC RISK
The risk inherent to the entire market or entire market segment. Also known as "un-
diversifiable risk" or "market risk."

Interest rates, recession and wars all represent sources of systematic risk because they affect the
entire market and cannot be avoided through diversification. Whereas this type of risk affects a
broad range of securities, unsystematic risk affects a very specific group of securities or an
individual security. Systematic risk can be mitigated only by being hedged. Even a portfolio of well-
diversified assets cannot escape all risk.

UNSYSTEMATIC RISK
Risk that affects a very small number of assets. Sometimes referred to as specific risk. For example,
news that is specific to a small number of stocks, such as a sudden strike by the employees of a
company you have shares in, is considered to be an unsystematic risk.

RISK-FREE RATE OF RETURN

The theoretical rate of return of an investment with zero risk. The risk-free rate represents the
interest an investor would expect from an absolutely risk-free investment over a specified period of
time.

In theory, the risk-free rate is the minimum return an investor expects for any investment since he or
she would not bear any risk unless the potential rate of return is greater than the risk-free rate.

In practice, however, the risk-free rate does not exist since even the safest investments carry a very
small amount of risk. Thus, the interest rate on a three-month Treasury bill is often used as the risk-
free rate.

RISK PREMIUM
The return in excess of the risk-free rate of return that an investment is expected to yield. An asset's
risk premium is a form of compensation for investors who tolerate the extra risk - compared to that
of a risk-free asset - in a given investment.

Think of a risk premium as a form of hazard pay for your investments. Just as employees who work
relatively dangerous jobs receive hazard pay as compensation for the risks they undertake, risky
investments must provide an investor with the potential for larger returns to warrant the risks of the
investments.

For example, high-quality corporate bonds issued by established corporations earning large profits
have very little risk of default. Therefore, such bonds will pay a lower interest rate (or yield) than
bonds issued by less-established companies with uncertain profitability and relatively higher default
risk.

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Probability Distribution- The weather this weekend
Outcome Probability
Sunny 80 %
Rain 10 %
Snow 9.99995 %
Volcanic Ash 0.00005 %
The total must equal 100%

Probability Distribution - In Business

Economic Outcome Probability Return on Investment
Great 20% 25%
Good 40% 15%
So-So 30% 5%
Really Bad 10% 0%
Economic Outcome = What might happen next year to the country's overall economy.
Probability = Estimate of the likelihood that the economy will be in each outcome.
Return on Investment = Estimate of your profit in each economic outcome.

Taking a Weighted Average - Expected Rate of Return (ERR)

What is the most likely return on your investments next year? Just multiply it out and add.
Probability Times Outcome Equals Result
20% X 25% = 5%
40% X 15% = 6%
30% X 5% = 1.5%
10% X 0% = 0%
Total 12.5%
So after taking a weighted average the Expected Rate of Return (ERR) is 12.5%

We can measure risk by using standard deviation. Higher standard deviation means higher risk.
ERR - the Probability
Economic Return on Expected of the
minus equals answer squared times equals Answer
Outcome Investment Rate of Economic
Return Outcome
Great 25% - 12.5% = 12.5 156.25 X 20% = 31.25
Good 15% - 12.5% = 2.5 6.25 X 40% = 2.5
So-So 5% - 12.5% = 7.5 56.25 X 30% = 16.875
Really Bad 0% - 12.5% = 12.5 156.25 X 10% = 15.625
Total = 66.25
So the total is 66.25. This is called the Variance. The square root of 66.25 = 8.139, Standard Deviation
is 8.139

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CAPM - The Capital Asset Pricing Model
Cap-M" looks at risk and rates of return and compares them to the overall stock market. If you use
CAPM you have to assume that most investors want to avoid risk, (risk averse), and those who do
take risks, expect to be rewarded.

Beta - Now, you gotta know about Beta. Beta is the overall risk in investing in a large market, like the
Kuala Lumpur Stock Exchange. Market Beta, by definition equals 1.0000 (1 exactly). Each company
also has a beta. You can find a company's beta at the Yahoo!! Stock quote page. A company's beta is
that company's risk compared to the risk of the overall market. If the company has a beta of 3.0, then
it is said to be 3 times more risky than the overall market.

Ks = Krf + B ( Km - Krf)
Ks = The Required Rate of Return, (or just the rate of return).
Krf = The Risk Free Rate (the rate of return on a "risk free investment", like government
Bonds)
B = Beta (see above)
Km = The expected return on the overall stock market. (You have to guess what rate of
return you think the overall stock market will produce.)

The Security Market Line

The formula for CAPM is Ks = Krf + B ( Km - Krf).

Let's assume that the risk free rate is 5%, and the overall stock market will produce a rate of return of
12.5% next year. You see that XYZ company has a beta of 1.7. If you make a graph of this situation, it
would look like this:

On the horizontal axis are the betas of all companies in the market
On the vertical axis are the required rates of return, as a percentage
The BOLD line is the Security Market Line.
How did we get it? We plugged in a few sample betas into the equation, Ks = Krf + B ( Km - Krf).
Security Beta (measures risk) Rate of Return
'Risk Free' 0.0 5.00%
Overall Stock Market 1.0 12.50%
XYZ Company 1.7 17.75%

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WHAT IS THE REAL RATE OF RETURN?

Consumer price index (CPI) and nominal interest rate data:

CPI Data
Year 1: 100
Year 2: 110
Year 3: 120
Year 4: 115
Nominal Interest Rate Data
Year 1: --
Year 2: 15%
Year 3: 13%
Year 4: 8%
How can you figure out what the real interest rate is for years 2, 3, and 4?

What is the Real Interest Rate?

We learned that a real variable, such as the real interest rate, is one where the effects of inflation have
been factored in. A nominal variable is one where the effects of inflation have not been accounted
for. An example shows how real interest rates work:
Suppose we buy a 1 year bond for face value that pays 6% at the end of the year. We pay $100
at the beginning of the year and get $106 at the end of the year. Thus the bond pays an interest
rate of 6%. This 6% is the nominal interest rate, as we have not accounted for inflation.
Whenever people speak of the interest rate they're talking about the nominal interest rate,
unless they state otherwise.
Now suppose the inflation rate is 3% for that year. We can buy a basket of goods today and it
will cost $100, or we can buy that basket next year and it will cost $103. If we buy the bond
with a 6% nominal interest rate for $100, sell it after a year and get $106, buy a basket of
goods for $103, we will have $3 left over.

How Do You Calculate the Real Interest Rate?

Before we start making the calculations we need to introduce some notation:
Notation
ip: is the Inflation Rate
n: is the Nominal Interest Rate
r: is the Real Interest Rate
To calculate the real interest rate, we need to know the inflation rate (or expected inflation rate, if
were making a prediction about the future). From the data given we dont have the inflation rate, but
we can calculate it from the CPI data:

Calculating the Inflation Rate

We need to use the following formula:
IP = [CPI (this year) CPI (last year)] / CPI (last year).
So the inflation rate in year 2 is [110 100]/100 = 0.10 = 10%. We do this for all three years and get
the following:

Inflation Rate Data

Year 1: --
Year 2: 10.0%
Year 3: 9.1%
Year 4: -4.2%

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Now we can calculate the real interest rate. The relationship between the inflation rate and the nominal
and real interest rates is given by the expression: (1+r) = (1+n) / (1+IP). This expression is called the
Fisher Equation. However for low levels of inflation we can use the much simpler approximate
equation to calculate the real interest rate: r = n ip

Fisher equation: (1+ n) = (1+ r) (1+ IP)

Approximate equation: n = r + ip

Using this simple formula, we can calculate the real interest rate for years 2 through 4:
Real Interest Rate (r = n i)
Year 1: --
Year 2: 15% - 10.0% = 5.0%
Year 3: 13% - 9.1% = 3.9%
Year 4: 8% - (-4.2%) = 12.2%

So the real interest rate is 5% in year 2, 3.9% in year 3, and a whopping 12.2% in year 4.

Question
Im offered the following deal:

I lend $200 to a friend at the beginning of year 2 and charge him the 15% nominal interest rate and he
pays me back the $230 at the end of year 2. If I agree to this deal will I be made better or worse off?

You wanted to know if you should lend $200 to your friend at the beginning of year 2. If you do make
that loan, you will earn a real interest rate of 5%. Since 5% of $200 is $10, you will be financially
ahead by making the deal. It doesnt necessarily mean that you should make the deal.

Which is more important to you?

Getting $200 worth of goods (at year 2 prices) at the beginning of year 2, OR
Getting $210 worth of goods (also at year 2 prices) at the beginning of year 3?

There is no right choice to this problem: it depends on how much you value consumption (or
happiness) today relative to consumption one year from now (Economists refer to this as a persons
discount factor).

If you know what the inflation rate is going to be, real interest rates can be a powerful tool in judging
the value of investment as they take into account how inflation erodes purchasing power.

Final Interest Rate Data

Year CPI Nominal Interest Rate Inflation Rate Real Interest Rate
1 100 -- -- --
2 110 15% 10% 5%
3 120 13% 9.1% 3.9%
4 115 8% -4.2% 12.2%

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Internal Rate of Return (IRR) calculation
IRR is the discount rate that will equates the present value of future cash flows with the initial
investment. IRR can be found through trial and error process. Then, it follows with approximation by
linear interpolation method.

Example:

Year 0 1 2 3 4
(3,000) 1,500 1,200 800 300

Step 1:
Lets assume discount rate (DR) = 10%. Discounting the CFs at 10%, will give an NPV of
NPV = 3,000 - [1,500(1.10)-1 + 1,200(1.10)-2 + 800(1.10)-3 + 300(1.10)-4]
= 161.33

Step 2:
Since NPV is positive, use a higher DR to find a -NPV. Lets try DR= 15%

NPV = 3,000 - [1,500(1.15)-1 + 1,200(1.15)-2 + 800(1.15)-3 + 300(1.15)-4]

= -90.74

Step 3: Linear interpolation

Now, there are two rates that yield a positive NPV and negative NPV. We now know that the DR (IRR)
lies between 10% and 15%. Following method can be used as interpolation to find IRR:

K (IRR) = kL+ ( kH kL) (NPVL)

(NPVL-NPVH)
Where:
kL = 10%
kH = 15%
NPVL = 161.33
NPVH = -90.74

k = 0.1 + (0.15 0.10) (161.33) = 0.1 + 8.0665 = 13.2%

(161.33 (-90.74)) 252.07

Alternative Equation:-

IRR = A + a x (B-A) where :A = Lower discount rate

(a b) B = Higher discount rate
a = NPV at the lower rate
b= NPV at the higher rate

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