© Business eLearning
BBS 35 FT
Principles of Finance
(FIN2002S)
Presented by
Dr. June Neo
1
© Business eLearning
Module Introduction
2
Presented by Dr. June Neo
© Business eLearning
Part One:
Introduction to Finance
3
Presented by Dr. June Neo
© Business eLearning
The finance world
4
Presented by Dr. June Neo
© Business eLearning
The Finance World
• What is Finance?
– Financial decisions about money
• More money is preferred to less
• Earlier receipt is preferred to later
• Less risky is preferred to more
5
Presented by Dr. June Neo
© Business eLearning
The Finance World
• Main focus of Finance
– Financial Systems
• Financial markets, Financial intermediaries
and securities
– Investments
• Value of the investments and the optimal mix
– Financial services
• Management of money: how to invest
– Managerial finance
• Decision by corporate managers
6
Presented by Dr. June Neo
© Business eLearning
Financial Systems
7
Presented by Dr. June Neo
© Business eLearning
Functions of Financial Systems
1. Perform essential economic function
– Channels funds from person or business
without investment opportunities (i.e.,
“Lender-Savers”) to one who has them
(i.e., “Borrower-Spenders”)
8
Presented by Dr. June Neo
© Business eLearning
Functions of Financial Systems
2. Monetary function
– The introduction of money in the
economy enables savers and spenders to
separate the act of sale from the act of
purchase and enables them to overcome
the main problem of barter, which is the
‘double coincidence of wants’ (each of
the two parties involved in a transaction
has to want simultaneously the good the
other party is offering to exchange).
9
Presented by Dr. June Neo
© Business eLearning
Functions of Financial Systems
• provide the mechanisms by which
funds can be transferred from units in
surplus to units in shortage of funds,
which is to facilitate lending and
borrowing
• enable wealth holders to adjust the
composition of their portfolios
• provide payment mechanisms.
10
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Systems
• Financial Markets
• Financial Intermediaries
• Securities
11
Presented by Dr. June Neo
© Business eLearning
Financial Markets
12
Presented by Dr. June Neo
© Business eLearning
Financial Markets
• Financial markets are markets in
which funds are transferred from
people and Firms who have an
excess of available funds to people
and Firms who have a need of
funds
13
Presented by Dr. June Neo
© Business eLearning
Financial Markets Funds Transferees
Lender-Savers
1. Households/individuals
2. Business firms
3. Government
4. Foreigners
Borrower-Spenders
1. Business firms
2. Government
3. Households
4. Foreigners
14
Presented by Dr. June Neo
© Business eLearning
Perform essential economic function –
Channelling of Funds
• In direct finance, borrower borrow funds
directly from lenders in the financial markets
by selling them financial instruments which
are claims on the borrower’s future income or
assets.
15
Presented by Dr. June Neo
© Business eLearning
Functions Performed by a Financial System
16
Presented by Dr. June Neo
SECURITIES SECURITIES
© Business eLearning
Perform essential economic function –
Channelling of Funds
• In indirect finance, borrowers borrow
indirectly from lenders via financial
intermediaries (established to source both
loanable funds and loan opportunities) by
issuing financial instruments which are claims
on the borrower’s future income or assets.
17
Presented by Dr. June Neo
© Business eLearning
Functions Performed by a Financial System
1. Allows transfers of funds
from person or business
without investment
opportunities to one who has
them
2. Improves economic
efficiency
SECURITIES SECURITIES
CASH / LOANSCASH / DEPOSITS
18
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Systems – Financial
Markets
• markets in which securities (such as bond
and stock markets) are traded.
• Where funds are moved from people who
have an excess of available funds (and
lack of investment opportunities) to
people who have investment opportunities
(and lack of funds).
• have direct effects on personal wealth,
and the behaviours of businesses and
consumers.
• contribute to increase the production and
the efficiency in the overall economy.
19
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Markets
• Financial markets can be classified based
on:
– nature of the financial securities traded
(primary versus secondary markets),
– forms of organization (organized
exchanges versus over-the-counter
(OTC) markets),
–maturity of the financial instruments
traded (capital markets versus money
markets),
– and forms of trade intermediation
(dealer markets and brokered markets).
20
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Markets – Primary
and Secondary Markets
• A primary market: where new issues
of financial securities (both bonds
and stocks) are sold to initial buyers.
• A secondary market: where
securities that have been previously
issued can be resold.
• Primary markets facilitate new
financing to corporations, but most
of the trading takes place in the
secondary markets.
21
Presented by Dr. June Neo
© Business eLearning
22
22
Financial Markets
Firms
Investors
Secondary
Market
money
securities
SueBob
Stocks and
Bonds
Money
Primary Market
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Markets – Primary
and Secondary Markets
• Although firms do not raise additional
funds from the secondary market, it
serves two important functions:
– Provide liquidity, making it easy to buy and
sell the securities of the companies
– Establish a price for the securities, both
IPOs and SEOs.
23
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Markets – Exchange-
traded and OTC Markets
• Exchanges
– Trades conducted in central locations
(e.g. Euronext, CME group, SGX)
• Over-the-Counter (OTC) Markets
– Dealers at different locations buy and
sell
– Best example is the market for Treasury
securities, Foreign Exchange (FX) market
24
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Markets – Money
Markets and Capital Markets
• Money markets: short-term debt instruments
(maturity < one year) are traded.
– mainly wholesale markets (large
transactions) where firms and financial
institutions manage their short-term
liquidity needs (i.e. to earn interest on
their temporary surplus funds).
• Capital markets: long-term securities are
traded.
– E.g. equity instruments (infinite life),
government bonds and corporate bonds
(maturity > one year).
– often held by mutual funds, pension funds
and insurance companies.
25
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Markets –
Dealer and Brokered Markets
• Dealer markets
– Dealer or market-maker is on one side of
every trade. (Market makers quote prices
and stand ready to buy and sell at these
quotes, hence provide liquidity)
– Dealers hold an inventory of the security,
which fluctuates as they trade. They profit
from charging a bid-ask spread and from
speculating.
– E.g. Bonds market, FX market
26
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Markets –
Dealer and Brokered Markets
• Brokered markets,
– brokers perform active search role to
match buyers and sellers.
– They do not provide liquidity but they find
liquidity. i.e. they hold no inventory as
they do not participate in the trade
themselves.
– E.g. Stocks market.
27
Presented by Dr. June Neo
© Business eLearning
Discussion
28
Presented by Dr. June Neo
© Business eLearning
Financial Intermediaries
29
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Systems – Financial
Intermediaries
• agents who specialize in the activities
of buying and selling (at the same
time) financial contracts (loans and
deposits) and securities (bonds and
stocks).
• Note that financial securities are easily
marketable, while financial contracts
cannot be easily sold (non-marketed).
30
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Systems – Financial
Intermediaries
• Banks
– the largest financial institution.
– accept deposits (loans by individuals or
firms to banks) and make loans (sums
of money lent by banks to individuals or
firms)
– i.e., they borrow deposits from people
who have saved and in turn make loans
to others.
31
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Systems – Classification
of Financial Intermediaries
• Depository Institutions (or DIs): accept
deposits and make loans
– Commercial banks
– Savings and loan associations
– Credit unions and Building societies
32
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Systems – Classification
of Financial Intermediaries
• Contractual Savings Institutions (CSIs):
acquire funds from clients at periodic
intervals on a contractual basis and
have fairly predictable future payout
requirements
– Insurance companies
• Life Insurance
• Fire and Casualty Insurance
– Pension funds
33
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Systems – Classification
of Financial Intermediaries
• (Other) Investment intermediaries
– Finance companies
– Mutual funds
– Money Market Mutual Funds (MMMF)
– Investment banks
34
Presented by Dr. June Neo
© Business eLearning
Types of Financial Intermediaries
35
Presented by Dr. June Neo
© Business eLearning
Discussion
36
Presented by Dr. June Neo
© Business eLearning
Financial Securities
37
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Systems – Securities
• also called financial instruments, can be
classified into debt instruments and equity
instruments.
• are financial claims on the issuer’s
(borrower’s) future income or assets.
• represent financial liabilities for the
individual or firm that sells them (i.e.
borrower or issuer of the financial claim in
return for money),
• represent financial assets for the buyer
(lender or investor in the financial claim).
38
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Systems – Securities
• Governments issue debt instruments
while corporations issue debt and
equity instruments to finance their
activities
• Debt holders and equity holders are
funds providers
39
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Systems – Securities
• Debt markets
– borrowers issue a security, known as bond,
that promises periodic interest (coupon
payments) until the maturity date, and pay
back the par value (face value) to the
investor at the maturity date.
– The interest rate is the cost of borrowing.
– Short-Term (maturity < 1 year) e.g. Bills
– Intermediate term (maturity in-between)
e.g. Notes
– Long-Term (maturity > 10 year) e.g. Bonds
40
Presented by Dr. June Neo
© Business eLearning
Issuers
• Governments
• Municipal bonds
• Corporations
41
Presented by Dr. June Neo
© Business eLearning
Government Bonds
Treasury Notes and Bonds
• The U.S. Treasury issues notes and
bonds to finance its operations.
• Normally with low interest rates,
often considered the risk-free rate.
• The following table summarizes the
maturity differences among the
various Treasury securities.
42
Presented by Dr. June Neo
© Business eLearning
Treasury securities
Treasury Bills, Notes and Bonds
43
Presented by Dr. June Neo
• Treasury bill: less than 1 year
• Treasury note: 1 to 10 years
• Treasury bond: 10 to 30 years
© Business eLearning
Municipal Bonds
• Issued by local, county, and state
governments
• Used to finance public interest
projects
• Tax-exempted
44
Presented by Dr. June Neo
© Business eLearning
Corporate Bonds
• Typically have a face value of
$1,000, although some have a face
value of $5,000 or $10,000
• Pay coupon semi-annually
45
Presented by Dr. June Neo
© Business eLearning
Corporate Bonds
• Cannot be redeemed anytime the
issuer wishes, unless a specific
clause states this (call option).
• Degree of risk varies with each bond,
even from the same issuer.
Following suite, the required interest
rate varies with level of risk.
46
Presented by Dr. June Neo
© Business eLearning
Credit Rating
47
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Systems – Securities
• Equity markets
– where common stock (or just stock, also
known as ordinary shares), representing
ownership in a company, are traded.
– claims by shareholders in the net
income and assets of a firm.
– do not have a maturity date.
48
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Systems – Securities
• Equity markets
– Companies initially sell stock (in the
primary market) to raise money. But
after that, the stock is traded among
investors (secondary market).
– Pay dividends, in theory forever.
49
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Systems – Securities
• Equity markets
– Equity claims are riskier than debt
instruments.
– First, firms are not contractually obliged to
make periodic payments to shareholders:
the payment of dividends is a discretionary
decision of the firm.
– Second, firms must pay all their debt
holders before they make any payment to
shareholders: therefore shareholders are
residual claimants.
50
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Systems – Securities
• Equity markets
– Shareholders have ownership rights while
debtholders have no ownership interest but
are creditors of the firm.
– Ownership rights have two main
implications:
• shareholders benefit from increase in the
income or asset value of the company.
When stock price increases, holders can
obtain high capital gains.
• have the right to vote for directors or on
certain issues.
51
Presented by Dr. June Neo
© Business eLearning
Structure of Financial Systems – Securities
• Equity markets
– The proportion of economic and
ownership rights is different between
• common stockholders and
• preferred stockholders.
52
Presented by Dr. June Neo
© Business eLearning
Equity Instruments – Common Stocks
• Common stocks
– represent ownership interests in the firm.
– stockholders receive dividends (when
distributed), take capital gains (or losses)
when the stock price on the market
increases (decreases),
– have the right to vote during AGM and
EGM.
53
Presented by Dr. June Neo
© Business eLearning
Equity Instruments – Preferred Stocks
• Preferred stocks
– limited ownership rights in comparison to
common stocks.
– differ from common stocks in several ways.
– First, preferred stocks distribute a fixed
constant dividend, which makes them
more similar to bonds than to common
stocks.
54
Presented by Dr. June Neo
© Business eLearning
Equity Instruments – Preferred Stocks
• Preferred stocks
– Second, the price of preferred stocks is
relatively stable, as the dividend is a
constant amount.
– Third, NO voting rights during AGM. May
have voting rights during EGM.
– Finally, have residual claim on assets
and income after creditors have been
paid, but have priority claim over
common stockholders.
55
Presented by Dr. June Neo
© Business eLearning
Priority vs Residual claims
• In order of priority,
– The debtholders will have the first
(priority) claim on firm’s future income
and assets, followed by
– Preferred stockholders (aka hybrid
securities, and
– Last to claim is the common
stockholders
Presented by Dr. June Neo
56
© Business eLearning
Discussion
57
Presented by Dr. June Neo
© Business eLearning
Investments
58
Presented by Dr. June Neo
© Business eLearning
What contributes good Investments
• Value of the investments
– Amount of cash flows
– Risk and returns
– Timing of cash flows
• Optimal mix of securities
59
Presented by Dr. June Neo
© Business eLearning
Financial Services
60
Presented by Dr. June Neo
© Business eLearning
Financial Services
• one of the economy's most important
and influential sectors.
• broad range of more specific
activities such as banking, investing,
and insurance.
• can lead to economic growth OR drag
down a nation's economy
61
Presented by Dr. June Neo
© Business eLearning
Managerial Finance
62
Presented by Dr. June Neo
© Business eLearning
Managerial Finance
• What long-term investments
should the firm engage in?
• How can the firm raise the money
for the required investments?
• How much short-term cash flow
does a company need to pay its
bills?
63
Presented by Dr. June Neo
© Business eLearning
The Balance-Sheet Model
of the Firm
64
Presented by Dr. June Neo
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Total Value of Assets:
Shareholders’
Equity
Current Liabilities
Long-Term Debt
Total Firm Value to Investors:
© Business eLearning
The Balance-Sheet Model
of the Firm
65
Presented by Dr. June Neo
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Total Value of Assets:
Shareholders’
Equity
Current Liabilities
Long-Term Debt
Total Firm Value to Investors:
What long-
term
investments
should the
firm engage
in?
The Capital Budgeting Decision
© Business eLearning
The Balance-Sheet Model
of the Firm
66
Presented by Dr. June Neo
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Total Value of Assets:
Shareholders’
Equity
Current Liabilities
Long-Term Debt
Total Firm Value to Investors:
The Capital Structure Decision
How can the firm
raise the money
for the required
investments?
© Business eLearning
The Balance-Sheet Model
of the Firm
67
Presented by Dr. June Neo
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Total Value of Assets:
Shareholders’
Equity
Current Liabilities
Long-Term Debt
Total Firm Value to Investors:
How much short-
term cash flow
does a company
need to pay its
bills?
The Net Working Capital Investment Decision
Net
Working
Capital
© Business eLearning
Hypothetical Organization Chart
68
Presented by Dr. June Neo
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
President and Chief
Operating Officer (COO)
Vice President and
Chief Financial Officer (CFO)
Treasurer Controller
Cash Manager
Capital Expenditures
Credit Manager
Financial Planning
Tax Manager
Financial Accounting
Cost Accounting
Data Processing
© Business eLearning
Cash flow
from firm (C)
The Firm and the Financial Markets
T
a
x
e
s
(
E
)
Firm
Government
Firm receives money
via issuing securities (A)
Retained
cash flows (G)
Invests
in assets
(B)
Dividends (F) and
debt payments (D)
Current assets
Fixed assets
Financial
markets
Short-term debt
Long-term debt
Equity shares
Ultimately, the firm must be
a cash generating activity.
The cash flows from the
firm must exceed the cash
flows from the financial
markets.
Presented by Dr. June Neo
© Business eLearning
Discussion
70
Presented by Dr. June Neo
© Business eLearning
The Objective of the firm
71
Presented by Dr. June Neo
© Business eLearning
The Corporate form of business
• The corporate form of business is the
standard method for solving the
problems encountered in raising
large amounts of cash.
• However, businesses can take other
forms.
72
Presented by Dr. June Neo
© Business eLearning
The Corporate form of business
• The Sole Proprietorship
• The Partnership
• The Corporation
• Advantages and Disadvantages
– Liquidity and Marketability of Ownership
– Control
– Liability
– Continuity of Existence
– Tax Considerations
73
Presented by Dr. June Neo
© Business eLearning
The Corporate form of business
74
Presented by Dr. June Neo
Corporation Partnership Sole
Proprietorship
Liquidity Shares can easily be
exchanged.
Subject to substantial
restrictions. No liquidity
Voting Rights and
control
Usually each share gets
one vote
General Partner is in
charge; limited partners
may have some voting
rights.
One and only
person. Itself
decides
Taxed at personal
level
Received all the
amount
Unlimited liability
Limited life
Taxation Double = once at corporate
level, another at shareholder
level e.g. classical tax system
Partners pay taxes on
distributions.
Reinvestment and
dividend payout
Broad latitude All net cash flow is
distributed to partners.
Liability (for the owners) Limited liability = limited
to the amount invested
General partners may
have unlimited liability.
Limited partners enjoy
limited liability.
Continuity Perpetual life Limited life
© Business eLearning
The Objective of the firm
• Traditional answer: Maximisation of
Stockholders’ wealth
–Timing, amount and risk associated
with expected cash flows
• Compare with profit maximization
• Note: Profit maximization  Wealth
maximization
75
Presented by Dr. June Neo
© Business eLearning
Managerial Goals
• Managerial goals may be different
from shareholder goals
– Expensive perquisites
– Survival
– Independence
• Increased growth and size are not
necessarily the same thing as
increased shareholder wealth
76
Presented by Dr. June Neo
© Business eLearning
Discussion
77
Presented by Dr. June Neo
© Business eLearning
Agency Theory
78
Presented by Dr. June Neo
© Business eLearning
Separation of Ownership and Control
79
Presented by Dr. June Neo
Board of Directors
Management
Assets
Debt
Equity
S
h
a
re
h
o
ld
e
rs
D
e
b
th
o
ld
e
rs
© Business eLearning
80
Separation of Ownership and Control
The disadvantage of this separation of
ownership and management is that it
causes potential principal-agent
problems.
Agent – managers
Principal – Shareholders
Presented by Dr. June Neo
© Business eLearning
81
Agency Problems
In most large companies the managers
are not the owners and they might be
tempted to act in ways that are not in
the best interests of the owners.
For example, they might buy luxurious
corporate jets for their travel, or
overindulge in expense-account
dinners.
Presented by Dr. June Neo
© Business eLearning
82
Agency Problems
They might shy away from attractive but risky
projects because they are worried more about
the safety of their jobs than the potential for
superior profits.
They might engage in empire building, adding
unnecessary capacity or employees.
Such problems can arise because the managers
of the firm, who are hired by the shareholders
owners, may act in their own interests.
Presented by Dr. June Neo
© Business eLearning
83
Agency Problems
• Conflict of interest between the
managers and shareholders
Presented by Dr. June Neo
© Business eLearning
84
Agency Costs
Agency costs are caused by conflicts of
interest between managers and
shareholders, the owners of the firm. In
most large corporations, the principals
(i.e., the stockholders) hire the agents
(i.e., managers) to act on behalf of the
principals in making many of the major
decisions affecting the corporation and its
owners.
Presented by Dr. June Neo
© Business eLearning
85
Agency Costs
It is unrealistic to believe that the agents’
actions will always be consistent with the
objectives that the stockholders would like
to achieve. Managers may choose not to
work hard enough, to over-compensate
themselves, to engage in empire building,
to over-consume perquisites, and so on
Presented by Dr. June Neo
© Business eLearning
Shareholders are in Control?
• Agency relationship
• Shareholders (principal) hires an
Manager (agent) and delegates
decision-making authority to that
agent to act on behalf of the
principal
• Problem exists when there are
conflicts of interest between
stockholders and Managers
86
Presented by Dr. June Neo
© Business eLearning
Shareholders are in Control?
• Shareholders vote for the board of
directors, who in turn hire the management
team.
• Contracts can be carefully constructed to be
incentive compatible.
• There is a market for managerial talent—
this may provide market discipline to the
managers—they can be replaced.
• If the managers fail to maximize share
price, they may be replaced in a hostile
takeover.
87
Presented by Dr. June Neo
© Business eLearning
Ethics
• Firm’s attitude and conduct toward
its stakeholders
• Ethical behavior: fair and honest
treatment toward stakeholders
88
Presented by Dr. June Neo
© Business eLearning
Compliance
• Sarbanes-Oxley Act (SOX) 2002
– Corporation must:
1. a committee of outside directors
overseeing audits
2. an external auditor
3. information about procedures used to
construct financial statements
89
Presented by Dr. June Neo
© Business eLearning
Good Business Ethics
• Avoids fines and legal expenses
• Builds public trust
• Attracts business from customers
• Welfare of employees
• Social Supports
• Etc.
90
Presented by Dr. June Neo
© Business eLearning
Discussion
91
Presented by Dr. June Neo
© Business eLearning
Corporate Governance
92
Presented by Dr. June Neo
© Business eLearning
Corporate Governance
• “set of rules” when conducting business
• Purpose: facilitate effective,
entrepreneurial and prudent management
that deliver long-term success of the
company. A system by which companies
are directed and controlled, responsible by
Boards of directors.
• provide stakeholders:
– How executives run the business
– Who is accountable for important decisions
93
Presented by Dr. June Neo
© Business eLearning
Good Corporate Governance
• Ensures management of a company
considers the best interests of
stakeholders;
• Helps companies deliver long-
term corporate success and economic
growth;
• Improves control over management and
information systems (such as security or
risk management)
94
Presented by Dr. June Neo
© Business eLearning
Discussion
95
Presented by Dr. June Neo
© Business eLearning
Part Two:
Valuation of Securities
96
Presented by Dr. June Neo
© Business eLearning
Time Value of Money
97
Presented by Dr. June Neo
© Business eLearning
Time Value of Money (TVM)
Time Value of Money (TVM) is an important
concept in financial management. It can be
used to compare investment alternatives and to
solve problems involving loans, mortgages,
leases, savings, and annuities.
TVM is based on the concept that a dollar that
you have today is worth more than the promise
or expectation that you will receive a dollar in
the future. Money that you hold today is worth
more because you can invest it and earn
interest. After all, you should receive some
compensation for foregoing spending.
98
Presented by Dr. June Neo
© Business eLearning
Time Value of Money (TVM)
For instance, you can invest one dollar
for one year at a 6% annual interest rate
and accumulate $1.06 at the end of the
year. You can say that the future value
of the dollar is $1.06 given a 6%
interest rate and a one-year period.
It follows that the present value of the
$1.06 you expect to receive in one year
is only $1.
99
Presented by Dr. June Neo
© Business eLearning
Time Value of Money (TVM)
A key concept of TVM is that a single
sum of money or a series of equal,
evenly-spaced payments or receipts
promised in the future can be converted
to an equivalent value today.
Conversely, you can determine the value
to which a single sum or a series of
payments will grow to at some
future/present date.
100
Presented by Dr. June Neo
© Business eLearning
Present value and
Future value
101
Presented by Dr. June Neo
© Business eLearning
102
TVM Concept
Future Value - Amount to which an
investment will grow after earning
interest.
Compound Interest - Interest earned
on interest.
Simple Interest - Interest earned only
on the original investment.
Presented by Dr. June Neo
© Business eLearning
103
TVM Concept
Example - Simple Interest
Interest earned at a rate of 6% for five
years on a principal balance of $100.
Note: for simple interest, only the
principal earns interest
© Business eLearning
104
TVM Concept
Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.
Interest Earned Per Year = 100 x .06 = $ 6
© Business eLearning
105
TVM Concept
Example - Simple Interest
Interest earned at a rate of 6% for five
years on a principal balance of $100.
Today Future Years
1 2 3 4 5
Interest Earned
Value 100 106
© Business eLearning
Compound Interest Rate
Compound interest is calculated
each period on the original
principal and all interest
accumulated during past periods.
Although the interest may be stated
as a yearly rate, the compounding
periods can be yearly, semiannually,
quarterly, or even continuously.
106
Presented by Dr. June Neo
© Business eLearning
Compound Interest Rate
The interest earned in each period is
added to the principal of the
previous period to become the
principal for the next period.
107
Presented by Dr. June Neo
© Business eLearning
108
TVM Concept
Example - Compound Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.
© Business eLearning
Compounding and discounting
Compounding Interest Rate is used
to find the Future Value.
Discounting Interest Rate is used to
find the Present Value.
109
Presented by Dr. June Neo
© Business eLearning
Present Value
Present value is a financial term
used to define the value of a certain
amount of money today.
It is an amount today that is
equivalent to a future payment, or
series of payments, that has been
discounted by an appropriate
interest rate.
110
Presented by Dr. June Neo
© Business eLearning
Future Value
Future Value is the amount of money
that an investment made today (the
present value) will grow to by some
future date.
Since money has time value, we
naturally expect the future value to be
greater than the present value. The
difference between the two depends on
the number of compounding periods
involved and the going interest rate.
111
Presented by Dr. June Neo
© Business eLearning
The Single Cash flows Case:
Future Value
• In the single cash flows case, the
formula for FV can be written as:
• FV = PV×(1 + r)t
– Where
– PV is present value of the cash flow today
(at time zero)
– r is the appropriate interest rate i.e.
compounding rate, quoted annually
– t is the number of periods over which the
cash is invested
112
Presented by Dr. June Neo
© Business eLearning
Illustration
• If you were to invest $10,000 at 5-percent
interest for one year, How much is your
investment in one year’s time?
• Using the formula FV = PV×(1 + r)t
• The value of the investment in one year’s
time
• = $10,000 x (1 + (5/100))1
• = $10,000 x ((1 + 0.05)1)
• = $10,000 x (1.05)
• = $10,500
PV = 10000
r = 0.05
t = 1
113
Presented by Dr. June Neo
© Business eLearning
The Single Cash flows Case:
Present Value
• In the single cash flows case, the
formula for PV can be written as:
• PV =
– Where
– Ct is (future) value of the cash flow at time
– r is the appropriate interest rate i.e.
discount rate
– t is the number of periods over which the
cash is invested
Ct
(1+r)t
114
Presented by Dr. June Neo
Ct = FV
C0 = PV
© Business eLearning
Illustration
• If you are going to receive $10,500 in one
year’s time. What is the present value of
this amount if you invest at 5-percent
interest for one year?
• Using the formula PV = Ct / (1 + r)t
• The present value of the investment
• = $10,500 / (1 + (5/100))1
• = $10,500 / ((1 + 0.05)1)
• = $10,500 / (1.05)
• = $10,000
FV = 10500
r = 0.05
t = 1
115
Presented by Dr. June Neo
© Business eLearning
116
Present Values
Example
You just bought a new computer for $3,000. The
payment terms are 2 years same as cash. If you
can earn 8% on your money, how much money
should you set aside today in order to make the
payment when due in two years?
© Business eLearning
Discussion
117
Presented by Dr. June Neo
© Business eLearning
PV of Multiple Cash Flows
• PVs can be added together to
evaluate multiple cash flows
(Principle of value additivity)
N
N
r
C
r
C
r
C
r
C
PV
)1()1()1()1(0
...
3
3
2
2
1
1
++++
++++=
118
Presented by Dr. June Neo
© Business eLearning
PV of Multiple Cash Flows
- Illustration
Example
Your auto dealer gives you the choice to pay
$15,500 cash now, or make three payments:
$8,000 now and $4,000 each at the end of years
1 and 2. If the discount rate is 8%, which do you
prefer?
119
Presented by Dr. June Neo
© Business eLearning
Discussion
120
Presented by Dr. June Neo
© Business eLearning
Perpetuity
A constant stream of cash flows that lasts
forever.
$100
Year 4
$100
Year 3
$100
Year 1
$100
Year 2
---
---
Year 0
PV0
121
Presented by Dr. June Neo
© Business eLearning
(Ordinary) Perpetuity
Formula for Present Value of Perpetuity:
PV0 = + + + … =
C = cash payment
r = interest rate
t is infinity
C
(1+r)
C
(1+r)2
C
(1+r)3
C1
r
122
Presented by Dr. June Neo
© Business eLearning
Perpetuities
Example - Perpetuity
In order to create an endowment, which
pays $100,000 per year, forever, how
much money must be set aside today in
the rate of interest is 10%?
123
Presented by Dr. June Neo
© Business eLearning
Growing Perpetuity
A perpetual cash flow stream that grows at a constant rate
(denoted as g) over time. The value of a growing perpetuity
can be calculated as:
PV0 =
C1 = cash payment at year 1
r = interest rate
g = constant growth rate of cash flows
C1
r - g
124
Presented by Dr. June Neo
© Business eLearning
Growing Perpetuities
Example – Growing Perpetuity
An investment will produces a perpetual
stream of cash inflows. Next year, the
cash inflow will be $10.50, and this cash
inflow will grow at 5% per year forever. If
the discount rate is 10% p.a., what is the
Present value of this investment?
125
Presented by Dr. June Neo
© Business eLearning
Discussion
126
Presented by Dr. June Neo
© Business eLearning
Annuity
A constant stream of cash flows with a fixed
maturity.
$100
Year 4
$100
Year 3
$100
Year 1
$100
Year 2
$100
Year 5
Year 0
PV0
127
Presented by Dr. June Neo
© Business eLearning
(Ordinary) Annuity
Formula for Present Value of Annuity:
PV0 = + + + … +
= [ 1 - ]
C = cash payment
r = interest rate
N = Number of years cash payment is received
C
(1+r)
C
(1+r)2
C
(1+r)3
C
(1+r)N
C
r
1
(1+r)N
128
Presented by Dr. June Neo
© Business eLearning
Annuities
Example - Annuity
You are purchasing a car. You are
scheduled to make 3 annual installments
of $4,000 per year. Given a rate of
interest of 10%, what is the price you are
paying for the car (i.e. what is the PV)?
129
Presented by Dr. June Neo
© Business eLearning
Annuities
Example - Future Value of annual payments
You plan to save $4,000 every year for 20
years and then retire. Given a 10% rate of
interest, what will be the FV of your
retirement account?
130
Presented by Dr. June Neo
© Business eLearning
Discussion
131
Presented by Dr. June Neo
© Business eLearning
Valuation of Stocks and
Bonds
132
Presented by Dr. June Neo
© Business eLearning
Valuation of financial assets (securities)
• Based on present value principle
applying on real asset valuation
• Focus on bonds and common stocks
valuation
133
Presented by Dr. June Neo
© Business eLearning
Valuation of Bonds
134
Presented by Dr. June Neo
© Business eLearning
Presented by Dr. June Neo
135
Coupon rate = 5% p.a. payable annually
Face value (principal) = $1000
Coupon amount = 5% x $1000 = $50 annually
Term to maturity = 4 years
Coupon bond
© Business eLearning
Valuation of financial assets
(Coupon Bonds)
• Value of coupon bonds = present
value of future interest (coupon) and
principal payments to be paid to the
lender (bondholder) by the borrower
(firm issuer of the bond).
136
Presented by Dr. June Neo
© Business eLearning
Valuation of financial assets
(Coupon Bonds)
Where
Pcb,ann means coupon payments occur annually
FV = Principal payment
C = interest or coupon payment at time t
rann = annual discount rate
N
annannann
anncb
r
CFV
r
C
r
C
PVice
)1(
...
)1()1(
P r
21, +
+
++
+
+
+
==
137
Presented by Dr. June Neo
© Business eLearning
Valuation of financial assets
(Coupon Bonds)
Example
➢ Assume you buy on 1 January 2008, a 2010
UK Treasury bond, with a coupon rate of 4
per cent and a face value of £1,000. The
discount rate is 2.5 per cent, which is the
interest rate offered by other medium-term
UK Treasury bonds on 1 January 2008. The
interest payments perceived at the end of
years 2008 and 2009 are £40. At the
maturity date (end of 2010), the government
pays the principal (£1,000) plus the interest
(£40).
138
Presented by Dr. June Neo
© Business eLearning
Example
Coupon rate = 4%
Coupon amount = 4% x £1000 = £40
Term to maturity = 3 years
Yield = discount rate = 2.5% = 0.025
Bond price
Valuation of Coupon Bonds
Presented by Dr. June Neo
139
= Coupon x
1
r
1 −
1
1 + r T
+ Par Value x
1
1 + r T
© Business eLearning
Valuation of financial assets
(Coupon Bonds)
• If coupon payments occur semi-annually,
then
Where
Pcb,sem means coupon payments occur semi-annually
FV = Principal payment
C/2 = semi-annual interest or coupon payment
rsem = semi-annual discount rate
N
semsemsem
semcb
r
CFV
r
C
r
C
PVice
221, )1(
2/
...
)1(
2/
)1(
2/
P r
+
+
++
+
+
+
==
140
Presented by Dr. June Neo
© Business eLearning
Valuation of financial assets
(Coupon Bonds)
Example
➢Recall the previous 2010 UK Treasury
bond, and assume it makes semi-annual
coupon payments.
➢Find the bond price
141
Presented by Dr. June Neo
© Business eLearning
Example
Coupon rate = 4% per year (1 period = 6 months)
Coupon amount = (4% x £1000)/2 = £20 per period
Term to maturity = 3x2 = 6 periods
Yield = discount rate = 0.025/2 = 0.0125
Bond price
Valuation of Coupon Bonds
Presented by Dr. June Neo
142
= Coupon x
1
r
1 −
1
1 + r T
+ Par Value x
1
1 + r T
© Business eLearning
Valuation of financial assets
(Zero coupon Bonds)
• Bonds with no coupon payments,
then
Nzcb r
FV
PVice
)1(
Pr
+
==
143
Presented by Dr. June Neo
© Business eLearning
Example
➢Consider a Treasury bill maturing in six
months and paying $10,000. Assuming a
compounded annual rate of 4.08 per cent,
what is the price today.
Valuation of Zero Coupon Bonds
Presented by Dr. June Neo
144
© Business eLearning
Example
Coupon rate = 0%
Coupon amount = 0
Term to maturity = 6 months = 1 period
Yield = discount rate = 0.0408/2 = 0.0204
Bond price
Valuation of Zero Coupon Bonds
Presented by Dr. June Neo
145
= Coupon x
1
r
1 −
1
1 + r T
+ Par Value x
1
1 + r T
=
© Business eLearning
Discussion
146
Presented by Dr. June Neo
© Business eLearning
Valuation of Stocks
147
Presented by Dr. June Neo
© Business eLearning
Valuation of financial assets
(Common stocks)
• Using discounted cash flow models
• Assumption: value of a stock is equal
to the present value of the cash
flows the stockholders expect to
receive from the firm.
• Payoffs = dividends and capital gains
148
Presented by Dr. June Neo
© Business eLearning
Valuation of financial assets
(Common stocks)
Where
Div1 = expected dividend to be paid at
time 1
P0 = current price of the stock
P1 – P0 = capital gain on the stock
0
011)(
P
PPDiv
RE
−+
==Return Expected
149
Presented by Dr. June Neo
© Business eLearning
Valuation of financial assets
(Common stocks)
Where
re= required annual rate on similar
equity stocks
er
PDiv
P
+
+
=
1
11
0
150
Presented by Dr. June Neo
© Business eLearning
Valuation of financial assets
(Common stocks)
Example
If Fledgling Electronics is selling for $100
per share today and is expected to sell for
$110 one year from now, what is the
expected return if the dividend one year
from now is forecasted to be $5.00?
151
Presented by Dr. June Neo
© Business eLearning
Valuation of financial assets
(Common stocks)
For a period of N years,
N
e
N
N
t
t
e
t
N
e
NN
ee
r
P
r
Div
r
PDiv
r
Div
r
Div
P
)1()1(
)1(
...
)1()1(
1
2
2
1
1
0
+
+
+
=
+
+
++
+
+
+
=

=
152
Presented by Dr. June Neo
© Business eLearning
Valuation of financial assets
(Common stocks)
Example
Current forecasts are for XYZ Company to
pay dividends of $3, $3.24, and $3.50 over
the next three years, respectively. At the
end of three years you anticipate selling
your stock at a market price of $94.48.
What is the price of the stock given a 12%
expected return?
153
Presented by Dr. June Neo
© Business eLearning
Valuation of financial assets
(Common stocks)
If N approaches infinity
• dividend discount model
• Need to forecast the future dividends to infinity
• Need to know the appropriate discount rate


= +
=
→+
+
++
+
+
+
=
1
2
2
1
1
0
)1(
...
)1(
...
)1()1(
t
t
e
t
N
e
N
ee
r
Div
r
Div
r
Div
r
Div
P
154
Presented by Dr. June Neo
© Business eLearning
Valuation of financial assets
(Zero growth model)
• Constant dividend stream,
i.e. Div = Div1 = Div2 = … = Div
• Value the stock as a perpetuity
er
Div
PerpetuityP 10 ==
155
Presented by Dr. June Neo
© Business eLearning
Valuation of financial assets
(Zero growth model)
Example
Consider stock ABC, which is expected to
pay a dividend of $9.5 forever. What is the
stock price today, assuming a required rate
of return of 11 per cent.
156
Presented by Dr. June Neo
© Business eLearning
Valuation of financial assets
(Gordon growth model)
• Expected dividend grows at a
constant rate, g
i.e. Div1 = Div0(1+g)
Div2 = Div1(1+g)
• Value the stock as a growing
perpetuity
gr
Div
P
e −
= 10
157
Presented by Dr. June Neo
© Business eLearning
Valuation of financial assets
(Gordon growth model)
Example
Consider stock WZY, which is expected to
pay a dividend of $5 one year from now and
this dividend is expected to grow at 5 per
cent per year forever. Assuming a required
rate of return of 11 per cent, what is the
price today?
158
Presented by Dr. June Neo
© Business eLearning
Valuation of financial assets
(Gordon growth model)
Example
Consider stock WZY, which is expected to
start paying a dividend of $5 three years
from now and this dividend is expected to
grow at 5 per cent per year forever.
Assuming a required rate of return of 11
per cent, what is the price today?
159
Presented by Dr. June Neo
© Business eLearning
Discussion
160
Presented by Dr. June Neo
© Business eLearning
Part Three:
Capital Budgeting Decision
161
Presented by Dr. June Neo
© Business eLearning
Net Present Value (NPV)
162
Presented by Dr. June Neo
© Business eLearning
Net Present Value (NPV)
• NPV = sum of the present values of
all the cash inflows (Ct) generated by
the project to the firm in each of the
next t years, less the sum of the
present values of the cash
investment (I) associated to the
same project.
163
Presented by Dr. June Neo
© Business eLearning
Net Present Value (NPV)
• The NPV formula is given by:
• NPV = PV of all inflows – PV of all outflows
Where
I = PV of cash investment
Ct = cash flows generated by project at time t
r = rate of return of the project
N = life of the project
( )=
−
+
=
N
t
t
t
r
C
NPV
1 1
I


164
Presented by Dr. June Neo
© Business eLearning
165
The formula for NPV can be written as:
NPV = -Cost + PV
Net Present Value Concept
© Business eLearning
Net Present Value (NPV)
• If the NPV is positive, accept the
project
• If the NPV is negative, reject the
project
• If the NPV is zero, no different …
166
Presented by Dr. June Neo
© Business eLearning
Net Present Value (NPV)
• Consider a firm that has to decide on
the purchase of new equipment
(termed project A). Assume that the
relevant opportunity cost of capital is
9% p.a., and the investment cost is
£1,500. The cash inflows generated
by the new equipment would be
£500 over four years. What is the
NPV of project A. Should project A be
accepted?
167
Presented by Dr. June Neo
© Business eLearning
Net Present Value (NPV)
168
Presented by Dr. June Neo
© Business eLearning
Net Present Value (NPV)
• Assumption:
– shareholders can reinvest their money
at this market determined rate.
– the same rate is used to discount cash
flows occurring in different years i.e. flat
interest rate term structure
169
Presented by Dr. June Neo
© Business eLearning
Net Present Value (NPV)
• The rate of return used to discount the
expected cash inflows is termed opportunity
cost of capital.
• It is the return forgone by investing in the
project rather than in financial assets.
• ‘cost of capital’: The costs of all the sources
of capital (both equity issues and debt
issues) have to be taken into account.
170
Presented by Dr. June Neo
© Business eLearning
Net Present Value (NPV)
- Opportunity cost of capital
• Suppose you believe the project is as
risky as investment in the stock
market
• Stock market investments are
forecasted to return 12 percent.
• What is the appropriate opportunity
cost of capital?
171
Presented by Dr. June Neo
© Business eLearning
Net Present Value (NPV)
• The cash flows discounted are the
incremental cash flows, which are the
additional cash flows from the project.
• Sunk costs are excluded because they
are incurred whether or not the project
is accepted.
• Implicit assumption: cash flows can be
estimated without error.
172
Presented by Dr. June Neo
© Business eLearning
Net Present Value (NPV)
Example
Consider a firm that has to decide on the
purchase of new equipment. The
Investment cost is $9000, cash inflows
generated by the new equipment are
$5090, $4500 and $4000 at the end of
years 1, 2 and 3 respectively. If the cost
of capital is 10% p.a. What is the NPV of
the project? Should the firm accept the
project?
173
Presented by Dr. June Neo
© Business eLearning
Net Present Value (NPV)
- Rules of decision
• Net present value rule: firms invest in real
assets with a positive NPV. In fact, the
maximisation of the NPV increases the
market value of the stockholder’s share in
the firm.
174
Presented by Dr. June Neo
© Business eLearning
Discussion
175
Presented by Dr. June Neo
© Business eLearning
Internal Rate of Return
(IRR)
176
Presented by Dr. June Neo
© Business eLearning
Other real asset appraisal techniques
- Internal rate of return (IRR)
• The rate at which the present values
of the cash inflows associated with a
project equal the cash investment.
I.e. NPV = 0
• Mathematically,
( )
0
11
I

=−
+
=
=
N
t
t
t
r
C
NPV
177
Presented by Dr. June Neo
© Business eLearning
Internal rate of return (IRR)
Example
Consider the purchase of additional
machinery. The investment cost of the project
is $9,500 today. Positive cash flows equal to
$4,000, $5,000 and $4,000 will be generated
respectively in years 1, 2 and 3. What is the
IRR on this investment?
( )
( ) ( ) ( )
09500
1
4000
1
5000
1
4000

0 I
1

321
1
=−
+
+
+
+
+
=
=−
+
=
=
IRRIRRIRR
r
C
NPV
N
t
t
t
178
Presented by Dr. June Neo
© Business eLearning
Internal rate of return (IRR)
Step 1: Try IRR = 10%, NPV = +$1273
Step 2: Try IRR = 20%, NPV = -$380
Step 3: Repeat steps 1 & 2 if need be.
Step 4: Plot these two combinations on a
graph, and choose the IRR that gives the
desired NPV of zero.
179
Presented by Dr. June Neo
© Business eLearning
Internal rate of return (IRR)
180
Presented by Dr. June Neo
© Business eLearning
Internal rate of return (IRR) –
Using linear interpolation
where
r1 = lower discount rate
r2 = higher discount rate
NPV1 = NPV estimated using r1
|NPV2| = NPV estimated using r2
(note |NPV2| = absolute value of NPV2)
181
Presented by Dr. June Neo
© Business eLearning
182
The general investment rule is clear:
Accept the project if IRR is greater than
the discount rate.
Reject the project if IRR is less than the
discount rate.
The Internal Rate of Return (IRR)
© Business eLearning
Internal rate of return (IRR)
- Limitation
Limitation 1:
• Discount rate is IRR
 reinvest at internal rate
 implies different rates exist for
different projects with same risk
183
Presented by Dr. June Neo
© Business eLearning
Internal rate of return (IRR)
- Limitation
• Limitation 2:
• IRR sometimes ignores the magnitude of
mutually exclusive projects.
• Example:
• A company wishes to evaluate the following
mutually exclusive investment proposals.
• NPV and IRR rank the projects differently
• Calculate each proposal’s net present value
and internal rate of return. Assume the
hurdle rate is 10 percent.
Cash Flows ($)
Proposal
Year
0
Year
1
Year
2
Year
3
IRR
NPV
at 10%
F -9 000 6 000 5 000 4 000 33.33% 3592.0361
G -9 000 1,800 1,800 1,800 …  20% 9000

184
Presented by Dr. June Neo
© Business eLearning
Internal rate of return (IRR)
- Limitation
Limitation 2: - Cont’d
Hurdle rate = 10%
15.60% is known as the crossover rate
185
Presented by Dr. June Neo
© Business eLearning
Internal rate of return (IRR)
- Limitation
Limitation 3:
• IRR method can give either no or more than one
solution (multiple IRR). Because of possible changes
in the structure of cash flows over time.
• Example:
Calculate the project’s internal rate of return and
net present value, assume the hurdle rate is 10
percent.
Cash Flows ($ Thousands)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
-1 000 800 150 150 150 150 -150

186
Presented by Dr. June Neo
© Business eLearning
Internal rate of return (IRR)
- Limitation
Limitation 3: - Cont’d
Hurdle rate = 10%
187
Presented by Dr. June Neo
© Business eLearning
Discussion
188
Presented by Dr. June Neo
© Business eLearning
Payback period methods
189
Presented by Dr. June Neo
© Business eLearning
Payback period method
• The number of years needed to
recover the (initial) capital
investment for the project.
• Target a payback period.
• Accept if calculated payback period <
target
• Reject if calculated payback period >
target
190
Presented by Dr. June Neo
© Business eLearning
191The Payback Period Method
Here is how the payback period method works.
Consider a project with an initial investment of
$50,000. Cash flows are $30,000, $20,000, and
$10,000 in the first three years, respectively.
Cash inflow $30,000 $20,000 $10,000
Time 0 1 2 3
Cash outflow ($50,000)
© Business eLearning
192The Payback Period Method
Firm receives
Y1 = CF1 = $30,000
Y2 = CF2 =
Total Original Investment = $50,000
Two years is the payback period.
$20,000
$50,000
© Business eLearning
Payback period method
Example
Examine the three projects and note the
mistake we would make if we insisted on only
taking projects with a payback period of 2
years or less. (Assume cash flows are evenly
distributed)
050018002000-C
018005002000-B
50005005002000-A
10% @NPV
Period
Payback
CCCCProject 3210
193
Presented by Dr. June Neo
© Business eLearning
Payback period method
- Limitation
Limitation 1:
• it ignores the cash flows after the
cut-off date.
Expected Cash Flows for Projects A through C ($)

Year A B C
0 -100 -100 -100
1 20 50 50
2 30 30 30
3 50 20 20
4 60 60 60,000
Payback period (years) 3 3 3

194
Presented by Dr. June Neo
© Business eLearning
Payback period method
- Limitation
Limitation 2:
• it ignores the time value of money
• Can be resolved by discounting cash
flows (discounted payback period)
Expected Cash Flows (£)

Project C0 C1 C2 C3 Payback NPV
G -2,200 +350 +2,100 0 -$111
H -2,200 +2,100 +350 0 +$21

195
Presented by Dr. June Neo
© Business eLearning
Payback period method
- Limitation
Limitation 3:
• Arbitrary Standard for Payback Period
– When a firm uses the NPV approach, it can go
to the capital market to get the discount rate.
There is no comparable guide for choosing the
payback period, so the choice is arbitrary to
some extent.
196
Presented by Dr. June Neo
© Business eLearning
197Example of Investment Rules
Compute the NPV, IRR and payback period for the
following two projects. Assume the required return is
10%.
Year Project A Project B
0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150
For A: NPV = IRR = payback =
For B: NPV = IRR = payback =
© Business eLearning
Other project appraisal
methods
198
Presented by Dr. June Neo
© Business eLearning
Profitability Index (PI)
199
Presented by Dr. June Neo
© Business eLearning
Profitability Index (Benefit-cost ratio)
• Index calculated by dividing the present value of
the future net cash flows by the initial cash outlay:
• Profitability Index =
• Decision rule:
– accept if profitability index > 1
– reject if profitability index < 1
PV of net cash flows
|Initial cash outlay|
=1+ NPV .
|Initial cash outlay|
© Business eLearning
Discussion
201
Presented by Dr. June Neo
© Business eLearning
Part Four:
Portfolio Theory
202
Presented by Dr. June Neo
© Business eLearning
Risk and Return
203
Presented by Dr. June Neo
© Business eLearning
Risks
A fundamental idea in finance is the relationship
between risk and return.
The greater the amount of risk that an investor is
willing to take on, the greater the potential return. The
reason for this is that investors need to be
compensated for taking on additional risk.
204
© Business eLearning
Risk-Return Tradeoff
The principle that potential return rises with an
increase in risk. Low levels of uncertainty (low risk)
are associated with low potential returns, whereas
high levels of uncertainty (high risk) are associated
with high potential returns.
In other words, the risk-return tradeoff says that
invested money can render higher profits only if it is
subject to the possibility of being lost.
205
© Business eLearning
Risk and return of
a single financial security
• Relationship between risk and return is another
fundamental concept of finance
• Risk and return influence the value of financial
assets
• Actual return is the amount received divided by
the amount invested
• How to calculate actual return?
206
Presented by Dr. June Neo
© Business eLearning
Actual Returns of stock
The gain or loss of a stock in a particular period.
The return consists of the income (dividend) and
the capital gains (or loss) relative on an investment.
It is usually quoted as a percentage.
Total return = Dividend Income + Capital Gain
207
Presented by Dr. June Neo
© Business eLearning
Dollar Return = Dividend + Change in Market Value
yieldgainscapitalyielddividend +=
Dividend + change in market value
=
Beginning market value
Dollar return
Percentage return =
Actual Returns of stock
Beginning market value
208
Presented by Dr. June Neo
© Business eLearning
Returns
Assuming the price at the beginning of the year is $37
per share and the dividend paid during the year on
each share is $1.85. Hence the percentage of
income return, or called the dividend yield, is



Dividend yield =
Price
Div

209
© Business eLearning
Returns
Suppose, at the end of the year the market price of
the stock is $40.33 per share. Hence the percentage
of capital gains return, or called the capital gains
yield, is






Capital gain =
t
t1t
P
)P(P −+

210
© Business eLearning
Returns
By combining these two results, the total return (R) on
the investment per share will be:
R = 5% + 9% = 14%
Formula:
Rt+1 = +
Divt+1
Pt
Pt+1 - Pt
Pt
211
© Business eLearning
Illustration
Suppose a stock begins the year with a price of $25
per share and ends with a price of $35 per share.
During the year it paid a $2 dividend per share.
What are the total return and percentage return for
the year? Find Dividend yield and capital gain yield.
212
Presented by Dr. June Neo
© Business eLearning
Expected Rates of Return
• Risk is uncertainty that an
investment’s actual return will
be different than expected. This
includes the possibility of losing
some or all of the original
investment.
• Probability is the likelihood of an
outcome
213
Presented by Dr. June Neo
© Business eLearning
Expected Rates of Return
There is uncertainty associated with returns on shares.
Assume we can assign probabilities to the possible returns
— given the following set of circumstances, the expected
return is, E(R) is as follows:
E(R) = p1R1 + p2R2 + … + pnRn
where:
E(R) = expected return
Ri = return of the state of nature i
Pi = probability of occurrence of the return Ri
n = number of possible states of nature (outcomes)
214
Presented by Dr. June Neo
© Business eLearning
Illustration
Percentage Return, Ri Probability, Pi
9 0.1
10 0.2
11 0.4
12 0.2
13 0.1
Calculate the expected return of the following set of
data:
215
Presented by Dr. June Neo
© Business eLearning
Measuring the Risk of a security
• Risk is present whenever investors
are not certain about the outcome an
investment will produce.
• Risk measured by variance — how
much a particular return deviates
from an expected return.
• Using variance and standard
deviation to measure risk.
216
Presented by Dr. June Neo
© Business eLearning
Variance
A measure of the dispersion of a set of data points around
their mean value. It is a mathematical expectation of the
average squared deviations from the mean.
Variance measures the variability from an average. So this
statistic can help determine the risk an investor might take
on when purchasing a specific security.
217
Presented by Dr. June Neo
© Business eLearning
Standard Deviation
Standard deviation is calculated as the square root of the
variance.
It measures the dispersion of a set of data from its mean.
The more spread apart the data is, the higher the deviation.
The standard deviation tells us how much the return is
deviating from the expected normal returns.
A risky stock would have a high standard deviation.
218
Presented by Dr. June Neo
© Business eLearning
Measuring the Risk of a security
219
Presented by Dr. June Neo
© Business eLearning
Illustration
Percentage Return, Ri Probability, Pi
9 0.1
10 0.2
11 0.4
12 0.2
13 0.1
Using the previous illustration, calculate the variance
and standard deviation:
220
Presented by Dr. June Neo
© Business eLearning
Discussion
221
Presented by Dr. June Neo
© Business eLearning
Relationship between risk and return
• Positive relationship, known as risk-return tradeoff
• potential return rises with an increase in risk.
• Low levels of uncertainty (low risk) are associated
with low potential returns, whereas high levels of
uncertainty (high risk) are associated with high
potential returns.
• Reason: investors require compensation for bearing
risk.
• The level of risk tends to reduce over longer holding
periods
222
Presented by Dr. June Neo
© Business eLearning
Risk Attitudes
• Risk-neutral investor:
– One whose utility is unaffected by risk; when chooses
to invest, investor focuses only on expected return.
• Risk-averse investor:
– One who demands compensation in the form of
higher expected returns in order to be induced into
taking on more risk.
• Risk-seeking investor:
– One who derives utility from being exposed to risk,
and hence, may be willing to give up some expected
return in order to be exposed to additional risk.
223
© Business eLearning
Risk Attitudes
• The assumption in finance theory is
all investors are risk averse.
– This does not mean an investor will
refuse to bear any
risk at all.
– Rather, investors regards risk as
something undesirable, but may take up
on board if compensated with sufficient
return; trade-off between risk and
return.
224
Presented by Dr. June Neo
© Business eLearning
Discussion
225
Presented by Dr. June Neo
© Business eLearning
Portfolio analysis:
mean-variance
portfolio theory
226
Presented by Dr. June Neo
© Business eLearning
Risk and return of a portfolio
• We now know that the risk of an individual
asset is summarised by standard deviation
(or variance) of returns.
• Investors usually invest in a number of
assets (a portfolio) and will be concerned
about the risk of their overall portfolio.
• Now concerned about how these individual
risks will interact to provide us with overall
portfolio risk.
227
Presented by Dr. June Neo
© Business eLearning
Portfolio weight
• The share of each individual asset
over the total value of the portfolio
• sum of the weights of all the
assets of the portfolio must be
equal to one
228
Presented by Dr. June Neo
© Business eLearning
Illustration
• Consider an investor with a portfolio
composed of two stocks: 75 The Coca Cola
Company stocks and 50 Microsoft stocks.
On 28 February 2008 the market prices of
the two stocks were: The Coca Cola
Company $41.16, Microsoft $26.67. The
total value of the portfolio is $4,420.50
• What is the portfolio weight for The Coca
Cola Company and Microsoft?
229
Presented by Dr. June Neo
© Business eLearning
Working
230
Presented by Dr. June Neo
© Business eLearning
Expected return of a portfolio
• Expected return of a Portfolio return E(Rp) is
the weighted average of all the expected returns
of the stocks held in the portfolio:
wi = portfolio weight for stock i
n = the number of stocks in the portfolio
( )
( ) ( ) ( )
( )
=
=
+++=
n
i
ii
nn
p
REw
REwREwREw
RE
1
2211 ...



231
Presented by Dr. June Neo
© Business eLearning
Illustration
• Going back to our previous example,
assume that the expected return over
the coming year will be 10 per cent for
The Coca Cola Company and 15 per
cent for Microsoft. What is the expected
return of the portfolio?
232
Presented by Dr. June Neo
© Business eLearning
Portfolio Risk
• Portfolio risk that comprising two stocks depends
on:
– The proportion of funds invested in each stock (wi).
– The riskiness of the individual stock (i
2).
– The relationship between each stock in the portfolio
with respect to risk, correlation coefficient (1,2).
– For a two-stocks portfolio, the variance is:
212,121
2
2
2
2
2
1
2
1
2 2  wwwwp ++=
233
Presented by Dr. June Neo
© Business eLearning
Illustration
• Recalling our portfolio composed of The
Coca Cola Company and Microsoft, let us
calculate its variance. In the past the
standard deviations were 35 per cent for
The Coca Cola Company and 50 per cent
for Microsoft. Assume that the two stocks
are positively but not perfectly correlated
(i.e. ρ1,2 = 0.5). What are the variance and
standard deviation of the portfolio?
234
Presented by Dr. June Neo
© Business eLearning
Working
235
Presented by Dr. June Neo
© Business eLearning
Working
236
Presented by Dr. June Neo
© Business eLearning
Illustration
• In the past the standard deviations were
35 per cent for The Coca Cola Company
and 50 per cent for Microsoft. Assume that
the correlation between the two stocks is
0.5 (i.e. ρ1,2 = 0.5). What is the standard
deviation of the portfolio? Re-calculate the
standard deviation of the portfolio,
assuming ρ1,2 = +1, 0, -0.5 and -1.
• Comment on your answer.
237
Presented by Dr. June Neo
© Business eLearning
Working
238
Presented by Dr. June Neo
© Business eLearning
Working
239
Presented by Dr. June Neo
© Business eLearning
Illustration
Assume 60% of the portfolio is invested in security 1
and 40% in security 2. If returns of security 1 and 2
are 8% and 12%, the variances of security 1 and
security 2 are 0.0016 and 0.0036, respectively, and
the correlation (1,2) is –0.5: Find expected return
and risk of portfolio.
240
© Business eLearning
Working
241
Presented by Dr. June Neo
© Business eLearning
Systematic and Unsystematic Risk
• Intuitively, we should think of risk as comprising:
Total Risk = Systematic risk + Unsystematic risk
• Systematic risk: Component of total risk that is due
to economy-wide factors. (non-diversifiable risk)
• Unsystematic risk: Component of total risk that is
unique to firm and is removed by holding a well-
diversified portfolio.
• The returns on a well-diversified portfolio will vary
due to the effects of market-wide or economy-wide
factors.
• Systematic risk of a security or portfolio will depend
on its sensitivity to the effects of these market-wide
factors.
242
Presented by Dr. June Neo
© Business eLearning
Benefits of diversification
• By forming portfolios (or by including
additional assets in the portfolio), risk-
averse investors are able to cut risk. This is
known as diversification.
• In real stock return data, the correlations
between returns are less than perfect.
• Diversification does not work where returns
move perfectly together.
243
Presented by Dr. June Neo
© Business eLearning
Benefits of diversification
• Diversification gain is related to correlation
coefficient () value.
• The degree of risk reduction increases as the
correlation between the rates of return on two
securities decreases.
•  = +1, Risk reduction does not occur by
combining securities whose returns are perfectly
positively correlated.
• -1 <  < 1, If the correlation coefficient is less than
1, the third term in the portfolio variance equation
is reduced, reducing portfolio risk.
•  = –1 If the correlation coefficient is negative, risk
is reduced even more
244
Presented by Dr. June Neo
© Business eLearning
Benefits of diversification
• As shown in next slide, diversification can
reduce the risk by half.
• The portfolio variance falls as the number of
assets held increases.
• This benefit can be achieved even with a
relatively small number of stocks (around 20
stocks)
245
Presented by Dr. June Neo
© Business eLearning
Benefits of diversification
246
Presented by Dr. June Neo
© Business eLearning
Discussion
247
Presented by Dr. June Neo
© Business eLearning
Efficient Portfolios
248
Presented by Dr. June Neo
© Business eLearning
Mean-standard deviation portfolio theory
Given the following 2 portfolio, which one is
better?
1. Portfolio one: maximum return with same
level of risk
2. Portfolio two: minimum risk with same level
of return
249
Presented by Dr. June Neo
© Business eLearning
Mean-standard deviation portfolio theory
• Developed by Markowitz (Also known as
Markowitz portfolio theory)
• Combining stocks into portfolios can reduce
standard deviation (risk), below the level
obtained from a simple weighted average
calculation.
• Correlation coefficients make this possible.
• The various weighted combinations of stocks
that create this standard deviations constitute
the set of efficient portfolios.
250
Presented by Dr. June Neo
© Business eLearning
Mean-standard deviation portfolio theory
• Assumption:
• Investors base decisions solely on expected
portfolios return and standard deviation (risk), so
their utility curves are a function of expected return
and the expected variance (or standard deviation)
of returns only.
• Investors prefer maximum utility.
• For a given risk level, investors prefer higher
returns to lower returns. Similarly, for a given
level of expected returns, investors prefer less risk
to more risk.
251
Presented by Dr. June Neo
© Business eLearning
Mean-standard deviation frontier
(2 risky assets)
X
Y
Expected
Return E(R)
Standard
deviation
Goal is to move
up and left.
WHY?
252
Presented by Dr. June Neo
© Business eLearning
Efficient frontier
Return
Low Risk
High Return
High Risk
High Return
Low Risk
Low Return
High Risk
Low Return
Risk
253
Presented by Dr. June Neo
© Business eLearning
Efficient frontier
Return
Low Risk
High Return
High Risk
High Return
Low Risk
Low Return
High Risk
Low Return
Risk
X
Y
Goal is to move
up and left.
254
Presented by Dr. June Neo
© Business eLearning
Mean-standard deviation frontier
(2 risky assets)
V
Y
Expected
Return E(R)
Standard deviation
X
• The upper part of the mean-standard deviation
frontier will be of interest to risk-averse investors
• Portfolios on the frontier and to the right of V
maximise the expected return for a given standard
deviation.
255
Presented by Dr. June Neo
© Business eLearning
• It’s possible to create a complete
portfolio by splitting investment
funds between safe and risky assets.
– Let y=portion allocated to the risky
portfolio, P
– (1-y)=portion to be invested in risk-free
asset, F.
Portfolios of One Risky Asset and a
Risk-Free Asset
256
Presented by Dr. June Neo
© Business eLearning
The Efficient Frontier of Risky Assets
with the Optimal CAL
257
Presented by Dr. June Neo
© Business eLearning
rf = 7% rf = 0%
E(rp) = 15% p = 22%
y = % in p (1-y) = % in rf
The Efficient Frontier of Risky Assets with
the Optimal CAL Example
258
Presented by Dr. June Neo
© Business eLearning
Example (Cont’d.)
The expected
return on the
complete
portfolio is the
risk-free rate
plus the
weight of P
times the risk
premium of P
( ) ( )c f P fE r r y E r r = + − 
C: Complete portfolio
259
Presented by Dr. June Neo
© Business eLearning
• The risk of the complete
portfolio is the weight of P
times the risk of P:
PC y =
Example (Cont’d.)
260
Presented by Dr. June Neo
© Business eLearning
Example (Ctd.)
• Rearrange and substitute y=C/P:
( ) ( ) fPfC rrEyrrE −+=
( )
22
8
=
−
=
P
fP rrE
Slope

261
Presented by Dr. June Neo
© Business eLearning
Discussion
262
Presented by Dr. June Neo
© Business eLearning
Capital Asset Pricing Model
(CAPM)
263
Presented by Dr. June Neo
© Business eLearning
Asset Pricing models
• Capital asset pricing model (CAPM)
– A theory that identifies the tangent
portfolio
• Asset pricing theory (APT)
– Requires that the returns on any stocks
be linearly related to one factor or a set
of factors.
264
Presented by Dr. June Neo
© Business eLearning
Capital asset pricing model (CAPM)
Assumptions:
• Investors maximise their utility only on the basis of
expected portfolio returns and return standard
deviations.
• Unlimited amounts can be borrowed or loaned at the
risk-free rate.
• Markets are perfect and frictionless (i.e. no taxes on
sales or purchases, no transaction costs and no short
sales restrictions).
• Investors have homogeneous beliefs regarding future
returns, which means that all investors have the
same information and assessment about expected
returns, standard deviations and correlations of all
feasible portfolios.
265
Presented by Dr. June Neo
© Business eLearning
Capital asset pricing model (CAPM)
Implication:
• In equilibrium, the tangent portfolio is the
market portfolio.
• Equilibrium between risk and return:
E(Ri) = Rf + i [E(Rm) – Rf]
where
i = the covariance of the returns on asset i with
the return on a market portfolio, divided by the
variance of the market return;
E(Rm) = expected return on the market portfolio
[E(Rm) – Rf] = market risk premium, which is the
amount by which the return of the market
portfolio is expected to exceed the risk-free rate.
266
Presented by Dr. June Neo
© Business eLearning
Risk Premium
Presented by Dr. June Neo
267
© Business eLearning
Capital asset pricing model (CAPM)
• CAPM states that the expected return of a
given risky asset (or portfolio of assets) is
equal to the risk-free rate plus a market risk
premium multiplied by the asset beta (β).
• Three elements are required:
– risk-free rate
– beta
– market risk premium.
268
Presented by Dr. June Neo
© Business eLearning
Risk-free Rate
The theoretical rate of return of an investment with zero
risk. The risk-free rate represents the interest an investor
would expect from an absolutely risk-free investment over
a specified period of time.
269
Presented by Dr. June Neo
© Business eLearning
What is Beta?
• measures the sensitivity of an individual security to the
market movements. It measures systematic risk.
• Beta of market is 1.
• Each company has its own beta. A company’s beta is
that company’s risk compared to the beta (risk measure)
of the overall market.
270
Presented by Dr. June Neo
© Business eLearning
Concept of Beta
If  > 1  Risky Security
If  < 1  Less Risky Security
271
Presented by Dr. June Neo
© Business eLearning
Concept of Beta
If a company has a beta of 3.0, then it is said to be 3
times more risky than the overall market.
If a company has a beta of 0.5, then it is said to be
less risky than the overall market.
272
© Business eLearning
Portfolio Betas
• The beta of a portfolio (p) is simply
the weighted average of the betas of
the individual assets in the portfolio
(i), where the weights are the
portfolio weights (wi).
p =  wi i
273
Presented by Dr. June Neo
© Business eLearning
Example of portfolio beta
You invest 30% in stock A and 70% in stock B. if the
betas of stock A and B are 1.5 and 0.8 respectively.
Determine the portfolio beta. Comment on the
portfolio beta.
© Business eLearning
Risk-free Rate
In theory, the risk-free rate is the minimum return an
investor expects for any investment since he or
she would not bear any risk unless the potential rate
of return is greater than the risk-free rate.
In practice, however, the risk-free rate does not exist
since even the safest investments carry a very small
amount of risk. Thus, the interest rate on a three-
month U.S. Treasury bill is often used as the risk-free
rate.
275
© Business eLearning
Risk premium
• An investment in stocks is far less guaranteed, as
companies regularly suffer downturns or go out of
business. Therefore, a higher rate of return is required
to entice investors to take on riskier investments.
• The excess return that compensates investors for
taking on the relatively higher risk of the equity market
is called the Risk Premium.
276
Presented by Dr. June Neo
© Business eLearning
Illustration 1
If the expected return on a stock is 15% and the
risk-free rate over the same period is 7%, What is
the stock risk premium? If the expected market
return is 12%, what is the market risk premium?
What is the stock beta?
277
Presented by Dr. June Neo
© Business eLearning
Illustration 2 (CAPM formula)
Consider Microsoft stock. Given a beta equal to 1.527, a
market risk premium of 9 per cent, and a risk-free rate of
3.5 per cent, what is the expected return for Microsoft?
278
Presented by Dr. June Neo
© Business eLearning
Security market line (SML)
• Capital asset pricing model (CAPM) implies
– linear relationship between the expected
return and β
– In equilibrium every stock must lie on
SML as investors can always obtain a
market risk premium by holding a
combination of the market portfolio and
the risk-free asset.
– SML is a graphical representation of CAPM
279
Presented by Dr. June Neo
© Business eLearning
Security market line (SML)
280
Presented by Dr. June Neo
© Business eLearning
Diversifiable risk and market risk
• In equilibrium, assets with identical expected
returns must have identical betas, standard
deviations may differ.
• Recall, total risk = systematic risk + unsystematic
risk
• Market will not compensate investors who take on
diversifiable risk with excess returns
• For a well diversified portfolio, only market risk
matters
• Magnitude of market risk depends on the average
betas of the securities included in the portfolio.
281
Presented by Dr. June Neo
© Business eLearning
Example
A stock has a required return of 19%, the risk-free
rate is 6%, and the market return is 15%.
a. What is the market risk premium.
b. What is the stock’s beta? Interpret your answer.
c. If the stock’s beta is 0.81, what will happen to the
stock’s required rate of return? Assume the risk-
free rate and the market risk premium remain
unchanged. Explain your answer.
d. If the stock offers an expected return of 18
percent, should you proceed with the investment?
Explain your answer.
282
© Business eLearning
Limitations of CAPM
• The exact composition of the market
portfolio is unobservable – therefore return
on market cannot be measured. A proxy
must be used  Introduces error.
• On the LHS of the CAPM there is expected
return and on the RHS there is expected
return on the market. Expected return is
not known with certainty and must be
estimated. Hence introduces measurement
error.
283
Presented by Dr. June Neo
© Business eLearning
Limitations of CAPM
• Problems arise when using CAPM to test
market efficiency:
• First, it might be the case that the market
portfolio is efficient (and hence the CAPM is
valid), but the proxy chosen is inefficient (and
hence the empirical tests incorrectly reject the
CAPM).
• Second, the proxy for the market portfolio
might be efficient (and hence the empirical
tests validate the CAPM), but the market
portfolio itself is not efficient (and hence the
validation is false).
• Third, the CAPM equation might be incorrect
284
Presented by Dr. June Neo
© Business eLearning
Factor models
• Basic idea of factor model: variations in
stock returns are generated by movement
in one factor (or a set of factors)
• Factors can be represented by
macroeconomic conditions, financial
conditions or political events. E.g. interest
rate, change in forecast of inflation, yield
spread etc.
285
Presented by Dr. June Neo
© Business eLearning
One-factor model
• A one-factor model assumes that there is only one
factor. Formally, it can be written as:
Ri = ai + bi1F1 + i, E(i) = 0
where:
ai = expected level of return for stock i if all factors
have a value of zero;
F1 = value of the factor 1 that affects the returns
on stock i.
bi1 = sensitivity of the returns on stock i to factor 1.
εi = random error term.
286
Presented by Dr. June Neo
© Business eLearning
Multi-factor model
• Where a set of j factors affects the returns
on stock i, a multi factor model becomes:
Ri = ai + bi1F1 + bi2F2 +… + i, E(i) = 0
• To determine the return on a portfolio,
given the factor structure, we need to
calculate the portfolio weighted averages of
the individual factor sensitivities i.e. a and b.
287
Presented by Dr. June Neo
© Business eLearning
Illustration 1 (One-Factor)
• Consider two stocks (X and Y), whose
returns are determined by the following
one-factor model:
Rx = 0.03 + 0.9F1 + x,
RY = 0.06 + 0.8F1 + Y,
Calculate the return of an equally weighted
portfolio of the two assets.
288
Presented by Dr. June Neo
© Business eLearning
Illustration 2 (Multi-Factor)
• Consider two stocks (X and Y), whose
returns are determined by the following
two-factor model:
Rx = 0.02 + 0.8F1 + 0.4F2 + x,
RY = 0.03 + 0.7F1 + 0.3F2 + x,
Calculate the return of a portfolio with the
following weights of the two assets: 30% in
stock X and 70% in stock Y.
289
Presented by Dr. June Neo
© Business eLearning
Arbitrage pricing theory (APT)
• Less complicated than CAPM
• Simply requires that the returns on any
stock be linearly related to one factor (or a
set of factors), as with factor models.
290
Presented by Dr. June Neo
© Business eLearning
Assumptions of APT
• There are no arbitrage opportunities.
• Returns of risky assets can be described by
a factor model
• Financial markets are frictionless
• There is a large number of securities and so
investors hold well-diversified portfolios.
This implies that diversifiable (or
unsystematic) risk does not exist.
291
Presented by Dr. June Neo
© Business eLearning
Expected risk premium
• Since APT is that a factor model with no
arbitrage opportunities  assets with the same
factor sensitivities must offer same expected
returns in financial market equilibrium.
• Expected risk premium on an individual asset
depends on the sum of the expected risk
premium associated with each factor multiplied
by the asset sensitivity to each of these factors
292
Presented by Dr. June Neo
© Business eLearning
Expected return on individual asset
E(Rx*) = Rf + b1x1 + b2x2 + … + bjxj
where:
j = (RFj – Rf), which is the risk premium over
the risk-free rate associated with factor j.
• The risk premium is affected only by
macroeconomic factors, and not by unique risk
(note the similarity with the CAPM). Moreover,
it varies in direct proportion to the asset’s
sensitivity to the factor.
293
Presented by Dr. June Neo
© Business eLearning
Illustration
Consider a three-factor Arbitrage Pricing Theory (APT)
model.
Factor Risk premium Sensitivity to
each factor
Change in GDP 4% 0.5
Change in interest rate 1.5% 0.8
Inflation ratio 2% 0.2
Assuming a risk-free rate of 4%, calculate the
expected return of this stock.
294
Presented by Dr. June Neo
© Business eLearning
Advantages / disadvantages of APT
• Advantage : it does not require us to
identify and measure the market portfolio,
thereby solving most of the problems on
the theoretical limitations of the CAPM.
• Disadvantage : it does not tell us what the
underlying factors are (unlike the CAPM,
which collapses all the macroeconomic
factors into the market portfolio).
295
Presented by Dr. June Neo
© Business eLearning
Discussion
296
Presented by Dr. June Neo
© Business eLearning
Efficient Market Hypothesis
297
Presented by Dr. June Neo
© Business eLearning
What is an efficient market?
• An efficient market is a market that efficiently processes
information.
• Prices at any time are based on a “correct” valuation of
all available information.
• Prices fully reflect all available information.
• In an efficient market prices react quickly and correctly
to new information.
298
Presented by Dr. June Neo
© Business eLearning
Why care about market efficiency?
• Because prices are fair.
• When firms issue securities they will get fair prices.
• Investors will pay fair prices.
• The market will allocate resources smoothly (inefficient
allocation of resources can seriously hurt the economy).
• An efficient market protects the less informed from being
taken advantage of by the more informed.
• If prices are “correct” then the only way an investor gets
higher returns on average is by taking on more risk (no free
lunch).
299
Presented by Dr. June Neo
© Business eLearning
Informational efficient markets
• Reasons for informational efficiency in capital
budgeting:
• First, main objective of capital budgeting is maximise
shareholder wealth (i.e. to maximise the value of the
firm’s stocks), it is important that financial markets
are able to value the firm’s stocks correctly.
• The signal given by the financial market to the
stockholders (through the price) has to reflect the
firm’s decisions on investment projects accurately.
300
Presented by Dr. June Neo
© Business eLearning
Informational efficient markets
• Second, if financial markets were inefficient, then
managers are unable to make rational investment
decisions as it would be impossible to identify the
discount rate for the NPV calculation.
• This implies that different investments with the same
degree of risk could generate different rates of return,
and the managers would not be able to choose the best
available forgone rate of return.
301
Presented by Dr. June Neo
© Business eLearning
Informational efficient markets
• Third, if financial market is inefficient in pricing
securities, then the equilibrium return determined
by CAPM or APT will be unreliable, since this
contradicts the main assumption in portfolio
theory that financial markets are reasonably
efficient.
302
Presented by Dr. June Neo
© Business eLearning
Theoretical framework
• Recall that the equation for estimation of
expected rate of return, E(R):
Where
Div1 = expected dividend to be paid at time 1
P0 = current price of the stock
P1 – P0 = capital gain on the stock
0
011)(
P
PPDiv
RE
−+
==Return Expected
303
Presented by Dr. June Neo
© Business eLearning
Theoretical framework
• Generalize the equation in any period from t
to (t+1), we have
Where
C = cash flow (dividend or coupon)
received in the period t to t+1
Pt = price of security at time t
Pt+1 = price of security at time t+1
t
tt
P
PPC
RE
−+
== +1)(Return Expected
304
Presented by Dr. June Neo
© Business eLearning
Theoretical framework
• EMH : Financial markets are efficient when security
prices incorporate all available information.
• It is impossible to make abnormal returns by using this
same set of information.
• If market is efficient, expected value has to be equal to
the forecasted value using all available information.
305
Presented by Dr. June Neo
© Business eLearning
Illustration
Suppose that a share of Microsoft had a closing price
yesterday of $90, but new information was announced after
the market closed that caused a revision in the forecast of
the price for next year to go to $120. If the annual
equilibrium return on Microsoft is 15%, what does the
efficient market hypothesis indicate the price will go to
today when the market open? Assume there is no dividends.
306
Presented by Dr. June Neo
© Business eLearning
Rationale Behind the Hypothesis
• When an unexploited profit
opportunity arises on a security
(so-called because, on average,
people would be earning more than
they should, given the characteristics
of that security), investors will rush
to buy until the price rises to the
point that the returns are normal
again.
307
Presented by Dr. June Neo
© Business eLearning
Rationale Behind the Hypothesis
• In an efficient market, all
unexploited profit opportunities will
be eliminated.
• Not every investor need be aware of
every security and situation, as long
as a few keep their eyes open for
unexploited profit opportunities, they
will eliminate the profit opportunities
that appear because in so doing,
they make a profit.
308
Presented by Dr. June Neo
© Business eLearning
How do we test efficiency?
• To test market efficiency  how the market determines
prices.
• Develop economic models that tell us how the market
determines what prices should be today.
• Models are usually developed so that they tell use how
the market determines expected returns (and prices).
• If the model is right and market is efficient, then the
returns will be consistent with the predictions of the
model about expected returns.
309
Presented by Dr. June Neo
© Business eLearning
The Joint hypothesis problem
• Every-time we test market efficiency we are also testing our
model of expected returns.
• Any test is simultaneously a test of efficiency and of the
correctness of the model of expected returns.
• If market efficiency tests are unsuccessful we do not know
• if the market is truly inefficient, or
• we have a bad model of expected returns.
• This is called the joint hypothesis problem.
310
Presented by Dr. June Neo
© Business eLearning
3 Levels of market efficiency
– Fama (1970)
• Weak Form Efficiency
• Market prices reflect all historical information
• Semi-Strong Form Efficiency
• Market prices reflect all publicly available information
• Strong Form Efficiency
• Market prices reflect all information, both public and
private
311
Presented by Dr. June Neo
© Business eLearning
Weak form efficiency
• The market incorporates all useful information in past
pricing data when it sets prices today.
• What does past pricing data include:
• Prices and trading volume (number of shares traded)
• Financial characteristics of the firms
• Information on macroeconomic conditions
• Main Implication: Cannot use past price data to consistently
generate excess returns that are unrelated to risk.
312
Presented by Dr. June Neo
© Business eLearning
Semi-strong form efficiency
• The market correctly uses all relevant public information
available at time t to set prices at time t.
• Public information includes:
• Past stock price data (weak form)
• Financial Accounts information and press announcement
• Analyst’s forecasts.
• Main Implication: Cannot use any public information to
consistently generate excess returns that are unrelated to risk
313
Presented by Dr. June Neo
© Business eLearning
Strong form efficiency
• The market correctly uses all relevant public and private
information available at time t to set prices at time t.
• This is an extreme version of the efficient market hypothesis.
• Private information includes:
• Insider information
• Investors and Analysts’ own analysis.
• It means that even people with insider information cannot
consistently generate excess expected returns unrelated to
risk.
314
Presented by Dr. June Neo
© Business eLearning
Weak-form:
Past prices & volume
3 Levels of the EMH
Semistrong-form:
Public information
Strong-form:
Public and private information
-f r :
Past ri s l
315
Presented by Dr. June Neo
© Business eLearning
• Technical analysis - the study of past financial
market data, primarily through the use of charts,
to forecast price trends and make investment
decisions.
• In its purest form, technical analysis considers
only the actual price behavior of the market or
instrument, based on the premise that price
reflects all relevant factors before an investor
becomes aware of them through other channels.
• Technical analysts believe that the historical
performance of stocks and markets are
indications of future performance.
Implications of EMH
- Technical Analysis
316
Presented by Dr. June Neo
© Business eLearning
Implications of EMH
- Technical Analysis
• Weak form efficiency implies that Technical analysis
will not be able to consistently produce excess returns,
though some forms of fundamental analysis may still
work.
317
Presented by Dr. June Neo
© Business eLearning
• Fundamental analysis of a business involves
analyzing its financial statements and health, its
management and competitive advantages, and its
competitors and markets.
• The analysis is based on historical and present data,
but with the goal to make financial projections.
• Fundamental analysis is about using real data to
evaluate a security’s value. The end goal is to produce
a value (intrinsic value) that an investor can compare
with the security’s current market price in order to
decide what position to take with that security.
Implications of EMH
- Fundamental Analysis
318
Presented by Dr. June Neo
© Business eLearning
Implications of EMH
- Fundamental Analysis
• Semi-strong form efficiency implies that Fundamental
analysis will not be able to reliably produce excess
returns.
319
Presented by Dr. June Neo
© Business eLearning
Corporate insiders and strong-form
efficiency
➢ Company’s directors using insider information to
trade stock and earn excess returns.
➢ Empirical evidence : insider trades can be used to
predict subsequent stock price changes.
➢ This is inconsistent with strong-form efficiency.
320
Presented by Dr. June Neo
© Business eLearning
Evidence on
Efficient Market Hypothesis
Favorable Evidence
1. Investment analysts and mutual funds don't beat
the market
2. Stock prices reflect publicly available info:
anticipated announcements don't affect stock
price
3. Stock prices and exchange rates close to random
walk
4. Technical analysis does not outperform market
321
Presented by Dr. June Neo
© Business eLearning
Evidence on
Efficient Market Hypothesis
Unfavorable Evidence
1. Small-firm effect: small firms have abnormally
high returns
2. January effect: high returns in January
3. Market over-reaction / under-reaction
4. New information is not always immediately
incorporated into stock prices
322
Presented by Dr. June Neo
© Business eLearning
Discussion
323
Presented by Dr. June Neo
© Business eLearning
324
Presented by Dr. June Neo

欢迎咨询51作业君