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life.
OUR INSTRUCTORS
Sample covariance = Cov (X,Y) =
E
n
i = 1
(X
i
X)(Y
i
Y)/(n 1)
where:
n = sample size
X
i
= ith observation of Variable X
X = mean observation of Variable X
Y
i
= ith observation of Variable Y
Y = mean observation of Variable Y
Sample correlation coefficient = r =
Cov (X,Y)
s
X
s
Y
Sample variance = s
X
2
=
E
n
i = 1
(X
i
X)
2
/(n 1)
Sample standard deviation = s
X
= s
X
2
Test-stat = t =
r n 2
1 r
2
Where:
n = Number of observations
r = Sample correlation
Test statistic
Regression model equation = Y
i
= b
0
+ b
1
X
i
+ c
i
, i = 1,...., n
- b
1
and b
0
are the regression coefficients.
- b
1
is the slope coefficient.
- b
0
is the intercept term.
- c is the error term that represents the variation in the dependent variable that
is not explained by the independent variable.
Linear Regression with One Independent Variable
CORRELATION AND REGRESSION
2013 ELAN GUIDES
QUANTITATIVE METHODS
Regression line equation = Y
i
= b
0
+ b
1
X
i
, i = 1,...., n
E
n
i = 1
[Y
i
(b
0
+ b
1
X
i
)]
2
Regression Residuals
where:
Y
i
= Actual value of the dependent variable
b
0
+ b
1
X
i
= Predicted value of dependent variable
SEE =
1/2
( )
n 2
E
n
i = 1
(Y
i
b
0
b
1
X
i
)
2
1/2
( )
E
n
i = 1
(c
i
)
2
n 2
= =
( )
SSE
n 2
1/2
The Standard Error of Estimate
Hypothesis Tests on Regression Coefficients
CAPM: R
ABC
= R
F
+ |
ABC
(R
M
R
F
)
R
ABC
R
F
= o + |
ABC
(R
M
R
F
) + c
- The intercept term for the regression, b
0
, is o.
- The slope coefficient for the regression, b
1
, is |
ABC
The Coefficient of Determination
R
2
= =
Explained variation
Total variation
Total variation Unexplained variation
Total variation
= 1
Total variation
Unexplained variation
Total variation = Unexplained variation + Explained variation
E
n
i = 1
(Y
i
Y )
2
^
RSS = Explained variation
The regression sum of squares (RSS)
E
n
i = 1
(Y
i
Y
i
)
2
^
SSE = Unexplained variation
The sum of squared errors or residuals (SSE)
2013 ELAN GUIDES
QUANTITATIVE METHODS
s
f
2
s
2
= 1 + +
1
n
(X X)
2
(n 1) s
x
2
[ ]
Y t
c
s
f
^
Prediction Intervals
Source of Variation
Regression (explained)
Error (unexplained)
Total
Degrees of Freedom
k
n (k + 1)
n 1
Sum of Squares
RSS
SSE
SST
Mean Sum of Squares
MSR =
RSS
k
RSS
1
= RSS =
MSE =
SSE
n 2
k = the number of slope coefficients in the regression.
ANOVA Table
2013 ELAN GUIDES
QUANTITATIVE METHODS
Multiple regression equation = Y
i
= b
0
+ b
1
X
1i
+ b
2
X
2i
+ . . .+ b
k
X
ki
+ c
i
, i = 1,2, . . . , n
Y
i
X
ji
b
0
b
1
, . . . , b
k
c
i
n
= the ith observation of the dependent variable Y
= the ith observation of the independent variable X
j
, j = 1,2, . . . , k
= the intercept of the equation
= the slope coefficients for each of the independent variables
= the error term for the ith observation
= the number of observations
Multiple regression equation
c
i
= Y
i
Y
i
= Y
i
(b
0
+ b
1
X
1i
+ b
2
X
2i
+ . . .+ b
k
X
ki
)
Residual Term
MULTIPLE REGRESSION AND ISSUES IN REGRESSION ANALYSIS
b
j
(t
c
s
b
j
)
(1 + i
FC
)
(1 + i
DC
)
F
PC/BC
= S
PC/BC
(1 + i
PC
)
(1 + i
BC
)
F
PC/BC
S
PC/BC
=
1 + (i
BC
Actual
360
)
1 + (i
PC
Actual
360
)
F
FC/DC
S
FC/DC
=
1 + (i
DC
Actual
360
)
1 + (i
FC
Actual
360
)
Forward exchange rates (F) - Any Investment Horizom
Currencies Trading at a Forward Premium/Discount
F
FC/DC
S
FC/DC
= S
FC/DC
(i
FC
i
DC
)
Actual
360
1 + (i
DC
Actual
360
)
( )
( )
F
PC/BC
S
PC/BC
= S
PC/BC
(i
PC
i
BC
)
Actual
360
1 + (i
BC
Actual
360
)
2013 ELAN GUIDES
CURRENCY EXCHANGE RATES: DETERMINATION AND FORECASTING
The expected percentage change in the spot exchange rate can be calculated as:
Covered Interest Rate Parity
F
PC/BC
1 + (i
BC
Actual
360
)
1 + (i
PC
Actual
360
)
S
PC/BC
=
Forward premium (discount) as a % =
F
PC/BC
S
PC/BC
S
PC/BC
Forward premium (discount) as a % ~ F
PC/BC
S
PC/BC
~ i
PC
i
BC
Uncovered Interest Rate Parity
Expected future spot exchange rate:
(1 + i
FC
)
(1 + i
DC
)
S
e
FC/DC
= S
FC/DC
i
= Beta of project or asset i
[E(R
M
) R
F
] = Market risk premium
2013 ELAN GUIDES
CAPITAL BUDGETING
Economic Income
Economic income = After-tax operating cash flow + Increase in market value
Economic income = After-tax operating cash flow + (Ending market value Beginning market value)
Economic income = After-tax operating cash flow (Beginning market value Ending market value)
Economic income = After-tax cash flows Economic depreciation
Economic Profit
Economic profit = [EBIT (1 Tax rate)] $WACC
Economic profit = NOPAT $WACC
NOPAT = Net operating profit after tax
$WACC = Dollar cost of capital = Cost of capital (%) Invested capital
Under this approach, a projects NPV is calculated as the sum of the present values of economic profit earned
over its life discounted at the cost of capital.
E
(1 + WACC)
t
EP
t
NPV = MVA =
Residual Income
Residual income = Net income for the period Equity charge for the period
Equity charge for the period = Required return on equity Beginning-of-period book value of equity
The RI approach calculates value from the perspective of equity holders only. Therefore, future residual income
is discounted at the required rate of return on equity to calculate NPV.
NPV =
E
(1 + r
E
)
t
RI
t
Claims Valuation
- First, we separate the cash flows available to debt and equity holders
- Then we discount them at their respective required rates of return.
o Cash flows available to debt holders are discounted at the cost of debt,
o Cash flows available to equity holders are discounted at the cost of equity.
- The present values of the two cash flow streams are added to calculate the total value of the company/asset.
2013 ELAN GUIDES
CAPITAL BUDGETING
CAPITAL STRUCTURE
r
WACC
= r
D
(1 t) + r
E
The Capital Structure Decision
r
WACC
= r
D
+ r
E
r
0
=
( ) ( )
MM Proposition II without Taxes: Higher Financial Leverage Raises the Cost of Equity
Independent variable Intercept
Dependent variable Slope
r
E
= + r
0
(r
0
r
D
)
The systematic risk () of the companys assets can be expressed as the weighted average of the systematic
risk of the companys debt and equity.
= |
A
+
( ) ( )
This formula can also be expressed as:
= |
E
+ (|
A
|
D
)
( )
r
D
= Marginal cost of debt
r
E
= Marginal cost of equity
t = Marginal tax rate
D = Market value of the companys outstanding debt
E = Market value of shareholders equity
V = D + E = Value of the company
Companys cost of equity (r
E
) under MM Proposition II without taxs is calculated as:
The total value of the company is calculated as:
V = +
r
E
EBIT Interest
r
D
Interest
2013 ELAN GUIDES
CAPITAL STRUCTURE
= +tD
Relaxing the Assumption of no Taxes
r
WACC
= r
D
(1 t) + r
E
The WACC is then calculated as:
r
E
= + r
0
(r
0
r
D
) (1 t)
And the cost of equity is calculated as:
Modigilani and Miller Propositions
Without Taxes With Taxes
=
r
E
= + r
0
(r
0
r
D
)
+ tD =
r
E
= + r
0
(r
0
r
D
) (1 t)
Proposition I
Proposition II
The Optimal Capital Structure: The Static Trade-Off Theory
V
L
= V
U
+ tD PV(Costs of financial distress)
2013 ELAN GUIDES
CAPITAL STRUCTURE
DIVIDENDS AND SHARE REPURCHASE
P
w
= Share price with the right to receive the dividend
P
X
= Share price without the right to receive the dividend
D = Amount of dividend
T
D
= Tax rate on dividends
T
CG
= Tax rate on capital gains
Double Taxation System
ETR = CTR + [(1 CTR) MTR
D
]
ETR = Effective tax rate
CTR = Corporate tax rate
MTR
D
= Investors marginal tax rate on dividends
Split-Rate Tax System
ETR = CTR
D
+ [(1 CTR
D
) MTR
D
]
CTR
D
= Corporate tax rate on earnings distributed as dividends.
Stable Dividend Policy
The expected increase in dividends is calculated as:
Expected dividend increase = Increase in earnings Target payout ratio Adjustment factor
Adjustment factor = 1/N
N = Number of years over which the adjustment is expected to occur
Analysis of Dividend Safety
Dividend payout ratio = (dividends / net income)
Dividend coverage ratio = (net income / dividends)
FCFE coverage ratio = FCFE / [Dividends + Share repurchases]
P
W
P
X
= D
The expected decrease in share price when it goes ex-dividend can be calculated using the following equation:
2013 ELAN GUIDES
DIVIDENDS AND SHARE REPURCHASE
Industry Life
Cycle Stage
Pioneering
development
Rapid
accelerating
growth
Mature
growth
Stabilization
and market
maturity
Deceleration
of growth
and decline
-
-
-
-
-
-
-
-
-
-
Industry
Description
Low but slowly
increasing sales
growth.
Substantial
development costs.
High profit
margins.
Low competition.
Decrease in the
entry of new
competitors.
Growth potential
remains.
Increasing capacity
constraints
Increasing
competition.
Overcapacity.
Eroding profit
margins.
Types of
Merger
Conglomerate
Horizontal
Conglomerate
Horizontal
Horizontal
Vertical
Horizontal
Horizontal
Vertical
Conglomerate
-
-
-
-
-
-
-
-
-
-
Motives for Merger
Younger, smaller companies may sell
themselves to larger firms in mature
or declining industries to enter into a
new growth industry.
Young companies may merge with
firms that allow them to pool
management and capital resources.
To meet substantial capital
requirements for expansion.
To achieve economies of scale,
savings, and operational efficiencies.
To achieve economies of scale in
research, production, and marketing
to match low costs and prices of
competitors.
Large companies may buy smaller
companies to improve management
and provide a broader financial base.
Horizontal mergers to ensure survival.
Vertical mergers to increase efficiency
and profit margins.
Conglomerate mergers to exploit
synergy.
Companies in the industry may
acquire companies in young
industries.
-
-
-
-
-
-
-
-
-
-
Source: Adapted from J. Fred Weston, Kwang S. Chung, and Susan E. Hoag, Mergers, Restructuring, and
Corporate Control (New York: Prentice Hall, 1990, p.102) and Bruno Solnik and Dennis McLeavy, International
Investments, 5th edition (Boston: Addison Wesley, 2004, p. 264 265).
Mergers and the Industry Life Cycle
MERGERS AND ACQUISITION
2013 ELAN GUIDES
MERGERS AND ACQUISITION
Major Differences of Stock versus Asset Purchases
Payment
Approval
Tax: Corporate
Tax: Shareholder
Liabilities
Stock Purchase
Target shareholders receive
compensation in exchange for
their shares.
Shareholder approval required.
No corporate-level taxes.
Target companys shareholders
are taxed on their capital gain.
Acquirer assumes the targets
liabilities.
Asset Purchase
Payment is made to the selling
company rather than directly to
shareholders.
Shareholder approval might not be
required.
Target company pays taxes on any
capital gains.
No direct tax consequence for target
companys shareholders.
Acquirer generally avoids the
assumption of liabilities.
E
n
i
(
Sales or output of firm i
Total sales or output of market
100
)
2
Herfindahl-Hirschman Index (HHI)
Post-Merger HHI
Less than 1,000
Between 1,000 and 1,800
More than 1,800
Concentration
Not concentrated
Moderately concentrated
Highly concentrated
Change in HHI
Any amount
100 or more
50 or more
Government Action
No action
Possible challenge
Challenge
HHI Concentration Levels and Possible Government Response
FCFF is estimated by:
Net income
+ Net interest after tax
= Unlevered income
+ Changes in deferred taxes
= NOPLAT (net operating profit less adjusted taxes)
+ Net noncash charges
Change in net working capital
Capital expenditures (capex)
Free cash flow to the firm (FCFF)
Net interest after tax = (Interest expense Interest income) (1 tax rate)
Working capital = Current assets (excl. cash and equivalents) Current liabilities (excl. short-term debt)
2013 ELAN GUIDES
MERGERS AND ACQUISITION
Comparable Company Analysis
TP = Takeover premium
DP = Deal price per share
SP = Targets stock price per share
TP =
SP
(DP SP)
Bid Evaluation
Target shareholders gain = Takeover premium = P
T
V
T
Acquirers gain = Synergies Premium
= S (P
T
V
T
)
S = Synergies created by the merger transaction
The post-merger value of the combined company is composed of the pre-merger value of the
acquirer, the pre-merger value of the target, and the synergies created by the merger. These
sources of value are adjusted for the cash paid to target shareholders to determine the value of
the combined post-merger company.
V
A*
= V
A
+ V
T
+ S C
V
A*
= Value of combined company
C = Cash paid to target shareholders
2013 ELAN GUIDES
MERGERS AND ACQUISITION
Perceived mispricing:
Perceived mispricing = True mispricing + Error in the estimate of intrinsic value.
V
E
P = (V P) + (V
E
V)
V
E
= Estimate of intrinsic value
P = Market price
V = True (unobservable) intrinsic value
EQUITY VALUATION: APPLICATIONS AND PROCESSES
2013 ELAN GUIDES
EQUITY VALUATION: APPLICATIONS AND PROCESSES
RETURN CONCEPTS
Holding period return =
P
H
P
0
+ D
H
P
0
Intrinsic Value =
Next years expected dividend
Required return Expected dividend growth rate
V
0
=
D
1
k
e
g
k
e
(IRR) = g +
D
1
P
0
If the asset is assumed to be efficiently-priced (i.e. the market price equals its intrinsic value), the IRR would
equal the required return on equity. Therefore, the IRR can be estimated as:
Required return (IRR) = + Expected dividend growth rate
Market price
Next years dividend
Holding Period Return
P
H
= Price at the end of the holding period
P
0
= Price at the beginning of the period
D
H
= Dividend
Required Return
- The difference between an assets expected return and its required return is known as
expected alpha, ex ante alpha or expected abnormal return.
o Expected alpha = Expected return Required return
- The difference between the actual (realized) return on an asset and its required return
is known as realized alpha or ex post alpha.
o Realized alpha = Actual HPR Required return for the period
When the investors estimate of intrinsic value (V
0
) is different from the current market price
(P
0
), the investors expected return has two components:
1. The required return (r
T
) earned on the assets current market price; and
2. The return from convergence of price to value [(V
0
P
0
)/P
0
].
Internal Rate of Return
2013 ELAN GUIDES
RETURN CONCEPTS
Equity Risk Premium
The required rate of return on a particular stock can be computed using either of the following two approaches.
Both these approaches require the equity risk premium to be estimated first.
1. Required return on share i = Current expected risk-free return +
i
(Equity risk premium)
- A beta greater (lower) than 1 indicates that the security has greater-than-average (lower-than-
average) systematic risk.
2. Required return on share i = Current expected risk-free return + Equity risk premium
Other risk premia/discounts appropriate for i
- This method of estimating the required return is known as the build-up method. It is discussed
later in the reading and is primarily used for valuations of private businesses.
GCM equity risk premium estimate = + g r
LTGD
D
1
P
0
Gordon Growth Model (GGM) Estimates
Macroeconomic Model Estimates
Equity risk premium = {[(1 + EINFL) (1 + EGREPS) (1 + EGPE) 1] + EINC} Expected RF
Expected inflation =
1 + YTM of 20-year maturity TIPS
1 + YTM of 20-year maturity T-bonds
1
The Captial Asset Pricing Model (CAPM)
Required return on i = Expected risk-free rate + Beta
i
(Equity risk premium)
The Fama-French Model
r
i
= RF + |
i
mkt
RMRF + |
i
size
SMB |
i
value
HML +
mkt
= Market beta
size
= Size beta
value
= Value beta
The Pastor-Stambaugh model (PSM)
liq
= Liquidity beta
r
i
= R
F
+ |
i
mkt
RMRF + |
i
size
SMB |
i
value
HML + |
i
liq
LIQ +
2013 ELAN GUIDES
RETURN CONCEPTS
BIRR model
r
i
= T-bill rate + (Sensitivity to confidence risk Confidence risk)
+ (Sensitivity to time horizon risk Time horizon risk)
+ (Sensitivity to inflation risk Inflation risk)
+ (Sensitivity to business cycle risk Business cycle risk)
+ (Sensitivity to market timing risk Market timing risk)
Build-up method
r
i
= Risk-free rate + Equity risk premium + Size premium + Specific-company premium
For companies with publicly-traded debt, the bond-yield plus risk premium approach can be
used to calculate the cost of equity:
BYPRP cost of equity = YTM on the companys long-term debt + Risk premium
Adjusting Beta for Beta Drift
Adjusted beta = (2/3) (Unadjusted beta) + (1/3) (1.0)
Estimating the Asset Beta for the Comparable Publicly Traded Firm:
where:
D/E = debt-to-equity ratio of the comparable company.
t = marginal tax rate of the comparable company.
To adjust the asset beta of the comparable for the capital structure (financial risk) of the project
or company being evaluated, we use the following formula:
where:
D/E = debt-to-equity ratio of the subject company.
t = marginal tax rate of the subject company.
B
ASSET
reflects only
business risk of the
comparable
company. Therefore
it is used as a proxy
for business risk of
the project being
studied.
B
EQUITY
reflects
business and
financial risk of
comparable
company.
ASSET
=
EQUITY
)
1
(
1 + (1 - t)
D
E
B
PROJECT
reflects
business and
financial risk of the
project.
B
ASSET
reflects
business risk of
project.
PROJECT
=
ASSET
1 + (1 - t)
D
E
Country Spread Model
ERP estimate = ERP for a developed market + Country premium
2013 ELAN GUIDES
RETURN CONCEPTS
Weighted Average Cost of Capital (WACC)
WACC = + r
MVCE
MVD + MVCE
r
d
(1 Tax rate )
MVD
MVD + MVCE
MVD = Market value of the companys debt
r
d
= Required rate of return on debt
MVCE = Market value of the companys common equity
r = Required rate of return on equity
2013 ELAN GUIDES
RETURN CONCEPTS
Justified leading P/E ratio =
P
0
E
1
D
1
/E
1
r g
= =
(1
b)
r g
Justified trailing P/E =
P
0
E
0
D
1
/E
0
r g
= =
(1
b)(1
+ g)
r g
D
0
(1
+ g) / E
0
r g
=
P/E ratio
Present value of Growth Opportunities
V
0
= + PVGO
E
1
r
V
0
= The value of the stock today (t = 0)
P
1
= Expected price of the stock after one year (t = 1)
D
1
= Expected dividend for Year 1, assuming it will be paid at the end of Year 1 (t = 1)
r = Required return on the stock
One-Period DDM
Multiple-Period DDM
DISCOUNTED DIVIDEND VALUATION
V
0
+ = =
D
1
(1 + r)
1
P
1
(1 + r)
1
D
1
P
1
(1 + r)
1
+
V
0
+ =
D
1
(1 + r)
1
P
n
(1 + r)
n
D
n
(1 + r)
n
+ + ...
V
0
+ =
D
t
(1 + r)
t
P
n
(1 + r)
n E
n
t = 1
Expression for calculating Value of a share of stock
V
0
=
D
t
(1 + r)
t E
t = 1
V
0
=
D
0
(1 + g)
(r g)
, or V
0
=
D
1
(r g)
Gordon Growth Model
2013 ELAN GUIDES
DISCOUNTED DIVIDEND VALUATION
g
S
= Short term supernormal growth rate
g
L
= Long-term sustainable growth rate
r = required return
n = Length of the supernormal growth period
Two-Stage Dividend Discount Model
g
S
= Short term high growth rate
g
L
= Long-term sustainable growth rate
r = required return
H = Half-life = 0.5 times the length of the high growth period
The H-model equation can be rearranged to calculate the required rate of return as follows:
The H-Model
r = [(1 + g
L
) + H(g
s
g
L
)] + g
L
D
0
P
0
) (
The Gordon growth formula can be rearranged to calculate the required rate of return given the other variables.
r = + g
D
1
P
0
V
0
=
D
r
Value of Fixed-Rate Perpetual Preferred Stock
V
0
=
E
n
t = 1
D
0
(1 + g
S
)
t
(1 + r)
t
+
D
0
(1 + g
S
)
n
(1 + g
L
)
(1 + r)
n
(r g
L
)
V
0
=
D
0
(1 + g
L
)
r g
L
+
D
0
H
(g
s
g
L
)
r g
L
Sustainable growth rate (SGR)
b = Earnings retention rate, calculated as 1 Dividend payout ratio
g = b ROE
2013 ELAN GUIDES
DISCOUNTED DIVIDEND VALUATION
ROE can be calculated as:
ROE =
Net income
Sales Total assets
Sales Total assets
Shareholders equity
g =
Net income
Sales Total assets
Sales Total assets
Shareholders equity
Net income - Dividends
Net income
PRAT model
g = Profit margin Retention rate Asset turnover Financial leverage
2013 ELAN GUIDES
DISCOUNTED DIVIDEND VALUATION
FCFF = NI + NCC + Int(1 Tax Rate) FCInv WCInv
Computing FCFF from Net Income
FCInv = Capital expenditures Proceeds from sale of long-term assets
Investment in fixed capital (FCInv)
WCInv = Change in working capital over the year
Working capital = Current assets (exc. cash) Current liabilities (exc. short-term debt)
Investment in working capital (WCInv)
WACC =
MV(Debt)
MV(Debt) + MV(Equity)
r
d
(1 Tax Rate)
MV(Equity)
MV(Debt) + MV(Equity)
r
+
= Firm Value
E
t=1
FCFF
t
(1+WACC)
t
Equity Value Firm Value Market value of debt
=
Equity Value
=
E
t=1
FCFE
t
(1 + r)
t
FCFF/FCFE
FREE CASH FLOW VALUATION
Table: Noncash Items and FCFF
Noncash Item
Depreciation
Amortization and impairment of intangibles
Restructuring charges (expense)
Restructuring charges (income resulting from reversal)
Losses
Gains
Amortization of long-term bond discounts
Amortization of long-term bond premiums
Deferred taxes
Adjustment to NI to
Arrive at FCFF
Added back
Added back
Added back
Subtracted
Added back
Subtracted
Added back
Subtracted
Added back but requires
special attention
2013 ELAN GUIDES
FREE CASH FLOW VALUATION
FCFE = EBIT(1 Tax rate) Int(1 Tax rate) + Dep FCInv WCInv + Net borrowing
Computing FCFE from EBIT
FCFE = EBITDA(1 Tax rate) Int(1 Tax rate) + Dep(Tax rate) FCInv WCInv + Net
borrowing
Computing FCFE from EBITDA
FCFF = CFO + Int(1 Tax rate) FCInv
Computing FCFF from CFO
FCFF = EBIT(1 Tax rate) + Dep FCInv WCInv
Computing FCFF from EBIT
FCFF = EBITDA(1 Tax rate) + Dep(Tax rate) FCInv WCInv
Computing FCFF from EBITDA
FCFE = FCFF Int(1 Tax rate) + Net borrowing
Computing FCFE from FCFF
FCFE = NI + NCC FCInv WCInv + Net Borrowing
Computing FCFE from Net Income
FCFE = CFO + FCInv Net borrowing
Computing FCFE from CFO
Table: IFRS versus U.S. GAAP Treatment of Interest and Dividends
Interest received
Interest paid
Dividend received
Dividends paid
IFRS
CFO or CFI
CFO or CFF
CFO or CFI
CFO or CFF
U.S. GAAP
CFO
CFO
CFO
CFF
2013 ELAN GUIDES
FREE CASH FLOW VALUATION
Value of the firm =
FCFF
1
WACC - g
FCFF
0
(1 + g)
WACC - g
=
WACC = Weighted average cost of capital
g = Long-term constant growth rate in FCFF
Constant Growth FCFF Valuation Model
Value of equity =
FCFE
1
r - g
FCFE
0
(1 + g)
r - g
=
r = Required rate of return on equity
g = Long-term constant growth rate in FCFE
Constant Growth FCFE Valuation Model
Increases in cash balances
Plus: Net payments to providers of debt capital
+ Interest expense (1 tax rate)
+ Repayment of principal
New borrowings
Plus: Net payments to providers of equity capital
+ Cash dividends
+ Share repurchases
New equity issues
= Uses of FCFF
Increases in cash balances
Plus: Net payments to providers of equity capital
+ Cash dividends
+ Share repurchases
New equity issues
= Uses of FCFE
Uses of FCFF
Uses of FCFE
An International Application of the Single-Stage Model
Value of equity =
r
real
g
real
FCFE
0
(1 + g
real
)
2013 ELAN GUIDES
FREE CASH FLOW VALUATION
General expression for the two-stage FCFF model:
E
n
t = 1
Firm value =
(1 + WACC)
n
1
FCFF
t
(1 + WACC)
t
FCFF
n+1
(WACC g)
+
Firm value = PV of FCFF in Stage 1 + Terminal value Discount Factor
General expression for the two-stage FCFE model:
Equity value =
E
n
t = 1
FCFE
t
(1 + r)
t
FCFF
n+1
r g (1 + r)
n
1
+
Equity value = PV of FCFE in Stage 1 + Terminal value Discount Factor
Terminal value in year n = Justified Trailing P/E Forecasted Earnings in Year n
Terminal value in year n = Justified Leading P/E Forecasted Earnings in Year n + 1
Determining Terminal Value
Non-operating Assets and Firm Value
Value of the firm = Value of operating assets + Value of non-operating assets
2013 ELAN GUIDES
FREE CASH FLOW VALUATION
MARKET-BASED VALUATION: PRICE AND ENTERPRISE VALUE
MULTIPLES
Trailing P/E ratio =
Current Stock Price
Last years EPS
Forward P/E ratio =
Current Stock Price
Expected EPS
P/B ratio =
Market price per share
Book value per share
P/B ratio =
Market value of common shareholders equity
Book value of common shareholders equity
Book value of equity = Common shareholders equity
= Shareholders equity Total value of equity claims that are senior to common stock
Book value of equity = Total assets Total liabilities Preferred stock
P/S ratio =
Market price per share
Sales per share
P/E Net profit margin = (P / E) (E / S) = P/S
P/CF ratio =
Market price per share
Free cash flow per share
Leading dividend yield = Next years dividend / Current price per share
Trailing dividend yield = Last years dividend / Current price per share
Price to Book Ratio
Price to Sales Ratio
Relationship between the P/E ratio and the P/S ratio
Justified leading dividend yield
Justified trailing dividend yield
Price to Cash Ratio
Price to Earnings Ratio
Dividend Yield
2013 ELAN GUIDES
MARKET-BASED VALUATION: PRICE AND ENTERPRISE VALUE MULTIPLES
V
0
=
D
1
(r g)
Justified P/E Multiple Based on Fundamentals
Justified leading P/E multiple
Justified leading P/E =
P
0
E
1
D
1
/E
1
r g
= =
(1
b)
r g
(1 b) is the payout ratio.
Justified trailing P/E multiple
Justified trailing P/E =
P
0
E
0
D
1
/E
0
r g
= =
(1
b)(1
+ g)
r g
D
0
(1
+ g) / E
0
r g
=
Justified P/B Multiple Based on Fundamentals
=
P
0
B
0
ROE g
r g
ROE = Return on equity
r = required return on equity
g = Sustainable growth rate
Justified P/CF Multiple Based on Fundamentals
V
0
=
FCFE
0
(1 + g)
(r g)
P
0
S
0
=
(E
0
/S
0
)(1
b)(1
+ g)
r g
Justified P/S Multiple Based on Fundamentals
E0/S0 = Net profit margin
1 b = Payout ratio
Justified Dividend Yield
D
0
P
0
r g
1 + g
=
2013 ELAN GUIDES
MARKET-BASED VALUATION: PRICE AND ENTERPRISE VALUE MULTIPLES
P/E-to-growth (PEG) ratio
TV
n
= Justified leading P/E
Forecasted earnings
n +1
TV
n
= Justified trailing P/E
Forecasted earnings
n
TV
n
= Benchmark leading P/E
Forecasted earnings
n +1
TV
n
= Benchmark trailing P/E
Forecasted earnings
n
Terminal price based on fundamentals
Terminal price based on comparables
Enterprise value = Market value of common equity + Market value of preferred stock
+ Market value of debt Value of cash and short-term investments
EBITDA = Net income + Interest + Taxes + Depreciation and amortization
Alternative Denominators in Enterprise Value Multiples
Free Cash
Flow to the
Firm =
EBITDA=
EBITA =
EBIT =
Net
Income
Net
Income
Net
Income
Net
Income
plus
Interest
Expense
plus
Interest
Expense
plus
Interest
Expense
plus
Interest
Expense
minus
Tax Savings
on Interest
plus
Taxes
plus
Taxes
plus
Taxes
plus
Depreciation
plus
Depreciation
plus
Amortization
plus
Amortization
plus
Amortization
less
Investment in
Working Capital
less
Investment in
Fixed Capital
Justified forward P/E after accounting for Inflation
1
+ (1 ) I
P
0
E
1
=
= The percentage of inflation in costs that the company can pass through to revenue.
= Real rate of return
I = Rate of inflation
PEG =
P/E
Growth (%)
EV/EBITDA Multiple
2013 ELAN GUIDES
MARKET-BASED VALUATION: PRICE AND ENTERPRISE VALUE MULTIPLES
Unexpected earnings (UE)
UE
t
= EPS
t
E(EPS
t
)
SUE
t
=
EPS
t
E(EPS
t
)
o[EPS
t
E(EPS
t
)]
EPS
t
= Actual EPS for time t
E(EPS
t
) = Expected EPS for time t
o[EPS
t
E(EPS
t
)] = Standard deviation of [EPS
t
E(EPS
t
)]
Standardized unexpected earnings (SUE)
2013 ELAN GUIDES
MARKET-BASED VALUATION: PRICE AND ENTERPRISE VALUE MULTIPLES
RESIDUAL INCOME VALUATION
The Residual Income
V
0
= Intrinsic value of the stock today
B
0
= Current book value per share of equity
B
t
= Expected book value per share of equity at any time t
r = Required rate of return on equity
E
t
= Expected EPS for period t
RI
t
= Expected residual income per share
E
t
rB
t-1
(1 + r)
t
V
0
= B
0
+
E
i = 1
RI
t
(1 + r)
t E
i = 1
=
B
0
+
Intrinsic value of a stock:
Residual income = Net income Equity charge
Equity charge = Cost of equity capital Equity capital
RI
t
= E
t
(r B
t-1
)
The Residual Income Model
RI
t
= Residual income at time t
E
t
= Earnings at time t
r = Required rate of return on equity
B
t-1
= Book value at time t-1
Capital charge = Equity charge + Debt charge
Debt charge = Cost of debt (1 Tax rate) Debt capital
Residual income = After-tax operating profit Capital charge
NOPAT = Net operating profit after tax = EBIT (1 Tax rate)
C% = Cost of capital (WACC)
TC = Total capital
Economic Value Added
EVA = NOPAT (C% TC)
Market value of company = Market value of debt + Market value of equity.
MVA = Market value of the company Accounting book value of total capital
Market Value Added
2013 ELAN GUIDES
RESIDUAL INCOME VALUATION
RI
t
= EPS
t
- (R B
t-1
)
RI
t
= (ROE - r)B
t-1
V
0
= B
0
+
E
t = 1
(ROE
t
r)B
t-1
(1 + r)
t
Residual Income Model (Alternative Approach)
Tobins q =
Market value of debt and equity
Replacement cost of total assets
Tobins q
ROE r
r g
B
0
+ B
0
V
0
=
V
0
= B
0
+
E
T - 1
t = 1
(E
t
rB
t 1
)
(1 + r)
t
+
E
T
rB
T-1
(1 + r e)(1 + r)
T1
e = Persistence factor.
When residual income fades over time as ROE declines towards the required return on equity, the intrinsic
value of a stock is calculated using the following formula:
V
0
= B
0
+
(E
t
rB
t 1
)
(1 + r)
t
+
P
T
B
T
(1 + r)
T
T
E
t = 1
Multi-Stage Residual Income Valuation
g = r
(ROE r) B
0
V
0
B
0
[ ]
Implied Growth Rate
2013 ELAN GUIDES
RESIDUAL INCOME VALUATION
PRIVATE COMPANY VALUATION
DLOC = 1 -
1
1 + Control Premium
V = Value of the equity
FCFE
1
= Free cash flow to the equity for next twelve months
r = Required return on equity
g = Sustainable growth rate of free cash flow to the equity
V =
FCFE
1
r g
V
f
=
FCFF
1
WACC g
f
V
f
= Value of the firm
FCFF
1
= Free cash flow to the firm for next twelve months
WACC = Weighted average cost of capital
g
f
= Sustainable growth rate of free cash flow to the firm
The Capitalized Cash Flow Method
Discount for Lack of Control (DLOC)
Methods Used to Estimate the Required Rate of Return for a Private Company
Capital Asset Pricing Model
Required return on equity = Risk-free rate + (Beta Market risk premium)
Expanded CAPM
Required return on equity = Risk-free rate + (Beta Market risk premium)
+ Small stock premium + Company-specific risk premium
Build-Up Approach
Required return on equity = Risk-free rate + Equity risk premium + Small stock premium
+ Company-specific risk premium + Industry risk premium
2013 ELAN GUIDES
PRIVATE COMPANY VALUATION
PRIVATE REAL ESTATE INVESTMENTS
Net Operating Income
Rental income at full occupancy
+ Other income (such as parking)
= Potential gross income (PGI)
Vacancy and collection loss
= Effective gross income (EGI)
Operating expenses (OE)
= Net operating income (NOI)
The Direct Capitalization Method
Cap rate = Discount rate Growth rate
The cap rate can be defined as the current yield on an investment:
Capitalization rate =
NOI
1
Value
Rearranging the above equation, we can estimate the value of a property by dividing its first-
year NOI by the cap rate.
Value =
NOI
1
Cap rate
An estimate of the appropriate cap rate for a property can be obtained from the selling price of
similar or comparable properties.
Cap rate =
Sale price of comparable property
NOI
The cap rate derived by dividing rent by recent sales prices of comparables is known as the all
risks yield (ARY). The value of a property is then calculated as:
Market value =
Rent
1
ARY
Gross income multiplier =
Selling price
Gross income
Value of subject property = Gross income multiplier Gross income of subject property
Other Forms of the Income Approach
2013 ELAN GUIDES
PRIVATE REAL ESTATE INVESTMENTS
Value =
NOI
1
(r g)
The Discounted Cash Flow Method (DCF)
Terminal value =
NOI for the first year of ownership for the next investor
Terminal cap rate
The Terminal Capitalization Rate
Appraisal-Based Indices
Return =
NOI Capital expenditures + (Ending market value Beginning market value)
Beginning market value
LTV ratio =
Loan amount
Appraised value
Debt Service Coverage ratio
DSCR =
Debt service
NOI
Loan to Value ratio
Equity dividend rate/Cash-on-cash return
Equity dividend rate =
First year cash flow
Equity investment
2013 ELAN GUIDES
PRIVATE REAL ESTATE INVESTMENTS
PUBLICLY TRADED REAL ESTATE SECURITIES
Capitalization rate =
NOI of a comparable property
Total value of comparable property
NAVPS =
Net Asset Value
Shares outstanding
Net Asset Value per Share
Capitalization rate
VALUATION: RELATIVE VALUATION (PRICE MULTIPLE) APPROACH
Funds from operations (FFO)
Accounting net earnings
Add: Depreciation charges on real estate
Add: Deferred tax charges
Add (Less): Losses (gains) from sales of property and debt restructuring
Funds from operations
Adjusted funds from operations (AFFO)
Funds from operations
Less: Non-cash rent
Less: Maintenance-type capital expenditures and leasing costs
Adjusted funds from operations
AFFO is preferred over FFO as it takes into account the capital expenditures necessary to maintain
the economic income of a property portfolio.
VALUATION: NET ASSET VALUE APPROACH
2013 ELAN GUIDES
PUBLICLY TRADED REAL ESTATE SECURITIES
Post-money value =
Exit value
(1 + Required rate of return )
Number of years to exists
Required wealth = Investment (1 + IRR)
Number of years to exit
Proportionate ownership of the VC investor
= I / POST
Post-money value
Required wealth
Quantitative Measures of Return
- PIC (paid in capital): Ratio of paid in capital to date to committed capital.
- DPI (distributed to paid-in) or cash-on-cash return: Value of cumulative distributions
paid to LPs as a proportion of cumulative invested capital.
o (DPI = Cumulative distributions / PIC)
- RVPI (residual value to paid-in): Value of LPs shareholdings held with the fund as a
proportion of cumulative invested capital.
o RVPI = NAV after distributions / PIC
- TVPI (total value to paid-in): Value of portfolio companies distributed (realized) and
undistributed (unrealized) value as a proportion of cumulative invested capital.
o TVPI = DPI + RVPI
NAV before distributions = Prior years NAV after distributions + Capital called
down Management Fees + Operating results
NAV after distributions = NAV before distributions Carried interest Distributions
Total Exit Value
Exit value = Initial cost + Earnings growth + Multiple expansion + Debt reduction
Post-money valuation (POST)
POST = PRE + I
PRIVATE EQUITY VALUATION
Ownership proportion = Required wealth / Exit value
Ownership propotion
2013 ELAN GUIDES
PRIVATE EQUITY VALUATION
Shares to be issued =
Proportion of venture capitalist investment Shares held by
company founders
Proportion of investment of company founders
Price per share =
Amount of venture capital investment
Number of shares issued to venture capital investment
Adjusted discount rate = 1
1 + r
1 q
r = Discount rate unadjusted for probability of failure.
q = Probability of failure.
Adjusted discount rate
Shares to be issued
Price per share
2013 ELAN GUIDES
PRIVATE EQUITY VALUATION
FUNDAMENTALS OF CREDIT ANALYSIS
Expected loss = Default probability Loss severity given default
Expected Loss
Yield on a corporate bond:
Yield on a corporate bond = Real risk-free interest rate + Expected inflation rate
+ Maturity premium + Liquidity premium + Credit spread
Yield spread = Liquidity premium + Credit spread
For small, instantaneous changes in the yield spread, the return impact (i.e. the percentage change
in price, including accrued interest) can be estimated using the following formula:
ASpread Modified duration Return impact ~
For larger changes in the yield spread, we must also incorporate the (positive) impact of convexity
into our estimate of the return impact:
Return impact ~ (MDur ASpread) + (1/2 Convexity ASpread
2
)
Yield Spread:
2013 ELAN GUIDES
FUNDAMENTALS OF CREDIT ANALYSIS
TERM STRUCTURE AND VOLATILITY OF INTEREST RATES
X
t
= 100 ln
y
t
y
t1
( )
where
y
t
= yield on day t
Measuring Historical Yield Volatility
Annualizing the Standard Deviation
Annualized standard deviation = Daily standard deviation \ No. of days in a year
Variance =
E
T
t = 1
X
t
2
T 1
Variance =
E
T
t = 1
W
t
X
t
2
T 1
where:
W
t
= the weight assigned to each daily yield change observation such that the sum of the weights
equals 1.
Calculating Variance of Daily Yield Changes
... assigns an equal weight to all observations
... attaches a greater weight to more recent information
2013 ELAN GUIDES
TERM STRUCTURE AND VOLATILITY OF INTEREST RATES
Specific Bond Sector with a Given Credit Rating Benchmark
Treasury Market Benchmark
Nominal
Zero-volatility
Option-adjusted
Treasury yield curve
Treasury spot rate curve
Treasury spot rate curve
Credit risk, liquidity risk and option risk
Credit risk, liquidity risk and option risk
Credit risk and liquidity risk
Spread Measure Benchmark Reflects Compensation For
Nominal
Zero-volatility
Option-adjusted
Sector yield curve
Sector spot rate curve
Sector spot rate curve
Credit risk, liquidity risk and option risk
Credit risk, liquidity risk and option risk
Credit risk and liquidity risk
Spread Measure Benchmark Reflects Compensation For
Issuer-Specific Benchmark
Nominal
Zero-volatility
Option-adjusted
Issuer yield curve
Issuer spot rate curve
Issuer spot rate curve
Liquidity risk and option risk
Liquidity risk and option risk
Liquidity risk
Spread Measure Benchmark Reflects Compensation For
Summary of Relationships between Benchmark, OAS and Relative Value
Benchmark
Treasury market
Bond sector with a
given credit rating
(assumes credit rating
higher than security
being analyzed)
Negative OAS
Overpriced (rich) security
Overpriced (rich) security
(assumes credit rating higher
than security being analyzed)
Zero OAS
Overpriced (rich)
security
Overpriced (rich)
security
(assumes credit rating
higher than security
being analyzed)
Positive OAS
Comparison must be made
between security OAS and OAS
of comparable securities
(required OAS):
If security OAS > required OAS,
security is cheap
If security OAS < required OAS,
security is rich
If security OAS = required OAS,
security is fairly priced
Comparison must be made
between security OAS and OAS
of comparable securities
(required OAS):
If security OAS > required OAS,
security is cheap
If security OAS < required OAS,
security is rich
If security OAS = required OAS,
security is fairly priced
VALUING BONDS WITH EMBEDDED OPTIONS
2013 ELAN GUIDES
VALUING BONDS WITH EMBEDDED OPTIONS
Determining Bond Value at a Node Applying Backward Induction
1-year rate at the
node at which we
are calculating the
bond's value, V
HHL
Bond's value in higher-rate
state 1-year forward
N
HHL
r
3,HHL
V
HHL
V
HHHL
+ C
r
4,HHHL
N
HHHL
N
HHLL
r
4,HHLL
V
HHLL
+ C
Cash flow in higher
rate state
Cash flow in lower
rate state
Bond's value in lower-rate
state 1-year forward
2V
0
2V
0
(Ay)
2
Convexity =
V
V
+
2V
0
(Ay)
Duration =
Conversion value = Market price of common stock Conversion ratio
Market conversion price =
Market price of convertible security
Conversion ratio
Market conversion premium per share = Market conversion price Current market price
Market conversion premium ratio =
Market conversion premium per share
Market price of common stock
Premium payback period =
Market conversion premium per share
Favorable income differential per share
Favorable income differential per share =
Coupon interest (Conversion ratio Common stock dividend per share)
Conversion ratio
Determining Call Option Value
Value of call option = Value of option-free bond Value of callable bond.
Determining Put Option Value
Value of put option = Value of putable bond Value of option-free bond
Traditional Analysis of a Convertible Security
Premium over straight value =
Market price of convertible bond
Straight value
1
2013 ELAN GUIDES
VALUING BONDS WITH EMBEDDED OPTIONS
An Option-Based Valuation Approach
Covertible security value = Straight value + Value of the call option on the stock
Covertible callable bond value = Straight value + Value of the call option on the
stock Value of the call option on the bond
Covertible callable and putable bond value = Straight value
+ Value of the call option on the stock
Value of the call option on the bond
+ Value of the put option on the bond
2013 ELAN GUIDES
VALUING BONDS WITH EMBEDDED OPTIONS
Single Monthly Mortality Rate (SMM)
SMM
t
=
Prepayment in month t
Beginning mortgage balance for month t Scheduled principal payment in month t
Prepayment in month t = SMM (Beginning mortgage balance for month t
Scheduled principal payment in month t)
Conditional Prepayment Rate (CPR)
CPR = 1 (1 SMM)
12
SMM = 1 (1 CPR)
1/12
Given the CPR, the SMM can be computed as:
Average life =
E
t = 1
T
t Projected principal recieved at time t
12 Total principal
t = Number of months
Average Life
Prepayment Risk in Different PAC Tranches
Tranche
PAC I - Senior
PAC I - Junior
PAC II
Support
Prepayment Risk
LOW
HIGH
V
+
2V
0
(A y)
Duration
VALUING MORTGAGE-BACKED AND ASSET-BACKED SECURITIES
2013 ELAN GUIDES
ASSET-BACKED SECTOR OF THE BOND MARKET
DERIVATIVES
Value of a Forward Contract
St
F(0,T)
(1 + r)
T-t
Time
St
F(0,T)
(1 + r)
T-t
ST F(0,T)
Long Position Value
Zero, as the contract is priced to
prevent arbitrage
F(0,T) ST
Short Position Value
Zero, as the contract is priced to
prevent arbitrage
At expiration
At initiation
During life of the
contract
Price of an Equity Forward with Discrete Dividends
PV(D,0,T) =
E
n
i = 1
D
i
(1 + r)
t
i
F(0,T) = [S
0
PV(D,0,T)] (1 + r)
T
FV(D,0,T) =
n
E
i = 1
D
i
(1 + r)
Tt
i
F(0,T) = S
0
(1 + r)
T
FV(D,0,T)
... Approach I
... Approach II
F(0,T) = (S
0
e
o
c
T
)e
r
c
T
F(0,T) = S
0
e
(r
c
o
c
)T
o
c
= Continuously compounded dividend yield
r
c
= Continuously compounded risk-free rate
Price of an Equity Forward with Continuous Dividends
Value of an Equity Forward
V
t
(0,T) = [S
t
PV(D,t,T)] [F(0,T) / (1 + r)
T t
]
PV(D,t,T) = PV of dividends expected to be received over the remainder of the contract
term (between t and T).
Assuming continuous compounding, the value of a forward contract on a stock index or portfolio
can be calculated as:
V
t
(0,T) = S
t
e
oc(T t)
F(0,T)e
rc(T t)
V
t
(0,T) =
S
t
e
oc(T t)
F(0,T)
e
rc(T t)
FORWARD MARKETS AND CONTRACTS
2013 ELAN GUIDES
DERIVATES
Calculating the No-Arbitrage Forward Price for a Forward Contract on a Coupon Bond
F(0,T) = [B
0
C
(T+Y) PV(CI,0,T)] (1 + r)
T
Or
F(0,T) = [B
0
C
(T+Y)] (1 + r)
T
FV(CI,0,T)
B
C
= Price of coupon bond
T = Time of forward contract expiration
Y = Remaining maturity of bond upon forward contract expiration
T+Y = Time to maturity of the bond at forward contract initiation.
PV(CI,0,T) = Present value of coupon interest expected to be received between time 0
(contract initiation) and time T (contract expiration).
FV(CI,0,T) = Future value of coupon interest expected to be received between time 0
(contract initiation) and time T (contract expiration).
Valuing a Forward Contract on a Coupon Bond
The value of the long position in a forward contract on a fixed income security prior to expiration
can be calculated as:
V
t
(0,T) = B
t
C
(T+Y) PV(CI,t,T) F(0,T) / (1 + r)
T t
PV(CI,t,T) = Present value of coupon payments that are expected to be received between time
t and time T.
B
t
C
(T+Y) = Current value of coupon bond with time T+Y remaining until maturity
FRA(0,h,m) =
360
m ( )
1
1 + L
0
(h + m)
360
h + m
( )
1 + L
0
( h )
h
360 ( )
FRA(0,h,m) = The annualized rate on an FRA initiated at Day 0, expiring on Day h, and based
on m-day LIBOR.
h = Number of days until FRA expiration
m = Number of days in underlying hypothetical loan
h+m = Number of days from FRA initiation until end of term of underlying hypothetical loan.
L
0
= (Unannualized) LIBOR rate today
Pricing a Forward Rate Agreement
2013 ELAN GUIDES
DERIVATES
Valuing FRA prior to expiration
FRA payoff =
1 + [Market LIBOR (No. of days in the loan term / 360)]
NP [(Market LIBOR FRA rate) No. of days in the loan term / 360]
FRA Payoff
g = Number of days since FRA initiation.
V
g
(0,h,m) =
1
1 + L
g
(h g)
) (
h g
360
1 + L
g
(h + m g)
360
h + m g
) (
1 + FRA(0,h,m)
360
m
) (
NP [(Current forward rate FRA rate) No. of days in the loan term / 360]
1 + {Current LIBOR [(No. of days in loan term + No. of days till contract expiration) / 360]}
Pricing a Currency Forward Contracts
(1 + R
DC
)
T
(1 + R
FC
)
T
F(0,T) = S
0
F and S are quoted in terms of DC per unit of FC
R
DC
= Domestic risk-free rate
R
FC
= Foreign risk-free rate
T = Length of the contract in years. Remember to use a 365-day basis to calculate T if
the term is given in days.
Valuing a Currency Forward Contract
The value of the long position in a currency forward contract at any time prior to maturity can
be calculated as follows:
V
t
(0,T) =
(1 + R
FC
)
(Tt)
S
t
(1 + R
DC
)
(Tt)
F (0,T)
Assuming continuous compounding, the price and value of a currency forward contract can be
calculated by applying the formulas below:
V
t
(0,T) = [S
t
/ e
r
cFC
(T t)
] [F(0,T) / e
r
cDC
(T t)
]
r
c
here represents a
continuously
compounded risk-
free rate in these
formulas.
or F(0,T) = S
0
e
(r
cDC
r
cFC
) T
F(0,T) = (S
0
e
r
cFC
T
) e
r
cDC
T
Or:
2013 ELAN GUIDES
DERIVATES
FUTURES MARKETS AND CONTRACTS
If we ignore the effects of the mark-to-market adjustment on futures contracts, we can make the
simplifying assumption that the futures price and forward price are the same.
f
0
(T) = F(0,T) = S
0
(1 + r)
T
f
0
(T) = Futures price today of a futures contract that expires at time T.
F(0,T) = Forward price of a forward contract that expires at time T.
S
0
= Spot price of underlying asset today
r = Annual risk-free rate
The Effect of Storage or Carrying Costs on the Futures Price
f
0
(T) = S
0
(1 + r)
T
+ FV(SC,0,T)
The Effect of Monetary Benefits on the Futures Price
f
0
(T) = S
0
(1 + r)
T
FV(CF,0,T)
FV(CB,0,T) = Costs of storage Nonmonetary benefits (Convenience yield)
If costs exceed benefits, FV(CB,0,T) is a positive number and is known as cost of carry. In this
case, the general futures pricing formula is given as:
f
0
(T) = S
0
(1 + r)
T
+ FV(CB,0,T)
The Effect of Non-Monetary Benefits on the Futures Price
Pricing Treasury Bond Futures
f
0
(T) = B
0
C
(T+Y) [(1 + r
0
(T)]
T
FV(CI,0,T)
B
C
= Price of coupon bond
T = Time of futures contract expiration
Y = Remaining maturity of bond upon futures contract expiration
T+Y = Time to maturity of the bond at futures contract initiation.
r
0
(T) = Interest rate at time 0 for period until time T.
FV(CI,0,T) = Future value of coupon interest expected to be received between time
0 (contract initiation) and time T (contract expiration).
The adjusted futures price of a t-bond futures contract is calculated as:
f
0
(T) =
B
0
C
(T + Y) [1 + r
0
(T)]
T
FV (CI,0,T)
CF(T)
CF(T) = Conversion factor on CTD bond
2013 ELAN GUIDES
FUTURES MARKETS AND CONTRACTS
Pricing Stock Index Futures
f
0
(T) = S
0
(1 + r)
T
FV(D,0,T)
f
0
(T) = S
0
e
(r
c
o
c
)T
Pricing Currency Futures
f
0
(T) = S
0
(1 + r
DC
)
T
(1 + r
FC
)
T
F and S are quoted in terms of DC/FC
r
DC
= Domestic currency interest rate
r
FC
= Foreign currency interest rate
T = Length of the contract in years. Remember to use a 365-day year if maturity is given in days.
If interest rates are assumed to be continuously compounded, then the no-arbitrage futures price
is calculated as:
f
0
(T) = S
0
e
(r
cDC
r
cFC
)T
r
c
represents the continuously compounded risk-free rate.
2013 ELAN GUIDES
FUTURES MARKETS AND CONTRACTS
Put-Call Parity
C
0
+ = P
0
+ S
0
X
(1 + R
F
)
T
Synthetic Securities
Value
C
0
+
X
(1 + R
F
)
T
C
0
P
0
S
0
X
(1 + R
F
)
T
X
(1 + R
F
)
T
C
0
S
0
+
P
0
+ S
0
X
(1 + R
F
)
T
P
0
+ S
0
P
0
+ S
0
C
0
C
0
+
X
(1 + R
F
)
T
P
0
Value Strategy
fiduciary call
long call
long put
long
underlying
asset
long bond
long call +
long bond
long call
long put
long
underlying
asset
long bond
Consisting of
=
=
=
=
=
Equals
Protective
put
Synthetic call
Synthetic put
Synthetic
underlying
asset
Synthetic
bond
Strategy
long put + long
underlying asset
long put + long
underlying asset
+ short bond
long call + short
underlying asset
+ long bond
long call + long
bond + short put
long put + long
underlying asset
+ short call
Consisting of
OPTION MARKETS AND CONTRACTS
2013 ELAN GUIDES
OPTION MARKETS AND CONTRACTS
One-Period Binomial Model
Computing the two possible values of the stock:
S
+
= Su
S
-
= Sd
Binomia Call Option Pricing
Call payoff = Max(0, S
+
X)
t =
(1 + r d)
(u d)
c =
t c
+
+ (1 t) c
-
1 + r
Calculating the value of the call option:
n =
c
+
c
-
S
+
S
-
Hedge Ratio
Binomial Put Option Pricing
Put payoff = Max (0, X S
T
)
Compute the risk-neutral probabilities:
p =
t p
+
+ (1 t) p
-
1 + r
Calculating the value of the put option:
Intrinsic value of caplet at expiration:
Caplet value =
Max {0, [(One-year rate Cap rate) Notional principal]}
1 + One-year rate
Floorlet value =
max {0, [(Floor rate One-year rate) Notional principal]}
1 + One-year rate
Intrinsic value of floorlet at expiration:
2013 ELAN GUIDES
OPTION MARKETS AND CONTRACTS
Put-Call Parity for Forward Contracts
Call and Bond
Buy call
Buy bond
Total
Put and Forward
Buy put
Buy forward contract
Total
Transaction
c
0
[X F(0,T)]/(1 + r)
T
c
0
+ [X F(0,T)]/(1 + r)
T
p
0
0
p
0
Current Value
Value at Expiration
S
T
X
X F(0,T)
S
T
F(0,T)
0
S
T
F(0,T)
S
T
F(0,T)
S
T
> X
0
X F(0,T)
X F(0,T)
X S
T
S
T
F(0,T)
X F(0,T)
S
T
s X
Delta =
Change in option price
Change in underlying price
Change in option price = Delta Change in underlying price
An approximate measure for option delta can be obtained from the BSM model:
- N(d
1
) from the BSM model approximately equals call option delta.
- N(d
1
) 1 approximately equals put option delta.
Therefore:
A A N(d
1
) 1] ~ p S
N(d
1
) ~ S A c A
The Black-Scholes-Merton Formula
c = S
0
N(d
1
) Xe
r
c
T
N(d
2
)
p = Xe
-r
c
T
[1 N(d
2
)] S
0
[1 N(d
1
)]
Where:
d
1
=
o T
ln(S
0
X) + [r
c
+ (o
2
2)|T
d
2
= d
1
o T
o= the annualized standard deviation of the continuously compounded return on the stock
r
c
= the continuously compounded risk-free rate of return
N(d
1
) = Cumulative normal probability of d
1
.
2013 ELAN GUIDES
OPTION MARKETS AND CONTRACTS
Delta
c
0
+ = p
0
X F(0,T)
(1 + r)
T
Forward Contract and Synthetic Forward Contract
Forward Contract
Long forward contract
Synthetic Forward Contract
Buy call
Sell put
Buy (or sell) bond
Total
Transaction
0
c
0
p
0
[X F(0,T)]/(1 + r)
T
c
0
p
0
+ [X F(0,T)]/(1 + r)
T
Current Value
Value at Expiration
S
T
F(0,T)
0
( X S
T
)
X F(0,T)
S
T
F(0,T)
S
T
s X
S
T
F(0,T)
S
T
X
0
X F(0,T)
S
T
F(0,T)
S
T
> X
Put-call-forward parity
The Black Model
The Black model is used to price European options on futures.
Where:
d
1
=
o T
ln(f
0
(T) X) + (o
2
2)|T
d
2
= d
1
o T
c = e
r
c
T
[f
0
(T)N(d
1
) XN(d
2
)]
p = e
r
c
T
(X[1 N(d
2
)] f
0
(T)[1 N(d
1
)])
f
0
(T) = the futures price
Notice that the Black model is similar to the BSM model except that e
r
c
T
f(T) is substituted for
S
0
. In fact, the price of a European option on a forward or futures would be the same as the price
of a European option on the underlying asset if the options and the forward/futures contract
expire at the same point in time.
2013 ELAN GUIDES
OPTION MARKETS AND CONTRACTS
SWAP MARKETS AND CONTRACTS
Swap fixed rate =
1 B
0
(N)
B
0
(1) + B
0
(2) + B
0
(3) + ... + B
0
(N)
) (
100
The Swap Fixed Rate
Present value of floating-rate payments Present value of fixed-rate payments
Value of pay-floating side of plain-vanilla interest rate swap:
Present value of fixed-rate payments Present value of floating-rate payments
[(1 + Return on equity) Notional principal] PV of the remaining fixed-rate payments
[(1 + Return on equity) Notional principal] PV (Next coupon payment + Par value)
[(1 + Return on Index 2) NP] [(1 + Return on Index 1) NP]
Valuing Equity Swaps
Pay a fixed rate and receive the return on equity swap
Pay a floating rate and receive the return on equity swap
The value of a pay the return on one equity instrument and receive the return on another equity
instrument swap is calculated as the difference between the values of the two (hypothetical)
equity portfolios:
Payer swaption
Notional principal (Market fixed-rate Exercise rate)
No. of days in the payment period
360
Receiver swaption
Notional principal (Exercise rate Market fixed-rate)
No. of days in the payment period
360
Valuing a Swap
Value of pay-fixed side of plain-vanilla interest rate swap:
2013 ELAN GUIDES
SWAP MARKETS AND CONTRACTS
Table: Caps, Floors, Interest Rate Options, Bond Options and Interest Rates
Security
Long cap (floor)
Long call (put) option on interest rates
Long call (put) option on a fixed income instrument
Benefits when
Interest rates rise (fall)
Interest rates rise (fall)
Interest rates fall (rise)
Payoff to the buyer of an interest rate cap
Payoff to the buyer of an interest rate floor
Payoff = Max [0,(Market interest-rate Cap rate) Notional principal]
No. of days
360
INTEREST RATE DERIVATIVE INSTRUMENTS
Notional principal]
No. of days
360
Payoff = Max [0,(Floor rate Market interest-rate)
2013 ELAN GUIDES
INTEREST RATE DERIVATIVE INSTRUMENTS
Expected return on Two-Asset Portfolio
E(R
P
) = w
1
E(R
1
) + w
2
E(R
2
)
E(R
1
) = expected return on Asset 1
E(R
2
) = expected return on Asset 2
w
1
= weight of Asset 1 in the portfolio
w
2
= weight of Asset 2 in the portfolio
Variance of 2-asset portfolio:
1 1 P 2 2
o
2
= w
2
o
2
+ w
2
o
2
+ 2w
1
w
2
1, 2
o
1
o
2
o
1
= the standard deviation of return on Asset 1
o
2
= the standard deviation of return on Asset 2
1, 2
= the correlation between the two assets returns
Variance of 2-asset portfolio:
Cov
1,2
=
1, 2
o
1
o
2
1 1 P 2 2
o
2
= w
2
o
2
+ w
2
o
2
+ 2w
1
w
2
Cov
1,2
Expected Return and Standard Deviation for a Three-Asset Portfolio
Expected return on 3-asset portfolio:
Variance of 3-asset portfolio:
1 1 P 2 2 3 3
o
2
= w
2
o
2
+ w
2
o
2
+ w
2
o
2
+ 2w
1
w
2
1, 2
o
1
o
2
+ 2w
1
w
3
1, 3
o
1
o
3
+ 2w
2
w
3
2, 3
o
2
o
3
Variance of 3-asset portfolio:
E(R
P
) = w
1
E(R
1
) + w
2
E(R
2
) + w
3
E(R
3
)
1 1 P 2 2 3 3
o
2
= w
2
o
2
+ w
2
o
2
+ w
2
o
2
+ 2w
1
w
2
Cov
1, 2
+ 2w
1
w
3
Cov
1, 3
+ 2w
2
w
3
Cov
2, 3
PORTFOLIO CONCEPTS
2013 ELAN GUIDES
PORTFOLIO CONCEPTS
o
2
P
o
2
=
1
n
+
( )
P
o
2
=
1
n
o
2
+
n 1
n
Cov
Variance of an Equally-weighted Portfolio
E(R
P
) =
E
n
j=1
w
j
E(R
j
)
The variance of the portfolio is calculated as:
P
o
2
=
E
n
j=1
E
n
i=1
w
i
w
j
Cov(R
i
,R
j
)
For a portfolio of n assets, the expected return on the portfolio is calculated as:
Standard Deviation of a Portfolio Containing a Risky Asset and the Risk-Free Asset
E(R
P
) = RFR + o
P
[E(R
i
) RFR]
o
i
o
P
= w
i
o
i
Expected Return for a Portfolio Containing a Risky Asset and the Risk-Free Asset
Expected Return and Variance of the Portfolio
2013 ELAN GUIDES
PORTFOLIO CONCEPTS
Equation of CML:
E(R
P
) = R
f
+ o
P
E(R
m
) R
f
o
m
E(R
P
) = w
1
R
f
+ (1 w
1
)E(R
m
)
Variance of portfolios that lie on CML:
o
2
= w
2
o
2
+ (1 w
1
)
2
o
2
+ 2w
1
(1 w
1
)Cov(R
f
,
R
m
)
1 f m
Expected return on portfolios that lie on CML:
CML
The Decision to Add an Investment to an Existing Portfolio
|
i
= =
Cov(R
i
,R
m
)
o
2
o
2
i,m
o
i
,o
m
=
o
i,m
o
i
m m m
Calculation and Interpretation of Beta
E(R
i
) = R
f
+ |
i
[E(R
m
) R
f
]
The Capital Asset Pricing Model
>
E(R
new
) R
F
o
new
E(R
p
) R
F
o
p
( )
Corr(R
new
,R
p
)
Market Model Estimates
R
i
= o
i
+ |
i
R
M
+ c
i
R
i
= Return on asset i
R
M
= Return on the market portfolio
o
i
= Average return on asset i unrelated to the market return
|
i
= Sensitivity of the return on asset i to the return on the market portfolio
c
i
= An error term
- |
i
is the slope in the market model. It represents the increase in the return on asset i if
the market return increases by one percentage point.
- o
i
is the intercept term. It represents the predicted return on asset i if the return on the
market equals 0.
E(R
i
) = o
i
+ |
i
E(R
M
)
Expected return on asset i
2013 ELAN GUIDES
PORTFOLIO CONCEPTS
Cov(R
i
,R
j
) = |
i
|
j
o
2
M
Covariance of the returns on asset i and asset j
Correlation of returns between assets i and j
Corr(R
i
,R
j
) =
|
i
|
j
o
2
M
j M
(|
2
o
2
+ o
2
)
1/2
c
j
M i
(|
2
o
2
+ o
2
)
1/2
c
i
R
i
= a
i
+ b
i1
F
DY
+ b
i2
F
PE
+ c
i
R
i
= the return to stock i
a
i
= intercept
F
DY
= return associated with the dividend yield factor
F
PE
= return associated with the P-E factor
b
i1
= the sensitivity of the return on stock i to the dividend yield factor.
b
i2
= the sensitivity of the return on stock i to the P-E factor.
c
i
= an error term
b
ij
=
Assets is attribute value Average attribute value
o(Attribute values)
Fundamental Factor Models
Standardized sensitivities are computed as follows:
Var(R
i
) = |
2
o
2
+ o
2
i M c
i
Variance of the return on asset i
R
i
= a
i
+ b
i
1
F
INT
+ b
i
2
F
GDP
+ c
i
Market Model Estimates: Adjusted Beta
Adjusted beta = 0.333 + 0.667 (Historical beta)
Macroeconomic Factor Models
R
i
= the return to stock i
a
i
= the expected return to stock i
F
INT
= the surprise in interest rates
F
GDP
= the surprise in GDP growth
b
i1
= the sensitivity of the return on stock i to surprises in interest rates.
b
i2
= the sensitivity of the return on stock i to surprises in GDP growth.
c
i
= an error term with a zero mean that represents the portion of the return to stock i
that is not explained by the factor model.
2013 ELAN GUIDES
PORTFOLIO CONCEPTS
Active specific risk =
E
n
i=1
i c
i
w
a
o
2
Where:
w
a
= The i
th
assets active weight in the portfolio (i.e., the difference between the assets weight
in the portfolio and its weight in the benchmark).
o
2
= The residual risk of the i
th
asset (i.e., the variance of the i
th
assets returns that is not explained
by the factors).
i
c
i
Active factor risk = Active risk squared Active specific risk.
Active return = R
p
R
B
Active return = Return from fctor tilts + Return from asset selection
Active return =
E
K
j=1
[(Portfolio sensitivity)
j
(Benchmark sensitivity)
j
] (Factor return)
j
+ Asset selection
Active Return
E(R
P
) = R
F
+
1
|
p,1
+ ... +
K
|
p,K
Arbitrage Pricing Theory and the Factor Model
E(R
p
) = Expected return on the portfolio p
R
F
= Risk-free rate
j
= Risk premium for factor j
|
p,j
= Sensitivity of the portfolio to factor j
K = Number of factors
Active Risk
TE = s(R
p
R
B
)
Active risk squared = s
2
(R
p
R
B
)
Active risk squared = Active factor risk + Active specific risk
2013 ELAN GUIDES
PORTFOLIO CONCEPTS
FMCAR
j
=
K
i=1
E
b
a
j
b
a
i
Cov(F
j
,F
i
)
Active risk squared
FMCAR
j
=
Active risk squared
Active factor risk
K
i=1
E
b
a
j
b
a
i
Cov(F
j
,F
i
) = The active factor risk for factor j
where:
b
a
= The portfolios active exposure to factor j
j
Factors Marginal Contribution to Active Risk Squared (FMCAR)
IR =
R
p
R
B
s(R
p
R
B
)
The Information Ratio
2013 ELAN GUIDES
PORTFOLIO CONCEPTS
THE THEORY OF ACTIVE PORTFOLIO MANAGEMENT
The expression for the optimal weight, w*, of the active portfolio (Portfolio A) in the optimal
risky portfolio (Portfolio P) is given as:
w
*
=
o
A
o
A
(1|
A
) + R
M
o
2
(e
A
)
o
2
M
Assuming (for simplicity) that the beta of Portfolio A equals 1, the optimal weight, w
0
, of Portfolio
A in Portfolio P is calculated as:
w
0
=
o
A
R
M
o
2
(e
A
)
o
2
M
o
A
/o
2
(e
A
)
R
M
/o
2
M
=
If the beta of Portfolio A does not equal 1, we can use the following equation to determine the
optimal weight, w*, of Portfolio A in Portfolio P.
Information Ratio
w
*
=
w
0
1 + (1|
A
)w
0
Evaluation of Performance
Sharpe Ratio
The Sharpe ratio of the optimal risky portfolio (Portfolio P) can be separated into contributions
from the market and active portfolio as follows:
S
P
=
2
S
M
2
+
o
2
(e
A
)
o
2
A
=
R
M
o
M
| |
+
o(e
A
)
o
A
| |
2 2
Weight of security k in the active portfolio (Portfolio A)
w
k
=
E
n
i=1
o
i
/
o
2
(e
i
)
o
k
/
o
2
(e
k
)
2013 ELAN GUIDES
THE THEORY OF ACTIVE PORTFOLIO MANAGEMENT
o(e
A
)
o
A
| |
2
o(e
i
)
o
i
| |
2
E
n
i=1
=
Imperfect Forecasts of Alpha Values
Actual (realized) alpha: o = R |R
M
= R
2
=
o
2
of
o
2
o
o
2
o
o
2
c
+
o
2
o
o
2
of
o
2
o
o
2
c
+
=
To measure the forecasting accuracy of the analyst, we can regress alpha forecasts (o
f
) on realized
alpha (o).
We can evaluate the quality of the analysts forecasts by calculating the coefficient of determination
of the regression described above.
2013 ELAN GUIDES
THE THEORY OF ACTIVE PORTFOLIO MANAGEMENT
o
f
a
0
+ a
1
o + c =
For simplicity, we assume that a
0
and a
1
equal 0 and 1 respectively. Given that forecast errors (c) are uncorrelated
with true alpha (o) i.e., Cov
c,o
equals 0, the variance of the forecast is given as:
This estimate of R
2
is used as a shrinking factor to adjust the analysts forecasts of alpha.
Risk Tolerance
Willingness to Take Risk
Below Average
Above Average
Below Average
Below-average risk tolerance
Resolution needed
Above Average
Resolution needed
Above-average risk tolerance
Ability to Take Risk
Return Requirements and Risk Tolerances of Various Investors
Individual
Pension Plans (Defined
Benefit)
Pension Plans (Defined
Contribution)
Depends on stage of life,
circumstances, and obligations
The return that will adequately
fund liabilities on an inflation-
adjusted basis
Depends on stage of life of
individual participants
Varies
Depends on plan and
sponsor characteristics,
plan features, funding status,
and workforce characteristics
Varies with the risk
tolerance of individual
participants
Return Requirement Type of Investor Risk Tolerance
Foundations and
Endowments
Life Insurance
Companies
Non-Life- Insurance
Companies
Banks
The return that will cover
annual spending, investment
expenses, and expected inflation
Determined by rates used to
determine policyholder reserves
Determined by the need to price
policies competitively and by
financial needs
Determined by cost of funds
Determined by amount of
assets relative to needs, but
generally above- average
or average
Below average due to factors
such as regulatory constraints
Below average due to factors
such as regulatory constraints
Varies
THE PORTFOLIO MANAGEMENT PROCESS AND THE INVESTMENT POLICY
STATEMENT
2013 ELAN GUIDES
THE PORTFOLIO MANAGEMENT PROCESS AND THE INVESTMENT POLICY STATEMENT