Corporate

Finance
Global edition
.
 1) The corporation

a) The 4 types of firms

A1) Sole proprietorships

- Businness owned and run by 1 person.

- Very small
- With few, if any, employees
- Straightforward to set up
- NO separation between the firm and the owner = 1 ownership
- The owner has unlimited personal liability for any of the firm’s debts
- Life of this is limited to the life of the owner.

A2) Partnerships

- Like sole proprietorships but it has more than 1 owner

- All partners are liable for the firm’s debts => the lender can require any partner to
repay all the firm’s outstanding debts.
- Ends on the death or withdrawal of any single partner
A2 bis) Limited partnerships

- 2 kinds of owners => general partner = the same rights and privileges as partners
in a (general) partnership so they are personally liable for the firm’s debt
obligations. Limited partners = their liability is limited to their investment.
- Death or withdrawal of a limited partner doesn’t dissolve the partnership and a
limited partner’s interest is transferable.
- !!!! llimited partner has no management authority and cannot legally be involved
in the managerial decision making for the business.

A3) Limited liability companies

- Limited partnership without a general partner

- All the owners have limited liability
- Limited partners can also run the business

A4) Corporations

- Legally defined, artificial being, separate from its owners.

- Solely responsible for its own obligations
- The owners of a corporation are not liable for any obligations the corporation
enters into.
- The corporation is not liable for any personal obligations of its owners.
- No limit on the number of owners a corporation can have
- The entire ownership stake of a corporation is divided into shares known as stock.
- The collection of all the outstanding shares of a corporation is known as the
equity of the corporation
 - An owner of a share of stock is known as a shareholder, stockholder or equity
holder and is entitled to dividend payments.

b) Tax implications for corporate entities

The corporation’s profits are subject to taxation separate from its owner’s tax
obligations. Indeed, shareholders of a corporation pay taxes twice. Once on its profits
and then on their own personal income so it’s a double taxation. There is an excemption
to this double taxation , this is the S-corporation. In this case, the firm’s profits are not
subject to corporate taxes and after the distribution to the shareholders their income is
subject to taxation.

c) The stock market

The value of the shareholders’ investment is determined by the price of a share of the
corporation’s stock. Given that private companies have a limited set of shareholders
and their shares are not regularly traded than the value of their shares can be difficult to
determine. Fortunatly, many corporations are public companies, whose shares trade on
the stock market (stock exchange).

2) Financial statement analysis

a) The balance sheet (IFRS : statement of financial position)

List the firm’s assets and liabilities => the assets are on the left side and the liabilities on
the right.
Stockholders’ equity = the difference between the firm’s assets and liabilities =
accounting measure of the firm’s net worth.

The balance sheet identity => Assets = liabilities + stockholders’s Equity

In the long-term assets, the company will reduce each year the value recorded for this
equipment by deducting a depreciation expense.
The book value of an asset = its acquisition cost – accumulated depreciation.

The difference between current assets and current liabilities is the firm’s net working
capital. = the capital available in the short-term to run the business.

The stockholder’s equity = the book value of equity.

!!!!!! Market value VS book value!!!!

Often the market value of the assets is far higher than the book value so the book value
of equity will often differ from the amount investors are willing to pay for the equity.

Total market value of a firm’s equity = shares outstanding x Market price per share.

The market to book ratio (price to book ratio) = Market value of equity / book value
of equity.
Meaning : often the market to book ration > 1 for the most successful firm, indicating
that the value of the firm’s assets when put to use exceeds their historical cost.

Analysts often classify firms with low market-to-book ratios as value stocks and those
with high market-to-book ratios as growth stocks

Thus a firm’s market capitalization measures the market value of the firm’s equity or
the value that remains after the firm has paid its debts. Besides the enterprise of a firm
(total enterprise value TEV) asseses the value of the underlying business assets,
unemcumbered by debt and separate from any cash and marketable securities.
TEV = Market value of equity + debt – cash

b) The income statement (statement of financial performance)

It lists the firm’s revenues and expenses over a period of time. Besides the last or
“bottom” line of the income statement shows the firm’s net income, which is a measure
of its profitability during the period. Sometimes the firm’s net income is reffered to the
firm’s earnings.

Components

The income statement shows the flow of revenues and expenses generated by the assets
and liabilities between 2 dates.
1) Gross profit : the revenue from sales of products and the costs incurred to make
and sell the products = Difference between sales revenues and the costs.
2) Operating expenses : Expenses from ordinary course of running the business that
are not directly related to producing the goods or services being sold. They
 include administrative expenses and overhead, salaries, marketing costs and
R&D expenses. About th depreciation and amortization, it represents an estimate
of the costs that arise from wear and tear or obsolescence of the firm’s assets.
Thus, operating income = the firm’s gross profit net of operating expenses.
3) Earnings before interest and taxes (EBIT) : After we included other sources of
income or expenses that arise from activities that are not central part of a
company’s business. E.g : Income from the firm’s financial investments. Than we
get the EBIT.
4) Pretax an net income : From EBIT we deduct the interest expense related to
outstanding debt to compute the frim’s pretax income and then we deduct the
corporate taxes to determine the firm’s net income.
Net income represents the total earnings of the firm’s equity holder => often
reported on a per share basis as the firm’s earnings per share (eps) = Net income /
shares outstanding

c) The statement of cash flows

It indicates the amount of of cash the firm has generated. In the income statement, there
are no indication of the amount of cash because there is non cash entries (amortization
and depreciation) and there is no report of the purchase of building or expenditures on
inventory but the cash flow statement uses the informations from the income statement
and the blance sheet to determine how much cash the firm has generated and how that
cash has been allocated.
Components

A) Operating Activity

The first section adjusts net income by all non-cash items related to operating activity. In
this section, we add back any other non-cash expenses (deferred taxes or expenses
related to stock-based compensation) + depreciation. Then we adjusts for changes to net
working capital that arise from changes to accounts receivable (-), payable(+), or
inventory.(-)

B) Investment activity

This is the cash required for the investment activities. Purchases of new property, plant
and equipment are referred to as capital expenditures.
C) Financing activities

That shows the cash flow from financing activities. E.g : Dividends. Retained earnings =
Net income – Dividends.
Another point is any cash the company received from the sale of its own stock, or cash
spent buying (repurchasing) its own stock.

!!!!! A negative operating cash flows and relatively high expenditures on investment
activities might give investors some reasons for concern.
 D) Other financial statement information

1) Statement of stockholders’ Equity

Financial managers use the statement of stockholders’ equity infrequency.

It breaks down the stockholders’ equity computed on the balance sheet into the amount
that came from issuing shares (par value + paid in capital) vs retained earnings.

Change in stockholders’ Equity = retained earning +net sales of stock = Net income
– Dividends + sales of stck – repurchases of stock.
2) Management discussion and analysis

It’s a preface to the financial statements in which the company’s management discusses
the recent year, providing a background on the company and any significant events that
may have occurred.

E) Financial statement analysis

Investors often use accounting statements to evaluate a firm in 1 or 2 ways :

1) Compare the firm with itself by analyzing how the firm has changed over time.
2) Compare the firm to other similar firms using a common set of financial ratios.

We will use different ratios : profitability, liquidity, working capital, interest coverage,
leverage, valuation and operating returns ratio.

1) Profitability ratios

The income statement provides very usefuls information regarding the profitability.
a) Gross Margin = Gross profit / sales
A firm’s gross margin reflects its ability to sell a product for more than the cost of
producing it.
b) Operating margin = Operating income / sales
The operating margin reveals how much a company earns before interest and taxes
from each dollar of sales.
c) EBIT margin = EBIT/sales

By comparing operating or EBIT margins across firms within an industry, we can assess
the relative efficiency of the firm’s operations.

d) Net profit margin = Net income/ sales

The net profit margin shows the fraction of each dollar in revenues that is available to
equity holders after the firm pays interest and taxes.

2) Liquidity ratios

We often use the information in the firm’s balance sheet to assess its financial solvency
or liquidity.

a) Current ratio = Current assess / current liabilities

This ratio is useful to assess whether the firm has sufficient working capital to meet its
short-term needs.

A more stringent test of the firm’s liquidity is the quick ratio, which compare only cash
and “near cash” assets, such as short term investments and accounts receivable, to
current liabilities. = (cash +accounts receivable ) / total liabilities

A higher current or quick ratio implies less risk of the firm experiencing a cash shortfall
in the near future.

b) Cash ratio = cash / current liabilities

Gauging their cash position by calculating the cash ratio because firms need cash to pay
employees and meet other obligations.

3) Working capital ratios

WE can use the combined information in the firm’s income statement and balance sheet
to gauge how efficiently the firm is utilizing its net working capital. To evaluate the
speed at which a company turns sales into cash, firms often compute the number of
accounts receivable days.

a) Accounts receivable days = Accounts receivable / average daily sales

= Number of days to collect paymentfrom its customers.

b) Accounts payable Days = Accounts payable / average daily cost of sales

It reflects the total amount paid to suppliers and inventory sold (daily cost of sales).
c) Inventory days

d) Inventory turnover = Annual cost of sales / inventory

It’s an alternative way to measure working capital. The firm’s sold X times its current
stock of inventory during the year.
e) Accounts receivable turnover = (annual sales / accounts receivable)
f) Accounts payable turnover = annual cost of sales / accounts payable)

Note : Higher turnover = shorter days, and thus a more efficient use of working capital.

4) Interest coverage ratios

Lenders often assess a firm’s ability to meet its interest obligations by comparing its
earnings with its interest expenses usig an interest coverage ratio. Thze most common
ratio is the firm’s EBIT as a multiple of its interest expenses. A high ratio means that
the firm is earning much more than is necessary to meet its required interest
payments. As a benchmark, creditors often look for an EBIT/ interest coverage ratio 5
x for high quality borrowers. When it falls below 1.5, lenders may begin to question a
company’s ability to repay its debts. As amortization and depreciation are not cash
expenses for the firm. Therefore, we compute the EBITDA, as a measure of the cash a
firm generates from its operation and has available to make interest payments.

5) Leverage ratios

We collect the information from the balance sheet, or the extent to which it relies on
debt as a source of financing. Debt-equity ratio has an important consequence fro the
risk and return of its stock.

Debt-to-capital ratio = the fraction of the firm financed by debt . Moreover, the cash
reserve to reduce risk is the frim’s net debt, or debt in excess of its cash reserves. Finally,
with the debt-to enterprise value ratio, we can determine how much the frim’s business
activity is financed via debt.

The firm’s equity multiplier =

a) in book value term => Showing tha amplification of the firm’s accounting returns
that resut from leverage.
b) in market value term=> Showing the amplification if shareholers’ financial rish that
result from leverage.

6) Valuation ratios

The first ratio to gauge the market value of a firm is the frim’s price-earnings ratio (P/E)
= the ratio of the value of equity to the firm’s earnings, either on total basis or on per-
share basis. So, it’s the number of times that investors are willing to pay the firm’s
earning to purchase a share. It’s simply used to know if a share is over- or under- valued
with the idea that a the value of a stock is proportional to the level of earnings it can
generate for ots shareholder.

7) Operating returns

Return on equity (ROE) : It provides a measure of the return that the firm has earned on
its past investments. A high ROE may indicate the firm is able to find investment
opportunities that are very profitable.

Return on assets : we include this time the interest expenses and it’s less sensitive to the
leverage than ROE. Nevertheless is sensitive to working capital.

Return on invested capital : it measures the after tax profit generated by the business
itself, excluding any interest expenses, and compare it to the capital raised from equity
and debts holders that has already been deployed. => It is the most useful in assessing
the performance of the underlying business.

The Dupont Identity

It expresses the ROE in terms of the firm’s profitability, asset efficiency, and leverage.
ROE = ( Net income / sales) * (Sales / total assets) * (Total assets / book value of equity)
Net profit margin Asset turnover equity multiplier
The first term measures its overall profitability, the second term measures how efficiently the
firm is utilizing its assets to generate sales, together, these terms determine the firm’s return on
assets. The greater the firm’s reliance on debt financing, the higher the equity multiplier will be.
 3) Financial decision making and the Law of one price

3.1 Valuing decisions

A financial manager have to take some decisions behalf of the firm’s investors in order to
increase the value of the firm to its investors . For good decisions, the benefits exceed
the costs. To determine it the first step is to analyze costs and benefits ( 1° identify the
costs and benefits; 2°quantify the costs and benefits; 3°compare them), the second step
is to use Market prices to determine the cash values, this step determines a general
priniciple : whenever a good trades in a competitive market ( we mean a market in
which it can be bought and sold at the same price) that price determines the cash
value of the good. (competitive market => not depend on the views or preferences) =>
this principle is called Valuation principle.

3.2 Interest rates and the Time value of Money

For most financial decisions, costs and benefits occur at different points in time.
A) The time value of money

Example : investment opportunity :

- Cost : $ 100.000 today
- Benefit : $ 105.000 in one year

We cannot compare the project’s net value 105.000 – 100000 = 5000$ because this
calculation ignores the timing of the costs and benefits, and it treats money today as
equivalent to money in one year. In general , a dollar today is worth more than a dollar
in one year. The difference in value between money today and money in the future is
called the time value of money.

B) The interest rate : An exchange rate across time

The rate at which we can exchange money today for money in the future is determined
by the current interet rate. The interest rate allows us to convert money from one point
in time to another. It tells us the market price today of money in the future.

For instance, the current annual interest rate is 7 %. By investing or borrowing at this
rate, we can exchange $ 1.07 in one year for each $ 1today. We define the risk free
interest rate rf, for a given period as the interest rate at which money can be borrowed
or lent without risk over that period. So, we can exchange ( 1 + rf) $ in the future per $
today, and vice versa, without risk. (1+rf)= the interest rate factor for risk. !!!! the risk
free interest rate depends on the supply and demand.

Value of investment in One year : Cost today * (1+rf) in one year = cost in one year
Value of investment today : cost (benefit) in one year * (1/1+rf) today = cost (benefit)
today
Presnet versus future values : When we express the value in terms of dollars today , we
call it the present value (PV) of the investment and If we express it in terms of dollars in
the future, we call it the future value (FV) of the investment.
3.3 Present value and the NPV decision rule

As long as we convert costs and benefits to the same point in time, we can compare them
to make a decision but in practice, most corporations prefer to measure values in terms
of their present value.

Net present value

We define the net net present value of a project or investment as the difference between
the present value of its benefits and the present value of its costs : NPV = PV (benefits)
– PV (costs) => benefits = positive cash flow (+) / costs = negative cash flow (-). Thus,
the NPV is the total of the present values of all projects cash flows. Actually, the present
value is the cash cost today of “doing it yourself” – is the amount you need to invest at
the current interest rate to recreate the cash flow.

The NPV decision rule

Afterwards we get all the costs and benefits of the project, decisions with a positive NPV
will increase the wealth of the firm and its investors.

The NPV decision rule = when making an investment decision, take the alternative
with the highest NPV. Choosing this alternative is equivalent to receiving its NPV
in cash today.

NPV > 0 = accepting the project

NPV =0 or NPV < 0 = rejecting the project (reduce the wealtg of investors, whereas not
doing them has no cost)

3.4 Arbitrage and the law of one price

The practice of buying and selling equivalent goods in different markets to take
advantage of a price difference is known as arbitrage. More generally , we refer to ant
situation in which it is possible to make a profit without taking any risk or making any
investment as arbitrage opportunity.Because an arbitrage opportunity has a
positive NPV, whenever an arbitrage opportunity appears in financial markets,
investors willrace to take advantage of it.
We call a competitive market in which there are no arbitrage opportunities a normal
market.

Law of one price

If equivalent investment opportunities trade simultaneously in different competitive

markets, then they must trade for the same price in all markets.

3.5 No arbitrage and security prices

An investment opportunity that trades in a financial market is known as a financial

security.

Valuing a security with the law of one price

We can use the law of one price to value a security if we can find another equivalent
investment whose price is already known. One type of security is the bond = a security
sold by governments and corporations to raise money from investors today in
exchange for promised future payment.

1) Indentifying arbitrage opportunities with securities

Recall that the law of one price is based on the possibility of arbitrage : If the bond had a
different price, there would be an arbitrage opportunity.
2) Determining the no-arbitrage price.
3) Determining the interest rate from bond prices

The NPV of trading securities and firm decision making

Thus, we have established that positive NPV decisions increase the wealth of the firm
and its investors. If you buy a security as an investment decision, the cost of the decision
is the price we pay for the security, and the benefit is the cash flows that we will receive
from owning the security. If the security trade at no-arbitrage prices, the cost and
benefits will be equal in a normal market and so the NPV of buying a security is zero.

NPV (buy security) = PV (all cash flows paid by the security) – Price (security) = 0
If we sell a security :

NPV (sell security) = Price (security) – PV (all cash flows paid by the security) = 0

For understanding !!!!!

Every trade has both a buyer and a seller. In a competitive market , if a trade offers a
NPV>0 to one party, it must give a NPV<0 to the other party. But then one of the two
parties would not agree to the trade. Because all trades are voluntary, they must occur at
prices at which neither party is losing value, and therefore for which the trade is NPV =
0.
Separation principle
Security transactions in a normal market neither create nor destroy value on their own.
Therefore, we can evaluate the NPV of an investment decision separately from the decision
the firm makes regarding how to finance the investment or any other security transactions
the firm is considering.

Valuing a portfolio

Value additivity

Suppose a security C additional to security A & B , the C is equivalent to the portfolio of A

& B, by the law of One Price, they must have the same price. This idea leads to the
relationship known as value additivity; that is, the price of C must equal the price of the
portfolio => price of combined price of A and B :

Price (C) = Price (A+B) = Price (A) + Price (B) => The security C has cash flows equal
to the sum of A and B. Otherwise, an obvious arbitrage opportunity would exist.

TO maximize the value of the entire firm, managers should make decisions that
maximize NPV. The NPV of the decision represents its contribution to the overall value of
the firm.

The price of Risk

Risky versus Risk-free cash flows

a) Risk aversion and the risk premium

Investors pay less to receive 1100$ on average than to receive 1100$ with certainty
because they don’t like risk. The personal cost of losing a dollar in bad times is greater
than the benefit of an extra dollar in good times.
The notion that investors prefer to have a safe income rather than a risky one of the
same average amount is called risk aversion.

We cannot us the risk-free interest rate to compute the present value of a risky future
cash flow. When investing in a risky project, investors will expect a return that
appropriately compensates them for the risk.

When we compute the return of a security based on the payoff we expect to receive on
average => expected return

Expected return of a risky investment = Expected gain at end of year / initial cost
Example : investors who buy the market index for its current price of 1000$ receive
1100$ on average at the end of the year, which is an average gain of 100$ or a 10%
return in their initial investment.
The actual return will be higher or lower. If the conomy is strong, the market index will
rise to 1400, which represents a return of
 Strong = (1400-1000)/1000 =40%
If the econmy is weak, the index will drop to 800, for a return of
 Weak = (800-1000)/1000=-20%
We can also calculate the 10% expected return by computing the average of these
actual returns : ½(40%) + ½(-20%) =10%
Investors in the market index earn an expected return of 10% rather than the risk free
interest rate of 4% on their investment. The difference of 6% between these returns is
called the market index’s risk premium.

When a cash flow is risky, to compute its present value we must discount the cash flow we
expect on average at a rate that equals the risk free interest rate plus an appropriate
risk premium.

The No-arbitrage price of a risky security

The risk premium of the market is determined by investors’ preferences toward risk.
We can use the risk premium of the market index to value other risky securities. We can
use the Law of One price to compute present values by constructing a portfolio that
produces cash flows with identical risk.

Risk premiums depend on risk

The risk of a security must be evaluated in relation to the fluctuations of other investments
in the economy. A security’s risk premium will be higher the more its returns tend to vary
with the overall economy and the market index. If the security’s returns vary in the
opposite direction of the market index, it offers insurance and will have a negative risk
premium.

Risk, Return, and market prices

The discount rate (rs) = rf + (risk premium for investment s)

The risk premium of an investment depends on how its returns vary with the overall
economy.

Arbitrage with transactions costs

In most markets, you must pay transactions costs to trade securities.

You must pay 2 types of transactions costs :
1) you must pay your broker a commission on the trade.
2) Because you ‘ll probably pay a slightly higher price when you buy a security (the ask
price) than you receive when you sell (the bid price) => you’ll also pay the bid-ask
spread.
The price of a security should equal the present value of its cash flows, up to the
transactions costs of trading the security and the cash flows.
When there are transactions costs, arbitrage keeps prices of equivalent goods and
securities close to each other. Prices can deviate, but not by more than the transactions
costs of the arbitrage.
 4) Reminder : THE time value of money

A) The timeline

The stream of cashflows = It’s a series of cash flows lasting several periods.
The timeline is a linear representation of the timing of the expected cash flows.

E.G : we assume that a friend owes you money => hes has agreed to repay the loan by
making 2 payments of 10,000$ at the end of each 2 years.

B) The rules of the time travel

Rule 1 : Comparing and combining values

It’s only possible to compare or combine values at the same point in time. So any
cash flows in the same units can be compared or combined.

Rule 2 : Moving Cash flows forward in time

That stipulates that to move a cash flow forward in time, you must compound it.
Compound => process of moving a value or cash flow forward in time.
The difference in value between money today and money in the future represents the
time value of money and that reflects the fact that by having money sooner, you can
invest it and have more money later as result.

The effect of earning “ interest on interest” is known as compound interest.

Thus, to take a cash flow C forward n periods into the future, we must compound it by
the n intervening interest rate factors. Ift the interest rate r is constant, then

FVn = C x (1+r) x(1+r)x…….x(1+r) = C x (1+r)n

Rule 3 : Moving cash flows back in time

That stipulates that to move a cash flow back in time, we must discount it.

Dicounting = Process of moving a value or cash flow backward in time (finding the
equivalent value today of a future cash flow).

To move a cash flow C backward n periodes, we must discount it by the n intervening

interest rate factors. If the interest rate r is contant, then

PV = C/ (1+r)n
 C) Valuing a stream of cash flows

The present value of a cash flow stream : N

PV = C0 + (C1/ (1+r)) + ( C2/(1+r)) +………+ Cn / (1+r) = ∑ (Cn / (1+r)n)
n

n=0
The present value is the amount you need to invest today to generate the cash flow
stream C0, C1,…., CN. That is, receiving those cash flows is equivalent to having their
present value in the bank today.

Future value of a cash flow stream with a present value of PV :

FVn = PV x (1+r)n

D) Calculating the Net Present Value

We have already seen that the NPV = PV(benefits) – PV(costs)

In this context the benefits are the cash inflows and the costs are the cash outflows.
So NPV = PV (benefits – costs)
E) Pertpetuities and Annuities

We consider 2 types of cash flow streams, perpetuities and annuities, and we learn
shortcuts for valuing them.
Perpetuities

A perpetuity is a stream of equal cash flows that occur at regular intervals and last
forever.

The present value of a perpetuity with payment C and interest rate r is given by

Cn= C because the cash flows for a perpetuity is constant.

Annuities

An annuity is a stream of N equal cash flows paid at regular intervals. The difference
between an annuity and a perpetuity is that an annuity ends after some fixed number of
payments.

The present value of an N-period annuity with payment C and interest rate r is
Future value of an annuity

Growing Cash flows

In this case, we have the cash flows that are expected to growth at a contant rate in each
period.

Growing perpetuity = This is a stream of cash flows that occur at regular intervals and
grow at a constant rate forever.

Example : a growing perpetuity with a first payment of 100$ that grows at a rate of 3%.

Convention : The 1st payment doesn’t include growth.

Present value

If we suppose g>= r. Then the cash flows grow even faster than they are discounted; each
term in the sum gets larger, rather than smaller. In this case, the sum is infinite! => It’s
impossible so we assume that g< r for a growing perpetuity.

Growing annuity = It’s a stream of N growing cash flows, paid at regular intervals. It’s a
growing perpetuity that eventually comes to an end.
Because the annuity has only a finite number of terms, so g> r works this time.

F) Non-annual cash flows

We have this time another interval: we’ll work monthly. For this, we need that
1) The interest rate is specified as a monthly rate
2) The number of periods is expressed in months

G) Solving for the cash payments

Sometimes we know the present value or future value, but don’t know the cash flows.
We simply use the PV formula.

H) The internal rate of return

The internal rate of return (IRR), defined as the interest rate that sets the present value
of the cash flows equal to zero.
 5) Interest rates

5.1 Interest rate quotes and adjustments

The effective annual rate

Interest rates are often stated as an effective annual rate (EAR), which indicates the
actual amount of interest that will be earned at the end of the year. So far, we used the
EAR as the discount rate r in our time value of money calculation. (e.g. an EAR of 5 %, a $
100,000 investment grows to $ 100,000 * (1+r) = 100,000*(1.05) = 105,000$ in one year.

Adjusting the discount rate to different time periods

In general, by raising the interest rate factor (1+r) to the appropriate power, we can
compute an equivalent interest interest rate for a longer time period.

We can use the same method to find the quivalent interest rate for periods shorter than
one year. In this case, we raise the interest rete factor (1+r) to the appropriate fractional
power. For example : earnings 5 % interest in 1 year is like receiving ( 1+r) 1/2 = (1.05)1/2
= $1.0247 for each $ 1 invested every half year, or equivalently, every 6 months.

General equation for discount rate period conversion

Equivalent n-period discount rate = (1+r)n – 1

In this formula, n can be larger than 1 ( a rate over more than one period) or smaller than
1 (rate over a fraction of period).

Annual percentage rates

Banks quote interest rates in terms of an annual percentage rate (APR), which indicates
the amount of simple interest earned in one year, that is, the amount of interest earned
without the effect of compounding. Thus , the APR is less than the actual amount of
interest that you will earn.

The APR does not reflect the true amount yu will earn over one year, we cannot use the
APR itself as a discount rate. Instead, the APR with k compounding periods is a way of
quoting the actual interest earned each compounding period :

Interest rate per compounding period = APR / (k period/ year)

Now, the effective annual rate corresponding to an APR with k compounding periods per
year is given by the following conversion formula :
Converting an APR to an EAR : 1+ EAR = (1+ APR/k)k

Discount rates and loans

Computing loan payments : We equate the outstanding loan balance with the present
value of the loan payment using the discount rate from the quoted interest rate of the loan
, and then solve for the loan payment.

Many loans, like car mortgages and car loans, are amortizing loans, which means that
each mont you pay interest on the loan plus some part of the loan balance. Usually, each
monthly payment is the same, and the loan is fully repaid with the final payment.

Example :

The determinants of Interest rates

Some factors may influence interest rates, such as inflation, government policy, and
expections of future growth.
Inflation and real versus nominal rates

The nominal interest rates indicate the rate at which your money will grow if invested
for a certain period but if prices in the economy are also growing due to inflation, the
nominal interest rate does not represent the increase in purchasing power that will
result from investing.
The real interest rate denote by rr. If r is the nominal interest rate and i is the rate of
Inflation, we can calculate the rate of growth of purchasing power as follows :
Growth in purchasing power = 1 +rr = 1+r / 1+i = Growth of money / growth of
prices

The real interest rate : rr = r-i / 1+i = r-i

When the inflation rate is high, a higher nominal interest rate is generally needed to
induce individuals to save.

Investment and interest rate policy

Interest rates also affect firms’ incentive to raise capital and invest.
More generally, when the costs of an investment precede the benefits, an increase in the
interest rate will decrease the investment’s NPV. All else equal, higher interest rates will
therefore tend to shrink the set of positive NPV investment available to firms.

The federal Reserve in the US and central banks in other countries use this relationship
between interest rates and investment to try to guide the economy. They can raise
interest rates to reduce investment if the economy is “overheating” and inflation is on
the rise, and they can lower interest rates to stimulate investment if the economy is
slowing or in recession.

The Yield curve and discount rates

The relationship between the investment term and the interest rate is called the term
structure of the interest rates. We can plot this relationship on a graph called the yield
curve.
Warning : all our shortcuts for computing present values (annuity and perpetuity
formulas,…) are based on discounting all of the cash flows at the same rate. They cannot
be used in situations in which cash flows need to be discounted at different rates.

The yield curve and the Economy

Interest rate determination

The Federal Reserve determines very short term interest rates throught its influence on
the federal funds rate, which is the rate at which banks can borrow cash reserves on an
overnight basis. All other interest rates on the yield curve are set in the market and are
adjusted until the supply of lending matches the demand for borrowing at each loan term.
So the major effect of the future interest rates is the investor’s willingness to lend or
borrow for longer terms ( the shape of the yield curve).

Interest rate expectations

The shape of the yield curve will be strongly influenced by interest rate expectations. A
sharply increasing yield curve, with long term rates much higher than short term rates,
generally indicates that interest rates are expected to rise in the future.

Risk and taxes

1) Risk and interest rates

When we refer to the “ risk-free interest rate”, the rate on US treasuries. All other
borrowers have some risks of default. For these loans, the stated interest rate is the
maximum amount that investors will receive. Investors may receive less if the company has
financial difficulties and is unable to fully repay the loan. Thus, to compensate for the risk
that they will receive less if the firm defaults, ivestors demand a higher interest rate than
the rate on US. Treasuries.
When discounting future cash flows, it’s important to use a discount rate that matches
both the horizon and the risk of the cash flows. The right discount rate for a cash flow is
the rate of return available in the market on other investments of comparable risk and term.

2) After-tax interest rates

If the cash flows from an investment are taxed, the investor’s actual cash flow will be
reduced by the amount of the tax payments.
Taxes reduce the amount of interest the investor can keep, and we refer to this reduced
amount as the after-tax interest rate.

In general, if the interest rate is r and the tax rate is t, then for cash 1$ invested you will
earn interest equal to r and owe tax of t *r on the interest. Therefore,

After-tax interest rate : r-(t*r) = r(1-t)

6) Investment decision rules

1) NPV and stand-alone projects

In the case of a stand-alone project, we must choose between accepting or rejecting the
project. So with the NPV rule, we compare the projects’s NPV > 0.

The NPV profile and IRR

The NPV of the project depends on the appropriate cost of capital. Often there may be
some uncertainty regarding the project’s cost of capital. In this case, it’s helpful to
compute an NPV profile : a graph of the project’s NPV over a range of discount rates.
In the case where NPV = -250 + 35/r

The NPV is + only for discount rates that are less than 14% and as we saw in the chapter
4 : The internal rate of return (IRR) of an investment is the discount rate that sets the NPV
of the project’s cash flows = 0. In our case the IRR = 14%
The IRR of a project provides useful info about the sensitivity of the project’s NPV to
errors in the estimate of its cost of capital.
In our case, if the cost of capital is > 14% , the NPV will be negative.
Alternative rules VS the NPV rule

Altough the NPV rule is the most accurate and reliable decision rule, in practice a wide
variety of tools are applied, aften in tandem with the NPV rule.

2) The internal rate of return rule

One interpretation of the internal rate of return is the average return earned by taking on
the investment opportunity. The IRR investment rule is based on this idea : if the average
return on the investment opportunity is greater than the return on other
alternatives in the market with equivalent risk and maturity (i.e. the project’s cost of
capital), you should undertake the investment opportunity.

IRR Investment rule : take any investment opportunity where the IRR exceeds the
opportunity cost of capital. Turn down any opportunity whose IRR is less than the
opportunity cost of capital.

The IRR rule is applied to single, stand-alone projects within the firm => it will give the
correct answer in many-but not all- situations. Actually, the IRR rule is only guaranteed to
work for a stand-alone project if all of the project’s negative cash flows precede its positive
cash flows. Let’s examine several cases in which the IRR fails.

Pitfall 1 : Delayed Investments

The 23.38% IRR is arger than 10 % opportunity cost of capital. So according to the IRR
rule, he should sign the deal but the NPV rule say : NPV = 1,000,000 – 500,000/1.1 –
500,000/1.1² - 500,000/1.1^3 = -243.426$
At a 10% discount rate, the NPV is negative, so signing the deal would reduce star’s wealth.
We can see on the figure 7.2 that the NPV rule is the opposite of what the IRR rule
recommends.
Pitfall 2 : Multiple IRRs

Star decided to sweeten the deal before he will accept it. The publisher offers him a royalty
payment when the book is published in exchange for taking a smaller upfront payment.
So, he will receive $1,000,000 when the book is published and sold four years from now,
together with an upfront payment of $550,000.

By setting the NPV = 0 and solving r, we find the IRR. In this case, there are 2 IRRs, because
there are more than one IRR , we cannot apply the IRR rule.

Pitfall 3 : nonexistent IRR

7.3 The payback rule

The payback investment rule is an alternative decision rule for single, stand-alone
projects, it states that you should only accept a project if its cash flows pay back its
initial investment within a prespecified period.

To use the pay back rule, we first calculate the amount of time it takes to pay back the
initial investment = payback period. Then we accept the project if the payback period is
less than a prespecified length of time. Otherwise, you reject the project.

According to the payback rule analysis, Fredrick’s will reject the project. However, as we
saw earlier, with a cost of capital fo 10%, the NPV is $ 100,000,000. So, following the
payback rule would be a mistake.

Payback rule Pitfalls in Practice

The payback rule is not as reliable as the NPV rule because it ignores the project’s cost
of capital and the time value of money, ignores cash flows after the payback period,
and relies on ad hoc decision criterion (what is the right number of years to require for
the payback period?).
If the required payback period is short ( 1 or 2 years), then most projects that satisfy the
payback rule will have a positive NPV.

7.4 Choosing between projects

NPV rule and mutually exclusive investments

When projects are mutually exclusive, we need to determine which projects have a
positive NPV and then rank the projects to identify the best one. In this situation, we have
to pick the project with the highest NPV

IRR RULE and mutually exclusive investment

Because the IRR is a measure of the expected return of investing in the project, you might
be tempted to extend the IRR investment rule to the case of mutually exclusive projects
by picking the project with the highest IRR. But, picking one project over another simply
because it has a larger IRR can lead to mistakes. Actually, when projects differ in their
scale of investment, the timing of their cash cash flows, or their riskiness, then their
IRRs cannot be meaningfully compared.
Differences in Scale

With a return , you cannot tell how much value will actually be created without knowing
the scale of the investment. If a project has a positive NPV , then if we can double its size,
its NPV will double. And so, doubling its cash flow must make it worth twice as much. The
IRR rule doesn’t have this property.=> It’s unaffected by the scale of the investment
opportunity because the IRR measures the average return of the investment. Thus, we
can’t use the IRR rule t compare projects of different scale.

Differences in timing

Even when projects have the same scale, th IRR may lead you to rank them incorrectly
due to differences in timing of the cash flows. The IRR is expressed as a return, but the
dollar value of earning a given return and therefore its NPV depends on how long the
return is earned. Earning a very high annual return is much more valuable if you earn it
for several years than if you earn it for only few days.

Differences in Risk

We must compare it to the project’s cost of capital to know if the IRR of a project is
attractive, which is determined by the project’s risk.
Thus, an IRR that is attractive for a safe project need not be attractive for a risky project.
!!!!! Ranking projects by their IRRs ignores risk differences!!!!

The incremental IRR

When choosing between 2 projects, an alternative to comparing their IRRs is to compute

the incremental IRR, which is the IRR of the increment cash flows that would result from
replacing 1 project with the other. It tells us the discount rate at which it becomes
profitable to switch from one project to the other. And so we can evaluate the decision to
swich from each other by the IRR rule.

Be careful because we face the same problems that arose with the IRR rule.

7.5 Project selection with resource constraint

Situations where the choice have differing resource needs.
Evaluating projects with different resource requirements
Managers work within a budget constraint that limits the amount of capital that may
invest in a given period. Thus, the manager’s goal is to maximize the total NPV and staying
whitin her/his budget.
Profitability index

This value tell us that for every dollar invested in Project 1, we will generate $ 1.10 in
value. This index shows the optimal combination of projects to undertake.

Shortcomings of the profitability index

2 Conditions must be satisfied :

1) The set of projects taken following the profitability index ranking completely
exhausts the available resource.
2) There is only a single relevant resource constraint.

7) Fundamentals of capital budgeting

7.1 Forecasting earnings

A capital budget lists the projects and investments that a company plans to undertake
during the coming year. To determine the list, firms analyse alternative projects and
decide which ones to accept through a process called capital budgeting.
Beginning by forecast earnings -> 1 ) determine the incremental earnings of a project (
the amount by which the firm’s earnings are expected to change as a result of the
investment decision). 2) Demonstrate how to use the incremental earnings to forecast the
cash flow of the project.

Revenue and cost estimates

1) Reviewing the revenue and cost estimates for the company

( all about expenditure, marketing,…)
Incremental earnings forecast
Given the revenue and cost estimates , we can forecast company’s incremental earnings.

Recall from chapter 2 that while investment in plant, property, and equipment are cash
expense, they are not directly listed as expenses when calculating earnings. Instead, the
firm deducts a fraction of the cost of these items each year as depreciation. The simplest
method to compute depreciation is straight-line depreciation, in which the asset’s cost
is divided equally over its estimated useful life.
We saw that to compute a firm’s net income, we must first deduct interest expenses from
EBIT. Finally, the final expense we must account for is corporate taxes. The corporate tax
rate to use is the firm’s marginal corporate tax rate, which is the tax rate it will pay on
an incremental dollar of pre-tax income.
The incremental income tax expense = EBIT x tc
Tc = tax rate
Unlevered net income = EBIT x (1-tc) = (Revenues- costs-depreciation) x (1-tc)

Indirect effects on incremental earnings

There are indirect effects which will also affect company’s earnings, we must include them
in our analysis.
The opportunity costs => the opportunity cost of using a resource is the value it could
have provided in its best alternative use. We should include the opportunity cost as an
incremental cost of the project => because this value is lost when the resource is used
by another project.

Project externalities => they are indirect effects of the project that may increase or
decrease the profits of other business activities of the firm.
Cannibalization => when sales of a new product displace sales of an existing product. If
this reduction in sales of the existing product is a consequence of the decision to develop
the other product, then we must include it when calculating company’s incremental
earning.

Sunk costs and incremental earnings

Sunk cost = any unrecoverable cost for which the firm is already liable. Important rule =
If our decision doesn’t affect the cash flow, then the cash flow should not affect our
decision. Thus if a cost is already expended then we cannot include it in the incremental
earning. Some sunk cost :
1) Fixed overhead expenses : associated with activities that are not directly
attributable to a single business activity but instead affect many different areas of
the corporation.
2) Past R&D expenditures
3) Unavoidable competitive effects : Aout cannibalization, if sales are likely to decline
in any case as a result of new products introduced by competitors, then these lost
sales are sunk cost and so we shouldn’t include them in our projection.
Real-World complexities

There are a lot of factors that could be considered when estimating a project’s revenues
and costs such the inflation and the fact that for most industries, competition tends to
reduce profit margins over time.
7.2 Determining free cash flow and NPV

The incremental effect of a project on the firm’s available cash, separate from any
financing decisions, is the project’s free cash flow.

Caluclating free cash flow from earning

There are differences between earnings and cash flow => earnings include non-cash
charges, such as depreciation, but don’t include the cost of capital investment => it’s a
method used for accounting and tax purposes to allocate the original purchase cost of the
asset over its life.
 In the cash flow => we include the actual cash cost of the asset when it’s purchased
=> we must add back the depreciation expense for the new equipment and substract
actual capital expenditures.
Net working capital (NWC) : the difference between current assets and current liabilities.
NWC = Current assets – current liabilities = cash + inventory+receivables- payables.

Most projects will require the firm to invest in net working capital. Firms mayneed to
maintain a minimum cash balance to meet unexpected expenditures, and inventories of
raw materials and finished product to accommodate production uncertainties and
demand fluctuations.
The firm’s receivables measure the total credit that the firm has extended to its customers.
The firm’s payables measure the credit the firm has received from its suppliers.
Tade credit : Receivables – payables.

Any increase in net working capital represent an investment that reduces the cash
available to the firm and so reduces free cash flow.

∆NWCt = NWCt – NWCt-1

Calculating free cash flow directly

The only effect of depreciation is to reduce the firm’s taxable income. Thus,

Tc * Depreciation = depreciation tax shield = The tax saving that results from the ability to
deduct depreciation.

Calculating the NPV

We must discount its free cash flow at the appropriate cost of capital.
The cost of capital is the expected return that investors could earn on their best
alternative investment with similar risk and maturity.
7.3 Choosing among alternatives

We can make the best decision by first computing the free cash flow associated with each
alternative and then choosing the alternative with the highest NPV.

Evaluating manufacturing alternatives

To choose between 2 alternatives, we compute the free cash associated with each choice
and compare their NPVs to see which is most advantageous for the firm. When comparing
alternatives, we need to compare only those cash flows that differ between them. We can
ignore any cash flows that are the same under either scenario.

7.4 Further adjustments to free cash flow

We consider a number of compliccations that can arise when estimating a project’s free
cash flow.
1) Other non-cash items : actual cash revenues or expenses included in project’s cash
flow.
2) Timing of ach flows : Cash flows will be spread throughout the year.
3) Accelerated depreciation : MACRS (modified accelerated cost recovery system), by
doing so, the firm will accelerat its tax savings and increase their present value.
 4) Liquidation or salvage value : Assets that are no longer needed often have a resale
value, or some salvage value if the parts are sold for scrap.
We include the liquidation value of any assaets that are no longer needed and may be
disposed of. When an asset is liquidated, any gain on sale is taxed.

Gain on sale = Sale price – book value

Book value = Purchase price – accumulated depreciation

We must adjust the project’s free cash flow to account for the after-tax cash flow that
would result from an asset sale :
After-tax cash flow from asset sale = sale price – (tc * gain on sale)
 5) Terminal or continuation value
For investment with an indefinite life, such an expansion of the firm, in this case, we
estimate the value of the remaining free cash flow beyond the forecast horizon by
including an additional, one time cash flow at the end of the forecast horizon called the
terminal or continuous value. = the market value of the free cash flow from the project
at all future dates.

6) Tax carryforwards

Tax loss carryforwards and carrybacks allow corporations to take losses during a current
year and offset them against gains in nearly years.
7.5 Analyzing the project

The most difficult part of capital budgeting is deciding how to estimate the cash flows and
cost of capital. Thus, we’ll look at methods that assets the importance of this uncertainty
and identify the drivers of value in the project.

Break-even analysis

We need to determine the break even level of the input to a capital budgeting decision,
which is the level for which the investmet has an NPV of zero. (we saw the IRR).
Remind: IRR of a project tells you the max error in the cost of capital before the optmal
investment decision would change.

In a break-even analysis, for each parameter, we calculate the value at which the NPV of
the project is zero.

Sensitivity Analysis

It breaks the NPV calculation into its component assumptions and show how the NPV
varies as the underlying assumptions change.
Thus, sensitivity analysis allows us to explore the effects of errors in our NPV estimates
for the projects.

To determine the importance of this uncertainty, we recalculate the NPV of the company’s
project under the best- and worst case assumptions for each parameter.

Scenario Analysis

Scenario analysis considers the effect on the NPV of changing multiple project parameters
(e.g.price changes)
The current strategy is optimal.

That shows the combinations of price and volume that lead to the same NPV of 5,000,000
as the current strategy. Only strategies with price and volume combinations above the
line will lead to a higher NPV.

8) Valuing stocks
8.1 The dividend-discount model

The law of One price implies that to value any security, we must determine the expected
cash flows an investor will receive from owning it. The first method to value a stock is the
dividend-discount model.

A ONE year investor

There are 2 sources of cash flows from owning a stock : 1) dividend to the shareholders
2) The investor might generate cash by choosing to sell the shares at some future date.

At the end of the year, the investor will sell her share at the new market price, P1.
Of course, the furture dividend payment and stock price in the timeline above are not known with
certainty; rather, these values are based on the investor’s expectations at the time the stock is
purchased. We must discount the PV based on the equity cost of capital, rE ( because it’s a risky),
for the stock, which is the expected return of other investments available in the market with
equivalent risk to the firm’s shares.
 1° condition :
Investors would be willing to buy the stock !

2° condition :
Investors would be willing to sell the stock.

For every buyer of the stock there must be a seller, both equations must hold :

!!!!! in a competitive market, buying or selling a share of stock must be a 0-NPV investment
opportunity.!!!!

Dividend Yields, Capital gains and total returns

Dividend yield = the percentage return the investor expects to earn from the dividend paid by the
stock.
Capital gain = the investor will earn on the stock, which is the difference between the expected
sale price and purchase price for the stock (p1-p0).
Capital gain rate = percentage return of capital gain.

The sum of the dividend yield and the capital gain rate = the total return of the stock
The expected total return of the stock should equal the expected return of other investments
available in the market with equivalent risk.
!!!! If the sotck offered a lower expected return, investors would sell the stock and drive down its
current price until (the formule) was again satisfied.

A Multiyear investor
This time, we planned to hold the stock for 2 years. Then, we would receive dividends in both year
1 and year 2 before selling the stock.

While a one year investor does not care about the dividend and stock price in year 2 directly, she
will care about them indirectly because they will affect the price for which she can sell the stock
at the end of year 1. Thus, the formula for the stock price for a two year investor is the same as the
one for a sequence of two one year investors.
The Dividend-Discount Model Equation
Model for any number of years by replacing the final stock price with the value that the next holder
of the stock would be willing to pay.

For any horizon N, all investors (with the same beliefs) will attach the same value to the stock,
independent of their investment horizons.
For the special case in which the firm eventually pays dividends and is never acquired, it’s possible
to hold the shares forever :

9.2 Applying the dividend-discount Model

Constant dividend growth

The simplest forecast for the firm’sfuture dividends states that they will grow at a constant rate ,
g, forever.

The expected dividends are a constant growth perpetuity.

With constant expected dividend growth, the expected growth rate of the share price matches the
growth rate of dividends.

Dividends VS investment and growth

The firm faces a trade-off : increasing growth may require investment, and money spent on
investment cannot be used to pay dividends :

Firm’s dividend payout rate = the fraction of its earnings that the firm pays as dividends each year.
The firm can increase its dividends in three ways :
1) It can increase its earnings (net income)
2) It can increase its dividend payout rate
3) It can decrease its shares outstanding
A firm can do 1 of 2 things with its earnings : it can pay them out to investors, or it can retain and
reinvest them. By investing more today, a firm can increase its future earnings and dividends. SO,
if all increases in future earnings result exclusivey from new investment made with retaned
earnings, then :

The firm’s retention rate= the fraction current earning retained by the firm :

If the firm chooses to keep its dividend payout rate constant, then the growth in dividends will
equal growth of earnings :
g= retention rate * return on New investment

this growth rate is referred to as the firm’s sustainable growth rate, the rate at which it can
grow using only retained earnings.

Profitable growth

A firm can increase its growth rate by retaining more of its earnings. However, if the firm retains
more earnings, it will be able to pay out less of those earnings and, will have to reduce its dividend.
The effect of cutting the firm’s dividend to grow crucially depends on the return on new
investment.
Cutting the firm’s dividend to increase investment will raise the stock price if, and only if, the
new investments have a positive NPV.

Changing growth rates

We can use the constant dividend growth model to value the stock of young firms that often pay
no dividends, their growth rate continues to change over time until they mature.
To calculate the future share price of the stock PN once the firms matures and its expected growth
rate stabilizes :

If the firm is expected to grow at a long-term rate g after year N+1, then from the constant dividend
growth model :
9.3 Total payout and free cash flow valuation models

Share repurchases and the total payout model

In a share repurchase, the firm uses excess cash to buy back its own stock. There are 2
consequences : 1) the more cash the firm uses to repurchase shares, the less it has available to pay
dividends. 2) The firm decreases its share count, which increases its earnings and dividends on a
per-share basis.
The total payout model : when a firm repurchases shares -> a model which values all of the firm’s
equity, rather than a single share.

The discounted free cash flow model

The discounted free cash flow model => we first determine the total value of the firm to all
investors (both equity and debt holders) -> we begin by estimating the firm’s enterprise value :
Enterprise value = Market value of equity + debt – cash
The benefit of the discounted free cash flow model is that it allows us to value a firm without
explicity forecasting its dividends, share repurchases, or its use if debt.
Valuing the enterprise :
Estimate a firm’s enterprise value : we compute the present value (PV) of the firm’s total payouts
to equity holders. Also, we compute the present value of the free cash flow (FCF) that the firm has
available to pay all investors, both debt and equity holders.

Firm’s net investment

Net investment = investment intended to support the firm’s growth, above and beyond the level
needed to maintain the firm’s existing capital.

Free cash flow measures the cash generated by the firm before any payments to debt or equity
holders are considered.

Given the enterprise value, we can estimate the share price :

In the dividend-discount model, the firm’s cash and debt are included indirectly through the effect
of interest income and expenses on earnings. (discount model ignores interest income and
expenses)
Implementing the model
A great difference between the discounted free cash flow model and the earlier models is the
discount rate.

Here we are discounting the free cash flow that will be paid to both debt and equity holders. Thus,
we should use the firm’s weighted average cost of capital (WACC), denoted by rwacc , which is
the average cost of capital the firm must pay to all of its investors, both debt and equity
holders.
If the firm has no debt, then rwacc = rE (equity cost of capital)
If the firm has debt, rwacc is an average of the firm’s debt and equity cost of capital. In that case,
because debt is generally less risky than equity, rwacc is generally less than rE.
WACC also reflects the average risk of all of the frim’s investments.

GFCF + Long run growth rate that ‘s typically based on the expected long run growth rate of the
firm’s revenues.

9.4 Valuation based on comparable firms

Law of one price = the firm’s value is the present value of its future cash flow because the PV is
the amount we would need to invest elsewhere in the market to replicate the cash flows with the
same risk.

The method of comparables = we estimate the value of the firm based on the value of other,
comparable firms or investments that we expect will generate very similar cash flows in the
future.
Valuation multiples
We can adjust for differences in scale between firms by expressing their value in terms of a
valuation multiple, which is a ratio of the value to some measure of the firm’s scale.

The price-earnings ratio

A firm’s P/E ratio = the share price / earnings per share

Brcause differences in the scale of firm’s earnings are likely to persist, you should be willing to
pay proportionally more for a stock with higher current earnings.
Enterprise value multiples
Valuation multiples based on the firm’s enterprise value. Because the enterprise value represents
the entire value of the firm before the firm pays its debt. Common multiples to consider are
enterprise value to EBIT, EBITDA, and free cash flow.

Free cash flow growth is constant.

This multiple is higher for firms with high growth rates and low capital requirements.

9) Capital market and the pricing risk

In this chapter, we will be quantify the relationship between risk and return and so the investors
demand a risk premium to bear the risk.
10.2 Common measures of risk and return
Probability distributions
The return indicates the percentage increase in the value of an investment per dollar initially
invested in the security. => When an investment is risky, there are different returns it may earn.
A probability distribution : a probability, pr, with each possible return, R, will occur.

Expected return
Given the probability distribution of returns, we can compute the expected return. => We calculate
the expected return as a weighted average of the possible returns, where the weights correspond
to the probabilities.
The expected return is the return we would earn on average if we could repeat the investment
many times, drawing the return from the same distribution each time.

Variance and standard deviation

2 common measures of the risk of a probability distribution are its variance and standard
deviation.
1) The variance = the expected squared deviation from the mean
2) The standard deviation = square root of the variance

If the retun is risk free the variance = 0 and never deviates from its mean.

In finance, we refer to the standard deviation of a return as its volatility. (SDR)

10.3 Historical returns of stocks and bonds

Computing historical returns

The realized return is the return that actually occurs over a particular time period.
Return for a stock :

Calculating realized annual returns

We assume that we reinvest all dividends immediately and use them to purchase additional shares
of the same stock or security. If a stock pays dividends at the end of each quarter, with realized
returns RQ1,……, RQ4, each quarter, then its annual realized retun, Rannual, is

Comparing realized annual returns

Once we have calculated the realized annual returns, we can compare them to see which
investment performed better in a given year.
Empirical distribution of the returns = plot the probability distribution in this way using
historical data.
Average annual returns
The average annual return = the average of the realized returns for each year.