Course is very foundational

Moving into new topics each week

Aware of the different facets of finance
Specialise in Fixed income, bank management etc in year 3 and 4.
Conceptual and analytical skills necessary to make sound financial decisions

Textbook: S.A. Ross, R.W. Westerfield, B.D. Jordan, J. Lim and R. Tan (2016), Fundamentals
of Corporate Finance, 2nd Asia Global Edition, McGraw-Hill Education.

A financial calculator is also necessary – Texas Instruments BAII Plus Financial Calculator is
recommended (Approved by CFA institute)

1. Class Participation - 25%

2. Mid-Term - 25%
3. Final Examination - 40%
4. Group Project - 10%

Lecture 1:
Education objectives:

1. What is Finance? Know the basic types of financial management decisions and the role
of the financial manager
2. Know the financial implications of the different forms of business organization
3. Know the goal of financial management
4. Understand the conflicts of interest that can arise between owners and managers
(agency relationships)
5. Understand the various types of financial markets

Groups of 3: Before Week 3, Email him the names

1 - 1.5 hours: Lecture

Break
Tutorial presentation

What is Finance?
Accurate assessment of value: What any asset is actually worth
Is the investment a good one to embark on: Project, Stock, Bond etc.

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E.g A company wants to replace its current production line with a line of new more expensive
and more efficient machines. Should the company buy the new machines or leave the old ones
in place?
E.g A company is trying to decide whether to develop a new product - how can it deal with the
fact that most of the development costs will be incurred before any sale revenues have been
realized?

E.g All businesses, from international conglomerates to small “hawker” shops, have to decide
how they’ll finance their operations. Will they borrow or will they bring in new
investors/shareholders?

Government project: High Speed Railway From Singapore to Kuala Lumpur

Financing as a complicated task

Significant investments in land, etc.
Land acquisition is a major issue
Many options of financing the project: Best way to raise the money needed
Mix of public or private funds (Involvement of private enterprises has many issues: They
must make a profit, risk allocation, viability of project)
Safest is to get both governments to pay for it (raise taxes and collect more funds)

Ensuring a revenue stream to ensure private enterprises will be interested in investing in the
project
Assess the value and figure out how to allocate resources to it

Cost estimate increased dramatically over time, you realize bit by bit some things you may have
missed out in terms of costs

Three main areas of Finance:

1. Investments (Lecture 6 & 7 Stocks and bonds, 8 & 9 Projects and company valuations)
2. Financial Markets and Intermediaries (Not covered in this course, very specialised topics:
Study of insurance and investment companies and banks)
3. Corporate Finance (or Business Finance) (Little bit in capital budgeting and net working
capital management 8, 9, 10)

Investments
1. The study of financial transactions from the perspective of investors (us) outside the firm
2. How to assess the risk and return characteristics of investments (L4&5)
3. What happens if you combine investments together? (Few people buy only one stock,
how to ensure you combine them correctly) (L4&5)

Financial Markets and Intermediaries

1. The study of markets where financial securities (such as stocks and bonds) are bought
and sold.

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 2. The study of financial institutions (such as commercial banks, investment banks, and
insurance companies) that facilitate the flow of money from savers to demanders of
money.

Corporate Finance:
Corporate Finance addresses the following:
1. What long-term investments should the firm take on? (capital budgeting decision)
a. How to budget capital, allocate the resources correctly?
b. What does the business want to do in the long-term?

2. Where will we get the long-term financing to pay for the investment? (capital structure
decision)
a. How are we going to get the money?

3. How will we manage the everyday financial activities of the firm? (working capital
management decision)
a. Need to be liquid to be able to pay short-term debts, and workers and taxes and
utility bills etc, everyday expenses
b. Many SMEs don’t survive because of this reason: Unable to manage cash flow
(L11)

There are many ways a company can raise capital: Selling bonds (debt) or sell stocks (equity)
Crowdsourcing is also another way.

Banks offer supply chain finance (L11) where many small shops don’t have much cash so this
scheme enables them to delay paying their bills. Helps them to sustain their business. Idea is to
remain liquid.

We want to understand how money is flowing in the system and how corporations make their
decisions…
2 models we can use:

1. Investment vehicle model

a. Understand groups of people: Investment vehicles
b. When we buy shares, we are providing firms financing, in exchange these firms
give us financial securities (Stocks for cash etc)
c. The firm invests these funds in assets and generate income which is then
distributed to the investors (i.e., the holders of the firm’s financial securities). Or
reinvested

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 2. The Balance Sheet model (AKA Accounting Model of the Firm)
a. Investment decisions are represented on the asset (i.e. left hand) side of the
balance sheet. (Answer the what question: What the firm has decided over the
years in terms of capital budgeting, what has changed? Whether the assets have
grown or not)
b. Financing decisions are represented on the liabilities and equity (i.e., right hand)
side of the balance sheet. (Where does the firm get their money from? If liabilities
and equity has grown as a whole, is it from debts or equity?)

The net working capital of the firm tells us the day-to-day activity management: What is the
policy for working capital? Does this firm always ensure that its current ratio is very healthy,
does it have a lot of current liabilities coming up?, etc. Understand the financial health, whether
the company has a very stable net working capital policy etc.

Goal of the firm is to increase the value of the pie (Balance sheet)
Structure of the firm: How you split the firm into debt and equity? And how this impacts the value
of the firm
Capital Structure (Financing Decision): The Capital Structure decision can be viewed as how
best to slice up the pie. This can take on an infinite range of possibilities.

The top financial manager within a firm is usually the Chief Financial Officer (CFO)
1. Treasurer: oversees cash management, credit management, capital expenditures and
financial planning
2. Controller: oversees taxes, cost accounting, financial accounting and data processing

Alternative Forms of Business Organization:

1. Sole proprietorship
a. Under this organization method, an individual owns and manages the business

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 Advantages
● Easiest to start (One person, no
negotiations necessary)
● Least regulated
● Single owner keeps all the profits
(losses)
● Taxed once as personal income
(depending on income you make,
it may be higher or lower than the
corporate tax, so may not be an
advantage)
Disadvantages
● Limited to life of owner
● Equity capital limited to owner’s
personal wealth
● Unlimited liability (Liquidate
personal property if unable to pay
back debtors)
● Difficult to sell ownership interest

2. Partnership
a. Under this organization method, a group of individuals collectively own and
manage the business.
b. A partnership has roughly the same advantages and disadvantages as a sole
proprietorship.

Advantages
● Two or more owners
● More capital available
● Relatively easy to start
● Income taxed once as personal
income
Disadvantages
● Unlimited liability
• General partnership (All partners as well
as managers, all have unlimited liability)
• Limited partnership (At least one partner
has limited liability, usually a company,
the others are running the partnership)
• Limited liability partnerships (All partners
have limited liability, law firms, dentists,
doctors, etc.)
● Partnership dissolves when one
partner dies or wishes to sell
● Difficult to transfer ownership

3. Corporation
a. Ownership and management are separated.
b. A corporation issues equity shares. The holders of these shares are the owners
of the firm. Although stockholders own the corporation, they do not necessarily
manage it. Instead, they vote to elect a Board of Directors (BOD). The BOD
represents the shareholders and in this vein, (i) selects the management team,
(ii) appoints the auditors and (iii) is responsible for checking/monitoring
management’s actions.
c. Debtholders are those who buy the bonds, but has no one to represent their
interests: so hold the management accountable. The bond is a legal contract,

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 coming with a indenture stipulating the terms of the contract. Hope to get interest
regularly and at the end the principal.
d. A corporation is created via Articles of Incorporation.
e. These:
i. Set out the purpose of the business.
ii. Establish the number of shares that can be issued.
iii. Set the number of directors to be appointed.

Advantages
● Limited liability
● Unlimited life
● Separation of ownership and
management (may be a
disadvantage, with more people
there is more possibilities of
conflict, different views of what is
good for the firm)
● Transfer of ownership is easy
● Easier to raise capital
Disadvantages
● Separation of ownership and
management (and the resulting
potential for agency costs)
● Double taxation (income taxed at
the corporate rate and then
dividends taxed at personal rate)*
* Not for Singapore

Private Companies – firm’s shares are usually closely held, i.e., ownership is closely
held by a relatively small number of shareholders and shareholders often include the
companies’ original founders, some financial backers (e.g., venture capitalists) and
others. Shares are not traded on any exchange.

Public Companies – firm’s shares are listed on a stock exchange, whereby the
company’s shares are widely dispersed and traded in the secondary markets.

Two main sources of External Financing:

1. Debt: (More about bonds in L6) A debt contract is a legally binding agreement. It
specifies principal, interest, maturity date and specific protective covenants.
a. Even though returns tend to be lower than buying stocks, however it’s
deemed less risky than buying stocks. In case of bankruptcy, debt holders
collect before equity holders. However, different debt holders have
different priority claim to the cash flows and assets of a bankrupt firm,
according to their respective debt contracts. Government -> Banks ->
Debt holders -> Shareholders

2. Shares:
a. Shareholders are the residual claimants of the firm.
b. Shareholders’ Payoffs – shareholders receive monetary returns in the
following ways:

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 i. Dividend per share, paid to investors from the corporation’s after
tax dollars.
ii. Capital gain from the sale of shares (ownership rights) at a price
higher than they were purchased for.

In Finance, the goal is to maximize the owner’s wealth. Maximizing the share price of the firm.
By maximizing the share price:
– Maximize the value of the firm
– Maximize the wealth of its owners
– Maximize the price of its stock
– Maximize its contribution to the economy

What determines stock prices?

The share price is a reflection of the underlying firm’s ability to generate cash flows.
So if a firm can generate more cash, it will translate to a higher share price.
What affects this cash then?
● Amount of cash flows expected by shareholders (How much cash it generates)
● Timing of the cash flow stream (How fast it can generate cash)
● Riskiness of the cash flow stream (Chance of success in the projects it is involved in)
⇒ All three determine the stock’s Intrinsic Value* *Your text refers to this as “Market Value”

Intrinsic value of stock Market value of stock

○ The intrinsic value is an estimate of a
stock’s “true” value based on accurate
risk and return data, factoring the
amount, timing and risk of cash flows
○ An “estimated” value, not a precise
objectively known measure
○ The market price is based on
perceived information as seen by the
marginal investor (can be theoretically
incorrect)

If we believe that the market is efficient and is able to process all information immediately, than
the market price and intrinsic price value will be the same (True most of the time)

Corporation separates owners from managers. Shareholders known as principals and

managers seen as agents. Principal hires an agent to represent their interest. Thus, there is an
agency relationship.
Agency problem
– Conflict of interest between principal and agent (may not act in the interest of principals)
Corporate Organization Potential Conflict of Interests:
– Shareholders and managers (conflicts of interest)
– Shareholders and creditors (conflicts of interest)

How do we manage these agency problems? How do owners ensure that managers act in their
own interests? Spend a bit of money to ensure they are paid well etc.

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Agency Costs
Direct agency costs
○ Expenditures that benefit management: car and accommodation, big office, high pay
(carrots)
○ Monitoring costs: hire auditors, audit committee, corporate governance (Sticks)
Indirect agency costs
○ lost opportunities which would increase firm value in the long run, if accepted
(Disagreements which lead to prolonged meetings which may mean lost opportunities)

But the following factors affect managerial behavior:

– Compensation plans tied to share value
– Direct intervention by shareholders
– The threat of firing
– The threat of takeover

How To Handle The Agency Problem?

1. Compensation plans that tie the fortunes of the managers to the fortunes of the firm
2. Monitoring by lenders, stock market analysts and investors
3. The threat that poorly performing managers will be fired
4. The growing awareness of the importance of good Corporate Governance

What is corporate governance?

It refers broadly to the rules, processes, or laws by which businesses are operated, regulated,
and controlled. Structure, levels of standards, SOP etc.
One of the standards of corporate governance is to ensure that there is independence between
the board and the management.

What are financial markets (not covered in this course in detail)?

○ markets where “financial instruments” are traded
○ act as intermediaries between savers and borrowers
○ Money Markets (Instruments of less than one year of maturity are traded) usually carried
out by dealers vs Capital Markets (Instruments of more than one year of maturity are
traded) more auction based, no dealer, just go to brokerage and place offers.
○ Primary Market (First introduction of stocks to the public space, security comes directly
from the issuer) vs Secondary Market (Public selling stocks subsequently to others)

Lecture 2:
Capitalized expenses and expenses are very different. Expenses must be recognized within
which you spent the money. Capitalized expenses are depreciated over a useful life.
Capitalizing expenses instead of treating them like expenses inflates assets, deeming

8
everything you buy an asset. Expenses are also under-reported because only a portion is
recorded as expenses.

Educational Objectives
1. Explain and list the type of information found in an annual report, including the four basic
financial statements
2. Know how to compute and interpret important financial ratios
3. Be able to compute and interpret the Du Pont Identity

The Annual Report

1. Balance sheet – provides a snapshot of a firm’s financial position at one point in time.
2. Income statement – summarizes a firm’s revenues and expenses over a given period of
time.
3. Statement of retained earnings – shows how much of the firm’s earnings were retained,
rather than paid out as dividends.
4. Statement of cash flows – reports the impact of a firm’s activities on cash flows over a
given period of time.

Balance Sheet Characteristics:

ASSETS = LIABILITIES + EQUITY
Order of Listing – Highest to Lowest Liquidity, Cash at the top, Fixed assets at the bottom
Valuing of Items - Generally at original cost (also known as Historical Cost)
• Exceptions: Marketable Securities and Inventories (Can be revalued)

Book Values and Market Values

1. Book Values (historical costs less accumulated depreciation) are determined by GAAP
(Generally Accepted Accounting Principles)
2. Market Values are determined by current trading values in the market
Market Value of Shareholders’ Equity = “Market Capitalization” = Share Price x Number of
Outstanding Shares

EXAMPLE: Market Value vs Book Value

According to GAAP, your firm has equity worth $6 billion, debt worth $4 billion, assets worth $10
billion. The market values your firm’s 100 million shares at $75 per share and the debt at $4
billion. What is the market value of your assets?
Assets = $11.5 bil = (Debt = $4 bil + Equity = $7.5 bil)
Enterprise Value:
The enterprise value of a firm assesses the value of the underlying business assets (however
financed), and separate from the value of any non-operating cash (i.e., “excess cash”) and
marketable securities that the firm may have. Excess cash is cash the firm doesn’t need for
operations. In theory, the cost of a company if someone were to acquire it.
○ Enterprise Value = Market Value of Equity + Debt – Cash
Sometimes, unable to get market value of debt, that means debt must be trading on the market,
bonds. So use the book value of debt. Similarly for cash, should be excess cash, but sometimes

9
it’s difficult to separate operating and non-operating cash unless you have inside knowledge. So
to simplify things, subtract all cash. When you buy over the firm, you have to pay the
shareholders and the debtholders. Cash is cash so essentially cancels each other.

Example: Computing Enterprise Value

Problem: In October 2007, H.J. Heinz Co. (HNZ) had a share price of $46.78, 319.1 million
shares outstanding, a market-to-book equity ratio of 8.00, a book debt-equity ratio of 2.62, and
cash of $576 million. What was Heinz’s market capitalization? What was its enterprise value?

Share Price $46.78

Shares outstanding 319.1 million

Market-to-book 8.00

Cash $576 million

Debt-to-equity (book) 2.62

Market capitalization = $46.78 × 319.1 million = 14,927,498,000

Book value of equity = 14,927,498,000 ÷ 8 = 1,865,937,250
Book value of debt = 1,865,937,250 × 2.62 = 4,888,755,595
Enterprise value = 14,927,498,000 + 4,888,755,595 - 576,000,000 = 19,240,253,600

Basic Stock Concepts

Profits vs. Cash Flows

Differences
1. “Profits” = net income - depreciation (a non-cash expense: didn’t spend cash on it)
a. Profits understates amount of cash

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 2. “Profits” ignore cash expenditures on new fixed assets (the expense is capitalized)
a. Depreciation expense over time is recorded year by year
3. “Profits” record income and expenses at the time of sales, not when the cash exchanges
actually occur
a. Can record a sale but have not collected it, etc.
4. “Profits” do not consider changes in working capital

Sources and Uses of Cash:

Sources of cash (activities that bring in cash):
1. decreases in assets (other than cash)
2. increases in equity and liabilities.
Uses of cash (activities that involve cash outflows):
1. increases in assets (other than cash)
2. decreases in equity & liabilities.

Statement of Cash Flows

Changes divided into 3 major categories:
1. Operating Activities– includes net income and changes in most current accounts (A/P
A/R Inv)
2. Investment Activities – includes changes in fixed assets
3. Financing Activities – includes changes in notes payable, long-term debt and equity
accounts as well as dividends

Understanding the statement of Cash flows

Assets = Liabilities + Equity
(Current assets + net fixed assets) = (current liabilities + long-term debt) + common stock +
retained earnings
Bring current liabilities over:
Net working capital + net fixed assets = long-term debt + common stock + retained
earnings
Break up NWC: Net working capital = Cash + Other CA – CL
Break up CL: CL = non-interest bearing CL + interest-bearing CL
Move everything except cash to the right:
ΔCash = Δretained earnings + Δcurrent liabilities – Δcurrent assets other than cash – Δnet fixed
assets + Δ long-term debt + Δ common stock
Positive sign: Source of cash, Negative sign: Use of cash

Statement of Retained Earnings:

Retained Earnings, beginning of year
Add: Net Income
Less: Dividends
Retained Earnings, end of year

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Dividend Payout Ratio = Dividends / Net income (How much the firm pays out in dividends is
determined by this ratio)

Book value vs Market value

Book value is objective, what was paid for something, historical cost.
Market value is more relevant, updated according to the changes in the economy and changes
to the worth of the asset when demand and supply changes.

Cash flow from assets or Free Cash flow:

1. Cash Flow From Assets (CFFA) = Operating Cash Flow (OCF) – Net Capital Spending
(NCS) – Changes in NOWC (Net Operating Working Capital)
a. NOWC includes Operating cash, Inventory, Accounts Receivables etc. ,
Accounts payable
b. Interest bearing liabilities such as Notes payable, Short-term debt not considered
operating, but financing activities. Thus these are excluded from NOWC.
2. Cash Flow From Assets (CFFA) + Interest Tax Shield = Cash Flow to Creditors + Cash
Flow to Stockholders
a. Interest tax shield is the savings on taxes that you get because of interest
payments. Stripped out from Cash flow from Assets.
b. Get interest expense because you have chosen to take on interest bearing debt
which is a financing decision, this benefit you get of paying less taxes is as a
result of financing decision. Savings on cash was not because of an operating
activity so we take it out.
Example:

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Cash flow from assets = OCF - NCS - Changes in NOWC
OCF = EBIT*(1-Tax Rate) + Depreciation
= 694 (1-34%) + 65 = 523 million (Won’t be the same as that shown in the statement of
cash flow under operating activities)
(What you spend on fixed assets) NCS
= Ending Net Fixed Assets – Beg. Net Fixed Assets + Depreciation

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= 1709 – 1644 + 65 = $130

Depreciation expense for the year will go to accumulated depreciation and reduce the book cost
of the ending fixed asset. So depreciation expense needs to be added back.

Changes in NOWC (Operating CA - Operating CL)

= Ending NOWC – Beginning NOWC
= (160 + 688 + 555 – 266) - (104 + 455 +553 - 232) = $257

CFFA = 523 – 130 – 257 = $136

Interest tax shield = Interest * Tax rate = $70 * 34% = $70 * 0.34 = $24

Cash flow to creditor (Any interest bearing liability is considered a borrowing)

= interest paid – net new borrowing (LT Debt and Notes Payable)
= $70 – [(123+454) – (196+408)] = $70 – (-$27) = $97

Cash Flow to Stockholders (Do not include change in retained earnings)

= dividends paid – net new equity raised
= $103 – ($640 - $600) = $63

Cash flow to Creditors and Stockholders

= $97 + $63 = $160
= CFFA + Interest Tax Shield = $136 + $24 = $160

Standardized Financial Statements

Standardized statements make it easier to compare financial information, particularly as the
company grows. They are also useful for comparing companies of different sizes, particularly
within the same industry:
1. Common-Size Balance Sheets
a. Compute all accounts as a percent of total assets
2. Common-Size Income Statements
a. Compute all line items as a percent of sales
3. Common-Base Year Statements
a. Compute all line items as a percent of base year
4. Combined Common-Size and Base Year Assets
a. Firm grows significantly in the year, just divide year to year, won’t be useful
because everything improved dramatically, so instead of using the raw numbers,
use the percentages (of composition).

Ratio Analysis:
Ratios are not very helpful by themselves; they need to be compared to something:
1. Time-Trend Analysis (over time)

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 a. Used to see how the firm’s performance is changing through time
2. Peer Group Analysis (with others)
a. Compare to similar companies or within industries

The 5 Major Categories of Ratios

1. Liquidity ratios (Short-Term Solvency) measure the firm’s ability to pay bills in the short
run.
a. Can we make required payments as they fall due?
2. Long-Term Solvency (Financial Leverage) ratios show how heavily the company is in
debt.
a. Do we have the right mix of debt and equity?
3. Asset management (Turnover / Efficiency) ratios measure how productively the firm is
using its assets
a. Do we have the right amount of assets for the level of sales? Are they collecting
receivables fast enough?
4. Profitability ratios measure the firm’s return on its investments:
a. Do sales prices exceed unit costs, and are sales high enough as reflected in PM,
ROE, and ROA?
5. Market value ratios provides indications on the firm’s prospects and how the market
values the firm:
a. Do investors like what they see as reflected in Price-Earning (P/E) and Market-to-
Book (M/B) ratios?
b. Higher the better, other investors are positive about the firm

Liquidity ratios:
Liquidity is the ability to convert assets to cash quickly without a significant loss in value.
Liquidity Ratios indicate a firm’s ability to meet its maturing short term obligations. Government
bonds are considered liquid assets. Too high a liquidity ratio compared to competitors, is a
potential indication that the firm has run out of ideas, the cash generated is not redeployed, so it
hoards cash. If the firm is not using its cash well, it won’t be maximising the stock price because
cash earns nothing. Instead, redeploying this cash into something productive like R&D will allow
the stock price to increase. High liquidity ratios also mean the enterprise value of a firm will be
very low since you take away the cash. Thus, it would be a good target for takeovers.

Current ratio = Current assets / Current liabilities (units times)

Quick Ratio = (CA – Inventory) / CL (units times)
Cash Ratio = Cash / CL
NWC to Total Assets = NWC / TA
Interval Measure = CA / average daily operating costs

Long-term solvency ratios:

Financial leverage relates to the extent that a firm relies on debt financing rather than equity.
Total Debt Ratio = Total Debt / Total Assets
Debt/Equity Ratio = (total assets – total equity) / total equity

15
Equity Multiplier = total assets/total equity
= 1 + debt/equity ratio
Long-Term Debt Ratio = long-term debt / (long-term debt + total equity)

COVERAGE RATIOS: how much of your earnings can cover interest expense
Times Interest Earned Ratio = EBIT / interest
Cash Coverage Ratio = (EBIT + depreciation) / interest

Asset Management Ratios

Or activity ratios, measure how effectively the firm’s assets are being managed:
1. Inventory ratios measure how quickly inventory is produced and sold
2. Receivable ratios provide information on the success of the firm in managing its
collection from credit customers
3. Fixed asset and total asset turnover ratios show how effective the firm is in using its
assets to generate sales

Inventory Turnover = COGS / Inventory (Higher the better)

Days’ Sales in Inventory = 365 / Inventory Turnover (Lower the better)

Rec. turnover = Sales / Receivables

Days Sales Outstanding or Account Receivable Days or Average Collection Period = The
average number of days after making a sale before receiving cash, DSO = Account Receivable
/ Average Daily Sales = 365 / Receivables Turnover

FA Turnover = Sales / Net fixed assets

TA Turnover = Sales / Total assets

Profitability ratio
Measure how successfully a business earns a return on its investment. Show the combined
effects of liquidity, asset management, and debts on operating results.
Profit margin = Net income / Sales
BEP (Basic Earning Power) = EBIT/Total assets (Higher the better)
ROA = Net income / Total assets
ROE = Net income* / Total common equity
*If there is preferred dividend, you should deduct it from net income

Effects of Debt on ROA and ROE

ROA is lowered by debt - interest expense increases with more debt which lowers net income,
hence lowering ROA.
Say you keep total assets unchanged, but only change the capital structure such that there is
more debt than equity. Interest expense increases and so net income decreases. However, the
use of debt lowers equity, and if equity is lowered more than net income, ROE would increase.
Normally, since interest rates are very low, ROE tends to increase because net income
decreases by a small amount (due to interest expense increase), but the total equity falls by a

16
very large amount. Can’t really tell what happens to ROE if you take on more debt, could be
either way.

Market value ratio:

1. P/E: How much investors are willing to pay for $1 of earnings.
2. M/B: How much investors are willing to pay for $1 of book value equity.
For each ratio, the higher the number, the better but if too high, it may reflect a bubble that is
unstable.

P/E = Price / Earnings per share

M/B = Mkt price per share / Book value per share

The Dupont System

Breaking down the ROE into more details:
ROE = NI / TE
Multiply by TA/TA
ROE = (NI / TA) (TA / TE) = ROA * EM (Leverage ratio)
Multiply by (Sales/Sales)
ROE = (NI / Sales) (Sales / TA) (TA / TE)
ROE = PM * TA TO * EM

The Three Ratios of the Dupont Identity

1. Profitability ratio: Profit margin (PM) is a measure of the firm’s operating efficiency – how
well does it control costs
2. Management ratio: Total asset turnover (TA TO) is a measure of the firm’s asset use
efficiency – how well does it manage its assets
3. Long-term solvency ratio/ Leverage ratio: Equity multiplier (EM) is a measure of the
firm’s financial leverage

Limitations of ratios:
1. Can’t find a good peer group
2. Seasonality issues (during celebration times it will look better)
3. Different accounting and operating practices can distort comparisons
4. Window dressing techniques can make statements and ratios look better.
5. Ratios may be very good but what if the firm is dependent on merely 2 buyers (risky)

Lecture 3: Time value of money

In Finance, cash is king. Three main factors that affect the cash flow: Amount, timing, and risk.
Time value of money is all about timing. When we have two different cash flows at different
times, how do we assess them and make comparisons.

17
It’s difficult if we just leave it at different times. It’s hard to say which is better: $100 in 1 years
time or $200 in 3 years time. The idea is that we want to move these cash flows to a common
time so that we can then objectively compare. First thing to note is that $1 today is worth more
than $1 tomorrow. We’d prefer having the former than the latter.

Today:
Going to learn how to calculate future values which is basically moving a cash flow from today
into the future. If you’re given $100 today, what would it be worth in 5 years time.

Then we’ll also learn how to calculate the present value which is basically moving a cash flow
from the future into the present. That is, if you’re given $500 in 5 years time, what would it be
worth today. We’ll use timelines to represent these problems. Finally we’ll introduce the
amortized loan schedule.

Why is $1 today preferred to $1 tomorrow?

– lost earnings: can invest the money to earn interest
If given the $1 today, you could do something with it, perhaps put it into investments, or
bank deposit etc. so it would generate earnings
– loss of purchasing power: because of the presence of inflation
The same $1 could buy less products in the future because the products become more
expensive
– trade-off depends on the rate of return
Removal of risk, who knows what is going to happen from now to the future. If you wait,
you may not get it.

The banks realize that there is opportunity cost when they take money away from you, owing to
the above reasons, so in exchange for taking your money, they would give us an interest. This
is to compensate you for the opportunity cost, the longer you put the money in the bank for, the
higher the interest in general.

But what if the interest rates are negative? Swiss Francs and you put in in Julius Baer Account.
In other words, instead of getting interest from the banks for every dollar you deposit, you’d be
paying the bank interest. Instead of having earnings, you have a loss in a sense when you put it
in the bank.

In some countries, for example Denmark, if you borrow money from the bank, instead of paying
interest on the loan to the bank, the bank pays you. This is because rates are negative so the
interest on the loan is also negative.

If there are negative interest rates, then it would convulate the statement that $1 today is
preferred over $1 tomorrow. Utility, Inflation and Removal of risk however remains as important
factors.

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Timelines:
Every mark made on the line represents the end of the period. The end of the period is also the
beginning of the next period.

Present Value (PV)

the value of something today. On a timeline t = 0. Present Value is also referred to as the
market value of a cash flow to be received in the future. Translating a value that comes at some
point in the future to its value in the present is referred to as discounting.

Future Value (FV)

the value of a cash flow sometime in the future. On a timeline t > 0. Translating a value to the
future is referred to as compounding.

Annuity
A regular stream of cash flows. There are three conditions that define an annuity:
1. Cash flow must be a regular amount, same all the time
2. Occur at regular intervals, every month, year etc
3. Must have a maturity date, stop at some point of time
There are two types of annuities.

Ordinary annuity (Default, annuity)

Cash flows are received or paid at the end of the period. E.g at the end of year 1, 2, or 3 etc.
Examples: Bond coupons, the interest on the bond paid back regularly to bondholders)

Annuity due
Cash flow is received at the beginning of the period, for instance if you pay something regularly
at the start of each month, that’s an annuity due. Examples: Insurance policy premiums paid per
month must be an annuity due because insurance companies are not going to insure you if you
haven’t paid them, Magazine subscriptions, Rental payments.)
Perpetuity
Cash flows that go on forever. Set of equal payments that are paid forever.

Growing perpetuities
Cash flow grows at a constant rate each period. $100, $110, growth rate of 10% and goes on
forever at regular intervals.

Growing annuities
??

19
If the cash flows fit any of these descriptions then we use the given formulas to find the present
and future values. If they don’t fit, then we’d have to do it manually.

Principal
When you borrow money, the original amount borrowed.

Interest
the compensation for the opportunity cost of funds and the uncertainty of repayment of the
amount borrowed. Sometimes, referred to as:
Ø Discount rate
Ø Cost of capital
Ø Opportunity cost of capital
Ø Required return

Example of drawing a timeline

Positive cash flows refer to inflows and negative ones refer to outflows.

Calculating future value

Depends on whether you have simple interest or compound interest.
Simple Interest:
Interest earned only on the original investment.
Compound Interest:
In addition to interest earned on the original investment, interest is also earned on interest
previously received (on the original investment).

Simple Interest example

Today you deposit $100 into a fixed deposit account paying 5% simple interest. How much
should you have in 5 years?
Solution: $100 (Principal) + 5 years * 100(5%) (Interest earned per year, $5) = $125
This is linear growth because you’re adding the same amount each year.

20
Compound interest example
Suppose now you deposit your $100 into a Savings Deposit where interest is earned at 5% on
the previous year’s balance: Interest Earned Per Year =Prior Year Balance x 5%
After 1 year: FV1 = PV + INT1 = PV + PV (i)
= PV(1 + i) = $100(1.05)
= $105.00
After 2 years: FV2 = PV(1 + i)2 = PV(1 + 2i + i * i)
= PV(Principal + 2 years of Simple Interest + Interest on Interest)
= $100(1.05)2 = $110.25
In General, FVn = PV(1 + i)n

The difference in the amount we get from compound interest compared to simple interest grows
the more years pass. The growth is no longer linear for compound interest.

If the principal amount is large, then the difference between compound interest and simple
interest will be larger. Or when the interest rate is larger.

Calculator:
To go to home screen, use the quit function. Time value of money factor buttons are those in
white. N: Number of periods, I/Y: interest rate per year, PV: Present value, PMT: Annuity
payments, FV: Future value.
Defaults to start with: Default the periods per year to 1. P/Y above I/Y should be 1.
Leave all final answers to 3 decimal places. Change decimal places go to format on the decimal
point, then enter the number of decimal places needed and enter. To clear the inputs for time
value of money, CLR TVM. Others CLR WORK. You have to be in the Time value of money
function to clear it.

Another compounding example

Suppose one of your ancestors deposited $10 at 5.5% interest 200 years ago. How much would
the investment be worth today? FV = 10(1.055)200 = 447,189.84
In the calculator, press the number before N etc. The calculator receives the interest rates in
percent form so you don’t have to change anything. Negative values of PV mean outflow, you
give it to the bank. Clear TVM before trying again. Simple interest = 10 + 200(10)(.055) =
120.00
Future value interest factor
( F V I F ) = (1 + r)t

Another compounding example 1

Suppose your company expects to increase unit sales by 15% per year for the next 5 years. If
you currently sell 3 million cars in one year, how many cars do you expect to sell in 5 years?
§ FV = 3,000,000(1.15)5 = 6,034,072
The calculator is programmed such that if you key in a positive PV, you’d get a negative FV and
vice versa. Positive FV gives a negative PV. Negative PV is like putting an investment today, so

21
you expect a positive FV. If you borrow money today, positive PV, you must pay it back in future
so negative FV.

If you don’t have a calculator, you can use a future value interest factor table which gives the
FVIF for various years and interest rates, then you can just multiply that to the PV to get the FV.

Limitation of the table is that it only provides whole number interest rates and whole number of
periods.

Quick review
What is the difference between simple and compound interest? Suppose you have $500 to
invest and you believe that you can earn 8% per year over the next 15 years. How much would
you have at the end of 15 years:

Using simple interest?

$500 + 15($500)(.08) = $1,100.00
Using compound interest?
$500(1.08)15 = $500(3.172169) = $1,586.08

Present value
PV = FV / (1 + r)n
= FV (1 / 1+i)n
(1 / 1+i)n : PV interest factor

Present value one period example

Suppose you need $10,000 in one year for the down payment on a new car. If you can earn 7%
annually, how much do you need to invest today?
PV = 10,000 / (1.07)1 = 9,345.79

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Present value example 2
You want to begin saving for your daughter’s university education and you estimate that she will
need $150,000 in 17 years. If you feel confident that you can earn 8% per year, how much do
you need to invest today?
PV = 150,000 / (1.08)17 = 40,540.34

Present value example 3

Your parents set up a trust fund for you 10 years ago that is now worth $19,671.51. If the fund
earnt 7% per year, how much did your parents invest?
PV = 19,671.51 / (1.07)10 = 10,000

Quick review 2
What is the relationship between present value and future value? Suppose you need $15,000 in
3 years. If you can earn 6% annually, how much do you need to invest today?
PV = $15,000 / (1.06)3 = $15,000(.8396) = $12,594.29
If you could invest the money at 8%, would you have to invest more or less than if you invested
it at 6%? By how much?
PV = $15,000 / (1.08)3 = $15,000(.7938) = $11,907.48
Difference = $12,594.29 - $11,907.48 = $686.81

One cash flow to another is pretty boring so what about multiple cash flows!

Multiple cash flows example

Suppose you plan to deposit $100 into an account in one year’s time and $300 into the account
in three years from now. How much will be in the account in five years if the interest rate is 8%?

FV = $100(1.08)4 + $300(1.08)2 = $136.05 + $349.92 = $485.97

Using the calculator, you can treat them as 2 separate cash flows and then compute their FV
and add them together. To get negative numbers press the +|-
Example Multiple cash flows

What is the PV of the entire cash

flow?
Year 1 CF: 200 / (1.12)1 = 178.57
Year 2 CF: 400 / (1.12)2 = 318.88
Year 3 CF: 600 / (1.12)3 = 427.07
Year 4 CF: 800 / (1.12)4 = 508.41
1432.93 = PV
How do you solve it using the calculator?

23
To find PV of cash flow streams, we use the cash flow function, CF. CF0 = 0 in this case. Press
down arrow. C01 = 200 then enter. Frequency = 1, drawing the timeline into the calculator. After
keying in all the cash flows, to find the present value, you press NPV. Type in the interest rate
and enter then press down arrow. Press compute.

If the cash flows were 200, 400, 200, 400, the frequency will still be 1 each. F can only be used
if it’s sequential. If the cash flow is 200, 200, 200, 400, then C01 =200, F01 = 3, C02 =400, F02 =1.

The limitation of the calculator is that it can only calculate PV of cash flow streams and can’t
calculate FV of them.

Example of FV for multiple cash flows

Before you begin, clear the memory under the cash flow function. When you’re in the CF
function, press CEC CLR work. Split this problem into two. First find the present value. Then
find the future value of that PV.

CF0 = 0, C01 =100, F01=1, C02=0, F02=1, C03 =300, F03=1

Press NPV, enter interest, down arrow and compute.
The PV of these two cash flows is 330.7422649
You want to find the FV of this. You can copy down the value, quit and go to time value of
money. Alternatively, you can transfer this value into the PV in the calculator directly. Just press
PV, whatever is shown on the screen is registered as that input. Quit. If after you quit, you press
PV to check it’s correct, the value will be overridden with 0 because that’s what was on the
screen. So don’t press PV again.

Difference between annuity due and annuity

For ordinary annuity, you get cash flow at the end of the period, but for annuity due you get it a
period earlier in the beginning of the period. So annuity due should be worth more than an
annuity right? Because $1 today is worth more than tomorrow. The difference is an extra period
of compounding. One extra period of interest earnt for every cash flow.

PV of an ordinary annuity
What’s the PV of a 3-year
ordinary annuity of $100 at
10%?

Alternatively the cash flow

function can be used to find
NPV.

24
The fastest way would be input PMT as 100, N=3, I=10, compute PV

Formula for PV of Annuity and Annuity due

Formula for FV of annuity and annuity due

Regardless of FV or PV, annuity due is always more than annuity by (1+r) because you get the
payment a period earlier.

FV of an ordinary annuity example

10 year annuity means that you’re going to get payments at the end of every year for 10 years.
Interest is 6%.

25
In the calculator, can just use the TVM functions, type in 100 for annuity payments, PMT, N, I/Y
and then compute FV.

FV of an annuity due example

Still only have 10 cash flows, so you can’t change n to n+1. The calculator is defaulted to
receive end of period cash flows. So we need to change the default to calculate annuities due.
Press 2nd PMT, END tells you it’s receiving end of period cash flows. To change it press 2nd
enter and it will show BGN. BGN will be shown.
Annuity- Lottery example
Suppose you win a $10 million lottery prize. The money is paid in equal annual end-of-year
installments of $333,333.33 over 30 years. If the appropriate discount rate is 5%, how
much is the sweepstakes actually worth today?
PV = $333,333.33[1 – 1/1.0530] / .05 = $5,124,150.29

Perpetuities

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Can’t key in the calculator infinity. Have to use formulae.
PV of perpetuities = C / r

Growing perpetuities
A set of payments that grow at a constant rate forever.
PV = C1 / r - g
C2 = C1 ×(1+ g) & C3 = C2 ×(1+ g) = C1 ×(1+ g)2
g :growth rate of the cash flows

What is the FV of perpetuity?

Infinity.

PV of growing annuities
A growing annuity is a set of payments which grow at a constant rate, g, up to a certain maturity
date. If the first payment is $C1, then the present value of the growing annuity is:

FV of growing annuity
If the first payment is $C1, then the future value of the growing annuity is:

Very important: We need to know how to distinguish between two types of interest rates: the
annual percentage rate and the effective annual rate (EAR)

Annual percentage rate

Rate quoted by law. Whatever rate the bank tells you when you open an account etc. Not
necessarily what you may end up actually earning or paying. It’s just what is communicated to
you.
E.g Credit card may have 24% per annum interest rate but there is actually compounding taking
place each month. Number of periods per year is 12 because frequency of compounding is

27
monthly. The APR is 24%. Period rate = APR / number of periods per year = 2%. Instead of
being charged 24% per year, you’re charged 2% per month. For all time value of money
problems, we have to reduce problems to period rates.

Example
You put in $10 every month, the account earns you 10%, compounded monthly. How much
would you have after 3 years? What’s the period rate? 10% / 12. 10% in the question is the
annual percentage rate. Almost always, annual percentage rate is given unless specifically told
otherwise. If we have the word earns you ___ “effectively” means it is the effective rate not the
annual rate but this is rare. So always remember to divide the APR by the number of periods to
get the period rate.

Computing APRs
What is the APR if the monthly rate is 0.5%?
⇒ 0.5% * (12) = 6%
What is the APR if the semiannual rate is 4%?
⇒ 4% * (2) = 8%
What is the monthly rate if the APR (based on the monthly rate) is 12%?
⇒ 12% / 12 = 1%

When we try to find period rates, we’re actually trying to match the interest rate to the cash flow
frequency.

Effective annual rate (EAR)

The real rate that you’ll have to pay or earn, owing to the fact that within the year there can be
compounding. If there is compounding within the year, then the APR will not be the same as the
EAR. If there is compounding within the year, then the EAR must be higher than the APR.

Example: How do we find EAR for a nominal rate of 10%, compounded semiannually?

28
Example: Credit card
The credit card APR=24%, n=12, so what is the effective annual rate of the credit card?
EAR = [1+ (0.24/12)]12 - 1 = 0.268 = 26.8%. The credit card debt is not 24% effectively even
though that is communicated to you. Actually, you end up paying 26.8% effectively simply
because of compounding within the year.

The more frequently you compound, the higher is the interest rate.

Example: Computing EAR

Example: Comparing Savings accounts

You are looking at two savings accounts. One pays 5.25%, with daily compounding. The other
pays 5.3% with semiannual compounding. Which account should you use?
- First account:
Ø EAR = (1 + .0525/365)365 – 1 = 5.39%
- Second account:
Ø EAR = (1 + .053/2)2 – 1 = 5.37%
Go with the 5.39% Savings account, you want higher interest. Don’t just look at the headline
rate (APR), find the effective annual rate.
Implied discount rate
FV = PV(1 + i)n

29
§ i = (FV / PV)1/n – 1

Example: Implied Discount Rate

You are looking at an investment that will pay $1200 in 5 years if you invest $1000 today. What
is the implied rate of interest?
§ r = (1200 / 1000)1/5 – 1 = 0.03714 = 3.714%
With a Calculator – the sign convention matters! N = 5,PV = -1000 (you pay 1000 today), FV =
1200 (you receive 1200 in 5 years), Compute I/Y = 3.714%
When you are inputting PV and FV, then they must be of opposite signs if not there’ll be an
error.

Finding n, the number of periods

FV = PV(1 + r)t
§ ln FV = ln PV(1+r)t = ln PV + ln (1+r)t
§ ln FV – ln PV = t * ln (1+r)
§ t = ln(FV / PV) / ln(1 + r)

Example: Number of periods

Suppose you want to buy a new house. You currently have $15,000. To buy the house you
need to have a 10% down payment plus an additional 5% in closing costs.* If the type of house
you want costs about $150,000 and you can earn 7.5% per year, how long will it be before you
have enough money for the down payment and closing costs? *Note: closing costs are only paid
on the loan amount, not on the total amount paid for the house.
How much do you need to have in the future?
Down payment = 0.1(150,000) = 15,000
Closing costs = 0.05(150,000 – 15,000) = 6,750
Total needed = 15,000 + 6,750 = 21,750

Using the formula

Ø t = ln(21,750 / 15,000) / ln(1.075) = 5.14 years

Amortized loan
The most common type of loan. Usually when you borrow is an amortized loan. Every payment
or installment you make is the same amount. Every payment made is split into interest and
principal paid in different ways. In the first payment, you pay the most towards the interest and
the remaining towards paying the principal. Following the first payment, then the payment
towards interest gets less and less while the payment towards the principal becomes more and
more.

30
Amortized loan example
Consider a 4 year loan with annual payments. The interest rate is 8% and the principal amount
is $5000. What is the equal sum paid each year? Work out the annuity payment of the loan.
PV of the loan: $5000, N:4, I/Y:8, compute PMT: -1509.60

Need to know how to construct an amortization schedule or payment schedule.

Year Beginning Total Interest Principal Ending

Balance Payment Paid (interest Paid Balance
rate *
beg.bal)

1 5,000.00 1,509.60 400.00 1,109.60 3,890.40

2 3,890.40 1,509.60 311.23 1,198.37 2,692.03

3 2,692.03 1,509.60 215.36 1,294.24 1,397.79

4 1,397.79 1,509.60 111.82 1,397.78 0.01

Totals 6,038.40 1,038.41 4,999.99

Suppose there is a bank loan for 30 years and the interest rate is 1.2% each year. The principal
amount is 1,000,000.

31
 To find the interest paid monthly
for year 1, you take the 1.2%
annual rate and divide it by 12 to
give 0.1%. Then multiply that
with the principal of 1 million to
get $1,000.

In the calculator, PV=1 million,

N= 30*12 = 360 periods,
I/Y=period rate = 0.1
PMT = 3,309.08

Different Types of Loans

a. Pure Discount Loans
○ Interest and principal paid at maturity.

32
 ○
○ Pure Discount Loans - Example: Treasury bills are excellent examples of pure
discount loans. The principal amount is repaid at some future date, without any
periodic interest payments. If a T-bill promises to repay $10,000 in 12 months
and the market interest rate is 7 percent, how much will the bill sell for in the
market?
○ Ø PV = 10,000 / 1.07 = 9345.79

b. Interest Only Loans

○ Interest paid throughout the loan period; principal paid at maturity

○
○ Interest Only Loan - Example: Consider a 3-year, interest only loan with a 7%
interest rate. The principal amount is $10,000. Interest is paid annually. What
would the stream of cash flows be?
○ Years 1 – 2: Interest payments of .07(10,000) = 700
○ Year 3: Interest + principal = 10,700
○ This cash flow stream is similar to the cash flows on corporate bonds.

c. Loans with Fixed Principal Payments

○ Interest and fixed amount of principal paid throughout the loan period.

33
 ○
○ Loan with Fixed Principal Payment -Example: Consider a $50,000, 10 year loan
at 8% interest. The loan agreement requires the firm to pay $5,000 in principal
each year plus interest for that year.

d. Amortized Loans
○ Interest and a portion of the principal paid throughout the loan period

Implied discount rate example 2

Suppose you are offered an investment that will allow you to double your money in 6 years.
What is the implied rate of interest?
FV = PV (1+r)t

34
FV = 2, PV = 1, t = 6
r = (2/1)1/6 – 1 = 0.122462 = 12.25%

Implied discount rate example 3

Suppose you have a 1-year old daughter and you want to provide $75,000 in 17 years towards
her college education. You currently have $5000 to invest. What interest rate must you earn to
have the $75,000 when you need it?
FV = PV (1+r)t
FV = 75, PV = 5, t = 17
r = (75,000 / 5,000)1/17 – 1 = 0.172688 = 17.27%

Final example

35
Lecture 4: Risk and Return (Part 1)
Why is it important for us to buy stocks from different industries, countries etc? Why is it
important to buy stocks, bonds, assets etc? Why is it important to diversify?

How would have an investment put in since 1925 perform over time? $100 could be spent on
many different options:
1. Standard & Poor’s 500 (S&P 500): Index that captures the largest 500 companies in the
US, in terms of market capitalization or market value of their equity. This index allows
the investor to be diversified across many industries by simply buying the index.
2. Small stocks: A portfolio of stocks of U.S. firms whose market capitalizations are in the
bottom 10% of all stocks traded on the NYSE.
3. World Portfolio: Very more diversified because you’re going into different geographies
4. Corporate Bonds: A portfolio of long-term, AAA- rated U.S. corporate bonds with
maturities of approximately 20 years.
5. Treasury Bills: An investment in three-month U.S. Treasury Bills (reinvested as the bills
mature). Considered risk free. But low return.

How do you calculate investment returns?

Investment returns measure the financial results of an investment. Returns may be historical or
prospective (anticipated). Returns can be expressed in:
§ Dollar terms: Amount received – Amount invested
§ Percentage terms: Amount received – Amount invested / Amount invested

36
When an investor buys a stock or a bond, their return comes in 2 forms:
1. Any dividend or interest payment (income) received, and
2. A capital gain or a capital loss (due to change in price)

Percentage return:
Total % return = Dividend Yield + Capital Gain Yield
Dividend Yield = Dividend / Initial Share Price
Capital Gain Yield = Capital Gain / Initial Share Price

The returns calculated above are called nominal returns. These have not corrected for the
inflation effect. You still don’t know if you’re able to buy more or less products compared to
before. A positive nominal return does not necessarily mean you’re richer or you can afford to
buy more things. Even if you make a 15% nominal return on your investments, if inflation was
20%, you’d be able to buy less.

The increase in purchasing power is called the real rate of return. The real rate of return tells
you how much more you will be able to buy with your money at the end of the year. So how do
you convert a nominal return to a real rate of return?

What’s the impact of inflation?

To convert from a nominal to a real rate of return:
1 + real return = 1 + nominal return / 1 + inflation rate

A common approximation for the real rate of return is:

Real return = nominal return - expected inflation

Example: Fisher Equation

Given a 10% nominal return, you can only buy 5.77% more phones. 5.77% is the real rate of
return because it tells us how much more purchasing power you have.

So how do you know if a stock is a good buy or not?

First you need to identify what are the expected returns from the stocks, bonds etc.

37
Expected returns are returns that take into account uncertainties that are present in different
scenarios. Thus an investor must estimate the different return scenarios possible and the
probability of each return scenario. (Decision trees!)

Expected return: 𝑟̂ = ∑𝑛𝑖=1 𝑟𝑖 𝑃𝑖 , Where ri = Possible return and Pi = Probability of possible

returns
Note: there are n possible returns.

What if you don't have the future events and their associated probabilities? Instead all you have
is historical data… Then another way to get an understanding of what we think might happen
∑𝑇𝑡=1 𝑟𝑡
would be: Find the simple arithmetic average of return 𝑟= The value arrived at
𝑇
could be used as an estimate of the average future return.

What do we do with the expected returns whether it’s found through future events and
probabilities or through historical averages?

We have to compare them with benchmarks. But what should be the benchmark? It is the
required rate of return on the investment. What does this required rate of return depend on? It
depends directly on the risk of the investment.

If an investment is very risky, often we’d say we would want a higher rate of return if not we
wouldn't buy it. We compare the expected return with this required rate of return based on the
amount of risk there is in taking up the investment.

But what is risk? Risk is the uncertainty associated with future possible outcomes. Covers both
upside and downside risks. Your risk tolerance, determines the type of investments you buy.

Example:

While both the stocks have the same

expected rate of return, Stock Y has a much
wider dispersion. Thus, investors would be
more confident in getting their expected
return for Stock X compared to Stock Y.

How do we measure the dispersion? By

calculating the standard deviation.
𝜎 = √𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = √∑𝑛𝑖=1 (𝑟𝑖 − 𝑟̂ )2 𝑃𝑖 , 𝑟̂ : 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛
Standard deviation measures total risk, also called the stand-alone risk of an investment. Stand-
alone risk is the risk an investor would face if he/she held only this one asset.

38
Example:

When Alta does well, Repo does poorly.

Calculate the expected returns and standard deviations of the above investment alternatives.

T-bill Alta Repo Am F. MP

Expected return = 8(0.1)+8(0.2)+8(0.4)+8(0.2)+8( 17.4% 1.74% 13.8% 15%

∑𝑛𝑖=1 𝑟𝑖 𝑃𝑖 0.1)= 8%

Standard deviation Sqrt [(8-8)2(0.1)+(8-8)2(0.2)+(8- 20.04% 13.36% 18.82% 15.34%

= 8)2(0.4)+(8-8)2(0.2)+ (8-
2
√∑𝑛𝑖=1 (𝑟𝑖 − 𝑟̂ )2 𝑃𝑖 8) (0.1)] =0

In the case where the expected returns are calculated based on historical data, to find the
standard deviation, the following formula is used instead (because this time there would be no
corresponding probabilities):
𝑛 2
√∑𝑡=1 (𝑟𝑡 − 𝑟𝑎𝑣𝑔)
Estimated 𝜎 = 𝑛−1
(Divide by n-1 if it’s a sample, for a population, n)
Normal distribution: Assuming stock returns are normally distributed, they’d fit this model:

39
What is the probability that you’d lose half your investment in a stock with a probability
distribution like that of the above? The probability that your investment will give a -50% return on
stock will be less than 0.5%.

Most of the time, it will be higher the risk, higher the returns, lower the risk, lower the returns. If
there is a high expected return, it would usually be accompanied by a high standard deviation,
𝜎.If there is a low expected return, it would usually be accompanied by a low standard
deviation,𝜎.

So then how do we compare a stock with high return and high 𝜎 with a stock which has a low
return and low 𝜎?
Coefficient of Variation is a standardized measure of dispersion about the expected value, that
shows the risk per unit of return.

CV = Standard Deviation / Expected Rate of Return OR CV = Standard Deviation / Mean

Higher CV means a more riskier asset given
every unit of return.

If you have two stocks, both having the

same standard deviation and mean, but B
has a higher expected rate of return than A.
Which stock will have a higher CV? A
because you take the same 𝜎 but divide it
by a smaller rate of return. A is more risky.
Always standardize in order to have a better appreciation of the riskiness of an asset.

40
In the market there is a risk-return trade-off. If you want higher returns, you must be willing to
bear more risk.

In general, investors are risk averse. What does that mean? Risk aversion – assumes investors
dislike risk and require higher rates of return to encourage them to hold riskier securities. The
“extra” return earned for taking on risk is referred to as risk premium. The risk premium is the
return over and above the risk-free rate.

What is the correct risk-free rate to use?

In most developed markets, where the government can be viewed as default free, Treasury bills
(maturity of 1 year or less) are considered to be risk-free. Mostly, a one-month treasury bill is
used as the risk-free rate. The default risk is the least. But if you’re doing a long-term study,
then a long-term government bond would be more representative of what a long-term risk free
rate should be.

What happens if people buy more than one stock? How do you find out the combination return
and combination risk of the portfolio?

How do you calculate the expected rate of return of the portfolio? Use the weighted average
𝑛
return. 𝑟̂𝑝 = ∑𝑖=1 𝑤𝑖 𝑟̂𝑖 , where wi is the fraction of the portfolio’s dollar value invested in
Stock i. Note, the wi’s must add up to 1.

If you didn’t already calculate the expected returns of each individual stock, the alternative
approach to finding the rate of return for the entire portfolio would be as follows:

Now that we can find the expected rate of return of the portfolio, how do we find the risk
(standard deviation)?

41
𝜎𝑝 =
√(3.0 − 9.6)2 (0.1) + (6.4 − 9.6)2 (0.2) + (10 − 9.6)2 (0.4) + (12.5 − 9.6)2 (0.2) + (15 − 9.6)2 (0.1)
= 3.3%

Alternatively, the standard deviation can be calculated in the following way:

By definition, the standard deviation of a 2 stock portfolio is:
𝜎𝑝 = √𝑤1 2 𝜎1 2 + (1 − 𝑤1 )2 𝜎2 2 + 2𝑤1 (1 − 𝑤1 )𝐶𝑜𝑟𝑟(𝑅1 , 𝑅2 )𝜎1 𝜎2
= √𝑤1 2 𝜎1 2 + (1 − 𝑤1 )2 𝜎2 2 + 2𝑤1 (1 − 𝑤1 )𝑝12 𝜎1 𝜎2
Covariance = Corr (R1,R2) 𝜎1 𝜎2 , Correlation coefficient = p12
We need to know the covariance and the correlation coefficient. So how do we get the
correlation coefficient?

Before that note that the standard deviation of the portfolio,𝜎𝑝 , at 3.3%, is much lower than the
standard deviation of either stock Alta, 20%, or Repo, 13.4%. Average of Alta and Repo’s
standard deviations (16.7%). How is this possible? This is because the two stocks have a
negative covariance which arises from the negative correlation between the stocks as we saw
before in the returns. When one does well, the other does poorly. There is a benefit in investing
in these two stocks together because it reduces risk.

Back to how do you calculate covariance? There are 3 different methods.

When looking at the risk of a portfolio of assets, it is important to recognize and consider the
interaction between the individual stocks with one another, that is how the performance of two
assets “move” or “do not move” together.

Alta Repo case-> 2nd method: Covi,j = (0.1)(-22-17.4)(28-1.74) + (0.2)(-2-17.4)(14.7-1.74) +

(0.4)(20-17.4)(0-1.74) + (0.2)(35-17.4)(-10-1.74) + (0.1)(50-17.4)(-20-1.74)

1st method is for when you have historical data and you divide by n-1 if you have a sample and
divide by n for a population.
How about correlation coefficient?
(perfectly negatively correlated) -1 ≥ ρXY ≥ 1 (perfectly positively correlated)

42
The correlation coefficient between two stocks (X and Y) , denoted by ρXY measures the extent
to which two securities X and Y move together. In general, we find that stocks from the same
industry tend to have stronger correlations. E.g Apple and Dell 0.5, Apple and Starbucks 0.2 etc.

In general, there tends to be no negative correlations. In the real world, it’s very difficult to find
stocks which are negatively correlated.

What happens if you combine stocks together that are either perfectly positively correlated or
perfectly negatively
correlated?

The returns turn out to

be a straight line.
Standard deviation =0.

Get returns which are

exactly the same, you
don’t get double
because you take 50%
of each. S.D is same
also.
It is possible for us to form a riskless portfolio if we join two stocks that have a p= -1. Standard
deviation can become 0 for the portfolio but it all depends on the weights of each stock.

43
Risk is not reduced at all if the two stocks have p = +1.

In general, stocks have ρ ≈ 0.65, so risk is lowered but not eliminated. σ ≈ 35% for an average
stock. In theory, the ability to reduce the standard deviation by combining stocks together
(reducing risk) increases by combining stocks which are negatively correlated. So if p -> -1,
you’re able to reduce more risk. The risk of the portfolio becomes smaller as the p (correlation
coefficient) tends toward -1. So as long as you combine stocks that have p < +1, you’d already
have some diversification benefits and be able to reduce standard deviation.

The standard deviation of a two stock portfolio is: (as mentioned)

𝜎𝑝 = √𝑤1 2 𝜎1 2 + (1 − 𝑤1 )2 𝜎2 2 + 2𝑤1 (1 − 𝑤1 )𝑝12 𝜎1 𝜎2

= √𝑤1 2 𝜎1 2 + 𝑤2 2 𝜎2 2 + 2𝑤1 𝑤2 𝑝12 𝜎1 𝜎2, If correlation coefficient p12 = +1, then
= √𝑤1 2 𝜎1 2 + 𝑤2 2 𝜎2 2 + 2𝑤1 𝑤2 𝜎1 𝜎2
Let A = w1𝜎1 and B = w2𝜎2
𝜎𝑝 = √𝐴2 + 𝐵2 + 2𝐴𝐵
= √(𝐴 + 𝐵)2
= A+B
= w1𝜎1 + w2𝜎2

If p12 = -1, then 𝜎𝑝 = √𝐴2 + 𝐵2 − 2𝐴𝐵 = √(𝐴 − 𝐵)2 = (A-B) = w1𝜎1 - w2𝜎2
If you want a risk free portfolio, w1𝜎1 = w2𝜎2 , so there are two conditions for a risk free portfolio:
1. p12 = -1
2. w1𝜎1 = w2𝜎2

Thus if p12 < +1, 𝜎𝑝 < w1𝜎1 + w2𝜎2 (end up less than the weighted average)
So when you combine stocks together, the goal is to find stocks with as little correlation as
possible (ability to reduce 𝜎).

What if join more than two securities? Then the formula becomes a bit more complicated.
We will need the additional 𝑤3 2 𝜎3 2 and to understand how the third asset covaries with 1 & 2. So
we need the covariance of 2 & 3 and covariance of 1 & 3. All together you’d get nine terms.

Var (rp ) = 𝑤1 2 𝜎1 2 + 𝑤2 2 𝜎2 2 + 𝑤3 2 𝜎3 2 + 2𝑤1 𝑤2 𝜎12 + 2𝑤2 𝑤3 𝜎23 + 2𝑤1 𝑤3 𝜎13

3 variance terms: 𝑤1 2 𝜎1 2 + 𝑤2 2 𝜎2 2 + 𝑤3 2 𝜎3 2
6 Covariance terms: 2𝑤1 𝑤2 𝜎12 + 2𝑤2 𝑤3 𝜎23 + 2𝑤1 𝑤3 𝜎13

44
 Covariance matrix:

If you want to join 10 stocks in a portfolio, you’ll need to draw up a 10 by 10 matrix.

Earlier it was mentioned that 𝜎, standard deviation gives total risk. However, this total risk can
be broken down further.

Total risk = Company-specific risk (Unsystematic risk) + Market risk (Systematic risk)
When we try to combine different stocks, what risk are we trying to diversify away? Company.

There was an experiment done to illustrate this. As they added more stocks, the standard
deviation of the portfolio fell but there was diminishing returns. Less and less reductions in the
standard deviation as more stocks were added. The rate at which you can reduce 𝜎 falls and
eventually the 𝜎 plateaus. Even after many stocks are added, the 𝜎 cannot go below a level.
There is an inherent level of 𝜎, called the market risk. So you can only get rid of the company-
specific risk as you add more stocks to the portfolio. Company-specific risk is diversifiable unlike
market risk.

Diversifiable risks: These are caused by random events. E.g., lawsuits, unsuccessful marketing
program, losing a major contract, and other events unique to a specific firm. Since the bad
events in one firm can be offset by good events in another, their effects are eliminated in a
portfolio.

Market risks: Market risk stems from factors that systematically affect most firms. E.g:
– War – Inflation – Recessions – High interest rates
Most, if not all stocks, are affected by these factors. Thus market risk cannot be diversified away
by combining stocks into a portfolio. Stocks will generally all move in the same direction (all
benefit or all suffer, but in varying degrees).
The market does not reward you for bearing unnecessary risk, so if you choose to buy only one
stock, and you bear total risk, the reward that comes from this stock is only linked to market risk,

45
you get no reward from bearing company-specific risk. You only are rewarded for bearing
market risk.

So how do you measure market risk? Remember, to find out which stock you should buy, you
have to consider the rate of return and then compare it to the required rate of return and this is
dependent on the risk and now we have a better idea of what type of risk we’re actually
interested in. The required rate of return is completely dependent on the market risk, not total
risk.

We recognize that market risk remains in all portfolios. Some investments (portfolios or
securities) will be more sensitive to market factors than others and will therefore have higher
market risk. How do you measure market risk? Use Beta.

Beta is a measure of an asset’s market risk. It measures the covariance of the asset against the
market divided by the variance of the market. It tells you the sensitivity to changes in the market.

𝜎
𝛽 𝑖 = 𝑐𝑜𝑣(𝑟𝑖 2,𝑟𝑀) = 𝑝𝑖𝑀𝜎𝑖2𝜎𝑀 = 𝜎𝑖 𝑝𝑖𝑀
𝜎𝑀 𝜎𝑀 𝑀
𝛽of the market = 1. All the other 𝛽are relative to the market’s 𝛽. 𝛽has no units, it’s completely a
relative measurement.

If 𝛽𝑖 > 1, The asset has more systematic risk than the market. Most stocks have betas in the
range of 0.5 to 1.5. If 𝛽𝑖 < 1, The asset has less systematic risk than the market. It indicates how
risky a stock is if the stock is held in a well-diversified portfolio, because you won’t have any
company-specific risk, you’d then be concerned about how additions of new stocks will affect
the market risk of the new portfolio.

Lecture 5: Risk and Return (Part 2)

Recap of last week: We suggested that if you want to invest in any asset, you not only have to
look at the returns but also factor in the risks. In general we said, high risk high returns, low risk
low returns.

In general investors are risk-averse: For a given level of expected return, investors prefer less
risk to more risk. However, they are willing to take on more risks, if there are higher potential
returns.

This excess returns that investors expect are called risk premiums. Differences between the risk
and returns of an individual security and a portfolio. As we combine assets together in a portfolio
we enjoy diversification benefits, resulting in a reduction of the standard deviation because we

46
are successfully able to reduce company-specific risk. As we add more assets from different
industries and sectors, the company-specific risk gets reduced because poor performances in
one stock are negated by good performances in other stocks.

Non-diversifiable risk or systematic risk is left after you add all these stocks in a portfolio. This is
essentially the inherent standard deviation across the entire system. You won’t be able to
reduce the standard deviation below this level even if you add more stocks from different
industries and sectors. Call this market risk as well. We use Beta to measure this sensitivity,
which is market risk.

We want to understand better how we can get the Beta for an individual security, or for a
portfolio and how you can use this Beta to calculate returns, which is the Capital Asset Pricing
Model. Then finally we will look at how that affects portfolio management.

Portfolio Returns Example:

Suppose you invest $100,000. You buy 200 shares of Apple at $200 per share ($40,000) and
1000 shares of Coca-Cola at $60 per share ($60,000).

At the end of the year, if Apple’s stock goes up to $240 per share and Coca-Cola stock falls to
$57 per share and neither paid dividends, what is the new value of the portfolio? What return did
the portfolio earn? If you don’t buy or sell any shares after the price change, what are the new
portfolio weights?

Current portfolio weights: 40% Apple, 60% Coke based on the market value of the components.
New value of the portfolio: $105,000 (increased by: $40*200 - $3*1000 = +$5,000)
Return earned by the portfolio: 5,000 / 100,000 = 5% return
We can get the same answer by using the weights, Apple 40%, Coke 60% and the returns on
Apple were 20% and for Coke was -5%. We can then get the weighted average return for this
portfolio = 40% * (20%) + 60% *(-5%) = 5%
New portfolio weights calculated based on the market prices: Apple price $240, own 200
shares, value of shares is $48,000. Coke price $57, own 1000 so total value is $57,000.
Weights: Apple (48,000 / 48,000 + 57,000 = 45.71% and Coke (57,000 / 105,000 = 54.29%)

Now Assume that Apple and Coca-Cola are the only assets in the economy:
Apple had an original market cap of $400,000 (2000 shares at $200/ share) and Coca-Cola had
a market cap of $600,000 (10,000 shares at $60/share). The weightage of Apple in the
economy is 40%, while Coca-Cola is 60%.

At the end of the year, what are the new market weights? So again based on the new share
prices, Apple ($240*2000 = 480,000) and Coke ($57*10,000 = 570,000). Apple weight in the
market = 45.71% and Coke weight in the market = 54.29%.

47
When you buy any security, you won’t be overly concerned about the individual’s stock’s return
and risk but more concerned on what would be the impact of this stock on the overall portfolio’s
return and risk.

Example: Portfolio Volatility

Inversely related stocks: When one does well the other and vice versa.
Invest equally in Stocks A and B.

State, i Probability i A B Portfolio(rpi)

Boom 0.4 30% -5% 12.5% (0.5*30%+0.5*-5%)

Bust 0.6 -10% 25% 7.5% (0.5*-10%+0.5*25%)

Expected returns of portfolio = 0.4*12.5% + 0.6*7.5% = 9.5%
Standard deviation = Sqrt [0.4(12.5-9.5)2+0.6(7.5-9.5)2] = 2.45%

Expected A: 0.4*30%+0.6*-10% =6% B:0.4*-5%+0.6*25% P:0.5*6+0.5*13

returns =13% =9.5%

Standard 19.6% 14.7% NA this way by

deviations sqrt[0.4(30-6)2+0.6(-10-6)2] sqrt[0.4(-5-13)2+0.6(25-13)2] taking half of both
The above example illustrates how you’re able to reduce standard deviation significantly when
you have negatively correlating stocks.

Suppose you start out with 3 stocks with exactly the same standard deviations and expected
returns. Portfolio choices:
1. Half of each airline
2. Half of airline and one oil company stock
The airline and oil stocks have some sort of negative relationship, when airline stocks do well,
the oil stocks don’t and vice versa. Expected since when oil prices increase, oil stocks will do
well whilst the airline stocks will not.

What happens in choice 1, you’d get the same expected return since both have the same
returns each to begin with. However, you’re still able to reduce the standard deviation to a small
extent so there are still merits in combining these stocks, as there are diversification benefits.

However in choice 2, when airline stock is combined with the oil stock, because of the negative
relation between the two stocks, the standard deviation reduces significantly.

Here is an example of how you don’t even sacrifice returns because they stay exactly the same
but you’re able to reduce the standard deviation. Enjoy same return with lower risk.

The idea is that we want to diversify across several different asset classes or sectors. We want
to combine stocks which have less than one correlation into a portfolio as this would help to

48
reduce the overall volatility. The idea of diversification is to substantially reduce the variability of
returns without an equivalent reduction in expected returns.

In the case of stocks A and B above, if you initially had stock B and you add Stock A, it may
reduce the expected returns but there is also a more than proportionate decrease in the
standard deviation.

The risk that cannot be

diversified away is called
systematic risk.

If we can combine many

stocks and assets from
different industries etc. in
theory we would be able
to reduce unsystematic
risk to 0.

Hence for very well-diversified portfolios, we’re going to assume that unsystematic risk =0.
Hence all that is left is simply the systematic risk. This is not true for individual stocks which
would be exposed to stand-alone risk which is total risk.

Thus, the onus is on the investor to diversify. The market does not reward you for bearing
stand-alone risk. NO reward for bearing risk unnecessarily, which is the company-specific risk.

When deciding which stock to buy, we look at the expected returns and then compare that with
the required return which only depends on systematic risk.

In finance theory, the best measure of the risk of a security when held in a large portfolio is the
beta (βi) of the security, defined as follows:
𝐶𝑜𝑣(𝑟𝑖 , 𝑟𝑀 )
𝛽𝑖 =
𝜎𝑀 2
Covariance of the asset against the market divided by the variance of the market. This Beta
measures the sensitivity or responsiveness of the asset and security against the market’s
movements. So if the Beta = 1.5, when the market moves by 10%, your stock moves by 15%. If
the stock has a beta =0.5, when the market moves by 10%, your stock moves by 5%. Relative
responsiveness or sensitivity to the market’s movements.

If you try to regress the stock’s returns against the market returns, and you get the slope of the
line which basically shows you responsiveness of the stock’s returns against the market returns
(change in stock returns per change in the market returns). The slope of the line would then be
the Beta of the stock.

49
In the above chart, excess returns is plotted against each other. We take (Ri - Rf) and plot it
against (Rm - Rf). This is the most accurate way of regressing to get Beta of a stock.
Nevertheless if you plot the stock’s returns against the market returns, that is Ri against Rm, the
Beta you’d arrive at would be almost identical to this Beta. Difference only seen in the 3rd or 4th
decimal place which won’t materially affect your analysis.

If you want to find the Beta of an average stock in the NASDAQ index, you’re going to regress
the excess returns of the NASDAQ, which means the returns of the NASDAQ index over how
many periods you want minus the risk free asset returns and then you plot it against the market
return minus the risk free return. But what is the market?

The market must include all risky assets in the entire economy so this is difficult to form. This
will transcend stocks, to include stocks, bonds, commodities, properties, anything that can be
invested into that will give you some return that has risk must be part of the portfolio. Practically
speaking we can’t actually get a market portfolio so it exists as a concept, it’s the portfolio of all
risky assets in the market.

We hence need a proxy, something that will represent this market portfolio to tell us that this is
the constitution of all the assets in the market. Normally we’d use the stock index for that
market. In this case, we use S&P 500 as the proxy for the market portfolio.

We regress the excess returns of NASDAQ against the excess returns of the market which is
the S&P 500, then we get the gradient of the best fit line and find Beta=1.43. This tells us that
every stock on the NASDAQ on average will be 1.43 times the responsiveness of the market’s
movements which means when S&P 500 increases by 5%, then the stock on the NASDAQ will

50
move by about 7% (1.43*5%). 1.43 times more responsive. We’d say that stocks on the
NASDAQ index in general have more systematic risk than the average stock in the market.

Now that we understand that required returns depend on systematic risk, we can try to find a
relationship between Beta, market or systematic risk and this required return. So we plot
required returns against Beta.

What are some of the points we should already know based on this relationship? Firstly we
know the risk-free rate. Suppose the risk-free rate is at 8%. We also know that the risk free has
a Beta of 0. The risk free has no systematic risk, so a beta of 0, so you could plot the first point
on the graph. The market has a return, and again using S&P 500 as a proxy, what’s the annual
returns of the S&P 500, and let’s say it’s 15%. We also know that the Beta of the market is 1, so
we can plot this point as well. So we can join these two points together. We call this line the
security market line (SML).

The Security market line tells us the relationship between required returns and Beta. What is the
gradient of this line? The gradient of this line is found by taking dy/dx of the line, which gives
dy:RM - Rf and divide it by dx which is: 1-0.
𝑅𝑀 −𝑅𝑓
Gradient = = RM - Rf
1−0

Hence the slope of the Security Market line is simply the market risk premium, the excess return
you get for bearing the market risk in excess of the risk free. Hence the equation of the Security
market line (SML) is as follows:
𝑅𝑗 = 𝑅𝑓 + 𝛽𝑗 (𝑅𝑀 − 𝑅𝑓 )

Hence the required return of any asset j, is given as the risk free rate + the gradient of the line
(RM - Rf) multiplied by the x-coordinate, which is Betaj. This shows us the required return-Beta
relationship.

51
We call the slope of this line the reward to risk ratio as well. The risk premium enjoyed is
referred to as the reward. Because if you’re willing to take on more risk, you get incremental
returns as a reward. The gradient of the line is hence the reward to risk ratio.

Suppose you have a stock which has a Beta=0.5, which perhaps may be 12% according to the
above risk-free rate is at 8% and market has a return of 15%. What that means is that the
reward for the stock is (12%-8%) and the risk is 0.5.

In equilibrium all assets and portfolios must have the same reward to risk ratio. What does that
mean? It means that in equilibrium, all assets and portfolios would be on that line, Security
market line (SML). In order to have the same reward to risk ratio, everybody must be on the
same line. As long as you’re not on the line, you’d have a different reward to risk ratio, which is
the gradient of the line drawn from the risk free rate to that asset.

So what is equilibrium? In equilibrium means, in the market, demand equals supply such that in
this case, there is no propensity for the stock price to change. The expected return of the stock
will be equal to the required return.

In equilibrium, all assets and portfolios would be plotted on this Security Market line (SML). The
equation of the SML also gives us the Capital Asset Pricing Model (CAPM). CAPM can be used
to price all assets in terms of their required returns. We can use this model to not only price
financial assets but also physical ones.

The components of the model is the risk-free rate. What is the risk-free rate? It’s the return from
buying a treasury bill in our context. Why would the government give you a return for buying
their treasury bill? Cannot be because you expose yourself to risk right? It’s not in exchange for
bearing risk. You get a return for buying treasury bills because you have given up the use of this
money for a said period of time because this is a risk-free instrument. In exchange for the
money spent on the treasury bill, the government recognizes that there is opportunity costs and
hence will compensate you for that. Hence the risk free rate is simply a compensation for the
time value of money.

There is premium for bearing risk for any asset j, this is captured by taking Beta, which is the
responsiveness of the asset against the market movements or market risk of that particular
asset multiplied by the market risk premium which is given by (𝑅𝑀 − 𝑅𝑓 ).
𝑅𝑗 = 𝑅𝑓 + 𝛽𝑗 (𝑅𝑀 − 𝑅𝑓 )

If you move Rf to the left of the equation, you’d get:

𝑅𝑗 − 𝑅𝑓 = 𝛽𝑗 (𝑅𝑀 − 𝑅𝑓 )

52
What is 𝑅𝑗 − 𝑅𝑓 ? this is simply the asset’s risk premium. The risk premium is defined as the
incremental return you receive over and above the risk free rate. Now we know the asset’s risk
premium is = 𝛽𝑗 (𝑅𝑀 − 𝑅𝑓 ), Beta times the market risk premium.

Prove that the Beta of the market is 1:

𝐶𝑜𝑣(𝑟𝑖 , 𝑟𝑀 )
𝛽𝑖 =
𝜎𝑀 2
𝐶𝑜𝑣(𝑟𝑀 ,𝑟𝑀 ) 𝜎2 (𝑟𝑚 )
𝛽𝑀𝑎𝑟𝑘𝑒𝑡 = = 𝜎2 (𝑟 =1
𝜎𝑀 2 𝑚)

Prove that the Beta of the risk free asset is 0:

𝐶𝑜𝑣(𝑟𝑓 , 𝑟𝑀 ) 𝜌𝑓𝑚 𝜎𝑓 𝜎𝑚 0 × 0 × 𝜎𝑚
𝛽𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑎𝑠𝑠𝑒𝑡 = = =
𝜎𝑀 2 𝜎 2 (𝑟𝑚 ) 𝜎 2 (𝑟𝑚 )
=0
When we regress the excess returns of the stock against the market’s excess returns, the
gradient of that line is Beta. Beta can be more than 1 or less than 1. We want to understand
whether the stock has more or less systematic risk than the average stock in the market.

Can Beta be negative? If the correlation is negative, the Beta will be less than 0, negative.
Beta’s equation is covariance over variance, Covariance is 𝜎𝜎𝜌, since 𝜎 can’t be negative, only
𝜚can cause Beta to be positive or negative. So if the 𝜚against the market is negative, then Beta
will be negative.

It’s possible for Beta to be negative, having said which, it’s not easy to find. Technically people
may tell you that gold has a negative Beta but it doesn’t actually. It’s Beta is just really small,
almost 0 based on long periods of history. If you take selected periods of time, then you can
demonstrate that any stock can have a negative Beta. If you take over longer periods of time
and use more data, then it’s extremely difficult to find stocks with negative Beta.

Is there a maximum Beta for any asset? No because if you look at the formula there is no
maximum. There is no standardized measurement like in the case of correlation, where it exists
between -1 and 1. However, Betas usually range between 0 to 2.5 maximum based on long
term studies.

In summary, how do we measure systematic risk?

We use the beta coefficient to measure systematic risk
• What does beta tell us?
Ø A beta = 1 implies the asset has the same systematic risk as the overall market
Ø A beta < 1 implies the asset has less systematic risk than the overall market

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Ø A beta > 1 implies the asset has more systematic risk than the overall market

Example: Total Risk versus Systematic Risk

Consider the following information:

Standard Deviation Beta

Security C 20% 1.25

Security K 30% 0.95

►Which security has more total risk? SD tells you total risk, so K.
►Which security has more systematic risk? Beta tells you systematic risk, so C.
► Which security has the higher unsystematic risk? K, total risk = SR + UR, so if K has high
Total risk but lower systematic risk, it must have higher unsystematic risk.
►Which security should have the higher expected return? Assuming both stocks are in
equilibrium, the expected return of the stock will be equal to the required return. Required return
is only dependent only on the systematic risk so whichever stock which has higher Beta would
in equilibrium come with higher expected returns.

Today you don’t have to do the regressions yourself because there are many providers online.
However, you have to be careful about using Betas from different providers, because their
definitions may differ. Beta is simply a regression but you don’t actually know what they regress
until you actually look at the definitions they use. Some may give you 3 year Beta, 5 year beta, 3
month weekly returns, 3 month monthly returns. Unless you find out the definitions used, you
can’t use Betas from different providers and assume they’re the same.

How do you get the Beta of the portfolio? Now you know the Beta of a single stock, through
𝐶𝑜𝑣(𝑟𝑖 ,𝑟𝑀 )
either the equation 𝛽𝑖 = or through the regression. The Beta of the portfolio is
𝜎𝑀 2
simply the weighted average Beta:
𝛽𝑗 = ∑𝑚
𝑗=1 𝑤𝑗 𝛽𝑗
Bear in mind that the weights in the portfolio changes every time the prices of the stocks in the
portfolio changes.

Example: Alta has an expected return of 17.4% and Beta = 1.29. Given a risk free rate of 8%
and market return of 15%, what is the required return for Alta?
𝑅𝑗 = 𝑅𝑓 + 𝛽𝑗 (𝑅𝑀 − 𝑅𝑓 )
𝑅𝑗 = 8% + 1.29(15 − 8) = 17%
This means that if you plot the Security market line (SML), you have risk free rate at 8% with
Beta =0, Alta’s Beta =1.29 which will give a 17% required return. So the line can be drawn. So
that’s where Alta should be:

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Alta is able to give higher returns than it is required based on its risk. Would you buy Alta? Yes.
You’d buy because you’d expect to get higher returns than required, so demand will increase.
As demand increases for this stock in the market, the stock price rises. Hence the expected
return drops as the price rises. So the dot moves towards the line downwards. Once it gets onto
the line, we say there is market equilibrium because expected return = required return at 17%
and everybody thinks that the stock is where it should be and there is no more propensity for the
stock price to change.

In equilibrium, all stocks will be on the line. Because if it’s not on the line, there will be actions in
the market that will cause the stock to move. If you find a stock which is below the SML, it
means that the expected return is less than the required return, so it’s a stock that nobody
wants since you get less than what you require. So people would sell the stock and as they sell
it, the price falls and the expected return goes up. The stock will move upward onto the line and
there will be equilibrium.

When expected return exceeds required return: We say these stocks are attractive, another way
is to call them underpriced or undervalued.

If expected return equals required return: We say the stock is fairly priced or valued.

If expected return is less than the required return: We say the stock is overpriced or valued.

Stocks above the SML are considered underpriced and stocks below the SML are considered
overpriced.

How do you use the Capital asset pricing model to price other types of assets like physical
assets?

Example: Valuation of a Project

A project is expected to generate the following cash flows:
Year Cash flows

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 1 $5,000
2 3,000
3 2,000
Given that the project beta is 1.5, the risk-free rate is 6% and the market risk premium is 8%,
what is the maximum you should pay for this project?
You can calculate what you would require as a return based on this risk, the Beta=1.5. So using
the Capital asset pricing model: that would tell us the required return for this project based on its
risk.

Be careful in questions like these because here you’re already given the market risk premium,
8% (Rm - Rf). Don’t have to minus the 6% anymore. Sometimes you may be given the security
risk premium, which by definition = 𝛽(𝑅𝑚 − 𝑅𝑓 ), so you’d take the whole thing without
multiplying it with the Beta.
Required return for Project A = 6% + 1.5(8%) = 18%, If you require a return of 18%, you can
discount each of the cash flows by 18%, and the total of each would be the breakeven price for
these cash flows.

If you pay $7,609.10 today, you’d get a return of 18%. If you pay more than $7,609.10, then
you’d have overpaid, and the return would turn out to be something less than 18%. If you pay
less than $7,609.10, you’d get a return which is much higher than 18%. You shouldn’t pay more
than $7,609.10 if you want to get a return commensurate with the risk.

Normally you’d use 5 years’ worth of monthly data for regressions. So this is the standard in a
sense. We try to have 5 years’ worth of monthly data to get the Beta. Sometimes when you
have a new stock which IPO only last year, you won’t get 5 years’ worth of data so what do you
do? So to work around that you might have to resort to using weekly data. Find weekly returns
for a year or 1 and a half years, then you’d have sufficient data points to form some confidence
in terms of the regression.

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What happens when inflation rate changes? What is the impact on the Security Market line
(SML)? If inflation rate changes by 3%, the returns in the market will all approximately move up
by 3% based on the approximate Fisher equation but if you use the Fisher’s equation then you
can get the exact new nominal rate. But by approximation, we know that the new nominal rates
will all move up by approximately 3%. The risk free rate which was originally 8% will now
become approximately 11% with the new inflation rate. On average, the stock market proxy was
giving up 15% as the market return but because every stock moves upwards by 3%, now on
average the market return would be 18%. If you draw the new SML, you’d realise that the
gradient doesn’t change simply because each stock has gone up by 3%. So the gradient
remains 7% in this case (18%-11%) or (15%-8%). There has been a translation for the SML.

What causes the slope of the Security Market Line (SML) to change? What is the slope of the
SML? It’s the reward to risk ratio in equilibrium which is the measure of risk aversion, Rm - Rf ,
it’s the market risk premium, it’s the incremental return you need to give investors to incentivise
them to take on more risk.

If in general, investors become more risk averse in the market, then they need higher returns in
order to convince them to take on more risk. This would cause the SML to steepen because the
reward to risk ratio must now be higher.

In general, if investors across the market are becoming more risk loving or risk tolerant, then the
SML would become gentler because the risk premium would be less.

Example: Consider an asset with a beta of 1.2, a risk-free rate of 5% and a market return of
13%.
– What is the reward-to-risk ratio in equilibrium? (The gradient of the SML)

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Rm - Rf = 13% - 5% = 8%
– What is the required return on the asset?
Rf + 𝛽(𝑅𝑚 − 𝑅𝑓 ) =5% + 1.2*(8%) = 14.6%

With CAPM, we understand the required returns for each individual asset. We develop this
theory to understand how we can manage an entire portfolio? Is there a way to understand
which is the best portfolio for any individual investor?

Markowitz Portfolio Theory was introduced in the 1950s. Continues to be used even till today.
People continue to rely on this model to develop portfolios for investors. What is this theory
about?

If you combine assets into a portfolio, we know that we’ll be able to enjoy diversification
benefits. You’d get weighted average return but you’d get less than weighted average standard
deviation. Overall this is good. This is the result from combining stocks together with less than
perfect positive correlations.

When you try to combine assets together based on different weights, you can arrive at
numerous portfolios. Among all these portfolios, if you fix a level of risk, say you only want to be
exposed to 20% standard deviation, then you scan across all the portfolios, which of those
portfolios fulfill this condition. The one that gives you the highest return is defined as an efficient
portfolio. It’s efficient because for a given level of risk, it gives you the highest level of return.

Alternatively, you could have a goal of return, a minimum of 20% return, again scan all the
portfolios which give you a 20% return and the one which has the lowest risk is also defined as
an efficient portfolio. For a fixed level of return, it gives the lowest risk.

If you join up all the different efficient portfolios together into a diagram, and are able to
understand what are the different possibilities for the different levels of risk, this line would be
called the efficient frontier.

Example: Start off with two assets and combine them together to form a portfolio. What happens
when you join these stocks into a portfolio? You can have different possibilities of joining them
based on the weights assigned to each stock.

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Portfolio mean = Weighted average mean
Portfolio Standard deviation = √𝑤1 2 𝜎1 2 + (1 − 𝑤1 )2 𝜎2 2 + 2𝑤1 (1 − 𝑤1 )𝑝12 𝜎1 𝜎2
The curve shows all the portfolio combinations for GM and Microsoft.

Compare: 90% GM vs 60% GM, both have almost the same standard deviation at about 23%
but the 60% GM gives you a higher return of 34% instead of 19%. Hence by logic all the points
below the 60% GM point can be thrown away because no rational investor would pick those,
because at that level of risk, you could find a portfolio with higher returns than those you find
here.

For any given level of risk, the portfolio which gives you the highest return is said to be efficient.
So between the 90% GM vs 60% GM portfolio, the 60% GM portfolio is efficient. So by
extension all the points above the leftmost part of the curve are all efficient portfolios because
for any given level of risk, draw vertical lines, these portfolios would have the highest amount of
return. The line from the leftmost point and above joining all the efficient portfolios is called the
efficient frontier.

In general when you join two stocks together with non-perfect positive correlation, you get
something like the curve above. The leftmost part of the chart is called the minimum variance
portfolio (MVP), it’s the portfolio which gives the lowest standard deviation. It’s not the best
portfolio. MVP doesn’t mean it’s the best. All the portfolios above the MVP form the efficient
frontier, because it joins up all the portfolios that are deemed efficient and rational investors
would choose portfolios on this frontier.

How do you get the frontier for the entire market? So far we only looked at two stocks. Have to
do this for all the stocks in the market, so first you join stock A to stock B. After that you get
another stock N, and join AB to N and then you get the MVP for ABN and then join to C and so

59
on. Replicate this process for all the stocks in the market. Imagine there are many curves,
because not only do you have to join A and B, but also A and N, N and B, B and C and A and C
etc. all combinations
possible. Then you join
the leftmost point of all
these curves. That is how
you get the efficient
frontier for the market as a
whole.
Normally if you look at
diagrams that represent
the portfolios in the
market, we’d almost
always only see this one
curve because these
curves in the middle won’t
be useful to you because
you would only want to
target the efficient portfolios. There are trillion portfolios inside the curve, for every possible level
of risk, you could possibly pick many points within the curve but you’d want to pick the point on
the efficient frontier for the market because it gives the highest return for the given level of risk.

What if you want to combine a risk free asset to this frontier? What happens when you join a
risk free asset to any risky asset?
Earlier we mentioned that when you join two assets together, as long as the correlation is not 1,
you’d get a curve. If you join a risk free asset to any asset, do you also get a curve? No. In
terms of returns, when you combine a risk free asset to any risky asset, the returns is simply the
weighted average returns. However what happens to the 𝜎, which is on the x-axis.
Portfolio standard deviation = √𝑤1 2 𝜎1 2 + (1 − 𝑤1 )2 𝜎2 2 + 2𝑤1 (1 − 𝑤1 )𝑝12 𝜎1 𝜎2
𝜎𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 = 0, Hence we end up with Portfolio standard deviation = √(1 − 𝑤1 )2 𝜎2 2 = w2𝜎2 , which
is a direct relationship.

If you invest 80% of the portfolio into stock A, the portfolio’s standard deviation will be 80% of
Stock A’s standard deviation. Hence, it translates to weighted average since the risk free has 0
standard deviation. If the y-axis is weighted average and the x-axis is also weighted average,
then a straight line is formed. So a straight line is formed when you join a risk free to any risky
asset. Now we combine a risk-free to any portfolio on the efficient frontier and let’s say we
choose portfolio A. If we join risk free to any point on the frontier, you’d get a straight line that
joins risk-free to A. Markowitz did this and then he thought can we improve this combination?
Are we able to get a better return for any given level of risk? You can. How? Pick a different
portfolio, say B and join risk-free to B, you’d get a different line.

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So is the second line better than the first line? Yes because for any given level of risk, the
second line will give higher returns. Therefore, by extension what is the best line that you could
possible draw if you join the risk free to the frontier? It will be the tangent line. The steepest line
that could be possibly drawn that joins the risk free to any portfolio in the frontier. It hence gives
you the best reward to risk ratio.

That’s what Markowitz did. He established that if he wanted to join a risk-free asset to any risky
portfolio, it would only make sense to choose the portfolio which is tangent to the line. We call
this tangent line, the Capital Market line (CML). CML is the line that joins the risk-free to the
frontier. The CML is also referred to as the new efficient frontier. Definition of efficient being for
any given level of risk, this is the highest return. The line will always be on top of the curve,
since it’s a tangent. So for any given level of risk, the line will give you a better return than the
curve.

If everyone knew how to find the returns and the standard deviations for these assets, we’d all
end up with the same diagram. Hence, at this point there would be no difference between any
investor in the market because as long as information is the same for everyone, all can get the
returns and risk for every asset, all can get the risk free return in that market (return of the T-
bill), thus we’ll all be able to plot the same line and all will end up choosing the same portfolio
combination.

Mathematically, if we all want to choose the same portfolio combination, the only way that’s
possible is if we buy the market value weighted portfolio. What is the market value weighted
portfolio? It’s the portfolio for which all risky assets are included in proportion to their market
value.

Example of Apple and Coke: Assume they’re the only stocks available in the entire market and
their weights are 46%, 54% in terms of their market cap. If you hold a portfolio with 46% Apple
and 54% Coke, you’re holding the market value weighted portfolio because the weights in your
portfolio is the same as the weights in the market.

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The market value weighted portfolio will be completely diversified since it contains all risky
assets so the portfolio which is the dot on the tangent line to efficient frontier, labelled M, is a
completely diversified portfolio so it has no unsystematic risk, only systematic risk.

Although everyone ends up with the same diagram, everyone may be at different points on the
tangent line, CML. Even though we recognize that the line represents the new efficient frontier,
which is the best combination that we can draw for the market, but where you choose to end up
on the line is completely up to investors. No matter where you end up on the line, you’d have
the same rewards to risk ratio because that’s the gradient of the line. So as long as you’re on
the line, you get the same rewards to risk ratio. But some might only be willing to bear a lower
amount of risk, and others are more risk loving and will be willing to bear higher risk. Your risk
tolerance determines where you end up on the line, CML.

The yellow cross, is for more risk averse investors as they invest 50% in Risk free and 50% in
the market. Suppose you start off with an investment of $100,000, and the market is 40% apple
and 60% Coke. Spend $50,000 on T-bills, $20,000 on Apple and $30,000 on Coke. 40% apple
and 60% coke.

If the investor is more risk loving, he would choose to be at the green cross, so the weights are
150% market, -50% Risk free. What does negative weights mean? Negative sign means that
you borrow against the asset. Markowitz assumed that you could borrow against the risk free
asset which means you borrow at the risk free rate. So you’d have -$50,000 T-bill (borrow
$50,000 at the risk free rate) and put $150,000 into the market portfolio with $60,000 in Apple
and $90,000 in coke again with the same market weights. This is the markowitz portfolio theory
which suggests that this is the most efficient combination which is to mix risk free with the
market portfolio. The second step of this theory is that depending on your risk tolerance you
decide where you want to end up.

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In higher level finance mods, we’d learn how to derive the points exactly for any investor based
on their risk appetite. We convert their risk tolerance into a utility function which allows us to
then draw indifference curves. Non-examinable. Based on the indifference curve of the investor,
we then superimpose the indifference curve onto the diagram.

If the risk free rate changes the CML changes, it’s not like the SML which will translate, the CML
can’t translate because it has to remain tangent to the efficient frontier. So the slope changes
and you have to change the tangent point.

What is the difference between the SML and the CML? SML tells us return to Beta relationship
and CML tells us the return to standard deviation relationship. CML shows us combinations of
the risk free with the market portfolio. Different weights of the risk free with the market is what
CML shows us. CML is made up of diversified portfolios while you adjust the weights between

63
the risk free and the market. The market is diversified. Any portfolio on the CML is a diversified
portfolio.

However, if you look at the SML, recall we mentioned that all assets and portfolios will be on the
SML in equilibrium. So SML will contain all assets and portfolios because every stock has a
beta and thus has a return. SML will show us for all assets, stocks and portfolios whereas the
CML only shows combinations of the risk free with the market portfolio which means only
diversified portfolios are included on the CML. Individual assets will not be on the line, they’d be
inside the efficient frontier as points.

Lecture 6: Bonds
If comparing just stock 1 against stock 2 alone, how do you find out which one is riskier?
We use CV, but most of the time we assume the portfolio is diversified so we worry more about
Beta.

If stocks are correctly priced, they would all have the same reward-to-risk ratio.

Video reminds us that even though we say we should diversify our assets across all asset
classes, we can’t actually assume that that will actually result in diversification benefits.
Sometimes asset classes that appear not to be related at all can actually be highly correlated.
No extra diversification by spreading investments across various asset classes because they
may follow the same trend over history, very correlated.

Look at the underlying risk of each investments

Equity how much your investment moves with the broad market
Credit
Inflation some do well like gold
Illiquidity

You still have to understand the correlation and perhaps study the asset class etc.

Different risk factors: In higher levels of finance, you’d learn about the other models to price
assets. CAPM is just one model. We argue that the return of the asset is simply determined by
the market risk premium. Other pricing models may have more than one factor. All these factors
would affect the determination of the final return for the asset.

Bond valuation:
Lecture 6 onwards, things are very similar in nature, the idea is to value securities, starting off
with bonds. After which, we’d look into stocks, then projects and companies etc. Concept used
is exactly the same every week. A lot of time value of money is involved. As long as you
understand time value of money and how to get present values there shouldn’t be much
problem.

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In terms of valuation we want to compare benefits and cost. If benefits outweigh cost, then the
investment is worthwhile. Benefits are present value of all inflows or positive flows. Costs are
present value of all outflows, or negative flows.

Going to go through some bond features, terminologies, understand how bond prices change,
how inflation affects interest rates, what bond ratings mean and finally understand the term
structure.

What is a bond?
A bond is the long-term debt instrument sold to raise money.

When governments or firms want to raise money, one possible way is to sell bonds. Bonds are
like a long-term loan. Usually issued by governments, or companies.

Buyers of bonds are treated as creditors not as stockholders, creditors are not owners.
Creditors are people whom the firm owes money to, so they can't dictate how the firm runs, no
voting rights neither do they have a board representing them.

Property companies in 2014 in Singapore raising money ahead of time when interest rates were
very low so that when recovery comes that’s when they start buying land and developing places
and being able to launch these properties. Raise as much money as possible when interest
rates are very low because loans are cheaper; pay less interest over the time.

Basic terminology:
Coupon payment: Interest received from buying bonds is referred to as coupon payment.
Bond comes with Coupon rate which would help you then calculate what the coupon payment
is.

What is Par?
Par value: principal of the bond, face-value, amount you get paid back at the end of the life of
the bond, assume $1,000 for this course but sometimes it can be $100 depending on the
country and type of bond we’re looking at.

Take for instance if your coupon rate is 5%, and you get paid annual coupons, then the coupon
payment will be = [5% ($1000)] / 1= $50, every year you get $50 from buying the bond.
Maturity date: When bond is fully paid up.
Term of the bond: Remaining life of the bond, this is what we care about when finding the
present value.

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For this course, we assume that bonds always mature. They have finite lifetimes and there’s a
date they'll expire, that’s when you get back the face-value. There are bonds that don't mature,
called perpetuals. Not many of perpetuals relative to bonds that mature.

When you buy a bond, the issuer promises to pay you back the par value at the maturity date.
Up until the maturity date, they will pay you your coupon payments based on the coupon rate.

Example: If you buy GE bond with a $1,000 Face Value, a 5% Coupon Paid Annually and a 10-
year Maturity.
This means that GE will promise to pay back $1,000 in ten years time, and for the next ten
years, GE would pay $50 every year, calculated by 5% (1000) / 1. If you hold this bond to
maturity, then this cash flow stream is known and fixed, it will never change. Unless GE goes
bankrupt, the situation remains unchanged. Know for sure, that for the next 10 years, you’d get
$50 and on year 10, you’d get $1000.

For this reason, bonds are also called fixed income instrument, because the income is fixed,
they won't fluctuate. Bond returns are much less volatile than stock returns.

Example: What happens if you have Semi-annual coupons?

A Bond with a $1,000 Face Value, a 5% Coupon Paid Semi-Annually
Coupon payment = 5% * 1,000 /2 = $25 every 6 months.

More Terms:
Some bonds come with callability feature. There is a Call option embedded into the bond, which
gives the holder of the option the right to buy the bond at a pre-determined price or date. There
is a choice, which lies with the issuer of the bond. The company issuing this bond has the right
to buy back or redeem this bond prior to the maturity date at the Par value of the bond usually,
occasionally they may pay a call premium so they give slightly more than par. This allows the
company to buy back the bond before its maturity date.

Putability: There is a put option embedded into the bond. The put option gives the owner of the
bond the right to sell the bond before the maturity date. The choice of being able to exercise this
option of selling back the bond lies with the investor, so the investor has the right to sell back
the bond to the issuer prior to the maturity date and the price at which they would sell it at would
also be the par value.

It’s not possible for a bond to be both putable and callable at the same time.

Seniority: Bonds come with different seniority levels. Senior or junior bonds or subordinated
bonds. These are labels which help you define the packing order in terms of hierarchy, paying
priority, these payments refer to both coupon payments and in event of bankruptcy the Senior
bondholders get their payments back first, so senior bonds are less risky since they have first
right to the money.

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Debenture: Unsecured bond, bond bought in good faith, no collateral. Believe the company will
return the money and there is no guarantees. You just buy the bond because you think the
company has credit worthiness.

Bond yields or returns are expressed in Basis points: A basis point is one hundredth of a
percentage. 1% is 100 Basis points. So if the return is 5.5% and it goes up to 5.62%, the
increase is 0.12%, so we describe it as an increase of 12 basis points. We don’t even say 5.5%
but instead say 550 Basis points to 562 Basis points.

Convertibility: Another option embedded into the bond which allows the bondholder to convert
their bonds to shares, there is a conversion ratio as well as specified terms.

Protective covenants: Protect the investor. Covenant is an agreement between two parties,
covenant here is between the issuer and investor. Agreements set out by companies when they
first issue the bond to assure investors that they'd have enough money to pay them back. E.g of
these covenants would be if the company says it would cap its debt ratio at a certain level, won’t
issue any more senior bonds, Net working capital must be this much etc alluding to financial
health. This guarantees investor.

Sinking fund bonds: Sinking fund is like a regular savings plan, the company sets aside money
every period perhaps every quarter. The Sinking Fund is then used to periodically buy back the
bond. E.g Every quarter the company sets aside $3 million, then in year 6 it wants to buy back
10% of the outstanding bonds using the money in the sinking fund. Buy back in portions at
relevant intervals. The investor will thus experience lower credit risk, the risk that the company
doesn't have enough to pay you back. Knowing that the company sets aside money intentionally
for the purpose of redeeming their bonds, then investors know that there is more assurance,
reduces credit risk. If the company buys back the bond before the full ten years, then this
reduces the average maturity of the bond based on a weighted average basis.

For this course, we assume that the sinking fund bond reduces risk, seen as less risky than
plain bond. Sinking fund is managed by bond trustee, third party usually financial institution
manages the fund. This creates independence of management. The investor knows that
someone else is managing the fund so the Company can't use the fund for other purposes.

Indenture: bond contract, contains all terms.

High risk, high return, low risk low return. Same in the case of bonds. When bonds are more
risky it must come with higher returns. If the coupon rate is determined based on the risk of the
bond when issued, it would suggest that if the bond is riskier it must come with a higher coupon
because the coupon is one source of return for the investor. More risky bonds should have
higher coupons. On issuance date, coupon rate is determined and stays with the bond until
maturity date.
Example: Between these pairs of bonds, which should have a higher coupon?
Secured bond vs Unsecured bonds (debentures)

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Subordinated vs Senior debt ; Subordinated more risk
A bond with a sinking fund versus one without?
A callable bond versus a non-callable bond

Why are callable bonds more risky?

Callable bond is more risky, because option lies with issuer not with bondholder, so bondholder
doesn’t know when the bond will be called. If you had bought a 30 year callable bond, and
thought you’d get 30 years worth of coupons but then in year 10, they call back the bond, then
you lose coupons for the next 20 years. Have to re-invest the $1000.

In the same sense, it makes putable bonds less risky than normal bond because the right is with
the investor.

How do you value bonds?

The bond has fixed coupons and a par value at the end. To price bonds, simply present value
the annuities of the coupons and present value of the par or lump sum.
Bond value = PV of coupons + PV of par

PV of annuity formula and PV of FV formula. Add together gives the price.

If you hold a bond to maturity you never lose principal, always get back $1000 unless the firm
goes bankrupt. However, if you choose to sell the bond prior to the maturity date then you might
not get $1000 because you’d get whatever the sell price is based on the market price at that
time.

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Let’s say you choose to hold the bond for one year and now you want to sell it. So how do you
calculate the Annual rate of return?

Formula is same as when trying to calculate annual stock returns when you have dividends, a
change in price and divide them by the original price.

Example: You receive $80 as coupons, bought the bond at $863.73. End Price = $870.10
Capital gain = $870.10 - $863.73 =$6.37
Add to coupon:Total return = $86.37,divide by original bond price= ($80 + $6.37)/$863.73 =
10%

In the world of bonds, we seldom calculate returns for bonds this way. Because we don’t believe
the investors trade bonds. More common for bondholders to hold the bond till maturity, unlike
stocks where you’d buy and sell. When you buy bonds, the idea is that you buy bond because
of the high return and because bonds are not volatile, you’re willing to hold on to this instrument
to enjoy this return as part of your portfolio. Thus its common for bankers to buy bonds and hold
them till maturity.

Thus, more commonly we calculate Yield to maturity: the rate earned if you hold the bond to
maturity. Use this yield as the discount rate to discount back all the future cash flows to price the
bond. So this Yield to maturity is also the discount rate that we use to discount back the
coupons and the par to price the bond, and the yield thus becomes the market rate. Market rate
means that if you go to the market prices, whatever yield found there is the market rate which is
also the yield to maturity that will then determine the market price. Yield to maturity is often just
called yield because it's the most commonly used yield in the world of bonds. YTM is the
default.

Example: A bond has a $1,000 par value due at t = 10, 10% coupon rate, annual $100 coupon
payments, and a discount rate of 13%, YTM=13%. Discount back all the cash flows by 13%.
Price of the bond is then $837.21

Example:A bond has a $1,000 par value due at t = 10, 10% coupon rate, annual $100 coupon
payments, and a discount rate of 10%, YTM=10%. On the calculator:
FV: 1000, N: 10, I/Y:10 (discount rate), PMT: 100

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On thing to note when valuing bonds: keep the YTM or discount rate completely separate from
the coupon rate. Coupon rate is used to determine the coupon, used to find PMT, never used as
I. I is the YTM or discount rate.
Answer from calculator would be PV=$1000, price of the bond is hence $1000.

Rule 1 for bonds:

If coupon rate equals discount rate, the bond will be priced at par, price of bond equals its face
value. In this case, coupon rate = 10%, YTM=10%, if they’re the same then the bond is
automatically priced at $1000.

So what happens if there is inflation?

When inflation increases, then all market rates would increase, in which case the discount rate
will also increase from 10% to 13% if inflation rises by 3%. So what would the price of the bond
be now? Everything remains the same except for the discount rate. On the calculator:
FV: 1000, N: 10, I/Y:13 (discount rate), PMT: 100
Answer from calculator would be PV=$837.21, price of the bond is hence $837.21.

Rule 2 for bonds:

Rule 2: If coupon rate is less than the yield, then the price is less than the par, these type of
bonds are called discount bonds. If the price of the bond is less than $1000, we call these bonds
discount bonds.

The reverse can happen when inflation falls, then discount rate falls.

Example: Inflation falls, discount rate falls

Suppose the discount rate falls from 10% to 7% if inflation falls by 3%. On the calculator:
FV: 1000, N: 10, I/Y:7 (discount rate), PMT: 100
Answer from calculator would be PV=$1210.71, price of the bond is hence $1210.71. The price
of the bond will be higher than $1000.

Rule 3 for bonds:

If the coupon rate is higher than the discount rate, then the price of bond is higher than its face
value, call these bonds premium bonds. Premium bonds simply mean that the bond price is
more than $1000. They don’t allude to being of greater quality, doesn’t mean it’s better.

What happens if you have Semi-annual coupons? How do you calculate the price of the bond
with semi-annual coupons? If the price of the bond is simply the present value of all future cash
flows, if you have semi-annual coupons, you have to think in terms of semi-annual periods.
Same principle as time value of money.
Example: Suppose you are looking at a bond that has an APR or stated coupon rate of 16%,
paid semi-annually, and a face value of $1000. There are 20 years to maturity and the semi-
annual yield to maturity* is 10%.
How many coupon payments (periods) are there?

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20 years * 2 = 40 coupons in total
What is the semiannual coupon payment?
Coupon payment formula:
APR = 16% ⇒ semi-annual coupon rate = 16%/2 = 8%
Semi-annual coupon = 16% / 2 * $1000 = 8% * $1000 = $80
Price of this bond will be found on the calculator:
N:40, I/Y:10, PMT: 80, FV: 1000, Compute PV=804.419

Current yield:
Calculated as the Annual coupon divided by the current market price.
Example: If a $1,000 bond selling for $850 and paying an 8% coupon rate (or $80 per year) has
a current yield of 9.41% ($80 divided by $850).

Current yield is not used much because we feel that it’s Inadequate in terms of a representation
of the return of the bond. Current yield only shows you the return of that coupon only, the
coupon as a proportion of the market price (what is paid for the bond). Almost like the return
from the coupon but doesn't capture the difference between the purchase price and the par
which is also another form of return. Hence current yield is not a full understanding of the total
return from buying the bond. YTM is a better measure of return.

YTM becomes a key piece of information to compare all investments of the same risk. Bonds of
the same risk must all have the same yield. (important principle)

Don’t just look at the coupon rates to compare bonds, but look at the YTM instead. Bond with
high coupon rate, but it could be very highly priced. This is the same as a bond with a low
coupon rate but at a very low price, because YTM would be the same. Looking at the coupon
rates could be misleading in this case.

What’s the relationship between YTM and bond prices?

Since the bond price is usually the discounting of the future cash flows and the yield. The yield
is simply the discount rate and by time value of money we understand that the higher the
discount rate, the lower the present value. If yields go higher, bond prices become lower. If yield
drops, bond prices increase.

Nonetheless, if you hold the bond to maturity, you’re guaranteed to get your principal back. If
interest rates rise in the market causing bond prices to tank, if you intend to hold the bond to
maturity, you wouldn’t be worried at all because you’ll always get back $1000. Market price of
the bond may be $600, but if you hold the bond to maturity, you’ll still get back the $1000.

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The relationship between YTM and bond prices is a curve that is downward sloping. Convex
shaped curve.

If the bond is issued at 8% coupon, you’d have an 8% YTM with $1000 bond price. If interest
rate rises to 10%, the bond price drops to $810.71. When interest rates increase, bond prices
drop and when interest rates drop, bond prices increase.

Example: You buy a $1000 bond, matures in 10 years time with coupon rate of 10% paid
annually. Get $100 every year for the next 10 years.
In this case, YTM 10%= Current Yield (Annual coupon / current market price = 10%)= Coupon
Rate 10%
How do you tell that the YTM is 10%, because the bond is a par bond. Bond is priced at par
then the YTM = Coupon rate (Rule 1 for bond).

Example continued: 7 years later, the same company issues new bonds. Issue new 3 year
bonds and the term of the bonds purchased before is also 3 years. The firm issues the new
bonds at 5% YTM so it means that interest rates have changed in the environment after 7 years.
If these new bonds are issued and sold at par as well, then they would also come at 5%
coupons which pays $50 every year. New bonds give $50 each year but the previous bonds if
sold in the market will give $100 every year. So which bond will be preferred by the market?
Without knowing the price, the idea is that $100 > $50, so the market will say the former is more
worth. Hence, the bond you hold giving $100 per year must be priced above $1000. If newly
issued bonds with $50 coupons priced at $1000, your bond that gives $100 every year must be
priced above $1000. So how much more will be it be priced at?
How do you price your bond with 3 years left to maturity? It would be priced at $1136.16.

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Use the calculator:
N:3 (3 years to maturity), I/Y:5, PMT: 100, FV: 1000, Compute PV.
Bonds of the same risk must have the same yield so the current bond and the newly issued
bond have the same risk since they are issued by the same company. If the newly issued bonds
with 3 year maturity come out with 5% YTM, your bond will also have the same YTM of 5%
since they both have the same risk. So even though your coupon rate is 10%, and the new
issued bond is 5% coupon rate, what changes is the price. Both will still have the same YTM.
Just that if you buy your bond, you’d pay more for the higher coupon. This is a premium bond
since it is more than $1000.

Premium bonds:
For premium bonds this inequality holds:
YTM < Current Yield < Coupon Rate
YTM is the lowest, coupon rate the highest and the current yield is in between.
In this case, the Current Yield for the premium bond = 100/1136.16 = 8.8%
5% < 8.8% < 10%

Discount bonds:
Reverse is true for discount bonds.
Coupon Rate < Current Yield < YTM

Par value bonds:

Coupon Rate = Current Yield = YTM

Some bonds don’t give any coupons at all. These bonds are called Zero coupon bonds. Zero
coupon bonds: no current yield, entire yield to maturity for this bond must come completely from
difference in price and par. If you expect positive returns from buying zero coupon bonds, they
must be priced nothing more than par, $1,000 if not you get a negative return at the end of
maturity. For a positive interest rate environment, you should pay something less than $1000 to
get a positive return on this bond. In countries where interest rates are negative, it’s possible to
buy zero coupon bonds that are more than $1000. For this course, since we assume interest
rates to be positive, we don’t expect zero coupon bonds to be priced more than par, $1000.
Zero coupon bonds are also called pure discount bonds, since they’re always at a discount.

To find the YTM use the calculator and input in all the other values. Without the calculator, it’s
just trial and error into the formula for the bond price.

Example: Suppose you have a bond with 10% coupon rate, 15 years to maturity and par value
of $1000, price is $928.09. How do you calculate the YTM? Do you expect it to be higher or
lower than 10%? Higher because it's a discount bond, price is lower than $1,000, the YTM must
be greater than the coupon rate. Key in following in calculator: Since keying both FV and PV,
make sure they’re of opposite signs.
N:15, PV: -928.09, PMT: 100, FV: 1000, Compute I/Y. I/Y=11%

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Both PMT and FV must be of the same sign. Inflows are positive sign.

Example: Semi-annual coupons

Think in terms of periods. Suppose a bond with a 10% coupon rate paid semiannually, has a
face value of $1000, 20 years to maturity and is selling for $1197.93. Premium bond.
Is the YTM more or less than 10%? Lower.
Semi-annual coupon payment = 10% (1000) / 2 = $50
YTM can found with the calculator:
N:40, PV: -1197.93, PMT: 50, FV: 1000, Compute I/Y. I/Y=4%
Stop here and it’s wrong because the YTM under this is only for a 6 month period. But the YTM
is an annualized number.
YTM for the year = 4% * 2 = 8%
YTM is like the APR after you find the period rate, 4% multiply by 2 to get YTM.

Bonds of the same risk must have the same yield. This is useful in the sense that if you have an
entire pool of bonds with the same risk, but you only know the price of one bond. You can use
the price of the one bond to deduce the yield. Since all the bonds have the same risk, they have
the same yield, then you can price each. You only need to know the price of one.

What happens to bond prices over time?

Common sense would tell you that bond price will go closer and closer to its par, $1000 over
time. Why? Because you’re going to have less and less coupons to discount so if you think
about it, if the bond matures tomorrow, how much will you willing to pay for this bond? Just very
close to the par because tomorrow you get the par value, how much would you pay for it today?
Not much more than $1000. 1 day to maturity close to $1000 would be paid. 2 days to maturity
and you’d still pay close to $1000. Thus, over time, the bond price gets closer to its par.

So if you issue a 30-year zero coupon bond at 5% discount rate, over time if interest rates stay
at 5%, the bond price will go higher until it reaches close to $1,000. There is less discounting
taking place. If you issue a 10% coupon bond, it will be premium bond but over time also the
price goes lower to 1000, because you’re receiving less coupons.

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Jagged lines suggest that even if interest rates do deviate from 5%, the bond price can be
volatile in the market but nevertheless the overall trend is that it will still head towards $1000.

Bond ratings determine their creditworthiness, or safety in terms of whether to buy them. Triple
A: safest of all, almost zero default risk, issuer almost always pays you back.

There is a separation of bonds into 2 groups. Any rating of Triple B and above are considered
investment grade bonds. And anything below Triple B ratings are called junk bonds or high yield
bonds, speculative bonds. High risk high returns. Very safe bonds would come with lower
returns. High risk bonds will come with higher returns.

How do rating agencies come up with the ratings?

Owing to the solvency of the firm, debt ratios, current ratios, liquidity ratios, based on historical
matrix, fall in a category which determines the rating. The characteristic of the bond also affect
its ratings.

Government bonds:
Government bonds are known as Treasuries.
1. T-bills – pure discount bonds (zero coupon bonds) with original maturity of one year or less
2. T-notes – coupon debt with original maturity between one and ten years
3. T-bonds - coupon debt with original maturity greater than ten years

In Singapore we have two sources of government treasuries one from MAS and another from
the Singapore Government Securities.

How do taxes affect returns?

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If you get Taxed for bonds, you have to worry about after tax returns. Suppose corporate bond
has a yield of 8% and a non-taxable municipal government bond has a yield of 6%. Suppose tax
rate is 20%.
After tax, 8% becomes 6.4% = 8% (1 - 0.2), still worth it to buy the corporate bond, although it
comes at a higher risk than the government bond.

At which tax rate would you be preferring the government bond instead?
Equate after tax returns to 6%, 8% (1 - T) = 6%, T = 25%, if tax rate is 25%, you’d buy the risk
free government bond.

In this course, we only deal with fixed coupon bonds where the coupon rates is determined at
issuance and remains the same but in the real world there are coupon rates that can change
based on certain changes in other rates, usually these coupon rates are pegged to other
indices, like the CPI, protect you against inflation increase.

Bonds names indicate what the funding is for. Disaster bonds, pandemic bonds, catastrophe
bonds, raise funds to pay for times of natural disaster.

Income bonds are bonds which have fluctuating coupon rates depending on the income of the
firm. When the firm makes higher income, you get higher coupons and vice versa.

How are bonds traded in the market? They’re traded over the counter. Stocks are bought
through online brokerage, where you put in your bid and an online third party handles all
matching of the bids and the offers. Everything is done through an exchange such as New York
Stock exchange. Not the case for most bonds, most bonds are transacted from dealer to dealer,
banker has to speak to other bankers. Most bonds usually held by these financial institutions.
Bond transaction data is thus not published as regularly as stock data, not up to date
information as stocks, especially for illiquid issues. Recall in L2, we talked about Enterprise
value: we need Market value of debt, not updated so we fall back to book value of debt.

Quick Review Question

On March 1, 2006, Ford Motor Company issues a ten-year $1000 bond. The coupon rate is 8%
paid semi-annually. You buy the bond at par.
a. What occurs on March 1, 2006? Buy the bond from Ford for $1000.
b. On what dates will the interest be paid? Six months from the issue date of March 1 is August
31. Six months from August 31 is February 28. Interest is paid on those dates every year until
the final payment is made on February 28, 2016.
c. What is the amount of each interest payment? 8% * 1000 /2 = $40
d. How many interest payments will be made? 10 *2= 20
e. How much total interest will be paid over the life of the bond? 20*40 = $800
f. What is the face value of the bond? $1000
g. What is the maturity date of the bond? Feb 29, 2016

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All returns calculated for securities are nominal returns. So when we calculate annual stock
returns, YTM they're all nominal so they don't correct for inflation, don't tell you how much more
purchasing power you have now. Need to correct it for inflation using Fisher's equation.

For instance if you want a 10% real return, and inflation rate is 8%, then how much nominal
return do we need?
Nominal r = (1.1)(1.08) – 1 = .188 = 18.8%
Approximation: r= 10% + 8% = 18%

Term structure: Understand the relationship between yields and terms (remaining life of bond)
Another term used to explain this relationship is the Yields curve. Plot graph of returns against
terms. To plot the graph, you have to remove all the other factors that convulate the
relationship. So the bonds used to plot the graph must have same risk, same coupon, ceteris
paribus, only have the term as different. Easiest way to do this is to use treasuries, because
they’re risk free.

Normally the Yield curve is upward sloping, when the economy is doing well. Why? Common
sense: Expect to have higher return for longer term bonds, because of time value of money, to
sacrifice the utility of money for a longer period of time, you’d expect a higher compensation of
higher returns.

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However, sometimes the curve could be downward sloping, where longer term yields can
actually be less than shorter term yields.

Upward sloping curve can be broken into three parts: Real rate, inflation premium and interest
rate risk premium for bonds.

Inflation premium tells you the inflation rate expectations. So in normal times when you expect
the economy to continue to grow, inflation premium would increase over time.

Interest rate risk premium also increases as term increases. Interest rate risk: risk that prices of
bonds change with changes in interest rates. Longer term, longer time exposed to interest rate
changes. Shorter term bonds will have less interest rate risks and longer term bonds have
higher interest rate risks. So you have to compensate for this additional risks with additional
returns.

If we look at the downward sloping curve, the interest rate premiums always increases with
longer terms. Idea is that as long as you’re exposed to interest rate changes over a longer time,
then interest rate risk will be high with longer terms. What changes is the inflation premium. In
very recessionary time, downward sloping curve is obtained. Expectations for inflation
decreases with time. We call this abnormal or inverted curves, last for maximum couple of
months before they correct back to positive sloping curves.

At some point the curve can become flat.

Factors that affect bond yields:

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1. Real rate of interest
2. Expected future inflation
3. Interest rate risk
4. Default risk
5. Taxability
6. Lack of liquidity

Suppose you’re company A issuing bonds today. How do you determine the coupon rate or
interest to give? If you sell at par, the YTM is equal to the coupon rate. All of the above factors
affect the coupon rate.

The first three factors are captured in the Yield curve of the treasuries so that will be the rate for
risk free bonds. That becomes the lower benchmark, can’t possibly issue bonds with lower
returns than the government, they’re risk free. On top of the risk free bond rate, you have to add
default risk premiums because the company can default. Not as default free as the government
because the government can always print money.

Assume you need to add 100 basis points, and the current government bond rate is 3.3%, then
now you’re at 4.3%.

Next you have to worry about taxes. The government bonds are tax free. Based on the average
tax rate of investors, you have to calculate if after tax, is the bond still worth buying. If it’s not
worth buying for investors, then you can adjust it upwards up to 5%.

Additionally you have to add liquidity premiums, the additional premiums added for liquidity
risks. Risk that investors cannot liquidate their bonds, convert it to cash at no significant loss of
value. Say about 2 years down the road, can investors still sell the bond quickly and yet obtain a
good price for it. The possibility is that they may not if there is no one willing to buy the bond,
then they can’t sell. There are potential liquidity risks for buying any other issues apart from
government bonds which are most liquid because everyone wants to buy government bonds.
So there is a possible lack of liquidity so you have to add liquidity premiums. Finally bringing it to
6%.

The first three reasons are captured in the treasury yield curve so for that reason the
government always has to be a big player in the bond market especially for Singapore.
Singapore government issues bonds not to raise money. Budget statement, where the money
comes from is mostly from taxes, not much from the bonds. Why issue?
1. Provide the benchmark, if no one knows what the risk free rate is then no one knows
how to price their bonds.
2. Create a more vibrant bond secondary market. If more govt bonds are in the market, this
creates greater liquidity. Greater confidence that secondary market is alive and active.
Encouraging firms to come here and list, issue bonds.
Tutorial: Shortest 5 qns
All qns hinge on valuation

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How to price the bonds, all time value of money
Create relationships between pricing and other factors
How does term affect the price?
How does coupon rate affect the price?
You’ll find certain relationships as you do the tutorials.

Lecture 7: Stock valuation

Last week we talked about bond valuation where we present valued all the coupons and present
valued the par and we determined the price of the bond. Likewise for stocks, when it comes to
stock valuation again we are going to present value all future cash flows. So it’s extremely
similar except that for stocks we have different cash flows.

The idea is that the stock price today depends on its future dividends. So if we present value all
the future dividends, that becomes the stock price. There are 2 models we’ll be introduced to in
terms of how to evaluate stock:
1. Dividend growth or Dividend discount model
2. Corporate valuation model or Free cash flow model

Last few stuff on IPOs and how the securities reach the market are non-examinable.

When you buy stock, there are two ways to make returns:
1. Capital gains yield
2. Dividend yield

What are dividends?

Cash disbursements from the firm as part of their net income. So if the firm makes profits, as a
way to return value to the shareholders the firm can decide to give back a portion of that net
income as dividends. However, dividends are absolutely in the discretion of the management so
it’s the management that decides if they want to give you dividends or not. Hence, it's not a
liability until declared. So shareholders can’t sue the company if it doesn’t give them dividends.
It’s purely a management decision, shareholders can’t insist on it. This is unlike the coupon
payments on a bond which are contractual obligations. So a firm cannot go bankrupt for not
paying dividends.

How are dividends taxed?

In Singapore, dividends received by the investor aren’t taxed, the government taxes the firm on
their earnings, out of this earnings, their net income, the corporation then gives out dividends.
So the same and same dollar is not taxed again. Since dividends come from the net income it
has already been taxed at the corporate tax level. This is not true in all countries.

What happens for the firm is that there is no tax rebate or clawback from taxes from dividends.
This is unlike coupon payments for bonds. So when you raise money through bonds, you pay

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coupon payments and this will appear as interest expenses in your income statement. Since it
appears as interest expense on the income statement, you get an interest tax shield, so you end
up paying less taxes. However, this is not the case for dividends. Dividends come out purely
from net income, so there is no tax deduction.

So far we’ve been using these 3 values.

There are several types of value, for example
1. Book Value: The price paid to acquire the asset (including betterments), less
accumulated depreciation. (What you find in the financial statements, its equal to
historical cost less accumulated depreciation)

2. Market Value: The price of an asset as determined in a competitive marketplace. (What

something is worth today, if you need to sell the asset today, what is it’s worth or how
much can you raise or sell it for?)

3. Intrinsic Value: What an asset is really worth. In finance, estimated by the present value
of the expected future cash flows discounted at the decision maker’s required rate of
return from CAPM or its true required rate of return. (Derived from financial models and
estimations and projections of what the cash flows are in the future, this involves some
kind of modelling and we present value all the future cash flows and that’s what we
deem to be true value which is termed as intrinsic value.) The intrinsic value will depend
on the amount, timing and risk of those projected cash flows. The risk is translated to
some required return using the capital asset pricing model. As you can recall, the CAPM
suggests that the required return of an asset is simply the risk free rate + the asset’s risk
premium. The asset’s risk premium is then therefore determined by the systematic risk
of the asset. Even then the intrinsic value can and often is different for everybody. This is
because everyone has different ideas of what the projections would be. Given slightly
different information and different ways to analyse what is going on, we could all have
different expectations of what is going to happen in the future, we could all have different
ideas of what the firm could do in the future and so this would then generate different
projected cash flows, and different intrinsic values for everyone. This then creates the
financial market. If everyone had the same intrinsic value, there’s no way that the stock
price would change because everyone thinks that the stock price is going to go in the
same way, in which case everybody wants the same direction of the trade. So if your
intrinsic price is $100 and someone else’s is $95 and the stock price is at $97, then
that’s where you’d buy and the other would sell, because the other thinks the stock price
would go down whereas you think that the stock price will go up. So that’s where there is
a market. So if everyone thinks the same way and the stock price is wherever it is, then
the stock price will basically never move. That’s the idea.

Dividend growth model:

Let’s start with a 1 year example: Assume you have this stock and in 1 years time you’re going
to receive a $2 dividend and you also sell the stock for $14. So what kind of cash flows do you
have?

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You’re going to have a $2 dividend after one year and a $14 sale price. So there’d be two cash
flows. Assuming that the required return of the stock is 20%, so we’re going to discount back
these two cash flows, at the rate of 20% for one period and we get the price of the stock at
$13.33.

Now let’s assume we sell the stock after 2 years. In which case, what is the cash flows? After 1
year, you get $2, and after 2 years, let’s say the firm pays us a $2.10 dividend and also we sell
the stock for $14.70. So if we look at the timeline, what are the cash flows:
$2 dividend after one year, $2.10 after two years, and a sale price of $14.70 after two years.
Again we discount these future cash flows at a discount rate of 20%, add them together which
gives us the stock price of $13.33.

Let’s say we delay the sale again by one more year. So what are the cash flows now? We’re
going to get a $2 dividend after one year, $2.10 dividends after 2 years, and $2.205 cents after
three years and we can sell it at $15.435. If you discount all these cash flows at a rate of 20%,
the stock price today will be $13.33 based on these expected cash flows in the future.

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So the dividend growth model works as such, let’s assume that we continue to delay the sale of
this stock, or we might never sell this stock, in which case there is no sale price to worry about.
If you delay the sale of the stock, the sale price would be at infinity in which case when you
discount it back, it’d be zero. Hence the stock price will simply be the present value of all future
dividends. Thus the model suggests that the price of the stock is simply going to be all future
dividends discounted:

However, then the question becomes, how do you know what D is? The dividends after all are
completely in the discretion of the management and then there is actually no way to understand
what these future dividends are. So we need to come up with some simplifying scenarios to
make the situation fit into some model. So we’ve got 3 possibilities, there are infinite possibilities
but we just have 3 to make it simple.

1. Constant Dividend (Zero-Growth Dividend)

a. The firm will pay a constant dividend forever
b. The price is computed using the perpetuity formula
When the dividends are the same every year, so if the firm starts to pay a $2 dividend,
we assume it continues paying $2 dividends.

2. Constant Dividend Growth (Stable Growth)

a. The firm will increase the dividend by a constant percent every period
Assume that the dividends would grow but they grow at a constant rate, g. So for
example if the firm pays $2 dividend, and the next year if g=5%, then the firm pays $2.20
and the following year it pays $2.205. So the rate of growth is constant at 5%. That is a
constant dividend growth stock.

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 3. Supernormal Growth (Non-constant Growth)
a. Dividend growth is not consistent initially, but settles down to constant growth
eventually
Break up the dividends into stages. So maybe from period 1-5, there is a 20% growth in
dividends and from year 6-10, there is a 10% growth of dividends and from year 10
onwards, there is a stable growth of say 5%. We break it down into stages based on
these expectations and that would make it suitable for this model.

Scenario 1: Constant dividend

So if the firm gives you $2 dividends, it will pay you $2 dividends forever. If it pays you the same
dividend each year then the present value of this stream of cash flows is simply the present
value of the perpetuity. It would fit the definition of a perpetuity because there is the same cash
flow, experienced every same period, in this case let’s say annual and it goes on forever. So the
stock price becomes the present value of this perpetuity. So that’s the formula:

For the context, of a stock its P0 = D1 / r , so what is r? It’s the required return of the stock and is
derived from your capital asset pricing model and then D1 is just the dividend that you get.

Example: Let’s say you’re given $0.50 of dividend every quarter and your stock required return
is 10% with quarterly compounding let’s say. Then what is the price of this stock? Present value
of this perpetuity = 0.50 / 2.5% = $20 which will be the price of the stock. Constant dividend is
nothing more than a perpetuity.
Scenario 2: Constant Dividend Growth
So there is constant growth of g of the dividend. So the year 1 dividend, D1 = D0 * (1+g)
Year 2 dividend, D2 = D1 * (1+g) = D0 * (1+g)2
Year 3 dividend, D3 = D2 * (1+g) = D0 * (1+g)3
So if you put it back into the model, which says that the P0 is simply going to be the present
value of all dividends and you substitute all the Dividends with D0 * (1+g)n. The equation can be
simplified:

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This is no different from the growing perpetuity formula simply because there is a constant
growth g, which fits the definition of a growing perpetuity. So in scenario 2, the stock price
becomes the present value of a growing perpetuity, which is calculated as the first cash flow
divided by (r-g). For stocks, the first cash flow is D1 , the dividend at the end of year 1. And r is
the required return on the stock. When do we apply this scenario in real life? If we expect the
firm to have a constant dividend growth, this must come as a result of the fact that the firm must
be experiencing constant profit growth. Because if dividends come out from the net income and
if we assume that the firm has a dividend payout policy in which they fix a percentage of their
net income as dividends, then the dividend would grow only if net income grows and usually at
the same rate. This scenario can then be applied to firms where we expect very stable long-
term growth, very mature company, been around for a while, notice a pattern of net income
growth. This scenario would then be applicable.

The long-term stable growth is usually in line with the long-term GDP growth of a country.
Failing all other information, if you don’t have enough, normally in financial models, we would
apply the long-term growth rate of the country as the long-term growth. So you wouldn’t expect
a very high number for the long-term growth rate, it is usually at the most from 1-6%, especially
for developed countries this is a reasonable rate to use.

If we go back to the present value of perpetuity formula, which is P0 = D1 / (r-g)

We said that this formula only works if g<r, g must be smaller than r in order for this equation to
work. Why? What if g is more than r? When g is more than r, the price of the stock does not
become negative, instead it heads towards infinity. Even though in the formula it looks like when

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g is greater than r, then P0 is negative, this is not true. P0 actually goes towards infinity. G is the
growth rate of the dividend which is the cash flow. rE is the discount rate, which is the rate at
which you’re trying to bring a future cash flow to a smaller number today. That’s what
discounting does. If the discount rate is lower than the growth rate, it suggests that when you try
to bring back the future cash flow back to today, you end up with a number that cannot be
contained simply because the stream of cash flows that you’re trying to compress and discount
continues to grow. The stream of cash flows just keeps growing and growing so much so that
you can’t actually contain it to a finite number so the stock price becomes infinity. So that’s the
limitation of this formula but fortunately for us because g is the long-term constant growth, it
goes forever, it is impossible for it to be higher than rE. rE is the cost of capital based on the
equity and g is the long-term constant growth so we would not normally expect g to be higher
than rE, so this formula should work for us most of the time.

Example: A company just paid you a dividend of $0.50, it tells you that the growth rate of
dividends is 2%, which is g, and the required rate of return is 15%, which is rE. So what is the
price of this stock? For these questions, the main thing to worry about is what is this D that they
tell you. In this case, they just paid a dividend of $0.50, so is this D0 or D1 or what? The words
just paid suggest that this is actually D0 , D0 is actually a dividend which you have already
received. It’s almost like saying today you received the dividend but now you’re trying to value
the stock after you received the dividend. That’s what we’re trying to do in these models. The
next dividend you receive will therefore be exactly one year later, D1 and it would be calculated
as $0.50 * (1.02). P0 = 0.50(1+0.02) / (0.15 - 0.02) = $3.92

The next two graphs confirm that if r-g is close to zero, then the stock price tends to infinity. For
example if r is 20%, and we keep increasing g closer and closer to 20%, then you can see that
the stock price goes to infinity.

If you fix the growth rate at 5%, and we have lower and lower required return, again tending
towards the growth rate, then the stock price would once more tend towards infinity.

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Another Example: Let’s say a firm gives you $2 dividends in one year’s time, growth rate of
dividends is 5%, g, and rE is 20%, then what is the price of the stock? Use $2 as D1 , no longer
have to multiply it by (1+g) because this dividend is given to you in one year, hence that is
already D1. P0 = 2 / (0.2 - 0.05) = $13.33

Example: A firm is expected to pay a $4 dividend next period, which means this is D1 , and the
growth rate is 6%, and the required return is 16%. So what is the price of the stock?
P0 = D1 / (r-g) = 4 / (0.16-0.06) = $40

Then what is the price of this stock in year 4? So you want to find P4. Based on the dividend
discount model, what is P4? P4 will be D5 / (1+r) + D6 / (1+r)2 + …
So you only want to factor in the future dividends from D5 onwards. So basically the formula
becomes P4 = D5 / (r-g) = D1 (1+g)4 / (r-g) = 4(1+0.06)4 / (0.16 - 0.06) = $50.50
To find the dividend in year 5, you take the dividend in year 1, and compound it for 4 periods of
growth to move it from period 1 to period 5.

So what we now know is that P0 is $40 and P4 is $50.50, so what is the implied growth rate of
this stock price? Going from $40 today to $50.50 in 4 years, what is the growth rate?
PV= -40; FV = 50.50; N = 4 ⇒ CPT I/Y = 6%
We can tell that the stock price has grown by 6% every year. What we then notice is that this
percent of growth for this capital or stock price is exactly the same as the growth rate of the
dividends. So that is the Gordon Growth model.

Gordon Growth model:

This model says that for all constant dividend growth stocks, the stock price will grow at the
same rate as the dividend growth.

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Throw in CAPM into the equation, to refresh our knowledge of CAPM. Let’s say the stock has a
β = 1.2, risk free = 7%, return on Market = 12%; D0= 2.00; g = 6%. What is the required return of
this stock and what is its market price?
For required return, simply use the CAPM equation:
Required return, rE = 7% + 1.2 (12% - 7%) = 13%

What is the stock price?

P0 = D1 / (r-g) , D1 = D0 (1+g) = 2 (1.06) = 2.12
P0 = 2.12 / (0.13 - 0.06) = $30.29

What is the stock’s market value one year from now, P1?
P1 = D2 / (r-g) = D1 (1+g) / (r-g) = 2.247 / (0.13 - 0.06) = $32.10

So what we know now is:

D1 = $2.12
P0 = $30.29
P1 = $32.10
We can then calculate for this stock, the dividend yield and the capital gains yield.
Dividend yield = D1 / P0 = 2.12 / 30.29 = 7%
Cap gains yield = (P1 - P0) / P0 = (32.10 - 30.29) / 30.29 = 6%
Total return = 7 + 6 = 13% = (32.10 - 30.29 + 2.12) / 30.29
We realize that this 13% is no different from the required return of this stock. The expected
return of this stock is 13% and the required return of this stock is also 13%. So this stock is thus
in equilibrium, and will plot on the SML.

If we use this equation of P0 = D1 / (r-g) and then make rE the subject of the equation then we
get this equation:
rE = (D1 / P0) + g
What does this suggest actually? rE : required return of the stock based on CAPM. This
suggests that rE , the required return is equal to the dividend yield (D1 / P0) + growth rate of the
dividends. But in constant growth stock, g, the constant growth rate of the dividends will also be
the change in the stock price. That’s how it is for Gordon Growth which happens to be the
capital gains yield for the one year, g is hence the capital gains yield. So what we’re trying to
say is that in equilibrium, expected return = required return. The expected return = dividend
yield + capital gains yield which will also equate to rE the required return in equilibrium.

What happens when g=0? It becomes scenario 1, a non-growing dividend, constant dividends,
the price of the stock will simply be the present value of a perpetuity but we can actually
continue to use the P0 = D1 / (r-g) formula by simply substituting g as 0. So we don’t have to
worry about scenario 1 because all the formulae we have for scenario 2 apply for scenario 1, we
just substitute g as 0.

Scenario 3: Non-constant growth or Supernormal growth

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Example: The firm is expected to grow dividends by 20% for the 1st year, 15% for the second
year, and then a constant growth of 5% thereafter. If the last dividend was $1, and the required
return is 20%, what is the price of the stock?
Last dividend means the most recently received dividend. D0 .
In this situation, we know that the growth rate of the dividend is not constant from time period 0.
But it does become constant after year 2. So at the point where it becomes constant, which is
from time period 2, we can use the constant dividend growth formula. Draw a timeline.

D0 = $1, what is D1?

D1 = 1 (1.2) = $1.20 because there is 20% growth in the first year. What is D2?
D2 = D1 (1.15) = 1.20 (1.15) = $1.38, because there is 15% growth in the second year, what is
D3?
D3 = D2 (1.05) = 1.38 (1.05) = $1.449 because there is 5% growth and it remains forever at this
rate
We don’t have to work out D4 , D5 and more because from end of year 2 onwards we know it’s
constant growth. Hence we can apply the constant dividend growth formula from then on. At the
point of time when growth becomes constant, we try to present value all the future dividends to
the point of end of year 2. P2 = $9.66, the price at the end of year 2, which will simply be
D3 / (r-g). The idea is that if you take the timeline and throw away the first two dividends, and
now substitute 2 as 0, and time=3 as time=1, this becomes a constant dividend growth stock.
With D1 being $1.449 with a constant growth of 5%. We’re just trying to find the stock at t=0,
knowing that D1 = $1.449 and g=5%. The price of the stock then would be D1 / (r-5%) = $9.66.

Then we bring back the first and second year’s dividends and find that for this stock, the price of
the stock at year 0 is the present value of D1 , D2 and the present value of the P2 . So we will

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entire stream of infinite cash flows to just 3, simply because $9.66 already captures the
dividends to infinity. We call the price at year 2, terminal value 2. We call it terminal value simply
because it is the last value for the model. It’s the last one we have to worry about.

So we discount back these three cash flows and we get the price of the stock as $8.67. Quite
simply, for a non-constant growth example or situation, at the point of time when the growth is
not constant, you have no choice but to calculate the dividends individually and discount them
back because there is no simplifying formula. Then from the point where it becomes constant
growth, then you can use the constant growth formula.

We can actually break down the dividend growth into stages. Sometimes we can see a two-
stage dividend growth model, in other words, the first 5 years say is 20% growth and then
thereafter is a 5% stable growth. That’s two stages of growth.

Quick review: If you have constant dividend of $2 and the required return is 15%, what is the
price of the stock?
P0 = D1 / (r-g) , where g=0, then P0 = 2 / 0.15 =$13.13

If you then thereafter increase dividends by 3% per year, what is the price of the stock?
$17.17 = 2*(1.03) / (0.15 – 0.03)

What we can see here is that a stock that grows its dividends would be priced higher than a
stock which has constant dividends. The company for which the dividends grow suggest that the
profits are also growing, which then implies it’s a more profitable company at this time compared
to the previous company. Hence, you’d be willing to pay more for the stock.

Quick review 2: Now you have two stages of growth, the first stage is 30% for 3 years and
subsequently 6% forever. D0 = $2, and the required return = 13%, so what is the price of the
stock?
So again draw a timeline to visualize the problem. D0 = $2, calculate D1 , D2 and D3 individually,
which in this case is multiplied by 1.3.
D1 = D0 (1.3) = 2.6
D2 = D1 (1.3) = 3.38
D3 = D2 (1.3) = 4.394
Thereafter, you’re told that there is a constant long-run growth of 6%, so D4 = D3 (1.06) = 4.658
And when growth becomes constant, this is when you can use the constant dividend growth
formula. So you’d calculate terminal value 3, using P3 = D4 / (r-g) = 4.658 / (0.13-0.06) = TV3
Thus the infinite stream of cash flows are reduced to just 4. Present value D1 , D2 , D3 and TV3
to get the price of the stock which will be $54.11.

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Just want to be careful when drawing the timeline, do not add D0 into the price of the stock. Do
not add the D0 dividend because it has already been received, it’s not a future cash flow.

If the company has cyclical growth, how do you present value the dividends which grow
cyclically? So if the company has a growth rate of 10% for the first three years and then 6% for
the next three and 10% again for the next 3 years and so on and so forth, then you can’t find the
present value. There is no choice, you have to dumb it down to a constant dividend growth, if
you are to use this model. If you’re very sure that the dividends do not fit into any of these 3
scenarios, then don’t use this model and instead use the next model. That’s the advice. The
next model has the same limitation as this model, in all models if you’re projecting something
into infinity, there’s no choice but you have to dumb it down to a constant growth or no growth at
all. There must be a limitation to the model. There’s no way you could project something to
infinity. We have to come up with assumptions, that’s the limit of these models.

So we have these two formulae:

1. Price of the stock, P0 = D1 / (r-g) , for constant dividend growth stocks and if we re-
arrange this, we’re able to derive that the return of the stock is:
2. rE = (D1 / P0) + g, dividend yield + capital gains yield and that would equate to the
required return.

Coming back to the question, we can see that the models are limiting. So is it possible for us to
fit into the real world these 3 scenarios to any stock? Actually no. Is the dividend constant for
any stock? No. Is the dividend at constant growth? No. Because it’s at the discretion of the
company so every year it’s different and it’s completely haphazard. There is no real number you
can pin it to. These are just models to help you estimate what you can expect, but they would

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not give you the exact number per say in that sense. There will always be estimation risk in that
sense.

Example: Let’s say the stock sells for $10.50. So that’s P0. And they just paid a dividend of $1,
and the dividends are expected to grow at 5%, what is the expected return of the stock, rE?
rE = (D1 / P0) + g = [1*(1.05)/10.50] + 0.05 = 15%
In equilibrium, if expected return = required return, we can apply the formula above.

What is the dividend yield? 10%

What is the capital gains yield? 5%

In equilibrium, expected returns must equal required returns so the two equations below will
give the same answer:
𝐷1
rE = rf + β(rM - rf) <- required return and 𝑟̂𝐸 = +𝑔 <- Expected return
𝑃0

If you recall, we said that if a stock is above the SML, it’s underpriced, wherein the expected
return is higher than the required return. If it’s underpriced, then of course, people will want to
buy the stock. And as people buy the stock, the price of the stock goes higher. When the price
goes higher, then (D1 / P0) goes down and as such rE will go down. Hence that’s how the
expected return goes down.

Conversely if a stock is overpriced, underneath the SML, people will sell. Price drops, dividend
yield or (D1 / P0) goes up and as such expected return goes up and the dot moves up towards
the SML.

So P0 = D1 / (r-g). Using this equation we can understand what causes prices of stocks to
change. Why would stock prices change?
If there is a change in any of the three factors in the equation, then the stock price will change.

What is the numerator, D1? D1 = D0 (1+g)

So what would cause D1 to change?
If g changes, because D0 is known, it’s just paid, It becomes unchangeable. In which case, D1
becomes a function of g. So now we have reduced it to only two factors, the stock price only
changes if rE or g changes.

What causes rE to change? rE is the required return based on CAPM, rE = rf + (rM – rf)βi. What
can change rE, so let’s say if the risk free rate changes. If you recall, we said that if inflation
increases, the risk free rate rises and the whole SML goes up, then all required returns go
higher. If all required returns goes higher, then the stock price goes down. Inflation goes up,
stock prices come down. That’s the basic understanding, may not be true all the time but for
now just believe that this is true.

What else can cause rE to change? We also said that in general in the economy if all investors
become more risk averse then the SML steepens. As such, risk premiums increase, and rE

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becomes higher, and with that stock prices will come down. So those are some examples of
how rE can change.

Then what causes g to change? What is g? G is the growth rate of the dividends, which is linked
to the growth rate of the profits. So in that case, what causes the firm to be more profitable?
That would simply be the economic situation. It can either be a macroeconomic kind of factor
that would cause g to be altered for the entire economy or it could be a firm specific kind of a
factor which causes these firms’ profits to change. As long as we understand that there are
changes to the growth prospects of the firm, then the stock prices would change.

In the world, couple of things that people look at would be whether rE is changing or g is
changing. One of it would obviously be the interest rates. We look at the interest rates to see
whether rE is changing. Every time the Fed speaks, then everything starts moving because they
give the direction for rates across the world. So when the Fed raises the rates, the idea is that
the benchmark rate is being moved so the expectations are that the rates are going to get
higher across the world. When Fed increases the rates, the stock prices come down, this is
what is usually seen.

“Most other regional indexes also fell after the U.S. central bank delivered a widely-expected 25-
basis-point rate increase and kept its forecast for another hike this year.” If you recall, we talked
about the efficient market hypothesis, that all publicly available information is already priced into
the stock so if you make an announcement that is in line with the expectations, you do not
expect prices of stocks to change. It has to be new information in order for the prices to change.
The above statement illustrates that it was a widely-expected increase. Then what caused the
prices of the stock to change? “This week’s increase was widely expected, but investors were
hoping for lowered projections for future hikes”. Hence, the current stock prices were priced
based on the fact that investors thought that future interest rates were not going to be as high as
what the Fed now thinks. If you priced the stock based on the modelling of what you thought the
future rates would be, if you’re told that in future the rates are going to be even higher, then you
have to adjust your prices because that’s new information. So it’s not the 25 basis point
increase at this time, because it was widely-expected and everyone had already factored that in
but rather the future, where investors now have to price in the new projections for the future
interest rates. New information causes prices of stocks to change.

What about g? G is linked to the profits of companies. Tokyo Zoo panda gives birth and the
shares of retailers surge. What in the world is the connection here? This is owing to tourism, if
there is a new panda in the zoo, you’d expect more tourists to come to the zoo so because
tourists need to eat, the restaurants around the zoo, the share prices of these restaurants go up.
The rise in stock prices are actually significant, 38% increase for a chinese restaurant and 11%
for the french restaurant. This is owing to the new information. In fact, when there were
announcements that the pandas were mating, this had already resulted in the stock prices to
rise. That is new information that the pandas are mating and thus in the future there may be a
panda, and thus there would be more profits and hence the price rises. In this case, the birth of
the new panda itself is new information because there is no certainty that the panda would

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actually be born because there are 10,000 complications and mating may not be successful. So
this is still considered new information. The economic impact of the baby panda was 26.7 billion
yen (USD $242 million). A lot of money generated for the economy by one baby panda. Any
expectations of how the profits of the companies are going to go up will cause the stock prices
to change.

In the past few days, there has been a lot of news about how if the US introduces tariffs, taxes
on steels etc, these are the companies that would be most affected. So what we’ve been seeing
is a lot of see-sawing in terms of stock prices because one day people are very concerned
about taxes and the next day people say it’s not likely to happen and then the next day they say
it will happen and then etc. g can be speculated. This is based on how g is expected to change.

What is a preferred stock and why is it preferred? There are two types of stocks:
1. Preferred stock (preferred)
2. Common stock (common)

Why is it preferred? Because there is a packing order to the firm’s payment of dividends.
Preferred suggests that you get paid your dividends first before common shareholders. If the
firm goes bankrupt, you as the preferred shareholder will get your money back first before the
common shareholders if any money is to be given at all. Preferred shareholders are above the
common shareholders in the packing order. Another benefit of having a preferred share is that
most are cumulative in nature which basically means that if the firm misses dividends, they must
cumulate dividends before paying the common shareholders. For e.g if the firm does not pay
dividends for 2 years because it has been making losses, in year 3, it makes a healthy profit and
hence declares dividends but it would pay the preferred shareholder 3 years worth of dividends,
since it missed the last two dividends, and only after that can they pay the dividends to the
common shareholders.

What’s the downside of buying a preferred share? Main downside is that the dividends do not
grow, so it’s almost like a perpetual bond, the dividends are made known, so if the firm says the
dividends are $2 for preferred shares, it would remain as $2 forever, it would not grow. So if the
firm does very well and g goes up, it continues to make strong profits, for the common
shareholders their dividends would grow but for preferred shareholders it doesn’t. Additionally
preferred stock generally do not come with voting rights.

What is the expected return for preferred share? For a stock that does not have a growing
dividend, it is a constant dividend stock, we can continue to use the formulae for the constant
dividend growth stock but we just substitute g=0. So what is the expected return formula:
rE = (D1 / P0) + g
For preferred dividend, we know that g=0, so rE = (D1 / P0)
For a preferred stock with dividend of $5, and sale price of $50, the rE = (5 / 50) =10%

Quick review: Let’s say the price of the stock is $18.75. Dividend growth is 5% and the most
recent dividend was $1.50. So what is the expected return?

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rE = (D1 / P0) + g = [1.50 (1+0.05) / 18.75] + 0.05 = 0.134 = 13.4%

That’s all for the dividend growth model. We believe that the stock price is the present value of
all future cash flows, in this case, it would be the dividends being the only cash flow. We
assume that we never sell the stock or we delay the sale until very far away. We have no choice
but to simplify these assumptions on what the dividends can be. Come up with simple
assumptions: either that it’s going to be constant, or constant growth or at least at some point in
time it would reach constant growth even if want to have some realism and assume some non-
constant growth in the start. The next model is known as the corporate valuation model.

Corporate valuation model:

The idea is that the value of the firm is the present value of all its future free cash flows. We’re
going to present value all these future free cash flows and that becomes the market value of the
firm and then we subtract the market value of its debt which will give us the market value of its
equity. Then we divide by the number of outstanding shares and this would give us the intrinsic
price per share. That’s in a nutshell the model.

So what is free cash flow or CFFA? CFFA* = OCF – NCS – Changes in NOWC
The idea is that we have to project the CFFAs into infinity because we have to assume that this
firm will exist and remain going. So how do we do this? The formula involves us having to
project the firm’s financial statements to infinity.

You have to come up with pro-forma statements for the firm for x number of years at least and
then assume that the CFFA would also grow at a constant rate.

Steps:
1. Present value of all the future CFFAs becomes the market value of the firm
2. Subtract the market value of the debt and that gives you the market value of the equity
3. Divide market value of equity by the number of outstanding shares and that gives you
the intrinsic price of the share.

Why is this model used as opposed to the dividend growth model? Because there are many
stocks out there that don’t pay any dividends at all. So if a stock does not pay any dividends at
all, is it worth 0? No. There hence must be a different way to value these types of stocks. So for
this reason we have to use this corporate valuation model. Firms like Amazon, Google,
Salesforce and Berkshire all the big supergiants that don’t pay dividends.

This model and the dividend growth model share the same challenge or limitation which is this
constant growth assumption as mentioned before. In other words, g becomes very critical so if
you get g wrong, or at least you apply a very unreasonable value for g, then the intrinsic price
you’d get would be quite wrong. G becomes a limiting factor. One of the factors that affect the
intrinsic price would be this g. It becomes a very critical assumption but no choice because you

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have to forecast something to infinity, and so you’d have to assume at some point of time that
there is a constant number or constant growth.

Example: Let’s assume that we have derived the future CFFAs, so let’s say CFFA for year 1 is 5
million, CFFA2 = 10 million, CFFA3 = 20 million, and CFFA4 = 21.20 million. And the long-run
constant growth for this CFFA is 6%. So you can work out CFFA4 and so on. For this corporate
valuation model, the discount rate that we use is not rE. It’s this thing called WACC, weighted
average cost of capital. Why do we use WACC, because now we’re trying to value the firm. If
we’re trying to value the firm discounting all the CFFAs generated from the projects they’ve
done, then we have to discount it based on the cost of the funds that’s used to finance these
projects. The funds that are used could actually have a mix of debt and equity because a firm in
all likelihood has bonds, loans and raises money through stocks, then there is actually two
sources of funding. So we have to do a weighted average of the cost of the funds to understand
what would be the final cost to discount back to make it fair so that’s why we use the weighted
average cost. The formula for the equation will only be gone through in lecture 10.

Why is the cost of debt always lower than the cost of equity? The risk premium for debt will
always be less than equity since there is lower risk in holding bonds compared to stocks. Risk
premium is the incremental return you have to give investors to buy the particular security so
because debtholders have less risk since they know they’d get their money back first before
shareholders, firms need to give them less risk premium. Hence, the cost of debt will be in all
likelihood be lower than the cost of equity simply because there is more risk in buying stocks
than buying bonds. So you’d need to give bondholders less.

Is there any way that somehow a firm gives out so much of bonds that its cost of debt becomes
larger than its cost of equity? Unlikely because no matter what you do, even if you issue loads
of bonds, you become so distressed that you’d argue that at that point of time, you’d have to
give a lot of risk premium to bondholders but essentially the stock prices would also be re-
priced. The idea is that if stockholders know that you’re going crazy issuing out so much debt,
then the stock price would also correct and hence when you calculate the required return of the
stock it also becomes much much higher as well. So owing to the nature of debt and equity, in
all likelihood, the return on equity is still much higher than the return on debt.

If the firm has no debt, then the WACC would be the same as rE. It’s weighted average, so if
there is no debt then there is no weight there. Later in lecture 10 when we go through the
equation for WACC, you’d realize why debt is a preferred method of capital raising compared to
equity. This would be addressed later on.

The process of getting the future CFFAs is not so simple. You have to pro-forma the financial
statements, and you have to project the statements forward using 10,000 assumptions again on
what you think would happen in the future in terms of both the whole economy as well as the
firm. Given these many assumptions going into the model, telling how accurate they are no one
can say.

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The idea is again to come up with these CFFAs and then present value these CFFAs using the
WACC, and then $416.942 becomes the value of the firm. This is very similar to the dividend
growth model, at a time where growth becomes constant, you use the present value of a
growing perpetuity formula. Don’t have to worry about CFFA5 , CFFA6 , CFFA7 onwards
because at this point of time onwards, we know that it is constant growth. So you only have to
worry about the next one CFFA4. Take CFFA4 / (WACC - g). That gives you terminal value 3.
Terminal value 3 already captures 4,5,6, all the way to infinity, because you have present
valued this growing perpetuity. Divide the market value of equity by the number of outstanding
shares and that would give you the price per share. If there are 10 million shares, then the price
per share = $37.69.

That’s all that is examinable, the dividend growth model and the corporate valuation model. The
latter is used more because we don’t want to worry about dividends in that sense, whether the
firm gives or doesn’t give dividends, the corporate valuation model can still be used, so why
bother about the dividend growth model if we can use the corporate valuation model for
everything. So most analyst would actually use the corporate valuation model more than the
dividend growth model.

How do you value a firm that has negative cash flows all the time? This would be difficult, but at
some point of time, you’d expect future cash flows to someday be positive. If you’re having
negative cash flows all the time, then the firm is in deep trouble. The firm will be insolvent if
you’re not getting positive cash flows from the projects you’re investing in which means you’re

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investing in loss-making projects all the time. So then no one would want to invest in your firm.
It’s not impossible to have negative cash flows in the future. Sometimes CFFA can be negative
because the firm may be investing in assets, making some changes to working capital. It’s not
uncommon, because it’s often done with the idea that investing now will enable you to do better
in future. At some point of time however the cash flow should turn positive.

How do stocks reach the public? How do stocks reach people outside the firm, more
accurately?
There are three main ways:
1. Private placement (Not to the general public, only open to a small select group of
investors, institutions actually)
The firm wants to sell some securities and wants to get some investors into its mix. It
would select a group of investors based on some criteria who they also think a) have the money
and b) are interested in buying the shares. They would then sell their company to these
prospects by putting on a sales pitch, tell them how profitable the company is and why they’d
want to invest in them, and what’s in it for the investors, the kind of returns they can expect etc.
Faster process than initial public offerings (IPOs) simply because there is a lot less regulations,
less paperwork and bureaucracy to go through for the private placement method. The main
drawback to this method is that subsequent to this step, there is no secondary market. When
you buy a share from a private placement, you’ll find that it’s very difficult to subsequently sell it
if you need the money because there is no secondary market. It’s not listed in the public domain
per se so it’s difficult for you to have liquidity thereafter.
2. General cash offerings (IPOs fall under here)
a. Securities are offered to the public
b. As a firm, you’d hire the investment banks, and the investment banks do these
things for you
i. Formulate the issue method
ii. Price the new securities
iii. Sell the new securities
c. They’d do the corporate valuation model for you, they’d get your financial
statements, project forward for you, they’d interview you over a lengthy period of
time to see if your company is doing well etc., understand your company’s model,
project it for you using the macroeconomic factors and so on and then determine
the intrinsic price for your stock. After they determine the intrinsic price of your
stock they then advice you about what price to sell it at. Many times it’s lower
than the intrinsic price, so if intrinsic price is at $100, they’d advice you to sell at
$80. The main reason why they’d advice you to sell at lower than the intrinsic
price is to generate interest. Based on their modeling, if the firm sells at a
cheaper price, there is a story for them to tell when they sell the stock. They
become the salesperson as well, setting up roadshows, talking to all the financial
institutions, prospective clients etc. That’s their job and that’s why you pay them
commission for. They’d also give you advice on the timing. You want to launch
IPO when people are pro-stocks. The market is doing well and people are all
trying to shift their portfolios into more stocks. People are all thinking that the

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 economy is going to do well. So if you IPO in a recession, then there’d be no
demand for your stock, in which case, you wouldn’t expect to sell a lot of your
stock. Sometimes the investment bank buys the entire issue by themselves and
then they subsequently sell it, they’re underwriters, essentially underwriting the
entire issue. That’s one method. But most of the time they do it on a best efforts
basis, so they don’t buy all the stocks but they just try to sell it for you at their
best efforts (more common). Only if the investment bank really likes your stock
and is confident that they can get rid of it. There is no regulation that says they
can’t hold the stocks. It’s not common practice for them to hold your stocks as
part of their portfolios. There are two separate departments in investment banks
that buy and sell the stocks so they don’t get any advantage since the
departments are independent and they buy it at the same price that others are
given.
d. The first time a private company becomes public is known as initial one. The first
public equity issue that is made by a company is known as initial public offering
(IPO). Whereas subsequent times of issuing more securities is known as
seasoned equity offering but both of these would fall under general cash
offerings.
3. Rights offering
a. The firm wants to issue more securities but it is going to give rights to its existing
shareholders to buy more shares. So it’s not to the general public but rather to
the existing shareholders. The privilege here for existing shareholders is that they
get to buy shares at a discounted price. When you receive this right from the firm
you can do one of 3 things:
i. Exercise their rights and subscribe for the shares. (For example the firm
says that for every 10 shares you own, you have the right to buy one
share at a discounted price. So you could exercise the right and buy the
share)
ii. Sell the rights to interested investors if they do not want to buy new
shares. (Let’s say you have 100 shares so you have the right to buy 10
shares but you only want to buy 5 more shares, so you can sell the right
to buy the other 5 shares to someone else at some fee that you can
negotiate yourself)
iii. Do nothing and let the right expire.

Normally the rights issue is advertised. The discount is advertised.

Why do firms want to issue rights if the issuing of bonds is cheaper since they need to pay less
risk premium for bonds?
Sometimes firms have to issue equity because they have already maximized their debt ratio. So
those are possible factors. For instance if the firm has a protective covenant set in for the
bonds, which caps your debt ratio at a certain level, and the firm deems that it is already close
to it and hence the firm doesn’t want to breach it and thus would have to sell equity instead.
Other reasons could be whether there is demand for it. If the firm deems that at this point of

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time, given the pros and cons of both, people are not looking for bonds, the firm assesses that
there isn’t enough demand for bonds and instead people are more positive towards stocks, then
it’s easier for them to raise capital through stocks. As such, they’d go through the equity route.
Yes it’s more costly but it’s easier to raise the capital and they’re willing to pay for it in that
sense. Liquidity will always trump profitability. You must stay liquid, which means you need to
have the money even if it costs you an arm or leg. So that’s business, if you need capital within
a certain time period, then you have to weigh what you can do and even if it costs you more
money than too bad, no choice.

There’s another method people use to value stocks, which is de-emphasized here. It’s known as
the multiples approach or relative valuation.

Multiples approach or Relative valuation (NON-EXAMINABLE)

This happens to be the most commonly used method. However, it is potentially problematic.
You’ll figure out why later on. If you recall, there is a category of ratios known as market ratios.
Market ratios basically involves us using the share price and some metric in the financial
statement as a ratio. For example Price-earnings ratio, we take the price of the share and divide
by the earnings per share. Or the market-book ratio, we take the market price of the share
divided by the book value of the share and many other types of market ratios.

So the idea is to form a peer group with your firm, then by logic, these market ratios of your peer
group must be similar to the firm’s, because that’s what the argument is that for all financial
ratios with a peer group, we shouldn’t expect very vast differences. So if we apply this to market
ratios as well, we’re trying to say that we’ll value the firm by looking at the peer group financial
ratio or market ratio and then we value the firm.

For example we calculate the P/E ratios of all these peer group companies and we then
average them, and that then becomes the benchmark to use, multiply it with the firm’s earnings
per share or earnings at least and that should give the total equity value and that’s how we end
up pricing the share based on this multiple, hence why it’s called the multiples approach.
It’s relative because it’s relative to your peers. Hence the naming is as such. In terms of the
multiples what can we use? We can use Price to Earnings, EBIT, EBITDA, Sales, Cash flow,
and a lot of other metrics that others come up with for example: Price to number of subscribers,
hits, square footage etc. All depends on which industry you’re in and which sector, in terms of
how you generate your money. What makes sense for that peer group in terms of the metric
that people look at. That’s how they value your stock.

Why is this the most commonly used method?

Because it’s the fastest method, wherein there’s hardly any work to be done because the
metrics are all available. It’s very likely that you can download all these multiples from a
database. Price to Earnings ratio, Price to cash flow, price to sales etc almost all are available.
Extremely simple to do. Trying to value a firm, XYZ, get a peer group, and the peer group based
on the industry method is also very simple to determine, just go by the industry code, SIC code,
if you belong in the same code, I’m going to include you in the same peer group. For the first cut

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may be that way, but second cut could be more detailed. Nonetheless it’s still a very quick
process. Find the multiples for which you then multiply against your financial statement of the
firm you are trying to value, to get the equity value of the firm.

Sometimes instead of doing regression, some may use a peer group Beta and unlever it
according to the debt of the particular firm and relever based on the company’s debt then you
get a beta for that company. If you don’t have historical data for a company then there is no way
to conduct regression so this method may be applicable, base it on some other firm’s beta. The
comparables according to some, will always have more error than using the firm’s own data.

Any comparables method is usually faster because it involves some simplification. You apply a
relative measurement against something else and assume that it’s going to be the same as
yours and then multiply with some other metric. It doesn’t really involve one analyzing the firm’s
information per se.

Problems with the method:

Whatever problems that showed up in the accounting ratios lecture in terms of the lecture on
financial statement ratios would be applicable here since we’re relying on ratios.

For example, if the peer group company chosen is actually wrong, then to use that as the
benchmark would be wrong. That’s the most fundamental problem.

Then of course, there are the other problems that we have with ratios: Seasonality problem,
window dressing problem, different accounting principles that you might adopt in terms of Last
in last out or first in first out, whether you revalue inventory, etc.

All three of the models gone through each have their problems. There are limitations. It is a
model so it won’t give you the exact precise number. They give you estimates based on certain
assumptions. So what do people in the industry do? They would try all the methods if they have
the time. They’d do the corporate valuation model, the multiples approach, to check to give
them some range and then they’d do some sort of sensitivity analysis to make sure the numbers
can withstand certain variances and different changes to certain variables to make sure the
estimate is reasonable. Most of the time, a range is given, simply because they are possibilities
for the variables to change and there are a lot of assumptions going into the model.

Project: Corporate valuation

Change your variables, and the valuation would change completely. That’s how sensitive it is to
these assumptions, which is quite scary if you’re trying to value it for real.

Lecture 8: Capital Budgeting (Part 1)

Today we’re going to go through 7 different techniques to do capital budgeting. 7 different
methods that we can apply to understand if the project is something you want to do or not:

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What is Capital Budgeting?
If you recall lecture 1 when we said that a firm asks itself 3 big questions.
1. What question
2. Where can we get the money?
3. How do you manage the day-to-day cash flows?

These are the 3 questions that firms have to continually ask themselves to ensure that they are
adding value to the shareholders.

The what question is the capital budgeting question.

What are we going to do long-term, what is the business that we are going to embark on, what
are the projects we're going to do etc. all that is meant to give returns to the shareholders.

For example, Jurong Aromatics Corporation building a US$2 billion petrochemical plant on
Singapore’s Jurong Island, they need to be aware of course where the money comes from but
also how can they ensure that this project gives them returns, where’s the revenue going to
come from, what’s the returns like, how fast will they break even, what’s the rate of return etc.
So all these questions must also be understood before embarking on anything.

What is the difference between current expenses and capital expenses?

From Lecture 2, recall the example of WorldCom where they treated current expenses as
capital expense,
Current expense: Something that needs to be spent in this period, this expense is recognised
within the period
Capital expense: Treating the item bought as an asset and then depreciate it over a useful life.
Capital expense would usually be referred to only for fixed assets, property, land etc, items that
you’d be using over several years.

Capital budgeting: How do we want to allocate our scarce resources of capital on projects we
want to embark on, that’s the process of capital budgeting.

The overriding rule is simple, Cost-benefit analysis is done, the seven different methods have a
different way of looking at the benefits.

Basically if the benefits outweigh the costs, we’d argue that this is a profit-making or value-
adding project and so we would embark on it. If the cost outweighs the benefit then we’ll not
embark on the project.

What are the seven different methods to carry out capital budgeting?

1. The Payback Rule

2. The Discounted Payback
3. Average Accounting Return

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4. The Internal Rate of Return (IRR)
5. Modified IRR (MIRR)
6. Net Present Value (NPV)
7. The Profitability Index

How do you distinguish these 7 methods? Is there a way to help us understand whether within
these 7 methods, there are methods that are better than others? Or are there methods that are
preferred? And why would they be preferred?

What makes a method good?

We ask these 3 questions for every method:
1. Does it account for time value of money? Does the method factor in the time value of money
aspects of these cash flows that we’d expect to receive from doing this project?
2. Does the method also account for the risk of the project?
3. Does this method show us how much value we add to the firm?

If the answer to the above 3 questions are all Yes!, then that makes the method a good one.

Example: Spend $165,000 today, It’s a 3 year project so

Year 0: CF0 = -165,000
Year 1: CF1 = 63,120; Net Income = 13,620
Year 2: CF2 = 70,800; NI = 3,300
Year 3: CF3 = 91,080; NI = 29,100
Average Book Value = $72,000 (Book value of the assets that are required for this project, on
average over the three years, this is the book value that we’ll have)
Assume that we have already calculated the required return for this project, this is the cost of
the capital, or the hurdle rate for which, we need to ensure that the returns of the project is
above this number in order to have benefits outweighing the cost. Suppose that the required
return is 12%.

1. Net present value method

The name tells you what this method is about which is that we’re going to present value all the
future cash flows and then net if off with the initial cost. This would then give the net present
value.

The process will require us to first understand what is the future cash flows, so we need to
figure out what are the future cash flows that we need to expect, plot them all on a timeline.

Step 2: Discount all the future cash flows back to the present value. We need to then find out
what is the appropriate discount rate, Assuming we already have the required return of 12% in
this case, if we didn’t then we’d have to calculate that using CAPM to derive the cost of equity,
and after that using the yield to maturity of the bonds and calculating the WACC.

Let’s say we have the required rate of return in order to discount these cash flows.

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Step 3: Present value these cash flows to time period 0, and then we minus the cost.
If the net present value >0, it would suggest that this is a value-adding project, because the
present value of all future cash flows is higher than the cost.

The present value of all future cash flows is simply the intrinsic value of the project. Recall the
last two weeks when we went through valuations of bonds, stocks, all that we were doing was to
present value the future cash flows. For the bonds, we’d present value the coupons and the par.
For stocks, we’d present value the dividends. And what we’d arrive at is the intrinsic value of the
stock or the bond. For projects it’s no different, the present value of all the future cash flows is
known as the intrinsic value of the project.

So positive NPV tells you that the intrinsic value of the project is higher than its cost. We would
obviously choose these projects because these projects add value to the shareholders wealth.

Example shown on a timeline:

For the NPV method, we’re going to present
value all these future cash flows. Discount
each cash flow in year 1-3 using the discount
rate of 12%, then we’d sum up the entire first
column.

NPV = Present value of all the future cash flows - Initial cost = 12,627.40
Can also find this using the cash flow function in the calculator,

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CF0 = -165000
CF1 = 63120
F01: 1
CF2 = 70800
F02: 1
CF3 = 91080
Press <NPV> I = 12
<CPT> NPV, NPV = 12,627.41

For the NPV method, we ask ourselves 3 questions to determine whether this a good method or
not:
1. Does NPV method account for time value of money? Yes, because we present value all
the future cash flows.
2. Does it account for the risk of the cash flows? Yes, because we discount the cash flows
at the required return, the required return is calculated using the risk of the project, the 𝛃
of the project is there for us to calculate using the CAPM the required return. We
understand based on this risk, the hurdle rate that would be needed which is then used
to discount all future cash flows. In that sense, we have accounted for the risk.
3. Does the NPV rule provide indication about increase in value? Yes because the
12,627.41 is exactly the dollar value that will be added to the firm. Clearest indication of
increase in value using the NPV method.
Should we consider the NPV rule for our primary decision criteria? Yes, because all the 3
questions above are Yes.

2. Payback period method

As the name suggests, payback suggests a break even kind of analysis. When we say payback
period, we are obviously interested in the length of time. Putting it together in terms of the
definition, payback period suggests how long will it take for you to breakeven.

In terms of the process it’s simply cumulating all the cash flows you have on the timeline in a
nominal sense, so we don’t do any discounting and simply just keep adding the cash flows until
we breakeven.

In terms of the criteria, we need to set ourselves a cap. The management would then decide
how long they’re willing to wait to break even. For instance if the management decides that the
cap is two years, then only projects that break even within 2 years would be chosen. Projects
that take longer than 2 years would be rejected.

So the cap is an arbitrarily set limit, which is set by the management. Completely up to
management depending on how long they are willing to wait.

Suppose the firm has chosen 2 years as the cap. So for our project how long does it take to
break even?

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We know that in year 0, we pay 165,000. Year 1 we get an inflow of 63,120, so after this inflow,
we’d still have 101,880 to make back. After the inflow of 70,800 at the end of year 2, we have
31,080 left to payback. With the year 3 cash flow of 91,080, the cumulative cash flow becomes
60,000, which suggests that we’ve broken even because it’s a positive cash flow. What that
means is that somewhere before the end of year 3, is when we break even. Assuming that
these cash flows are only received as one lump sum at the end of the year then of course the
answer is 3 because you wouldn’t be getting cash flows throughout the year.

Year 1: -165,000 + 63,120 = -101,880 still to recover

Year 2: -101,880 + 70,800 = -31,080 still to recover
Year 3: -31,080 + 91,080 = 60,000;

Let’s assume that we do get the cash flows throughout the year, and they are uniformly
received. So in that case, we would divide the short fall of 31,080 by the final cash flow, 91,080,
to get a fraction of the year. In this case, then we’d break even after 2.34 years.

Would we accept or reject this project? We’d reject the project because it takes more than 2
years to break even.

Ask ourselves the three questions for this method:

1. Does it account for time value of money? No because there is no discounting.
2. Does it account for the risk of the cash flows? No.
3. Does the Payback period method provide indication about increase in value? No,
because all we know is how fast you break even but you don’t know how much value
you’ve added. This metric is more focused on the length of time rather than the value.
We know that the project is going to breakeven after 2.34 years but we still don’t know
how much value this project will add to the firm.
Hence we would not consider the Payback period method for our primary decision criteria. FOR
NOW…

Advantages of Payback period method Disadvantages of Payback period method

Fastest to calculate and easiest, simply

adding up all the cash flows

Very intuitive and easy to understand, any

business person understands the concept of
break even

Adjusts for uncertainty of later cash flows Ignores cash flows beyond the cutoff date

How does this method do this? In what circumstance would you say that
It ignores them, assuming the project is a 6 ignoring future cash flows would be
year project, then maybe there are more cash dangerous?

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flows in year 4, 5, & 6 but once you break
even you stop adding because you already
get the length of 2.34 years to break even, so
the rest of the future cash flows would not be
included into the equation at all. Almost like
treating them as 0.
Since they are so far away, they are more
uncertain, do not include them in the equation
and hence the method adjusts for their
uncertainty by not including them.
Biased towards liquidity because it’s always
about time, how fast you payback.
1. The future cash flows could be
negative, you think that you have
broken even, but subsequently you
get negative cash flows which would
then make you question the concept
of break even, have you really broken
even or not? Potentially dangerous to
ignore future cash flows for that
reason
2. What if the future cash flows are
positive then what happens? When
you are comparing two projects then
that’s where it becomes potentially
misleading. For example, one project
may have a payback period of 1.5
years and another 1.6 years. Based
strictly on the payback period, you’d
choose the one that pays back faster.
But the one that pays back after 1.6
years actually has more cash flows
later on which would cause the net
present value of it to be much larger
than the project that pays back faster.
This would not have been factored in
when using this method. The
additional waiting of 0.1 years could
have resulted in a much larger net
present value. Ignoring the future cash
flows has this potential drawback.
Biased against long-term projects, such as
research and development, and new projects,
projects that require you to invest a huge
amount first, wait very long and then get large
cash flows later on will never be chosen.
Requires an arbitrary cutoff point
Any method that requires an arbitrarily set cut
off point becomes very subjective in nature.
For example in our project that takes 2.34
years to break even, at the current moment
the firm decides the cut off is 2 years. But at
the end of the day, no one is stopping them
from adjusting this cut off to accept this
project. If the management really likes the
project or the person who is working on the
project is a close friend so they feel obliged to
work with the person, it would then be easy to
convince the management to adjust the cut
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 off to 2.5 years instead and suddenly the
project becomes acceptable.

Hence the presence of an arbitrarily set cut

off opens this method to a lot of adjustments
or manipulations.

Ignores the time value of money

Example of how by ignoring future cash flows we could be potentially short changing ourselves:

If the payback period cut off is 2 years, then we would choose project B above. For project A,
you add 5,000 and you still have $5,000 to payback, and add $4,000 and you still have 1,000 to
payback. Therefore, you only pay back in 2.25 years so you reject project A.

But at some reasonable level of discounting, Project A would have a much higher NPV than B.
In this case, you’d have picked a project that actually adds less value to the firm. That’s
potentially a problem.

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Since we have not accounted for time value of money in the payback period method, we should
modify this method to account for time value of money.

3. Discounted payback period method

Works exactly the same way as the payback period method except for the fact that we’d now
cumulate discounted cash flows. We similarly still need an arbitrarily set cut off point and then
we just cumulate the cash flows and instead of nominal cash flows, we’d cumulate the
discounted cash flows.

Step 1: Discount back all future cash flows to year 0 and then cumulate these cash flows.

Starting from the -165,000 we have in year 0, we add the discounted cash flow from year 1,
56,357, and we’d have 108,643 left to payback. We then add the discounted cash flow from
year 2, 56,441 and we’d still have 52,202 to pay back. We add the discounted cash flow from
year 3, and we get a positive cumulative cash flow of 12,627. Therefore we know that before the
end of year 3 we pay back.

Year 1: -165,000 + 56,357 = -108,643

Year 2: -108,643 + 56,441 = -52,202
Year 3: - 52,202 + 64,829 = 12,627 project pays back in year 3

Assume that the cash flow is received throughout the year, and they are uniformly received. So
in that case, we would divide the short fall of 52,202 by the final cash flow, 64,829, to get a
fraction of the year. In this case, then we’d break even after 2.81 years. Since the value is still
more than 2, we still reject this project.

Now we appraise this method using the three questions:

1. Does it account for time value of money? Yes because there is discounting.

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 2. Does it account for the risk of the cash flows? Yes because we discount it back at the
required return.
3. Does it provide indication about increase in value? No, because it is still a time metric,
still focused on the the length of time it takes so we still don’t really know how much
value this project will add to the firm.
Therefore, the discounted payback rule would still not be considered for our primary decision
criteria.

Advantages of Discounted Payback period Disadvantages of Discounted Payback period

method method

Includes time value of money May reject positive NPV investments

Chosen to reject the project even when it had
a positive NPV as per the above example.

Since this method is time-centric, it doesn’t

really matter whether it is a positive NPV
because you’re only concerned about the
time, so you could end up rejecting positive
NPV projects.

Easy to understand Requires an arbitrary cutoff point

Does not accept negative estimated NPV Ignores cash flows beyond the cutoff point
investments

How does this happen?

If you cumulate all the discounted cash flows
and realize that you don’t even pay back at
all, that suggests it’s a negative NPV project
so you’d never end up choosing them.

If you pay back at some period of time using

discounted cash flows, if we assume that the
future cash flows are all positive, then the
project will always be a positive NPV project.

Biased towards liquidity Biased against long-term projects, such as

R&D and new products

4. Average accounting return method

Average net income divided by the Average book value for the project (book value required by
the cash flows of the project)
What is the average book value of the project? Book value of the assets required by the project.
Let’s say it’s a 3 year project, so at year 0 we have the book value of the project, at the end of
year 1, we have the book value of the project after depreciation and at the end of year 2, we’ll

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have the book value of the project after depreciation and at the end of year 3, we’ll have the
book value of the project after depreciation.

If we do a straight line depreciation to 0, so full depreciation, then the average book value is just
divided by 2 from the initial. (Initial + 0) / 2 = Average book value. You straight line it all the way
down to 0, so it’s just a triangle in a sense, so the average book value is just the initial book
value divided by 2.

However, if you do an accelerated depreciation method, in which case it’s not going to be a nice
triangle, it’s a curve in terms of the book value. In which case, the average book value will be
lower, in which case you’d have to manually calculate each years' book value and then average
it.

Similar to the previous two methods, we still need an arbitrarily set cut off point. There’s no
reference point per say that we can use. Instead the management decides.

If the AAR exceeds the cut off then we'll pick the project.

Example: Suppose the cut off or the hurdle rate determined is 25%. Let’s calculate the AAR for
this project. The numerator is the net income. So given the 3 years worth of net income, we
simply average it.
(13,620 + 3,300 + 29,100) / 3 = 15,340

The denominator is the average book value which is given as $72,000 in the example. So we
take 15,340 / 72,000 = 21.3%

Do we accept or reject this project?

Reject the project since 21.3% < 25%, it fails to meet our hurdle rate of 25% so we reject the
project.

Now we appraise this method using the three questions:

4. Does it account for time value of money? No because we simply averaged those
numbers so there is no correction in a sense of a later net income versus the one that is
more recent.
5. Does it account for the risk of the cash flows? No, in fact it doesn’t even take into
account cash flows to begin with. It’s net income, not even cash flows.
6. Does it provide indication about increase in value? Maybe, Debatable. Depending on
how you argue what is the definition of increase in value.
Therefore, the average accounting return method would still not be considered for our primary
decision criteria because there is no factoring of time value of money which is key for finance.

Advantages of average accounting return Disadvantages of average accounting return

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 method method

Easy to calculate Not a true rate of return; time value of money

is ignored

In finance, you’d argue that this is not a true

rate of return, even though in accounting it
could be seen as a rate of return.

If you divide net income by the book value of

the assets, that’s simply the return on assets
(ROA). It’s almost like saying this is the return
on assets for this project. Is that a rate of
return? Arguably.

Based on an accounting idea, it would

possibly be interpreted as a rate of return. But
the problem is that because the project spans
across a number of years, if we don’t take
into account the time value of money, in
finance we argue that we have not accurately
captured the rate of return. It’s not a good
enough representation of the rate of return.

Necessary information is easy to obtain Uses an arbitrary benchmark cutoff rate

Based on accounting net income and book

values, not cash flows and intrinsic/market
values

Accounting net income and book values are

open to manipulation and differences in
depreciation etc.

5. Internal rate of return method

Internal rate of return by definition is simply the discount rate that you can discount the future
cash flows so that the net present value is 0.

For example using the timeline of the cash flows we already have:
Let’s find a discount rate at which
you can discount these future
cash flows so that you’d end up
with a NPV of 0.

We argue that this is the most

important alternative to NPV, so
of course we can already
assume that this is one of the

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primary criteria we'd use apart from NPV. This method is based entirely on the cash flows so
without even knowing the required return first, we just get the cash flows we can calculate the
Internal rate of return, because it’s like working backwards almost.
How do we know whether to accept the project?
If IRR > required return, then we’d pick this project. This makes intuitive sense if you think about
it. If you can discount the future cash flows by a very high discount rate and end up with a NPV
of 0, it must mean that if you discount it at a lower discount rate, you’d end up with a positive net
present value. IRR> required return, it suggests that NPV>0.

Diagrammatically, we have the timeline of the cash flows. We want to discount year 1 cash flow
by 1 period, year 2 cash flow by 2 periods and year 3’s cash flow by 3 periods. Add up all these
cash flows and we want it to be 0. What is this discount rate?

In an equation it looks like this:

63120 70800 91080
𝑁𝑃𝑉 = −165000 + + 2
+ =0
(1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅)3
Solve for IRR. Solve for the root of the above equation.

Fortunately for us, with the financial calculator it is extremely simple. Key in the cash flows into
the cash flow function. Instead of pressing the net present value button, you press the IRR
button, next to the NPV button. After keying in the cash flows into the cash flow function you
press IRR, the calculator tells you the IRR. When you key in the cash flows into the calculator,
you’d find the NPV and also the IRR. So you don’t have to clear the memory and re-key in the
cash flows again.

If you don’t have a financial calculator, the only other way to solve for the IRR is by plotting the
curve to find IRR. Either GC or Excel. Plot the graph to see where it cuts the x-axis, that’s how
you solve for the IRR. If don’t have any of these, then it’s just trial and error.

Substitute values in to see what you get. If you substitute a number into IRR that is too high,
then the NPV will be negative. So you have overshot and made the number much higher than
the IRR supposed to be. If you substitute too low a number for the IRR, the NPV will be positive
and large, nowhere close to 0. So you increase the number substituted until you get NPV=0.

IRR calculated for the above project will be 16.13% which is higher than the required return
which is 12% so we would accept the project.

We can plot the line called a NPV profile. You need to know how to get this line.

The NPV profile shows us the NPV given different

discount rates. If we for example discount our
project by 12%, we’d get an NPV of 12,627.41.

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If the discount rate was 6% instead for this example, then the NPV will be more than $30,000.
How do you get this line, simply keep changing the discount rates and then get the NPVs and
then plot all of the points.

A much faster way would be to disregard the intermediate points so you just need two points
and you can join them to get the curve. So how do you get the two points?

The y-intercept has a discount rate of 0, simply means that you’ll just cumulate all the cash
flows. So you don’t discount at all and just add up the cash flows. Add up all the cash flows and
that gives you the y-intercept (Same as payback period method calculation of cash flows).

The x-intercept is of course the IRR, by definition. The discount rate for which the NPV is 0.

With these two points, you can join the two points to get the NPV profile. However, be careful
that when you join the two points, it is not a straight line. It’s a gentle curve. Because we are
discounting to get the NPV so it is not a linear relationship between the discount rate and the
NPV.

This NPV profile line shows us why we would choose projects where the IRR > Required return.
If the IRR is higher than the required return, it means that at the required return, NPV will be
positive given the shape of this line. If the required return is say 20%, and IRR is 16%, it means
that at a higher discount rate, NPV will be negative.

1. Does the IRR rule account for the time value of money? Yes, because we are
discounting all these cash flows at the IRR.
2. Does the IRR rule account for the risk of the cash flows? Yes, because we end up
comparing this discount rate with the required rate of return. Reverse way of looking at
the risk.
3. Does the IRR rule provide an indication about the increase in value? Yes, because we
have calculated the rate of return of the cash flows themselves, hence the name internal
rate of return.
Hence we should consider the IRR rule for our primary decision criteria.

Advantages of IRR:
Easiest to communicate and most intuitive for a business person.

For example, using this project, if you tell a business person that the rate of return is 16%, he or
she will be able to use this percentage return and compare it with others he's familiar with. If you
know the CIBOR rate, five year loan rate, deposit rate if you invest the money instead, etc. you’ll
be able to appraise the project based on these measurements. You’ll be able to tell if the project
is good or not because the IRR can be used as a comparison. But if you tell someone the
project gives $12000, it’s not good enough information because the investor doesn’t know how
much he has to actually invest. If the investor had invested $10 and he gets a return of $12,000,

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then it’s fantastic. But then if the investor had to invest 10 million to get a return of $12,000 then
it becomes a horrible project. So just telling someone the net present value with not enough
information about the size of the investment makes it not the best way to communicate. In the
industry, IRR is preferred since it is a rate.

If the IRR is extremely high of say 70%, you don't have to really worry about the cost, because
in all reasonableness you won't expect the cost to be anywhere close to those numbers.

For this project so far we have gone through 5 methods and have ended up with differing
conclusions:

So would you accept or reject?

If NPV and IRR both say accept, you would defer to those methods more because they are
primary criterias. Lean towards accept.

Could you still reject this?

In the real world we could still reject this project. Why? We imagine Small and medium
enterprises in Singapore, where the number one problem for these companies is cash flow, so if
they are told that the net present value of the project is $10 million, IRR = 200%, but the
payback period is 50 years, would they choose the project?

No SME would choose the project, no matter how nice the NPV and IRR is, they’d always be
constrained by the payback period because they are fully aware that they cannot survive till that
time, so why bother thinking about it. Payback period becomes more real when you apply this
and try to run a business.

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In the industry, when we survey people on what methods they used to assess their projects:
Number 1 was IRR and number 2 was payback. Many of them would use both together. In other
words, they’d accept projects that would meet the cutoff for both.

SMEs use payback more than discounted payback although we know that discounted payback
is more logical in theory because you discount back the cash flows, but discounted payback is
not used actually. Why? Because it’s troublesome. At the end of the day, people want a method
that makes sense but at the same time must be very quick to calculate and usable. Rather than
add on additional factors that may be enhances the method to some degree but adds on a lot
more work then overall the value isn’t there. So they don’t need it. As a business person, you’d
want to apply methods that are accurate enough that give you informed decisions, but at the
same time must be easy to apply. So it still is going to fall back to IRR and payback even though
we know that payback is flawed but is enough as a good estimate for them to understand if they
want to take on the project or not.

In our classroom and for our exams, we would defer back to the NPV. Number one method is
NPV. So if NPV tells you to accept and every other method tells you reject, you still accept in
our classroom. In reality however, you have to use common sense to see if the payback period
is too long or not.

We have seen that if the Net present value profile is a downward sloping line, then the NPV and
the IRR will always give you the same decision. But there are some exceptions as to when both
would give you the same decision. In other words, there are some cases where both methods of
NPV and IRR may differ in conclusions. NPV will tell you to do one thing and IRR will tell you
the opposite.

So when are these exceptions:

1. When dealing with mutually exclusive projects. Between two projects, you have to choose
one. In such a case, NPV would tell you to take project A, IRR could tell you to take project B.
That’s a problem. When does this happen?
a) If the two projects have very differing sizes, initial investment for project A is very small
say 10k, and the initial investment for project B is large at $10 million. It is possible or
quite likely in this case that you’d end up with a conflict.
b) If the timing of the cash flows are very different, if both projects are of the same size,
both spend $10 million, in project A the year 1-3 cash flows are very large and after that
from year 4-6 they are very small. In project B, the year 1-3 cash flows are very small
and after that from year 4-6 they are very large. In such a case, you could end up with
conflicts between NPV and IRR.
2. You have a Non-conventional cash flow pattern, which means that your sign changes more
than one time. A conventional pattern is negative cash flow today, positive cash flows in the
future. Non-conventional suggests that for example you spend money today, Year 1-3 you get
positive cash flows, but in year 4 you need to inject more capital because of refurbishments or

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renovations of the factory etc. then you have negative cash flow in year 4, then positive in years
5-6 and then negative cash flow etc. If you have this type of negative positive negative positive
pattern then you'd have problems with IRR.

Definition of mutually exclusive:

Mutually exclusive means that you have to pick one. If you pick one project, the cash flows of
the other project will be detrimentally affected (usually due to limitation of available funds) such
that you would never pick it anymore, so you end up only choosing one.

Independent projects: It is possible to pick both. The cash flows of one are unaffected by the
acceptance of the other.

If you have questions that give you independent projects, it is possible for you to choose both as
long as both qualify based on the methods.

Scenario 2: Non-conventional cash flow pattern

When you have a Non-conventional cash flow pattern, and you try to solve for the root of the
𝐶𝐹1 𝐶𝐹2 𝐶𝐹3
equation, 𝑁𝑃𝑉 = −𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 + + + = 0 , you’d realize that the graph
(1+𝐼𝑅𝑅) (1+𝐼𝑅𝑅)2 (1+𝐼𝑅𝑅)3
cuts the x-axis more than once, which means that you’d have more than one IRR.

Suppose an investment will cost $90,000 initially and will generate the following cash flows:
Year 1: 132,000
Year 2: 100,000
Year 3: -150,000 (Decommissioning costs)
• The required return is 15%.
• Should we accept or reject the project?

This project has a non-conventional cash flow pattern because Year 0 is negative, Year 1-2 is
positive and Year 3 is negative. Plotting the NPV profile yields the following:

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It’s no longer a nice downward sloping line but instead now we have an N shaped curve so
obviously it cuts the x-axis twice, so we have two IRRs, which is 10.11% and 42.66%.

We know the required rate is 15%, so if we use the IRR =10%, since 10<15, we’ll say reject. If
we use the 43% IRR, 43>15, therefore we should accept. There’s a bit of confusion without
understanding the graph. You could end up with differing decisions by looking at the graph.

We know that by using the NPV method, it’s quite clear that we’d accept because the NPV is
positive. The problem is that if you just have IRR, for some calculators they will give you the first
IRR. So if you didn’t know this problem and simply applied the IRR rule and you calculate the
IRR and it gives you 10%, you’ll say reject.

So to solve ourselves of this problem, just do this. If you have non-conventional cash flow
patterns, don't use IRR. Not to say that you cannot, or that it’s not possible. You can still use
IRR with other corrections. If NPV profile is U-shaped and this …. Then …. and if it’s N-shaped
and …. Then ….. So then there would be many if...then scenarios to take into account so this
method would no longer be a robust method anymore. We’d find out how to adjust this later on.
But for now we know we cannot use the IRR.

Scenario 1: Mutually exclusive projects

Mutually exclusive means you have to pick one. If you are given two choices that are mutually
exclusive, how do you pick using the NPV rule, you simply pick the one with the higher NPV, the
one that adds the most value. Then if you use the IRR rule, which one would you choose? The
project with the higher IRR, which means that you can afford to discount the cash flows by a

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higher rate and still end up with a 0 NPV which means that at the same required return for the
two projects, you end up with a higher NPV for the one with a higher IRR.

But what happens if you have this scenario then?

IRR for B is higher but the NPV for A is higher at a discount rate of 10%. So which project would
you choose?

In all scenarios with mutually exclusive projects, even though they are of different sizes, you
have to assume that you don’t have that savings. Say one is a $10 project and the other is a
$10 million project, it doesn’t mean you can save the 9,999,990. There’s no other option, only
project A or B, no project C to think about.

In this case, you’d pick A because it has a higher NPV. Suppose, you weren’t given the IRR or
NPV, then the first thing to do is to look at the NPV profiles.

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Y-intercept is simply the addition of all the cash flows so you get $150 for A and $125 for B. The
x-intercepts are the IRRs for the two projects, 19% for A and 22% for B. This means that at
some point of time, the two lines would intersect since y-intercept is higher, but the x-intercept is
lower for project A. The point that they intersect is known as the crossover point.

What is the significance of this crossover point? The crossover point tells us the discount rate at
which we’ll be indifferent between the two projects, because they’ll both give the same NPV. At
the discount rate of 11.8%, these two projects will give you the same NPV.

Hence it means that if the required return is anything less than 11.8%, we’ll pick A. If the
discount rate is more than 11.8%, we’ll pick B. This gives you a bit more of sensitivity analysis
or leeway even if you didn’t know your required return at first. So suppose without calculating
you can estimate your required return, then you can make the choice based on the graph and
the crossover point.

Without plotting the curve, there is also a way to find the crossover point. This is part of the
tutorial. There’s a way to get the crossover point without plotting the curve.

Why do the NPV profiles cross?

It always has to do with the size and timing. These are the two main factors that affect mutually
exclusive projects.

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Different sizes will suggest that the Y-intercept will be very different. Large projects will have a
very large y-intercept because you’re just cumulating all the cash flows. Small projects will have
a much lower y-intercept.

For timing differences it’s a bit more complicated to understand. The idea is that if you have very
large cash flows in the early timing, then a high discount rate wouldn't affect this as much as if
you had very large cash flows at the end.

Think about it like a bond price sensitivity. In the bond lecture, it was suggested that long
maturity bonds are more sensitive to interest rates because the cash flows are all the way to the
end. When interest rates are high, you’d discount it by a lot more, (1+r)n.

Likewise for the projects, if you have very large cash flows at the early stage, by having a very
high discount rate, this would be affected less than if your cash flows were large at the end. So
if r is high, then early cash flows are preferred. That’s why at high interest rates, the NPV of B is
higher than it is for A. But this is just logically trying to understand it without plotting the curve.

So an example would be Project A and Project B are mutually exclusive and there are size
differences, A is a small project which you spend $100,000. B is a large project which you
spend $1 million. B would end up with a higher NPV.

NPV does not correct for size, in other words it’s not standardized. So a larger project would
normally end up with a higher net present value. Normally you’d expect it to, because if you
invest $1 million, it’s far easier to get a return of say $100,000 compared to investing $100,000
to begin with. So a larger project normally ends up with a higher NPV.

IRR being a rate of return of the initial investment is corrected for size, is more standardized
since it is a rate. So smaller projects could very well end up with higher IRRs. In the above
example, Project B, the smaller project indeed does have a higher IRR.

So if a small project has a higher IRR but then the larger project has a larger NPV, then there’d
be a conflict.

Then we’ve got timing differences as well. For a same size project, suppose A has large cash
flows at the start, and B has large cash flows at the end. Based on NPV, pick B. Based on IRR,
pick A. Again there are problems if the timing of the cash flows are very different.

Reinvestment rate assumption

There is another problem with IRR, a little more theoretical as a problem. So what is the
problem? The problem is this thing called the reinvestment rate assumption. There would be
academics and critics who would argue that this is not true. Just making you aware of this
possibility. Whether it’s true or not is debatable. What we argue is that the NPV assumes that
you reinvest cash flows at your required return. Why is this so?

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For any time value of money problem, we assume that the rate to discount is the same as the
rate to compound. So in order to keep the value of the cash flow the same, you move a cash
flow from period 10 to period 5 let’s say, you can still move this cash flow from period 5 to period
7 and move it from period 7 back to period 3, whatever, as long as the rate you use to move it is
always the same. The value of this cash flow doesn’t change. As long as the discount rate is
kept the same whether you’re discounting or compounding, the value of the cash flow doesn’t
change.

Therefore, for the NPV method, when we discount the future cash flows at the required return,
we’re also assuming that we can compound it at the required return, in order to keep the value
the same. When you compound something it means that you’re reinvesting the cash flow, hence
you get a larger cash flow because you get back the interest, that’s what we’re saying.

Therefore the IRR method, if you discount back by IRR, you’re also assuming that you can
compound at IRR to keep the value the same. It’s just arguable to assume that you can
compound at the WACC is more realistic than compounding at the IRR. It’s a theoretical
argument but in the real world no one cares. This does not stop people from using the IRR per
se. It’s just a very academic understanding and perhaps this could be an issue.

That’s why in the classroom especially we suggest that NPV is better for that reason. So for
exams, NPV. NPV method should be used to choose between mutually exclusive projects.

How about if we come up with a hybrid IRR? Make some adjustments to IRR and see whether
we can enhance it. Trying to improve on these flaws. What is this improved or changed IRR?
It is the modified IRR, MIRR.

6. Modified Internal rate of return method (MIRR)

There are three different ways to find MIRR. And all 3 would give you 3 different answers. So
we only learn one method which is known as the combination approach.

Explanation through a timeline:

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The discount rate is 10%, in other words, the required return is 10%. So the combination
approach for MIRR entails this process:

1. We’ll compound all positive cash flows to the end. 60 (1.1), 80 (1.1)2 to get 162.8
2. Discount back all negative cash flows to the start, time period 0. This process doesn’t
change, it is regardless of where the negative cash flow appears. -20 / (1.1)3 to get -15.
3. Add up all the cash flows at the start and add up all the cash flows at the end. -115 and
162.8.
4. Then find the implied discount rate. PV=-115, N=3, FV=162.8, CPT I= 12.28%. This is
the MIRR.
We would still use the same criteria by comparing the MIRR with the required return. If the
MIRR is more than the required rate of return, then we’ll accept the project. If MIRR is less than
the required return, we reject.

What does this method do? Or how is it helpful? It solves two problems for us:
1. MIRR addresses the reinvestment rate assumption problem because we are reinvesting
at the required rate of return by compounding our cash flows at the required rate of
return, we have put in a more “realistic” reinvestment assumption.
2. The other problem it helps us solve inadvertently is the non-conventional cash flow
pattern, because we’d never end up with non-conventional cash flows anymore because
we’d always end up with one negative at the start and one positive at the end.
So when you have non-conventional cash flow patterns you would also need to apply the MIRR
instead.
Another example: Non-conventional cash flow

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Straight away you know not to use the IRR, because you end up with multiples. Let’s try to look
at what the IRR actually tells us. We will end up with multiple IRRs. When you plot the curve it
will look something like this:

In this course, we’re not expected to know how to derive these multiple IRRs. The calculator will
tell you error, because there are more than 1 IRRs. The only way to find the IRR=400% is if you
graph this.

Why would you expect to have more than one IRR by logic?
Looking at the timeline,

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If you have a very small discount rate of 0.001%, very close to 0. Then discounting this 5,000 by
one period and discounting this -5000 by two periods is almost like saying there is no discount
since the discount rate is so small. In which case, these two would end up knocking each other
out more or less. Therefore, the NPV is going to be weighed down by the -800. At very low
discount rates, the PV of CF2 is large & negative, so NPV < 0.

Let’s say if we have a very high discount rate now, the discount rate is now 2000% let’s say. In
which case, if you discount 5000 by 1 period, and discount -5000 by two periods, it’s almost like
reducing them to a very small number of almost zero. So again they will more or less knock
each other out. You’d then still be weighed down by this number in your NPV. At very high
discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV< 0.

So far we’ve seen that very small discount rates give negative NPV, very large discount rates
also negative NPV. So how do you end up with positive NPV then?

It might be possible for you to end up with a positive NPV if you can discount back this $5000 by
one period and that must be larger than the discounting of the -5000 by 2 periods and add -800.
That’s when you’d end up with a positive NPV.

So it turns out that for discount rates between 25% and 400%, this is the time where NPV will be
positive. This thus explains how you end with more than one IRR.

For the example above, with -800, 5000 and -5000, since it it a non-conventional cash flow
pattern we cannot use the IRR, therefore we’d use MIRR. So again compound the $5000 being
a positive cash flow to the end and that is known as the terminal value because it’s the last
value. Then we discount back the -5,000 to time period 0 and add it to -800 and we get -
$4,932.2314. So find the implied discount rate. PV = -$4,932.231, FV = 5,500, N=2, CPT I=
5.6%. This is the MIRR. Since it is less than the required return of 10%, we reject.

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In summary, we argue that if you have a conflict between NPV and IRR, use NPV. In the
classroom we pick NPV. We know that IRR is unreliable in the following situations:
– Non-conventional cash flows
– Mutually exclusive projects (timing and size problems)

Use MIRR if you want to use a rate of return for non-conventional cash flow patterns.

MIRR will not solve the mutually exclusive problem. In the case of mutually exclusive projects,
when you apply MIRR, it doesn’t mean that your ranking problem gets resolved. You would still
likely end up with a conflict with NPV, because the MIRR is still corrected for size because it is a
rate. So it doesn’t resolve the ranking problem so it’s not going to solve all problems, only solves
the reinvestment rate assumption problem and non-conventional cash flow pattern problems. It
would not solve the ranking mutually exclusive problems.

It is possible for cash flows to not have any IRRs at all.

Example:
CF0: 2000
CF1: -6000
CF2: 5000
This is a non-conventional cash flow pattern. In a sense, you’d expect multiple IRRs, but
actually there is no IRR, if you plot the graph, you see that the curve tries to get close to the x-
axis but doesn’t reach it and instead bounces back up. There is no root for this equation so
there is no IRR. Just need to know that it is possible for cash flows to not have any IRR. In other
words, the NPV is either always positive or always negative depending on how the curve looks
like.

7. Profitability index
It is basically a cost benefit analysis. It’s a benefit to cost ratio. So if we find the present value of
all the future cash flows and add it to the original cost, then divide it by its costs, that gives the
Profitability index, PI. It’s the intrinsic value of the project divided by its cost.

Hence if the PI is >1, we should pick the project because the intrinsic value of the project is
more than the initial cost. So if PI>1, what can we say about the NPV of the project? The NPV
of the project is positive. You can see that it is closely linked. If PI > 1, therefore the NPV will be
positive. Hence it makes sense to pick the project.

PI=1.1 implies that if you spend $1 you get $0.10, very intuitive and easy to understand.

When do we use PI?

We use PI in situations where we are told or we know that we have limited capital. In a capital
constrained situation, liquidity problem situation, then PI becomes useful because we want to
maximize the return for every dollar we spend.

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Whereas for NPV, because it doesn’t correct for size, we use NPV assuming that we don’t have
a capital constraint problem, we always have enough money to buy or invest into the projects,
whatever the amount that is needed to invest we have it so no problem.

But for PI, we assume that we haven’t raised the capital yet, we’re trying to assess the projects
and we know that we might have difficulty raising capital, in that case, we want to maximize the
return from the funds then we use PI.

Advantages and disadvantages of Profitability index:

Why may PI lead to incorrect decisions in comparisons of mutually exclusive investments?

Think about when it would actually cause us to choose the wrong project.
It has to do with size differences so when you have two mutually exclusive projects, with
differing size, and let’s assume you don’t have a capital constraint problem but you choose to
use PI.

What would happen is that the larger project again would likely end up with the higher NPV but
the smaller project could very well end up with a higher PI, because PI corrects for size, by
dividing the present value of future cash flows by the cost. In that sense, you may have ranking
problems again. Hence you may end up choosing the wrong one because you don’t actually
have a capital constraint problem but you still chose to use PI instead as the method.

If you are given a choice of 6 projects, and the outlays are given, negative cash flows, and
you’re told the NPV for these projects. How would you find the PI for these projects given these
information?

PI for Project F with an outlay of $5, and NPV of 3.56, How do you get the PI=1.71?
Answer: (5+3.56) / 5 = 1.71

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Since NPV = intrinsic value - cost, therefore intrinsic value = NPV + cost

Once you calculate all the PIs, you can rank them from highest to lowest PI. Say you have $25
to spend and these 6 projects are independent projects, which means you can choose to do
multiple. You can’t repeat the projects. Which project would you do?

What would be the process you go about to find the projects you should do?
How do you maximize NPV for the project?
What would be the steps to take?

NPV of the two projects would be the sum of their individual NPVs.
First step: Come up with all combinations that fit within $25. There are only 6 projects so it is not
impossible for you to find the different combinations manually. But if you were given 10,000
projects and were asked for the same thing, then you’d die trying to find all the possibilities so
you need a program. This is where programming is important, you need to come up with a
program to give you all the possibilities that fit within $25

Second step: Compare the NPVs, choose the combination that gives you the highest NPV. You
realize that that combination may not give you the highest PI.

The one that gives you the highest PI, is found by picking a combination by PI ranks. Choose
the one with the highest PI rank, followed by that of the second PI rank and then squeeze in the
last remaining to be spent, choose the project that has the highest PI ranking which also costs
within the amount leftover. This would then give the combination with the highest PI rank, but it
doesn’t give the highest value, primarily because you may not have maximized the $25 budget,
only spent $20.

So what is the lesson here?

Given a budget, the first step is to always work out all the combinations that fit the budget,
rather than using the method of PI ranks because you might end up as in the case above,
where you don’t end up maximizing the use of the budget. If the outlays for all the projects were
the same at $5, then using the PI rankings would be the correct way to go, because you’d know
for sure that it would always fit nicely into the budget.

Example 1:
Consider the following Perma Filter example. The required return is 12% and required payback
is 5 years, which means that’s the cap that the management has set.

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1. What is the payback period? 4.94 years < 5 years (ACCEPT)
2. What is the discounted payback period?

7.51 > 5 years (REJECT)

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 3. What is the NPV?
Cash flow function:
CF0: 3985000 <+/-><ENTER> " CF0 = - 3985000
C01: 806000
F01: 5 (806,000 is received from t = 1 to 5)
C02: 926000
F02: 4 (926,000 is received from t = 6 to 9)
C03: 1171000 (CF10 = 1171000=926000+245000)
I = 12 (discount rate 12%)
CPT NPV= 893,416.82
CPT IRR = 16.97%
NPV >0, positive and IRR>12%, so (ACCEPT)
4. What is the IRR? IRR = 16.97%
5. Should we accept the project?
Accept the project.

Example 2:
An investment project has the following cash flows: CF0 = -1,000,000; CF1 to CF8 = 200,000
annually.
1. If the required rate of return is 12%, what decision should be made using NPV?
2. How would the IRR decision rule be used for this project, and what decision would be
reached?
3. How are the above two decisions related?

Example 3:
Consider an investment that costs $100,000 and has a cash inflow of $25,000 every year for 5
years. The required return is 9% and required payback is 4 years.

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 1. What is the payback period? 4 years
2. What is the discounted payback period? The project does not pay back on a discounted
basis.
3. What is the NPV? -$2,758.72
4. What is the IRR? 7.93%
5. Should we accept the project? Reject the project

Growth stocks: Total return will only be gained from capital gains yield.
Stock with no dividends, expect price appreciation to be higher, willing to buy
Anticipation of future dividends OR
Buying based on the expectation of takeover attempt, wait for takeover company to offer
premium price. 25 to $35. Enjoy the premium.

Firm experiences good growth, then expectations dividends for common stock will grow so
common stock will be more, present value for the future values will be more than preferred
stock.

Risk perspective, if firm is making losses, Preferred stock will be worth more, less risky, so
valued higher. Depends on situation and perspective at the time.

Lecture 9: Capital Budgeting (Part 2)

Just a recap of what we covered last week, we went through the 7 different methods to appraise
a project. We ranked these methodologies and we suggested that some are more reliable than
others:
1. NPV (intrinsic value of project - cost, hence we call it NPV as we net off the cost,
arguably the most reliable method, no serious deficiencies, we use this for most cases.)
2. IRR (discount rate that you can discount back the future cash flows at to get a NPV of 0.
For independent projects with conventional cash flow patterns, the IRR and NPV would
give the same decision. For unconventional cash flow patterns, then there would be
multiple IRRs so then we would have to use the MIRR and this would solve this problem
for us and we’d end up with one) For mutually exclusive projects, we’d have to make
ranking decisions, then the NPV and IRR could end up with different decisions with the
problems of size and timing of cash flows and so we then go back to NPV as a safer
alternative.
3. MIRR
4. PI: Benefit to cost ratio, we take the intrinsic value / cost, only choose projects with PI>1,
which would mean that NPV>0, however if you’re using this to rank projects and if you
don’t have a cash flow constraint then you could end up picking the wrong choice
because you may end up picking the one with the lower NPV.
5. Payback
6. Discounted payback (These two focus more on the length of time to break even so these
methods don’t tell you how much value you add to the firm but more focused on liquidity.

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 The other drawback is that they require arbitrary cut-off points which we feel is not too
good for these two methods.)
7. Average accounting return (de-prioritize this method as much as we can because this
method doesn’t even use cash flows for which in finance, we think that cash is the most
important thing. For that reason we do not encourage anyone to use this method.)

To conclude, NPV is the best method so far, in terms of any kind of capital budgeting project,
the idea is we need to project the cash inflows and outflows, then we need to find some
discount rate for which we can discount these cash inflows and outflows and then we make
some evaluation. Today we’re going to focus on how do we get these cash flows?

How do you get a cash flow that is only going to happen in the future? We need to do some kind
of projection and these projections are derived from the pro forma financial statements. In these
pro forma statements we need to ensure we pay attention to the effects of taxes on these
projected cash flows. We’ll introduce new formulas to calculate OCF and finally we’ll also look at
projects with different lifespans. How do you objectively compare projects with different
lifespans?

In any typical project, we see 3 stages of progress:

1. First stage: Startup phase
In this phase, most of the time you’d be required to make an initial investment. Buy
machines, invest money on a piece of land or buy a factory. On top of that you could
incur some form of development costs, so if you buy a machine you may need to do
some software updates, get it installed etc. These are all the one-timer expenses which
would then be capitalised, or depreciated over some useful life. Normally we’d also
expect some change in net working capital, so when you startup the business you’d
expect some increase in net working capital in time period 0.
2. Second stage: Ongoing phase
As the name suggests, the business is ongoing. So as you’re doing your business. In
this time you’d expect some changes to revenues and costs and therefore you’d need to
pay taxes as well for these years. Throughout this phase, there could also be changes in
the net working capital, changes in inventory, accounts receivable and payable etc.
3. Third phase: Shut down phase
At the end of the life of the project, if you’re fortunate enough you may be able to
salvage some money from the sale of fixed assets, e.g machines you’ve been using. In
terms of the sale price, you need to assess whether this sale price garners a profit or a
loss in the books. If it is a profit, then you have to pay taxes. If it’s a loss, then you’d get
a tax credit. The idea is that you have to add up the net salvage value, net of taxes.

During the shutdown phase, you might also have to incur shut down costs as you saw last week
in that example we had decommissioning costs and in other cases you may have reinstatement
costs etc. Say you open a retail shop, when the lease is over, you have to spend money to put
the shop back into its original state to return the place to the landlord. We would also expect a

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decrease in net working capital, you’d sell off remaining inventories, pay off payables, collect
receivables etc.

Reminder of the difference between finance and accounting:

In finance, we’re more focused on cash as opposed to the accounting earnings. What’s the
difference? In accounts, we have the matching principle where revenues and costs must be
recognized in the same time period. In finance, we worry more about whether we get cash, we
have cash. If we sell everything on credit, then you actually have 0 cash and that’s important for
us. Additionally if you make a large investment on a fixed asset at say $10 million, then finance
tells us that’s a $10 million outflow. But in accounting, you’d spread this $10 million over a useful
life and depreciate it over 10 years for instance. There are some key differences here that we
should be aware of.

One of the greatest challenges in capital budgeting is to identify if a cash flow is relevant or not.
That’s the key to it. Only able to do it correctly if you get this right. Because it’s really rubbish in
rubbish out. We hence need to make sure that whatever we put into the model is relevant.

So what’s relevant? All cash flows must be recognized after tax. Because tax is a cash
expense, we need to ensure that we account for taxes before we put the cash flow into our
model. All changes in net working capital are considered relevant as this affects cash. All cash
flows must be incremental. What does this mean? The idea behind recognizing whether a cash
flow is relevant or not is to ask ourselves the question about whether or not we’d see this cash
flow only if we do this project.

So if we do the project, we’d get this cash flow. If we don’t do that project, we won’t get that
cash flow, then that would suggest that this cash flow is relevant. If we have a cash flow that we
will experience regardless of whether we do the project or not, then that’s a irrelevant cash flow
for the analysis of this project because it won’t change. Making a decision on whether you
pursue this project won’t change the existence of this cash flow.

There are different types of cash flows:

1. Sunk cost (Cost that we incur in the past and cannot be altered)
This is the case where we spent some money so we can’t really change this amount of
money that you spent with the decision. Example could be you spent $100,000
renovating this factory, and now you’re deciding whether or not to pursue a new project
using the renovated factory. Alternatively you could just rent out the factory for some
amount of money and get rental income. So now you have to decide between the two,
rent out the factory or pursue the project. The money you spent on renovating the
building last year would be considered sunk and as such would not feature into this
decision making because it would not be altered. You have already spent that money so
regardless of what you do you can’t change it.

Examples of sunk cost: Money or other resources

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 School fees: If you prepaid school fees, and then you later decide that you did poorly in
exams, so you decide to change course, move to a different state to study some other
course, then given that the school fees paid is non-refundable, so it’s sunk, then whether
or not you decide to change your course of study, you should not factor in the fact that
you’ve already paid so much for school fees and so you should stay here. That’s a
wrong analysis.

Machinery: Bought some machine, but then you got some better machines or you decide
to pursue something else. In that case, the amount of money spent on the machine is
considered sunk.

Standing in line: If you’ve been waiting for a bus and it has been 20 minutes, you then
decide whether you should just take Uber. So the decision on the change, shouldn’t
factor in the 20 minutes that you’ve already waited. You’ve waited for 20 minutes already
so therefore you should just continue waiting. NO!

Research and Development Costs: Any kind of research cost is considered a sunk cost
because you can’t take back what you already spent on the research. Any research cost
to decide what to do is a sunk cost.

If a machine you bought can be salvaged, then the net salvage value needs to be
factored into the decision.

Spending on COE or a car: Let’s say you spent $200,000 on a car, but everyday when
you decide to drive the car it’s a choice. The $200,000 you spent on the car becomes a
sunk cost, because if you decide to drive the car, you have to pay for parking, sit in
traffic etc, and all those are going to be incremental costs. And the $200,000 won’t
change whether you drive or not. So that $200,000 would be a sunk cost to the decision
of whether you choose to drive it or not.

2. Opportunity cost: Cost of the next best alternative foregone when you pick this project.
Famous example is when you have a piece of land and you build a factory. Alternatively,
you could have sold the piece of land in which case then the after tax price of the land
becomes the opportunity cost because you have to give this up. Give up this opportunity
to embark on this project. You have to recognise what you gave up to fully understand
the cost of embarking on this project.

Examples of opportunity cost:

Any kind of education, the opportunity cost would be the salary if the education is a full-
time engagement. So you’d be expected to go to school and hence you have to give up
one year’s worth of salary.

Mutually exclusive in a sense, you either do the project or sell the land. You have two
options but if you do one, you can’t do the other.

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 3. Positive side effects and negative side effects (These are considered relevant)
For example, if you choose to do the project and then you introduce a new technology to
the firm and this technology allows you to produce more for other things in the firm. So
this technology allows you to produce good side effects for the total business. Good side
effects here would also be added on to the benefits of the project you’re analysing.

Alternatively there are negative side effects. If you’re introducing a new project, you’d
have to recognize that the sales of the current product may be negatively affected so the
drop in sales of the existing product should also feature in your analysis of whether or
not to launch a new product. So this is known as cannibalisation. Every time Apple
launches a new phone, they have to figure out how that would affect the sales of the
current phone and then they have to put that in to understand whether the new phone
becomes a viable project or not.

Examples:
Pollution: If the production process leads to major pollution that requires more people to
wear masks, and the cost of masks must be borne by the firm then it becomes relevant
but if other people have to buy the masks on their own account then it is not considered.
It depends on how responsible you want to be to include all these negative side-effects.

If you can wrap up a new project with an existing project under the same marketing
campaign, then perhaps there could be more sales and that’s a positive side effect.

For side effects, you have no choice but to convert them into a cash flow. Social benefits
of merit goods have to be converted into a number. So if one project improves the
efficiency of other projects, in terms of knowledge management, you’d have to convert
the effect into a value. For instance if it means it lowers the time spans, the machines
have to be running for less periods of time, it saves electricity and you pay less bills. So
you find a way to make sense of this in terms of numbers otherwise you can’t put it into
the model. That’s the limitation.

Ironically in finance, we ignore financing costs. So in terms of the cash flows, we don’t
include interest expenses and neither do we include expected dividends etc. So nothing
of financing goes into the cash flows.

Weighted average cost of capital (WACC)

We finally come to the equation called WACC. It’s the weighted average cost of capital.

Let’s look at the different terms:

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rD is the firm’s required rate of return on debt or YTM of Long-term debt, so if this firm has
outstanding long-term debt, we’d simply derive the YTM of that long-term debt and use that as
rD . In the most pure form of this equation, rD is actually answering the question of “if this firm
were to go and sell long-term debt today, at what rate must it sell this long-term debt?”, that’s rD
. If the firm doesn’t have any outstanding long-term debt, then we’d have to figure this question
ourselves. Because if we assume the firm issues LTD at par, then the coupon rate and the YTM
are the same. For this reason, we’d answer this question to ourselves, if the firm were to go
issue LTD today, what is the coupon rate? It’d be the YTM. But say it already has LTD, then
we’d use the outstanding long-term debt as an indicator. It’s much simpler.

(1-T) is 1-Tax rate. In this case, it's the marginal corporate tax rate. So why do we multiply by (1-
T)? Because of interest tax shield. So if you use debt to raise capital, you have a benefit of
interest shield because you end up paying interest expenses and this allows you to end up
paying less taxes. You get some clawback in terms of the cost of the debt in this way. So we’re
interested in the after tax cost of debt. So we multiply by (1-T).

Then we have D/V, which is the proportion of the firm that is made up of debt. D is the market
value of the debt and V is the market value of the firm which is basically D+E.

Then there is rE is the firm’s required rate of return on equity, and this is derived using the
CAPM. The rE used is the CAPM rE . E is the market value of equity and V is D+E.

So as we can see from this equation, this is why we call it the weighted average cost of capital
because it is the weighted average depending on the market value of the debt and equity
respectively and then it’s cost because it’s got to do with the cost of the capital right? The cost
of debt from the yields of the debt and the cost of equity from the required return.

How do you get the yield for floating rate bonds? Usually it’s indexed to something. Depends on
the index. So we use the historical CIBOR rate for instance. What if you need to project interest
expense, then how do you do that? You’d have to project the index itself. That’s how you project
forward the coupon rate in that sense. For floating rate bonds, they get repriced every period, so
if it’s a 3 month index, every 3 months they get repriced down back to par. So every reset, they
also reset the price. It’s a bit complicated. We don’t cover that in this class.

We worry about after tax cost in this case. Just that in the case of equity there is no tax shield
when you pay dividends. So there is no (1-T) in the sense for the equity.

Why do we not include dividends and interest expenses on the cash flow? Because they are
captured in the denominator, which is the WACC. In what sense? Let’s say the company has a
very high cost of debt, this causes the discount rate to be very high. With a high discount rate,
when you discount back these future cash flows, you end up having a lower NPV. So in that
sense, the company is already being penalized for this high cost of debt. But if you further
reduce the cash flows by the interest expenses, then you’d double count this penalty so called.
You’d treat the cash flows as lower because of the interest expense and discount it by a very

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high rate because of the interest charges and so there would be double counting. As such, for
this reason we don’t include the interest charges or financing costs into the numerators which
are the cash flows.

NPV or rather capital budgeting is basically about us trying to find the NPV of the project that
we’re trying to assess. We have cash flow 0, and then we have Cash flow C1 and so on and so
forth. And then we have to discount C1 by (1+r) and r here is the WACC.

Going back to the 3 stages of the project, startup phase, ongoing phase and shut down phase:
1. In the startup phase what do we do? We buy the machine. Buy a piece of land or factory
etc. Some fixed asset. And this would incur some investment outlay. We also say that
normally we’d experience some increase in net working capital.
2. In terms of the ongoing phase we have ongoing kind of OCF. So we need to calculate
the OCF in the ongoing phase. Sometimes in the middle we have one-timers. So say it’s
a 10 year project and perhaps in year 5, we’re told that we need to renovate the factory
so in which case that’s a one time capital change. Capital expense in the middle, some
major overhaul or development cost etc.
3. In the terminal year, what do we usually expect? First we have the net salvage value of
the asset. Second is the recovery of the NOWC.

We continue to use these equations for capital budgeting, OCF and CFFA.
Operating Cash Flow (OCF) = EBIT* (1-Tax Rate) + depreciation

Additional capital spending and changes in NOWC:

CFFA also known as FCF and as Net Cash Flow from Operations
= OCF – net capital spending (NCS) – changes in NOWC

Example: If you do this project you’d get more sales of 50,000 units and you can sell each for
$4. So that’s $200,000 of sales increase. The variable cost per unit is $2.50, so you’d spend
$125,000. Gross profit $75,000. Fixed costs are $12,000 and Depreciation expense is ($90,000
/ 3)= 30,000 per year for 3 years.

EBIT $33,000, Taxes (34%) $11,220, remaining is Net Income $21,780. This is a 3 year project
so this income statement is repeated for 3 years. Assumption here is that for the next 3 years, it
would be exactly the same, so in terms of projections, nothing will change. We’d sell 50,000
units per year, continue to keep the same selling price, and that’s why the income statement will
just be repeated for the 3 years.

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We know that we spend $90,000 on the machine and it’s going to be straight line fully
depreciated down to 0 over 3 years. The depreciation expense per year is just $30,000.
Additionally you’re told that in the startup phase of this project, you need to have an increase of
$20,000 in net working capital. And then you’re told that this $20,000 is required throughout the
duration of the project which means that there is no change to NOWC in the middle. So
basically there is an increase of $20,000 in NOWC in year 0, and then in year 1, 2 and 3 there is
no change because you need this $20,000 throughout. You’re told that you can recover this at
the end of the project. So we make the assumption that in year 3, you get back this $20,000 so
you see a decrease of $20,000 in year 3.

What’s the net capital spending per year? In this scenario, it’s clearly 0 because you’re not told
anything because you’re not told that you need to buy any new machines or that you need to do
any new renovations etc. so just by looking at the description of the situation you should know
that it’s 0. Nevertheless, if you want to apply the formula: Ending Net fixed assets - Beginning
net fixed assets + depreciation you can but because there is only one net fixed asset this is
what you get and of course it’s going to be 0:
In Year one NCS = (60,000 – 90,000) + 30,000 = 0;
In Year two, NCS = (30,000 – 60,000) + 30,000 = 0.
In Year three, NCS = (0 – 30,000) + 30,000 = 0

So this is the table of cash flows that we arrive at:

And of course for all capital budgeting questions, the goal is to arrive at this kind of table, a table
that describes all the cash flows so that we can then draw the timeline of cash flows at the end.

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So again in the startup phase, year 0, what do we do? We spend $90,000 on the machine and
that’s a one time cash outflow of $90,000. And then we also have an increase in net operating
working capital. An increase in NOWC is a cash outflow. Hence we have a -20,000. Minus sign
here is an increase in NOWC. Minus sign because it is an outflow and it is an outflow because
we increased the NOWC. We have the 3 years’ worth of OCF. OCF is derived by taking the
numbers on the income statement: EBIT (1-Tax rate) + depreciation = $51,780

OCF = 33,000 (1-0.34) + 30,000 = $51,780

That would be 3 years because we assume that the income statement would be the same for
the 3 years. We assume that we can recover back all the NOWC, so if there is an outflow of
$20,000 in year 0, we assume that we can get an inflow of $20,000 at the end of year 3.

We make this assumption for all capital budgeting problems even if you’re not told explicitly that
you’ll be able to fully recover it, we make this assumption that we can.

Then we sum up the cash flows for each column to understand for each year what are the net
cash flows. So for year 0, the cash flow is -$110,000, and for year 1 & 2 its $51,780 and for year
3 its $71,780.

Then this net cash flow line becomes what we have on a timeline which we then have to use to
get NPV. Now that we have these cash flows we have to calculate the required return to figure
out how to discount back. This 20% that we assume is actually the WACC. So assuming we are
not given the discount rate then we’d have to go and figure out what is the WACC. Use yield to

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maturity of long term debt if there is and that would give you the rD . Calculate the rE for the firm
based on its Beta and so on and so forth. So that’s how you get the WACC. In this case, say we
know that the WACC is 20%, so then what do we do?

We calculate the NPV and IRR which is simple and we get, NPV=10,648 and IRR=25.8%
We get a positive NPV and we know that the IRR is 25% which is more than 20%, the discount
rate. So we should accept the project.

Some nuances and things that we should worry about and be careful about:
1. Depreciation
For our course, we tend to focus more on straight line full depreciation, but we
understand that we can also do accelerated depreciation. For e.g MACRS (Modified
Accelerated Cost Recovery System). For capital budgeting we use the tax reporting
depreciation methodology. So in other words, in all firms, it is possible to use different
methodologies for different purposes. So the firm can produce two different accounting
books, one for accounting and one for tax reporting and they can use two different
methodologies for these accounting books. It is advantageous to report taxes using
accelerated depreciation because then you’d pay less taxes in the start because you’d
recognize higher depreciation expense. So it is possible for firms to do that if they want
to. For capital budgeting, we would use the tax reporting methodology as the one that is
relevant for us to calculate depreciation. Why are we more focused on the tax reporting
methodology than the accounting methodology? Simply because depreciation is actually
a non-cash expense so because of that we don’t care in terms of finance. Technically we
don’t worry too much about depreciation but why do we then have to at least factor it in?
Because it affects the taxes and tax is a cash expense. So for this reason, we worry
more about the tax reporting methodology because that would affect the taxes. And
because depreciation being above EBIT would then cause you to have a tax shield as
well similar to how interest works. So if you have a high depreciation expense, then
you’d end up paying less taxes so we also need to end up calculating this thing called
the depreciation tax shield which is exactly the same as interest tax shield. Interest tax
shield is just interest * tax rate. Depreciation tax shield is just depreciation * tax rate.

Again this tax rate here is the marginal tax rate that’s important to distinguish. You have
average tax rate and marginal tax rate. The marginal tax rate is the tax rate you apply to
the next dollar you earn. In all capital budgeting, we use the marginal tax rate, why so?
Because these are not incurred yet, so every dollar you make from these projects that
you’re trying to assess would be considered the next dollar. It would be incremental so
the marginal tax rate is what’s the relevant tax rate.

Within straight line depreciation, there are two different ways to do this. You can either
do straight line full depreciation down to 0 or you can do straight line depreciation taking
account the salvage value and this would of course result in 2 different numbers for
depreciation expense.

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 If you do straight line full depreciation, the book value at the end of its life would be 0, so
to find the annual depreciation, you simply take the total cost divided by the total years of
useful life. If you take into account the salvage value, you have to subtract off the
salvage value from the initial cost before you divide it by the number of years of useful
life.

Accumulated depreciation is just the depreciation multiplied by the number of years in

use. And Book Value (B) = Initial cost – Accum. depreciation

In our course, we allow the firm to decide which methodology they want to use. So even
though there is a salvage value for the asset, it doesn’t mean that we’d end up choosing
this method. It’s not a guarantee that we’d use this method if there is a salvage value
given to you. You still must understand which method is the firm doing.

2. What about net salvage value then? Net salvage value is simply the after tax salvage
value. So at the end of the life of the machine, you’d sell it off, there’s a salvage value.
Then you have to figure out whether there is a profit or a loss. How do we know if it’s a
profit or a loss? We have to compare it against the book value at the time of the sale. So
if you sell for a price that is higher than the book value at the time of the sale, then that’s
considered a profit. And because you made a profit, you need to pay taxes on this profit.
So the amount of taxes you’d pay = Tax rate * (S-B), where (S-B) is the profit. So you
pay taxes on the profit not on the full salvage value. That’s one thing to make sure that
we’re careful about.

Therefore after tax, the salvage value becomes the Salvage value - the amount of taxes
you pay. That is = S – T*(S – B), where T*(S – B) is the total amount of taxes that you
pay.

If you make a loss then what happens? So if you sell for a price that is lower than the
book value at the time of sale, sell for $20,000 but the book value at the time is actually
$30,000, then you’d make a loss of $10,000. If you make a loss, you’d get a tax credit
which is treated as a cash inflow. So the tax inflow would still be the tax rate * (S-B), the
same as before. It’s just that for the after tax salvage value, then you’d add it back to the
salvage value because it is an inflow. So the formula would be S – -T*|S – B| = S + T*|S-
B|. The absolute is there because the (S-B) would be negative.

If your salvage value is an exchange of assets, then the salvage value would be
measured by the difference in the book value of the two assets. It would still be
considered a cash flow. We would have to appraise the worth of the item. Bartering is
still considered a way of trading so there must be a worth to the item.

Just to be very careful about this, some may be confused about the signages of this. But
if you make a profit on a sale, then you must expect that your after tax salvage value is
less than your salvage value because you must pay taxes. If you make a loss on the

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 sale, conversely you must expect that the after tax salvage value is higher than the
salvage value because you would expect an inflow from the taxes. So that’s how you
remember and check to see if you have done it correctly.

Example: Say you purchase equipment for $100,000 and it costs $20,000 to have it delivered.
You can sell the equipment for $12,000 at the end of 6 years, so this is the salvage value. The
marginal tax rate is 40%, what is the depreciation expense each year and the after-tax salvage
value or net salvage value at the end of year 6?

So of course it depends on what methodology we use. So let’s first use the full depreciation
methodology:
Depreciation expense = (120,000 – 0) / 6 = 20,000 every year for 6 years
It’s120k because we have to find the total cost of the machine including the delivery cost.
BV in year 6 = 120,000 – 6(20,000) = 0
Net salvage value = 12,000 - 0.4(12,000 – 0) = 7,200
The full $12k is a profit so you have to pay taxes on it, after which you get the after-tax salvage
value.

What if we didn’t do full depreciation, and instead we take depreciation taking into account the
salvage value. In that case we have to first subtract the salvage value of $12,000 to work out
the annual depreciation.

D = (120,000 – 12,000) / 6 = 18,000 every year for 6 years

BV in year 6 = 120,000 – 6(18,000) = 12,000
Net salvage value = 12,000 - .4(12,000 – 12,000) = 12,000
There is no taxes to pay so the after-tax salvage value becomes 12k.

How about net capital spending then?

Net Capital Spending = Ending net fixed assets –Beginning net fixed assets + Depreciation

So in capital budgeting we must remember that there are times when we buy machines, so we
spend and so net capital spending will be positive. But at the same time, we could also be
selling off old machinery which in that case, we would be getting an inflow from those capital. So
if the amount of money we spend on buying new machines is less than the amount of money we
get from selling off old machines, then the NCS should be negative. So there is negative spend,
which means it’s an inflow. So it is possible to have a negative NCS.

Many times in capital budgeting, we deal with replacement rather than just from scratch. It’s
more common to assess projects that replace current projects rather than having nothing to
start with and assessing it from 0. So how does that change the situation? The only change is
that in this case, we work with incremental cash flows instead of just the total cash flow.

By incremental cash flow, what we mean is that currently there is a set of cash flows based on
the current projects that we’re doing, and now we’re deciding whether to change to something

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else so we need to then assess the incremental cash flows as a result of this change. That
means, if you change to something else, this is the cash flow, and you take the new cash flow -
the previous cash flow and use that as the cash flow in the analysis and if the NPV of the
incremental cash flows are more than 0, then it’s profitable to change. You can argue that you
could do it another way which is of course possible which is to take the NPV of the new project -
NPV of the current project and if the value is more than 0, then it makes sense to change as
well. That’s fine. It’s just faster to work with incremental cash flows. But if you want to do it
completely separately then that also works as long as you have sufficient information.

Since we work with incremental cash flows, then we have to make one assumption which is, if
we buy a new machine to replace the current one, we immediately sell off the current one. We
make this assumption just to simplify the situation for our course and to make sure that
everyone has the same assumption, there’s no other real good reason. In the real world of
course, if you buy a new machine and try to replace the current one, it is unlikely that you’d
immediately sell off the old machine because as a business person, you’d probably parallel run
it to be safe to ensure it’s working fine before you completely cut it. This is just to make it
cleaner for our analysis and to ensure that everyone has the same timing. If not you could make
your own assumptions, and there’d be ten thousand different answers. So for our course, let’s
assume this. If you buy a new machine to replace an old machine, we also sell the old machine
immediately.

So then our cash flow estimates have to reflect all the cash flow consequences of selling the old
machine today instead of at the end of its life based on the original life span. What is one thing
that we have to take care of? This is the one thing that is probably the most difficult to
remember, which is that if you sell the old machine today, the benefit you get today is the net
salvage value of the machine today. Sell off the old machine today and you’d get the salvage
value today and then you have to worry about taxes so you get the net salvage value of this old
machine today. But because you get the net salvage value today, you would no longer get the
net salvage value at the end of its life. So this loss of the net salvage value at the end of its life
is an opportunity cost. So you have to remember to also include that in the analysis. The
opportunity cost of not getting the net salvage value at the end of its life.

The other major change in terms of incremental expenses would be the differential depreciation
expense between the new and old machines.

Example:

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So currently we use a machine, bought it at $100,000 5 years ago. Annually you depreciate it by
$9000 therefore the book value today is $55,000. You can calculate that yourself even if you’re
not told. So accumulated depreciation will be 5*9,000 = $45,000. Initially it costs $100,000 and
the book value today is $55,000. If you sell this old machine today, you can salvage it for
$65,000. If you wait for another 5 years until the end of its life, you can salvage it for $10,000.

Now you want to consider replacing this old machine with a new one. The new machine will cost
you $150,000 today. It has a life of 5 years. And at the end of its life, you can salvage it for
$17,000. If you use the new machine compared to the old one, you’d be able to save $50,000 a
year on cost. Either lower maintenance cost or maybe you use less staff to mann the new
machine compared to the old machine etc. We’re just told there is some savings.

Straight line fully depreciated down to 0, so $30,000 per year for the 5 years. So how do
understand whether it makes sense to do replace or not? First you have to come up with a pro-
forma income statement. This pro-forma income statement is a statement of incremental
numbers. The entire statement is all incremental. We make the assumption that for the next 5
years, the income statement is the same.

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For year 1, this is the income statement. Year 2-5 is all the same. So far we have seen two
examples where we have made this assumption. You can’t assume that it would be this case all
the time. It is possible for you to have to use 5 possible different income statements if the
numbers do change. For example if you are told that in year 1 you save $50,000 and in year 2,
$60,000 and in year 3, $70,000 etc. So if that number keeps changing every year, then of
course the income statement would also look different every year as well. Just be careful about
that as well. Don’t assume that it’s always going to be the same.

Cost savings is right at the top of the income statement because it’s seen as a revenue. Cost
savings and revenue are treated the same way. The depreciation of the new machine is
$30,000, the depreciation of the old machine is $9,000, so incrementally we would recognize
$21,000 of depreciation. Because we would have $50,000 of incremental revenue so called and
then incremental $21,000 of depreciation, therefore we’re going to have an incremental EBIT of
$29,000 (50k - 21k). We have an incremental taxes of $11,600 and therefore we have an
incremental net income of $17,400.

So what is the relevant OCF in this analysis? We take EBIT (1-Tax rate) + incremental
depreciation. We have to remember that we always take incremental. When we calculate the
OCF, we don’t add the $30,000 which is the depreciation of the new machine. We only add
$21,000 because that is the incremental depreciation.

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So OCF = 29k (1-0.4) + 21k = $38,400. And this is the same for all the five years.

What else do we have to worry about to get the table of cash flows? What happens in year 0,
you buy the new machine, so you’d spend $150,000. Because we assume that if we buy the
new machine, we’d sell off the old machine, what are the consequences of selling off the old
machine? You’d get the net salvage value of the machine today. You’re selling it at $65,000,
today the book value is $55,000 so you make a $10,000 profit. So you have to pay 40% of taxes
on this $10,000 profit. So net salvage value of the old machine today would be = 65,000 - 4,000
= $61,000. This is an inflow. So net capital spending becomes one $150k outflow - $61k inflow
which is $89k outflow.

Year 5 what happens? You sell off the machine today, therefore you no longer get the net
salvage value at the end of year 5. What’s the net salvage value at the end of Year 5? You’re
told that you can salvage the old machine at $10,000 in year 5. What’s the book value of the old
machine at the end of year 5? $10,000 because you would have five more years of
accumulated depreciation = 55,000 - 5 (9,000) = $10,000. The book value is $10k and you
salvage it at $10k, so there is no gain or loss and this means that the net salvage value is just
the full $10k and this is an outflow because it is an opportunity cost. Additionally what else do
you also have to remember?

You’d also get the net salvage value of the new machine, so the new machine would be sold for
$17k. What is the book value at this time of sale? 0 because it is straight line fully depreciated.
So the full 17k is a gain so you have to pay 40% of this in taxes, which is $6,800. So the net
salvage value then becomes $10,200 and this is of course an inflow.

So we end up with this:

-89k in year 0, we’re not told anything about NOWC so we assume there is nothing. We have 5
years worth of OCF, we have the opportunity cost and the NSV of the new machine. And then
the recovery of the NOWC but in this case also nothing.

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The last three items at the end in the column of year 5, which is the NSV of the new machine,
opportunity cost of the old machine and the recovery of the NOWC. When we add up these 3
items together, we refer to this as the terminal cash flow. That is the terminal cash flow or the
terminal year cash flow.

We have the net cash flow line at the end and once we have that, the hard part is done. Just
use that to calculate the NPV and IRR and whatever else. Compute NPV = 56,690 and
Compute IRR = 32.66%, which is more than 10%. And therefore we would replace.

Formulae for OCF:

So now we are going to see 3 new formulae for calculating OCF: (Some more useful than
others)
First method is OCF = EBIT*(1-Tax Rate) + Depreciation (we know this of course)

Then the following formulae are all derived from the first:
1. Bottom-Up Approach (when there is no interest expense) -> This means that we use the
income statement and go bottom up, this method will only be useful if there is no interest
expense, if there is no interest expense then Net income = EBIT*(1-Tax rate)
a. OCF = NI + depreciation if there is no interest expense
b. NI = Sales – Costs – Depreciation – Taxes
c. Taxes = Tax Rate * (Sales – Costs – Depreciation)
2. Top-Down Approach (when there is no interest expense)
a. OCF = Sales – Costs – Taxes, only used when there is no interest expense
b. Don’t subtract non-cash deductions or interest expense
3. Tax Shield Approach (can use even when there is interest expense) (more useful than
the other two.)
a. OCF = (Sales – Costs)(1 – T) + Depreciation*T
EBIT is simply = Sales - Cost - Depreciation,
OCF = So if you have (Sales - Cost - Depreciation) * (1-Tax rate) + Depreciation
= (Sales – Costs)(1 – T) - Depreciation + Depreciation * T + Depreciation
=(Sales – Costs)(1 – T) + Depreciation*T

For capital budgeting, we tend to use this equation because it is faster than the other, because if
you’re not given an income statement with the EBIT line given where you can straight away plug
in the first equation and instead you’re given the entire situation, then you’ve got sales, Costs,
then you don’t have to calculate the EBIT in that sense so it’s slightly faster by using this
equation. If you continue using the first equation, you’re fine as well. Just some awareness of
the different possibilities.

Using this example, we can demonstrate that all four give you the same answer:
In this example, there is no interest expense, so you can use all four equations, and you should
get the same number which is OCF = $51,780

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OCF = EBIT*(1 – Tax Rate) + Depreciation = $51,780
1. Bottom-Up Approach (since no interest, get same answer)
a. OCF = NI + depreciation = $21,780 + $30,000 = $51,780
2. Top-Down Approach (since no interest, get same answer)
a. OCF = Sales – Costs – Taxes = $200,000 - $137,000 – 11,220 = $51,780
3. Tax Shield Approach (always get same answer)
a. OCF = (Sales – Costs)(1 – T) + Depreciation*T = $(200,000 – 137,000)0.66 +
$30,000 X 0.34 = $41,580 + $10,200 = $51,780
The cost in the two equations in 2 & 3, only refer to variable and fixed cost and do not include
depreciation expense. Don’t include depreciation expense in the cost.
The one highlighted in red is the depreciation tax shield.

What happens when you have machines of different lifespans? How do you try to figure out
which is better actually?

Example:

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So for machine 1, you pay $45,000 and you get OCF of $20,000 each year for 3 years. Machine
2 also costs $45,000 but then it’s a 6 year machine, so for the next 6 years you have an OCF or
cash inflow of $12,000 each year. The discount rate is said to be 14%.

How do you then figure out whether machine one or two is better?
Without further information, the first thing to do would be to look at the NPV. That’s the first train
of thought.

Step 1: Calculate NPV

• NPV1 = $1,432
• NPV2 = $1,664

NPV of 2 is better than the NPV of 1, so some people would say let’s pick 2 since the NPV is
higher. Well maybe this makes sense. But then the problem is of course that they are both of
different lifespans so it seems a bit unfair, there is some kind of difference there, it’s not
completely a comparison of potatoes to potatoes. So can we improve this methodology?

We can by making some assumptions. What we assume is that we can replace these
machines. If we are able to replace these machines and have exactly the same cash flow
patterns forever, then we can convert this NPV to an annuity over the useful life of the machine.
So how do we do that?

We’re going to convert the NPV into what we call the equivalent annual annuity - EAA. So for
machine 1, you get a lump sum of $1,432 today or in this case, if you use this as the PV, take n
as 3 and I as 14%, and CPT the PMT, $1,432 today is exactly the same as getting $617 each

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for the next 3 years at a discount rate of 14%. You have not changed the worth of the cash flow,
you’ve just spread it out over 3 years instead.

Do the same for machine 2. Of course machine 2 is 6 years. So you have to change the n to 6.
Enter PV = 1,664, N = 6, I/Y = 14%
<CPT> <PMT> $428. Receive 1,664 today for machine 2, you spread this out over 6 years, so
you’d get $428 each year for 6 years and the worth of the entire cash flow is $1,664 based on
the discount rate of 14%.

What happens now is that if you assume that you can replace these machines forever, at the
end of year 3, you’d simply buy another machine 1. If you buy another machine 1 at the end of
year 3, then in year 4, you’d get $617, year 5 $617 and for year 6 you’d get $617. At the end of
year 6, you’d buy another machine 1, and in year 7 you’d get $617. Year 8 $617. Year 9 $617.
And so on and so forth forever.

Same for machine 2. So at the end of year 6, you’d buy another machine 2 and in year 7 you’d
get $428, year 8 $428, year 9 etc. This equivalent annuity is also called replacement chain
methodology as you can see why. You literally keep replacing the machine. So in this way, we
no longer have a different time period to worry about because it goes on till infinity at $617 per
year or $428 per year.

Thus we can simply compare these EAAs. So if machine 1 can give you $617 per year but
machine 2 can only give $428 per year, then of course machine 1 becomes better. We pick the
higher EAA.

If we are comparing cost, then we’d pick the less negative EAA.
Example:

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Machine A will cost $5 million with a pre-tax operating cost of $500k. Machine B will cost $6
million with a pre-tax operating cost of $450k. Machine A is a 5 year machine and machine B is
a 8 year machine. The salvage value of machine A is $400k and for machine B it’s $700k.

So if you use a straight line depreciation taking account the salvage value, what is the
depreciation for A and for B?

One other thing to take note of in these types of questions is that it is possible to be given the
pre-tax or post-tax cost. They need to be treated differently. If you’re given the pre-tax cost, then
you know you have to still tax it so that you’d get the after-tax cash flow. But if you’re given the
post-tax cost, it’s already been taxed so you don’t have to tax it again. So that makes a
difference in terms of how much you recognize.

You’re then told that you can replace these machines forever, and there is no change in NOWC.
The required return is 9% and the tax rate is 40%. Which one do you choose?

Of course, therefore you need to go calculate the EAAs. So when you see these assumptions of
you can replace these machines forever, you immediately know its EAA. So what do we do? We
have to calculate the NPVs first.

It says that neither machine will have a differential impact on revenue. Which means that in
terms of incremental cash flow on sales there is nothing. There is no differential impact no
matter which machine you use. For this reason, the sales for the equation to find OCF is left as
0 because there is no change and hence there is nothing to worry about.

So for machine A, we spend $5 million to buy the machine then we have to calculate the OCF to
understand the cash flows for these five years. The OCF, using the tax shield approach is:

Tax shield approach to find OCF = (Sales – Costs)(1 – T) + Depreciation*T

= (0 - 500k) * (1-0.4)
Here’s where the difference is, if the post-tax operating cost was given then you wouldn’t need
to multiply it by (1-tax rate) but instead just put it into the equation as it is.

Then plus depreciation tax shield. How do you get the 920k. That’s the depreciation which is
found by taking (5 million - 400k) / 5 = 920k. So you get the OCF as 68k per year for five years.

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And then in the terminal value you get the net salvage value. So this machine is salvaged at
$400k and the book value at the time is $400k. So there is no taxes so the total salvage value
becomes the net salvage value. So you get the net cash flows and then you can calculate the
NPV, which is -4,475,531.16.

Then you want to convert this NPV into an EAA. Use the cash flow function to compute NPV,
then after you transfer this to PV and press N=5, I=9, CPT PMT. Convert this NPV into an
annuity for the 5 years. At this time, the calculator would give 1,150,625.30. Positive number
would be given by the calculator. But we have to remember that this number is actually negative
even though the calculator gives the number back in positive sign. Because the calculator will
change the sign owing to its assumption. But when we convert a negative NPV into an annuity,
it stays negative, because the value cannot change. We’re trying to say that instead of giving
me a lump sum today whatever the number is, try to spread it out. So if it’s negative to start
with, if you spread it out, it’s still negative. This must be remembered so it’s actually -
1,150,625.30.

Do the same for machine B. Machine B is bought for 6 million. We calculate the OCF per year
with exactly the same methodology. Sales=0, Cost is 450k, times by (1-tax rate) + depreciation
(tax rate)

OCF = (0-450k) (1-0.4) + 662.5k (0.4) = -5000

How do you get the 662.5k as depreciation? Take [6 million - 700k (salvage value) ] / 8= 662.5k
So the OCF per year is -5,000. What is the net salvage value for machine B? Same as for
machine A. The salvage value is $700k and the book value is also $700k, so there is no taxes
so the net salvage value is the salvage value. Compute the NPV. Convert this NPV into an EAA.
Exactly the same as was done for machine A apart from the fact that now N=8.

NPV for machine B= -5,676,367.70, and PMT = -1,025,574.20.

So you’d end up with these two numbers to compare:

Machine A Machine B
EAA = -$1,150,625.30 EAA = -$1,025,574.20

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Pick B because it has the less negative EAA. It’s called EAC if we’re looking at negative values,
because it’s a cost. Pick the less negative one if it’s only cost to consider.

Example:
Say we have to do this project where we have to spend $200,000 on the machine. $40,000 to
install this machine. So the total cost is $240,000. Always add the installation or delivery cost if
any.

Changes in working capital: You’re told that inventories will rise by $25,000 and accounts
payable will rise by $5,000.

Effect on operations: If you do this project, you’d be able to sell 150,000 units/year @ $2/unit
more and the variable cost: 60% of sales.

The economic life of the project is 4 years, so it’s a 4 year project. Straight-Line Fully
Depreciated over 4 years $240,000/4 = $60,000 per year. You’re told that you can salvage it at
the end of four years for $25,000.
Tax rate: 40% and WACC: 10%

The goal is to come up with this table:

For any capital budgeting, come up with this table. And this works for the exam as well. Present
answers in a table. Otherwise, if you have to search for the answers, it would be very difficult to
know whether you’ve got it right.

So in year 0 what happens? In year 0, you spend $240k on the machine. And also there is an
increase in the NOWC. Inventories go up by $25k and accounts payable goes up by $5k. So
therefore NOWC increases by $20k. That’s an outflow. Total outflow in year 0 is = $260k.

Then let’s look at the ongoing phase then:

We have to calculate the OCFs. For that we have to come up with the pro forma statement. In
this case, revenues would be 150k units * $2 per unit = $300k.

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The cost is 60% of this = $180k. We know that the depreciation is $60,000 per year. So the
EBIT becomes 60k. We tax 40%, we have a net income of 36k. We add back the depreciation
of $60k and we get an OCF of 96k.

Terminal net cash flow, what happens? Again terminal cash flow we have:
1. Recovery of NOWC, that’s the assumption we make, we have an outflow of $20k in year
0, so we’d have an inflow of $20k at the end of the life.
2. Net salvage value of the machine: We salvage it for $25k, Because we straight line fully
depreciate, the book value is 0, so the $25k is a gain. We tax 40% on this gain which is
$10k of taxes. Net salvage value becomes $15k.
So total inflow is $35k for the terminal cash flow.

Additional information that you’re told: You spent $50k to renovate the building last year. Is this
considered a relevant cost to decide whether to embark on this project? Of course the answer is
no. It’s a clear example of a sunk cost. You would have spent it anyway so it won’t change.

How about this? Instead of doing this project, you could have leased out your factory for $20k
per year. Would this be a relevant cost? Yes, because this becomes opportunity cost, because
now you’ve got another option that you could’ve chosen as well. So this becomes an alternative,

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hence it’s a relevant cost for its opportunity lost. However, many students still get it wrong even
after they spot this $20k. Why so? Because they put the entire $20k as opportunity cost. That’s
wrong why? Because you have to factor for taxes. Everything that you put into the table must be
after taxes. So if you’re told that there is an opportunity cost, you still need to after-tax before
you put it into the table.

So the after-tax opportunity cost is only $12k.

After-taxed opportunity cost = $20,000 (1 – T) = $20,000(0.6) = $12,000 ⇒ NCF = $96K – $12K
= $84K

If you had chosen to rent this building out instead, you would’ve collected $20k per year, but
then you’d have to pay taxes on this $20k per year because it’s an income. So you’d still have to
pay $8k in taxes and so the after-tax benefit of renting this out is only $12k and that’s the
relevant opportunity cost. In this case we have decided to minus it off from the net cash flow so
it becomes $84k. So this becomes the final net cash flow line:

At year 0, you spend a total of $260k which is comprised of $240k for the machine and $20k
outflow for NOWC. Year 1-5 we have OCF of $96k minus $12k each year for the opportunity
cost. In year 5, we have additionally the 35k Terminal cash flow that is derived from the
recovery of the NOWC, as well as the net salvage value of the machine.

This terminal cash flow again, very often when you have this capital budgeting questions, you
have the question what is the terminal year cash flow? It’s just the $35k number not the $119k.
That’s just a special reference to the cash flow you get in the terminal year so it would only be
$35k.

Calculate NPV, and IRR, NPV = $30,174 ⇒ IRR = 14.96% or whatever methodologies you’re
told to use. IRR is more than 10%, so we choose the project. And NPV is positive so we would
go as well. With all these cash flows, you can then also calculate the payback, discounted
payback etc.

How does inflation affect our analysis? If there is expected inflation, the problem is that we
would have understated the NPV if we didn't’ correct the sale price of this item for inflation. In
other words, if there is inflation and we know there is inflation and we continue to recognize $2,

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as the sale price every year, then what happens is that the OCF becomes lower than what it
would've been if we had included inflation. So when calculate the NPV, we end up with a lower
NPV than what it should’ve been and that’s called double bias or understating.

This is because the discount rate we use, the WACC is a nominal rate. All interest rates are
nominal unless you correct it yourself. So we know that the discount rates are definitely nominal
so to ensure that we do apples and apples again, the cash flows must also be nominal. The
cash flows must include the impact of inflation. So possibly, if annual inflation is 10%, then we’d
have to change the pro forma statement accordingly. The revenues would have to grow by 10%
and the rest of it would have to follow because the cost would be 60% of the revenue. But you
must remember that the depreciation doesn’t change with inflation. Depreciation will stay at
$60k because that’s how depreciation is calculated. And the rest will be affected.

You have to increase all the different values in each year’s pro forma income statement only if
the question tells you there is an inflation rate of x.

Then you have to include the inflation into the pro forma income statements. If the question
didn’t say anything, there’s no mention of inflation rate then you assume that it’s the same price
like what we’ve been doing before.

Stand alone principle, the idea is that for a firm they’d have a lot of different departments picking
many different projects. The idea is that each project they look at is treated almost like a mini-
firm. They will appraise these projects in isolation but as long as everyone is using incremental
cash flows to analyse these projects, for the total firm, the full benefit will just be the addition of
all the NPVs of these mini firms. So that’s simply known as the stand alone principle where
we’re able to accumulate the total worth for these projects by aggregating it.

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Lecture 10: Financial Planning and Forecasting
Idea is that we want to be able to do projections of our income statements and balance sheets
ahead of time that’s why it’s called planning. The idea is that we need to have some
assumptions put in place and then figure out which line items in our income statement and
balance sheets will follow which assumptions. That’s basically it.

So why do we even need to have all these projections? We all make plans. Financial planning
would pertain to the numbers of the firm. The thinking about why we want to do it, what’s the
usefulness, what are things to look out for, it’s frankly no different from any other plan. So of
course we want to figure out the firm’s anticipated performance and measure this against some
targets that we have set for ourselves. We want to understand whether there are gaps. For
instance if we want a certain growth rate based on a certain income etc, then we tweak our
model and try to figure out whether if we grow at this rate, are you able to reach the target and
where is the gap and what else can you change. So the model if built correctly allows us to
understand the effects of proposed changes. So again if we make certain adjustments here and
there what is the follow on impact on the numbers? Of course if you want to grow at certain
rates, then again by allowing the model to change, we can also project future financing
requirements, whether or not we need more loans, to raise more capital. Of course having a
projected income statement and balance sheet allows you to calculate the cash flows from
assets which would then be useful in terms of valuations and sometimes we may use it as
targets for compensation as well.

Firstly we want to understand what financial planning is about. We will go through two different
methods to ascertain whether we need financing or not, the two methods are known as 1) The
Percentage of Sales Approach (Financial Statement Method) where we actually come up with
the entire pro forma of the balance sheet and income statement and 2) The AFN Equation
Method (AFN = Additional Funds Needed).

We will then understand when to use what. We will then further look at two more equations
known as the internal growth rate and the sustainable growth rate. These are special which we
will find out more about.

In general, financial planning process is about thinking about the future of course, evaluating
alternative investments, projecting any requirements for financing and of course in a real firm,
when we have a plan and execute according to the plan we need to continue to monitor the plan
whether we are facing increasing gaps owing to changes in our assumptions, etc. Things that
we thought were going to happen may not exactly happen and so we may continue to get
differences between our actuals and our plans. So management team of the company has to
figure out what we can adjust based on the model.

What goes into the plan? The three big decisions. Every firm must ask itself these 3 questions:
Capital budgeting, Capital structure, Net working capital management.

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What are we going to do? Long-term assets.
How are we going to get money? Capital structure.
What are the certain working capital policy decisions that we want to make?

All these feed into the model. Finally another item is the dividend policy. Dividend policy would
dictate how much money you’d give away out of your net income. The more money you give
away would mean you’d have less money for yourself. This means that you would retain less of
your earnings, and hence less money to work with based on internal financing. The more you
give away as dividends, increases the likelihood that you’d need external financing, which
means you’d need to raise more capital if you want to grow as fast. So this is another decision
that would also influence the pro forma balance sheet and income statement.

Normally firms would do long term and short term planning. Short term planning is usually about
one year and usually broken up by either months or quarters. Whereas long term planning is
usually about 5 years, usually people do either 3 year or 5 year plans. Normally it doesn’t go
beyond that because it doesn’t really make logical sense because everything changes.

Stand alone principle mentioned last week. The idea is departments within the firm will make
their own separate plans and then the CFO’s job is to aggregate or combine these plans to
ensure consistency across the firm, ensure things are not double counted, to ensure allocation
of resources are done correctly.

We expect to try to aggregate them, make sure also that the interactions are okay, the
consistency is there across the firm because if department A has a different idea about what to
assume from department B then of course this doesn’t make sense. Thus consistency across
the firm is important.

Refresh our minds about how the income statement and the balance sheet are linked. So every
year when you have a net income, you then decide how much to give away as dividends and
whatever you don’t give away is kept by yourself as retained earnings and so this is the amount
that you’d add to retained earnings. And this is then added to the balance sheet item called
retained earnings. So this is how the income statement links to the balance sheet.

When we do pro forma statements, one key assumption that we need to make is the sales
forecast. That means how fast do we want to grow sales, do we want to grow sales by 5%,
10%, 15%, etc? This is one of the most integral assumptions that you’d make because many of
the other assumptions would flow from this assumption.

So you set up your plan to grow sales at whatever rate.

But then again, we also have to worry about asset requirements. In other words, once you
decide on how much growth you want for your sales, you then need to figure out if you need
more assets. Say if you want to grow very aggressively at 25% of sales, then you realize that

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you can’t even reach that level if you don’t buy more machines. So you need to buy more
machines to produce more goods to sell. So you could need more fixed assets and that would
go into the asset requirements.

So two ratios here could be useful:

1. Capital intensity ratio - Total assets / Total sales
2. Target ratio (pertaining only to fixed assets) - Fixed assets / Capacity sales.

Once we figure out that we may need to buy more fixed assets, then that will also affect the
financing requirements because where do you get the money to buy the fixed assets. So
everything is linked: If you want more aggressive sales, you need to buy more fixed assets, then
you’d need more money to buy the fixed assets so you’d need new financing requirements.

When we look at pro forma statements, we need plug variables. What are plug variables for?
Plug variables is the line item that you allow to shift or change independently on the balance
sheet to make the balance sheet balance. Everything else in this model must link to something
so that if you change one item, everything else in the income statement and balance sheet will
change. But then there is one line which doesn’t link to anything and that’s simply going to be
the final number that you change so that the balance sheet balances. This is called the plug
variable as the name suggests if there is a hole, we use a plug. That’s what the plug variable is
for.

Let’s go through a simple example:

On the left hand side, we have the balance sheet which is just assets and equity.

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And on the right hand side, we have the income statement which is just revenue, cost and net
income, kept really simple for now. Revenue is currently $2000. And let’s assume that the firm
wants to grow by 15%. So in this case, in 2011 the income statement would reflect a $2300
($2000 * 1.15).

Then we also assume that all costs move with sales so if that’s true then the cost would also
grow by 15% from $1600 to $1840. And therefore, the net income would also grow by 15% from
$400 to $460. So everything else grows with sales.

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But what happens to the balance sheet? In the case of the balance sheet, there could be many
possibilities. We’re only going to look at two of the possibilities. It all depends on what
assumptions you want to put.

Case 1:
Let’s assume that all assets grow with sales. Then the left hand side of the balance sheet would
show a growth from $1000 to $1150 ($1000 * 1.15). But what happens to the right hand side?
We know that our net income for 2011 is $460. And if we choose to retain 100% of this net
income, this entire $460 would be added to the retained earnings. It suggests that therefore if
we choose to retain 100%, the right hand side of the balance sheet would then go up to $1460
($1000+460). This is too much because the left hand side is $1150 while the right hand side is
$1460, so obviously something needs to be changed and this is where the plug will come in.

But taking a step back, what if the firm only wants to grow everything by 15%, so the firm
decides that it wants to grow sales by 15% but it also allows everything on the balance sheet to
grow by 15%... So in this case, debt is going to grow by 15% so it would grow from $400 to
$460 (400 * 1.15). And equity is going to grow by 15% from $600 to $690 (600 * 1.15).

So in this case, the balance sheet would then balance because the left hand side would be
equal to $1150 and the right hand side would also be $1150 (460+690). But what are the
implications for this firm? We know that the net income is actually $460, and yet the equity only
increased by $90 ($600 to $690), so this suggests that the addition to retained earnings was
only $90. This thus must mean that the firm has chosen to give out the remaining $370 ($460-
90) as dividends because out of the $460 of net income we only have $90 as addition to
retained earnings. So the missing $370 can be deduced to have been given out as dividends.
We also notice that this firm raised money from bonds or debt worth $60 even though it gives

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out $370 in dividends. So this is the case where the firm is continuing to give out dividends even
though it raises debt in order to do so. This is interesting yet not totally uncommon, there are
firms which do this.

Case 2:
Again same thing, we first assume that all assets grow with sales, the left hand side would again
grow to $1150, but this time let’s assume that the firm does not give away dividends at all. So
we know for sure that the equity would increase by the total net income which is $460.

So equity is going to increase from $600 to $1060 because we have to add this to the addition
to retained earnings. We allow debt to be the plug variable this time and therefore the balance
sheet would look like that:

We know that equity will be $1060, and yet total liabilities and equities must add up to $1150,
and if debt is the plug variable, meaning that it is going to be allowed to change so that the
balance sheet can balance, then debt must become $90 ($1150-1060). If debt becomes $90,
what can we infer? We can infer that the firm has chosen to pay down $310 ($400 - 90) in debt.

So this is basically it for the pro forma, the idea is that you’d get more line items and many times
we make assumptions about the link between the balance sheet and the income statement as
seen in the project description.

In the excel file, there are an entire list of assumptions that link the balance sheet to the income
statement so for instance there’d be current assets to sales ratio, CL to sales, FA to sales etc.
So this allows you to come up with pro forma statement simply by adjusting the sales, so if the
sales grows you know that current assets, CL would grow etc. This is how we link these two and
based on assumptions.

Sometimes when you need to grow, you need additional funding. And how do you determine
how much financing you need? There are two methods:
1. Percentage of sales approach

Percent of sales approach:

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Percentage of sales approach requires us to come up with entire pro forma statements and then
figure out if there is a gap. So what are the items that move with sales first of all. In order to
come up with a pro forma, we need to have all these assumptions about which items are going
to reasonably move with sales... so first of all let’s assume that all costs move with sales, and
based on our assumption or income statement if it’s so simple like the one before, then of
course profit margin would be the same. Because if sales move and costs move and there is
nothing else, then profit margin would also move.

But we know dividends are management decisions so these would not move with sales, these
are up to the discretion of management.

How about the balance sheet? First of all let’s assume always that total assets move with sales
(at this stage). How about the liabilities then? Only operating current liabilities would move with
sales so in our course again, most likely you’d end up with only accounts payable. In general all
operating current liabilities move with sales.

All financing items would not move with sales because this would be a capital structure decision
so in terms of notes payable, long term debt, common stock, etc. These would not move with
sales but rather depend on what’s going on.

Retained earnings would change but they also would not move with sales instead they’d move
with the addition to retained earnings that comes from the income statement. Based on what the
net income is based on the pro forma, and the dividend payout policy whatever is left behind
would be added to the retained earnings as addition to retained earnings. That’s how the
retained earnings would change.

Example:

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Now we have Sales, Costs, EBT, Taxes, Net income and dividends and retained earnings. We
keep it simple because firstly we don’t have depreciation and interest in this income statement
so this simplifies it a lot because depreciation would not move with sales and interest too.

Figure out what happens if you have depreciation and interest. Some may say that depreciation
would move with sales because if we assume that all fixed assets move with sales and we keep
a constant depreciation rate on the fixed assets, then depreciation would move with sales. But
in our projects, depreciation would not move with sales because the way depreciation is
calculated is slightly different. Figure it out.

Nevertheless we come back to this simplified income statement. We have sales, costs, EBT, net
income and taxes, etc. We identify which items move with sales so again we assume all costs
move with sales so 60% of sales, so create a column called percentage of sales, hence the
name of the method. So simply, we divide each line item by $5000 so $3000/$5000 = 60%,
EBT = $2000 / $5000 = 40% etc.

As long as the item before moves with sales, this item would also move with sales, so you’d
continue to move with sales as long as all the items before that item moves with sales. So if
costs moves with sales, we know that EBT moves with sales, if EBT moves with sales, then
taxes would move with sales and then net income would move with sales. In fact, if net income
moves with sales, then the dividends would move with sales and generate two more ratios
below Net income.

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So we have the column of percentage of sales and we only calculate the percentages for items
that move with sales. Let’s assume that this company wants to grow sales at 10%. So sales are
going to increase from $5000 to $5500 ($5000 * 1.1). Then what happens to the rest of the
income statement. We simply take the percentage of sales multiplied by the new sales.

In this case, it’d be (60% * $5500), (40% * $5500), (16% * $5500) etc. Then you can get the
income statement for 2011.

Simply because everything moves with sales, so with a new sales, you'd expect each number to
continue to have the same ratio. Of course you could simply take 10% more of everything in
each line. it's the same. Just that this is the method we’re trying to show. The dividends are
50%, as per the dividends payout ratio =50%, so 50% of the new net income is retained which
is $660. This $660 would be added to the retained earnings on the balance sheet.

How about the balance sheet? First of all, let’s assume all assets move with sales. So if all
assets move with sales, then we’d calculate for every item on the assets, the percentage of
sales. So again, $500 is 10% of $5000 sales. $2000 is 40% of sales, $3000 is 60% of sales.
Everything as a percentage of sales.

Likewise we take the percentage of sales multiplied by the new sales to generate this new
proforma of assets. Again if you simply take 10% of the original, you can get the same as well.

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So what we know now is that the left hand side of the balance sheet would change from $9,500
to $10,450. How about the right hand side then? So again only accounts payable moves with
sales so 18% of the new sales = $990. So accounts payable increases from $900 to $990.

But then, financing items don't move with sales so notes payable, long term debt and common
stock doesn't change. How does retained earnings changes? Retained earnings changes by
adding the addition to retained earnings so we add the $660 found earlier to the $2,100 (current
retained earnings) and we know that this number would become $2760. So this is not a 10%
increase, we know that this will not change with sales but will change with the addition to
retained earnings.

So now on the right side, Liabilities + Equity gives us $10,250 ($5,490 + $4760). So we have
$10,450 on the left hand side and $10,250 on the right hand side. Then we have a gap. So at
this stage, the balance sheet does not balance. So how do make it balance? We have to
increase the right hand side by $200 somehow. This is known as the additional funds needed,
AFN or external financing needed, EFN. In our textbook we use the AFN abbreviation.

So we know that we have to increase the right hand side by $200. But where does this $200
come from? That’s where the plug variable comes in, depending on what the plug variable is.
The firm can decide on whatever plug they want. So say notes payable is the plug, then
increase notes payable by $200, if long term debt is the plug, increase long-term debt by $200.
Perhaps dividends is the plug, then we simply give $200 less of dividends, so that we add more
to the retained earnings.

That was the percentage of sales approach, which means we have to come up with the entire
pro forma and income statement so that you can figure out where the gap is. But the next
method known as the AFN equation is simply one equation and you can find it somewhat.

AFN:
So how does this work? Here’s the equation:

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What’s A*? A* is the spontaneous assets that move with sales. What does that mean? This is
the total amount of assets that would change with a change in sales. In our case, if we assume
that all assets move with sales then A* is total assets.

What’s S0? S0 is the current level of sales.

What’s ΔS? ΔS is the change in sales, which is S1 - S0 , but that is a dollar change. ΔS is the
dollar change in sales which in our case is $500, because we want to grow from $5000 to
$5500. So the change is $500.

Then what’s L*? L* is the spontaneous liabilities, which again is the liabilities that change with
sales, again in our case it’s just going to be operating liabilities which for this course ends up
most of the time being accounts payable only.

What’s M? M is the profit margin and this margin is calculated using the current income
statement, so you take current income divided by current level of sales, that’s your profit margin.

S1 is the new level of sales, which is $5500 in our example. And RR is the retention ratio which
is 50% in our example as well.

So if you look at this equation a bit deeper, what can we see actually? Which is well...what is the
first term actually?

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 𝐴∗
(𝛥𝑆)
𝑆0
What does this actually give you? That actually tells you just the change in assets given a
change in sales. Again if we assume that total assets would change with sales, you take total
assets divided by current sales, that’s the ratio, then multiply that with the change in sales and
that would give you the change in assets.

Likewise the second term:

𝐿∗
(𝛥𝑆)
𝑆0
Would tell you the change in liabilities given the change in sales.
Then what’s the last term there?

𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 0
(𝑀)(𝑆1 )(𝑅𝑅), 𝑤ℎ𝑒𝑟𝑒 𝑀 =
𝑆0
Profit margin, M multiplied by new sales, S1 , if you assume that the profit margin is the same
from this year to the next year then taking this profit margin multiplied by the new sales gives us
next year’s net income. Next year’s net income multiplied by the retention ratio tells us what is
the addition to retained earnings. The addition to retained earnings tells us the change to the
equity given this change in sales. Because we assume that common stock doesn't change, so
what else is there in equity, there’s only retained earnings and common stock at least for our
course.

So if we look at this equation, this equation is just balancing the balance sheet, which is what
you’re doing when you are doing the percentage of sales approach, just that then you’re spelling
it out whereas here it’s a shortcut. So the equation is the change in assets - change in liabilities
- change in equity, of course if you end up with a number, it suggests that your left hand side is
more than your right hand side on your balance sheet. So this would then tell you if you need
additional funds.

So we plug in the numbers from our example into this equation:

𝐴∗ 𝐿∗
(𝛥𝑆)- (𝛥𝑆) -(𝑀)(𝑆1 )(𝑅𝑅)
𝑆0 𝑆0
= (9500 / 5000) (500) - (900 / 5000) (500) - 24% (5500) (50%)
= $200

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The answer $200 is the same as what we got in the percentage of sales approach. This is much
faster. This equation can only be used if these 3 assumptions hold:
1. Firm operates at full capacity (What does this mean, or what’s the implication of this
actually? It means that this firm is currently using its fixed assets to its maximum ability
so the fixed assets cannot be used anymore to generate more sales, it’s already
generating as much sales as it possibly can generate. That’s full capacity. So the next
dollar of sales that you want to get must require you to buy new fixed assets. That’s what
the implication is of full capacity. Therefore, what we know is that therefore total assets
will change with sales if the firm operates at full capacity. What you realize again later on
is that the way we do these projections is that we assume that we can buy fixed assets
that match the growth in sales in other words you can buy a fraction of a machine based
on how we’re doing it, which of course in the real world, you’d have all these other
considerations to think about because it’s going to be lumpy. Your investments in fixed
assets cannot be the way we calculate which is just based on the percentage growth in
sales because well if you need new machines, it would just be the cost of the old
machine, you can’t buy a fraction of the machine. Those are practical considerations you
have to think about and adjust accordingly in the real world. But for our course right now,
we’re just going to assume that that’s fine.
2. Constant profit margin
3. Constant dividend payout ratio

If you look at the equation again,

𝐴∗ 𝐿∗
(𝛥𝑆)- (𝛥𝑆) -(𝑀)(𝑆1 )(𝑅𝑅)
𝑆0 𝑆0
M and RR are based on this year’s assumptions so we calculate M based on this year’s income
statement and we need it to be the same for next year so that we can use it to derive the
addition to retained earnings for next year. If M changes from year to year then of course the
third term in the AFN equation will no longer be accurate.

Likewise for the retention ratio, if you’re going to change your dividend payout policy next year,
then the RR would affect the addition to retained earnings calculation so again if it’s not
constant again we have to take note of that for this equation.

What happens if the firm is not operating at full capacity? What’s the implication? The
implication is that we might not need new fixed assets. So we actually don’t know, we have to
figure it out.

So how do we figure this out? So the first step to figure out is how much sales can this current
level of fixed assets actually support if you work it to capacity? So if you take the current level of
sales divided by the current capacity (ratio of capacity used currently compared to maximum
capacity allowed) this allows you to gross up to 100% capacity.

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So if at current level of 80% capacity, it can support 5000 sales. At 100% capacity, it therefore
would be able to support 6250 ($5000 / 0.80) of sales. So this is not the same as taking $5000 *
1.2. You cannot take $5000 * 1.2 instead you have to take $5000 / 0.80.

So we know that the full capacity is $6250 but what do you do with this information? We then
have to compare this $6250 to our target sales. So if we say we want to grow sales to $5500
next year, but we know that the current level of machinery that we have can actually support up
to $6250 of sales. So if we work the machinery harder, maybe switch it on for longer hours, turn
up the speed in terms of production, etc, it can actually help us to reach $5500 of sales at 88%
capacity (5500 / 6250). So therefore it means actually that we don’t have to buy new fixed
assets. So what does this now going to cause us to do?

We have to now go back and adjust the pro forma statement because we know now that in this
case, the total assets do not move with sales, because now the fixed assets will not move at all.
So if you go back to the balance sheet, what’s the change that we need to do? The change
would be here:

Instead of allowing fixed assets to change from $4000 to $4400, we know that we actually don’t
need this incremental $400 of fixed assets so fixed assets can actually stay at $4000. So if
that’s true, then the left hand side would then become $10,050, because it would be $400 less.
The right hand side would be $10,250. So we have a gap of $200 now. But now it’s on the other
side. So now the right hand side is more than the left hand side.

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So what does this mean for us? What it means is that we no longer need additional funds but
what we have is a case where we have generated additional funds. We have generated funds
that we can actually put to use in the firm because the right hand side is more than the left hand
side. So then we have to figure out where to put this $200 of funds, this gap, so that the balance
sheet can balance again. It again goes back to what the plug is… If the plug is notes payable,
we pay down the notes payable, if the plug is long term debt, we pay down long-term debt, if the
plug is common stock, we buy back stock, if the plug is dividends, we give away more money,
pay more dividends. Additionally, if you have excess money, the additional possibility is to park
it into cash. So instead of reducing both sides to $10,050, you have the option of also increasing
the left hand side to $10,250 to match. So this is also possible if you have excess funds. Notice
that this option is not available if you have insufficient funds when LHS is more than RHS. We
don’t actually take out from cash to meet this additional funds just now, when the left hand side
is more than the right hand side.

In our projects, you’re told to use debt as the plug variable, so when you set up the model, debt
is the one that would change to balance the balance sheet and everything else has to be linked
to each other.

What's a good estimate for a growth rate? Normally we rely on what the analyst tell us. The
analyst would have greater knowledge of the firm, they would have focused their energies on
analysing the firms and observing over history and looking at projections etc. So we’d rely on
the analyst reports to tell us. Say we can’t find anything, then of course the safest and most
conservative assumption to use would be the GDP growth rate.

Now we go into understanding internal growth and sustainable growth.

At low levels of growth, we know that internal financing can be sufficient. What do we mean by
this? Internal financing refers to the addition to retained earnings. That’s internal financing. So if
you imagine that sales grow at 2%, so if that’s the case what you need to know is say full
capacity? Let’s say assets would also grow by 2%, and current liabilities would also grow by
2%. But then you’d have generated some net income for which there would be some addition to
retained earnings. And if you park that to retained earnings, this addition to retained earnings
could finance this increase in assets. So actually you don’t need AFN, you don’t need any
additional funds at all, there would be no gap in your balance sheet. This is what is means.

But then if you grow even faster, have more aggressive targets, then it becomes more likely that
this internal financing would not be sufficient to finance your asset requirements. Then there is
no choice, you have to go out and get more financing. So you’re going to figure out this
relationship. In other words the relationship between growth and the need for financing? In other
words, at what level of growth do you start to need financing?

Additionally it also tells you this. If the company grows very very fast, there is a higher likelihood
that it would need financing. So if you observe a company that is raising capital, there could be
one of two possibilities. Either this firm is doing very well and hence growing very fast so that’s
why it needs financing or the firm is in trouble and hence needs financing. But we can't conclude

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immediately which one is the case unless we know the firm. So that’s the point which is that you
cannot straight away jump to the conclusion that just because a firm needs funds it means that it
isn’t doing well. In fact the contrary could be true.

So how do we get these two equations then? There are two growth rates that we want to pay
attention to: 1) Internal growth rate and 2) Sustainable growth rate.

We don’t need to be able to create the equation ourselves. We will be told the equation. But in
case you’re curious, these equations are created from the AFN equation. So if you go back to
the AFN equation:
𝐴∗ 𝐿∗
(𝛥𝑆)- (𝛥𝑆) -(𝑀)(𝑆1 )(𝑅𝑅)
𝑆0 𝑆0
Which is spontaneous increase in assets - spontaneous increase in liabilities - increase in
retained earnings, we make one further assumption which is that the L* is 0. We further assume
that liabilities are non-spontaneous and hence make L* =0. Then we drop off the middle term in
the AFN equation and we’re only left with the remaining two terms.

This actually just simplifies the equations and helps us. It doesn’t change the situation at all, it’s
just simplifying the equation. So now we have just two terms here which is spontaneous
increase in assets and increase in retained earnings. Then we use this relationship to then solve
for the next two equations. The first being the internal growth rate.

Internal growth rate:

What does this actually mean? The internal growth rate is the rate of growth that the company
can grow up to while relying only on internal financing. This is the maximum growth that the
company can grow at while only relying on internal financing, which means that at this growth
rate AFN=0.

To derive this equation for internal growth rate which is:

𝑅𝑂𝐴 ∗ 𝑏
Internal growth rate = , where b=Retention
1−(𝑅𝑂𝐴∗𝑏)
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
ratio=
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
We actually equate AFN to 0 because that’s what it means. So we know that AFN =0, so we let
it be 0, we have spontaneous increase in assets = Increase in retained earnings, and then we
solve for g, internal growth rate, which is the growth rate in sales. So we solve for g and we get
the above equation. We don’t have to know how to derive the equation but we need to know this
equation.

Derivation of the internal growth rate formula:

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 𝑅𝑂𝐴 ∗ 𝑏
Internal growth rate =
1−(𝑅𝑂𝐴∗𝑏)
ROA is based on this year’s income statement so: we take Net income = 1200, Total assets =
9500, b = retention ratio = 50% in our case.

1200
∗(0.50)
9500
Internal growth rate = 1200 = 6.74%
1−[ ∗(0.50)]
9500
So let’s verify this number, so what we’re saying is that at 6.74% growth the firm can rely on
internal financing, it doesn’t need any additional funds. So what that means is that AFN should
be 0 if we allow this firm to grow at 6.74%. So let’s try, the new sales would be:
New sales = $5000 * 1.0674 = $5337. And we then plug everything back into the AFN equation:
𝐴∗ 𝐿∗
(𝛥𝑆)- (𝛥𝑆) -(𝑀)(𝑆1 )(𝑅𝑅)
𝑆0 𝑆0
9500 1200
= 5000 (337) − 0 − (5000)(5337)(0.50) = −0.14 = 0
L* is 0.

We’re also saying that if you allow this firm to grow at more than 6.74%, then it’s exceeding the
internal growth rate hence it must need some AFN. So again if we allow the firm to grow at 10%,
and plug the values into the AFN, you’d get:
9500 1200
= 5000 (500) − 0 − (5000)(5500)(0.50) = 290

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So that makes sense, if you allow the firm to grow at a rate higher than the internal growth rate,
you must expect some positive AFN because this firm will need to go out and get additional
funds.

Question: Why is the AFN now $290 whereas earlier we got $200 for the AFN at 10% growth?
Because this time we force the L* to be nothing, whereas earlier this spontaneous increase in
liabilities would have been $90. But this time, we’re saying let’s just make it 0 so that it’s simple.
This standard $290 will come from anywhere, doesn’t really matter, whereas previously we
assumed that the $90 came from the accounts payable increase as well.

So this doesn’t change the equation per se, it just simplifies the derivation of the growth rate, g.

One more question: If you were to grow at lower than the internal growth rate, so say you allow
the firm to grow at 5%, less than 6.74%, what would we expect the AFN to be? Negative.

What does negative AFN actually mean? It means that we have generated funds. So if you
grow at even less than the internal growth rate, then you would generate funds. So your internal
financing, your addition to retained earnings would be more than enough to cover your asset
requirements in this case. Then you have a case whereby your right hand side would be higher
than your left hand side.

Sustainable growth rate:

This is the maximum growth rate that the firm can grow up to while relying on two sources of
funds: 1) Internal source of funds, and 2) Increasing debt.

But this increase in debt is capped up until the level where debt-equity ratio stays the same as
current. So you have two sources of funds, one is the internally generated funds, which is the
addition to retained earnings and 2) We allow the firm to raise debt but up to the level where
debt-equity ratio stays constant.

Hence we call this the sustainable growth rate because it’s only sustainable if some added
constraint is there, which in this case is that the debt-equity ratio must stay the same. You can’t
unilaterally keep increasing your debt-equity ratio and basically keep on taking on more debt
then that’s not sustainable.

Take one step back. What does this imply for the internal growth rate? If you were to grow at the
internal growth rate, what does it mean for your debt-equity ratio? What happens to the debt-
equity ratio? It decreases. Why? Because equity is increasing owing to your increase in retained
earnings but debt does not, because you don’t allow the firm to grow debt. So definitely you’d
expect the debt-equity ratio to fall. And the debt-equity ratio falls at any growth rate lower than
the sustainable growth rate.

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The sustainable growth rate is the one and only growth rate where the firm actually grows such
that the debt-equity ratio stays exactly the same. If it grows less than this sustainable growth
rate, the debt-equity ratio drops. If it grows more than this growth rate, the debt-equity ratio
would increase.

What’s the equation for this sustainable growth rate?

𝑅𝑂𝐸 ∗𝑏
Sustainable growth rate =
1−(𝑅𝑂𝐸∗𝑏)
This equation is also derived back from the AFN equation, it’s just that we tweak the
assumptions there for the AFN equation. We adjust the AFN equation such that it allows the
debt-equity ratio to stay constant. Then you manipulate to get g. Don’t worry about the
derivation, you just need to know the equation.

Derivation of sustainable growth rate: KIV

https://www.coursehero.com/file/12036974/Proofs-for-the-Internal-and-Sustainable-Growth-
Formulas/

ROE is calculated based on the current income statement and balance sheet. So you take ROE
which is net income divided by equity, multiplied by Retention ratio, b and divide accordingly.

Two common mistakes when calculating these rates:

1. People often confuse b, the retention ratio, as the dividend payout ratio. b is the
retention ratio, it’s what you choose to retain not what you choose to give away. So b is
not the dividend payout ratio, b is 1- dividend payout ratio
2. People somehow also forget that the denominator term (ROE*b) is in brackets, so you
have to calculate it first and then subtract from 1. Do not take (1-ROE)*b because that’s
obviously different.

1200
∗0.50
4100
Sustainable growth rate = 1200 = 17.14%
1−( ∗0.50)
4100

So you get 17.14% and of course you must expect the sustainable growth rate to be higher than
the internal growth rate because this time you allow the firm to raise money by selling more debt
so this must therefore translate to a higher growth rate because they are now having more
money to work with. Let’s verify.

So if you allow the firm to grow at 17.14%, what you’d expect is that the debt-equity ratio stays
exactly the same. So you calculate the AFN:

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 9500 1200
(857.142857) − 0 − (5857.142857)(0.50) = 840
5000 5000
Taking an estimated value of 857 as the change in sales:
9500 1200
(857) − 0 − (5857)(0.50) = 925.46
5000 5000
This is increase in debt.
5400
You calculate the current debt-equity ratio = = 1.32
4100
Then do a projection for the debt-equity ratio going forward =
5400+925.46
, where the addition to retained earnings =
4100+𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛 𝑡𝑜 𝑟𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠
[$1200 (1.1714)] / 2 = 702.84. So it’s (current level of debt + new debt) divided by (current level
of equity + addition to equity). Where did $702.84 come from? It’s just the addition to retained
earnings.

5400+925.46
So you calculate your projected debt-equity ratio, = = 1.32
4100+702.84
It’s also 1.32, so again it makes sense, 17.14% is correct as the sustainable growth rate.
Therefore, if you allow the firm to grow at a rate higher than this, say 20%, then what happens?
Let’s check:

So if you allow the firm to grow at 20%, New sales = $5000 (1.2) = $6000. Plug in the values
into the AFN:
9500 1200
𝐴𝐹𝑁 = (1000) − 0 − (6000)(0.50) = 1180
5000 5000

Again what’s the projected debt-equity ratio,

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑑𝑒𝑏𝑡 + 𝑁𝑒𝑤 𝑑𝑒𝑏𝑡 5400 + 1180
= = 1.37
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛 𝑡𝑜 𝑅𝐸 4100 + 720

720 = (1200 * 1.2) / 2, where 1200 is the current net income.

5400
Current debt-equity ratio = 4100 = 1.32

You get 1.37 which is higher which is also what you expect. If you grow at a rate less than the
sustainable growth rate, then the debt-equity ratio goes down. If you grow at a rate higher than
the sustainable growth rate, then the debt-equity ratio will increase.

So what then determines the sustainable growth rate. Let’s say between firm A and firm B,
knowing these 2, you are asked which one will have the higher sustainable growth rate? Of
course if you go back to the equation, it’s just two variables. It’s only ROE and b. So the firm
with the higher ROE, everything else the same must have a higher sustainable growth rate. Or
the firm with the higher b must have the higher sustainable growth rate.

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But what determines ROE?
Then we have to go back to Dupont, so we can then break up the ROE into 3 more
determinants,
1. Profit margin
2. Total asset turnover
3. Equity multiplier

In other words, what are we trying to say here? We’re trying to say that given all things the
same, the more profitable company will have a higher sustainable growth rate. The more
efficient company will also have a higher sustainable growth rate. The company that currently
relies on greater leverage will also end up with a higher sustainable growth rate. And finally the
company that retains more for itself, instead of giving away dividends will also have a higher
sustainable growth rate. All this makes sense logically.

The model itself, the excel and coming up with the pro forma is easy because you just need to
ensure your things are correct and then just drag it. For x number of years, you have no
problem. But then actually in the real world we have to continue to question these assumptions
that we put in. One of the most important ones that we should question is how long do these
assumptions hold for? So if we drag it out and say we want to do this for 5 years, but maybe
after 3 years these assumptions don't hold anymore, then we need to change the assumptions
going forward perhaps. Then we also need to question ourselves whether or not are there any
inconsistencies in the way we have done this etc. There are some qualitative questions that we
ask ourselves after we doing the quantitative part. Because the quantitative part is always
easier.

Examinable example:
Let’s go through one more example. A longer and examinable example.
So now we have more items on the balance sheet:

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And the income statement:

178
Forget about the variable and more costs, just assume that it’s total variable cost of 1.9 billion.
We have interest expense in this case, and taxes of 40% and we have a 70% retention ratio.

So again, you’re given a 30% dividend payout ratio therefore the retention ratio is 70% (1-
dividend payout ratio).

With these financial statements, you can calculate your financial ratios.

Additionally you’re told these things:

1. The firm operates at full capacity, therefore all assets move with sales!
2. Only payables on the right hand side move with sales. Which means only operating
current liabilities move with sales.
3. Profit margin is constant at 2.52% and dividend payout ratio is constant at 30%.

So obviously the 3 assumptions required for the AFN equation are there, full capacity, constant
profit margin and constant dividend payout ratio. Sales are expected to increase by $500
500
million. So the percentage increase = = 0.25 = 25%
2000

Given the 3 assumptions are there, we will apply the AFN equation.
1000 100 50.40
AFN = 2000 (500) − 2000 (500) − ( 2000 )(2500)(0.70) = 180.9 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

So in other words, this is the additional funds that the firm requires. We need to then figure out
what is the plug. Say we’re told that this firm uses 50% notes payable and 50% long-term debt
as the plug. So in this case, if the AFN is 180.9, it means that 90.45 will come from notes
payable and 90.45 will come from long-term debt. So each of these two lines would increase by
$90.45 each.

Let’s now check using the other method which is the percentage of sales approach.

Percentage of sales approach:

So the income statement looks like that:

These variable costs would move with sales, so

we calculate percentage of sales. EBIT will also
move with sales so actually we can calculate for
EBIT the percentage which is 0.05%. For these
items, we can multiply the percentage of sales
with the new sales to get these 4 values for 2013
forecast column. But the problem arises because
we have interest expense. So interest expense is
a result of taking on debt which does not move
with sales.

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So for now we don’t know what this number is so we keep it flat. The moment you keep
anything flat or for that matter, something doesn’t move with sales, then everything else below it
would no longer move with sales. So for the other items below interest, you’d realize the
percentage column is blank and we don’t have to calculate anymore because it doesn’t matter
already. So to derive those numbers we do it like normal, how it’s done for an income
statement. So EBT = 125 - 16 = 109. Multiplied by 40% you get taxes, EBT minus taxes would
then give net income, and 30% of net income is dividends while 70% of net income is retained.
So $46 is added to retained earnings.

Let’s check the balance sheet:

So since the firm operates at full capacity, we know that total assets would move with sales, so
every item here we calculate the percentage of sales and then multiply the percentages to the
new sales to generate the column for 2013. Total assets thus increases from $1000 to $1250,
which is a 25% increase.

How about the right hand side of the balance sheet?

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So well accounts payable moves with sales. So we calculate percentage of sales, multiply it with
new sales to get the number. These are all financing, so we keep it flat. And then retained
earnings changes by the addition to retained earnings found before = $46 from the net income.

So the right hand side now equates to $1071 and the left hand side is $1250. So what’s the
gap? The gap is $179. So we have an AFN of $179. Now you’re scratching your head because
with the percentage sales approach we get 179 but then with the AFN equation we get 180.9.

So why is there a difference? Basically the interest expense is the problem. If we look at where
it actually contributes to the problem really, to make it simpler, it’s the fact that with interest
expense your profit margin can no longer stay constant. So that’s what we said just now.
Depreciation expense also has that problem that’s why if you notice all the income statements
thus far didn’t have it. Though there were fixed assets, there was no depreciation. It’s like that
just to make life simpler.

But so what we know is that therefore profit margin actually cannot stay constant. And thus the
assumption of constant profit margin which is required for the AFN equation is no longer true.
So technically you can’t use the AFN equation. Or rather in this case you know that it would give
you a slightly off answer depending on how material your profit margin changes.

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Nevertheless in the exam, if this type of question comes up, it’s still very possible for examiners
to ask us to still use the AFN equation. Sometimes the questions are very explicit so it’ll say
things like use the AFN equation and determine how much additional funds the firm requires.
And you look at the income statement and realize there is interest expense. So actually you
know you cannot use the AFN equation but because the question tells you to use the AFN
equation please use the AFN equation. In other words, calculate the profit margin based on the
current income statement and assume it stays the same even though you know it doesn’t.

So we calculated $179 as the AFN and we know that we’re going to split it 50% 50% notes
payable and long-term debt. But then the problem that we realize is that if we take on more
debt, then of course we must incur more interest expense. So then the interest expense will
change the income statement, so you can’t keep the interest flat at $16 actually. You would
have some number that is higher in the later year. But then if the interest expense increases,
then net income would drop. If net income drops, then your addition to retained earnings would
drop, and if addition to retained earnings drops, then the AFN would go up. If AFN goes up
some more, you’d take on more debt. More debt means more interest expense, more interest
expense means less net income. Less net income means less addition to retained earnings,
more AFN, more debt and so on and so forth. So then there is a circular problem. It’s a circular
reference or a feedback loop.

So if you do this on excel, then there is no problem, you just check the iteration box, the function
that allows you to let excel solve this problem for you. So excel will literally go through these
rounds as many times as it requires until it reaches this equilibrium state where it no longer
needs to be resolved itself. Hence in our projects, please turn on the iteration function before
you start doing anything because there will be circular references.

How about in the exam hall? No excel. In the exams, we ignore this feedback loop, so after you
calculate the AFN of $179 and you know it’s going to become $89.5 each for the notes payable
and long-term debt, you’re not required to go back and change the interest expense. So you
change the notes payable and long term debt like so to reflect this AFN.

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Get the right hand side of the balance sheet to balance the left hand side of the balance sheet.
Both to show $1250. Leave it alone, don’t go back and change the interest expense anymore.
Otherwise you’d end up in this loop. So that’s all that’s expected in the exams.

Of course, the percentage of sales approach is more flexible because it doesn’t constrain itself
with these 3 assumptions and frankly these 3 assumptions are quite unrealistic in the real world
because obviously you’d have interest expense, depreciation expense. But nevertheless, the
AFN equation gives us a good estimate as long as these things don't change that drastically
from year to year.

If you’re curious, this is the excel solution which therefore reflects the increase in the interest
expense and this feedback loop so actually the total AFN goes up by slightly more to $386 after
a couple of iterations.

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With the new financial statements, you can therefore be expected to calculate new financial
ratios as well. Then you could be asked to compare the previous ratios to the new ratios, what
has changed, what has improved etc.

With the new statements, you can also calculate the free cash flows which you’re required to do
for your projects.

2 very important considerations:

First one we have actually gone through just now. Again just to crystallize this concept, what
happens when this firm is not operating at full capacity? So again whenever you see this
situation, automatically the first step is to calculate capacity sales.

So first step: Calculate Capacity sales, so how to calculate capacity sales = Current level of
sales / Current capacity. = $2000 / 0.75 = 2,667 (this is the capacity sales), given that fixed
assets had only been operating at 75% capacity in 2012.

Then you compare the capacity sales to your target sales. Again similar to just now, you only
want to grow sales to 2,500, your current capacity is 2667, you know you don’t need anymore
fixed assets. So you’ve got to adjust your AFN for the increase in fixed assets. So how much did

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you project to increase by just now? From $500 to 625, a 25% increase, so 125 increase in
value terms. So you can therefore reduce your AFN by this $125 to just $54 (179-125). So
where did we get this $125 from? It comes from the balance sheet where we projected that fixed
assets would grow from $500 to 625 with this 25% increase in sales but now we know that we
actually don't need that. So this 125 will not be there anymore. Therefore, the left hand side of
the balance sheet will actually be 1125 (1250-125). And therefore 1125(LHS)-1071(RHS) = $54.

On top of this 75% capacity, we’re told that we want to increase sales to 3,000 instead of 2500.
What is the implication here? This means that this is actually higher than capacity sales which is
$2667. So we need to then calculate this thing called the target ratio. Target ratio = FA /
Capacity sales.

So what does this ratio tell us? It tells us that for every dollar of sales, how much fixed assets
we need. So the current level of fixed assets is $500 million would support up to $2667 million
sales. Therefore the current level of machinery, in other words, one dollar of sales needs 18.75
cents of the machine. (500 / 2667 = 0.1875…). That’s basically what the ratio is telling us.

So how much more fixed assets do you need then? If you want to grow sales to $3000 million,
you have to take the difference of 3000 from the capacity, this additional 333 million (3000-
2667) is what you need to support. Because your current machine can go all the way up to
$2667 million. Then from then on you need new fixed assets to support the rest of 333 million.

So we simply take 333 million multiplied by 0.1875 (the target ratio calculated for the machine).
So we need to have incremental fixed assets of $62.4 million (333 * 0.1875). Again this is
supposing that we can buy fractions of machines because we simply multiply by this ratio. In the
practical world, we can’t really do this. But you’ll have to work based on those lumpy
investments. But for our course we just use this.

When you have excess capacity what happens to your ratios?

We say that sales growth remains the same regardless of excess capacity. What does that
mean? We’re trying to say that if you want to grow sales to $3 billion, whether or not you have
excess capacity is immaterial. It would not change this growth that you want to grow to. So what
gets changed? So what’s impacted when you have excess capacity? It is the rate of growth of
the assets, because now we know that actually your total assets would not grow with sales so
sales grows at a certain rate but your total assets would grow at a lower rate because either you
don’t need fixed assets at all or even if you need a fraction of fixed assets, you know your total
assets would not grow at the same rate as the sales, it would be a lower rate.

Therefore what is the implication? It would actually cause your turnover ratios to actually
improve. Because your assets are not growing as fast as that sales.

Additionally we can see just now as well that you’d actually require less AFN and this therefore
means that you take on less debt. If you take on less debt, then your debt ratios would actually
improve and then your profitability ratios would also improve because you take on less debt and

185
so you pay less interest and when you pay less interest therefore higher net income. So we can
verify again…

If you look at this chart, compare the first column and the second:

186
So with a sales of 2500 that you want to grow to, these tell us the different ratios given full
capacity assumption and some slack capacity. What you can see is that again, profitability ratios
are better, turnover ratios and debt ratios are better.

What do you need to know from this topic?

Two methods of calculating the AFN: 1) % of sales approach and 2) AFN equation
Internal growth rate and sustainable growth rate.
Pro forma financial statements that comes under the percentage sales approach.
Not difficult.
Need this for our projects to create 5 years’ worth of pro forma statements. For which you then
use to value the firm.

Assumptions replacing to infinity makes it unrealistic, assuming cash flow remains the same,
expect cash flows exactly the same if you replace, no factor of technological innovation,
economy.

Net 6.4 million, how we interpret this number is that it's after tax. Sale price of land is 6.4 million,
must had after after-tax operating cost as cash flow.

Qn3) illustrates necessity to add all externalities, positive and negative add them on top of
incremental cash flows to ascertain relevant impact.

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No gain, recovery of NOWC, so it's just 50k for terminal cash flow. Terminal cash flow.

NPV for A = 541,843.17

Display human emotions like empathy,

Training people, to use these technologies, re-skill,keeping up with the changes

Lecture 11:
Today we’re going to go into working capital management so this answers the 3rd question that
the firms asks itself. The first question being the what, which is the capital budgeting decision,
the second question being the where do you get your money from which is the capital structure
decision, and then finally today we’ll talk about how do you manage your day-to-day capital.

So what is working capital? This refers to the amount of money or liquidity that you need to
manage your firm day-to-day to ensure that the firm continues to operate, have to pay for
utilities, wages, etc. So that’s working capital.

We cannot get confused between firms that are large and appear to be profitable and have lots
of assets compared to firms that are liquid. These two can be completely separate things. Just
because a firm appears large and has a lot of assets, does not necessarily mean it’s liquid. You
need to manage both, you need to grow your firm and value while also ensuring that your
working capital is liquid enough to ensure that you’re able to operate on a day-to-day basis.

Working capital management refers to these decisions basically:

How much current assets and current liabilities you want to hold and that would determine the
short-term liquidity position that you have.

What’s gross working capital: Total current assets

Net working capital: current assets minus current liabilities.
Net operating working capital (NOWC): current assets minus non-interest bearing current
liabilities

NOWC = Operating CA – Operating CL =(Cash + Inv. + A/R) – (Accruals + A/P)

From lecture 2, we emphasize on cash as always, so we created an equation for cash from the
balance sheet to understand what causes cash to change. Those terms on the right hand side
of the equation with positive coefficients would be sources of cash, those with negative
coefficients would be uses of cash.

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Source of cash would be if you take on more debt, or if you sell off inventory or fixed assets.

Use of cash: Buy more machines and inventory or you pay down your debt

We’re going to cover 4 sub-topics today on managing working capital.

First one being the operating and cash cycle.

1.Operating and cash cycle:

So what is the operating cycle?

Using the diagram to explain it, so what is operating cycle. The operating cycle is the time from
when you buy the inventory until you receive cash for the final product that you sell. So it’s the
length of time from when you buy the inventory all the way until receiving cash for the final
product that you sell. This is known as the operating cycle, which can be split into two parts
operating cycle. So if you follow the first part of the diagram you have the inventory period and
then the accounts receivable period.

So what is the inventory period? It’s the time difference between buying the inventory and
selling the inventory. So it’s the length of time in which the inventory sits in your premises
basically.

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Then the second part is the accounts receivable period. So what's accounts receivable? If you
sell a product on credit, you won't exactly collect cash right from the start because you give
customers some time to pay back. So the length of time for which you collect money, right so
you sell the product and collect the money from the customer that’s known as the accounts
receivable period. So the addition of these two things totals the operating cycle.

Now if you look at the bottom half, you can split the operating cycle into two other parts as well.
So it could also be the summation of the accounts payable period and the cash cycle. So what's
the accounts payable. The Accounts payable period is the length of time when you buy the
inventory and then you pay your suppliers for that inventory. So likewise, similar to how you give
your customers credit, your suppliers will also likely give you credit, so they would not collect
cash for the inventory that you buy and instead they’d give you some credit terms. So say they
give you 45 days to pay, that would be your accounts payable period. So it’s the length of time
you take to pay for your inventory.

Then the remaining time between when we pay for the inventory and when we collect money
from the customer is known as the cash conversion cycle or the cash cycle. It’s called a cash
conversion cycle because you’re converting an outflow into an inflow.

So these are again the definitions of the time periods:

Definitions of these terms are as follows:
Operating cycle – time between purchasing the inventory and collecting the cash from selling
the inventory.
Inventory period – time required to purchase and sell the inventory
Accounts Receivables period (DSO) – time to collect on credit sales
Operating cycle = Inventory period + Accounts receivables period
Then on the bottom half we have the accounts payable period and the cash cycle.

What’s the formula for accounts payable period?

AP period = 365 / Payables turnover

Payables turnover =

𝑇𝑜𝑡𝑎𝑙 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 𝑓𝑟𝑜𝑚 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑟𝑠

𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
𝐶𝑂𝐺𝑆 + 𝐸𝑛𝑑 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
=
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
This formula is slightly different from the textbook. For this topic on calculation of items on the
balance sheet, we would be required to take the average numbers from the balance sheet. In
other words, using the two years’ worth of balance sheet data, you would average the balance

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sheet data so for e.g in the payables turnover equation above, the average payables refers to
the (payables in year 1 + payables in year 2) divided by 2. So you average over the two years.

In finance, we’re most concerned with this cash cycle. Difference between when you pay for the
inventory and when you collect money from the customer. Supposing that you didn’t have any
money to start with, and you have to pay someone first before collecting from someone else
then you have to borrow money. You’re obliged to pay suppliers first so you have to borrow
money to pay them. And you’d only pay back this loan once you receive money from the
customers. So the cash cycle is basically the time that you finance yourself because you’re
taking on this short term loan to pay your suppliers. So obviously the goal is to keep the cash
cycle very short. You want to minimise this cash cycle so as to lower your financing cost. The
shorter you can borrow this loan for, the less interest you end up paying. So the goal is to
minimise the cash cycle.

So if you go back to the diagram again:

The 3 formulae that you need to learn from this diagram:

1. Accounts Payable period = 365 / Payables turnover
2. Inventory period = 365 / Inventory turnover
3. Accounts receivable period = 365 / Receivables turnover
For the balance sheet data, you want to take averages. So the inventory turnover equation is
given by COGS / Average inventory.

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Receivables turnover = Sales / Average receivables

For all balance sheet information for this topic please use average numbers.

For receivables turnover, if you have the breakdown between credit sales and cash sales, then
of course we should only take the credit sales. But if not, then we’d usually take total sales.

The goal again is to minimise the cash cycle. So what are some ways in which we can ensure
that our cash cycle is reduced or small? What steps do we take to try and minimise this cash
cycle:

1. Increase accounts payable period, so shift the bottom arrow to the right so that the cash cycle
would become smaller. How can we do that practically? Main thing is to negotiate with our
suppliers for better terms. This would only be possible if we have greater bargaining power with
our suppliers, so perhaps we have to figure out what quantities to order. Perhaps if we order
more, consolidate ordering, order significant quantities at a time to better be able to negotiate
since we’d have greater bargaining power.

2. Pre-order system: Customer pays ahead of time, shrinks receivables period, no receivables
to speak of.

3. Tightening of credit policy, instead of giving people 60 days to pay, you give them 30 days to
pay so your receivables period can be reduced so you reduce your cash cycle.

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4. Reduce inventory period: Coming up with schemes to ensure products are sold faster or
manage inventory better using JIT systems, don't hoard inventory such that it just stays in the
warehouse.

5. Improve manufacturing processes, if you’re able to manufacture items faster, it’ll stay in the
warehouse for a shorter period of time.

These are all ideas to keep the cash cycle very very short.

Can we make the cash cycle negative?

Yes, prepaid. If you collect money ahead of time before you even need to pay for the inventory
then your cash cycle would be negative. Collect money from customers first and your suppliers
give you 30 days to pay, then technically you have a -30 days of cash cycle. So that’s ideal.

How does a negative cash cycle help you as a business?

Positive cash cycle translates to you financing yourself, you’ve got to pay some interest on
some loan. Conversely a negative cash cycle means you have money ahead of time to invest,
before you even need to pay suppliers, hence during this time you are investing this money so
there’d be a positive return instead of an interest expense. Instead, you’d be using this money to
invest in your own investments or your company’s ROE for example. So there’d be some
positive returns from negative cash cycles.

Real life Examples: Amazon is prepaid, we all pay for the items first before they’d do anything
about it. If you look at the cash cycle for Amazon, compared to its competitors of Costco and
Walmart. These are all brick and mortar companies. Walmart has a cash cycle of about 10 days
and Costco has about 5 days of a cash cycle.

But what we observe about Amazon is that it has a negative cash cycle of about -30 days. So
this obviously helps the business tremendously. Able to invest other people’s money in the
sense. Collecting money from customers, eventually you’d have to pay your suppliers but in the
meantime, you’re able to use this money to do investments. This is the case also for Alibaba,
which is how they grow so fast.

Main causes as to why Amazon can do this: It takes excruciating long for Amazon to pay its
suppliers which is about 96 days compared to the competitors which takes about a month. 3
months vs 1 month, obviously that’s where the main benefit comes from. You can only do this
however if you’re a large company. Big companies have greater bargaining power and they will
be able to negotiate with suppliers much better.

Singapore companies: Dairy Farm international, the guys who manage Cold Storage, Giant and
the like. The inventory period is about 48 days. Receivables period is 9 days so the operating
cycle is 57 days. Then the payables are 115 days so they take almost 4 months to pay their
suppliers. So the cash cycle is -58 days (57-115).

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How about another supermarket? Sheng Siong which is smaller. Inventory period is 29 days,
receivables period is 5 days so operating cycle is 34 days. Then the payables period is 64 days.
So again another negative cash cycle, -30 days.

So the goal is obviously to minimise the cash cycle and if you can get it to be negative, that’s
even better. That’s of course going to help you in terms of cash flow management.

Of course, if you’re small, then you’ll be complaining. Bigger companies would take very long to
pay small companies supplying them. So you’re small, there’s no choice so you just suck it up
and accept the terms of the large players. Large players generally take 3 months to pay, about
97 days.

At the same time, sometimes people are just late. So even if you give people the time to pay, it
doesn’t mean that they’ll end up paying to begin with. So in 2017, in the second quarter, the
amount of debt that was paid on time is 37%, so slightly more than ⅓ is on time, which means
generally close to ⅔ is not on time. In terms of how not on time, 1/7 which is about 14% are late
by at least 90 days, so you give them 3 months to pay and they’d pay you after 6 months. That’s
super late.

So again, we have to manage these expectations in terms of the collection of debt. Then of
course, owing to these payment delays then you have cash flow problems, and that’s why many
SMEs will not survive because you always face cash flow problems.

On one hand, you’re subjected to large companies terms which are not very favourable to begin
with and on the other hand if you deal with other small companies then you have these other
problems which is that you have to accept late payments. So it’s always a struggle.

Apple Company: Apple’s cash cycle is negative, -56 days in 2014. Tim Cook joined apple in
1998 as the chief procurement officer, job is basically to negotiate with suppliers. So what did he
do once he joined? All these helped to improve the cash cycle.
1. Cut manufacturing times by half. He improved the manufacturing process and this
reduces the inventory period because inventory stays with you for a much shorter time.
But most of the other things that he did has to do with the payables period.
2. He reduced strategic suppliers by 75%, how does this help? Increase your order
quantities and hence bargaining power. There’s a tradeoff however, you can't reduce it
until you have a handful at the same time because then the bargaining power shifts to
them instead of you. There needs to be a balance. Can’t keep shrinking the size of your
suppliers, just reduce it to the amount where you think you’d still have the power.
3. Mandated 90 day terms, they don't pay suppliers back in any time less than 90 days.
4. Relocate supplier plants to within proximity: If you were to supply Apple, you have to
move your plant near Apple. This improves the delivery timing, so whenever Apple
needs inventory and needs it to be delivered, it won't take long because it’s within
proximity, just drive trucks as opposed to shipping or flight. So you don’t have to wait
very long, it’d probably take about 1 day.

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 5. Mandate suppliers to keep 2 weeks of inventory on hand. So suppliers can’t run out of
inventory, so it’s literally on demand, so whenever you need inventory or materials, when
you order it, you should have it on hand. Suppliers can’t say they don’t have, they have
to have at least 2 weeks’ worth. You can only do this if you're large, so small companies
can't dictate these things. This allows them to shrink inventory periods and lengthen
payables period because of the 90 day terms. Then of course the cash cycle became
negative.

Look at some ratios for Company SKI:

If we want to study working capital management for a company, we should be looking at ratios
involving current assets and current liabilities. Which ratios involve current assets?
Current ratio = Current assets / Current liabilities (relevant)
Turnover of cash and marketable securities (These are part of current assets so relevant)
DSO (receivables so relevant)
Inventory turnover (inventory which is a current asset so that’s relevant)

We’ve got these 4 ratios to look at. From these what can we tell about the company?

SKI Industry Average Comments

Current 2.25x 1.75x High current ratio

compared to the
industry

Turnover of cash and 16.67x 22.22x Low cash turnover

marketable securities compared to the
industry, this
suggests you have a
lot of cash, more than
the industry

DSO (days) 45.63 32 Take much longer to

collect money than
the industry,
suggesting that you
have a lot of
receivables

Inventory turnover 4.82x 7x Low inventory

turnover suggesting
you have a lot of
inventory

All these 4 ratios suggest that this company has a lot of current assets in general, a lot more
cash, inventory and receivables.

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Arguably, we can say that SKI is either very conservative or inefficient. Conservative suggesting
that it hoards these things because it's a safe company. “We don't really know if the guys would
run out of stock of our raw materials so we order a lot and hoard it in our warehouse”. “We don’t
really know if our forecasting for cash is good so let’s just hoard a lot of cash just in case”. Etc.
Very conservative kind of mindset perhaps, we don’t know exactly yet. That’s one possibility.

Or SKI could just be very inefficient. SKI didn’t plan properly in terms of inventory management
so it’s just going to hoard inventory, no awareness of the processes etc.

It’s possible that the company is conservative and yet also profitable. In which case then, people
would be more forgiving. But if you look at SKI’s profitability ratios, it’s not doing very well vis a
vis the competitors.

SKI Industry

Profit margin 2.07% (lower) 3.50%

ROE 10.45% (lower) 21%

So obviously this strategy doesn’t seem to be translating into profits. So we need to figure out
how we can help this company. So first of all, let’s try to calculate the cash cycle for this
company:
Cash cycle = (Top half of the diagram before =Inventory period + Receivables period) -
Payables period

So what’s the inventory period?

Inventory period = 365 / Inventory turnover
Inventory turnover = 4.82x (given)
Inventory period = 76

Receivables period = DSO (given) = 45.63 = 46

Accounts payable period = Length of time you take to pay your suppliers, so let’s say we don’t
have the financial statements to calculate this, but we know based on their invoices that
suppliers in general give them about 30 days to pay. So just use that as an estimate.

Cash cycle = 76 + 46 - 30 = 92 days

Is this a lot or not? Hard to say. Have to compare it over time as well as against peers to have a
better idea.

When we look at the working capital management and understand how much current assets we
should hold: Should we be very conservative or aggressive, live on the edge, order JIT all the
time.

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There are some trade-offs to take note of:
Involves comparing carrying cost vs shortage costs.
So what’s carrying cost: cost you incur from holding these current assets. So for example when
we talk about inventory, the carrying cost for inventory would be the warehouse cost. The more
inventory you have, the more warehouse space you need. Then of course you have to finance
these inventories so the more inventory you order, the more loans you’d probably be taking to
pay off these inventory.

If you talk about cash, what’s the carrying cost of cash? It would be the opportunity cost of not
being able to invest that money into something else which would earn a lot more interest.
There’s always carrying cost when you hold current assets.

But then there’s also shortage costs. So on the flip side, if you don’t hold anything, then there
are shortage costs. What are some examples of shortage costs?
1. Perhaps ordering costs, so if you don’t hold an inventory and you order very often
instead, so maybe each time you order, the supplier charges you for delivery, and some
other admin fees etc. And actually the accumulation of these fees can add up
significantly. So perhaps the order costs add up to so much more than what you
would’ve paid if you just had your own warehouse for example. Then that wouldn’t make
sense, so order costs to consider.
2. Then another shortage cost is lost sales. Perhaps again you don’t hold any inventory
whatsoever, and then the customer comes in with a very urgent order with significant
quantity and you’re not able to fulfil this so you have to end up turning away the
business. So that’s lost sales. So again you have to do this measurement of trade-off
between carry cost and shortage cost.

This is no different from taking water into the desert. If you imagine asking yourself the question
of how much water you should carry into the desert, you’re going to walk across the desert, how
much water do you carry. So there is carry cost, if you carry too much, then you’d walk very
slowly. There is also shortage costs, say you decide not to carry water at all, then firstly you’d
probably die. Likewise with liquidity, if you have no money, the business would also become
insolvent. At the same time, if you were to go with no water, eventually you'll end up searching
for water and that would cause you to lose time, lose energy etc.

SMEs in India having to turn away business, so this is a shortage cost. Not having enough
current assets (which is working capital) and thus losing sales. This company in India would
love to hire more and keep up with the demand, but is unable to gain a bank loan. He needs the
loan to pay the wages of the workers. So not enough cash to operate so he has to turn away
business. Lost sales of 1.6 million and this is how it is for SMEs. SMEs are locked in this sort of
vicious cycle because the problem is to generate business they need to borrow money, but
banks don't want to lend them because they're not making enough money so banks are afraid
that they won’t get paid. So it's kind of like a chicken egg problem because without borrowing
they cannot actually make money to begin with. Another chicken-egg vicious cycle things is job
applications that require 3 years of experience. So many SMEs are caught in this plight.

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4 reasons why firms hold cash:
1. Transactional reasons: sometimes you need cash just to get things moving, to pay
people fast, do some cash transactions etc.
2. Precautionary reasons: Conservatism, want to have some safety stock of cash
a. For businesses, precautionary holding of cash can be reduced by having:
i. Line of credit (basically a loan negotiated with the bank for which you can
tap on when you need the money. You only get charged when you use
this money, in the meantime if you don’t touch it at all, then there’s no
charge. No different from say your credit card in the sense. So if you run
out of liquidity and have no more cash in your wallet, you can continue to
use this credit card where you actually pay later on.
ii. Marketable securities (Like treasury bills, firms can elect to buy treasury
bills instead of holding cash. T-bills are considered extremely liquid and
yet it would earn slightly more interest.)
3. Compensating balances: Mandatory holding of cash, can’t really dictate this at all for the
firm, so if you take on a loan from the bank, sometimes it comes with this requirement for
you to have a compensating balance, which is basically a portion of the loan you borrow
that you must leave with the bank.
4. Speculation reasons: Many firms keep cash so that they’re able to take advantage of
opportunities that arise. So main suspects of this would be like Apple, Facebook,
Google, etc. They actually have so much cash that if they want to acquire a company
they can do it with cash, no need to waste time raising capital etc to get money.

Cash earns nothing. So we don’t want to hold too much cash even though we need some cash.
So the goal is of course to hold enough to do what we need to and yet we don't want to hold
excess.

Going back to the 4 reasons for holding cash, which of these 4 would be easiest to tackle to
ensure that we aren’t holding surplus. This surplus is unnecessary in the sense.
1. Not really Transactional because transactional is something that we need to operate so
we need to have transactional cash.
2. Precautionary cash
3. Compensating balance is something we cannot control because it is stipulated by the
bank.
4. Speculation is something we actually want so we don’t really want to reduce that
because that’s something that is advantageous to us.

Hence therefore it’s precautionary cash that we need to reduce. So how does a firm reduce the
need for this safety cash?

We’ve already mentioned 2 ways:

1. Get a line of credit so you don’t have to hold cash
2. Marketable securities

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 3. Increase its accuracy of forecasting owing to better projections. If the firm knows ahead
of time how much cash it would need it would just hold that amount and no extra.
4. Manage the float. What is the float? Float is the difference between the bank’s books
and the firm’s own books. The difference between what the bank says you have and
what your own accounting books tell you you have. That’s defined as float.

2. Float
By managing this float well, we have less need for safety cash. So what is float exactly?
Say that SKI collects cheques in 2 days but those to whom SKI writes cheques don’t process
them for 6 days, then SKI will have 4 days of net float. Because it clears its money much faster
than people taking money out from its bank, which is when the checks get cleared when SKI
writes these checks. So this 4 days of net float translates to money, how does it do that?

Assuming the cash that SKI receives and pays are all worth $1 million per day then 4 days of
net float would equate to $4 million of extra cash. The 4 days’ worth of $1 million each means
that a total of $4 million sits in SKI’s bank account which SKI can actually use on a continual
basis if this 2-day 6-day happens all the time, forever. Then SKI would always have $4 million
more cash in its bank account than it would have had if it didn’t have this float.

Total float is made up of 2 parts: Disbursement float + Collection float

Float is simply the difference between the bank’s book and the firm’s own books.

Disbursement float is generated when you disburse money. So when you write a check or make
a payment so when you write a check, the accountant in the firm would update the firm’s books
first. So the firm’s own accounting books would be updated first to reflect this outflow, so your
own books would reflect a lower cash balance compared to what the bank would tell you you
have. Because until this check gets cleared, the bank continues to reflect a higher bank
balance. Bank balance - Book balance would be a positive number which is the amount of the
check. So that positive number is known as the disbursement float.

Collections: When you receive checks in the mail and you open it, the first thing would be for the
accountant to update the firm’s accounting books. So the receipt of this money would be added
to the firm’s cash balance in its accounting books. Until this check gets cleared in the bank, the
bank is unaware that you have this money so the bank balance would not get updated yet. So
the bank balance would be a lower number than the book balance. Hence the Bank balance -
Book balance = negative number, this negative number is known as the collection float.

When we add the disbursement float and collection float together, that is the net float. Do we
want the net float to be larger or smaller? Larger. How do we get the net float to be larger?

Do we want the disbursement float to be more positive or less positive? More positive.
Do we want the disbursement float to be more negative or less negative? Less negative.

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So that’s the goal: We want to have a very large disbursement float (more positive) and a very
small collection float (less negative). So that the net float in total would be as large as possible.

Example:
You have $3000 in your checking account. You just deposited $2000 and wrote a check for
$2500.
a) What is the disbursement float? (generated when you write checks)
i) $3000 (bank books) - $500 (own books) = $2500
b) What is the collection float?
i) $3000 - $5000 = -$2000
c) What is the net float?
i) $2500 - $2000 = $500
d) What is your book balance?
i) $5000 - $2500 = $2500
e) What is your available balance?
i) $3000 (book balance remains until both transactions get cleared.)

So we can see that the size of the float depends on two main factors:
1. Amount of money involved and (If the amount of money you’re depositing or writing out
is also large, then the measurement of this float also becomes large in magnitude)
2. Total length of delay, delay meaning how long it takes for the bank books and
accounting books to reconcile. If it takes very long for it to reconcile then in the
meantime, you'd have a large float.

We focus more on the delay than the amount of money because the amount of money is not
really controllable per se.

Delay:
The delay can be broken down into 3 parts. Don’t forget that we’re talking about cheques here
or some payment mechanism that requires some time, so not talking about online payment or
immediate transfers etc.
Total delay = mailing time + processing delay + availability delay

What is mailing time?

You write a check, you have to post it. So imagine you need to pay someone in Kansas, so
you’ve got to airmail the check, and that would take a couple of days at least. Given a very
efficient postal system, perhaps it would take 3 days. But in places with less efficient postal
systems, it could take a week. Hence mailing time can be stretched in the sense.

What’s processing delay?

It’s the length of time that the firm takes to get the check to the bank. If you’re talking about
collections, then its your own processing delay because you receive the check, and you have
the check on hand but how long does it take for you to get this check to the bank to get the
money cleared. That’s processing delay.

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Of course, if you're making a payment then it’d be your supplier’s processing delay which is not
really within your control. Once you mail the check out to the supplier, how fast he takes is not
your problem. That would be his processing delay, how long he takes to get the check to the
bank.

What’s availability delay? It’s the bank's process, so in this case no one can control it other than
the bank. In Singapore of course, it’s just 1 day so if you deposit money in the morning, it would
be available to you the next day, so 1 day availability delay.

Example: Say you mail a check every month, $1000 per month. And this is the only transaction
you have. So the total delay is 3 days for mailing, 1 day for processing, and 1 day for availability
delay so a total of 5 days for the delay. So what’s the average daily float (assume 30 days/mth)?

Easiest way to look at it is by looking at method 1:

1. Method 1: (3+1+1)($1,000)/30 = $166.67
a. For 5 days your bank and book balance would not be the same, because you
wrote the check for $1000 so it would be recorded in the books as an outflow of
$1000. So for these 5 days of delay, the bank and book balance would be off by
$1000. But for the remaining 25 days, there would be no difference, so you’ve
got no more float for the remaining 25 days. So for 5 days you have $1000 float
and for the 25 days zero float, so the average float is $166.67.
2. Method 2: (5/30)($1,000) + (25/30)(0) = $166.67

So when we talk about collection float, we want to keep this very small. Mainly because we want
to collect money very fast. So if you can provide a service that improves your collecting speed,
then it must be worth some money. You then have to figure out how much it is worth, this
service.

Example:
Suppose everyday you receive $3 million and the weighted average delay is 5 days.
a) What is the total amount unavailable to earn interest?
• 5*$3 million = $15 million
We can only understand this if we project forward to the 6th day onwards. Imagine this is a
steady state basis, so everyday you receive $3 million, so all in all $15 million would always be
stuck in the delay, waiting.

First day you receive $3 million, it gets stuck, the second to fifth day all the $3 million collected
also gets stuck. On the 6th day, the 3 million you receive is still stuck, but then you clear the first
day’s $3 million because now the first day’s 3 million would have met the 5 day delay. So that
would get cleared but you continue to have 5 days worth of money stuck, 2nd day to the 6th
day. On the seventh day you receive another $3 million but it’s stuck, instead you collect the
2nd day’s $3 million, but you still have 5 days worth that is stuck from day 3 to day 7. So you
always have 5 days’ worth of $3 million stuck, hence $15 million is always unavailable to you.

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b) If you can reduce this delay by 3 days, what’s this new efficient system worth to you actually?
So the 3 day reduction in the waiting time frees up $9 million in total, again on a steady state
basis.
So if the systems costs $8 million but it frees up $9 million, then of course, it would still be a
positive NPV of $1 million. So that’s how we view this, based on total amount that is available.

So like we said earlier, collection delay is made up of 3 parts:

Mailing time, processing delay and availability delay.

Availability delay again is not within your control because it’s the bank’s problem so the only
thing you can do for your firm is to improve these two things. So you want to shorten the mailing
time, how long people take to mail this payment to you and you want to reduce the processing
delay which is of course you want to upon receipt of this check, get it to the bank as fast as
possible.

This is easier said than done especially if you’re a small business. Because for example if
you’re managing a very small business, you might not want to actually go to the bank every
single day because it’s actually very time consuming, so you’ve got to travel to the bank, join the
queue, get to the teller, clear all the checks and that could take actually a few hours so most
SMEs don’t go to the bank everyday. They’d do it once a week or twice a week at most. Imagine
that you go to the bank every Wednesday for example and then Thursday you receive the check
so you have to wait until the next Wednesday to clear the check, so the processing delay can
actually take some time. Depending on resources you have.

The goal again of this float is to make the net float as large as possible. So we want a very large
disbursement float but a very small collection float. So to get a very large disbursement float, we
need to delay the payments as much as we can.

Arguably this isn’t very ethical. So while it’s true that if you delay payments it would increase
your disbursement float, it may not be the best way to do it.

However, based on common sense if a bill is due on the 13th don't pay any earlier. All our bills
even in our personal life comes in a cycle. So we’ve got cable bills, phone bills, even credit card

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bills, they’re always due on the same day of every month. The goal is to set up GIRO accounts
and settle them on the actual day itself. You don’t actually want to pay early. Paying early
basically allows the companies to enjoy the float rather than you.

These 2 accounts the: Zero-balance account & Controlled disbursement account can help us
manage the cash amount, they don’t delay payments so they don’t help us to delay payments.
However, they help us to hold less unnecessary cash. That still helps us overall in terms of our
working capital management. So how do they do it?

What’s a Zero-balance account?

As the name suggests, it’s an account which requires you to have zero balance, in other words
there is no minimum balance account required for this account. It’s a checking account that is
linked to a savings account. What the bank does is that every time you write a check out from
this account, the bank will transfer money from your linked savings account down to this
checking account before it disburses money out from the checking account.

SMEs tend to open many checking accounts simply because it improves book-keeping ability to
make it neat and easy to do your accounting at the end of the year. You open different accounts
for different suppliers you pay. You then link all these separate accounts to one master parent
account, which is the savings account which earns interest. The separate accounts for the
suppliers do not earn interest. Since they are zero-balance account, you don’t hold anything in
these accounts, so you have separate checkbooks and when you want to write a check for
supplier A, you use checkbook A, B etc. The bank simply transfers money from your savings
account to these respective zero balance accounts before disbursing it out. So how does that
help you? Because previously you’d have had to hold 3 separate checking accounts holding 3
minimum balances as part of the checking account requirements without the zero-balance
account invention. Then therefore you’d have had to hold three minimum balances which earn
nothing. So there'd be a lot of carrying cost there. But with these zero-balance accounts, then
there is no requirement, so you continue to earn interest from the savings account up until the
day where you actually write the check and it gets disbursed.

What’s a Controlled disbursement account?

It’s quite similar, apart from the fact that now the bank informs you ahead of time of what
amount needs to be disbursed. This time there is no linking, so it’s just a checking account but
the service that the bank provides you is to inform you ahead of time how much needs to be
disbursed from this account at some date. So your job is to transfer money from anywhere else
into this account in time for them to disburse the money out. So this is a controlled disbursement
account because they inform you ahead of time and then you have to transfer the money in.
And you can transfer the money from wherever, so if you’re holding money outside in
investment account which earns more interest that’s possible before you have to take that
money out.

So these two accounts allows you to hold less unnecessary cash.

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So how do you improve collection float then?
You want to collect very fast. (Pay very slow, collect very fast). How do you collect faster?
Can offer customers some of these things:
1. Lock boxes
2. Prepaid envelopes (What’s a prepaid envelope? If you want customers to pay fast, you
give them an envelope which comes with a stamp, postage paid, all that customers have
to do is write the check, put it in the envelope and post it. So it makes it convenient for
them because they don’t have to go find their own envelopes, or buy stamps etc. Meant
to quicken this process.),
3. Discounts for customers who pay early
4. Alternatively you could also insist on wire transfers. As a business, the easiest way is to
ask customers to pay you online but of course provided that you’re in a developed
country. If you go to a less developed country, then this might or might not be possible.

So what’s a Lockbox?
It’s like a Mailbox, literally a box that collects checks. So the management of the lock boxes are
done by the banks. You go to the bank, set up this lock box service with the bank and then tell
your customers to drop off checks at these lock boxes instead of mailing the checks to you.
Everyday the Bank would send its own staff down to the lock boxes to open the boxes and clear
out the checks and process the money for you. So how does this help you in terms of collection
float? So you’d reduce mailing time since there is no mailing, and you’d reduce processing time
because the checks reach the bank straight away. If you imagine you’re an international firm
and you’re trying to sell to many different states in this country, so you’d need to get an account
with a bank which has presence in all these states so that you can have lock boxes in all these
states. This then makes it more convenient for customers to walk to the lock box location, drop
the check and then the branch of that state would deal with the money for you and update your
accounts. So that helps you. So lock boxes are useful in this way but of course again this
supposes that we still write checks.

Every bank in Singapore has lock box service although these would soon become extinct. The
idea is there are many benefits:
The outsourcing results in optimised cost savings on in-house processing time, reduce
operating costs and free up staff for other needs etc.

How much will the lockbox service actually cost you?

Say the lock box service improves your collection by 2 days. Daily interest rate on T-bills =
.008%. On average you receive 3000 checks per day. Each check on average is $600. The fee
that the bank charges is $0.08 per check. And a $10 fee per day.

How much is the initial investment that you’d make for this lock box?
So we’re trying to calculate the CF0 , so we know the daily cost but then we’re trying to figure
out what is the initial investment that we’d pay for this service.

So what’s the benefit to us of this service?

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It frees up 2 days worth because it improves collection time by 2 days. So what’s this worth to
us?
Again everyday we collect 3000 checks each worth on average $600. That means each day we
get $1.8 million. So for two days, it’d be $3.6 million that we free up. (288/ 0.008% = 3.6 million,
if you think about the daily interest rate, $288, then you’d think about it as a perpetuity anyway,
so you’d end up getting the full $3.6 million.)

What’s the cost to us?

3000 checks at $0.08 each so that would be $240. And a $10 daily fee which would add up to
$250 per day.

So if we imagine that this goes on forever, then we can calculate the present value of this
perpetuity and that is:
PV = $250 / 0.00008 = $3.125M (the $250 daily cost is a perpetuity)
0.00008 comes from the daily interest rate on T-bills = 0.008%.

So we free up $3.6 million and it costs us $3.125 million, therefore there is a positive difference
of $475,000. So that means that we cannot pay more than $475,000 today for this lock box
service. That’d be the maximum initial cost that we’d pay for this to be a viable project.

Alternatively, you could think of it in terms of daily benefits. So again you free up $3.6 million at
a daily rate of 0.008%, that works out to give an interest of $288.

The daily cost is $250. Hence the daily benefit is the difference, which is $38. And then you
perpetuate this $38. So the present value of the perpetuity of $38 is also $475,000. They’re
exactly the same mathematically just the perspective is slightly different.

Both methods are similar, just one thinks about it based on the total amount you free up and the
other thinks about it in terms of daily interest.

Who still writes checks?

Many transactions are still carried out through checks while there was a decreasing trend, in
2017 you can see the trend is plateauing. It doesn’t seem like we can reduce the use of checks
anymore. It’s still hovering around $15-20 billion using checks. Americans are the main culprits.
People in Europe have accepted online payments a bit better, and Asia as well. But in America,
they still continue to use checks.

GoodYear Tyre and Rubber company based more than half of its invoices in checks. This is one
of the biggest tyre companies. The cost of writing checks are as much as 5 times that of e-
payments, but they still continue to write checks. Have to pay for the checkbook, banks want to
encourage you to use e-payments because they don’t want to process the checks. The
inefficiencies of sending checks through the mail have financial advantages, the extra time it
takes for the bill payment to make its way to the postal system gives the company a few extra
days of liquidity helping to manage short-term cash needs. Get to earn interest on the money

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until it clears so this is practical. So for customers you tell them to pay you online and for
suppliers you write them checks so they wait. Pay very slow, collect very fast, that’s how it
works.

3. Cash budget
Cash budget helps us to improve forecasting ability. Nothing more than a forecasting tool so we
want to project what is the amount of inflows and outflows and then figure out how much we
have. We don't want to have excess so we need to then compare with what we feel is the safe
amount to hold and then therefore anything excess we should deploy elsewhere.

Example: Supposing this is SKI’s cash budget and in January they collect 68k, February they
collect 63k and these are the amount of payments that they need to make: wages, purchases,
rental etc. So the net cash flow basis for January they have 14k and for February they have 18k.

Supposing that they start off January with a beginning balance of $3k in cash, they add the net
cash flow for January. They have an ending balance of $16.8k. This becomes the beginning
balance for February then they add the net cash flow from February and they get an ending
balance for February of $35k.

Then you compare against this thing called the target cash. Target cash is basically the safety
stock that you want to hold. The minimum amount you think is good, which in this case they
have decided that $1.5k is enough. So in terms of excess they have 15k in January and then in
February by the time the 18k comes in, they’d have 33k in excess of their safety stock. Which is
of course ridiculously high, too much.

So if you hold 20 times more than your safety stock, then something is wrong. So we can
conclude therefore that SKI is holding way too much cash and they can improve their value by
investing this amount of cash. So basically they should not hoard the cash unnecessarily.
Unless SKI is holding it for speculation reasons. So maybe you’re hoarding cash in the
meantime because you’re targeting to takeover a certain company in the next month etc. then
that’s a possible good reason for hoarding cash. But apart from that, then you need to be able to
figure out how much cash you want to hold.

In terms of cash budgeting, we forecast inflows and outflows. So when it comes to inflows, not
only do we forecast our sales but these are just other one off items that we could also take into
account when we look at the potential inflows:
1. Proceeds from the sale of fixed assets
2. Proceeds from stock and bond sales
3. Interest earned
4. Court settlements

When it comes to inflows also, when we look at sales, we should also factor in this thing called
bad debts. What is bad debts? When you sell on credit and yet customers don’t end up paying
at all. Based on historical records, you’d be able to determine that for every $100 you sell,

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maybe $3 never get paid owing to some customers who just never pay you. Hence in such a
case, you might want to reflect this 3% as a conservative estimate of what you should expect to
receive. Just to make your projection more accurate.

Why would firms want to maintain such a high amount of cash?

We’ve determined that SKI has superb amounts of surplus. What are possible reasons for why
they might want to do such things?
Possibly speculation reasons as mentioned before which can be justifiable. Or alternatively they
just don’t have faith in their forecasting in which case they should improve this.

Example:
Today we start off with a cash balance of $200 and last month december we sold $600. This
month we project the sales as $1200 and for February we project the sales at $800. COGS is
70% of sales and we buy our products one month in advance to the month of sale. Accounts
payable is 30 days, accounts receivable is 10 days. And every month we spend $300 on other
expenses.

So what do we collect in January?

So first of all for these questions, let’s assume that the sales and also the payments for the
products is done on a daily basis. So for the $600 sales in December, assuming 30 days in
December, means that everyday we sell $20. Likewise for January, it’d be $40 etc. So think
about it in terms of everyday basis instead of one lump sum for both the collections as well as
the payments.

Amount collected in Jan = ⅓ ($600) + ⅔ (1200) =$1000 Assume sales and payment for
products are done on a daily basis. Everyday basis instead of a lump sum.

If the accounts receivable is 10 days what it means is that if you sell on the first day of the
month, you only collect on the 11th of the month. So you sell on the 2nd, you collect on the
12th, you sell on the 3rd, you collect on the 13th etc. So what it means is that you can only
collect for the first 20 days of the month within the same month. So whatever you sell from the
first to the 20th of the month you will collect within that month. But what is sold on the 21st on of
the month, you’d end up collecting in the next month. So therefore in January, what you end up
collecting is the last ten days’ of December sales + the first 20 days of January sales.

What do you pay for in January in disbursements then?

Payment in January = $1200 (0.7) + $300 = $840 +$300
So to understand why it’s simply because goods are purchased one month prior to the month of
sales. So if we project $1200 sales in January, we would have to buy the goods we intend to
sell in January in December. So we’re going to buy goods that we’re going to sell in January in
December so (0.7) (1200) in December we order this amount of goods. But then because
accounts payable is 30 days, we’d end up paying for this in January. So whatever you order in
December, you pay for in January.

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Pay attention to this: There are actually two things going on, the ordering which is a month prior
to the month of sale and the accounts payable period, how long it takes before you need to pay.

Therefore what is the ending balance for January = $200 + $1000 - $840 - $300 = $60

4. Credit
Why do firms grant credit?
Granting credit basically means that you sell your products but you don't expect cash on
delivery. So you’re not expecting cash, you give them some time to pay, 30 days or more that’s
credit.

Arguably, granting credit can increase sales. Possibly customers would be attracted to you
because you give them credit as opposed to expecting them to pay cash. Your competitors may
insist on cash but when you give customers credit, then of course customers would come to
you. Everybody in business wants to pay very slow and collect fast. So when you give credit
and your competitors don’t then of course you’d get more sales because people will come to
you because they can pay very slow. So that helps.

But there are costs involved if you give credit. What are these costs?
1. Bad debt, there are some customers who end up never paying
2. In the meantime when you’re providing customers credit, you have to finance yourself as
mentioned before.

So there’s always a trade-off, another trade-off here between how much credit to give because
there is the pro: which is maybe the increased sales and the con: which is that you may not get
paid and in the meantime you have to finance yourself as well.

Total accounts receivable in the balance sheet is basically the credit sales per day * length of
time you take to collect the money in total.

Day sales outstanding =

𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝐴𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
, 𝑤ℎ𝑒𝑟𝑒 𝑆𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦, 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑠𝑎𝑙𝑒𝑠 =
𝑆𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦 365

What’s an aging schedule?

Aging schedule is the way that firms would track outstanding debt. So any outstanding
payments would be tracked using this schedule which tells us how much is how late. For e.g, in
banks, we track aging schedules for credit card debt based on months that it’s late. So if you’re
one month late, 2 months late, 3 months late all the way to 6 months late. So this allows us to
understand what’s the total amount of balances that are late and this is useful for us because
we would track it to understand the trends. So is it getting progressively worse, in which case, it
suggests that either the economy is doing poorer so then people are facing more liquidity
problems and therefore more and more late OR it could also suggest that we’re granting too
much credit. So if the bank is being too liberal in granting credit, very easy to get loans etc, then

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you’d have a lot of subprime problems in the sense because people are being given too much
loans when these people actually have no ability to pay so they would end up paying late.
Hence banks would have to clamp down on this granting of credit. So this is the usefulness of
the aging schedule.

So what can we say about DSO of SKI?

SKI’s DSO is about 46 days, while the industry’s is 32 days. So obviously customers are taking
far longer to pay or SKI is taking way much longer to collect the money. So customers are
paying less promptly so SKI should tighten their credit policy.

There are 4 elements of credit policy that we can adjust:

1. Credit period
2. Discounts for early payments
3. Credit standards
4. Collection policy

What’s a credit period?

Credit period is the total length of time given to pay. So if you give customers 40 days to pay,
that’s the total length of time, credit period.

Discounts for early payments: Of course if you adjust your discounts, you’d be able to change
the policy a bit by giving customers more discounts for early payment and also determining for
how long these discounts would apply for so that’s known as the discount window. So for
example, if customers are given 40 days to pay, but they pay within the first 10 days, then they
would be given a 3% discount. So you can adjust the discount rate but also can adjust the
discount window, like how long the discount can apply for.

What are credit standards? It’s who you give the credit to. So as a business, you don’t have to
give credit unilaterally, not all customer should get the same credit. Some customers you can
give 20 days, others 30 days, and yet others 60 days etc. So it’s up to you as a business
person, so you have to use your own discernment about who you think can be given credit so if
customers are habitually late, then it would be beneficial for you to reduce the credit terms and
credit period, so you can’t give them 30 days because you know that they are always 2 weeks
late. So you might as well give them 15 days if you want them to pay after 30 days.

Collection policy: When do you start calling customers, do you start calling customers if they are
1 week late, 2 weeks late etc. and how often do you call them. So if they are 1 week late, you
call them once a day, if they’re 2 weeks late, you call them twice a day etc. Maybe, so that’s all
part of the policy as to how you should try to get back your money that is late.

Terms of sale: 2/10 net 45, What does that mean? It means that you get a 2% discount if you
pay within 10 days, otherwise you have 45 days to pay. That’s what the 3 numbers there mean.

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The first number is the discount, the second is the discount window, which is how long the
discount applies for and the last number is the credit period.

So again if you bought something worth $500, if you pay within the first 10 days, you get a 2%
discount which is $10, so you pay $490.

Again the credit period is the total amount of time given to pay. If you reduce this number of
course you’d reduce the DSO because you collect faster but the potential downside or risk here
is that you could lose some sales. Because you grant credit, you’re able to increase your sales.
But now that you shrink your credit period, some of these customers who were initially attracted
to you because of your long credit period, would decide then that now they would go back to the
other competitor. So that’s the risk.

Cash discounts: You can give discounts and also decide how long it applies for.

Credit standards: Again it’s about who you give credit to. So if you make tighter your credit
standard, then of course you’re giving away less credit, which means you could reduce bad
debt. So for people who you know would never pay, never give them credit, instead always
insist on cash. So this reduces bad debts but again this could also lead to reduced sales
because again customers are attracted by your credit, so if you don’t give them credit, they may
walk away so that’s something you’d have to deal with.

Collection policy: How tough you want to get.

So Citibank in 2011 was charged with murder of a man who had owed the bank $5700. Fierce
interrogation may have occurred. This is all about collection policy, how fierce do you want to
get for $5700. Banks in Indonesia actually outsource collections. So these people collecting the
money on the bank’s behalf are professional collection agencies. They do nothing but collecting
money which is their job. So they are quite fierce. But since then the Central Bank in Indonesia
has outlawed this. So all banks in Indonesia no longer outsource this process so they have to
hire their own collectors and internal staff. So now things are bit more friendly.

Example: Cash discounts

How expensive is the discount really?
Even though the discount looks like a 2% discount which seems quite pathetic, it would actually
cost the business a lot. How so?

So let’s understand this credit term: 2/10 net 45. Which is a 2% discount.
Go through the mathematics:
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 2 2
Period rate = 100−𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 = 100−2 = 98 = 2.0408%

Length of each period = Credit period - Discount window

= 45 days - 10 days
= 35 days

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How many periods are there in the year?
365
Take 365 / Length of each period = 35
= 10.4286 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟

So to find the effective annual rate:

(1 + 𝑃𝑒𝑟𝑖𝑜𝑑 𝑟𝑎𝑡𝑒)𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 − 1 = (1 + 0.020408)10.4286 − 1 = 23.45%

So effectively this 2% discount is actually 23.45% for effective annual rate. So it looks quite high
actually as an EAR.

Now to understand the mathematics, so if we

look at this timeline:

What we can understand is that there are 2

cash flows, 1 on day 10 and one on day 45.

We don’t expect cash flows on any other day

actually because the discount applies for the
first ten days so it would make no sense for anyone to pay on day 1, day 2, etc. If you want to
qualify for the discount, you’d pay on day 10. If you missed the discount window, then you’d also
not pay on day 11. It would make no sense to pay $100 on day 11, neither day 12 etc. So if you
missed the discount window, you’d wait all the way to day 45 to pay. So there’s only 2 dates that
people would pay based on rationality. Day 10 or day 45.

Now if they pay you on day 10, they’d pay you $98. Either that or on day 45 they’d pay you
$100. Now on day 10 if the customer comes and doesn’t pay you the $98, it is tantamount to
him taking a $98 loan from you.

So the situation is as such, the customer comes and wants to give you $98 on day 10 but then
after he changes his mind. He decides to take back the $98 for now and give $100 instead on
day 45. So effectively he has taken a $98 loan from you on day 10 basically. This is from the
customer’s perspective so he takes the $98 loan from you and then he pays you $100 on day
45.

So this is a $98 principal loan with $2 of interest, because the interest is just (P+I) - P. So the
2
period rate of this interest would be 98, because it’s just interest over the principal.

So imagine if this was a 5% discount now. So if the terms are now 5/10 net 45, then how would
it change?

So in such a case, now instead of paying you $95, the customer would borrow $95 from you
5
and give you $100 on day 45. So likewise the interest would be $5, so you take 95, so that’s why
the period rate is calculated like that which is discount divided by 100-discount.

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Then this note is of course for 35 days (45 -10). So he borrows it on day 10 and returns on day
45, that’s a 35 day loan. So the period rate applies for this period of 35 days. And then we
calculate the EAR of this loan which is 23.45%.

By giving the customer a discount, we are effectively giving him a loan in that sense. And this
loan would cost the business 23.45% EAR. Which is extremely high. So ironically, the company
benefits when the customers forego the discount. In that sense, we’re trying to say that even
though the companies give the discount, the companies actually do not want the customers to
take that discount. Companies are actually saying “please don’t take the discount!” because it’s
so costly.

If you think about it from the company’s perspective now, if the customer takes the discount,
what would happen? The customer would basically give you $98 on day 10. But actually what
do you want? You actually want $100 on day 45. So in effect, what you got to do is make your
$98, $100 yourself. So you’d have to invest this $98 and then after 35 days you want it to
become $100, which means that you have to invest this $98 into any investment product that
also gives you a 23.45% EAR basically, which the problem is you can’t find. Because this is
actually a very high rate. So while we say the company benefits in a very non-qualitative sense,
there’s actually a qualifier there, which is to say that this EAR here would in most cases, exceed
any investment that you can find outside. So you can’t make your $98, $100, that’s basically the
problem. So the discount actually comes at a cost.

You can tighten your credit policy based on those 4 things mentioned: Credit period, Discounts
for early payments, Credit standards, Collection policy.

So if you tighten your policy based on those 4 variables, you would be able to collect faster but
then you might end up discouraging sales so there’s always pros and cons. So in the short run
you could end up collecting faster. But in the long run at the same time you want to be able to
do something with that cash. There’s no point for you to collect your money very fast and then
just hoard that cash. That doesn’t really help you much apart from the fact that your numbers
look better but then if you're hoarding the cash and still not earning money from the cash then
there’s still not much point.

Credit policy effects:

From the firm’s perspective, if it grants credit, it is possible for it to increase sales and in fact
possible to increase price as well. So if you pay cash you get a different price than if you paid
using credit.

How about the cost of granting credit?

There is a possibility that customers may not pay at all. You need to figure out the probability of
customers taking the discount and then after you have to finance yourself during the interim
when you grant credit so you have to figure out the cost of that debt. So there’s a lot of costs to
consider when it comes to granting credit.

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Simplified Example: Evaluating policy
Say currently you collect cash on your sales but you considering to move into a net 30 policy
which means you want to give people 30 days to pay. The price of every unit you sell is $100
and it costs $40 to produce. And you sell 1000 units currently.

If you change to a credit policy you think you could sell more because more people will come to
you and so you can sell 1050 units. The required monthly return is 1.5%. So how do you know
whether this makes sense or not?

So what's the benefit to you actually? The benefit comes from the ability to sell more. You
currently only sell 1000 units with the switch you can sell 1050 units. So this extra 50 units at a
$60 margin would earn you $3,000 more. $3,000 more if you imagine this as a perpetuity this
translates to a present value of $200,000 ( 3,000/0.015 = 200,000).

But what's the cost? What's the cost of switching to this policy? The cost only appears in the
first month, or is only borne in the first month. The cost is that firstly you no longer collect $100
in the first month because that's what you used to collect. You used to collect $100 for the 1000
units that you sold but now you would no longer collect this 100 dollars so the total $100,000
would be delayed. You’d also bear the production cost of this extra 50 units for the first month,
which is $2000 ($40 * 50). So the total cost is $102,000. For the rest of the months, there is also
these costs. This is only for the first month but for the rest of the months, it’s actually covered
here, it’s been captured here so you don’t have to worry about that. But for the first month
especially you have to worry about it here separately.

So the NPV is $98,000 [200,000 + (-102,000)]. So you should switch since it’s positive. This is
actually quite difficult to imagine what is going on so you may prefer this other method:
This is a table to understand what is happening based on the timing of the flows.

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So the top half is the current flow, and the second half is the new flow. The current flow is that
you sell 1000 units at a $60 margin each. So therefore, $60,000 is made every month.

The new flow is that you sell 1050 units but for month 2’s $100, you’re actually collecting for
month 1’s sales. Each $100 you collect is from the previous month’s sales. But if you imagine
this goes on forever then it really doesn’t matter.

But then it costs $40 to produce every month for each product. So to calculate the cash flows:
From month 2 onwards, it’s $60 (1050) = $63,000. So you take new cash flow - old cash flow
under the cash only system, and the difference is $3000. This $3000 is no different from the
previous $3000 that you calculated under the other method.

In terms of this month, this cash flow would be(-40) * 1050 = -42000 and then new cash flow -
old cash flow to give you -102,000. Again no different from what was calculated before under
the other method. So you can see that you have the $3000 perpetuity and the $102,000 but now
you can see that the $102,000 is just actually in month 1.

So the NPV is again 98,000 for this table because you take the last incremental cash flow row
and sum up the perpetuity of $3000 and the -102,000. But this table also allows you to change
the price of each unit. So if you’re told that you not only sell more but also can charge more, so
you can sell 1050 and sell at $105. Then quite simply, you just change the new cash flow, take
the new cash flow - old cash flow and understand that this number would change.

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If you want to use the formula, there is no problem, it’s just that you have to figure out that the P
must be P’ because the price would change in the further example.

Compensating balance:
Recall that there are 4 reasons why firms hold cash:
1. Transactional nature
2. Precautionary
3. Compensating balance
4. Speculation

This compensating balance comes from borrowing money from the bank. So if you negotiate a
line of credit with the bank, the bank would tell you that it would give you a $500,000 line of
credit but for every dollar that you borrow, you must leave $0.15 in the bank as a compensating
balance. For this example, the compensating balance does not earn anything, no interest
earned.

So say the quoted interest rate is 9%, how much would we need to borrow if we need $150,000
actually?

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Assuming we have no money to start with, so we cannot do without the compensating balance.
So we actually have to over-borrow so that even after leaving 15% with the bank, we have the
$150,000 that we need. So how much do we borrow?

We take $150,000 / (1-0.15) = 176,471

So we end up borrowing 176,471. This is not the same as taking $150,000 (1.15). So this works
the same way as capacity sales from last week.

So how do we ensure that this is the correct calculation? Simply take 85% multiplied by
176,471, then we must end up with what we need which is $150,000.

Now that you have the amount of money that you need to borrow, you’ll be charged 9% interest
on this amount that you borrowed. So it’s 176,471(.09) = 15,882. That’s the total interest that
you’d pay.

So effectively, the rate that you end up paying for this loan is the interest divided by what we
can use. So this effective is not effective annual rate (EAR). It’s a completely different thing.
This is just to say actually this is the amount that you end up paying because you’ll only be
allowed to use $150,000 of the amount of 176,471 that you borrowed. Effective rate =
15,882/150,000 = .1059 or 10.59%. So it’s 10.6%.

So what’s the lesson that we learn from here? When you borrow money from the bank and it
comes with a compensating balance, then we also need to compare the compensating balances
between banks and not just the interest rates because if you get a loan with a quoted interest
rate of 8% which is lower than 9% and so seems to be better but then the compensating
balance is say 35%, then effectively the rate that the bank would charge you would be higher.
You’d end up paying a higher effective rate. So banks can actually play around with these, so
it’s not just the quoted rates that are important you also have to look at the compensating
balances to understand how much the banks hold back.

Sometimes the compensating balance can also earn interest. If that's the case, you have to
calculate the interest earned by that compensating balance.

So what’s the compensating balance here? It’s 176,471 - 150,000 = 26,471. That’s the amount
you leave behind. So suppose that that $26,471 earns 1% interest, so in terms of the interest
that you actually earn will be 1% of 26,471 = $265 approximately.

So you have to subtract the interest earned of $265 from the interest paid for the loan which
was 15,882, to get the net interest that you pay. So it’s the interest paid - interest earned.

So effectively you pay (15,882 - 265) of interest on a net basis. Then similarly divide that by
$150,000. That’s if the compensating balance earns interest.

4 sub-topics:

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Operating cash cycle (Cash cycle = Inv period + AR period - AP payable)
Float (While we want to minimise the cash cycle, we want to maximise the float. So how do we
do that? We pay very slow and collect very fast. Disbursement float you want it to be very big,
and collection float you want it to be very small. Delay payments and speed up collections if you
can)
Cash budgeting, just a projection
Credit policy

NON-examinable:
Say a company has seasonal patterns of sales. To support this level of sales, they would need
to have assets. So invariably this would also be the pattern of assets. So then how do you
finance these assets?

There are 3 possibilities that you could possibly use to finance this asset requirements:
1. Flexible policy: Finance the peak amount of assets using total long term debt, so you
basically borrow long term money, say 20 year loans to buy these assets. So of course
in times where you don’t need the money because of course the asset requirement is
actually dropping, then you’d be using the money to buy marketable securities. So in
other words you over-borrow, borrow all the way to the max, using long term money so
in times when you don’t need the assets you’d have surplus money which you can
convert to marketable securities.
2. Restrictive policy: Completely opposite of flexible policy. So you do long-term borrowing
for up to the trough, and during times when you have seasonality demand for your sales
and hence assets, you need to do short-term financing. So you borrow short term for the
peak assets needed.
3. Compromise policy: Is in the middle, where you end up doing both.

How do firms choose these policy, whether they want flexible or other?
Most firms would carry out maturity hedging. So they try and match the maturity of the assets
and the liabilities. So if you have a long term asset, you’d borrow long term to finance it, for a
short term asset, you’d borrow short term to finance it. So that’s the simplest way to minimise
interest rate risk.

Sophisticated companies can do this, if you’re a larger company, you have more resources and
have a dedicated finance department to oversee what is going on in the market, then you could
play around with the interest rates. So as long as the yield curve is upward sloping, what it
means is that you can choose to finance long term assets with short term debt.

For example a bank would provide a 20 year loan and it would charge you say 10%. How does
the bank get the money to lend you? They actually go out and borrow from the markets. So they
go to the financial markets and borrow but this time you’re not going to borrow 20 year loans to
match the 20 year that you would give the borrower.

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Instead borrow one month money, so you go for short term borrowing to finance this long term
loan. So the one month money that you borrow from the markets, would only cost 0.3% and
then you lend it out at 10% so instead you’re making the difference. As long as you can roll over
this one month borrowing, you’d continue to make this difference. So if the one month rate
continues to stay at 0.3%, then you’d continue to make 9.7%. And if you can roll over this one
month borrowing for 20 years, then you’d end up making the full 9.7%. So that’s how banks
make money.

Of course, the danger here is that if the rates increase here very fast, so if the one month rate
keeps going higher and higher, then basically your profits would continue to reduce. So banks
will have then to decide at what time to close this gap, so they’d have to decide to borrow for the
rest of the duration and stop worrying about it. To lock in that gap, the difference or worse still,
there is a credit crunch in the market and no one is willing to lend you anything then you have a
big problem because you’re no longer able to borrow anything. That’s the even more dangerous
thing which is a liquidity risk. Most SMEs don’t do this, this is only for bigger companies that are
more risk taking.

EOQ: apply for carry cost and shortage cost. Talked about this when it comes to working capital
management. This will also be relevant when it comes to EOQ. EOQ basically tells you what is
the optimal order quantity to minimize the total cost of order cost and carry cost.

Multi-period cash budget:

Single period cash budget is examinable. What’s the January payables, collections and hence
the ending balance. So it’s one period because everything is asked for January.

For multi-period, they’d ask you for over a certain period of time, month 1 & 2 etc. But there is
no difference actually because in the exams they could easily ask what is the quarter 3 ending
balance then to get there you still need to figure out what is the Q1 and Q2 balance. So advice
is to read this to familiarise yourself with how the numbers are generated. This is more
complicated because there are a lot more fractions, got ⅓, ⅔, ½ etc but it’s a good example to
study.

Lecture 12: Options

Why do we study options? What’s the big deal about options?

If you Google, “top ten biggest trading losses in history”, you’d arrive at a list similar to this:

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Which you’d discover that all of them involved some kind of derivative. These people were
basically trading derivatives and that led to their large losses in their trades. What this tells us is
that it’s only through the trading of derivatives that you’re able to amass such large positions. So
if you get it right, then you’d have made a lot of gains. The counterparts on these people’s gains
are the people who made huge gains. Someone has to make the gains that account for these
people’s losses. So if you get it wrong you can end up losing a lot of money, so hence the risk is
high.

Today we’re going through one type of derivative which is just options. What’s examinable is:
1. Terminology for options
2. 4 different option positions
3. Pricing bounds
4. Determinants of option value
So the actual valuation of options itself would not be examinable (big relief).

Definition of derivative (parent group of options):

A derivative is an instrument for which the value of this instrument is actually dependent on
something else. Hence the word derivative, because it’s a derived value. So what types of
derivatives are there:
a) Options: Calls and Puts
b) Forwards & Futures
c) Extended Derivatives: Swap contract / Convertible Securities / Other Embedded
Derivatives (Call feature of a bond)
When we looked at callable, putable and convertible bonds these are bonds with an embedded
derivative in them.

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We won’t cover forwards, futures and swaps. We’d only look at that in year 3. Today we just
focus on options. Derivatives can be used for 2 main purposes. We either use it for speculation
as we saw earlier in terms of how they amass their losses because they were betting on certain
underlying asset prices but you can also use it for risk management purposes. For e.g if an
airline company wants to lock in a price for oil, what they’ll do is to buy the oil future. As the
name suggests, the futures is a way for you to lock in the price ahead of time. So you’d basically
know what you’re going to pay for oil and so knowing this price you can work it into your
financial plan to help you understand how much the cost would be.

The range of underlying assets for which the derivative can be priced on is quite large. It goes
all the way from agricultural products(: Corn, wheat, soybean, wheat, milk, juice, wood) all the
way to metals, currencies, stocks, bonds, indices, interest rates etc. So anything and everything
that has a price it seems for which a trader would be interested to lock in ahead of time actually
come with a derivative. “Necessity is the mother of invention”, if there are out there merchants
who actually want to fix prices of their products ahead of time, then someone would create a
derivative for them.

You can either buy derivatives off the exchange or you can trade them over the counter. So
exchange-traded derivatives are derivatives you can find on the exchange. There is a middle
person, which is the exchange that sells, which acts as the middleman between these third
parties. But then the downside is that these would come with standardized contract sizes of 100
for stock options. And the dates for which they mature are also fixed by the exchange.

In contrast, the over-the-counter variety would be totally customizable based on your

requirements. So these would be based on your negotiation with the counterparty. So the exact
quantity and exact date that you need. So the over-the-counter variety would tend to come with
a slightly higher fee.

Options:
There are only 2 types of options:
1. Call options
2. Put options

What’s a call option? It’s the right to buy. So owning this option gives you the right to buy. Buy
what? So you have the right to buy this underlying asset. So the option can be thought of as a
voucher basically for which you can exercise that allows you to buy something else which is the
underlying asset. The option comes with a predetermined price for which you can buy this
asset. So you’d know the price at which you can buy this asset at and there’s a date for which
we can exercise this option.

There are 4 types of options:

1. European options
2. American options

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 3. Bermudan options
4. Asian options
For this course, we’ll focus on the first 2. So what’s the difference between European options
and American options.

European options are those for which the option can only be exercised on one day which is the
date of expiration. So you can only exercise the option on 1 day only. On the maturity date or
the expiration date.

American options on the other hand, allow you to exercise the option at any time, up until the
expiration date. So of course, the american options are a lot more flexible in that sense.

Put options: Give you the right to sell. So you have the right to sell this underlying asset, all
other features are similar to the call option. So in this case, there is a predetermined price for
which you’re allowed to sell this asset, there is a date for which you can exercise and there is
the underlying asset obviously. So options are generally just side-bets. So for e.g if you and I
have worked out an over-the-counter option for Facebook stocks, then obviously Facebook, the
company would not be involved in this trade. So Facebook would obviously be concerned about
maximising their own share price but the option market is completely irrelevant to them. They
won’t really be involved in this market at all. They won’t need to worry too much about it. So it’s
a completely different market space. It’s just anybody can create an option.

You can write an option and I can buy it from you and then that’s the market. So you don’t have
to involve the firm and neither do you have to involve the exchange because this can be done
over the counter.

So say I sell you a call option. So now you hold this call option. If you choose to exercise the
option which means therefore that you want to buy the underlying asset, the seller of the option
is obligated to sell you the asset. In other words if you choose to exercise your option, you want
to buy the underlying asset, the seller cannot say no, the seller cannot choose to not produce
the asset if the buyer of the option chooses to exercise the option. The seller is obliged while the
buyer of the option has the right. So the holder of the option always has the rights. The seller of
the option is obliged. So the seller of the option has no rights.

Likewise if I sell you a put option, in which case you now have the right to sell this underlying
asset to me. If you choose to exercise the option, I’m obliged to buy the underlying asset from
you. Again the seller cannot say no, they don’t want the asset. Again the seller of the option has
no rights so the seller is always obliged to act as the counterparty of what the holder wants to
do.

Some other terminologies for options:

If you buy an option, you’re said to be ‘long’.

If you sell an option, you’re said to be ‘short’ or ‘writing’ an option.

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Exercise price is also known as the strike price.
The price of the option is known as the premium. Just like insurance premiums.
Expiration and maturity date mean the same thing.

Four option positions:

There are only 4 positions that you need to worry about.
1. You can either be the holder or the seller of the call option
2. Or the holder or seller of the put option

Some notations to look at so that we can understand the payoff diagrams later on (in this course
we just look only at stock options to keep it simple, so the underlying asset is the stock):
S - Price of underlying asset generally, stock price
S0- Price of underlying asset today, price of stock today
ST- Price of underlying asset at option expiration date, price of stock at maturity date
X - Exercise or Strike Price of the option (also referred to as E, K)
r - Interest rate (the risk free rate)
C0 - The price of a call option today
CT - The price of a call option at the option’s expiration date, value of the option at maturity date

Call holder:
Say you own a call option. So the call option gives you the right to buy the underlying asset. But
the question of course to ask ourselves would be when would you choose to exercise the
option? When would it make sense? So you have the right to buy the underlying asset at X,
which is the exercise price.

The stock market sells this stock at S. So let’s say S is at $120. Whilst X is $100. So you have
the right to buy the underlying asset at $100, whilst the stock market sells it at $120. In which
case, it would make sense for you to exercise your option. So you’d use this voucher in a sense,
and say: “Great, I’ve got this chance to buy this stock at $100”. So what do you make from this
trade? What is your payoff?

The payoff would be the difference between the stock market price and what you bought it at
which is $20, which is S-X. How do you see this? Simply because you’d buy this underlying
asset at $100 and it’s assumed that you’d then immediately sell it back to the market at the
stock market price which is $120. That’s how you’d realize this $20 gain. So the call value, CT in
this case is ST -X.

If X is more than S, for example if the stock is now selling at $80, but you have the right to buy it
at $100, then of course it would make no sense for you to exercise your option. If you wanted
the underlying asset, you’d just go out to the market and buy it at $80 so no point buying it at
$100, it doesn’t make sense. So in which case, the value of the option is nothing, it’s just a
completely worthless piece of paper.

So therefore the option payoff takes this function: CT = Max {ST - X, 0},

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CT is either ST - X or 0, whichever is higher. So that’s the payoff function for a call.

So what we see in this case is that the payoff for a call option can never be negative and that
makes sense. Hence the word option. The option always gives you choice, so you want to use
this choice only if it’s advantageous to you. So in a situation when it’s not advantageous then
you simply don’t use the choice and then nothing happens.

However, you need to pay some money for this option. And that’s known as the premium. So
therefore the net profit, or total gain from the option would be the:
Payoff - Premium.

The payoff is what you gain from exercising or not exercising the option. And the premium is
what you paid to get this option to begin with, the price of the option.

This diagram shows us the payoff diagram for a call option at maturity date:

On maturity day, let’s say X is $100 again. S is $120. What we can see is that our payoff would
be $20 as what we went through just now. ST - X = $20.

However, if S is $80, then we wouldn’t exercise our option, for which the call then becomes
worthless. So we can see that as long as S is less than X, this call is worth 0. And the moment
when it exceeds X, we have a one to one relationship between the call value and the stock
price. Hence the 45 degree angle, in other words the gradient of the upward sloping line is 1.

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So for example if the stock goes to $101, then the call value is $1. If the stock value is $102, the
call value is $2. If the stock value is $103, then the call value is $3. Every $1 that the stock
increases over the exercise price, adds $1 to your call value.

We describe options by their moneyness:

There are 3 terms associated with moneyness. Options are either:
If today were the exercise date, if today were the expiration date and you could exercise the
option today, then if you exercise and you have a
1. In the money: Positive payoff, then we describe this option as being in the money.
2. At the money: payoff of exactly 0, in which case S=X, then you’re at the money.
3. Out of the money: negative payoff, or in this case 0 because you would’ve chosen not to
exercise, then we say that you’re out of the money. So in the case of a call, it’s when
S<X. So say S=$80 but X is $100. In this case, this is an out of the money option.

So looking at the above diagram, the pink line shows us again the payoff diagram for the call
option at maturity date. Again if the stock is at $120, then we know that the call value is $20.

We translate this pink line downwards by the premium of the option because the premium would
be spent regardless of what the payoff of the option is. So we translate the entire pink line
downwards by the premium, so if the premium was say $14, the entire line goes downwards by
$14. So the dash line is the profit line. So this suggests that of course that a $114 stock price
would be where this entire transaction would breakeven. Simply because you’d have already
paid $14 for this option.

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Nevertheless the decision to exercise an option is based on the payoff not the profit. So as long
as the payoff is positive, you’d choose to exercise the option regardless of whether the profit is
positive or not. Why?

Using an example. Say the stock price is $110. You have an exercise price of $100. You’d buy
the asset at $100 and sell it back to the market at $110, getting a $10 payoff. So would you
choose to exercise the option? The answer must be YES! So your call value is $10 but because
you paid $14 for this option, the profit becomes -$4.

Supposing you chose not to exercise the option, in which case then, your payoff for the option
would be 0. But you would have paid $14 for this option so net profit would become -$14 which
is worse. So exercising the option allows you to clawback some portion of your premium
whereas not exercising means that you’d just pay your premium. So in other words, you can see
that the premium is just a sunk cost.

The premium is spent regardless of anything that happens. So you can’t get it back anymore in
that sense. So decisions that you make on whether to exercise or not must be forward looking.
So you cannot consider the sunk cost just like we said in capital budgeting.

So we make decisions on exercising only based on the payoff, as long as S>X, in this case for a
call.

Call writer:
This is a diagram for a call writer (the person that sells the call option):

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So the call writer has this diagram, with a straight line until X and then a 45 degree line
downwards beyond X. So what do you notice about the diagram before and this diagram for call
writers?

It’s just flipped. If you look at this diagram, it’s for the call buyer. And then if you completely flip it
over the x-axis, you get the diagram for call sellers or call writers. What does this mean? It
means that if you add the payoffs between the holder and writer, you’d get 0. If you add the first
pink line with the second pink line, everything would cancel out each other. You’d just get a
horizontal line on the x-axis, which is nothing. So there’s no value at all. Between the holder and
the writer, there’s actually no value created. It’s a zero sum game. The option market is a zero-
sum game. Whatever writer makes is what the holder loses. Whatever the holder makes, the
writer loses. So there is no additional value in that sense. So it’s quite simple in that sense
because you only have to remember one position, as long as you remember the call holder
position and what it looks like in the diagram, you can simply flip it over the x-axis and that’s
your call writer position.

What we notice about the call writer of course is that the call writer would make the premium
regardless of the situation because he would’ve charged the premium ahead of time. What does
the call writer want for the stock to do? He of course wants the stock to go downwards.

Let’s say the exercise price is $100, he writes this call. The stock price goes to $120 instead.
What happens is that the holder of the call option, the person who bought this call option from
him would come back to him and exercise the option. The holder would say that he wants to buy
this underlying asset at $100. So the writer of the call option, the person who sold this option,
doesn’t actually own this asset. So what does the seller of the option do?

One thing is that the seller of the option is obliged to sell the asset so he can’t say he doesn't
have the asset. The seller has the obligation to sell the asset, so what does he do? He has to
buy the asset. He buys the asset from the market. So the market sells the asset at $120, and
the seller of the option buys it at $120 and sells it to the call holder for $100. So the call writer’s
payoff would be -$20. Therefore the call writer’s payoff is basically X - S = $100 - $120 = -$20.

However, if the stock goes to $80, this time the call holder would not come back to the call writer
because he knows that he would not exercise the option. That’s great. So the option just expires
and nothing happens and so the call writer makes the premium.

What’s the maximum potential gain for the call holder? Infinity, unlimited maximum potential. As
long as the stock continues to go up, the pink line continues to go up so there is no cap on a call
holder’s maximum profit and payoff. Therefore what the maximum loss that the call writer can
make? It’s is also infinite. As long as the stock price goes higher, this call payoff can actually go
all the way down to -infinity in theory. So just bear that in mind.

Put holder:
This is the put holder diagram:

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This is the diagram for someone who owns the put option. The put option gives you the right to
sell the underlying asset at some exercise price. So as a put holder, what you want for the stock
to do is to go downwards. You want the stock price to drop because you have locked in a sale
price so the lower the price of the stock is in the market, the greater is your payoff because
you’ve already locked in a sale price for yourself.

So how does this work? So again the exercise price is $100. The put option diagram is as
shown above, a 45 degree line downwards and then a straight line. So let’s say the stock drops
to $80, you have the right to sell the stock at $100 so of course you’d come back to the put
writer and exercise the option to sell the stock at $100. But one problem is that you don’t
actually own the stock. Then how? How do you exercise the option if you don’t own the stock?
You have to go and buy the stock from the market at $80. And then you come back to the put
writer and sell it to him for $100. So there you make $20, positive payoff.

However, if the price in the market is $120 and the exercise price is $100, then it would make no
sense to exercise the option whether or not you own the asset to begin with. If you own the
asset, you still wouldn’t sell the asset at $100 if you could sell the asset at $120. So the put
option is worthless, it’s value is $0. As long as the stock price is above the exercise price, the
put option is nothing. Again, as the holder of the option, you must always pay the premium
ahead of time so we basically translate the entire line downwards to get the profit diagram.

What’s the maximum payoff for the put option? It’s the exercise price. Why is the exercise price
the maximum? Simply because the underlying asset cannot be negative. The lowest the
underlying asset can be is 0. So the maximum payoff is experienced when the underlying asset
price goes to 0. So you get the greatest distance when the underlying goes to 0, which is just X
- S. So it’s going to be if S=0, then you’d make X. So the highest the payoff is for the put option

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is only X. Hence in this case, there is a cap, there is a maximum for put option in contrast to the
call option.

There is no diagram for the put writer, so draw it yourself:

So just flip it over the x-axis. Starting from -$100, 45 degree line upwards all the way till stock
price is $100, after which a straight line at $0. That’s the diagram for the put writer.

Say you don’t like diagrams, then you could always work it out by looking at situations. There
can only be 2 situations:
1. Either S ≥ X
a. If S>X and you’re a holder of a put option, would you choose to exercise your
option? NO! So you can only sell it at lower than what the market sells at, so it
won’t make sense. In which case, the value of the put is nothing.
2. Or S < X
a. If S < X, if the exercise price is say $100 and the stock market sells it at $80, of
course you’d exercise the option and make X - S in this case $20. What’s the
profit? The profit is = Payoff - Premium.

How do you get the payoff for the writer? Again you only have to remember the outcomes for
the put holder because the outcome for the put writer + that of the put holder will give 0 because
it’s a zero sum game between the holder and the writer.

So in the same situation, if:

1. S > X, the put holder makes nothing, so the writer makes nothing.
2. S < X, the put holder makes X - S so the put writer - (X - S).

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So each scenario plus the corresponding scenario above must equal 0. So very simple. But you
must remember that the profit to the put writer is always + premium instead. This is potentially
an area that people may be careless in. The writer will have + premium, the holder will have -
premium.

Say you’re given $10,000 to invest. And there are 3 strategies that you could do with this
$10,000. The stock is currently priced at $100, the option on this stock is priced at $10 for an at
the money option. So an at the money option means that the exercise price = stock price. So
the exercise price is also $100.

1st strategy is to use all the $10,000 to buy 100 stocks.

2nd strategy is to buy 1000 options because the options cost $10 each.

Last strategy is to buy some call options, and some treasury bills. So you’re going to spend
$1000 to buy 100 options and then the remaining $9000 is spent on treasury bills to give you
some guaranteed return of 3%.

Now let’s look at their returns. Depending on what the stock price goes to, say today the stock
price is $100 and it drops to $95. If you have bought 100 stocks, your portfolio is now worth
$9,500, which is simply 100 * $95.

Likewise for the other scenarios of prices:

Price $95 $105 $115

Portfolio value $9,500 $10,500 $11,500

That’s the scenario if you bought 100 stocks.

But if you bought 1000 options, and the stock price drops to $95, then your options would be
worth nothing because they are all out of the money, so you would exercise none of the options.
So 1000 options * $0 = $0.

If the stock goes to $105, and you have the option in this case to buy the underlying asset at
$100, so for every option, you get $5. $5 * 1000 options you have = $5,000.

Likewise for the other scenario:

Price $95 $105 $115

Portfolio value $0 $5,000 $15,000

How about for the last strategy where you have both call options and treasury bills?

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In the case where the stock price falls to $95, all the call options are worth nothing. You have
100 of them so all you have left would be the return you get from the treasury bill which is 3%.
So you take 1.03 * $9,000 = $9,270.

In the case where the stock price rises to $105, each of the call options are worth $5 each. You
have 100 options, so you get $500 from the options added to the $9,270 and you get $9,770.

In the last case, where the stock price rises to $115, each of the options are worth $15 each.
$15 * 100 options = $1,500. This added to $9,270 will give you $10,770.

Price $95 $105 $115

Portfolio value $9,270 $9,770 $10,770

Now let’s calculate the percentage returns:

So if you take each of the numbers before and subtract $10,000 and then divide by $10,000,
that would give you the percentage returns.

Price $95 $105 $115

100 stocks -5% 5% 15%

1000 options -100% -50% 50%

100 options and -7.3% -2.3% 7.7%

$9000 worth of T-bills

This table only takes into account the payoffs and does not consider the premiums of the
options.

Range of values for the all stock strategy is small between -5% to 15% for these 3 scenarios.
Whereas if you had bought all options, the possible range is from -100% to 50% which is wide,
a lot of variance.

Let’s plot it onto a graph and see what happens:

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When you plot it on a graph it looks like the above. The y-axis is the rate of return in percentage
and the x-axis is the stock price.

So the pink line is the all stocks, equity strategy. Whereas the dash line is the all options
strategy. If you look at the all options strategy, you can see that as long as the stock price is
below $100, you’d lose everything, so -100% return. When the stock price exceeds $100, then
this line will climb. And you know that $110 becomes the breakeven price because $10 is the
premium of the option. So you know that at $110 the profit will be 0 so you can join the two
points and you know that this would continue to go up so that’s the gradient of that line.

What you notice is that the gradient is extremely steep compared to the pink line suggesting that
for every $1 that the stock increases by, you make a disproportionately large percentage return
on your portfolio of all options compared to the gentle line. For the pink line of course it’s going
to be commensurate, proportionate to the stock price because it’s all stocks. So what this shows
us is that option strategies are the rich strategies which allows you to get exposure to multiple of
the underlying. And this is of course possible because the option is always priced at a fraction of
the underlying asset. In this case, the option is now 1/10th the price of the asset. So for the
same amount of money you can basically buy 10 times the amount of options compared to the

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asset. 10 times the options of course allow you to be exposed to 10 stocks, 10 underlying. This
is almost to say that with the same amount of money you can buy 10 times the underlying asset
compared to just one asset. So of course that increases your ability to either make a lot of
money or in this case also lose a lot of money.

Additionally, options are quite amazing because for any set of payoffs that you want, you can
actually create a diagram based on combination of options. So say today the stock price is
$100, and you think that the stock price is either going to go above $110 or it could drop below
$90. For both of these scenarios you still want to make money. So you want positive payoffs no
matter what happens. So one way would be to buy a put option at the exercise price of $90 and
buy a call option at the exercise price of $110. That gives you a positive pay off in both of these
scenarios. So that’s how we create different strategies using combinations of options based on
our views of what the underlying prices of assets would go to. Of course that just limits us to
buying one and one. But you can buy multiple, you can buy one put option with 2 call options
etc depending on the conviction of your view. So the world of options is actually quite exciting,
very creative people actually are involved in options trading.

Let’s just look at one very simple strategy:

Protective put strategy:

So as the name suggests, it’s a protection strategy to protect us against significant loss. It
involves a put option. So we start off first by having a stock. The payoff of the stock is simply a
45 degree line starting from 0.

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233
So the payoff of the stock is simply the sale price of the stock. So it would not have included the
cost of the stock yet so it’s just the payoff.

Now let’s say we buy a put option on this stock. The put option is as shown, with a 45 degree
line downwards from X to X and then straight line 0. So since we own these two things, let’s add
the two pink lines together to get the combined payoffs. So you end up with the final pink line.

At the point X, you get X + 0 = X. At the y-intercept, you have 0 + X = X. So you can see that
from the point of 0 to X on the x-axis, you get a straight line at X. When the stock price exceeds
X, you have a 45 degree line upwards and a horizontal 0 line. So you retain the 45 degree line
upwards. So the protective put diagram looks like the above. And when you try to get the profit
diagram for this, you translate the pink line downwards by the cost of the strategy, which is the
cost of the stock + premium of the option. So it’s S0 + P. So you get [X - (S0 + P)]. So every
point on the pink line is reduced by (S0 + P).

Now let’s compare this profit diagram with the profit if you had only had the stock. How do you
draw the diagram for the profit of the stock. Before you had the payoff diagram for the stock, so
now you’d translate the pink line downwards by the cost of the stock, S0, to give you the red
dash line.

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So it’s still a 45 degree line but now it starts from -S0 and goes upwards. So this is the diagram
for the profit of the stock and the profit on the protective put. So what do you see?

We see that we protect ourselves from losses from 0 to X of the stock price. So the protective
put floors your loss, so it gives you a maximum possible loss whereas if you didn’t have this
protective put then you expose yourself to incurring more loss. This diagram does not do justice
to this strategy because in the diagram it looks like the difference between -P and -S0 is not that
far apart but actually it’s quite far apart.

So first of all, why do we arrive at only -$P? Previously it was X - (S0 + P) and then now it’s -P.
Why’s that so? Because we bought an at the money put option, so if it’s an at the money put
option then S0 = X. If S0 = X, then the two would cancel out so it would be X - S0 - P, which
leaves -P only. P is the premium of the put option which would be a fraction of the underlying
cost so P can be like $3, $4, $5 and S0 can be $100. So the distance is actually quite large
whilst the diagram misrepresents that. So we lock in a maximum loss which is not that much.

So this is known as protective put. You obviously carry out this strategy if you’re concerned that
the stock is going to fall in price, a significant fall in price. But liquidating the stock is something

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you may not want to do because of transaction costs or other factors such as taxes, or you feel
that in the long term it’s still a good stock to hold so you’d rather hold on to it. So temporarily
you’d buy a put option to hedge this position.

Another strategy gives us exactly the same payoff diagram. On one hand, we have investment 1
which is the protective put. And on the other hand, there is another strategy which is to buy a
call option and treasury bills.

So if you look at the pink line from the diagram before the one above, it looks suspiciously like a
call option payoff diagram, which is just a straight line until X and then a 45 degree line
upwards. This line is exactly the same as the call diagram apart from the fact that now it’s
elevated above the x-axis. So if you were to create another strategy which can give you the
exact same payoff, that would be to elevate the call option above at the degree of X. So how do
you do that? You do that by buying a treasury bill with face value which equals to X.

This allows you to always get X at the maturity date because for a treasury bill you’d always get
the face value at the end of the maturity. The payoff of these two items are therefore the same
and therefore they would cost the same today. That’s the law of one price.

So for any two investments that give you the same payoff, they must cost the same, otherwise
people would just buy the cheaper one and sell the more expensive one. Make money today
and have no risk because the payoff is the same at the maturity date.

So what is the cost of the protective put? The cost is S0 + P.

What’s the cost of the call option and T-bill? It’s C, the premium of the call and the face-value
discounted. So if you PV the face value, that’s the price of the T-bill simply because there are no
coupons. Just face value discounted.

So if prices are not equal then arbitrage would be possible. So let’s convince ourselves that the
payoffs are the same:

So we start off first with the call diagram, so again this call payoff diagram which is familiar to
you, a straight line until X, and then a 45 degree line upwards.

So again the other half of the strategy is to buy a T-bill with a face value equal to X. So the T-bill
will give you X on maturity. So therefore since you own these two things, you’d add the green
line with the brown line, and get the red line which looks exactly the same as the protective put
payoff.

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Say you’re not convinced by the diagrams. So we look at situations. So again either S is less
than X or S ≥ X.

Say S < X, and you have a protective put. Would you exercise your put option if S < X? Yes,
you have the right to sell at X, and the stock market sells it at a lower price so it makes sense
for you to use the option. So you exercise the option.

What’s the payoff from exercising the option? It would be X - S. So you get X - S from the put
but then you continue to hold the stock so you continue to have S. So it’s X - S + S, which is just
X.

If S > X, then you wouldn’t exercise the option because it’s out of the money so then you’d only
have the stock which is S.

If you have a Call and a treasury bill and S < X, this time your call is worthless. You have the
right to buy the underlying asset at $100 but the market sells it at $80. Of course it wont make
sense so the call is worth nothing, so all you have left is the treasury bill. The treasury bill will
give you X upon maturity.

On the other hand, if S > X, you will exercise the option to buy the underlying asset at X and sell
it back to the market at X, you’d then make S - X. You still have the treasury bill which would
give you X. So you’d have S - X + X, which is S. So again you can see that regardless of the
situation, these two would always give you the same payoff.

Put call parity:

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 Value at expiration

S<X S≥X

Stock + Put X S

Call + PV (X) X S

Therefore they must cost the same today. And this relationship is known as the put call parity,
one of the most important relationships in the world of options. So the protective put, S+P
always equals to the call + PV of treasury bill with a face value of X.

Price of Underlying Stock + Price of Put = Price of Call + PV of Exercise Price

So what’s so important about this relationship? This relationship governs the prices of calls and
puts with the same exercise price and same maturity date. So calls and puts of the same
exercise price and maturity dates must adhere to this relationship, otherwise they would be
arbitraged.

So this is useful because then knowing the price of one option allows you to the price the other
option. So it you know the price of the call, then you’d know the price of the put as well.

The total value of an option is made up of 2 parts:

1. Intrinsic value
2. Time value

The definitions of these 2 values are completely different compared to what we’ve been familiar
with. So the definitions of these 2 terms, even though they sound the same, are different from
what we’re familiar with.

So what’s the intrinsic value of a stock? It’s simply the present value of all the future cash flows.
That’s the intrinsic value of the stock.

What’s the intrinsic value of a project? It’s the present value of all the future cash flows. The
cash flows that you discount back that’s the intrinsic value.

But for options, the intrinsic value is a completely different definition. The definition is “If today’s
the exercise date and you exercise your option, what is your payoff”. That’s the intrinsic value of
the option.

We know that the option payoff is simply S - X or 0 whichever is higher, so that would be the
intrinsic value. So for the call it would be S - X or 0 whichever is higher. For the put option, it
would be X - S or 0 whichever is higher. If today is the exercise date and you exercise it, are

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you in the money or out of the money. If you’re out of the money then it’s worth nothing. In the
money then you get a payoff, which is the vertical distance on the payoff diagram.

Say that this was not on maturity date, say there is 3 months more until maturity, then the price
of the option will come with time value which is the extra amount of money that you would pay
for because there is still time until maturity. Time is worth something simply because it gives you
opportunity to allow the stock price to continue move in your favour. So you always want more
time. More time means more chance to make more money for options. So there is always a
price for time. But this isn’t time value of money per se. We’ll see why later.

Time must of course come together with volatility. Why is that so? You only want time because
it allows your stock to move. If the stock is not volatile, then no matter how much time you give
it, nothing would happen. It would not change so no point having a time. So time and volatility
come together. So if the stock is volatile, you want more time so that there is a chance that the
stock price would move, so thus you’d pay for these 2 things.

Pricing bounds:
What’s the lowest that a call can be priced at, and the highest the call can be priced at.

The highest that the call can be priced at would be the stock price or the underlying asset price.
It would not make sense for a call option to cost more than the underlying asset because that’s
just silly because you might as well buy the underlying asset. So the point of having options
allows you to be rich, allows you to get some multiple. So the maximum that a call option can be
priced at would be at the stock price. The highest price is S.

The lowest that the call can be priced at is? At maturity date, the call must be priced at higher
than its intrinsic value. At maturity date, the lowest that the call can be priced at takes on the
intrinsic value function which is (ST - X or 0) whichever is higher. The intrinsic value is the lowest
price of the call option at maturity day.

Let’s see why is this so? Why must the call be priced higher than the intrinsic value at maturity
date?

Let’s say for e.g that S= $105 and X = $100. The call price is $2. So today is the maturity day.
Of course this is not feasible and there is an arbitrage opportunity here simply because one can
simply buy this option today at $2, exercise the option immediately because today is maturity,
buy the underlying asset for $100 and sell it back to the market at $105, and make a $3 net
profit. This won’t last as long as there are people taking advantage of arbitrage. This will cause
the price of the option to increase until the point of equilibrium which will make it go to a
minimum of $5. So for this reason, we can see that the call can never be priced below the
intrinsic value of the option at maturity date.

That’s all you need to know for this course, the last two points are not examinable. (57.07)

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Prior to maturity day, then we present value the intrinsic value. So the pricing bounds become
the present value of S0 - PV(X), instead of S-X or 0. And then S becomes S0, the present value
of S. It’s just present value because it’s not maturity yet. Present value based on the interest
rate and the length of time left to maturity. But this is not important for the exam.

If we look at it on a diagram: this is what it looks like

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This is the only graph that you have that is before maturity. All other payoff diagrams seen so far
are all at maturity date. So what we know is that at maturity date, the payoff diagram for the call
takes the diagram shown before with the horizontal line till X and then a 45 degree line upward
(the black line above). And that forms the intrinsic value, which is the maximum (ST - X, 0). S-X,
that’s the intrinsic value.

But then prior to maturity date, the value of the option is actually the pink curve. Why is there
this difference? The difference between the pink cure and the black line is time value, simply
because now it’s before maturity date. So you pay for time. So the total value of the option is
made up of intrinsic value + time value.

Then you have the light grey line which is S0 - PV(X), which is what was the function we saw
earlier, the lower bound of the call option before maturity date, S0 - PV(X), or 0 whichever is
higher. The pink curve would never touch the line because there would always be time.

This means of course that when you approach maturity date, the distance between the pink
curve and the black line should reduce because you pay less and less for time now that you
have less time.

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So 6 months to maturity, the distance is maybe this much. 3 months to maturity you see that the
distance would go lower but still it does not touch. Just gets very close. This basically illustrates
that you pay less for time.

What are the 5 determinants of option prices?

The + and - shows us the relationship between the prices of these options and a higher factor.

For e.g when stock price increases, the call price or value would increase. Why? Because the
intrinsic value of a call option is max(S-X,0). So if S is higher, S-X is higher, then the call value
is higher. So higher stock price means high call value.

For put options, the intrinsic value of a put option is max(X-S,0). So if S is higher, then X-S is
lower, so the put value is lower.

2. Exercise price: works the same way

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The intrinsic value of a call option is max(S-X,0), so if X is higher, then S-X is lower and the call
value is lower.

For put options, the intrinsic value of a put option is max(X-S,0), if X is higher then X-S is higher,
so the put value is higher.

4&5. Volatility and expiration date

We know that time is always worth money, pay more for time. Time must always come with
volatility. So you pay more for volatility also. Volatile underlying assets allow the price of the
assets to move in your favor. You want volatility and time.

Why is that true for options? Option diagrams show that these are asymmetric payoffs. The
lowest payoff you can make is zero and the highest is some positive number and in the case of
calls it’s infinity. So there’s only upside when you have an option. You won’t make a negative
payoff in this case. So you don’t really worry about the stock moving against you. So more
volatility and more time is always a positive thing. You want the stock to move, because it
means there is greater chance that it would move in your favor. If it moves against you, the
worst thing that happens is that you get a 0 payoff.

3. Interest rates:
Imagine interest rates are very high. The call costs $2, the underlying asset $100. If you want
the asset, you could spend $100 to buy it. But then there is a call available so you only spend
$2. So now you save $98, and can invest this in the high interest rate environment and earn
some interest from that. So this is an additional benefit because of this call option and this would
be factored into the call. The call writer would understand that because he made the call option
available, the call holder has the opportunity to invest at high interest rate, so the call writer
would be able to charge higher for the option.

The call option allows you to delay the expenditure, you only have to pay for the option rather
than the total cost of the asset. Hence this delay helps you benefit in a high interest rate
environment. Hence high interest rate means call option is worth more.

The put option is the delay of the sale of an asset. So put holder delays the selling of the assets
today and hence foregoes the opportunity to invest the returns in securities that give high
interest. Put option forces the holder to wait until maturity date to exercise and sell the asset.
This is hence the opportunity cost of not being able to get the cash proceeds. Hence, it causes
the put option to be worth less.

Example:

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Today is Nov, 03. Trying to find the price of an option that matures in Apr,04. Stock price today
is $60. Want to buy an option that allows you to buy the stock at $65 that matures in Apr, 04. So
you know you’re going to pay $1.95 (premium of the option).

Two things about these pricing tables:

1. Time is always worth more money. So if you are given more time, compare apr,04 to
Jul,04, the July options must cost more than the april options since there is more time.
The $55 exercise price stocks is costlier in July than in April etc.
2. Within the same maturity date, options with higher exercise prices must cost less
because these are call options. The higher the X, lower call value.

What is the time value of the option bought at $1.95?

What’s the intrinsic value of this option? 0 because it’s an out of the money option, because if
today is the exercise date, the exercise price is $65, but the stock is priced at $60 in the market,
so you’d actually not exercise the option. So the payoff is 0. So the intrinsic value of this option
is 0.

But the total value of the option is intrinsic value + Time value. So time value=$1.95. So you’re
paying $1.95 because you have 5 more months to maturity.

What about the option at $60 exercise price? The time value is $3.85 because this is an at the
money option. S=X. So the intrinsic value is still 0. S-X.

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The time value of the option with a $55 exercise price = $6.70 - $5 (intrinsic value) = $1.70. This
is an in the money option.

What we notice is that all these 3 options have the same maturity. So there is actually the same
amount of time but all 3 have different time values. Hence we can conclude that this time value
is not simply time value of money because if not they should all be the same.

You can only calculate the time value by taking the price - intrinsic value.

Time value is the difference between the price of the call and the intrinsic value.

As shown, the vertical distance is always different depending on what your exercise price is. So
if X=S, then the time value is actually the highest. (3.85 is the highest.).

For out of the money options, the intrinsic value is 0, so all you pay for is time. (1.95).

If you’re in the money, then you have some vertical distance from the intrinsic value, so you pay
for both time value and intrinsic value.

Spot arbitrage opportunities if these don’t hold, so if there is an option that matures later but is
priced less then there is something wrong.

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We need a formula to help us price call option for exams. We use simplified black scholes
formula. C = S0 - PV(X).
PV (X) = X / (1+r)t

Price of the call would be derived by assuming that the put is worth 0:
S + P = C + PV(X)

For the put option, it’d be: P = PV(X) - S

P = C + PV(X) - S

Pricing an option:
1. Think about what the payoff is at maturity date.
2. Create portfolio that gives us the same payoff
3. Price the portfolio.

Examinable:
1. Terminologies
2. 4 Diagrams
3. Pricing bounds for call options
a. Lower bound at maturity: Intrinsic value MAX(ST-X,0)
b. Upper bound: Stock price at maturity, ST
4. 5 determinants of option value

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