Introduction to Corporate Finance

Prateek Sharma
Contact Details and Evaluation Scheme
 Contact Details Continuous Evaluation Scheme
◼ Office: 2nd Floor, Third
office. ◼ Quizzes(Best 3 out of 4 quizzes) 30%
◼ Drop-by Hours: 2:30 ◼ Projects(2) 20%
p.m. to 3:30 p.m. on ◼ Mid-term Exam 25%
days when classes are ◼ End-term Exam 25%
scheduled ◼ Class Participation ±5%
◼ Email:
[email protected]

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Selecting Project Firm
 Publicly listed
 At least 5 years of data
 Do not select a firm with a very niche business
 Indian firm (recommended but not necessary)
 Data for the project
 No two students can select the same project firm

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Timeline
1. Deadline for selecting the project firm 13th October, 23:59:59
2. Deadlines for Project Submissions
◼ Project 1: 25th October, 23:59:59
◼ Project 2: 29th November, 23:59:59
3. Mode of Submission
 Turnitin
 Do not submit through email or Moodle
4. CF - Quiz 1: 28th October
5. CF - Quiz 2: 5th November
6. Mid Term: 11th November
7. CF - Quiz 3: 25th November
8. CF - Quiz 4: 9th December
9. End Term: 27th December 4
General Instructions
1. Please read your course outline
2. Please read your prescribed texts/cases/articles
3. Deadline for project submission is 23:59:59 on the day
of submission.
4. Each project needs to be checked for plagiarism using
TURNITIN software.
5. Bonuses and Penalties (ref. Points 3 and 4)

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Pedagogy
 Finance is not difficult, it is tricky because of the
interaction of two features
◼ Nature of the course
◼ Heterogenous exposure of course participants
 Introductory course
◼ Good questions and (advanced) Good questions
◼ Resolving advanced queries
 Last 5 minutes of the session
 Post-class discussion (over email/in person at office)

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“Get your facts first, and then you can distort them
as much as you please”
~Mark Twain

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Introduction
 What is a corporate finance decision?
◼ Every decision that a corporate takes that has any
financial implications.
◼ In other words, every business decision
◼ What about Marketing, HR or Strategy decisions?
 Economic basis of business decision-making

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Objectives of the course
◼ General framework of decision making under
risk
◼ First principles of valuation
 Stock or a bond
 Strategic decisions/Tactical/ Operational decisions
 Projects
◼ Introductory and Applied Course
 Advanced: The Theory of Corporate Finance, Jean Tirole

9
Transitioning from Accounting to Finance

Assets Liabilities
Fixed Assets Current Liabilities
Current Assets Debt
Other Long-term
Investments
obligations
Intangible Assets Equity
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Purchase Price allocation

Goodwill is the value you

doodle onto your balance sheet
after you buy something and
can’t count every dollar you
paid for in the value of your
purchased assets.

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HP acquires EDS (HP Annual report 2008)
 CEO letter
◼ The EDS Acquisition—Disciplined Execution of a Multi-
year Strategy
 EDS is an excellent fit both financially and operationally.
 EDS provides a strong base of recurring revenues and a
meaningful opportunity to capture synergies and expand
earnings per share.
 EDS adds a world-class, globally scaled services capability to
HP’s established leadership in hardware and management
software. This is a powerful combination that puts HP in a
distinct position to lead the industry and deliver for our
customers and stockholders
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HP acquires EDS (HP Annual report 2008)

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HP Q3, 2012

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HP Q4, 2012

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Four years after the autonomy deal
“We haven’t done anything
stupid in the last four years,”
she noted on a September
2015 analyst call, “and we
don’t intend to do anything
stupid in the future.”

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Transitioning from Accounting to Finance
 Accounting is backward looking (historical)
◼ Book values are often not a reliable indicator of the
market value or intrinsic value
◼ Rule-based
 Finance is forward looking.
 Cashflows rather accounting income, intrinsic
values rather than book values.

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Financial Balance Sheet

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We believe the amount of goodwill is primarily attributable to
expected synergies from future growth, from potential monetization
opportunities, from strategic advantages provided in the mobile
ecosystem and from expansion of our mobile messaging offerings.

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The objective function
 Do we need an objective function for taking business decisions?
 In your opinion, what should be the objective of a business?
 Should you have a single objective or multiple objectives?
◼ Hospital: Delivering high-quality and affordable care
 Characteristics of a good corporate objective function
◼ Clear and unambiguous
◼ Objectively Measurable & Timely
◼ Does not ignore Social costs
 Classical objective in corporate finance theory
◼ Maximize the value of business

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What is the value of a business?

 Efficient Markets
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Advantages of Stock price as an objective
 Readily observable
 Instantaneous
 Unbiased
 If markets are efficient, than stock price is the best
estimate of the intrinsic value of the equity
 Long-term
 Can you think of some limitations too?
◼ Private firms
◼ Inefficient market
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Criticisms of stock price maximization
 If you focus on maximizing stock price..

◼ You don’t care about your employees

◼ You don’t care about your customers

◼ You don’t care about the society

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Assumptions under which stock price
maximization works perfectly
STOCKHOLDERS

Hire & fire Maximize

managers stockholder
- Board wealth
- Annual Meeting

Lend Money No Social Costs

LENDERS Managers SOCIETY
Protect All costs can be
Lenders’ traced to firm
Interests
Reveal Markets are
information efficient and
honestly and assess effect on
on time value

FINANCIAL MARKETS
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The real world
 Manager-Stockholder
◼ AGMs
 Economics
 Proxy Votes
 Institutional Investors
◼ BOD
 Appointments
 Conflicts of interest
 Independent Directors
 Directors rely on management for information
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The real world
 Majority vs Minority Shareholders
◼ Closely held companies (business group owned/family
owned) the majority shareholders
 Appoint their board of directors and senior management
 Determine the outcome of shareholders vote
 Majority shareholders may refuse to declare dividends and
may drain off the corporation's earnings in a number of ways.
◼ Exorbitant salaries and bonuses to the majority shareholder-officers
and perhaps to their relatives
◼ High rentals for property the corporation leases from majority
shareholders

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The real world
 Unreasonable payments to majority shareholders under
contracts between the corporation and majority
shareholders or companies the majority shareholders
own
 May cause the corporation to sell its assets at an
inadequate price to the majority shareholders
 Majority shareholders may also organize a new
company in which the minority will have no interest,
transfer the corporation's assets or business to it

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The real world
 Managers-Bondholders/Lenders (Ripping off lenders)
◼ Dividends/Share buybacks, Leveraged Buyout of firm, Risky projects
 Managers-Financial Markets (Lying to financial markets)
◼ There is some subset of companies that cook their books, firms like Satyam,
Enron or WorldCom. Outright fraud Bre-X
◼ A large number of firms, try to manage the information, delay it or bundle
bad news with good news
 Managers-Social Costs
◼ All business create social costs
◼ The social costs of private enterprise - K. William Kapp

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Earning announcements

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 The Cuban Thaw, 17 December 2014,
 Lifting of U.S. travel restrictions
 Fewer restrictions on remittances
 U.S. banks access to the Cuban
financial system
 The establishment of a U.S.
embassy in Havana
 First US flight to Cuba since 1961
 Obama became first US President
in 88 yrs to visit Cuba

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Stock price maximization with Self-
correcting mechanisms

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Examples of regulatory action
 General Motors fails to disclose a deadly ignition switch problem
and is fined $900 million.
 Citicorp, JPMorgan Chase & Co., Barclays PLC, The Royal Bank
of Scotland plc Agree to Plead Guilty In Connection With The
Foreign Exchange Market and Agree to Pay More Than $2.5
Billion In Criminal Fines
 ConAgra is penalized $11 million for distributing contaminated
peanut butter. A Johnson & Johnson subsidiary is hit with a $20
million criminal fine for selling contaminated children’s
medications.
 BP pays more than $20 billion to resolve civil and criminal cases
stemming from the 2010 Deepwater Horizon disaster in the Gulf
of Mexico. 36
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 Proxy advisory firms
 Proxy advisers provide market-moving guidance on a
plethora of issues, including corporate governance,
gender equity and political spending policies.
 ISS and Glass Lewis, two proxy firms effectively
control nearly 38 percent of shareholder votes
 Asset managers rely on these recommendations as they
frequently must consider thousands of votes at annual
meetings: an estimated 600 billion shares will be voted at
about 13,000 shareholder meetings in 2019.
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Proxy advisory firms
 This information overload has ushered in a concept
known as robo-voting, or asset managers voting
proxies automatically without evaluation, relying
completely on proxy firms’ recommendations.

 A recent study of 175 asset managers by the

American Council of Capital Formation found that
the firms follow ISS’ recommendations 95 percent
of the time (for half of the entities, it’s 99
percent). 39
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A Case Study: Kodak - Sterling Drugs

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Examples of Bond Covenants
 Limitation on Indebtedness
 Limitation on Restricted Payments
 Minimum level of liquidity
 Limitation on Liens
 Limitation on Asset Sales
 Change of Control
 Financial Disclosures
 Events of Default
◼ Coupon step up
◼ Principal repayment

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Alternatives (Intermediate measures)
 Maximizing earnings
 Maximizing revenues
 Maximizing firm size
 Maximizing market share
 Maximize magic bullets EVA, CFROI, CROCI
The key thing to remember is that these are
intermediate objective functions.
 To the degree that they are correlated with the long term
health and value of the company, they work well

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Maximizing earnings (Wells Fargo)

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Assignment 1: Corporate governance
 Joint position CEO and chairman of the board
 CEO Employment Contracts and Compensation Practices
◼ No change in top executives despite continued poor performance
 Longtime CEO dominates insider filled board, and investors calls for
changes are generally rejected
 Board has consultants and lawyers that do business with other
promoter group firms
 Do the directors provide an appropriate range of skills and
experience?
 Stock ownership of board members?

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Assignment 1: Corporate governance
 How independent they are?
◼ How many other boards they sit on?
◼ Bloomberg people search
◼ Inside directors (employees, ex-employees, relatives)
 Does the board permit frequent special charges or earnings
restatements?
 Does the board ever stop/stall the management decisions?
 Board Compositions and activity
◼ How many directors?
◼ How many of them are independent?
◼ How many BoD meetings took place?
◼ How many meetings did each attend?
 Break-up of independent and insiders 48
Assignment 1: Corporate governance
 How many classes of shares are there?
 Is it a group company?
◼ Cross-holdings
◼ Pyramidal structure and indirect control
 Block stockholders: Are there inside stockholders who have
more power than minority shareholders?
 Who holds the true decision making power in your company

Management Promoters Lenders Government Employees

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Assignment 1: Corporate governance
 Does auditor provide services other than auditing?

 Is the auditor report qualified?

 Are the remuneration, nomination and audit committees

primarily composed of independent directors?

 Are there any influential individuals on board? (Buffet/Tata)

 Do founders still hang on? (They may make emotional decisions)

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Corporate Finance: Big Picture

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Basic Principles
1. Objective of corporate decisions is to maximize the
value of the business
2. If you can borrow money at 8%, do not borrow at 9%
◼ If your cashflows are in euro, take euro denominated debt
◼ If your assets are long-term, take long-term debt
3. If you borrow at 8%, do not invest in projects that
earn you less than 8% (This is the focus of this course)
4. If you can’t find such project, please return the money
◼ Repay debt, pay dividends or buyback stocks

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Basic Principles of TVM
 Nominal Growth, Real Growth, Inflation
Why charge an interest rate on loans?
1. Safe cashflows are more valuable than risky cashflows.
2. A rupee earned today is more valuable than a rupee earned in
future.
3. Present value (PV) is the current worth of a future cashflow or a
stream of future cash flows.
4. The value of an asset is the present value of the future expected
cash flows.

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Present Value of a single CF
 The present value of a single cash flow C expected n periods
from now is given by:-
𝐶
1+𝑟 𝑛

 The interest rate r factors in risk, the exponent n factors in

delay in receiving cash flow
 r is rate per period. Periods may be yearly, monthly,
daily etc.
◼ If you have yearly cashflows use yearly interest rates, if you have
monthly cashflows use monthly interest rates.
◼ It may be called discount rate or opportunity cost or hurdle rate
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PVIF Tables
 PVIF for 2 periods (n=2) at 5% discount rate (r= 5%) is .907
1
𝑃𝑉𝐼𝐹𝑟,𝑛 = 𝑃𝑉𝐼𝐹5%,2 = = 0.907
1+𝑟 𝑛

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Future Value of a single CF
 The future value of a single cash flow C at a time n
periods from now is given by:-

C * 1+𝑟 𝑛

 You can also use the FVIF table

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FVIF Tables

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Practice Problems
P.1 Assume r = 10% p.a.
A. PV of 110 received at the end of year 2

B. Value at t = 1 of 110 received at the end of year 2

C. Value at t = 4 of 110 received at the end of year 2

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Practice Problems
P.2 Out of the two alternatives mentioned, which
alternative is better assuming you could put whatever
money you receive in an investment that returns 15%
annually?
i. Receive 1000 two years from now OR 1500 two years
from now.
ii. Receive 1000 two years from now OR 1000 five years
from now.
iii. Receive 1000 two years from now OR 1500 five years
from now.
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Practice Problems
P.3 I don’t know what is the interest rate, but I
assume that it should be positive (Fair assumption)
In this case, what would you prefer
A) Receive INR 2 at year 1
OR
Receive INR 1 at year 1 and year 2
B) Receive INR 500 for 4 years, starting one year from now
OR
Receive INR 400 for 5 years, starting one year from now
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Practice Problems
P.4 You have two options to pay a loan. Which one
would you choose assuming rate of interest is 8%?
◼ Pay 40,000 at the end of each year for the next four
years
OR
◼ Pay 20,000 at the end of the first year, 30,000 at the
end of the second year, 50,000 at the end of the third
year, 70,000 at the end of the fourth year?

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Perpetuity

 Perpetuity is when the same cash flow C is paid every year for
an infinite period, starting from t=1 (after one year)
C
PV =
r
 C is the periodic cash-flow
 r is the discount rate
 PV is the present value of this cash flow stream
Example C=100, r=10%
PV=?

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 Yale’s bond, written on goatskin,
was issued on May 15, 1648 to Mr.
Niclaes de Meijer for the “sum of
1,000 Carolus Guilders of 20
Stuivers a piece.” According to its
original terms, the bond would pay
5% interest in perpetuity. (The
interest rate was reduced to 3.5%
and then 2.5% during the
17th century.)

 The water board used the money

raised to construct a series of piers
near a bend in the river that
regulated its flow and prevented
erosion.
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Practice Problems
P.5 What would be the present value if the earlier perpetuity,
C=100, r=10%, started at t=0 instead of t=1?
◼ What value would the perpetuity formula (C/r) represent if cashflows
start at t=5 (Ans: Value of all cashflows at t=4)
P.6 I will get a series of cashflows starting after 10 years.
The present value of these cashflows is 1000, and the
interest rate is 5%. What will be the new PV if I shift all
cashflows left, towards t=0, by 3 years
◼ Makes cashflows more valuable because you receive them
earlier
◼ New PV = 𝐸𝑎𝑟𝑙𝑖𝑒𝑟 𝑃𝑉 * 1 + 𝑟 𝑛
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Practice Problems

P.7 I will get a series of cashflows starting after 10 years.

The present value of these cashflows is 1000, and the
interest rate is 5%. What will be the new PV if I shift all
cashflows right, away from t=0, by 5 years
◼ Makes cashflows less valuable because you receive
them later
X
◼ New PV = 𝑛
(1+𝑟)

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Practice Problems
P.8 Calculate the value of an investment that pays
Rs.1,000 every two years, starting two years from
now and continuing forever. Assume annual interest
rate is 6%.

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Growing Perpetuity

 When the cash flows paid out every year grow at constant rate of
growth g
𝐶1
 𝑃𝑉 =
𝑟−𝑔
 C1 is the cash-flow received at the end of year 1
 r is the discount rate
 g is the growth rate
 PV is the present value of this cash flow stream
Example C1=100, r=10%, g=5%
PV=2000

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PV of Annuity

 When the same cash flow C is paid out for n periods

𝐶 1
𝑃𝑉 = 1 − 𝑛
𝑟 1+𝑟
 C is the periodic cash-flow
 r is the discount rate
 n is the number of periods for which the cash flow will last
 PV is the present value of this cash flow stream
 Suppose you take a loan of value PV for n periods, then
◼ Periodic Installments: C = EMI (Equated Monthly Installments) if n is in
months, C = Annual installments if n is in years

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PVIFA Table
 Alternatively, the PVIFA table can also be used to
calculate the PV of an annuity

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Future value of Annuity
 The future value of an annuity formula is used to
calculate what the value at a future date would be
for a series of periodic payments.
 𝐹𝑉 𝑜𝑓 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 𝑃𝑉 𝑜𝑓 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 ∗ (1 + 𝑟)𝑛
𝐶 1 𝑛
𝐹𝑉𝑜𝑓 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 1 − × (1 + r)
𝑟 1+𝑟 𝑛

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FVIFA Table
 To calculate future value of an annuity, you can use
the FVIFA table

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Growing Annuity

 When the cash flows paid out every year grow at constant
growth rate g and are paid for n years
𝐶1 1+𝑔 𝑛
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟 𝑛
 C1 is the cash-flow received after one year
 r is the discount rate
 g is the growth rate
 n is the number of periods for which the cash flow will last
 PV is the present value of this cash flow stream

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Practice Problem
P.9 a) You estimate that by the time you retire in 35
years, you will have accumulated savings of $2 million. If
the interest rate is 8% and you live 15 years after
retirement, what level of expenditure will those savings
support in your first year after retirement?
b) Unfortunately, inflation will eat into the value of your
retirement income. Assume a 4% inflation rate and work
out a spending program for your retirement that will allow
you to increase your expenditure in line with inflation.

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Cash flows starting at beginning of year

 All the present value formulae discussed so far assume that

cash flows start at the end of year (t=1). If cash flows start at
the beginning of year (first cash flow is at t=0), then the present
values can be calculating by multiplying all the PV formulae by
an additional 1 + 𝑟 factor

 The rationale is that is cash flows start at time 0, then every

cash flow is effectively being discounted for one less year.

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Interest rate terminology
 Effective annual rate (EAR)
◼ This is the rate you should use with annual cashflows.
 Assumes interest is compounded annually.
◼ If r is the annual rate of interest and 𝑚 is the number of
compounding periods
𝑟 𝑚
𝐸𝐴𝑅 = 1 + −1
𝑚
◼ If you have a 10% annual rate with semi-annual
0.1 2
compounding. 𝐸𝐴𝑅 = 1 + − 1= 10.25%
2

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Interest rate terminology
P.10 You invest Rs. 100 at a 10% annual rate with monthly
compounding for two years.
 What is the EAR?
 What is the amount that you will receive after two years?

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Interest rate terminology
P.11 In the district of Hillington, Gerard Law was for
twenty years the number one loan shark. He used the
Argosy pub on Paisley Road West as his office,
spending most working days there, despite himself
being a teetotaler. A typical borrower would borrow a
small amount like ten pounds and paid back 12.50
pounds(principal plus interest) a week later.

What is the EAR?

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Annualized Percentage Rate
 You just take an weekly rate or a monthly rate and
multiply it with the number of weeks or number of
months
◼ This is different from Annual rate with weekly or monthly
compounding

 What is the APR in the previous example?

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Interest rate terminology
 If r is continuously compounded annual interest rate,
that is number of compounding periods is 𝑚 = ∞
𝐸𝐴𝑅 = 𝑒 𝑟 − 1

P.12 You invest Rs. 100 at a 10% annual rate with continuous
compounding for two years, the amount that you will receive after
two years is
 What is the EAR?
 What is the amount that you will receive after two years?
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Assume a $10,000 investment for one year,
with 15% stated interest rate
 Annual Compounding
◼ FV = $10,000 x (1 + (15% / 1)) (1 x 1) = $11,500
 Semi-Annual Compounding
◼ FV = $10,000 x (1 + (15% / 2)) (2 x 1) = $11,556.25
 Quarterly Compounding
◼ FV = $10,000 x (1 + (15% / 4)) (4 x 1) = $11,586.50
 Monthly Compounding
◼ FV = $10,000 x (1 + (15% / 12)) (12 x 1) = $11,607.55
 Daily Compounding
◼ FV = $10,000 x (1 + (15% / 365)) (365 x 1) = $11,617.98
 Continuous Compounding
◼ FV = $10,000 x 2.7183 (15% x 1) = $11,618.34 82
Interest rate terminology
 𝑟 is the annually compounded rate (EAR)
 𝑟𝑐 is the continuously compounded rate
If your cashflows are paid annually, and you have a continuously
compounded rate 𝑟𝑐 . You need to convert it to annually
compounded rate
𝑟 = 𝑒 𝑟𝑐 − 1
If your cashflows are paid continuously, and you have annually
compounded rate 𝑟. You need to convert it to continuously
compounded rate
𝑟𝑐 = ln(1 + r)
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For continuously received cashflows
 You need to use continuously compounded rate 𝑟𝑐
 If you have annually compounded rate 𝑟, first
convert it into continuously compounded rate 𝑟𝑐
 In the formulae, replace
◼ 𝑟 by 𝑟𝑐
◼ 1 + 𝑟 𝑛 by 𝑒 𝑟𝑐 ∗𝑛

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For example in case of Annuities
𝐶 1
 𝑃𝑉 = 1− works with annual cashflows and
𝑟 1+𝑟 𝑛
annually compounded rate

For a continuously received cashflow, with

continuously compounded rate use the following
𝐶 1
 𝑃𝑉 = 1−
𝑟𝑐 𝑒 𝑟𝑐∗𝑛

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Be consistent with cashflows and discount rates
Always adjust your discount rate to match your cashflow frequency

1. Cashflows are received at the end of every year, use annually

compounded rate.
2. Cashflows are spread out evenly through the year, use
continuously compounded rate.
3. In your timeline, t= 0, 1, 2 doesn't have to mean an annual
period, it could mean six-monthly periods, it could mean 5-year
periods

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Practice Problems
P.12
◼ You have semi-annual cashflows but you are given
10% as annual rate, what interest rate will you use
 effective semiannual rate (1+r)^2 = 1.1, find r
◼ You get cashflows every 5 years but are given 10%
as annual rate,
 effective 5-year rate (1.1)^5 -1 = r, find r

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Practice Problems
P.13 Aman has been approached by a bank to invest
in one of their schemes. The scheme promises to give
Aman INR 5000 at the end of every year forever.

Aman expects that the effective annual rate will be

10% for the next 8 years and will reduce to a
continuously compounded rate of 8% thereafter. How
much should he be willing to pay for this promised
cash-flow stream?
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Net Present Value
 Net Present value is the present value of all future (expected)
cashflows plus the cashflow due to initial investment
◼ In any period: Cashflow = Cash outflow – Cash inflow
 If there are n future cash flows C1 to Cn
𝐶1 𝐶2 𝐶𝑛
𝑁𝑃𝑉 = 𝐶0 + + 2
+ ⋯+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑛
𝑛 𝑛
𝐶𝑖 𝐶𝑖
= 𝐶0 + ෍ 𝑛
= ෍
(1 + 𝑟) (1 + 𝑟)𝑛
𝑖=1 𝑖=0
𝑁𝑃𝑉 = 𝑃𝑉 𝑜𝑓 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 − 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡(𝐶0 )
What if the future cashflows are not certain? 89
Net Present Value
 Should you invest in a project?
◼ You should do so if NPV is positive, that is, the present value
of its future cash flows exceed the initial investment that is
required.
◼ A positive NPV implies that the rate of return on your
investment is higher than your opportunity cost of capital,
that is, higher than you could earn by investing in equally
risky securities in the financial markets.
◼ Firms can best help their shareholders by accepting all
positive NPV projects (Caveat)

90
Decision rules
 Net present value rule. Accept investments that have positive
net present values.
 Internal Rate of return rule. Accept investments that offer rates
of return (IRR) in excess of their opportunity costs of capital.
 Relation between NPV and IRR. IRR is the discount rate which
makes NPV equal to zero.
𝑛 𝐶𝑖
𝑁𝑃𝑉 = 𝐶0 + σ𝑖=1 = 0, 𝑖𝑓 𝑟 = 𝐼𝑅𝑅
(1+𝑟)𝑛
𝐶1 𝐶2 𝐶𝑛
𝐶0 + + 2
+ ⋯+ 𝑛
=0
(1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅) 1 + 𝐼𝑅𝑅

91
 𝐶1 𝐶2 𝐶𝑛
𝑁𝑃𝑉 = 𝐶0 + + 2
+ ⋯+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑛

 Discount rate
 Opportunity Cost
 Hurdle Rate
 Cost of capital (project-specific)
 Market interest rate (cost of debt)
 Cost of equity

92
Value creation & Value additivity
 Suppose a firm with a value V takes up two new projects A and
B, then the value of the firm becomes V + NPV(A) + NPV(B)

 To the extent that firm is taking value enhancing (positive NPV)

projects, it is maximizing the value of the business

 If the capital is not rationed(perfect capital markets), than the

firm should take all positive NPV projects.

93
Practice Problem P.14, 2-14
 Factory costs 800,000
 Produces 170,000 for 10 years
 Find
◼ A. Its NPV if r = 14%
 (86,739.66)
◼ B. Value of factory at the end of 5 years
 (583,623.76)

94
Practice Problem P.15, 2-25
 If r= 8% per annum, what amount needs to be set
aside for
◼ A perpetuity of 1 bn every year
 12.5 bn
◼ Perpetuity of 1 bn every year growing at 4%
 25 bn
◼ 1 bn for 20 years
 9.82 bn
◼ 1 bn spread evenly over the year for 20 years
 10.20 bn

95
Practice Problem P.16, 2-34
 Couple retires in 3 yrs
 Needs 15k per month, gets 9k from other sources
 Has a fund of 1,000,000
 Fund grows at 3.5%
 For how many years can withdrawals be made?
 Assume 72k (12x6k) is withdrawn annually, and the
first annual withdrawal occurs three years from today
◼ 21.38 yrs

96
Shyam Lal Case

97
Shyam Lal Case
 New investment proposal
◼ Which discount rate should you use?
 Discount rate should be based on riskiness of the individual project and
not cost of capital for the firm.
◼ Should you use after-tax discount rate or pre-tax discount
rate?
◼ Should SLA invest in the new plant?
◼ How much value will be added to the business by this
decision?

98
Shyam Lal Case
 Cost Saving Proposal
◼ Should you purchase the machine by paying the entire amount in
cash, or should you go for eight annual installments?
◼ What is the annual installment amount?
◼ How much will be paid towards interest and principal repayments
each year?
◼ Interest payments are tax deductible, so what is the cost of
machine to SLA as on today if they buy on installment basis?
◼ If the life of machine is 15 years, how much annual after-tax cost
savings are required to recover your investment?

99
Shyam Lal Case
 Expansion proposal
◼ What is the interest rate charged by distributor?

◼ What is the effective interest rate to SLA after

considering tax benefits?

◼ What will be annual instalment amount if distributor

agrees to earn a 13 percent return?

100
Shyam Lal Case
 Financing Proposal
◼ What is the value of the loan at maturity?
 7 year loan
 15% per annum interest rate
 Interest and Principal paid at maturity
◼ How much should he invest every year to repay the loan
at maturity?
 SLA can invest at 18.5% p.a.
 Assume that investment is made at the end of each year (yr
1 to yr 7)

101
Bonds

102
Bonds named after food . . .
•Dim sum: Renminbi bond issued in Hong Kong by a Chinese entity
•Kimchi: Non-Korean won bond issued in the Korean market by a foreign entity
•Baklava: Turkish lira bond issued in the Turkish market by a domestic or foreign entity
•Maple: Canadian dollar bond issued in Canada by a foreign entity
•Kiwi: New Zealand dollar bond available only to New Zealand residents
•Masala: INR denominated bond issued outside India

Bonds named after animals . . .

•Bulldog: British pound bond issued in the UK market by a foreign entity
•Panda: RMB-denominated bond issued in the Chinese market by a foreign entity
•Kangaroo: Australian dollar bond issued in the Australian market by a foreign entity

Bonds named after people . . .

•Yankee: US dollar denominated bond issued by a foreign entity in the US market
•Samurai: Japanese yen denominated bond issued by a foreign entity in the Japanese market
103
Simple coupon bond
 Face Value (FV)– Principal amount or the maturity payment from a
bond
 Coupon – Periodic cash flow from the bond.
Each coupon payment = Face value * Periodic coupon rate
 Coupons are always quoted as annualized percentage rates (APR).
Periodic coupon rate = (APR/number of coupons in the year)
◼ 2-year bond with 5% semiannual coupon vs. 2 year bond with 5%
annual coupon, both have a FV of 100

104
 Valuing Bond

https://www.nseindia.com/products/content/debt/wdm/gsec_reporting_homepage.htm

105
Simple coupon bond
 FV is not same as Price.
 Price – price the bond is trading at in the market
◼ For a bond with FV of 100, what does a price of 106.8
mean?
◼ If price = 100, Trading at Par (Price = FV),
◼ If price = 105, Trading at Premium (Price > FV)
◼ If price = 94, Trading at discount (Price < FV)

106
Valuing a Bond
 The value of the bond is the present value of future cash flows

 Where C is coupon ($25), M is the maturity amount or face

value ($1000), 𝑖 is the discount rate (Annual rate/2), N is the
number of periods (10 half-year periods)
 𝑖 is the discount rate, or market interest rate, or required
rate/yield, yield to maturity (YTM).

107
Valuing a simple coupon bond

 Two parts of a coupon bond

◼ Present Value of coupons (you can use annuity formula)
◼ Present value of face value/maturity value
 Practice Problem P.17
◼ Value a 12% semi-annual 5-year bond, with a Face
Value of 100, if market interest rate is 8% per annum,
compounded semiannually

108
Practice Problem P.18
 ABC Corporation issues ten-year bonds (face value $1,000)
with a coupon rate of 8.6% that pay interest semiannually.
Similar ten-year bonds with semi-annual coupons are paying
8.0% interest (annually). What is the value of the bond

 Coupon per period = 4.3% of $1000 = $43

 Discount rate = 4% per half-year period

 Value of the bond = $584.37 + $456.40 = $1,040.77

109
Types of fixed income instruments
 Fixed Rate Bonds
◼ Corporate Bonds, GOI Bonds
 Fixed rate zero coupon (deep discount)
◼ T-Bills
 Floating rate
◼ TIPS
◼ LIBOR linked (Simple/Inverse)
 Bonds with options
◼ Puttable/Callable/Convertible

110
Risks of investing in bonds
 Risk of investing in a bond
◼ Default risk
◼ Reinvestment risk
◼ Interest rate risk
◼ Inflation
◼ Liquidity risk

111
Yield to Maturity
 Yield to maturity is that single discount rate which
when used to discount all future cash flows of a
bond, makes the price equal to the present value of
cash flows

 This is the rate that market wants the bond to pay.

112
Yield to maturity (YTM) of a bond

 Suppose this bond is trading at $990 (at issuance)

 YTM is the discount rate at which the present value of cashflows
are equal to the market price of the bond
25 25 1025
+ + ⋯+ = 990
(1+𝑌𝑇𝑀) (1+𝑌𝑇𝑀)2 1+𝑌𝑇𝑀 10
Easiest way of calculating YTM is to use IRR function with cashflows
-990, +25, +25, … , +1025
◼ Note that you will get a semi-annual YTM!
113
YTM
P.19 A five year, 4.50% semiannual coupon
government bond is priced at 98 per 100 of par value.
Calculate the yield-to-maturity on
◼ Semi-annual basis (Quoted as APR)
◼ Effective annual basis
◼ Effective quarterly basis
◼ Effective continuous compounding basis
◼ Effective 2-year compounding basis

114
Yield to Maturity
 What happens to price of a bond when
◼ YTM rises?
◼ YTM falls?

115
Price changes with interest rate
 Value a Face value =100, 12% annual coupon, 5
year bond if
◼ YTM is 14%
 Trading at discount
◼ YTM is 10%
 Trading at premium
◼ YTM is 12%
 Trading at par
 YTM can also be referred to as current cost of debt,
or prevailing interest rate for the issuer
116
Practice Problem
P.20 Bond A has a coupon rate of 10% and yield to
maturity of 10%. Bond B is a zero coupon bond. If
bonds A and B have the same price and the same face
values, what is the yield to maturity of bond B?

117
Current Yield
 Current yield equals annual coupons received
divided by bond price
Curr. Yield = (Sum all Coupons received in a year) / Price
 Current yield > YTM when bond is selling at
premium
 Current yield < YTM when bond is selling at a
discount

118
P.21, 3-2
 If bond is selling at discount
➔ Price < FV
➔ Coupon Rate < Current Yield < YTM

 If bond is selling at a premium

➔ Price > FV
➔ Coupon Rate > Current Yield > YTM

119
Relation between coupon rate, current yield, YTM

Assume that these are annual coupons

120
P.22, 3-1
 10 yr bond with a FV of 1000, Coupon of 60. If
market interest rate increases
◼ What happens to coupon rate?
◼ What happens to bond price?
◼ What happens to YTM?

121
Bond Strips
 The coupons of a bond can be sold separately
 Such coupons are called bond strips

122
Macaulay Duration (Measured in Years)
 Investors and financial managers calculate a bond’s average maturity
by its duration (Macaulay duration)
◼ The weight for each year is the present value of the cash flow received at that
time divided by the total present value of the bond.
 Duration is the weighted average of the times when the bond’s cash
payments are received.

◼ PV is the sum of present value of all future cashflows (C1 to CT) = Price of Bond
 Unit of duration calculated using above formula will be time (years /
half-years / months).
◼ For example, semi-annual coupons would lead to duration measure in half-years.
To annualize:6 half-years=3years(Macaulay duration is always measured in years)
123
Interest rate sensitivity
 Modified Duration
◼ Measures % change in bond price when yield changes by 1
percentage point
◼ If interest rate increases (decreases) by 𝑚%, than bond price
decreases (increases) by 𝑚𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛 × 𝑚 %

 If YTM is expressed as annualized percentage rate, then use 𝑦𝑖𝑒𝑙𝑑 =

𝑌𝑇𝑀/𝑚, where 𝑚 is the number of coupons per year.
 In other words, yield is yield per period.
 % Change in Bond price = - Modified Duration * Percentage point change
in Yield
124
P.23
 A 3-year, 8% coupon bond with a face value of INR 100, has the
following cash flows to be received at the end of next three
years.
Year 1 8
Year 2 8
Year 3 108
 The bond is currently trading at par, that is, the current price of
the bond is INR 100. What is the approximate increase in the
bond’s price, if the yield declines by 1% (today)?

125
P.24
 Rank the following in order of increasing duration

Bond Coupon Time to Maturity

A 15 20
B 15 15
C 0 20
D 8 20

126
Spot rates and Term Structure
 If a different discount rate is applied to each future
cash flow depending on how far in the future the
cash flow arrives, such discount rates are called
spot rates

 A graph of spot rates against time left to maturity

is called term structure

127
Forward Rates and Bootstrapping
 Forward rate is rate at which you can agree to
borrow or lend money in future e.g. a rate agreed
upon to borrow INR 100k for 3 years at a time 5
years from now is called a three year forward rate
starting five years later
 Is there a relationship between spot rates and
forward rates?
 (1 + r2)^2 = (1 + r1) * (1 + f12)

128
P.25
 You observe that a one-year bond with annual
coupon of Rs. 6 and par value of Rs. 100 has a
current price of Rs.102.91. A two-year bond with
annual coupon of Rs.6.50 and par value of Rs.100
has a current market price of Rs.101.10.
 What are the one period and two period spot rates?
 Compute the prices of one-year and two-year zero
coupon bonds with Rs.100 par values

129
P.26
 Two 5-year bonds with 8% and 10% coupon rates (annual
coupons) and a FV of 100 are priced at 85.85 and 93.13
respectively.
 You believe that the spot rates of the two bonds are identical for
each of the next five years. However, you do not believe that
their YTMs would be exactly same.
 What should be the price of a zero coupon bond with FV = 100
and 5 years to maturity, if the 5-year spot rate for this zero
coupon bond is the same as the 5 year spot rate for other
bonds. Assume you can buy or sell any quantity of any bond.

130
 BACK TO
MAXIMIZING VALUE

131
Maximizing value of the business
 When we talk about maximizing the value of the firm,
what time period are we talking about?

 Implications
◼ Project term
◼ Structuring incentives

 What if markets do not see the long-term value?

132
Markets can value synergy
 Bell Atlantic and Vodafone had a bidding war to acquire Air-
Touch Communications
◼ Bell Atlantic initially offered $73 per share, or $45 billion, a
7% premium above Air-Touch’s closing share price $68. Bell
Atlantic’s stock price immediately declined by 5%. Clearly,
the market did not like the deal.
◼ Vodafone paid $97 per share, for a total of $62 billion. That
price was 33% more than Bell Atlantic’s original offer and
43% more than AirTouch’s share price. During the course of
this bidding war, Vodafone’s stock price actually increased
some 14%.

133
Markets can value synergy
 Vodafone was strong in European countries where AirTouch was not
◼ Together, they would create the first complete pan-European cellular
telephone company. This was only possible because Vodafone had a much
larger share of the cellular market than Bell Atlantic did in Europe.
◼ As a result, Vodaphone-Airtouch would be able to save a tremendous
amount in roaming fees paid to other cellular operators and in
interconnection fees paid to fixed line operators.
◼ Vodaphone-Airtouch could offer a pan-European flat-rate pricing plan.
Competitors active in individual European country would be forced to
respond through complicated joint ventures or consolidations.
 Markets anticipated savings from high-volume purchases of equipment such as
handsets, switches, which the two companies were already basing on the
same technology and buying from the same suppliers.

134
Risk
 Investment Decision
◼ Invest in projects which return more than hurdle rate

◼ Hurdle rate depends on riskiness of projects, and how they are

financed (Business Risk + Financing Risk)

◼ Hurdle Rate = Risk-free rate + Risk Premium

◼ First, we need to measure the risk

◼ Second, we need to translate that risk into a risk premium

135
Risk
 What is risk?
◼ Uncertainty, volatility, bad things happening
 Is it always bad? Is there an upside of risk?
◼ Rewards are inherently related with risk
 Essence of business is not to avoid risk, but to take
right kind of risks
◼ Casino

136
Risk and Returns
 In DCF or NPV analyses, your numerator represents
the returns, expected cashflows.
 In your view, which of the following two bets would
most people prefer?
Bet A: 75% chance of winning 10 lakhs and 25% chance of
losing 10 lakhs
Bet B: A certain sum of 5 lakhs
 Investors are risk-averse
◼ They would seek additional reward for bearing risk.
◼ This is what we call risk premium, the higher the risk the
more return investors would require to take that risky bet. 137
Risk and Returns: Indian Corporate bond spreads
Spread = (YTM-Risk free rate)

Annualised spreads 0.5 1 5 10

(Basis Points)
AAA 77 90 103 121
AA+ 102 115 128 146
AA 127 140 153 171
AA- 152 165 178 196
A+ 177 190 203 221
A 207 220 233 251
A- 242 255 268 286
BBB+ 282 295 308 326
BBB 327 340 353 371
BBB- 377 390 403 421
138
Risk-return tradeoff

Note: Stocks are represented by the Standard & Poor's 90 Index from 1926 to March 3, 1957; the S&P 500 Index from March 4, 1957,
through 1974; the Wilshire 5000 Index from 1975 through April 22, 2005; and the MSCI US Broad Market Index thereafter. Bonds are
represented by the S&P High Grade Corporate Index from 1926 to 1968; the Citigroup High Grade Index from 1969 to 1972; the
Barclays U.S. Long Credit AA Index from 1973 to 1975; and the Barclays U.S. Aggregate Bond Index thereafter. Data are through 139
December 31, 2013. Source: Vanguard.
Risk and Return for U.S. Asset Classes by Decade

1930s 1940s 1950s 1960s 1970s 1980s 1990s 2000s* 1926–

2008
Large company Return –0.1 9.2 19.4 7.8 5.9 17.6 18.2 –3.6 9.6
stocks Risk 41.6 17.5 14.1 13.1 17.2 19.4 15.9 15.0 20.6
Small company Return 1.4 20.7 16.9 15.5 11.5 15.8 15.1 4.1 11.7
stocks Risk 78.6 34.5 14.4 21.5 30.8 22.5 20.2 24.5 33.0
Long-term Return 6.9 2.7 1.0 1.7 6.2 13.0 8.4 8.2 5.9
corporate bonds Risk 5.3 1.8 4.4 4.9 8.7 14.1 6.9 11.3 8.4
Long-term Return 4.9 3.2 –0.1 1.4 5.5 12.6 8.8 10.5 5.7
government bonds Risk 5.3 2.8 4.6 6.0 8.7 16.0 8.9 11.7 9.4
Treasury bills Return 0.6 0.4 1.9 3.9 6.3 8.9 4.9 3.1 3.7
Risk 0.2 0.1 0.2 0.4 0.6 0.9 0.4 0.5 3.1
Inflation Return –2.0 5.4 2.2 2.5 7.4 5.1 2.9 2.5 3.0
Risk 2.5 3.1 1.2 0.7 1.2 1.3 0.7 1.6 4.2
Returns are measured as annualized geometric mean returns.
Risk is measured by annualizing monthly standard deviations.
* Through 31 December 2008.
Source: 2009 Ibbotson SBBI Classic Yearbook (Tables 2-1, 6-1, C-1 to C-7).

140
Risk and Returns
 At the heart of every financial scandal is a promise
of high returns with no (or almost no) risk
◼ Chinese Investment Scandal Highlights ‘Shadow Banking’ Risks
◼ A Simple Plan: How Allen Stanford Stole $7 Billion
◼ SEC accuses Texas mortgage lender of running massive Ponzi
scheme
◼ Recent Fraud Cases Show Investors Must Remain Vigilant
◼ http://www.berkshirehathaway.com/letters/2014ltr.pdf

141
Measuring risk
 Why Standard deviation (or Volatility) measures risk?
◼ Let 𝑋𝑖 denote weekly returns for the past n weeks for a
stock.
◼ What is the expected return for the next week
 Expected return 𝑋𝑜𝑟
ത 𝐸 𝑋 = 𝑝1 𝑋1 + 𝑝2 𝑋2 + … + 𝑝𝑛 𝑋𝑛
= (𝑋1 +𝑋2 + ⋯ + 𝑋𝑛 )/n
◼ Risk is the chance that the actual return next week may be
different from my expected return
 This is exactly what variance or std. deviation quantifies
 𝑉𝑎𝑟(𝑋) = 𝐸(𝑋 − 𝐸 𝑋 )2 it is often denoted by 𝜎 2 . The standard deviation is
the square root of variance and it is denoted by 𝜎

142
 Mean-Variance Framework
 Mean is the expected returns of your asset (or a portfolio of
assets).
 Risk is measured using variance of returns.
 If portfolios A and B have same risk, and A has higher expected
returns than B, than investors with mean-variance preference
would prefer to invest in A.
 For a given level of risk, mean variance framework tries to
identify the portfolio with highest expected returns. Such
portfolios are called efficient portfolios.
 Mean and Variance of the return distribution are all that matters

143
 Mean-Variance Preferences

Which investment would you prefer

between A and B?

Which investment would prefer

between B and C?

144
Portfolio with 2 assets & 3 assets
Expected Returns of Portfolio Variance of the portfolio
𝑤1 𝑅1 + 𝑤2 𝑅2 𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎12

Expected Returns of Portfolio Variance of the portfolio

𝑤1 𝑅1 + 𝑤2 𝑅2 + 𝑤3 𝑅3 𝑤12 𝜎12 + 𝑤22 𝜎22 + 𝑤32 𝜎32 + 2𝑤1 𝑤2 𝜎12
+ 2𝑤2 𝑤3 𝜎23 + 2𝑤1 𝑤3 𝜎31

𝑤𝑖 is the portfolio weight for asset 𝑖. If half of your total portfolio

capital is invested in asset 𝑖, 𝑤𝑖 will be equal to 0.5.

In the portfolio variance formula for n assets, there will be n

variance terms and n(n-1)/2 covariance terms.
145
Expected returns and variance of a
portfolio of n assets
 Expected returns of a portfolio, 𝑅𝑃 , is a weighted average of
expected return of individual assets,
𝑅𝑃 = σ𝑛𝑖=1 𝑤𝑖 𝑅𝑖
◼ 𝑛 is the number of assets in your portfolio
◼ 𝑅𝑖 is the expected return of asset 𝑖
◼ 𝑤𝑖 is the portfolio weight for asset 𝑖. If half of your total
portfolio capital is invested in asset 𝑖, 𝑤𝑖 will be equal to 0.5.
 Sum of all 𝑤𝑖 ’s should be equal to 1
σ𝑛𝑖=1 𝑤𝑖 = 1

146
Expected returns and variance of a
portfolio of assets
 Expected variance of a portfolio,𝜎𝑃2 , is NOT a weighted average
of expected variance of individual assets
𝑛 𝑛

𝜎𝑃2 = ෍ ෍ 𝑤𝑖 𝑤𝑗 𝜎𝑖𝑗
𝑖=1 𝑗=1
◼ when 𝑖 = 𝑗, you get 𝜎𝑖𝑖 terms. 𝜎𝑖𝑖 is the variance of the returns
of asset 𝑖
◼ when 𝑖 ≠ 𝑗, 𝜎𝑖𝑗 is the covariance between the returns of assets
𝑖 and 𝑗.
 𝜎𝑖𝑗 = ρ𝜎𝑖 𝜎𝑗 , ρ is the correlation between the returns of
assets 𝑖 and 𝑗.

147
P.27
 Two securities have following characteristics:
 Security 1 Expected Return: 0.10 (i.e. 10%); Variance = 0.0025
 Security 2 Expected Return: 0.16 (i.e. 16%); Variance = 0.0064

 Suppose the correlation of returns is -1, what fraction of the

investor's net worth should be held in security 1 and in security
2 in order to produce a zero risk portfolio?
 If riskless return of 10% on Treasury Bills is available, would the
investor holding the above portfolio want to invest in Treasury
Bills?

148
Not all risk is rewarded
 The risk that potentially can be eliminated by diversification is
called specific risk.
 But there is also some risk that you can’t avoid, regardless of
how much you diversify. This risk is generally known as market
risk.
◼ That is why stocks have a tendency to move together.
◼ That is why investors are exposed to market uncertainties, no matter how
many stocks they hold.
 Since you can eliminate specific risk using diversification, only
market risk is rewarded
 The predominant source of uncertainty for a diversified investor
is that the market will rise or plummet, carrying the investor’s
portfolio with it. 149
Why specific risk can be reduced?
 Firm-specific risk can be reduced, if not eliminated, by
increasing the number of investments in your portfolio (i.e., by
being diversified). Market-wide risk cannot.
 Diversifying and holding a larger portfolio eliminates firm-specific
risk for two reasons-
a. Each investment is a much smaller percentage of the portfolio, muting the
effect (positive or negative) on the overall portfolio.
b. Firm-specific actions can be either positive or negative. In a large portfolio,
it is argued, these effects will average out to zero. (For every firm, where
something bad happens, there will be some other firm, where something
good happens.)

150
How diversification reduces unsystematic risk

151
Limits to diversification: Why Stop?
 Marginal benefits of diversification become
smaller as the portfolio gets more diversified.
But they are not zero, than why stop
diversifying?
1. Limited capital
2. Transaction costs
3. Private information

152
Limits to diversification: Why Stop?
 Natural limit to diversification
◼ The limit of diversification is to hold every traded risky asset
(stocks, bonds and real assets included) in your portfolio, in
proportion to their market value
◼ The market portfolio
 Most efficient portfolio of risky assets, in a world with no private
information and no transaction costs.
 Most diversified portfolio, you have removed all risk that could have
been diversified away.
 Everyone should hold the market portfolio
◼ But what about differences in risk aversion?

153
Two fund theorem
 Market portfolio and Risk free asset are all you need to get to any efficient
portfolio allocation
◼ An efficient portfolio is one that for a given level of risk has the highest expected return

 Individual investors will adjust for risk, by adjusting their allocations to this
market portfolio and a riskless asset (such as a T-Bill):
Preferred risk level Allocation decision
No risk 100% in T-Bills
Some risk 50% in T-Bills; 50% in Market Portfolio;
A little more risk 25% in T-Bills; 75% in Market Portfolio
Even more risk 100% in Market Portfolio
A risk hog.. Borrow money; Invest in market portfolio

154
Why market portfolio
 I want high expected returns and I am willing to take a lot of
risk. Why can’t I find the riskiest firms to make my portfolio of
risky assets?
 Since its not feasible to construct the true market portfolio we
use a broad market value weighted equity index as a proxy for
market portfolio.
◼ S&P CNX 500 (recommended)
◼ Why CNX 500, why not market weighted portfolio of all listed stocks?
◼ Most systemic risk factors: Interest Rate, Inflation, Exchange Rate, Index
of Industrial Production, Money Supply, Gold Price, Silver Price & Oil Price
display long run relation with equity market indices

155
Risk-return relationship
 Calculate the portfolio risk and return for a equally
weighted two stock portfolio if the returns of stocks
A and B are 10% and 15% each, their standard
deviations are 16% and 20% respectively, the
coefficient of correlation between the two is one.
 How does this relationship change if the correlation
coefficient decreases from 1 to -1?

156
Risk-return relationship

Expected Return

Standard Deviation of Portfolio

Return (σ)

157
Risk-return relationship
 What happens in a 3 stock portfolio?
◼ As number of stocks in a portfolio increase, the number of
covariance terms increase and more weight starts going
towards the covariance terms
 What happens in a n-stock equally weighted portfolio?
◼ n variance terms and n*(n-1)/2 covariance terms
◼ (1/n)2 *n* Average variance + (1/n)2 * n* (n-1)* Average
covariance (Assuming each asset has a weight 1/n)
◼ (1/n)*Average variance + (1–1/n)* Average Covariance
 What happens when we consider all the risky stocks in
the market?

158
Risk-return relationship
Portfol
io
Return

Standard Deviation of Portfolio

Return (σ)
159
 op set border efficient frontier cap market line assets

80%

60%
return

40%

MARKET
PORTFOLIO

20%

Risk Free
Asset

0%
0% 25% 50% 75% 100% 125% 150%

risk
160
Translating risk into risk premia
 Variance is a measure of total risk
◼ We need a measure of market risk (systematic risk).
Why?
 A model that can translate that market risk into a
risk premium
◼ Asset pricing models

161
Capital asset pricing model (CAPM)
 For a well diversified investor, the risk of adding a new asset is
only the systemic (or market) risk of that asset.

 For any risky asset the expected return 𝑟 is

𝑟 = 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + 𝑅𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
𝑟𝑓 + 𝑀𝑒𝑎𝑠𝑢𝑟𝑒 𝑜𝑓 𝑠𝑦𝑠𝑡𝑒𝑚𝑖𝑐 𝑟𝑖𝑠𝑘 ∗ 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑟𝑖𝑠𝑘

𝐶𝐴𝑃𝑀 𝑀𝑜𝑑𝑒𝑙: 𝑟 = 𝑟𝑓 + 𝛽 ∗ 𝑀𝑎𝑟𝑘𝑒𝑡 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚

Market risk premium (equity risk premium) is the difference
between the expected return on a market portfolio and the risk-
free rate (𝑟𝑚 − 𝑟𝑓 )
162
Capital asset pricing model (CAPM)
 Default Choices
◼ Risk free rate: Long term (10-yr) treasury bond yield or
10 year yield from the ZCYC of Risk-free borrower
 We assume here the GOI is a risk free borrower
◼ Beta: Sensitivity of asset returns to the market returns
 Regression betas
 Bottom-up betas
◼ Market Risk Premium: Historical Premium
 Over a long term, how much extra return does one get if one
invests in market as compared to investing in the risk-free
asset
163
Risk-free rate
 For the purpose of this course (your assignments, exams etc.)
◼ Rf is yield on 10-year government bond
 https://www.bloomberg.com/quote/GIND10YR:IND

◼ 10-year Zero coupon yield

https://www.ccilindia.com/RiskManagement/SecuritiesSegment/Pages/
ZCYC.aspx

164
The Historical Premium Approach

 Defines a time period for the estimation (Longer the better)

 Calculate average annual returns on a stock index during the
period
◼ Use CAGR not simple average to calculate average returns
 Calculate average annual returns on a Treasury-Bond over the
period
 Calculates the difference between the two averages and use it as
Historical market risk premium
 The limitations of this approach are:
◼ Backward-looking
◼ Depends on estimation period you use & it is a noisy estimate
◼ Significant structural changes can effect your estimate

165
Beta
 The risk of any asset is the risk that it adds to the market
portfolio. This risk can be measured by how much an asset
moves with the market (covariance of asset returns with
market returns)
 Beta is standardized measure of this covariance. You
standardize this covariance by dividing it with by the variance of
the market.
𝑐𝑜𝑣(𝑟𝑖 , 𝑟𝑚 )
𝛽𝑖 = 2
𝜎𝑚
◼ Now, beta of market becomes 1. Any asset having a beta of 1 has the
same level of risk as the market (average risk). A beta of 2 indicates twice
as much risk as the market and so on.
166
Beta as sensitivity
 Any asset having a beta of X means that if
market moves by 1%, this asset moves by X%
 For example, if Beta = 2, then
◼ If market portfolio declines by 2%, this asset will decline
by 4%
◼ If market portfolio increases by 5%, this asset will
increase by 10%

167
P.28
A security analyst’s expected return on two stocks for
two particular market returns is:
Market Returns Stock A Stock B
5% 2% 3.5%
20% 32% 14%

Based on the above, what do you think are the betas

of the two stocks?

168
Estimating Beta

The standard procedure for estimating betas is to regress stock returns (Ri)
against market returns (Rm):
𝑅𝑒𝑔𝑟𝑒𝑠𝑠𝑖𝑜𝑛: 𝑅𝑖 = 𝛼 + 𝛽𝑅𝑚
where 𝛼 is the intercept and β is the slope of the regression.
 Notice the following outputs
 The intercept
 The β coefficient
 The standard error of the β coefficient
 R-squared

169
Intercept can be used to calculate Jensen’s
alpha
𝐶𝐴𝑃𝑀: 𝑅𝑖 = 𝑅𝑓 + 𝛽(𝑅𝑚 − 𝑅𝑓 )
𝐶𝐴𝑃𝑀: 𝑅𝑖 = (1 − 𝛽)𝑅𝑓 + 𝛽𝑅𝑚 Expected Return
𝑅𝑒𝑔𝑟𝑒𝑠𝑠𝑖𝑜𝑛: 𝑅𝑖 = 𝛼 + 𝛽𝑅𝑚 Actual Return
 Jensen’s alpha is the difference between Actual return and
Expected return based on the market risk of the asset (its 𝛽)

◼ Jensen’s alpha = α − (1 − 𝛽)𝑅𝑓

Do not confuse Jensen’s alpha with regression alpha (intercept)

170
Jensen’s alpha
 Jensen’s alpha is the average return on the stock over and above that
predicted by the CAPM. If the stock is fairly priced, its Jensen’s alpha
must be zero.

 A positive Jensen’s alpha means the asset return is higher than

expected by CAPM based on the market risk (Beta) of the asset

 A negative Jensen’s alpha means the asset return is lower than

expected by CAPM based on the market risk (Beta) of the asset
171
 Beta and Std. Errors
 Definition of Beta
◼ Graphical: Regression slope
◼ Statistical: β = 𝑐𝑜𝑣(𝑅𝑖 , 𝑅𝑚 )/𝑣𝑎𝑟(𝑅𝑚 )
◼ Economic : Beta measures the risk
added on by an asset to a diversified
portfolio
◼ Standard error of Beta: Accuracy of
your beta estimate
 68–95–99.7 rule
 Sample size

172
Estimating Beta
1. Choose a broad market Index
◼ Sensex vs. S&P CNX 500 (Nifty 500)
 CNX 500 represents 500 companies from 73 industries. It
95.77% of the free float market capitalization of the stocks
listed on NSE
2. Use either weekly returns for 2 to 5 years, or monthly
returns for 5 years in your regression
◼ Jensen’s alpha calculation: With weekly returns you will get a
weekly regression intercept, similarly with monthly returns you
will get a monthly regression intercept.

173
 Estimating Beta for Yes Bank
30.00%

20.00%

10.00%
Yes Bank

0.00%
-8.00% -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00%

-10.00%

-20.00%

-30.00%
CNX 500(Mkt)
Yes Bank Predicted Yes Bank 174
175
Estimating Beta for Yes Bank
 Estimation period: 5 years
 Return frequency: Weekly returns
 Market Index: CNX 500 Index
 Intercept = 0.376%
◼ This is an intercept based on weekly returns. Thus, it has to
be compared to a weekly risk-free rate.
 Annualized risk-free rate = 7.696%
 Weekly Risk-free Rate = 0.142%
 Risk-free Rate * (1-Beta) = 0.142% * (1-1.405) = -
0.058%
◼ Weekly Jensen’s Alpha = 0.376% - (-0.058)% = 0.434%

176
Estimating Beta for Yes Bank
 Yes Bank did 0.434% better than expected, per week in the last 5
years.
◼ Yes Bank’s annual excess return = (1.00434)(365/7) -1= 25.33%
 Yes bank made what it needed to make in accordance to its risk
[𝑅𝑓 + 𝛽(𝑅𝑚 − 𝑅𝑓 )] + an additional 25.33% per year.

 R-squared is 25%
◼ If I buy just Yes Bank stock, how much of the total risk am I exposed to?
◼ If I hold a diversified portfolio, how much of the total risk am I exposed to?

 The R-squared of the companies has increased after the financial

crisis of 2008.
◼ Implication for the investors
177
P.29
 A regression of monthly returns of Infosys against
monthly returns of NSE 500 index (market index)
generated the following output:
 Return of Infosys = 1.47% + 1.45 Return on
Market
 An analyst has correctly estimated that the stock
did 21.7% better than expected annually during
the period of regression. What is the annualized
risk-free rate that the analyst used to come up with
this estimate? 178
Historical Betas – R-Squared
 What does the R-squared imply?
◼ What proportion of risk in this company’s returns are explained by
market movements?
 If two stocks are similar in cash flows, growth and have the
same beta coefficients and standard errors. Which one do
you pick if stock A has 75% R-Square and stock B has 25%
R-squared?
◼ A
◼ B
◼ It depends
 Which one if you were a diversified investor?
 Which one if you were not a diversified investor?

179
Decomposition of regression Beta
 Regression beta is a measure of risk and this risk emanates
from two sources
◼ Business Risk or Nature of your business
◼ Financial Risk or leverage

 Regression beta is also called levered beta (𝛽𝐿 ) because it

includes the effect of both business risk and Leverage

 You can remove the effect of leverage from beta, and this beta is
called unlevered beta 𝛽𝑢

180
Firm risk (equity risk) = business risk +
financing risk

𝐷
𝛽𝐿 = 𝛽𝑢 1 + (1 − 𝑡)
𝐸
𝐷
 𝑡 is the tax rate, is the ratio of market value of debt to market
𝐸
value of equity

 Unlevered beta 𝛽𝑈 (also called asset beta) represents only business

risk. It assumes that firm is 100% equity financed or unlevered.

 Levered beta 𝛽𝐿 represents the combined business risk and financing

risk. This is your regression beta. 181
Beta of a portfolio
 The beta of a portfolio is always the market-value
weighted average of the betas of the individual
investments in that portfolio.
𝑉1 𝑉𝑛
𝛽𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = 𝛽1 + ⋯ + 𝛽𝑛
𝑉 𝑉
Where 𝑉𝑖 is the market value of the investment in
asset 𝑖. 𝑉 is the total value of the portfolio
𝑉1 + 𝑉2 + ⋯ + 𝑉𝑛 = 𝑉
 Implication: Large cash holdings can reduce your
beta because cash has a beta of zero 182
Firm Betas versus divisional Betas

 Firm Betas as weighted averages: The beta of a firm

is the weighted average of the betas of its individual
projects.

 Firm Betas and Business betas: At a broader level of

aggregation, the beta of a firm is the weighted
average of the betas of its individual division.

183
What should happen to a firm’s beta if..
 It sells half of its business and invests the proceeds in T-
bills
 If it acquires a similar value business that has a beta that is
three times its beta
 Starts liquidating its business and investing the proceeds in
market portfolio, by buying market index based ETFs
 Starts diversifying into new businesses and product lines
 It reduces its debt to equity ratio to the lowest in its
industry

184
Problems with regression beta

 The regression beta has three problems:

◼It has high standard error

◼It reflects the firm’s business mix over the period of the regression,
not the current mix

◼It reflects the firm’s average financial leverage over the period rather
than the current leverage.

185
Fundamental Betas
 This is also known as bottom-up beta
 The idea is that beta of firm should be a factor of
◼ Business
◼ Financial Leverage
◼ Cash
 Large Cash holding can reduce your beta, because cash
has a beta of zero

186
Bottom-up Betas

1. Find comparable publically traded firms in your firm’s business, and

calculate regression betas for all of them. Then, compute the average
beta for the business. This is the levered beta for the business,
levered means that it also imputes the risk of leverage.

2. Adjust for leverage: Unlevered beta removes the effect of financing

and only represents risk of the business operations
Average 𝛽𝐿,𝐶𝑜𝑚𝑝𝑎𝑟𝑎𝑏𝑙𝑒 𝑓𝑖𝑟𝑚𝑠
𝛽𝑈,𝐵𝑢𝑠𝑖𝑛𝑒𝑠𝑠 =
𝐷
1 + 𝐸 (1 − 𝑡)
D/E is the average (or median) debt to equity ratio for all firms identified
in step 2. Debt and Equity are measured at market value. We assume
book value of Debt is same as market value of debt
187
Bottom-up Betas
3. Adjust for cash: Investments in cash and marketable securities have
betas close to zero. Consequently, the unlevered beta that we obtain
for a business by looking at comparable firms may be affected by the
cash holdings of these firms.
𝛽𝑈,𝐵𝑢𝑠𝑖𝑛𝑒𝑠𝑠
𝐶𝑎𝑠ℎ − 𝑎𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝛽𝑈,𝐵𝑢𝑠𝑖𝑛𝑒𝑠𝑠 =
𝐶𝑎𝑠ℎ
1−
𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒
Where “Cash/Firm value” is the average proportion of cash holdings
for all firms identified in step 2. Firm value can be calculated as
market capitalization + book value of debt (assuming that book value
of debt is same as market value of debt)
In the presence of outliers, Median is generally better than Average

188
Bottom-up Betas

 First three steps removed the effect of leverage and cash and
give you “pure business beta”, reflecting only “business risk”

 Now, in the final two steps 4 and 5 we account for our firm’s
leverage and cash holdings

 In steps 4 and 5 we use the proportion of cash holdings and D/E

ratio of your firm to lever the “average unlevered beta”
computed in step 5

189
Bottom-up beta
4. Add the effect of your company’s cash holding
𝐶𝑎𝑠ℎ
𝛽𝑢,𝑓𝑖𝑟𝑚 = 𝐶𝑎𝑠ℎ − 𝑎𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝛽𝑈,𝐵𝑢𝑠𝑖𝑛𝑒𝑠𝑠 × 1 −
𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒

5. Add the effect of your company’s cash holding

to get bottom up beta for your firm (𝛽𝐿,𝑓𝑖𝑟𝑚 )
𝐷
𝛽𝐿,𝑓𝑖𝑟𝑚 = 𝛽𝑢,𝑓𝑖𝑟𝑚 × 1 + (1 − 𝑡)
𝐸

190
Why bottom-up betas?
 The standard error in a bottom-up beta will be significantly lower
than the standard error in a single regression beta. Roughly
speaking, the standard error of a bottom-up beta estimate can be
written as follows:
Average Std Error across Betas
Std. error of bottom-up beta =
Number of firms in sample

 The bottom-up beta can be adjusted to reflect changes in the

firm’s business mix and financial leverage. Regression betas
reflect the past.
 You can estimate bottom-up betas even when you do not have
historical stock prices. This is the case with initial public offerings,
private businesses or divisions of companies.

191
CAPM – Concept checker
 XYZ Ltd. has a beta of 1.2. The historical return
from market on average was 11% and the
historical risk-free rate was 8%. The yield of a 10
yr. government bond as of today is 7%. If the
market expects this stock to return 11% over the
next year, is the stock over-valued or under-valued
given its risk and returns expected by the market?

192
Plotting CAPM – Security market line

193
CML vs. SML Security Market Line

194
CML vs. SML

195
Fundamental Betas – Concept checker
 You are trying to estimate the beta of Moon
Pharma. The pharma sector in the industry has an
average regression beta of 0.8. The average debt
ratio of the pharma sector is 20% and cash on
average contributes 10% of the firm value. Moon
Pharma has a debt equity ratio of 40% and cash
contributed only 5% of its firm value. What is the
equity beta for moon pharma. Tax rate is 30%?

196
Cost of Equity
 In finance, cost of any asset is the expected return on that asset.
◼ You find out the risk in the asset and based on that you form an
expectation of expected returns
◼ CAPM is one way of doing that, gives you expected returns based
on the market risk you take. In CAPM your measure of risk is beta.

 If your business is 100% equity financed, your expected return is the

expected return on your equity investment in that business. This will
be your cost of equity

197
Cost of Equity
 We can estimate the cost of equity as Rf + βL * (Market Risk
Premium)
 For the purpose of this course (your assignments, exams etc)
◼ Rf is yield on 10-year government bond (or 10-year Zero coupon yield if
available)
◼ βL is bottom-up beta (if not available than use regression beta as your
levered beta)
◼ Market Risk Premium is your historical market risk premium
 In the context of cost of equity, “Market risk premium” is also called
“Equity risk premium”

198
Cost of Debt
 The cost of debt measures the current cost to
raise long-term debt for a firm
◼ Cost at which you can borrow for long term today

 It has the following variables

◼ The prevailing risk-free rate
◼ The current default risk perception of your firm
Cost of debt = Rf + Risk Premium (or spread)

199
Cost of Debt
 The cost of debt can be estimated as follows
1. If a company has long term bonds which are actively traded
in the market, the YTM on such bonds can be treated as the
cost of debt
2. If corporate credit ratings of long term debt or bank
loans is available for your company, use that rating.
 Credit rating may be available at
http://www.crisil.com/ratings/credit-ratings-list.jsp, or other
credit rating agencies ICRA, CARE
 It may also be available at your firm’s website or in its
annual report

200
Cost of Debt
3. If your firm is not rated compute the interest
coverage ratio of your firm, and then identify a
synthetic credit rating using the following link
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/
datafile/ratings.htm

On the same link you will find risk premium (spread over
risk free rate) corresponding to the credit rating.

201
Calculating Cost of Debt
4. For Rf, go to CCIL website to get the latest ZCYC curve
◼ https://www.ccilindia.com/RiskManagement/SecuritiesSegment/Pa
ges/ZCYC.aspx

5. An alternative way to find corporate bond spread is to go to

Bloomberg and find out FIMMDA Annualized corporate bond
spreads corresponding to your company’s credit rating for long
term borrowing (just type FIMMDA BB on Bloomberg search)

6. Calculate cost of debt by adding 10 year risk-free rate from the

ZCYC curve + 10 year corporate bond spread for your company
202
203
204
205
Cost of debt for Tata Steel
 Credit rating for long term borrowing BB- (S&P)

 Corporate spread for BB- bonds for 10 year is

5.89% (FIMMDA)

 10-year GOI zero coupon yield is 6.98% (CCIL)

 Cost of Debt for Tata Steel = 5.89% + 6.98% =

12.87%
206
Weighted Average Cost of Capital (WACC)
 WACC is the cost of total capital (both debt and equity) for the firm
𝐸 𝐷
𝑊𝐴𝐶𝐶 = ∗ 𝑘𝑒 + ∗ 𝑘𝑑 1 − 𝑡
𝐸+𝐷 𝐸+𝐷
◼ 𝑘𝑒 is cost of equity, 𝑘𝑑 is cost of debt, 𝑡 is tax rate and 𝐸 and 𝐷 are
market values of equity and debt
◼ When the risk of the project is the same as the average risk of the
firm’s investments, the WACC can be used to value the project
 The project’s business risks are the same as those the firm and remain so
for the life of the project.
 The project supports the same fraction of debt to value as the overall
capital structure, which remains constant for the life of the project.
◼ What do you do when leverage and business risks differ?

207
Project’s cost of equity
 Project has similar business risks and leverage as the firm
◼ Use firm’s COE
 Multiple Businesses with Different Risk Profiles: Project Risk
similar within each Business
◼ Estimate the cost of equity for each business separately and use that cost
of equity for all projects within that business.
 Each project has different business risks and leverage
◼ Calculate unlevered bottom-up beta for the project based on comparable
firms
◼ Lever it at project’s leverage
◼ Use this beta in CAPM to calculate the COE for the project

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Project’s cost of debt
 Project is small and has similar business risks and leverage to
the firm
◼ Use cost of debt for the firm
 Project is large and has different business risks and leverage
◼ Use cost of debt of comparable firms, assuming it will have average debt ratio of
comparable firms
 If it has significantly different debt ratio than the comparable
firms.
◼ We can estimate a synthetic rating for a project based on its financial
ratios. Find cost of debt based on synthetic rating.

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Assignment 2: Cost of capital
 Estimating regression betas
Extract monthly data for 5 years for share price of your company and
the market index values (Can we use daily returns? Why not 10 years?)
◼ Choice of market index
◼ Estimate a regression equations of monthly returns on your firm’s
stock against the monthly returns on the market index and
interpret the following (Can you regress prices instead of returns?)
 What is the intercept? Did the stock perform better or worse
than expected for the duration of 5 years?
 What is the beta coefficient? What does it tell you about the
riskiness of the stock relative to the market?
 How precise is the estimate of the beta coefficient?
 What proportion of this firm’s total risk is attributed to market 210
Assignment 2: Cost of capital
 Estimating top-down (fundamental) betas
 Choose at least 8 comparable firms which are closest to your
firm on the basis of similarity of business
 Estimate their regression betas using SLOPE function of excel
 Extract the market capitalization, debt and cash data for these
firms
 Take out the effect of D/E and Cash to compute the unlevered
beta for the business – Pure Business Beta
1. Average (median) regression betas first then unlever, OR
2. Unlever regression betas first then average (median)
 Adjust the cash of your firm and lever the beta obtained after
such adjustment with the debt-equity ratio for your firm 211
Assignment 2: Cost of capital
 Cost of equity
 Estimate the historical risk premium (Long period, as long as possible)
◼ CAGR of Market Index – CAGR of Risk free asset (10 year T Bond)
 Risk free rate
◼ 10 year T bond yield or 10 year Zero Coupon yield. Why 10, why not 30?
 Use CAPM estimate the cost of equity for the firm
 Cost of Debt
◼ Rf + Risk Premium based on your firm’s long term credit ratings
◼ Synthetic credit ratings
◼ Example of Tata Steel
 Cost of Capital
◼ Use the cost of equity, cost of debt, market capitalization of the firm and the
amount of debt of the firm to estimate the weighted average cost of capital for
your firm(Use market value weights) 212
Mariott Case
Discussion

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Valuing equity (stocks)
 Why not use book value of equity?
 Some B/S items are recorded at fair value
◼ Cash and Cash equivalents
◼ Short term marketable securities
 What about..
◼ Receivables
◼ Inventory
 Some B/S are recorded at historical costs (less accumulated depreciation)
◼ Long-term tangible assets
◼ Purchased Intangibles – Licenses, Patents, Copyrights
◼ Goodwill (Acquired)
 Investments Classification
 Ultimate backward looking number – Book Value of Equity

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Why not use book value of equity?
 Many intangible assets are not on B/S
◼ Brand Name
◼ Customer Base
◼ Customer Loyalty
◼ Skill of employees
◼ Competency of Managers
◼ Technical knowhow
◼ Collaborations with other firms
◼ Relations with suppliers
◼ Knowledge assets developed internally
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Why not use book value of equity?
 Because of these differences there can be significant difference
between the book value and market value of equity
 Can Market value of equity become negative?
 Can Book value of equity become negative?
 Can Book value of equity of good companies become negative?
 In June 2005, Amazon.com had total liabilities of $2.6 billion
and a book value of equity of –$64 million. At the same time,
the market value of its equity was over $15 billion. Clearly,
investors recognized that Amazon’s assets were worth far more
than their book value.

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Why not use market value of equity?
 Markets may not be
correct
 Private stocks are not
traded on an exchange
 To follow the objective
of maximizing value,
we need to understand
the drivers of value

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Equity valuation approaches
1. Dividend discount models

2. Discounted cashflows (FCF/FCFE)

3. Residual Income valuation

4. Relative valuation

5. Contingent claim valuation

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Discounting Dividends (DDM)
 Any discounted cashflow based valuation model requires just
three inputs
1. Cashflows
2. Growth rates
3. Discount rates
 “Dividends are the cashflows received by an investor who buys and
holds a share of stock”

 Dividends are less volatile than earnings and other return concepts,
the relative stability of dividends may make DDM values less sensitive
to short-run fluctuations in underlying value

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DDM valuation approach
 Dividends—Distributions to shareholders authorized by a corporation’s board
of directors
 Are dividends the only method to redistribute capital to shareholders?
 Single period DDM

◼ V0 = the value of a share of stock today, at t = 0

◼ P1 = the expected price per share at t = 1
◼ D1 = the expected dividend per share for Year 1, assumed to be paid at the end of the year
at t = 1
◼ r = the required rate of return on the stock

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DDM valuation approach
 Suppose that you expect ACME Inc. to pay a Rs. 2 dividend next year and the
price of GM stock to be Rs. 58 in one year. What is your estimate of the value
of ACME stock if the required rate of return is 10%
 Ans: 54.55
 Multi period DDM

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DDM with stable perpetual growth:
Gordon growth model
Gordon growth model (Single Stage or Stable growth DDM)

 Suppose that an annual dividend of Rs. 5 has just been paid (D0 = 5).
The expected long-term growth rate is 5% and the cost of equity is
8%. Calculate the value of stock
Ans: 175
 Because the model is based on indefinitely extending future dividends,
the model’s required rate of return and growth rate should reflect long-
term expectations.
 Model values are very sensitive to both the required rate of return, r,
and the expected dividend growth rate, g.
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DDM Types
 Can the stable growth rate be negative? What would it imply for the
value of the firm?
 Value a firm with current DPS of Rs. 5 growing at –5% a year forever
and a cost of equity of 10%
 5(1-.05)/(.1+.05) = Rs. 31.67 per share
 How much would you pay if it was growing by +5% instead?
 5(1+.05)/(.1-.05) = Rs. 105
 What should be the Gordon growth model valuation for Preference
shares
 g = 0 because dividends are fixed for preferred stock

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DDM with stable perpetual growth:
Gordon growth model
 What about the reinvested earnings? The portion that the firm does
not pay back as dividends. Does DDM ignore it?
◼ Reinvested earnings should increase the future dividends

 Growth can be found out in multiple ways

◼ Historical growth
◼ Analyst estimates
◼ Fundamental growth

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Fundamental growth in Net Income
(Earnings)
 Growth in NIt = Retention ratiot-1 * ROEt
 ROEt = NIt / BV of Equityt-1
Notice book value of equity is measured at the beginning of
the year

 Retention ratio = 1 – Payout ratio

In per share terms, you can write it as growth in
earnings per share (EPS)
 Growth in EPSt = Retention ratiot-1 * ROEt
225
Fundamental growth in Net Income
(Earnings)
 It is common for companies to have high growth
rates in initial phase (with high retention ratios),
and then stabilize into a low long term growth rate
(with a constant and low retention ratio)
 Growth in NIt = Retention ratiot-1 * ROEt
 Assuming ROE is stable (constant) over years, then
◼ If retention ratio stabilizes in year 3, the Growth rate of
income (and also dividends) will stabilize from year 4.

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Discounting Dividends (DDMs)
 Firm paying no dividends
◼ Young firms
◼ High growth firms
 Dividends are distribution of wealth rather than creation of wealth
 Dividend policy can be arbitrary and not linked to value added –
“Sticky dividends”.
 It does not incorporate other ways of returning cash to stockholders
(such as stock buybacks).

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Is DDM valuation approach relevant?
Use DDM only when dividends bear an understandable and
consistent relation to the company’s profitability
Firm A
EPS 0.41 0.12 −0.36 1.31 1.86 0.39 0.88 1.58 4.26 4.92
DPS 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00
Payout
ratio 244% 833% NA 76% 54% 256% 114% 63% 23% 20%
Firm B
EPS 0.62 0.66 0.77 0.79 0.52 0.72 0.93 1.11 1.2 1.3
DPS 0.18 0.22 0.25 0.29 0.3 0.39 0.32 0.33 0.35 0.37
Payout
ratio 29% 33% 32% 37% 58% 54% 34% 30% 29% 28%

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Sticky Dividends

229
DDM: Gordon growth model
Implied growth rate from market price
 Suppose a company has a beta of 1.1. The risk-free rate is 5.6%
and the market risk premium is 6%. The current dividend of Rs.
2 is expected to grow at 5% indefinitely. What is the value of
the company’s stock? The price of the stock is Rs. 40.What
growth rate would be required to justify the current market
price?
 Ans: V0 = Rs. 29.17 and g = 6.86%
Implied Cost of Equity

230
DDM: Gordon growth model
 Advantages: GGM is useful for
◼ Valuing mature stable companies
◼ Valuing broad portfolios like equity indices
◼ Understanding the relationships among value and growth,
required rate of return, and payout ratio.
◼ Easily used as a component in other more sophisticated
valuation models. For example, it may be used for
 Estimating the expected rate of return given efficient prices
 Estimating terminal value in Free cash flow based DCF models

231
DDM: Gordon growth model
 Disadvantages
◼ Not useful if the firm does not pay dividends
◼ Needs to include stock buyback, but there are some issues
◼ Not relevant if dividends do not bear any relation with
profitability
◼ Valuation: Values are very sensitive to the assumed growth
rate and required rate of return
◼ Implied cost of equity: Market price is same as the intrinsic
value
◼ Stable growth?

232
Lifecycle of a company
 Startup phase
 Growth phase
◼ Rapidly expanding markets
◼ high profit margins
◼ an abnormally high growth rate in EPS
 Transition Phase
◼ Competition puts pressure on prices and profit margins
◼ Sales growth slows
◼ Earnings growth rates may be above average but declining
towards the growth rate for the overall economy
233
Lifecycle of a company
 Maturity Phase
◼ The company reaches an equilibrium in which investment
opportunities on average just earn their opportunity cost of
capital
◼ Return on equity approaches the cost of equity;
◼ Earnings growth, the dividend payout ratio, and the return on
equity stabilize at levels that can be sustained long term.
 Declining Phase?

234
Some of the oldest companies still in Business

 Kongō Gumi Co., Ltd. 578

 Beretta 1526

 Grolsch 1615

 London Gazette 1665

235
Another way ?

236
MULTISTAGE DDMS
 Which Growth pattern is consistent with GGM?

237
Two stage DDM-Concept Checker
 A stock is expected to pay a dividend of INR 5 next
year. This dividend will grow at 8% till year 6. The
dividend expected in the seventh year is INR 8.33. It
will continue to grow at 4% thereafter. What is the
value of the stock today if cost of equity is 10%
 Ans: PV of Growing annuity + PV of growing perpetuity
➔Price = 26.063 + 78.368 = 104.431

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Present Value of Growth Opportunities (PVGO)
 Value of equity= Value of assets already in place + PVGO
◼ Assuming 100% equity based financing
 What are growth opportunities?
◼ Future (new) positive NPV Projects
 A company without positive (expected) NPV projects is a no-growth
company
◼ What should it do with its earnings?
◼ Assuming constant ROE and no further equity infusion, what would
happen to its future earnings?
◼ What will the value of such a firm?

239
Present Value of Growth Opportunities (PVGO)

𝐸𝑃𝑆0
𝑉0 = + 𝑃𝑉𝐺𝑂
𝑟
 If prices reflect value (P0 = V0)
 If PVGO is 80% of your price, the market assigns 80% of the
company’s value to the expectation of future growth
 For a no growth company, assuming that the prices reflect value
(P0 = V0), the earnings yield (EPS0/P0) is equal to the expected
rate of return
r = EPS0 /P0.

240